Wednesday, January 26, 2011

Free Market Energy

By Nick Sorrentino
One of the core principals of conservative political and economic thought is that the market must be allowed to work. When the market breathes innovation flourishes, costs come down, and entrepreneurs and businesspeople can make economic decisions based on what will grow their businesses, not how best to avoid red tape. Businesses rise and fall based on the degree to which businesses can deliver a product that meets a need in the market. This is the key economic principal to which most conservatives say they adhere. Why then do we not insist on a free market in energy?

In the United States the debate over energy usually pits the eco-green-left with it’s desire for increased subsidies for “alternative” energy sources versus those on the right for whom increased oil drilling, the increased use of coal, and the increased development of nuclear energy are perceived as the best routes to solving America’s energy challenges in the 21st Century.

Interestingly both general dispositions have a common thread. Neither approach is based in the principals of free market economics.

This is obviously true for the subsidation of “green” energies. When taxpayers are forced to pay for the development of technologies that are “challenged” in a competitive marketplace, we only serve to encourage resentment among some and to create corporate cultures of dependence. This is what has happened to the ethanol industry over the past few years

What is less obvious is the degree to which even mainstream energy sources are anti-market.

Oil, for instance is held up by many as the source of cheap energy that the market demands. It is true that the market does demand petroleum and lots of it, but the degree to which the current oil market is inefficient and propped by government rules, regulations, tax breaks, and outright subsidies is less understood. Is oil really that inexpensive?

It is easy for most common sense conservatives to see why government mandated, taxpayer funded, solar power farms in the Nevada desert are unwise. It is more difficult to pull apart the web of government favors given to the current kings of the energy industry.

One fairly obvious example however of how market dynamics are tossed aside for the benefit of entrenched energy interests is the BP oil spill of last summer.

One of the reasons things went so wrong in the Gulf last year was that BP was drilling nearly a mile under water without the technology readily available to turn off the oil flow if something went wrong. The risk was immense, but it still made economic sense to pursue such drilling for BP. Why?

There are a number of factors, among them a general upward tend in oil prices and increased scarcity, but most of all it was likely the fact that for BP the endeavor appeared to have little downside and huge upside due to the limits of oil spill liability drillers in the US are subject to.

In a nutshell a driller’s liability in the event of an oil spill is capped at $75 million in the United States, with any spill costing between $75 million to $1 billion covered by a pooled industry insurance regime.

For a well that over its lifetime might generate billions in revenue the economic equation is pretty easy to calculate. Why wouldn’t BP drill in a mile of water? There was almost no downside to the endeavor.

It is true that BP was in fact saddled with a $20 billion bill to be paid out over many years. Also the cost of the debacle in the Gulf to it’s reputation was and is very significant. However as the Horizon project was assessed by BP’s planners and accountants, this extra-legal exposure was likely minimized. A catastrophe such as the one in the Gulf of Mexico last summer had never occurred before.

Had the $75 million limit of liability not been in place it is unlikely that BP would have pursued drilling in an environment as inhospitable as 1 mile of water. Had BP’s exposure been unlimited, as it would be in a free market, or alternatively had BP had to pay properly adjusted insurance premiums to compensate for the risk, the planners and accountants in London would very likely have understood that the potential return on the Horizon well was not enough to compensate for the risk. Thus the pain and economic disruption in the Gulf of last summer would likely have never have occurred. The free market would have saved dolphins, pelicans, and barrier islands, to say nothing of the fishing and tourist industries on the south coast.

The drilling liability cap is a subsidy, plain and simple. The citizens of the United States essentially underwrite off-shore drilling for the oil industry and in so doing we undermine the ability of the market to apply it’s discipline. The upside for BP and it’s shareholders is privatized, the downside is socialized.

Additionaly the oil industry is privy to much in the way of tax breaks. The tax code for oil companies has been written over the last century with a multitude of loopholes.

For instance according to the Congressional Budget Office capital investments such as oil field leases and drilling equipment are taxed at an effective rate of 9%. This is versus 25% on such investments for most other businesses in the US. This break is worth billions to the oil industry.

