Markets, Not Government, Should Determine Energy Prices

The following is IER’s response to the National Journal Energy Insiders question, “Is the (Energy) Price Right?“

Especially since the breakup of the Soviet Union, Western intellectuals and government officials have acknowledged the flaws in top-down central planning, and have paid lip service to the wonders of a decentralized market process in determining prices and the allocation of resources. Yet as our recent policy debates illustrate, the central planner mentality is alive and well in the corridors of power, especially in the energy sector. Hardly a day goes by without some new proposal to tax, regulate, mandate, and otherwise coerce American producers and consumers to alter their energy choices. Yet the urge to tinker is as harmful here as in other areas of the economy: The proper energy prices should be set through competition in a free market, not by government edict.

The specific rationale for overriding the market outcome in energy markets has changed over time. Back in the 1970s, the claim was that the United States was on the verge of depleting its domestic petroleum resources, and hence the urgent need to ration usage and develop alternatives. Now that the United States is poised to lead the world in natural gas and oil production, that particular rationale is impotent. But don’t worry, proponents of government intervention are very creative; they will always come up with another good reason.

Lately, the rationale has been anthropogenic global warming. In terms of textbook economic theory, markets work great unless there is a “negative externality”—in this case, greenhouse gas emissions that impose harms on future generations. Intuitively, the claim is that energy derived from CO2-intensive sources has a price that is too low, because it doesn’t reflect all of these harms. Levying a carbon tax or other measures is supposed to lead people in the market to “internalize the externality,” so that markets can get on with their great work in efficiently allocating resources.

That’s the theory, but there are several fundamental problems with this type of argument. First, even on purely theoretical grounds, the calculation of the “social cost of carbon” (SCC)—which is needed to calibrate a carbon tax or other restrictive measures—is a very dubious enterprise. For example, the SCC is highly sensitive to assumptions about the proper discount rate. The recent Working Group report estimated a 2010 SCC at $11/ton using a 5% discount rate, but $52/ton using a 2.5% rate. That is an enormous range, almost a fivefold increase, just from adjusting the dial on the discount rate we use in the calculation.

But the problems are worse than just extreme sensitivity to mild adjustments in parameters. A recent peer-reviewed article from an expert MIT economist was absolutely scathing in its assessment of the “Integrated Assessment Models” used to calculated the social cost of carbon. The author, Robert Pindyck, has the following to say about the climate change “damage functions” in the three computer models used by the Obama Administration’s Working Group to generate the latest round of SCC estimates:

[The] loss function [in the DICE model] is [not] based on any economic (or other) theory. Nor are the loss functions that appear in other IAMs [Integrated Assessment Models]. They are just arbitrary functions, made up to describe how GDP goes down when T [temperature] goes up.

The loss functions in PAGE and FUND, the other two models used by the Interagency Working Group, are more complex but equally arbitrary…[T]here is no pretense that the equations are based on any theory. [Robert Pindyck, “Climate Change Policy: What Do the Models Tell Us?,” p. 11.]

So we see that there are very serious problems with the calculations of the “negative externality” from greenhouse gas emissions. But now we hit a second problem: Even if we accept the claim that markets underprice energy, that doesn’t mean the government would be justified in imposing even more restrictions.

U.S. energy markets are already flooded with gasoline taxes, CAFE standards, power plant regulations, and various other measures designed to penalize CO2-intensive fuels. At the same time, so-called “green” energy sources have received lavish subsidies and mandates to encourage their use. As a result, the government is already heavily tilting the field away from CO2-intensive fuels. When you count the implicit cost to the consumers from these various measures, the final price of energy is already far higher than it would be in a truly free market. I have yet to see a study quantifying the implicit “carbon price” embedded in these other regulations, to see how much lower a new carbon tax ought to be.

Instead, the argument is always to throw on yet more regulations, as if we’re starting from a laissez-faire blank slate.

As both economic theory and history attest, government officials and scientific “experts” do not possess the wisdom or the incentives to plan an economy. The price of energy—just like the price of food and clothing—should be determined in a competitive marketplace, free from political interference.

IER President Thomas Pyle authored this post.