The U S Energy Outlook Will It Go From Bad To Worse

Page 1: the issues iNsiDe the FishBOWL seRies THE U.S. ENERGY OUTLOOK: WILL IT GO FROM BAD TO WORSE? Prof. Joseph P. Kalt John F. Kennedy School of Government Harvard University

Page 2: the issues iNsiDe the FishBOWL the u.s. eNeRGY OutLOOK: WiLL it GO FROM BAD tO WORse? ABSTRACT1 The political, economic, diplomatic, and even the military future of the United States is inextricably tied to the world energy market. What does that future hold? In this article, Joseph P. Kalt – a professor at Harvard’s Kennedy School and a Senior Economist with FTI Consulting’s subsidiary Compass Lexecon – examines what will shape the future of energy sources, technologies, supplies and prices. Pessimism may not be fashionable, but Prof. Kalt lays out the evidence for a decidedly bleak outlook over the coming decades. He argues that we will be much better off if we face our energy future rationally and prepare for the unpleasant and downright dangerous times ahead. The most difficult challenge will be to sustain intelligent policies and strategies when fear and uncertainty make energy policy and related foreign affairs all too ripe for political demagoguery that promises roses rather than the thorns of reality. 1 THIS ARTIcLE IS AN UpDATE OF MY ARTIcLE: “EcONOMIcS, LAW AND pOLITIcS: WHAT WILL DRIvE ENERGY’S FUTURE?” WHIcH I pRESENTED AT THE 50TH ANNIvERSARY INSTITUTE OF ROcKY MOUNTAIN MINERAL FOUNDATION, JULY 22, 2004, AND WHIcH WAS pUBLISHED IN THE ROcKY MOUNTAIN MINERAL FOUNDATION ANNUAL INSTITUTE pROcEEDINGS, vOLUME 50, p 1-1 (2004). 2

Page 3: INTRODUCTION Whether the focus is on national security, politics, economics, or conservation, issues related to energy and energy policy have often been at the center of the nation’s attention in recent years. Energy consumption in the United States is rising, our dependence on foreign sources of energy is increasing, and worldwide demand is growing. Add to this the reality that many energy supplies continue to be concentrated in political hot-spots, and there is certainly reason to be concerned about our energy future. The nation’s energy future is not bright. This requires that energy policy be focused on identifying reasonable and rational responses to difficult problems, rather than allowing our energy future to be dictated by political whims and demagogues. LESSONS FROM THE PAST, OUTLOOK FOR THE FUTURE In this article, I address the future of energy: the futures of energy economics, energy politics, and energy policy. While we may be lulled periodically into complacency by calm markets and low prices, recent economic, political, and military events serve to remind us that management of our energy affairs is critical to the country and the world. But where to start? In order to try to get a grasp on what the future holds for energy markets, politics, and policy, it makes sense to start with a look at the past. Just over three decades ago, energy entered the broad civic consciousness as its own topic – as a fundamen- tal area of public policy, warranting its own federal department; as a newfound specialty for ballooning numbers of economists, attorneys, activists, and public officials; and as a floundering point for a generation worried that the good times had been theirs, but might not be their children’s. For the general public in this land of plenty, the original cauterizing events of the 1970s were natural gas shortages and long lines at gas pumps. We were mortified when we saw ourselves waiting in those lines – like dreary Soviet consumers waiting in line for the last ham hock. Now, thirty years later, we have built a culture and politics in which it is de rigueur to point fingers of shame at profligate energy use. We worry that we confront a looming global environmental disaster caused by decades of burning fossil fuels; and, at this stage, almost any steps we can conceive of actually taking to turn back a disaster seem like hopeless drops in the bucket. Energy firms and their leaders are publicly flogged – sometimes with good reason – as the scourges of capitalist excess. We don’t even need media hype to be scared out of our wits that much of the military conflict, and even recent carnage on our own soil, have been “nurseried” in the Middle East – the Middle East that holds almost two thirds of the world’s oil supply. Looking forward, we seem to face a future in which energy markets, energy policy, and energy conflicts threaten to perpetually preoccupy, if not dominate, our concerns over economic growth, national security and domestic tranquility. As we look out over the next thirty years, what will shape the