NYT Story on Energy Efficiency, But Where Are The Prices?

Lynne Kiesling

Earlier this week there was a good story in the New York Times on energy efficiency and increasing industrial and commercial interest in improving their energy efficiency. In talking about getting utilities more interested in inducing their customers to implement more efficient technologies, the article notes that

Opportunities like this abound in the commercial and industrial sectors, requiring no new research or technology. But few places are doing an effective job of finding them, experts say. …

At present, most regulated utilities have their rates set by state officials by calculating how much money they would need for a fair rate of return, and dividing by the amount of electricity sold, to arrive at a price for each kilowatt-hour, or for a kilowatt of load. Spend dollars to make more power, and earn a return on that money; spend dollars to sell less, and watch your income fall. …

In Vermont, a different argument has carried the day. Cutting electric consumption at Green Mountain’s coffee roasting plant and hundreds of other places will eliminate the need to build some additional power plants, string transmission lines and fuel the plants.

The last few megawatts of power, from new generators and lines, is more expensive than the cost from existing plants and lines, so cutting growth in electricity demand also cuts high-cost supplies.

Finally! An energy efficiency story that notes two important things about prices: utilities have no incentive to sell less power given the existing regulatory structure, and dynamic retail pricing that does a better job of reflecting peak-hour generation costs will reduce the strain on the physical infrastructure and reduce the need for additional investment. Yay!

Newshour Story on Illinois Electricity

Lynne Kiesling

Sadly my 15 minutes of television fame came over Memorial Day weekend, but you can go watch last Friday’s Newshour with Jim Lehrer story on Illinois electricity. The piece gives a decent overview of the situation in Illinois, where the 10-year-old retail rate freeze has been lifted, inconveniently at a time of rising fuel costs. This has caused affordability problems for many Illinois consumers, and because the Illinois restructuring legislation has done a poor job of inducing competing retailers to enter the market to serve residential customers, there is little competitive discipline on prices.

Naturally, though, politicians want to reintroduce the rate freeze, even though the rate freeze and the lack of retail competition is what got us here in the first place. I’ll have more to say later on other approaches that would actually achieve more robust, dynamic benefits for Illinois residential customers.

Although my interview lasted for 40 minutes, the wee bit of my tape they used articulates a vision of retail competition that I at least hope will get some people thinking differently about the problem, and will start to challenge the fundamental assumptions on which the regulation of the retail sale of electricity service rests.

Carbon Tax or Cap & Trade: Does It Matter Which One?

Lynne Kiesling

The subject has roiled for the past few months: if the balance of the evidence has shifted toward the value of our taking more actions to reduce our greenhouse gas emissions, should the U.S. implement a carbon tax or a carbon market? Stated that bluntly, and based on centuries of experience with taxes and markets, the person who favors individual liberty and the use of market processes can be expected to favor a carbon market over a carbon tax, even if such a market involves government determination of the number of emission permits allowed in such a market.

Yet some prominent writers with classical liberal, pro-market inclinations have argued in favor of taxes over markets in this case, most recently Ron Bailey in Reason, Tyler Cowen at Marginal Revolution and George Mason University, Greg Mankiw at Harvard, and John Tierney at the New York Times. The imminently sensible John Whitehead sees little difference between the two policies.

I disagree, because I think all of these thoughtful and intelligent observers are making a fatal assumption and ignoring some crucial arguments that, for me, swing the balance toward carbon markets, notwithstanding the difficult design issues and costs. These arguments are the same reasons why I am not, and will never be, a member of The Pigou Club. They transcend, but encompass, the simple statement that institutions matter because they shape incentives and affect outcomes in a very complex and dynamic sense.

Starting with theory, as John Whitehead concisely and capably summarizes, if you make all of the standard neoclassical assumptions there’s no difference between the two policies. Or, as John puts it, “Both emissions taxes and cap-and-trade can achieve optimal emissions at the least cost to society.” They are most similar if the initial permit allocation process is an auction.

Ron Bailey’s argument for the tax, and Tyler’s support of his argument, cite some of the most important theoretical and practical reasons why these two policies would differ when implemented in reality. Ron channels Adam Smith a bit when he says

A carbon tax also offers less opportunity for corruption because it does not create artificial scarcities and monopolies.

There’s a public choice reason why the tax might have fewer implementation costs: the design of a carbon market, the establishment of the cap, the determination of the initial allocation of permits, all become prone to lobbying and political manipulation. One piece of evidence in support of this argument is the recent experience of the EU Carbon Trading Scheme, in which EU leaders caved in to political pressures when allocating the permits among countries and setting out rules for their distribution. Again citing Ron:

Business leaders see the policy handwriting on the wall and are rushing to help shape the emerging greenhouse gas (GHG) emissions regulatory scheme to their own best advantage. A government-created market in emissions permits would be particularly responsive to this kind of gamesmanship. In January, the U.S. Climate Action Partnership, consisting of ten big companies with a total market capitalization of $750 billion, including DuPont, Alcoa, General Electric, and BP America, issued a “blueprint for a mandatory economy-wide, market-driven approach to climate protection.”

Also in January, the Electric Power Supply Association, the lobby group that represents competitive power suppliers that account for 40 percent of the generating capacity of the U.S., acknowledged that “regulatory and legislative processes are moving forward seriously and with speed.” In February, the power-industry lobby group, the Edison Electric Institute, came out in favor of “federal action or legislation to reduce greenhouse gas emissions that…involves all sectors of the economy, and all sources of GHG.”

