Economics Of Energy Markets Research Paper

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The improved living standards of the developed world rest on industrial processes that make intensive use of renewable and nonrenewable energy sources. Economists’ attempts to understand that prosperity tend to focus on legal institutions and commercial practices rather than on resource endowments. As recently as the 1990s, David Landes’s (1998) The Wealth and Poverty of Nations focuses on these institutions that enable people to contract with each other and to construct long-lived enterprises of large scale, rather than on resource endowments, including energy, as the foundations of that wealth. Thus, prosperity rests on division of labor, mechanization, and capital markets in a legal framework that enables people to coordinate their activities. Those elements were present in Adam Smith’s (1776/1976) pin factory, which was supported by human and animal muscle power and wood. The energy source as contemporary economists understand it was not viewed as a constraint or as an opportunity in those days, although the limitations of existing sources of power imposed serious constraints on earlier economic powers.

Evolutionary biologist Matt Ridley summarizes the effect of those constraints:

We saw a quintupling of cotton cloth output in two consecutive decades, in the 1780s and 1790s, none of it based on fossil fuels yet but based on waterpower. … At some point, you run out of dams. You run out of rivers in Lancashire to dam. (Bailey, 2009, pp. 50-51)

The British avoided the fate of previous economic powers by changing their power source to coal:

By 1870 Britain is consuming the coal equivalent to 850 million human laborers. It could have done everything it did with coal with trees, with timber, but not from its own land. Timber was bound to get more expensive the more you used of it. Coal didn’t get more expensive the more you used of it. (Bailey, 2009, pp. 50-51)

A similar dynamic was at work in the United States, where Alfred Chandler (1977) claims, “Coal, then, provided the source of energy that made it possible for the factory to replace the artisans, the small mill owners, and putting-out system as the basic unit of production in many American industries” (p. 77). Those transitions were not inevitable. The term horsepower is a marketing comparison of the early steam era, used by advocates of steam power to highlight the advantages of their machinery over those using animal power, let alone human power or waterpower, as the primary energy source. Readers will see that the quest for energy efficiency neither implies nor is implied by quests for greater economic efficiency or greater prosperity.

Energy sources have contributed to episodes of technical progress and improvements in prosperity. A recent Economist report (Carr, 2008) notes,

Many past booms have been energy-fed: coal-fired steam power, oil-fired internal combustion engines, the rise of electricity, even the mass tourism of the jet era. But the past few decades have been quiet on that front. Coal has been cheap. Natural gas has been cheap. The 1970s aside, oil has been cheap. The one real novelty, nuclear power, went spectacularly off the rails. The pressure to innovate has been minimal. In the space of a couple of years, all that has changed. (p. 3)

This research paper surveys the principal features of energy markets. Energy markets, like any other markets, are environments in which prices provide incentives for substitution, conservation, and invention. Those incentives, however, are subject to properties of markets that are the subject of advanced study, including the economics of exhaustible resources, the economics of large-scale enterprise including natural monopoly and economic regulation, the economics of common properties, and the economics of externalities. The usefulness of energy resources for industrialization and prosperity makes the resources the object of resource wars.

Daniel Yergin’s The Prize (1991), a history of the oil business, identifies three defining influences on it. These influences—the emergence of industrial economies that use lots of energy, energy as a source of conflict, and the gains and losses from using nonrenewable energy—provide structure to his work. This research paper contains an overview of the role of energy in a modern economy, a more detailed look at the economics of exhaustible resources and of large-scale enterprises, and an examination of the public policy responses to the special problems those features pose. This research paper explores contemporary efforts to develop new sources of energy to cope with resource depletion and environmental damage. Noted also is the national security or strategic usefulness of energy supplies, without digression to the diplomatic and military consequences that are further removed from economic analysis.

History

Primary and Secondary Energy

The Industrial Revolution that Adam Smith and Karl Marx came to grips with is the use of machinery with some power source to augment muscle power. The term energy is a brief way of describing that power. The source can be what scholars and policy makers refer to as either primary or secondary energy. Primary energy refers to natural resources that can be used to provide energy, including human and animal power, wood and other combustible plants, water, wind, coal, oil, natural gas, and nuclear fission or fusion. Secondary energy refers to an energy source that requires conversion of a primary energy source. The most common form of secondary energy in the modern economy is electricity obtained from the use of fossil or nuclear fuels in a generating plant. The central steam heating plant of a university or hospital complex and the cogeneration by-product steam from a generating plant are also secondary energy sources.