future of energy sources, technologies, supplies, and prices? Perhaps even more importantly, how will energy shape our economic, political and legal landscapes? My task here is to address these questions: To ask where we have been, what we should have learned, and maybe what we have not learned about energy economics, law, and policy. Rationally facing our energy future is important to our nation. Being so much in the U.S. political consciousness means that energy and energy policy can be mined for political advantage – for good or ill. Energy issues provide fertile ground for demagoguery. But sound policy development based on coherent understanding of what we face in the energy sector can counteract demagoguery. How well we manage this perpetual tension between demagoguery and sound policy will substantially determine the energy future – and perhaps even the military future – of the U.S. and the world. As any professor should, I set about trying to address the questions of what energy policy, economics, and politics might look like in the coming decades by first examining the literature – academic, political, and pop. I wanted to see what we know about the state of affairs in the energy sector, and what the future might hold. Having performed my professorial duty, I am afraid I now emerge with a very pessimistic set of conclusions. If there is an overriding theme to my outlook, it is that our energy future is downright scary. This pessimism is based on three primary conclusions. 3

Page 4: While there has been much progress in technology, conservation, research, and even policy, three facts dominate the outlook for the future: First, economic development is combining with a growing world population to push energy demands ever higher. Over one-third of the world’s population lives in two countries, India and China. These two countries are making great strides in economic development, finally lifting some of the poorest people in the world up the economic ladder toward higher standards of living. This is a welcome and laudable change for the roughly two billion citizens in India and China. In fact, apart from Africa, economic development at last has a firm foothold across much of what we think of as the third world. The World Bank reports that, from 1980 to 2000, real average income per capita in the developing world (including Africa) rose almost 37%.2 Yet, even without the effects of rising incomes on the demand for energy, current projections estimate that 2 billion people will be added to the world’s population over the next 30 years.3 The combined forces of economic development and rising populations imply steady, powerful upward pressure on the demand for energy. Second, notwithstanding several decades now of ranting against reality, as we look to the future, petroleum will remain the world’s marginal source of energy. Moreover, the petroleum the world needs will remain overwhelmingly concentrated in the Middle East. This means that economic problems of OPEC cartelization, or at least dominant firm monopoly in Saudi Arabia, are unlikely to go away. Even more certainly, the dependency of the world on petroleum, and particularly on Middle Eastern petroleum, means that problems of international security will not go away. In fact, they are likely to worsen before they improve. Third, energy use, particularly the combustion of carbon-based resources, will remain linked in public policy debates to global climate change and local health policies. This linkage may portend not only undesirable climate change and related costly economic and lifestyle impacts. It also harbors the duality of an ultimately insoluble international governance problem that leads to irrational unilateral policy responses in which we shoot ourselves in the national foot. LESSONS: CAUSES AND CONSEQUENCES OF ENERGY CRISES Before undertaking a more detailed look at what I see as such a disturbing future, let’s see how we got to this point. For more than a century leading up to the first Arab oil embargo of 1973, the United States and the developed economies around the world had fueled their industrial economic growth with higher and higher levels of energy consumption. As technology and economic growth combined to produce modern transportation systems and industrial processes, the relative abundance and portability of fossil fuels channeled energy demand toward coal, gas, and especially oil. By the early 1970s, U.S. oil imports were on the rise and accounted for a third of the nation’s petroleum consumption.4 During the early 1970s, Arab-Israeli hostilities in the Middle East led to a six-month oil embargo on crude oil shipments to the U.S. by the Arab oil producing countries. Combined with rising U.S. demand, macroeconomic inflationary pressures, domestic supply that could not keep pace with demand, and the overhang of the Nixon administration’s price controls on gasoline and other petroleum products, Americans wound up having to sit in horrendous lines to fill up their cars with gasoline. Probably more than any single event in our lifetimes, those long lines ignited public rage and worry that have powered energy politics ever since. 