Honey Lake’s giving us a new way to do what we do best: take energy that would otherwise be wasted and convert it into clean power and processed steam, i.e., recycling energy. Whether recycling heat that would otherwise be thrown away at a metals plant or recycling biomass waste that would clog landfills, the principal is the same.

We’re going to put our capital and our team’s extensive clean energy expertise to work enhancing the plant’s efficiency and production. These enhancements could reduce California CO2 emissions by 44,000 metric tons per year. That’s the equivalent of taking more than 8,000 cars off the road. Sweet.

As RED’s own Sean Casten pointed out at the Environmental Law & Policy Center’s recent forum on Chicago’s clean energy economy, the Windy City is home to several energy recycling companies. It also boasts numerous research institutions and associations focused on this kind of clean energy, including the Energy Resources Center at the University of Illinois at Chicago and the Midwest CHP Application Center, which coordinates our region’s combined heat and power technologies.

Chicago also has several CHP and waste energy recovery projects nearby. For example, just south of the city, ArcelorMittal Steel’s smelters capture waste energy from their coke ovens and stacks in order to generate about as much electricity as a small coal-fired power plant, all without burning additional fossil fuel or emitting pollution or greenhouse gases.

Chicago as HQ for the leading energy-recycling businesses, research centers and installations makes it a great center for energy innovation.

No wonder we like it here.

A slew of organizations have signed a letter urging Congress to pass bills that would promote energy recycling at industrial facilities. These organizations range from environmentalists to manufacturers to unions to contractors.

What’s this eclectic bunch pushing for? We want investment tax credits to encourage combined heat and power (CHP) and waste energy recovery, probably the best ways to slash greenhouse gas emissions and power costs simultaneously. The specific bills include:

• S. 1639, sponsored by Senators Jeff Bingaman (D-NM) and Olympia Snowe (R-ME)
• H.R. 4144, sponsored by Rep. Jay Inslee (D-WA)
• H.R. 4751, sponsored by Rep. Paul Tonko (D-NY)
• H.R. 4455 sponsored by Representatives Mike Thompson (D-CA) and John Linder (R-GA)

These bills would encourage near-term, shovel-ready projects that will create and maintain thousands of jobs. Moreover, as I pointed out in a recent E&E TV interview, energy costs would fall through increased efficiency. Not bad.

West Virginia Governor Joe Manchin just signed legislation designating recycled energy a renewable source of power within the state’s renewable portfolio standard (RPS). That’s a big deal: it means utilities—which already have to buy a portion of their power from alternative and renewable sources—are now more likely to buy recycled energy from West Virginia manufacturers. The result will be a stronger manufacturing sector, more jobs, and a cleaner environment.

So what’s the takeaway here? It’s this: clean energy is clean energy, and it should be rewarded no matter what form it takes. Wind is clean. Solar is clean. Recycled energy is clean. All of it matters. We can’t be narrow-minded about what pathways to a clean energy economy we’re willing to pursue. If something works, we need to reward it.

West Virginia gets that. Which state is next?

Reality-based thinking may seem novel these days, but it was in abundance at this summit. Our own Tom Casten joined a panel on alternative energies moderated by TIME’s Bryan Walsh. Although Tom’s beat is combined heat and power, improving our world’s energy predicament will require creative solutions from all quarters. It needs them urgently.

American Businesses for Clean Energy (ABCE) launched four months ago with a simple goal: to demonstrate the vast amount of business support that exists for climate change legislation. Already, about 2500 businesses in 41 states have signed onto the initiative.

The lesson is that being pro-planet can also be pro-profit. We can’t have sustainable businesses in an unsustainable world. Even better, we can ensure that slashing greenhouse gas emissions reduces energy costs rather than increasing them. All we need is the creativity and political will to undertake real reform.

With the business community starting to holler, the chances for such reform just got better.

Instead of pointing out the immense barriers to competition and recommending that we tear them down, he suggests that we throw more money at innovation while the current system, presumably, would remain in place. Wrong, wrong, wrong. That’s not going to work — Sean Casten explains why we need to change current energy regulations in a Grist blog.

First, let me define my terms. By “free market”, I’m referring to the market of Econ 101 textbooks: no barriers to entry, no barriers to exit, no one entity can independently affect price, etc. By “mature”, I refer to industries wherein the next investment is unlikely to produce a product with a significantly lower cost structure than the industry average. Finally, by “capital-intensive”, I refer to any industry where the majority of the annual cost goes to capital recovery.

Economists have spent a lot of time figuring out how to structure markets to get as close as possible to that free market ideal. Much of the most interesting work in that vein has been in the design of auctions, especially in the electric sector. A host of models have emerged that seek to drive costs down the marginal cost of the highest-cost supplier necessary to meet supply needs. For the most part, these auctions have been successful. Yes, there are some high-profile screw-ups (see: Enron), but they are the exceptions that prove the rule — the absence of front-page stories on 99.99% of the world’s auctions is a testament to their effectiveness.

