Energy efficiency is a tough sell- Even when it is “free”!

Almost two weeks into the New Year, how are those resolutions going? Every year, my long list of resolutions includes several tasks I should be doing but have trouble finding time for, like going to the dentist and installing roof insulation (we have none).

It’s January 12 and I’ve already lost motivation to chase any of these to-dos off my list. I find it all too easy to ignore these low-dopamine tasks when something more pressing (or more fun) attracts my attention.

    But wait! This guy makes installing attic insulation look like fun for the whole family!
Source: http://go.hfcu.org/blog/topic/mass-save-financing

Take the insulation example. Everyone says that home energy efficiency improvements are good for us. An insulation upgrade reduces energy costs, reduce emissions (if emissions are not subject to a binding cap), and can make winters cozier.  But ask me if I want to spend my Saturday researching the recommended R-value for insulation in my climate zone, and I will come up with a long list of things that are more exhilarating.

Given limited time, motivation, and cognitive capacity, we all have to choose what we pay attention to and what information we act on. In a new E2e Project working paper, my co-authors and I document just how hard it can be to get people to pursue privately beneficial energy efficiency improvements.

Rational inattention?

Economists are increasingly interested in the idea that people possess a finite capacity to process – let alone act on- the information they receive. In the world of energy efficiency, this has some interesting implications.

Jim Sallee notes in a recent paper that “rational inattention” could help explain the apparent  gap between the  investments people make in efficiency improvements and the investments that are privately cost effective. The existence of this gap is largely predicated on cost-benefit analyses, including the famous McKinsey reports, that do not account for the “process costs” of implementing these improvements. If the additional time, hassle, and cognitive effort could be accounted for, the gap would surely look narrower.

This begs the question: how important are these hassle costs in determining the level of energy efficiency investment?

Energy efficiency is a tough sell… even when it is “free”

Co-authors (Michael Greenstone and Catherine Wolfram) and I are working on a study that examines, among other things, the role of information and process costs in households’ decision to pursue efficiency improvements.

We analyze participation in the Federal Weatherization Assistance Program (WAP), which aims to reduce the energy burden of low-income Americans by installing energy efficiency measures in their homes. Homeowners stand to benefit significantly from reduced energy bills. Importantly, all hardware and installation costs (averaging around $5000 per household in our study) are paid for by the Federal government.

Although households incur no direct monetary costs to participate, the process of applying for weatherization is onerous and time intensive. We ran a large field experiment in which we significantly reduced information and process costs for a random subset of presumptively eligible households.

Households assigned to our “encouraged” group were inundated with information about the program.  In addition, households were offered extensive personal assistance with completing their application.

To get the word out about both the program and our enrollment assistance, our field staff knocked on 7,000 doors, launched  23,500 targeted “robo-calls”, and mailed thousands of post cards. Once a household signaled interest, our staff would schedule a meeting to assist with the application materials. Over the course of more than 2,700 personal meetings and 9,000 phone calls, our staff worked with households to navigate the application process.

The graph below shows the impact of our efforts to reduce information and process-related barriers to weatherization.

This graph makes two important points.

First, it documents surprisingly low take-up of this substantive (and “free”)  energy efficiency retrofit, even among households that have been informed-  via multiple channels-  about the sizable benefits.  The figure shows that the application rate in our encouraged group is less than 15 percent (up from 2 percent among households that did not receive our encouragement and assistance).

Second, the graph shows an underwhelming response to our overwhelming encouragement efforts. The rate at which households took up the efficiency improvement increased by only 5 percentage points as a result of our encouragement.  In other words, a lot of effort to encourage a relatively small number of efficiency retrofits.

It is important to keep in mind that our intervention eliminated some – but by no means all – of the time and effort required to participate in the program. Households in the treatment group had to actively decide to participate, engage with our staff, meet with contractors, endure the hassle of having a construction team working in their home, etc. One interpretation of these findings is that these remaining hassle and effort costs exceeded the expected benefits from weatherization for a majority of households.

Not worth the hassle?

Our study suggests that non-monetary costs incurred to implement an efficiency retrofit are significant and can be prohibitive. Of course, we should be very cautious about drawing general conclusions from this specific context. For one thing, the importance of process costs is likely to vary across efficiency improvements (surely changing a light bulb requires fewer cognitive resources!).

