Can the invisible hand guide us towards a decarbonised energy system?

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The decarbonisation of society cannot be left to the market until the price mechanism is “repaired”, argues Thomas Nowak. [100% Campaign / Flickr]

Prices for many sources of energy do not reflect their true environmental and social costs, writes Thomas Nowak who proposes abolishing fossil fuel subsidies as one of four necessary measures to drive the transition to a low-carbon economy.

Thomas Nowak is an economist by trade. He is secretary general of the European Heat Pump Association (EHPA).

Europe is currently debating its energy future. The “clean energy for all” package strives to put the consumer at the centre of the energy transition while setting targets for the use of renewables and energy efficiency as well as defining standards for the built environment.

One of the main bones of contention is the ambition level. The distant aim of a zero-emission society is accepted by most but its implications on the next decade of energy policy until 2030 are far from clear. The level of mid-term ambition, expressed via the targets on renewables, energy efficiency and CO2 emission reduction is heavily debated, as is the necessary new governance mechanism.

Do we need 27%, 30%, 35% or even more? Should targets be mandatory or indicative? And which member state should contribute what? Should all sectors of society contribute equally or is it better to define sectoral targets for electricity, transport, heating/cooling? How much may all this cost and who is to pay?

In utopia, energy is affordable, reliable and clean. In reality it is cheap but dirty, often sourced in politically instable regions of the world.

The current energy system is not compatible with the decarbonisation target agreed upon at the COP21 in Paris. Achieving a maximum 1.5°C of global warming requires a fundamental change of how we generate and use energy.

Unfortunately, no government has the means to simply finance this transition. The key to success is rather the activation of private capital in favour of the overarching goal.

This is not a new idea: The Scottish economist and philosopher Adam Smith (1723-1790) used the term “invisible hand” to describe the connection between individual action and the common good. Striving to maximise the individual good would automatically benefit society he argued and it would achieve the common good even better than had this been the individual’s goal in the first place. This effect would be achieved automatically through the price mechanism facilitating trade and market exchange.

The invisible hand theory is at the basis of Europe’s neoclassical, market-based economies. It is therefore no surprise that it (maybe invisibly) guides policymakers when they defend their refusal to select the means to an end, be it in the areas of innovation, efficiency or renewables. “We do not pick winners” or “legislation must be technology neutral” is a phrase often used. It assumes that policy makers do not need to take these decisions, because the market mechanism based on prices and rational decision making leads to a better result. Rational choice by the individual will help society to achieve its goals.

This would be very elegant if it worked. What is typically forgotten is that Adam Smith was a moral philosopher too and his theory included one important side condition: human virtue. A responsible individual would include the side effects of its action into the rationale of his decision making. If decision making is solely based on the price as carrier of information, the invisible hand must fail in maximising the common good whenever the price does not tell the truth.

This is the case for our energy system: The price mechanism does not work – the invisible hand is broken. Prices for many energy sources do not reflect the cost of environmental and social impacts of their use.

The discount rate, used to determine the value of long term investments in current terms, is often set to a conservative, high value. This is detrimental to all those technologies/investments that are characterised by high upfront investments and low operating cost.

The combination of both effects does not only impact current individual decisions but also the modelling of a possible future. Which investment cost, operating cost and discount rates are used in scenarios and impact assessments has a fundamental impact on which policy is deemed most (cost) efficient to achieve a decarbonised society and by when.

It is obvious that a low price of fossil fuels, comparatively lower investment cost for fossil technologies and comparatively high discount rates result in an advantage for fossil solutions over their renewable energy competitors.

The decarbonisation of society can thus not be left to the market, until the price mechanism is “repaired”. At least by concept, this is surprisingly easy. It requires proper recognition of the environmental and social impacts of technical solutions by either adding a malus on polluting technologies/energy sources or a bonus on clean alternatives. Announcing this change of conditions clearly, early and loudly will influence investors who are very well able to anticipate change. As many energy technologies have long life-cycles (gas pipelines approximately 50 years, heating technology: up to 30 years, air conditioning 15-25 years) the impact of an early announcement of a change in the pricing structure will shape investment decisions away from potentially more costly, maybe even stranded assets.

Four measures are needed to fix the system:

  • Energy subsidies that distort the market mechanism need to be cancelled – that applies in particular to those paid for fossil energy/technologies;
  • Using carbon needs to become expensive – either via tightening the cap of the ETS and integrating all sectors in it or by establishing a price on carbon;
  • The cost of the energy transition need to be distributed equally to all energy sources (not only electricity). Energy taxes and levies need to be applied in relative, not absolute terms;
  • Demand-side flexibility needs to be given a value to facilitate new business models.

Policy makers are the doctors of the system. Applying the medicine suggested here will not only fixe the invisible hand, but will also allow much higher ambition levels and thus accelerate the energy transition, even possibly on time to limit global warming.

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