A Game Theory Perspective for Policy Proposals to Achieve Net Zero & Energy Security

Since the Russian invasion of Ukraine, it has been said that the UK is experiencing a cost of living crisis due to the shortage of commodities namely electricity and gas. Sanctions placed on Russia, an exporter of these commodities, have reduced gas supply levels, and other providers such as Norway are under strain due to high demand from the European Regions. This narrative has been easy to understand and follow, yet, it fails to explain the supposed shortages as the UK has increased its gas and electricity exports by 576% and 568% respectively since Q2 of last year. As such, as well as having an energy shortage due to being a net importer of energy, the UK has an energy retention problem. To rectify this, the following column will examine different policy approaches of controversial Energy Profit Levies (Windfall taxation) and regulation changes to achieve two outcomes. The first is to raise government revenue to allocate more resources toward supply-side policies that will achieve energy independence in the long run. And, second, to utilise these policies to reduce the UK’s total carbon footprint by changing the optimal strategy for firms to take on a game-theory matrix.

With total production and total consumption as of Q2 of 2022 being 27.4 million tonnes and 176.9 million tonnes respectively, the UK still has a long way to go to achieve energy independence. Nevertheless, output has been making strong progress as in the last year alone, total energy production rose by 21%. Yet, this high increase can be considered anomalous as in 2018 and 2019, production rose and fell by 3.7% and 0.5%. As such, the UK’s high growth within the energy production sector has been largely attributed to the Russian invasion of Ukraine and the subsequent role that the UK had been bestowed with by the market. That being the role of acting as a key supplier of gas to the rest of Europe. Whilst this position will be unsustainable with the conclusion of the mentioned conflict, UK energy companies have reaped large rewards during these conditions with firms such as Shell reaching profits of £8.2bn and £9bn. Although these profits have been derived from the free-market working as it should be, (lower global supply inflating energy prices and as such profits for companies) the ethical question should not be targeted as to how these profits have manifested, but rather what they will be used for. The optimists or perhaps ideologically motivated among us will suggest that these energy companies will be able to utilise their left-over supernormal profits on reinvestment into green technology, which will expand the UK’s renewable capacity.

However, one examination of the data shows that this viewpoint is naive and at best misleading. Despite an increase in profits, growth in the renewable sector had risen by 12% as opposed to non-renewable sources such as gas and oil which rose by 55% and 9.3% respectively. Although this does show that the production of non-renewable sources still significantly outweighs renewables, which now account for 38.6% of total domestic UK energy production, one can still appreciate that this 12% increase in renewable generation marks record growth. Yet, by only examining the domestic production of the UK economy, our analysis can window-dress and underestimate the extent to which the UK contributes to global pollution. For example, Liquefied Natural Gas (LNG) imports increased by 37% since Q2 of 2021 (no data had been provided on imports for renewable energy sources). As such, with global temperatures rising by 1.7C per century since 1970, just because the market is working this way doesn't mean it should. In other words, UK energy companies have two choices, to pollute, and, to reduce pollution and in this scenario, the benefits of polluting outweigh the costs of choosing to reduce pollution. Therefore, this makes climate change a game theory problem. (Figure 1)

In this example, we assume that we have two firms operating in the energy industry that are in direct competition with one another. Should firm A and B choose to pollute, under current legislation, they will see maximum profits. This is due to these firms not having to expend profits on R&D or reinvestment for green technology. Conversely, should firms choose to not pollute, they see an erosion in profits due to larger investments. In these cases, they can either lose revenue to a competitor in the complementary scenarios or, lose profits altogether if both firms choose to stop polluting.

By looking at climate change through this lens economists are able to specifically target areas of the problem to yield solutions. The difficulty of this of course boils down to computing the specific benefits of pollution, and the costs of not doing so. Unfortunately, the topic of climate change is one whereby both sides of the debate provide incomplete judgements and methodologies to support their respective positions. As such, drafting a game theory matrix becomes more difficult. Initially, one can already see problems arising as contemporary literature now suggests that the cost of providing renewable technology is drastically cheaper than that of non-renewables. Whilst the research on this is conclusive, it does not consider the hidden costs borne by a firm of not polluting such as; replacement of existing infrastructure, retraining of staff, contract terms and the reworking of supply routes. When all of these are considered, the issue becomes much more complex. Moreover, firms do not simply expand their existing capacity and production unless there is the possibility for greater profits. One channel that can yield these higher profits is a rise in demand to increase prices, yet, such a scenario only occurs if the National Grid commissions the construction of additional power plants, wind farms, and other energy generation sources through bidding, auctions or outright sale. Conversely, another channel is a reduction in supply, yet, such a solution is unsustainable and ethically questionable at best - to artificially restrict the supply of electricity during a cost-of-living crisis is a bold strategy. When comparing these costs of not polluting to the benefits of pollution such as synergies & internal economies of scale from expanding existing supply routes, factories and staff we see the problem becomes much more complex. As such, there is little reason for existing energy companies to heavily invest in increasing their renewable generation and capacity. The economy is sticky and as such there are heavy costs associated with change. Therefore, to rectify this issue, the government is to introduce policies that reduce the benefit to firms that have a ‘business-as-usual- approach, and, reduce the costs for firms that are willing to adapt. In this scenario, the optimal strategy on the game theory matrix would change as shown below. (Figure 2)

To punish firms that pollute and reap high rewards from their business activities, the UK government should reintroduce an adapted version of the Energy Profit Levy, which is more commonly known as the Windfall Tax. Under current legislation, the Energy Profit Levy had increased the headline rate of tax on the profits of oil and gas energy companies from 40% to 65%. Within this legislation, the scheme had also given 80% tax relief to oil and gas companies that choose to reinvest in infrastructure designed to raise oil and gas production. The objectives of this at the time were to increase government revenue to fund support payments made to families during the cost of living crisis and to increase UK oil and gas production to depress prices and raise energy security. Unfortunately, only the former objective was realised. The objective of domestic energy security was unfulfilled as evidenced by the large increases in exports mentioned in our introduction. Moreover, the goal of reducing price levels was similarly futile as gas and oil prices continued to rise due to the conflict in Ukraine.

