Punitive Measures Ineffective in the Energy Sector

By Tim Sklar | September 08, 2008
The prospect of increasing crude oil prices and $4- to $5-per gallon gasoline has consumers and politicians lashing out. U.S. politicians have singled out scapegoats for high oil, gasoline and diesel prices. Included on this list are oil companies, whose recent earnings are perceived to be a windfall. There are also public suspicions of collusion between oil companies in price-setting and widespread price gouging. Some politicians are now calling for aggressive enforcement of anti-trust laws, imposition of price controls on gasoline and other fuels, and instituting a windfall profits tax on large oil companies.

It is also widely perceived that the ethanol industry has been unduly favored and that increased production of corn ethanol is solely responsible for higher food prices. Many politicians are calling for the government to eliminate the tax credits now being received by ethanol/gasoline blenders, the agricultural subsidies received by corn growers and the tariffs on imported ethanol.

What is not widely discussed in the current energy policy debate are ways the U.S. government can best support the private sector in finding solutions to existing energy problems. This article revisits some of the mistakes made by government intervention in the energy sector. It also explores a range of positive incentives that ought to be considered to support development of a robust biofuels industry in the United States.

Overcoming Obstacles
To date, the United States has access to enough crude oil to supply its refineries, but more reliance on foreign oil has made U.S. refiners vulnerable to supply disruptions and oil price spikes. Periodic seasonal and regional shortages of fuels are occurring more frequently and contributing to price increases. There is an admitted shortage of refinery capacity in the United States and no new refineries have been built in the country in the past 30 years. The reasons for this include the increased cost to build and maintain refineries, intensive environmental requirements, low returns on refinery investment, and increased volatility in realization of acceptable refinery margins.

The biofuels industry faces similar obstacles. The renewable fuels standard will require many more first- and second-generation biorefineries to be built in the next 10 years, requiring large private sector capital investments. In addition, stable supplies of affordable biorefinery feedstocks have to be developed, and high fuel prices will also be needed to make investments in economically viable biorefineries. Because biorefinery technology is constantly being improved, those now investing in biorefineries are at risk of having their facilities become prematurely obsolete.

Past Punitive Measures
In early 1971, in response to high inflation rates Congress passed legislation allowing the Nixon administration to freeze prices and wages. Six months after the "freeze," Nixon's Cost of Living Council lifted price controls on all but the energy sector. The Federal Energy Office (FEO) was temporarily established to administer price controls on "old oil," which is the amount of oil produced in the U.S. in the base year 1972, and refined petroleum products. What happened over the next 10 years of price controls is illustrative of what would happen today if price controls were used as a means of trying to keep fuel consumers happy.

In early 1973 the Oil Producing and Exporting Countries-(OPEC) oil embargo caused price increases in U.S. refined products. It severely impacted the supply of home heating oil, as the FEO ceiling prices would not allow refiners to recover their increased costs. The FEO was then forced to allow oil companies to increase heating oil prices in order to increase supplies. In the winter of 1973-74 heating oil prices increased again, and FEO re-imposed price ceilings on heating oil. A further run-up of imported oil prices reduced the amount of refined products that major integrated refiners normally resold to independent refiners and marketers. In response, FEO created a two-tiered price control regimen on domestic oil producers, allowing new production of domestic oil to sell at market prices. FEO also decontrolled a number of refined products, but not transportation fuels. This attempt at partial decontrol failed.

FEO's new rules became too complex to enforce, as most refiners were able to reallocate their increased crude oil costs among all products, allowing them to sell controlled products at market prices. Many refiners were unable to compete, as they only had access to decontrolled oil. To remedy this, the Federal Energy Administration (FEA) established the Oil Entitlements Program in order to equalize profits across refiners and prevent small U.S. crude oil producers from closing. It didn't work, as lower-cost domestic, or old, oil quickly disappeared when refiners and oil traders has access to oil used in "foreignization" schemes. Some of these schemes were illegal but FEA was unable to effectively enforce these rules on old oil. FEA made a number of attempts to amend the Oil Entitlements Program but they only succeeded in creating further distortions. President Jimmy Carter wisely put price controls on hold in 1979, and President Ronald Reagan did away with them shortly after he took office, as they no longer served a useful purpose.

Clearly, the lesson is that price controls on energy do not work except for short periods, and even though we are facing similar market pressures today we should not repeat the mistakes made in the 1970s.

