Sunday, May 30, 2010

The Gulf Oil Spill and the Myth of Affordable Energy

The gulf oil spill (more accurately, the underwater gusher) has brought a new focus on U.S. energy policy. The spill has put the oil establishment on the defensive, but it is trying desperately to use the mantra of "affordable energy" to deflect criticism. "We need the oil that comes from the gulf to keep the economy moving," Sen. Mary Landrieu (D-LA) told the Wall Street Journal. "Affordable energy affects every sector of the economy," a spokesman for the American Petroleum Institute wrote in a letter to the New York Times.

If we cut through the rhetoric, do the facts support the thesis that countries with "affordable" (read: cheap) energy perform better than those with more expensive energy? They do not. The price of crude oil is about the same everywhere in the world, so we can use retail gasoline prices as a proxy for national energy policy. (A chart of retail gasoline prices and related data can be found in the PowerPoint slides that accompany this post.) Retail gasoline prices range from over $5 per gallon in much of Europe to just a few cents a gallon in countries like Iraq, Iran, and Venezuela.

One argument is that higher energy prices would undercut U.S. exports. However, among the world's four biggest exporters, Germany and Japan, the world export leaders in per capita terms, have far higher retail energy prices than the U.S. and China.

Another claim is that high energy prices would deepen the recession and worsen our already serious budget problems. But Norway, a rarity among energy exporters that keeps domestic retail prices purposely high, has experienced a far milder recession than the U.S. or the OECD average. Where the U.S. national debt is high and rising, the Norwegian government has net assets equal to 140 percent of GDP, bankrolled in part with high energy taxes.

The countries that outdo all others in the "affordable energy" sweepstakes are economic basket cases like Iran and Venezuela. They suffer high inflation and unemployment, and their energy policies are paralyzed by fears of social unrest. Iran actually has to import much of its gasoline, a dire threat to national security at a time when the country is threatened with sanctions.

Why does cheap energy undercut an economy? It's simple. For a market economy to function properly, prices should reflect opportunity costs. U.S. gasoline prices, and the prices of many other forms of energy, fall far short of opportunity cost because they do not reflect externalities like climate change, oil spills, smog, and traffic congestion.

Abraham Lincoln had a favorite riddle: "How many legs does a dog have, if you call a tail a leg?" Answer: Four. Calling a tail a leg doesn't make it a leg. By the same logic, calling cheap energy "affordable" does not make it affordable. If we don't pay the true cost of energy at the pump, we have to pay for it through economic distortions, pollution, and threats to national security.

The bottom line: We can't afford "affordable" energy. There Ain't No Such Thing as a Free Lunch!

Click here to download a free set of PowerPoint slides with data, text, and charts related to the myth of affordable energy. Cut-and-paste the slides into your economics lectures, or assign them as independent readings.

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  1. Thank you for this post. It really did caught my attention and continue reading til the end. The information I got from here really did help me out somehow.

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  2. "U.S. gasoline prices, and the prices of many other forms of energy, fall far short of opportunity cost because they do not reflect externalities like climate change, oil spills, smog, and traffic congestion."

    Well said! In a lot of online discussion, people frame energy taxes as the big nasty Government taking more of their hard-earned money. It's better thought of as decreasing a natural subsidy. In effect, our existing use of energy is already heavily subsidised because other people pay the costs.

  3. Ed, I am sorry, but if my student wrote this in an essay, I would mark it with a red sea of comments...

    you compare exports p.c. of germany and japan vs. US an China... two small economies vs. two big economies.. surely you must have a mention or two in your textbook that small economies *naturally* export more (division of labour etc.).. why not take Luxembourg as an example..

    norwegian government's gasoline monopoly/tax.. one data point.. what a proof.. why not also mention the UK which has in your own figures the highest gasoline price in the EU.. it hasn't weathered the storm all that well..

    how are traffic accidents an externality of low gasoline prices? why not of low (usually non-existent) road-use prices. surely you have something in your textbook about road pricing schemes that get at the HEART of congestion problem, without penalising rural drivers?..

    funny you posit some economic distortions associated with LOW gas prices.. surely the taxes you'd like to see imposed in order to double (!) the US gasoline price are a (pretty huge) distortion.. even if you could somehow guarantee that the money is somehow used to compensate for the externalities.. (how exactly?)..
    note the current administration's decision to charge the company/ies for the state clean-up bill.. isn't that targeting the culprits and thus incentivising them? an internalisation of an externality indeed?...

  4. Thanks for the red ink. Some points:

    US, Germany, China, Japan are usually ranked as the world's four largest economies, rank varying slightly according to exact measurement method (PPP vs. nominal GDP, etc.)

    "Norway . . . one data point . .. " The energy establishment argues that "affordable energy" is a necessary condition for a healthy economy. It only takes one counterexample to refute that argument, at least as far as formal logic goes.

    UK: Yes, an interesting case. The UK definitely has some problems (subject of a different post sometime) but its current account is close to balance, so at least it does not seem to have suffered a fatal loss of international competitiveness as a result of its high gas prices.

    I enthusiastically agree, road prices are the best solution for highway congestion, gas taxes a second best, but either is better than the dominant US policy of command-and-control mileage standards.

  5. Why should the price of crude be the same everywhere? Can you provide a reference? Thank you.

  6. In saying that the price of crude oil is "about the same" everywhere, I meant that crude oil is an internationally traded good, and as such, subject to the law of one price. There are small differences in the prices of various grades of oil (Brent, West Texas, etc.) and transportation costs (e.g., about one euro a barrel from the Middle East to Europe) also introduce a little variation. By comparison, differences in retail gasoline prices, which depend primarily on government policies, are huge.

  7. I appreciate your perspective. However, it is much worse than you indicate.

    Petroleum is a liquid extracted from the Earth's lithosphere. It is a resource of Matter, not of energy. It is not an energy supply and not stored "energy", it is a biologically sequestered Material that allows today's living climate to exist. This means energy efficiency is actually undefined. Thus climate crisis and every ecological sector in decline. Costs and values are much more subjective than acknowledged by the existing paradigm of state supported finance.