In this post, my plan is to lay out an analogy for understanding rate of return on investment and risk, using batteries and power plants as an analogy. The goal is to answer the following questions:
What is the definition of a power plant?
What does it mean for a power plant to have a positive rate of return on work invested?
How do we quantify risk?
What are the units of measure for risk?
Rate of return on investment of a power plant and the battery analogy
Let's begin to answer these questions by imagining that we start out with a battery that is not fully charged, but not completely drained either. Let's say that the maximum storage energy is 1 MWh and we currently have only 200 kWh of energy stored in the battery. This means that we have 200 kWh of useful work that we can spend. (Let's imagine also that there are no rules against fully draining the battery.)
So, what should we do with that 200 kWh of useful work? Should we spend it on building houses, cars, or TV's? If we spend it all on these items (as well as a whole list of items I can think of), then we will have spent all of the 200 kWh and we would have completely drained the battery. We will have no "useful work" left in the battery.
Instead, we could spend half of the 200 kWh of stored electricity by giving 100 kWh of electricity to companies that drill natural gas wells and that build natural gas combined cycle power plants. We can either give the electricity to the company in a form of a bond (in which the company agrees to give us a certain return on investment after X years) or in the form of stock (in which we become co-owners of the plant and get paid in dividends if/when there are profits.) In the case of bonds, after X years, the company may agree to pay us 200 kWh of electricity. In the case of stocks, as long as we chose a good company, the company will pay us (in electricity in this analogy) and the company will likely pay us more than 200 kWh of electricity in dividends after X years. So, if we spend our electricity on building natural gas wells and natural gas power plants, then after X years (where X is likely between 4 and 12 years in this analogy), we will have increased the amount of stored electricity in our battery. If we invested 100 of the 200 kWh, then after X years we will likely have more than 300 kWh of electricity. We could spent 50 kWh of electricity on goods, such as clothing, food, entertainment, etc..., and we would still have more than 250 kWh of electricity in the battery. [Note that there is no return on useful work when you invest in clothing, housing, and entertainment. We clearly need clothing, housing and entertainment, but these activities do not grow our economy, i.e. our capability to do useful work. These activities are necessary because humans run power plants and humans need clothing, housing, and entertainment.]
When we invest money in power plant companies, the company is basically agreeing to give us some of the electricity produced at the power plant in exchange for our investment into the initial capital cost of building the power plant. This cycle of investment of electricity and production of electricity can continue as long as there are exergy sources that yield positive rates of return on work invested (which will be the case for at least the next billion or trillion years.) This is the cycle of growth. You invest useful work into projects that increase the total amount of useful work. We started with 200 kWh and now we have more than 300 kWh of useful work, from which we can spend between 0 and 100 kWh of electricity during that time period on 'goods' and still have more electricity than when we began.
Definition#1: The technical definition of a power plant is a project that has a positive rate of return on useful work invested