A new role for the state in energy and water

 When building an economic model, economists describe consumers using a utility function – that is, a function which takes as its input the bundle of goods that are being consumed and outputs a value called the utility, which can be roughly thought of as the subjective benefit the consumer experiences as a result of consuming that bundle of goods. A common utility function used in trade and other macroeconomic models is the CES (constant elasticity of substitution) function. A key feature of this function is that it implies that given fixed prices for all goods, the demand of a consumer is some fixed proportion of their income. That is, if their income doubles, they buy double the amount of every good.

While this is mathematically useful for building a model of aggregate demand (the sum of demand of all consumers) and can produce accurate macroeconomic models, it sits badly with microeconomic empirical evidence. Engel’s law – which is more accurately an observation rather than a law – states that the proportion of income spent on food is a decreasing function of income. If a household’s income doubles, the amount they spend on food will increase, but not to the extent of doubling. This is intuitive. People need a certain amount of food to live, but after that the marginal benefit of more food is rather small.

This intuition is captured mathematically in a utility function called a generalised CES function, in which consumers have a minimum demand that must be met for certain goods, such as food. This is a more accurate description of people. People absolutely need a certain amount of food and a certain amount of water to prevent death, which is an event that is typically interpreted as providing extremely low utility. In the modern world, it’s also reasonable to say that people absolutely need a minimum amount of energy in the form of electricity and gas – they need to keep the lights on, they need to keep warm, they need to be able to cook, and they need access to the internet to participate in almost every aspect of modern life.

The role of the state should be to increase the liberty of its citizens. This includes freedom from not only state intervention or molestation by other individuals or groups, but also what was aptly described by Roosevelt and adopted by Beveridge as freedom from Want. People shouldn’t have the options available to them in their day-to-day life stripped from them by poverty forcing them to devote every moment to merely surviving. To that end, the state must build or incentivise systems that prevent such a situation.

While some have proposed radical solutions such as a universal basic income, we’re instead going to focus on addressing the issue of water and energy supplies specifically (food is still important, but is harder to address, at least with the mechanism proposed below). Universal basic income comes with all sorts of issues that are broader in scope and realistically, it isn’t going to happen in the UK.

The ideal world would involve free water and energy stemming from an infinite supply. Unfortunately, we live in a world of scarcity, which forces us to acknowledge that energy and water are – at least at any given moment – in finite supply. It also requires inputs that are finite in the form of labour and technology to get, and these inputs need to be paid for somehow.

Even were we willing to somehow set prices to zero, we would soon find shortages of both of these commodities. Water and energy are used not only out of necessity but also for leisure pursuits and other non-essential expenditure, which means that there is never an amount of water or energy that implies a marginal benefit of either good is zero – that is, a person (or at the very least, some people) would always want a bit more water or energy. The scarcity of these commodities must be signalled in the form of prices, so that demand is constrained.

Water and energy are distinct from other goods in that the total amount consumed by a household is measured with accuracy by the supplier and can’t be supplied by another supplier without it being obvious. That is, these goods are metered. Unlike something like DVDs or juice, a consumer can’t source from various places by just going to various shops and not disclosing how much they have purchased. All but a negligible amount of energy is drawn from the national grid, and all but a negligible amount of water comes from a natural monopoly provider’s infrastructure. It’s also not something that households are able to trade with each other.

This leaves it open to the possibility of non-linear pricing; that is, varying the marginal cost of the product as a function of the amount bought. In a traditional linear pricing system, the marginal cost of a good – its price – is a constant. If the price of a unit of a good is £x, and a consumer wants to purchase y units of that good, then they will pay £xy. Normally this is unavoidable so as to avoid arbitrage, since it would provide the opportunity for one agent to purchase a large amount at the lower marginal price and then reselling to consumers who demand a small amount at a higher marginal price (normally slightly below so as to undercut competition). There are exceptions, and most people are familiar with the idea of bulk-buying to reduce the average cost of each unit of whatever good is being purchased. This largely works because the supplier is under the impression that resale at a higher marginal price is unlikely (consider packets of crisps inside a multipack upon which the sentence “not for resale” is printed) or not a problem for them, and they do this to incentivise larger purchases.

In the example of bulk-buying, the marginal price (the amount paid for an extra unit of the good) is decreasing as a function of the amount bought. But marginal prices can also be increasing. This might sound odd, but people are actually familiar with at least one example of this. Income tax can be described as a price the government charges on people for earning income. It is also a progressive tax – the more income earned, the higher the proportion of that is paid in tax. That is, the price for a unit of income increases the more income you get. Here, arbitrage is avoided because it’s hard to split income among several people, both because it’s incredibly illegal and because you can’t guarantee people will give it back. It is worth noting that there is another form of arbitrage that can be exploited and indeed is advised for high-income households when taxes on income rise, which is by splitting the money up between current consumption and future consumption in the form of pensions. This isn’t particularly fatal to the argument here since it’s not overly clear how a similar temporal mechanism would work for goods and because this sort of arbitrage is encouraged by the state through policy.

In the case of essential commodities, the intention of a pricing system with increasing marginal prices is the opposite of the intention of the seller with decreasing marginal prices – that is, to disincentivise larger purchases. It should be easier to pay for the water a household needs to survive and clean with than the water needed to fill a private pool. It should be easier to pay for the energy to keep your food refrigerated and to cook, and to keep warm, and to connect to the internet than the energy needed for operating a tanning bed. This is no different to acknowledging that a pound earned by someone on a lower income should be charged less by the state than someone on a higher income because for someone on a lower income that pound is more valuable.

