Free market ideology and practice as a barrier to transitions

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The previous section made the general argument that energy systems experience strong path dependencies. At any moment in time, therefore, an energy system will, inevitably, experience powerful 'lock in' effects that make it difficult to move to a different path when new imperatives, such as the urgency of mitigating climate change, make such transitions necessary. But there are two specific issues that make the transition to a new path even more difficult in the contemporary energy system.

The first stems from the high capital intensity, longevity and fuel specificity of most capital assets in energy systems. This makes the more general phenomenon of lock-in especially acute in energy. A fossil-fired power station will generally have a lifetime of 40 years or more, and once built, cannot easily (or usually at all) be converted to a low carbon fuel use. Likewise, oil and gas exploration facilities are designed to last for decades and by definition can only produce the hydrocarbons near them. It is very expensive to truncate the lives of such investments and replace them prematurely with different kinds of asset of a low carbon nature.

This means that much world fuel use (coal, gas, oil, renewables, nuclear power) in the next 20 years and sometimes longer is already determined by investment decisions made over the last decade and more. The implication is that the world is not only locked in at the present moment to a high carbon system, it also means that much of the lock-in effect will persist for decades to come - even if it were possible from tomorrow to start down a radically new path. Equally, from a contemporary policy perspective, investment decisions made in the next decade will have a locking effect over decades to come, and it is therefore important to ensure they are consistent with a low carbon future.

This leads into the second issue that makes the path dependency issue more problematic - the effects of 'free market' ideology and associated structures, especially investment structures. Much discussion of free market ideology and its impact is abstract. To make it more concrete here, the real world example of future electricity generating investment is pursued to illustrate the problem. The IEA estimates that worldwide investment worth more than $11 trillion will be needed between 2005 and 2030 in the electricity system to keep up with the effects of old plant retirement and new demand (IEA, 2006c, p. 40). Even if this number is on the high side (energy efficiency might well reduce it somewhat) there is no doubt that much investment is needed.

In the UK, environmental restrictions on coal-fired power, the need to decommission most of the existing nuclear reactor stock and the probable need to cater for even modest demand growth means that investment in new capacity of at least 20,000 megawatts (MW) will be needed by 2020 (DTI, 2007a, p. 129), equivalent to some 25 per cent of all current capacity. The bill is uncertain and depends on technology choices but will conservatively amount to £15 billion and possibly much more. The choice of fuel for these new power stations will heavily condition electricity sector carbon emissions until mid-century - the time by which the UK aims for an absolute carbon emission cut of 60 per cent. To have any hope of getting near such an aspiration, new electricity generating capacity must be very low carbon. The possible outcomes are discussed later in this chapter after considering the ideological inheritance and its practical effects.

Starting in the Anglo-Saxon world in the 1980s there has been a major change in the way that economic systems have been organised, and nowhere has this been more fundamental than in the energy system. Between 1945 and the 1980s the 'mixed economy' dominated. Most of manufacturing and services were privately owned and operated in more or less competitive markets, while the energy and utility sectors (gas, electricity, sometimes coal, telecoms, as well as postal services and airlines) were monopolies - either in state ownership or privately owned but with close price regulation from state agencies. While these monopolistic sectors were responsible for a quite small proportion of total economic output, they accounted - as highly capital-intensive industries - for a much higher share of total investment.

From the 1980s onwards the mixed economy was fundamentally challenged. The exact agenda evolved and varied from country to country, but in the UK it involved a powerful ideological commitment to placing as much economic activity as possible into private ownership and then promoting vigorous competition where monopoly had previously ruled (Surrey, 1996). This was based on an idea of the failure of the state in economic life, and a conviction that private markets inevitably made better and, above all, more economically efficient decisions than governments. This was a radical agenda, effectively pursued by UK Conservative governments and largely continued by Labour governments after 1997. In the UK there is now no significant state ownership of energy assets left, and the consequence is that all investment decisions in energy are taken by private investors.

In its own terms - and as long as economic efficiency, pursued by private profit-seeking, was the primary objective - this shake-up has had substantial success. Existing assets have been well 'sweated' and stimulated by often quite effective revenue-based regulation and many costs have been squeezed out of the energy system (Helm, 2004a). As a system to optimise the use of existing assets, privatisation-with-liberalisation (private ownership plus competition) has worked well. But as argued below, when large-scale investment is needed, and in addition it becomes necessary to add pressing new social objectives to those of economic efficiency (notably climate change), commitment to competitive markets as a cornerstone of policy becomes more problematic.

UK governments have been consistently emphatic that competitive markets are the central element in energy policy, even under the new imperatives of climate change and (even more recently) energy security. This belief in 'open', 'efficient', 'transparent' and 'competitive' markets is core to UK policymaking domestically and in terms of advocacy in the wider world (DTI, 2007a). The corollary is that good policies must pass the 'market' test if they are to be effective. In its own terms this is not a bad thing: markets exist, and competition is good for short-term efficiency. So where markets can be made 'good servants' of policy they are undoubtedly useful.

But the emphasis on markets as the almost exclusive delivery vehicles for policy and the notion that governments need to take a hands-off role is excessive. 'Markets' are an abstraction and to say that the 'market is best placed to decide which technologies are most effective' (DTI, 2007a, p. 85, emphasis added) is to infer that markets are capable of free will and conscious action. In the real world, it is not markets that make decisions but entrepreneurs, firms, consumers, citizens, regulators and governments. To ignore the role of concrete actors, with their varying interests and bounded (incomplete) rationality, is to fall into the ideological position of regarding reified 'markets' as possessing wisdom and rationality of a kind that governments always lack.

