Getting Energy Prices Right

Last month Meredith wrote about coal being too cheap and Max wrote about gasoline being too cheap. But what is the right price for energy?

Nobody in recent years has done more to try to answer this question than Ian Parry, a University of Chicago trained economist now at the International Monetary Fund.  Over the last 20 years Parry has written dozens of articles on this topic, including influential work on gasoline taxes, pollution externalities, traffic congestion, and the double dividend.

ianparry

In his latest work, Parry has turned his attention in an ambitious new direction.  Together with a team of IMF researchers, Parry set out to quantify energy externalities for 156 countries.  The result is the aptly-named study, “Getting Energy Prices Right”.  The summary can be accessed for free here, or the entire report can be purchased for $28 here.  Following best practices for open science the team has also made all of the data from the project publicly-available here including all of the information on power plant locations, mortality rates, emissions factors and transport data.

These figures begin to give a sense of the scale of the project.  You want to know local pollution damages from coal in Bangladesh?  They have it. Traffic congestion damages from gasoline in Morocco?  Sure.  Vehicle accident externalities from diesel consumption in Sri Lanka?  Yep.  Previous studies had measured marginal damages for particular energy types and for particular individual countries, but this new work provides comprehensive estimates for the entire planet.

CoalCostsGasolineCosts

The results are fascinating.  Coal is indeed too cheap.  The bars in each figure indicate marginal external damages by externality type. Local pollutant damages from coal vary widely across countries because of differences in population exposure and other factors, but external costs exceed current tax levels everywhere.  Local pollutant impacts are also large enough so that, for most countries, carbon pricing would be welfare improving even if you ignore benefits that accrue to other countries. Meredith blogged about Parry’s related paper on these co-benefits here.

Gasoline and diesel also tend to be too cheap, but the story is more complicated.  Whereas coal and natural gas taxes are low around the world, many countries do have substantial fuels taxes. In fact, according to Parry’s estimates, Germany and the United Kingdom, for example, have taxes that exceed the marginal external damages from gasoline consumption. The United States has a much lower gasoline tax, well-below external damages. This is true even here in California, with our higher-than-average state gasoline tax.

But even more interesting are the countries like Egypt, Indonesia, and Nigeria that have gasoline subsidies rather than taxes. Despite increasing calls for reform, there are about two dozen countries that continue to provide subsidies for gasoline and diesel. In a new Energy Institute working paper available here, I use Parry’s estimates to quantify the external costs of global fuel subsidies. Cheap gasoline leads people to drive more, causing increased vehicle emissions as well as traffic congestion and accidents. Based on conservative assumptions about price elasticities, I find that global fuel subsidies cause $44 billion in external costs annually. This includes $8 billion from carbon dioxide emissions, $7 billion from local pollutants, $12 billion from traffic congestion, and $17 billion from accidents. To put this in some perspective, this $44 billion is about 1/3 the total size of the fuels market in countries that subsidize gasoline and diesel ($128 billion annually).

EX_Top_Ten

This figure shows annual external costs for the top ten countries. The list is dominated by OPEC members, mostly in the Middle East and Northern Africa. Cheap energy has long been a permanent fixture in many of these countries and is often viewed as part of sharing the resource wealth. This approach to redistributing resources is expensive, however. I find that it costs more than $1 in inefficiencies for each $1 that is transferred to consumers. This is very expensive, particularly when alternative approaches exist that could achieve the same distributional goals at much lower cost. Residents of Alaska, for example, receive an annual divided ($2,000 in 2015) derived from oil and gas revenues.

Also interesting is the large degree to which these external costs are driven by traffic congestion and accidents.These externalities are rarely mentioned in policy discussions about fuel subsidies but are quantitatively very important. Riyadh, Caracas, Tehran, and even Kuwait City, are well-known for severe traffic jams, so drivers are imposing a significant negative externality on other drivers in the form of reduced driving speeds. Moreover, a growing literature including Max’s work (here) shows that accident-related externalities are a major component of the external costs from driving.

caracas

Caracas

kuwait

Kuwait City

I’m a big believer in the idea that some number is better than no number. Quantifying the external costs from energy for 156 countries is an incredibly ambitious task that is impossible to get exactly right. Can the IMF numbers be refined and improved? Absolutely. But in striving to assign actual numbers to these externalities, Ian Parry and co-authors have taken a significant step forward. If policymakers are going to make informed decisions they need to be able to weigh the full social benefits and costs of different alternatives.

