TEXAS POWER CRISIS. MARKET OR REGULATORY FAILURES?

 

Viewed as independent countries California and Texas would both rank among the ten largest economies in the world. One Democrat and the other Republican, the feature they now have in common is failure to prevent extensive and disruptive interruptions to power supply – California in 2001 and Texas in February 2021. In both states near-catastrophic failures raise questions as to the viability of highly market-driven power systems, which contrast with the stability of more integrated models of the East Coast of the US, and internationally. The answers matter, not just for Texas, but for developed and developing economies everywhere.

In California, the new market structures had only recently been introduced. California had copied many features of the UK 1990 model, which had worked successfully, or at least without major mishap, for ten years. With the benefit of hindsight and a lot of analysis, there seems to be a reasonable consensus that the failures resulted from a combination of factors:

·         Weaknesses in the design of the new market structures

·         State regulatory authorities’ imposition of a price cap, which prevented the market working as it should, to reduce demand and increase supply.

·         Market abuse by Enron, notoriously exploiting the rules to gain large economic rents. Enron went on to become a major corporate scandal, but California was the setting for some of its most egregious wrongdoings.

The recent failures in Texas, celebrated as an example of liberalised market reform, are harder to explain. Unusual weather conditions may be a proximate cause but are hardly an adequate excuse for one of the wealthiest advanced economies in the world, in a liberalised power sector that has appeared to operate without serious mishap since the late 1990s. The other factor cited, the intermittency of wind, can be dismissed as a credible explanation; if relevant at all, it is a known risk that should have been easily managed in a well-functioning sector. We need to look further for adequate explanations of failure to provide reserve capacity.

Creating incentives for private operators to provide the level of reliability that the public want has always been a potential weakness of market-driven systems, usually resolved by the imposition of reserve margins, and financial incentives or penalties. Peter Cramton[1]  is Vice-Chair of ERCOT, the body that has coordinated the Texas power sector over this period, and has described[2] the approach taken to this problem in Texas. It is an administered scarcity price similar to that used in the 1990 UK reforms, which operated successfully up to the introduction of further changes in 2000.

A market in reliability

The Texas model, according to Cramton, sets out the rules to determine an administered scarcity price, in periods when there may be very high or peak demand or low supply.  In theory this should incentivise sufficient capacity (Q) at all times. The administered price aims to reflect the value of lost load (VOLL), and a high VOLL should in consequence result in high reserve margins for generating capacity. Texas sets a high value for VOLL. ^[3] Simple economics suggests high rewards will bring forward more than adequate supply.

One possible explanation for the current failure is simply that this scheme lacks credibility. If we look at these incentives for investors in potential reserve capacity, then the return on investment – the future revenue stream – may depend on achieving ultra-high prices in periods with an ultra-low probability of occurrence. This probabilistic estimate may indicate good “expected value” returns, but the very high chance of zero revenue is not attractive as a basis for large scale investments. Paradoxically the higher the value of VOLL, the rarer the occurrence of periods of scarcity and the less credible the projected revenue becomes. 

Closely linked is the matter of regulatory credibility: if prices need to go that high, as they must do to validate the investment in reserve capacity, and particularly if the price spikes impact on consumers, will the regulatory or political authorities really stand aside and let them happen? The 2001 California experience, at least as suggested in many accounts of that event, suggests otherwise.

What do UK market models tell us?

The UK used its own version of an administered scarcity price from 1990 up to 2000. Fortunately, this was a period with a legacy of surplus capacity, so the method was not subject to severe stress tests. It worked well but was also criticised for potentially allowing larger generators to exploit their market power. It was replaced in 2000 by trading arrangements which had no formal mechanism for capacity. It rapidly became apparent, however, that these would not incentivise new capacity, and would pose an increasing risk to reliability of supply. The UK moved gradually towards the establishment of capacity markets to supplement the new arrangements.

