[Economic Report of the President (2004)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 8

Regulation Energy Markets


Energy is essential to the U.S. economy, both as a final good and
as an input into the production of most other goods. In 2000,
energy expenditures equaled $703 billion, or 7.2 percent of GDP.
The markets that provide this energy function well and are
generally competitive. However, parts of the energy industry
have characteristics that are associated with market failures. For
example, the large fixed costs required to construct distribution
networks for electricity and natural gas make it unlikely that
more than one firm would be willing to invest in the infrastructure
needed to serve residential customers in a particular area. The
distribution company, therefore, may have market power, the ability
to charge prices significantly above the competitive price level
and profitably maintain those prices for a considerable period.
Another type of market failure involves negative externalities,
costs that economic transactions impose on third parties that the
parties to the transaction do not face. For example, energy
producers and consumers may not fully take into account the fact
that burning fossil fuels may cause acid rain or smog.

This chapter discusses economic issues relevant to several
different energy markets, including natural gas, gasoline,
electricity, and crude oil. The use of these different types of
energy involves different market structures and different potential
market failures. An important focus of the chapter is on the design
of regulations to address market failures in energy markets while
minimizing disruptions to the market. The key points in this
chapter are:

  Markets generally work well for energy products,
which in most ways are like other products in the
U.S. economy. While some aspects of energy markets
may require regulation, most segments of these
markets function well without regulation.
  Federal, state, and local regulations can have
conflicting goals. If the conflicting goals are not
balanced, competing regulations could lead to worse
problems than the market failures the regulations
attempt to address.
  Regulations need to be updated as markets evolve over
time to ensure that the original goals still apply
and that these regulations are still the lowest-cost
means of meeting those goals.
  The United States benefits from international trade
in energy products.


Market Forces and Regulation
in the Market for Natural Gas


Some energy markets require regulation. For example, because of the
high cost of natural gas distribution services, the market
generally supports only one local distribution company. Thus, the
delivery infrastructure, including pipelines and gas meters
connected to individual residences, is regulated. However, certain
segments of the natural gas industry are amenable to competition.
They do not require regulation even though the distribution segment
does. Indeed, in many areas of the country parts of the natural gas
market have been deregulated. For example, producers of natural gas
are no longer subject to price regulation. Furthermore, although
prices for transporting natural gas to homeowners are regulated, in
some states multiple firms now compete for the right to sell the
gas to homeowners. This type of partial deregulation has also been
applied to electricity markets; in many areas, local distribution
lines are still regulated while generation and retail marketing
are deregulated.

The last year has demonstrated how market forces have worked to
allocate scarce resources in the natural gas market. Demand for
natural gas is highly seasonal, with the greatest consumption by
far during the winter heating season. During the summer, a portion
of natural gas production is stored for use in the following winter.
Natural gas inventories in spring 2003 were unusually low after a
colder than normal winter in 2002-2003. This led to large increases
in natural gas prices in the spot and futures markets. In turn,
these high prices encouraged consumers to switch to other fuels or
reduce consumption over the summer, encouraged producers to
increase production, and encouraged importers to bring in
additional natural gas from outside North America. In combination,
these actions resulted in a near-record increase in natural gas
inventories in time for the winter heating season. As a result,
the United States entered the winter of 2003-2004 with slightly
above-average natural gas inventories. High prices have also given
firms an added incentive to invest in new projects, such as
liquefied natural gas (LNG) facilities, to bring additional
supplies of natural gas to the market in the future.


Market Forces and Regulation
in Gasoline Markets


Recent and past events in the gasoline market have shown how
unexpected shortages affect market prices and how government
regulation can make the situation worse. Wage and price controls
imposed in the early 1970s to combat inflation included government
regulations that kept gasoline prices below the market level. As a
result, when oil supplies were disrupted in 1973 and 1979 by
geopolitical events in the Middle East, consumers wanted to buy
more gasoline than suppliers were willing to supply at the
artificially low prices.

