Economics 331bFinale on economics of energy regulation

1

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

Economics of rebound effect

3

3

G

Price of vmt

Before mpg improvement

Gasoline consumption

Effect of efficiency improvement

“Rebound effect”

After mpg improvement

Economics of rebound effectAssume 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.

4

vmt gasoline

(1) vmt = f (p ,p ), vehicle miles traveled,

(2) cars = f (p ,p ), number vehicles

From this we can get the following:

(3) Gasoline use = G = vmt/ mpg

(4) p = p / mpg

(5) ln / ln

vmtvmt cars

carsvmt cars

d G d mp

gasoline

gasoline

-1 ln / ln ln / ln

But we know from (4) that ln / ln ln / lnp , so

(6) ln / ln -1 ln / ln ln / lnp

which gives us the important result:

(7) ln

vmt vmt

vmt vmt

vmt vmt

g d vmt d p d p d mpg

d p d mpg d p d

d G d mpg d vmt d p d p d

d

gasoline/ ln 1 ln / lnp

So rebound effect is equal to the elasticity of vmt with respect to gasoline prices,

which we have observed in countless studies.

G d mpg d vmt d

Empirical estimates of rebound effectBasic 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

6Source: UK Energy Research Centre, The Rebound Effect

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

"Oil supply monopsony macro

premium" price premium externality

supply oil -

price taxes

monopsony

pr

macro oil

- emium externality taxes

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 = 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.

8

Basics of deriving oil (monopsony) premium

Here is a more rigorous proof of the oil-import premium:

9

1/

(1) Domestic or consumer prices = = import price + tariff = p +

(2) Oil supply to the US: Q Bp B( - ) , or p = (Q/ B)(3) Assume that marginal value of oil in US is constant at (in

v

vv

[1 1/ ]

finitely elastic demand) So we want to

(4) max

Maximizing with respect to Q leads to a maximum value of tariff:(5) [1 1/ ] Since consumer prices are equal to marginal v

QvQ pQ vQ bQ

v p p

alue of ,

we set the optimal tariff as(6) = ( )/ 1/ = inverse elasticity of import supply.

v

p v v

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.”

The monopsony premium

1010

10Q(free market)

P, MC of oil

Imported oil

S

MSC

Import premium at free-market imports“Optimal

Tariff” atOptimized oil imports

Q(“optimal”)

D

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.

( )( ) ( )( ) ( ) ( )

oil priced realGDP realGDPd oil consumption oil price oil consumption

Macroeconomic externality

12

A standard macro/oil-price equation with “good” results. Dependent Variable: LOG(GDPQ_BEA) Method: Least Squares Sample: 1971Q1 2009Q1 Included observations: 153

Variable Coefficient Std. Error t-Statistic Prob. C 4.399688 0.027266 161.3626 0.0000

LOG(RPOIL08) -0.017205 0.003546 -4.851700 0.0000 TIME 0.007508 3.89E-05 193.0151 0.0000

R-squared 0.996011 Mean dependent var 8.841860

Adjusted R-squared 0.995957 S.D. dependent var 0.333864 S.E. of regression 0.021228 Akaike info criterion -4.847622 Sum squared resid 0.067591 Schwarz criterion -4.788202 Log likelihood 373.8431 Hannan-Quinn criter. -4.823485 F-statistic 18724.88 Durbin-Watson stat 0.166943 Prob(F-statistic) 0.000000

13

-.065

-.060

-.055

-.050

-.045

-.040

-.035

1970 1975 1980 1985 1990 1995 2000 2005

Effect of oil prices on real GDP(log = fractional; multiply by 100 to get percent difference)

Macroeconomic externality

14

Simplified derivation:

We can also derive that monopsony/macro = ε[GDP/pQ]

macro

premium

Assume that = 2 and = -

( )( ) ( )( ) ( ) ( )

[ln( )][ln( )]

150007

oil priceQ

oil priced realGDP realGDPd oil consumption oil price oil consumption

realGDP realGDPoil priceoil price

.014

macro $18 / bbl

premium.017 15000

7 2

Updated estimates

15

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

Numerical example for US

16

Variable

Elasticity of supply of oil 0.1 1 5

Domestic production (10̂ 6 bbls/ day) 6

Imports (10̂ 6 bbls/ day) 14

Domestic demand (10̂ 6 bbls/ day) 20

Global production (10̂ 6 bbls/ day) 85

Oil price (2009 $/ bbl) 50

Elasticity of demand for oil -0.5

Elasticity of imports w.r.t. oil price 2.9 8.0 30.5

Optimal tariff on oil ($/ bbl) 17.33$ 6.28$ 1.64$

Optimal tariff on oil (c/ gallon) 41 15 4

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.

le17

, , 1 79 ( .5) 658.0

79 65

S ROW ROW D ROW ROW

ROW ROW

S DS D

Price

Production

Short-run production capacity

18

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

The dead weight loss of taxes/regulation

2020

20

P, MC of oil

Imported oil

S + T1

S +T1+ T2

S

P0

P1

P2

AE

DC

B

If add new taxes (regulation):Additional revenues = D – BAdditional DWL = C + BMDWL/Mtaxes =(C+B)/D-B) ≈ (B)/D-B)

[When are you on the wrong side of the peak of the Laffer curve?]

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