Changing Fuel Sources

The first source of primary energy other than human, animal, or waterpower was wood. In the United States, coal emerged as a domestic source around 1850. It was the single largest source of power, providing approximately 20 quadrillion Btu (quads), equal to 21 trillion megajoules, per year from 1910 through World War II.

Petroleum emerged around 1900 and overtook coal in 1947. Current petroleum consumption is around 40 quads (42 trillion megajoules). Natural gas emerged as a source at about the same time and followed a similar growth curve, rising by around 1970 to 30 quads. Coal was not eclipsed by these new fuels. Current coal use is about 25 quads (U.S. Energy Information Administration [EIA], 2008, p. xx, Figure 5). The EIA expects coal use to exceed natural gas use as a primary energy source from 2015 on (Figure 6).

For 2007, the fossil fuels constitute 86.2 quads of primary energy used in the United States, comprising 22.8 quads from coal, 23.6 quads from natural gas, and 39.8 quads from petroleum. An additional 8.4 quads originate as nuclear electric power, with 6.8 quads provided by what the EIA (2008) classifies as renewable energy, aggregating “conventional hydroelectric power, biomass, geothermal, solar/photovoltaic, and wind.” Annual energy consumption was 101.6 quads, of which industrial users consumed 32.3 quads, transportation 29.1, commercial enterprises 18.4, and residences 21.8 (EIA, p. 3, Diagram 1).

Energy Intensity Diminishes

Although industrialization means an increase in an economy’s use of energy, the intensity with which an economy uses its energy tends to diminish. For instance, Natural Resources Canada (2009) reports that the aggregate energy intensity of Canadian industry was 13,000 Btu (13.6 megajoules) per 1997 dollar of gross domestic product in 1990, which falls to 11,000 Btu (11.3 megajoules) per 1997 dollar in 2006.

Declining energy intensity of industries and of entire economies is characteristic of most industries in most countries, although readers will see that energy prices or attempts to achieve greater energy efficiency are not necessarily driving these changes.

Na Liu and B. W. Ang (2007) evaluate the research on energy intensity in a paper that, although not explicitly a survey, includes references to numerous other surveys of the evidence. The most common outcome researchers identify is reduced energy intensity over time, accounted for either by industry-wide changes in energy intensity, which they refer to as intensity effects, or by changes in the mix of products within an industry, which can be a shift to a more or a less energy-intensive mix of products, which they refer to as structural effects. In Liu and Ang’s review, the modal outcome is industry-wide reductions in energy intensity and a less energy-intensive mix of products, although many studies uncover a switch to a more energy-intensive mix of products that is offset by industry-wide reductions in energy intensity. The article focuses on improving index number techniques, leaving work on the sources of changing intensity, whether driven by prices or by factor-neutral technical change, for future research. Readers will see that such research will be of value for policy makers coping with resource depletion and environmental degradation as consequences of energy use.

Economic Theories for Modeling Energy Markets

Although energy markets offer economists ample opportunity to apply the traditional tools of supply and demand and those tools have been used to great effect in changing public policies, there are some features of energy markets where special models provide additional insight. Many primary energy sources are depletable, providing opportunities to use the theory of exhaustible resources. Many primary and secondary energy producers are large enterprises, where the theory of a natural monopoly is useful. Because energy markets sometimes involve competition of a few firms, for use of a common source or with pollution of a common sink, game-theoretic approaches (generally based on the prisoners’ dilemma) help structure thinking about public policy. The large scale of energy enterprises is often a consequence of special equipment such as refinery vessels or turbogenerators, and energy users often make investments in special equipment, which in the home might be a refrigerator or an air conditioner or in the factory might be an energy management system or a new steel furnace. The common feature of all such special equipment is that it is lumpy (one can speak of a smaller refrigerator but not of half a refrigerator) and irreversible (that steel furnace cannot be turned into a slow cooker, and the resale market for steel furnaces is thin).

