Energy spending and household poverty

There is broad agreement that energy, especially polluting energy, is too cheap, calling for higher energy taxes. The problem is that such taxes are believed to be highly regressive, as poor households spend a larger share of their income on energy for transportation, heating and cooling. Of course, this could be alleviated by an appropriate redistribution of the proceeds, but to do this properly one first needs to understand well the energy spending of poor households.

Tooraj Jamasb and Helena Meier do this for the United Kingdom. There, households that spend more than 10% of their income on energy are considered "fuel poor" and deemed as having difficulties heating their home. I have always been suspicious of such definitions, as one may choose to spend more to heat at higher temperatures, for example, without being considered at risk. But this definition may indeed capture a good portion of the households of interest. While Jamasb and Meier find the usual conclusions (fuel poor households are poor, have children or are retired, spend more time at home), they also put high hope in smart meters. By showing current energy consumption, they hope that these meters will trigger behavioral changes and in particular help so far ill-informed households manage better the available energy and look for energy efficiency. As so often, good information goes a long way in managing scarcity.

Does it make sense to subsidize biofuels?

Ina relatively short time, biofuels have become remarkably popular, especially as an additive to regular petroleum based fuel. This is at least in part due to massive subsidies from the US to fuel and corn producers. As biofuels compete with food, this has lead to major price increases for corn and sugar, with adverse consequences for importing countries. This begs the question: is it actually a good idea to subsidize biofuels? I mentioned previously that it is preferable to tax other energy products rather than subsidize alternative energies (1, 2), but let us revisit this issue.

Subhayu Bandyopadhyay, Sumon Bhaumik and Howard Wall use a general equilibrium trade model and confirm that if there is a Pigovian tax on conventional fuels, subsidies are not needed. But if the Pigovian tax is not available or too low (as is the case in the US), then a subsidy for biofuels makes sense, But if the country in question is large, there are other implications through increased worldwide demand for food. In that case, a food exporter wants to subsidize biofuels and tax conventional fuels. A food importing country would only want to subsidize biofuels if the pollution reduction effect is large enough.

Hector Nuñez, Hayri Önal, Madhu Khanna, Xiaoguang Chen and Haixiao Huang look more specifically at the interaction of policies in the US and Brazil, the two largest producers of biofuels. Indeed, the US imposes a special tariff on the importation of biofuels, in particular the more advanced sugarcane based one from Brazil. Brazil is also the largest producer and exporter of beef. The paper uses a multi-country, multi-good model, unfortunately with a partial equilibrium, but it takes into account possible crop rotations and different categories of land. It concludes that eliminating the tariffs would significantly reduce biofuel production in the US, with the latter importing biofuels from Brazil and exporting corn. While this reduces producer welfare compared to the status quo, it increases consumer welfare. Given the political system in the US, guess what will happen.

A driving median voter reduces gas taxes

If you own a car, you are not too happy when gas taxes go up: it is more money out of you pocket, however you benefit from a reduction in congestion and lower pollution as long as this tax increase also implies a reduction in gas consumption. If you do not own a car, you would view positively the increase in gas taxes, as the state can now provide more services or reduce other taxes you may be paying. However, some goods with a high share of transportation costs may be become more expensive. Does this reasoning make sense in a political equilibrium, i.e., is the level of gas taxes determined by whether the median voter is a car driver or not?

Fay Dunkerley, Amihai Glazer and Stef Proost show that it does and figure out that in the OECD a car driving median voter leads to a gas tax that is 20% lower than a walking median voter. Of course any such estimate is fraught with endogeneity: the median voter is walking because the tax is high. To overcome this problem, the authors use a dynamic setup that takes into account when a median voter starts to drive.

Markets under-value fuel economy for new cars

Is it worth it to buy a fuel efficient car? If you ask an economist, he will look at the fuel consumption, the cost of gasoline, and calculate the cost benefit of a fuel efficient car, probably also factoring in a resale value and a discount rate. But a non-economist customer?

David Greene says the literature is really unclear, as customers seem to be under-valuing and over-valuing fuel efficiency depending on how you look at the data. Surveys seem to indicate that car buyers consider a very short horizon for the payback, 1.5 to 2.5 years. That makes it very difficult for fuel efficient cars, hence the need for subsidies, or better taxes on the inefficient cars (see why). But this provides little theoretical insight where car buyers differ from the economist I described above. Greene thinks this has to do with risk aversion about future gasoline prices, or loss aversion (being afraid of having taken a poor decision). But clearly, this requires more research.

