Energy Security: Why Markets Can Help edit

Feb. 13, 2006

«Energy security, in various interpretations, has become a standing issue on the G8 agenda», says the G8's chair, ahead of the St-Petersburg summit next July. This is indeed quite topical: Recent events have shown that we cannot take for granted that our houses will be correctly heated next winter, that power supply will not be rationed or that petrol stations will be open. To name but a few: when hurricane Katrina devastated some of the largest US refineries, European and Asian refiners were not able to compensate the loss of supply, thus, shortages happened; when Gasprom, Europe's biggest natural gas supplier, stopped gas supplies to Ukraine, the gas pressure fell in Poland, Germany, Italy and many other European countries; when Iran decided to resume its nuclear fuel program, markets shivered at the idea that the global oil supply could be reduced by 3 million barrels per day (3.8% of global production), as already happened in 1979-1980. Such a loss would probably send the price of crude oil well above $100/bbl.

-->A safe access to energy sources at reasonable prices is a necessary condition for economic prosperity; however it should by no means be taken for granted. Moreover, this is a not concern for rich countries only. In reality, energy is more critical for developing economies, which need to grow faster than mature ones in order to raise standards of living and are more sensitive to price volatility than rich countries, because they have less wealth. The world is, again, struggling to secure energy supply. This has happened many times in the past: historians think that some of the worst periods in Asian and European histories were caused by the depletion of what was then a major source of energy: wood. This time, we are talking about the world, not a particular region. This time, a massive energy shortage would result into hundreds of millions of deaths, mostly in poor countries. So what can we do?

The riskiest of all sources of energy is oil, for reasons both geological --we are quickly depleting a finite resource-- and political --60% of the world reserves are in the Middle-East. So let's use less oil. The most abundant source is coal, so let's use coal. The cleanest and most powerful source of power could be controlled nuclear fusion, so let's invest more in physics. And so on and so forth.

Unfortunately, things are not that easy in the real world. Driving big cars seems to be a part of the American way of life. Coal rich China could fully to switch to coal instead of oil, gas or nuclear power, but then, global warming would dramatically accelerate, not to mention acid rains. Funding research for new and clean sources of energy could mean to cut back on spending in other areas like welfare benefits.

Strong political will, supported by conscious public opinions, is a necessary condition to pursue sound energy policies, but it is not sufficient. Market forces, which are resulting from the confrontation of millions of rational (if correctly informed) individual decisions, should be used, I think. I will take two (and a half) examples.

Why is each American burning 3.2 tonnes of oil every year while his European counterpart is using only 1.5 (based on 2004 data for the USA and the EU-25). Why are cars used in Europe more fuel efficient than those used in the US? This is because gasoline is heavily taxed in Europe, not in the US. Price signals always work, provided that the markets can take on board the whole set of information. In the particular case of oil products, market forces alone cannot price the «externalities», as economists call them, caused by carbon dioxide emission. This is a well known case of market failure. By taxing oil products, the US government would hit three birds with one stone: it would reduce dependency on oil, trim the budget deficit and stimulate R&D for more fuel-efficient vehicles. In short, raise gasoline prices, let market forces do their job, and you will be surprised how nicely it works.

Is coal the solution? Contrary to oil, coal is widely spread over the globe: 33% of known reserves are in the Asia-Pacific area, 32% in Europe and Eurasia and 30% in the American continent, according to BP statistics. By contrast, 62% of oil reserves are in the Middle-East. However, coal has well-known drawbacks, such as carbon dioxide and sulphur emissions. A market-based solution was invented a long-time ago in the US, where companies may trade rights to use a limited quantity of polluting inputs, so that their cost structure is reflecting the true cost of pollution. Paradoxically, the European Union, which is often reluctant to embrace market-based practices, even to cope with market failures, has made trading of carbon emission rights compulsory, following the Kyoto protocol. The lower the total quota of carbon and sulphur, the higher the price of emission rights: there is no better incentive to use coal more efficiently and to invest in «clean coal» technologies. Since pollution is becoming a major concern in China, a market-based carbon trading system would not only be consistent with the broad goals of the Chinese leadership, i.e. turning a command economy into a modern market economy, it would also help the global economy to use coal more efficiently and reduce its dependence on oil.

In the end, technological innovation is our best friend, as it has been the case since the Neolithic Revolution. In theory at least, energy is much more abundant than air or water: it is trapped in every single particle. However, making it available for human needs is a daunting challenge, which only massive investment in science and technology can meet. Financial markets can help funding research in new and promising technologies. However, without clear signals from policy makers that more taxpayers' money will go to fundamental research and less to unproductive spending, such as the generous welfare programs Europe is addicted to, this time the markets will not do the job.