Energy and Climate Policy

Ashley Feng is a research associate for China Studies at the Council on Foreign Relations. Sagatom Saha is a Fulbright researcher studying energy reform. The future of transportation will be electric vehicles (EV). As battery costs come down and countries turn away from internal combustion engine vehicles, the most aggressive outlooks see EVs making up one-third of the global car fleet by 2040. Given the pressing need to decarbonize the global transportation sector, this seems like positive news. However, China, the emerging market leader, would stifle innovation if given the chance to dominate. Without competition from inventive American firms, the impending EV revolution would be one that slows the industry and speeds climate change in the long run. If Chinese innovation in the EV market is at all similar to its role in the solar panel industry, the world will only see “good enough” innovation; because there is no competition or pressing problem to stimulate technological breakthroughs, China will settle for minimum advances in EVs. For the past decade, China has identified new energy vehicles (NEVs), which includes electric vehicles, as a strategic and emerging industry, unlocking strong financial and political support from top leadership. Recent trends have demonstrated Beijing will not shy away from using the law to force non-defense related companies to transfer technology or store their data on Chinese servers. In 2013, Kawasaki, a Japanese company, found itself competing against its own designs abroad when CSR Sifang, its former partner in China, used transferred technology to export Japanese-designed high-speed rails to new markets in Europe. For foreign automakers to do business in China, they must have a joint venture with a domestic company as majority owner. The Chinese government also requires automakers to incorporate NEV technologies in their electric vehicles if they have them. Due to these stringent requirements, foreign companies end up forfeiting their intellectual property to Chinese competitors they are forced to work with, boosting domestic Chinese industry and harming their own bottom lines in the long run. Despite this, foreign companies have quickly realized that China is the hottest market for EVs and are still willing to compete there at any cost. Ford, the quintessential American automaker, is exploring developing its new line of electric cars in China, which would then be exported to America. Through leveraging its market size and government-directed economy, China is looking to lead the EV market. By poaching critical technologies and forcing joint ventures, China has leapfrogged to become the world’s second-largest producer in a fraction of the time it took foreign competitors to develop their products. The bad news is this situation will only result in incremental improvements that will not ultimately benefit the environment. Chinese companies are widely known for dumping products to create monopolies and bankrupt competitors, creating an uncompetitive environment in which China could fashion itself as a leader with little merit. While this practice is unproductive across the board, it could be truly damaging in the energy sector. Imagine a world where leading companies only improve marginally on cost and performance. Incremental progress will not sufficiently combat climate change. The U.S. needs to expand funding for research and development of new, innovative vehicle technologies, as government support is crucial to the commercialization of EVs and nearly all energy technologies, often defraying the upfront cost before mass-market viability. The Trump administration has correctly identified the danger that America’s unbalanced trade relationship with China poses to national security and should fight for fair market access for automakers in China. Even under unfair conditions, the U.S. still managed to export $8.9 billion worth of cars in 2016, indicating latent Chinese demand. Congress and the administration should work together to codify and fund the next generation of infrastructure needs, pouring financial support behind charging stations around the country to incentivize domestic EV sales. The U.S. has sustained economic growth through promoting fair and open markets, prioritizing R&D, and investing in national infrastructure. U.S. policymakers should now lead the transformation of America’s transportation sector, lest they leave the next generation in the Beijing’s hands. This piece originally appeared in Fortune.

