Subsidizing new energy technology

Several outspoken progressive bloggers have adopted an extremely market-driven view of energy policy: price carbon and then get the hell out of the way. Prominent proponents include Ryan Avent and Matt Yglesias.

As a market-oriented liberal, I have a great deal of sympathy for this argument. It mixes a progressive goal, stopping climate change, with a rigorous, economic take on the best way to achieve it. I'm upset by those who think that bashing Wal-Mart and free trade is necessarily "progressive," and thus I'm heartened to see prominent figures in the left half of the blogosphere express such market-friendly sentiments.

Unfortunately, they're wrong.

Not entirely wrong, of course. Pricing carbon should indeed be the centerpiece of any strategy to confront climate change, and government efforts to promote "environmentally friendly" technologies are often special interest boondoggles. (Think corn ethanol, clean coal, and hydrogen.) But there is an essential public component to developing alternative energy technology that we cannot ignore, and even the supposed wonders of carbon pricing cannot circumvent it.

To see why, consider that the price of residential solar electricity from photovoltaics averages almost 40 cents per kilowatt hour. We have reason to think that these prices will be falling dramatically in the near future, but at the moment they are far above standard residential electricity, which generally costs somewhere between 7 and 15 cents. Even an outlandish $100 a ton price on carbon, raising the price of coal power by 10 cents per kilowatt hour, would not make photovoltaics competitive at today's price levels.

Now imagine the situation several decades ago. Back then, solar cells were so outlandishly expensive that electricity from the sun was an impossible luxury. The power they produced cost hundreds of cents per kilowatt hour, and a only few small niches (e.g, isolated scientific instruments requiring a power source) provided any hope of a market. Even if we had implemented a crippling carbon price, solar electricity would not have been viable for many years.

How, then, did it get even close to viability? The natural niche markets were too insignificant to make much of a difference, but subsidies, direct research funding, and scattered, clunky "renewable energy mandates" provided the support that kept the industry developing. Over time, the price of solar power fell exponentially, until we reached the point we're at today, where solar electricity is the most promising component of a low-carbon energy future.

This would not have happened if 30 years ago we put a stiff price on carbon, eliminated our patchwork of alternative energy mandates, subsidies, and direct funding, and declared the job done. Solar electricity is unlike almost any other infant industry in the world: it has close to zero natural market until it reaches difficult cost thresholds.

Imagine if this was the case for computers. What if individuals, businesses and governments hadn't been willing to pay anything for computing power until it reached the level (and price) it's at today? Without any support in their earliest stages, computers simply wouldn't have developed. Keep in mind that even when computers were insanely expensive by today's standards -- millions of times less power per dollar -- they were still snapped up by industrial buyers, who apparently found them useful.

There is no analogous process of development for alternative energy, no demand curve that gently slopes downward and nurtures even the most expensive new technologies. The transitions are sudden and devastating. At 40 cents per kilowatt hour, solar power is a costly curiosity; at 5 cents per kilowatt hour, it is a spectacularly useful innovation. Without government intervention, as clumsy and piecemeal as it is, we would not have developed solar energy that is on the brink of competitiveness.

You might ask: why is this necessary? Why can't efficient markets make a massive investment in alternative energy, when the potential returns are so vast? As I've mentioned before, there is a compelling economic explanation: spillovers from research and development. Even with some degree of intellectual property protection, the benefits from research by one firm naturally "spill over" to the entire industry. If company A succeeds using a particular chemical compound in its product, companies B, C, and D will start trying similar compounds for themselves. If A's attempt fails, then B, C and D will have reason to suspect that its technique isn't practical. When Company C pioneers a particular method of efficient manufacturing, A, B, and D will rush to follow suit. Since each firm gains only a fraction of the returns from its research, the true economic gain from research isn't matched by the private benefit. Firms are profit-maximizing organizations that seek to increase their bottom lines, and thus this disparity between public and private benefit produces a systemic underinvestment in research.

In theory, this underinvestment adversely affects all kinds of research. It is particularly devastating, however, when a technology may not be viable for several decades, and when there aren't any clear intermediate technologies that can support the industry in the meantime. As we've discussed, alternative energy is the ultimate example of this dilemma: it may ultimately be the best option, but until it comes close to passing certain cost thresholds, it's dead in the water. And "coming close to cost thresholds" won't always happen spontaneously...

How to address this? Well, providing subsidies that make alternative energy practical in a few favorable markets is one solution. In capital-intensive cases like solar power, directly subsidizing the capital costs is an easy and controllable way to boost the industry. Direct funding for basic research is also a good idea, and even "portfolio standards" that mandate solar and wind power as a small part of the energy mix aren't necessarily as bad as they seem (although they're certainly not optimal policymaking).

In conclusion, I'm not sure how many environmental progressives realize that even with an enormous carbon tax, solar power from photovoltaics wouldn't be competitive today, and even solar thermal would be questionable. Yes, as my incessant cheerleading demonstrates, I think that they will become competitive in the next decade or two, but this is because of a research and development trajectory financed by special government subsidies and handouts. Our alternative energy policies are scattered and often terribly clumsy, showering billions on undeserving technologies, but they still are an essential part of development.