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...