Exhaustible Resources

Energy consumers have recognized for some time that their primary energy sources can be depleted. Deforestation inspired an early generation of conservationists in the mid-nineteenth century. The current generation of environmentalists might be surprised to learn that fears of the extinction of the whales arose at about the same time (Yergin, 1991). Where capital markets and property rights exist, there are incentives for people to invest in replacing the stock that they take. Tomislav Vukina, Christiana Hilmer, and Dean Lueck (2001) study the price of Christmas trees in North Carolina using a model of those incentives to provide the hypotheses they test. The same model can be used to consider the replanting of trees, sugarcane, or corn to provide feedstock for biomass fuels. There is no generalization of the theory to the oceans, which is regrettable for the whales.

One of the changes Geoffrey Carr (2008) refers to in contemporary energy markets is the dawning fear that the oil reserves will be depleted. In popular parlance, the expression peak oil, coined by Shell Oil petroleum geologist M. King Hubbert, refers to that time at which more than half the world’s proven reserves have been used or to the time at which the cost of extracting the oil reserves begins to rise. One could speak of peak coal in the same way: That neither Ridley nor Chandler characterized coal as subject, with increased use, to rising prices reflects improvements in the technology for mining coal as well as price competition from other sources of primary energy, including oil and natural gas.

The theory of valuing an exhaustible resource provides both a logical structure to the peak oil problem and an explanation of the nondepletion of coal. The theory begins with Harold Hotelling’s (1931) model. Although the mathematics (calculus of variations) proved daunting to economists of the day, the general principle is simple. A stock of an exhaustible resource is a capital asset. A wealth-maximizing holder of such an asset will use it in such a way as to be indifferent about the choice between consuming it now and holding it for later use. That indifference principle suggests the price of the resource will increase at the rate of interest, if the owner is in a competitive market. If the owner is a monopolist, the marginal revenue increases at the rate of interest. If extraction costs, either constant or contingent on the rate of depletion, are present, the argument becomes more complicated, but the general principle still applies. The results change in the presence of a backstop technology, which will replace the resource before it is depleted. Some models of exhaustible resources treat the time that a backstop technology becomes available as predetermined. The complementary problem, in which the Hotelling principle provides an incentive to develop the backstop technology, has not been investigated as intensively. Christopher Harris and John Vickers (1995) suggest a promising approach for such investigation.

Shantayanan Devarajan and Anthony Fisher (1981) revisit Hotelling’s paper, identifying further improvements on the model and providing empirical extensions. Robert Pindyck (1980) proposes a number of extensions, based on uncertainty in the resource markets. Empirical tests are difficult, owing to difficulties obtaining the price at which the exhaustible resource itself trades, because the resource itself is often extracted by companies that transform it into some other product before selling it. That is true of vertically integrated oil companies, which is one reason the model has not been used to test the peak oil hypothesis empirically, although James Hamilton (2008) addresses peak oil in light of the Hotelling principle, and C.-Y. Cynthia Lin, Haoying Meng, Tsz Yan Ngai, Valeria Oscherov, and Yan Hong Zhu (2009) offer a theoretical explanation for what they characterize as trendless oil prices where technical progress is a possible response to rising energy prices. Readers will also see that the absence of a trend in the price of oil or coal reduces the incentive to develop a backstop technology.

Large-Scale Enterprise

A second component of the theory of energy markets is that of markets that cannot be described using the perfectly competitive model. The first large-scale enterprises of the Industrial Revolution included the coal mines, along with the canals and later the railroads that came into being to transport the coal. From the beginning, public policy makers had to choose whether to create public enterprises or to rely on private investment. The roads and canals were among the first public internal improvements of the United States and Britain. The railroads and the mines tended to be private enterprises at first, although that is not universally true. Public policy makers had to improvise new legal structures both to make possible and to restrain those enterprises. In energy markets, the institutions of antitrust, regulation, and public enterprise each play a role.

