Push-me/Pull-you: Post-election Energy Policies

I've seen numerous commentaries on the energy implications of President Obama's narrow, 51%/49%  victory. One of the most intriguing of these, from Reuters, concerned the prospects for exporting a portion of the growing output of natural gas produced from US shale deposits.  This issue doesn't only affect gas drillers and their residential and industrial customers, but also developers of renewable energy projects, because of the way that gas and renewables compete in electricity markets.  As much as the President's reelection, the failure of Republicans to capture control of the US Senate might turn out to be a key factor in determining the fate of potential gas exports, and by extension the environment within which renewables like wind and solar power must compete.

A variety of energy issues has been in limbo for months, pending the outcome of Tuesday's election.  That includes approval of the Keystone XL crude oil pipeline from Canada, which might have gotten a favorable nudge as a result of Senate wins by pro-pipeline Democrats in North Dakota and Montana.  Environmentalists are committed to blocking the pipeline, so the President must soon choose which part of his winning coalition he will disappoint.  By comparison, the question of natural gas exports has received much less attention in the media, although it's been discussed extensively within energy and manufacturing circles.  The likely incoming chairman of the Senate Energy and Natural Resources Committee, Ron Wyden (D-OR), appears to have strong views on the subject.   

If Senator Wyden does replace the outgoing chairman, Senator Bingaman (D-NM), as expected, this would represent a shift in constituencies from a state with significant oil and gas production to one with essentially none.  Senator Wyden thus brings mainly an end-user perspective to his Energy and Natural Resources role, and from that standpoint his concern about the potential price impact of gas exports, whether in the form of LNG or otherwise, is understandable, although I would argue it is also short-sighted and potentially detrimental to renewable energy, which he strongly supports.

On the surface, restrictions on the export of US gas should result in lower domestic natural gas prices than if large quantities of gas were shipped offshore.  After all, low US natural gas prices, compared to those in Europe and Asia, are the main driver behind the desire to build export facilities, such as the Sabine Pass project of Cheniere Energy.  Natural gas is cheaper in the US than elsewhere for several reasons, including the high and growing output from shale gas resources, as well as the epic disconnect between the natural gas price and crude oil prices, which are the basis for most international LNG contracts. US gas at the wellhead is currently trading for the oil equivalent of $21 per barrel, compared to UK Brent Crude at $107 per barrel.  The extent to which exports might increase domestic prices is a matter of much speculation and study, and I wouldn't venture a guess.  However, we can't just look at demand in gauging the impact of export restrictions.

The efficacy of holding down US prices by keeping more gas here also depends on the response of producers.  If legislators or regulators turn the US gas market into a capped bottle, why would producers be content to supply steadily increasing quantities of gas at prices that don't provide them an attractive return?  To some degree the low prices we've seen this year were the result of the combination of a weak economy and a supply glut created by contractual commitments on the part of drillers to develop gas leases at a specified pace.  My understanding is that most such commitments have lapsed, and that a significant proportion of current gas supply is coming from wells that depend on the economics of their liquids output (crude oil and gas liquids), with the associated natural gas effectively a byproduct.  It's not clear how rapidly gas production can continue to grow without natural gas prices that make gas-only wells economically attractive.  So a US gas market with no export outlets would likely produce less gas in the long run, and that would constrain opportunities to use our abundant gas resources to support new industries, displace oil from transportation, and further reduce the use of coal in power generation.

Moreover, keeping a lid on the US gas market would compound the obstacles for renewable sources of electricity.  Wind power developers and turbine manufacturers now face the expiration of the Wind Production Tax Credit (PTC).  Even if it is extended, the output of wind farms competes with the output of gas turbines, while the grid relies on gas-fired power to provide a back-up for the intermittent output of wind and solar power.  The cheaper the gas, the tougher it will be for renewables to make a profit. Market competition with gas will become an even bigger issue for renewables as they expand beyond the capacity of a cash-strapped federal government to continue to subsidize them.  The one-year extension of the PTC under consideration could cost as much as $12 billion, an annual price tag that would only grow as renewables scale up--as they must if they are going to matter.

Navigating the complexities of allowing or restricting natural gas exports, and balancing the various constituencies involved, could provide an early test of the administration's commitment to an all-of-the-above energy strategy.  That's because "all of the above"--if not merely a slogan--implies more than just producing energy from a variety of sources.  It also entails competition among all these sources within a market in which some sectors of demand are declining, others growing, and new ones--including exports--are appearing all the time.  Pushing back on one part of this market will have large consequences in other parts, and regulators could soon be overwhelmed by unintended consequences. 

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Election 2012: Romney on Energy

After last week's review of President Obama's energy record and campaign materials on energy, Governor Romney's energy plans present a sharp contrast. They are based on a fundamentally different view of energy and the economy, relying on markets to allocate capital to the most productive opportunities, rather than on government to guide a mix of public and private investments along specific paths towards designated ends. They also emphasize technologies that are already deployed at scale today, not those still under development or striving to attain scale. Implicitly, the Romney plan prioritizes supplying the energy for a robust economic recovery over programs designed to address long-term environmental challenges like climate change. These positions present voters with a serious and consequential choice on November 6th.

The Romney campaign's website on energy arrays the candidate's ideas mainly in words, rather than with the kind of images and interactive features that dominate the Obama campaign's sites. Energy is the first plank of Governor Romney's five-point "Plan for a Stronger Middle Class", though it requires a little work to explore the details of his energy program. A list of bullet points  is backed up by a lengthy policy paper with numerous references to external sources, but you have to look for it.

The Romney energy plan focuses mainly on oil, gas, coal and nuclear energy, which together meet 91% of current US primary energy demand and which the Department of Energy projects will still provide nearly 90% in 2020 under the policies in place today. You won't find much on his campaign's website about the new renewables that generated electricity equivalent to 2% of our energy use last year, beyond a critique of the administration's investment in Solyndra and a commitment to R&D on new energy technologies.

Among the details of his plan are support for expanded offshore drilling, including areas such as offshore Virginia that were originally in the Obama administration's early-2010 offshore development blueprint, along with a comprehensive assessment of US resources using current technology, rather than further extrapolations based on 1980s technology. Governor Romney proposes expanding energy cooperation with both Canada and Mexico and would approve the entire Keystone XL pipeline. His goal of attaining North American energy independence is aggressive, yet recent analysis by Citigroup puts it within the realm of possibility. It appears to be based on an assessment by Wood Mackenzie, a top-notch energy consultancy, indicating that US oil and natural gas liquids output could expand by 7.6 million barrels per day, with 6.7 million of that coming from federal lands and waters currently off-limits to development. That compares to US net petroleum imports of 8.5 million barrels per day in 2011.

Another aspect of the plan aimed at streamlining the permitting of energy projects could be just as useful for utility-scale renewable energy projects as for oil and gas exploration and production. Regulatory and permitting delays are among the key reasons it takes longer and costs more to develop crucial energy and infrastructure projects here than in many of the countries against which our competitive standing has been slipping. Governor Romney also proposes giving states greater control of permitting on their non-park federal lands. That could substantially increase energy access and output, especially in the west, where the federal government owns over 280 hundred million acres, or 37% of those 11 states, net of tribal lands.

There are also some missing elements. I would have liked to see more about how renewables fit into Governor Romney's vision. He apparently supports the Renewable Fuels Standard but is silent about the increasingly urgent need to reform it. He is on record against the extension of the wind Production Tax Credit (PTC), a 20-year old subsidy roughly equivalent to the current price of natural gas, yet misses the opportunity to explain how all types of energy would be treated under his proposal to reduce corporate income tax rates while broadening the tax base--policy-speak for closing loopholes and eliminating incentives. In last night's debate he said, referring to the $2.8 billion in annual tax incentives for oil and gas identified by the Department of Energy, "... if we get that tax rate from 35 percent down to 25 percent, why that $2.8 billion is on the table. Of course it's on the table. That's probably not going to survive (if) you get that rate down to 25 percent." I'd also like to hear more about how Governor Romney would address greenhouse gas emissions once the economy returns to stronger growth.

