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July 7, 2008
Connecting ‘actions’ and ‘outcomes’ on energy policy

ray Hill is adjunct senior lecturer of finance at Goizueta Business School.

How much are gasoline prices going to rise? What should we do to bring them down again? What are the environmental benefits (or costs) of various energy policies? How should we shape energy policy to help the environment?

These are some of the questions we hear discussed virtually every day and in virtually every political arena in this election year. The answers to these kinds of questions involve many value judgments, since the costs and benefits of any policy are not borne equally across all the parts of our society, or across different generations. People who are well-informed and well-meaning will have differences of opinion about the right actions (policies) to take on energy and the environment because they will have differences of opinion about the desired outcomes.

Fortunately, we have a great democratic process that tries to settle on the appropriate compromises. I trust that process — although I often dislike its results. But I find myself shaking my head in disbelief almost every day as I hear energy issues discussed in the press or on the radio or television. Why? Because the actions that are proposed often have so little logical or factual connection to the desired outcomes that are professed.

Here is an example: Currently, most people seem to believe that we don’t have enough of an important commodity. Consumers and politicians all wish that there was more of it and that its price would fall. Our leaders both threaten and plead with others to produce more. Congress has directed its attention to dealing with this scarcity. How? By announcing they would try to punish the companies who have invested in producing the commodity and by trying to pass laws that would limit future investment in producing more of the commodity.

Wait a minute! Surely I have it backwards. We are trying to limit the production of the thing we want more of? How could this be?

Of course the commodity I have in mind is oil. Congress is proposing (but probably won’t succeed) to pass a “windfall” profits tax on oil producers and force them to invest more in alternative energy. Both of these actions will contribute to keeping gasoline prices higher than they would be otherwise. Higher gasoline prices may be an outcome which some people desire — but it is not the outcome that any member of Congress professes to desire.

Keeping track of the connection between actions and outcomes isn’t easy (otherwise, why would we need economics PhDs?). However, as we enter the height of our election season it may be worth keeping in mind some of the simpler observations of economics.

• Oil prices will be volatile — that means they will go down and well as up.
Both the demand and supply of oil are “inelastic.” This means that it takes time for both consumers and producers to adjust to changes in price (for consumers, using less; for producers, making more). When supply and demand are inelastic, then markets react to events with large price changes rather than quantity changes — initially. Right now the “events” are rising demand and production problems in several major producing countries. When supply and demand respond to current market conditions, we should expect prices changes to go in the other direction.

The last few decades provide us with a clear picture of how this works. In January 1981, oil was near a peak at just over $80 per barrel in inflation-adjusted dollars. By January 1988 the price had fallen to $25, and by January 1999 to $13 (both in today’s purchasing power). I don’t think we’ll ever see $13 oil again, but we need to keep in mind that decisions made today on the basis of an oil price of $135 per barrel have a risk of being very bad mistakes in the years to come.

If you think higher prices for fossil fuels are a good thing (because of environmental concerns), keep in mind the supply response to higher prices — this is why higher prices due to supply/demand conditions don’t produce the same result as, say, a “carbon tax.”

• Anything we do to make the production of oil more costly or risky will keep gasoline prices higher.
Current oil company profits are the payoffs on costly and risky bets made in the past (see above: oil prices are volatile). You may agree with Congress that current oil company profits are “excessive,” but any threat to have an exceptional tax on those profits today will reduce the incentive for companies to make new risky and costly bets and contribute to higher gasoline prices. You might even argue that a windfall profits tax is justified because it offsets some of the tax breaks oil companies are getting — but that won’t change the effect of a windfall profits tax on gasoline prices.

A number of countries have nationalized their oil industries over past concern about “excessive” profits flowing into private hands. Those countries are a good place to look for the current production problems, corruption, and an absence of the technological capacity of the big multinational oil companies.

• Forcing oil companies to invest in alternative energy won’t help the current “energy crisis.”
If we want the price of gasoline to go down, the quickest, surest way to achieve that end is to invest more in producing oil. Any diversion from oil production will keep gasoline prices higher over the next several years. There is no escaping this simple truth even if: A) you believe investments in alternative energy eventually pay off and eventually help to moderate oil prices, or B) you believe that we should produce less rather than more oil, for environmental or other reasons.

• Adjusting to higher energy costs will be painful.
Our politicians (from both parties!) often sound like, if elected, they could convert our energy “crisis” into a great event that would make us all better off. They appear to believe that government support for an aggressive program to invest in new technologies will make high oil prices irrelevant and solve our environmental problems because we won’t need to burn fossil fuels any more. Along the way, they tell us, these new technologies will create lots of new jobs and get the economy growing again! This is a fairy tale.

The world currently consumes just over 400 billion gigajoules of fossil energy per year. That is a very big number and it is rising. Any meaningful reduction in that amount — whether caused by the forces of supply and demand or because we impose limits on ourselves for environmental reasons — will be costly and have a negative effect on real incomes.

Of course, some people will get rich producing alternative energy and some people will get great new jobs — but, on average, we will lose, not gain.

Also, there is not even a remote prospect that the U.S. can achieve “energy independence” within the next generation (or two).

No matter who wins the election in November, the U.S. government will not do what it takes to get us anywhere near the kind of greenhouse gas emission reductions that seem to be required to have any meaningful effect on global warming. The cost is too high.