In practice this means that investment in new capacity does not depend on investors responding to market price signals and guessing future prices in the “energy only” electricity market.  Virtually all new UK generating capacity results either from government choices, long term contracts (nuclear plant), from feed in tariffs, or from capacity auctions.

If fixing prices (P) doesn’t work, try fixing quantities (Q)? P or Q?

Economists will be familiar with markets where the choice is to use price or quantity as the appropriate instrument of policy. A good illustration is the energy policy choice between a carbon tax (P) and setting emissions quotas (Q) which can traded. It is possible for the price and quantity outcomes to be the same under either regime, but the choice is important and is usually made on an empirical or pragmatic basis, of what is likely to work best or be more politically and socially acceptable. The UK approach, de facto, for reliability, is to concentrate on fixing Q.

In this context, capacity markets can fix Q if a central authority – government, regulator or utility – decides on the reserve margin and the reliability standard, and invites tenders to provide that capacity. This has the advantage of much more certainty that the reserve will be provided, but it places the onus on the central authority, not just to decide how much capacity but also, in practice, to determine the right technology mix, and to monitor delivery. It represents the abandonment of most of the tenets of a market fundamentalist approach to the power sector.

Regulation and Governance for the Power Sector

It is always tempting to read too much into a single event, when there will inevitably be multiple interpretations of what has happened, and rarely one simple explanation. Another focus will no doubt be on the general governance and regulatory arrangements in Texas, and the role of ERCOT (see below). However, the “standard model” of unbundled utilities, wholesale and retail competition, independent regulation and excessive reliance on markets, however flawed, must come under more scrutiny. Pioneered in the UK, promoted by the World Bank, the European Commission and others, it looks increasingly incapable of responding to today’s policy challenges, of which the climate emergency is just one.

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[1] Cramton is an academic economist, who has described and indeed promoted market-driven models for the power sector. He described the role of ERCOT and the power sector in Texas in a paper - Electricity Market Design - in the Oxford Review of Economic Policy.

[2] Oxford Review of Economic Policy, Volume 33, Issue 4, Winter 2017, Pages 589–612

[3] In Texas VOLL was set administratively at $9,000/MWh—367 times higher than the average energy price of $24.62/MWh in 2016.

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Additional Notes.

A regulatory issue. There is another feature of the power sector in Texas which is at odds with the “standard model” of liberalised markets and independent regulation. The Electric Reliability Council of Texas (ERCOT) effectively controls the functioning, in operational terms, of the Texas power system. It is an umbrella organisation, whose membership includes the utilities, generators and other stakeholders in the sector. It implicitly assumes responsibility for reliability and by its nature provides scope for formal or informal coordination within the sector. This might be interpreted as a quasi-regulatory role, violating one of the conventional principles of sound regulation, namely that the regulator should be independent of ownership and management.  There is an additional oversight from a Texas Public Utilities Commission, but it is unlikely this will have had the knowledge or expertise to probe ERCOT too closely, especially on technical issues

It is possible to argue that ERCOT also provides a vehicle for informal planning or informal guarantees for future investment, and that coordination and more rigorous planning disciplines, plus technical monitoring of capacity, should have been applied.  I would argue in this instance that it was reliance on a “market” mechanism that is the more likely prime cause of the failure.

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California. See for example Weare, Christopher (2003) The California Electricity Crisis: Causes and Policy Options  ISBN 1-58213-064-7;

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There is another important alternative to administered scarcity prices. It is to allow scarcity prices to be set in a market by consumer choices and consumer valuation of reliability, but that is generally seen as currently impractical, because consumers lack the technical capability to respond quickly to price or crisis signals. However increasing digitalisation, and concepts like differential reliability and supplier managed loads- see my tariffs paper - will take us in that direction in the future. 