Regulations that prevented suppliers from increasing prices meant
that consumers had to wait in lines or face limits on the amount
of gasoline they could purchase. As a result, some gasoline likely
went to consumers who valued it less than other consumers because
those who would have cut consumption as prices rose continued to
buy gasoline at the artificially low price. Keeping gasoline
prices artificially low also reduced the incentive for oil companies
to refine new sources of crude oil into gasoline--a supply response
that would have lessened the shortfall.

Gasoline markets also demonstrate how markets react to unexpected
changes in supply when prices are not regulated. For example,
several refinery problems on the West Coast in recent years have,
on occasion, temporarily reduced the supply of California Air
Resource Board (CARB) gasoline that meets strict California
specifications for reducing air pollution. After these disruptions,
prices typically increased quickly, and usually stayed high for
only a matter of weeks. These increased prices led consumers to
reduce their gasoline consumption.

During supply disruptions that were expected to last a relatively
long time, the high prices also led distant refineries to produce
and ship CARB gasoline to California. These refiners had to shift
their operations to make CARB gasoline instead of their normal
product, find an available tanker, and then ship the gasoline to
California--a process that takes three weeks or more. High prices
rewarded the refiners that were able to get CARB gasoline to
California quickly, while refiners whose shipments arrived too late
(that is, as prices started to come down again) would lose money.
The price spike provided an incentive for distant refiners to risk
making and shipping CARB gasoline to California, thus helping to
alleviate California's gasoline shortage.

Local and Federal Regulations May Conflict

As illustrated in the example above, not all gasoline sold in the
United States is the same. Differences in local specifications are
often the result of how local and state governments have responded
to the Clean Air Act of 1990. Chart 8-1 shows which areas of the
United States have adopted different fuel specifications.
Flexibility in how localities address air pollution abatement allows
them to implement an approach that best meets their needs. However,
different local or regional gasoline specifications add complexity
to the national gasoline production and distribution infrastructure,
reducing the reliability and availability of gasoline supplies.

The proliferation of fuel varieties produced for various locations
(called boutique fuels) reduces the number of potential suppliers
of each particular fuel and slows the industry response when there
are local or regional disruptions to the gasoline supply. Boutique
gasoline specifications likely contributed to the price spike in
the Midwest in 2000, which occurred after several refineries
experienced production problems around the same time that two major
pipelines supplying the region went out of service. Chicago and
Milwaukee were particularly hard-hit in part because of their
local







requirements for reformulated gasoline using ethanol. Nearby
cities using reformulated gasoline had different specifications,
so that existing reformulated gasoline stocks could not be shipped
to the area.

The impact of boutique fuel regulations demonstrates that there may
be benefits from standardizing regulations across geographic areas
for goods that are sold regionally or nationally. Gasoline markets
in the eastern half of the United States are interconnected by
pipelines, barges, and tankers. Reducing the number of gasoline
specifications could allow for increased flexibility of the
gasoline supply system. For example, production lost because of a
refinery problem in Chicago could be offset by shipments of
gasoline from refiners in other areas. The President's National
Energy Plan asked the Environmental Protection Agency (EPA) to
study ways to increase the flexibility of the Nation's fuel supply.

While there may be benefits from standardizing regulations across
geographic areas, standardization may require some areas to use
gasoline that is more expensive than necessary to meet local
air-quality standards. The benefits of standardization must be
weighed against any increased costs.

Local and State Regulations Lead to Different
Market Outcomes

State regulations can also increase the cost of marketing and
distributing gasoline to consumers. For example, several states and
the District of Columbia have divorcement laws that restrict
refiners' ability to own and operate retail stations. These
regulations have been found to increase prices at the pump; prices
in states with divorcement laws are almost 3 percent higher than
they would be without such laws. Similarly, regulations in Oregon
and New Jersey ban self-service gasoline sales because of putative
safety and environmental concerns. Economists have estimated that
gasoline prices in these states are between 2 and 6 cents per
gallon higher than they would be without the self-service ban
(gasoline prices in New Jersey are lower than in surrounding
states because of New Jersey's low gasoline taxes, but prices
would be even lower if self-service were allowed).


