The electricity sector is one in which, for decades, governments around the world have taken numerous steps to ensure security of supply. This is because at any time a failure to equalize supply and demand can lead to a collapse of the system of power generation and distribution. The challenge for policymakers here is complicated by two other factors: first, rationing of demand is either infeasible or costly; and second, only relatively small amounts of electricity can be stored. Under these circumstances private suppliers of electricity would, in the absence of state intervention, fail to take into account the social costs of building insufficient production capacity.
Key decisions in the design of supply capacity mechanisms
In response to these challenges, many governments have developed different types of capacity mechanism to ensure that the choice of total production capacity is not left to market forces. The design of such capacity mechanisms must address the following questions, each of which maps on to a key decision that a government has to take:
- What is the optimal capacity target?
- What is the optimal policy to achieve that target? And how can the desired level of supply be achieved at lowest cost?
- What form should any state aid to producers take? Should all production plants receive so-called capacity payments?
- How do such payments affect the functioning of energy markets? What flanking policy measures are needed to offset any undesirable side-effects of state aid?
- How should optimal policy change in light of technological advances, including the development and adoption of renewable forms of energy?
These questions make clear the decisions that must be made in devising a mechanism that directly targets supply levels in a context in which – in contrast to pandemic-related medical goods – the necessity of future demand is not disputed, and in which regular patterns of energy consumption and growth facilitate the forecasting of demand. Ultimately, the introduction of capacity mechanisms in the electricity sector has involved a substantial expansion in the role of the state, along with calls for a clear-sighted assessment of the pros and cons of such moves.
Assessment of supply capacity mechanisms in electricity and their relevance to other sectors
That this is a contentious area of public policy should serve as a warning to those seeking to adapt or replicate this approach in other sectors. The establishment of supply capacity mechanisms often pits competition enforcement agencies and unfavoured firms against subsidy recipients and governments. Furthermore, in the case of tradeable goods such as medical goods, in so far as subsidies are a major element of the policy mix, the measures taken by governments in leading producer countries may also result in trade tensions and disputes.
This is not to mention the evident moral hazard problem. Suppose, for the sake of argument, that a government established a mechanism that ensured security of supply for PPE. Then, other things being equal, the incentive to take prompt action when faced with a public health crisis, such as COVID-19, would be diminished. Given the concern that certain governments may have waited too long before taking aggressive measures to limit the spread of the coronavirus, a public policy to assure security of supply of PPE may, unintentionally, threaten lives. The law of unintended consequences strikes again.
There are other reasons why the lessons from the electricity sector do not necessarily carry over to other sectors in which a government may deem certain goods essential. A recent assessment asks how, in the context of potential future pandemics and other threats to national health, a government can confidently know which medical goods will be needed. Even if one could predict which goods would be needed, it would almost certainly not be possible to forecast with confidence the amount required following a surge in demand. Worse, since many medical goods (in particular, equipment such as ventilators) are produced from parts and components, ensuring domestic security of supply would require forecasting and assuring capacity for the individual parts and components too. Assuring sufficient capacity for the transportation of medical goods would be required as well – again, specific needs would be very difficult to anticipate (as in the case of COVID-19 vaccines that must be stored and transported at very low temperatures).
Once the ‘unknown unknowns’ associated with potential future health emergencies are taken into account, the notion that governments can objectively plan schemes that guarantee the supply of the ‘right’ essential goods should be dismissed. Instead, policy initiatives should be framed in terms of reducing the likelihood, scale and duration of any shortages caused by unexpected – and possibly fear-driven – spikes in demand for goods that arise once pandemics or other crises hit.
The following framework has been devised to that end.