Posted by: bmeverett | April 24, 2010

Dear Mr. Gates…


Celebrities posturing as political commentators can be very annoying. On the other hand, they don’t do much damage, since nobody really cares when Sean Penn and Barbra Streisand, both very talented artists, offer their left-wing rants. I expect better from Bill Gates, the founder of Microsoft, and a celebrity with real credibility among the public. After all, someone who has amassed a personal fortune of over $100 billion must really know what he’s doing. I was therefore really disappointed to read the April 23 Washington Post op-ed Mr. Gates co-wrote with former Dupont Chairman Chad Holliday entitled “Energy sector poised for innovation — with the right spark.”

After reading the article, I went back through it with a highlighter to select the fallacious arguments to address in this post. I ended up highlighting the entire piece.

Mr. Gates argues that “Although the information technology and pharmaceutical industries spend 5 to 15 percent of their revenue on research and development each year, U.S. companies’ spending on energy R&D has averaged only about one-quarter of 1 percent of revenue over the past 15 years.” This argument has no meaning. The IT and pharmaceutical industries sell products that have exceptionally short lifetimes. Microsoft first sold its Windows operating system in 1985. They are now selling Windows 7 – a major new core product every 3-4 years. When Merck develops a new drug, its patent lasts only 20 years from the date the drug is invented. The extensive time required to gain FDA approval and to market the drug comes out of that 20 years. In both cases, the company will quickly go out of business if it fails to have a pipeline full of new products. If Bill Gates can’t develop Windows 8 within the next year or so, some other company will, and Mr. Gates can sit on the beach for the rest of his career.

Energy is different. Although innovation is important in finding and producing hydrocarbons, improving fuel performance and enhancing supply-chain efficiency, natural gas is still pretty much what it was 100 years ago (mostly methane or CH4). Gasoline specifications are tighter, but it’s still pretty much the same stuff it was 100 years ago. ExxonMobil’s prosperity depends primarily on finding and producing more oil and natural gas than it produces every year, not in finding new fuels to replace hydrocarbons.

ExxonMobil management also knows that there are some businesses it is good at and some it is not. In the late 1970s, Exxon and Mobil both started down the “conglomerate” road in which business diversification was considered critical for survival. Exxon invested in solar energy, computers, uranium and minerals mining, nuclear fuel rod fabrication, hotels and electrical equipment. These business were not only failures, they were embarrassing failures. Exxon’s strength was its chemical engineering: finding, producing, transporting and processing hydrocarbons. It just didn’t know how to compete in those other areas. Mobil did many of the same things, even buying the Montgomery Ward department store chain. The idea of a chemical engineer overseeing a business dependent on choosing women’s fashions is a sad and comical image.

But people are smart, and they learn. ExxonMobil management knows, for example, that General Electric can make wind turbines far more efficiently than ExxonMobil can. Microsoft makes software, not computer chips or PCs. It leaves those parts of the business to other companies (Intel, Dell, IBM, Compaq, Toshiba, et al.) that know those businesses. Mr. Gates has no moral obligation to take Microsoft into business lines it doesn’t understand. The country doesn’t expect it, and it wouldn’t help anybody.

In 2009, ExxonMobil produced 2.4 million barrels per day (MBD) of liquid hydrocarbons, slightly less than 3% of the total world market. Whatever happens with energy technologies over the next 100 years, there will still be a market for this much oil, if produced, transported and processed efficiently.

It’s also disingenuous for Mr. Gates to select share of revenue as his metric for research dollars. In 2009, Microsoft had net income of $14.6 billion on revenue of $58.4 billion. In other words, its profits were about a quarter of its revenue. On the other hand, ExxonMobil’s revenue was $300 billion with net income of $19 billion – less than 7% of revenue. If Microsoft spends 5% of its revenue on R&D, it would be devoting 20% of its earnings. The rest would be available for new investments or to distribute to shareholders. Five percent of ExxonMobil’s revenue would be $15 billion or 80% of its earnings. The company would have to borrow money to pay its dividend. That makes no sense.

The next statement in the op-ed is “And despite talk about the need for “21st-century” energy sources, federal spending on clean energy research — less than $3 billion — is also relatively small. Compare that with roughly $30 billion that the U.S. government annually spends on health research and $80 billion on defense research and development.” Two points here. First, innovation in defense technology and public health can be the difference between national life and death. Defense and contagious disease control are public goods, and cannot be produced in the private sector. Government programs in both areas are incredibly expensive and inefficient, but we can’t do without them. Energy innovation is a commercial issue, not part of the government’s skill set or its constitutional responsibilities.

Mr. Gates wants to put energy into the same category. He echoes the popular, but factually incorrect conventional wisdom on climate change: “The science is also clear that without significant efforts to tackle the climate issue, the effects of warming will grow, undermining agriculture, making droughts and floods more common and more severe, and eventually destroying ecosystems.” Nonsense. (See my many previous postings on this issue.)

Mr. Gates then offers three reasons why the private sector cannot do what must be done on energy. All three are wrong. First, he claims that there are “profound public interests in having more energy options.” US interests can be served only by having energy options which are better than the energy sources we already have. New options which perform poorly, cost more and bring questionable environmental benefits do not help. Solar, wind, biofuels, tidal power, fusion and most of the other darlings of the federal research establishment all fall into this category. It would be nice to replace $80/barrel imported oil, but not with $300/barrel high-tech substitutes. (I always find it interesting when the uber-rich argue that cost doesn’t matter. It may not matter to Mr. Gates, but it does to the rest of us.)

