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The Texas economy: market-based instruments and energy policy.

The Texas Economy: Market-based Instruments and Energy Policy

Recent events have revived interest in a national energy policy. The invasion of Kuwait by Iraq has served as a forceful reminder that the cost of oil imported from any insecure source is far greater than the price paid in the market. Also, the passage of the Clean Air Act of 1990 has provided another reason to think again about policy. Many of the most serious environmental problems are associated with the production and consumption of energy from fossil sources. Ideally, a general energy policy should promote environmental objectives as well as lessen dependence on insecure sources of oil. In this article we shall show how market-based instruments of policy can serve both ends simultaneously.

Economics teaches that, as a general rule, a free (and competitive) market tends to promote efficiency and enhance the general welfare. But even in the freest and most competitive markets, the prices and quantities generated can be inconsistent with efficiency and maximum welfare if significant "externalities" are involved. Externalities are costs or benefits not fully borne or captured by producers, hence not reflected in market prices. Where there are cost externalities, prices are too low and consumption too high; where there are benefit externalities, the reverse is true.

Three externality examples are of particular relevance here. As widely appreciated, air and water pollution impose costs on society, but not necessarily on the polluting firms. Similarly, if a country imports oil or other critical material from insecure sources, the cost to society, reflecting the probability of a supply interruption damaging to the economy, is not fully assumed by the importer. In both examples, efficiency and the general welfare would be enhanced if the external costs were transferred to the producers or importers (internalized), thus raising prices and reducing consumption of the goods. Finally, when new knowledge that cannot be patented and sold or licensed to others is produced by research and development, the benefit to society is largely external. If internalized, the extra benefit captured by the producer would induce a higher and more efficient output of new knowledge.

We suggest three energy policy goals, corresponding to the three externality examples above, that could meet with widespread acceptance among the American people: (1) reduction in U.S. dependence on oil or any other energy source imported from insecure regions; (2) reduction of air, water, and land pollution associated with the production, distribution, and consumption of energy; and (3) encouragement of technological advances leading either to the development of new or cheaper domestic sources of energy that are commercially feasible and/or environmentally benign or to the development of more efficient and less polluting energy technology.

These goals need not conflict with each other and indeed may be mutually reinforcing. For instance, if the revenues generated by an appropriate combination of an import fee on oil and a tax on undesirable emissions were used to subsidize appropriate research, all of the desired ends could be served. The approach is "market-based in that it internalizes external costs and benefits and allows the resulting alteration of relative prices to motivate desired changes in output and consumption.

Market-based, cost-internalizing instruments may be classified as either taxes or marketable permits. The former include tariffs (or import fees), specific or general energy consumption taxes, carbon emission taxes, and the like; the latter, marketed import quotas and tradable emission permits. All raise the relative prices of the targeted goods or services, discouraging consumption and encouraging the substitution of alternatives. These instruments tend to internalize external costs, but having done so, they allow markets to perform their allocative functions. Unlike command-and-control measures (e.g., setting mandatory fuel efficiency targets in auto manufacture), they do not dictate the nature of response, but instead allow producers and consumers to choose the most economical response available.

Before examining some alternative market-based policy instruments, which work by altering relative prices, it will be helpful to recall how the relatively high oil prices of the seventies and early eighties effectively induced both energy conservation and domestic substitutions, thereby sharply lowering imports. As the accompanying figure shows, the two large increases in the real oil price in the seventies led, with some lag, to a declining energy/GNP ratio. From 1976 to 1986, the reduction was 24 percent, and the decline in the oil/GNP ratio was even larger, 31 percent, as other sources of energy were substituted for oil. The decline in the oil imports/GNP ratio was much larger still, 36 percent, as domestic production rose and was substituted for imports. The chief substitutes for oil after 1976 were coal and nuclear energy, gas substitution being inhibited by price and end-use regulation. If appropriate environmental policies had been in effect and gas markets had been free of regulation, undoubtedly the respective substitution roles of coal and gas would have been reversed.

Of the many possible market-based instruments and combinations, two relatively new and unfamiliar ones appear especially promising. The first, directed toward oil import restrictions, offers an alternative to quotas. The 1959-1973 U.S oil import quotas were ineffective, chiefly because the import permits were allocated in such a way as to invite ever-increasing applications for exceptions and special treatment. The system failed to create incentives based on economic efficiency. The alternative is to auction import permits, just as the U.S. Treasury auctions new issues of bills and notes. The Department of Energy, say, would establish the total number of barrels of oil to be imported during a period in accordance with some legislated policy. Twice a year, then, following announcements of the total allowable imports, potential importers would submit bids for permits, naming the quantity of imports (in barrels) applied for and the price offered per permit to import one barrel. All of the bids would be arrayed from the highest to the lowest and the associated quantities totaled. The lowest price at which the sum equaled the predetermined total imports allowed for the period would be established as the market-clearing price. All bidders of that or a higher price would receive the quantity of permits requested, but each bidder would pay only the market-clearing price. The winners would be allowed to sell their permits to others at any mutually agreeable price between auctions.

This procedure would both continuously assure meeting the target restriction of imports and continuously allocate import rights to those whose alternative energy costs were highest. Consequently, the societal costs of meeting the target would be minimized. The cost of imported oil (the world price plus the cost of a permit) would consistently be equal to the marginal cost (and price) of domestic alternatives. If the latter rose relative to the world price of oil, so would the price of a permit. Given the allowable imports, the market price of a permit would act as an automatic variable tariff equal to the excess of the marginal cost (and price) of domestic alternatives over the world price of oil, no matter how either might vary. Like any positive tariff, it would raise the price of imports and induce substitution of domestic energy sources, the extra demand raising their prices also, and thereby prompt general conservation of energy.

A second possible market-based instrument, with similar consequences for efficiency, could reduce air pollution. A target level of emissions would be established by the responsible agency (e.g., EPA) for a given georgraphical district and time period. Permits totaling this quantity would then by auctioned periodically to potential emitters by the process described above. Bidders would offer up to but not more than the marginal costs of reducing emissions by means of the least costly technique available to them. Thus, emission permits would be allocated through the auction to those with the highest cost alternatives, with winning bidders permitted to sell their permits to others at mutually agreeable prices between auctions. Every emitter consequently would have an incentive to search for ways to reduce emissions: either to save the purchase price of a required permit or to earn the selling price of a surplus permit. The total level of emissions in the affected district would be limited to the targeted maximum at the least possible cost to society.

The Clean Air Act of 1990 specifically authorizes the use of tradable permits in future efforts to control the emissions causing acid precipitation. We believe that this market-based control technique has many possible applications in pursuit of general energy policy objectives. Applied simultaneously to import and emissions control, it can induce efficient adjustments in the direction of both enhanced security and cleaner air.

-- Stephen L. McDonald Professor of Economics and Senior Fellow and Mina Mohammadioun Economist Bureau of Business Research
COPYRIGHT 1991 University of Texas at Austin, Bureau of Business Research
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:McDonald, Stephen L.; Mohammadioun, Mina
Publication:Texas Business Review
Date:Feb 1, 1991
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