 

ENDING RELIANCE ON THE MARKET ALONE TO DELIVER FOR THE POWER SECTOR

In recent years we have witnessed the central role, everywhere, of governments dealing with massive market failures, or potential failures, in critical parts of the economy and society. The most obvious crises and interventions have been in the financial sector, and in public health. But attention is also now turning to the biggest crisis of all, the looming threat of climate change. As with the pandemic and with finance, this makes the risk of systemic failure in the energy sector something that governments, of whatever ideological complexion, can no longer ignore. This may be the end for the road for market fundamentalism in the energy sector.

National Grid faces being stripped of its role … after the energy regulator concluded an independent body would better oversee the changes required to meet the UK’s 2050 net zero emissions target. It would also avoid potential conflicts of interest and allow for the “greater strategic planning and management” of the electricity system. (FT, January 2021)

The wheel turns full circle. We are now a million miles from the “liberalised” structure of markets and governance, with all investment choice driven by market signals, and celebrated as such an achievement after the complex and innovative restructuring of the UK power sector in 1990.  The government has already resumed its role as the prime decision maker on new generation investment, and nothing substantial is built without a long-term contractual commitment on off-take that only government or a regulated monopoly can provide. Government has become the de facto "central buyer". The new proposal simply follows the logic of a return to a more planned and coordinated power sector by explicitly extending this role to transmission. Since transmission investment is frequently an alternative to additional generation capacity (most obviously with international interconnection), this seems entirely logical.

While it is still not clear what changes will result from the OFGEM proposal, one obvious deduction is that we are moving towards the creation of a new body with a strategic responsibility for planning and coordinating all significant future investment in the power sector. It would be hard to avoid linking this with the existing functions of government in securing new capacity, through auctions or other means. In its fundamentals this represents the re-establishment of the planning functions of the old Central Electricity Generating Board (CEGB), but without the CEGB’s functions of ownership and operation of generation and transmission. If this interpretation is correct, and the proposals are implemented, then this represents an essential development for which I have been arguing on this site[1] and in other media for many years.

To understand how and why, even with successive governments as the most enthusiastic promoters of theoretical “free market” philosophies, we have got to this position, we need to look at some of the basics of power sector and infrastructure economics, and also at the climate policy imperatives.

The Infrastructure Investment Problem

Investors in high capital cost and immobile assets typically require long term contractual or similar assurance. Their assets are almost always specific to one purpose, and depend on a secure long term revenue stream. Reliance on a spot market or short term contracts, the core components of electricity market structures and both dominated by short term factors, are just not good enough to satisfy private investors. This is particularly so for key investors like pension or sovereign wealth funds who are seeking secure but modest returns. And the low cost of capital these investors can provide is exactly what is necessary to keep electricity prices affordable.

Along with construction risks, the biggest risk to infrastructure investors is that, having sunk the costs of their capital investment, future revenues are exposed to opportunistic actions by other parties. These include government, regulators and customer utilities, all with political or economic incentives to attack their future revenue stream. The owner cannot transfer the asset to an alternative use or jurisdiction, and faces expropriation of expected revenues in the interest of lower prices to consumers.

The two main options are inclusion in a regulated utility framework (traditionally vertically integrated monopoly) in which reasonably incurred costs are passed to consumers, or long term contracts with or commitment from a reliable counterparty, usually the only plausible party being the government.   In the UK, network investments have in recent decades typically depended on the former, and generation on the latter (via CfDs, feed in tariffs etc).

Either remedy can work but both draw a monopoly utility, or government, into strategic investment choices. Both are a long way from the paradigm of the fully liberalised market.

The Coordination Problem

Recent complaints have focused on failure to coordinate offshore wind development with the transmission investment necessary to bring it ashore. But there are plenty of other examples of the need for coordination with low carbon systems, mostly reflecting the fact that these sources are less controllable than conventional thermal fossil plant.  Factors include the advantages of planning for diversity in the siting of wind facilities, the need to get the right seasonal balance of solar and wind, issues around storage and whether to treat it as supply or demand. It looks improbable that any of these issues can be resolved either through short term price signals from power markets, or by “technology neutral” invitations to bid new capacity.

