Making Energy Markets Work

Advancing technology, rising energy prices, and the growing move to place a price on carbon emissions in many parts of the world have created an extraordinarily favorable market for new energy technologies. Reaching a true economic tipping point will depend on more than these simple variables, however. Energy markets virtually everywhere are regulated, complex, often inefficient, and rarely predictable. What happens to the energy economy, and to the world's climate, in the years ahead will be heavily influenced by hundreds of policy decisions made at interna

Building a Low-Carbon Economy tional, national, and local levels—and whether these new policies can be sustained.

Many energy economists argue that the reason fossil fuels dominate today is their inherently lower cost compared with the alternatives. This suggests that putting a price on carbon—likely through a carbon dioxide tax or a regulatory cap on emissions such as the one in Europe—would solve the climate problem. Getting the price signals right is an essential step, but its limits are demonstrated by the modest impact that the $50 increase in the cost of a barrel of oil has had on petroleum consumption in the past five years. That is equivalent to a carbon dioxide price of $120 per ton; the current price of a carbon credit in Europe is $32 per ton, while one of the leading climate bills before the U.S. Congress would cap the price of carbon at $12—equivalent to $5 per barrel of oil.34

The neoclassical economic view assumes an economically frictionless world in which buyers and sellers have all the information and capital they need, and there are no serious barriers to the introduction of new technologies. At the extreme, neoclassical economists sound like economic fundamentalists, envisioning an idealized, mechanistic economy that is never found in the real world. Economic research beginning in the 1920s has shown that the costs of transactions can greatly limit the effectiveness of markets, while other research suggests that people's behavior often fails to follow neoclassical rules. Nobel laureate economist Douglass North has shown that laws, customs, and social priorities greatly influence the working of the economy. Without them, most markets would work inefficiently if at all.35

Because energy markets have been shaped more than most others by government policy, institutional constraints, and the power of large industrial enterprises, simple economic theory provides minimal insight about how to spur change. The electric power industry is particularly far from the neoclassical model, governed as it is by extensive government regulation that is intended to facilitate development of large, reliable electric systems, with one company dominating most local grids and in some cases owning the transmission lines and power plants as well.

Although this economic model has been broadly successful in delivering affordable electricity to billions of people, it has done so mainly by making it easy to add energy supply—but providing much less incentive or opportunity to improve energy efficiency. Regulations have also favored large fuel-intensive generators at the expense of smaller, capital-intensive units. The result is an electricity system that is far from the economic ideal— and that will require major reforms if it is to maximize economic efficiency, let alone account for the massive environmental externalities represented by global climate change.

The profits of most electric utilities are determined by regulators based on the amount of power sold. This naturally makes them proponents of growth—the more electricity consumers buy, the more profitable the utility is. And as long as the regulator approves, there is no risk in building a power plant since there are no competitors, and costs are borne by the consumer. The utility also bears little risk if the plant burns a fuel whose price is volatile—fuel adjustment clauses allow price increases also to be passed to the customer.

Although consumers should in theory be interested in making investments in energy efficiency whenever it is economical, they face many obstacles, including a lack of capital to invest in conservation and a lack of information about which investments make sense. Perceiving the lack of demand, potential manufacturers and installers of energy-efficient equipment have little incentive to scale

Building a Low-Carbon Economy up production or build businesses that would facilitate efficiency improvements.

One of the easiest ways to overcome these kinds of market barriers is government mandates. Since the 1970s, many governments have required that home appliances, motor vehicles, and buildings meet minimum efficiency standards in order to be sold, and these standards have been gradually ratcheted up over time. Additional tightening is now in order, and many governments are moving quickly in that direction. Average auto efficiency standards, for example, will soon move to 47 miles per gallon in Japan and 49 miles per gallon in Europe, and the U.S. Congress is considering tightening the U.S. standard, which has been stuck at 27.5 miles per gallon for over two decades. Another approach to requiring efficiency can be seen in the law recently passed in Australia to phase out the use of most incandescent light bulbs, which would be replaced by compact fluorescent bulbs that are four times as efficient.36

Government mandates are also being used to compel the construction of more energy-efficient buildings and to require the introduction of renewable energy into electricity grids as well as the markets for liquid fuels. Several national governments and 24 states in the United States now have binding "renewable portfolio standards" requiring that specified amounts of renewable electricity be added to their grids. In Spain, a recent update of building codes requires all new buildings to incorporate solar water heaters. As of April 2008, the state government of Baden-Wurttemberg, Germany, will require that 20 percent of new buildings' heating requirements be met with renewable energy. Brazil, the United States, and the European Union are among the jurisdictions that require that a minimum proportion of biofuels be blended with gasoline and diesel fuel, spurring growth in their use.37

Such mandates can patch over some of the holes in a market economy, but they are at best blunt instruments that do not harness the full power of the market to effect change. While they are a useful backstop to ensure that minimal rates of change occur and to remove the very worst technologies from the market, it is also essential that markets reward innovation and investment that strives to achieve the best possible performance. One important step in this direction is to de-couple electric utilities' profits from the amount of power they sell by introducing a regulatory formula that instead rewards utilities for providing the best service at the least cost. California regulators have already made this change; as a result of this and other policies, Californians use less than half as much electricity per person as other Americans do. (See Figure 6-4.)38

John Hoffman, an energy efficiency expert and former U.S. Environmental Protection Agency official, has proposed an additional strategy for spurring efficiency investments—a "transaction bridge" that allows manufacturers and installers to share in the savings derived from installing more-efficient equipment in buildings. This would motivate them to continually develop better technologies, to work with utilities to accelerate the development of new markets, and to scale up both production and installation in order to lower cost. This mechanism could also be used to spur introduction of micro-power technologies such as photo-voltaics, as well as ground source heat pumps. And Hoffman has proposed a similar system for motivating the production and sales of efficient vehicles.39

European governments have developed another economic tool to spur investment in renewable energy. Beginning in the early 1980s, Denmark decided to reduce its dependence on oil-fired generation by encouraging its agricultural industry to enter the power

Building a Low-Carbon Economy

Figure 6-4. Electricity Use Per Capita, California and Rest of United States, 1960-2006

Figure 6-4. Electricity Use Per Capita, California and Rest of United States, 1960-2006

business by selling wind- and biomass-based electricity to the utilities at prices set by government. This stopped the utilities from thwarting potential competitors, and over two decades it reduced Denmark's dependence on fossil fuels and made it a leading generator of renewable power.40

Germany and Spain adopted similar market access laws in the 1990s, and they too moved quickly into the leading ranks of renewable energy development. Over time, the prices governments set have been adjusted downward as the cost of renewable technologies has fallen. As a result of this law, Germany now holds the pole position in solar PV and wind-generating capacity— despite the fact that it has modest resources of sun and wind.41

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