Feb 192014

The last year has seen much discussion about the price of energy. Nuclear plants, wind turbines, fracking, price caps and green subsidies are a staple part of the news and political vocabularies. And as usual with politics, most of the arguments make no sense when you examine the economics.


But before I get into that I need to cover an important economic concept, the idea of externalities.

In a perfect free market, competition ensures that the price of an item or service falls to the ‘correct’ price, which is the price of producing it plus the smallest profit margin necessary to persuade the producer to bother. The monetary cost of production is the cost of paying people for their time and skills in building things, digging stuff out of the ground, writing code or whatever. However, there are other potential costs – air pollution from a factory; noise from a mechanics; increased road traffic from delivery lorries. The producer often doesn’t have to pay these costs. If I open a curry house in my living room I don’t have to pay my neighbours compensation for the smell. These costs are called externalities (specifically negative externalities in this case, as it’s also possible to produce positive side-effects you aren’t paid for).

The effect of negative externalities is that goods and services are cheaper than they ‘should’ be. There is an amount of money I could pay my neighbours to appropriately compensate them for the curry smell, thus internalising the externality. My costs are now higher so I have to charge more, and my neighbours are happy. If I can’t make a profit with this extra charge then I should shut down and re-open the business in a location with less picky neighbours.

Schemes exist to account for externalities in many areas. Congestion charging in cities during the day encourages people to drive at night, or pay for the inconvenience they cause. High taxes on cigarettes and alcohol pay the costs of hospitals and police cleaning up the mess (although I assume this isn’t the primary reason for these taxes).

The point is that if all externalities are ‘internalised’, businesses can do anything they want to make a profit, safe in the knowledge that they are paying for any damage they are causing.

Carbon trading

So what does this have to do with the price of energy?

Most of our energy is produced by burning fossil fuels. Burning things produces carbon dioxide which contribute to climate change. Climate change is likely to cause humanity major costs in the future, due to increased extreme weather events, rising sea levels and the like. This is a prime example of a negative externality, unless the future costs of releasing carbon dioxide are included in the price of the energy.

There is an attempt to do just that with the EU Emission Trading Scheme. A limit is set on the amount of carbon that the regulated industries can produce, and the limit is shared between those industries in the form of tradeable emission permits. Businesses that reduce their emissions can sell their permits to high polluters. Highly polluting businesses aren’t a problem in this system – it’s more efficient to pay someone else to reduce emissions than to reduce their own, so goods remain cheap while overall emissions go down. Compare this to the less efficient system of flat caps – cleaner industries get no benefit, and goods from dirty industries get more expensive as they take expensive measures to clean up.

That’s the plan, but unfortunately due to political issues there are too many permits available. In 2008 permits sold for €20/tonne of C02, but in 2013 they could be picked up for €2.81/tonne. One of the major problems of externality charging is working out the correct price that should be paid. The true future cost of climate change is not known, but it seems likely that €2.81/tonne of CO2 is too low, and provides very little incentive to clean up.

Renewables and nuclear

Renewable (and nuclear) energy is more expensive than energy from coal and gas. One of the big arguments the Government has made in favour of fracking for shale gas is that it could reduce energy bills (although they’re playing this down now). This is short-sighted because it doesn’t take into account the externality of climate change.

Cheap fossil fuel energy now is like taking a loan to be paid back with considerable interest in 50+ years. It defers the cost of clean up by many decades. Renewables have little cleanup cost beyond dismantling them at end of life, so almost all costs are included up front. Nuclear has significant cleanup costs for decommissioning and waste storage, but these costs are known and again factored into the up front cost.

Taking loans isn’t always a bad idea. Governments and businesses frequently run up debt. As long as spending the loan produces greater returns than the interest on it then you can still come out ahead. With energy we have two options – take the loan for cheap energy now, or pay everything up front. If the increased economic growth from cheaper energy means it’ll be comparatively cheaper to fix the damage from climate change in the future then it could make economic sense. I’m no expert but personally I doubt that’s the case.

 Government energy schemes

All of this doesn’t change the fact that energy is becoming a real strain on less well off households (and likely to get even more so). In fact I’m making it worse by advocating more expensive bills. Politicians have come up with a few schemes to try to help:

1. Ed Milliband’s price cap. Energy companies may be forced to keep their prices fixed for 20 months. This is plainly a terrible idea. It makes very little difference to people’s wallets and inhibits investment.

2. George Osborne’s lifting of green levies on energy. This does exactly the opposite of what I’m talking about with addressing externalities. Applying additional levies on fossil fuels is a way of ensuring that energy costs the ‘correct’ amount. Removing these levies makes the situation worse.

3. Energy company profits. Ministers have been making noises about increasing competition and reducing profit margins. While more competition is good, this is a bit of a red herring. Average long term profit margins are around 5%, so even if profits were reduced to zero this would have very little effect on total bills.

4. Winter Fuel Payments. The elderly are entitled to an annual payment of £100-£300 to help with fuel bills. This is actually a good policy for a couple of reasons I’ll come to.

So what else would an economist do to try to help?

The ‘correct’ fix

The problem with attempting to reduce energy bills for all is that most people can afford to pay the bills already. It may mean cutting back on some luxuries as bills continue to rise, but as we’re steadily using up all the cheap fuels (North Sea gas, easily accessible oil wells etc) we have to accept that energy is just expensive, and adapt. A better approach is to target those in need specifically, and this is where the Winter Fuel Payment is a good model.

Firstly, it targets a group particularly in need of help – the elderly with low incomes. Targeting help at small groups is cheaper than attempting to help everyone, as the help goes to those who need it.

Secondly, it may actually reduce energy consumption. You could give ‘energy vouchers’ that can be redeemed to pay bills, undoubtably helping that person. Or you could just give cash (which is what actually happens). The recipient can then make more efficient use of the money by spending it on whatever they want. They may just spend it on the bill, and that’s fine. Or they might instead spend it on upgrading their boiler or insulating their home, reducing their usage permanently. It doesn’t matter that it’s not spent directly on energy – the cost of the scheme is the same, but the money can be used more efficiently than the equivalent in vouchers.

Using tax revenue to subsidise energy prices and keep bills low for all (which is what vote-winning energy policies tend to boil down to) is inefficient. Far better to let energy be priced at its correct level and redistribute the savings as cash to those who need it. Then as prices rise, everyone has both the incentive and the opportunity to reduce their own usage.

Unfortunately this kind of approach is a much harder sell, and wins fewer votes, than making vague promises to bring down bills. But I’m pretty sure more long term good would come from rational economics-based energy policy than any of the vote-grabbing gimmicks that are currently being thrown around.