The remedies are either informal coordination within the sector, which risks running foul of competition law or anti-cartel legislation, or a central direction of what types of generation are required.

I have previously argued that the National Grid already plays such a central role that one solution might have been an extension to include a more formal planning or even a central buyer role. But this may well not have been acceptable to a private sector management, and the OFGEM proposals may lead us to an equally satisfactory outcome.

The Carbon Emissions Externality

Climate change is the “biggest economic externality of all time”[2], to date addressed only to a very limited degree by carbon taxes or emissions pricing.  Low carbon prices, only partial in coverage, may be due to insufficient ambition or vested interest capture, but are grossly inadequate to match any serious estimate of the cost of the externality.

So failure to price emissions adequately means that market solutions cannot work on their own. Moreover the “Theory of the Second Best” implies that once we have one major failure in the market, like the failure to price carbon, we cannot assume that other policies, eg competition policy or a merit order[3], normally thought of as good, will actually improve welfare rather than reduce it. In our context even the best designed markets will produce the wrong seriously sub-optimal outcomes, for both operations and investment, if the damages of unconstrained emissions are not included in economic calculations.

Recent examples include the huge coal for gas substitution in 2013/14, driven by a temporary change in fuel price relativities, Dutch competition authorities prohibition of collusion between utilities to reduce coal use, and the UK exclusion of domestic gas, but not the power sector, from emissions trading.

But difficulty in allowing the market to “price” emissions is another prime reason why governments cannot and will not “leave it to the market” to meet its climate objectives. Societies can no more afford systemic failure in relation to energy and climate issues than in health or the financial sector.

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Suggested reading.

ETI publishes industry perspectives on how to deliver efficient networks for a low carbon future energy system.  19 September 2016

Markets, Policy and Regulation in a Low Carbon Future. John Rhys. January 2016

 

 Return to home page

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[1] Use the button LOW CARBON POWER at the top of this page for a more wide ranging discussion.

[2] Stern

[3] The merit order, in any power system, is simply a ranking of generating facilities in ascending order of cost, so that the cheapest are always used first to minimise total cost. If key elements of cost, in this case the damage from CO2 emissions, are not included, then there will be poor outcomes.

GLOBAL THREATS AND INTELLECTUAL PROPERTY

Another policy conundrum where the rules may need to be rewritten. Much of the logic of public goods and market failure will be common to most of the greatest issues facing humanity, but nowhere more than in health and the global environment. And knowledge is a crucial resource.

A number of my recent postings have discussed the concept of market failure in relation to global threats, most notably the current pandemic and the growing challenges posed by climate change. Freedom from disease can be regarded as a public good, as can a stable environment and climate, and in both instances there are numerous sources of potential market failure. One, though by no means the only one, is the way in which we manage knowledge and information of all kinds, and this leads us into some complex issues of policy, particularly in relation to the protection of intellectual property.

Knowledge is a public good in that its use by one person does not reduce the ability of others to use the same knowledge. A lighthouse has the same property – every ship that observes its beam can take action to avoid the same hazard. But like all public goods, if it is freely available, there may be an inadequate incentive to create it in the first place. With free use, then there may be insufficient incentive for the creator of that knowledge to invest their time or money in research or development while others can then enjoy a “free ride” on what they produce. Policies may therefore be necessary to support it, either by arranging to pay for it through public expenditure, or through the creation of property rights in respect of the knowledge created, through intellectual property law.

If knowledge is thereby not created (or discovered or reported), this is a market failure (under-production), which society, and hence governments, need to correct.

Intellectual property rights such as patents are one way to do this. But they do so at the expense of another market failure, and a potentially high economic cost. Monopolies prevent the full exploitation by others of the knowledge that is created, and the knowledge is under-used even though its further use would appear to have no cost to society as whole.