About Lucas Davis

Lucas Davis is an Associate Professor of Economic Analysis and Policy at the Haas School of Business at the University of California, Berkeley. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.
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23 Responses to Getting Energy Prices Right

  1. Pingback: Getting Energy Prices Right - Berkeley-Haas Insights

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  3. Mark Cooper says:

    The problem with this analysis is that it is not terribly important for sound policy making. Is there an external cost of fuel consumption? Certainly. How large is it? Even if the author is correct, that does not mean that a tax is the best policy. For example, the author finds that the external cost of gasoline in the U.S. is $0.43/gallon. This is the value that has not been priced into the market transaction. Analysis of fuel economy standards for light duty vehicles and medium and heavy duty trucks shows that the failure of market behavior to reflect that value of fuel that should have been priced into the market transaction is abysmal. American transportation fuel consumers are leaving $2.00/gallon on the table by failing to buy the efficiency enhancing technologies they should. There is no reason to believe that an extra $0.43 is going to make a big difference. Minimum efficiency standards and policies to induce technological change are much more important.

    The same is true in the electricity sector, where even 100% renewable scenarios are justified without including external costs. When the market is as profoundly imperfect as energy markets are with respect to efficiency, price is an inferior policy tool. Policy needs to address the underlying imperfections. If it does not, the price burden will either be ineffective, or have to be so heavy as to undermine political support. The price tool should be used carefully and gently, as a complementary policy supporting the more effective transformational policies.

    • mcubedecon says:

      HIgher gasoline prices do lead to increased hybrid and other fuel efficient vehicle sales. I don’t know about your assumptions about how much consumers are leaving on the table. I suspect these are from using your favorite single point assumptions about the future. Recent work has shown that consumers are better forecasters of fuel prices than the “experts.”

      • Mark Cooper says:

        If the efficiency gap were small or of short duration, then this might be a question of measurement error, but it is not. It was identified decades ago, is quite large and has been demonstrated in hundreds, if not thousands of solid, scientific studies.

  4. mcubedecon says:

    This blog lists congestion and accidents as gasoline use externalities. However, if the fleet switched to 100% EVs tomorrow, those externalities would continue to exist. It’s important to distinguish clearly between what’s the real external effect.

    • Lucas Davis says:

      Agreed. Interestingly, California is piloting a new program that would charge drivers a per-kilometer fee.
      This could eventually be used instead of a gasoline tax; would be more efficient for the exact reasons you mention.
      http://www.mercurynews.com/ci_29391190/california-road-use-fee-test-needs-volunteer-drivers

      • Mark Cooper says:

        I am not against price signals, I just want to use them when they can do the most good, without imposing unnecessary harm. For example, feebates that reflect the external value of fuel consumption into the price of the vehicle tend to get attention, because consumers and automakers are first cost sensisitive. Once the technology is embedded in the consumer durable, consumers will save money.

  5. The United States relies upon the gas tax to support highway and road construction via its Highway Trust Fund. Over the past decade, Congress had to top-off the funds several times to prevent the fund’s insolvency. Granted, the study does not seem to take into account the state of roads and bridges, which the American Society of Civil Engineers rated at a D+ and in need of $3.6 trillion by 2020 just for upkeep- but factoring those externalities into the gas price would probably change the implied result that US gas taxes are too high.

  6. As usual, this is an enjoyable debate and a subject of particular interest to me. It might of interest to everybody to know that I attended a presentation given by Ian Parry at a university in the Midwest last night and had an extensive discussion with him afterwards on the subject of CO2 pricing. He made a strong case for a CO2 tax as compared with all other available options. My discussion with Ian afterwards was mainly on the issue of subsidies and as to how the passing of a CO2 tax can actually help address this issue. What was equally interesting were the questions and concerns raised by the audience.
    The first question raised expressed concern as to how the revenues raised will be spent or distributed. Responses varied greatly ranging from the need to distribute the revenues equitably to compensating lower income individuals given the regressive nature of the CO2 tax to whether the political system will be bogged down in discussion over distribution of the revenues.
    Another question asked as to how a CO2 tax would fit with WTO. The consensus was that generally speaking this should not present a problem.
    Another question raised questioned as to whether a CO2 tax can actually be implemented in the US. The general feeling was that the likelihood of a CO2 tax to be passed in the next few years is slim in part as a result of its potential impact on the economy but also the political hurdles passing such a tax would face. Basically everybody agreed that whether such a tax is passed in the next few years would depend on what happens next in follow-up to the Paris meeting.
    A more interesting question probably was in regard to the magnitude of the CO2 tax, the speed by which it should be implemented, and how the economy at large and the fossil fuel industry particularly the oil industry may react. Generally speaking, the audience thought it would be unthinkable that a CO2 tax can be imposed at a level that can meet climate targets given where CO2 taxes are at today worldwide and where they should be based on Ian’s calculations. A gradual increase of CO2 tax that takes its economic impact inconsideration was also deemed ineffective due to the long and protracted path it would take to reach the desired targets.

