Part III. Exhaustible Resources

1. Part III. Exhaustible Resources Ozone Energy – Part 1

2. B. Energy Part 1 – Chapter 8

3. Introduction • Chapter 8: energy production and how that impacts the environment. • The production and consumption of energy crucial to the health of economies in both developed and developing countries, but it is responsible for a large portion of the environmental problems that these countries experience.

4. Effects of energy production • Global climate change, acid rain, air pollution • Drilling for oil and gas, cooling energy facilities, coal mining, and underground storage of oil – all affect water quality • Oil spills pollute oceans and waterways • Habitat destruction (strip mining, wetland destruction) is also a direct byproduct of energy production • Solid waste from mining and burning coal may lead to ground and surface water contamination

5. Historical Development of US Energy Policy • Formulation of energy policy mostly concerned with supply • 2 authors have had a very strong influence on the way we think about energy. • Thomas Malthus – scarcity is inevitable because population grows to exhaust its resource endowment. • Harold Hotelling – the invisible hand of the market would optimally allocate exhaustible resources and prevent shortages, because the market price of a resource such as oil reflects both its current value and its future value.

6. Hotelling • Fundamental proposition – the producer of oil must be indifferent between selling a barrel of oil today and waiting for future time to sell it. • Recall from chapter 2 – if producer expects prices to rise in future, wait. Others behave similarly, everybody waits, current price up and future price down. (and other way around) • This type of price change will continue until all producers are indifferent between selling today and selling in future. • Today's price includes user cost, which is the opportunity cost of not having the oil available at other periods in the future.

7. Hotelling cont. • Dynamic efficiency requires that the price at any point in time be equal to marginal extraction cost plus marginal user cost. • Because MUC part of price, and MUC reflects scarcity, market should efficiently allocate oil over time, with MUC reflecting scarcity value. • If future demand is perceived to be increasing or future supply is perceived to be decreasing, this will increase present user cost, reduce quantity demanded, leaving more oil for future. • Higher current price will also encourage substitution of other fuels for oil, increased exploration for oil, investment in more energy efficient technologies. • Market ensures that absolute scarcitynever happens because price so high - -reduces quantity demanded and encourages substitution

8. Malthus • Believed in the concept of absolute scarcity, which suggests that resources are used at an increasing rate until they are exhausted. • Neo-Malthusians have extended Malthus' arguments beyond land and food to general resources and environmental quality. • According to neo-Malthusians, growth of the economy and population will generate a dependence on resources that will eventually exceed capacity.

9. Debate • The debate about whether markets adequately address future supply continues to rage, and is a motivating factor behind much US energy policy (particularly during “energy crisis” of the 1970’s)

10. OPEC • The Organization of Petroleum Exporting Countries (OPEC) is a cartel of oil-producing countries formed in 1960 to counteract the economic power of multinational companies. • OPEC reached its zenith of power in 1973 when oil prices quadrupled due to oil embargo imposed on the US and other countries who supported Israel during Yom Kippur War. • A cartel is an organization of producers who agree to act in concert as a monopolist and restrict output to raise prices and generate profits. • In order to have power in the market, the cartel must be large enough so that quantity decisions affect market price. • Cartel members have powerful incentives to cheat. If one member secretly produces more, that member can earn higher prices at greater output.

11. OPEC • While OPEC was effective in the mid to late 1970s, its influence declined in the 1980s and 1990s. • OPEC lost market power as non-OPEC sources came on line in Mexico, the North Sea, and Alaska. • The dominant firm model of oligopoly can be used to illustrate OPEC's loss in power.

12. OPEC’s loss in power

13. OPEC’s loss in power • The dominant firm takes output of remaining firms as given, and meets unmet demand at that price. • OPEC views itself as facing a demand curve that is one that subtracts the quantity supplied by the competitive fringe from total demand. • As Figure 8.1 illustrates, the greater the size of the competitive fringe, which would be reflected as a shift to the right in the competitive supply function, the lower the world price of oil. • This was the case in 1980s and 1990s with growth in the non-OPEC supply of oil.

14. Different incentives w/i OPEC • Saudi Arabia – more reserves than other members, so don’t want prices too high (or else, demand for alternative energy technologies increase, driving price down in future). Also, less need for current revenue (sparsely populated, small economy) • However, countries like Nigeria, Venezuela, Indonesia – large populations, small reserves, want high prices NOW.

