Energy, Security, and Climate

Three months ago gas taxes were untouchable. Now, with oil prices down, they’re having a moment. Public voices from Larry Summers to Charles Krauthammer are calling for hikes. (Summers argues for a carbon tax; Krauthammer says the tax should be raised “a lot”.) More important, serious lawmakers from both sides of the aisle have gotten in on the game. The general thrust of the arguments on offer is that with oil prices falling, it’s now possible to raise the gas tax and still leave consumers better off than they were half a year ago. That right, but I think there’s an even stronger argument to be made. The standard argument is basically a political case about what voters will tolerate. (The theory is that they’ll tolerate a higher gas tax if they’re still better off than before.) It’s then paired with preexisting economic logic (a higher gasoline tax made economic sense when oil prices were higher too). This is essentially the pattern I flagged in a Financial Times column in November, when I argued that falling oil prices were creating an opportunity for leaders in developing countries to curb gasoline and diesel subsidies. But there is an economic case that’s peculiar to the current situation to be made too. Whenever you impose a new and unanticipated tax, some part of the existing capital stock becomes less valuable than it was before. (Some other part typically becomes more valuable, but if market participants were rational before, this downside should be smaller than the upside.) Adding, say, fifty cents to a gallon of gasoline makes pre-existing gas guzzlers, homes in the suburbs, and oil-based home heating systems worth less than before. Normally, that would reduce the net benefits of any new gasoline tax, particularly one phased in quickly. Conversely, when oil prices fall, fuel efficient cars, homes in city-centers, and public transit investments all drop in value. This can lead to economic waste: underused automobiles, unrented homes, empty subways. A particularly glaring example came on Wednesday when President Obama visited a Ford plant that makes fuel-efficient vehicles: because of the drop in oil prices, that plant was closed, wasting both the factory and the skills of the workers that it would have employed. In this world, a newly higher gasoline tax would actually avoid economic waste rather than creating it. Ford and others that invested money on the expectation that oil prices would remain relatively high (and, if options prices on oil futures as recently as six months ago are any indication, that means most businesses) would see their investments hold more value. The same goes for drivers who, facing higher oil prices, already spent their money on ever-more-fuel-efficient cars. (They’d still pay more at the pump, but the resale value of their cars would rise.) One can go down the list of oil-sensitive consumers and find more examples like this. Similar logic underpinned proposals from Robert Lawrence and from Jason Bordoff and Gilbert Metcalf several years ago for a variable gas tax that smoothed consumer prices (up when oil prices fell; down when they rose): it would allow consumers to better prepare for the future and would thus avoid economic waste. No one is talking about a variable tax now, but by hiking gas taxes while oil prices have fallen, lawmakers would be manually mimicking the mechanisms that these analysts proposed be made automatic. To be certain, there would still be losers as well as winners from raising the gasoline tax now. But almost everyone would come out ahead compared to where they were a year ago, and many would be even better off than they were with low gas prices but without the gas tax. Not everyone fits in one of those two categories – in particular, there is nothing here that’s good for oil companies, who would face less demand for their product over time. (Though combined oil and gas companies could make money on the other side from buildings that switch from oil to gas heating.) But that was always the case with any gasoline tax, and less important than many other policy decisions to the oil companies’ bottom lines. It has always made economic sense to make consumers pay for the full costs of the gasoline they use. There have also always been legitimate worries about the impact of higher gas taxes on vulnerable consumers, but those can be addressed by using the proceeds of a tax effectively. The fall in oil prices just adds to the reasons for getting U.S. energy prices right.