2 THE WORLD BANK REpORTS THAT AvERAGE INcOME pER cApITA (IN 1995 DOLLARS) IN THE DEvELOpING cOUNTRIES ROSE FROM $989 TO $1354 OvER 1980-2000. WORLD BANK, WORLD DEvELOpMENT REpORT 2003: SUSTAINABLE DEvELOpMENT IN A DYNAMIc WORLD (WASHINGTON, Dc, WORLD BANK, 2003), AT cHApTER 1, p. 1. 3 INTERNATIONAL DATABASE, TOTAL MID-YEAR pOpULATION FOR THE WORLD, U.S. cENSUS BUREAU, MARcH 2008. 4 NATIONAL ENERGY pOLIcY DEvELOpMENT GROUp, RELIABLE, AFFORDABLE, AND ENvIRONMENTALLY SOUND ENERGY FOR AMERIcA’S FUTURE (WASHINGTON, D.c.: ExEcUTIvE OFFIcE OF THE pRESIDENT, MAY 2001) AT 2-9. 4

Page 5: Even without public outcry and media overplay, the rise in world energy prices in the 1970s resulted in huge amounts of wealth being transferred to foreign oil suppliers from nations that hitherto had been outside the awareness of the American public. In a “shoot the messenger” frenzy, countless inquiries and lawsuits were launched against the companies that imported the crude oil demanded by the United States’ consumers and produced by foreign governments. Coal development boomed, and with this expansion came increased concern for the environmental consequences of burning particularly dirty fuels. Amidst all this, the American government launched propaganda campaigns such as “don’t be fuelish” and “energy ant” to teach us all to behave better. A second crisis arose at the end of the 1970s upon the fall of the western-friendly Shah of Iran to a zealous theocracy. In this crisis, we repeated our outbursts of shock and rage. And the nation told itself that it had finally gotten serious about its energy problems. This meant more emphasis on coal, more investigations, and more propaganda campaigns. We again tried to mask the scarcity of oil resources by regulating prices, and we again sat in lines at the gas pump. Seeing pessimism all around, Jimmy Carter told us we were trapped in a national malaise, and he lost his job when he couldn’t figure out a way to free U.S. citizens held hostage for 444 days in an oil-producing Middle East country ruled by a regime that was culturally and politically hostile to the core of American identity. As we approached the mid-1980s, international oil prices softened as OPEC’s ability to collude and control worldwide energy supplies eroded. Desperate for cash and fearful that high prices were bringing on too much conservation and too many substitutes, Saudi Arabia in particular let softer prices prop up energy consumption and squelch the growth of substitutes for what the Kingdom sells. In fact, during the 1980s and 1990s, apart from the spike in prices with the Gulf War, energy prices trended decidedly downward in inflation-adjusted dollars.5 The softening in real energy prices resulted in a return to bigger cars and the other symbols of lifestyles associated with cheap fuel.6 Generally declining energy prices of the 1980s and 1990s also meant the end of most energy-related propaganda; the end of cajoling us not to be “fuelish.” Soft prices also may have lulled us into thinking that energy crises were behind us, that conservation was a fad that had run its course, that the need to develop domestic coal and other energy supply sources had given way to some sort of post-industrial society that ran on knowledge and rather than Btus. In fact, the steady decline in energy prices during the 1980s and 1990s threatened to take energy off the public’s political landscape. Then, just when we might have thought that energy crises were behind us, just when we might have thought – or hoped – that the Arab oil producers were too disorganized to wield effective market power, and just when we might have thought that technology had built us safeguards – with hybrid cars, more efficient capital equipment, and an almost-to-fruition promise of renewable energy resources – a new series of crises struck. The spike that occurred in world oil prices upon the Iraqi invasion of Kuwait and the Gulf War in the early 1990s should have told us we were living on a thin margin of relatively abundant supplies. But this shock was relatively short-lived, as Kuwait’s supplies were brought back onto the market more rapidly than