Antitrust

The coal economy tended to involve smaller, less vertically integrated firms in which the mining, transportation, and retailing were functions for distinct businesses. The rudimentary rules of contract and liability, perhaps supported by the inchoate intellectual basis there was for understanding a competitive economy, sufficed as an energy policy. That was not the case for the oil economy, in which the Standard Oil Trust became an early example of a vertically integrated firm, combining refining with pipeline transportation and retail distribution, as well as working with railroads to obtain more favorable prices for transporting its inputs and outputs than its smaller competitors could bargain for. The trust emerged as a producer and distributor of kerosene for lighting and cooking well before the diffusion of private automobiles, a development that offered the oil companies the opportunity to vertically integrate into operating service stations.

Yergin’s (1991) The Prize provides a thorough overview of the emergence of the large oil companies. The worldwide extraction of crude oil, its refinement into fuels, lubricants, and petrochemicals, and its distribution to consumers led to firms of great scale and scope. In this expansion, entrepreneurs had many opportunities to get rich. The size of the stakes provided ample opportunities for corporations and governments to engage in acts of corruption and for owners to work together to take advantage of consumers.

Although the Standard Oil Company of New Jersey v. United States (1911) decision, which antitrust scholars call significant for its enunciation of the rule of reason as a general principle for enforcing United States antitrust laws, did not become the landmark case out of any special desire to make an example of the Standard Oil Trust, the legend of grasping and predatory oil barons the case inspires lives on to this day. John McGee (1958) interprets the evidence in the Standard Oil case to suggest that the oil trust, although clearly intending to monopolize sales of petroleum products, did so in such a way as to raise, rather than lower, its profits. He finds no evidence of the company selling at a loss to eliminate rivals.

The barons, however, more frequently operate in concert, rather than as a monopoly firm. In part, cooperative behavior is the only option in an industry where the dominant firm has been broken up by antitrust action. Cooperation, however, is a logical outcome for competing firms making common use of oil fields or pipelines. A similar logic applies to natural gas producers, and electricity producers share a common electricity transmission grid. Where firms have strong incentives to cooperate, government’s best response might be to supervise the competition, or it might be to operate the energy companies itself. The Organization of Petroleum Exporting Countries turns out to be an attempt by multiple governments to cooperate in such supervision.

Regulation

Establishing ownership of crude oil is not easy. An oil pool might extend under several parcels of property or under a national boundary. Common-law methods such as the rule of capture, which works for a hunter taking an animal on land, provide incentives for each oil producer to extract oil from under its property more rapidly, before somebody else pumps it out (Yergin, 1991). That rule also provides incentives for producers to engage in slant drilling, where the wellhead is on the producer’s land but the well draws from oil under a neighbor’s land. The consequence is uneconomic extraction of the oil, because additional wells dissipate the natural gas that provides pressure to push the oil to the surface. Some oil that would otherwise be extracted remains in the ground, and producers invest in pumps that they would otherwise not have to install. When the competition is between nations, drilling under national boundaries becomes a casus belli, as it did most recently in Iraq’s 1990 invasion of Kuwait.

The Texas Railroad Commission pioneered the use of an independent regulatory commission to manage the output of an oil field. Under a policy known as prorationing, each existing well received a production quota worked out with the intent of obtaining the maximum economic value of the field but often with the effect of enriching the firms subject to that regulation (Wilcox, 1971).

A prorationing policy with well-informed regulators can match the resource extraction behavior of competitive producers drawing down the resource in a Hotelling-optimal way. Those regulators can also match the resource extraction behavior of a monopoly, in which the marginal revenue from extraction rises at the rate of interest. The two outcomes are of more than academic interest, because the common property problem (Hardin, 1968) and the cartel problem (Osborne, 1976) can both be interpreted as prisoners’ dilemmas, in which the regulator can prohibit the individually rational but collectively suboptimal dominant strategy equilibrium, which is too rapid a depletion of the common property in the former but means lower prices for consumers in the latter. Yergin (1991) credits the Texas Railroad Commission with providing the Organization of Petroleum Exporting Countries, commonly called a cartel, with a model for their production quotas.

