European Affairs

Winter 2000

 

Global Energy Policies Must Be Updated for the 21st Century
by James Bond

The global energy industry is entering a period of revolutionary change, and it will not be easy to develop coherent policies for the 21st century.

This paper looks at how past policies have shaped the industry, the trends that must be taken into account in future policies, and what those policies should look like.

Winston Churchill said that "The further back you look, the further forward you can see." Before looking to the future, it is always instructive to look to the past. While I prefer time-spans measured in centuries, I will focus on the last 50 years or so.

The last half-century provides some interesting case-studies of past energy policies. Policy makers gave us energy price controls in countries like Japan and many developing countries, and associated these with energy subsidies that in developing countries amount to more than the total invested in energy infrastructure every year. In the electric power sector alone these amounts to $100 bn per year in developing countries. Moreover, these subsidies often target rich consumers over poor ones; in Malawi, for example, subsidized electricity tariffs favor the 20 percent of the population who are the richest and have access to electricity, over the 80 percent less well off who use traditional fuels.

Policy makers gave us national energy champions like PDVSA in Venezuela, Pemex in Mexico, Statoil in Norway, ENI in Italy, Elf in France (now part of Total-Fina), a drain on public finances and a refuge for mediocrity. Policy makers in the United States gave us some real beauties: the Energy Policy Act, which amongst other things banned the use of natural gas for electricity generation; PURPA, and a rash of stranded assets across the country. Policy makers had the foresight and the hubris to pick the technological winners for new energy sources: synfuels in this country, nuclear power in France, while MITI in Japan sponsored development of photovoltaic technologies, all failures in their different ways.

The electric power sectors of nearly all countries demonstrate the following characteristics: generation is a rigid, over-regulated, utility business, often owned and run by state-owned enterprises. It has been, and in many places remains, a monopoly business.

In the European Union, timid competition is just beginning to be introduced over the strident resistance of national utilities, while in the United States only two states – California and Pennsylvania – have open competition, serving 19 million households out of a total of about 66 million across the country.

The industry uses centralized command-and-control allocation of resources through grid dispatch, rather than using market-based allocation mechanisms. It goes for centralized solutions for siting its generating capacity; it builds big, and it builds dirty. Economic prices of electricity to the consumer (i.e., after reintegrating subsidies) are higher than they should be, or would be in a situation of full competition.

In those countries that have introduced competition – the Nordics, England and Wales, Chile, and Argentina – consumer prices have declined quite substantially. It is an industry which has until recently been characterized by very low levels of innovation.

While in information and telecommunications industries, the bulk of companies' profits are from products less than 18 months old, in the electric power industry the "breakthrough" of the past decade – combined cycle generating technologies – is based on aero-engine technologies of the late 1940s and early 1950s. It is an industry that has had, over the years, a tremendously negative impact on the environment.

Over 80 percent of environmental damage is energy-related, and I do not just mean global warming. In the great urban centers of Asia, levels of particulate emissions from electricity generation are 5 to 10 times the level of the World Health Organization's maxima, 20 times the levels in Tokyo or New York.

The health-related costs of this local environmental impact – from chronic bronchitis, early death, and reduced labor productivity – amount in China, today, to about 6 percent of GDP.

In developing countries it is an industry that has been particularly poor at actually doing what it is supposed to do: that is, provide energy to as many people as possible. Over the past 25 years, the electricity industry has connected 1.3 billion new people to the grid, while population has grown by 2 billion.

In other words, there are 700 million more people today who do not have access to electricity than 25 years ago. It is like Alice Through the Looking Glass; except that by running flat out, Alice was able to stay in the same place. By running flat out, the electricity industry has actually fallen behind. I could say similar things about the international petroleum industry.

But there is good news. The tide has turned, and reform is on the horizon in many regions of the world.

What are the lessons for our fledgling energy policy makers from our brief history lesson? I would say there are three: We must recognize that the energy business is complex, and policy makers cannot be clairvoyant. Policy makers must try not to pick winners; and try to resist the temptation to overregulate. Their thrust must, first and foremost, be to remove distortions in the industry, in the primary interest of the consumer. Policy makers must craft their interventions so that even if they do not do good, at least they do no harm.

The final objective of energy policy must be to deliver clean, reliable energy as cheaply as possible to as many consumers as possible, neither more, nor less. To know how to do this, we need to look at some of the trends affecting the energy industry.