anticipated. A second warning was sounded in 2000-2001, when the western gas and electricity sectors went haywire. Wholesale prices of natural gas and electricity, particularly in California and neighboring states, went to previously unseen heights. Clearly, more than anything else, the reality of an economy which roared through the Clinton years running into the combination of (i) pipeline, power plant, and transmission infrastructure that had not been incented or allowed to expand and (ii) inane Newspeak policies in California that labeled legislated retail price caps and contract restrictions at wholesale as “deregulation” literally turned the lights out for millions of Californians – not to mention turning the lights out on Governor Davis’ political career. 5 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY OUTLOOK 2007 WITH pROJEcTIONS TO 2030, AT 4, FIGURE 1. 6 SEE, FOR ExAMpLE, U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, “25TH ANNIvERSARY OF THE 1973 OIL EMBARGO,” AT HTTp://WWW.EIA.DOE.GOv/ EMEU/25OpEc/ANNIvERSARY.HTML, SLIDE 12. 5

Page 6: The California debacle in 2000-2001 shook our confidence in what we might have hoped, and certainly were told, would be price-reducing policy reforms and restructurings. Then, just as we seemed to be coming out of the shocks to the western energy markets, military conflict erupted in Afghanistan and Iraq and Arab- Israeli violence heightened. These developments disrupted supplies and the markets’ confidence. Once again, world oil prices went through the roof – in a way not seen on a sustained basis for nearly 20 years. Today, world oil prices are reaching record levels in nominal dollars and getting close to records in real (inflation-adjusted) dollars. Americans find themselves paying well over $3 a gallon for gasoline, despite a system of policy and economics that we hoped, apparently in vain, would be resilient to energy supply shocks. Once again, the American public expects their governments to act; and we need to worry that the demagogues are lining up again to try to meet their requests. So, given these events, what is an energy crisis? After all, goods and commodities are scarce; always have been, always will be. Moreover, we import large amounts of many goods, from lumber to beef; but few of us talk about a lumber crisis or a hamburger crisis, and we certainly don’t worry about going to war over such commodities. International security issues arise both with and without an energy component to them. So, what is an energy crisis? The energy crises that the United States, and to some extent the world, has faced over the last three decades are crises in part because they have resulted in real and large declines in energy consumer wealth. The U.S. is a net energy importer – a net buyer, a net consumer. Its economic interests fundamentally lie in abundant supplies at low prices. When energy gets more scarce relative to demand and prices rise, domestic suppliers of energy tend to make out better. On net, however, rising world energy prices mean an outflow of wealth from the U.S. as a whole. A 2000 study by Oak Ridge National Laboratory estimated that OPEC’s ability to hold world oil prices above competitive market levels during the last three decades had transferred as much as $7 trillion dollars of wealth from American consumers to international producers.7 Seven trillion dollars of lost wealth is real pain, and those transfers continue to mount as OPEC remains in control of world oil supply. This money could have funded innumerable college educations, houses, hospitals, shopping malls, movie theaters, highway bridges, and the thousands of other things people want in their lives. No wonder “energy” stays in the public consciousness. But in making energy shocks into “crises,” perhaps as important as the loss of wealth from high world prices is the loss of Americans’ felt sense of preeminent economic and technologic power. In our own self-image, we are not the country that sits in waiting lines that evoke those recurring Soviet meat lines. We are not the country that gets held hostage – literally, during the Carter years – by small foreign powers. We are not the country that can’t keep its lights on. In our national self image, we are the country that knuckles down and solves a problem. We are the country that determines its own economic tradeoffs and choices. We are the country that determines its own course in international affairs. What if these precepts of our national identity are, in fact, false? I think it is the threat to these precepts of our national self-image, repeatedly posed by shocks to our energy markets, that gives “energy” its political “kick” and turns energy market disturbances into such shocking economic and political crises. THE NATION’S TRACK RECORD IN RESPONDING TO ENERGY SHOCKS How have we responded to the energy shocks of the last thirty years? My overall assessment is that we have learned from history and we are in position to respond well. In fact, that is a primary reason for my pessimism as I look to the future: We have responded increasingly well to energy crises, and yet the crises keep coming and they keep bringing economic pain and ever greater international danger. Domestic Policy and Economics: Let’s first look at the economics of our domestic response mechanisms. In many ways, the economic adjustments that the U.S. and the other developed economies have made to the energy shocks and price spikes of the last thirty years have been impressive. For example, while aggregate 7 D.L. GREENE & N.I. TISHcHISHYNA, “cOSTS OF OIL DEpENDENcE: A 2000 UpDATE,” ORNL/TM-2000/152, MAY 2000, OAK RIDGE NATIONAL LABORATORY, WWW.ESD.ORNL.GOv/BENEFITS_cONFERENcE/OILcOST_Tq.pDF. 6

Page 7: energy use in the U.S. has risen with both our population and our income, the efficiency of energy use has improved sharply. It now takes only 48 percent of the energy needed in 1970 to produce a dollar’s worth of U.S. Gross Domestic Product (GDP).8 If energy efficiency had stayed at its 1972 intensity, by 2000, we would have consumed approximately 74 percent more energy than we actually consumed. That’s approximately 70 quadrillion Btus more than the 98 quadrillion Btus of energy actually consumed in 2000.9 In the same vein, from 1973 through 2000, the real size of the U.S. economy grew 126 percent, but energy use increased by only 30 percent.10 Overall these basic messages of improved efficiency hold across the developed world. Notwithstanding this progress in the advanced economies, however, the lessons from the developing world are discouraging in at least two respects. First, a key symptom of economic development is old capital – old cars, old machines, old tractors, old factories. And old capital is generally energy inefficient capital. Underdevelopment is first- and-foremost about the lack of access to or affordability of capital. From their transportation fleets to their factories, developing countries lag significantly behind developed countries in their ability to interject more energy efficient systems into their economies. With a combination of poverty and a relative inability to substitute capital for energy, tight energy supplies and the shocks of higher energy prices are felt doubly hard by poor countries and poor people.11 As development proceeds in the poorest countries, the capital they do acquire will tend to embody improved energy efficiency, but we should expect growth itself to bring net increases in their aggregate demands for energy. On the supply side, in the U.S. at least, we have some grounds for self-congratulations. All of our sources of energy, except oil, have seen expanded production since 1970. Natural gas production increased steadily from the late 1980s until experiencing a recent flattening. U.S. coal production is up by nearly 90 percent since 1970.12 Renewable resources started from a very modest base, and their growth rates have increased by leaps and bounds, growing 68% since 1970.13 Nuclear power has seen a similarly dramatic upward trend – accounting for almost 12% of our energy production, up from less than .5% in 1970.14 These economic changes have been aided, on net, by changes in our domestic energy policies. As we look back on the nation’s responses to the energy crises of the last thirty years, I think we have seen a gradual overall improvement in our domestic policies. When the energy crisis first hit in the first-half of the 1970s, the nation adopted a horrible policy posture. As I have noted, President Nixon had imposed economy-wide wage and price controls in the early 1970s. As these were lifted in other sectors, the petroleum sector was singled out for continued price caps. As any beginning economics textbook would predict, when the embargo hit and pushed market-clearing prices to then-record levels, the Nixon Administration’s price caps prevented many U.S. oil markets from clearing. The results were the memorable shortages and gasoline lines that so traumatized the public.15 Natural gas prices, too, were artificially suppressed by a Byzantine court ruling and federal legislation from decades earlier. By the mid-1970s, America faced gas supply curtailments, factory closings, and other disruptive consequences of natural gas shortages. These were the direct and predictable consequence of not letting natural gas prices and markets do their jobs of inducing supply and allocating demand.16 8 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY REvIEW, 2006 AT xIx, FIGURE 3. 