The large-scale enterprise provides a second, different rationale for government regulation when the enterprise is sufficiently large relative to its market that it is a natural monopoly. Perhaps the natural monopoly arises because the duplication of facilities, such as electric or gas distribution lines in a community, implies investments whose costs exceed any benefits that consumers might get from competitive supply of the electricity or the gas. Or perhaps the infrastructure involves large sunk costs, such that competing firms engage in Bertrand price competition down to avoidable incremental costs, risking the long-term profitability of both companies. In economic theory, a natural monopoly is an industry in which the cost function is subadditive, meaning any division of the outputs among two or more firms involves higher costs than a single firm would incur, over outputs likely to be observed in the industry’s market (Baumol, Panzar, & Willig, 1988). Where a single firm can serve the market more cheaply than two or more firms, that firm might be able to price like a profit-maximizing monopolist, with the attendant allocative inefficiencies.

The public utility concept, in which a company obtains a legal monopoly subject to supervision by an independent regulatory commission, emerged as a more flexible replacement for legislative or court supervision or for a public ownership that some policy makers viewed as ideologically suspect and others saw as subject to corruption. Before the Great Depression, most states had regulatory commissions, and by 1966, they had diffused to all the states (Phillips, 1969). As government agencies, however, regulatory commissions can be subject to the same public choice dynamics that confront public enterprises or governments themselves and make them imperfect instruments of control (Hilton, 1972).

Public ownership of the natural monopoly offers an alternative to direct regulation. Economic theory argues that natural monopoly is not a sufficient condition for monopolistic exploitation of consumers (Baumol et al., 1988, particularly chap. 8). These alternatives receive consideration in subsequent sections of the article.

Deregulation

Changes in the direct regulation of energy companies reflected both failures of the regulatory apparatus and improvements of market institutions. Alfred Kahn (1988, pp. xv-xvii) offers a useful summary of the events. Put briefly, regulatory failures in energy markets provided economists and policy makers with incentives to consider alternatives to direct regulation.

In natural gas, regulators had the responsibility of determining wellhead prices for natural gas, interstate transmission rates for common-carrier pipelines facing increasing returns to scale, and local delivery rates for consumers served by municipal gas mains that operated under canonical natural monopoly conditions. The outcome, however, was what Paul MacAvoy (1971) calls a “regulation-induced shortage” of natural gas. Because natural gas fields consist of multiple independently operated wells producing natural gas jointly with crude oil, standard formulas to price the output well by well or field by field broke down in administrative complexity. Today’s regulatory structure, in which city distribution companies and interstate transmission companies (where natural monopoly arguments make some sense) remain regulated while the gas wells enjoy relative freedom to compete in price, emerged as a less cumbersome alternative.

In electricity, a combination of perceived difficulties in regulating the enterprises with improvements in the implementation of market pricing led to the partial or full deregulation of the electric utilities. George Stigler and Claire Friedland (1962) suggest that regulators had relatively little effect on the price of electricity because electric utilities had relatively little monopoly power. The cost and duration of regulatory cases led regulators to circumvent their own procedures with automatic fuel adjustment clauses that raised production costs (Gollop & Karlson, 1978). Subsequent empirical research could not reject the hypothesis that regulated electric utilities were charging monopolistic prices (Karlson, 1986). At the same time, theoretical work considered the possibility of competition for the right to operate a natural monopoly, which in the work of Harold Demsetz (1968) takes the form of an auction, with the bidder offering to operate the service for the lowest price obtained the franchise, and in the work of Baumol et al. (1988) and extensive follow-on research takes the form of sufficient conditions under which potential competition compels a natural monopoly to price efficiently.

Paul Joskow (1997) provides an overview of the changed circumstances leading to deregulation. The transition to a deregulated environment came with difficulties, the most famous of which is the California power crisis of early 2001. Severin Borenstein (2002) evaluates what went wrong and suggests some directions for future improvements of policy.

Public Enterprise

In much of the world, the energy industries are private enterprises simply as a matter of course, with no ideological statement intended by the government or understood by the citizens (Viscusi, Harrington, & Vernon, 2005, chap. 14; Wilcox, 1971, chap. 21). In the United States, nuclear electricity is a by-product of research into the use of nuclear fission for purposes other than weapons. Contemporary efforts to develop solar, wind, and biofuels involve federal subsidies and public-private partnerships. The effectiveness of many of these projects will provide term paper topics for students later in the century.