Superficially, much of the Romney energy agenda evokes a return to the pre-2008 status quo: heavy on oil, gas and coal, light on renewables, and largely ignoring climate change. I see it from a different perspective: When Barack Obama began running for President in 2007, the US was considered by many to be tapped out on conventional energy, with domestic oil and natural gas production exhibiting signs of deep and permanent decline. In that context it made sense to look beyond those resources to the potential of renewable energy and vehicle electrification, even if the transition involved would be lengthy. That approach also appeared synergistic with reducing greenhouse gas emissions, and a strategy was born. In the meantime, however, it turned out that US oil and gas were far from exhausted, and the most productive new energy technology of this decade wasn't wind, solar or biofuels, but the combination of hydraulic fracturing ("fracking") and horizontal drilling that has unlocked hundreds of trillions of cubic feet of shale gas and tens of billions of barrels of shale oil or "tight oil" resources. Since 2008 the expansion of shale gas drilling has added as much new US energy production as over 250,000 MW of wind turbines or solar panels--8x the wind and solar power added in the same interval. To the surprise of many, the big global energy opportunity of the 20-teens is US hydrocarbons. The Romney plan reflects the unexpected energy transformation we're experiencing.

As in 2008, this blog isn't in the business of endorsing candidates. Energy remains an issue that, like the Cold War, demands bi-partisan cooperation and some level of consistency from one administration or Congress to the next. However, that doesn't prevent me from observing that the energy agendas of the two campaigns are not equally well-suited for a period of serious US fiscal constraints and shrinking federal discretionary expenditures, in which our energy security and economic growth will still depend largely on fossil fuels. In that context, it's highly relevant that the "all of the above" credentials of one candidate depend on oil and gas outcomes that his policies did little to support. Of course, energy isn't the only issue that matters, but then you wouldn't be reading this if you didn't think it was important.

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The Unlevel Playing Field for Energy

An editorial in last weekend's Wall St. Journal led me to a recent analysis by the US Energy Information Agency (EIA) summarizing the costs of the federal government's various "subsidies" for energy from different sources.  This is both useful and timely, since discussions of specific subsidies such as the expiring wind production tax credit inevitably lead to questions about how incentives for renewable energy compare to those for oil, gas, nuclear, and other more traditional sources.  As the Journal noted, the EIA stopped short of comparing these incentives on the basis of the relative productivity of different energy sources, but even without that it's still apparent that the category of new renewable electricity--excluding hydropower--received 21% of the federal energy benefits for 2010, while accounting for less than 3% of domestic energy production that year, when oil and gas, which provided 49% of US energy production, received less than 8% of these benefits.  Whether on an absolute or relative basis, renewables receive much more generous federal support than oil and gas.

Before digging further into the EIA's analysis, I should point out an important distinction between the federal expenses and incentives covered in the report and the externalities that are frequently conflated with them.  It is certainly true that many of these energy technologies involve significant impacts that aren't reflected in their market prices, and that the production and especially the consumption of fossil fuels create serious environmental and security externalities. However, to whatever extent federal subsidies address externalities they do so indirectly, at best, and in many cases inefficiently.  The focus of this posting, just like the EIA report's, is on the federal government's cash outlays and "tax expenditures"--deductions, credits, etc.--that have a direct bearing on the federal deficit and debt burden that are the subject of intense debate in this election cycle.

The tables in the report's executive summary reveal several key facts.  Between 2007 and 2010 federal energy subsidies in constant dollars more than doubled to $37.2 B, with most of the increase going to renewables and energy efficiency, except for a sizable bump in low-income energy assistance payments.   $14.8 B of the increase originated with the 2009 stimulus bill, none of which was directed at oil and gas, but which appropriated nearly $8 B to conservation and efficiency.  Overall, renewables received $14.7 B, split 55/45 between electricity and biofuels, while nuclear received $2.5 B and oil and gas $2.8 B.  The latter figure is lower than you'll see elsewhere, because among other incentives that the EIA chose to exclude from its analysis was the Section 199 deduction for manufacturers, which is budgeted at around $1 B/yr for oil and gas firms.  The logic behind that exclusion seems sound, because US manufacturers of biofuels, wind turbines, solar panels and other renewable energy equipment qualify for the same tax credit, and at a higher rate than oil companies.

I was also struck by the fact that oil and gas received just $70 million out of the more than $4 B spent on R&D. If there's one category in which federal expenditures on renewables should be expected to dwarf those for conventional energy, this is it, and they did so by a factor of more than 20 times.  (Coal R&D received more than $0.6 B, presumably for clean coal technologies.)

It's also the case that while the growth of renewable energy output from 2000-10 was dramatic, the relatively smaller net changes in oil and gas output in that period masked the substantial replacement of depleting resources that would have otherwise resulted in a large drop in output, especially for natural gas.  This is precisely the aspect of the mature oil and gas industry at which these federal incentives are aimed, to enable US projects to compete with the international opportunities to which many of these companies have access.

The authors of the report suggested caution in comparing the allocations of incentives to the energy produced by each technology, because some of these incentives were paid for projects still under construction and in some cases represented the front-loading of what would otherwise have been a 10-year stream of tax credits.  Fair enough.  Yet even with the conservative assumption that the entire $4.9 B of non-R&D subsidies for wind power in 2010 came in the form of cash grants in lieu of the 30% investment tax credit for new wind turbines that would produce for 20 years at a 30% capacity factor, that still equates to a subsidy of more than 16% of the average present wholesale value of all the electricity those turbines will produce, using prevailing industrial sector electricity prices as a proxy for wholesale prices.  By comparison, the $2.7 B of oil and gas tax incentives for 2010 represented just 1% of the wholesale value of US production of these fuels, before refining.

A serious debate about the appropriate level of US energy subsidies should begin with the facts, rather than with misperceptions. It should also focus first on the goals of such incentives, before jumping to the details of this tax credit vs. that one.  What do we want these measures to achieve?  If it's simply the promotion of energy production, then the current incentive system looks too heavily skewed in favor of renewables.  If it's jobs, then we should be realistic about how many can be added by such a capital-intensive sector.  If it's the promotion of both energy security and innovation, then at least parts of the current system look directionally right, though I'd argue that we'd benefit from spending more on renewable energy R&D and less on the deployment of mature-but-expensive technologies like wind.  However, if emissions and climate change are our primary concerns, then these incentives are not a terribly effective way to address them.  My own expectation is that regardless of whether the wind tax credit is extended for another year, most of the tax incentives that the EIA assessed here will eventually be swept away by tax reform focused on reducing corporate tax rates to improve US competitiveness, while eliminating loopholes to make the changes revenue-neutral.

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Cleantech Firms Paying the Price for Subsidies

In observing the recent struggles of various segments of the global cleantech industry, including renewable energy and advanced energy technology firms, a pattern is emerging. Today's Wall St. Journal reports "Wind Power Firms on Edge," as the US wind industry hunkers down pending the renewal or expiration of a key subsidy at the end of 2012. A maker of electric-vehicle batteries that received a federal grant to build a factory in Indiana is reorganizing via bankruptcy, wiping out the equity of its original investors. Meanwhile, the US International Trade Commission may be on the verge of imposing retroactive tariffs on imported Chinese solar power equipment. Each of these stories has unique features, but what they share in common is the consequences of renewable energy policies around the world that promoted overcapacity in manufacturing and fierce competition in deployment, effectively setting up some of their past beneficiaries for failure or at least a period of very low margins. Depending on your perspective, this is either an indictment of such subsidies or collateral damage on our way to a brighter future.