But here’s the rub: no one invests capital to cover their operating costs. We invest capital to earn profits in excess of our operating costs. And there are no profits if you’re only covering your marginal production cost. Robert Solow won a Nobel prize for noticing that the presence of profits (and its result: economic growth) is de facto proof of the absence of free markets. Solow’s conclusion was that the persistence of economic growth must therefore result from technological innovation. So long as opportunities exist for technological advance that allow one to produce widgets at a discount to the market clearing price, companies will make those investments, capture profits and reinvest in further growth.

But what happens when those opportunities don’t exist anymore? When’s the last time someone built a new integrated steel mill in response to a free-market price signal? Oil refinery? Cement plant? Might the deindustrialization of the United States result in part from an economic model that drove prices for manufactured goods down to their marginal cost once those industries reached maturity?

Moreover, as we look for places where we have invested in large capital projects in mature industries, a consistent feature emerges of heavy subsidization and distortion of free market principles. China has invested in basic infrastructure by government mandate. Regulated utilities build power plants on the back of rate-payer guarantees and monopoly franchises. Wind turbines have been built in response to technology-specific tax incentives and RPS mandates.

This becomes problematic when we look at what we are currently expecting markets to do. We have designed electric capacity markets to clear at the marginal cost of capacity services, but expect them to bring new investment forward. Greenhouse gas cap & trade markets will fail utterly if they fail to incentivize investments in CO2 reduction…but they too are being set up within the framework of auctions and marginal clearing prices. Market purists fall back on just-so stories when confronted with these failures, noting that the lack of investment in response to these markets suggests nothing more than that the investment wasn’t needed. Maybe they’re right. But if they’re wrong, we’re in dangerous waters — and since the economic theory upon which these markets are based is supposed to drive price down to the margin, why should we expect it to induce new investment?

This isn’t to suggest that we all turn socialist, but simply that we acknowledge the limitations of the tool. Markets structured to drive costs down to the margin are great at rationalizing production and forcing discipline on business managers. But asking them to also encourage new investment may be like trying to catch a deer with a fishing pole. In cases where new investment is needed — as is most obviously the case with any effective GHG regulation — we may need more tools.

Read more of Sean’s thoughts on markets and capital investment.

Hayward and the Journal seem to fear economic change.  Power plants, he argues, are long-lasting assets, “so a rapid switch to new technology will mean retiring assets before their useful life is over and diverting trillions in capital from other sectors.”  Yet do Hayward and the Journal lament the music-box factories made obsolescent by Steve Jobs’ tinkering?  According to Casten:  If old, dirty power plants are obsolete, “let ‘em die.  That’s how markets work.  And if they’ve been allowed to forestall obsolescence simply because they got a free pass on their environmental impacts … well then markets weren’t allowed to work.”

Sean also challenges Hayward’s assumption that you can’t reduce emissions without producing less energy.  Such a claim, says Sean, “requires the ratio of energy-in/energy-out to be forever fixed.  Says who?  Have we reached such degrees of societal perfection that we will never be able to increase our energy efficiency?  If so, someone please arrest the entire population of Denmark for so consistently and egregiously violating the laws of thermodynamics (they currently consume about half the fossil fuel of the U.S. per dollar of GDP).”

Now consider that you are a legislator trying to reduce CO2 emissions as quickly and as cheaply as possible. Should you bother putting a price on pollution to discourage its release? Noting the extreme rarity of “perfect markets” and the recent spate of financial scandals, should you not instead conclude that using markets as a policy tool is a waste of time?

The two questions are logically equivalent. Like training, markets do not guarantee perfection. But just as you can’t win unless you train, you cannot identify the lowest cost solutions to any given challenge without markets.

This point is too often lost in our public debate, which is framed as an argument between two equally illogical positions. One side argues for small-government policies on the tenuous basis that anything done by government can be better done by market forces in the guise of profit-seeking companies. The other side argues for big government on the grounds that only an enlightened regulator can ensure the public welfare. The one point of agreement between these extremes is that economic theory stipulates the existence of perfect markets (their dispute is over whether or not the purported theory is correct.) But that’s not what the theory says. It is like arguing whether the best way to run faster is to do nothing but push-ups or consume nothing but steroids.

The problem comes from a confusion of terms. Profit-seeking behavior, markets and efficient capital allocation are not synonymous, and the presence of one does not guarantee the presence of the others.

A “market”, after all is nothing more than a collective allocation their resources. Economists refer to markets as being efficient only when they meet a specific set of conditions, at which point the benefits that accrue from Adam Smith’s invisible hand are realized through the independent actions of profit-seeking actors. But most markets are inefficient – often woefully so. Effective regulatory processes can make markets more efficient – but regulatory processes that seek to bypass market forces will serve only to increase the inefficiency of the markets that remain.

