1. The Economic Approach to Environmental and Natural Resources, 3e By James R. Kahn © 2005 South-Western, part of the Thomson Corporation

2. Exhaustible Resources, Pollution and the Environment Part II

3. Energy Production and the Environment Chapter 8 © 2004 Thomson Learning/South-Western

4. 4 “Energy production and use are vital to the economies and environments of all countries. Furthermore, the mix of energy sources has profound consequences for environmental quality.” World Resources 1992-93

5. 5 Introduction The focus of this chapter is on energy production and how that impacts the environment. The production and consumption of energy is not only 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.

6. 6 Introduction The effects of energy production on water quality include such activities as drilling for oil and gas, cooling energy facilities, coal mining, and underground storage of oil. 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.

7. 7 Historical Development of US Energy Policy in the Post-World War II Era Two authors have had a very strong influence on the way the United States and other western nations think about energy. The first is Thomas Malthus, who argued that scarcity is inevitable because population grows to exhaust its resource endowment. The second is Harold Hotelling, who argued that 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.

8. 8 Historical Development of US Energy Policy in the Post-World War II Era The fundamental proposition of Hotelling’s dynamic market efficiency is that the producer of oil must be indifferent between selling a barrel of oil today and waiting for future time to sell it. Today's price includes user cost, which is the opportunity cost of not having the oil available at other periods in the future. Dynamic efficiency requires that the price at any point in time be equal to marginal extraction cost plus marginal user cost. 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.

9. 9 Historical Development of US Energy Policy in the Post-World War II Era Thomas 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.

10. 10 Historical Development of US Energy Policy in the Post-World War II Era U.S. energy policy pre-1970 did not follow either theory. The Texas Railroad Commission controlled most of U.S. oil production through a set of Texas state regulations that defined drilling rights to underground pools. These regulations also restricted present production and increased present price, creating short-term monopoly profits. Favorable tax policies also promoted restricted use of oil reserves. In addition, from 1959 to 1973, oil imports were restricted.

11. 11 Historical Development of US Energy Policy in the Post-World War II Era The U.S. natural gas policy is dictated by the Natural Gas Act of 1938, the purpose of which was to regulate natural gas transportation rates to keep them high enough to justify large capital expenses of natural gas pipelines. An effort to regulate wellhead prices to keep natural gas prices low resulted in reduced production, reduced exploration and a shortage of natural gas in the 1970s. Energy price control policies were set based on a perceived link between cheap energy and economic growth, a concern with equity over efficiency, and a perceived need to protect people from exploitation by oil companies.

12. 12 Historical Development of US Energy Policy in the Post-World War II Era 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. 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.

13. 13 Historical Development of US Energy Policy in the Post-World War II Era 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.

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15. 15 Historical Development of US Energy Policy in the Post-World War II Era 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.

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17. 17 Historical Development of US Energy Policy in the Post-World War II Era An additional reason for the fall in the price of oil is because Saudi Arabia, the dominant producer within OPEC, has different incentives than fellow members. Saudi Arabia has very large reserves, a century versus decades of pumping by Libya or Iraq. Large reserves imply a higher cost associated with potential development of an alternative energy source. Saudi Arabia desires to keep prices lower to prevent incentive for development of alternative sources. Price should be high enough to generate monopoly profits, but low enough to discourage research and development into alternative fuels.

18. 18 Historical Development of US Energy Policy in the Post-World War II Era With a relatively sparse population and a small economy, Saudi Arabia has less need for current revenue. In contrast, Nigeria, Venezuela, and Indonesia have very large populations and a pressing need for high profits to feed their populations. Iran, Iraq, and Libya desire monopoly pricing to meet high military expenditures.

