Beware putting too much faith in the market. What it needs is a proper policy framework - and that's exactly what we haven't got
When Labour came to power in 1997, the privatisation and competition paradigm was mostly taken for granted. Markets would keep the lights on, bringing forward timely investment, and independent regulators would make sure that monopoly was not exploited. From time to time, a light hand might be required on the tiller, but energy policy was defined largely in terms of the absence of intervention.
For a while - for as long as excess supply and low fossil fuel prices persisted, and the knock-on effect of coal closures reduced carbon dioxide emissions - this benign neglect worked. Indeed, after full liberalisation in 1998, prices fell sharply, reaping a political dividend.
But this proved an illusion. By the time the energy white paper was published in 2003, complacency had given way to unease; by 2005, there was real concern that the lights might actually go out. The problem was not just that politicians had pinned themselves to CO2 emissions targets they patently could not achieve, but that supply and demand had got a lot closer. The consequences of sweating the assets and low investment in the years of surplus capacity led to daily ministerial worry about whether we would get through the coming winter.
These consequences emerged gradually. First, there were the power cuts in 2003. The "wrong fuse" caused widespread power cuts in London, and Birmingham, too, suffered power failures. These experiences were international: a "tree fell on the lines" in Switzerland and took out power in northern Italy, while a single power plant helped to black out the north-east US. In the oil sector, a limited explosion in a single refinery moved the world price, long before Katrina reaped its havoc.
So why had investment not kept pace with demand? Why did the private market apparently fail to deliver? The answers reveal much about what is wrong with current energy policy. Although the private market is supposed to deliver, in practice the regulators determine much of the investment, particularly in the core networks. If, for example, the gas transmission system is not robust enough to deal with a cold winter and the new demands of gas fired electricity power stations, it is in part because regulators did not allow for enough investment when they set the prices. Once upon a time, nationalised industries planned infrastructures; now regulators are in a dominant position.
Regulators are quick to point out that the obligations actually lie with the companies, and government departments are quick to point to independent regulation. The answer to the question "who is in charge?" is ambiguous: if it all goes wrong, then the government and regulators can shift the blame, but in reality the process of fixing investment, and determining the risks to be taken with security of supply, is opaque.
If it were merely a matter of determining responsibilities, then legislation sorting out the institutions and their tasks would suffice. The government should determine the policy framework - such as the targets for climate change and security of supply - and delegate the delivery on those targets to an energy agency. The delivery mechanisms could be market-based (emissions trading and carbon taxes for climate change; and a capacity market for security of supply). Companies could then operate efficiently given the appropriate incentives.
But there are more fundamental investment problems. The electricity market is set up to reflect short-term costs. It does not provide adequately for longer-term contracts, and hence lacks incentives for investment in larger base-load power stations (designed to provide a continuous and steady supply). By 2020, most of the nuclear capacity - and much of the coal, too - will have closed down. Not much is being put in its place, precisely because the market does not provide the incentives. Instead, we have excessive volatility of prices. That worked well in the excess supply years. It does not now. Oil markets have similarly failed to provide adequate incentives for investment in refineries.
For many years, it has been fashionable to believe that if only politicians and regulators kept their hands off, the market would solve the problems. Supply always equals demand - it is just that the price has to go high enough. But this excessive market optimism is not only undermined by the evidence; it undermines the market itself. Competitive markets work best in the context of proper policy frameworks. Governments will always intervene in energy markets - the costs of market failures for the environment, security of supply, monopoly and the rest of the economy are just too great. It is not government or markets; it is government setting an appropriate energy policy framework within which companies operate.
The design of this framework, and the interface between government, regulators and industry, depends upon the historical context. We no longer live in the luxury of cheap oil and gas, cheap electricity and lots of spare capacity which we enjoyed in the 1980s and 1990s. We live in a carbon-intensive world of old assets - and with high oil prices, too. The task now is to invest relatively quickly in the creation of a new, low-carbon set of energy assets. It is wrong to think that private markets will do this alone - even the oil companies have talked of needing assistance if more refineries are to be built. It is also wrong to think that government can do it alone.
As the government comes to review its energy policy, and recognises that what is currently in place is not working, it will need to do more than tinker with the inheritance from the surplus years. As carbon dioxide emissions carry on rising rather than falling, as security of supply margins get tighter, as fuel poverty goes up, and as competitiveness goes down, it is time for a rethink. Energy policy is too often good at dealing with yesterday's problems. Now we need a new and clear institutional structure, fresh thought on the design of markets, and regulation for investment, not asset sweating. It's a new paradigm.
Dieter Helm is a fellow in economics at New College, Oxford. He is author of a major study of British energy policy since 1979, Energy, the State and the Market (revised 2004), and editor of Climate-Change Policy (2005), both published by Oxford University Press
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