Tuesday, April 7, 2009


This posting addresses some fundamental questions about the respective roles of regulatory and other policy measures, as against using prices as "market" signals to influence consumer behaviour towards reducing emissions

Earlier papers have touched on market failure in the power sector, and argued against undue reliance on market mechanisms in inducing major low carbon investment, and especially in decarbonising electricity generation. These arguments pointed to the need for policy interventions, such as direct contracting through a central purchaser or a floor price for CO2, to ensure some of the major investments that are a necessary condition for meeting ambitious low carbon targets. The focus however has been on large scale investments. This paper discusses some of the equally complex issues of balance between market-based approaches and regulatory or interventionist approaches in getting reductions in CO2 emissions through changes in the requirements or behaviours of millions of individual consumers. The case for a market approach, in the sense of relying on price signals to achieve emission reductions, is much stronger for the heating of buildings at the micro or consumer end than it is as a means of influencing large scale technology investments. Paradoxically this is the arena where governments are least willing to contemplate effective action through prices that reflect the social costs and long term damage associated with energy consumption.

The essential distinctions, in terms of policy, can be drawn between three types of instrument:

· Using higher energy prices as an instrument of policy, whether this is done explicitly via market mechanisms or through taxes justified in terms of the external costs of CO2.
· Regulation through the adoption of standards, mandatory requirements and penal sanctions for non-compliance, specifically targeted at the way energy is used.
· Indirect approaches, where lower energy consumption and emissions are important but incidental consequences of a different choice of policies that prima facie have a wider remit, such as general economic and fiscal policy, or housing and planning policies.

Market type approaches. The price mechanism as an instrument of policy.

The most obvious manifestation of a market approach is simply to find ways to allow and encourage the reflection into the prices consumers pay for fuel the very large costs of the damage associated with CO2 emissions. Policy intervention then needs to consist essentially of doing no more than setting some ground rules, based either on tradable emissions rights designed to achieve a given CO2 reduction or on a carbon tax that sufficiently reflects the cost of emissions and is calibrated to result in the same reduction. A particular form of market based policy is personal tradable quotas, which offset some of the redistributive concerns with a market approach but with high transactions costs of administrative complexity and enforcement. In each of these cases however the instrument for CO2 reduction is the price of using a fossil-based fuel and its associated emission, and it operates directly on the consumer who has to pay that price.

Market solutions have the advantage of providing a policy solution that is theoretically optimal in terms of economic efficiency, but this is only true if the full costs can be applied and translated into prices. The reality is that even in the major wholesale markets represented by the European emissions trading scheme (the EU ETS), CO2 prices fall a long way short both of the actual social costs and of the price levels that will drive down emissions and ensure low carbon futures. Moreover there are frequently institutional or other factors, such as the absence of international agreements or of adequate metering, that further inhibit a national market based approach or distort the translation of price signals developed in wholesale markets into prices to final consumers.

One can add to these factors the political difficulty, consumer resistance and possible economic dislocations of introducing dramatic changes in price relativities through major shifts in energy prices. It becomes clear that the immediate prospects for pure market solutions, based solely on the use of prices as an instrument to force reduced emissions, may be limited and insufficient on their own to achieve the reductions required.

However the fact that complete solution of the problem by market mechanisms currently seems remote does not eliminate the benefits of using prices or taxes as one of the major instruments of policy. The price mechanism has several well-known and powerful advantages, including the following:

· A strong price signal discourages actual waste and will eliminate or substantially reduce the continued use of energy for those purposes which are wasteful (the infamous patio heater) or least highly valued; these purposes will differ between households but might include, for example, the extra degree of convenience implied by heating an empty house or room, or the extra energy required for a one degree rise in internal temperature.

· It induces changes in behaviour that are essentially voluntary responses and are free of additional costs to the individual beyond the voluntary foregoing of the benefits of the extra energy that would have been used. Some of these, such as reducing internal temperatures, can be fast acting.

· It encourages market and individual innovation; individuals will find more innovative approaches to restoring their feelings of household personal comfort than can be hypothesised by regulators or planners, who tend to assume patterns of behaviour, and take heating levels or comfort standards as a given.

· It encourages lower energy lifestyle choices; it is hard to argue that the rapid growth in fuel intensive “weekending” flights from the UK would have developed on the back of aviation fuel taxed on the same basis as road transport.

· It will for most people have an impact on personal investment choices, eg on a new car[1], or a new domestic cooker, that have significant fuel consumption consequences; and it will promote the lower carbon alternatives.

· It respects and does not pre-empt the choices of individual consumers, for example in occasional low-mileage use of a vintage car or a limousine with very poor fuel consumption, which might be prohibited under a simplistic regulatory approach.

