Energy subsidies – an international policy

I wish to emphasize three truths that each of us sometimes overlooks in our understandable enthusiasm to get on with whatever energy projects we are pursuing. First, developed and developing nations alike have limited resources to devote to energy. Second, not every process that works, in the sense that it produces energy, can—or should—be pursued. Each must also pass the economic tests of producing energy more cheaply than alternatives and less expensively than doing without. Finally, nations do not stand alone. Autarchy in energy research and development, as well as in energy supply, is an expensive and ultimately elusive goal. While slavish dependence on others for energy is unpalatable, efforts to go it alone may be just as destructive to economic and social values.

In this paper, I wish to consider the criteria for subsidizing potential energy sources and to indicate the nature of the government policies which can most efficiently and effectively promote development of those sources which are decided upon. Let me note at the outset that conservation—doing more with less—is similarly important, and the principles relevant to subsidizing energy production mostly can be applied equally well to conservation. My remarks on energy production should be interpreted as encompassing energy conservation where applicable. I will keep my comments general so that they may be useful in the context of different national policies and diverse ways of organizing economic activity.

The increase in oil prices over the past six years, and such pressing problems as deforestation and desertification of vast tracts of land, have created a large menu of unexploited energy production and conservation activities that are economic and desirable now. The energy reality to which the peoples of the world must respond has changed, but behavior lags. Investments have not been made, skills have not been learned, and consumption and production patterns have not been altered. Because change has come so swiftly in the energy arena, there is a gap that must be bridged between what is and how we act, just as when looking to the future, we see a gap we wish to close between where we are and where we want to be. I will concern myself with both these long terms by addressing the issue of what actions are and are not wise for governments to foster now due to past and prospective changes in the world oil price.

The concern with governmental policies toward energy, especially the use of subsidies, is the result of four factors. The first two, noted above, are the very rapid rise in the price of oil and the widespread crises in the supply of fuel-wood and other dispersed indigenous fuel sources; the third is the accident of nature which concentrated easily accessible petroleum in a few areas of the world; and the fourth is the political reality that the nations controlling these deposits can vary supply and hold prices above the long-run replacement cost of energy. Additionally, major oil supplies are located in a politically unstable region from which oil supplies may easily be disrupted.

The desire for relief from the insecurity of imported oil is a powerful motive lending governments to foster indigenous energy supplies even if those supplies are more costly than imported oil. In an analogous way, uncertainty about future availability of energy offers a powerful incentive to invest now in developing new energy sources even if they are more expensive than conventional supplies. For this report, however, I will concentrate on the economic rather than the more political aspects of the rationale for energy subsidies, starting with the fact that current world energy prices may be influenced by the level of demand for oil, just as future prices will be affected by how much we use up in this generation.

Oil shares with most other mineral resource commodities the characteristic that higher levels of output engender higher unit production costs as known deposits are worked more intensely and more expensive reservoirs must be found and produced sooner. Higher rates of production also lead to increases in the value of oil in the ground, representing the higher cost at the margin of future sales forgone. And, finally, with greater demand, both the lower and upper limits of the range within which oil exporters exercise discretion over prices are also lifted. Thus, it appears likely that with greater oil demand, the price of oil flowing in world trade will rise.

The effect on consumers of an increase in the price of oil due to an increase in requirements for imported energy is multiplied because the higher price is paid for all oil, not just for the increase in imports. Other energy prices may rise as well. If demand of an extra million barrels per day raises the price of oil by, say, $1.00 per barrel, that extra million barrels adds its cost plus $1.00 per barrel for each of the millions of barrels of previously imported oil to the consumer's oil bill. This relationship makes each government's policy toward energy production and use a matter of concern for all members of the international community. Displacement of imported oil by alcohol in Brazil and by domestic oil in Pakistan, installation of nuclear power plants in Korea, use of solar cookers rather than kerosene in India, opening of hydropower facilities in China, and use of more fuel-efficient automobiles in the United States all tend to hold down the price of oil to everyone. In the same way, broadening the base of energy production and reducing consumption of depletable oil lessens its price in the future. Oil is today the incremental source of energy supply, and its price serves as the bridge between the energy policies of all countries of the world, and between present and future generations.

But what does this imply about national energy policies, and specifically about subsidies to energy production and conservation? Most importantly, it suggests that while the resource costs of reducing the demand for imported petroleum are borne by the country which acts, the benefits are shared with all net importers of energy. And those benefits in some measure are the result of transfers from oil producers. Lower oil imports by any country set in motion forces which alter the international distribution of wealth. It also may make the current generation worse off while benefiting those living in the future.