Market Forces and Regulation
in Electricity Markets


While a mix of market forces and well-designed regulation can lead
a market with market failures to perform more effectively and
efficiently, improper regulation can lead to worse outcomes than
even an imperfect market without regulation. The market for
electricity is a case in point. Some existing regulations in the
United States have the unintended effect of making the Nation's
electricity supply less reliable and more expensive. The same
attribute that makes competition in electricity difficult to
achieve--provision of electricity over a single network on which
the amount of electricity supplied must equal the amount of
electricity consumed at every moment--makes the consequences of
poorly designed regulation particularly costly. For example,
California's rolling blackouts in January 2001 appear to have
stemmed in part from regulations that fixed retail electric rates.
As a result, there was an insufficient supply of electricity during
the daily peak periods of demand. Fixed retail electric rates
provided little incentive for consumers to reduce their consumption
of electricity during these high-usage periods.

The Evolution of the Electric Industry from Local to Interstate
Markets


As the electric industry has evolved from local, largely
self-contained systems to a more national, integrated system, the
appropriate combination of state and Federal regulations has changed
as well. For many years, electricity was provided by integrated
utilities--local monopolies that generated power and distributed it
to residents and companies in a specific area--that were regulated
by state public utility commissions.

Over time, a high-voltage transmission network linking the local
monopolies developed. The network was originally designed to boost
reliability, but it has also had the effect of reshaping the
economics of the electricity market. The existence of this network
(called the transmission grid) gave rise to a market for wholesale
electricity through which utilities could buy electricity generated
elsewhere for use by their own customers.

Regulatory changes complemented the technological and structural
changes to make the electricity business more competitive. In
1978, new Federal regulations mandated by the Public Utilities
Regulatory Policies Act (PURPA) required state-regulated utilities
to buy power generated using renewable energy sources and
cogeneration plants (plants that produce electricity while
producing other products such as steam heating). These regulations
led to an expansion of wholesale markets in which regulated
utilities bought electricity generated by other firms and
demonstrated that independent electricity generators could coexist
with existing state-regulated utilities. In the late 1980s, Federal
regulators began revising regulations to encourage the development
of independent producers more generally. In 1996, Federal
regulators began requiring the public utilities that owned
transmission lines to make them available to independent
electricity generators. Today, more than half of all the electricity
generated is exchanged on the wholesale market before it is sold to
consumers.


Electricity Regulation in an Evolving Market


Wholesale electricity generation will become more efficient over
time as unregulated generating companies add new capacity based on
competitive market signals. Market signals will influence both the
timing of when new generation capacity is built and the type of fuel
these plants will use. For fully regulated electric utilities, these
decisions are made with the approval of local or state regulators.
Without the discipline of competitive markets, regulated utilities
are able to pass increased costs on to consumers regardless of
whether the utilities have made the most efficient choices.

Effects of Regulation on Transmission Capacity

Regulations in the electricity market continue to impose barriers
to competition and greater efficiency. Today's regulatory structure
may not encourage regulators in one jurisdiction to take into
account the full effects of their actions on the rest of the
transmission grid because the regulatory system is based on an
industry structure that no longer exists. For example, the
transmission grid crosses state boundaries, so what happens in
one state affects the residents of other states. However, state
regulators might not consider the costs and benefits of their
actions on citizens of other states. As a result, regulation of
the transmission grid has not kept up with changes in the market.

Extensive blackouts in the Northeast and Midwest in August 2003
and in the West in August 1996 demonstrated the potential costs
of not updating and coordinating Federal, state, and local
regulations. Despite the growing demand for electricity and the
growing demand for transmission capacity to satisfy the wholesale
market, construction of new transmission facilities has declined by
about 30 percent since 1990. The current mix of regulations has
facilitated increased use of transmission capacity, but has not
done enough to encourage companies to invest in building new
capacity. For example, some state and local regulations have
discouraged the construction of new local facilities, thus
encouraging increased transmission from more distant locations.

State deregulation may also give local utilities the incentive to
import lower cost electricity from generators in other states. The
growth of interstate transmission of electricity has increased the
need for Federal, state, and local governments to coordinate their
regulations that affect the interstate transmission grid.

