Free Markets, Energy Policy & The Easter Bunny

President Bush & Economic Adviser

Spoiler alert: Due to the sensitive nature of the following information, if there are small children or economists in the room you may wish to go here or here until privacy can be assured.


I’ve taken part in some discussions lately — and read many more — in which advocates of different energy sources claim that the invisible hand of the Free Market will “pick” the perfect mix for our energy portfolio. Not that this is a new argument. Laissez-faire capitalism was popularized in the 18th Century, i.e. long before Milton Friedman. What’s new is the context: a seismic shift to a “clean energy economy.” The irony, of course, is that this epic shift is required, and fast, because of the worst Free Market disaster in economic history: global climate change caused by the market’s failure to reflect the environmental costs of burning fossil fuels.

Studies of the environmental Costs of Electricity

Click to download document (pdf)

This limitation was addressed in a 1994 report by the Office of Technology Assessment, “Studies of the Environmental Costs of Electricity.” Here’s one key section from the document:

Environmental cost studies often focus on what appears to be the “bottom line” — the monetary value of environmental effects. In many cases, this is the most speculative and controversial aspect of the study, and effects that are not monetized are often ignored. In contrast, focusing on the earlier components of the study (e.g., the emissions and impacts stages) would emphasize aspects that are most amenable to scientific and technical resolution.

Monetization is useful, but its very nature allows the results of environmental cost studies to be reported in a highly aggregated form. This encourages use of the results without the full understanding of the assumptions and values that underlie them. Placing greater emphasis on reporting the results of earlier phases of the analysis (e.g., emissions and impacts assessments), and on clearly explaining the assumptions and values that underlie the estimates of monetary damages, would greatly assist the federal decision makers who may use the studies.

Cap and Regulate

So, how do we solve this self-imposed dilemma? The idea du jour is to tinker with the market to internalize the costs through cap-and-trade or cap-and-dividend or some other variation on the theme. I think advocates are half right. The “cap” side of the equation has to do with science and regulatory policy, both of which should play a far more muscular role than they have.

It’s the “trade” or “dividend” part that worries me, because that route is far more prone to corruption and manipulation. I think the benefits of the free market (without caps) would work best if we start from a position of pragmatism not ideology: regulating energy sources the way we already regulate most other environmental pollution, by setting strict emission levels.

We should continue to get better at internalizing the true costs of energy production. But we need to recognize the limitations of that tool. Which is where I part ways with the ideologues for whom the Free Market is a god to be worshiped rather than an economic arrangement that is valuable but fallible.

In other words: the Free Market is as real as the Easter Bunny — only not as cute.

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