Why global energy markets need governing

After a year of upheaval it may seem perverse to take the world’s financial system as a model for anything – least of all for governance. There is, however, a case to be made that the governance of global finance, however imperfect, is one of the better achievements of the last 100 years, and has lessons for important areas of economic life that are currently ungoverned.

One of the main reasons why the international financial system was not destroyed by the credit crunch is that its governance structure – linking the central banks and treasuries through the Bank of International Settlements, the G-7 and the International Monetary Fund – is well established and extremely professional. These institutions, and the multiple groupings that surround them, were responses to past failures, reflecting a gradual realisation that the combination of narrow self-interest and anarchy was a poor way of running complex international societies.

Finance is almost unique in having developed these mechanisms. The WTO (and its predecessor, the General Agreement on Tariffs and Trade) have succeeded in reducing trade barriers. But the process remains incomplete and is still a game of political negotiations rather than of professional management. In many other areas of economic activity, something close to the beggar-my-neighbour approach of the 1930s still prevails.

Energy is the best (or worst) example of this. There are numerous institutions working on energy issues – from OPEC to the American Petroleum Association and the grouping of European refiners, working under the banner of Europia. Many are very skilled in what they do but each is dedicated to advancing the interests of one group or another. Even the International Energy Agency (IEA), which holds great technical competence, is a club of importers drawn together at the height of the 1973/4 oil crisis. The agency monitors and analyses energy developments worldwide but important importers, such as China and India, remain excluded, as do all the major exporters.

Despite the fundamental importance of energy to daily life, no institution holds any remit for the development of orderly and stable markets. Last year provided clear evidence of the need for an institution that represents the global public interest. The oil price went from $60 a barrel at the start of the year to $140 in July (with some predicting further rises to $200) before crashing to $40 in the space of just 16 weeks. That sudden fall meant that the damage done to consumers began to shift to producers, many of which had written their 2009 budgets on the basis of $60, $80 or even, in the case of Iran and Venezuela, $90 a barrel. Even the best-run oil economies now find themselves in a position where economic planning is impossible. Several are now vulnerable to serious social unrest.

The damage does not end there. Volatility on this scale means that investment in both the exploration of resources and new infrastructure is less likely to occur, just at the time when it is badly needed. Established oil and gas provinces such as the North Sea and Alaska are declining. New developments are needed to replace them and to match additional demand. Last year the IEA calculated that investment of $350 billion a year is needed between now and 2030 in oil and gas and the associated infrastructure. Most of that investment should be coming through state-owned companies, which control the bulk of available resources. But they are the least able to adjust to the ups and downs of prices, given the pressures on them from governments to hand over funds which could and should be reinvested in energy. In the instability of 2008 lies the seed of the next crisis: population growth and the spread of prosperity, especially in Asia, will continue to drive energy demand upwards.

Instability similarly places a question mark over investment in the new and renewable sources of energy required for an orderly transition to a lower carbon economy. In 2008, for the first time in more than two decades, investment in renewable and alternative energy declined.

Markets provide the best way of matching supply and demand – so long as they are open and respond rapidly to price signals. The trouble is that energy markets are not open. Reserves of oil and gas are concentrated in a small number of countries, where investment by multinational oil companies is usually severely restricted. The environmental damage done by carbon emissions is not reflected in the prices we pay for our electricity or petrol. The global public interest in maintaining secure and reasonably stable markets, including the development of new, low-carbon supplies, is such that intervention is necessary. Volatility is the greatest enemy of true sustainability.

Is the establishment of some degree of order impossible? In the 1930s, it would have seemed inconceivable to establish any semblance of order in financial markets. But a global framework for the energy market is attainable. Its aim would be to manage both immediate pressures on supply and demand, and the long-term shift to a different energy mix. It should start with transparency. The new institution would provide an accurate and verified record of energy production, trade and investment. That alone would enhance confidence.

The institution would be open to all, producers and consumers alike. This breadth of membership would enable it to develop processes for managing market volatility through holding a cushion of reserves. These stocks would be augmented as prices fell and released gradually as they rose. A stability fund would enable oil (or any other fuel) to be bought if the price fell below a predetermined floor, and released if the price rose above a particular ceiling. The management of reserves in this way would dampen volatility and allow an ordered response to potentially disruptive crises.

 An institutional framework, managed by a combined grouping of producers and consumers, would not displace the market – in fact a well-designed framework would allow the market to operate with greater confidence, particularly in making the long-term investments which are so urgently needed. As in trade or finance, arrangements can evolve that take us beyond a situation in which one nation’s gain must be another’s loss.

Of course, the track record of the existing international institutions in financial markets and beyond leaves much to be desired. The last year has revealed gaps and weaknesses and there is much to be learnt. Effective institutions need resources and a degree of autonomy, as well as global rules and standards backed by the rule of law. But for all the weaknesses, events have shown that even imperfect structures are better than no structures at all.

For anyone following the energy agenda, 2008 was an exciting year. But mankind can only bear so much excitement. For producers and consumers alike, the costs of volatility are too great. In that common perception lies the best hope for the establishment of a new and more orderly regime.

Nick Butler chairs the Centre for Energy Studies at the Cambridge Judge Business School.