Price Signals Matter, But Which Prices?

Price Signals Matter, But Which Prices?

Nobody needs a barrel of oil in their living room or a kilowatt-hour of electricity in their hand. When you turn on the tap to take a shower in the morning, you’re looking for hot water, not the units of energy that are needed to warm the water up. When you reach for a cold beer later in the day, you don’t worry about the electricity that goes into cooling the fridge.

Management guru Peter Drucker wrote that there is no demand for any commodity: in any market, the demand driver is always some underlying service or amenity.The market for fuels and electricity is no exception. Managers and marketers imperil their enterprises when they lose sight of this fundamental truth, but it’s a common mistake.

Look no farther than an electric utility industry that was surprised by seismic shifts that started rumbling through the market in the 1970s, with aftershocks that continue to this day. Thinking they were in the business of meeting demand for electricity, rather than human amenities and services, utility planners were completely blindsided when they realized they were focusing on the wrong competitors. They thought they were up against alternative technologies for manufacturing electricity. The competition turned out to be insulation, compact fluorescent light bulbs, information processing, and a suite of other technologies and techniques that reduced the need forelectricity.

This thinking has profound implications for the role of fuel and electricity prices in reducing greenhouse gas emissions. Economic theory correctly points to a direct link between price and demand, but demand for what? If Drucker is right that there really is no demand for commodities, including energy commodities, then surely we should focus on the relationship between price and the demand for the underlying service.

Once we adjust our frame to think about fuel and electricity as contributors to a wider web of value creation driven by demand for services and amenities, the total cost of service provision becomes the most important question. Fuel and electricity might still be essential to providing the service–you won’t get your cold beer without electricity to power the fridge. But more often than not, energy contributes just a small part of the total cost of that service.

If you operate a steel mill, a paper mill, a smelter, or a cement kiln, fuel and electricity prices are a major concern. In these primary processing industries, fuel and electricity costs can be 20% of value added, sometimes much more. But these activities are the exception in our society. Fuel and electricity costs are well under two percent of value added for most manufacturers, and they might contribute 10% to the cost of owning and operating or renting a commercial building. Even the cost of car ownership is dominated by capital costs, with gas usually representing less than 20% of the direct cost of driving. And while we all grumble when the utility bill goes up, a single month’s mortgage or rent is about enough to pay for an entire year of fuel and electricity for most Canadian homes.

So before we decide to address the climate crisis by counting on higher prices and market signals, there are two important questions to ask:

  • How high would energy prices have to go to actually capture our attention?
  • How long can we afford to wait?

If the goal is an 80% greenhouse gas reduction by 2050, there are more direct ways to get there. We can start by focusing on the energy services we need–hot showers and cold beer, comfortable living space in winter and summer–and look for the most effective ways to get them without pumping more carbon dioxide into the atmosphere.

Sometimes, the answer will be new technologies. Often, it’ll be as simple as making wider use of tools and techniques that we’ve known about for years or decades. And before long, we’ll have to look at the underlying factors–like why highway commuters have to travel such long distances from home to work–that get in the way of deeper emissions cuts.

But one of the first steps is to stop assuming that price signals will be strong enough or fast enough to deliver the climate change action we need, when the history of energy pricing tells an entirely different story.

Your turn: Are today’s energy prices high enough to make you want to conserve? If not, how much higher would they have to go to make a real dent, in your wallet and your energy use?

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