Adi Imsirovic, Oxford - Jan 11,2022

Since September last year, Europe and most of the world have been in an “energy crisis.” Gas prices have reached record highs, pulling power prices up with them and substantially increasing living costs. The prices of coal and oil are also well above 2020 averages. Some people are blaming the green energy transition for driving up energy costs and demanding that the pace of change is slowed. But this isn’t really an option. Applying the brakes to the transition would almost certainly lead to higher social costs and possibly involve a risk of runaway warming if we pass a climate tipping point. History also offers some valuable lessons about ill-advised interventions.

There has been little frank and open discussion with electorates regarding the energy transition. This is certainly linked to higher energy prices. Massive changes that are required in our energy infrastructure to meet “net-zero” goals will be costly, and the list of necessary changes is long. New, green power generation needs to be built and old, polluting capacity shut, even though it may not have been fully depreciated. Industry processes need to be changed to cleaner fuels, and automobile factories converted from internal combustion engine to electric vehicle production. Old houses need to be insulated as well and new ones built to far higher standards.

Policy Imbalance

Instead of carefully planning for a smooth transition, governments have often made things worse by implementing cheap and easy policies that cause higher and more volatile energy prices. In general, there has been a large imbalance between supply-side policies, which are easier to implement, and demand-side policies, which directly affect voters. The result of this imbalance, with demand left unchecked, is an energy supply squeeze leading to higher prices.

The latest US administration has for example banned drilling for petroleum on federal land and refused to approve the proposed Keystone pipeline from Canada, but it does little to curb consumer demand for fossil fuels. Many European governments, including the UK, have also been shielding consumers from elevated gas and power prices through subsidies, price caps, tax exemptions and other methods. The combination of unabated demand and constrained supply helps to further drive up prices. While the needy should be helped through the welfare state, well-functioning markets should be left alone.

Lessons From History

This has echoes of the events of the 1970s, which can provide some useful lessons to help navigate the green transition. Energy markets in the key consuming countries then were inflexible and inefficient, and unable to respond to the oil shocks by curbing demand and increasing supply.

World energy markets went through turmoil in the 1970s from two oil shocks: the price increase in 1973 following the war in the Middle East, and then more supply problems in 1979 following the Iranian revolution. The 1973 crisis caused oil prices to nearly triple. They stayed high for the rest of the decade before going even higher in 1979, with major consequences for growth, inflation and people’s wages.

What is less well known is that government interference made these problems worse. Price controls introduced in 1971 by President Richard Nixon put a cap on gasoline prices in the US, which discouraged domestic petroleum exploration, production, seasonal storage and refining. Oil production seriously declined after 1973 and was further discouraged by punitive taxes for new production introduced in 1975. So, while cheap gasoline kept demand high, US domestic supplies were far tighter than they might have been. Meanwhile in Europe, market competition in the energy sector was essentially illegal in most countries.

Markets Unleashed

It wasn’t until the 1980s that nations like the UK and US finally withdrew their ill-advised market interventions. Artificially high demand for gasoline fell, ingenuity was unlocked, and new cheaper oil resources were found and developed. The power of Opec significantly weakened, and oil prices tumbled.

Unfortunately, markets are fragile, and people have short memories. In 2020, another US president brokered a deal between Opec and Russia to end another price war. President Donald Trump scored short-term political points by pleasing US oil producers, and “rewarding” the world with higher oil prices at the time when it could least afford them.

Sclerotic Monopolies

In an echo of the European monopolists of the 1970s, the countries finding it hardest to move to new, cleaner forms of energy now are precisely the ones with sclerotic monopolies with little reason to change the status quo. Japan and Russia are good examples. Japan has been liberalizing its energy market since 2013 to allow more competition against the incumbent utilities, but progress has been slow. As a result, coal still generates over 30% of Japan’s electric power. Russia, too, outside of existing hydrogeneration, has hardly any renewable power to speak of. Incumbent monopolies have no incentive to invest in clean technologies as they are guaranteed a return on existing assets.

In countries where energy is supplied by monopolies, it is also particularly difficult to attract sufficient private investment for clean technology. So even if their governments push for a green transition, they are likely to end up creating new “green” monopolies. Instead, they need competitive markets based on various clean energy sources including nuclear, solar and wind. This means that all nations should be keeping infrastructure operators independent from electricity suppliers, ensuring that markets are competitive, transparent and the rules are clear.

To create a competitive and level playing field, some form of carbon tax is essential, too. There can be no incentive for innovation if incumbent monopolies can get away with generating cheap power, while polluting the environment.

Take Demand More Seriously

Unlike in the 1970s, we also need to take demand more seriously. Even the world’s most liberalized electricity systems offer few or no tariffs to incentivize consumers to save power during peak times, when power is scarce. Markets for power at the retail level are virtually nonexistent. Peak electricity demand is usually met by switching on plants powered by fossil fuels, which seriously curtails efforts to stop climate change.

For oil itself, demand also needs to fall significantly, even if it will still probably be used for some time in transport and plastics. This means curbing demand through carbon taxes, providing good public transportation and plentiful charging points for electric vehicles. Without tackling both sides of the demand/supply equation, gas and power shortages may continue for years.

While far from perfect, when supported by policy, markets generally work well in reducing pollution. A great example is the Acid Rain Program initiated by the US in 1995. It forced coal-burning power plants to buy tradeable emissions permits for sulfur dioxide and was so successful that acid rain is rarely talked about now.

Put a Price on Carbon

Markets work, and we must put a proper price on carbon. The European Emissions Trading System was long ineffective but is finally starting to function now that the rules around emissions permits have been tightened. Elsewhere, unfortunately, carbon trading is still in its early stages.

One of the goals of the COP26 climate conference was to tackle this. It was not entirely successful as there were no commitments from any new nations — other than existing ones — to introduce carbon markets in near future, although there was an agreement about the standards they should follow. Our challenge for the future is to convert these plans into action.

Adi Imsirovic is author of the book Trading and Price Discovery for Crude Oils, published by Palgrave McMillan in June 2021. He is a Senior Research Fellow at the Oxford Institute for Energy Studies (OIES) and a former Global Head of Oil at Gazprom M&T in London.


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