Irreversible Investments

Many investments involve irreversible commitments to purchase equipment that cannot be easily converted to other uses. Electricity generating plants are large examples of such investments. Home air conditioners and refrigerators are smaller examples. All three are technologies that have the potential to reduce the economy’s energy intensity as new units replace older ones, in the first case by reducing the energy intensity of the generating system, in the second and third by reducing household energy use. All three have been the subject of economic research suggesting that investors hold out for returns on their investment that exceed the opportunity cost of capital.

That reluctance, in seeming defiance of all models of rational investment behavior, was observed so frequently among energy producers and energy users that it received a special name, the energy paradox. Kenneth Train (1985) offers an early survey of research that seems to identify a reluctance to invest. Kevin Hassett and Gilbert Metcalf (1993) suggest that investors in energy conservation technologies require a rate of return of about four times the cost of capital for the investments they make. In subsequent research, the same authors evaluate the quality of the data used in consumer studies to suggest that “the case for the energy paradox is weaker than has previously been believed” (Metcalf & Hassett, 1999, p. 516).

That reluctance to invest is neither necessarily suboptimal nor necessarily paradoxical. The act of making an irreversible investment involves the exercise of a real option—namely, to defer the investment until economic circumstances are more favorable, where favorable can mean a higher price for the electricity the generating capacity produces—or a higher price for the electricity used to power the refrigerator or air conditioner. Investor behavior is thus a manifestation of economic hysteresis. The general theory of irreversible investments has been the subject of extensive analysis, much of it specifically inspired by observed behavior in energy markets. Avinash Dixit’s (1992) “Investment and Hysteresis” is a straightforward introduction to the topic. Dixit and Pindyck’s (1994) Investment Under Uncertainty provides comprehensive treatment of several different models of irreversible investment, with energy applications that will reward careful study.

The recent (late-2007 to mid-2009) swings in crude oil prices call for such research. A permanently higher price, or a price rising at or with the interest rate, is a stronger incentive to work on a replacement technology. A falling price weakens that incentive. In the irreversible investment models, greater price volatility also weakens the incentive. Where there is currently no backstop technology available, delayed invention has the potential to leave an economy with a depleting resource and no replacement in development.

Energy and the Environment

The interaction between energy uses and environmental consequences presents researchers and policy makers with substantial challenges. On one hand, worldwide economic development means improved living standards for people whose parents or grandparents might have lived their entire lives in extreme poverty. On the other hand, that development involves additional demands for the stocks of nonrenewable resources, additional pollution from the use of the carbon-based and nuclear primary energy sources, and additional pressures on water and land that has uses other than as energy sources.

That global development is substantial. Thomas Friedman (2008) uses the expression Americum to refer to “any group of 350 million people with a per capita income above [U.S.] $15,000 and a growing penchant for consumerism” (p. 50). That figure once described to two populations, primarily in North America and western Europe. There are at least two more today, one each in India and in China, and an environmental consultant Friedman cites expects a world of eight or nine Americums, which Friedman characterizes as “America’s carbon copies.” That’s an ironic expression, referring to the potentially adverse economic and environmental consequences of that development.

There are several trade-offs at work. First, reductions in the energy intensity of the world economy are not necessarily improvements in the efficiency or the prosperity of the world economy. One does not have to contemplate a return to the less energy-intensive world economy of 1700, when living conditions were worse for everyone. The economic model of substitution in production provides the explanation for today’s economy: Allocative efficiency is the equating of marginal products scaled for input prices. A firm that reduces its energy use irrespective of the opportunity cost of other inputs, or a public policy that mandates reductions in energy use without regard to those opportunity costs, reduces output and the allocative efficiency of the economy. Adam Jaffe, Richard Newell, and Robert Stavins (1999) describe several differing visions of lowered energy intensity. Three are relevant to this research paper. First, there is a technologist’s optimum, in which economic efficiency is irrelevant as long as energy efficiency is increased. From an economic perspective, that outcome ignores the opportunity costs of the inputs that produce the outputs from which the derived demand for energy arises. Second, there is a theoretical social optimum, in which the cost of implementing energy-efficiency policies is irrelevant but the opportunity cost of other inputs is relevant. From an economic perspective, that outcome abstracts from the frictions of developing and implementing public policy. Third, they suggest a true social optimum, comprising those corrective policies that pass a cost-benefit test. The paper includes a useful list of references that supplements those noted in this research paper. The authors suggest that “market signals are effective for advancing [diffusion]” of new technologies, but imposition of minimum standards for energy efficiency, such as automotive fuel economy requirements, may not be. The market signals, however, can be incentives to adopt a technology because of its potential to lower the adopting firm’s costs (a process technical change) rather than because of the energy savings it promises (a price-induced technical change). For example, Gale Boyd and Stephen Karlson (1993) suggest that the process incentive, rather than the price incentive, induced steel companies to install new steel-making technologies.