After decontrolling oil prices in 1980, Carter reached a legislative compromise with Congress, allowing for the passage of a windfall profits tax on crude oil producers, as he feared that decontrol would lead to steep price increases. This tax went into effect March 1, 1980, and lasted through January 1988. It was an excise tax on domestic oil production and produced a modest amount of tax revenues, none of which was returned to consumers or taxpayers. In 1986, the price of oil collapsed and windfall profits tax collections were greatly reduced after serving no useful purpose. This tax also proved to be counterproductive, contributing to the reduction of domestic oil production by 3 percent to 6 percent and led to an increase in foreign oil imports by 8 percent to 16 percent. As with price controls, this punitive measure provided no direct benefit to the consumer and may have contributed to higher energy prices.

Recent Government Actions, Proposals
In 2005, Congress enacted a progressive piece of energy legislation titled the Energy Independence and Security Act of 2005. The Energy Bill, which was updated with the Energy Independence and Security Act of 2007, recognized the need for a number of energy initiatives, one of which is the mandate to produce 36 billion gallons per year of renewable fuels in 15 years. Unfortunately, this legislation does not provide funding for meeting this mandate and assumes that the private sector can find the funds.

Both candidates running for the presidency have announced their energy policies and recognized the need for a number of positive government incentives to facilitate increases in secure and clean energy supplies and to promote energy conservation. These initiatives are expected to encourage investment in alternative energy, but the candidates are split over how to achieve these goals. In particular, they are split on corn ethanol subsidies and extending subsidies to second-generation renewable fuels, and on funding of renewable energy programs.

The Senate Democrats have proposed placing a windfall profits tax on the five largest oil U.S. companies in order to raise as much as $150 billion for an energy fund. This fund is to be used to support a range of projects, including second-generation biofuels plants and biofuels distribution fuel infrastructure. Sen. Barack Obama has also announced a windfall profits tax as part of his energy plan. This would impose a windfall tax penalty on the top-grossing oil companies on oil they sell at more than $80 per barrel.

Industry testimony taken at a recent Senate hearing on high oil and gas prices included a number of ideas that could prove useful in promoting development of renewable fuels. Two different, and perhaps controversial, ideas include 1) providing government incentives for increased parity between petroleum diesel and biodiesel, and between E85, E10 and gasoline, and 2) increasing user taxes on fuels to reduce demand and to fund needed energy projects.

Ethanol Part of the Solution
If the existing Energy Bill's renewable fuels standard is met, 10 percent of U.S. fuel requirements will be supplied from renewable fuels. The investment to do this is significant, requiring $11 billion in four years, $46 billion in 10 years and $105 billion in 15 years.

Corn-based ethanol still has a major role to play in meeting the mandate. It currently provides most of this nation's renewable fuel, roughly 8.7 billion gallons per year. By 2015, corn ethanol production is expected to peak at 15 billion gallons per year, supplying 42 percent of the 36 billion gallons per year mandate. To meet this mandate, the corn ethanol industry must remain viable, but it may not if the government changes the subsidy ground rules and arbitrarily eliminates tax incentives.

The renewable fuels standard also requires that by 2022, 58 percent of the total biofuels produced be second-generation, with cellulosic ethanol providing 76 percent of this 21 billion-gallon-per-year requirement.

The government will have to take steps to stimulate private sector investment in biofuels plants and related infrastructure if the RFS is to be met. There will be a need for more research and development grants, tariff protections, tax holidays during ramp-up, accelerated amortization of investment in new technologies, and low-cost government-backed project financing and government loan guarantees. In addition, conventional fuel surtaxes may need to be employed to support the higher cost of distributing and marketing advanced biofuels.

The U.S. DOE's Loan Guarantee Program already offers loans and loan guarantees for biofuels projects. This program provides a set of rules for qualifying projects and project sponsors for such loans and loan guarantees. However, the $38 billion now authorized for loan guarantees will more than likely have to be increased. Obtaining Congressional approval for such increases should not be a problem, as this program does not create a drain on the U.S. Treasury or U.S. taxpayer unless a default occurs.

To develop biofuels projects in which local communities would have a stake, joint venture arrangements such as build-operate-transfer financing should be considered in order to attract local units of government or regional authorities as one of the project's partners.

Finding organizations to blame and passing punitive measures against them is counterproductive. The measures presented here illustrate ways that the U.S. government can facilitate private sector initiatives in biofuels. Such backing should only be offered if proposed projects adequately address energy policy goals and meet due diligence standards for commercially viable projects.

Tim Sklar is the president of Sklar and Associates. Reach him at sklarincdc@aol.com or (202) 257-5061.