Government and the Energy Marketplace

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GOVERNMENT AND THE ENERGY MARKETPLACE

Government intervention in energy markets involves either government ownership of industry resources or, more commonly, planning and regulation of privately held resources. The proper role of government planning and regulation has been a hotly debated issue among economists and politicians for many years. Through the twentieth century, governments of the United States and of most of the rest of the developed world have become increasingly larger and more involved in taking action that affect the outcomes of how energy is produced, transported, and consumed. Some believe government intervention in markets is the best solution; others believe government intervention should be avoided. Given the extensive number of energy markets and the extensive use of government intervention in those markets, it is not surprising that the record is mixed. Markets have proved to be reasonably efficient, yet also can be harsh; government action has provided important protections, yet also has made some good situations bad and bad situations worse.

THE VIRTUES OF THE MARKETPLACE

Markets decide what energy resources shall be produced, how they shall be produced, and who will receive the benefits of the production processes. With millions of different activity options, and millions of individuals making individual and collective decisions, it is an overwhelmingly complex process. At the same time, it is usually very efficient because self-interested market players communicate through the price system. A self-interested rational individual will make decisions based on true preferences, and follow those preferences in a way that will provide the greatest satisfaction. Choices will be made under certain constraints that apply to all consumers: income, energy prices, and the ability to switch fuels or fuel providers.

Economic theory holds that individuals will make decisions based on what is in their best interests. Government intervention distorts these capital investment decisions; it alters constraints by favoring or giving preferences or incentives to one choice or type of behavior over another. Government intervention tends to subtly manipulate supply and demand of energy, which usually increases costs to users, reduces supply, and leads to higher prices. Political revolt to government intervention is rare since the consumer often is unable to separate the interventionist component of price (the price premium attributable to regulation and taxation) from what the price would be in the free market.

REASONS FOR GOVERNMENT INTERVENTION

Government intervention is justified as a way to correct the shortcomings of the marketplace. Proponents of intervention do not necessarily believe that markets in general do not work, but rather that there are dynamics going on in certain markets that require intervention to cause them to work in a more socially desirable manner. First, intervention is justified in the energy arena because of problems arising from the laws regarding the ownership and exchange of property rights and the purchase and sale of energy rights. Property rights are far more troublesome in the oil and gas production business than most other businesses for two reasons: the commodity of value sits below the surface, and the commodity is a liquid or a gas not a solid, which means it can migrate many miles. Since energy resources know no boundaries (oil and gas deposits often straddle the property of several owners) a system is needed to assign energy rights.

Second, intervention is justified because social costs may exceed private costs as well as private benefits. For example, when an individual chooses to take a personal automobile to work instead of mass transit, the individual driver receives the short-term benefits (privacy, comfort, speed, and convenience) while the negative social costs (greater air pollution, highway construction, traffic jams, and resource depletion) are shared by all. Intervention usually is an attempt to lower the social costs. However, the problem is that social costs may be easily identifiable in theory, but much more difficult to accurately quantify in practice.

A third function of intervention is the oversight of energy utility monopolies for electricity and natural gas. Utilities have been considered natural monopolies because it was generally cost effective to have a sole generator, transmitter or distributor of electricity or natural gas for a local area due to the large infrastructure required and economies of scale. Without competitors, government historically felt a duty to protect customers from unfair price gouging. But new technology is challenging the concept of natural monopoly in the utilities, and has resulted in the deregulation of energy generation, transmission and distribution in the 1990s. Government's role is shifting to establishing the rules, guidelines, and procedures that attempt to be equitable to all parties (industry and customers) and minimize the social costs to society by ensuring these markets are also socially desirable.

Finally, government intervention is often called for to establish standards by essentially reducing informational market barriers. This is important because the rational individual can only make a decision in his best interest when the information is at hand to make that decision.