The relevant question for society is which of these two considerations is treated as more important in a given period or for particular social and economic conditions. Protection of intellectual property is of course often seen as a key component of free markets, and what we might loosely call modern capitalism, while more collectivist political philosophies, and in particular China, have been widely accused of refusing to respect this particular form of property right.

So it is perhaps surprising to discover the following quote from Thomas Jefferson, one of the most revered of the Founding Fathers and early Presidents of the United States. It is an impassioned defence of knowledge as a public good, and an argument against the idea of intellectual property.

“He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me. That ideas should freely spread from one to another over the globe, for the moral and mutual instruction of man, and improvement of his condition, seems to have been peculiarly and benevolently designed by nature, when she made them, like fire, expansible over all space, without lessening their density in any point, and like the air in which we breathe, move, and have our physical being, incapable of confinement or exclusive appropriation. Inventions then cannot, in nature, be a subject of property. Society may give an exclusive right to the profits arising from them, as an encouragement to men to pursue ideas which may produce utility, but this may or may not be done, according to the will and convenience of the society, without claim or complaint from any body. Accordingly, it is a fact, as far as I am informed, that England was, until we copied her, the only country on earth which ever, by a general law, gave a legal right to the exclusive use of an idea. In some other countries it is sometimes done, in a great case, and by a special and personal act, but, generally speaking, other nations have thought that these monopolies produce more embarrassment than advantage to society; and it may be observed that the nations which refuse monopolies of invention, are as fruitful as England in new and useful devices.”

However despite Thomas Jefferson, and throughout the late 20th century, the conventional wisdom has been that intellectual property should be protected, even if this had the effect of creating private monopolies. The main mechanism has been stringent patents strictly enforced. But this has created major problems, even in advanced economies, leading to re-evaluation of other new and established means to encourage and finance research, of which there a number, ranging from direct public or charitable sponsoring of research to the offer of prizes for solutions that meet particular needs. It is perhaps ironic, too, that the truly great leaps forward in understanding, for example in the mathematics and physics[1] that underpin virtually every element in the modern world, from electronics to medicine, never depended on intellectual property protection and indeed were largely unpatentable. 

Nobel prize-winning economist Joseph Stiglitz has argued[2] that the conventional philosophy of reliance on patents/ monopolies is increasingly dysfunctional. It has led to “an increasingly dense patent thicket, in a world of products requiring thousands of patents, [this] has sometimes stifled innovation”. Even within the research itself, the incentive may be targeted less at new products than at extending, broadening and leveraging the monopoly power provided by the original patent. Increasingly the objective appears to be the protection of corporate revenues rather than the public interest. Stiglitz[3] also argues that “the preponderance of theoretical and empirical evidence indicates that the economic institutions and laws protecting knowledge in today’s advanced economies are increasingly inadequate to govern global economic activity and are poorly suited to meet the needs of developing countries and emerging markets. They are inimical to providing for basic human needs such as adequate healthcare.”

“The US supreme court’s 2013 decision that naturally occurring genes cannot be patented has provided a test of whether patents stimulate research and innovation, as advocates claim, or impede them by restricting access to knowledge. The results are unambiguous: innovation has been accelerated, leading to better diagnostic tests (for the presence of, say, the BRCA genes related to breast cancer) at much lower costs.”

Stiglitz mounts powerful general arguments for the reform of current arrangements in respect of intellectual property, which he sees as more or less inevitable in the context of increasingly “weightless” economies, and the growing influence of many of the developing world economies. But few demonstrations could be more eloquent than the importance of speedy transfer and exchange of information and research in relation to the coronavirus pandemic, or of the other even larger threat of global climate change.