Another problem with existing regulation is that state and Federal
regulators approve transmission rates to provide the owners of
transmission lines a fixed rate of return, but the chosen rate may
not be high enough to encourage firms to invest in sufficient new
transmission capacity. One factor that is not fully considered in
rate-of-return calculations is the lengthy and uncertain permitting
process that requires companies to deal with multiple regulators.
Because these costs are not fully accounted for, the effective rate
of return often is too low to attract investment. Such regulatory
uncertainties are just one of many factors that make investing in
new transmission capacity risky. Higher rates of return may be
needed to spur investment.

Insufficient investment in new transmission capacity is not the
only problem stemming from improper regulation of rates of return.
Such regulation may also prevent investment from being channeled to
areas that most need new transmission capacity. Higher prices for
Use of the most congested parts of the grid would reduce
transmission over these parts of the grid and send a signal to
potential investors to expand capacity in those areas. Grid
operators in some parts of the country now use locational
marginal pricing to set prices in different locations based on
both the cost of generation and the cost of congestion. Areas
that are served by congested transmission lines pay higher prices
reflecting the cost of such congestion.

Congestion in the transmission grid leads to both lower reliability
and less competition. The lack of competition results from the
low-cost generators' inability to send power to high-cost areas,
forcing the high-cost areas to use less efficient, locally-produced
electricity. Adding new transmission capacity between low-cost and
high-cost areas could increase prices in low-cost areas in the
short run. However, these price increases would likely lead to new
generating capacity being built in low-cost areas, reducing prices
back toward existing levels.

Regulations That Require Updating

As electricity markets have become more competitive, Federal
regulations designed to prevent utilities from abusing their
government-granted monopoly power may have ceased to serve the
public interest. For example, the Public Utilities Holding Company
Act (PUHCA) was originally passed in the 1930s to limit the size
and type of operations in which a public utility may engage,
including the types of companies that can own utilities. Today,
these limits may actually increase prices to consumers by
preventing utilities from engaging in activities that could make
their businesses more efficient. These limits also may prevent
public utilities from expanding their operations in ways that would
increase competition in other parts of the country.

The evolution of the electric power industry from a natural monopoly
to an increasingly competitive market calls for regulations that
facilitate rather than hinder efficiency and innovation. The Federal
Energy Regulatory Commission (FERC) is working on new regulations
for wholesale electricity markets with the goal of having market
forces encourage the lowest-cost generators to provide electricity.

Demand Response to Electricity Production Costs


Many residential electric rates today are fixed throughout the day
at a level based on the average cost of generating and delivering
electricity to the residential customer. The cost of producing
electricity, however, is not fixed throughout the day. Instead,
electricity generators constantly adjust production to meet demand
hour by hour or even minute by minute. As a result, the marginal
cost of electricity production--the cost to produce one extra unit
of electricity--varies widely over the course of a day. Wholesale
prices reflect this, with lower prices in the middle of the night
(a period of low demand) and higher prices in late afternoon (a
period of peak demand). Under the current regulatory structure,
however, many consumers are charged the same rate regardless of the
wholesale cost of electricity so that utilities cannot raise prices
to reflect the true cost of generation. As a result, local
regulated utilities must have access to enough generating capacity
to meet peak demand, as well as enough transmission and distribution
capacity to get the electricity to all customers. Chart 8-2
illustrates the fluctuations in electricity consumption and
wholesale prices over a week in August 1999. During the week
illustrated, the regulated utilities were at times forced to sell
electricity at a loss because wholesale prices rose above the fixed
retail rate.

It is not cost-effective to store large quantities of electricity.
Therefore, the requirement that electric utilities meet all demand
at fixed retail prices





means that they must build enough capacity to meet the highest peak
demand during the year. They also need to maintain reserve capacity
to offset any supply lost due to generation or transmission
problems. Some of this capacity is only required during the
relatively few hours of the year when demand peaks, for example,
on the hottest days in August.