Having said this, I am puzzled at how little hybrid cars have been adopted in Europe, in particular compared to the United States. The cost of European gasoline is very significantly higher, and the environmental consciousness is also more pronounced. Is it because the alternatives to hybrid cars, the small fuel efficient sedans, are much better than in the US?

How to manage rents from non-renewable resources

Some countries are blessed with natural resources, although this turns too often into a curse as rent seeking can turn the economy into a corrupt hell-hole. To make things worse, this type of revenue is highly volatile and there is much incentive to extract rapidly with little thought for smoothing income or investing for the future. Hence, international organizations have pushed very hard for a more sensible management of resources incomes, and their advice has been to extract or invest income in a way to obtain a constant permanent income.

Anthony Venables thinks this is not appropriate for developing countries that have pressing needs right now, like poverty alleviation or a shortage of public infrastructure. In addition, one has to realize that sustained growth is not going to come from the public sector, but through private investment. And making private investment worthwhile can be helped by good, but limited government. This Venables thinks that revenue management should put more emphasis on current expenses than future ones, in order to make sure the country get out of a development trap and can continue growing on its own latter, with relying on its resource income.

PS: the paper's abstract was much more intriguing that the paper turned out to be. The reason is that the abstract make promises about the proper management of income from renewable resources, which would seem much less problematic, unless I was missing something.

Privatization-nationalization cycles

The past two decades have seen an impressive wave of privatizations all around the world, especially in utilities and resources. This trend has recently been reversed though, with several large nationalization waves, in particular Latin America. This kind of cycle is not new, as especially the gas industry has gone through several waves each way during the last century. Why all this back and forth?

Roberto Chang, Constantino Hevia and Norman Loayza observe that nationalizations typically happen when the price of the output of reference is high and inequality of wages is also high. The opposite is the case for privatizations. They can explain this with a model of a benevolent government that maximizes a social welfare function represented by the average utility of workers. Under nationalization, all workers are paid the same and exert little effort. Under privatization, firms can discriminate workers, who then put more heart at work, creating wage differentials. When prices for the commodity increase, this generates larger rents for the most productive, and inequality increases.

The story is then of a inequality-efficiency trade-off for the government. In the naturalized state, inequality is low, but so is efficiency. If prices are low, it is more important to increase efficiency, and the firm is privatized. But as it becomes more efficient and discriminates its workers, inequality becomes more important, and the firm is nationalized back. And the cycle continues, with an average of 12 years of privatization and 25 years for nationalization. While this is a very stylized story, after all the model assume an economy with a single sector that has no impact on world prices, it is still a compelling story.

How to solve the Kyoto and Copenhagen climate gridlocks

The Kyoto Protocol to reduce greenhouse emissions has not been widely adopted or followed and the Copenhagen climate summit ended in a fiasco. Why is it that the world community cannot cooperate on an important issue? And even if one doubts about global warning, one has to agree that this is a potentially large issue, and thus at least some coordination is required. People will immediately point out that there is a huge free rider problem, and they are right. As emissions are global, everyone benefits from the efforts of the others but little from one's own. Hence the need for cooperation.

Peter Cramton and Steven Stoft write that this cooperation problem becomes even more difficult depending on what the central coordination mechanism is. The argue that cap-and-trade makes things especially difficult, because it makes objectives of the negotiating parties even more divergent. If the rule of the game is that everybody needs to have individual and binding emission ceilings, then everyone will try harder for low (developed economies) or high (developing ones) emission caps. One solution out of this quagmire is to adopt a global emission ceiling that is enforced through a market-based mechanism, with the sale of pollution permits. We have known for a very long time that prices are very powerful enforcement mechanisms, and in the context of this public-goods game it is even better because it will foster more cooperation in the negotiation of the emission ceiling and lead to an agreement having a better chance of actually happening.

Energy taxes and employment

It seems quite obvious that the United States will have to increase energy taxes, first because energy prices need to better reflect the negative externalities they exert on the economy (pollution, wars, congestion, etc.), and second because the government will need to raise revenue from somewhere. So it is of particular interest to verify what consequence this would have, for example on labor markets. If the cost of an input increases, and it is cheaper elsewhere (or if not, the gap with elsewhere is reduced), one should expect labor demand to be reduced. But how much?