When it comes to more involved efficiency retrofits, however, these two qualitative findings generalize to my own experience.  In my house, the hassle/time/attention costs of making these kinds of home energy efficiency improvements have been prohibitive. And frankly, it will take a serious nudge to draw my attention away from my other going concerns (parenting, economics, Season 5 of Downton Abbey) up to the bare rafters of my roof.

On this blog, the need for accurate, field-based estimates of returns on energy efficiency investments has been emphasized. But there is also real value in accounting for hard-to-account, non-monetary costs. Taken together, accurate and comprehensive measures of benefits and costs can help policy makers identify the biggest negawatt for their nudge.

Raise the Gas Tax

On January 1^st, California’s cap-and-trade program was expanded to include gasoline and diesel.  Allowance prices are currently $12.58/ton (link), so this increases gasoline prices by $0.10 per gallon and increases diesel prices by about $0.13 per gallon (Severin’s post goes through this calculation). Like Jim and Severin, I strongly support this expansion, and believe this is a necessary step if California is going to follow through on its commitment to reduce carbon dioxide emissions. In fact, I’d like to see much higher gasoline and diesel taxes.

Total motor fuel taxes in California are now almost $0.75 per gallon (here). This may seem high, but gasoline and diesel are unlike most other goods that we consume.  Why? Because of externalities.  When we drive we impose a long list of negative externalities on others. Economic efficiency requires that prices reflect both private and external costs and the easiest way to achieve this is with motor fuel taxes.

So how high should gasoline and diesel taxes be?  Economists have been thinking about this for a long time.  Ten years ago the consensus was that the United States should have a tax of about $1.00 per gallon (see e.g., here). But this number has been creeping upward steadily and recent studies put the optimal motor vehicle fuel tax for the U.S. closer to $2.00 per gallon.

The latest study to get a lot of attention on this topic is the International Monetary Fund’s aptly-named report “Getting Energy Prices Right” (here). The study takes on the ambitious task of quantifying energy externalities for over 150 countries. For the United States, they come up with $1.60 per gallon for gasoline, and $2.10 per gallon for diesel.

Why is this so high? Let’s start with carbon dioxide. Burning gasoline emits .008 tons of carbon dioxide per gallon. Views about the external cost of carbon dioxide emissions vary widely, but most recent estimates are considerably higher than current allowance prices under AB-32.  For example, the value currently used by the U.S. federal government is $39 per ton (here). This is more than 3 times current allowance prices under AB-32 and corresponds to a tax of $0.31 per gallon for gasoline and $0.40 per gallon for diesel.

And this is just the beginning. Many economists believe that traffic congestion is the most significant negative externality from driving. When you drive, you impose a negative externality on other drivers in the form of reduced driving speeds. Based on available estimates in the literature, the International Monetary Fund concludes that this externality is a whopping $0.85 per gallon for gasoline in the United States. This is about twice as high as estimates from one decade ago, in part because the value of peoples’ time has gone up.

Perhaps even more important is traffic accidents. Our own Max Auffhammer has done innovative research on this topic (here) together with our UC Berkeley colleague Michael Anderson, finding that drivers impose accident-related costs of almost $1.00 per gallon on other drivers. This works both through miles driven and vehicle weight, which they show has a significant impact on the probability that there is a fatality when accidents occur. Interestingly, Auffhammer and Anderson also show that SUVs and trucks are more dangerous than cars, even after controlling for vehicle weight.

There are other externalities too.  I haven’t mentioned road damage costs or emissions of nitrogen oxides, VOCs, and other local air pollutants.  I haven’t tried to argue that gasoline consumption raises national security concerns by making us dependent on oil-exporting countries. Nor have I talked about how gasoline and diesel taxes would be more efficient than CAFE standards for increasing the fuel efficiency of the fleet.

One could envision more direct approaches for taxing some of these externalities. An efficient congestion tax, for example, would charge people more for driving at 5pm than at 2am. We are beginning to do some of this, for example, with “time-of-use” bridge tolls, but it seems unlikely that anytime soon we will see real-time location-based congestion taxes. Same can be said for more direct taxes aimed at accident externalities, e.g., based on miles traveled, vehicle weight, and other vehicle characteristics. With these more direct approaches out of reach for the moment, gasoline and diesel taxes make sense.