· Market based approaches generally have lower transactions/ administrative/ enforcement costs, subject only to provisos that some forms of market approach, such as tradeable personal quotas, do involve complex measurement and administrative requirements.

The effect of market measures based around price as the driving mechanism is greater the more price elastic the demand; price elasticities for the use of energy to heat buildings, for example, are likely to be significant. It is least, and price responsiveness lowest, when energy use is an essential complement to a highly valued activity such as personal mobility, or the use of typical domestic electronic equipment, but an insignificant element in total cost.

Regulatory instruments

The alternatives to market or price driven instruments include regulation and other indirect approaches to reducing energy consumption, including subsidies to investment. Simple relatively uncontroversial examples are building regulations, compulsory appliance labelling in terms of energy efficiency ratings, insistence on gas condensing boilers as replacement in domestic heating systems, and small-scale subsidies to install loft insulation. More controversial but still relatively low cost forms of regulation are the recent plans to end sale of traditional light bulbs, or proposals for speed limits introduced for fuel saving rather than road safety reasons. Much more intrusive forms of regulation have been considered however. For example a recent report by Brenda Boardman of the Oxford University Environmental Change Institute [2] has recommended a mandatory approach to the achievement of a low energy housing stock, including inter alia a proposal for legal prohibitions on sale or rent of properties not meeting very demanding insulation standards.

The limiting constraints on regulatory or associated subsidy approaches are that:

· It implies transaction and enforcement costs; local authority building inspection and enforcement for the existing housing stock, for example, would require an order of magnitude expansion of professionally qualified staff.
· Regulation may sometimes impose unnecessarily expensive and inefficient solutions on the consumer, for example in the conversion of equipment which is rarely used.
· It may lead to unnecessary or unproductive expenditure in subsidies; eg on insulation of second or holiday homes that are used only in summer.
· Expenditure that might in any case have been undertaken voluntarily is subsidised from public funds; so the public expenditure brings no additional value.
· It may destroy value through unnecessary destruction of particular parts of the housing stock.
· It ignores the preferences that consumers, if confronted with the true costs of their energy consuming choices, might choose to make, forcing them instead to accept an authoritarian view of how they should manage their affairs
But there are also many examples where a case can be made for regulatory and mandatory or interventionist approaches, and the factors disposing towards this approach are the following:

· There are very low collateral costs to either consumer or society at large in complying; this is most obviously the case in installing low cost basic insulation, or in building standards for new property.
· Low cost changes give disproportionately large savings within a particular sector of energy consumption; light bulbs, or the standby consumption of appliances, are a good example.
· The regulation is dealing with deficiencies in or lack of information, which would help to reinforce market signals; appliance labelling helps market or price signals work.
· Regulation is necessary to deal with a specific market failure; for example the economics of combined heat power (CHP) is usually critically dependent on the scale and density of the heat load scale; mandatory membership of new or retrofitted CHP might be a precondition of a scheme going ahead.
· Dealing with public goods, where the price mechanism is ineffective because the mechanisms of choice are unclear; heating of offices and public buildings is an example.
· The main obstacle to best practice is inertia or lack of information rather than consumer hostility; simple loft insulation is a good example.
· Enforcement is feasible and acceptable and there are low transaction costs.

Indirect Policies

Policies in wholly different domains can have profound implications for the demand for energy and the way it is consumed, and this is particularly the case in housing and transport.
It is very clear that the UK demand for housing has been inflated in recent decades by distortions, real or perceived, in financial markets. The number of households, and the size of properties, is a major driver of domestic energy demand, particularly for space heating. Several dimensions to this can be identified. One is the phenomenon of older people, whose children have left home, continuing to occupy large properties, sometimes in excess of their own preferred requirements, because property has been seen as the only “secure” investment. More generally the belief in the investment virtues of housing has undoubtedly expanded the housing stock and the number of households above its natural level, with large consequences.

The bold measure of introducing road pricing in London was undertaken primarily to ease congestion and improve journey times, but will nevertheless have had a consequential impact in reducing CO2 emissions, since congestion is a major cause of less efficient fuel consumption. However in a poorly analysed and ill-considered attempt to use the same policy instrument as a further driver for CO2 emission reduction, vehicles with lower emissions were exempted from the congestion charge, thus losing some of the lower congestion benefits and increasing CO2 emissions. Encouraging more lower emission vehicles into London will not only have added the still considerable emissions of those vehicles, but also increased the emissions of all the other less efficient vehicles on the road.

