Economics 331b Energy Regulation

1. Economics 331b Energy Regulation

2. Reasons for Regulation of Oil-Using Capital • Externalities • Local pollution • Climate change • Congestion • Road accidents • Macroeconomic/trade • Impact of oil price on business cycle • Optimal tariff • Political/military • Imperfect decisionmaking • Discounting • Split incentives • Poor information

3. First-best policy options

4. Inefficiencies with using second-best energy-regulatory policies • Ineffective because so far from target (example of CAFE standards and congestion). • Ineffective because of “rebound effect” which arises when target wrong input (capital instead of fuel). • Ineffective because covers such a small fraction of market (automobiles in global carbon market). • Not cost-beneficial if already have energy taxes.

5. Economics of rebound effect Assume that regulation increases energy efficiency of a capital good from mpg0 to mpg1. The question is whether the lower cost of a vmt (vehicle-mile traveled) would offset the lower cost. Here is the basic economics:

6. Economics of rebound effect Basic results from many demand studies:* Short-run gasoline price-elasticity on vmt = -0.1 (+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

7. Discounting Issues A common concern is that private-sector decision makers use discount rates that are higher than social discount rate. Each of these issues has a different policy implication: • Taxation: capital taxes lead to wedge between social and private. • Social underinvestment: leads to overall rate of return lower than social marginal utility • Behavior stuff: People can’t count • Capital market imperfections: Liquidity constraints mean that the cost of capital to individuals is above-market because of borrowing constraints, bankruptcy, … • Risk/CCAPM: Investment has high correlation with total output (or more properly the MU of consumption)

8. Optimal tariff argument on oil taxes 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 = Bpλ , λ>0 • US cost of imported oil = V = pQ = B-1Q(1+1/ λ) , k an irrelevant constant • marginal cost of imported oil = V’(Q) = (1+1/λ) B-1Q1/ 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.

9. Supply of oil imports into the US For numerical assumptions, see next slide.

10. Numerical example for US

11. Optimal tariff argument on oil taxes τ = 1/ λ = inverse supply elasticity. Complications: Formula actually is Some notes: • 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.) • The optimal tariff in $ terms depends upon the initial price because it is an ad valorem tariff. • The externality is a global externality for consuming countries because it is a globalized market. • 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

12. Price Short-run production capacity Production