TYPES OF GOVERNMENT INTERVENTION

Governments intervene in all energy markets—exploration, production, distribution, and consumption—and carry out intervention in many different ways. While some impacts of intervention are intended, other impacts occur indirectly as an unintended consequence. Examples of a direct impact are the price-lowering effect of subsidies for the biofuel ethanol, and the increased desirability of conservation resulting from a tax on energy use. Examples of unintended indirect impacts are the encouragement of single passenger driving over mass transit resulting from the provision of free parking, or a dramatic increase in the price of coal-generated electricity resulting from clean air regulations to reduce air pollution.

Taxes

Governments levy taxes to raise revenue and to discourage consumption of what is taxed. The primary purpose of United States federal and state gasoline taxes is to raise revenue for transportation infrastructure, particularly highway construction. In Europe and Japan, where gasoline taxes are many times greater (gasoline retails for over twice as much as in the United States), the purpose is also to discourage consumption. However, when taxes are implemented, rarely are drops in transportation energy consumption immediate. Even very steep increases in gasoline taxes usually take time to result in a reduction in consumption. People who drive fifty miles to work still need to get to work by driving in the short term. Only over the long term can people decide whether to move closer to work, change jobs, rearrange schedules to use mass transit or to carpool, purchase a more fuel efficient car, or accept higher energy costs by maintaining the same lifestyle.

Unlike the gasoline tax that only impacts the transportation sector, carbon taxes affect all sectors of the economy. Implemented by some European countries and proposed in the United States by the Clinton Administration in 1993, the carbon tax makes consumption of fossil fuels more expensive for the energy user. The goals of a carbon tax are to reduce the consumption of energy and to make non-carbon emitting sources like wind and hydroelectric more cost-competitive with fossil fuels.

Subsidies

Subsidies are transfer payments from governments to business interests and individuals. Governments have been involved in the subsidizing of energy since the early part of the twentieth century. For democratic governments, subsidies have been often used as a means to buy votes, and for authoritarian governments, as an important means of placating the masses. Price supports for ethanol, tax credits for renewable energy, depletion allowances for oil and gas production, and grants for energy conservation measures for low income families fit the narrow definition of energy subsidies. But if subsidies are considered in a broader context, trade barriers, regulations, and U.S. military spending to ensure the flow of oil from the Persian Gulf can be considered subsidies as well.

Regulation

Regulations are rules set by governments to protect consumers and to control or direct conduct in the marketplace. Production, transportation, consumption, and prices have all been affected by energy regulations.

Allocation control regulations affecting oil prices were issued in the 1970s in response to what was perceived as a number of market inefficiencies. The primary motivation was fairness to low-income individuals and families, yet price controls ended up exacerbating the inefficiencies—worsening the problem it was supposed to solve. Since prices convey critical information to buyers and sellers of energy, government intervention that tries to alter the message can distort market signals so that everyone ultimately ends up less satisfied. Price controls send the wrong signal by artificially stimulating consumption (more demand at a lower price) and reducing the quantity supplied (producers are willing to produce less at the lower price).

The most-well known energy regulations are probably the ones covering the production, transmission, and distribution of electricity and natural gas. To avoid the inefficiency of having multiple electric cables or gas lines run down each street and into every home, in the past governments awarded the right to serve an area to one firm—a "natural monopoly." Unlike most countries, where the government owns and operates electric and gas monopolies, in the United States most of the power industry remains privately-owned and the government regulates it by setting prices, the amount that can be earned, and the quality of service provided. Although Congress develops legislation that authorizes regulation, identifying and enforcing of the rules for specific cases are carried out by the Federal Energy Regulatory Commission and state public service commissions.

Criticism of the way public utility monopolies have been regulated usually centers around the builtin biases that may be favorable to the utility and the customer but are also socially undesirable. Electric utility regulation was structured so that companies earned more by building more facilities, selling more power, encouraging consumption, and discouraging conservation. In the late 1970s and early 1980s, states instituted demand-side management programs that attempted to shift the incentive away from consumption to conservation.

