Designing good rules for good outcomes
April 24, 2021
At the most basic level, rules are an effort to create good outcomes. There are generally two approaches to rule-making:
first, general rules that are designed to set forth basic principles that need to be followed, i.e., the “what” (usually referred to as “laws”); and
second, specific rules that are designed to explain the “how” of complying with the laws (usually referred to as “regulations”).
Rules also serve a normative purpose, i.e., they are a reflection of what types of outcomes we as a society collectively deem “good.” What is “good” is ultimately a reflection of what we view as an acceptable allocation of risk.
Examining the behavior of markets provides many rich examples of how rules can create good and bad outcomes. One interesting example in this respect relates to how regulators have sought to apply different rules to clean energy markets. This includes a variety of different measures, ranging from tax credits to tariffs, that affect the dynamics of market demand for clean energy, including wind, solar, hydropower, electric vehicles and biofuels, among others.
Regulation relating to renewable energy production is rooted in the oil crises of 1973 and 1979; regulation in the decades following was designed to encourage research and development into the viability of clean energy for power generation, initially more for economic reasons and, later, more for environmental reasons.
Although the global energy system is still very much dependent on fossil fuels, investments in clean energy are becoming much more significant. In 2015, for the first time, over half of new electricity capacity was from renewable sources, higher than investments in fossil fuels and nuclear power generation.[1] This has only accelerated since the onset of the pandemic and the Build Back Better movement that has followed.
One of most interesting examples of applying rules to a rapidly-shifting market is that of government incentives provided to solar energy providers. Many governments in Europe, the United States, Japan and Korea began providing economic incentives such as feed-in tariffs and tax credits to companies who are manufacturing, distributing or otherwise using solar power products, particularly solar panels.
Before looking at how tariffs and tax credits have affected the solar market, it is useful to recall the basics about tariffs. Tariffs are often used to help infant industries that may bring long-term benefits to society get off the ground until they can compete on equal terms with more experienced companies.[2] One of the critiques of this approach is to say if private investors are not willing to risk their own capital to finance these industries, why should the economic loss be borne by the public treasury?
Critics of such incentives point to the solar industry as a perfect example of how tariffs can distort markets quite considerably. The difficulty relates to the fact that the incentives are generally applied on a market-specific basis for a fixed period and then subject to renewal.
Because of the interconnected nature of the globalized economy, defining the tariff in a way that it produces the precise intended result is quite difficult. One example of this was in the United States’ decision in 2018 to put trade barriers up against certain goods imported from China. While this type of tariff is intended to protect U.S. manufacturers, it can actually have the unintended consequence of hurting them, due to the fact that they may themselves manufacture components in China and may experience increases in raw material costs if they are materially dependent on direct imports from Chinese manufacturers.
The complexity of regulating solar energy is also compounded by the fact that electricity consumption can be very unpredictable and is driven by a number of economic and environmental factors that can change from one year to the next. Tax credits for residential solar photovoltaic systems that allow users to engage in “net metering” whereby the user only pays for the grid if their home system cannot supply enough electricity can only be useful if regulators can accurately predict consumption. If consumption is overestimated and the tax credit is too high, the user may end up underpaying the utility for the electricity consumed from the grid. On the other hand, tax credits applied in a way that is not uniform across the industry has led to certain companies simply being unable to compete and being forced to declare bankruptcy.
We can therefore learn a few things when examining the regulation of solar energy consumption and taxation. On the one hand, trade restrictions that are too precisely defined can have secondary effects that weigh strongly against the interests that they were designed to protect. Equally, applying tax credits to markets that are still relatively nascent can result in very distorted outcomes.
Another important point developed elsewhere in this journal is how to design rules for systemic risk. The flight to clean energy, while lowering carbon emissions risk, creates other systemic risks that must also be considered — long-term environmental impact and the dependence on labor and raw materials being the foremost examples. A sustainable shift to solar and wind can only be assured if the ancillary systemic risks facing the business model are managed as well.
CPM
[1] See Stephen Peake, Renewable Energy: Power for a Sustainable Future, at page 599.
[2] See David Begg, Gianluigi Vernasca, Stanley Fischer, Rudiger Dornbusch, Economics, page 669.
