Economists agree that as long as energy prices are accurate (that is, as long as prices reflect total costs), the "right" (optimal) amount of investment in alternative energy will occur because capitalists like profits. If alternative energy makes economic sense, market actors will quickly figure that out from the price signals they receive and invest accordingly. Only if prices are inaccurate is there the possibility that government can improve market outcomes through taxes on or subsidies of particular energy sources.
Thus, the case for government promotion of alternative energy depends solely on the existence of inaccurate price signals in energy markets. Many argue that the cost of environmental pollution is not reflected in the price of energy. But governments aggressively regulate environmental emissions affecting air, land, and water quality. Those regulations impose costs that are then passed on to consumers. George Mason University economist John Nye persuasively argues that existing empirical work is incapable of telling us whether energy prices are "wrong" or, if so, how wrong they might be.1
Are the environmental regulatory costs embedded in final energy prices greater than, less than, or equal to the environmental damages imposed by energy consumption? No one knows for sure. Estimates of the environmental damages associated with energy consumption vary widely because health and medical professionals remain uncertain about the implications of long-term exposure to small concentrations of pollutants.2 Vanderbilt regulatory specialist W. Kip Viscusi, however, has found that — if we accept EPA assessments of these matters — oil prices fully reflect environmental costs, natural gas prices are overly high given the disparity between the external environmental costs associated with gas consumption and the regulations in place to control those emissions, and coal prices are too low because the regulations controlling coal emissions are not strict enough relative to the environmental damages that follow.3
Viscusi's findings are not definitive, however, because the EPA might well be wrong about the health effects of conventional pollutants. The literature provides plenty of evidence for those who want to argue that true environmental damages are higher or lower than EPA believes. And Viscusi doesn't consider greenhouse gas emissions in his calculations. But a recent survey of the literature by climate economist Richard Tol finds peer-reviewed estimates of the marginal impact of greenhouse gas emissions also vary widely because of scientific, technological, and socio-economic uncertainties about the future.4 Moreover, those widely disparate cost estimates are largely driven by different beliefs about how to best price (discount) impacts that will occur in the distant future.5
The argument that energy prices are wrong because they don't account for the national security costs associated with energy imports is even weaker.6 While it is probably true that U.S. military expenditures would be lower were the Pentagon not charged with the task of protecting friendly oil producing states and international oil shipping lanes, those expenditures are unnecessary. If the U.S. didn't provide oil security services for oil producers, oil producers would provide those services themselves as long as the marginal benefit of oil security expenditures exceeded the marginal benefits associated with alternative expenditures.
A separate national security issue is whether money spent on oil abroad worsens the problem of international terrorism. Conventional wisdom would answer yes, but we have analyzed the data and concluded there is zero correlation — none! — between oil profits and either the number of fatalities or the number of attacks from Islamic terrorists. Oil revenues fatten the coffers of anti-American regimes abroad, but there is no relationship between oil profits and anti-American actions from hostile states.
Finally, some argue that the reliance on imports leaves America vulnerable to embargoes. But once oil leaves the territory of the oil producer market agents — not the producer — decide where the oil goes. Fears of producer blackmail are greatly overblown because oil producing economies are far less diversified than oil consuming economies. For example, 85 percent of Iran's government revenue comes from the oil sector whereas only about 3 percent of U.S. disposable income is spent on oil and gas.7 Unilateral production cut-backs to achieve foreign policy goals would prove far more economically harmful to producers than to consumers.
Even if we think that prices for conventional energy are too low because they don't account for environmental or national security externalities, governmental intervention to promote alternative energy sources would not be the best remedy. Better would be an explicit or implicit tax on conventional energy to get prices "right." Correcting price signals allows the market rather than the government to pick industry winners.
Getting prices right would change the energy status quo but allow actors to find the best option through trial and error with their own money. We don't know whether alternative fuels (solar or wind), better controls on existing fuels (clean coal), a different mix of existing fuels (more nuclear), or energy conservation is more cost effective, and thus markets rather than government should decide. And even if we were confident about such things given the current state of knowledge, allowing markets to sort through the choices allows for a rapid change in investment patterns should technology change. Markets respond more quickly and more efficiently to changing economic conditions than do political or regulatory bodies.
If you are bullish about economics and future potential of alternative energy, then rigging the market to promote alternative energy is unnecessary. If you are more skeptical, then rigging energy markets to favor alternative energy is counterproductive. No school of serious thought, however, leads us to the conclusion that targeted assistance is the best policy.
This piece was submitted as the initial argument in a Google Knol debate. The full debate, including opposing arguments and rebuttal, can be found here.
- John Nye, "The Pigou Problem," Regulation 31:2, Cato Institute, Summer 2008, pp. 32-37.
- Thomas Sundqvist and Patrik Soderholm, "Valuing the Environmental Impacts of Electricity Generation: A Critical Survey," The Journal of Energy Literature 8:2, Oxford Institute for Energy Studies, December 2002, pp. 3-41.
- W. Kip Viscusi, Wesley Magat, Alan Carlin, and Mark Dreyfus, "Environmentally Responsible Energy Pricing," The Energy Journal 15:2, Summer 1994, pp. 23-42.
- Richard Tol, "The Marginal Damage Costs of Carbon Dioxide Emissions: An Assessment of the Uncertainties," Energy Policy 33, 2005, pp. 2064-2074.
- Davis Weisbach and Cass Sunstein, "Climate Change and Discounting the Future: A Guide for the Perplexed," Working Paper 08-19, AEI Center for Regulatory and Market Studies, August 2008.
- The best single academic treatment of this issue is Douglas Bohi and Michael Toman, The Economics of Energy Security (Boston: Kluwer Academic Publishers, 1996).
- The Iranian data can be found in the CIA World Factbook under the Economy subheading for Iran . The U.S. data can be found in the National Income and Product Accounts Table 2.5.5 line 75 (gasoline and oil expenditures) and table 2.1 line 26 (disposable personal income)