In the industry today, we see the end of the natural monopoly. With today's information and communications technologies there are very few situations where competition cannot be introduced in one form or another. And there is increasing realization that competition is better than regulation; and choice for the consumer is a very powerful organizing principle.

The death of the natural monopoly has profound implications for all utilities: telecommunications monopolies, electric utilities, water companies, not to speak of state petroleum monopolies. The intellectual underpinnings, which for decades provided a justification for a utility-centric organization of the electricity industry, have now been swept away.

The main obstacle to change today is the unwillingness of the utilities themselves to give up the comfort of a low-risk regulated business for the cold world of competition; and – dare I say it? – the reluctance of the regulators simply to let go.

A second revolution in the energy industry concerns economies of scale. This economic principle describes how, by building bigger, companies can reduce the unit cost of their output. It was the principle which explained the ever increasing size of electric power plants over the last half-century, and because gargantuan plants have become so important in the system, they need to be located in some central place. It is the economic mechanism that justifies, and provokes, centralization.

The advent of gas turbines and combined cycle technology has created an abrupt turn-around of this trend. Today, the cheapest plants to build are no longer the huge plants of 1980, but much, much smaller – about the size of the optimal plant of 1938: 20 MW, say.

As the trend continues, with micro-turbines beginning to be installed, the optimal size of a power plant is approaching the consumption of a shopping mall, a hotel, a housing subdivision. So no longer do they have to be located in a central position. Much better to locate them near the point of consumption, and economize on the cost of the grid.

The third key trend concerns heightened public awareness of the environmental costs of energy production and use, in part because of the rise over the last decade of what is called Civil Society.

The fourth factor that will shape energy policy in the years to come concerns the fact that people in poor countries pay three to six times as much per joule for their energy as people in industrialized countries, using batteries, kerosene, charcoal and wood fuel, and candles.

There are at least 2 billion people today who have no access to electricity, and similar numbers without access to petroleum products. It is a tremendous market. But developing country utilities, by their nature not very interested in business development, have simply not been up to the task of supplying this energy. Energy policy in these countries must focus on setting in place market structures able to supply these consumers with products tailored to their needs and their ability to pay.

Bearing in mind the four trends outlined above, what elements would a coherent energy policy contain? There is simply no justification, today, for government ownership and operation of energy facilities. This concerns the electric power sector, notably in Europe; and it concerns oil and gas resources in producing countries. If countries wish to appropriate part of the rent stemming from production of natural resources, they should do it through appropriate taxation, not through a national company.

It is clear that competition and consumer choice are very powerful principles: not only does competition allow maximum benefits for the consumer, it also provides a self-regulating mechanism on the structure of the industry itself. In an industry undergoing a transition from monopoly utilities to markets, the transition is complex and the process subject to capture by the more powerful players.

That is why regulation of the industry will continue to be necessary; no longer regulation of utility prices and returns, but safeguards of competitive principles such as interconnection tariffs, pool management, transparency of tariffs and other information.

Distributing energy to the unconnected poor is most likely going to entail solutions developed at the local level: the village, town or local community. These distribution solutions follow technological trends; furthermore, local solutions provide much better incentive structures for the reduction of theft of electricity and the improvement of system maintenance.

Policy makers – particularly those in emerging economies, but also in OECD countries as well – must guard against regulations that disfavor supply solutions at the local level over centralized solutions, in particular licensing and siting authorizations.

There may also be scope to promote the move toward distributed electricity by unbundling existing electricity utilities and privatizing distribution, and by promoting local electricity supply entrepreneurs by facilitating access to commercial financing.

More importantly, the energy sector must become responsible, particularly on the environmental front. Policy makers have an important role to play in this regard, by setting environmental standards, monitoring performance, and ensuring compliance with these standards.

There is an emerging consensus among economists and environmentalists that ensuring compliance through market-based schemes (such as permit trading) is economically much more efficient than the "one-size-fits-all" approach that mandatory standards impose; a very successful example of which was the SO2 permit trading system in the United States. So it is of some concern that I learn, in the context of the Kyoto Protocol CO2 reduction, that the European Commission is thinking of mandatory standards rather than trading.

Energy policy makers have difficult jobs, and they have all my sympathy. They have two re-doubtable opponents against them: First, the energy companies, which have grown comfortable with the safe, low-risk environment they have been operating in over the past 50 years. But more important, policy makers have against them the stranded regulators, who bring with them 50 years of the urge and the itch to regulate. They will be the most difficult to resist - but resist them they must, if they are to succeed in their task of handling the transition of the sector, and ensure cheap, clean, reliable energy for all.