19. 19 OPEC and US Energy Policy The 1973 Yom Kippur War and US support of Israel resulted in an oil embargo and quadrupling of oil prices. Price controls in natural gas were creating shortages. A series of laws were passed during the Nixon, Ford, and Carter administrations to deal with perceived problems of world oil market. The Emergency Petroleum Allocation Act extended oil price controls. Low prices stifled domestic production in direct conflict with energy independence objectives of Project Independence.

20. 20 OPEC and US Energy Policy

21. 21 OPEC and US Energy Policy Domestic dependence on a large number of foreign oil producers is not 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 separating costs into three broad categories:  the transfer of U.S. wealth to foreign producers.  macroeconomic costs.  political and military costs.

22. 22 OPEC and US Energy Policy Greene and Leiby argue that in the absence of an oil consumers’ cartel, all the extra costs of oil imports are a loss to the US economy. By raising prices through the restriction of output, oil producers transfer consumer surplus into monopoly profit. This loss is illustrated in Figure 8.2. The rising dependence on oil imports is illustrated in Tables 8.4 and 8.5.

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25. 25 OPEC and US Energy Policy 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 such as the establishment of Strategic Petroleum Reserve. 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.

26. 26 OPEC and US Energy Policy 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. A variety of factors has weakened OPEC’s power. However, the costs of dependence on foreign oil are not trivial, with $93 billion of total costs in 1990 compared to GDP, which was $5513 billion in 1990.

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28. 28 The Environmental Costs of Energy Production There are three types of environmental problems arising from the production of energy. The first is emissions of pollutants that occur on a continuous basis from energy facilities. The second type is episodic releases of pollution such as oil spills. The third type of environmental impact is the alteration of natural ecosystems as a result of production activities.

29. 29 The Environmental Costs of Energy Production Conventional environmental policy instruments, such as marketable pollution permits and economic incentives, are appropriate for the first type of pollution, although the US has historically relied on direct controls to manage this type 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.

30. 30 The Environmental Costs of Energy Production A second alternative would be to develop a liability system. Established by the Oil Pollution Act of 1990 and the Comprehensive Environmental Response, Compensation and Liability Act, 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.

31. 31 The Environmental Costs of Energy Production It is difficult to design an environmental tax or marketable pollution permit system that would manage the third 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.

32. 32 Portfolio Theory and Energy Choices Countries such as the United States 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. An energy policy based on increasing domestic petroleum supplies does not reduce the impact of the volatile prices (world wide demand for and supply of oil determine prices) or the potential for global climate change. Given the global trade links between countries, instability in the Persian Gulf would still impact the US economy, even without oil imports from that region. 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.

33. 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. 34 Conventional Energy Alternatives 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. 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 and the federal government, 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.

35. 35 Conventional Energy Alternatives A variety of other sources of disparity between private costs and social costs of nuclear power are presented in Table 8.8. These costs include construction costs, which are not fully represented in the price, and storage costs of spent fuel, 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.

36. 36 Conventional Energy Alternatives Other risks associated with nuclear power include the concern of 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. The controversy over Yucca Mountain is an excellent example of this point.

37. 37 Conventional Energy Alternatives Hydropower is often associated with an image an environmentally friendly option for power. The primary environmental impacts of hydropower are associated with the dams and reservoir and include inundation of terrestrial habitat, inundation of riverine habitat, sedimentation, reduction in aquatic dissolved oxygen levels, blockage of fish migration and conversion of free-flowing rivers into reservoirs.

38. 38 Conventional Energy Alternatives In the Pacific Northwest, hydropower has had a 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.

39. 39 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 impact (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.

40. 40 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 and waste heat through a chemical process. 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.

41. 41 Summary The US energy policy is based on the continued availability of inexpensive fuels. Three 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.

42. 42 Summary Global warming and depletion of the ozone layer are important environmental problems. The long lags between emissions and damages, the long lifetimes of the pollutants, and the complexity of the scientific relationships make the development of policy difficult. While there have been international agreements developed regarding the restrictions on ozone- depleting chemicals, the movement toward resolution of global climate change has been much less successful.