The ‘Energy-Food’ nexus – and how to tackle it

Over just a few years, the world economy has plunged into two commodity crises. Both have major security implications.

First, the price of oil has risen to historic highs, with most of the rise in the last 18 months alone. Second, a long simmering crisis in food commodities has hit the front page of newspapers in the last few months. Nearly all food commodities are trading at all-time high levels. Food shortages, a rarity that most governments thought they had extinguished with the “green revolution,” are now evident in a growing number of countries. Riots, confrontations and instability have followed.

Fixing the root problems will require governments to rely more heavily on market forces and to invest, especially in energy, in ways of cutting demand.

So far, governments have done very little to address the causes, and the most likely political outcomes will make things worse. In food, some governments who are under severe pressure to do something to feed their populations are imposing trade and price controls that seem likely to make shortages even more acute. In energy, the most striking fact is that governments — notably the United States, the world’s largest energy user — have done very little to encourage consumers to be more frugal.

Mapping out how to address these twin crises requires, first, an assessment of how the world got into this mess. High oil prices have their root in the fact that oil is not a normal commodity. A lot of oil is used for transportation, where it is prized for its high energy density and the fact that it is a liquid that is easily moved and stored. Transport systems are not very responsive when oil prices rise because there are no real substitutes. So demand has continued to grow even as oil prices have soared. (In time, buyers will find it cost-effective to conserve and that will dampen demand a bit. Airlines and car drivers, for example, are now buying more efficient equipment that will lower oil consumption once these machines are in widespread use.)

On supply, oil is even more perverse because most oil reserves are controlled by state-owned companies which don’t respond like normal companies - i.e. they don’t automatically boost output when prices rise. Some of these companies and their government owners are content just to bank the extra profits from high prices. They have weak incentives to amass even more money since they can barely invest and spend what they have already. That’s partly why Saudi Arabia and Qatar, among many others, have announced that they will slow or halt expansion projects.

Others, such as those plagued by the “resource curse,” strangely find that output actually declines when more money comes rolling in. Why? Because politicians scramble for the money and so undermine the business environment that is essential for long-term investment. So in Russia and Venezuela output is actually falling, even though those countries are rich in resources.

That’s why today’s prices are so high: the extra cost of oil doesn’t much affect demand and in some countries actually impedes supply. Looking globally, the demand and supply curves are nearly vertical in slope, which is why small shifts magnify into large swings in prices. (Private money amplifies those fundamental forces, not least because oil and food commodities are now investment vehicles - with other markets performing so poorly and the outlook for higher commodity prices, these investments have come rushing in).

It is trickier to explain why food prices are so high. Many pundits have pointed to high energy prices as the cause because some food crops are diverted to make biofuels — notably maize and sugar for ethanol (which is blended in gasoline) and soyabeans for biodiesel. The impact on food prices comes from diverting the grains into biofuels as well as creating strong incentives to shift cropping patterns away from food into more profitable biofuels.

While a popular story because its points the finger as a simple villain — the energy market — the exact impact of oil prices and biofuels on food costs is hard to pin down and probably not decisive. The details vary by crop, but careful studies suggest that perhaps 10 to 30 per cent of the current run-up in food commodities is due to investment in biofuels.

The impact on food prices is hardly the strongest reason to rethink biofuel investments. Some of the most popular biofuels —notably conventional maize-based ethanol as well as oilseed biodiesel — are very costly ways to cut dependence on oil, don’t do much to help global warming, and have a big ecological footprint.

The energy and food crises are connected not so much through biofuels as fundamentals. Demand for fuels and foods are rising in tandem — especially with the growth of the giant Asian economies of China and India. Supply is also constrained and sluggish due to forces that work in tandem. One-off factors that have sapped supply are causing already tight food and fuel markets to become discombobulated. Droughts in Australia, for example, have cut world supply of some food crops. Shortages in qualified engineers and drilling rigs have made it hard for oil suppliers to respond by designing and putting new oil fields into operation.

Some of these “one-off” factors may become more permanent. Climate change may hit agricultural output with ever-bigger jolts in the coming decades (at least until farmers find ways to be more productive); the tight market for engineering and heavy equipment looks tight for the foreseeable future.

In theory, the twin crises of food and fuel offer a tremendous opportunity for reform. Higher food prices send more income to farmers who are often the most potent force blocking sensible reforms in agriculture policy. In practice, no major government has used this opportunity for serious reform.

The United States, for example, is just now reconfirming its farm policies that send distorting subsidies to farmers, despite the fact that there is no time in the last generation when farmers have had less need for this manna. Basic distorting farm programmes in Europe and Japan are also little changed.

In some cases, governments are doing things that actually make farmers worse off. India, for example, has banned rice exports, which will lower the price that rice farmers get and undercut incentives to boost output. The only real way to assure food security is to allow farmers and consumers to interact with a world market which offers the most diverse sources of supply.

In energy, higher prices offer a powerful incentive for conservation. Yet many governments are blunting those market forces. Many of the oil-richest countries set prices for oil products way below world markets, such as in Iran and most of the rest of the Persian Gulf. (That, along with higher wealth, explain why the oil rich states are among the most rapidly growing sources of new oil demand.) China imposes some regulation on oil prices and exerts a stronger hand on electricity prices, which is partly to blame for the power blackouts earlier this year. Power generators faced rising coal prices but could not pass along the extra cost to customers; squeezed, they let their inventories of coal dwindle, which made them more vulnerable to disruptions in supply — as happened when snowstorms wrought havoc on the country’s rail system.

Fixing these problems requires fixing the fundamentals, and the hard truth about food and energy is that, in part because of globalisation, western governments don’t have much direct leverage.

In food, their policies affect both supply and demand but as the market globalizes no single government has a decisive impact. Governments might have some impact on food demand, but the much bigger leverage worldwide is in boosting supply from higher yielding crops.

In oil, western governments are notable for their lack of much leverage on supply, although as big consumers they could have a large impact on demand. But changing demand requires changing the way the economy uses energy, and those changes hinge on the innovation and application of new technologies.

One crucial means of boosting food supply and tempering demand for oil is through technological change. Yet smart technology policy is one of the hardest areas for government to mobilize its effort.

Technology requires long-term and patient investment; the outcomes are uncertain and the best investments are made in portfolios with smart managers attuned to market realities, where it is often particularly difficult for government bureaucrats to succeed. Politicians plunged into crisis, as today with high food and fuel prices, instead grasp for quick symbolic fixes with certain outcomes—they favour price controls, mandates for politically favoured groups such as biofuel producers, and trade restrictions.

It is worrying that actual investment in technology is lagging far behind what would be needed to fix fundamentals. Some western governments are actually trying to reduce public investment in the international crop research institutes that brought the “green revolution” and are best poised to repeat that success in the coming decades if given the resources they need. Investment in new energy technologies now appears to be reversing its long slide since the early 1980s, yet is far below what is needed.

Private sector investment is encouraging in a few areas, such as in advanced biofuels and in better batteries that will make it possible to shift from oil products to electricity in powering future cars.

But in the areas where government investment is most needed — such as in demonstration of advanced low-emission coal plants that will be needed if new electric supplies are to avoid harmful carbon dioxide effluent, the leading cause of global warming — the actual level of investment is paltry. Worldwide, today’s government investment plans will back perhaps a small handful of these advanced coal plants when several dozen in the next decade will be needed to prove a robust portfolio of technologies.

Today’s food and fuel crises are, at root, made by humans. They are the result of rising demand and constrained supply. Their solutions lie with human ingenuity as well. This will require much better organization by governments — especially in their investment in new technology.