Subsidies really do matter to the US oil & gas industry -- one in particular
Subsidies really do matter to the US oil & gas industry -- one in particular
A subsidy that pads company profits & make new projects profitable.
Appears in this episode
Fossil fuel subsidies are a vexed and peculiar topic. On one hand, everyone seems to agree they’re bad and should be eliminated (it’s in Biden’s jobs bill, for instance). On the other hand, they never go anywhere.
In part, it’s because we lack a clear understanding of what constitutes a subsidy and what impact they have. Analysts are forever arguing over exactly what counts, trying to tally up the total subsidies fossil fuels receive, but there are very few bottom-up attempts to document the concrete effects of subsidies on the economics of oil and gas projects.
That’s why I was interested in this new paper in Environmental Research Letters, by Ploy Achakulwisut and Peter Erickson of the Stockholm Environment Institute and Doug Koplow of Earth Track. It breaks down the effect of 16 specific, direct US fossil fuel subsidies on the profitability and emissions of US oil and gas production.
As for those subsidies, there are three basic categories: “forgone government revenues through tax exemptions and preferences; transfer of financial liability to the public; and below-market provision of government goods or services.” (Note that this study does not get into unpriced environmental externalities like air pollution and greenhouse gases, which are themselves a kind of subsidy.)
Subsidies either enrich oil & gas investors or spur new oil & gas projects
One reason there aren’t many bottom-up analyses like this is that it’s devilishly difficult to pin down the economic effect of a subsidy. Doing so always involves a counterfactual baseline — what would have happened absent the subsidy. Anytime counterfactuals are involved, there lots of assumptions to make and variables to account for.
To take just a couple of examples, the effect a subsidy will have on the decision whether to invest in a new oil and gas project will depend on oil and gas prices and the hurdle rate. (The hurdle rate is the rate of return investors require to fully cover risks; more aggressive decarbonization efforts will presumably mean more risk and thus a higher hurdle rate.) The study actually runs several different scenarios based on different values for those variables, producing a cost curve for each region of the US. It gets complicated.
For clarity, they chose to highlight two scenarios: 2019’s higher oil and gas prices with a 10 percent hurdle rate and 2020’s lower prices with a 20 percent hurdle rate. Here are the results:
We find that, at 2019 average market prices of oil and gas, the 16 subsidies could increase the average rates of return of yet-to-be-developed oil and gas fields by 55% and 68% over unsubsidized levels, respectively, with over 96% of subsidy value flowing to excess profits under a 10% hurdle rate. At lower 2020 prices, the subsidies could increase the average rates of return of new oil and gas fields by 63% and 78% over unsubsidized levels, respectively, with more than 60% of oil and gas resources being dependent on subsidies to be profitable under a 20% hurdle rate.
The way to think about this is, subsidies can have one of two negative effects, depending on market circumstances.
With higher prices and a lower hurdle rate, “only 4 percent of new oil and 22 percent of new gas resources would be subsidy-dependent, pushed into making profits,” Achakulwisut told me. That means most of the projects didn’t really need subsidies and the extra money is all going to bigger profit margins for oil and gas investors.
With lower prices and a higher hurdle rate, “subsidies would matter a lot,” she says, “and 61 percent of new oil and 74 percent of new gas would be subsidy-dependent.” The subsidies would directly lead to more production.
Achakulwisut summarizes: “In one case, it's going to profit, amplifying the incumbent status of the oil and gas industry. In another, under more aggressive decarbonization policy and low oil and gas prices, it's actively working against the climate goal by spurring additional production.”
Either of those effects is bad. In 2021, we don’t want bigger profit margins for oil and gas companies and we don’t want more oil and gas production.
One subsidy to rule them all
What’s interesting is that the benefits to oil and gas are not spread evenly over different subsidies. In fact, one in particular dwarfs the others: the expensing of intangible exploration and development costs (“intangible drilling costs,” or IDC), a policy that’s been around for over a century.
The chart below shows the “average effect of each subsidy on the internal rate of return (IRR) of new, not-yet-producing oil and gas fields, at average 2019 prices of USD2019 64/barrel of oil and USD2019 2.6/mmbtu of gas.”
As you can see, in every region, the IDC deduction is the dominant subsidy. It “increases US-wide average IRR by 11 and 8 percentage points for oil and gas fields respectively.”
The IDC deduction has been the subject of controversy for ages. The Committee for a Responsible Federal Budget (CRFB) has a good breakdown here. A definition:
Intangible drilling costs are defined as costs related to drilling and necessary for the preparation of wells for production, but that have no salvageable value. These include costs for wages, fuel, supplies, repairs, survey work, and ground clearing. They compose roughly 60 to 80 percent of total drilling costs.
Since the dawn of the federal income tax code in 1912, US law has allowed oil and gas companies to deduct all these costs up front, rather than as they are incurred. The idea is to defray the risk that an exploration project will come up dry; in practice, it’s a fat financial reward at the front end of every project.
The industry and its defenders offer an array of arguments in favor of the deduction, which CRFB adeptly summarizes:
Supporters of the deduction argue that oil and gas and exploration and development is a high-cost industry, and allowing expenses to be recovered immediately encourages companies to invest. They explain that altering the deduction could result in job losses, since wages are included in the deduction.
