Part III. Exhaustible Resources
A. Ozone
B. Energy – Part 1
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B. Energy
Part 1 – Chapter 8
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Introduction
• Chapter 8: energy production and how that
impacts the environment.
• The production and consumption of energy
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.
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Effects of energy production
• Global climate change, acid rain, air pollution
• Drilling for oil and gas, cooling energy facilities,
coal mining, and underground storage of oil – all
affect water quality
• 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
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Historical Development of US
Energy Policy
• Formulation of energy policy mostly concerned
with supply
• 2 authors have had a very strong influence on the
way we think about energy.
• Thomas Malthus – scarcity is inevitable because
population grows to exhaust its resource
endowment.
• Harold Hotelling – 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 both5
its current value and its future value.
Hotelling
• Fundamental proposition – the producer of oil must be
indifferent between selling a barrel of oil today and waiting
for future time to sell it.
• Recall from chapter 2 – if producer expects prices to rise in
future, wait. Others behave similarly, everybody waits,
current price up and future price down. (and other way
around)
• This type of price change will continue until all producers
are indifferent between selling today and selling in future.
• Today's price includes user cost, which is the opportunity
cost of not having the oil available at other periods in the
future.
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Hotelling cont.
• Dynamic efficiency requires that the price at any point in
time be equal to marginal extraction cost plus marginal
user cost.
• Because MUC part of price, and MUC reflects scarcity,
market should efficiently allocate oil over time, with MUC
reflecting scarcity value.
• 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.
• Higher current price will also encourage substitution of
other fuels for oil, increased exploration for oil, investment
in more energy efficient technologies.
• Market ensures that absolute scarcity never happens
because price so high - -reduces quantity demanded and 7
encourages substitution
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.
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Debate
• The debate about whether markets
adequately address future supply continues
to rage, and is a motivating factor behind
much US energy policy (particularly during
“energy crisis” of the 1970’s)
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OPEC
• 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
due to oil embargo imposed on the US and other countries who
supported Israel during Yom Kippur War.
• 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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OPEC
• 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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OPEC’s loss in power
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OPEC’s loss in power
• 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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Different incentives w/i OPEC
• Saudi Arabia – more reserves than other members,
so don’t want prices too high (or else, demand for
alternative energy technologies increase, driving
price down in future). Also, less need for current
revenue (sparsely populated, small economy)
• However, countries like Nigeria, Venezuela,
Indonesia – large populations, small reserves,
want high prices NOW.
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Costs of foreign dependence
•
•
•
Domestic dependence on a large number of
foreign oil producers is not necessarily 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 examining the
cost of dependence on a foreign monopoly for oil
supplies.
It is the simultaneity of the monopoly problem +
foreign dependence that generates costs to US
society
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Costs of foreign dependence
• They separate costs into three broad
categories:
1.The transfer of U.S. wealth to foreign producers
2. Macroeconomic costs.
3. Political and military costs.
• Argue that in absence of an oil cartel, all the
extra costs of oil imports are a loss to the
US economy
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Costs of foreign dependence
• By raising prices through the restriction of output,
oil producers transfer consumer surplus into
monopoly profit
• This loss is illustrated in Figure 8.2.
• With competitive market, whole shaded area CS.
Under foreign monopoly, square transferred to
foreign profit (because this leaves our economy –
represents pure loss). Additionally, DWL triangle.
• The rising dependence on oil imports is illustrated
in Tables 8.4 and 8.5.
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Other costs
• 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.
• 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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Total social costs
• 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.
• Consistent with the variety of factors that have
weakened OPEC’s power.
• However, the costs of dependence on foreign oil
are not trivial – $93 billion of total costs in 1990
compared to GDP of $5513 billion.
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Implications for the present?
• Previous analysis showed costs associated with
dependence on foreign oil sources from politically
volatile regions
• Today, international terrorism arising out of same
region, conflicts in Afghanistan and Iraq, and
continued violence in the Middle East – social cost
of depending on oil from this region is likely to be
much HIGHER today.
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The Environmental Costs of
Energy Production
3 types:
1. Emissions of pollutants that occur on a
continuous basis from energy facilities.
2. Episodic releases of pollution such as oil
spills.
3. Alteration of natural ecosystems as a result
of production activities.
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1. Continuous emissions
• Conventional environmental policy instruments,
such as MPP and taxes, are appropriate for the
first type of pollution, either would lower the level
of emissions in a fashion that minimized total
abatement costs.
• However, the US has historically relied on direct
controls (C & C) to manage this type of pollution.
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2. Episodic releases 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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Episodic releases of pollution
• A 2nd alternative would be to develop a liability system.
• Established by the Oil Pollution Act of 1990 and the
CERCLA, 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.
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3. Alteration of natural ecosystems
• Again, difficult to design an environmental tax or MPP system that
would manage the 3rd 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 & Energy Choices
• Given the insecure availability of energy and the
environmental costs associated with energy, how
to design policy?
• Countries such as the US 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.
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These risks include:
1. Potential economic impacts from price
instability or from high prices associated with
increasing scarcity
2. Social costs associated with the national defense
and homeland security implications of
dependence on oil from politically volatile areas
3. Potentially catastrophic global climate change
and other sever environmental impacts
associated with production and consumption of
fossil fuels
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Portfolio Theory & Energy Choices
• An effective energy policy would reduce these
risks
• Current US policy ineffective because it is based
on fossil fuels (especially in trying to increase
domestic production of petroleum)
• 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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Portfolio Theory
• Developed to provide a better understanding of
financial risk associated with investment strategies
• Indicates that the more diversified a portfolio of
investments, the lower its risk
• A portfolio consisting of foreign and domestically
produced oil is not very diversified (highly
correlated economic, national security, and
environmental risks)– thus is associated with high
levels of risk
• A much more diverse portfolio that includes very
different types of energy 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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Nuclear power
• 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
• It was however also believed that nuclear power
had the potential for solving the nation’s energy
problems (despite its expense compared to
conventional energy production)
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Nuclear power – liability issues
• 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 (20%
liability) and the federal government (80% liability), 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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Nuclear power
• A variety of other sources of disparity between
private costs and social costs of nuclear power are
presented in Table 8.7
• These costs include construction costs, which are
not fully represented in the price, and expected
damages from an accident, 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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Nuclear power – other risks
• 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 (NIMBY).
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Hydropower
• Hydropower is often associated with an image an
environmentally friendly option for power – but it
is NOT without its environmental impacts
• The primary environmental impacts of
hydropower are associated with the dams and
reservoirs and include inundation of both
terrestrial & riverine habitat, sedimentation,
reduction in aquatic dissolved oxygen levels,
blockage of fish migration and conversion of freeflowing rivers into reservoirs.
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Hydropower
• An interesting economic and environmental
consideration is that because so many rivers
have been converted into reservoir systems,
free-flowing rivers and healthy riverine
ecosystems have become increasingly
scarce – implying that the opportunity cost
of constructing dams on free-flowing rivers
is likely to be HIGH.
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Hydropower
• In the Pacific NW – 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, co-polymerization, fuel cells,
and geothermal energy.
• Some of these have been used for centuries, but their 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 carbon-based
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 through a
chemical process (more on hydrogen Friday).
• 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
•
•
US energy policy is based on the continued
availability of inexpensive fuels.
3 sets of costs associated with fossil fuels are
important to consider in developing an energy
policy:
1. The impact of fossil fuel use on greenhouse gas
emissions.
2. The other environmental impacts of these
emissions.
3. 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
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its risk by diversifying sources of energy.