One blogger from an advanced battery trade association noted that "Ener1 Is No Solyndra", and I tend to agree. As I've noted previously, the decision to award Solyndra a $535 million federal loan was ill-advised, not just because of competition from other solar manufacturers, but because at the time the government approved the loan the failure of Solyndra's business model was essentially already predetermined. Solyndra didn't contribute much to the global overcapacity in solar modules and panels, because its technology was never competitive. By contrast, Ener1's problems appear more fundamental. Like much of the global wind industry and solar industry, it was induced to invest in new capacity, the market for which depended almost entirely on subsidies and regulations that governments might not be able to sustain as these technologies scaled up, and that has gotten significantly ahead of demand.

The best examples of that are probably the various solar feed-in tariff (FIT) subsidies in Europe, which until recently were so generous that they not only supported the intended growth of an indigenous solar industry to capitalize on them, but also gave rise to an entirely unintended new export-oriented solar industry in Asia that had essentially no local market when it started, yet has since gone on to dominate global solar manufacturing and eat the lunch of the European solar makers and developers who got fat off the earlier stages of the FITs.

Or consider the US wind industry, including the imported equipment that still supplies around half of the US wind turbine value chain, according to the main US wind trade association. If the 2.2¢ per kilowatt-hour (kWh) Production Tax Credit (PTC) is renewed, and if wind generation grows from the current level of 115 billion kWh per year to 141 billion kWh by 2021, in line with the latest Department of Energy forecast, then over the next 10 years the wind industry would collect up to $30 B, with much of that locked in for projects that have already started up, less the amount generated by projects that opted for the expired Treasury cash grants in lieu of the PTC to the tune of $7.9 B from 2009-11. Yet based on these figures, wind would supply just 3.2% of US electricity in 2021. The industry now seems to be arguing that it needs just one more renewal of the PTC in order to become competitive. As of 2012, this benefit has been in place on an on-again, off-again basis for twenty years.

Although the theory that underpins such subsidies doubtless has some validity--that governments can help new technologies to develop quicker than markets alone would support, create markets for them by stimulating demand, and thereby move them down their learning curves to earlier competitiveness with conventional technologies--in practice such policies also have the serious shortcomings we are seeing. Because they do not operate in Soviet-style centrally planned economies, none of these governments can tell manufacturers precisely how much production capacity to build, or how much they will sell when it comes on-stream. In the absence of such powers--which in any case proved to be over-rated--companies and their investors are at the mercy of the boom-and-bust cycles such policies generate, with the normal, self-correcting mechanisms of industry consolidation dampened by continued intervention. Nor do the policies now in place seem very successful at creating industries that can survive without them. If you doubt that, ask the US wind industry for their forecast of new installations next year if the two-decade-old PTC is not renewed. According to the Journal, it would be somewhere between 0% and 30% of 2011's 6,810 MW, which was itself a third below the 2009 peak of 10,000 MW, despite the late-2010 extension of the cash grants to cover last year's projects.

The appropriate response to all of this depends on one's politics and the firmness of one's belief that these technologies are essential tools for combating climate change. Falling between the extremes of "just say no" and "look the other way" is the view that governments at least have an obligation to learn from the past and avoid the temptation to yield to demands that they leave existing subsidies in place until their beneficiaries decide they are done with them. If wind tax credits are extended, it should be at a level that recognizes the narrowing competitive gap with conventional energy and phases them out on a schedule. Electric vehicle subsidies should also be reassessed so that we don't find ourselves still providing upper-income taxpayers with incentives of $7,500 per car, even after sales have taken off and sticker prices fallen significantly. And solar subsidies ought to be fundamentally rethought to make it less attractive to install solar panels in regions with low sunlight, such as New York and New Jersey, than in those with abundant sun. And we shouldn't do that just for the benefit of taxpayers and in response to trillion-dollar budget deficits, but in the interest of producing healthy, globally competitive companies in these industries.

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The Battle to Extend Wind Incentives

With the end of the year approaching, the annual Congressional debate over extending a variety of expiring federal tax credits and other benefits is gearing up again. Few of these measures are as high-profile as the payroll tax cut, but each has a vocal constituency, including renewable energy. The American Wind Energy Association (AWEA) has launched a major effort seeking inclusion of the Production Tax Credit (PTC) for wind power in this year's "tax extenders" package. That might seem premature, since the PTC won't expire until the end of 2012, until you realize that eligibility for the stimulus-funded Treasury renewable energy grants for which many wind project developers have opted over the PTC ends in a few weeks with little chance of a further extension. However, before simply tacking another year (or four!) onto a tax credit that began nearly 20 years ago, Congress should answer two basic questions: Is this still the most effective way to promote renewables like wind, and does wind power now require subsidies at all?

I don't blame AWEA for tackling this issue early, since the US wind industry has experienced significant volatility when previous PTC expirations went down to the wire, and in several cases lapsed for up to a year. At the same time, taxpayers deserve a more compelling rationale for continuing to subsidize wind power than the one now being offered. The "green jobs" argument is wearing thin, post-Solyndra, and it has become increasingly evident that helping to create a market for renewable energy technologies is a necessary but not sufficient condition to establishing a sustainable, globally competitive renewable energy manufacturing industry. Although more of the wind power value chain is now produced in the US than previously, too much of each wind subsidy dollar still goes offshore for this to be deemed an efficient way to boost to US jobs and manufacturing without reform.

In order to address the first question I posed, concerning the continued suitability of the PTC, it's important to understand how it works and how it compares to other renewable energy incentives. The current PTC provides wind project owners (or the parties to whom the tax benefit has been sold via a "tax equity swap") with an income tax credit of 2.2 cents per kilowatt-hour (kWh) of electricity actually generated and sold from the completed facility. Based on recent estimates of the levelized cost of electricity from unsubsidized wind power, that's over 20% of a typical wind farm's production cost. It's also equivalent to more than half of this year's average wellhead price of natural gas--a far larger subsidy per BTU than the controversial tax benefits currently provided to oil & gas firms.

The best thing about the PTC is that it is entirely outcome-based. You only receive the benefit when your project is completed, brought online, and as power is sold to customers. Mess up any of those steps and you get zilch. Put your project in a location with poor wind resource or limited access to transmission, and you won't get nearly as much tax benefit. So from that standpoint--ignoring the green jobs angle that arose mainly from expediency when the financial crisis and recession hit--we are getting what we pay for: actual low-emission energy. The structure of the PTC has cash-flow implications that are viewed as a problem by many wind developers but might be regarded as a useful feature by taxpayers. Smaller developers, in particular, have greater difficulty financing projects when the incentive must be deferred until after start-up, or they may lack sufficient taxable income to take full advantage of the credit. They complain about the need to transact swaps with bankers and other investors to realize the subsidy sooner, at a cost. But perhaps it's not such a bad thing for companies that small to have to convince an experienced third party that their project is really viable.

There are many alternatives to the PTC, including the 30% Investment Tax Credit (ITC), the same one received by solar and other technologies. The stimulus bill extended the ITC as an option for wind and allowed the Treasury Department to pay it as a cash grant, rather than waiting for subsequent tax filings. This certainly put money in the hands of wind developers much quicker--$7.6 billion since 2009 including $3.3 billion so far this year--and it has the added benefit of automatically scaling down as the cost of the technology falls. The solar feed-in tariffs favored in Europe didn't have such a feature, with the result that countries have had to cut them numerous times, but only after the fat tariffs gave birth to a huge export-oriented solar manufacturing industry in Asia. Similar competition is now emerging in the wind industry.

