[Peakoil] Fwd: AFR: Energy policy needs oil change

[Alex P]

A sensible opinion from the AFR. I think subsidies to regional areas, but 
without directly subsidising fuel costs, are a reasonable idea. Longer 
term, rail infrastructure would be a good subsidy.

Follows the Weekend AFR editorial from Saturday on oil prices that I 
actually agreed with.

Alex
O4O4873828

ACT Peak Oil discussion list
http://act-peakoil.org


------------- Forwarded message follows -------------

Energy policy needs oil change
2005 Sep 26
Feedback Adam McHugh

http://afr.com/premium/articles/2005/09/25/1127586743751.html

Now that the recent increase in crude oil prices has dispelled the
complacency of the past couple of decades, we have the opportunity to
reassess what it means, for Australia and the world, to be so reliant on
a non-renewable input at every level of production.

Since the industrial revolution we have become very good at, quite
literally, fuelling economic growth. Oil has created great material
wealth, at least in developed countries like Australia. But an
industrialised spending spree paid for by natural resource depletion
cannot last forever.

This would not be a problem in itself if we were to strategically invest
in capital to eventually replace oil-based technology. Unfortunately,
resources have been insufficiently allocated to sustainable
infrastructure development, especially in Australia.

Instead, we continue to buy into a system that is on an accelerating
slide to redundancy; a system that, as a result, is making the economy
increasingly vulnerable to short-run price shocks.

Analysis of oil scarcity should always take proper account of the
explicit trade-off between the short run and the long run. This entails
a widening of vision from the usual focus on oil's above-ground flow, so
that the constraints imposed by our natural resource stocks can be
understood, as well as the relationship between stock and flow.

As a starting point, the long run of global oil scarcity can be thought
of as a race to depletion between two factors of production.

On the one hand, the input side of the economy, we have geological
scarcity - there is only so much oil left in the ground and some day it
will begin to run dry.

On the other hand, the output side of the economy, we have environmental
scarcity - the atmosphere's capacity to assimilate waste is being
exceeded, and as a result global temperatures are rising.

Economic management is important in this context primarily because the
price mechanism fails to place this depletion race under automatic
restraint.

This is particularly so with the atmospheric resource stock, where
over-exploitation occurs because pollution, which has no market price,
is overproduced. The inefficiency in terms of economic welfare of this
situation is a well-established concept in economics.

But with geological scarcity, there is less of a consensus on price
effects. One view is that the higher oil prices resulting from oil
depletion will encourage entrepreneurs to develop substitute
technologies - and if this is limited to motive, it is an idea that has
some merit. Indeed, economists define such behaviour as rational.

Unfortunately, geological information on oil is also a matter of
scarcity - so much so, in fact, that profits and price signals are based
almost entirely on short-run expectations of above-ground flow.

Rather than the oil price rising steadily with the interest rate (as
famously declared optimal by economist Harold Hotelling), we observe
extreme volatility.

Political and geographical linkages are one mechanism through which
long-run critical scarcity can manifest itself as short-run volatility.
In fact, long-run analysis of the famous supply shocks of the 1970s
(induced by the Organisation of the Petroleum Exporting Countries) shows
that geological scarcity has already led to short-run shocks.

Before 1973, global oil production had always risen steadily, with
increasing demand consistently matched by increasing supply. But as
long-run geological scarcity worsened, resulting in the drying up of
low-cost producing oilfields in North America, the distribution of
economically accessible oil across the earth's surface became
inconsistent with the geography of its consumption.

This not only defined oil as a commodity of international trade but also
enabled the OPEC cartel to restrict short-run flow and generate
monopoly-like revenues. The result was two rapid price rises, one in
1973 and the other in 1979.

The situation has not improved. Oil's geographical maldistribution is
intensifying, increasingly threatening Australia's economic security.
Today the Middle East is dominant in the allocation of low-cost oil, and
its proportionate share of production will only increase as the resource
dries up elsewhere.

Meanwhile, global demand has accelerated rapidly, overwhelming
above-ground supply, as ever-greater numbers in China and India join the
developed world in claiming access to the wealth that oil has created.

This has resulted in the first demand-side oil shock in history. And
unlike the supply shocks of the 1970s, it is here to stay.

The consequence of this rapidly rising demand is a global economy
super-sensitive to supply-side impacts, such as war in the Middle East
and natural disasters in North America. With the demand curve constantly
shifting upwards, even the mere hint of a backwards shift in the supply
curve will result in dramatic price rises. The world now faces the risk
of a dual shock operating simultaneously on both sides of the economy.

