Achieving Oil Security: A Practical Proposal

November 1, 2001 Topic: EnergySecurity Regions: Americas Tags: AcademiaEnergy PolicyIndustryOil CrisisPeak Oil

Achieving Oil Security: A Practical Proposal

Mini Teaser: The key to U.S. energy security does not lie ultimately in the Middle East. Cutting domestic demand is critical to near-term American success--and it can be done without raising taxes.

by Author(s): Martin Feldstein

The terrorist attacks on September 11 and the subsequent demonstrations of anti-Americanism throughout the Middle East increase the saliency of America's dependence on oil imports from the Gulf states. The United States now imports more than half of all the oil it consumes, and roughly a quarter of those imports comes from Saudi Arabia, Kuwait and Iraq. If there is no change in U.S. policy, that dependence will grow, since those three countries together with the United Arab Emirates have more than half of the world's reserves of oil, while the United States has only two percent of total reserves.

America's dependence on imported oil is a serious cause of economic vulnerability and a major constraint on U.S. foreign and defense policy. Political leaders in the Middle East know that U.S. dependence on their oil gives them leverage over American policies. The possibility of increasing that leverage emboldened Saddam Hussein to invade Kuwait in order to extend the share of Mideast oil controlled by Iraq. And while the governments of Saudi Arabia and Kuwait are basically friendly to the United States, recent events have made it clear how potentially vulnerable those governments are to radical elements within their own countries. All of this is a cloud over the stability of the oil supply from the Middle East.

Political leaders and expert commissions have been calling for a reduction in U.S. dependence on oil imports since at least 1974, when President Nixon established Project Independence with the goal of achieving energy independence by 1980. That goal was never reached. To the contrary, U.S. dependence on imported oil was still 42 percent of domestic consumption in 1980, and rose to 52 percent in 2000.

What can be done to reverse this trend? Increased oil production in the United States could help to reduce dependence on imported oil. Some increased domestic production will occur as a natural response to higher oil prices that result from increasing global demand. A higher price will induce more exploration and more extraction from such higher-cost sources as deep wells and off-shore sites. But even with such market forces at work, experts predict that oil imports will rise to 70 percent of U.S. consumption by 2020.

Relaxing some government restrictions on oil drilling can increase U.S. production further, but the impact on our dependence will be small. For example, although the administration's proposal to open some of the Arctic National Wildlife Refuge to oil drilling would eventually increase production in Alaska by 600,000 barrels a day, that would equal only about seven percent of what we now import from the rest of the world. Neither is it possible to reduce dependence on Middle Eastern oil by importing more from Mexico, Canada and Venezuela, since the U.S. already takes virtually all of the oil that they have for export.

U.S. dependence on foreign oil, and specifically on Middle Eastern oil, can only be limited in a significant way through the reduction of domestic consumption. There is substantial room to achieve such reductions, since the consumption of oil per dollar of GDP is now more than 40 percent higher in the United States than it is in Germany and France. Nevertheless, politicians have been reluctant to pursue consumption-reducing measures aggressively because it has been assumed that doing so would require a European-style gasoline tax. As anyone who has driven in any European country knows, an important reason for their lower consumption of oil is that taxes cause gasoline prices to be nearly three times higher on average than they are in the United States. The political impossibility of imposing such a tax was brought home clearly by the abject failure of President Clinton's 1993 proposal for a general BTU (British Thermal Unit) energy tax. Fortunately, however, it is possible to provide the incentives needed for a substantial reduction in oil consumption without any new tax, by using tradeable Oil Conservation Vouchers.

Before describing how such a voucher system would work, it is useful to review the primary policy tool currently used by the Federal government to reduce oil consumption: the Corporate Average Fuel Economy Standard (CAFÉ). Automobile manufacturers are required to keep the average number of miles per gallon on the entire fleet of new cars in each model year above some level set by the Federal government. That standard has been 27.5 miles per gallon since the 1985 model year, up from 18 miles per gallon for the 1978 model year when the CAFÉstandards were first introduced. Manufacturers may produce some cars with lower fuel efficiency, but these must be balanced by cars that get more than 27.5 miles per gallon so that the average fuel efficiency for all cars sold by the company in the year exceeds 27.5 miles per gallon.

This standard has forced companies to seek ways to design more fuel-efficient cars. Because of the pricing differences that have resulted from the CAFÉ standard, it has also induced many households to shift from conventional autos to sport utility vehicles and other light trucks, since these are subject to a more lenient fuel efficiency standard (now 20 miles per gallon). The net effect on fuel economy is therefore difficult to determine.