Here we come upon a difficult and troublesome international aspect of energy policy. Whose welfare is to be sought? Energy choices would be relatively simple if we were concerned solely with maximizing the welfare of the world as a whole, and if a world authority existed to implement decisions taken. Energy sources would be exploited in turn, the cheapest first, and research and development would be directed to develop new energy sources as they become economic and not before. When the cost of producing the old sources rose above the prospective cost of exploiting new techniques or deposits, the latter would begin to be produced and the question of subsidies would never arise.

If all net energy importers were brought together under the single goal of minimizing the cost of energy, again the prescription would be clear: Alternative energy sources will be brought on stream, least expensive first, until the extra cost of more indigenous energy was equal to the extra cost of importing more oil, including the higher price for all oil imported that importing more caused.

But neither of these conditions exists, nor are they likely to hold for the foreseeable future. It is unfortunate, but we are unlikely to see credible agreements between energy exporters and importers as to how the benefits of more rational energy development would be divided. Similarly, agreements among energy importers as to what share of the costs of extra production and conservation each will bear in order to gain the benefits of lower oil prices are not in prospect. And realistically, the likelihood of nations acting knowingly in the interests of others and against those of their own people is as slim with regard to energy as it is in other matters.

Let us analyze, then, the circumstances under which a country acting solely in its own interest should subsidize energy production or conservation. First of all, added production would have some influence on the world price and thus would be worth more to the nation as a whole than the price of the imported oil it displaced. For most countries acting alone, however, the impact of their import savings on price would be very small.

Second, the added security of an indigenous source of energy may be worth a considerable premium. Energy represents a small portion of the value of most countries' total consumption, but the energy input is vital. Thus, a substantial premium may be worthwhile to assure that, in the event of an oil supply disruption, economic activity and, for some, life itself will not be seriously affected.

Third, indigenous energy supplies, so long as they do not require too much reported capital to create, do not cause the drain on foreign exchange which has been so destabilizing a factor in the international financial operations of oil-importing countries.

Fourth, some alternative forms of energy are labor intensive, and for countries bedeviled with a chronically underemployed labor force, some premium over imported oil prices may be justified. In effect, the subsidy to energy production and conservation is partially offset because the resources going into its production would otherwise have had no useful employment. As an adjunct to this argument, those unemployed or underemployed who are newly drawn into the labor force have an opportunity to learn new skills and to experience the discipline of wage labor. In effect, the new energy industry may create cadres of trained workers acclimated to industrial tasks. Those cadres can be drawn as development proceeds.

Fifth, the nation may be able to concentrate energy production in the least developed portions of the country and have added value for that reason. There it can serve the three functions of tying such regions more closely to the rest of the nation, raising the level of living in the depressed area, and providing growth centers around which industry and other economic activity can develop.

Finally, energy production and conservation activities may be subsidized for traditional economic reasons: They may fit the category of infant industries which, as they reach an adequate size, can compete on even terms in the world market. They may have otherwise unaccounted for spillover benefits of value to the nation. Or again, the energy produced may at present be more costly than imported oil, but may promise not to increase much in cost while imported oil can be predicted to do so.

Each of these reasons for subsidizing energy production and conservation is framed to provoke the rigorous test that the subsidy leaves the nation itself demonstrably better off than before. This test forms a defensible basis for a national energy policy with staying power—one that can survive shifts in fads, changes in governments, and redirections of priorities. It also means that some technically feasible and intellectually exciting projects will not be supported.

The plain fact is that in some nations there are few opportunities to enhance, wisely, indigenous energy production. The natural resources and human energies of such nations can better be used doing something else, with the full knowledge that this means continuing to depend on ever more expensive and possibly unreliable imported oil. By the same token, even for the best endowed nations, opportunities are limited. Just because subsidizing one type of energy production or conservation is attractive at some level of output does not mean that doing more is necessarily better or that other energy activities are necessarily wise.

This point deserves elaboration. Unfounded promises, based on faulty cost comparisons, are sometimes made for conservation and for alternative energy technologies. What is ignored is that costs rise as the best locations, applications, and raw materials are exploited. For example, a U.S. study shows that the average cost for different waste material feedstocks in producing ethanol varies by a factor of four; when differences within each feedstock at different levels of use are taken into account, the variation is even greater. If virgin undamaged raw material were considered, the range becomes a factor of seven or eight. The projected difference in feedstock costs alone, even among waste inputs, is only a little less than the current cost of petroleum. The point is that some ethanol may be economic at only slightly higher petroleum prices, but costs rise rapidly as more and more ethanol production is brought into being. The same principle holds for conservation. As the number of Btus saved rises, the cost per Btu escalates until further energy saving would not be worthwhile.

