Paying Tomorrow for Energy Today

National policy has long followed the assumption that the more we extract and use our natural resources, the faster we build up the economy. The larger the volume of materials we process, the richer and more secure we become. By extracting “dormant” resources today, so the idea goes, we can turn them into productive assets, promising future generations a higher level of well-being than they would enjoy if we were to let the resources lie fallow in the ground.

This exploitative policy toward natural resources does not appear to have been entirely intentional, nor has it been completely uniform. Yet the policy bias toward development and exploitation has been pronounced.

In the past, this may have made sense: our resources appeared limitless, and the pollution and other environmental costs associated with their extraction were relatively small and localized. Now that conditions are changing, however, we are caught in a pattern of our own making. Whatever our stated policy, we will be forced to rely on new domestic sources and to pay higher prices for energy in the years to come. And as we adjust to a less energy-intensive economy implied by the higher prices, the amount and pain of adjustment will be increased by our previous policy encouraging exploitation.

We cannot fall back on the once comforting assertions that we have hundreds of years’ supply of coal and shale oil: in many cases the environmental costs of developing these resources are so high that much of the material may best be left in place. Suddenly we find ourselves in short supply of energy commodities.

For the short run, at least, we are “locked in” from both sides. Short-term adjustments in demand for energy will be painful, and many of the supply options will take years to develop.

How are we to decide on the amount and type of conservation needed, and how are we to decide on which new sources to develop, under what timing, and on what scale? So far, many of these decisions have been left to the marketplace. The desirability of the market decision in the case of energy development and consumption depends upon three conditions: (1) the competitiveness of the energy industries, (2) the nature and size of environmental costs, and (3) the degree to which those affected by today’s market decisions are fairly represented in today’s market.

When the decision is left to the marketplace, it is made upon the test of profitability. It is sometimes thought that by leaving these decisions to the market, economic efficiency will automatically be achieved. But in the market, the only costs and benefits considered are private ones, those borne by the firms making the decisions. Environmental costs are excluded from the analysis except as the firms are forced to bear them by rules of liability, government regulation, or pollution taxes. (It is important to point out that the failure to include environmental costs is not unique to decisionmaking by the marketplace: in choosing and developing new sources of supply, government agencies, too, have often neglected environmental costs.) By the test of private-market profitability, new sources will be scheduled in order of their private costs, from lowest to highest.

Largely in reaction to this approach, environmentalists have stressed the importance of considering the environmental costs in choosing and developing new sources of supply. Occasionally, they go so far as to advocate the selection of new sources on the basis of environmental costs alone. By this criterion, new sources would be scheduled from those lowest to highest in environmental costs, regardless of the private costs.

Ever since the time of Pigou, in the early twentieth century, economists have pointed out that such decisions should be made on the basis of both private and environmental costs. Certainly both types of costs should be taken into account, but while this position has made fine reading in textbooks, it has not prevailed in practice. The environmentalists’ criterion—which is conceptually just as inefficient as the private-market solution and dramatically opposite to it—does serve a useful purpose in this regard: it nudges us away from the prevailing concentration on private costs and toward a consideration of total social costs.

All this may seem simple and obvious, but there are pitfalls for the unwary practitioner. For example, it is sometimes suggested that environmental costs should be considered along with private costs in deciding upon a set of admissible projects, but that once this set is chosen, environmental costs need play no further role, leaving the selection and scheduling of projects from the admissible set to be made on the basis of private costs alone. Such a procedure would be efficient only if the ratio of private to environmental costs were constant over all the projects in the admissible set.

A deeper problem surfaces when we consider how to count costs and benefits (whether private or environmental) which are distributed over time. By standard practice, future costs and benefits are discounted, but discounted at what rate? Here, again, we run into an unresolved controversy. It has been argued that when a proposed project carries with it the risk of irreversible costs, or when a project’s stream of net costs are growing, the project should be discounted at a higher than normal rate. And in response to the Atomic Energy Commission’s cost-benefit study of the breeder reactor, the Natural Resources Defense Council goes further to argue that, for projects imposing the risk of very large future costs, one necessary, but by no means sufficient, test should be that the project have a favorable cost-benefit ratio under a wide range of discount rates, including the highest (before tax) rates found in the private economy.

However, when there are uncertainties, irreversibilities and potentially catastrophic consequences, the matter is both more fundamental and broader than somehow choosing a discount rate. Basically, the problem is one of intergenerational equity. In the example of the breeder reactor, the present generation receives the electricity while future generations are burdened with perpetual care of plutonium, which is both extremely toxic and a prime weapon material. Generally, markets are considered fair only if all those affected by the outcomes are present in the market (without externalities) and the distribution of market power is considered fair. In the case of deciding which new supplies to develop, the distribution of market power is indeed uneven: the present generation controls the total stock of resources, leaving future generations with no voice in today’s decision. Another way of describing the situation is that the present generation may choose not to undertake some projects of benefit to it when such projects lead to what it considers an unfair distribution of welfare. One can be a beneficiary of an outcome and still feel that others are victimized by one’s own good fortune—and so it may be between generations.

So far, our decisionmaking institutions have not systematically resolved the question of intergenerational equity. Yet, as our means of transferring costs from the present to the future increase—for example, by generating long-lived pollutants—the need to bring intergenerational fairness into the decisionmaking process becomes more compelling. This is especially the case with projects carrying small and largely unknown probabilities of future catastrophes.

How should institutions for this type of decisionmaking function, and what form should they take? These questions are difficult to answer, but it seems clear at least that, since the future cannot represent itself, there should be broad opportunity for different groups to bring the charge of unfairness. The decision of what is fair intertemporally is too important to be left to small elite groups of decisionmakers, especially when there are vested interests at stake. The institutions should function in such a way that the larger the potential adverse effect, and the more uncertain the probability of its occurrence, the more cautious and thorough the decisionmaking procedure should be, and the more information should be generated by the procedure itself. Projects with greater risk of future catastrophe should pass stricter tests. There should be some way of setting up barriers against a possible unfair risk burden on the future.

One such barrier would be to subject a potentially risky project to a “penalty” charge at its inception. Presumably, the charge would increase with the size and uncertainty of the risk and would be determined by a decisionmaking process involving opponents and advocates. For a once-only charge, his scheme appears equivalent to subjecting the more risky project to a higher effective discount rate. But if the charge were to be more flexible—levied over several years, from the beginning of the project, in response to what is learned about the project’s consequences—the scheme is no longer equivalent to a single adjustment in the discount rate.

Beyond this conceptual difference, a charge explicitly levied and collected would have an important practical effect. We commonly, and often appropriately, subsidize projects with large risks of not attaining good outcomes. Frequently, however, these projects are mixed affairs involving some risk of very bad outcomes, so that the government inadvertently finds itself underwriting programs with potentially catastrophic effects. A charge scheme would tend to reverse this, making it possible to discriminate between risks of adverse—as contrasted with beneficial—outcomes.

The question of intertemporal fairness logically precedes the typical efficiency questions posed by economists. A full and open debate must attend projects in proportion to the potential size and relative uncertainty of their redistributional effects. Only in this way will sufficient knowledge be generated to make sensible decisions, ones we can live with. Setting up institutions whereby this can be done is of primary importance.