Ed Dolan's Econ Blog

Why Do We Need Government to Tell Business to Be Energy Efficient?

In response to my interview “The Myth of Affordable Energy,” my friend and fellow blogger Gary Alexander asks an excellent question. Many readers of the interview on various sites where it has been reposted have asked similar questions, and the following is addressed to them, as well.

Gary asks:

Ed, I need your clarification on a comment you made in the opening section, in which you said that the increase in energy efficiency in the U.S. is “pretty remarkable, considering that we haven’t really had a policy environment that is supportive of efficiency. Think what we could do if we did.”

My question: Isn’t efficiency (getting more done with the same or less) a constant goal of most businesses? Why would these businesses need an official federal government policy to direct this efficiency from afar? Nearly every technology has increased efficiency and/or lowered cost over time, in the natural course of conducting business in a cost-conscious manner. Or am I missing something?

Excellent question.

The goal of businesses is to make a profit. Part of their strategy for doing that is to adjust their input mix to minimize the total cost of producing their product. I that sense, yes, they are constantly pursuing the goal of efficiency and the government does not need to nudge them to do so.

However, businesses have no inherent goal to economize on any one input. For example, if market prices signal that plastic is cheap and steel is expensive, an automaker will substitute plastic bumpers, door handles, and so on for steel. Vice-versa if plastic is expensive. An automaker has no inherent goal of reducing its use of steel, just reducing costs.

What we need, then, are not government policies that tell businesses to use energy or any other resource efficiently in response to market prices. What we need are policies that safeguard the integrity of the price system itself. That is why we need energy policies that are consistent with the principle of full-cost pricing.

As I discussed in the interview, that means doing two things.

First, it means stopping government subsidies that make the prices of some inputs artificially low. For example, without subsidies to corn farmers and ethanol blenders, we would use less corn ethanol in our automotive fuel. According to most studies I have seen, less ethanol would mean a more efficient fuel mix.

Second, it means fixing government policies that allow businesses to take resources without paying for them. Promarket economists like my early mentor Murray Rothbard have long argued that pollution is a form of “taking” via uncompensated harm to other people and their property. That means harm to people and property owners who live downstream or downwind from a specific factory or power plant, and in the case of some pollutants, it means harms that are felt even more widely, even globally.

Look at it this way: A business owner is like a dog owner. Just as the burden of cleaning up the dog’s poop is the owner’s responsibility and becomes part of the cost of owning a dog, the harm that pollution does to downwind residents and property owners is a both a moral and an economic responsibility of the businesses.

In an ideal world, the market would capture pollution costs and impose them back upon the polluter. Downwind property owners and others living downwind would sue under the tort concepts of nuisance and trespass. The court costs and damages would give the needed price signal to the polluter to cut back on the use of inputs that cause heavy damage in favor of cleaner ones.

But that is in an ideal world, one where streets were privately owned, one where street owners would write anti-poop clauses into the contracts they signed with dog walkers and would go to court to recover damages from dog walkers who did not respect those contracts. For better or worse, we do not live in that kind of Heinleinian anarcho-capitalist utopia.

Instead, we have government streets and government fines on irresponsible dog walkers. In my mind that is better than just absolving the dog owners of their responsibilities and leaving the rest of us to step in the poop.

Similarly, to safeguard the integrity of energy pricing we can use government fines, or pollution charges, or taxes, or whatever you want to call them. So much per ton of SO2, so much per ton of carbon  and so on. Yes, in some philosophical sense, that is a second best, a less elegant solution than one that internalizes all pollution costs through voluntary contracts and the enforcement of property rights. Yes, it is hard to get the prices just right. But I see it as the best hope we have for making our planet cleaner, healthier, more sustainable and–importantly–more efficient.

7 Responses to “Why Do We Need Government to Tell Business to Be Energy Efficient?”

barfOctober 19th, 2012 at 6:10 pm

businesses have an interest in maximizing profit? says you maybe. i say "they have interest in maximizing waste, fraud and abuse" myself. their interest is ONLY to make things DEAR…every and ALL things. to DRIVE UP prices, costs, expenses…YOU NAME IT. That's the ONLY interest business has. Why have a DOE? WELLLL. Let me count the ways: do you want the private sector as the sole actor vis a vis nuclear power? NO THANKS. Sure…Governments do cover things up…and as Fukushima and Chernobyl have shown they can create far great catastrophes than a private sector can even imagine. Having said that the utility grid is PUBLIC for a reason…and that reason is COST first and foremost…but also FREEDOM as a powerful second. I can plug in a power source and sell that energy BACK TO the grid if i want…and that is something only a PUBLIC utility would do. What else? Oh…how about ENGINE TECHNOLOGY. Sure…the private sector loves their oil and oil byproducts. But is it in the public interest? there are ENVIRONMENTAL considerations are there not? we used to have leaded gasoline…no more. and look at the explosion in wildlife as the result of getting rid of it. private sector? yeah, right. with the New York City media front and center in standing in the way of that public benefit…yes, yes? of course. so now we come to "why gasoline period"? the market economics is crystal clear: natural gas is cheaper, it does not need to be refined, it is more efficient and more reliable–the list goes on and on and on and on and on and on and on and on….