Heating of Domestic Buildings

Applying some of these ideas to the question of how to achieve reductions in CO2 emissions associated with domestic heating, there are a number of issues to cover. Two contrasting approaches along a spectrum from relying solely on price increases or taxation to lower use, to assuming that reductions can be achieved solely by mandating and subsidising technical means to change the energy efficiency of the housing stock.

First there are clear a priori arguments for using fuel prices at least as one of the instruments of policy, in order to limit wasteful or less highly valued energy consumption. The argument starts from the presumption of a significant responsiveness of demand, and the evidence that there have been significant increases in both aggregate fuel consumptions and internal home temperatures over a period of falling real prices. Look at domestic electricity demand since 1990.

The impact on household budgets of higher energy prices would be lessened by measures to improve standards of household energy efficiency, which higher prices would encourage, but the reality is that higher prices would be designed to change behaviour and reduce intrinsic demand as well as to encourage a more energy efficient housing stock. Minor changes in desired heat have dramatic effect on consumption. Risk that without price signals higher insulation is absorbed in higher desired temperatures.

A frequent argument raised against the use of prices in this way is the interaction with income inequality, and the real concern with fuel poverty. However it is hard to accept that a problem which starts from income inequality can only be solved by continuing the major market distortion of refusing to price at least some of the external social cost of CO2 into consumer prices. In any case the poverty issue can be addressed in several other ways. The most obvious way is to address income inequality directly and reduce it. However the simplest solution is the introduction of so-called “lifeline” or “rising rate” block tariffs, where each household gets a ration of low-priced energy, but pays a full price above that level.

The main alternative is the intensification of a mandatory approach well beyond the low-key measures already in place. The Boardman/ Oxford ECI report provides some examples in its recommendations. An interesting and explicit feature of Boardman’s analysis has been the identification of the “large empty nest” syndrome (parents with large houses whose children have left home) as responsible, through over-occupancy, not only for a housing shortage but also for an implicit higher per capita energy consumption in larger houses. An obvious but very intrusive regulatory remedy would be tax or other measures to limit home size.

The Boardman/ ECI second major concern is with the very low rate of turnover of the UK housing stock, and they propose a fairly draconian regime to enforce the adoption of very high standards of insulation, without which the owner would be unable legally to sell or rent the property. Implicitly this would render large parts of the existing housing stock unusable, forcing a much faster rate of turnover and new house build. The resource and financial implications of this approach are potentially very substantial, which raises very serious questions of whether or not the same or superior results could be achieved through intelligent application of the “market” instrument of higher prices.

The third area, of indirect policies, is also of particular relevance to housing. It is now becoming clear, for example, that one of the potentially damaging consequences of the asset bubbles created by the absurd over-leveraging of financial markets has been an inflation of the demand for housing, particularly by inflating “investment demand” and house prices, and contributing to the “large empty nest” syndrome. A positive side-effect of the financial crisis may well be that per capita heated living space, a major driver of energy demand for heating, is reduced.
The most appropriate conclusions to draw on policy towards a low carbon future for domestic heating are that:
  • there is clearly a need for a balanced mix of policies, including both mandatory elements where these are not excessively costly or intrusive, and
  • attention to the indirect consequences of other policies, including economic policies which distort housing demand, but also
  • a willingness to use prices as signals to drive changes in consumer behaviour
Road Transport

Road transport presents a quite different economic profile. Individual consumer demand for fuel for transport is highly contingent on where people have chosen to live and the cars they have chosen to drive. The short run elasticity of demand is likely to be very low or negligible and the responsiveness of consumption to emissions pricing will therefore be low. Road transport is already very highly taxed and while European tax levels may have delivered more compact and efficient cars they will not on their own deliver sustainable levels of demand for fossil-based fuels in the private transport market.

The only viable long term solutions for transport, which accounts for about 30 % of emissions, depend on technical change, most probably through the introduction of electric vehicles. However in the interim it is still worthwhile to look for measures which will generate substantial savings in the short and medium term.

Two obvious and well-known contributors to higher road transport emissions are speed and road congestion. This suggests two particular candidate policies in addition to the battery of possible regulations for more efficient vehicles:
  • lower motorway speed limits and/or stricter and more comprehensive enforcement of existing limits.
  • road pricing aimed specifically at congestion, and not entangled, like the current London congestion charge, with an ill-conceived strategy to mould the composition of the local vehicle fleet.

[1] It is no coincidence that the US with low gasoline prices became the home of the gas guzzler while other countries became leaders in compact and fuel efficient cars.
[2] Home Truths; a low carbon strategy to reduce UK housing emissions by 80% by 2050; a research report for the Cooperative Bank and Friends of the Earth. Brenda Boardman, November 2007

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