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strategy and business
Published: November 30, 2006


Toward a Flexible Energy Future


Illustration by Lars Leetaru

In most of the industrialized world, there is a growing consensus that nations must reexamine and restructure their energy portfolios. A number of factors have contributed to this awareness: increasing fuel prices, the insecurity of energy supplies, and the recognition that humanity must reduce its carbon dioxide (CO2) emissions to address global climate change. Even countries that have enjoyed steady supplies of electricity, transportation fuel, and heating fuel in the past will find it much more difficult to maintain control over those supplies in the future. Any responsible government that is not thinking seriously about its country’s energy investments today — from both the public and private sectors — risks being caught cold, powerless, and immobile in the future.

But there is typically a five- to 10-year lag between an energy investment and the time the new capacity comes online. After that, countries are stuck with the facilities they have built for at least several decades. Thus, every major decision made now about energy involves a bet about the future. Because we don’t know which mix of fuels will be available or most useful in the coming years, how can investments best be allocated among natural gas, coal, oil, nuclear power, renewables, or improved energy efficiency?

The debate over these choices is contentious. In my own country, the United Kingdom, there are heated arguments over whether nuclear power should be promoted or decommissioned; whether increased use of natural gas is or is not a viable option; and whether wind farms represent an ecological breakthrough or an inefficient blight on the countryside. In any given year, new energy technologies (hybrid cars, hydrogen fuel, biofuels) emerge and add to the contention. The only way that political and business decision makers can appropriately manage these options is through a flexible portfolio: not a choice about a particular mix of fuels but through an effective and resilient marketplace that can take advantage of economic principles to help us settle on the optimal combination of investments at any given time.

In policy circles, this is coming to be known as the “modified market approach.” The government (or perhaps a regional political structure like the European Union) establishes a framework for energy prices. This framework incorporates the prices and costs of energy, as set by supply and demand, but also takes into account the social and ecological benefits and harms of each fuel source. Fuels that exacerbate climate change, for example, are made more expensive; fuels that reduce the danger cost less. An implied surcharge on carbon-based fuels reflects the desired CO2 reduction target. Once a rationale is agreed on, the government embeds the new framework in permits, surcharges, and regulations, after which the various technologies can effectively compete in the marketplace.

The modified market approach is a relatively recent innovation. Traditionally, governments have handled energy decisions in two ways: “Add it up” and “laissez-faire.” Adding it up is a time-honored approach. Government planners assess worldwide energy needs and generation capacity, make projections for the next 20 years, calculate the gap between future demand and supply, and decide which mix of fuels to subsidize, tax, or invest in.

Flexible Portfolios
Even at its best, this approach has many shortcomings. It is static; if energy technologies, supply constraints, or demand patterns change, another plan will be needed. It is also vulnerable to lobbying, with the verdict going to whichever pressure group shouts loudest that “our favorite fuel is better than yours.” And if political priorities change, the desired goals cannot be adjusted without a new plan. This makes it extremely difficult to take advantage of lower-cost opportunities, such as new technological developments, that emerge in later years.

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