Last week, the journal Nature Energy published an article from scholars at the Stockholm Environment Institute arguing that the tax breaks given to oil companies by the U.S. government could lead to carbon emissions that eat up 1 percent of the world’s remaining “carbon budget.” (The carbon budget is scientists’ best guess of how much more carbon dioxide the world can emit while still having a chance of limiting global warming to 2°C.) This is an enormous figure—few other national policies reach that level of climate impact. So, if true, this analysis provides a powerful argument in favor of ending preferential tax treatment for U.S. oil and gas firms (see Vox’s piece for an accessible discussion). But that conclusion flies in the face of the conclusion reached by a paper published here at the Council on Foreign Relations by energy economist Gilbert Metcalf. His paper concluded that tax breaks for oil companies modestly increase U.S. oil production, but, more importantly, global prices for and consumption of oil barely budge as a result, minimally affecting the climate. (The paper came to a similar conclusion about the climate impacts of tax breaks for U.S. natural gas production.) I was closely involved in the review and editing process for that paper, and I can attest that Professor Metcalf’s methodology was rigorously stress-tested. So who’s right? In a nutshell, I stand by the CFR paper’s conclusion that federal tax breaks for oil and gas companies aren’t a major contributor to climate change. The biggest reason is that both the Nature Energy and CFR papers are in agreement that the tax breaks barely alter global oil prices, which implies insignificant changes in global consumption of, and emissions from, oil. In fact, the Nature Energy authors do not dispute this, and they only explicitly say that tax breaks cause emissions from burning U.S. oil to increase. But their omission that those tax breaks likely cause emissions from burning other countries’ oil to decrease can easily mislead a casual reader to assume that they mean global emissions will increase as much as emissions from burning U.S. oil will.  The two papers also have some other quantitative disagreements, and the Nature Energy paper might have more up-to-date industry data than the CFR paper. Nevertheless, I don’t think those other disagreements justify overturning the CFR paper’s overall conclusion about the limited climate effects of the tax breaks. Finally, the two papers do agree on one thing: the tax breaks should go. The Nature Energy paper contends that ending the tax breaks would bring “substantial climate benefits.” Although the CFR paper concludes that emissions “would not change substantially,” the two papers agree that tax reform has symbolic value that would strengthen U.S. climate leadership; U.S. taxpayers would also benefit from a few billion dollars annually of recouped government revenue from oil companies. Back to Basics The two papers are in agreement that there are three major tax breaks that oil companies get from the federal government that promote more U.S. oil production. The first allows firms to immediately expense “intangible drilling costs” (IDCs), which account for the majority of drilling costs, rather than deducting them from their taxable income over several years. The second tax break, percentage depletion, allows some oil companies to deduct a fixed percentage of their taxable income as costs rather than deducting the value of their reserves as they are depleted. And the third tax break allows oil companies to write off a percentage of their income through the domestic manufacturing deduction. Together, these three tax breaks amount to around $4 billion in foregone government revenue annually. (The Nature Energy paper considers several other tax breaks but concludes that these three are the important ones.) Both papers then set out to quantify how much more oil U.S. firms produce as a result of the tax breaks. In general, the two papers go about this in a similar way. The Nature Energy paper uses real industry data on U.S. shale oil fields to calculate which fields are profitable to produce oil from with the tax breaks but aren’t worth drilling without those breaks. And the CFR paper uses a new theoretical tool along with empirical statistics to find the percentage of wells that tax breaks make profitable to drill. But the two papers differ in their bottom-line conclusions. The Nature Energy paper rings the alarm bells by concluding that the total amount of oil in the fields that tax breaks turn from unprofitable to profitable is between 13 and 37 percent of the total amount of profitable oil (depending on where oil prices are between $75 and $50 per barrel; higher prices mean that less oil becomes economic to produce as a result of tax breaks—see figure 1). As a result, the authors conclude, if all of the oil in the fields turned profitable by tax breaks were produced by 2050 (and burned), the world would emit 6–7 gigatons of carbon dioxide, roughly 1 percent of the remaining carbon budget. Figure 1: Nature Energy paper summary figure: “The impact of subsidies is highly sensitive to oil price. These