The economic inefficiencies of our energy policies

A friend recommended "Environmental Economics and Policy" by Tietenberg and it's pretty interesting for those who are eco and econ novices. There's a big chapter on energy policy and how various government actions and corporate incentives reduce the "economic efficiency" of energy (or the total net benefits to society). In other words, we're not getting the most out of our energy use, and our poor decisions are making our energy problems worse. Dynamic efficiency takes the future into account, so it is the best allocation of resources that will maximize the net benefits to both present and future peoples. This is important because so often short-term thinking creates problems (Wall Street quarterly reporting, the House's 2-year election cycle, etc.). Many incentives exist to "rob from the future" in order to increase profit or look better today, and if only future peoples could invent a time machine to advocate for their interests now.

Environmental economics helps to inform policy decisions to increase "fairness" and "sustainability". Fair, sustainable decisions should not leave future generations worse off than we, in terms of aggregate natural and man-made capital available. Carbon trading operates on this principle. Although company X is polluting in the present and thereby hurting the future, it can become more sustainable by offsetting its damage with conservation/research outlays that benefit the future. So the general strategy is to find policies that satisfy sustainability criteria, and of those choices implement the ones with the highest dynamic efficiency. Of course the strictest sustainability criterion mandates that we should preserve the natural world exactly as it is for the future, so that our consumption is limited by the replenishment rate of the resource (forest, fishery, etc.). But that is a hard sell these days, and of course impossible for non-renewable resources like minerals and fossil fuels. Peak oil is probably behind us and the discovery/creation of new deposits is greatly outpaced by our consumption rate. If we can't leave our progeny the same abundance of fossil fuels as we enjoy now, at least our energy use should create profits that can become capital set aside to compensate the future. Alaska basically does this and pays its residents yearly dividends from its "permanent fund" (but really all of it should be off limits).

Republicans and some Democrats pre-BP spill were advocating "drill baby drill" to solve our energy problems. But from a fairness standpoint you can see that makes no sense (we're just leaving less oil for the future). And since domestic oil generally has higher costs of production (labor, regulatory compliance, insurance), we're retaining less profit, even if we were nice enough to set it aside for the future. Plus there's not much left to tap. "Easy oil" has already been exploited in the US, so untapped deposits entail a lot of risk and cost. Deep-water drilling blowouts, arctic pipeline leaks, and water pollution from natural gas fracking are not just hypothetical dangers, but we've witnessed them with horror. Even though the environmental costs of production aren't really included in the retail price of energy, exploration in hard-to-access locations is already super expensive. It's only cost-justified when the demand for oil pushes the market price above $70/barrel like it is today.

The booming tar sands industry in northern Canada and elsewhere is a consequence of this. If you're not familiar: building-size earth movers (that consume a lot of fuel as you can imagine) dig up tons and tons of dirt, transport it to giant boilers that heat up the sludge and separate the usable fuel from the sand. And all this takes place at the top of the world, so there are a lot of costs associated with moving equipment and people up there, keeping them warm and sane, and pumping the fuel back to civilization. Beyond the environmental damage and infrastructure concerns, it also costs about 3 gallons of cleaner natural gas to make 1 gallon of dirty oil from tar sands. Even a child could see that something is amiss with that paradigm. But just because the market says this transaction makes sense doesn't mean we should accept it at face value.

Speaking of natural gas, it's not a panacea either. Since methane is gaseous at normal temperatures, high-pressure transportation and storage is challenging. In order to be cost-effective, it has to be super-cooled to -259 F for international tanker transport. Although we've been lucky so far, LNG facilities are an attractive terrorism target, as an LNG fire is much hotter and harder to contain than an oil fire. Also, methane is much more potent than CO2 for greenhouse effect.

But shouldn't we drill more at home to reduce our dependence on imports? Only if it will make us better off, and it usually doesn't. It's just easier to buy foreign oil - that's why we still do it despite the risks. Yes our money goes to people who may not like us very much, but it's hard to quantify how much actual damage that is causing. What about Middle East terrorism? We are implicitly paying a "security premium" for foreign oil. Some of that is our taxes to fund the US Navy that is mostly in charge of keeping the sea lanes safe for tankers and other vessels. Other monies are allocated to maintain the Strategic Petroleum Reserve: a billion barrels of oil stored in caves in the South in case of embargoes or other supply disruptions. And of course there are the oil wars and support to oil dictatorships. The security premium is good in that it lowers consumption and makes domestic supply more attractive, but the bitter truth is the premium is more efficient than trying to be energy independent (that would require a major US economic downsizing). So we have to live with OPEC and volatile imports, but how can we reduce our pain? Conservation always helps, but it won't fix the problem because of the oil we still need to use, much of it will be foreign. In addition, the government can impose tariffs equal to the security premium. The revenues collected could fund alternative energy research and pollution control. But tariffs piss people off (people we depend on), so DC would prefer to subsidize domestic suppliers (but that won't make oil any cheaper to consumers).

