Mr Lim Hng Kiang at the 3rd MTI Economic Dialogue, 14 Oct 2010

SPEECH BY MINISTER LIM HNG KIANG AT THE 3RD MTI ECONOMIC DIALOGUE, NANYANG TECHNOLOGICAL UNIVERSITY ON 14 OCT 2010

Professor Su Guaning, President, Nanyang Technological University

Faculty and Students of Economics from NTU, NUS and SMU,

Ladies and Gentlemen

In Singapore, more so than in most other countries, we place a high premium on applying rational thinking and empirical evidence in analyzing and designing policies. Economics can be a powerful tool to clarify complex issues in public policy and to evaluate the costs and benefits of various policy options. Let me illustrate this briefly with the example of energy policy – one of the most complex and challenging policy issues in Singapore.

We rely almost exclusively on expensive imported energy. We rely on just one fuel source – piped natural gas - to meet 80% of our electricity generation needs. There is also a growing impetus to seek cleaner sources of energy given global concerns about climate change issues. Our energy challenge is to balance among three competing ends: cost competitiveness, energy security, and environmental sustainability. It is not just a dilemma, but a trilemma!

How can we solve this trilemma? This is where sound economics can help. Well-intentioned but misguided interventions can do more harm than good. Let me highlight three popular fallacies in energy policy that careful economic thinking can help dispel.

Energy Fallacies, Economic Realities

The first fallacy is that the best way to achieving reduction in carbon emissions is to set regulatory standards. For example, many environmentalists believe that governments should set a certain energy efficiency standard for equipment and appliances. Economists, however, know that regulation imposes a shadow price – just because you don’t see the price explicitly does not mean it is not there. Regulations will force consumers and companies to comply with the regulations, and this adds to cost. Is this cost worth the benefit of improved energy efficiency?

Even if the cost is worth the benefit, do we know if regulation is the least cost – or most efficient – option to derive this benefit? For example, the government could force firms and households to purchase more expensive energy saving lights. Sure, energy use may fall, but how can the regulator be sure that there aren’t cheaper ways to improve energy efficiency?

The empirical record on misguided regulation is quite instructive. For example, according to a report by Lehman Brothers, regulations to reduce automobile emissions in Europe cost 700 – 2,300 Euros per tonne of carbon reduced. On the other hand, carbon permits in European carbon trading markets cost fewer than 50 Euros per ton of carbon. Even if we assume that the true social cost of a ton of carbon emitted is twice as much, the cost incurred in reducing that ton of carbon turns out to be 7 to 23 times the benefit!

Regulating the emission standards of automobiles is thus not a cost effective way to reduce carbon. In the same vein, many regulations to encourage renewable sources of energy like solar ignore the costs they impose. Subsidizing the generation of renewable energy has imposed on many governments a high fiscal cost. Some countries have even had to unwind these subsidies.

The lessons for Singapore are clear. We must improve our energy efficiency and even reduce our consumption of energy. We must switch to cleaner sources of fuel where we can. But we must do so with full recognition of the costs involved, and not be led astray by fad or fashion. Economics 101 teaches us that we must reduce carbon emissions to the level where the marginal social cost of doing so is equal to its marginal social benefit.

In Singapore, the marginal social costs of renewable energy – at least given current levels of technology – are quite high. This is because Singapore is what we call “alternative energy disadvantaged” - meaning that many renewable sources like wind or tidal energy are not feasible due to our geography and climatic conditions. If we force through regulatory measures without properly accounting for the underlying economics, the high resultant costs will sap the public will for carbon abatement over time.

A second fallacy is that regulations give certainty over the amount of carbon reduced. For example, if the government imposes efficiency standards for cars, one can estimate the amount of gasoline saved. However, the economic reality is that a substantial amount of uncertainty remains, because of what is known as the rebound effect. If a car requires less gasoline for the same distance, the driver might use the car more often. The rebound effect has been confirmed by economists – studies have found that up to 30% of gasoline savings might be lost to the rebound. Similarly, it has been observed that subsidizing energy efficient air-conditioners encourages consumers to use them more often, thereby increasing overall energy consumption!

