At last some sense on climate change

A few years back perennial BS vendor Naomi Klein wrote a book called This Changes Everything. She argued, in typically economically illiterate fashion, that the threat of climate change requires us to reject mainstream economics and instead embrace the sort of socialist, planned economy that she has always supported. Klein and her ilk’s political opportunism may explain why so many on the right are sceptical of climate change. But, as we have argued before, climate change offers no rationale to abandon faith in free market economics.

On that note, Prof Dieter Helm’s government report into the cost of energy ought to be commended. He argues that repeated government intervention in the energy market has made tackling climate change much more expensive than it needs to be. The ‘free market’ solution to carbon emissions is straightforward: work out the cost of the external damage caused by pollution and force the polluter to pay it, usually in the form of a Pigouvian tax. Let the market do the rest. No need for lobbyists and politicians to bang on about their favoured technology.

Unfortunately, this system isn’t the status quo. When Helm asked BEIS to list the main interventions in the energy market, they listed seventeen (!) different interventions. They ranged from obligations on energy suppliers to source a proportion of their energy from renewables to Contracts for Difference which guarantee low-carbon electricity generators a fixed price above the market rate paid by consumers via a levy on energy suppliers.

Helm argues that there are two main problems with the existing approach. First, they often require the government to make forecasts about energy prices. As Helm points out ‘If the government is going to get deeply involved in being the central contractor, to contract on a technology-by-technology basis, and run multiple policy interventions, it needs to try to second-guess the results the market would otherwise have produced’.

But it just so happens that government is woefully bad at forecasting prices.

If the government instead accurately forecast falling fossil-fuel prices then it would have revealed that subsidising renewables was more expensive than first thought, and that switching from coal to gas should have been a much more important part of the decarbonisation process.

As Helm points out, there is a difference between government and market forecasts. “While the private sector has to forecast, and its investment decisions reflect companies’ assessment of the net present value of projects, it is important to recognise that this is not necessary for government, except in some specific and difficult cases. In a competitive electricity industry, prices are the outcomes of a competitive process, and they are revealed in the wholesale and capacity markets. They are not assumptions.”

But, government forecasts are not merely inaccurate. As the assumptions that government makes determine subsidy levels, they invite lobbying and policy-driven evidence.

That leads to a second problem: regulatory capture. The sheer complexity of interventions and how they interact with one another means that a straight-forward cost-benefit analysis of a particular programme is beyond even the brightest civil servants. This leads to a classic case of regulatory capture – “the particular interested party would have superior information. Asymmetric information between the government and regulators on the one hand, and the vested interest on the other, is a bigger problem, the more complex the interventions.”

Rather than the market determining the cheapest way to cut carbon emissions, rent seekers lobby to have their preferred energy sources subsidised. Helm notes that “Every main energy company and every main energy-consuming company has its own regulatory team, and a number of significant and in some cases highly effective trade bodies have emerged.”

Rather than attempting to centrally plan the energy sector, the Government should adopt Helm’s recommendation to replace the myriad interventions and shift to a single, unified carbon price that includes emissions from agriculture and transport as well as electricity. This would blunt the tools in the rent-seeker’s arsenal and incentivise the market to discover the cheapest way to cut emissions. Better yet, any revenue from a carbon charge could be used to eliminate the most pernicious effects of the tax system. We could boost investment by letting businesses deduct the full cost of their investments from their tax bills and protect the poorest by raising the NI threshold to £12,500.

It would surely be better than the status quo where instead of the market we rely on the government to pick winners. Government isn’t very good at picking winners, but as Helm says, “losers are good at picking governments”.