The main problem with the ITC is that when viewed from an outcomes perspective, which really gets to the question of effectiveness, the outcome being promoted is construction, rather than energy production. You would get the same tax credit for a project with the best wind resource as for one with the worst. (This has also led to a lot of solar installations in places that would never otherwise have been considered.) So of the two main policy tools the federal government has used to subsidize renewable electricity, the PTC is probably more cost-effective in delivering the result we should really want, which is more renewable energy. As it is, even with rapid growth over the last decade, wind accounted for just 2.8% of our power generation this year through August.

That brings us to the bigger question of whether wind should be subsidized at all after the current PTC term expires. I get emails practically every day from folks who have serious concerns about the health and environmental impacts of power, as well as its cost- and emissions-reduction effectiveness. Even if we ascribed all of these concerns to NIMBYism, it doesn't change the fact that the wind PTC, complete with annual inflation adjustment, is providing the same level of incentive as it did when the technology was much less mature and cost many times what it does today; AWEA cites wind costs having fallen by 90% since 1980. Other factors have also changed in the last twenty years. A majority of US states--and most of those with attractive wind resources--now have in place Renewable Portfolio Standards requiring utilities to include increasing proportions of renewable power in their supply. These mandates create a similar redundancy as the one between the ethanol blenders credit, which is also due to expire 12/31/11, and the biofuel mandates of the federal Renewable Fuels Standard. In the absence of the PTC, the state RPS system should provide a safety net--and more--for the industry.

There are two other key factors missing from AWEA's arguments for extending the PTC. The first is the economy, which is the main reason that US electricity demand has not been growing at a rate that would support large generating capacity expansions of any kind. New wind installations have been anemic for the last two years, in spite of last year's extension of the Treasury grants. Moreover, wind must now compete with the explosion of domestic natural gas production from shale, which when used in combined cycle gas turbines produces cheaper electricity than wind, with low emissions of the air pollutants that are of the greatest concern to most Americans, while still beating coal-fired power hands down on greenhouse gases.

Where all this leaves us depends on your priorities. If your main focus is on reducing greenhouse gas emissions and you see renewable power as a key strategy, then in the absence of a price on carbon you might support extending the PTC for at least a little longer. If you are concerned about climate change but more worried in the short term about the deficit, then letting the PTC lapse next year and relying on state RPS quotas to put a floor under wind looks reasonable. If boosting US cleantech manufacturing is your aim, you should prefer a more direct incentive than the PTC. And if your main worry is oil imports, then the PTC is irrelevant, since the US gets less than 1% of its electricity from burning oil, and most of that in remote and back-up power roles that wind can't easily fill. On balance, if after considering all the alternatives the Congress decides to extend the Production Tax Credit, it should be for an explicitly final period, at no more than the 1.1 cent/kWh rate that technologies like marine, hydropower and waste-to-energy now receive, and without the annual inflation adjustment that undermines the incentive to continue reducing costs.

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Is the Photovoltaic Price Trend Sustainable?

It has been widely assumed among pundits and policy makers that the continued expansion of solar photovoltaic (PV) installations will drive down PV costs until the electricity they produce is competitive with conventional power sources without the need for subsidies. This belief is grounded in both recent PV cost trends and the well-known "experience curve" effect in manufacturing, in which costs tend to fall in proportion to cumulative output. However, anyone following the fortunes of big PV manufacturers like First Solar, SunPower, and China-based Suntech and Trina Solar might have reason to question this conventional wisdom. Their latest earnings reflect an industry stressed by softening demand in its core market in Europe and facing global overcapacity along the supply chain. This has me wondering how much of the recent decline in PV prices was due to the inherent progression of the technology, and how much to unsustainable market and competitive pressures.

The solar industry has made tremendous progress in the last several years. One indication of that is the price trend for PV in the annual "Tracking the Sun" survey from Lawrence Berkeley Lab. Between 2007 and 2010 the average cost of PV installed in the US fell by around 22%, with the largest portion of that drop occurring last year, followed by a further 11% decline in the first half of this year. Most of the reduction is attributable to the falling price of solar modules, rather than from the non-module, or "balance of system" costs (inverters, structures, installation, etc.) The fact that these declines coincided with an explosion of global PV capacity and output seems entirely consistent with expectations about the likely path of PV costs. Cumulative global PV capacity doubled twice in that interval, based on figures in the newly released Renewables 2011 Global Status report from REN21, so we'd expect to see strong experience-curve cost reductions.

The problem is that the industry dynamic behind this trend didn't much resemble the pristine image that the term "experience curve" evokes, of diligent engineers relentlessly focused on continuous improvement. Without diminishing the contribution of a lot of smart people, a key driver was the tough competition for market share between silicon-based PV, which had to overcome a major bottleneck in the supply of its primary raw material, polysilicon--the price for which spiked and subsequently collapsed--and cheaper but less efficient thin-film PV technologies relying on entirely different chemistries such as cadmium telluride and copper, indium, gallium and selenium.

A further hint that this wasn't quite the standard picture of predictable cost declines promoted by the PV industry is that PV prices appear to have been falling faster than actual costs, which in the case of at least some manufacturers are no longer dropping much at all. This can be inferred from the compression of gross margins reported by the leading firms, and in results that show profits stalling or falling even as volume grows. SunPower, the largest US silicon-based PV maker, reported a net loss for the third quarter of 2011, following a loss in Q2, and issued guidance forecasting a loss in 4Q, as well. We'll get a better picture of the health of the big China-based producers when they report 3Q earnings next week, but in the second quarter Suntech, the world's largest solar panel maker, reported a substantial loss, even though sales were up by a third from a year earlier, similar to results at rival JA Solar. In response Suntech and other Asian producers have apparently slowed planned expansions and reduced throughput at existing facilities, while US PV leader First Solar postponed its new factory in Vietnam.

It's a testament to the ingenuity of the big, established PV producers that they haven't all shared the fate of Solyndra after investing so much in expanding capacity ahead of demand--a major accomplishment in itself when demand has been growing by roughly 80% per year--only to see the market weaken due to a prolonged economic slump and a financial crisis in Europe that has undermined the ability of governments to provide generous subsidies for PV installations. Assumptions about the future cost trend of PV won't mean much if the industry doesn't emerge from its current difficulties as a collection of healthy firms with solid balance sheets and financial performance that investors find attractive. That will require better margins achieved by some combination of improved pricing power--implying better matching of capacity to demand--and cost reductions that don't just rely on further scale-up, which will become less fruitful as experience-curve benefits stretch out.

In other words, even if PV manufacturing costs continue to fall quickly for the next few years, it's less clear that the PV prices paid by project developers, businesses and consumers will follow suit, particularly if the current low margins lead to a global shakeout or consolidation among producers. Time will tell whether the solar industry can sustain the cost path that it's been on, or if future cost reductions will be more modest, in which case a number of scenarios for future PV penetration and renewables-based emissions reductions would require revision.

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Key Renewable Energy Subsidies About to Expire

The US renewable energy industry faces a greatly altered incentive environment next year, as eligibility for two of its largest current subsidies comes to an end at the close of 2011. The corn ethanol sector will likely see the complete withdrawal of the blenders' credit that has fueled its growth for more than 30 years, while new projects generating electricity from renewable energy sources must shortly attract investment without the Treasury grants that provided up-front cash in place of federal investment tax credits against taxable income--a commodity sometimes in even shorter supply among recipients than the energy they seek to generate. With these expirations taking place against the backdrop of a US presidential election campaign and record levels of deficit and federal debt, the prospects for another round of one-year subsidy extensions look slim. Yet renewable energy development in the US won't grind to a halt without them, because these two programs represent merely the most generous layer of the complex web supporting renewables.

