Senior Fellow Kevin A. Hassett

Energy policy in the U.S. is easily the most repugnant area of economic policy making. Everything about it is ludicrous, from senseless government cash for any oil alternative that can drum up enough funds to finance a lobbyist, to subsidies for domestic exploration that lower the cost, and drive up the demand, of oil itself.

It's hardly a surprise when politicians fail us. Last week, with energy policy in play, we saw disappointments galore.

But the biggest surprise of the week was a bill introduced by Congressman Devin Nunes, a California Republican, that may, if enacted, lead to a dramatic improvement in U.S. energy policy. It has been a long time since someone in Washington thought outside the box. The brilliantly crafted Nunes bill marks the third-term Congressman as a rising star in the Republican Party.

Nunes, a third-generation farmer from the heavily agricultural San Joaquin Valley, has proposed a pilot futures market project that is a financial economist's dream come true. Clearly, he has put his graduate degree in agriculture to good use, since well-trained farmers are old hands working with futures markets.

Here's the back story. Nobel Prize-winning economist Joseph Stiglitz studied situations where the nonexistence of markets can cause economic systems to end up in strange places. Nunes's fascinating insight is that energy markets might be a case study in the kind of market failure that Stiglitz had in mind.

A Big Deal

Nunes's specific application is in alternative energy. Imagine you are deciding whether to sink a billion dollars into a plant that makes an oil substitute. If you eyeball the history of the oil market, you will immediately see a problem. The price goes up and down over time, frequently falling to levels so low that factories producing alternative fuels would be uneconomical.

You could drop your money into a costly plant, then watch the price of oil drop and lose your entire investment.

This type of uncertainty is a big deal for financiers. If a new plant has a working life measured in decades, then uncertainty over the future price of oil is a significant impediment.

Firms often use futures contracts to help them reduce the risk of their projects. If you are worried that the price of oil might drop below, say, $70, then you can purchase a futures contract that allows you to sell your barrel of oil for $70 three years from now. The problem in this setting is this: The futures that you need to cover a really long-term investment are either illiquid or don't exist.

Government-Created Market

If you want some action in the next few years, you can operate in existing markets. If you want to buy the right to sell your alternative fuel for the equivalent of $70 at any time in the next couple of decades, you are out of luck.

The Nunes solution is to have the government create a market for long-run put options for alternative fuels. This would give those who have constructed qualifying facilities the right to sell (or "put") their product at a minimum price to the government should the actual price drop below that.

If you are planning to invest a couple of billion dollars in a coal-to-liquid plant, then you could purchase a U.S. government-backed option that would guarantee you a minimum price of, say, $70 a barrel. If the actual price is above that, you can sell your product for more than that. If the price drops below $70, the government pays you the difference between the market price and $70.

The price of these futures contracts would, under the Nunes bill, be set at auction. Accordingly, the policy would probably raise revenue in near-term forecasts. In the long run, taxpayers would be taking on a risk that oil prices will drop, but that risk is a natural one for them take.

Booming Economy

If oil prices fall so low that the government must pay lots of money to alternative fuel providers who have purchased these options, then that would mean the economy will be booming because of the low energy prices. In addition, tax revenue will be flowing in, and the Treasury's coffers will be full.

The beauty of this policy is that it should remove a major source of uncertainty for those who would produce alternative energy. This should increase the amount of money that flows to this area and lower the cost of capital for alternative fuel providers. In other words, it uses markets, and not subsidies, to solve our problems.

Nunes's bill proposes using coal-to-liquid plants as a pilot project. If it becomes law, then my guess is the project will be highly successful and will rapidly apply to any alternative to imported oil. And when government creates this missing futures market, the flood of capital into alternative energy will make all the silly targeted subsidies unnecessary.

If that happens, a congressman from an agricultural district will have turned U.S. energy policy on its head. Costly, politically motivated subsidies will be replaced by a valuable futures market that costs the taxpayers little.

Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.