Without the ability to increase retail prices during peak demand
to encourage consumers to cut their energy consumption,
insufficient generation capacity would lead to a rationing of
supply, for example, rolling blackouts. While some electric
utilities offer time-of-day pricing, a system in which retail
rates are higher during periods of peak demand, these prices do
not vary with the actual cost of generating electricity on a
particular day. These programs reduce the average peak demand but
do not provide the needed incentives to cut power usage on days
with extreme peak demand.

Some consumers also receive lower rates in exchange for allowing
the electric company to interrupt their service if wholesale costs
increase above a certain level. There are some programs that allow
the utility to cut off all of a consumer's power, while others
simply allow the utility to turn off the consumer's
air-conditioning. There are also typically limits on how long or
how many times the utility can cut off power. These programs to
reduce peak electricity usage thus represent only a partial
implementation of variable pricing.

A reduction in peak demand achieved through variable pricing would
allow regulated utilities to build less generation, transmission,
and distribution infrastructure. Because they cannot increase
retail prices, these utilities use other means to reduce peak
demand, such as rebates to consumers who purchase energy-efficient
appliances or incentives to improve weatherization of homes. While
these programs reduce peak demand by increasing energy efficiency,
they do not use the market to determine which ways of cutting
electricity demand would have the lowest cost. Furthermore, as
electricity markets evolve, there may no longer be one firm that can
capture all of the benefits from reducing peak demand. As a result,
these programs may not be able to continue because individual
companies have less incentive to implement them.

Current programs that attempt to reduce peak demand still leave
customers unaffected by changes in the cost of production until
shortages and interruptions in service result. If retail prices
were allowed to increase, consumers could decide to cut their
consumption (possibly to zero). This approach could improve overall
welfare by reducing the number of peaking plants needed; that is,
it may be less costly to curtail demand than to add to supply by
building expensive generation capacity that is rarely used.
However, for variable pricing to be completely implemented, new
meters and smart appliances may be needed so that consumers can
acquire the information and technology needed to adjust their
usage as electricity prices change.

Energy and Trade

The United States benefits greatly from global trade in energy
markets. Gasoline and diesel fuels refined from crude oil are
currently the most widely used transportation fuels. By importing
petroleum, U.S. firms are able to continue to supply gasoline and
diesel at real prices comparable to historical averages, even as
environmental regulations have increased the costs of refining.
Adjusted for inflation, gasoline prices are much lower than at
their peak in 1981. However, this beneficial trade requires
reliance on imports that could be subject to supply disruptions.

Because crude oil is traded throughout the world, its price is
affected by global changes in supply and demand. Disruptions to
the supply of oil from areas that do not supply the United States
would affect domestic prices of oil even if U.S. imports are not
directly affected. Indeed, domestic prices of oil would be affected
even if the United States produced all of its oil domestically
(unless petroleum exports were prohibited). The outcome is the
same because the price of oil is set in global markets.

Meeting all U.S. energy needs from domestic sources would require
significant changes to the U.S. economy, including changes in the
types of transportation fuels used by Americans. The costs of
these changes would probably exceed the costs resulting from
periodic unexpected increases in the global price of oil. This is
suggested by the fact that prior oil market disruptions did not
lead to such structural changes in the U.S. economy. Moreover, oil
markets have undergone tremendous changes since the 1970s that
likely reduce the risks to the U.S. economy from a disruption in
crude oil production and imports.

U.S. Energy Sources

Most energy consumed in the United States is produced in North
America. In 2002, the main energy sources were petroleum (39
percent), natural gas (24 percent), coal (23 percent), and nuclear
power (8 percent). In 2002, roughly 80 percent of U.S. energy needs
were met by North American sources, including 59 percent of crude
oil, 99 percent of natural gas, 100 percent of coal, and roughly
45 percent of uranium for nuclear power generation. Petroleum is
the main energy source that the United States imports in
significant amounts from outside North America. Hence, discussions
of energy security focus on imports of crude oil. In the future,
analysts expect the United States to import more natural gas, but
there are many potential suppliers.

The United States also imports a large share of uranium from outside
North America, but there are sufficient North American reserves of
uranium that could be used if less-expensive foreign sources were
not available. Furthermore, uranium fuel represents a relatively
small portion of the cost of nuclear electricity generation. Also,
most uranium is produced in stable parts of the world, with Canada
and Australia producing about half of the world's total.

