Transcript Chapter 6

The Economic Approach to
Environmental and Natural
Resources, 3e
By James R. Kahn
© 2005 South-Western, part of the Thomson Corporation
Part II
Exhaustible Resources,
Pollution and the
Environment
Chapter 8
Energy Production and the
Environment
© 2004 Thomson Learning/South-Western
“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
quality.”
World Resources 1992-93
4
Introduction
 The focus of this chapter is on energy
production and how that impacts the
environment.
 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.
5
Introduction
 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.
6
Historical Development of US Energy
Policy in the Post-World War II Era
 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.
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Historical Development of US Energy
Policy in the Post-World War II Era
 The fundamental proposition of Hotelling’s 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.
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Historical Development of US Energy
Policy in the Post-World War II Era
 Thomas Malthus believed in the concept of
absolute scarcity, which suggests that
resources are used at an increasing 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.
9
Historical Development of US Energy
Policy in the Post-World War II Era
 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.
 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.
 In addition, from 1959 to 1973, oil imports were
restricted.
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Historical Development of US Energy
Policy in the Post-World War II Era
 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.
 An effort to regulate wellhead prices to keep natural
gas prices low resulted in reduced production,
reduced exploration and a shortage of natural gas in
the 1970s.
 Energy price control policies were set based on a
perceived link between cheap energy and economic
growth, a concern with equity over efficiency, and a
perceived need to protect people from exploitation
by oil companies.
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Historical Development of US Energy
Policy in the Post-World War II Era
 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.
 In order to have power in the market, the cartel must be large
enough so that quantity decisions affect market price.
 Cartel members have powerful incentives to cheat. If one
member secretly produces more, that member can earn higher
prices at greater output.
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Historical Development of US Energy
Policy in the Post-World War II Era
 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.
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Perfect competition
14
Chapter 24
Figure 24.4
Monopoly
15
Monopoly and Competition compared
16
OPEC as a Monopoly
17
Historical Development of US Energy
Policy in the Post-World War II Era
 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.
 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.
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19
Historical Development of US Energy
Policy in the Post-World War II Era
 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.
 Price should be high enough to generate monopoly
profits, but low enough to discourage research and
development into alternative fuels.
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Historical Development of US Energy
Policy in the Post-World War II Era
 With a relatively sparse population and a
small economy, Saudi Arabia has less need
for current revenue.
 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 desire monopoly pricing
to meet high military expenditures.
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OPEC and US Energy Policy
 The 1973 Yom Kippur War and US 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.
22
OPEC and US Energy Policy
23
OPEC and US Energy Policy
 Domestic dependence on a large number of
foreign oil producers is not bad; however,
the U.S. and others are dependent upon a
few countries with unstable political
histories.
 Greene and Leiby analyzed 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.
political and military costs.
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OPEC and US Energy Policy
 Greene and Leiby argue that in the absence
of an oil consumers’ cartel, all the extra costs
of oil imports are a loss to the US economy.
 By raising prices through the restriction of
output, oil producers transfer consumer
surplus into monopoly profit.
 This loss is illustrated in Figure 8.2.
 The rising dependence on oil imports is
illustrated in Tables 8.4 and 8.5.
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Transfer of Consumer Surplus and Deadweight Loss
26
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OPEC and US Energy Policy
 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.
 Greene and Leiby (1993) point out that it is difficult to ascribe
the readiness costs and actual costs of the Persian Gulf War
solely to dependence on foreign oil. In absence of oil
dependence, the US may have participated in the war to help
oil-dependent allies.
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OPEC and US Energy Policy
 Table 8.6 indicates that the total social costs
of dependence on a foreign monopoly for oil
increased through the 1970s and declined
through the 1990s.
 A variety of factors has weakened OPEC’s
power.
 However, the costs of dependence on foreign
oil are not trivial, with $93 billion of total
costs in 1990 compared to GDP, which was
$5513 billion in 1990.
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30
The Environmental Costs of Energy
Production
 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 from 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.
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The Environmental Costs of Energy
Production
 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.
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The Environmental Costs of Energy
Production
 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 in case an accident occurs.
 The idea is that if transporters of oil are responsible for
damages from spills, they will take steps to reduce the
likelihood of an accident.
33
The Environmental Costs of Energy
Production
 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.
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Portfolio Theory and Energy Choices
 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 is oil imported from politically
volatile areas.
 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 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.
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Conventional Energy Alternatives
 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.
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Conventional Energy Alternatives
 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.
 One of the biggest obstacles to establishing a nuclear power
industry is the potential liability if there were a nuclear power
plant disaster.
 In response to this 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 a limit on liability suggests significant
divergence between private and social optimum with respect to
nuclear power.
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Conventional Energy Alternatives
 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,
and storage costs of spent fuel, which are
not reflected in current costs.
 Although it was predicted that nuclear power
costs would fall, that has not happened
primarily due to delays in obtaining permits
and construction of power plants.
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Conventional Energy Alternatives
 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.
 Some nuclear waste remains dangerously
radioactive for over 100,000 years.
 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.
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Conventional Energy Alternatives
 Hydropower is often associated with an
image an environmentally friendly option for
power.
 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.
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Conventional Energy Alternatives
 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.
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Alternative Energy Sources
 Unconventional alternative energy sources include
wind, solar energy, biomass energy, copolymerization, 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.
 Energy from the sun can be used to produce
electricity through the use of photovoltaic cells that
convert the sun’s light into electricity.
 Biomass fuels come from living sources, such as
plants and waste products.
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Alternative Energy Sources
 Thermal depolymerization is a process that has been
developed relatively recently to convert carbonbased substances (food waste, agricultural waste,
human waste, plastic, medical waster, etc) into oil.
 Fuel cells produce energy through a chemical
process that converts hydrogen and oxygen into
electricity and waste heat through a chemical
process.
 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.
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Summary
 The US energy policy is based on the continued
availability of inexpensive fuels.
 Three sets of costs associated with fossil fuels are
important to consider in developing an energy
policy:
 The impact of fossil fuel use on greenhouse gas
emissions.
 The other environmental impacts of these emissions.
 The national security cost of being dependent on oil that
is imported from regions of political volatility.
 Portfolio theory suggests that the US can reduce its
risk by diversifying sources of energy.
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Summary
 Global warming and depletion of the ozone layer are
important environmental problems.
 The long lags between emissions and damages, the
long lifetimes of the pollutants, and the complexity
of the scientific relationships make the development
of policy difficult.
 While there have been international agreements
developed regarding the restrictions on ozonedepleting chemicals, the movement toward
resolution of global climate change has been much
less successful.
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