Energy and Environment

The market as a learning process

A long time ago – when people were more worried about global cooling than warming, but were just as worried as now about energy costs – our company built its new head office next to one of our gravel pits. We decided to use the energy in the lake to heat the building.

The heat pump saved costs in unintended ways. Staff learned to wear thick layers to stay warm in the office. And they would get their work done quickly so they could head off somewhere warmer as soon as possible.

But comfort usually trumps frugality when people can afford it. The heat pump was replaced with a more dependable heating system.

This is not to imply that heat pumps can never be an effective heating option. Knowledge and technology advance. Probably, modern heat pumps would have heated the building more effectively. Certainly, modern construction standards would have made the building retain more of the heat. Maybe it would have been unsuitable even with modern technology, but current knowledge might have identified that and suggested better options.

Someone sold the system with a claim that it would do the job. We bought it on that basis. Nowadays, people are inclined to assume bad faith and/or incompetence, but such cynicism is neither healthy nor usually warranted. The supplier probably believed it would work, partly because it was theoretically possible, and partly because they needed to believe it. We gave them the benefit of the doubt partly because we hoped it was true, and partly because you learn by doing.

The harm of that error was limited. In fact, arguably the benefits outweighed the harm. We learnt things about buildings and heating that we could apply elsewhere in the business.

Even if the costs outweighed the benefits, there was no broader cost to society. The costs fell where they should – on those who took the risk. Skin in the game, as Taleb would say. It is the essence of true (as opposed to crony) capitalism.

Society would have benefited even if we did not, because it is part of a broader learning process. We absorb the lessons and improve our deployment of capital, or we continue to make mistakes and see capital gradually move to those who are better at deploying it. In a free market, this process should be happening in millions of cases at any moment, each one specific to its circumstances but with potential to adapt and apply the lessons elsewhere. Whatever the cost or benefit to us, society benefits from this process of discovery and creative destruction.

Now imagine a different process. The heat pump supplier gets together with his rivals and tries to sell not a product to a businessman, but the concept to a policymaker. They argue that it is somehow the “right” technology generally, rather than specifically to each buyer’s case.

The supplier has more to gain from this. Rather than the laborious task of persuading someone to spend their own money in order to make a single sale, they stand to gain multiple sales by persuading the policymaker to skew the market in their favour. In economic terms, they are seeking “rent” from the government.

The policymaker has neither hands-on experience nor skin in the game, but is always looking for solutions that justify their role. The rent-seeker tries to persuade them that the market is not delivering as much of their solution as would be good for society. The policymaker is inclined to believe it. Why would you go into policymaking if you did not believe you could correct “market failure” to the benefit of society? If they were as concerned about “expert failure” and “government failure” and the risk of doing more harm than good, they would not be in the job.

So the policymaker picks some of the “winners” being sold to them by rent-seekers, and implements policy to try to deliver these magic bullets, to the disadvantage of alternatives.

The policymaker will not always be wrong. The difference between markets and central planning is not that businessmen are right and central planners are wrong. It is that market participants carry their own costs and learn their own lessons from being right or wrong. Central planning shifts the burden of being wrong on to taxpayers or consumers. The consequences of being wrong are less acute, both to the rent-seekers and to the policymakers, so the right lessons are less likely to be learned.

Indeed, it may not seem like the lessons are negative. The intervention may well deliver more of what it was intended to deliver. If you are not conscious of what might have been (Bastiat’s ce qu’on voit et ce qu’on ne voit pas), that might look like success. It probably seems successful to the policymaker, and credible in the eyes of rationally-ignorant voters. The benefits are concentrated and the costs are diffuse. Voters probably do not associate their satisfaction with the apparent effect of the policy (ce qu’on voit) with their dissatisfaction with an economy that is not as efficient as it might have been without such policies (ce qu’on ne voit pas). The winners talk loudly about how successful it has been, while the losers have neither the means nor the profile to mount a challenge (and even if they did, it would look like sour grapes).

Again, none of this assumes bad faith. The rent-seekers probably believe genuinely that greater deployment of their solution is in society’s interests. The policymakers probably believe sincerely that they are correcting market failure and delivering social benefits. Voters probably believe that government interventions benefit them (until they do not, at which point they vote for a new government with a new set of sincere but misguided promises).

My father was still a youngish man when he bought that heat pump (he had been in the business a long time, but was still in his thirties). The world moves forward by people (often the young) not accepting that the way we have been doing something is the best way it can be done, and deciding to try something different.

They are not always right. The young, in particular, do not have the experience to help judge credible ideas from follies. That does not mean we do not want them trying and succeeding or failing. Society needs it. And how else are they going to get the experience?

But there is a world of difference between:

  • “I’ve got an idea. Let’s see if we can do it well enough to beat the alternatives.”

  • “I’ve got an idea. It’s so smart that government should make it hard for people to prefer alternatives.”

If you have got a great idea, try to make it happen. Do it and learn from it. If you need investors, see if they buy your idea. If they have got money to invest, they have probably invested successfully before and have valuable insight into what works. Or go and work in the sector, and see if day-to-day practicalities support your idea (it is surprising how much you do not know you do not know until you do something). If it still looks good, see if your employer wants to invest in your idea, or use the credibility from being in the industry to attract investment in a startup.

If investors or customers do not like your idea, consider that the problem may be the idea, not market failure. You will have learnt a better lesson than blaming other people and looking for government to correct it. Apply those lessons, and hopefully, through this process, you will eventually come up with something that people want. If not, entrepreneurship may not be for you. That is still not something for the government to fix.