The 114th Congress is in session and the Keystone XL pipeline is at the top of its docket. Senate Republicans have vowed to push the pipeline through and President Obama has threatened to veto any bill that does that. After five years of battle, this is mostly more of the same. But one thing about the world has changed radically since the Keystone XL pipeline became a top tier issue: oil prices have plunged. So what do lower oil prices mean for the costs and benefits of the Keystone XL pipeline? Expert discussion has been focused on the State Department Environmental Impact Statement (SEIS). This is more relevant to political handicapping than to actual cost-benefit analysis, but it’s still worth digging into. The SEIS concluded that the pipeline would probably have no “substantial impact” on greenhouse gas emissions. This seemed to line up with President Obama’s statement that he would only approve the pipeline if it did not “significantly exacerbate” climate change. But the SEIS claimed that there was one exception: if oil prices were between $65 and $75, the Keystone XL pipeline could make a significant difference, tipping the economics of Canadian oil production from red to black and thus increasing emissions. Hence the political hook. Indeed as oil prices fell below $75 late last year, I began getting calls from reporters asking if this was a game changer for Keystone. Once oil dropped below $65, the calls stopped. The $65-$75 range was never particularly compelling in the first place. No matter what the prevailing price of oil, if you reduce the cost of transporting it, you will improve project economics, and, at the margin, you should expect oil companies to produce more. How much more is impossible to confidently predict. Among other things, the breakeven price for Canadian oil will likely move with the oil price and with transport costs: if nudging transport costs a little when oil costs $70 a barrel really does threaten to shut in a large amount of Canadian oil, there’s a good chance that the Alberta government will try to blunt the impact through changes in tax and royalty treatment. On top of all that, of course, is the fact that oil is no longer trading between $65 and $75, and no one knows when it next will. It’s much more interesting to ask how lower oil prices affect the costs and benefits of approving the pipeline. As a starting point, it’s important to stipulate that no one really knows where the long-run oil price will settle. And it’s the long-run price, not the current one, which matters when you’re talking about the consequences of a pipeline that has the potential to operate for decades. So let’s focus on what “lower” oil prices mean for Keystone XL rather than what any particular prices does. Lower oil prices reduce both the costs and the benefits of approving the Keystone XL pipeline by reducing the odds that it will ever be fully used. There’s an outside chance that, if prices are sustained at an extremely low level, the Keystone XL pipeline won’t get built. That scenario isn’t likely – among other things, if Canadian production doesn’t grow, the odds of sustained low prices decline substantially – but it’s not zero. Lower prices also raise the odds that the pipeline will be built but not fully utilized. In that case, you still get the up-front construction stimulus, but you get less benefit from greater oil production, and less climate damage from the same. You also have a waste of economic resources. The more likely scenario, though, is that the Keystone XL pipeline gets built and used. In that case, lower oil prices reduce its economic benefits without any clear impact on its climate costs. If you assume a constant elasticity of oil demand, then a given addition to world oil production should push down prices by the same percentage, regardless of what the starting point is. Imagine you think that the Keystone pipeline would boost net world oil production by 100,000 barrels of oil a day and you believe that would cut world oil prices by 0.3 percent. If prevailing oil prices start at $100, you’re cutting them by 30 cents; if they start at $50, you’re reducing them by only 15 cents. In both cases the marginal reduction in oil prices saves Americans money through reduced import costs and reduced absolute price volatility. (There is one countervailing force – at lower oil prices, U.S. imports are higher, and therefore a given reduction in oil prices yields more economic benefit – but this shouldn’t fully offset the main economic effect.) The upshot is that, in the lower oil price world, any savings from Keystone XL are reduced. What about the climate impact? For a given net impact of Keystone XL on world oil production, the climate damages should be unchanged – the impact is a fixed function of how much extra oil is produced in Canada and how much additional oil is consumed worldwide. So whatever you think the excess of benefits over costs is for Keystone at $100 a barrel oil (and many people, of course, think that “excess” is negative), you ought to think that it’s smaller when prevailing oil prices are reduced. Keystone XL, like any oil production project, is less compelling when prices are lower. What about the absolute impact on both economics and climate? This is much more difficult to pin down. The absolute impact of Keystone XL on both depends on how other producers respond in the long run to any additional production that it enables – that’s what determines the net impact on world production and consumption. How that changes depending on the prevailing oil price is unclear. Nailing that down would require knowledge of global oil supply economics, as well as oil producer politics, that no one confidently has. What hasn’t changed is that both the climate damages and the economic benefits from Keystone XL are small in the grand schemes of climate change and the U.S. and global economies. A Keystone XL decision will have much larger consequences for U.S. politics, U.S.-Canada relations, and perhaps the broader rules-based global trading system than it will for climate change or the economy – and that’s where serious decision-makers ought to mostly focus. Lower oil prices haven’t changed any of that.