Olivier Deschenes does such an empirical exercise by exploiting the cross-state variation in energy prices and finds a price elasticity of 0.15. Given that the electricity prices are supposed to rise by 4%, a reduction in employment of 0.6% or 460,000 people is inferred. Unfortunately, these estimates cannot be relied on for several reasons. First, estimates are based on employment differences across states due to energy price differences. Imagine that electricity prices increase in Michigan, and this drives some jobs to Wisconsin. This is what this elasticity measures. But when electricity prices increases in all states, cross-state movements of jobs should not happen. They may move abroad, but this is not measured with this procedure, which certainly overestimates the correct elasticity.

Second, these are reduced form estimates that give us very little understanding how various agents in the economy would react to those price changes, especially if they are larger that the one observed in the data. One needs here some structural model to understand what would happen, a model that would, for example, include the industrial structure of each state. Computable general equilibrium (CGE) models have been used extensively for similar exercises, and should be much more reliable than this reduced form (Lucas Critique anyone?). Third, if you do not increase energy prices, it is quite obvious that some other tax will have to increase. An obvious candidate is labor income tax. Now that is certainly going to reduce employment as well, and possibly more than the 0.6% from above. In other words, the energy tax can very well be a lesser evil (on top of reducing pollution).

Some press will pick up this paper and rail against energy taxes. That is most unfortunate.

US households under-estimate gains from fuel efficiency

If you compare the cars sold in Europe and the United States, the US ones are woefully fuel inefficient. And it is striking that even American automakers provide better cars in this respect abroad than at home. Of course, fuel is much more expensive in Europe, so this should not be surprising. But does this difference in fuel efficiency reflect only the price difference?

One clue about this question is given by Hunt Allcott and Jean-Nathan Wozny who use variations in gas prices in the US and look at how this translated in car sales by fuel efficiency. It turns out Americans are only willing to pay $0.61 to reduce gas consumption by $1.00, after controlling for other car characteristics, the expected usage of cars and even how new cars filter through the used car market over time. Are consumers really that dumb? I suspect rather that it is 'uncool' to have an efficient car, something that the data cannot identify. And how do you take care of such an attitude? One way is a paternalistic way, by setting fuel efficiency standards for all cars. Another way would be to tax cars by fuel efficiency, or equivalently tax gas more, in order to get households to increase fuel efficiency to the dollar.

The green paradox

The fear that oil is running out has been replaced by the fear that oil will pollute the life on earth out of existence. In both cases, the countermeasure is to find alternative sources of energy. This alleviates the first fear as it allows to stretch the use of oil over a longer period, one would hope. But what about the second fear?

Reyer Gerlagh makes the observation that things could take a turn for the worse. Indeed, if there is a sufficiently high probability that oil will be replaced by some alternative energy sources in the future, then current suppliers of oil have every incentive to dump all their supply on the market now. Oil consumption would dramatically increase and the pollution problem worsens. The solution, once again, is to tax oil to counter this effect. Americans, this is how you should be financing your health care reform.

Introduce real time electricity pricing?

Prices are a wonderful mechanism to allocate scarse resources, especially as it is a really cheap mechanism compared to command and control. But there are times where the price mechanism is not good enough. Take for example congestion pricing. In principle, charging higher tolls when many people are on the road, or raising public transportation prices during peak times, should entice those who have other options to travel at other times or in other ways, thus reduceing the need to accomodate peek demad with oversized infrastructure. But this is only going to work if consumers are sufficiently price elastic and congestion pricing is not too expensive to implement.

The same reasoning would apply to residential electricity supply. Hunt Allcott studies this and comes to the conclusions that consumers are not sufficently price elastic to justify the additional metering costs. While households react to higher prices in peak periods, they do not adapt during more inexpensive off-peak periods. Thus, their welfare decreased. But seeing how large parts of the world have differentiated pricing for electricity and have remarkably adapted to this, for example with heating systems that accumulate heat in off-peak periods, one has to wonder whether there are multiple equilibria. Uniform pricing with no incentive to start an industry that takes advantage of off-peak periods, and congestion pricing where such an industry is in place. Maybe with some initial costs, a switch to congestion pricing could be worth it in the long run.