Taxing gasoline and diesel is also a much better way to raise government revenue than taxing wages.  Gasoline has even been shown to be a complement with leisure, i.e., people like to drive around when they aren’t working, which means that a gas tax actually helps undo some of the disincentive to work caused by taxing wages. Economists Sarah West and Rob Williams (here) find that this “cross-elasticity” is large enough to matter in practice.

So the $0.10 increase this week is a great step in the right direction. No question.  But let’s all join the “Pigou Club” and support higher gasoline and diesel taxes. With gasoline prices at their lowest levels in years and the economy turning the corner, now would be a great time to put through a significant tax increase.

Maybe it’s not all just about dollars and cents

I am a pretty hardcore neoclassical economist. I do think that people generally try and make themselves as happy as possible given budgetary and other physical constraints. I do think firms try to maximize profits. I do believe that smart government policy can correct market failures (e.g. negative externalities like pollution, inadequate provision of public goods, asymmetric information). I do believe that markets are an incredible way to allocate scarce resources.

Underlying this belief system is an assumption that participants in markets have easy access to reliable information about pretty much everything. This is clearly not true in many settings, but when it comes to bigger purchases individuals tend to go to great lengths to gather as much information about possible alternative options. So when it came to buying a new car, I tried to channel my inner Zettelmeyer/Knittel and got every piece of information I could find on hybrid, Diesel, and plugin hybrid vehicles in my price range. I test drove all of them. I had spreadsheets that took into account basic things like the number of miles driven, depreciation, fuel cost, changes in electric rates, length of average trip taken etc., etc.

I settled on the Ford C-Max Plug-in hybrid. Even though I complained that even under reasonable increases in gas prices the plugin had similar if not worse costs per mile, the subsidies were just too good. Even if I did not plug it in, I would not be worse off than had I bought the regular hybrid.

Now it’s a month later and my neoclassical soul is deeply in love. It’s got nothing to do with my a priori dollars and cents calculations. Here is what I have learned:

• I literally feel like I am a better person driving down the road. If I dim my configurable cabin lighting, and squint my eyes, I can see my own halo. Watch me snicker at those earth crushing SUVs and their clearly non-haloed drivers.
• My Teutonic road rage tendencies have disappeared. Why? My car is so quiet. At the traffic light, all I hear is some quiet Schubert oozing out of the speakers reaching for my halo. And while I am driving, the absence of that Rambo-esque roar from my former turbo engine lowers my testosterone levels by a lot.
• I am no longer maximizing quarter mile speed on the on ramp. I am trying to squeeze every last mile out of that battery pack in the back. Those AB32 covered kWhs I pumped in there better last all the way to Berkeley.
• My kid loves (un)plugging the car every day. It makes me feel like I am investing in a future generation’s appreciation for low carbon transport. OK, maybe I am taking this a bit too far.
• I don’t spend time at gas stations. The weekly trip has turned into a monthly trip. That will surely diminish my Snickers consumption as well.

So while I could squeeze all of the above into some fancy economic model, which involves learning by using, this did not enter my financial calculations that made me choose this car. I would like to end 2014 by saying that I sometimes tend to take the net present value calculations a card carrying neoclassical economist is supposed to base every decision on a bit too seriously. I may just use 2015 to go and live a little. Who knows, maybe I’ll even install some solar PV on my roof (which actually might be the right decision purely based on a NPV calculation).

I wish all of you a very good start into 2015 and we will see you back here next year. There are many exciting developments in the world of energy and we will blog about them right here!

Good Energy Reading for the Beach?

I used to spend the week between Christmas and New Year’s Eve with my in-laws in Portland, OR. A couple years ago, it snowed for two days straight, and the city shut down. My brother-in-law has taken it upon himself to find a warm-weather holiday destination for the family ever since.

As I head for the beach, I’d love guidance on good reading material. For starters, below are a couple books I’ve come across or that colleagues have recommended.

1. The Boom: How Fracking Ignited the American Energy Revolution and Changed the World, by Russell Gold. I’ve gotten a lot of endorsements for this. Colleagues claim it is very well written and a thorough treatment of fracking, including technological, environmental, economic and social aspects. Gold is an energy reporter for the Wall Street Journal.

