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 / Winter 2006 / Issue 45(originally published by Booz & Company)


Toward a Flexible Energy Future

Faced with these complexities, many governments take the “laissez-faire” approach: they leave it to the oil and power industries to govern their own investments. But this method, too, has many shortcomings. Market prices do not capture such externalities as the environmental impact of fuels, and they do not recognize the complex interdependencies among different forms of energy, the infrastructure required to maintain them, the security of supply, the needs of customers, and the uncertainties of the future.

To their credit, many governments are gravitating to the flexible portfolios of the modified market approach. In the U.K., for example, the government (controlled by the Labour Party) and the largest opposition party (the Conservative Party) agree on four basic objectives: to reduce CO2 emissions; keep the economy competitive (by reducing the price of energy); maintain security of supply; and ensure that people on all levels of society, including the poor, have heat and mobility. Both parties have encapsulated these objectives in a rationale that, when it is complete, will allow energy sources to compete and evolve, without regulators and investors having to predict in advance precisely which technologies will be adopted by the market.

For a modified market approach to succeed, there must first be a clear set of targets for the reduction of CO2 emissions. In setting the formulas that determine a nation’s energy portfolio, we should favor not merely the cheapest fuels, but the optimal fuel mix that adjusts over time, operates effectively during scarcities and surpluses, produces energy when the wind blows and when it doesn’t, and is independent of the vagaries of international oil politics (it must be viable whether or not a nation is on good terms with Russia, Nigeria, Saudi Arabia, Iran, or Venezuela). To accomplish this, three elements, in particular, must be reflected: the ecological impact of carbon, the variability of fuel supply, and the costs of energy security. If we understand how to factor in those elements, then all available energy sources — oil, gas, coal, alternative fuels, hydrogen, nuclear power, hydropower, and renewables — can compete on an equal footing.

Environmental Shadow Prices
In the coming years, faced with general climate change and more extreme weather patterns, every government will have to make a decision: To what levels must carbon fuel emissions be reduced to affect the rate of global warming, and by what year? No government can ignore this imperative for long. There is a growing body of opinion which (drawing on conclusions from such groups as the International Intergovernmental Panel on Climate Change and the American Association for the Advancement of Science) recognizes that human activities are contributing significantly to the dangers of global warming. Already, serious efforts to mitigate climate change are moving forward, with those political leaders who refuse to participate finding themselves marginalized; for example, a July 2006 greenhouse gas reduction agreement between U.K. Prime Minister Tony Blair and California Governor Arnold Schwarzenegger bypassed Washington completely.

The effective modified market approach must reflect the real environmental costs of different fuels. Having set a CO2 reduction target — taking into account the estimated effects of global warming on sea levels, crops, and the weather, and the destruction such effects could cause — governments must engineer a “shadow price of carbon” that delivers that target. The new framework would, in effect, modify the price of every fuel and technology, reflecting the increased risks caused by its CO2 emissions, while exempting fuels and technologies that emit little or no CO2.

The process for setting a shadow price must be transparent enough to draw open criticism from both environmental and economic experts, and robust enough to meet or incorporate that criticism without losing scientific credibility. It must also be consistent enough to enable suppliers to make informed predictions about costs and to set prices with confidence. Documentation would be required for each estimated cost — and costs would be revisited periodically to take into account changes in technology, practices, and damage assessment techniques. Priorities could no longer be determined by pressure groups demanding, for example, expansions of natural gas lines, bans on nuclear power, or restrictions on windmills.

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