Consequently, with the levy only targeting oil and gas production, it is the case that the UK government prioritised a gamble of attempting to reduce energy prices rather than incentivising firms to increase investment in renewable technology. As such, with the Energy Profit Levy only so far satisfying one out of three of its policy objectives, it can be seen as a failed intervention as trade-offs between tax relief and increases in output to reduce prices did not manifest. As a result of this, this column suggests manipulation of government policy to fit the narrative of climate change being a problem fundamentally dictated by the game theory matrix. Such an adaptation would involve the aforementioned reduction in benefits to firms that continue to pollute. This can be done by making it so that the Energy Tax Levy will be placed on companies that do not increase investment into their green technology rather than oil and gas. Therefore, this will reduce the benefits for firms continuing to pollute, bringing the optimal strategy on the matrix towards the state whereby both firms choose to reduce dirty economic activity. (Figure 2)

However, it must be considered whether or not such a policy would actually divert sufficient investment into renewable technologies by the private sector. Once again, the economy is very sticky and increased investment into the renewable sector is only viable for private companies should the potential for profits either outweigh the costs of expanding or replacing existing inputs. It must also be noted that any taxation measures placed on energy suppliers can continue to place cost-push pressures on energy distributors. This is because commodities are highly inelastic by nature, thus, the incidence of taxation will be passed down supply chains towards the consumers. And, although the UK energy price cap system is designed to protect consumers from price rises, the trade-off of this policy is either increased market concentration because of rising insolvencies of distribution companies, (due to increased costs from suppliers) or, increasing inflationary pressures on households. (should the price cap change due to the risk of insolvency) Therefore, the introduction of this scheme during the cost of living crisis would yield detrimental effects towards the UK fuel poverty and the stability of the energy market. This means that if the tax is not computed correctly, the benefits of polluting will still outweigh those of not polluting and no change will occur in the behaviour of the private sector.

Nevertheless, should the change in the Windfall tax yield no change in investment, the economic trade-off would be an increase in government tax revenue as few firms would take the ‘super-deduction’ style investment-related tax cuts. Yet, this is not necessarily a policy failure. In the context of the cost of living crisis, increased tax revenue due to energy firms failing to meet investment quotas in green technology works as an effective wealth redistribution policy. In other words, these taxes can be used to support policies such as crisis support payments to households. At the same time, tax revenues could be used for contributions to the UK’s national debt of £2.4 trillion. Moreover, during periods of economic stability, the UK government can use this tax revenue to continue to nudge energy companies to go green and to achieve increased energy independence in the long run. Such a decision would complement the other half of the issue that energy companies face when having to invest in green technology - the cost. What we propose is for the adapted windfall tax to be used to reduce the benefits of polluting whilst using the taxation revenue to subsidise green technology transmission thereby reducing costs. The objective of these subsidies would be to reduce the friction large energy firms face when switching or integrating existing production (which tends to be more fossil fuel based) to and for green energy which will move the optimal strategy on the Game Theory Matrix. (Figure 2) This can be done by the government covering the costs of retraining, capital investment, or, even subsidising the cost of replacing existing capital. As such, this will allow for more dynamic energy transmission to manifest as firms who previously did not want to replace plants now have the costs of retrofitting subsidised by the state. In fact, retrofitting itself is a new area of technology that has a lot of recent developments with Bill Gates-backed utility developer, PacifiCorp, looking at whether or not it is possible to turn old coal power plants into nuclear ones.

Another potential supply-side policy for discussion is the domination of large firms in the energy industry. With a concentration ratio of almost 75% for the largest firms, the energy supply of the UK is virtually dominated by large incumbent firms. And, although standard economic theory suggests that larger firms can be more dynamically efficient, (allowing for innovation of the production process) this paper suggests that due to the large fixed costs associated with the replacement of capital, labour, and other resources such as supply chains, innovation is too slow for the climate change effort. Aside from government subsidies to reduce fixed costs, one casual recommendation we would also like to make is for policymakers to look at the possibility of smaller firms entering the market to provide green energy. With smaller firms having a greater capacity for flexibility, this could be a good way of increasing competition in the energy industry whilst achieving emission targets. The only problem is the entry barriers, however, government agents and the National Grid can either make legislative changes or adapt bidding structures to allow smaller and more dynamic firms with a focus on green technology to enter the market and grow. For instance, a new scheme by BEIS, the Contracts for Difference, allows firms to expand capacity with a guarantee of future stable income. At the same time, financial support can be offered to these firms through various grants for research and development or standard loan support available for small businesses to reduce the risk of expanding operational capacity. All of this would allow for more firms to enter the market that does not suffer from the same problems that larger firms do, such as the large costs of replacing existing production that is leading to the stickiness in the change we described earlier. In the long run, this paired with an adapted Windfall tax would make the domestic energy market more competitive, and sustainable. In conclusion, this diversification of the UK energy supply towards electricity powered by various green sources will make it less susceptible to shocks in commodities such as gas (boosting domestic stability) whilst reducing greenhouse gas emissions.