GuestNovember 6th, 2012 at 2:26 pm

Ed, I have pondered your post for a number of days….and it will not exit my mind. This simple minded engineer has to inquire.

Are you proposing a pollution tax on the oxidation of carbon? If so, is the new tax “full costing”, or simply a new pollution tax? Assuming this is just a new tax, it begs a couple of questions: What are you going to do with the revenue? Who gets the money? How can citizens be assured the money is used as intended?

I shall try to take your idea and implement it. Let us assume I build a wind mill off the shore of New Jersey….in the perfect location….a location where the wind blows most of the time. What will happen? The electric system the wind mill is integrated into will increase the amount of carbon dioxide and other pollutants from carbon oxidation.
This pollution claim may sound counter intuitive, but let me help with the physics. When one has a wind mill making electricity, one has to also have a combustion turbine burning natural gas following the load of the wind….so the “quality” of the electricity is high. If the quality is low, the electrical current will burn out all those electric gadgets we have become addicted to…and then the lawyers get rich through litigation.

Here is why the system burns more gas. Think of your auto in stop and go traffic versus driving on a freeway at optimum speed. I might burn half as much fuel to go the same distance in my auto if I am running at optimum speed versus stop and go. Same thing happens when a combustion turbine has to load follow a wind mill making electricity.
Getting back to your new tax; so when I sell electricity, the government is going to make me add a tax onto the sale of my wind generated electricity…because my new wind turbine has a huge carbon foot print…and your full cost pricing says my electricity is unfair to those down-wind from my “windmill and combustion turbine” combination.

I can see only one way the people down wind may win. The price rises for electricity, and therefore, less electricity has been used. Yes, electric cost is elastic…that is, rising prices results in less usage.

On the other hand, my experience has been that when nations try this approach, users of electricity find ways to avoid the tax. For instance, in countries trying this scheme, factories buy their own generation sets versus using a central station to buy their electricity. The result is a rise in cost of electricity and a rise in pollution because when individuals step outside the regulated electric business, they cut corners that cannot be sufficiently regulated to hold down pollution.
I collect the tax. Who do I give the tax to? The Government? What do they do with the tax? I can see the government using its new found wealth to build more roads, buildings, a bigger military, and increasing the heating and cooling in government buildings…..each of which will increase pollution.

If your proposal is to use the tax money to make the “up wind” nation more efficient, then let us consider that. Efficiency is the sweet fruit of the tree. If there are not trees (energy generation), then there will be no fruit. Further, the nation quickly reaches a point that the trees reach maximum production of fruit. One is physically limited by the amount of fruit (efficiency) a tree (energy) can produce. One must increase the energy production of the nation, then increased production will results in increased pollution.

Which leads us to the final thought: Which source of energy has the least pollution? Which source of energy is the most productive? Which source of energy is the safest? Which source of energy results in the lowest cost, so the nation can use energy as a source of competitive advantage? I propose the answer to these questions is simple: A nation’s energy policies should determine the right mix of electrical generation sources that optimize the needs of the citizens. How does your scheme head a nation in that direction? How could your scheme be integrated into the complex global set of regulations? How would your scheme assure the money collected is allocated and spent on beneficial activities?

Ed Dolan EdDolanNovember 6th, 2012 at 3:09 pm

Thanks for the questions, all of them important ones. I'll try to answer them.

1. Yes, "full cost pricing" can be implemented by pollution taxes, not the only way, but perhaps the simplest. Often I talk about "carbon taxes" as a short of shorthand since carbon is one of the pollutants of widest concern, but in principle, we would want a tailored pollution tax for every source that would include charges for carbon, SO2, particulates, mercury, groundwater pollution and so on. But a stand-alone carbon tax might be a good place to start.

2. What to do with the revenue (you come back to this several times, I'll try to answer it all at once because it is a very important question.

My answer is that deciding the overall level of taxes is a three-step process. First, how much should the government spend, and on what? Second, what level of revenue is appropriate, given the amount government wants to spend? Three, which particular taxes should we use to raise the revenue? If we assume the first two are already answered before the pollution tax is introduced, then the answer to your question is that we should use revenue from the pollution tax to reduce other taxes that cause greater economic distortions, for example, corporate profit taxes or payroll taxes. The pollution tax itself, by its nature, does not cause distortions; it corrects for the distortions caused by externalities. In principle, then, a pollution tax should make the overall tax system more efficient.

