As I started high school, my father gave me a book by a world-class physicist. Mr. Tompkins in Wonderland explained quantum mechanics and relativity at a popular level. I soon found that quite a few top-flight physicists delighted in explaining math and physics to the public. Travel fast enough for long enough and you will be only 30 when your twin turns 60. Some infinities are bigger than other infinities. Contrary to Euclid, triangles with straight sides do not always have 180 degrees in their three angles. The world is full of surprises, and I loved it.

Economics, though still a primitive science, contains a few surprising and delightful ideas of its own. Unfortunately it seems less interested in explaining them to a broad audience simply because the ideas are fascinating. Fortunately, there are signs this is changing. I hope this book will be part of a new tradition. However writing the book has a second motivation which is purely practical. Our nation, and in fact most of the world, is embarking on an enormous and untested set of economic policies, and it is at risk of a global policy meltdown.

Such a failure would not just waste most of the money spent on novel energy policies, but would also fail to achieve its goal of curbing climate change and reducing tensions over fossil fuel supplies. With this book, I hope to make such a failure just slightly less likely. I would hope for more had I not been down this path once before.

I had the privilege of watching, from close up, the design of the California electricity market and later acting as the expert economic witness for the California Public Utility Commission and Electricity Oversight Board as they sued the federal regulator (FERC) to undo some the long-term electricity contracts signed at the height of the crisis. Forty billion dollars of electricity was purchased over a three month period at double the normal cost of power. These contracts "protected" Californians from presumed astronomical prices for up to ten years. Three months later, the cost of power was back to normal -- but not because of these contracts.

While California was busy paying double for its future electricity, Enron, having foreseen the summer's price collapse was busy selling the market short. Contrary to popular belief, California's frantic buying was pushing future prices higher while Enron's short selling was pushing them lower. It is easy to view California's delusions as peculiar, but a month before they started paying double, the Democratic Chairman of FERC dragged California and some large power sellers into the Republican White House and instructed California to start buying. At that time California refused the prices it was offered.

After more than 15 years of design and experimentation, it is not clear that electricity markets have done more good than harm. Watching the development and implementation of new global warming policies feels strangely familiar. There is much enthusiasm and there are many good ideas, but major programs have already gone far astray.

The price of CO2 in the EU carbon market collapsed from $30 to $1 in a single year. Hydrogen powered FreedomCars, all the rage in 2002, made a U turn by 2006. Their multi-billion dollar funding then shifted to ethanol. In 2006 we spent $7 billion extra on subsidies and higher prices for ethanol with the result that greenhouse gases were reduced by 0.054%. This is not a typo. One hundred times more is 5.4%, enough to make a small difference. But 100 times more would cost of $700 billion per year and the use of 20 times the 2006 corn crop instead of 20% of it.

It's easy to criticize such policy efforts, but hard to fix them. Technically it is not so difficult. Good techniques are available and there are experts who could apply them. But choose the wrong "expert" and we are no better off, and who will make this choice? In any case, this approach is simply not in the cards. The only hope is a broad increase in the understanding of economic policies. That was the goal of my book on electricity markets. It sold well and was even translated in to Chinese and Russian, but I think it fell short of my hopes because I did not pay enough attention to fundamental misconceptions.

One of the most difficult things about economics is changing perspective--giving up misconceptions. It's like Einstein's switch from an absolute system of space and time to one that is defined relative to the observer. It is extremely hard for the human mind to accept that length and time actually depend on who is measuring, and there is no single right answer. It seems almost as difficult to imagine that even if the US produced enough ethanol to stop importing oil, drivers would be just as affected by OPEC's next oil shortage as they are now. My apologies if that seems disconcerting, and please don't stop reading. It actually does make sense, and it's a lot simpler than relativity. To free ourselves from the trap of fossil dependence and climate change, a real understanding of energy markets it necessary, and--if you enjoy new and different--you may even find it exhilarating. Commonplace misconceptions are simply not up to the challenge. Much that seems obvious runs at right angles to the truth.

The hardest part of explaining new ideas lies in getting people to seriously question their old ones, and while I attempted to take this into account in my first book, I did not take the problem seriously enough. I should have listened to Mark Twain. "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." This book spends a lot of time discussing "what we know for sure."

The idea of focusing on fundamentals fits perfectly with my view of good policy. As much as possible, policy makers should stay away from the scientific, engineering and business details. In particular they have no business deciding that hydrogen, or solar roofs, or wind farms are the technology of choice. Although this book looks at many of these, the point is not to pick and choose. The point is to show that picking and choosing has led to gross errors and that it is possible to harness the market to pick and choose if the policy makers just get the fundamentals right.

As to markets, the reader should know from the start; I think they are tremendously useful--I'm an economist. But, I don't think they solve all problems--I was a scientist before I was an economist. I find pro- and anti-market ideologies equally irrational. Fortunately, standard economics is fairly good at identifying what markets can and cannot do, and its getting better at it. Unfortunately, quite a few economists and many more economic imposters know for sure, without bothering to check, that markets can do any number of things--just because, as Adam Smith thought, the invisible hand is the hand of God. Just as unfortunately, many ecologists know for sure, without bothering to check, that markets cannot do any number of things--just because money is the root of all evil.