charts shows how much oil is economic at price levels between US$30 and US$100 per barrel according to whether it is already producing; discovered and economic without subsidies; discovered and economic only because of subsidies (‘subsidy-dependent’); or not yet discovered. a, Results at the base, 10% discount rate. b, Results at an alternative discount rate of 15%. The subsidy-dependence of the not-yet-discovered fields was not assessed, as these quantities are speculative, based on Rystad Energy’s assessment. Still, should they prove as subsidy-dependent as the fields we do assess, the impact of subsidies at higher prices would be larger than we currently estimate.” The CFR paper finds that 9 percent of the wells that oil companies drill each year are induced by tax breaks. But most of the additional oil that the U.S. produces will be offset by reduced production elsewhere in the world. After using a simple model of global oil supply and demand, the paper concludes that increased U.S. production translates only to at most a 1 percent decrease in global oil prices, and a measly half a percent increase in global consumption of oil (see table 2, which projects the oil market impacts of taking away tax breaks). Such a small uptick is washed out by the ordinary volatility of oil prices and resulting changes in consumption. So the CFR paper concludes that the nearly-undetectable change in global oil consumption means that the climate effects of U.S. tax breaks are negligible. Table 2: CFR paper summary table: “Table 2 presents the modeled equilibrium values of global oil price, supply, and demand in 2030. The first column lays out four ways that the global market could develop: two future oil price possibilities considered by the Energy Information Agency (EIA), and within each of those cases, the two scenarios for OPEC to be price-responsive or exhibit cartel behavior to maintain its market share. Within each of these four alternatives for how global markets might behave, the second column presents two options for domestic policy: the United States can maintain existing tax preferences (baseline), or it can repeal the three major preferences. The tax reform is assumed to shift the domestic oil supply curve by 5 percent. The remaining columns in table 2 report the equilibrium Brent oil price—the benchmark for most of the world’s oil—in 2012 dollars; supply, in million barrels of oil per day (mbd) from the United States, OPEC, and the rest of the world (ROW); and global demand. Table 2 shows that the long-run effects of U.S. tax reform are minimal under a wide range of input assumptions for how the future oil market behaves. The highlighted figures demonstrate that global prices and demand change by up to 1 percent, and U.S. production changes by less than 5 percent, regardless of the assumptions of future oil prices and how OPEC will respond. Although these changes are greater than those projected by previous studies, they are still small. An oil price increase of up to 1 percent would be over three hundred times smaller than price spikes in the 1970s and ten times smaller than the average annual increase in oil prices from 2009 to 2014. It would raise domestic gasoline prices by at most two pennies per gallon at the pump." I don’t think the Nature Energy paper makes any explicit errors, but I do think it’s written in a misleading way. The paper has a supplementary section in which it also runs a simple global oil supply and demand model, which produces a similarly small price change (a 2 percent increase) in response to U.S. tax breaks as the CFR paper reports. What the Nature Energy paper is really concluding is that tax breaks to U.S. oil companies increase the slice of the global emissions pie that is attributable to U.S. oil being burned, but they don’t commensurately increase the size of that pie. Remaining Quibbles Between the Papers Still, there is some legitimate disagreement between the papers even before running a global supply-and-demand model, suggesting that the CFR paper’s estimate of oil market impacts might have been understated. The Nature Energy paper finds that tax breaks convert 13–37 percent of reserves from uneconomic to economic to extract. It uses actual data on the size and extraction cost of reserves in different shale oil plays to make this conclusion, and the article implies that U.S. production could actually increase by 13–37 percent in the long run as a result of the tax breaks. By contrast, the CFR paper’s estimate of the long-run increase in U.S. supply is much smaller—less than 5 percent. As explained above, the CFR paper first finds that tax breaks account for 9 percent of domestic drilling. Then, the paper further diminishes its estimate of the impact of tax breaks. The difference between drilling rate and long-run supply arises because the CFR paper uses industry data to conclude that the fields that the tax breaks turn from uneconomic to economic to drill are smaller than the average field. Therefore, even though the tax breaks account for 9 percent of the new wells, those smaller wells produce less than 5 percent of U.S. oil supply. The CFR paper does use industry