That does not mean there are no market failures, or government can do nothing to fix them. But government should not target specific solutions or outcomes. By doing that, it replaces discovery with its own judgment, and creative destruction with crony capitalism.



Bruno Prior is a trustee of the Institute of Economic Affairs and a Director of Summerleaze Ltd, which is involved in the construction materials, property, waste management and energy sectors. For most of his thirty years with the company, Bruno's main focus has been renewable energy, such as the generation of electricity from landfill gas, and the supply of wood pellets for heating.

3 thoughts on “The market as a learning process”

  1. Posted 26/01/2022 at 22:53 | Permalink

    Good article, Bruno.

    It makes you feel so naive when you try to compete on quality and realise your much cleverer opponents have just had the rules changed.

    As a man who supplies wood pellets for heating you will have seen how biomass boilers went from zero to huge and back to zero, in parallel with the Renewable Heat Incentive. So bad was it in Northern Ireland they had the “Cash for Ash” scandal.

    I am not sure if you raised the heat pump issue coincidentally, but ironically I think now represent a free market opportunity. Building Regs are changing to respond to the Climate Change Act and from ~2025 will ban fossil fuel systems (gas boilers), but they don’t mandate heat pumps, they will just be the best option that meets that criterion. You could use a biomass boiler, as an alternative. Assuming you don’t believe in no regulation whatsoever, the approach is reasonable.

    Where we do see regulatory capture is around heat networks. They have always been an option but never used because they were too expensive. Instead of competing to show how they could be better, the industry has influenced policy so that £800m of subsidies have gone in that direction, and planning policies often require them. Because most use gas they are actually increasing GHG emissions. One area you don’t mention, that has contributed to the public policy capture is the amount of jobs it has created in local authorities. That is why it is hard to change policy; it would be turkeys voting for Christmas.

  2. Posted 27/01/2022 at 13:00 | Permalink

    We need a thumbs-up option. Many good points. But I don’t agree that banning new gas boilers is just another regulation, and that opposing that would be tantamount to opposing all regulation. It should be determined on price (inc externalities), not by banning. It may well be that the loss of utility from not having the option to use gas even when it’s cold, dark and windless is greater than the social cost of the carbon that would be emitted if gas heating were still permitted.

    For instance, one solution to the big problem of network stresses with mass electrification could be heat pumps as complement rather than replacement for gas boilers. The heat pump does most of the heat and hot water, but when it’s very cold (so low COPs) or electricity is very expensive, the gas boiler takes over. Otherwise, we have to improve the network to cope with an extra 70 GW of peak electric heating demand, plus whatever we need for car charging if they coincide. I’m pretty sure the carbon impact of that costs less than the system reinforcement (generating or storage as well as network capacity) needed for the occasional extremes.

    Fortunately, it’s not exactly a ban on gas boilers. It’s a ban on gas boilers in new-build properties. But unless there’s a major change in our housing policy, that’s a tiny fraction of the building stock each year. It’s still wrong to ban as opposed to price them, but limited impact. There’s also the requirement to make gas boilers “hydrogen ready”, but I understand the cost of that is quite small, so gas is likely to remain the default unless the fuel-cost prices it out of the market, or the government takes other action.

    One problem for heat pumps is that the change in gas and electricity prices has left electricity still around 4X the cost of gas, which means gas heating remains a better bet than heat pumps at current prices. Rising gas costs only help heat pumps if electricity doesn’t go up too. Given the difference in capital costs (not just boilers but also changes to the building efficiency and heat distribution system to accommodate heat pumps), the energy cost differential has to be a lot less than the efficiency differential to signify.

    So I fear it won’t be as laissez-faire as you imply. The government has an explicit target to install 600,000 heat pumps per year. I bet they don’t leave it to the market to judge whether they’re right. And I bet the market doesn’t install 600,000 standalone heat pumps a year without a pretty big push from government. If they ban new gas boilers more broadly, I bet a roaring trade develops in repairing gas boilers, unless gas has been priced out of the market (in which case, they wouldn’t need the ban).

    Heat networks are a big problem. I agree with you about how they’ve tried to deliver them. The reality is (a) many heat decarbonisation options are easier with them, but (b) markets are very reluctant to install them for rational reasons. If gas prices stay high, that might change, but I have a feeling they won’t stay high enough for long enough.

    We may be stuck with gas for a while yet, but the market signals are pointing in the same direction as our strategic interests: we should reduce our dependency on it. If we allowed the market to encourage the reduction of gas consumption, rather than being obsessed with its elimination, I suspect we could get a much quicker and cheaper reduction, but not to zero. For the climate, earlier is better. And for the economy, cheaper is better. Net Zero is a dog that is used to justify irrational policy in everything it touches.

  3. Posted 30/01/2022 at 09:32 | Permalink

    I’m long retired, but studied economics at LSE then worked inter alia as an economic policy adviser to bodies chaired by UK and Australian Prime Ministers, the latter including some state premiers as well as business, union and other reps, and for the Queensland government. The longer I worked, the more I became convinced that a combination of much smaller government and increased free enterprise was far superior to larger government, for many reasons. Unfortunately, in Australia, the situation has continued to deteriorate, with vested interests – including the public service – pursuing what they see as their own benefit, and beholden to various vested interests, in some states notably to trade unions, who now represent only 9% of non-government workers (I think 40-50% in the public service). I was driven out because, a high-level supporter told me, the heads of department et al felt threatened by my “honesty, integrity, intellect and analytical rigour.” In short, it was more difficult for them to give the nod to bad, politically-driven policy if I was involved. I believe that things have got much worse since then.

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