2. Unreal City: Las Vegas, Black Mesa, and the Fate of the West, by Judith Nies. My husband just finished this – kind of the energy version of the movie Chinatown (which I’ve watched, so won’t be downloading for the trip – I recommend it if you have not seen it). It describes the politics and business deals that unlocked 21 billion tons of coal on the Navajo and Hopi Reservations to bring electricity to Las Vegas, Phoenix and Los Angeles.

3. The Boy Who Harnessed the Wind: Creating Currents of Electricity and Hope, by William Kamkwamba. This is an autobiographical story about a boy in Malawi who built a windmill from scratch to bring energy to his village. He is discovered by NGOs and reporters and eventually invited to do a neat TED talk/interview. Again, multiple recommendations for this.

4. The Bet: Paul Ehrlich, Julian Simon, and Our Gamble over Earth’s Future, by Paul Sabin. This uses a famous bet between two academics over the future path of prices for five raw materials to examine the resource catastrophe movement of the 1970s and 1980s. Severin Borenstein describes it as, “essential context for understanding the climate change debate today, both the similarities and the critical differences.”

5. Why Nations Fail: The Origins of Power, Prosperity, and Poverty, by Daron Acemoglu and James Robinson. This is not an energy book (the power in the title is a synonym for “might” on the world stage), but I had to put it on the list as Lucas Davis pointed out that some of their best evidence comes from comparing electricity/lighting use between S. and N. Korea. I love world-at-night pictures, and this one is impressive.

6. Waiting for the Electricity: A Novel, by Christina Nichol. This is the only entry in the fiction category, but I am a sucker for fiction with an energy theme. The Wall Street Journal included it on their best books of 2014 list (though maybe this is like taking stock tips from the New York Review of Books…?)

Any thoughts, loyal blog readers? If you’ve read these books, which would you recommend? Any others to add to the list?

I debated adding The Prize, by Daniel Yergin, but (a) I’m the lone holdout in my family and don’t own a Kindle, so I can’t imagine lugging that to the beach, and (b) I have read parts of it already.

Happy Holidays!

On the meaning of existence

Here at the EI blog, we don’t shy away from addressing the deep questions in energy and environmental economics. With this week’s blog, we tackle the very meaning of existence (with respect to power plants regulated under proposed greenhouse gas emissions standards).

Source (Rodin) ; Source (power plant)

The graph below helps set the stage by summarizing the increasing role of natural gas fueled power plants in the power sector.  The bars indicate EIA projections of new investment in electricity generating capacity (by fuel type) in the United States through 2040. After 2020, the EIA projects that natural gas will account for over 70 percent of new investment.

Source: AEO2014 Reference case from 2013 to 2040

Importantly, these EIA reference case projections do not reflect recently proposed greenhouse gas standards for power plants.  Whereas new source performance standards are not expected to materially affect new investment decisions, the proposed Clean Power Plan, a centerpiece of Obama’s climate change policy agenda, could heighten the role of new investment in natural gas fired generation.

The extent to which new gas capacity investment is affected by these standards depends in part on the meaning of “existence.” The Clean Power Plan sets emissions standards for existing sources.  Digging into the Regulatory Impact Analysis, an existing source is defined as:

“A fossil fuel-fired electricity generating unit that was in operation or had commenced construction as of January 8, 2014.” 

This means that a natural gas plant that breaks ground today and starts generating electricity (and emissions) in 2015 will not actually “exist” in the eyes of the EPA for the purpose of administering these existing source standards.  This non-existence factor has potentially significant implications for future investments in new natural gas capacity.

New investments under existing source standards

To think intuitively about how the proposed emissions standards for existing sources could affect the decision to invest in new natural gas generation, let’s review some basic mechanics of the rule.

Under the proposed Clean Power Plan, the EPA has defined state-specific emissions standards in terms of a ratio that can be summarized approximately as the CO2 emissions from sources covered by the rule divided by the sum of electricity generated at covered sources plus energy saved via demand-side efficiency improvements:

Note that electricity and emissions generated at a “new” fossil plant do not factor directly into the rate calculation above.[1]  In fact, investing in new, relatively clean natural gas generation will reduce the emissions intensity of a state’s electricity generation if it displaces production at more emissions intensive plants.  By excluding new fossil generation from the rate-based standards that define compliance, the effect of new gas investment on emissions intensity is not fully captured.