What is needed is to put a price on carbon, so that the consumer knows the marginal cost of his carbon emission and will adjust his behavior accordingly. Putting a price on carbon will send a powerful signal throughout the economy to encourage energy efficiency, switch to renewable sources of energy, and to reduce energy consumption. Unlike regulations or subsidies, a uniform price will let each individual, firm, or industry work out the most efficient response.

I must clarify, however, that not all regulations are undesirable. Nor will a carbon price alone be sufficient. This is because there might be market failures that weaken or nullify price signals. For instance, individuals may not be aware of simple energy-saving practices or products (information asymmetry). Or the electricity user might not be the person paying the bill (split incentives). A study in the US found that those who rent their homes are less likely to purchase energy efficient appliances than those who own their homes. A good understanding of the various market failures is important because it helps policymakers identify where the problems are, and craft targeted policies to address them.

A third fallacy is that we should set lower prices for the first block of electricity than subsequent blocks of electricity. There are well-meaning reasons for such a proposal. A uniform electricity price will likely be regressive, as lower income households spend a larger proportion of their incomes on basic necessities like electricity than higher income households. A uniformly higher electricity price or a carbon price will therefore affect the poor more in relative terms. By pricing the first block of electricity more cheaply than subsequent blocks, the intent is to benefit the lower income groups who generally consume less electricity than higher income groups.

But economic intuition will tell us that tiered pricing is a flawed approach. Setting a lower price for the first block of electricity will only encourage all households – rich and poor – to consume more energy. A more efficient way to help lower income households is to have a single higher price for electricity or carbon, and to give them direct cash transfers to partially or fully offset the impact of the higher price.

This argument has backing in empirical research. Through careful application of econometric techniques, our economists have found that an increase in income leads to a less-than-proportionate rise in electricity consumption. Raising the price of electricity or carbon and offsetting this through a cash transfer allows poorer households to meet their general consumption needs while encouraging them to reduce electricity consumption.

The Economist Service

The energy trilemma is a complex topic, and we cannot base our decisions on instinct and gut feel. We need intellectual honesty and rigorous analysis to chart an optimal path through the energy landscape. Our policies must be based on clear objectives and sound evidence. In this regard, energy economics has a vital role in shaping energy cost, carbon, and security considerations.

Our officers in the Economist Service have played an active role in this area. They have articulated the importance of a carbon price to drive cost-effective carbon abatement measures. They have used econometric tools to examine the drivers of household electricity consumption, and evaluated the effectiveness of energy policies through policy pilots.

While I have highlighted the specific issue of energy and climate change today, I must emphasize that our economists are deployed widely across the public sector. They work on many policy issues across the whole of government, including international trade, labor, housing, and fiscal policies. They are passionate about the issues they study, and enjoy the intellectual challenge of navigating through complex policy questions. Most importantly, they are motivated by the desire to improve public policies that affect the lives of Singaporeans. Many of them are here with us tonight, and I encourage you to take this opportunity to find out from them more about their work.

Prize winners

Before I end, let me take the opportunity to congratulate the prize winners. The thesis by Tan Boon Hua from NUS sheds light on the interaction between recidivism, sanction schemes, and rehabilitation. He found that lower wages and higher rates of time preference increases the likelihood to offend and to recidivate. He also suggested the use of rehabilitation as an alternative to escalating sanctions, as it is more cost-effective and can increase wages for ex-convicts.

The other two winning theses demonstrate the usefulness of experiments in research. The joint thesis by James Lim, Nguyen Phuong Linh and Nguyen My Hanh from NTU looks at gender differences in charitable giving behavior through laboratory experiments. They found that women exhibit more generous charitable giving behavior than men. As a result, they suggest charitable organizations use different marketing strategies for the different groups. Joshua Wong from SMU also conducted experiments to compare different forms of auctions. He found some interesting results to fill the gap in the experimental literature on multi-unit auctions.

I am impressed by the maturity of thought and the excellent application of research methods by the prize winners. I hope some of them will join the public sector, and help shape sound economic and social policies for Singapore.

Conclusion

Economics helps us think about complex policy issues in a systematic and robust way. By applying its methods, we can understand the world in a more rigorous manner, and develop policy solutions that are more effective and relevant.

Thank you.