Chapter 4 Dynamic Efficiency: Oil and Other Depletable Energy Resources: Part B Peter M. Schwarz Professor of Economics and Associate, Energy Production and Infrastructure Center (EPIC), UNC Charlotte

Outline Part B Introduction Dynamic Efficiency Competition Monopoly Other Factors Sustainability Risk of 21

Monopoly (1) Recall that monopoly may be the conservationist’s best friend. But in a dynamic framework, competitive firms have a built-in incentive to conserve. Perfect competition results in efficient conservation Assuming no other market failures Pollution Using “too high” a discount rate Monopolists over-conserve. of 21

Monopoly (2): Example 3 Gazprom is the sole supplier of natural gas to Finland. The company has remaining reserves of 100,000 cubic meters of natural gas. The company must sell its reserves today or one year from now. Marginal extraction cost = 0. Demand is P = 180 - 1Q, where Q is in thousands of cubic meters. Discount rate is 10%. How much should Gazprom sell in each period? Compare to the competitive outcome, and the DWL. of 21

Monopoly (3): Example 3 (cont.) Profit maximization MR = MC Since MC = 0 MR0 = PV (MR1) Equimarginal Principle P = 180-1Q MR = 180 –2Q MR0 = 180 –2Q0 = PV (MR1) = (180 –2Q1)/1.1 Q0 + Q1 = 100 (thousand cu m). of 21

Monopoly (4): Example 3 (cont.) MR0 = 180 –2Q0 = PV(MR1 ) = (180 –2(100 - Q0))/1.1. Solving Q0 = 51.9 thousand cu m (and P0 = $128.10). In turn, Q1 = 100 – 51.9 thousand cu m = 48.1 tcm (and P1 = $131.90). Note that Hotelling’s Rule no longer applies. P - MC rises by less than the discount rate between t = 0 and t = 1. Inefficient. Monopoly over-conserves. of 21

Monopoly (5): Example 3 (cont.) Case Q0 (tcm) Q1 (tcm) P0 ($/tcm) P1 CS ($) PS ($) SW (S) Monopoly 51.9 48.1 128.1 132 2,297.65 12,420.39 14,718.04 Compet’n. 56.2 43.8 123.8 136.2 2,451.24 12,381.34 14,832.58 Notes: Bolded figures highlight expected findings. Table 1: A Comparison of Results for Monopoly and Competition for the Two-Period Dynamic Model. Monopolist over-conserves. of 21

Other Factors (1): Change in Demand Demand grows at g = r. Competitive Outcome Produce equal amount in each period. If g > r, leave more for the future If g < r, more will be produced today. P0 = (a – b Q0) = PV (P1) = ((a – b Q1) (1 + g))/ (1 + r). If g = r, right-hand terms cancel and (a – b Q0) = (a – b Q1) Q0 = Q1 Sustainable of 21

Other Factors (2): Increase in Total Reserves Move towards static case Output in each period higher Price in each period lower. of 21

Other Factors (3): Change in Technology Decreases MC of extraction. MC = 2Q replaced by MC = Q. Increases today’s production. Leaves less for the future of 21

Other Factors (4): Backstop Technology Renewable fuel available if price of conventional fuel gets high enough Perfectly elastic supply High fixed cost Zero marginal cost Example: Biofuel available at $40 per unit of oil-equivalent. In initial competitive example: P0 = $38.10, P1 = $41.90 (PV = $38.10). Now, period 1 price is $40 (PV = 36.36). So more production is shifted towards the present until P0 = $36.36. Q0 = 5.455 (an increase from 5.238 when there was no backstop technology available in period 1). That leaves Q1 = 4.545 barrels of oil for the future. Since demand at next year’s price of $40 is 5.455, biofuel will equal 0.91 oil-equivalent units. of 21

Figure 4.4 Effect of Backstop Technology on Dynamic Equilibrium Backstop quantity of 21

Other Factors (5): Change in Interest Rate The higher the discount rate, the less we leave for the future. Efficient outcome, as long as we use the socially efficient discount rate Firms use cost of borrowing Can make argument that social discount rate (s) = rate of growth in real GDP ≈ 3%. If r > s, we will over-discount the future. of 21

Sustainability (1) Discounting generally leaves less for the future than we consume today. Revisit the question: Should we spend $10 million today to redesign car engines to emit less carbon, worth $50 million 50 years from now? of 21

Sustainability (2) Future Value Interest Rate (%) Present Value $50,000,000 0% 5% $18,844,474 10% $7,432,181 Yes, at interest rate of 0% or 5%. No, at interest rate of 10% of 21

Sustainability (3) Sustainability advocates call for a 0% interest rate. Then why lend or save money? And would the future be better off if we invested the proceeds In education (Texas) In a social security pension system (like Norway) In a bank, and let the future decide how to spend it? of 21

Sustainability (4) And does it make sense to slow our rate of growth to help future generations? Redistributes income from today’s citizens Including today’s poor. Future generations typically will be better off than the present. And may actually leave the future with fewer resources. Suppose we slow today’s growth from 3% to 2% Rule of 72. It will take 36 years, instead of 24, for income to double. of 21

Managing Energy Price Volatility(1) Energy markets can be highly volatile. Fluctuating prices Oil, natural gas and wholesale electricity markets are among the most volatile markets. Derivatives market Derived from the underlying commodity, such as oil. Derivatives allow you to lock in a price today for future delivery of 21

Managing Energy Price Volatility(II) Southwest Airlines Example Today’s jet fuel price is $2/gallon. Southwest Airlines wishes to protect itself against a rise in price six months from now. How? It can buy a contract that will offer to deliver oil six months from now at $2 a gallon. The seller will charge a premium to cover the risk that gas may be higher in the future. of 21

Managing Energy Price Volatility(III) Hedgers vs. Speculators Southwest Airlines is hedging Goal is to reduce price uncertainty Not to earn a profit on the contract The seller of the contract is speculating Makes money if the price of oil in six months is lower Still gets today’s price of $2 Of course, if oil price is higher in 6 months, speculator loses. of 21

Managing Energy Price Volatility(IV) Speculators unpopular with the government Accused of causing price spikes like in June 2008. Economists believe speculators increase efficiency And reduce price volatility If speculators guess right, they buy when P is low and sell when P is high. So they drive up low prices, but drive down high prices Thus reducing P volatility. More on oil derivatives in Chapter 5 on Oil. of 21