15. Costs of foreign dependence • Domestic dependence on a large number of foreign oil producers is not necessarily bad; however, the U.S. and others are dependent upon a few countries with unstable political histories. • Greene and Leiby analyzed the question of the costs of foreign dependence by examining the cost of dependence on a foreign monopoly for oil supplies. • It is the simultaneity of the monopoly problem + foreign dependence that generates costs to US society

16. Costs of foreign dependence • They separate costs into three broad categories: • The transfer of U.S. wealth to foreign producers • Macroeconomic costs. • Political and military costs. • Argue that in absence of an oil cartel, all the extra costs of oil imports are a loss to the US economy

17. Costs of foreign dependence • By raising prices through the restriction of output, oil producers transfer consumer surplus into monopoly profit • This loss is illustrated in Figure 8.2. • With competitive market, whole shaded area CS. Under foreign monopoly, square transferred to foreign profit (because this leaves our economy – represents pure loss). Additionally, DWL triangle. • The rising dependence on oil imports is illustrated in Tables 8.4 and 8.5.

20. Other costs • Macroeconomic losses occur when sudden price increases or shortages of oil shock the domestic economy and lead to inflation, losses in GDP, and losses in employment. • It is important also to consider the cost of mitigating price shocks. • There are also costs associated with military and policy aspects, particularly given the historical problems with the region. • Greene and Leiby (1993) point out that it is difficult to ascribe the readiness costs and actual costs of the Persian Gulf War solely to dependence on foreign oil. In absence of oil dependence, the US may have participated in the war to help oil-dependent allies.

21. Total social costs • Table 8.6 indicates that the total social costs of dependence on a foreign monopoly for oil increased through the 1970s and declined through the 1990s. • Consistent with the variety of factors that have weakened OPEC’s power. • However, the costs of dependence on foreign oil are not trivial – $93 billion of total costs in 1990 compared to GDP of $5513 billion.

23. Implications for the present? • Previous analysis showed costs associated with dependence on foreign oil sources from politically volatile regions • Today, international terrorism arising out of same region, conflicts in Afghanistan and Iraq, and continued violence in the Middle East – social cost of depending on oil from this region is likely to be much HIGHER today.

24. The Environmental Costs of Energy Production 3 types: • Emissions of pollutants that occur on a continuous basis from energy facilities. • Episodic releases of pollution such as oil spills. • Alteration of natural ecosystems as a result of production activities.

25. 1. Continuous emissions • Conventional environmental policy instruments, such as MPP and taxes, are appropriate for the first type of pollution, either would lower the level of emissions in a fashion that minimized total abatement costs. • However, the US has historically relied on direct controls (C & C) to manage this type of pollution.

26. 2. Episodic releases of pollution • The second type of environmental problem, episodic problems, cannot be adequately managed with economic incentives. • In this case not only does the magnitude of the environmental problem need to be controlled but also the probability of occurrence. • One alternative is to use direct controls which dictate basic safety regulations, technological requirements, and operating requirements.

27. Episodic releases of pollution • A 2nd alternative would be to develop a liability system. • Established by the Oil Pollution Act of 1990 and the CERCLA, liability systems establish liability for damages on the part of transporters of oil. • If a spill occurs, the company can be taken to court and sued for damages. • Under a liability regime, the company would also take steps to have a rapid response program in case an accident occurs. • The idea is that if transporters of oil are responsible for damages from spills, they will take steps to reduce the likelihood of an accident.

28. 3. Alteration of natural ecosystems • Again, difficult to design an environmental tax or MPP system that would manage the 3rd type of environmental impact, the impact on production activities on habitats and ecosystems. • Direct controls can play a large part through specification of how pipelines should be constructed or how waste should be handled to minimize the impact on the ecosystem. • An alternative to direct controls would be performance bonds. • Performance bonds require a firm to pay a large amount of money upfront, before they begin their activities. • The money is place in an escrow account and is returned to the firm after completion of the project, if they have met the appropriate environmental standards.

29. Portfolio Theory & Energy Choices • Given the insecure availability of energy and the environmental costs associated with energy, how to design policy? • Countries such as the US face a set of risks associated with the use of fossil fuels, especially when a large component of this fuel use is oil imported from politically volatile areas.

