chapter 7sbkunwar.weebly.com/uploads/1/0/9/8/109848430/chapter_7.pdf · graph) creates a burden on the consumers. • This inefficient policy was pursued based on rent-seeking behavior

Chapter 7

Energy: The Transition from Depletable to Renewable Resources

© 2012 Pearson Education, Inc. All rights reserved. 7-2

Chapter 7: Energy: The Transition from Depletable to Renewable Resources

• Introduction• Natural Gas: Price Controls• Oil: The Cartel Problem• Fossil Fuels: National Security and Climate

Considerations• The Other Depletable Sources: Unconventional Oil

and Gas, Coal, and Nuclear Energy• Electricity• Energy Efficiency• Transitioning to Renewables


Introduction

• Energy is a complex subject and the chapter covers a large amount material and concepts.

• This chapter:– Issues associated with the efficient allocation of

energy resources – How economic analysis can be used in policy

making.


Introduction

• Oil & Natural gas supply 59% of all energy consumed worldwide (IEA).– With coal, it is 86% of all energy consumed.– Heavy dependence on these resources

currently.

• How can we transition to new sources?


Natural Gas

• History of Natural Gas:

– A natural gas shortage of 2 trillion cubic feet, or 10 percent of the marketed production, occurred in 1974–1975.• Efficient allocation would not lead to this outcome.

– SO, What happened?» REGULATION

• In 1938 the Natural Gas Act was passed. – The Federal Power Commission (FPC) was charged with

maintaining “just” prices. (Fair price)– Price controls were imposed on natural gas shipped

across state lines.


Natural Gas: Price Controls

• Phillips Petroleum Co., v. Wisconsin (1954): – The Supreme Court forced the FPC to extend its price

control regulations beyond pipeline companies to the producers too.

• Price ceilings were imposed which prevented prices from reaching their normal levels:Demand Side– Overconsumption of natural gas, causing

shortages,– More resource used in earlier years.


• Price ceiling Supply side

– Producers could not make profit in existing prices.

• =>Producers who expected price ceilings to be lifted had incentives to slow production and wait for higher prices, thus exacerbating existing shortages.



FIGURE 7.1 (a) Increasing Marginal Extraction Cost with Substitute Resource in the Presence of Price Controls: Quantity Profile. (b) Increasing Marginal Extraction Cost with Substitute Resource in the Presence of Price Controls: Price Profile

The combined impact of these demand-and-supply effects would be to distort the allocation significantly. Market reaction to price control were: (1) Leaving more of the resource in the ground, (2) Increasing the rate of consumption, (3) Causing the time of transition to be earlier, (MC = price ceiling, no more production!)(4) Creating an abrupt transition with prices suddenly jumping to a new higher level.


FIGURE 7.1 (a) Increasing Marginal Extraction Cost with Substitute Resource in the Presence of Price Controls: Quantity Profile. (b) Increasing Marginal Extraction Cost with Substitute Resource in the Presence of Price Controls: Price Profile

• Lower price, higher consumption => resource depletes faster.• Abrupt transition to substitute.

• There is a huge jump before the switch point (quantity consumed more because of the introduction of price ceiling.• This means more allocation of resource towards the present.

• In graph (b), over time MC increases eventually intersecting with the price. At that point,there is a significant jump towards the substitute.


• Discontinuity in the transition (in the previous graph) creates a burden on the consumers.

• This inefficient policy was pursued based on rent-seeking behavior.– Politically very attractive.– But, the losses to future consumers and producers are

greater than the gain to current consumers.

• By January 1993, price controls on natural gas were completely removed.– Now, the demand + price has been rising.

Natural Gas


• When the marginal extraction cost ultimately reaches the level of the price control, the amount supplied will drop the zero. Extracting more would make no sense to suppliers because their cost would exceed the controlled price. Since the demand will not be zero at that price, a shortage will develop. Price ceiling will restrict higher prices.

• Congress may impose this type of policy in order to transfer revenue to current consumers. However, in actuality, this is a transfer from future consumers to current consumers. Scarcity rents are important for efficient allocations over time.



Oil: The Cartel Problem

• Price controls are not the only source of inefficiencies in energy resource allocations.

• Another source of inefficiency in the energy markets:– Collusion in oil markets.

• E.g., Oil Cartels like Organization of Petroleum Exporting Countries (OPEC)

• OPEC countries collude to gain monopoly power.

