Modern economic theory provides a succinct description of the conditions under which the price system produces optimal outcomes in an idealized "laissez-faire" economy of perfectly competitive markets. This is the "First Welfare Theorem"; any competitive equilibrium is "Pareto optimal" (i.e., no agent in the economy can have his or her well-being increased except at the expense of another agent). Against this benchmark, the theory describes conditions under which policy interventions can, in principle, improve upon the performance of the unregulated market system. The possibility of such improvement arises from the existence of market "failures" or "imperfections," which are factors in or features of particular markets that cause private decision-making to produce less-than-optimal economic outcomes.
Historically, the key imperfection in energy markets was thought to be "economies of scale," or "declining average costs," in electric power generation. This means simply that this was the kind of industry where a single firm's costs of producing power would fall as its output was increased. Under this condition, unregulated market equilibrium with more than one competing firm would not result in economic efficiency, specifically the provision of power at minimum cost. Instead, power generation was a "natural monopoly"—a single firm could produce at lowest cost (in a given geographic area). This feature of power generation was the motivation for the U.S. system of privately owned, publicly regulated power companies, granted an exclusive license within a given service area with rates set by regulators. In the past several decades, however, technological change in electric power generation has resulted in a loss of economies of scale sufficient to motivate the deregulation or "restructuring" of this industry into a competitive form.
Currently, a different feature of energy markets having to do with the use of fossil fuels in energy production is recognized as entailing market failure. Among the assumptions required for the efficiency of competitive markets are that all commodities be both "rival" and "excludable." A rival commodity is one whose use by one precludes its use by another, while an excludable commodity is one whose production and consumption imposes no "side effects" on anyone not party to direct transactions involving the commodity. The market failures now most commonly ascribed to energy markets arise from the nonrivalry and nonexcludability of certain byproducts of energy consumption and production: so-called "environmental externalities," or side effects that have deleterious effects on health or welfare. Key examples are carbon monoxide emissions from vehicles, sulfur dioxide emissions from electric power generation, and emissions from power generation and from the use of fossil fuels. The creation of these by-products creates costs that are not reflected in market prices for energy products, so that in the absence of regulation or some other policy intervention there are no incentives to control them.
Sulfur dioxide emissions resulting from fossil fuel can have negative effects on urban air quality and create acid rain that harms aquatic life. These emissions are nonexcludable in that there is no private action that a particular individual can take to avoid this impact, and they are nonrival in that their effect on any one individual does not preclude or offset their effect on any other.
Another, more controversial, idea is that there may be market imperfections underlying the "energy-efficiency gap," the long-recognized apparent under-investment by consumers and firms in energy-efficient technology. Beginning in the 1970s, energy analysts used the term "market barrier" to refer to any of the various possible reasons for such under-investment. Since then, there has been some effort to distinguish those "barriers" that constitute market imperfections. Although no consensus has emerged, there is general agreement that the energy-efficiency gap may arise in part from informational problems involved in private investment decisions. It is now widely recognized that the nonrivalry of information can result in market imperfections. To the extent that informational problems impeding optimal energy-efficiency investments are pervasive, the efficiency gap may be seen as another important example of an energy-related market imperfections.
U.S. environmental regulations have for the most part tried to mitigate health and welfare effects from pollution through technological control strategies such as requiring installation of pollution reduction equipment. There has been a gradual increase of interest, however, in analyzing and attempting to correct environmental externalities within the paradigm of market failures or imperfections. In this paradigm, in the presence of market failures the government can under idealized assumptions reallocate resources to make some consumers better off while making none worse off—a "Pareto improvement." However, the recognition that in practice there will always be both winners and losers from a given policy led to the development of a less ambitious notion of the goals of policy. Thus, the focus of cost-benefit analysis is to determine how market failures justify policies in which some are better off, and these winners could in principle compensate the losers and still come out ahead. This is the "compensation principle."
We often think that solving the problem of environmental externalities means eliminating them altogether, but the cost-benefit approach applies a different criterion: emissions should be held to an optimal level, which is less than the unregulated level but in most cases not zero. The threshold is that the marginal damage from emissions should be equated to the marginal cost of abatement. This, in turn, naturally suggests the economic means of controlling emissions: the government should impose taxes or charges on them so that this marginal condition holds. This policy mechanism has been studied extensively as a way of reducing carbon emissions in an effort to mitigate global climate change. An alternative approach is for the government to issue permits to emitters that restrict the overall quantity of emissions; these permits would then be traded among emitters so that, overall, the cost of abatement would be minimized.
Alan H. Sanstad