The Replacement Cost of Energy

In June of this year, RFF's Milton Russell was requested by the Budget Committee of the House of Representatives to testify on energy problems in relation to the proposed budget. In his statement, he said, "In my view, the aim of energy policy should be to lessen future real energy cost increases and to minimize the effect upon the potential level of living—including environmental amenities—of those higher costs already imposed by OPEC. These goals are best achieved when energy is produced and used efficiently. Efficiency follows when energy prices to both producers and consumers reflect the replacement cost of energy, and that replacement cost is now set by the cost of imported oil, including a security premium." Below are edited versions of Congressman Jospeh L. Fisher's queries on this part of the statement and Russell's responses.

Question from from Congressman Joseph L. Fisher:

What is the implication of basing the "replacement cost" of energy on the price of imported oil? That price is not a competitive price but instead is a price agreed upon by the OPEC cartel. Moreover, that price may fluctuate at the whim of OPEC because it does not reflect underlying resource costs.

Response:

The resource cost to the United States of imported oil is equal to its price, and is paid either by exporting goods and services of equivalent value produced in the United States (which if they did not go to pay for oil could be used for domestic consumption or investment) or else it is paid by transferring ownership of U.S. assets to the oil exporters. That ownership gives the exporter a claim on future U.S. production—a claim which may be exercised at any time.

The replacement cost of domestic oil is equal to the cost of imported oil (including a premium over the private landed cost to compensate for its insecurity) because that cost measures the flow of resources out of the country caused by additional oil consumption or reduced domestic oil production. In other words, when less oil is consumed or more domestic oil is produced, the resources saved are equal to the cost of imported oil which need not be paid for.

The replacement cost of nonoil energy sources also depends upon the cost of imported oil. Energy sources are substitutable one for another. The substitution is not perfect and universal, of course, nor need it be to make the energy market one whole. All that is required is that, in some uses, there be a bridge among energy services so that in some way, even if only indirectly, all sources compete for markets. In large measure this condition exists in the United States today. It exists either directly, as where more than one fuel is used for a single purpose, or potentially, as where only one fuel is used but where others might be when new installations are built. At present the United States is a net importer of energy. Thus, in general, at any one time, use of more energy—whatever its source—leads to additional oil imports, just as conservation of energy of any type, or additional domestic production, reduces oil imports. Domestic energy prices matter in this regard because at higher energy prices less is consumed and more produced.

Energy sources are not perfect substitutes on a Btu basis. Some fuels require more capital in use and create other costs as compared with oil. Further, there is a difference in the thermal efficiency with which different fuels are transformed into useful work. Consequently, the fact that the incremental source of energy is imported oil, and that other energy sources are direct substitutes for it, does not imply that on a delivered Btu basis their prices would be the same in equilibrium.

A price differential among fuels is not, therefore, necessarily inconsistent with the earlier conclusion that the re-placement cost of energy is its imported oil equivalent. It merely indicates that the proper cost comparison is with what oil does—after accounting for other cost differentials—not with oil on a Btu basis per se.

The reasoning behind the assertion that the potential level of living of U.S. citizens would be maximized if energy were produced and consumed in all sectors as if its price were equal to its replacement cost deserves some elaboration. On the production side, if a given increment of energy (measured again by the function it performs) can be produced at lower real cost domestically than it can be imported, more real resources are left over to meet other wants. At the limit, the nation is best off, in terms of what it has to give up to get more energy, when the resource cost of increments to domestic production are exactly equal to the cost of increments to imports. On the consumption side, U.S. consumers are best off when they are able to adjust their spending in such a way that the benefits they obtain from additional units of energy equal the benefits they might have obtained by consuming additional units of anything else that used the same energy resources. Taking both consumption and production together, then, it is necessary for maximizing the potential level of living to have energy produced, consumed, and imported as if it were priced equal to its replacement cost—and that replacement cost is equal to the secure-equivalent price of imported oil.

Does the Basis of the Import Price Matter?

This analysis allows us to approach the first specific question posed—does the fact that the replacement cost of energy is set by a cartel and not by competition make any difference? The short answer is probably not, or not very much, and if any difference does exist, it would probably be better that the price be higher in the United States than replacement cost, not lower.