– They can restrict supply and force prices higher than otherwise.



• A monopolist can extract more scarcity rent from a depletable resource by restricting supply. – The monopolistic transition => slower rate of

production, higher prices.– The monopolistic transition to a substitute,

therefore, occurs later than a competitive transition. • It also reduces the net present value society receives

from these resources.

– Monopoly power results in inefficient allocations.• Oil cartel is an example of monopoly.



• Effective cartelization needs four factors to make it possible:– Price elasticity of demand for OPEC oil in both SR and

LR.– Income elasticity of demand for oil.– Competitiveness from non-OPEC producers.– Compatibility among OPEC member countries.


FIGURE 7.3 Real Crude Oil Price (1973–2009)


• Price elasticity of demand for oil– Price elasticity of demand measures the responsiveness of

quantity demanded to a change in price, measured in percentage terms.

– Oil and oil products are price inelastic.– The available substitutes are expensive.

– Price elasticity of demand depends in part on the availability of substitutes.

• 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.



• Income elasticity of demand– Income elasticity of demand measures the

responsiveness of quantity demanded to changes in income, measured in percentage terms.

– Income grows => Oil demand grows• This increase in demand fortifies the ability of OPEC to raise

prices.

– The higher the income elasticity of demand, the more sensitive demand is to the business cycle.

• Recessions can thus put pressure on OPEC (1983,2008) and expansions are beneficial to the cartel.



• Non-OPEC Suppliers– Non-OPEC suppliers are called the competitive fringe.

– A cartel will have more market power if it can prevent new suppliers from entering the market and undercutting the price.

• OPEC must take non-OPEC members into account when setting prices.

• A cartel will set a different prices (lower) in the presence of a competitive fringe than in its absence.

– Prior to fracking, OPEC produced approximately 45% of the world’s oil.

– Pressure on the cartel was evident in the mid-1980s when production was down and prices fell.



• Compatibility of Member Interest– Unlike a monopoly, a cartel is dependent on internal cohesion.– Individual cartel members have incentives to cheat on

production agreements. • By raising their own production, they can capture some of the

profits from the higher prices. This behavior, however, can cause the collapse of the cartel.

– Price elasticity of demand facing each individual member is higher than for the cartel.

• With higher price elasticity, lowering price maximizes profit. – Enforcing the collusive agreement is essential for the success of

the cartel. – Members must also agree on pricing and output decisions. Countries

with larger reserves (e.g., Saudi Arabia) will have more incentive to preserve their value in the LR. Countries with smaller reserves (e.g.,Nigeria) will be more with the near future and current price.



TABLE 7.1 The World’s Largest Oil Reserves


Fossil Fuels: National Security and Climate Considerations

• All fossil fuels contain carbon. – When these fuels are burned, unless the resulting carbon

is captured, it is released in the atmosphere as carbon dioxide.

• 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


TABLE 7.2 Carbon Content of Fuels


• Valuable strategic imports such as oil have an added cost that is not reflected in the market place. (E.g., National Security)

• National Security Dimension– National security is a public good. The market would generally

result in an excessive dependence on imports.• b/c the importer has no incentive to consider the national security

consequences of importing oil.

• Hence, leaving the determination of the appropriate balance between imports and domestic production to the market generally results in an excessive dependence on imports due to both climate change and national security considerations.

Fossil Fuels: National Securityand Climate Considerations


FIGURE 7.2 The National Security Problem

Efficient allocation is incorporating the national security and climate change considerations.

In the absence of any correction for national security and climate change considerations, the market would demand and receive D units of oil.

The domestic production would be A and ‘D-A’ would be imported

In Efficient allocation, C units would be consumed. The domestic production would be B and ‘C-B’would be imported.


FIGURE 7.2 The National Security Problem

Remember, Sd1 is the domestic supply curve, given enough time to develop the resources.

What happens when an embargo hits?In an embargo, you can’t really import anything.

You are only producing domestically.

So, SR supply curve is perfectly inelastic (vertical) at A. The intersection of supply and demand gives price of P*.

The loss is consumer surplus is large.

If an embargo hits, developing additionalresource cannot happen immediately.


• To reduce the potential damage of an embargo, the U.S. has developed a stockpile called the strategic petroleum reserve.