Consider the venerable ethanol tax credit, which was made mostly redundant by the passage of the Energy Independence and Security Act of 2007, with its Renewable Fuels Standard mandating the use of increasing quantities of ethanol in gasoline. In fact, ethanol producers were never more than indirect beneficiaries of the $0.45 per gallon credit, which was paid to refiners and other gasoline blenders in order to help create a market for ethanol. Mission accomplished. Moreover, with US gasoline sales having stalled at a level that can barely absorb all the ethanol that existing US ethanol plants can produce, unless gasoline blends containing more than 10% ethanol become popular, there is simply no need for corn ethanol output to expand further. In fact, the market will be more than sufficiently challenged providing outlets for the limited quantities of cellulosic and other advanced ethanol likely to be produced in the next few years. As I've noted previously, forward-looking members of the industry are now seeking help in expanding the market for high-ethanol blends, rather than perpetuating an outdated support for existing sales.

The situation for renewable electricity sources like wind, solar and geothermal energy is more complicated. The expiring Treasury grants were introduced as part of the 2009 stimulus to stand in for the "tax equity swap" market, a category of financial transactions that froze up during the financial crisis. These swaps provided a private-sector cash-flow bridge between project expenditures and tax credits that only paid off after start-up as income was earned or energy produced. That was particularly helpful for smaller, less profitable developers, but it also provided an additional check on marginal projects. Even after credit markets eased, most developers understandably preferred the cash grants, which reduced their financing costs and avoided the fees that bankers charged on tax equity deals. However, that preference doesn't justify continuing the cash grant program--particularly for the large, profitable corporations that increasing dominate this space. The industry should focus more effort on fostering the revival of a liquid and competitive tax equity market and less on lobbying for an extension of a temporary stimulus measure.

Either way, the tax credits behind these grants and swaps won't last forever. Under current law, the principal federal tax credit for wind will be in place only through 2012, for biomass and geothermal through 2013, and for solar through 2016. Instead of a scenario of perpetual last-minute extensions such as we've seen in the past, the industry and its investors should be thinking about a scenario in which all these tax credits end, either as part of comprehensive tax reform that eliminates most such "tax expenditures"--including the ones for the oil and gas industry that have become so contentious in the last few years--or a transition to providing renewables with similar sorts of incentives as oil and gas, which essentially amount to forms of accelerated depreciation and modest tax breaks for manufacturing in the US, rather than in other countries.

It's also important to realize that even without these tax credits and in the absence of comprehensive federal energy legislation that looks unlikely any time soon, the industry would still retain numerous state-level benefits, starting with the renewable portfolio standards (RPS) for electricity currently in place in 29 states and the District of Columbia, a tally that encompasses most of the states with the best wind and solar resources. These RPS's are similar to the Renewable Fuel Standard for biofuels in requiring utilities to include increasing proportions of renewable energy in their supply portfolios, whether owned or purchased. Such standards, including California's aggressive RPS targeting 33% renewable electricity by 2020, stand outside the polarizing political debate over taxation and government expenditures. They function as an implicit tax on ratepayers, rather than taxpayers, because they show up within customers' utility bills rather than on their 1040 forms. That distinction could be particularly important if the congressional supercommittee fails to reach a consensus, and the default spending cuts built into the Budget Control Act that resolved this summer's debt ceiling crisis kick in.

So while it might appear that the US renewable energy industry is about it be cut loose from the key incentives that enabled it to grow to its present dimensions, it will continue to benefit from supports not enjoyed by other industrial sectors. Even when the current tax credits expire, renewables will have a mandated market providing a floor beneath them. Ethanol output won't revert to 2005 levels, nor will renewables vanish from the landscape, even if their growth slows a bit while the rest of the economy struggles to emerge from the aftermath of the Great Recession and financial crisis, and to avoid a double-dip. Meanwhile, global overcapacity in wind turbine and solar module manufacturing will keep their prices trending lower--and installations stronger--pending industry consolidations that will position both for healthier, more sustainable growth in the long run. All of this falls well short of the level of help for the industry that most renewable energy supporters would like to see, but it's far more than the level playing field (ignoring externalities) that would see cheap and abundant natural gas sweep away all competition for new power generation.

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The American Jobs Act's Poison Pill(s)

I had a completely different topic in mind for today's posting, but I'll have to come back to the energy implications of a potential European financial crisis later. Since President Obama's jobs speech to Congress last week I have been awaiting the text of the actual proposed bill, rather than the summaries I'd been seeing. It finally came out at the end of the day yesterday. I feel obliged to point out a few provisions that haven't been widely advertised, either in the original speech or on the fact sheet that the White House published. These include several measures related to alternative energy, such as the inclusion of some project categories within the purview of the proposed National Infrastructure Bank, or the funding for putting solar panels on abandoned and foreclosed buildings as part of their rehabilitation. However, I'm not sure how much any of this matters, because the bill sent to the Congress also includes a slate of provisions that were certain to be regarded as a "poison pill"--sections that would preclude passing it on the all-or-nothing basis that the President seemed to be pushing for last Thursday. Energy features prominently in these poison pill measures.

I can't do justice to a 155-page legislative draft in the few hours I've had to review it. I'll restrict my comments today to the "offset" provisions that escaped being mentioned in the administration's fact sheet and reserve comment on the other aspects of the bill for a later date, if necessary. It seems clear from reading Sections 431-442 that the architects of this bill view the US domestic oil and gas industry as a declining cash cow, rather than as the source of new jobs and growth that I described in last Thursday's posting. Those sections set out to repeal every single oil and gas industry tax benefit of which I was aware, and a couple I hadn't even heard of. Included are the Section 199 manufacturing tax credit enjoyed by every other manufacturing company in America, along with portions of the tax code designed to prevent US companies from being subject to double taxation on their global income, protections that I believe their non-US competitors enjoy automatically under the territorial tax systems in use in most developed countries. In a different context I wouldn't have found any of this surprising, but rather a measure of consistency, since the administration has pursued the termination of these benefits in every budget proposal since 2009 and in a number of bills introduced by its allies in Congress.

The surprise comes from their inclusion in a bill intended to provide immediate relief for the large number of Americans still out of work, and possibly to avert a double-dip recession--a bill described as consisting mainly of provisions that have been backed by both parties at various times. However, the legislative history and likely fate of the poison pill provisions is abundantly clear: they have failed every time they were proposed, including in the previous Congress in which the President's party held overwhelming majorities in both houses. Along with the other "offset" provisions, such as those limiting itemized deductions for taxpayers making more than $200-250,000 per year, or going after the tax treatment of hedge fund income and corporate jets, it's hard to see their inclusion in the American Jobs Act as anything other than politically motivated. This morning's headlines reflect the entirely predictable reaction to them.

It's not that these measures aren't a legitimate subject for debate and action. However, that debate is part and parcel of the growing bipartisan consensus on the need for comprehensive reform of our convoluted tax code, in which the majority of current deductions and exemptions, including those for energy, would be sacrificed in exchange for the lower tax rates necessary to make all US businesses--not just a chosen few--more globally competitive. Squandering that opportunity to pay for a short-term boost to the economy would, among other outcomes, leave the US energy sector less competitive and the nation worse off in the long run. Meanwhile, when the Congress rejects these poison pills and proceeds to cherry-pick among the bill's headline measures, it might also adopt the American Jobs Act's final provision, which dumps the problem of paying for it in the laps of the Supercommittee appointed to find the remainder of the deficit reductions agreed in the Budget Control Act of 2011--already a pretty tall order.

