Market forces

Government is the problem, not the solution

1 February 2009

“Obama ... should recognise that the solution is not the government but the market, and create policies that empower free market forces to develop and shape the new green economy.”

Twenty-eight years ago when Ronald Reagan gave his inaugural presidential address during an economic crisis, he said government is not the solution; it is the problem. When Barack Obama gave his inaugural presidential address in January he said the opposite – that only watchful government can prevent the market from spinning out of control. Obama argues that today’s crisis is more severe than that of 1981, and he is right in this assessment, yet the scale of a crisis should not dictate whether government is the solution and in a crisis that was precipitated by poor governance it cannot be the government that solves the crisis.

Regardless of the rights and wrongs, governance will play a powerful role in the energy markets over the coming twelve months. Energy markets are being increasingly driven by politics and economics, and with a global recession likely for much of this year there is little doubt these factors will play a significant role in energy issues throughout 2009.

President Obama has made clear that building a new green economy will be a key policy during his term, and in the UK Gordon Brown has made a similar pledge. There is certainly some rationality behind such a strategy. At some point this year, or possibly next, the economic downturn will bottom out and when it does the ‘new’ economy should be as green as possible. But there are risks with such a policy.

Energy policy was prominent during last year’s US presidential election campaign. Both John McCain and Obama declared their commitment to emission reductions and taking a leading role in global climate talks, but their policies differed markedly on the US’s dependence on foreign oil. McCain saw the solution as expanding drilling in the US, both onshore and offshore and in particular in Alaska, while Obama argued that the US should be weaned off foreign oil through investing in a new green economy.

Since he was elected 44th president the economy has further worsened and oil prices have collapsed below $50/bbl. This being so the political urgency to put in place a future oil policy has been eroded. But Obama will have to give some intelligent thought to the US’s oil future and this will in turn impact on global energy markets.

Obama has been rightly applauded for his vision of creating a new green economy but there are two challenges to be addressed that will determine how successful his vision is. The first of these challenges is the rate of conversion from a carbon to green economy. The US economy will always have a degree of oil dependence, as will the global economy, and the risk of rapidly ditching oil is that OPEC may see this as destroying oil demand certainty.

Last year OPEC made clear that it would respond to any perceived destruction of demand by halting investment in new production. Such a threat, if carried out, would ramp up energy prices and could potentially undermine a developing green economy.

The new president therefore needs to understand that there has to be a sustainable balance between the existing oil-based economy and a new green economy, which is particularly important during the current economic downturn. Over time this balance will move further toward the green economy but this rate of transfer cannot be predetermined; it has to be market led.

The need for market forces leads to the second challenge facing Obama. There are two strategic approaches that can be taken to develop a green economy: one is to shift prices with an explicit or implicit tax in order to capture the true cost of using oil and other carbon-based energy sources and let producers and consumers decide for themselves how to adapt; the other approach is to micro-manage a transition to new oil and carbon-saving technologies through a mixture of mandates and subsidies.

From his recent speeches it would appear Obama wants to adopt a mix of taxation and subsidisation, with more of a leaning to subsidies. Such a leaning would be true to the Democrat belief in big government where the state dictates the actions to be taken. The UK has taken a similar approach through the Renewable Obligation.

There is a persuasive argument that as government has created the current economic problems it cannot be the solution. A similar argument can be applied to the energy markets, with the ‘climate challenge’ seeing European governments rush to micro-manage energy and climate policies to redress the problems that government had created one or two decades earlier.

This climate action rush is best illustrated by the carbon cap-and-trade schemes, with the first US scheme – the Regional Greenhouse Gas Initiative – commencing 1 January. Although well intentioned, these schemes offer too much scope for gaming the system with profiteering almost endemic in the first phase of the EU ETS, create difficulties in creating coherent international schemes out of national carbon abatement schemes, and, most importantly, have failed so far to create a carbon price that is sufficient to provide the necessary low/zero carbon investment incentive.

A fairer approach would be carbon taxation, particularly if the level of taxation increased when the oil price fell. A carbon tax would remove the need for renewable/green economy subsidies by creating a level investment field based purely on the carbon cost. This would obviate the need for government to choose the energy winners and losers and would give over the development of a new green economy to free market forces.

Having had ample time to observe the successes and failures of US and EU energy and climate policies of the past decade, Obama should be bringing some fresh thinking to energy and climate policy. He should recognise that the solution is not the government but the market, and he should create policies to empower free market forces to develop and shape the new green economy.

In his election campaign, President Clinton’s famous mantra was ‘it’s the economy, stupid’ and this is just as relevant today as it was in 1993, indeed more so. Obama says he wants to be a president of change, and 2009 has to be the year that the seeds of these changes are implemented on the economy, on energy supply and on climate change. Obama should re-work Clinton’s mantra into ‘it’s the market, stupid’ and if he does he will provide a valuable policy lead to other global economies.

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