Alternative energy and the market.

While markets have problems, they are generally far preferable to government intervention.

One of the ways in which markets fail occurs when capital costs are high and when the time required to bring alternatives into production is long. Too often, Government's first response is regulation. It should be a last resort.

Right now, the vast majority of our energy is derived from fossil fuels. Unfortunately, fossil fuels were created over millions of years and burning them can be likened to spending an inheritance rather than investing it for sustainable income.

At some stage, in the not so distant future, the supply of fossil fuels will be insufficient to meet the demand. We will have spent so much of our inheritance that there is not enough to support our lifestyle.

While the exact date is not important, it is clear that conversion to sustainable energy sources (wind, solar, tidal etc.) will be a long process. It is also clear the immediate costs of sustainable energy sources make them mostly uncompetitive now.

How then should the government react when the market is not yet giving price signals that will enable conversion to sustainable energy sources in a timely manner?

Just considering the supply issues, we can agree - even without introducing issues of global warming - that burning fossil fuels is bad idea (although not, perhaps, if we don't care about our children and grandchildren) and that we need to convert to sustainable and renewable sources of energy.

Europe has introduced a so-called "cap and trade" mechanism for controlling Carbon Dioxide (CO2) emissions. In theory, this will limit the use of carbon based fossil fuels and encourage those who can reduce their usage at the least cost to do so.

Unfortunately there were two fatal flaws in the first phase of the system. First, emissions permits were issued at no cost to the recipients and, second, far more permits were issued than were demanded. This is a classic case of government regulating and getting it wrong. The result was that there were large costs incurred to produce little that was good. The second phase may be better but the market is still best.

The U.S. government is now considering a cap and trade system. It also subsidizes alternative energy sources. So we have the government regulating - with the risk of getting it badly wrong - while simultaneously setting the scene for the lobbying industry to get its clients favored at the expense of economic sense - and trying to pick winning technologies.

Sometimes, in the case of the subsidies for domestic ethanol combined with sky high import duties on Brazilian ethanol, it does both at the same time!

Since government's record in picking winners is really poor, we need another way forward. That solution is the market but, in this case, the market needs a bit of help.

Since burning fossil fuels is a bad idea, tax them - a lot. To avoid economic disruption raise the taxes over a period of a few years which will allow energy users and suppliers to adjust in a controlled manner. Reduce or abolish other taxes (many are inefficient, unproductive, or outright harmful) to compensate for the increase in energy costs.

Since no one really knows what alternative technologies will work best, let the market choose.

To tax what we know is bad will work far better than trying to guess what might be good - and then subsidizing it.