1. Economics 331b Finale on economics of energy regulation 1

2. We are heading into a major period of energy/climate-change regulations. Here are some of the major economic issues: 1.Rebound effect Energy efficiency standards affect the energy-intensity of new capital goods Because they lower the MC, they may increase utilization, leading to the rebound effect. 2.Oil premium Increase oil use leads to higher oil world price This leads to higher total imports costs and macro disturbance 3.Public finance issues Regulation and energy taxes lead to higher prices These lead to dead-weight loss when P > MC This leads to “double dividend hypothesis” and to concern about using standards (with no revenues) instead of taxes (with revenues that can lower other taxes) 4.Cost of capital/discounting (later on this one) 2

3. Economics of rebound effect 3 3 G Price of vmt Before mpg improvement Gasoline consumption Effect of efficiency improvement “Rebound effect” After mpg improvement

4. Economics of rebound effect Assume that regulation increases energy efficiency of a capital good from mpg 0 to mpg 1. The question is whether the lower cost of a vmt (vehicle-mile traveled) would offset the lower cost. 4

5. Empirical estimates of rebound effect Basic results from many demand studies:* Short-run gasoline price-elasticity on vmt = -0.10 (+0.06) Long-run gasoline price-elasticity on vmt = -0.29 (+0.29) Therefore, the rebound would be 10 to 29 percent of mpg improvement. This can be applied to other areas as well. Reference: Phil Goodwin, Joyce Dargay And Mark Hanly, “Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: A Review,” Transport Reviews, Vol. 24, No. 3, 275–292, May 2004, available at http://www2.cege.ucl.ac.uk/cts/tsu/papers/transprev243.pdf 5

6. 6 Source: UK Energy Research Centre, The Rebound Effect

7. Oil premium The “oil premium” refers to the excess of the social marginal cost of oil consumption over the private marginal cost. Analytically, this is 7

8. Monopsony premium Basic argument. The point is that the US has market power in the world oil market. By levying tariffs, we can change the terms of trade (oil prices) in our favor. Regulation and taxes are a substitute for the optimum tariff. Example: world supply curve to US: Q = Bp λ, λ>0 US cost of imported oil = V = pQ = B -1 Q (1+1/ λ), k an irrelevant constant marginal cost of imported oil = V’(Q) = (1+1/λ) B -1 Q 1/ λ = p (1+1/ λ) So optimal tariff is ad valorem: τ = 1/ λ = inverse elasticity of supply of imports Reference: D. R. Bohi and W. D. Montgomery, “Social Cost of Imported Oil and UU Import Policy,” Annual Review of Energy, 1982, 7, 37-60. 8

9. Basics of deriving oil (monopsony) premium Here is a more rigorous proof of the oil-import premium: 9 Notes: (1) This does not have to be a tariff. It is really a “shadow price” on oil imports. (2) Example of “Ramsey tax theory.”

10. The monopsony premium 10 Q(free market) P, MC of oil Imported oil S MSC Import premium at free-market imports “Optimal Tariff” at Optimized oil imports Q(“optimal”) D

11. Macroeconomic externality 11 Somewhat more tenuous is the macroeconomic externality. Idea is that there are impacts of changes in oil prices on macro economy because of inflexible wages and prices. So have another linkage: The second term was discussed in optimal tariff. The first term comes from macroeconomics (see next slide). This, however, is very controversial and the estimates are not robust.

12. Macroeconomic externality 12 A standard macro/oil-price equation with “good” results.

13. 13

14. Macroeconomic externality 14 Simplified derivation: We can also derive that monopsony/macro = ε[GDP/pQ]

15. Updated estimates 15 Cited in Hillard G. Huntington, The Oil Security Problem, EMF OP 62, February 2008.

16. Numerical example for US 16

17. Optimal tariff argument on oil taxes τ = 1/ λ = inverse supply elasticity. Complications: Formula actually is Some notes: 1.Supply elasticity depends critically on whether oil market is at full capacity (2007 v. 2009). Very inelastic in full capacity short run; quite elastic when OPEC adjusts supply. (See next slide.) 2.The optimal tariff in $ terms depends upon the initial price because it is an ad valorem tariff. 3.The externality is a global externality for consuming countries because it is a globalized market. 4.Note this is a pecuniary, not a technological externality. So it is a zero- sum (or slightly negative-sum) game for the world. This has serious strategic implications and suggest that the diplomacy of the oil-price externality is completely different from true global public goods like global warming. le 17

18. Price Production Short-run production capacity 18

19. The “double dividend” hypothesis Some have argued that using “ecological” or environmental taxes has a double dividend: 1.Get environmental benefit when P < MSB. 2.Can use revenues from ecological taxes to reduce other burdensome taxes In economics, the burden is measured as “deadweight loss” (DWL) [Related issue in current context is whether the additional debt incurred by the stimulus package has such high DWL that the net economic effect is negative (Kevin Murphy).] 19

20. 20 The dead weight loss of taxes/regulation 20 P, MC of oil Imported oil S + T 1 S +T 1 + T 2 S P0P0 P1P1 P2P2 A E D C B If add new taxes (regulation): Additional revenues = D – B Additional DWL = C + B MDWL/Mtaxes = (C+B)/D-B) ≈ (B)/D-B) [When are you on the wrong side of the peak of the Laffer curve?]

21. Thoughts on double dividend hypothesis 1.Do not have DWL if raising price to the Pigovian level; actually lowing the DWL from a “subsidy” -Actually a little more complicated because need to look at existing taxes (e.g., gasoline) and complementarity/substitution patterns with other goods and services. 2. A regulation is a tax with the revenues rebated to the polluter. If use regulations rather than taxes, you therefore lose the second half of the double dividend. -This is key argument in cap and trade v. carbon taxes (or more generally regulation v. taxes) 3. If standards are beyond Pigovian levels, then can incur serious DWL if do not attend to the revenue side of the issue. 4. Empirical estimates of MDWL of taxes: all over the place from $0.2 to $2 per dollar of revenue. 21