A major event of this kind would have a severe macro-economic impact, to
which Australia, as a small open economy, would be acutely exposed.
Being a net exporter of energy will not save us: the success rate of
Australian oil exploration has halved since 2000, production has dropped
35per cent, we consume 159per cent of what we produce, and our export
performance relies squarely on the economic health of our highly
energy-dependent trading partners.

Nor can we be expected to weather the storm by relying solely on
reactive macro-economic policy.

In fact, monetary policy carries the risk of actually exacerbating an
oil shock's recessionary effects. This is because the current
low-inflation targeting regime runs contrary to the expansionary bias
one would expect in reaction to a severe oil shock.

The consumer price index is made up of a basket of goods that all use
oil as a substantial input into their production. Obviously higher oil
prices mean higher prices in general. Under inflation targeting, this
means higher interest rates.

The angst caused by this predicament may lead us to consider other
short-run management tools, such as inventory stockpiling, investment in
supply capacity, increased exploration, or reductions in fuel excise.
However, while these flow-based solutions may dampen price by addressing
immediate energy demand - thereby taking some pressure off the Reserve
Bank - they can only do so by increasing long-run scarcity, thus
exacerbating our vulnerability to the very shocks we are attempting to
manage.

Patently, any policy arrangement that deals with short-run scarcity by
increasing the flow of oil cannot be sustainable in the long run.

Consider what it will be like when geological scarcity becomes so
globally acute that no amount of investment in oil-based capital or
exploration will increase its flow.

This will occur with certainty - but exactly when is unpredictable. With
price signals inhibited by a geological veil, critical depletion could
result in abrupt and permanent oil shortages.

Potentially, this could undermine the economy's physical capacity for a
smooth transition to alternative energy. Irrespective of how high the
oil price suddenly spikes, would-be innovators may not be able to
capitalise upon entrepreneurial drive.

After all, we are talking about full-scale technological change - a
total infrastructure overhaul. Intuitively, a transition of this
magnitude would be much better accomplished while energy prices are
still relatively low and energy availability relatively high.

There is thus a need to develop policy instruments that instil the right
mix of incentives in what is essentially a failing technology market.

Economists specialise in analysing failures of the price mechanism.
Unfortunately the short-run nature of the political market often
inhibits the uptake of optimal long-run economic policy. This is evident
every time oil price rises are accompanied by public outcry over the
level of fuel excise and taxation.

Such pressure was manifest in last week's federal cabinet decision to
repeal the 0.6¢ increase in fuel excise due for implementation on
January1 next year - revenue from which was earmarked to pay oil
companies to develop low-sulphur fuels.

By reducing one aspect of social cost associated with oil consumption -
air pollution - and having consumers pay for it, this planned excise
increase would have been a small step in the right direction.

That said, however, it must also be recognised that subsidising a
non-renewable input-based technology is, by definition, not sustainable.

Economic stability requires us to reduce our long-run reliance on oil.
Thus a more forward-thinking policy is needed, one that will see tax
subsidies redesigned so that innovative technologies - alternatives to
oil - are better able to compete against the massive economies of scale
of the established global oil infrastructure.

The required approach, based in part on the original work of economist
Arthur Pigou, can be specified concisely. Perverse subsidies to the oil
industry should be removed. Taxes on oil should be increased. The
revenue generated should be directed towards research and development: a
combination of programs and incentives aimed at oil substitution and
conversion to non-oil based infrastructure.

To economists, Pigovian tax-subsidies are relatively non-controversial:
an established technology is forcing uncompensated costs on society; an
alternative technology would provide free benefits to society by
reducing these social costs; the established technology is squeezing the
alternative technology out of the market; thus, the established
technology should compensate society, and society the alternative
technology, to the optimal level.

Raising the purchase price of oil in relation to other goods provides
both a disincentive to consume oil and an incentive to develop
substitute technologies. A high taxation rate would be preferable,
implemented in gradual increments so that firms and consumers have time
to adjust. This could, and should, be offset by supplementary policy -
income tax cuts, increased welfare payments or concessions for regional
areas, for example - to manage any distributional (or political)
problems that higher fuel prices might transmit. Such policy
combinations enable flexibility in finding the right trade-off between
social efficiency and social equity outcomes.

Technology market transfers would support smooth economic progress, and
not only because they address the long-run basis for short-run
instability. Nobel laureate Robert Solow found that technological change
accounted for 87.5per cent of economic growth. Of the remaining factors
of production, human capital (know-how) is now considered just as
important as physical capital.

Thus, investment in the development of alternative technology and
technical knowledge is a social trifecta. It removes unpriced costs,
reduces vulnerability to oil shocks and promotes economic growth.

It is inevitable that the technological transition will need to be made
one day, at which point there will be a strategic advantage to those
countries that have already established a position in the new global
market.

* Adam McHugh is a lecturer in energy economics at Murdoch University.