More broadly, supporters point out that the oil and gas industry receives the same treatment that other manufacturing or extractive industries receive, and are merely a target because of the now-controversial nature of reliance on fossil fuels. Finally, supporters of energy independence often support the IDC deduction, as it promotes further exploration and development of wells within the United States.
The thing is, all those arguments are true. But the subsidy is still bad.
Yes, deducting IDCs encourages investment in new oil and gas projects and creates new jobs. That’s what subsidies do! It just happens that we no longer want to encourage investment in oil and gas.
Yes, other manufacturing and extractive industries get similar deductions. The difference is that we want to encourage investment in those other industries and we no longer want to encourage investment in oil and gas. That’s the whole point.
The issue is not whether the subsidy does what it’s designed to do. It does. The question is whether we still want to do the thing it does. We do not.
People have been calling for removal of this subsidy for decades. It’s still a good idea.
Oil and gas also benefits from offloading its environmental regulatory costs onto the public
The other subsidies that substantially boost oil and gas profit margins are “regulatory exemptions that lower [oil and gas] production costs at the expense of the health and safety of workers and the public.” Two such exemptions shift financial liability for well closure and reclamation from companies to state governments, which saddles places with lots of abandoned wells — Texas, Pennsylvania, and Oklahoma, for example — with an average of $10 billion a piece in remediation costs, which well exceeds what those states have set aside in cleanup funds.
Another allows oil and gas to treat solid wastes from extraction as non-hazardous, despite the fact that they frequently contain toxic chemicals or radioactive materials. This reduces per-well operational costs an average of $60,000.
Keep in mind, this study didn’t try to tally up the public health benefits of removing these subsidies. Others have done so, like a recent study from Yale’s Matthew Kotchen that tried to tally up the “implicit subsidies” to US fossil fuel producers represented by “externalized environmental damages, public health effects, and transportation-related costs.” His conclusion:
The producer benefits of the existing policy regime in the United States are estimated at $62 billion annually during normal economic conditions. This translates into large amounts for individual companies due to the relatively small number of fossil fuel producers.
Those implicit subsidies are far larger than any direct subsidies. In 2017, the International Monetary Fund tried to tally up implicit subsidies across the globe and came up with an eye-popping $5.2 trillion.
Like much climate policy, removing fossil fuel subsidies requires directly confronting fossil fuels
I take three things from this research. One, fossil fuel subsidies really do strengthen the economics of US oil and gas companies and accelerate investment and exploration. That’s what they’re designed to do, and they do it. Two, the oil and gas industry really does materially benefit from being allowed to offload its environmental risks onto the public.
And three, the deduction for intangible drilling costs is the main fight. It is the big subsidy, the one that’s actually pushing new oil and gas projects over the line into profitability, and it is a much more specific target than “fossil fuel subsidies.” It seems like something some clever group ought to be able to build a campaign around.
It’s worth noting that Joe Biden’s proposed 2021 budget would eliminate the IDC deduction, along with a host of other fossil fuel subsidies. Then again, Obama included the same kinds of provisions in virtually every one of his budgets, and Congress never complied. Like I said, fossil fuel subsidies just hang around.
In this way, they represent the sad reality of federal climate policy in the US, which involves a lot of heady talk and future targets, but very little that would confront fossil fuel industries head-on over the next decade. (I wrote about this the other day.)
The problem is that the benefits of fossil fuel exploration and production are concentrated in a few regions and communities and the members of Congress who represent those communities are hyper-motivated to preserve existing advantages. In contrast, the benefits of ramping down fossil fuel production are spread out, geographically and temporally, so few members of Congress will champion it with the same vigor.
That’s how climate policy runs aground in the US — in the translation from high-flown rhetoric to policies that will materially affect the bottom lines of fossil fuel companies.
This study offers us a marker of serious commitment: repealing the deduction for IDCs. When Congress actually gets around to addressing that age-old subsidy, we’ll know we’re finally getting somewhere.
Subsidies really do matter to the US oil & gas industry -- one in particular
While it is great that more work is being done to understand the subsidies for production of fossil fuel commodities, I feel that insufficient attention is being paid to subsidization of the transmission and distribution of fossil fuels. The end-user cost of these fuels is, of course, something like the sum of the costs of production, transmission, distribution, taxes, etc. Thus, a reduction in transmission or distribution costs has the effect of allowing more headroom to support higher commodity costs whether or not production is directly subsidized. I'll give two examples below of distribution programs that have the effect of subsidizing gas production: Demand Management programs and straight-line (time-based) cost-recovery.
The purpose of a Demand Response Management (DRM) program is to modify consumer's demand profiles in such a way that utilization of the existing distribution infrastructure can be "safely and reliably" increased while avoiding the cost of installing more infrastructure. Thus, DRM is often pitched as providing cost-saving benefits to consumers. While this makes sense for electric DRM programs, since electricity is a commodity that we want people to use more of, it doesn't make sense for natural gas, a commodity that we must use less of in the future. Nonetheless, environmentalists often translate their very wise support for electric-DRM into unthinking support for gas-DRM since they assume that it is useful to reduce the gas consumption by the large users who subscribe to gas-DRM programs. What they miss is that trimming the peaks allows filling the valleys and thus increasing aggregate gas throughput even if peak throughput is reduced.