The punch-line: The rate-based standard defined above lowers the incentive to invest in new, relatively clean natural gas plants as a means of reducing emissions (versus a standard that covers both new and incumbent sources).

Things get more interesting when you consider that, under the proposed Clean Power Plan, states have the ability to convert their rate-based standard into a mass-based cap on emissions from existing sources. In this scenario, any electricity produced at a new source will not count against the emissions cap.  In contrast to the rate-based standard, excluding new capacity from a mass-based standard exaggerates incentives to invest in new natural gas generation because it allows a state to move electricity generation – and emissions – out from under the emissions cap.

An existential problem worth worrying about?

It is relatively straightforward to think about how a rate-based (or mass-based) standard could distort investments in new gas generation under the proposed rule. It is not so straightforward to assess the extent to which these incentives might actually affect real-world investment decisions.

Enter Dream Team Bushnell/Holland/Hughes/Knittel (aka BHHK)

In a recent – and impressive! – working paper, BHHK analyze, among other things, the potential effects of the Clean Power Plan (CPP) on power sector operations in the Western United States.

The authors develop a model of electricity production that they calibrate using data from the western interconnection and the emissions standards proposed in the CPP. They use the model to simulate investment in new combined cycle gas turbines under alternative policy scenarios. The results are striking.

In a scenario in which all states adopt a mass-based standard, excluding new fossil capacity investments from the regulation almost doubles the amount of new natural gas capacity due to the distorting investment incentive discussed above.  Conversely, under a rate-based scheme, new investment is reduced by 20 percent when new gas capacity is excluded (versus included) from the regulation.

Perhaps more concerning, these distortions are greatly exacerbated under a highly plausible scenario in which some states adopt a rate-based standard while others convert to a mass-based target.  In this scenario, new investment will occur in the rate-based regions if it is included under the CPP, but shifts dramatically to mass-based regions if excluded from the rule.

Should we redefine the meaning of existing?

What can be done to mitigate the extent to which the proposed policy distorts investment incentives?  Here is where things get murky for someone without a law degree.

Take, for example, the Clean Power Plan scenario most preferred by many economists in which all states adopt a mass-based standard.  In this case, it is clearly preferable to bring both new and existing sources under the regulation in order to eliminate the incentive to over-invest in new, uncapped natural gas capacity.  This could be achieved explicitly by redefining “existing” to mean any plant that physically exists.  Or it could be achieved implicitly by requiring states to offset any emissions from new sources at “existing” sources.

This seems like a simple fix. But there is much ambiguity and nuance surrounding EPA’s ability to expand the scope of existing source standards (implicitly or explicitly). Different legal scholars seem to have different opinions about what is/is not possible under the auspices of the Clean Air Act.

Presumably, the rationale for keeping new source regulations distinctly separate from existing source standards is to avoid redundancy and unnecessary overlap in regulatory requirements. In this case, subjecting new sources to both new and existing source standards is not redundant. New source standards ensure any new plants that are built will meet mandated performance standards. But the level and location of this new capacity investment will depend on how these investments are factored into compliance with existing source standards. These are long-lived investments, so getting the incentives right (or wrong!) will have lasting implications.

 

 

 

 

[1] The indirect effect of new investment on the emissions rate used to determine compliance will depend on the relative emissions intensity of any “existing” generation that is displaced by the new capacity.

What’s a University to do about Climate Change?

About a year ago, I blogged about the fossil fuel divestment movement at universities, arguing that it is unlikely to have any effect, and that even if it did it would be to raise fuel prices, which we could do more directly with a carbon tax.  I said that those of us at the University of California (and other top universities) should fight climate change by researching the science and policy changes that could make a real difference.

In the last year, I’ve changed my mind.  Not on divestment, but on what a university can do.  I owe my enlightenment to Frank Wolak, my colleague, friend and sometimes co-author at that other top university in the bay area that I will not name.  Frank wrote an excellent op-ed for the Los Angeles Times last May and has since co-authored a longer policy paper, both arguing that university action against climate change should start at home, with a campus carbon tax.  All expenditures by campus units would be assessed a tax based on the GHG emissions associated with whatever they are buying or activity they are supporting.  Of course, that raises issues like how large the tax should be and who should get the money, which I return to below.