A more serious weakness of the CAFÉ standard approach to reducing gasoline demand is that it does nothing to change how cars are used. It provides no incentive to rely more on car pools and public transportation, or simply to travel less. Neither does it provide any incentive to drive at speeds that reduce fuel consumption or to scrap old cars in favor of newer ones with better fuel efficiency. In this latter regard, several promising technologies may soon offer commercially viable substitutes for the traditional internal combustion engine. These include engines that use natural gas, or that can switch between gasoline and electric battery power, or that are powered by hydrogen fuel cells. All three major U.S. auto companies plan to introduce cars equipped in these ways by 2004 or 2005. Although these cars will initially cost more, the high price of gasoline in Europe may induce some car buyers there to pay a higher up-front cost in order to achieve subsequent savings in fuel costs. It will be difficult, however, to induce American car buyers to select these new technologies because of the relatively low U.S. price of gasoline.

If American drivers had to pay what I would call the "full cost" to the nation of driving, there would be a strong incentive to change driving habits and to seek new technologies that deliver lower fuel costs. By the “full cost†I mean not just the cost of producing gasoline and distributing it through gasoline stations, but also the implicit cost to our nation imposed by the national security effects of an increased dependence on imported oil, the adverse environmental effects of air pollution, and the increased risks of automobile accidents that result from a greater number of drivers on the road.

Although the Europeans might use this notion of "full cost" to justify the very high taxes that they levy on gasoline, an acceptable solution in the United States must not involve a new large tax on gasoline. Bringing U.S. gasoline prices up to European levels by an additional gasoline tax of two dollars a gallon would impose a tax of about $2,000 a year on the average American household. The government would have new tax revenue of more than $250 billion a year, equivalent to one-fourth of the total current income tax revenue and more than double the annual tax cuts in the recent Bush tax package.

While that money could in principle be returned by lower income taxes or a specific tax rebate, most Americans would doubt that the funds would in fact be returned. Such a tax-based policy is clearly a political non-starter.

Fortunately, we can achieve the favorable incentive effects of a higher gasoline tax without actually imposing any tax at all by the use of tradeable Oil Conservation Vouchers (OCVs).4 Here is how the tradeable Oil Conservation Vouchers would work.

Consider a government policy that seeks to cut U.S. dependence on oil imports in half, i.e., reducing total imports from the current level of about 130 billion gallons a year to about 65 billion gallons a year. This reduction would be about the level of total U.S. oil imports from the OPEC countries. Each Oil Conservation Voucher would permit its owner to purchase one gallon of gasoline or some other petroleum product, such as heating oil or industrial raw materials. (I will focus my discussion on the application of OCVs to reducing gasoline consumption, returning briefly after that to discuss how it might be extended to other uses of oil.)

Gasoline production currently requires about 180 billion gallons of oil per year. Since gasoline accounts for about two-thirds of all oil consumption, a useful starting point would be a reduction in gasoline consumption to account for two-thirds of the overall desired reduction, i.e., by 43 billion gallons of gasoline. This would reduce gasoline consumption from 180 billion gallons to 137 billion gallons, a reduction of about 25 percent.

The government would therefore distribute 137 billion Oil Conservation Vouchers to American households. There are many ways that these vouchers could be distributed, but it might best be done by the state governments. Since a household in a geographically large and rural state is likely to drive more miles per year than one in a smaller or more urban state, the Federal government might distribute vouchers among the states in proportion to the miles driven in 2001 (as indicated by Federal gasoline tax collections in each state). The states would then decide how to distribute the vouchers within their own jurisdictions. They might give an equal number to each household with a car, or an equal number per car, or a number that varies by region within the state. All of this would be easy for the states to do since they register all cars. It would be up to each state to decide what is the fairest distribution under local conditions. Since the vouchers are tradeable, the incentive effects of the OCV system would not depend on this initial distribution.

A household that receives 1,000 OCVs and that drives 20,000 miles during the year at an average of 20 miles per gallon will have just enough OCVs to purchase the gasoline that it uses. If the household that receives 1,000 OCVs wants to buy more than 1,000 gallons of gas in the year, it will have to buy a voucher from a household that receives more OCVs than it needs. A market price would quickly evolve that brings the supply and demand for these vouchers into equilibrium. Gasoline stations, convenience stores and others might provide the service of buying and selling vouchers as a way of attracting customers, so that individuals who want to sell or buy would not have to find someone in the opposite situation.