Now, I would like to ask one favor of the reader. When you come upon an idea that seems foreign and almost certainly wrong, please keep an open mind. I am not asking that you accept my argument, only that you say to yourself, "Well he just might be right, and if he were, that means the world works a bit differently from how I imagine it. So I will first try on this new way off thinking before deciding one way or the other." Remember, it's what we know for sure that gets us in trouble. Meanwhile, I promise the reader I will do the same and post any new conclusions, no matter how disconcerting, on the book's web page (zfacts.com/p/111.html) for all to see.

Preface: Breaking the Energy Deadlock
Activists vs. Dolittles
The Dolittles say fixing the energy problem will cost a fortune, so we should do very little. Activists claim it could be so cheap--some say cheaper than free, that we can cut carbon-based energy use to the bone. Because both sides focus on how much to cut energy, a lot or a little, the county has been deadlocked for a quarter century.

For the most part, this means the Dolittles win, but at times the activists get the upper hand, and throw a billion dollars at solar roofs. There's smarter approach, but it requires that the two extremes compromise. Fortunately there is one point of agreement. Although one side says "only a little" and the other says "as much as possible," they both agree--for opposite reasons==that it shouldn't cost us much. Here are their positions in a nutshell:

Activists: Save lots of energy, the net cost will be small or nothing.
Dolittles: Save a little energy, keep the cost very low.

Here's the compromise. Commit to spending a little more than verified dollar savings. Both sides should love this. If the Activist are right we can save a lot of energy and the net cost will be small to negative. So they will get what they want. If the Dolittles are right, the dollar savings won't materialize and that will limit spending. So they will get what they want.

Of course both sides will suspect the other's accounting, so impartial score-keeping is crucial. For example, large amounts of energy can be saved by putting a $1 per gallon tax on gasoline and refunding the entire tax on a per-driver basis. The Activists will want to count this a free, but the Dolittles will correctly point out there's a cost. Coming up with fair estimates of costs and savings is tricky, but the National Academy of Sciences has the expertise and credibility that is lacking in the advocates.

Spending Targets Are Better Than Energy Targets
Besides deal-making the spending-target approach has numerous practical advantages. First it's realistic. Energy targets come in two varieties, just-for-show targets, and cost-based targets. "Show" targets are most common. Politicians may say "we will roll back CO2 emissions to 10% below the 1990 level," but they say this only if they think they can't be held responsible. One method is Schwarzenegger's "unless it would hurt the economy" clause. Another is the Canadian "and the other party has six-months to figure out how" dodge. Politician show remarkable creativity when it comes to dodging responsibility.

Cost-based energy targets, make more sense. First a political decision is made that, say, an extra 1¢/kWh is OK, but that is the limit. Then someone figures that an X% cut in energy, probably won't raise electricity prices more than 1¢/kWh. Then three or four safety-values are added just to be sure. The result is something that sounds like an energy target, but is actually just a clumsy and cumbersome cost target in disguise.

Second, spending targets make sense. There is no right CO2 target independent of cost. The more CO2, the more damage to the environment. If it cost nothing to cut CO2 by half, as some activists claim, then we should certainly cut it by half. If it costs a huge amount as some Dolittles claim, we should do only a little because the first cuts will be cheapest and do the most good. Limiting how much we spend speaks to both possibilities: If the Activists are right, we will cut CO2 by half as they suggest. If the Dolittles are right that the cost is high, we will do only a little.

Level Playing Fields Save Money
Everyone wants a level playing field that tilts more in their direction. They argue for fairness and they know what's fair. All this squabbling gets us nowhere, but there is one leveling principle that's hugely important. It is so basic that it is both a key economic principle and a key principle of good shopping.

Shopping: If you can buy it for $10, don't pay $11.
Economics: Equalize marginal costs.

Unfortunately, US energy policy does not even check the prices, let along equalize them. Read through any of the Activist's lists of policies--they rarely mention this basic shopping principle and when they do, they apply it very narrowly. That's because when you think things are almost free, or cheaper then free, why shop around? So subsidies are hugely unequal, and we are paying far more than we need to. If the government offers to pay $1000/ton of carbon saved by method X, and $10/ton for method-Y savings, there will be some method-Y savings needing an $11 subsidy that gets left out. There will also be some method-X savings that needs a $900 subsidy goes forward to be paid the full $1000 subsidy. So this unevenness results in spending $1000 for a ton of savings when the same savings could have been bought bought for $11.

Good, Cheap Energy Policy
The best energy policy is the cheapest energy policy that can gain the necessary votes. One strategy for political acceptance is to hide the costs. This works fairly well and is behind virtually every policy that's been passed. Unfortunately, hiding costs is about the best way to prevent proper cost control, making current policies far more costly than necessary. In the long run, wasteful policies are self defeating.

This book describes how to design least-cost policies. The good news is they are much simpler than the boondoggle mishmash currently in place. The bad news is they are not as good at hiding costs and paying off powerful interests. In spite of this, they have some political advantages. Since politics matters, compromises are also examined. In short, this book is a toolkit for practical, pretty-good policy design. And "pretty-good" is fabulous compared with where we're headed.


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http://zfacts.com/p/829.html | 08/29/08 15:37 GMT
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