The proposal therefore is that for households, the marginal price of water and energy should be increasing according to the amount of water or energy purchased respectively.

As we have argued, this is because of the necessity of a certain amount of each good for life. That it is possible is because there is a single source of supply, and hence the pricing mechanism can’t be circumvented, and because the nature of the distribution of these commodities is such that arbitrage isn’t possible or at least is so difficult to not be worthwhile. While households could conceivably store massive tanks of water to sell to richer households at a lower price than legitimate suppliers and therefore make a profit from that arbitrage, it doesn’t seem like most households that would need to do that would have the capacity to do so, as well as the fact that they would have to still purchase water for their own needs now at the higher rate. For energy, it’s even more unlikely that arbitrage could be exploited since consumption of gas is measured as it’s burned and hence cannot be sold on further, and to sell on electricity would require significant and expensive infrastructure in the form of large batteries and their transportation.

Such a pricing policy could occur under a variety of mechanisms available to the state. As Anthony Crosland notes in The Future of Socialism, it is to some extent a moot point whether the state has ownership as the sovereignty of parliament implies that any law can be made to force the actions of a privately owned body. Should the government wish to preserve the current structure while still employing progressive pricing policies, it could simply allow Ofgem and Ofwat the latitude to set pricing in this way, which would achieve the same result from the perspective of households.

There is good reason to think that this would be suboptimal. The largest issue is the question of incentivising capital investment into these companies. This is already an issue that companies face, and with dire consequences for the environment. These companies are profit-motivated, and were they not, they may as well be replaced by a state-owned entity. In an environment where the only margin for adjustment is cost (and not the price they can charge to households), and where consumers are unable to change provider, companies are incentivised to reduce costs however possible, resulting in significant externalities, to which the country has drawn its attention as raw sewages renders swathes of UK waters unsafe for bathing. There is also a disincentive to long-term capital investment due to the short-termism of shareholders coupled with the lack of alternative options to consumers who may wish to pay more to purchase from a company that isn’t polluting their community’s environment. To be clear, this is true under any situation in which the system of pricing is forced upon consumers, including the status quo.

This might suggest that state ownership of supply is preferable. We should however be wary of nationalisation in industries that benefit from risk-taking behaviours. Innovation is vital in these sectors, particularly energy, and requires throwing money at new technologies or developing technologies in house, which will lead to some money lost chasing technologies that turn out to not represent improvements in either reducing costs or reducing negative externalities of production. Such losses are an inevitable consequence of innovation since by its nature one can’t know with certainty which ideas will develop into something useful. Investment must therefore be incentivised by the possibility of profits or other rewards granted by the state. The public is quite rightly wary of the state spending the money it has taken from them in tax without generating a predictable and obvious benefit, and hence this type of risky investment is best left to the private sector.

It therefore may be preferable to leave the issue of production to private companies that are profit-motivated and less risk-averse than the state. However, for the reasons we’ve given regarding lack of outside options for consumers and incentives to cut corners, it would be difficult to implement a progressive pricing policy when producers are selling directly to consumers. The appropriate role for the state might be as a monopsonist purchaser and re-seller of these commodities. A monopsony is a situation in which there are multiple suppliers (here producers) and one (or virtually one) buyer, which in this case would then act to distribute the commodity according to its own pricing system of choice.

This isn’t unprecedented in the UK – the most prominent example of the state acting in this way is the NHS. While staff are of course employed directly by the state, the provision of medical care can also be thought of as distributing privately produced medical goods such as drugs and medical equipment. By and large the pricing system the state chooses to address demand among the population is a flat price of zero for medical equipment – users aren’t charged for an MRI scan – and a flat price for prescription drugs. The progressive pricing system proposed for energy and water would of course be more complicated, but only slightly, and certainly nothing exceeding the complexity of any standard issue of state interference in markets to ensure basic provision of goods.

The advantage of this system is that government can create competition in the supply of the commodities by ensuring the private role in production and maintaining a profit incentive, thus ensuring continued innovation in the sector, while still ensuring that necessary consumption of energy and water is possible for every household without risking shortages. The role of the state as the monopsonist also gives the state significant power in this market, ensuring good value for money. The state would be at liberty to form distinct contracts with different entities, so that it is able to incentivise and reward behaviour desirable from suppliers, relating from anything to environmental concerns to governance issues, as well as paying rates that allow for costly innovation to be pursued but households would be unable to afford.

For completeness, it’s worth stating that some supply of energy should be owned by the state. Labour’s plan for a nationalised producer of green energy is positive, since state investment in this way is a guaranteed way to speed development of the kind of energy supply that is needed to mitigate climate change, as well as assuring private companies that the state intends to create an environment beneficial to such industry since the state now has a clear incentive to ensure the sector thrives. Similarly, the state should stop wrangling with various private providers and devising new and more complicated funding structures for the provision of new nuclear energy and instead just directly build and own nuclear power plants.

Above exceptions aside, the relationship suggested here would represent a new partnership between the public and private sector, more akin to the operations of the NHS than either the status quo of privatisation or the previous settlement of full nationalisation. It would marry the strengths of the private sector in innovation and the strengths of the public sector in social and environmental responsibility. It would not preclude deeper state involvement where necessary, such as the examples given above, but also acknowledges that the smooth running of a country depends on the participation of both government and individuals. Labour’s aversion to full nationalisation is warranted, but this relationship perhaps provides the way forward for these sectors.