IEEJ: February 2012 All Right Reserved
Special Bulletin

A Japanese Perspective on the International Energy Landscape (74)

February 3, 2012

Viewpoint for Considering Energy Problems: Market-State Relationship
Ken Koyama, PhD
Chief Economist, Managing Director
The Institute of Energy Economics, Japan

Energy sources vary from crude oil, petroleum products and gas to coal and electricity. As
far as each source is an economic good, a market exists with market transactions conducted in eachphase of its development, production, transportation, distribution, sales and consumption. Therefore,
it is very important for each market to fully work to demonstrate its functional utility including
optimum resource allocation through the pricing mechanism.

If the market works fully, all market participants from consumers to producers may enjoy
great benefits including utility maximization. The history and realities, including the failure of aplanned economy, undoubtedly indicate that it is important to make best use of market mechanisms.

At the same time, however, it may be important to give considerations to the following
points in analyzing the actual world of energy.

First, energy is indispensable and necessary for civilian life and economic activities.
Energy may sometimes be emphasized as a military or strategic good. In this sense, it is verysignificant to acquire necessary and sufficient quantity of energy at reasonable prices. This is a
simple definition of energy security. In a nation state, its national government is responsible for thewell-being and good order of citizens as components of the state and is thus often required to ensure
energy security.

Second, the price elasticity of energy supply and demand is relatively lower particularly
over a short term because energy is an indispensable good with some limits imposed on its
substitution. Therefore, prices tend to substantially fluctuate when market supply/demand conditions
change, in particular in the short term. This tendency has tended to be accelerated by the growing
linkage between energy and financial markets (the growing influence of money factors) over recentyears. Wild energy price fluctuations can trigger economic dislocation by rapidly and substantiallychanging income distribution among various market participants such as consumers and producers.
1IEEJ: February 2012 All Right Reserved
At a national level, substantial energy price fluctuations shake national economic conditions, bringabout large-scale income transfers (including energy importing countries' increased payments andenergy exporting countries' increased income) and increase the strategic value of energy in line withgreater needs for securing energy to affect the international balance of power. In this sense, therefore,
it is natural for national governments to become sensitive to energy problems.

If without fears or concerns on present and future energy market stability, nationalgovernments may not grow sensitive to energy problems. In the present energy market, however,destabilizing factors are increasing, including growing geopolitical risks, the rise of emerging
countries and their substantial demand expansion, and growingly uncertain investment environments.
Under such situation, the energy market now sees various national interests conflicting with eachother over such issues as energy security and global warming. In another fact, giant state-run
corporations representing nation states have had great presence in the actual energy market. In asense, countries or national governments themselves are major energy market players.

Furthermore, economy of scale can often easily work in the energy market. Giant market
players frequently emerge and exist, for example, in a form of natural monopoly. In such case,national governments are expected to address large-scale players' market dominance or their market
power. It is also important that national governments are naturally held responsible in a sense forestablishing and enforcing safety standards for the energy production, transportation andconsumption phases.

In summary, given today's energy market realities, states or governments are required toplay a diversity of important roles. As a matter of course, this does not mean that government roles
should have to be left to expand. Inappropriate or excess state or government intervention can distort
the market. "Government failures" have been seen frequently. At the same time, however, it may beunrealistic to expect that energy security will be ensured with no problems caused if the market iscompletely left untouched.

How to interpret the market-state relationship regarding energy problems has been debatedglobally over a long time. In my view,

the pendulum has swung between the market and the state

depending on market environments, worldviews and epoch-making events. If based on any
unbalanced argument where the pendulum swings too much in either direction, however, any choicemade may bring about great problems for the present and future. Every country must have a strategy
to secure the best balance between the market and the state, based on its national situation, existing
resources, industrial reality, technological capacity, international relations and other conditions.
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