Energy, Security, and Climate

Innovation will be critical to confronting the world’s energy problems, but the promise of energy innovation has too often been oversold. In an essay in the new issue of Issues in Science and Technology I explain why. In the wake of the Copenhagen debacle and the collapse of cap-and-trade, Americans have been searching for new ways to tackle climate change. One of the most popular ideas to emerge has been a call to focus on energy innovation. Proponents of this approach argue that focusing on making clean energy cheaper rather than on making dirty energy more expensive would transform the domestic and international politics (and perhaps economics) of climate and energy policy. I argue in my essay that a focus on innovation will need to involve serious policy in order to be effective, but that innovation policy itself entails a host of tricky political and economic challenges. At the domestic level, there is considerable opposition to the regulatory, spending, and tax tools that it would need to use; there are also serious hurdles to implementing innovation policy properly. At the international level a focus on innovation may ultimately replace a fight over dividing the burden of emissions reductions with a new fight over dividing the spoils of clean energy markets. And, after all that, innovation alone is exceedingly unlikely to solve our climate and energy problems. The article isn’t an argument against promoting energy innovation through markets and policy. It is, however, a caution against expecting too much and hence neglecting other essential elements of an effective approach. It also offers up some ideas for how to tailor innovation strategy so that it has a greater prospect of sustained acceptance and effectiveness. I encourage you to buy a copy of Issues – there are other interesting articles in the current edition. You can also download a pre-print version of the article here.

In a post earlier this month, I showed that by some measures crude oil price volatility is nearing a low ebb historically, though looking at historical volatility in isolation can mask the magnitude of recent years’ price changes in absolute terms and relative to the size of the broader economy. Bob McNally, president of Rapidan Group, suggested a follow-up post modifying the calculus slightly. What would the graph look like if volatility times spot price were divided by U.S. GDP? Framing it that way might help provide a very rough sense of the scale of the movement relative to the size of the domestic economy over time. See the result in Figure 1 in log scale below. Source: Bloomberg; U.S. Bureau of Economic Analysis One point to keep in mind when thinking through the macroeconomic implications of  oil price movements is that consumers, and hence government officials, experience these fluctuations much differently than volatility traders, for instance, do. Yes, implied and historical volatility may be historically low, but normal people live in a world where short-term swings in nominal prices have outsized importance. That said, the degree to which U.S. consumers are coping with retail fuel prices at today’s levels (including by driving less) would have defied the predictions of many economic models a few years ago.

In an exchange about the Keystone XL pipeline earlier today, NASA’s Gavin Schmidt made an important point: “Many things can raise the effective carbon price: tax, cap-and-trade, regulatory action (mercury standards, pipeline decisions etc)”. (I’ve taken the liberty to expand some twitter abbreviations.) That’s true. So what carbon price would blocking the Keystone XL pipeline be equivalent to? It’s a trickier question than one might think; there are actually no clean analogies. But here are two useful ways to think the issue through. (And a preemptive note: I understand that one can’t boil the Keystone fight down to a little cost-benefit calculation. I’m just picking up on an issue that others have raised.) I’d be eager to hear from others who have issues with these approaches, or who have other ideas -- the broader challenge of thinking through "carbon price equivalents" for regulatory and other non-price measures is an important one for domestic and international climate policy alike. What level of carbon price would be required to have the same impact on pipeline development as simply rejecting the thing? It’s easiest to look at this by first focusing on a concrete price.  Take $100/tCO2, which is many times in excess of the shadow price that the U.S. government applies in its regulatory decisions. Producing and refining a barrel of oil sands crude entails about 100 kilograms of carbon dioxide emissions. That translates to $10 a barrel in extra charges. At the same time, applying the same carbon charge to U.S. oil use would add about $40 to the cost of using a barrel of oil. Demand elasticity for U.S. oil is low. Increasing the price of U.S. oil by this increment (let’s assume a base price of $120) would eventually lower U.S. demand by perhaps 15 percent (again I’m being generous). U.S. oil is about a fifth of the global market, so that would lower total global oil demand by about 3 percent. The IMF estimates that elasticity of world oil demand is around -0.072 in the long run; the net result should be about a 34 percent decline in the oil price. (This is a very, very conservative lower bound, since OPEC members would cut back investment, and other countries would pick up some consumption, but let’s run with it.) Assuming that we start $120/bbl oil, that takes us down to $79 oil. (Again, in reality, probably not nearly so far.) Most oil sands producers can make their investments work – even after paying the extra $10 – at this price. How high a carbon cost would be required to negate other positive externalities from oil sands development? Oil production doesn’t just cause damages that aren’t accounted for by market prices – it also brings benefits. Let’s focus on just one: more production pushes down oil prices. That creates benefits for all U.S. oil consumers. What level of carbon damage would be required to fully offset this? Imagine that you boost net world production by one million barrels of oil a day. (This could be one million additional Canadian barrels; it could be five million additional Canadian barrels and four million barrels of offsetting OPEC cuts. The absolute magnitude of the number doesn’t matter – all of what I’m about to do scales linearly. That’s one of the things I particularly like about this line of analysis.) Let’s stick with the same IMF estimates of demand elasticity. The resulting price hit is a bit less than $20 a barrel. Now apply that to the roughly 7 million barrels of oil the United States imports each day. You’re talking a total cost of about $130 million a day. Climate damages need to be around $130 dollars a barrel – approaching $300/tCO2 – just to get even.