Changes in the Oil Market

A disruption in crude oil production in an area that does not
supply the United States would still affect the United States by
raising oil prices in the worldwide market. However, the power of
the Organization of the Petroleum Exporting Countries (OPEC), or
of any one country, to affect world oil prices is less today than
it was in the past. OPEC's influence on the market has fallen with
the decline of its market share from 55 percent in 1973 to 39
percent in 2002. Other evidence of the diversification of sources
of crude oil is that in 1973, the top eight producing countries
produced 75 percent of the world's oil, while in 2002 the top
eight producing countries produced only 54 percent. Access to a
greater number of sources of oil reduces the impact of a disruption
in any one region on the world oil price. In addition, the
increased sophistication of financial markets for oil and related
products has made it easier to hedge oil price risks. With
financial instruments such as futures contracts, firms are better
able to avoid having potential disruptions in the crude oil market
lead to substantial immediate cost increases from their energy
inputs.

Another significant difference between today and the 1970s is that
the United States no longer has price controls on gasoline and oil.
During the oil shocks of the 1970s, Federal government mandates
kept consumer prices artificially low and dampened the amount of
gasoline conservation that otherwise would have occurred in
response to increased prices. As a result, people wanted to
consume more gasoline than suppliers were willing to supply at
the artificially low price leading to shortages in the United
States.

When prices are not regulated, large swings in oil prices do not
disrupt the economy nearly as much. For example, between June 15,
1998, and November 27, 2000, the price of West Texas Intermediate
(WTI) crude oil more than tripled from $11.69 to $36.24 per barrel
without throwing the economy into disarray. These price increases
did not cause major economic disruptions for two main reasons.
First, energy consumption per 1996 dollar of real GDP has dropped
43 percent, from 18,360 British thermal units (BTU--a measure of
the energy content in fuels) per dollar in 1973 to 10,450 BTU per
dollar in 2001. Second, market signals have worked to increase the
flexibility of U.S. energy markets, allowing them to adjust and
adapt to market changes. This is why market forces work better to
allocate goods than command-and-control measures such as price
controls.

Another change from the 1970s has been the expansion of the
strategic reserve of crude oil that can be used during severe
disruptions to the oil market. Created in 1975, the Strategic
Petroleum Reserve held 634.7 million barrels as of December
2003--enough oil to replace U.S. crude oil imports from the
Persian Gulf for approximately 287 days. While maintaining the
Strategic Petroleum Reserve entails storage and inventory costs,
holding reserves to increase energy security is less likely to
distort the market than other measures, such as attempting to
replace U.S. oil imports with more expensive sources of energy.

Trade in Oil and Price Stability

In considering whether it is worth taking steps to decrease U.S.
reliance on petroleum imports from outside North America, it is
useful to compare the movement of oil prices with the prices of
other commodities in which the United States is self-sufficient.
It turns out that having a supply of a commodity in the United
States or North America is not an assurance of stable prices.
Numerous factors affect both the supply and the demand of goods
so that commodities such as natural gas, wholesale electricity,
and many agricultural goods also exhibit price volatility even
when supplied wholly from North American sources.

Relying on imported oil reduces the United States' overall
expenditures on energy. Without crude oil imports, the cost of
gasoline and other petroleum products (or alternative
transportation fuels) would be higher. Therefore, the United States
would have to devote a greater portion of its resources to paying
for the costs of energy, especially for transportation, than is
the case today. Without petroleum imports, it would be necessary
to use significantly less gasoline and more transportation fuels
made from corn, soybeans, or other agricultural products, or
liquid fuels from coal, natural gas, oil sands, or oil shale.
Under current technologies, these substitutes all cost
substantially more to produce than gasoline from crude oil.


