Ideas
Energy policy: politics v economics
Published 15 May 2006
Politicians should focus on creating long-term markets in carbon reduction and in security, not on picking technological winners
Energy policy tends to bring out the worst in politicians of all parties. Not only do they want to pursue multiple and often incompatible goals, but they have an inherent tendency to support pet technologies. Thus when the last energy review began in 2001, the Prime Minister declared that the aim was "cheap energy" which was also "sustainable and secure" - and indeed, that energy review went on to make the extraordinary claim that a 60 per cent cut in carbon dioxide (CO2) by 2050 could be achieved at little cost to the economy. The two "winners" then were renewables (largely wind) and energy efficiency. Some five years later, the "winners" now appear to the Department of Trade and Industry to be clean coal and microgeneration (and for the PM, perhaps nuclear power, too).
Politics is all about designing outcomes that, in the short term, satisfy as many interest groups as possible without creating too many losers. A good political energy policy is one that gets the largest number to cheer at the end. And the last white paper in 2003 did just that.
A political approach to energy works reasonably well when the background conditions are benign. In the 1980s and 1990s, there was general excess supply - in power stations, networks and commodity markets. Prices could fall without endangering supplies and, as prices fell, competitiveness improved and fuel poverty declined. Further, the contraction of the coal industry meant that, from 1990-97 (but not thereafter), CO2 emissions fell. Echoing Voltaire's Candide, all was for the best in the best of all possible worlds - and politicians were keen to take the credit.
After 2000, virtually all of these background conditions went into reverse. Oil prices rose continuously from $10 to $70 a barrel. Gas prices rose, too. Ageing power stations need to be replaced. The networks need modernising. And CO2 emissions are now rising.
What is needed now is a huge investment programme in low-carbon generation and networks, against a background of rising prices (and fuel poverty). Not all the interest groups can be placated, and the economic fundamentals have punctured the complacency behind the 2003 white paper. A political success has turned economically nasty.
The natural instinct of politicians is to "pick winners" all over again - and lots of corporate and NGO lobbying is encouraging them to do so. But they should resist if they want to avoid more trouble ahead on both security of supply and climate change.
Energy policy should primarily focus on the objectives. It is for politicians to decide what CO2 targets should be set and what level of security of supply is needed. These are both public goods - not the outcome of competitive markets.
But that is largely all they should do. Delivery of the targets is best left in large measure (but not entirely) to the market and market-based instruments. Achieving a reduction in CO2 by the cheapest means requires a price of carbon to be set, either directly through a carbon tax or indirectly via a permits system. That price then incentivises investment and R&D. A carbon price encourages both the demand and supply sides of the market to respond, and it avoids politicians choosing technologies.
Similarly, for security of supply, the excess supply that provides security needs an incentive, and the answer in generation is a capacity market. Otherwise there will be insufficient investment, since no rational profit-seeking business would deliberately create excess supply.
These instruments would need to be set and adjusted - but this is a matter for delivery, not policy-setting. There is a good case for doing this through an independent energy agency, charged with delivering the objectives and reporting publicly on progress. Because it would be independent, the agency would have credibility; it would be less vulnerable to lobbying by vested (technological) interests; and it would be able to develop expertise and a more long-term focus.
The long-term perspective is particularly important for energy. Investments made in networks and new power stations now will probably still be part of the system in 2050. Thus, not only must the value of carbon and security be reflected in markets now, it also needs to be predictable so that investors can finance projects.
Right now the price of carbon in the EU Emissions Trading Scheme (ETS) runs through to 2008 and permits have yet to be allocated for 2008-12. Beyond 2012, there is no post-Kyoto agreement and no ETS in place. And there is no capacity market at all.
The government could auction long-term carbon contracts now for at least some of the carbon reductions that will be needed beyond 2012, and in due course sell these contracts into the ETS once there is agreement about the post-2012 period (which will probably not be before 2011). Creating a capacity market is not rocket science. It can be grafted on to the existing system. Indeed, historically, there have typically been separate capacity and energy markets in the electricity industry internationally.
Why, then, won't ministers take the least-cost route? Why are they still bent on picking winners? There are two possible answers: either the crisis is simply not yet serious enough to force effective action; or they remain captured by vested interests. In the former case, it is not just that the lights have not yet gone out or the prices spiked high enough; it is also because politicians are reluctant to bite the bullet on climate change. In practice, the government is allowing emissions to rise, rather than taking the radical action its own targets imply. In the latter case, the capture reflects a deep hostility to markets by lobbyists. Having to bid into a long-term carbon market reveals actual - rather than claimed - costs. Nuclear, wind, clean coal, microgen and all the other technologies would have to put their money where the lobbyist's chequebook is now being deployed. Markets may create efficient solutions but they create losers, too. Politicians don't like that.
So it would be a brave minister who - short of a serious crisis - actually did the right thing: set the objectives, delegated their delivery to an independent energy agency, and used carbon auctions, carbon markets and capacity markets as the main instruments. None of the previous six energy ministers has done so, and the history of energy policy suggests that the current incumbent will not either - unless, of course, the scale of the security of supply and (especially) climate change crisis becomes too big to duck.
Dieter Helm is a fellow in economics at New College, Oxford
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