In the late 1970s, public policies began to focus on opening up power generation markets so that non-utility generators and independent power producers could have access to transmission systems and electricity markets. By the early 1990s, much more aggressive public policies were being considered and adopted. These public policies envisioned giving customers in all customer classes the opportunity to select their electricity suppliers. It was recognized that allowing customer choice would require not only providing open access to transmission systems but also the total "unbundling" of power production from power delivery and customer service functions to prevent discriminatory transactions and self dealing.

While unbundling was seen as a necessary step for deregulation, utility companies pointed out that unbundling could create "stranded assets." The creation of stranded assets could be devastating to those utility companies that had made investments in nuclear power plants and other assets that would be uneconomic or unable to compete in open markets. To address the stranded assets issue, government intervention sought to create transition plans elevating rates above market values and allowing the recovery of stranded costs. In the longer term, it is likely that many electric power marketers will be buying power from many different electricity producers, and then turning around and selling the power to industry, business and the residential customers.

"Cross subsidies" have traditionally been used in establishing rates. Industrial customers pay a higher rate for their electricity than residential customers and, in effect, subsidize the power supply for residential customers. In a different context, "cross subsidies" can be created to select power generation technologies based on their environmental impact. There is political pressure from the environmental interest groups to include ratepayer cross-subsidies so that the less desirable power generation technologies (e.g., coal-fired steam turbines) subsidize the more desirable power generation technologies (e.g., wind turbines). This is being considered as part of the deregulation process. Pollution costs fall largely on third parties. In the case of fossil fuel electric power plants, only a small fraction of air pollution costs are borne by the beneficiaries of the power production. Proponents view cross subsidies as an effective way to raise the cost of fossil fuel energy production, lower the cost of renewable energy, and support energy efficiency and conservation programs. Programs like "Plant a tree whenever you build a new fossil fuel power plant" are, in effect, cross subsidy programs because they balance environmental objectives with economic objectives in power generation planning.

Compared to regulation, cross subsidies are a more market-based approach for discouraging air pollution emissions from energy production. Economists generally agree that economic approaches to pollution control (taxes, subsidies, pollution allowances, and trading programs) have been far more efficient and equitable solutions than "command and control" approaches to regulations that have mandated specific emission levels and specific technology.

Since there is an environmental impact with almost all energy production, environmental regulations and policy are indirectly having a greater impact on the energy industry than direct energy policy. Clean air regulations continue to make it more expensive to burn fossil fuels, especially coal; clean water regulations present expensive challenges for the transportation (oil tankers) and storage (underground fuel tanks) of petroleum products; carbon dioxide reduction policies to prevent global warming favor the growth of renewable energy over fossil fuels.

Safety is another major regulatory area. The Occupational Safety and Health Administration (OSHA) enforces many worker safety regulations covering the operation of refineries and electric power plants, and the Nuclear Regulatory Commission oversees the regulations ensuring the safety of nuclear power plants. There are also numerous safety regulations covering the operations of oil and natural gas pipelines and oil tankers. These protective programs have unquestionably provided major social benefits. However, critics contend that these programs have gone too far, have been too expensive, and have placed too much emphasis on government as the interpreter of safety.

When regulation fails to achieve the intended objective, the question arises of whether it was a failure solely of administration or of theory too. If advocates of regulation can prove failure to be largely administrative, it is easier to make the case for new regulations under improved administration.

Information

There have been considerable efforts made at moral persuasion aimed at the social conscience to convince those involved in high consumption behavior to behave more responsibly. During the 1970s, the United States government embarked on a campaign to persuade the public to conserve energy by, among other things, driving 55 mph, keeping car tires inflated, and turning down thermostats in buildings to 65 degrees. In the 1980s, energy use appliance labels were mandated so that rational consumers could compare the efficiency of models and purchase the more energy efficient models. (This was followed by Energy Star Labeling, a joint action of the EPA and DOE in the 1990s that recognizes products such as computers or windows that meet a given energy efficiency standard. Early in the twenty-first century, an emerging target of moral persuasion is the sports utility vehicles (SUV). Compared to the average automobile, the average SUV consumes about 30 percent more fuel per mile and generates more air pollutants and far greater carbon dioxide emissions. The message is that it is unpatriotic to purchase these energy-guzzling, high-emission vehicles. The combination of moral persuasion and the reclassification of SUVs as automobiles (to meet the tougher emission and Corporate Average Fuel Economy standard for automobiles) could be an effective means of curtailing SUV purchases.