data—including a constant estimate of the elasticity of drilling with respect to price and a regression of well initial production against profitability—but my read is that the Nature Energy paper’s dataset might be more up-to-date. (There are a few other disagreements in assumptions, such as whether the hurdle rate for new investments is 10 or 15 percent and whether the future oil price will be closer to $50 or $75 per barrel. The Nature Energy paper, however, is careful to run a sensitivity analysis and copy the CFR paper’s assumptions to enable comparison.) As a result, the CFR paper’s estimate of the increase in U.S. supply as a result of tax breaks—less than 5 percent—might be a bit of a lowball. In some sense we are comparing apples and oranges by comparing the CFR paper’s estimate of annual U.S. production attributable to tax breaks to the Nature Energy paper’s estimate of total reserves converted from uneconomic to economic. But there is some reason to believe that the effect of tax breaks might be to induce greater than 5 percent of U.S. oil production. Even if that is true, however, it is unlikely that tax breaks materially affect global consumption of oil, mediated through price changes, because the United States accounts for less than 15 percent of global production. Therefore, the conclusion of the CFR paper—that tax breaks to the oil and gas industry are immaterial to climate change in terms of directly induced emissions—probably stands. That doesn’t mean the tax breaks are a good idea. In fact, both papers argue forcefully that the tax breaks should be abolished, at the very least because the United States in doing so can demonstrate leadership in the G20 and other forums where it urges other countries to eliminate fossil fuel subsidies. The effects of those subsidies, on a global scale rather than a national scale, are in fact material to climate change. The world would be better off if they were sharply curtailed.

This guest post was written by Lindsay Iversen, associate director of climate and resources at the Council on Foreign Relations. In the week since Donald Trump’s election, the energy and environment community has struggled to come to grips with candidate Trump’s positions on climate change and energy policy—positions that were not deeply explored during the campaign or raised by the moderators in any of the debates. If enacted, the policies Trump has proposed will reverberate beyond American borders, with potentially serious ramifications for U.S. leadership in other foreign policy realms. President-Elect Trump has made clear that he does not believe climate change is a serious—or indeed even a real—phenomenon, calling it a “hoax,” a “very, very expensive form of tax,” and a “money-making industry.” His America-First Energy Plan reflects this belief. In it, he pledges to end U.S. participation in the Paris climate deal, cancel all U.S. payments to United Nations climate change programs, rescind the Clean Power Plan (President Barack Obama’s signature emissions reduction policy), shore up the U.S. coal industry, open federal lands to fossil fuel exploration, and back expansions of U.S. energy infrastructure, including authorizing the Keystone pipeline. Many of these policies were sufficiently important to the candidate to make their way into his plan for his first one hundred days in office. The United States has been the central actor in international climate diplomacy for the past thirty years. Where it has exercised leadership—in securing consensus around the 1987 Montreal Protocol controlling ozone-destroying gases, or the 2015 Paris climate accord—it has been easier to galvanize international cooperation. Where the United States has hung back—failing to ratify the Kyoto agreement, for example—entire accords have collapsed. It is far from clear that any other country could successfully assume the United States’ central position in climate policy. China, the world’s largest carbon emitter, has criticized Trump for threatening the Paris deal and signaled that it will seek a leadership role in international climate diplomacy. Next year’s Clean Energy and Mission Innovation Ministerials (Obama administration initiatives to convene major economies to ramp up investment in clean energy technologies) will take place in China.  And its intensive efforts to develop and deploy affordable solar and wind technologies put China in a strong position to lead by example. China’s willingness to step up abroad is at least in part a reflection of the intense domestic political pressure driving Beijing to clean up its heavily polluted air and water at home. But it is also a reflection of China’s careful but increasingly overt drive to expand its influence and diplomatic power to a level commensurate with its economic heft. It remains to be seen, however, how leadership in climate diplomacy would square with the other elements of China’s international agenda. Beijing has in recent years been criticized for its mercantilist relationships with natural resource suppliers in Africa, illegal island-building in the South China Sea, and territorial spats with several critical neighbors. It has also, Paris