Price controls are a touchy issue too. We know that the middle and lower classes are getting squeezed by higher energy prices, and we don't want people to lose their jobs because they can't commute or die because they can't afford to keep the heater/AC on. It isn't humane if some people are priced out of access to energy. Of course OPEC and other local monopolies reduce supply in order to capture more "economic rent" or resource royalties. But when the gov't holds commodity prices below their market price, it causes consumption to increase, which exacerbates climate change, hurts the future more than it helps the present, and makes it harder for alternative energy to gain market share. If price controls are in place long-term, consumption will be so high that all the cheap gas will be used up until the extraction costs of harder sources equal the price cap. Then producers have no incentive to sell gas. And even though prices are forced lower, during shortages there's no guarantee that poorer people will get access to fuel. Subsidies make a lot more economic sense. Let prices rise to the market rate, but compensate the poor so that they can afford it.

Price controls also create perverse incentives for suppliers. Politicians may cap prices to look good in an election year, but if producers know the cap will expire next year, they may cut back supply to make more money in the future. So we'd have over-consumption plus supply shortage. This happened with natural gas in the US in the 1970s. For some reason, the gov't put price caps on interstate gas purchases but not intrastate. So suppliers preferred to sell locally, which totally screwed people in gas-poor states.

And then there's the whole issue of energy deregulation. Traditionally, utilities were regulated monopolies where gov't would set price, but suppliers were obligated to service all customers in an exclusive area. But in 1992, Congress decided to let suppliers sell electricity on open markets, and lower prices to compete for customers. Well, that was the plan at least. If price leadership is key, firms have incentive to cut safety corners and use the dirtiest inputs to provide the cheapest watts. Dysfunctional California joined the party in 1995 since the state was paying power rates about 50% higher than US average. But a perfect storm ensued to cripple the state. Drought reduced hydroelectric productivity and many fossil fuel plants were due for scheduled maintenance shutdowns. This boosted wholesale costs, but suppliers couldn't pass them onto consumers due to a price cap that was law. So rolling blackouts ensued, and some firms like Enron affiliates (famously) exploited the chaos. They deliberately withheld power in various markets to take advantage of short-term supply inelasticity, which raised prices and allowed them to reap monopoly profits. So the poorly and hastily designed "free market" turned monopolistic anyway. PGE even had to declare bankruptcy in 2001, the voters blamed Gov. Davis, and replaced him with the Terminator.

Even China knows that coal is literally a dead-end, but how about nuclear? If the energy market functioned properly, nuclear power would never exist. Besides the yearly tax breaks, gov'ts had to offer huge assistance to promote plant construction, because if suppliers had to absorb the real costs of nuclear accident risk and waste disposal, there would be no takers. We passed the Price-Anderson Act in 1957 to cap liability damages at $560M for a nuclear disaster (and the taxpayer would cover 90% of that, though not sure if those are 1957 or 2011 dollars). It was supposed to expire in a decade (by that time nuclear plants were supposed to figure out safety so that accident risk was a nonfactor), but it hasn't. The gov't share has fortunately shrunk, and now private insurance covers the difference.

Like other insurance, plants pay premiums into a big accident fund, but in this case the sick pay as much as the healthy. Plants with great safety records and top-of-the-line equipment don't get rate discounts, so there's no incentive to provide sufficient safety. But no one wants another Chernobyl, right? Well economically speaking, it makes no difference for nuclear firms. Due to gov't and insurance risk underwriting, they are no worse off if they wet the bed. And I'm not sure how much responsibility companies bear for waste disposal (my guess is not much, otherwise they wouldn't be in business). How scary is that? Sure I believe they still have a conscience and don't want to take the PR hit from an accident, but it concerns me that negligence can't really be punished financially. As we've already discussed, the NRC that oversees nuclear facilities is underfunded and bullied by Congress to back off the plant operators. A fair alternative would be to tax the nuclear firms to compensate those affected by nuclear power issues. France already forces plants to sell cheaper power to those living nearby, and the same should be done for those living near waste disposal sites, in order to make up for lost property values and potential risks. Then future residents can decide whether those incentives make it worthwhile to live there. But after Fukushima, I think nuclear won't be experiencing growth for at least a generation.

To close, energy use is a double-edged sword. Low or high prices are both good and bad for the environment. Low market prices increase consumption (and pollution), but will cause us to deplete our resources faster and transition to sustainable renewable energy. But this will exacerbate scarcity conflicts, force us into riskier exploration before the tech is ready, and probably make the energy transition more traumatic. High market prices will reduce consumption and conserve more resources for future peoples (who can hopefully extract the remaining energy more safely and efficiently), but most of the profits will go to OPEC and other suppliers. High prices will also make alternative fuels more attractive and stimulate research. And of course if energy prices truly reflected social and environmental costs of use ($100-200B/year in the US according to the author), they would be much more expensive ($10/gallon for gas). I am not sure which scenario I am rooting for, but higher prices seem probable. Any way it goes, fossil fuels will dwindle until the remaining supplies are as expensive to extract as renewable alternatives (hopefully by then hydrogen and clean electricity will be viable for vehicles). But if we plan intelligently, we'll be ready that day for a smooth transition instead of furiously struggling to cope.