What’s the deal with energy price inflation? And is it a big deal?

Given current concerns about rising prices, both at home and abroad, I thought I’d review how inflation plays into investment decisions.

If you’re reading up on solar, or other forms of alternative energy, you’ve probably come across the following rationale: One of the best reasons to install PV panels—or purchase energy-saving technologies for your home, or put up a wind turbine—is that such investments will reduce your exposure to inflation in the price of retail electricity. This not only limits future uncertainty. It also is likely to save you a heck of a lot of money. Intuitively, this makes sense. By reducing your monthly electric bill, say, by half, a set of PV panels will lessen the impact of future price hikes. To explore this general conclusion, I’ll offer a couple of points.

(1) Nationwide, the annualized inflation rate for retail electricity is about 5 percent. Let’s assume that Sam, our representative resident of California, uses 10,000 kilowatt-hours (kwh) per year for a household of four (see the U.S. Energy Information Agency website for data on U.S. electricity use). On average, Sam pays 16 cents per kwh (for more info on electricity rates, see this previous blog post on tiered pricing). This year, Sam will spend $1600 on electricity. Assuming 5 percent annualized inflation, by 2020 this figure will be $2,800; by 2030, it will be $4,680.

Now, it’s important to remember that inflation will affect all prices. In nominal terms, Sam will be making a LOT more money. So the prospect of a $4600 energy bill shouldn’t automatically be cause for alarm.

But what if inflation in energy prices turns out to outpace inflation in the broader economy? This is currently the case, as core inflation (which doesn’t include food or energy) is lower than the increases in price for oil and natural gas. What if, for example, Sam’s salary increases only 4 percent year over year, while electricity prices increase at a rate of 6 percent (an increase already seen in parts of California). In this case, Sam would naturally feel the pinch more and more with each passing year.

(2) Now let’s assume that Sam installs a PV array that yields 5,300 kilowatt-hours per year (which is an entirely feasible amount of output). As a result, Sam’s monthly electricity bill is reduced by more than half. This year, Sam will spend not $1600, but $752 on electricity. And instead of dropping $2,800 in 2020 and $4,680 in 2030, Sam will now be on track to spend $1,277 and $2,199, respectively. This is a considerable amount of money to save. Of course, these future savings must be discounted. And upfront costs must be financed and maintenance costs must be accounted for. Only then can Sam determine the present value of installing a PV system (an issue I’ll be taking up in the near future). But suffice it to say here that reduced exposure to energy inflation is one of the main selling points of solar power and other types of renewables.

(3) The focus so far has not been on specific inflation numbers. This is mainly because it’s impossible to reliably predict where wage prices and energy prices will go in the future. Nevertheless, what can be said? It is safe to say that the current environment of 5 percent inflation is unlikley to persist for more than a year, maybe two. Put simply, the powers that be (e.g., the Federal Reserve) will ensure that prices don’t spiral out of control for too long, even if it means sacrificing economic growth in the near term.

But there are a number of longer-term trends that suggest energy price inflation is likely to persist in the coming decades. Asia’s growing demand for oil and gas is unlikely to relent. As a result, electricity produced from oil or natural gas turbines will continue to face upward price pressure. Moreover, any future U.S. climate policy would likely increase the costs of some utilities, particularly those that produce electricity from coal. These costs may be passed on to you, the consumer. New nuclear plants could lower prices. As could improvements in energy efficiency (by reducing the amount of energy consumed per capita, such improvements could, in theory, reduce overall demand and thus help drive energy prices down). But there’s no guarantee that the overall effect will lead to appreciably lower electricity rates.

It is these kinds of uncertainties that commonly play to the favor of renewable sources, like solar PV. Solar panels derive value by enabling you to avoid or offset monthly utility charges. The larger those charges, the more you stand to gain from installing PV. Ultimately, if you believe that electricity price inflation will continue, you’d be wise to look seriously into alternative electricity sources. This is particularly true if you believe electricity price inflation will outpace inflation in the broader economy. If, on the other hand, you don’t think electricity prices will continue their historic upward trend, you could sensibly choose against installing a renewable-energy system.

Is energy price inflation a big deal? We at Getsolar think, yes, it is. And ultimately it’s one of the factors that will lead to broader adoption of renewable-energy technologies. We encourage you to review what’s out there and come to your own conclusions, of course. And please share your opinions and findings.