The high energy prices are a wonderful thing. We needed to get off oil for numerous reasons, since politics can’t do it, especially in the US, how about a great dollup of market mechanism. This, in fact, is exactly what is happening.

The price mechanism is a wonderful thing. It will achieve weening us off oil in a much more efficient manner. The seemless ever increasing price of oil will create the necessary incentives for:

• Energy conservation.
• Looking for oil in previously uneconomical locations and/or with innovative extraction technologies (deep ocean drilling: Petrobras).

And it does all this not by central command, but by enlisting a good many of the best brains in those respective fields and providing incentives for all of us to change our behaviour.

It’s already happening:

“We saw a real change in the industry demand for pickup trucks and SUVs in the first two weeks of May,” Ford Chief Executive Alan Mulally said. “It seemed to us that we reached a tipping point where customers began shifting away from these vehicles at an accelerated rate.” Or as Erich Merkle, director of forecasting for consulting firm IRN Inc, put it: “What we are seeing is a massive rotation out of trucks and into cars.”

Americans complain but in Europe and elsewhere, gasoline prices are twice as high, and, not surprisingly, the shift to more energy efficient cars is in a much more advanced stage.

Of course, one should have used the price mechanism as an instrument to achieve those ends, which an approach they embarked on in Europe. It’s pretty simple, just put a decent tax on the price of gasoline and, hey presto, incentives are in place.

Such higher tax would not only dampen the impact of higher crude oil prices for motorists because many more of them would drive more energy efficient cars, but the price rises of gasoline itself would have a muted response to the ever increasing price of crude oil.

Without tax, gasoline prices rise one-on-one with crude prices (as they do in the US), but the higher the tax on gasoline, the more muted the retail price increase would be as crude prices rise. Funny enough, although gas prices are twice as high in Europe, you don’t hear that many people complaining, or stories in the press about the summer’s driving season being in danger.

But what happens in the US? Actually, just because taxes are so much lower, the percentage increase in gasoline prices is a lot more marked, creating an outcry. This has led politicians to propose rather silly things..

When did Hilary Clinton lose the primaries, when she came up with that ludicrous idea to give drivers a tax holiday for the ‘driving season’. Big oil and energy already get more than enough subsidies (fair enough, she proposed to pay for the drivers holiday out of these).

The US needs to enlist the price mechanism to provide the incentives for changed behaviour and more research. There are sound economic reasons for doing so. Not all the societal cost are reflected in energy prices anyway.

When you buy a gallon of gasoline, it’s price doesn’t reflect the increase in greenhouse gases or pollutants, it doesn’t include the damage to the environment, or the health cost this produces. Instead of subsidizing big oil, it should be taxed.

If you compare the US with Europe and Japan, you will find out that since the mid 1970s, oil consumption in Europe and Japan has hardly moved, in the US it has doubled. This led Newsweek columnist Fareed Zakaria argue that:

The single biggest shift in global demand over the past decade has not been the rise of China but the rise of SUVs.

One of the consequences is that the big three US car manufacturers lag others in producing energy efficient cars, something which could even endanger their future.

As of April, GM, Ford and Chrysler had already seen their combined share of the U.S. market slip below 50 percent. By contrast, at its recent peak in 1980, GM alone had 45 percent.

Had the US embarked on similar policies as Japan or Europe, this would almost certainly not have happened as the incentives would have been in place for US manufacturers to take energy efficiency much more serious.

What could be some of those measures to help the market provide the right incentives? According to Zakaria:

If the president and Congress were to propose a powerful package of measures—higher gas taxes, fuel-efficiency standards starting at 30 and rising to 40 miles per gallon, tax credits for new technologies—it would begin to wean the United States off its addiction to oil. And, it would signal to the market that demand for oil in the United States was likely to slow and stabilize.

Indeed, that would do two things:

1. Include some of the real cost of fossil fuels in their price.
2. Provide the necessary incentives we were talking about above.

Markets do not always get it right. Prices sometimes do not reflect all cost inflicted on society (a phenomenon known as ‘external effects‘). There might also be significant transaction cost hampering solutions, like in the following example considering investment in energy efficiency:

The problem, analysts explain, is a series of distortions and market failures that discourage investment in efficiency. Often, consumers are poorly informed about the savings on offer. Even when they can do the sums, the transaction costs are high: it is a time-consuming chore for someone to identify the best energy-saving equipment, buy it and get it installed. It does not help that the potential savings, although huge when added up across the world, usually amount to only a small share of the budgets of individual firms and households. Despite recent price increases, spending on energy still accounts for a smaller share of the global economy than it did a few decades ago.

So, although markets are our best bet for relief in the global energy crisis, markets do sometimes need a little help from a friend…