This is certainly true, and a valid and important concern. However, I don’t understand why setting a tax rate and determining its legal incidence (as opposed to its economic incidence, which reflects how producers pass on the tax in prices based on price elasticity of demand) is substantially less prone to political manipulation than establishing a carbon permit market. Tax supporters who ground their argument in the practical public choice foundation should explain why that’s the case, or else they are committing the Nirvana fallacy.

Another concern, again illustrated by the EU scheme, is the transparency of price signals and their transmission of true opportunity costs to the parties subject to carbon policy. A tax is simpler, clearer, and at least in terms of legal incidence more transparent and less potentially volatile. That creates a less risky environment for parties subject to carbon policy.

I have three critiques of that argument. First, Pigouvian taxes are indirect instruments because they are levied on an output or activity, not on the actual carbon emission. If you are going to tax my output based on an estimate of the amount of carbon its production process creates, why am I going to have any incentive to innovate my production process to make it less carbon-intensive? I’ll still get taxed as if I’m producing the higher amount of carbon. That’s a problematic disincentive to innovation unless we can monitor, measure, and tax the carbon directly. I don’t think the technology’s there yet.

Second, in the quest to reduce the regulatory risk we face a tradeoff here between simplicity of instrument and accuracy of price signal. Maybe the tax is simpler, and maybe cheaper to implement, but how well does it reflect the true opportunity cost facing those subject to carbon policy?

Finally, but most importantly, how do we know the right level at which to set the tax? This is where we get to the Coasian/Hayekian crux of the problems with Pigouvian taxes that the other commenters did not account for in their analyses. The most problematic aspect of Pigouvian taxes is that they rely on the assumption that the policymaker has sufficient knowledge to be able to set the optimal tax. The knowledge of the optimal level of emissions and the optimal tax rate is not, in Hayek’s phrase, given to any one mind. That is the knowledge problem. That means that the policymaker has to have information about production processes, production costs, the epidemiological and other health and consumption effects of the product, and the economic value of those epidemiological and other consumption effects. That is a heroic assumption. No one person or group of people, however well-informed and well-intentioned, can ever determine the optimal emissions or tax through a centralized process. A political process will stumble upon the optimal tax rate by luck; through analysis we can only approximate that rate. If we are wrong and have to revise it, then we violate the above-stated benefit of certainty and transparency. The best mechanism we have for discovering the optimal emissions is through a decentralized process that can aggregate this widespread, diffuse, personal knowledge; this decentralized process is a market.

Note that this diffuse knowledge criticism of Pigouvian taxes can also apply to cap-and-trade: no centralized process of determining the cap on emissions is going to result in the optimal level, except by luck. However, the distortionary effects of an incorrect cap feeding in to a decentralized market process may be small relative to the dynamic efficiency gains that are possible from the innovation incentives that are embedded in decentralized market processes. But here I would note the Bailey caveat from above; political manipulation of the market institutions can undermine many of those dynamic efficiency gains, so minimizing the politicization of the market design is important (and the EU, as usual, provides a cautionary tale in excessive politicization).

This critique, derived from Hayek, also provides a fundamental foundation for the Coasian approach to emissions trading, which involves reducing the transaction costs that prevent private parties from being able to bargain to a mutually beneficial solution. This is precisely the approach underlying the voluntary carbon market (and carbon futures market) at the Chicago Climate Exchange.

The most robust long-term policy approach is one that reduces the (sizeable) transaction costs preventing private parties from achieving mutually beneficial outcomes. Even in something as diffuse as carbon, which is admittedly more challenging than the sulfur dioxide market was in the U.S. in the 1990s, we should not lose sight of the importance of this fundamental objective. Another member of “The Coase Club” who has made a wonderful and thorough argument on these points is Steve Postrel.

Thus while I am sympathetic to the political economy arguments for the lower implementation costs of a carbon tax, the knowledge problem and the right set of institutions for inducing dynamic efficiency through innovation make me favor pursuing a carbon market, designing it well, and testing it carefully.

An Easy Introduction to Gasoline Prices

Michael Giberson

The Consumerist seeks to answer the recurring question, “Why Is Gas So Freakin’ Expensive?” We could quibble with bits and pieces of the story they offer, but overall it is a solid introduction to the economics of gasoline prices. Easy enough for an interested high-schooler, or perhaps a conversation starter for your freshman economics class.

The Consumerist offers up a counter-intuitive twist that suggests politicians have it all wrong if they want to look for price gouging when prices are rising:

Despite popular misconceptions, price gouging almost never occurs as prices rise. Instead, price gouging occurs when dealers keep prices artificially high in order to gain a little extra profit or recoup costs, even though the [wholesale gasoline] price has declined.

Actually, as long time KP readers know, dealer margins do tend to improve when prices are dropping. In an October 2005 posting I quoted from an Associated Press story (story no longer online):

When pump prices skyrocketed after Hurricane Katrina, gasoline retailers were caught in an uncomfortable paradox — they were accused of gouging at the same time their profits were being squeezed by runaway costs at the wholesale level.

Now the reverse is true. The outrage from consumers and Congress has died down just as gas stations around the country are reaping some of their best returns at the pump in years by passing along huge savings at the wholesale level as slowly as possible.

The problem isn’t that the dealer suddenly decides to “gain a little extra profit” or “recoup costs” — after all, dealers are almost always trying to cover costs and find extra profit. Instead, consumers are to blame. As I wrote back in October 2005, with links to the relevant research: “When retail gasoline prices are rising, consumers search harder for the best price; when prices are falling, consumers ease up on search.”

(Consumerist link found via Freakonomics.)