Moral persuasion has been most effective in times of short-term emergencies, like the energy shortages of the 1970s, but is far less effective in the long-term and for problems not universally viewed as problems. The benefits of such efforts are the speed, the inexpensiveness of the approach, and the implicit threat behind the effort: stop the undesirable activity by choice or society will take direct measures to curtail it.

Research and development

Europe, Russia, Japan, and the United States have spent billions for energy research and development since the 1970s. The United States alone spent over $60 billion from 1978 to 1996. Nations liberally spend on energy research to try to expand supply options, to develop indigenous resources for national security reasons, and to speed invention and innovation that will benefit society. When the energy research and development budget was significantly boosted in the mid-1970s, the hope was that nuclear fusion, solar energy and other renewable energy sources could develop into the primary energy sources of the next century. But because there have been no major breakthroughs, and fossil fuels have remained relatively inexpensive, renewables' share of energy production has actually fallen. Fossil fuels research and development have shown better results: cleaner transportation fuels and vehicles, more efficient natural gas turbines, and the clean coal program, which raised efficiency and reduced the harmful emissions from coal burning power plants. Largely because of the disappointing overall results of federal spending on energy research and development—the poor track record of picking winners, the inequitable funding based more on politics than scientific merit, and the draining of research and development capital away from the private sector—the amount of money spent on energy R&D has been falling throughout the 1980s and 1990s as a percent of total U.S. research and development. It is uncertain whether this trend will continue. Many energy experts still advocate government spending because industrial goals are usually short-term and do not necessarily reflect national goals such as energy security and environmental quality.

THE NEXT ENERGY CRISIS

Historically government intervention has been primarily crisis-driven. During the Energy Crisis of the 1970s, it was easy for government leaders to gather popular support for government policies that subsidized alternative energy sources (boosting supply) and promised to lower the price of energy. Yet once the crisis passed, gathering support for new initiatives became much more difficult. That is largely why there have been only minor new energy initiatives since the end of the Carter Administration in 1980.

Freer and more diverse world energy markets make another major energy crisis less likely. If one does occur, it is likely to again trigger strong cries for government action. But because of the valuable economic lessons learned from government actions in the 1970s, any crisis-related intervention should achieve better results; the ineffective and harmful mistakes of the past are unlikely to be repeated. Moreover, because the total value of crude oil to the economy is much smaller, any oil supply disruption is unlikely to be as severe for the American economy as the oil price hikes of 1973 and 1979. The economy can more easily substitute coal and natural gas for petroleum, and the very energy-dependent industries like aluminum, steel and petrochemicals have grown more slowly and make up a smaller share of the economy than high growth industries like pharmaceuticals, computer technology and the service economy.

John Zumerchik

See also: Appliances; Behavior; Capital Investment Decisions; Demand-Side Management; Efficiency of Energy Use, Economic Concerns and; Efficiency of Energy Use, Labeling of; Environmental Economics; Environmental Problems and Energy Use; Government Agencies; Green Energy; Market Imperfections; National Energy Laboratories; Property Rights; Regulation and Rates for Electricity; Subsidies and Energy Costs; Taxation of Energy; True Energy Costs

BIBLIOGRAPHY

Asch, P., and Seneca, R. S. (1988). Government and the Marketplace. Fort Worth, TX: HBJ School.

Bradley, R. L. (1996). Oil, Gas and Government. Lanham, MD: Rowman & Littlefield Publishers, Inc.

Yergin, D., and Stanislaw, J. (Contributor) (1998). The Commanding Heights: The Battle Between Government and the Marketplace That Is Remaking the Modern World. New York: Simon & Schuster.

Weidenbaum, M. L. (1995). Business and Government in the Global Marketplace. Englewood Cliffs, NJ: Prentice-Hall, Inc.

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Government and the Energy Marketplace