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Market failures and barriers in the energy sector

Posted by Zoe Bodinetz on 13 December 2019 at 11:38 am

What are they and how can they be overcome?

Why do we continue to live in houses that are energy inefficient even though it loses us money through high energy bills? Why do fossil fuels continue to be the cheapest option even though we know the dangers of using them? Why don’t more people use solar panels if they can supply ‘free’ energy from the sun?

A basic ‘market’ is built on the interactions between supply and demand, producers and consumers and the price of goods. In theory, in a ‘perfect’ market, the supply, demand and price will reach an equilibrium where the price is high enough that the producers are making enough profit, and low enough that the consumers are able to buy the particular good, and the outcome is ‘socially optimal’.

 Unfortunately, real life markets are never perfect, and the energy market is no exception; it has a number of ‘barriers’* and ‘failures’ that prevent this socially optimal outcome, and explain why we continue to live in a world where the cleanest, most efficient, and indeed cheapest energy sources are not always the ones being used.

 

Capital costs

The capital cost is the ‘up-front’ cost of a particular good, and renewable energy options tend to have very high capital costs for installation. However, production and distribution of renewable energy is often much cheaper than fossil fuel equivalents, so over time this should pay back the initial capital cost, saving the buyer money long-term. An example of how this barrier could maybe be overcome, is for the government to give grants to smaller businesses or lower income households to allow them to replace their current energy technologies with cleaner, more effective ones. Subsidies from the government into development renewables could also lower this initial capital cost.

Low Incentives

A similar problem can be seen in energy efficiency of houses. Making changes to your house to improve its energy efficiency (such as double glazing, insulation and LED lighting) will save you money in energy bills but will have a high capital cost. Additionally, increasingly in the UK people are renting rather than owning their houses, so there is no incentive for tenants to pay for efficiency improvements to a house that they may not be living in very long, because they will get none of the pay-off of long term energy bill reduction. From the landlord’s perspective, they will not want to pay for home improvements to save money on bills that they are not paying. It may be possible to overcome this barrier by setting up some sort of scheme where the cost of efficiency improvement is shared between landlord and tenant, or a law that places the responsibility for housing efficiency on the landlord.

 

External costs

Fossil fuels have what is known as an ‘environmental externality’, which means their use has an effect on the environment, which we know to be contribution to climate change through greenhouse gas emission. The price of fossil fuels is based on the cost of production, purification, distribution etc but the environmental costs are not taken into account when the market price is decided. This means the price of fossil fuels is too low and therefore the consumption of fossil fuels is too high (from a welfare point of view). The environmental cost could be included in the market price by adding a ‘carbon tax’ to the price of fuels which have known, damaging effects on the environment.

 

Market power

The uneven distribution of energy resources often means that only a few producers can make certain goods. For example, most of the oil reserves on the planet are concentrated in the middle east, so only a few countries are supplying the rest of the world with oil. This means that they have more ‘market power’, and can result in much higher prices because they have fewer competitors. It also means that if supply from one source is lost for some reason, there are not enough other sources to satisfy the demand so the price will become much higher very quickly. However, there is currently a big increase in the number of producers of renewable energy, so this should begin to reduce the effect of market power in the energy market.

 

Lack of information

In the energy market particularly, it can be very hard for consumers to know the quality of their supplier. People will not pay the maximum price for something they cannot guarantee is the ‘best’, and producers have no reason to be offering the ‘best’ if they can’t charge the maximum price for it. This cycle could be broken by a trustable grading system, that allows transparency of product quality. This would allow people to pay for cleaner and more effective technologies, with the knowledge they are getting their money’s worth.

This basic analysis of a few of the market barriers and failures in the energy sector should hopefully provide at least a partial explanation of why it is taking so long to move towards a more sustainable and efficient system. It has shown that government intervention is needed to influence the market forces, and accelerate this transition.

 

If you have a question about anything in the above blog, please ask it in the comments section below.

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