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Energy: The Transition from Depletable to Renewable Resources Chapter 8 Energy: The Transition from Depletable to Renewable Resources Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Introduction Let’s examine some of the issues associated with the efficient allocation of energy resources Plus – let’s discuss how economic analysis can be used in policy making. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Energy An essential component of life sustenance on earth 62% of the world’s energy needs are met through gas and oil Accurate predictions are not possible  controversy regarding estimates  necessity of planning the transition to substitutes Models of resource extinction  smooth and harmonious transition; often not the case Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Natural Gas: Price Controls A natural gas shortage of 2 trillion cubic feet, or 10 percent of the marketed production, occurred in 1974–1975. In 1938 the Natural Gas Act was passed. The Federal Power Commission (FPC) was charged with maintaining “just” prices. Price controls were imposed on natural gas shipped across state lines. In Phillips Petroleum Co., v. Wisconsin (1954), the Supreme Court forced the FPC to extend its price control regulations to the producers. What could be some impacts of price ceilings? On consumers? On producers? Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Price ceilings were imposed which prevented prices from reaching their normal levels: overconsumption of natural gas, causing shortages, causing more of the resource to be used in earlier years and with a sudden jump in price. Transition occurs earlier, and is abrupt with prices suddenly jumping to higher levels when price controls are removed or when resource declines On the supply side, producers who expect price ceilings to be lifted have incentives to slow production and wait for higher prices, thus exacerbating existing shortages. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The Effect of Price Controls Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

When a government attempts to use price controls in this fashion, the result is an overallocation to current consumers and an underallocation to future consumers. So: (1) a transfer from producers to consumers; and (2) a transfer from future consumers to present consumers Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The Natural Gas Policy Act was passed on November 9, 1978. Natural gas prices began to be decontrolled in the early 1980s causing rapid price rises. By 1993, no sources of natural gas were subject to price controls. The demand for natural gas has been rising and as such prices have also been rising. Imports have also risen, much in the form of Liquefied Natural Gas (LNG). Other issues to consider? Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Oil: The Oil Cartel Definitions: Cartel: a group of producers having an agreement to collude on setting prices and output and sharing the market Monopoly: a market situation where we have: Many buyers Only one seller who can impose his own conditions Compared to perfection competition, monopoly = source of inefficiency because of higher prices and lower quantities imposed on consumers Oligopoly: a market situation where we have A small number of companies own or control the price of a particular good within the market Regarding consumers’ well being, this situation is very similar to a monopoly Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

OPEC The member countries of the international cartel called the Organization of Petroleum Exporting Countries (OPEC) organize to gain monopoly power. 4 factors affecting cartel power: Price elasticity of demand (A) Income elasticity of demand (B) Existence of a competitive fringe (C) Compatibility of members interest (D) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Oil and oil products are price inelastic. Price inelasticity of demand for oil in both the long run and the short run (in general) The lower the price elasticity of demand (in absolute value), the larger the potential gains from cartelization. Oil and oil products are price inelastic. Price elasticity of demand depends in part on the availability of substitutes. Thus in the long run, price elasticity of demand is usually larger. Substitutes for oil are expensive and transition times are long. Solar energy sets a long-run upper limit on the ability of OPEC to raise prices. What does that mean? Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

High income elasticity of demand At constant prices, as income grows, oil demand should grow. (how is this manifested?) The higher the income elasticity of demand, the more sensitive demand is to the business cycle. Recessions can thus put pressure on OPEC and expansions are beneficial to the cartel. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Non-OPEC suppliers A cartel will have more market power if it can prevent new suppliers from entering the market and undercutting the price. 1/3 of oil production – by non-OPEC countries They represent a “competitive fringe” (Salant, 1976) Cannot set the price of oil directly (since the cartel sets the price to maximize its collective profits by restricting production) But can choose the level of production What effect does that have on price? OPEC must take non-OPEC members into account when setting prices. How can OPEC influence the production of non-OPEC countries? How do non-OPEC members benefit from OPEC? Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