The analysis goes something like this. The basis by which the imported oil price is set does not affect the fact that imported oil establishes the replacement cost of energy faced by the United States. Thus, unless U.S. actions with regard to domestic price policy (and thereby the level of imports) would affect the imported oil price differently if competition existed than if prices were set by a cartel, the allocational efficiency argument for replacement cost pricing is not affected.

With regard to that possible difference, though, it can be argued that the impact of a change in demand on the cartel optimal price would be greater than on a world price set competitively. While cartel behavior need not follow short-term profit maximizing precepts, if it did, the benefits to consumers (in the form of lower import price) from lowering demand would be greater—not less—in a cartel than in a competitive world. In addition, reduced demand may cause the cartel to choose a still lower price to lessen the excess supply that would otherwise threaten cartel cohesion. Thus, given the existence of the cartel, it may be plausible to argue that holding domestic prices above the cost of imports would be desirable, but it is difficult to conceive of a justification (again on potential out-put grounds) for holding them below.

Does the Potential for Price Manipulation Matter?

The final aspect of the question has to do with possible dangers from allowing domestic energy prices to fluctuate freely with changes in the price of imported oil when that price may be changed at the whim of OPEC. The alternative would be to establish now a policy that such fluctuations would be held within certain levels.

In responding to this question I am deliberately limiting myself to analyzing effects on energy consumption and production. I am ignoring the possible macroeconomic adjustment effects, the potential social disruption, and the uncertainty costs occasioned by rapid fluctuations in the price of so important an item as energy. These effects must be considered, however, in adopting policy. But they can be addressed as problems per se, and in so doing, the direct effects of allowing or not allowing domestic prices to track world prices must be identified.

In considering whether to adopt now a policy regarding domestic prices vis-a-vis fluctuating OPEC prices, it is well first to recognize that OPEC is unlikely to engage in price manipulation of this sort. Pricing decisions are particularly difficult for any cartel to make, and doubly so for a cartel of sovereign nations whose interests inherently conflict and who find compromise on price difficult. Any change is difficult, and fluctuations in prices would be so fraught with danger to the unity of the cartel as to be almost unthinkable.

Unintended price changes may nonetheless occur, more likely as a result of temporary cartel disarray rather than as deliberate policy. In this event, it would still be in the economic best interest of the United States that its policy be to allow domestic prices to follow the world price.

First, domestic prices that track world prices increase the elasticity of the demand faced by OPEC and in this way lessen its monopoly power and restrict its freedom of action. Consider: if domestic prices are held down by controls, OPEC price increases are met by no additional U.S. production and by only a fraction of the demand reduction that would follow if all energy prices rose. The OPEC price can be raised, therefore, with the oil exporters suffering only a fraction of the reduction in the market that they would otherwise face. Price increases are made more attractive to OPEC. Consider: if domestic prices are held up by a floor, countries which seek to market more oil (and perhaps undercut the cartel) do not get the added sales which would follow if their price declines were fully reflected in increased consumption and lowered domestic production. Price declines are made less attractive to cartel members. Thus vis-a-vis the cartel and the goal of lower real energy costs, the United States is better off if domestic prices fluctuate freely with the replacement cost of energy.

Second, for reasons discussed in the previous section, the potential output of the economy is enhanced when all resources are produced and consumed as if they were priced at their replacement cost.

Third, whatever the policy, if it were decided in the actual event that a particular imported oil price fluctuation should not be followed by domestic price changes, Congress could always respond in a timely fashion. There are no problems sufficiently large and demanding of immediate response that they could not be handled after the fact. In this way, the beneficial effects on the cartel price, outlined in the first point above, could be secured at little cost, and the decision reversed if need be.

Conclusions:

(1) There is no reason on narrow economic grounds for the United States to adopt a policy that holds domestic energy prices below the equilibrium level based on the replacement cost of energy—the landed cost of imported oil plus some insecurity premium.

(2) Similarly, there is no reason that action should be taken ahead of time to prevent those prices from adjusting even to fluctuations in imported oil prices—even deliberately manipulative fluctuations.

(3) But, there do exist equity problems (relating to the distribution of income), adjustment problems (relating to a speedy transition to replacement-cost pricing of energy) and inflation and unemployment problems (associated with rising energy costs and changes in the distribution of income) that demand attention.