In the presence of any kind of market power (which is virtually everywhere in the real world of energy, even where competitive forces exist), market structures tend to favour incumbents, who will be well adapted to the existing energy system, with all its inevitably locked-in characteristics. Transitions require the establishment of new technologies and practices, many of which have their origins outside incumbent firms, while existing market structures favour conservatism and slow change (see Chapters 4 and 9).

But even within a dominantly market-based paradigm there are opportunities for governments to effect real changes. In this context it is important to recognise that there are no such things as 'free' markets.

Markets may be competitive but they do not exist in a social or political vacuum - least of all in energy, where political stakes are so high. In the privatisation processes, governments and regulators had to design the markets that replaced the old state monopolies. Market rules may then be deliberately changed, often with significant effect - as for example when the England and Wales electricity market was moved from the old 'Pool' system to a more commodity-imitating market structure known as 'NETA' (Helm, 2004a). Rules for the operation of EU gas and electricity markets are a major issue for all parties and a raft of directives has come from Brussels over the last decade seeking to establish a common framework of rules for these markets.

Governments and regulators can also create markets that did not previously exist, and they can design them to have incentive properties that favour low carbon objectives. The classic case is the rise of emissions trading in the last decade or so, with the EU ETS as the prime example, covered fully in Chapter 11. The EU ETS illustrates both the strengths and weaknesses of markets as instruments of climate change policy. It undoubtedly gives incentives for switching from the use of higher carbon to lower carbon fuel sources within the existing stock of assets. Thus when there is a significant carbon price, utilities have incentives to substitute gas use for coal within the existing portfolio of power stations. But for the longer term, investment behaviour is critical and here the EU ETS does not yet (and may never) give useful incentives. To factor carbon prices into investment decisions, investors need to have a good idea of the likely carbon price at least ten and often twenty years ahead. Without such knowledge, today's carbon prices will have no effect on investment decisions. Chapter 11 makes it clear that while carbon pricing is a necessary condition for a lower carbon future it is far from sufficient.

While markets can therefore be managed and shaped to help low carbon objectives, there are nevertheless, in policy choice, important boundary questions between using markets and engaging in more direct intervention. Smart metering provides a good UK example. Ofgem, the UK gas and electricity markets regulator, has been instrumental in making potentially contested areas firmly subject to a strict competitive, market-based regime. Smart metering is treated in the UK as a matter of individual consumer choice (Ofgem, 2006, pp. 25-9) and the consequence is patchy implementation and a variety of systems. If smart metering were to be redefined as essential infrastructure, to be installed in a universal and well coordinated way (as in Italy), progress towards low carbon objectives would be faster - and in all probability more economically efficient. In these boundary areas between use of markets on the one hand and direct regulation and government intervention on the other, the balance will need to swing towards intervention if rapid enough progress is to be made.

The ideological pre-eminence of markets also has an important impact on the way that public agencies undertake appraisal. Cost-benefit analysis (CBA), under which economic efficiency is the basic criterion, is a valuable tool under some circumstances. It can be adapted to take account of externalities and income distribution (Pearce, 2000) - though in the latter case while necessarily abandoning its claim to discriminate in favour of the most efficient outcome. And of course efficiency matters and CBA can give a useful guide to the relative costs and benefits of different courses of action within the existing market and political contexts.

But energy policy is concerned with climate change, security and access to energy as well as economic efficiency. This makes it vital to develop and use other tools of appraisal than modified CBA. A range of multi-criteria techniques has been developed in recent years, often combined with direct forms of public and stakeholder input in developing and weighting criteria (e.g. Stirling, 2006).

Tools have also been developed that aim to look at 'whole-systems effects' of specific policy or technology decisions, challenging the partial equilibrium basis (one market at a time) of CBA. A good example is the extension of portfolio analysis from finance theory to energy systems (Awerbuch, 2006; Awerbuch et al., 2005: see Chapter 8 for more detail). In most energy and electricity systems renewables are a small component and their stand-alone costs - measured using CBA techniques - are often higher than the costs of dominant fossil fuel technologies. Portfolio approaches can show that the diversifying effect on the risk profile of the system as a whole will often have such a large value that the economic result is that renewables are the best option for new investment, viewed from the perspective of minimising system expected costs. This kind of analysis can be powerful, but finding ways in which it can influence market-based decisions - where the renew-ables investor cannot capture the system-wide benefits - inevitably leads us back to government intervention.

Returning finally to the 20 GW of power stations that the UK needs to invest in over the next decade, the dominant technology likely to be chosen under current market-based conditions (and restrictions on coal-fired emissions) is the gas fired CCGT. Although this technology produces only half the carbon emissions of coal firing per unit of power generated, it will not take the UK electricity system close to the zero carbon state which it must achieve if the overall 60 per cent emission cuts are to be remotely achievable. Why will this choice be predominant? The answer is simple: with no clear way in which carbon savings can yet be privately valued over the long term, and given the dominance of CCGT technology in the existing electricity system, CCGTs will be the cheapest option for private investors. CCGTs will, if built, also reduce the overall system diversity, which - all else equal - will be bad for energy security. At present the UK government does not have any clear notion of how it might be able to prevent or even modify such a result. In 2008 it was even busy preparing to approve a very large new coal-fired station without CCS. Only by seriously modifying its current position - that having set the framework, it will simply wait for the market to know best - can the UK government avoid this result.

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