Loading the Dice

A lengthy comment posted by a reader over the weekend reminded me of the extreme range of our energy policy options. While growing concerns about energy security and climate change are generating strong interest in energy-saving technology, higher CAFE standards, and government incentives to promote alternative fuels, some people believe that our problems are so severe that only mandates will answer. Businesses and consumers must be forced to switch to renewable energy sources and employ the latest efficiency measures, or suffer penalties. In light of our modest response to the last three years of high energy prices, I can appreciate the frustration that gives rise to such notions. However, in the absence of World War II-style consensus and resolve, this sort of approach is unthinkable. Nor would it be desirable, because of the gross inefficiencies that central planning invariably causes. The challenge for the administration and the new Congress is to find an effective approach somewhere between the poles of laissez-faire reliance on the market and command-and-control mandates, to accelerate the decarbonization of energy and the decoupling of energy consumption and economic growth.

This is a bitter pill for those, like me, with a strong market orientation. When it comes to rationing a shortage of supply or choosing which new technology should be adopted, the market has a much better track record than government intervention. But the market alone isn't going to provide the clear, consistent signals we need to reduce our dependence on imported oil, and on fossil fuels in general, in time to avert an economic or climatic disaster down the road. The lead times are too long, and the market too fickle. Anyone doubting the latter has only to look at the behavior of the long end of the oil futures market last year.

During 2006 the futures price of West Texas Intermediate crude for prompt delivery ranged from a low of $56/barrel to a high of $77. That was an entirely understandable reflection of current fundamentals and risks. But during that same period, the price for delivery in December 2012 bounced around from under $60 to over $70, closing at $62 last week. This behavior probably had more to do with trading strategies for inter-period price differentials than with any underlying change in supply and demand or risk. Companies planning alternative energy projects that rely on oil prices being over $60 in four or five years must be getting a little nervous. Are we on the verge of another catastrophic oil price decline, such as we saw in the mid-1980s or late 1990s? Or is this just the short-term over-reaction of a market driven by speculation? In any case, the "true" future oil price hasn't changed; what has changed is the market's view of it, and those are not the same things at all.

If the country can agree that we have two big energy-related problems, the solutions to which require a reduction in our national energy intensity, especially for oil, and that the market alone won't get us there, then we need an approach that works with the market, amplifying its weak signals and providing alternative energy investors with greater confidence in their outcomes than a volatile, unpredictable commodity market can. We have a broad menu of choices available to do just that, ranging from carbon cap-and-trade, carbon taxes, investment tax credits for R&D and infrastructure construction, consumer tax credits for efficient cars, appliances or light bulbs, increased gasoline taxes, electricity taxes, and a host of other ideas that are circulating around Washington.

As intrusive as many of these proposals may seem to market purists, they are still a far cry from the kind of mandates my reader suggested. But those who can't bring themselves to consider any of the policy tools listed above should understand clearly that inaction--total reliance on the market to tell us when and whether to change--stands a good chance of leading us into a world in which the time for working with the market will have passed, and only draconian measures will be effective--or popular.