A brief Economist’s view on the current draft Energy Bill

UK energy markets are in a mess for two basic reasons.

First, market liberalization, which began in the 1980’s under Thatcher, has not yielded the investment necessary to secure future supplies in the face of an ageing stock of coal and nuclear powered generators. The Government estimates, for example, that £110 billion is needed by 2020 to update and expand capacity.  

Second, the environmental costs of the sector remain stubbornly high, accounting for around 40 percent of total UK carbon emissions.  And there remains a considerable way to go in order to meet the Government’s stated goal to reduce emissions by 32 percent against 1990 levels by 2020.

The Government released its draft Energy Bill in May, which is set to be finalized in the forthcoming Parliamentary session. At its core are two government procurement measures, designed to encourage “green” energy investment, particularly in nuclear power; and help expand overall generating capacity, particularly from natural gas.

The case for policy intervention in relation to the first problem is well established. To avoid economically costly black outs, we need spare capacity. But operating such safety margins is not profit maximizing from the generators’ perspective. Thus procuring additional capacity on our behalf through a competitive tendering process, as is provided for under the draft Bill, appears not unreasonable. 

However, managing the later issue is more problematic. There are a number of economic theories for managing externalities. In the case of a global concern such as climate change, the lessons from Pigou are arguably much more powerful than, say, Coase (efficient outcomes are unlikely to be achieved through bargaining when everyone on the planet is affected, including future generations). Essentially, we should be trying to systematically tax the sources of the problem, like fossil fuels and deforestation. The extra revenue could be handy too, and arguably a far better tax base than investment or labour, say. 

Some progress has been made to this end, with the establishment of an EU Emissions Trading Market (ETS) in 2005, which covers the power and industrial sectors (although the revenues from this policy have so far been squandered through handouts of pollution rights to industry participants). But governments across Europe, including in the UK, have generally preferred to subsidise alternative technologies than strengthen the disincentives for polluting investments.

The draft Energy Bill effectively extends existing subsidies, which currently flow mostly for the wind industry, to Nuclear. The Government asserts that such temporary support is essential to ensure the necessary advancement in green technologies. However, this argument is weak, not least because the proposed contracts are long term, often extending over several decades (and subsidies are politically difficult to reverse in practice). And the effectiveness of past financial support is often only weakly demonstrated.

Even accepting the case for subsidy for a moment, the proposed measures raise a number of issues. A system of fixed payments to energy suppliers essentially transfers financial risk from new energy investments onto consumers. Arguably, this may be justified only to the extent that households are more willing and able to assume such risk than the industry players. This is far from clear…

…Moreover, the proposed system of contacts requires the government to forecast future energy prices in order to determine the “correct” subsidy level to particular technologies. This is inherently challenging and increases the chances of “regulatory capture”. Getting such assessments wrong may result in either too little (or the wrong type) of investment, and/or excessive rents flowing to private investors.

So faced with such a draft bill, and an understanding of the basic economics of the issue, what should the politicians do?

Unfortunately, reform cannot wait. Action is required now to avoid potentially costly supply shortages in the future, especially given the currently weak investment climate. However, the policy on renewables is a mess and needs rethinking. Working with EU partners, the Government should strengthen the incentives for green investment under the EU ETS; in particular by tightening the emissions cap and broadening the scheme’s coverage. It could also simplify the schemes’ administration, and raise some cash by auctioning pollution rights rather than the currently complex system of handouts.

It should also seek to roll back subsidies for “green” (as well as “brown”) energies, which are imposing significant costs on consumers at a time of falling real wages (remember that the term subsidy can refer to many things, including favourable tax treatment relative to other markets). 

By removing, rather than adding, to energy market distortions (and avoiding interventions in favour of specific technologies) the government may ultimately achieve cleaner energy, and a more efficient allocation of scarce resources in this critical sector...

English Talent Stifled?

During the coming term (subject to confirmation!) we'll be talking about the economics of sport in Contemporary Issues. One thing we'll think about is applying the economically appealing concept of competition into the context of sport.

Roy Hodgson has spoken directly into that arena today, bemoaning that English talent is being stifled because of lack of opportunity in the Premiership. I should make it clear - I'm a big fan of Hodgson and fully believe he was the right appointment back in the Spring. However, his talent lies in coaching, rather than analysing events through the lens of economics.

You'll hopefully recall the first and second theorems of welfare economics from econ101a last year - that a competitive outcome is Pareto optimal, and that a Pareto optimal outcome is also a competitive outcome. In laymans terms this says we can't do better than the competitive outcome. Restrict competition, and while you might benefit some, you'll have an overall net negative impact - you'll negatively affect others.

English players, forced to develop within the Premiership system, have about the best training imaginable - each week they play against (and alongside) the greatest players in the world (bar those that have left for Barcelona or Real Madrid). They aren't in squads because they are protected by rules telling teams how many players from particular types of countries they can field.

The most likely impact of this is that the English players that make it are of world class - the other likely consequence is that there are fewer of these players. So what Roy Hodgson faces, compared to, say, what Bobby Robson faced in the late 1980s, is a smaller pool of higher quality players. But Hodgson knows that the ones he can put in his team are familiar with playing against the best players in the world week in, week out.

Surely that's much better than having a large pool of mediocre players?