Mr. Gates’ second reason is “… a new electric power source can cost several billion dollars to develop and still carry the risk of failure. That investment does not compute for most companies.” It doesn’t compute for most private companies, because its chances of commercial success are small. Companies make multi-billion investments all the time, and they all carry the risk of failure. ExxonMobil alone spent $27 billion last year on capital and exploration investments, none of which was a slam dunk as a commercial success. Private capital markets use money invested voluntarily by people who believe they have a good chance at a return on their money. When the government invests, it takes the money by force from the population. Congress then tends to use the money to reward powerful interests in their districts. Return on investment? Not part of the equation.

The third reason? “… the turnover in our power system is very slow. Power plants last 50 years or more, and they are very cheap to run once built, meaning there is little market for new models.” Governments at all levels have been working diligently over the past 100 years to make sure that electric power companies make just enough money to stay in business while adding the absolute minimum required amount of new generating capacity. At the federal level, regulations such as New Source Review make new power plants much more expensive than older ones. This is a recipe for suppressing innovation. As government has imposed more and more expensive safety and fuel economy regulations on automobiles, people keep them longer. In 1967, the fleet turnover ratio (total registered vehicles divided by annual sales) was about 10 years. It’s now between 20 and 25 years. Do we really expect that people will not respond to the perverse incentives government creates?

Mr. Gates goes on to promise that “Prices are declining in solar energy and wind, and they could fall further with new technology.” That’s true, but we need to measure price, not its rate of change. Solar and wind power have improved from “outrageously expensive” to merely “excessively expensive” in just a few short decades. That’s what we’ve gotten for massive federal spending programs. These technologies are hitting physical limits, however, and there is no assurance that they will ever be commercially viable. Without the prevailing heavy government subsidies, there would be virtually no solar or wind industry in the US today.

The article then states the obvious: “There is a critical need for better electricity storage technologies to enable electric vehicles and very-large-scale renewable energy.” Sure, there’s also a critical need to bring world peace, cure cancer, eradicate poverty, prevent earthquakes and find a way for David Ortiz to start hitting again. We invest research money where we believe there’s a likelihood of success, not just where the problem is pressing. Electric cars were an early entry into the automobile market in the early 20th century. Manufacturers realized very quickly that battery technology was not good enough. We’ve been working on this problem for over 100 years. The economic prize for success would be enormous, possibly dwarfing even Mr. Gates’ record wealth. That’s why so many companies are working on battery technology. What does the government bring to the party?

Next: “New efficiency technologies can cut energy demand by half or more in dozens of applications — in cars, buildings and some industrial processes.” Again, true, but only if efficiency allows us to perform these tasks at lower cost and without losing functionality. A one-bedroom apartment in a high-rise is more energy-efficient than a four-bedroom colonial house in the suburbs. It would not be an economic enhancement to force people into smaller housing. The same is true with vehicles. They can be much more fuel-efficient, but only at either higher cost (hybrids) or loss of function (smaller, lighter cars). Is this always a good trade-off?

Next: “Vigorous federal commitments to new energy technology would bring these options to commercial viability.” You have got to be kidding. The US government has spent over $125 billion (in $2010) on energy research over the last four decades and has produced absolutely nothing of any commercial significance. The government is good at solving certain technical problems at very high cost, e.g., the Manhattan or Apollo Projects, but it has never produced commercial technologies.

Next: “We are pleased that energy innovation has never become politicized because Republicans, Democrats and independents share a common interest in scientific breakthroughs that improve people’s lives.” Personally, I’m not pleased. Congress loves energy research because it allows them to parcel money out to their districts while claiming that they are serving a critical national interest. This “slush fund” is shared happily by both Republicans and Democrats – a wonderfully bipartisan form of highway robbery. This would be a great area for some serious partisan bickering in which someone (anyone?) in Washington stands up and asks what the taxpayer is getting for all this money.

Finally: “The federal government must invest more and be smarter about the innovation process.” Really? I wonder if Microsoft would be better off today if it had taken the government as a partner in the early stages of Windows development. Mr. Gates succeeded by developing a wonderful product under the radar. If he thinks that energy research is such a great investment, I know where he could get $100 billion to start the process.

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Responses

  1. Hmmm… That’s interesting. Where did you first hear about this? Do you have other blog posts I can take a look at?

    Justin Davis
    MK Partners
    Workplace Efficiency Experts

  2. […] This post was mentioned on Twitter by Henry Cowell. Henry Cowell said: Dear Mr. Gates… « Bruce Everett's Weblog: Microsoft makes software, not computer chips or PCs. It leaves those par… http://bit.ly/dpUR5a […]

  3. […] Read full story […]

  4. While Exxon was spectacularly unsuccessful with the ‘Office of the Future’ (I’m old enough to remember being puzzled why I was using an ‘Exxon’ brand electric typewriter), BP and Shell do have significant renewable energy divisions. BP is even a leading manufacturer of solar photovoltaic equipment, although it would be a good question how it can keep up with the cost pressures in that difficult market.

    More generally, on renewable power projects, while BP and Shell have some successes, there is a tension within their businesses whether the risk/reward profile is compatible with their oil and gas businesses. A typical power project might earn a return of 10%, and with financing could achieve 13% returns assuming long term contracts lock in the power price. On the other hand, E&P targets returns over 20%. The majors don’t like to use debt even though they could: while this increases the level of return it decreases the cash flow unless they could target more projects.

    So the oil companies have a problem allocating resources to projects with lower target returns (10-14%) in renewables compared to E&P. The power business overall tends to be lower return (and only lower risk if prices are hedged, eg. the bankruptcies of Mirant, Calpine etc.) That isn’t to say there isn’t a place for investing in power, particularly renewable power, but it isn’t clear high risk/ return companies like the oil sector are the right vehicles for supporting these businesses.

  5. not many places were you can find this much content and valuable information, thank you for this post
    Perry


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