Two decades of U.C. Berkeley’s Greenhouse Gas Emissions                                              Source: http://sustainability.berkeley.edu/climate

The idea is brilliant.  First, it avoids the hypocritical appearance of the divestment movement, marking fossil fuel producers as evil polluters while happily continuing to consume their product.  Second, it puts real incentives in place to reduce GHG emissions and sets a price against which reduction strategies can be compared.  Third, and probably most valuable, it makes the campus grapple with all the difficult real-world issues that come with trying to implement cost-effective national or global policy for carbon reduction.  In doing so, it creates teachable moments that could fill many courses and inter-disciplinary research projects.

The standard knock on divestment is that it is pure symbolism, with no real effect on oil or coal companies. But in an important way, I think it may be worse than that.  The symbolism is likely to be counter-productive if the divesting university takes no broad-based action to reduce its own carbon footprint. To an outsider it may sound like “Shame on fossil fuel companies for producing their products. Oh, and we have no credible plan to reduce our dependence on those fuels.”  I’m among the many – at least from the reactions to divestment I’ve read– who thinks that divestment is just cheap talk, because it requires no sacrifice by the divesting organization.

Estimates of U.C. Berkeley’s 2012 carbon footprint                                                                    Source: http://sustainability.berkeley.edu/climate

The analogy to the South Africa divestment movement is inapt in many ways, but in any case the South Africa divestment movement was accompanied by a boycott of South African goods.

A campus carbon tax skips the moral judgment distraction and gets right to demonstrating a plan for change, a market mechanism that rewards reductions in GHG emissions.  By putting a price on emissions, it also confronts a reality that is too often sidestepped: reducing emissions is costly, and not all strategies for reduction are worthwhile.  If you work on climate change issues at a university, you have seen plenty of shiny campus plans for alternative energy or energy efficiency that are never clear on the cost per ton of emissions reduction.  A campus carbon tax would set a marker and naturally point the analysis towards cost effectiveness.

U.C. Berkeley’s Combined Heat and Power Plant.  More information (and source of this photo) at: http://files.harc.edu/sites/gulfcoastchp/ProjectProfiles/UCBerkeley.pdf

Finally, the complexity of instituting a campus carbon tax is actually its strength.  The campus – and countless student seminars and senior theses – would confront the challenges of real-world issues in GHG reduction:

• What GHG emissions count? Just emissions on campus or also from upstream? How far upstream?
• Practically, how will GHG emissions be measured? This is a particular challenge for the upstream emissions for goods and services coming from places with no GHG monitoring.
• Does the tax just cover GHGs from fossil fuels? What about agricultural products?
• How big should the tax be? A starting point might be California’s cap-and-trade price around $12/ton or the U.S. government’s estimate of the “social cost of carbon” (i.e.,  GHG emissions), which is now commonly cited as $37/ton.   In any case, a lively debate on the right tax level would be educational for all.
• Should a unit on campus be allowed to buy offsets in order to reduce its tax liability? How would the campus determine if the offsets really reduce world GHGs (i.e., are really additional)?
• Some departments or faculty are more carbon-intensive than others, perhaps due to different energy usage (a chemistry lab versus English literature research) or different travel needs (an international diplomacy scholar versus a professor who focuses on the local urban economy). Should there be some compensation for those hit hardest by the tax?  How to design that compensation without distorting incentives to reduce?
• What should be done with the tax revenues? Should they be redistributed to all faculty research funds on a per-capita basis, or used for scholarships or tuition reduction, or invested in energy efficiency and alternative energy projects?
• How would this affect the competitiveness of the university? Would it make it harder to excel in energy-intensive fields?  Would it help make the school a leader in alternative energy research?  Would it strengthen the school’s brand?

The beauty is that these are the same issues that come up in any broad-based scheme for GHG reduction whether at the city, county, state or national level.  Doing it at the campus level would bring a deeper understanding of the challenge that we face in reducing GHGs and could lead to new insights about how to overcome those challenges.  Students coming out of such an experience would be far more prepared to work in the companies, governments and non-governmental organizations that are grappling with climate change policy within all the constraints of the real world.