Climate change and non-committal governments

As I reported yesterday, gas taxes are the best way to reduce carbon pollution. However, that will only be effective if governments can commit to future gas taxes as well. If they can, investment in energy efficiency will happen in an ... efficient way. If they cannot, energy efficiency is out of the window.

In that case, Alistair and David Ulph study how the policy should be altered. The major consequence is that current governments need to overdo in some way current policy in order to make sure future outcomes are coherent with current wishes. In other words, the potential time inconsistency of public policies makes that current government want to lock in future governments. One way to do this is to invest in green technologies, as obviously the private sector would not do it. This can also be attained with investment credits.

I think this opens a ethical question about current governments deciding for future generations. While it is obvious that you do not want to put future generations in a disadvantage due to current choices, it is less clear that it would be advisable to force the choices of future generations to conform with the preferences of current ones. There is a distinction between solving a commitment problem and forcing the hand of future governments.

Gas taxes are still the best option to reduce CO2 emissions

I have advocated numerous times on this blog that high gas taxes are required in order to take into account the various negative externalities of gas consumption. Yet, in the real world, not only are gas taxes low, other means to reducing gas consumption are applied, such as fuel-efficiency standards and special taxes on gas-guzzlers. How do they really compare.

Rüdiger Pethig looks at combinations of the three and finds that gas taxes dominates them all. The reason is that a gas tax is the closest you can get to a CO2 emissions tax. And to reduce the emissions of CO2, nothing beats the price mechanism. The other two means just increase the price of cars, but do not impact the price of gas, and thus the marginal effect of gas consumption: you just end up driving more and consuming only slightly less gas.

And this without even considering that gas taxes can replace labor distorting labor income taxes, while standards provide no revenue.

Predicting oil prices from interest in electric cars

You have heard or read the public opinion theories that the oil companies are acting like monopolies (i.e., they conspire) to manipulate gas prices. While I have yet to see hard evidence that they collude, I find it troubling that little production capacity has been added despite higher prices. But that could be due to environment regulation, as is credibly claimed.

Jose Azar adds a troubling observation to the debate. He finds that whenever interest in electric cars increases, oil prices happen to decline. And not just a little, half of oil price changes can be explained by the frequency of Google searches about electric cars. But that can also show that markets really work: when there is interest in substitute goods, prices decline.

Again: tax, do not subsidize

I reported previously that if the goal is to improve the environment, one should tax polluters rather than subsidize non-polluters. The reason is that subsidizing increases the use of resources and necessitates taxing something else to generate the income.

David Kelly provides another argument. While a subsidy may improve the environment in the short run, it hurts it in the long run. This has to do with higher interest rates, which lead to over-accumulation of capital and an increase the opportunity cost of the environment. Subtle, and this shows that partial equilibrium analysis can lead you astray.

How to best auction natural resources

It is now well known that many natural resources suffer from the tragedy of the commons: because they are not owned, they are overused and depleted. The solution is for the state to sell rights to them. Those rights were typically set administratively and often with political considerations, thinks of the ultra-low grazing rights on federal lands. But governments can obtain more for the natural resources, not only because it increases revenue, but also because it encourages an efficient use of scarce resources. After all, the market price is still a wonderful signal. Thus auctions come into play. But auctions can go horribly wrong as well, as documented by Paul Klemperer. Every auction is different, and details are important.

Peter Cramton offers a handy guide for the design of efficient natural resource auctions. It focuses on oil and mineral rights in developing economies, but there are lessons to be learned for other auctions as well. There is an incredible array of auction designs, which helps accommodate a multitude of market situations and government goals. So, the next time you have an oil field to sell, you know where to look!

Should we adopt solar energy before it is more efficient than fuel energy?

Renewable energy, and in particular solar energy, is not yet as efficient as the generation of energy from exhaustible sources, such as oil, gas and coal. Yet, because the latter will at some point be exhausted, a switch from the latter to the former will have to happen at some point. Some want to encourage this now, none the least because of the pollution aspect of exhaustible resources, and I have argued before that such encouragement should happen by taxing 'bad' energy instead of subsidizing 'good' energy.

Now imagine that switching is costly, but that switching brings us into a regime where the quality of life grows faster. Then one would not want to switch when the two energy sources are equally efficient, but rather earlier. The main reason is that one wants to exploit the additional growth effect. This is essentially the argument of Simone Valente in a recent paper, using an endogenous growth model.