To summarize, there are good social and economic reasons for ignoring "business as usual” criteria in energy policy. A number of justifications for subsidies to energy production and conservation exist. But we should all beware of programs defended solely on the basis of such vague catch-all criteria as that energy should be saved or produced because it is scarce, because it is important, because the world will some day run out of oil, or because it is any nation's responsibility to others.

Nations have limited resources but many pressing social and human needs, of which energy production and conservation is only one. This means that it is important to consider carefully how much of a nation's wealth of talent and resources is to go to energy projects, to choose those projects which will have the greatest long-term benefit to the nation, and to see to it that each project is pursued efficiently and abandoned if it turns out to have been a mistake. These criteria lead to a few widely applicable principles for selecting and administering energy projects.

It is important to keep in mind that energy projects form only one section of a nation's agenda, and each project is only one item among a large array of potential energy activities. Thus, it is not sufficient merely to demonstrate that an energy project is worthwhile. It is also necessary to show that it is more worthy of support than competitive endeavors which it will not be possible to pursue if the energy project goes forward.

In evaluating energy and other projects, the timing and certainty of expenditures and returns is important. Clearly, the earlier the benefits and the later the costs the better. Certainty of costs and benefits is also a factor. Some projects that promise very high returns may also be very risky, and if in addition the benefits are far in the future, a project with far less dramatic potential may be the better choice. Formal analysis leading to precise calculation of present expected net benefits from alternative projects may not be either practical or useful, but efforts at formulating alternatives in this way can discipline choices and help prevent serious errors. Re-evaluation of programs is also important. As one moves ahead it may make another less valuable because both will serve the same end. Similarly, if an inferior technology can be deployed now, it may make pursuit of a better process uneconomic. The cost advantage of the superior process may not pay for the expenditures needed for its development. Choices among energy processes are always required, and wise decisions are not easy to make in the best of circumstances.

Decisions which promote the national wellbeing can best be assured when institutions created to administer programs have incentives which approximate those of the nation as a whole. An important principle in organizing a national energy program is to keep decisions about energy (and other projects) out of the hands of partisans of any one energy form or process. Otherwise, the incentive is to continue the pursuit of programs even if they prove uneconomic or otherwise impractical. There is a tendency to underestimate difficulties and even dangers and to overestimate results when the professional future and perhaps livelihood of the decision maker depend on continued government support of a particular process or technology. In practice, this means that agencies and laboratories should not be narrowly specialized—that it is not wise to establish a bureau for exploitation of the water hyacinth. Instead, set up a bureau to investigate the use of a range of renewable and other resources. In general, it is wise to pursue a range of energy activities through the early and cheap exploratory phase so long as there can be ruthless pruning of those which do not prove useful. The likelihood that necessary pruning will be done is greater when those affected (and especially those doing the pruning) know that other opportunities are open to them when one project is abandoned.

Another principle is that necessary subsidies should be designed to maintain the incentive for efficiency at the operating level. In practice this means that subsidies should be such that each reduction in cost or increase in output goes directly to the producer as added profits. Similarly, each loss in efficiency or failure should come directly from the return to those doing the producing. For example, subsidies should be directed toward paying part of the capital costs but not of the operating costs of a process. It is always unwise for subsidies to be structured in such a way as to make up the losses of a project. Under such a scheme the incentives are all wrong—they lead to activities and expenditures which enhance the ends of those doing the work. They remove the pressure to produce energy at as low a cost as possible.

Finally, there is always the danger that technicians and scientists are more interested in the game than in the score. There is the understandable tendency to seek the path which satisfies scientific curiosity, which offers the elegant solution, or which yields the applause of colleagues at home and abroad. Only accidentally does such a path coincide with the one which produces the most practical benefit to the nation. Perhaps the most serious temptation is to play to the plaudits of countrymen by surrendering to nationalistic pride, by attempting to do everything at home. Instead, every effort should be made to borrow or buy technology and processes abroad rather than to develop then more expensively domestically. There is much work to be done in the world—too much to waste scarce talents and skills in duplicating developments available elsewhere. This leads to the furthest point that specialization and then cooperative exchange is as useful in energy activities as it is in others.

One is astounded by the vast array of processes for extracting and producing usable energy. Some of these processes are economic now, some only need development to make theirs practical, others would be attractive if the costs of alternative energy rose substantially, and some may never prove usable at meaningful scale. The key questions are which processes fall into which categories and how subsidies for promising processes might best be provided.

It is important to each of us that we be as insightful in rejecting alternatives as soon as they prove fatally flawed as we are in discerning new opportunities to produce and conserve energy. In this way we can make the world's resources go further. We can save scarce skills and talents to be applied more productively elsewhere. And for the long run we can foster the confidence of our governments and peoples that will lead to continued support for our work.