Though Frank Wolak proposed the campus carbon tax, Stanford shows no signs of adopting it, though Yale, Harvard and MIT, among others, are discussing it.  Stanford divested its (practically non-existent) coal investments last year and there was a lot of back-patting, that is, until it came out that they are deepening investment in oil and natural gas.

It is time for U.C. Berkeley to adopt its traditional leadership role on environmental issues and get ahead of other universities on the campus carbon tax.  Just the process of establishing and implementing the tax would be an immense learning experience for students, staff, faculty and administrators.  And it would show that we take climate change so seriously that we are willing to adopt Stanford’s best ideas to address it.

Goin’ for Broke in Texas…Protecting the Environment without Slowing Economic Growth

U.S. crude oil production has reached almost 9 million barrels per day, driven by enormous production increases in the Permian, Eagle Ford, and Bakken formations. This is one of the biggest oil booms in history and it is fueling economic growth and providing tremendous benefits to the U.S. economy.

At the same time, however, this growth raises important questions about environmental risks. Setting aside climate concerns, the challenge for policymakers is how to encourage the continued development of these valuable resources while ensuring environmentally safe drilling and production. This is no easy task, but as Judson Boomhower shows in a new Energy Institute at Haas working paper (available here), making producers more accountable for environmental damages can help balance these different objectives.

As the paper explains, there is a moral hazard problem that can lead oil and gas producers to take too many risks. Bankruptcy protection insulates small companies from worst-case outcomes by limiting their liability to their current assets. In addition, some types of environmental damage, like groundwater contamination, may take years to be detected. At that point, small producers may no longer exist or have the resources to finance cleanups or compensation.

So how do producers respond to these incentives? In “Drilling Like There’s No Tomorrow” Boomhower uses a formal economic model to show that in markets like this we should expect to see a large number of small and medium-sized firms. By staying small, producers can limit their liability. The business plan is pretty simple. You produce as much oil and gas as you can and then, if a serious environmental accident occurs, you go bankrupt. (This New York Times article from a few days ago includes a couple of vivid examples.) Sounds kind of cynical, but this is exactly what you would expect given the way bankruptcy protection works.

Boomhower then shows how much this incentive problem matters in Texas onshore oil and gas production. The market is surprisingly unconcentrated. There is a group of larger firms that produces a substantial share of total output. But there are also thousands of small and medium-sized producers. These are companies few of us have ever heard of, most of which have relatively few assets that can be used to pay for environmental damages. In fact, many are unable to pay even the relatively modest expenses associated with “plugging” a well after production has been completed, to say nothing of the much higher costs of surface- and groundwater pollution events.

Texas introduced legislation in 1991 and 2001 aimed at reducing the bankruptcy problem. Essentially, these policies required producers to post bonds.  Most producers complied by buying a “surety bond” from an insurer.  In exchange for annual premiums, the insurer agrees to pay for environmental liabilities left over if the producer goes bankrupt. Bonding requirements are commonplace in the oil and gas industry (but there is little direct evidence on their effectiveness).  From no bonding before 1991, Texas now has some of the stricter bonding requirements in the U.S.

What happened? High-risk producers found that they faced very high bond premiums, just like  unsafe drivers face high auto insurance premiums. This meant that many higher-risk producers were no longer profitable.  Hundreds of producers exited the market immediately. Both in 1991 and again in 2001, you see in the figure below a significant spike in exit that corresponds exactly to when the new requirements were being rolled out across firms.

Although this is a large number of producers, the exiting firms tended to be small and unproductive. In addition, 88% of the oil and gas leases owned by these exiting firms were transferred to larger firms that had better safety incentives. Consequently, total oil and gas production in the market was essentially unaffected by the new requirements.

The exiting firms represented only a small share of the market, but they were responsible for a disproportionate share of total environmental damages.  Boomhower documents significant improvement in several environmental outcomes. After the bonding requirements are imposed, you see fewer violations of water protection rules, fewer blowouts, and fewer unplugged wells.

Boomhower’s paper shows that well-designed regulations can protect the environment without slowing economic growth. This is important, particularly given the enormous recent increase in U.S. oil and natural gas production. Several states are considering new environmental regulations, but there is a glaring lack of evidence on whether and how regulation creates the right safety incentives for producers. This research is directly on point for those discussions. Moreover, this is one of the first economic studies, in any market, to convincingly show how bankruptcy protection can distort industry structure.