# Non-renewable resources & energy Economics, management, and policy.

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Non-renewable resources & energy Economics, management, and policy

Non-renewable resources No “sustainable yield”: dx/dt = -h Recall Fisheries: “how much to harvest”? Forestry: “when to harvest”?, “how to harvest”? Can we say anything in general about how non-renewables will be extracted by the private sector? Predict prices? Predict adoption of renewables? Predict resource use over time?

Scarcity value of non-renewables Since limited supply, non-renewable resource command a “scarcity value” Problem: You own a barrel of oil. Can sell today for \$30. Should you sell today, or wait for next year? (r=.05)

If p 1 >\$31.5, wait If p 1 <\$31.5, sell today In equilibrium: p 1 =p 0 (1+r)

Hotelling “rent” Prices should rise at rate of interest. If think they won’t, firms would deplete reserves today. What about extraction costs? R t = P t – MC t implies R t+1 = R t (1+r) Also called “user cost”, “royalty” Present value of rents = through time. Indifferent between selling barrel today or any point in future.

What about quantity extracted? Recall demand curve: \$ Barrels of oil D If price increases through time, quantity must decrease. Confounding factors: 1.Shifts in demand 2.New discoveries 3.New extraction technology 4.Backstop technology

Prices and quantities over time time Price Quantity

New discoveries time Rent p-MC With new discoveries, resource becomes less scarce, so “scarcity rent” drops.

Switching to a “backstop” Backstop technology: a perfect substitute for non-renewable resource that can be produced in any amount at constant (usually high) price. When price of non-renewable = price of backstop, we’ll switch.

The effect of a backstop technology MC b Price path with backstop time \$

Other factors that affect price path: with a backstop technology Decreasing extraction cost: Lower price initially, then rises more quickly Sudden increase in demand: Price jumps suddenly, decreases current consumption. Monopoly: Price higher but rises more slowly, but extraction is slower so extends life of the resource.

The monopoly case Time Price Time Quantity MC b Monopoly

Are we running out of resources?

Physical measures of “scarcity” Reserves: known amount that can be profitably extracted. Changes with tech, discoveries, cost, price. Inventory ~ constant through time Reserves/Production: Assumes constant demand Crustal abundance: total amt in crust. Ignores cost of extraction Ultimately recoverable: total to 1 km depth Arbitrary, different for all resources, no new tech.

Economic measures of “scarcity” Marginal cost of extraction: likely to increase as stock decreases, but ignore price Price: Ignores extraction cost. Hotelling rent: Difficult to observe, but probably best measure of scarcity.

Stock pollution Consumption of oil generates pollution Stock of carbon in atmosphere = x t Rate of natural decay  x t+1 = x t –  x t + s t Where s t is flow of pollution Climate change caused by x (not s) But cannot directly control x.

Consider two policies 1.Tax consumption of oil (e.g. gas tax) 2.Subsidize alternative, renewable energy sources. How would each policy alter the stock pollutant (carbon) that causes global climate change? What are the pros/cons of each?

Taxing oil consumption Remember, damage is caused by x. Standard economic argument: internalize the externality. If we can charge polluters the social cost of pollution, then it will be internalized. Taxing oil consumption raises the price of oil & can internalize the externality.

Gas taxes in the real world Strong political opposition to gas tax. RFF discussion paper: gas tax that would internalize externalities = \$1.01 per gallon…probably an underestimate. Federal gasoline tax: \$0.18 California gasoline tax: \$0.18 Highest: Montana (\$0.27) Lowest: Wyoming (\$0.09)

Subsidizing renewable energy Remember our model: Price of non- renewable rises until it reaches price of backstop. If extraction cost = 0, extract all non- renewable before switching (more likely, won’t extract all of it). If MC b decrease from subsidy, current price of oil will decrease, and consumption of oil will increase.

The effect of decreasing MC b MC b 0 MC b 1 Price path with high backstop price Price path with low backstop price time

Comparing the two policies Taxing the thing that causes damage (oil consumption) can internalize externality. Subsidizing renewables may have unintended consequence of pushing consumption of fossil fuels to the present! Principle of targeting: design regulation or policy to target (internalize) the externality.

OPEC Organization of petroleum exporting countries Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, Venezuela Controls most of world oil production. Maintain low production to keep prices (profits) high. Why would prices ever drop?

The “Prisoner’s Dilemma” Kuwait Saudi Arabia cooperate defect cooperatedefect 30 10 40 5 5

Maintaining cooperation An example of a “Nash Equilibrium” – both countries do what is in their best interest given what the other does. Defecting from the original agreement is a dominant strategy for both countries. Intuitively, incentive to cheat (by overproducing) is very high. Because other countries restrict output to keep prices high.

The California energy crisis Pre-1999 3 regulated monopolies that owned and operated generation, transmission, distribution (PG&E, SCE, SDG&E) Federal Energy Regulatory Commission regulates wholesale power transactions (one utility to another) California Public Utilities Commission regulates retail prices (to consumers)

Restructuring electricity Designed competitive wholesale market Argued it would decrease prices Could pass savings on to consumers by giving them a choice of supplier But consumer side still regulated. Didn’t work Prices skyrocketed over 500% between 1999- 2000. Utilities paying far more than consumers paid. State had to bail out industry, cost \$60 billion.

From Joskow: “The wholesale prices prevailing between June and September 2000 were much higher than the fixed retail price that the utilities were permitted to charge”

Why did wholesale prices rise? Rising natural gas prices (natural gas is an input to electricity production) Large increase in demand in CA (growth) Reduced imports from other states (heat waves) Rising prices for NOx emissions credits (costs of producing electricity) Market power (in wholesale spot mkt)

Why didn’t it work & lessons Technically challenging to create competitive wholesale market Consumers were insulated from wholesale market prices (because retail market still regulated). Deregulated wholesale, failed to deregulate retail prices or to allow forward contracts. Required utilities to buy at unregulated price and sell at regulated retail price.

What next? State committed to long-term contracts at unreasonably high prices – cost \$60 billion. Prices likely to remain high to pay off. Prices dropped in 2001 due to increased supply, decreased demand. SCE and PG&E effectively bankrupt. Replaced deregulated wholesale with state procurement and regulated prices

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