ECON 310 Chapter 8 Notes

Energy Production and the Environment

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 policy. (World Resources 1992-93)

CHAPTER SUMMARY

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. 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.

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.

The fundamental proposition of 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. Dynamic efficiency implies that there is no need to have an energy policy, as the market works efficiently and will prevent a shortage of oil. Harold Hotelling assumed a perfectly competitive market.

Thomas Malthus believed in the concept of absolute scarcity, which suggests that resources are used at an in- creasing 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.

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. Regulations were directed at controlling excess use of common property resources. 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.

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. The extension of these regulations to the well-head kept well-head prices low. According to Marcus, price controls in the 1970s received popular support. There was a widespread belief that high energy prices lead to inflation. There was a greater concern with equity than with efficiency. It was felt necessary to protect people from exploitation by oil companies who were believed to be earning windfall profits.

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. The cartel must be large enough so that quantity decisions affect market price. Most countries outlaw formation of cartels. Cartel members have powerful incentives to cheat. If one member secretly produces more, that member can earn higher prices at greater output. If everyone follows, price drops.

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.

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, a residual demand curve. 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.

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. As a result, Saudi Arabia advocates a limit on pricing. Price should be high enough to generate monopoly profits, but low enough to discourage research and development into alternative fuels. With its low population density, it is still possible to invest all oil resources within its own economy.

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 press for monopoly pricing to meet high military expenditures.

The 1973 Yom Kippur War and U.S. 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.

Domestic dependence on a large number of foreign oil producers is not bad; however, the U.S. and others are dependent upon few countries with unstable political history. Greene and Leiby analyze 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, and political and military costs. Then Greene and Leiby argue by raising prices through the restriction of output, the oil producer's cartel transfers consumer's surplus into monopoly profit. 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. Even thought OPEC's market power has weakened, the cost of dependence on foreign oil is not trivial.

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 form 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.

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.

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 to respond to an accident if one should occur.

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. If the company does not meet the standards, the money is forfeited and the government often uses this money to pay a third party to restore the land to the appropriate condition.

As discussed throughout this chapter, 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 in oil imported from politically volatile areas. These risks include potential economic impacts from price instability or from high prices associated with increasing scarcity; social costs associated with national defense and homeland security implications of dependence on oil from politically volatile areas; and potentially catastrophic global climate change and other severe environmental impacts associated with production and consumption of fossil fuels.

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 in 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.

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.

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. Peaceful uses promoted to encourage technical innovation in support of nuclear powered naval vessels. There is a possibility of solving energy needs through nuclear power. However, one of the biggest obstacles to establishing a nuclear power industry is the potential liability if there were a nuclear power plant disaster. 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 limit on liability suggests significant divergence between private and social optimum with respect to nuclear power. 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. Storage costs of spent fuel are not reflected in current costs. Nuclear power arose out of the wartime Manhattan Project where project managers were scientific managers. Their focus was on technical risk and human factors of boredom, stress, and intoxication were ignored. Mistakes occurred and one resulted in Three Mile Island. The predicted fall in nuclear energy had not occurred primarily due to delays in obtaining permits and construction. Designs vary plant to plant, resulting in little ability to learn by experience. In contrast, France has standardized design in all plants.

There was a hiatus of construction of new plants in 1980s and 1990s because of high costs and concerns about accidents. A recent concern about global warming has rekindled interest in nuclear power. New designs will probably utilize "passive" safety systems. An example of a passive system is a cooling system that relies on the property that hot water rises.

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.

The problem with nuclear waste is that it has to be safely stored for an incredibly long time. Some nuclear waste remains dangerously radioactive for over 100,000 years. Power plant waste is minor compared to nuclear weapon waste. 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.

Hydropower is often associated with an image an environmentally friendly option for power. However, this is not the case. 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.

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. It is unlikely that hydropower will offer a significant opportunity to reduce the need for the use of fossil fuels. Other 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. Large propeller blades are mounted on towers and when the wind spins the blades, this turns a turbine and generates power. The faster the wind blows, the more efficient the production of electricity and the cheaper the cost. Other factors that determine costs include the distance to transmit the electricity to the final customer. There are aesthetic costs and migratory patterns of birds need to be taken into consideration before developing a field of propeller blades.

Energy from the sun can be used to produce electricity through the use of photovoltaic cells that convert the sun’s light into electricity. One disadvantage to solar power is the need for a sunny day. The fact that peak usage for electricity occurs during the summer would mitigate this disadvantage, somewhat. Another advantage to solar power is that it can be implemented on a small scale, for example, each building could have its own roof mounted photovoltaic cells. If excess power from the roof mounted cells could be sold back to the power transmission companies, this would accelerate the adoption of solar power technology.