Few recent stories will have generated more international outrage than the Die Welt report that the White House had attempted to relocate CareVac, a research company based in Tuebingen, in order to secure exclusive access to the vaccine “only for the United States”. Equally it is impossible to understate the importance of the Chinese authorities’ early release[4] of the virus genome (after earlier delays in recognising and admitting the seriousness of the outbreak), or the exchange of data between countries on their individual experiences of the disease. Had any of these been treated solely as the property of the gatherers of the initial information, for their own commercial advantage, efforts to deal with the virus would be in a much worse position than they are today.

Similar importance can be attached to the free exchange of information in relation to climate matters, both in terms of the climate science itself, and in terms of the technologies and ideas required to limit and mitigate its consequences. There is a double emphasis when both the objective, health or global environment, and the means of achievement, knowledge and information, can properly be classified as public goods of the greatest possible value.

Two comments on this post.

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[1] Without quantum theory, to take just one example, no transistors or electronic systems, no electron microscopes, and virtually nothing we take for granted in modern medicine.

[2] Wealth before Health? Why intellectual property laws are facing a counterattack. Joseph Stiglitz 19 October 2017. Guardian.

[3] Innovation, Intellectual Property, and Development: A Better Set of Approaches for the 21st Century.
Dean Baker, Arjun Jayadev and Joseph Stiglitz, July 2017. Shuttleworth Foundation.

[4] “Potentially really important moment in global public health-must be celebrated, everyone involved in Wuhan, in China & beyond acknowledged, thanked & get all the credit,” Jeremy Farrar, head of the Wellcome Trust in London, wrote in a tweet. “Sharing of data good for public health, great for those who did the work. Just needs those incentives & trust.”

PANDEMICS, CLIMATE AND OTHER THREATS TO HUMANITY.

 And the Ubiquitous Nature of Market Failure

"The huge sums of money being committed by the UK government and others to support companies will inevitably lead to a larger role for the state. This should not become the norm once the virus abates.” (Financial Times Editorial 29 March 2020)

"Nonsense. That ship has sailed. The torrent of interlinked challenges facing us, from climate change to oceans to antibiotic resistance, all have at their core some form of fundamental market failure - mainly failures to address externalities. All imply national and international interventions on a substantial scale.

Markets are an important and powerful force, but they need to be the servants of mankind not the masters.

Wake up FT. We are in the 21^st century." (A reader’s response.)

This recent exchange neatly summarises a fundamental sea change in political discussion and public attitudes, namely our perceptions of the respective roles of markets and the state. It also highlights the concept of market failure. The Oxford Martin School, to which I have an attachment within one of their most active programmes, has a focus on public policy problems with a global dimension, with several programmes in the field of health, climate change and the global environment.[1] Market failure emerges as the common thread, so it is worth examining the concept a bit more closely, not least because the implications may be too important to be left only to economists.

There are useful formal definitions, but the simplest characterisation of market failure is that individuals (or businesses or governments) have an incentive (or at least no disincentive) to do things which carry significant costs for others or society as a whole. Simple to understand examples in the context of the Martin School programmes might include casual disposal of waste plastic (oceans), individual failure to vaccinate or excessive use of antibiotics (health), and wasteful use of energy (climate). In each case this can be seen in contexts of both individuals’ actions and widespread commercial practices – a single unnecessary antibiotic prescription or widespread use in animal husbandry, or one person throwing an empty bottle in the river against the widespread promotion of single-use plastics. In all these examples there is no or negligible immediate cost of a particular action, but the collective impact over time on society as a whole may be huge.

Economists have sometimes classified market failures in terms of externalities such as those above, or on market failures that stem from unregulated monopolies, or on asymmetries of information. The latter typically occurs where the seller (buyer) has more information than the seller (buyer) and possibly also conceals it. Volkswagen cheating on diesel emissions tests[2] was a prime example. 

But the possibilities for market failure and similar perverse outcomes can arise from a variety of circumstances and some of the most common features are the following:

·         where there are public goods involved, where use by one individual does not reduce availability to others, but there are insufficient individual incentives for the resource to be created or maintained; the creation of knowledge is a prime example, and provides a key justification for patents and intellectual property protection.