agreement aside, demonstrated that its main domestic goal remains economic growth and political stability; local officials have been caught falsifying air quality data in major Chinese cities to meet environmental standards without sacrificing economic performance. In other words, China may be willing to take the lead in international climate diplomacy, but that is no guarantee that other countries will follow. Mitigating carbon emissions, meanwhile, is only half the puzzle. Countries are already grappling with the need to adapt to climate change, and with how to pay for it. Small island states such as Kiribati command attention because of their near-existential plight, but abnormal climate conditions have caused serious damage from the Arctic to Louisiana and beyond. The agenda for the 2016 UN climate summit in Marrakech included, among other things, setting up a financing mechanism to help poor countries adapt to the expected effects of climate change in the next few decades. Many were already skeptical that countries would be able to mobilize the $100 billion per year of public and private funding they pledged in Paris. It does not seem likely that cash-strapped Europe will be willing or able to take up the slack if the United States ends its climate financing, as Trump has promised to do, or have the diplomatic clout to induce China, India, Brazil, or other major emerging economies to contribute. If that is the case, the assistance will simply not materialize, leaving millions of impoverished people to face their fate alone. Abdicating leadership in mitigation and adaptation, finally, will have ripple effects that extend far beyond international climate policy. If the United States demonstrates that it will not fulfill its commitments in one realm, countries will have little reason to trust its word in others—and indeed, Candidate Trump gave no indication that climate agreements would be the only ones under threat. The Iran nuclear deal, trade agreements, and even core military alliances could all be on the chopping block. Trust and leadership are fragile things. National reputations built over the course of generations can be demolished astonishingly quickly through careless and destructive stewardship. Will Trump pull back from his campaign rhetoric and maintain faith with the United States’ international partners? Climate change policy may prove to be the canary in the coal mine.

This post is co-authored by Sagatom Saha, research associate for energy and U.S. foreign policy at the Council on Foreign Relations. When policymakers mandate adoption of a particular technology, they run the risk that the technology may not yet exist or is too expensive for consumers. Similarly, when the government funds research, development, and demonstration (RD&D) of new technologies, it can’t be sure that any advances it underwrites will get picked up by the private sector and successfully taken to market. Even if the government pursues both activities separately—“pulling” technologies into the market through mandates or standards and “pushing” the development of new technologies through RD&D funding—these risks don’t go away. But the strategy embodied in the Obama administration’s recent push to clean up emissions from large vehicles could address both of these risks in one fell swoop. Last month, the administration released new rules limiting emissions from heavy-duty vehicles like vans, trucks, tractors, and buses. Alongside the standards, it also announced $140 million in new funding for innovative technologies to improve the efficiency of both light and heavy vehicles. Pairing these pull- and push-policies has already proven effective at making sure the right technologies are developed to achieve ambitious standards. This strategy could work to commercialize other energy technologies as well. Indeed, tight coordination of push and pull policies is a staple in other fields, like defense and global health, and should be applied more broadly to energy innovation. That will be tougher politically, however, requiring institutions to cooperate in ways that weren’t envisioned when they were set up. Who’s A-Freight of Efficiency Standards? Under the recent Obama administration standards issued by the Environmental Protection Agency (EPA), heavy trucks must reduce their carbon emissions by 25 percent. Although these vehicles only account for 5 percent of vehicles on the highway, they guzzle 20 percent of the fuel. And because carbon emissions from the transportation sector recently overtook those from the power sector, curbing heavy truck emissions could be crucial to meeting U.S. obligations under the Paris Agreement to reduce its emissions by 26–28 percent by 2025. Although the administration can’t guarantee that manufacturers will be able to meet the mandate, it has strong evidence suggesting they will. Under the Supertruck I program from 2010 to 2015, the Department of Energy funded truck manufacturers and suppliers to improve trucks’ “freight efficiency,” or the amount of freight hauled per gallon of fuel used. All but one manufacturer successfully beat the target of a 50 percent increase in freight efficiency over