Biomass fuels come from living sources, such as plants and waste products. Liquid fuels are the most important types of biomass fuels because they can be made using existing cars, trucks, and boiler systems. For example, ethanol can be made from corn, sugar cane and many other crops. The two major environmental benefits to using biomass liquid fuels is that biomass fuels burn more cleanly and biomass fuels do not contribute to global warming. Solid biomass fuels, produced by pelletizing or shredding wood, dried grass, or crop residues, have the same benefits as liquid biomass fuels.

The problems associated with the use of biomass fuels are associated with the agricultural techniques used in growing crops. These include chemical contamination from fertilizers, pesticides and herbicides. There are also potential problems with erosion and sediment run off. Any move to biomass fuels would have to take these problems into consideration.

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. A series of steps involving pressure and heat results in a product which is refined into natural gas, light oils, heavy oils and water. The oils can be used to produce gasoline, kerosene and so on. A test plant has successfully produced 10 tons of natural gas, 11 tons of minerals, 21,000 gallons of clean water and 600 barrels of high quality oil every day using the feathers, guts, feet, blood, heads and other waste from a poultry plant which processes 30,000 turkeys per day.

Benefits to thermal depolymerization include conversion of waste into usable products, the capture of minerals so that they are not released into the environment and the process does not contribute to global warming.

Fuel cells produce energy through a chemical process that converts hydrogen and oxygen into electricity and waste heat through a chemical process. Fuel cells are already in use in a number of pilot applications. Fuel cells produce significantly less emissions. If is critically important that the fuel used to power the fuel cell be derived from a renewable sources rather than from fossil fuels. A fuel derived from a renewable source would cycle carbon, while a fuel derived from a fossil fuel would release stored carbon.

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. How do we get from the present time to the time when these innovations in energy are available, or how do we establish a portfolio of energy sources? One option is to implement tax breaks or subsidies for innovative technologies. A more general approach would be to place a tax on fossil fuels. A modest tax on petroleum-base fuels (10 – 20%) would probably trigger large scale development of alternative fuels. Short term solutions would be biomass liquid fuels which could use existing infrastructure. Changing transportation systems or cultural views regarding energy use will take much longer.

KEY CONCEPTS AND DEFINITIONS

Wetland Area – swampy area important in the life cycle of many land and water based species.

Thomas Malthus – his essay on the population predicted that at the current (early 19th century) rate of growth, the population would outstrip the means of production and starvation would occur. Neo-Malthusians have modified this theory to include general resource base and environmental quality.

Harold Hotelling – 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. Hotelling's work formed the conceptual basis for dynamic market efficiency.

Dynamic Market Efficiency – fundamental proposition is that the producer of oil must be indifferent between selling a barrel of oil today and waiting for a future time to sell it. Dynamic efficiency requires that the price at any point in time be equal to marginal extraction cost plus marginal user cost.

Marginal Extraction Cost – the additional cost associated with extracting an additional unit of a resource, i.e. pumping an additional gallon.

Marginal User Cost – this reflects the opportunity cost associated with not having a unit of the resource available in future time periods.

Texas Railroad Commission – responsible for a set of Texas state regulations that defined drilling rights to underground pools. In effect, this commission controlled most of the US oil production in time period before 1970.

Natural Gas Act of 1938 – regulated natural gas transportation rates. The result was that rates were high enough to support large capital expenses on natural gas pipelines. These regulated rates kept well-head prices low.

OPEC – Organization of Petroleum Exporting Countries. A cartel of oil producing countries formed in 1960 to counteract the economic power of multinational companies. Reached its zenith in 1973 with oil embargo and quadrupling of oil prices.

Dominant Firm Model of Oligopoly – a model of firm pricing behavior within an oligopoly market structure. Within this model, the dominant firm takes the production of the remaining firms as given and sets output and price accordingly. This model can be used to examine the success of OPEC in the 1980s as the competitive fringe increased production and reduced market share left for OPEC.

Competitive Fringe – production by firms which are not part of dominate firm. Production by the competitive fringe can put downward pressure on price.

Strategic Petroleum Reserve – US developed this after the oil shocks of the 1970s. The US buys oil and stores it for release during shortages. These releases are intended to make the shortage of oil less severe and, therefore, reduce the upward pressure on the price of oil.

