Nordhaus on Energy and Bathtubs

I rarely venture beyond the narrow confines of macroeconomics, monetary theory and monetary policy on this blog, and I am not planning to change that focus. But it’s my blog, so I get to write about whatever I choose to. How’s that for libertarianism in action? At any rate, I just read an excellent essay on energy policy by William Nordhaus of Yale (“Energy: Friend or Enemy?” in the New York Review of Books, 10/27/11), not the least of whose many accomplishments was being chosen by Paul Samuelson as co-author of later editions of Samuelson’s legendary principles textbook (a wonderful textbook, but not the best economics textbook ever written.) Nordhaus’s essay is structured around a review of two new books The End of Energy: The Unmaking of America’s Environment, Security and Independence by Michael J. Graetz, and Hidden Costs of Energy: Unpriced Consequences of Energy Production and Use a report by the National Research Council’s Committee on Health, Environmental, and Other External Costs and Benefits of Energy Production and Consumption. National Academies Press (available for free at http://www.nap.edu).

Rather than try to summarize Nordhaus’s essay, I will just mention what seem to me to be the two most important points. First, all the major sources of energy now used in the US, (petroleum, natural gas, and coal) are associated with significant external effects (aka externalities), causing damage to property and injury to the health and well-being of individuals as well as contributing to global warming. Nordhaus cites estimates from Hidden Costs of Energy that if taxes on sulfur, carbon dioxide and other pollutants were imposed at levels corresponding to the damages caused, $300 billion a year in additional revenue would be raised. (Nordhaus doesn’t say what assumptions were made about the effect of taxation on the amount of pollution generated. If the estimates assume no reduction, less than $300 billion in revenue would be raised.) And these estimates include only taxes on electricity generation, transportation, and heat production, leaving out other industrial and commercial uses of energy.

To put the $300 billion a year estimate in perspective, consider that the recent ill-fated Congressional super-committee was charged with reducing federal deficits by $1.5 trillion over 10 years. Thus, taxing pollution would generate (subject to the qualification mentioned in the previous paragraph) about twice as much deficit reduction as Congress agreed, but failed, to implement. Insofar as taxing pollution would lead a reduction of pollution, there would be further long-term budgetary benefits by reducing future expenditures on medical treatment for illnesses and diseases caused by pollution as well as avoiding income (and tax revenue) losses associated with those illnesses and diseases. “Environmental taxes,” Nordhaus observes,

can play a central role in reducing the fiscal gap in the years to come. These are efficient taxes because they tax “bads” rather than “goods.” Environmental taxes have the unique feature of raising revenues, increasing economic efficiency, and improving the public health.

Nordhaus sums up our dysfunctional energy-policy paralysis in a truly depressing paragraph.

In reality, U.S. energy policy has largely shunned environmental taxes in favor of environmental regulation. Virtually every proposal for an energy tax from Nixon to Obama was defeated in Congress. By way of explanation Graetz writes, “We have eschewed taxes and instead employed virtually every other policy too imaginable. Handing out tens of billions of dollars in subsidies annually is far more seductive to politicians.” And many of these subsidies mainly serve as tax shelters. Graetz quotes Congressman Pete Stark: “They are not wind farms; they are tax farms.”

Instead of raising taxes on energy to match the full costs of producing and using energy, we have engaged in an endless series of ad hoc regulatory interventions supposedly designed to reduce energy consumption and dependence on foreign oil. CAFE standards require car manufacturers to meet minimum average fuel economy standards on passenger cars. Do CAFE standards reduce fuel consumption? Perhaps they do, but not necessarily. Increasing average miles per gallon of new cars reduces the marginal cost of driving those cars, so the number of miles they are driven increases as a result. If the percentage increase in miles driven exceeds the percentage increase in miles per gallon, the net effect is an increase in fuel consumption. On the other hand, if you tax gasoline consumption, you raise the marginal cost of driving (at least compared to the cost if there is no tax), so fewer miles would be driven than with no tax on gasoline.

The second important point made by Nordhaus is the unity of the world oil market. The unity of the world oil market makes the very concept of national energy independence, to which every administration since the Nixon administration has paid foolish lip service, a snare and a delusion.

We can usefully think of the oil market as a single integrated world market – like a giant bathtub of oil. In the bathtub view, there are spigots from Saudi Arabia, Russia, and other producers that introduce oil into the inventory. And there are drains from which the United States, China, and other consumers draw oil. Nevertheless, the dynamics of the price and quantity are determined by the sum of these demands and supplies, and are independent of whether the faucets are labeled “US,” “Russia,” or “China.” In other words, prices are determined by global supply and demand, and the composition of supply and demand is irrelevant. . . .

This means crude oil is fungible, like dollar bills. A shortfall in one region can be made up by shipping a similar oil there from elsewhere in the world. U.S. oil policies make no more sense than trying to lower the water level in one end of the bathtub by taking a few cups of water from that end.

We know that the world oil market is unified because there is a single price of crude oil that holds no matter what the source. For example, we can look at whether prices (with corrections for gravity and sulfur) in fact move together. . . . A good test of this view would be to ask whether a benchmark crude price predicts the movement of other prices. Looking at crude oil from 28 different regions around the world from 1977 to 2009, I found that a 10.00 percent change in the price of “Brent” crude oil – a blend of crude often used as a benchmark for price – led to a 9.99 percent change in the prices of other crude oils. . . .

The implication of the bathtub view is profound. It means that virtually no important oil issue involves US dependency on foreign oil. Whether we consider pollution, macroeconomic impacts, price volatility, supply interruptions, or Middle East politics, our vulnerability depends upon the global market. It does not depend upon the fraction of our consumption that is imported.

Nordhaus is undoubtedly correct in emphasizing the bathtub view. However, he may be overstating the case just a bit. Over the past couple of years, and especially in 2011, the spread between WTI and Brent crudes, which for years was almost nil, has widened to an extraordinary extent, approaching $30 a barrel in July and still remaining close to $10 a barrel. See the chart below.

Nordhaus argues that the bathtub theory implies that imposing sanctions or an embargo on Iranian oil exports would be futile, but I suspect that although an embargo on Iranian oil exports could not cut off Iranian oil exports from the world market, it could impose a real hardship on Iran, reducing its income from oil exports by some non-negligible amount, quite likely at least 5-10%, though probably less than 25%. But I am just quibbling about a detail, an important detail to be sure, but still a detail. If you want to understand energy policy and how it fits in with other aspects of economic policy, read what Nordhaus has to say.