The Evolution of Energy Markets


Energy sources have changed as society's needs have evolved over
time. Wood was replaced by coal, which was replaced by petroleum.
Eventually, the energy market may evolve to include substantial
energy production from new sources, such as renewable energy,
hydrogen, or nuclear fusion. Government policy can help move this
evolutionary process forward by encouraging research in new energy
technologies. However, forcing the transition to new technologies
before the market signals that old technologies should begin to be
phased out could involve tremendous costs to society.


Market signals have already altered U.S. energy consumption. In
response to higher crude oil prices, U.S. crude consumption fell
by 21 percent between 1978 and 1983 even as real GDP grew by 7.8
percent. Demand shifted towards coal, which experienced the
smallest price increase of any major fuel, and away from oil and
natural gas, which experienced the greatest increases. Even with
the increased consumption of coal, total U.S. energy consumption
declined 1.8 percent annually between 1978 and 1983. This
decrease occurred despite the longer-term upward trend of energy
consumption, which averaged 1.1 percent annually between 1971 and
2001. Energy conservation programs and other nonmarket forces may
have been responsible for some of the reduced demand for energy.
However, at least 80 percent (and probably more) of the demand
reduction can be attributed to higher prices and overall changes
in the economy.

Market signals have also triggered a great deal of innovation to
lower the cost of finding and extracting oil. For example,
three-dimensional seismic technologies have lowered the cost of
finding oil, and directional drilling has lowered the cost of
extracting oil so that reserves that were not viable in the past
can be extracted profitably today. Similarly, technological
advances have lowered the cost of extracting oil from oil sands
so that production from oil sands is competitive at today's oil
prices. As a result, at least one industry publication has
classified a portion of Canada's large oil sand deposits as proved
oil reserves; estimates of Canada's proved oil reserves are now
second only to those of Saudi Arabia.

The technology exists to convert large North American reserves of
oil sands, oil shale, natural gas, coal, wood, and agricultural
products into liquid fuels such as gasoline, diesel, methanol, and
ethanol. Some of these processes are now prohibitively expensive,
but these fuels could compete with fuels produced from crude oil
if oil prices increased or if research and development lowered
their production costs. Chart 8-3 illustrates the range of
estimated costs of producing synthetic fuels that could compete
with oil in the market for liquid fuels. For example, at a price
for oil of $20 a barrel, liquid fuels from oil sands and natural
gas may be able to cover production costs, while oil shale, coal,
ethanol, and biodiesel would not be viable sources. Higher prices
could eventually make these alternatives commercially viable. Note
that the extraction process for some of these fuels may have
adverse environmental consequences that could limit their use and
that some of these processes yield low-sulfur fuels that may burn
more cleanly than fuels produced from crude oil. The chart does
not consider either the costs of the externalities or the benefits
of the cleaner fuels.

There is a role for government in subsidizing research and
development into new energy sources. For example, hydrogen shows
strong potential as a possible future fuel, though many
technological hurdles must be overcome





before it becomes practical for everyday use. Even if hydrogen
became a feasible energy source, there would be still more
problems to be resolved before the technology became economically
competitive. Government subsidies for research and development
may aid the private market in developing technology to produce,
transport, and use hydrogen economically as a fuel. However,
market forces should decide when commercial adoption of hydrogen
as an energy source will be competitive.

Policy makers should avoid forcing commercialization of new energy
sources before market signals indicate that a shift is required.
One potential problem with forcing this process is that
technological breakthroughs may lead to alternatives that are not
seriously considered today. Premature adoption of new technologies
would raise energy costs before the need arises, causing society
as a whole to spend more on energy than needed, a misallocation of
resources that would hurt the U.S. economy. For example, forcing
adoption of energy sources other than oil to gain complete energy
independence would be prohibitively expensive; it would require
tremendous reductions in the use of energy derived from crude oil
through the use of alternative energy sources that are far from
competitive.

Conclusion

Regulations can improve the performance of energy markets by
addressing market failures such as externalities and market power.
However, it is essential to design regulations to address these
potential market failures without reducing the benefits from
markets. An added complication occurs when the goals of local and
Federal regulators conflict. Regulators should adjust the rules
as markets evolve and ensure that the regulations' goals are
achieved. Finally, regulators should be careful not to adopt
regulations that cause more harm than the potential market failure.