A Price Floor for Oil?

That's what Philip Gordon of the Brookings Institution says we need to provide the proper incentives for long-term investment in alternative energy or energy saving programs:

An improbable cure for oil addiction, by Philip Gordon, Commentary, Financial Times: With public anger rising at petrol prices that now exceed $3 per gallon, American politicians are predictably rushing forward with proposals designed to show that they are “doing something” about the problem.

Democrats are investigating oil companies and proposing a 60-day suspension of the federal gas tax while Republicans are clamouring to start drilling in the Arctic National Wildlife Reserve, having withdrawn their initial proposal for a $100 “holiday rebate” in the face of public ridicule.

These measures may make some politicians feel good but they will provide little relief to consumers. ... Instead of supporting politically cynical palliatives, Mr Bush should take the opportunity created by high oil prices to ask Congress to impose a “price floor” on a barrel of oil. The mechanism would be very simple. The government would announce that, as part of a comprehensive energy strategy, it will henceforth not allow the price of oil to fall below a particular floor of, say, $60 per barrel. If high oil prices continue, the proposal would have little impact and cost nothing, either politically or financially.

But if prices fall below that level ... the government would intervene to keep the price stable, with the difference between the floor and the market price reverting to the state as revenue.

If consumers and industry knew that the price of a barrel of oil would never again fall below $60 per barrel – the level around which US-produced corn-based ethanol fuel becomes economically viable – they could make long-term investment and consumption decisions in a way that makes little economic sense so long as price stability is not guaranteed. Americans will not take long-term decisions to buy fuel-efficient automobiles, create distribution networks for alternative fuels, or invest in technologies such as hydrogen fuel cells, flex-fuel vehicles or wind power unless they know that a future sharp fall in oil prices will not undercut them.

To make the proposal even more palatable politically, Washington could promise to spend any revenue on education, healthcare, homeland security and even tax cuts rather than use it for deficit reduction, a noble purpose but one that rarely excites voters. ...

As we consider these policies, I would prefer we begin with identifying why the market outcome is suboptimal, i.e. the cause of the market failure the intervention is intended to overcome. Is it pollution externalities? Is it because we don't properly discount the future? Is it monopoly power? Do market failures somehow prevent hedging of future risk and distort investment? The problem this policy is designed to overcome is lack of investment in alternative energy or energy saving programs, but it is not clear from the article why the expected average future price of oil is delivering a distorted market signal. I don't mean to say I believe the signal is necessarily correct or that this policy might not be useful, there are many reasons to believe the market is distorted, only to comment that it's useful to identify the specific problem a policy is designed to overcome. Different causes of distortions can produce similar economic symptoms but require different solutions, so knowing the source of the problem is an important step in designing an optimal policy response.