It is a waste of effort to construct pathways to 2050 mapping out the deployment of existing low-carbon technologies. There is no feasible plan, based on known technology, that gives us the assurance that the UK’s 80 per cent carbon emissions reduction target will be met.
So if planning does not work, what does? We need to muster all of human ingenuity. Companies, individuals, universities and local communities all have to be given the opportunity for profitable innovation. Profits are not good and they are not bad – they are simply a great motivator.
There are two different approaches to harnessing innovation: we can either aim to prescribe the outcomes of profitable innovation or set the rules by which such innovation is conducted. This distinction between trying to set rules and trying to set outcomes is fundamental. It will drive the extent to which any given policymaker, regulator, non-governmental organisation or observer will advocate markets over targets.
Effective markets are adaptive social institutions that harness competition. The big strength of competition lies in its ability to allow new and economically valuable information to emerge and to be effectively used. Markets also have strong self-regulating features: bad ideas fail; companies that are unable to innovate and compete on price and product go under; and lazy incumbents are spurred into action.
Exactly because an effectively working market harnesses all of human ingenuity in response to the incentives it sets, we cannot know what its outcome will be. What we do know is that it will be the sum total of the endeavour of all the market participants and it will be better than any one of them could have achieved, better than any central planner could ever imagine today.
To make matters concrete: to reduce carbon emissions, we can adapt market rules to put a cost on carbon. If necessary, rules can be applied to enhance the effectiveness of competition. It is crucial to get these initial market rules and incentives right. But once an effective market is in place, leave it to human inventiveness to discern how exactly carbon emissions are reduced. The European Union Emissions Trading System (EU ETS) essentially takes this route.
The alternative approach is to try to prescribe the steps that lead to carbon reductions – to determine the outcome of the innovation and competitive process between market participants. Setting a renewable energy target and trying to ration air travel are examples of this latter approach.
There are some who argue that there is no time to wait for the outcomes of innovation, that the UK should take radical, prescriptive action now and hope others will follow. The danger with this is that we could lock into sub-optimal technology paths and approaches and in so doing incur greater costs on society than would have been the case if we had greater confidence in innovation.
Trying to prescribe outcomes also tends to create significant government involvement. It refocuses market participants’ minds from innovation to rent-seeking from government, and substitutes the risk of market failure with the risk of government failure. Moreover, if the UK takes unilateral action and the public sees that British citizens and industry are suffering costs and restrictions that other nations are not, will only serve to hasten the likely loss of public support.
The UK has an admirable track record for innovation and for building robust legal, regulatory and social institutions that support effective market functioning. The EU ETS is a market-based approach and if anyone can contribute to its success, it is the UK. We should ask how we can make market-based approaches to carbon reduction work more effectively.
Both the Commission and member states have contributed to weakening the impact of the EU ETS, usually through green policies and overlapping policy development. Examples include the UK carbon price floor, renewable energy targets, nuclear energy and coal policies aimed at supporting national champions, the Energy Efficiency Directive and others. Taken together, these measures either directly depress the carbon price, or increase the extent to which there is an over-allocation of allowances.
It is crucial that the EU ETS Phase III has a tighter cap. We should also consider the impacts of an auction reserve price. The functioning of the EU ETS can be improved – the carbon market is distorted and related markets are frequently insufficiently competitive or are excessively politicised.
Carbon pricing can increase energy costs and incentivise the reduction of energy consumption, and hence reduce carbon emissions. It is a necessary condition for decarbonisation, but not a sufficient one. Energy prices are very good at incentivising efficient choices between existing alternatives. The problem is that creating new alternatives is usually expensive (at least up front) and the price increases required to incentivise them might not be socially or commercially acceptable. There is an additional need for government policies that create demand for low-carbon innovation and help its diffusion, while ensuring that the measures taken facilitate and enhance competitive processes rather than replace them.
A good example of innovation and competition-enhancing measures are appropriately-designed regulatory and product standards – for instance, the innovation effects of the ban on old-fashioned light bulbs. Governments also have an important role to play in creating demand for innovative products through their own purchasing policies.
Governments can also take steps to remove obstacles to innovation and support low-carbon research and development directly where needed. For example, in a climate of capital constraints and high levels of risk aversion, governments might make available finance in co-investment vehicles that effectively act as venture capital seed money for early stage research and development.
The EU ETS is far from perfect, and price signals on their own are not sufficient to ensure that low-carbon innovation is rewarded. There is still some market failure and some policy failure to be tackled. But addressing these is far more preferable than central planning.
Enese Lieb-Doczy is an economist in LCP’s energy, utilities and regulated industries service. The views expressed in this article are those of the author and not necessarily those of LCP as a firm.
This article first appeared in Utility Week’s print edition of 20 April 2012.
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