If there was ever a chance for a "clean" jobs bill to pass intact, the pursuit in this venue of the administration's long-standing agendas with the oil and gas industry, hedge fund managers, and corporate jet owners erases it. Whatever the outcome of the negotiations with and within the Congress over this bill, you can count on hearing a lot more about these issues between now and next November.

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US Renewables Need A Fallback Plan

When I described some of the energy implications of the debt limit crisis last month, the most serious ones were associated with a default by the US government in the event the debt ceiling wasn't extended. That risk has been resolved, for now. But that doesn't mean that everything looks rosy, especially for renewables. Renewable energy technologies and projects are far more dependent on government assistance and policies than conventional energy. The fate of a wide range of federal energy incentives looks highly uncertain, and the impact of that uncertainty is matched by doubts about the health of the US economy and its growth prospects. With the pace of growth already slowing in some renewable energy sectors, any manufacturers or project developers that aren't thinking seriously about how they would manage without federal incentives could be setting themselves up to become roadkill.

Understanding why requires taking a closer look at the debt ceiling bill that Congress passed in the context of the federal budget baseline--never mind that the US Congress has not enacted a budget in more than two years. In April the Congressional Budget Office (CBO) published its assessment of what the economy would look like under the budget submitted by President Obama in February, as well as under the laws already on the books. The latter comprises the "March CBO Baseline" that was mentioned frequently during the debt limit talks and that formed the basis for comparing different proposals. (See Table 1-5 of the CBO report.) Without factoring in this week's debt limit agreement, the CBO projected a cumulative deficit for fiscal years 2012-21 of $6.7 trillion. That figure is important for several reasons.

First, it serves as a reminder that even after the $917 billion of cuts agreed up front and the $1.2-1.5 trillion of future cuts to be determined later this year, the US debt would still grow by more than $4 trillion over the next decade, mainly through increases in mandatory, or non-discretionary spending--entitlements and other untouchables. That won't change even under the deal done by the Senate and House this week; all of its pre-programmed cuts are to discretionary spending, the category into which most federal spending on renewable energy would fall.

But even that $4 trillion figure looks optimistic. As I understand it the CBO baseline assumes that next January 1 all of the Bush-era tax cuts will expire on schedule, resulting in substantial increases in taxes on both ordinary income and dividend income. And that's not just for those earning more than $200,000 per year, or whatever the threshold of "wealthy" is determined to be; it's for everyone. Nor would the Alternative Minimum Tax, which has been biting a growing number of middle class families every year, be indexed as proposed. It also assumes that the Social Security payroll tax will revert to its normal level of 6.2%, up from this year's 4.2%. Barring a dramatic improvement in the economy between now and the end of the year, it seems unlikely that all of those tax increases will be allowed to take effect. That means that the government's revenue through 2021 is likely to be significantly lower than the CBO forecast, because both growth and tax rates are likely to be lower. That translates into bigger deficits and more pressure for deficit reduction.

So the environment for continued support for renewables will be one in which the government's projected deficits continue as far as the eye can see, even after painful cuts, while its ability to continue borrowing on that scale looks suspect. With the main focus of budget cuts falling on the category that includes cash support for renewables, how likely is it that the Congress would extend the Treasury renewable energy cash grant program when it expires on December 31, 2011, or add new appropriations for the Department of Energy's Loan Guarantee Program? And if the Congressional super-committee's proposals include tax reform that would eliminate many "tax expenditures"--tax credits and deductions--then a host of programs such as the solar investment tax credit, the wind, biomass and geothermal energy production tax credit, various biofuel tax credits, and the electric vehicle purchase tax credit, could end up on the cutting block. In the coming scramble to avoid the budget knife, renewables will be competing with better-established programs with broader and more influential constituencies.

It has always been a risky proposition to build companies and industries, the economics of which depended on substantial government subsidies. Some folks could be on the verge of finding out just how risky. If we go down that path, it will probably also result in awkward questions being asked about some of the decisions made by the stewards of these government programs. They should be; I've never understood what kind of due diligence could have resulted in hundreds of millions of dollars in grants or "loans" going to to clean energy and automotive startups with minimal track records, when private investors weren't willing to bet on those risks at that scale. From a national energy policy and strategy perspective, our focus should not be on saving individual companies--no TARP for renewables, I suspect--but on preserving key capabilities essential to ensuring a long-term competitive US position in the global clean energy market.

What would that entail? First, as government funding for renewables becomes constrained it should be focused on R&D at the expense of deployment. Not only would the available money go much farther, but it would also create more options for the future. The next step should be to ensure that whatever the government does spend on deployment should go to projects that are close to being viable without help, or in the case of the military that enhance combat capabilities. That means, for example, focusing solar development assistance on sunny places like the southwest--preferably in proximity to existing transmission infrastructure--and putting an end to paying people to install utility and rooftop solar in places that receive less than about 5 "peak sun hours" (kWh/m2) per day, on average. Again, the money would go farther, and we'd be shoring up nearly viable operations, instead of trying to command the tide not to overwhelm the marginal ones. And finally, as I suggested last week, a greater emphasis on exports to developing country markets, where energy demand is growing at impressive rates and where renewables are becoming increasingly popular, would increase export earnings and employment while participating in volume-related unit cost reductions. And looking beyond renewable energy, the US government has a bird's nest on the ground in the form of the potential lease bid and royalty income from the substantial oil and gas resources that have been placed off limits for various reasons. Tapping those looks like a much smarter source of revenue--not to mention job creation--than selling off the Strategic Petroleum Reserve bit by bit.

If that sounds like a recipe for putting the US cleantech industry on life support after years of robust government-supported growth, then that's consistent with the severity of the fallback plan that could become necessary. The need for this would depend on the priorities set by the special Congressional deficit reduction committee established by the debt ceiling bill, and by the Congress as a whole, along with the subsequent efforts that will be necessary to prevent our long-term debt from growing beyond our ability to service it. Nor would it be quite the starvation diet it might appear, as long as states kept their renewable portfolio standards in place. This isn't a scenario the cleantech industry would willingly choose, but it's one that it can't ignore.

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Has the Solar Market Reached A Turning Point?

Several trends appear to be converging to make 2011 a watershed year for solar power, though not quite along the lines that solar advocates have been telling us to expect. The long-awaited arrival of "grid parity", when the unsubsidized cost of power from solar panels finally becomes competitive with that of power from the grid, is still either imminent or elusively out of reach, depending on who you ask. In the meantime, solar power remains critically dependent on government incentives. Changes in subsidy levels in key countries and the rapid growth of solar manufacturing in Asia are setting the stage for a shift in the geographical focus of the industry, with important implications for national energy policies.

Last year most of the new solar photovoltaic (PV) capacity in the world was installed in Europe, accounting for roughly 4 out of every 5 Watts of global PV additions. That shouldn't have surprised anyone, because it fits a long-standing pattern. However, the European policies that made it possible for PV to compete, even in such un-sunny northern locations as Germany, have come under considerable pressure as governments have been forced to confront high debt levels and other priorities. Feed-in tariffs (FIT) that guaranteed above-market power prices for the life of a PV installation have been slashed across Europe, including in Germany, Italy and France, in a trend that has lately spread beyond Europe. This is beginning to translate into lower demand. The reason it hadn't already resulted in a big reduction in European PV installations is that the cost of PV was dropping rapidly, further justifying legislated cuts to generous FITs.