·         “the tragedy of the commons”, where a common resource, like fish or grazing land, or indeed the capacity of the atmosphere to absorb additional carbon without adverse consequences, is limited and over–exploited

·         badly designed taxes or regulations which distort the market and create perverse incentives; in the UK energy sector social and environmental policy burdens are placed on the electricity sector, which is the future of carbon-free heating, but not on gas which accounts for significant greenhouse gas emissions.

·         tariffs that are not cost-reflective result in over-use of what is under-priced  and under-use of what is over-priced; the issue is explored for energy tariffs in an earlier posting on this subject

·         short termism, often itself associated with other market imperfections

·         uncertainty and risk, which most people find difficult to address in a consistent way

·         transactions costs, where markets can be established, but the complexity of the transactions results in costs that exceed the notional benefits of a competitive market, and results in distorted choices; the US health sector is a particularly good example

·         “moral hazard”, often stemming from asymmetric information

·         imperfections in capital markets

·         when active coordination, rather than competition, is essential to good outcomes (current competition between US states for medical resources to cope with the coronavirus is a good example)

·         inequality can be regarded both as a source of market failure and a result of it; of this subject deserves far fuller discussion in its own right.  

The above serve to illustrate some of the pitfalls in policy making. They do not apply only to the existential concerns of health and environment, both of which are now very high on policy agendas, but health and environment are both complex subjects and pose unique policy issues. Of course governments are capable of other policy failures too, even in the process of identifying and rectifying market failure, and that is something we should continue to examine on a policy by policy basis.

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[1] Current programmes include Collective Responsibility for Infectious Disease, Pandemic Genomics, Planetary Health, Renewable Energy, Post Carbon Transition, and Oceans.

[2] The Volkswagen emissions scandal began in September 2015, when the United States Environmental Protection Agency issued a notice of violation of the Clean Air Act to German automaker Volkswagen Group. Volkswagen had intentionally programmed turbocharged direct injection diesel engines to activate their emissions controls only during laboratory emissions testing. The vehicles' NO x output met US standards during regulatory testing, but emitted up to 40 times more NO x in real-world driving.

THE THEORY OF THE SECOND BEST. SOME INCONVENIENT TRUTHS.

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.

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[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 ...

[4] EUROPEAN ENERGY AND COMPETITION POLICY. AN OBSESSION WITH MARKET STRUCTURES THAT DO NOT WORK.

[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

AN ECONOMICS AND ENVIRONMENTAL CASE FOR TRAVEL CONCESSIONS TO PENSIONERS.

And how subsidies, even if to the not so poor, can make a small contribution to the public good and saving the planet.

It is tempting to assume that the pensioner bus pass, or in London the Freedom Pass, is just another item within the host of benefits, tax reliefs, grants and subsidies that make up the complex of arrangements that reflect our welfare state and public spending choices. On this interpretation, it might be viewed as a policy choice based on political priorities. According to your political persuasion and generational perspective, it is then either just another bung to an over-privileged age group who happen to turn out in greater numbers to vote, or, alternatively a redistributive measure which can be a major help to some low income households. I have to declare a personal interest as a beneficiary; but even among pass holders many will have inclined to the former rather cynical explanation, a view which will likely be shared by large numbers of millennials.

The politics matter, but a little more thought and investigation reveals some hidden dimensions for the policy that may actually be just as important. Even if the policy is of benefit mainly to wealthier pensioners, it may still add significantly to the public good.

The Energy and Environment Connection

First there is an inevitable connection with energy use and hence with policies for a low carbon economy. Road transport is a major source of CO₂ emissions, so any policy that has a significant impact on traffic volumes will also have a corresponding impact on emissions. We also know that two of the biggest factors influencing a driver’s fuel use for any given journey are, first, cruising speeds, and, second, traffic congestion, particularly when it results in stop/ start movement.