Since the total number of vouchers available is about 25 percent less than the number of gallons that individuals currently purchase, the vouchers would command a positive price. The combination of the price of gasoline at the pump (which would not change unless there is a change in world oil markets) and the price of the voucher would have to be higher than the current price of gasoline in order to induce individuals to reduce their gasoline purchases by 25 percent. Some of that reduction would be achieved by driving less (using car pools and public transportation or simply traveling less) or being more conscious of the driving speeds that save fuel. Further reductions could be achieved over time as old cars are scrapped in favor of newer ones that get more miles per gallon. The price of a voucher would therefore be higher in the short-run (when it takes a higher price to reduce gasoline consumption) than in the longer run, when there are more ways in which demand can be reduced.

A rough guess is that the value of a voucher might be about 75 cents in the first year. If a household that receives 1,000 OCVs wishes to drive 25,000 miles with a fuel efficiency of 20 miles per gallon, it will need to purchase an additional 250 vouchers at a cost of about $190. Conversely, if a household that receives 1,000 OCVs only wants to purchase 800 gallons of gasoline, it will be able to sell its 200 excess vouchers for $150. Although these cash amounts are not large, the voucher system creates the right incentives because each individual recognizes that the cost of another gallon of gas is both the approximately $1.30 that he pays for the gasoline and the 75 cents that the voucher is worth. The same is true both for someone who needs to buy vouchers for 75 cents and for someone with excess vouchers that he could sell for 75 cents.

Achieving the same 43 billion gallon reduction in gasoline consumption by a 75 cent a gallon gasoline tax would cost the average American household about $750 a year in higher taxes and produce revenue of about $100 billion a year. Moreover, since the 75 cent value of the voucher is just an estimate, there is no guarantee that a 75 cent tax would even achieve the desired reduction. And just as the price of the voucher is likely to come down (unless the number of vouchers is reduced) as individuals shift to more fuel efficient cars, the gasoline tax would also have to be adjusted over time, making it even less likely that the policy would achieve its desired goal. The voucher system would automatically limit consumption to the desired amount and would do so in a way that gives every gasoline buyer the same incentive to conserve gasoline.

Since higher-income households generally consume more gasoline than lower-income households, the likely effect of the OCV system would be to make higher-income households buyers of vouchers and lower-income households into net sellers. The most recent available data (for 1994) show that households with incomes below $15,000 consumed about 700 gallons of gasoline per year while those with incomes over $35,000 consumed an average of about 1,250 gallons per year. With a distribution of 750 OCVs per household (about 25 percent less than average current consumption), the lower-income households would receive about $170 from selling vouchers while the higher-income households would pay an extra $150 to buy vouchers.

The OCV system could be extended from gasoline to heating oil and other forms of oil consumption. The distribution of heating vouchers might also be left to the states, with the Federal distribution to the states reflecting the amount of heating oil currently used in each state. A distribution to households and businesses based on the amount of heating oil purchased in the year before the program began might be regarded as the most fair, but other distributions taking income and family size into account might also be considered. Again, the desirable incentive effects for reducing oil use would not depend on the initial distribution, since these OCVs would be tradeable. Each household or business would face the same implicit price for oil regardless of whether it was a buyer or a seller.

All Oil Conservation Vouchers could be interchangeable. Gasoline vouchers need not be different from heating vouchers or industrial use vouchers. In this way, the extra "price" implied by the value of the voucher would be the same for any use of oil. Having different vouchers with different market prices for different uses of oil would prevent available oil from being directed to its most productive uses.

I have stressed the importance of reducing oil consumption to strengthen national security. A reduction of oil consumption would, of course, also cause a reduction in air pollution. For those pollutants that affect the local environment, these reductions would be significant. For carbon dioxide, the environmental effect would not be large because it is diffused into the global atmosphere and represents only a small reduction in global carbon dioxide. It would, however, have the politically significant effect of reducing U.S. fossil fuel use below the level of use in 1990, a key issue in international discussions of environmental policy.

There are no doubt ways to improve on the system of Oil Conservation Vouchers described here. The detailed design of the system is not as important as the broad conclusion that it is possible to develop a market-based plan to substantially reduce America's oil vulnerability without any tax increase.

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