Here's where the narrative diverges from the storyline that advocates outside the solar industry have been touting for years. Although a substantial portion of those cost reductions is attributable to economies of scale and experience curve effects--manufacturers finding new ways to cut costs as output climbs--a large slice of the reduction in global PV prices has been due to increased competition from lower-cost producers entering the game. The largest PV manufacturers in the world are now mainly based in China, rather than Europe, and PV producers outside Asia have had to shift much of their manufacturing to lower-cost locations in response. So for the last couple of years we've seen a global PV market focused mainly on sales in Europe but increasingly dominated by export-driven manufacturing in Asia. That picture is now changing as domestic demand in Asia picks up, along with growing installations in the US.

China is rapidly becoming the key country for solar, from both a supply and demand perspective. In addition to hosting leading PV producers such as JA Solar, Suntech Power, Trina Solar and Yngli Green Energy, China's latest five-year plan increases the country's solar power target to 10,000 MW by 2015 and 50,000 MW by 2020. That compares to global solar capacity of around 37,000 MW at the end of 2010, nearly half of which is in Germany. Ramping up installations to meet its new goals, as ambitious as they are, is unlikely to turn China from a net solar exporter to a net importer, as happened earlier for oil. That's because China's PV manufacturers are still adding capacity at a rate that should allow them to satisfy domestic demand in China--where they face only modest competition from foreign firms--while remaining highly competitive elsewhere.

With these developments, policy makers in Europe and the US who have been as focused on the creation of national solar manufacturing industries as on the deployment of solar as an element of their broader renewable energy strategies must answer a crucial question: As the PV industry develops and matures, will it follow the path of wind turbine manufacturing, in which established US and EU firms have been able to remain globally competitive, similar to the aerospace industry, or is it likelier to emulate consumer electronics, for which manufacturing is now dominated by Asian producers? If it's the latter, then the whole system of solar incentives must be rethought.

In the meantime, the shift of the solar power center of gravity away from northern Europe should advance the prospects for grid parity, because low-cost solar power depends as much on high-quality solar resources as on cheap PV panels. Geography isn't always destiny, but in the case of solar power its full potential will only be achieved when its deployment aligns large power demand with high average annual solar irradiance. In the long run, that points to a global PV market focused squarely on the US and China.

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The Oil Earnings Backlash

Another oil industry earnings season bolstered by high oil prices has sparked the customary controversies about price gouging and industry subsidies. Last Thursday I participated in ExxonMobil's press call following the release of that company's first quarter earnings. In addition to the responses to my questions about access to non-US energy resources and the progress of the company's algae venture with Synthetic Genomics, I was intrigued by the answer of Ken Cohen, VP of Public and Government Affairs, to a question concerning Exxon's crude oil sales to other refiners. It resonated with my own experience in commodities trading at Texaco in the 1980s and '90s. Not only do major companies like Exxon, Chevron, Shell and BP control only a small fraction of the world's petroleum reserves and production, but they are often large net buyers of crude oil for their refining operations. Understanding the relationship between industry profits, gas prices and the federal tax deductions and credits designed to promote domestic energy production requires a deeper look into the results.

It's discouraging how much confusion still exists in the media concerning oil prices and gasoline prices, as noted in an excellent posting on the topic by Robert Rapier. Members of the public who are convinced that oil companies are manipulating prices to gouge them can always find some poorly reported news story or garbled explanation to justify their belief. Yet while it's certainly true that oil companies benefit from the higher oil prices that result when global demand for petroleum products is strong and supply is constrained and/or subject to unusual risks--both factors are at work today--their interests are not quite as divorced from those of gasoline consumers as they appear, because they are, to a very large extent, also consumers themselves.

A quick look at ExxonMobil's 1Q11 earnings release shows their net global production of crude oil and natural gas liquids at 2.4 million barrels per day (MBD). Meanwhile the company's refineries processed nearly 5.2 MBD in support of global refined product sales of nearly 6.3 MBD. In other words, Exxon had to buy more crude oil from other suppliers than it produced itself in order to feed its refineries, and then still had to acquire more than a million barrels per day of additional refined products from other refiners to meet its marketing demand. Meanwhile, 81% of its nearly $10.7 billion of first quarter earnings was attributable to oil and gas production, and 85% of that was from production outside the US. By comparison, just 6% of that $10.7 billion came from the domestic refining and marketing activities affected by US gasoline prices.

That's a fairly typical pattern for the majors, which have generally been short of crude oil for their refining systems since the big wave of nationalizations and expropriations in the 1970s. My old company, Texaco, refined about twice as much oil as it produced and sold roughly half-again more products than it refined. That meant that my trading colleagues and I were in the market every day, buying crude oil and refined products from our competitors, in order to keep our refineries and marketing outlets supplied. When supplies were tight, the only way to secure what we needed was to bid more than the next company, and that reinforced the dynamic of rising prices until supplies expanded or demand slackened. I see that as of the first quarter, Texaco's successor Chevron Corp. (of which I am a shareholder) produced about as much oil globally as it refined, though not in the US, where it processed 80% more crude than it produced domestically. Global product sales exceeded refinery throughput by more than a million barrels per day. Royal Dutch Shell's results exhibit an even more pronounced case of net purchases of both crude oil and refined products.

So while higher oil prices are good for some parts of these companies' businesses--the exploration and production divisions that contribute the majority of profitability in most years--other business segments find higher prices a mixed blessing, at best. That's particularly true for the parts of these companies with which US consumers have the most contact.

As for the questions I posed to Mr. Cohen, I was somewhat surprised to hear that ExxonMobil isn't looking for the US government to provide it with any assistance in gaining access to resources around the world. Foreign governments routinely help their national and quasi-national oil companies to negotiate for access. ExxonMobil seems able to compete in this arena without help from the US government but is much more concerned about the latter's restrictions on access here at home, and its efforts to tax non-US income that has already been taxed by host governments overseas. And with regard to ExxonMobil's activities in algae, I was informed that R&D is progressing well in both California and in Baytown, TX, where a large pond has just been completed. Mr. Cohen stressed that it was still early days for algae.

The purpose of drawing my readers' attention to the distinction concerning oil companies' large net oil and product purchases isn't to solicit sympathy for an industry that's obviously having a very profitable run, but to remind you that the oil and gasoline price situation is a lot more complicated than suggested by the sound bites we often hear. The biggest companies make most of their profits producing oil and gas outside the US, while refining and marketing here remains a capital-intensive and relatively low-return sideline that many of them have been quietly exiting for years. Ending the industry's tax breaks outside of the comprehensive tax system reform I believe to be necessary probably wouldn't harm the big oil companies as much as it would accelerate their shift away from operations in the US that contribute less to company profits than they do to US energy security.

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Cutting the Federal Budget Wisely

This week the administration issued its third budget since taking office in January 2009. In a year otherwise focused on belt-tightening, the proposal includes a 12% increase for the Department of Energy, focused on additional R&D for renewables and nuclear power. The increase would be offset by cuts in fossil energy programs and the elimination elsewhere in the budget of various tax deductions and tax credits--"tax expenditures" in Beltway parlance--that benefit the US oil and gas industry. Also new for this year are proposed additional fees on the industry to cover the increased cost of issuing drilling permits in the aftermath of the Deepwater Horizon accident, along with another provision to raise the cost of holding inactive oil and gas leases. Aside from the politics involved, this exercise reminds me of the periodic waves of cost-cutting I experienced at Texaco, Inc. in the 1980s and '90s. Unfortunately, the government hasn't yet learned the vital lesson that my former company and many in other industries finally figured out after years of experience: Reducing expenses only helps your bottom line when the items you are cutting contribute less in revenue than they cost.