In the short run, we could find ourselves in a situation where simultaneously we needed a pollution tax to control externalities and we also needed more revenue relative to the amount of government spending we want. Then as a shortcut we could roll steps two and three into one and use the pollution tax as a source of new revenue. In principle, though, we should think of two and three as separate decisions.

3. "How can citizens be assured the money is used as intended?" I wish I could answer that. Sigh. I voted recently for a slate of candidates that I thought would do slightly better than the other slate, but I know they will do a far from perfect job. However, our concern that our elected representatives may not implement good policies should not deter us from trying to describe what good policies would, in principle, look like. If we don't start by describing what good policy looks like, how can we even criticize government policy as not being good?

4. I don't quite understand the physics of your windmill example, in which you suggest that adding wind turbines to a gas system results in more total carbon than generating the same kWh with gas alone. For the sake of discussion, I'll assume you have the physics right. If that is true, then we should have a higher pollution tax on wind power than on gas because wind power causes more pollution. Certainly, economists need help from physicists, engineers, others to know what is the actual pattern of externalities before they can be taxed.

5. People who step outside the grid to generate electricity, say, with their own gas or diesel generators would also pay the pollution tax on the fuel they use, the particulates they generate, and so on. That would reduce the advantage of going off grid. But there are probably cases in which going off grid is good, for example, if there are opportunities for co-generation, using cooling water for process heat, etc.

6. "One is physically limited by the amount of fruit (efficiency) a tree (energy) can produce. One must increase the energy production of the nation, then increased production will results in increased pollution." I agree, there are limits to the efficiency of any given process, for example, how many Btu's are needed to heat a building of given size. However, changes in prices also change the output mix, for example, toward smaller houses or fewer people moving to areas where temperatures are extreme. It is also possible that the total rate of growth of the economy could slow. There is nothing that says economies always have to grow.

7. "A nation’s energy policies should determine the right mix of electrical generation sources that optimize the needs of the citizens. How does your scheme head a nation in that direction?"

It heads in that direction by balancing demand for energy against demand for a clean environment. Right now energy is underpriced so we get a mix that has too much energy use and an environment that is not clean enough (meaning clean enough from the point of view of the citizens' own preferences, of course, not those of some energy czar or clean air czar.)

8. " How could your scheme be integrated into the complex global set of regulations?" That is one of the thorniest problems. It is true that if just one country adopts a pollution tax, it can drive pollution activities abroad to countries with even weaker controls. I don't think anyone really has a good answer to how to regulate pollution on a global scale. Even so, I think we should each be responsible for our own country's policy. We should not use the fact that other countries have bad environmental policies as an excuse not to improve our own policies.

Bonnie GoodellNovember 7th, 2012 at 7:30 pm

Instead of carbon tax: carbon costs insurance premiums.

Why not use (and tie the rates of) carbon tax to pay the premiums on insurance to cover the losses and damage for individuals and governments for disasters caused by the pollution they create, thus directly and flexibly putting the costs into the marketplace? It's actuaries would be in the business of determining what portion of climate -related disasters are anthropogenic due to fossil-fuel pollution. As one scientist put it (more or less), you can't say any given home run by Barry Bonds was due to steroids but you can project a percentage of the home run totals that were due to steroid use. How actuarial.

The damage done by Irene, and the cost of recovery, or last summers drought, or the abandonment of Pacific islands, or loss of corals – all those can be cost quantified, risks projected, etc. It is already being done for many of them, and premiums set and paid, and now with the fine tuning to say this % is due to God and this to fossil fuel carbon-loading. So, it is "merely" a matter of a floating carbon tax, collected globally, with insurance for carbon-loading's share of damage automatically provided to whoever and whatever suffers damages and disasters.

Whether or not one buys one's own crop insurance, collects taxes for FEMA, wants to build surge gates on the Hudson or move people out of floodplains, fossil fuel's share of the cost is calculable. If you are right that energy costs are not tied long term to prosperity, this should get us where we need to go pretty quickly with automatically self-correcting market integration of more of the costs of fossil fuels.

Ed Dolan EdDolanNovember 7th, 2012 at 7:46 pm

Interesting concept. I'm not sure the insurance and legal system would be robust enough to handle the flows of payments involved, but the idea of using some revenue from pollution charges to compensate victims certainly makes sense.

Ed Dolan EdDolanNovember 13th, 2012 at 2:06 pm

Thanks, David, this is great, and I recommend anyone interested in this thread to read David's post (and my brief comment there). I will try to do a full post soon addressing the important issues your post raises.