    • Mark Cooper says:

      I think the results of the analysis reflect the output of a long term model, rather than the impact of specific regulatory policies, which is the level at which I work. The climate change literature strongly supports the proposition that targeting and inducing technological change accelerates the transformation and dramatically cuts is cost (by at least a factor of two). Imposing a tax large enough to accomplish the goal unnecessarily crushes the economy (picking the winners and losers in recycling revenues is just as hard and fraught with risk as picking winners and losers in technology). Transform first, tax second.

      The performance standards literature strongly supports the proposition that the costs of standards are always overestimated in the regulatory analysis and the benefits are underestimated. The gap between economically beneficial investment and market behavior is created by strong and persistent market imperfections that have been well documented in the efficiency gap literature. Again, the best recommendation is transform first.

      The right answer is that transformational policies and taxes are complements. My conclusion is that transformation should take precedence with price the complement.

      Vigorous public policy across a wide range of activities across the entire life cycle of technology (research, finance, standards, behavioral nudges) is essential.. Studies that claim a 6-1 advantage and beat the drum for a tax first, directly and indirectly suggesting that a tax is all you need do, more harm than good, since they feed the ideological and ignorant belief that the market would do the job if the government just got out of the way.

    • Lucas Davis says:

      Anees– Fascinating to hear the questions/concerns raised at the Parry presentation. The whole “marketing” of carbon policy is super interesting. If carbon policy were a new product, how would you sell it to consumers? What would you call it? (perhaps not a “tax”) Which messages/images/arguments would be most effective? How would you use the revenues to best gain support from key constituencies?

      • Mark Cooper says:

        Great question. I argued in a recent paper that there was no acceptable solution a quarter of century ago, when the UN treaty on climate change (that the U.S. ratified) was negotiated because it was impossible to navigate between the horns of the energy dilemma (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2722880)
        the need to continue economic development for the large number of people who have not yet achieved it (which means more energy consumption) and
        the need to decarbonize.
        A quarter of a century of a progressive capitalist revolution has provided us with the tools to achieve both goals. The technological revolution was guided and funded by active state policy and performed best when it supported and unleashed the private sector to refine and deploy the technology the state had helped to create. We need to show (not sell) that the electrification of the transportation and industrial sectors using low carbon, low pollution, low cost electricity, is achievable at very little net increase in economic cost (plus a huge indirect public health and environmental benefit).
        In order to sell that idea,
        we have to force the neoclassical/laissez faire ideologues, who either deny the carbon problem, or insist a tax is all you need, off the stage (exeunt, stage right).
        We also need to force the extremist environmental, degrowthers, who insist growth is impossible, and their anticapitalist allies (who are always looking for the end of capitalism) off the stage (exeunt, stage left).
        The Paris agreement forcefully occupies the center stage. For the third time in a quarter of a millennium, progressive capitalism has produced the tools of its own resurrection. The right is panicked because they could not sell the tax it to death argument and the state continues to play an important role. The enviros and anti-capitalists are not happy because they could not regulate it to death and the market continues to play an important role.

      • Yes, what everybody expected was a challenge to the methodology or questioning of the CO2 cost estimates. The emphasis instead was on the political feasibility of the CO2 tax and how best use the revenues to gain constituents support.

  7. The last three postings here bring forward another key issue of interest. In my view and based on engineering and economic analysis my team conducted in primarily oil producing and developing countries, these countries are at a point where they can benefit from a carbon tax or similar instrument. The reasons are as follows: 1) necessary energy efficiency and utilization technological change and transformation has already taken place and continues to take place and 2) key developing countries such as China, India, and Saudi Arabia are at a critical point to stem high energy consumption growth resulting from growth in income in combination with highly subsidized energy prices. Improved energy saving and conversion technologies and processes are already in place at relatively reduced costs and a successful track record in their application does exist: end-use energy efficient products and appliances, renewable energy, generation technologies, heat recovery, combined cycle, etc. What continues to lag is information exchange, access to financing, and serious upgrade of institutional framework in the developing countries. The developing countries thus can benefit from the application of a CO2 tax at this time. Such a tax will correct the allocative inefficiencies and consumer purchase behavior of durables, impact directly the energy and carbon intensities of these countries, and reduce the runaway energy consumption growth rate in these countries considerably.

  8. Pingback: Our Newest Energy Consumer |

  9. Pingback: Driving Taxes for the 21st Century |

  10. Pingback: notes on self-driving cars – Tools of our Tools

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