Of course, this result hinges on the fact that renewable energy leads to stronger growth. As non-renewable energy sources become more scarce, their price increases. But this price is capped by the price of renewable energy. This means that once the price of energy does not increase anymore, or even declines as this renewable energy becomes more efficient, growth can rely more on energy again and not build down energy use due to its scarcity.

Speculators are not the problem

The US Congress has finally found the scapegoat for high oil prices. While most of the increase is due to the fall of the US dollar that will eventually rectify itself, it found speculators to be guilty and intends to rein them in. This is nonsense.

Speculators are regularly vilified because they manage to make money without being apparently productive. Yet, they provide some very important functions on the market: they help hedging against risks, and more importantly, they help prices being informative of true economic conditions. Through their arbitraging, they make sure that goods are properly priced. For example, if an under-supply of oil is expected, they make sure that the price of oil reflects this. This allows producers and consumers to adjust to conditions. If prices would not reflect markets conditions, rationing could appear.

Yet it seems Congress wants exactly that: prices that do not reflect economic conditions. The current proposal is to inhibit the ability of speculators to arbitrage by preventing them to resell (which is at the core of arbitraging) and to deal with foreign markets.

There is no question that whenever markets are manipulated, intervention is necessary. How do you define manipulations? Albert Kyle and S. Viswanathan define a two-pronged test: Price manipulation needs to simultaneously undermine both pricing accuracy and market liquidity. In other words, their is manipulation if prices do not provide signals about economic conditions while there is evidence that someone is preventing trades from happening. Prices could be poor signals in liquid markets, but their is nothing one can do and nobody is benefiting from it. Prices can be accurate in illiquid markets, and that is not a problem. But both happening at the same time is a sign of manipulation.

Are oil prices currently manipulated? Given the size of the market, this is unlikely. But it has happened before, for example when the Hunt brothers manipulated the silver bullion market in 1979-80. At that time, they severely curtailed the liquidity of the market by hoarding. That does not seem to be the case with oil today. Oil markets are very liquid, and prices do reflect a real scarcity in addition to risk.

Note that what Congress proposes would be considered price manipulation, as transactions are prohibited (which lowers market liquidity) and prices likely would not reflect economic conditions (which undermines pricing accuracy). In other words, the proposal would make things worse... But it is responding to the call of doing something, and this is what counts in politics, right?

The Economics of energy subsitution

The increase in oil prices allows nicely to highlight the mechanics of substitution. The increase in the price of most goods lead to a decrease in its use, while increasing the demand for its substitutes. This leads to an increase in the price in the other goods. We have seen this in the past month nicely with increases in electricity and food prices, although these are not pure substitution effects (oil is at least partly an input).

Another substitution effect come form the use of goods that were not used before. In the case of energy, using alternatives like solar energy or windmills becomes more economical, thus creating goods that were not in demand before. But again, this is not a pure substitution effect, because these alternative energy sources have been pushed for other reasons as well, such as pollution reduction.

For automobiles, the rise of hybrid cars is a substitution effect, although they still use some gas. What about a car that does not use energy from oil at all? Enter the AirCar, which simply runs on compressed air. The concept is ten years old, but was not economical until now (except for some cars running in Spain). Tata Motors, the major Indian car manufacturer now announced it will start producing a car based on this concept in August 2008. The MiniCAT will have a range of 300km for a maximum speed of 105km/h, the refill will come to $2.00 at a station, and an emergency compressor can be plugged into a socket to refill as well.

Note that this car does not use the air pressure per se, but rather the thermodynamic effect when you change the pressure and the volume of the air. The emissions are thus only very cold air, which can be used for air conditioning...

Energy policy: taxing or subsidizing?

How should one encourage to use of alternative energy sources? There are essentially two market based means: subsidizing the good sources, and taxing the bad ones. So what would be optimal to do?

Essentially, the goal is to create a price wedge between good and bad, so that consumers are encouraged to choose more frequently good energy sources. So at first sight, taxing or subsidizing does not make a difference. However, subsidizing has several drawbacks. First, as the average price of energy decreases, the overall use of energy increases, which may be an unintended consequence. Second, the subsidy must be financed with some other revenue, which is typically through some distortionary taxation that generates a deadweight loss.

Thus: tax fossil fuels, do not subsidize renewable energies. Use the revenue to offset distortionary taxes.