Beyond “Getting the prices right”: Exploring the practical economics of the low-carbon transformation
The rapid pace of innovation in low carbon policy making is outpacing capacity to learn lessons. Policy learning should be accelerated to avoid costly mistakes. Climate change policy is moving beyond traditional instruments to drive market reforms, innovative financing and infrastructure policy.
Reviewing a wide range of recent experience of policy implementation the following conclusions were drawn:
• Understand the limits of price signals: experience suggests that issues of market structure, political risks and multiple uncertainties reduce the impact of policy induced price signals on driving low carbon investment and innovation. Price signals have been important in driving operational decisions, signaling the overall trajectory of decarbonisation and comparing the efficiency of policies.
• Getting the markets right: the role of prices is more usefully analyzed in the context of getting market structure right. Markets must encourage efficient investment, competition, new entry and innovation. Regulated markets must incentivize areas where maximum cost reduction and value creation can be realized; hence a growing focus on developing demand side markets. Governments are increasingly acting as “market makers” setting demand and support incentives. This requires them to more carefully balance investor certainty and policy flexibility through predictable policy processes to revise incentives and targets; this has similarities to interest rate and utility regulation.
• Risk manage the decarbonisation trajectory: the low carbon transition is characterized by pervasive uncertainty. Good policy can reduce some risks but others are unavoidable and need to be managed. Policy risk cannot be completely removed from political markets. Policy makers can use road-mapping to understand the economic and environmental costs of different technology and policy scenarios, analyze interdependencies, and design effective “no-regrets” and options-based strategies.
• Don’t over-pay for action: efficient policies are very important, including to maintain public support for decarbonisation. Ensuring energy efficiency opportunities are fully exploited through a “demand –side first” approach will help hold costs down. Policy-driven prices and subsidies can be expensive and may risk capture by vested interests resulting in large deadweight losses; policies should avoid locking incumbents into “low-carbon corporatism”. High degrees of transparency and contestation are important, and policies should be designed to avoid excessive market concentration.
• Integrate innovation and infrastructure policies: increased levels of innovation and enabling infrastructure are implied in all cost-effective decarbonisation trajectories. There is a need to fully integrate innovation and infrastructure policy in all delivery and market systems.
Providing decision support to design policies in specific economies will require new tools. This will require a cross-disciplinary approach drawing on a wide range of economics such as: behavioral and institutional economics; principle agent and game theory; industrial and disequilibrium economics; finance and business theory; portfolio and option theory; public goods and welfare economics; risk management.