Liability Systems for damages – established by the Oil Pollution Act of 1990 and the Comprehensive Environmental Response, Compensation, and Liability Act, liability systems established this system. The idea is that if transporters of oil are responsible for damages that may result in spills, they will likely want to avoid this large costs and will take steps to reduce the likelihood of occurrence.

Performance Bonds – these require a firm to pay a large amount of money up front, before they begin their activities. This money is then placed in an escrow account, but is returned to the firm after completion of the project, if they have met the appropriate environmental standards. If not, the bond is forfeited and the money is used to pay for clean up.

Price-Anderson Act – enacted by Congress, this act exempted individual utilities from having to pay damages as a result of an accident. Many claimed that this served as a subsidy for the nuclear power companies.

NIMBY Syndrome – stands for “Not in my back yard.” This is an important issue when local communities object to the placement of waste facilities in their area. This is one issue of concern related to the nuclear waste storage facility proposed for Yucca Mountain.

Thermal Depolymerization – a process developed to convert any carbon-based substance into oil through the use of pressure and heat. Using this process it is possible to convert food, agriculture or human waste into fuel.

Chapter 8 Short-answer questions

1. What is the major difference between Thomas Malthus' view of resource use and Harold Hotelling's?

· Malthus argued that scarcity was inevitable as population growth outstripped resource endowments. Hotelling argued that market forces would result in rising prices for scarce resources, modified use of these resources, and incentives to explore alternatives.

2. Why does marginal user cost change as the resource is used through time?

· Marginal user cost changes through time because it is based on current demand, current supply, expectations about future demand and future supply. As expectations change, so will marginal user cost.

3. OPEC's ability to have a significant influence on the price of oil changed in the 1980's. Explain why.

· The cartel lost market power as non-OPEC sources came on line in Mexico, the North Sea, and Alaska.

· Saudi Arabia had different incentives than the others in the cartel. Saudi Arabia preferred lower price oil to prevent incentives for development of alternative energy sources. Saudi Arabia also did not have as pressing a need for higher current income.

4. What conditions within the current energy markets would create incentives for research and development into alternative fuels?

· Rising prices within current markets would promote an investment into research and development into alternative technologies.

· Economic and national security issues related to a dependence on foreign producers could promote the development of alternative domestic energy sources.

· Rising taxes on oil-based energy products could promote investment in alternative technologies as would subsidization of alternative energy technologies.

5. According to Greene and Leiby what are the three broad categories of costs associated with depending on foreign oil?

· Transfer of wealth to foreign producers.

· Macroeconomic costs from sudden price rises or oil shocks.

· Political and military costs associated with depending on a volatile region of world for oil (as evidenced by the first Gulf War).

6. What are the three types of environmental problems arising from the production of energy?

· Emission of pollutants that occur on a continuous basis from energy facilities. An example would be smoke stack emissions from a coal burning power facility.

· Episodic releases of pollution which create damage to the environment. An example would be an oil tanker spill.

· Alteration of a natural ecosystem as a result of production activities. An example would strip mining which fundamentally changes the landscape in the area of the mine.

7. What types of environmental policy instruments can be used to address each of the three types of environmental problems?

· Direct control methods stipulating equipment to be used to clean up emissions are the standard approach to the first type of environment damage. However, marketable pollution permits and economic incentives could also be used.

· Direct controls concerning basic safety regulations, technological requirements and operating requirements have been used to address episodic releases of pollution. Liability systems would be another alternative.

· Direct controls concerning pipeline design and waste disposal have been used to address alteration of natural ecosystems. Performance bonds are another alternative.

8. Why wouldn’t an energy policy based on increasing domestic oil supplies reduce the potential for oil shocks to the economy?

· The price of oil is set in the world market, where US supplies are a very small part.

· Because the majority of our trading partners are also dependent on Persian Gulf oil, instability in that region will impact their economies and our trade relationships. The US economy will suffer because of the loss of these markets.

9. What is the difference between conventional energy sources and unconventional energy sources?

· Conventional energy sources are defined as those that are already employed at some level. In the US this would include, other than fossil fuel-based sources, nuclear power and hydropower.

· Unconventional energy sources may have been used for centuries, but their impact and use in modern times has been relatively small. Some unconventional energy sources in the US include wind, solar, biomass fuels, thermal depolymerization (very new) and fuel cells.

10. Which alternative fuel should the US choose and why?

· Portfolio theory suggests the best approach is to choose a mix of energy sources. In addition, future technological changes may result in an entirely different set of choices regarding energy.