that of 2009 trucks (the last firm is expected to meet the goal this year). Moving forward, the administration believes manufacturers can match the previous improvement so that the freight efficiency of trucks in 2021 is 100 percent higher than those in 2009. But not only is the administration betting that manufacturers are capable of meeting the new standards—they’re supplying resources to ensure they do. Along with pulling up vehicle performance through regulatory emission standards, the administration is pushing technology improvements through the newly announced Supertruck II program, which will spend $80 million on RD&D programs. The program will aim to build on its predecessor’s progress in commercializing technologies like lighter materials, more aerodynamic designs, and lower-resistance tires. Together, the standards and RD&D funding compose a coordinated push-pull approach that has a better chance of succeeding than either component alone. And we’ve seen examples of orphaned push or pull policies for clean energy before. For example, in 2007 Congress enacted the Renewable Fuels Standard, a pull policy that set mandates more than a decade into the future for the quantities of advanced biofuels that oil refineries would need to blend into gasoline. But few manufacturers have been able to make such advanced fuels, so the federal government is forced to relax the standards year after year. And a memorable example of a failed push policy is the notorious Synthetic Fuels Corporation, into which the federal government poured billions of dollars but cancelled when falling oil prices erased any market demand for oil substitutes. Together, these examples demonstrate that push without pull, or vice versa, can doom policies promoting technological change. Finally, a push-pull approach could overcome political barriers that obstruct pull approaches in particular. When it came time to create the heavy truck standards, the Obama administration had already provided RD&D funding to manufacturers and suppliers like Freightliner and Cummins; these firms were then willing participants in helping set ambitious but achievable efficiency standards. Contrast this collegiality to the simmering tensions between the administration and the auto industry as the two sides spar over the future of light-duty vehicle fuel economy (CAFE) standards. Perhaps a compromise to maintain stringent CAFE standards, paired with additional RD&D support for automakers to meet them, would be mutually acceptable. Extending the Pipeline In their book, Technological Change in Legacy Sectors, Chuck Weiss and Bill Bonvillian argue that the military has adeptly combined push and pull policies, creating an “extended pipeline” to fund innovation from basic research all the way through commercial deployment. For example, institutions like the Defense Advanced Research Projects Agency (DARPA) funded the development of drone prototypes and precision strike capabilities, and the military services later procured these technologies at the other end of the pipeline. Despite some bureaucratic wrinkles, this model worked well to identify a need, specify a desired technology, and acquire the resulting product to guarantee a market to private sector partners. More recently, the U.S. Navy collaborated with the DOE and the Department of Agriculture to create an extended pipeline for advanced biofuels to run military ships and planes--the partnership includes funding for biorefineries to produce military-spec fuels that (presumably) the Navy will then procure. Elsewhere in the global health field, coordination of push and pull policies is common. Indeed, Doctors Without Borders has expanded this paradigm to develop drugs to fight tuberculosis, coining a “Push, Pull, and Pool” model. As before, this model would provide RD&D “push” funding, and it would “pull” new drugs by offering a prize or advanced commitment to purchase a substantial quantity upon development of an effective and affordable drug. On top of this, to be eligible for funding or prizes, private firms would have to agree to submit their chemical discoveries into a pool to enable collaborative research and technology licensing. These models hold lessons for clean energy, and the Obama administration’s coordinated clean truck policies are a step in the right direction. But broadening this approach will require some heavy institutional lifting. Currently, energy R&D is funded in the United States largely by the National Science Foundation (NSF) and the DOE. Demonstration—the middle of the extended pipeline—is funded somewhat haphazardly by DOE. And then deployment standards and support emanate from various other agencies (for example, the National Highway Traffic and Safety Administration (NHTSA) and EPA set light-duty vehicle fuel economy standards). Getting all of these organizations to coordinate with one another is a tall order, and in the long run an institutional reorganization akin to what the United Kingdom undertook in recent decades may be necessary. In the meantime, President Obama has left his successor with a modest but effective blueprint to push and pull energy innovation at the same time.