What about within OPEC? Compatibility of Member Interest Individual cartel members have incentives to cheat on production agreements. Price elasticity of demand facing each individual member is higher than for the cartel. With higher price elasticity, lowering price maximizes profit. Enforcing the colllusive agreement is essential for the success of the cartel. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fossil Fuels: National Security and Climate Considerations Climate Dimension Carbon dioxide is a contributor to climate change. Climate considerations affect energy policy: Level of energy consumption mix matters The mix of energy sources matters Market-based energy choices imposes externality to energy users. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

National Security Dimension National security is a public good. The market would generally result in an excessive dependence on imports. Thus, economically, the reliance on oil imports is viewed as a threat to national security The long run domestic supply curve of oil reflects increasing availability of domestic oil at higher prices. Using the graph to show that the efficient allocation including national security costs is less than the market outcome. The market consumes too much oil and domestic production is too small. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Oil and national security… What happens when there is an oil embargo? Is self-sufficiency a good solution? See debate 8.1 Some of the policy options that a government can use to reduce vulnerability to imports Strategic reserves (contingency programs) Tax on energy consumption Subsidization of domestic supply Tariff quota on imports Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Transition Fuels: environmental problems Will the transition to renewable sources proceed so rapidly that no transition fuels will be necessary? Are transition fuels already in use? Fuels receiving the most attention as transition fuels are coal and uranium Main issue defining the role for these two fuels is their environmental impact Coal: air pollution. High sulfur content. Acid rain. Plus – climate change. Uranium: (1) nuclear accidents; and (2) storage of radioactive waste ; compensation for those living near to nuclear sites (France) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Electricity How is the transition to long-term solutions to be maintained by the electrical utilities sector in light of the problems associated with the transition fuels? Conservation. High oil and natural gas prices + cost of nuclear and coal-fired stations => reduced electrical demand Conservation defers capacity expansion. Each new electrical generating plant costs more, and the cost increase is frequently substantial. With new costs => rate increases Average cost pricing entails averaging high cost sources with lower-cost sources. The resulting rate will be lower than the true marginal cost of power and thus is inefficient. What to do? Invest in conservation (rebates for residential customers to install conservation measures, for examples. Result: less power consumed and energy supplies lasting longer) Another concern: how energy demand is spread out over the year Peak-load pricing is a pricing structure where consumers using power during peak periods are charged higher rates during the peak periods The cheapest source of power is not necessarily the best environmentally What to do? Internalize environmental costs. NY added 1.4 cents to their kilowatt hour to the estimated cost of electricity produced from fossil fuel sources to account for the various environmental effects Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Deregulating electricity? Historically: electricity was generated by regulated monopolies. In the US: in return for accepting governmental control of prices plus an obligation to service everyone, utilities were given the exclusive right to service specific geographical areas Recently, in the US, electricity distribution separated from electricity generation. Deregulated generation of electricity and kept distribution as a monopoly Lower prices but higher pollution because of uninternalized externalities (decentralized power) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Energy Efficiency Improving energy efficiency reduces greenhouse gases emissions and dependence on foreign oil. While new technologies emerge, the level of energy efficiency chosen by the market is low. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Transitioning to Renewables Hydroelectric Power Clean energy source Helpful with national security concerns Having impact on ecosystem Wind Cost effective in favorable sites Environmental effects have triggered debates Photovoltaics Direct conversion of solar energy into electricity Attractive in developing countries Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Active and Passive Solar Energy for heating Input energy is costless while transformation and distribution requires capital investment. Ocean Tidal Power The plant has impact on coastal ecosystem. Construction costs are high. Biomass Fuels Have the potential to reduce greenhouse gases and imports on oil (book says). But… Both the type of fuel produced and the type of biomass used to produce it matter. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Geothermal Energy Hydrogen Derived from the earth’s heat Initial cost is high, the payback periods vary from 2-10 years. Hydrogen Technologies of using hydrogen is expensive, and the infrastructure is undeveloped. Using government subsidies has impact on promoting the renewable energy resources. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.