What Economic Theory Actually Says About Markets

Basic economic theory says that price is a function only of supply and demand, and therefore is a perfect reflection of all of the information affecting both sides of that equation: production costs, consumer preferences, future availability of raw materials, competing options, possible changes in regulation, and so on. To the extent that this price-omnipotence is obtained, markets for the good/service in question are completely free to optimally allocate their scarce resources: money flows to its best use, labor is perfectly matched to the talents and demands of the community and natural resources are precisely consumed in careful consideration of both their present and future values.

Assuming perfection makes for easy choices. Adonis didn’t have to worry about changes to his diet, exercise routine, fashion sense or hairstyle since knew that any change to his perfect form would, by definition, render him imperfect. Many regulators and journalists fall into this same Adonis-trap when discussing markets. Any policy change intended to encourage different behaviors is dismissed as a step towards imperfection – and any unsuccessful business/technology is not worthy of regulatory support since “if it’s such a good idea, our perfect markets would have already done it.”

But here’s the rub: economic theory does not claim that markets are perfect. It simply explains how capital would be allocated if they were. As proof, look no further than the Nobel committee:

• Robert Solow won the Nobel in 1987 in part for making the observation that economic theory implies that prices will always be driven down to the marginal cost of production. If this occurred, corporate profits, the reinvestment of those profits and ultimately economic growth would be mathematically impossible. Solow’s insight was that this persistent “impossibility” exists in part due to technological progress. But note the implication: the presence of economic growth implies the absence of perfect markets.
• Daniel Kahneman and Vernon Smith shared the 2002 Nobel for their work in behavioral economics. They showed (among other things) that prices depend significantly on context rather than fundamentals of supply and demand, and thus the “signal” that price sends to the market is often incompatible with that required for efficient capital allocation.* Again, note the implication: perfect markets may incompatible with the way the human brain works.

*(An example: would you go 10 minutes out of your way to save $20 on a $100 piece of furniture? Would you also go 10 minutes out of your way to save $20 on a $20,000 car? If you answered yes to the first but no to the second, you have demonstrated economic irrationality by “charging” for your time based on variables other than supply, demand and your marginal cost. Shame on you!)

So why does the perfect market theory persist? Two reasons:

1. It’s a useful approximation tool. Knowing how to calculate the area of a circle is helpful, even if there are very few naturally-occurring perfect circles. Similarly, there are many markets (commodities being an obvious example) where actual behavior can be very nearly approximated and understood with perfect market theory.
2. It’s a useful policy tool. If we understand the conditions that allow a perfect market to exist, we are better able to craft policies that will reap its rewards.

For policy purposes, this latter point is critically important. Recall Solow’s insight that perfect markets are incompatible with profits. That is understood at a gut-level by every business owner who has seen competition drive down their margins – which is why businesses seek to make their markets as imperfect as possible. In turn, we have created regulatory agencies (like the SEC) to counter-balance. That is a healthy tension, and a good model for well-informed policy: don’t simplify markets as pure good or pure bad, but rather seek to create conditions that facilitate efficient markets.

So what are the conditions under which “perfect” markets exist?

1. There are no barriers to entry and exit.
2. No single entity can independently act to control price.
3. Markets consist of many buyers and many sellers.
4. There is perfect information; all prices up and down the value chain are fully known to all buyers and sellers.
5. All sellers seek to maximize their profits.
6. The good/service traded in the market is perfectly homogeneous, such that there is no differentiation (other than price) between competing suppliers.

It’s pretty easy to identify imperfect markets with from this list. Want to find a barrier to entry? Try to start a new car company tomorrow. Barrier to exit? Try to sell your house. Imperfect information? Look no further than Bernie Madoff. But it’s also easy to use this list to guide good policy that will steer markets towards perfection.

Policy Consequences for CO2 regulation

So let’s return to the question posed at the start. If you are a legislator seeking to craft policies to reduce CO2 emissions, how should you approach the problem?

1. Avoid polemicists. Do not assume that price alone is sufficient to drive market behavior, but do not discount the tremendous power of markets to provide least-cost solutions to complex problems.
2. Maximize market participation. Exempting sectors from participation in CO2 markets permanently or temporarily (e.g., through a phase-in) increases the likelihood that individual actors will be able to control price to their advantage.
3. Craft rules to ensure price consistency. The cost of a ton of emissions release ought to be identical to the revenue received for a ton of emissions reduction. The cost a ton of CO2 imposes on our climate is independent of the location or corporate structure of the source; its price shouldn’t either.
4. Maintain robust market oversight. The lesson to take from the California power crisis is not that markets don’t work, but that markets can fail when large players can independently affect the supply/price of a given commodity. Trade watchdogs will be no less critical for emerging CO2 markets.