• Conservation can help decrease reliance on foreign imports. A tax on energy consumption is one tool that can be used to encourage conservation.

• Domestic subsidies are another possible tool. • A final option is the use of tariffs and quotas on

imports.

Fossil Fuels: National Security and Climate Considerations


The Other Depletable Sources: Unconventional Oil, Coal and Nuclear Energy

• Unconventional Oil Sources– Sources that are typically more difficult and

expensive to extract• One unconventional source of oil and natural gas is

shale. There has been a boom in shale gas production in recent years due to hydraulic fracturing (fracking).

– Concerns on their environmental impact• Using more energy to extract the resource• Emission of air pollutants, water contamination,

leakage (methane)• Guardian Article on NM fracking

problem:https://www.theguardian.com/environment/2015/aug/14/new-mexicos-gas-wells-fracking-air-pollution






• Coal– An abundant energy source

• More than 1/4 th of the total coal in the world is in US. ~257 billion tons.

• Heavily used in electricity production in countries like China.

– Main Drawback:• Air pollution: sulfur dioxide (leads to acid rain), particulate,

mercury and carbon dioxide emissions• Global warming is a long-term effect.





• Uranium– Potential transition fuel. It is used in nuclear electrical-

generation stations.– Limitations- Abundance and Safety.

• Abundance: Resource availability is a problem with uranium as long as we depend on conventional reactors.

• Safety:– Sources of concern: nuclear accidents and storage of

radioactive waste

• Nuclear Accidents: The production of nuclear requires radioactive contents, and if it comes in contact with human, it can induce birth defects, cancer or death. E.g., Fukushima, Japan 2011.

• Storage of radioactive waste: Proper storage of nuclear wastes with risks lasting up to 240,000 years is a large concern. On the other hand, the generation of nuclear energy does not result in greenhouse gases.



• Uranium• Examples of serious nuclear accidents include the Chernobyl plant

accident in 1986 when a serious core meltdown occurred and the earthquake in Japan in 2011 that caused severe damage to a nuclear power plant. As a result of the nuclear disaster in Japan, many countries have begun to examine the regulations that govern the use of nuclear power.

– The market will not make the correct choice for nuclear power.The market is likely to overproduce nuclear energy because safety considerations are not fully internalized.

– Nuclear power has also been beset by economic challenges. New nuclear power plant construction became much more expensive, in part due to the increasing regulatory requirements designed to provide a safer system.



Electricity: Transition to renewables

• Ultimately, our energy needs will need to be fulfilled from renewable energy sources:

– Depletable resources will be exhausted

– The environmental cost of using depletableresources will over time become so high that renewable resources will be cheaper.



• Renewable energy sources for electricity generation include:

1.Hydroelectric power2.Wind power3.Photovoltaics4.Active and passive solar energy5.Ocean tidal power



• The extent to which these renewable sources will penetrate the markets will depend on their relative cost and consumer acceptance.





• How can we create an incentive for transition to renewables?– Subsidizing renewable energy purchases (e.g., tax

credits).• Give incentives for producers to take financial and

engineering risks. (PTC, ITC etc.)• Solar investment tax credit: Deduct 30% of the cost of

installing a solar energy system from your federal taxes. – Installation of solar has grown by 1600% since 2006 when the

ITC started!

• But, it has not been uniformly effective because the tax credits have been on a “on-again/off-again” basis.– ITC ends after 2021.– Wind power production tax credit


• Renewable energy credits (REC)– RECs help facilitate the transition to renewable energy sources

such as wind or solar.

– Producers can recover the additional costs of producing renewable energy by selling REC.

– The market for these credits comes from consumers who want to support renewable energy and companies that have adopted renewable portfolio standards, whereby a certain percentage of electricity must be generated using renewable sources.

• E.g., you can purchase it at: https://www.green-e.org



Energy Efficiency

• Promoting energy efficiency is becoming increasingly important.

• 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.


Summary

• Price control and energy conservation• Transition to a sustainable-energy future• National security and climate change

concerns on oil• Environmental difficulties on oil, coal and

uranium• Government’s role and energy efficiency,

conservation and electric load-management

Documents

chapter 7sbkunwar.weebly.com/uploads/1/0/9/8/109848430/chapter_7.pdf · graph) creates a burden on the consumers. • This inefficient policy was pursued based on rent-seeking behavior