The achievement of any form of energy efficiency is more difficult because energy use produces negative non-pecuniary externalities. Completing energy markets, by taxation or regulation to address those externalities, is therefore likely to be a long-lived project for researchers and for policy makers. Such market completion might foster development of replacements for nonrenewable energy resources. It also changes the incentives energy consumers will face. The business that seeks all profitable opportunities to conserve on fuel use, for instance, currently faces prices that do not reflect the mortality or morbidity of a smoggy city or of proximity to a uranium mine or a nuclear waste pile, let alone the potential lost output that would follow a melting of the polar ice caps. The cost-benefit test that yields the true social optimum of Jaffe et al. (1999) requires somebody, or some collectivity, to determine what benefits and costs make up that test.

More recent research contemplates policy mixes to achieve compliance with tighter environmental standards, such as the Kyoto Protocol targets, while reducing the economic welfare or efficiency losses that compliance might imply. William Pizer (2002) simulates several policy changes looking forward to 2010. He suggests that policy makers combine mitigation policies, rather than rely on emissions targets or corrective taxes alone, to achieve greater efficiency gains. Bob van der Zwaan, Reyer Gerlagh, Ger Klaassen, and Leo Schrattenholzer (2002) introduce endogenous technical change, perhaps induced by environmental policies, into several macro-economic simulations to suggest that improvements in technologies other than fossil-fuel-using technologies are more promising at reducing carbon emissions. The results of these simulations are not surprising, although they suggest opportunities for research on the actual evolution of new energy sources and new energy-conserving technologies in 2010 and beyond, perhaps in combination with work on irreversible investments and improved trading regimes for pollution permits.

Second, efforts to mitigate climate change without returning world standards of living to those of 1700 involve additional equity and efficiency trade-offs. Mitigation in an equitable way poses problems that may not be the comparative advantage of economists. Richard

Tol (2001) summarizes the challenge: The poorer countries, as measured by their low energy use, also face the greater harm from climate change. “Greenhouse gas emissions and vulnerability to climate change show a strong negative correlation. This is the moral issue at the heart of the climate problem” (p. 71). He describes his paper as “academic constructs” with the potential to “help to inform further thinking about how to handle the enhanced greenhouse effect” (p. 84).

Third, although renewable energy sources provide a way around depletion of the nonrenewable sources, those sources also involve trade-offs. Fuels that make use of biomass, including ethanol and vegetable oils, are carbon compounds. The act of growing the plants can serve as a carbon sink, but the net carbon balance need not be positive. Waterpower cannot escape the running out of rivers to dam. Reservoirs pose a common property problem in which maintaining sufficient depth for electricity or other industrial use means holding water back from downstream drinkers or recreational users. Wind power requires a connection to the electric transmission grid. The most reliable winds are in sparsely settled parts of the United States, and the power grids are where the people are. Thomas Ackermann (2005) provides a comprehensive survey of the technical challenges facing wind-power producers. Finally, land occupied by solar collectors is sometimes not available for other uses. Each of these technologies further involves an irreversible investment facing competition from exhaustible resources whose prices neither follow Hotelling paths nor incorporate the effects of negative externalities.

Conclusion

Energy markets allocate the primary and secondary energy sources that have relaxed the constraints of human and animal power on creating, producing, and exchanging. Those markets have also called for economic analysis using models other than the standard perfectly competitive model. Those models have suggested public policy reforms and reforms to those public policies. The use of primary energy requires that producers, consumers, and policy makers deal with resource depletion and environmental degradation. The challenges of these problems will continue to provide economists with theoretical and empirical research opportunities.