He writes: “The dramatic images of the oil spill in the Gulf of Mexico serve as a stark reminder that America needs to transition to a new clean energy economy… For the last 30 years, I have watched America increase our energy dependence and lose our competitive edge, in part because of a grossly inefficient energy system… Despite its potential to cut energy costs and greenhouse emissions while preserving manufacturing jobs, energy recycling languishes in the U.S. because of outdated and badly misguided energy policies… By enacting meaningful clean energy legislation, the federal government can finally unleash a wave of American innovation, cutting our dependence on fossil fuels while we develop both cleaner and cheaper domestic power.”

Read the full op-ed here.

Photo courtesy of NOAA.

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?

The event is entitled Gray Is the New Green: How Energy Recycling Curbs Both Global Warming and Power Costs. It will take place February 21 at 8:30am in San Diego.

The panelists include several renowned energy experts:

• Tom, who will discuss the economics of clean energy by comparing the costs of 14 clean energy options such as wind, solar, nuclear, and cogeneration. Casten will argue that improving “generation efficiency” has the greatest potential to benefit the economy while reducing greenhouse gas pollution.
• Lester Lave, professor at Carnegie Mellon University and co-director of the Carnegie Mellon Electricity Industry Center. He will report on the work of a committee on energy efficiency that he recently chaired for the National Academy of Sciences. Among other things, Lave will report that the U.S. could bring total energy use back to mid-1980s levels simply through energy efficiency.
• Marilyn Brown, professor at the Georgia Institute of Technology and former leader at Oak Ridge National Laboratory. She will discuss the many policy barriers to energy efficiency and present policy suggestions to help overcome these barriers. Her recommendations will be based on her own research and emphasize the imperative of serving current economic needs without blocking efficiency investments.
• Lawrence Ambs, professor at the University of Massachusetts at Amherst and co-director of the Northeast Regional Combined Heat & Power Application Center. He will serve as the symposium’s discussant, or moderator.

Those who are familiar with RED’s work know the basic contours of Tom’s argument, which is this. The U.S. energy system is grossly inefficient. The typical power plant throws away two-thirds of its energy, largely in the form of waste heat, when producing electricity. This abysmal rate, while tragic, presents an opportunity: increasing the efficiency of our energy system would help enable us to stave off the catastrophic effects of climate change while increasing national income and improving the quality of life.

Tom has never before presented to the AAAS, so this is an exciting opportunity.

Sean Casten writes, “The Waxman-Markey proposal to reduce CO2 emissions by 17 percent over ten years is constrained only by its ambition.”

Cutting CO2 emissions by 20 percent could be realized with our existing assets — by ramping up our nation’s gas-powered electricity generators and ramping down our coal-fired generators.

Read more about how we can shift our electricity production away from a dirty resource to a clean one.

In 2006, CHP produced more than 12 percent of total U.S. power generation. The report calls for high-deployment policies that would generate $234 billion in new investments and create nearly 1 million new highly-skilled, technical jobs throughout the U.S. In this scenario, more than 60 percent of the projected increase in CO2 emissions between now and 2030 would be avoided.

Read more about how CHP can help create jobs and decrease global warming.

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.

Two policy proposals are advanced. A Clean Energy Standard Offer Program (CESOP) would provide clean power at a discount, while output-based pollution credits would keep the government from selecting technology winners and allow clean-energy producers to benefit directly from polluter payments.

While the Climate Change bill is sure to ignite fierce and bloody battles on the Hill, it’s critical not to lose sight of the opportunity it presents. We have a chance to drive innovation and inspire entrepreneurs to move forward with bold plans that can simultaneously lower greenhouse emissions and energy bills.

Read the full article to learn more about how federal laws are currently discouraging simple, proven and available solutions to the greenhouse gas problem.

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.