Of course, CO₂ emissions are not the only important factor in terms of environment and the quality of urban life. More traffic can mean poor air quality, especially due to diesel fuel, and longer journey times for drivers. But in this instance, I would argue, all the effects are moving in the same direction. Less traffic means less CO₂, better air quality, and shorter travel times.

Enter Market Failures and the Search for Second Best Solutions

Market failures occur when the fairly strict conditions, under which the unfettered operation of competitive markets can be shown to lead to a “best of all possible worlds” social welfare optimum, are simply not met. They often provide classic and compelling arguments for policy interventions. In addition, it will very often be the case that, if the failures are bad enough, then other generally sensible measures, like competition policy, will also start to show serious flaws (see an earlier essay on gas for coal substitutionin Europe). The “second best”, given that the theoretical “best” is unattainable, can be hard to find.

Failure to comply with these “welfare” conditions is particularly rife in relation to monopolies, networks (as in the Braess paradox), failure to “internalise” social, health, or environmental costs caused by pollution of various kinds, and difficulties in the allocation of fixed costs into (marginal) prices. And unfortunately transport networks and road travel display these characteristics in spades.

·         Drivers do not face any penalty when they add to congestion and increase the journey times of all other drivers.

·         Fuel costs may not reflect the full environmental and health costs that their use incurs, although UK fuel taxes probably go quite a long way in this direction.

·         Most of the costs of operating a bus or rail service are fixed, at least in the sense that the (short run) marginal cost of an additional passenger is usually close to zero, but fares will still need to recover the high fixed costs.

Subsidising pensioner travel. The Bus Pass meets some sensible public policy tests

Particularly in big cities, traffic volume is the major cause congestion and hence of increased journey times, higher fuel consumption per vehicle journey made, and hence higher emissions. Subsidising pensioner travel on public transport can significantly reduce the number of vehicle journeys and hence traffic volumes. This helps address the first two bullet points above.

But, one might ask, why not make all travellers pay higher charges in the form of road pricing – which is what economists might recommend as a first best solution? The answer is first, that there is a lot of political resistance to raising travel costs for commuters travelling to work, some of whom may not have a public transport option and already pay a high percentage of their income on commuting to work. Second, introducing a road pricing scheme can be a complex and costly exercise.  In the UK, for example, it is currently confined to central London.

In the absence of effective road pricing, subsidising travel by public transport can be a useful part of a “second best” solution. Pensioners are a group more likely to switch to public transport in response to a financial incentive, partly because they will tend to be less constrained by working hours. Because the marginal cost of taking an extra passenger is mostly close to zero (the third bullet point), this discrimination between categories of traveller does not in this instance lead to any serious distortions in the use of resources.

And, finally, is it fair that only pensioners enjoy free travel? The answer is probably no, but free travel for all could also bring its own problems, influencing fundamental long term decisions on choice of where to live in relation to work, for example. And as a practical matter of public finances, the transport system does need to be paid for, at least in substantial part, by travelling passengers. Given that most of the costs are typically fixed, and that pensioners are the group most likely to revert to personal transport if faced with higher fares, there is again a pragmatic case for offering them lower fares or free travel. This is essentially the same motivation[1] that leads private rail companies to sell tickets at lower prices to groups deemed to be price sensitive, eg old people or students.

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Readers are also recommended to two much more comprehensive evaluations of the benefits of these particular subsidised travel schemes.

Greener Journeys. The costs and benefits of concessionary bus travel for older and disabled people in Britain.   September 2014

UK Department for Transport. Evaluation of Concessionary Bus Travel The impacts of the free bus pass. 2016

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[1] Ramsey pricing. This is a well known economics approach to recovering fixed costs in a monopoly situation. In technical terms it means allocating fixed costs in inverse proportion to the elasticity of demand. Sometimes unfair because it means that charges fall more heavily on "essential users".