30. These risks include: • Potential economic impacts from price instability or from high prices associated with increasing scarcity • Social costs associated with the national defense and homeland security implications of dependence on oil from politically volatile areas • Potentially catastrophic global climate change and other sever environmental impacts associated with production and consumption of fossil fuels

31. Portfolio Theory & Energy Choices • An effective energy policy would reduce these risks • Current US policy ineffective because it is based on fossil fuels (especially in trying to increase domestic production of petroleum) • The primary problem with the US energy policy is that it is insufficiently diversified. A more diverse portfolio of very different types of energy sources would be much less risky

32. Portfolio Theory • Developed to provide a better understanding of financial risk associated with investment strategies • Indicates that the more diversified a portfolio of investments, the lower its risk • A portfolio consisting of foreign and domestically produced oil is not very diversified (highly correlated economic, national security, and environmental risks)– thus is associated with high levels of risk • A much more diverse portfolio that includes very different types of energy would be much less risky

33. Conventional Energy Alternatives • Conventional energy sources can be defined as those that are already employed at some level. • If fossil fuels (coal, natural gas, oil and its derivatives) are defined as the primary source of energy, then the alternative conventional substitutes for fossil fuel are nuclear power and hydropower.

34. Nuclear power • Peaceful uses of nuclear power have been regulated heavily by the government because of the potential for disaster and the national defense implications of the use of nuclear power • It was however also believed that nuclear power had the potential for solving the nation’s energy problems (despite its expense compared to conventional energy production)

35. Nuclear power – liability issues • One of the biggest obstacles to establishing a nuclear power industry is the potential liability if there were a nuclear power plant disaster. • In response to this the Price-Anderson Act enacted by Congress exempted individual utilities from having to pay damages as a result of an accident. • The claims are paid by consortium of utilities (20% liability) and the federal government (80% liability), and there is a maximum limit on claims. • Opponents claim a limit on liability suggests significant divergence between private and social optimum with respect to nuclear power.

36. Nuclear power • A variety of other sources of disparity between private costs and social costs of nuclear power are presented in Table 8.7 • These costs include construction costs, which are not fully represented in the price, and expected damages from an accident, which are not reflected in current costs • Although it was predicted that nuclear power costs would fall, that has not happened primarily due to delays in obtaining permits and construction of power plants

37. Nuclear power – other risks • What to do with the nuclear waste and the risks that uranium or plutonium that is used in power plants could wind up in the wrong hands, where it could be used to make a nuclear weapon. • Some nuclear waste remains dangerously radioactive for over 100,000 years. • While we must develop a way to safely store nuclear waste, there is general opposition among the public to the construction of a nuclear waste storage facility (NIMBY).

38. Hydropower • Hydropower is often associated with an image an environmentally friendly option for power – but it is NOT without its environmental impacts • The primary environmental impacts of hydropower are associated with the dams and reservoirs and include inundation of both terrestrial & riverine habitat, sedimentation, reduction in aquatic dissolved oxygen levels, blockage of fish migration and conversion of free-flowing rivers into reservoirs.

39. Hydropower • An interesting economic and environmental consideration is that because so many rivers have been converted into reservoir systems, free-flowing rivers and healthy riverine ecosystems have become increasingly scarce – implying that the opportunity cost of constructing dams on free-flowing rivers is likely to be HIGH.

40. Hydropower • In the Pacific NW – devastating impact on a variety of species of Pacific salmon. • A series of dams have blocked major river systems, preventing salmon from migrating from the open ocean to the headwaters of the rivers where they spawn and where the fish remain as juveniles before returning to the ocean. • Although fish ladders and elevators have been constructed to aid the fish, they have not proved effective in preventing the decline in numbers. • The environmental impacts of hydropower are typically controlled through direct means involving a federal and state licensing process for dams.

41. Alternative Energy Sources • Unconventional alternative energy sources include wind, solar energy, biomass energy, co-polymerization, fuel cells, and geothermal energy. • Some of these have been used for centuries, but their use in modern times has been relatively limited. • The use of wind as an energy sources is very clean and it has the potential supply a small portion of our electric power needs. • Energy from the sun can be used to produce electricity through the use of photovoltaic cells that convert the sun’s light into electricity. • Biomass fuels come from living sources, such as plants and waste products.

42. Alternative Energy Sources • Thermal depolymerization is a process that has been developed relatively recently to convert carbon-based substances (food waste, agricultural waste, human waste, plastic, medical waster, etc) into oil. • Fuel cells produce energy through a chemical process that converts hydrogen and oxygen into electricity through a chemical process (more on hydrogen Friday). • Which is the best? Portfolio theory argues that we should not pick any particular fuel but rather it is important to have a mix. • In addition, technological developments may result in greater efficiencies in the future.

43. Summary • US energy policy is based on the continued availability of inexpensive fuels. • 3 sets of costs associated with fossil fuels are important to consider in developing an energy policy: • The impact of fossil fuel use on greenhouse gas emissions. • The other environmental impacts of these emissions. • The national security cost of being dependent on oil that is imported from regions of political volatility. • Portfolio theory suggests that the US can reduce its risk by diversifying sources of energy.