What sometimes seem like complex abstractions lead to some clear and
important real world conundrums.
There is a well-known principle in economics, the theory of the second
best, which calls into question the neo-liberal paradigm of reliance on free
markets alone to produce the best or even reasonably satisfactory outcomes
without external intervention. The impeccable logic of the theory tells us that
in a complex system (such as any modern economy), a serious market failure in
one part, such as failure to tax greenhouse gas emissions or to develop cost
reflective retail tariffs, can change the rules of the game in a disturbing
way. Policies normally assumed to be fundamental necessities of a market
economy, such as competition policy, can then actually make things worse. The
subject is most often discussed in relation to international trade, but the
energy sector also provides many examples. We need to recognise them and
address the underlying issues.
The perfectly competitive idealisation of the
market economy, the neo-liberal paradigm, leads in equilibrium to an efficient
allocation of resources and a socially optimum outcome. This philosophy is
based on elegant mathematical and logical proofs of the wisdom of the invisible
hand, but the proofs depend in turn on important assumptions about the nature
of the real world which the theory is intended to describe. Recognition of the
questionable nature of many of these assumptions leads in turn to many of the
complexities of policy making often discussed in this blog. This piece is
intended only as a simple and brief “umbrella” exposition of some general ideas
about the nature and implications of market failure.[1]
A recognised glitch in the philosophy of the neo-liberal paradigm is
known as “the theory of the second best.” It qualifies the presumption for
unfettered markets with the caveat that as soon as you’re dealing with an
imperfect world, then there is no guarantee that taking away any single
distortion will make things better, rather than worse. In terms of pure logic
these arguments are unassailable, and have rarely been challenged to any
effect. In consequence they are often used to justify government interventions
to correct or mitigate the effects of market failures. Such interventions
may well be imperfect, but, provided the initial diagnosis of market failure is
correct, it is hard to claim they are unnecessary. Market failures can result
from inadequate competition, externalities such as pollution, taxes, trade
barriers, financial barriers and distortions, poor policy, and many other
causes.
The energy sector currently provides some particularly striking illustrations,
most evidently in approaches to dealing with the damaging consequences (social
and environmental costs) of greenhouse gas emissions (GHG). It is particularly
easy to show, inter alia, that in the absence of rational pricing
policies, especially in relation to greenhouse gas emissions, many of the
conventional nostrums of energy policy, such as the importance of enforcing
competition policy, can lead to more damaging outcomes when the bigger issue,
adequate levels of carbon pricing, remains unaddressed.
There are many major market failures that impact
the energy sector, but the simplest to describe and most prominent starting
point is the “greatest market failure in human history”[2]. This is the fact that social and
environmental costs of CO2 emissions (an “externality” for economists) are
either not priced at all into production and consumption choices, or, as with the EU’s emissions trading scheme (ETS), are only priced at a fraction
of the true cost. [The current European carbon price is
around €22 per tonne, and has been below €10 for most of
the last decade. I have in other contexts quoted, purely as indicators, a UK
Committee on Climate Change number of around €75, and of anywhere from €200 to
€600 per tonne for carbon sequestration (“carbon trees”). Others, focusing on
the potentially catastrophic consequences of out of control climate change,
will suggest even higher numbers.] The real point is
the massive scale of consequential economic distortion, reflecting both the
size of the anomaly and the central and essential role of the energy sector.
At least for the energy sector, we certainly inhabit a world of the
second best. Even apparently simple economic nostrums become highly suspect.
Policies and measures that were assumed automatically to promote the greater
good suddenly become questionable.
Competition policy can become dysfunctional. Ensuring more effective competition is supposed to benefit us all. If
so, what should we make of anti-cartel measures[3] to
prevent European power generators from reaching an agreement to limit US coal
imports? The effect of this is to substitute coal for gas, and substantially
increase carbon emissions. The social and environmental cost of this will be an
order of magnitude higher than the relatively small benefit to European
consumers. (See also this link[4] on this
site.)
Serious distortion means improvements in productive efficiency can make
things worse? More efficient production leads, in a
competitive environment, to lower prices for consumers and encourages higher
consumption. Usually this is a good thing, but if the consequences include
higher emissions this may not be the case. Again, the “true” cost of additional
environmental and social damage will outweigh the apparent benefit to
consumers.
The Green Paradox. The absence of adequate carbon pricing
now, combined with the uncertainties around future carbon taxes or
restrictions, creates a positive incentive to accelerate fossil resource
depletion and greatly increased emissions. (See recent comment[5] on this
site.)
Distortions to environmental policy. Even when there are
policy interventions to compensate for the absence of an adequate carbon tax,
these will be distorted by failure to reflect the high cost of emissions, and
particularly current against future emissions, ie the time profile.(See a
longer article on, and one referenced[6] from, this
site.)
Interaction with deficiencies in retail tariffs. Further issues are introduced when gas and electricity retail tariffs
are not cost reflective in recovering the network costs of supplying consumers,
but recovering too much fixed cost through a unit rate partially offsets the
failure to price carbon correctly. Some of these issues are discussed in a recent paper[7] for
Energy Systems Catapult, but their resolution will get more attention, and we
will return to this subject.
And what should we conclude from all this? The main
observation perhaps is that the world is a complex place, does not conform to
theoretical conditions, and has problems not amenable to simplistic economic
theories or ideologies. The intricate reasoning and analysis around market
imperfections are in one sense what policy, and energy policy in particular, is
all about. This is a general theme to which we shall return time and again.
[1] An excellent summary
of the divide, on this issue, between economists is provided by this link to a
Rodrik blog: https://rodrik.typepad.com/dani_rodriks_weblog/2007/08/why-do-economis.html
Many articles and blogs by economists like Stiglitz and Krugman will
also deal with examples of market failure in areas as diverse as trade policy
and health care.
[2] Nicholas Stern
[3] These issues are
very well described in this link, to a 2013 case involving Dutch competition
authorities: Sustainable Competition law; Competition Law Kills Coal
Closure ...
[5] . NORWAY’S DISINVESTMENT IN OIL, THE GREEN PARADOX, AND A
WEAKNESS OF POLICY TOWARDS GLOBAL CLIMATE RISKS.
[6]Fuller discussion on
this topic can be found in the author’s earlier paper. Cumulative
Carbon Emissions And Climate Change: Has The Economics Of Climate Policies Lost
Contact With The Physics?, John Rhys, OIES Working Paper EV 57, July 2011.
[7] See the full report here: Cost Reflective Pricing in Energy Networks: The nature of
future tariffs, and implications for households and their technology choices
No comments:
Post a Comment