Of course, the large gas customers who subscribe to DRM or interruptible-use programs are well compensated, through reduced rates, for their willingness to curtail gas use by temporarily switching to oil or other fuels. Also, the the gas utility will often be rewarded for meeting DRM targets by being permitted to increase its allowed return-on-equity. Both the utilities and gas producers also benefit since their costs can be spread across greater unit sales. This allows more headroom for either increasing the cost of the produced commodity or for other further increases in the utilities' allowed rate of return.
Ratepayer funded gas DRM programs support higher gas throughput and increased profits for the entire gas supply chain. They are an important, although often overlooked, form of fossil fuel subsidy.
Straight-line depreciation allocates the costs of assets equally over each year of the asset's expected useful life. Thus, if a gas pipe is expected to have an EUL of 85 years, then 1/85th of its cost would be recovered each year. This method has traditionally worked reasonably well and equitably for both electric and gas assets since those assets tended to be heavily used throughout their lives. However, we'll soon discover that straight-line depreciation no longer makes sense for gas assets since we expect, and in states like New York we require, that gas throughput must decline dramatically in the future. Thus, we expect that future gas ratepayers will benefit proportionately less from the existing gas infrastructure than do current ratepayers. But since current and future ratepayers will pay the same each year for existing assets, this means that costs are being shifted from current users to future users. The result is an inter-generational cost-shift that artificially reduces today's gas rates, and thus encourages its continued and even increased use, while requiring either that future gas rates must increase dramatically to cover the use of them unused assets or that taxpayers, or electric ratepayers, will eventually have to subsidize the costs of a less used gas system. (We'll have to keep gas flowing until folk convert to something else since we can't let people freeze in the winter...) We should also realize that wealthier customers are likely to have the capital needed to abandon gas and switch to heat pumps, etc. Thus, the gas customer base will become increasingly low and moderate income (LMI). This means that LMI folk are going to be stuck paying the costs of assets built for, but abandoned by, wealthier ex-ratepayers... Not good.
A more appropriate means of allocating costs, for a system whose use is expected to decline, would be what is known as the UoP or "Units of Production" method. For gas, this method would require an estimate of the total volume of gas to be delivered during the life of a pipe. Then, ratepayers would be allocated costs which are proportional to the quantity of gas actually delivered to them during the billing period. (For example, if the asset has a 30 year life, straight line depreciation would charge ratepayers 1/30th of the costs each year even if, during that year, they actually consumed 1/20th of the volume of gas that would be reasonably expected to be delivered during the asset's life. The difference between 1/30 and 1/20 (i.e. 1.6%) is the amount of money shifted from current to future ratepayers. As asset utilization decreases, the amount of the cost-shift rises dramatically...)
The continued use of straight-line depreciation is often supported by consumer advocates since it results in lower rates for current gas users. These advocates have little concern for future users. The benefit to the gas supply chain is, of course, that lower rates today increase sales and provide more headroom for profit. The utilities aren't terribly concerned about the growing risk of ballooning gas delivery charges, due to the inter-generational cost-shift, since they are confident that regulators and government will allow them to recover their full costs whatever they might be (see: The mythical "Regulatory Compact.").
Straight-line depreciation is a means to have future ratepayers subsidize current ratepayers and thus artificially lowers today's gas rates while increasing the opportunity for profit taking in the gas supply chain. This is a common, but overlooked, form of subsidy for fossil fuels.
I could go on, but will spare you the details. (For instance, allowing fossil fuel transmission and distribution systems to use eminent domain and also receive free easements or the use of public rights-of-way is another big subsidy.) My point is that there are many hidden or non-obvious subsidies for fossil fuels, particularly for gas, We need to look beyond subsidies for the fossil fuel commodity and more carefully analyze subsidies for the commodity's transmission, distribution, etc.
It may be hard to get rid of subsidies like the IDC but I guarantee you it would be a helluva lot easier to do so than to pass a carbon or gas tax. The only way we're going to establish climate change policy that is intended to create disincentives to use fossil fuel or change people's options is to do it indirectly. Asking people to vote for carbon taxes (a la Washington state) won't work; the legislature passing bills (and hoping there's no backlash at the polls) just might. Establishing a mandate to stop the sale of ICE vehicles in 10 years or so may work (coupled with building an EV infrastructure); raising the gas tax to incentivize buying EVs won't.
Getting rid of the IDC would almost certainly lead to higher fossil fuel costs for the consumer. That's what we want. But it will be hard for anyone to make the argument after the fact that that was caused by getting rid of the IDC subsidy: it won't fit on a bumper sticker.
It may not be a big or comprehensive enough policy as others in this thread argue, but the political forces are so arrayed against increasing the costs of using FF that we have to use any and every means at our disposal. It may be hard to pass legislation to do so, but I'm getting the feeling that the FF corporations are not as strong as they used to be. Fingers crossed.