Add the Herculean efforts made by this country to defend the flow of oil, on the high seas, in the Middle East, in Central Asia, and in various other places around the globe, it becomes increasingly clear that oil is not nearly as inexpensive as many believe. In fact it is the defense of such interests that may actually be the greatest subsidy of all for the oil industry.

According to The National Defense Council Foundation (a conservative think tank based in Arlington Virginia) in their 2007 paper The Hidden Cost of Oil: An Update they found;

“In October of 2003, the National Defense Council Foundation released the results of a year-long review of oil-related defense costs that entailed the most comprehensive analysis of that subject ever conducted. The entire order of battle of the United States armed forces was examined down to the battalion or equivalent level, including close scrutiny of roles and mission statements and unit histories. In addition, the entire Department of Defense budget was reviewed to determine if there had been any extraordinary expenditure that could be directly related to protecting oil supplies.

The analysis concluded that the fixed costs of defending Persian Gulf oil amounted to $49.1 billion annually. These estimated, however were based on data compiled prior to the initiation of Operation Iraqi Freedom. As a result, in 2006, the Foundation revisited the issue to take into account any additional outlays that could be reasonably assigned to the protection of oil supplies.

Based on a review of current circumstances, the initial estimate was increased to $137.8 billion.”

The paper can be seen HERE.

The cost of a gallon of gas is in actuality far higher than $3.00 per gallon.

When the real cost of energy is understood, when “externalities,” that is the hidden costs passed on to others by the oil industry are considered, solar, wind, and other so called “alternative” energies suddenly appear much more economically viable.

But what about nuclear?

Unfortunately nuclear, though less costly in terms of “defense,” is also highly subsidized.

Like oil, nuclear benefits from a government sponsored limit of liability in the event of a catastrophic occurrence.

The Price-Andersen act of 1957 protects the nuclear industry from lawsuits arising from the release of radiation and the harm that radiation causes. Liability of up to $10 billion is covered under a quazi public/private no fault insurance fund, and anything beyond $10 billion is then shouldered by the American taxpayer.

Thankfully as yet such limits have not yet been tested. The 3 Mile Island incident in 1979 incurred about $70 million in total liability. However it is easy to see how in the event of a Chernobyl type meltdown with massive economic disruption how the cost of such an event could stretch into the tens of billions. If that happened the owner of the reactor(s) is currently insulated from claims. The American public pay twice. First, in terms of economic dislocation and lives lost, and then again for the claims that result from the disruption. Again the profits are privatized for the company and shareholders, but the downside exposure is on the American taxpayer.

In addition to the Price-Andersen Act, the nuclear industry is privy to huge taxpayer backed loans given to nuclear energy developers.

Such special government sponsored deals have been widely supported by the Republican Party, despite the fact that they undermine a free market in energy generation.

If we are to have a truly informed debate about how best to deal with energy issues we must take the market skewing special deals that legacy energy currently enjoys into account. Such deals increase the barrier to entry for other energy producers, which then in turn feel they must lobby for special deals of their own to compete. This creates a market in which actors are dependent on government intervention to gain market share. This is what we have now.

If we continue to subsidize energy producers, be they wind, nuclear, oil, solar, or something else we will never have a clear picture of the best way forward with energy .

We must realize the actual cost of energy. We must take into account the cost of limits of liability, defense, and even perhaps most importantly the impact of carbon emissions on the globe.

The legacy carriers may indeed turn out to be the best sources of energy, but at this point we don’t truly know. We should work toward a more transparent and free market in energy. The burden of supporting energy producers of any kind should not fall on the taxpayers. The market should determine the best way forward.

* President Obama in the most recent State of the Union speech rightly highlighted the subsidies given to the oil industry. However he did not denounce subsidies in general, in fact he encouraged the expansion of subsidy support for some. It is not the place of government to pick winners and losers in this writer’s opinion. We should however encourage an increasingly level playing field for energy in general and begin the process of desubsidation of all energy. Not a small task, but a good goal.

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About Me

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Nick Sorrentino is the Editor of The Liberty and Economics Review and CEO of a social media management company.