Start with the oil and gas subsidies, which I've discussed previously. The newly submitted budget estimates these at approximately $4 billion per year. As we heard the President say in his latest State of the Union address, "I'm asking Congress to eliminate the billions in taxpayer dollars we currently give to the oil companies. (Applause.) I don't know if--I don't know if you've noticed, but they're doing just fine on their own. (Laughter.) So instead of subsidizing yesterday's energy, let's invest in tomorrow's." It's a guaranteed applause line, as the White House's own text indicates, despite including potentially serious errors of fact.

Now, one could argue in the abstract whether a tax credit or deduction constitutes a gift of "taxpayer money" (i.e., the government's) or an opportunity for the taxpayer in question to remit less of his own money to the government. I know how I feel about that when it comes to filing my form 1040. One might even arrive at different answers in different situations. As a practical matter, however, what counts in the current context is not whose money this is in the first place, but whether taking more of it leaves either the federal government or the US economy better off. Even from the perspective of tax revenue, a recent study found that after an initial increase, the long-term impact of higher taxes on the oil & gas industry resulted in reduced government revenue. Higher taxes on US oil & gas production will translate into less of both--and so less to tax--while also yielding more future imports and higher trade deficits, along with reduced energy security.

The President's remarks also suggested incorrectly that oil and gas are yesterday's energy, and not also today's and tomorrow's. In 2009 oil and gas accounted for 62% of our energy consumption, and the US Department of Energy expects them to continue to supply as much as 57% of our needs in 2035, after subtracting the contribution of liquid biofuels. Treating these key energy sources as undesirable could have serious consequences for our energy and economic security in the years ahead. Nor would it assist our efforts to reduce greenhouse gas emissions. Natural gas can contribute significantly to reducing the emissions from the power sector, which accounts for 40% of US CO2 emissions, and the main opportunities for reducing emissions from transportation, where most of our oil use takes place, are on the user side--conservation and more efficient cars, trucks and planes--and not on the extraction, refining and distribution side of the industry.

If the administration couldn't get these tax changes enacted in the previous Congress, they stand even less chance this term. However, that might not be the case for the additional "user fees" and lease fees, since they are new this year. The former are related to the redesign of the oversight agency for offshore drilling and were recommended by the Presidential commission investigating the accident. As I noted when their report came out, we already have a mechanism for recouping the expenses that the Bureau of Ocean Energy, Management, Regulation and Enforcement (formerly the Minerals Management Service) incurs in the course of reviewing leases and drilling permits and monitoring offshore activity. That mechanism is the lease bids and royalties that brought in $8 billion from onshore and offshore oil and gas in fiscal 2010. In a good year these sums could cover the entire Interior Dept. budget, let alone that of BOEMRE. Adding new fees on top of the existing royalties further reduces the attractiveness of drilling in US waters, on top of the "moratorium/permitorium" --now in its tenth month--for which critics finally received a belated explanation earlier this month. The net result of new fees would be less drilling here and more drilling in places like offshore Brazil.

Then there's the notion of "establishing fees for new non-producing oil and gas leases (both onshore and offshore) to encourage more timely production." This is clearly an outgrowth of the "idle leases" canard that was making the rounds in 2008. However, in light of protracted delays in issuing new permits and the likelihood that fewer permits will be issued in the future than in the past, it seems almost Kafkaesque to penalize companies for not drilling sooner on more of their leases. In truth, companies already pay twice for non-producing leases: once when they pay a bid bonus to acquire the lease, and then every year in the form of a lease rent that is due as long as the lease remains undeveloped. Companies factor this into the bonuses they bid, along with their assessment of the likelihood that a lease contains commercial quantities of oil or gas. Additional fees on non-producing leases seem likely to result in one or more of the following outcomes: lower bonus bids, fewer bids, and an increased focus outside the US. None of that would help either the deficit or energy security.

I'm entirely supportive of the government cutting expenses, including unwarranted subsidies, in order to begin the difficult task of bringing the federal budget closer to balance within the next few years. This seems essential if we're to avoid serious consequences for our credit rating, interest rates, and exchange rate. However, along the lines of what I saw when the oil industry reduced expenses in the aftermath of the big oil price drops of the mid-1980s and 1998-9, it would be counterproductive to do so in a manner that would actually result in lower overall tax receipts, while reducing domestic energy production in the bargain. Ultimately, it makes a lot more sense to target repealing the tax expenditures in question as part of the broader tax reform that seems inevitable if we want to get the deficit under control. That would eliminate specific tax breaks but simultaneously reduce overall corporate tax rates to make US industry more competitive globally, not less. A budget that proposes to double corporate income tax receipts by 2013--to a level higher than their 2007 asset bubble peak--is out of step with the competitiveness agenda that the administration has espoused, aside from its shortcomings in narrowing the long-term deficit.

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What Does $19 Billion Buy?

I see in the Washington Post that two members of Michigan's Congressional delegation have proposed more than doubling the current federal purchase subsidy for electric vehicles to around $19 billion. They would do that by increasing the numbers of vehicles from each manufacturer eligible for the $7,500 EV tax credit from 200,000 to 500,000, over ten years. Although I firmly believe that EVs and other advanced vehicles represent an important and inevitable part of our national energy strategy and future vehicle fleet, it's worth considering what this $19 billion would buy, in terms of the outcomes we really care about. After all, putting EVs on the road is not an end in itself. As the article's title in the print edition suggested, this looks like a pricey plan.

The two main factors behind the government's support for electric vehicles are concerns about energy security and greenhouse gas emissions. At least on these metrics and even with the most optimistic assumptions--that EVs will displace average cars rather than efficient hybrids and that they will be recharged from zero-emission sources of electricity--the $7,500 per car benefit looks expensive. If the average EV were driven 10,000 miles a year for 10 years, which seems reasonable in light of the range limitations of current models and the uncertainty surrounding battery life, then each car would save 4,000 gallons of fuel and avoid CO2 emissions on the order of 40 tons during its life. So from an energy security perspective taxpayers are paying the equivalent of $79 for each barrel of oil saved, or from an emissions perspective $188/ton. The former is nearly the current cost of oil, while the latter is ten times the estimated cost of emissions credits used by supporters of the last unsuccessful cap & trade bill.

Aggregating the oil savings attributable to these EVs over the roughly 2.5 million cars implied by the $19 billion figure gets us to the equivalent of 66,000 barrels per day once they're all on the road. That is only about a tenth of the domestic oil production that the latest industry estimate suggests we stand to lose by 2019 if the implementation of new rules for deepwater drilling results in significant delays in obtaining permits and beginning new deepwater exploration and production projects. I understand that this isn't exactly an apples to oranges comparison, but I have a hard time seeing why the same energy security considerations involved in the current EV push wouldn't apply at least as much to ensuring that the federal offshore permitting process is as streamlined as we can make it, consistent with the complexity and risks of these projects, and that the agency issuing permits has a large enough budget to hire a technically qualified staff sufficient to the task.

To the extent that subsidies are necessary to make today's electric vehicles attractive to ordinary consumers, our elected representatives should be focused on making sure those subsidies are as smart and responsive as possible. Paying the same subsidy as today for an EV produced in 2020, when we are frequently assured that battery and other costs will be much lower, makes no sense and invites inefficiency. Instead of more than doubling subsidies just when the current ones--along with generous manufacturing grants, tax credits, loans and loan guarantees--are succeeding in getting carmakers into the EV game, Congress should now be thinking about how to phase them out. We must avoid creating the kind of subsidy addiction that the ethanol industry has exhibited since its start in the late 1970s. We might have been able to afford that kind of approach once, but no longer, particularly when around 40% of the $19 billion in question here will result in new federal debt.

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