9 NATIONAL ENERGY pOLIcY DEvELOpMENT GROUp, Op. cIT. AT xI AND FIGURE 4; U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY REvIEW, 2006 AT xIx, TABLE 2.1A. 10 NATIONAL ENERGY pOLIcY DEvELOpMENT GROUp, Op. cIT. AT xII. 11 INTERNATIONAL ENERGY AGENcY, HIGH pRIcES HURT pOOR cOUNTRIES MORE THAN RIcH – IEA UNDERLINES DEvELOpING NATIONS’ DILEMMA (pARIS: INTERNATIONAL ENERGY AGENcY, MARcH 20, 2000). 12 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY REvIEW, 2006 AT 203, TABLE 7.1. 13 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY REvIEW, 2006 AT 203, TABLE 10.1. 14 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY REvIEW, 2006 AT 203, TABLE 1.1. 15 KALT, JOSEpH p., THE EcONOMIcS AND pOLITIcS OF OIL pRIcE REGULATION: FEDERAL pOLIcY IN THE pOST-EMBARGO ERA (cAMBRIDGE: MIT pRESS, 1981). 16 MAcAvOY, pAUL W. AND ROBERT S. pINDYcK, THE EcONOMIcS OF THE NATURAL GAS SHORTAGE (1960-1980) (NEW YORK: AMERIcAN ELSEvIER, 1975). 7

Page 8: As the era of energy crises came upon us, rolled-in average cost pricing for both electricity and natural gas created artificially low price signals during periods of energy scarcity and rising marginal energy prices. America was effectively subsidizing consumers to try to overuse scarce and insecure commodities. On the supply side, federal oil and gas price controls sent the economy the distorted signal that those fuel sources were relatively abundant and worth producing. This was done right at the peak of the scarcity of and premium on domestic energy supply. To top it off, obscure federal oil policies actually subsidized the importation of foreign oil by U.S. refiners, propping up foreign oil prices charged by the very sellers most hostile to us. Meanwhile, just as both the marketplace and the government started to push coal development in the U.S. in the 1970s, speed bumps were put in the way of that development by both expensive old-style command-and- control approaches to abating coal-related pollution. These impediments were accompanied by supply-side environmental policies that protected vested interests by imposing regulations with questionable cost-benefit ratios on new, potentially abundant coal resources. As a result, coal development was initially held back.17 In the case of nuclear power, the coincidental timing of the first energy crisis with the rise of the environmental movement, followed not long after by the Three Mile Island and Chernobyl disasters, ran nuclear power headlong into a NIMBY barricade. Fortunately, we learned some lessons from the flawed policies of the 1970s. In a rare, almost secret agreement between Democrats and Republicans, Presidents Ford and Carter started – and Presidents Reagan and Bush the elder finished – the decontrol of oil and gas prices. Only the demagogues failed to understand (or perhaps just risked loosing too much political capital in acknowledging) that we needed to allow markets to work properly by letting market-determined prices signal buyers and suppliers as to the need for more domestic supply and the overall scarcity of energy. In fact, the impressive improvements in energy efficiency since the early 1970s have been due almost entirely to the effects of higher prices on demand. Public information campaigns and cajoling by politicians and the media seem to have made little difference that can be teased out of the data. In short, the important strides that the U.S. (and other developed economies) have made in energy conservation over the last several decades have been driven by policies allowing prices to do their job by signaling scarcity in the marketplace. With the advent of market-based regulatory reforms in gas and electricity, for all the setbacks along the way, we have taken the right (if somewhat attenuated) steps toward showing final consumers more accurate price signals for their utility-delivered fuels. Then, too, we have moved a long way toward letting the forces of competition drive investment in and operation of necessary infrastructure (including power lines and pipelines). On the environmental side, the advent of systems of tradable environmental permits and related performance-based regulatory approaches has allowed us to make huge strides in protecting the environment while holding down the costs of our demands for cleanliness, better health, and other environmental amenities.18 Thus, we have made progress in the arenas of both energy policy and environmental policy. International Security: Now let’s turn to an examination of where we have been in terms of international security. As a card-carrying economist, rather than an international security specialist, I will leave judgments of success or failure at the interface between energy and security to others. It can at least be said, however, that the increasing frequency and size of military engagements in the Middle East have had oil at their roots – or at least as their engendering nutrient. After all, the first Arab oil embargo in 1973-74 was the direct retort of the anti-Israeli interests to military conflict and loss. The fundamentalist regime that allowed hostages to be taken in Iran in 1979 also knew 17 KALT, JOSEpH p., “THE cOSTS AND BENEFITS OF FEDERAL REGULATION OF cOAL STRIp MINING,” NATURAL RESOURcES JOURNAL, OcTOBER 1983; KALT, JOSEpH p. AND MARK A. ZUpAN, “cApTURE AND IDEOLOGY IN THE EcONOMIc THEORY OF pOLITIcS,” AMERIcAN EcONOMIc REvIEW, JUNE 1984. 18 SEE, FOR ExAMpLE, cOUNcIL OF EcONOMIc ADvISERS, EcONOMIc REpORT OF THE pRESIDENT: 2004 (WASHINGTON, D.c.: U.S. GOvERNMENT pRINTING OFFIcE, 2004), AT cHApTER 9, FOR A SUMMARY OF pOLIcIES AND DATA. 8

Page 9: enough to choke oil supplies. When we look back at the micro-events leading up to Iraq’s invasion of Kuwait in 1990, the case is strong that the real reason for Hussein’s invasion was that Kuwait would not go along with supply quotas.19 Certainly, blowing up Kuwait’s oil wells was a seldom-seen (though not unheard of) cartel de- vice for limiting supply and driving up price. Finally, today’s generation of terrorists in the Middle East seems to well understand the physical vulnerability and economic importance of oil pipelines and tankers. It is easy, even fashionable, to say that U.S. policy in the Middle East has been a failure. But isn’t that too glib? Every Administration since at least the early 1970s has tried to solve the problems of the Middle East, but these problems have proven intractable at some very deep level. And maybe that is exactly what they are. It may simply be a cultural conceit that we assume that we can – and expect that our leaders always will–solve problems like those in the Middle East and allow us to move on in peace, tranquility, and easy economic abundance. We may just have to live with a future in which some very valuable resources are concentrated by nature in a locale populated by lots people who do not agree with us, do not like our values, and do not share our ideologies or political systems. Short of massive cultural change that probably would require decades if not centuries,20 it is difficult to see how the economics of energy and the world’s dependence on Middle East oil imply anything different about international security as we look into the future. CONFRONTING THE FUTURE OF ENERGY MARKETS, POLITICS, AND SECURITY Having reviewed how we got to where we are today, let us examine what looks to be such a pessimistic future. I have noted at least three key factors that dominate our energy future. These are: (i) the continuing upward pressure on energy demand, particularly emanating from economic growth in the developing world; (ii) the continuing U.S. and worldwide dependence on oil, and especially Middle Eastern oil; and (iii) the linking of energy use and production to our environmental problems and policies. The United States is becoming increasingly dependent on imported energy – especially oil. Notwithstanding political rhetoric of the day, there is no sign of turning the situation around. In 1973, oil imports amounted to about 35 percent of U.S. oil consumption. Today, after all the rhetoric, legislation, and preaching, we rely on foreign sources for nearly 60 percent of the petroleum we consume.21 In fact, imported energy of all kinds currently accounts for about 34 percent of total energy use.22 That share will grow unless we can do substantially better at encouraging domestic supply development than we have over the last decade.23 The Energy Information Administration projects that U.S. dependence on imported oil will increase, not lessen, and the EIA expects imports to rise to 66% of total petroleum supply over the next twenty years.24 Total U.S. energy consumption is likely to grow another 30% during that period, and imports of all kinds of energy are expected to reach more than 30% of U.S. energy consumption.25 Looking worldwide, only one-third of the earth’s population now enjoys access to energy that enables them to flip a switch to turn on the lights. Another third has intermittent access of this quality and quantity. The poorest one-third of the world’s population simply does not have access to modern energy supplies and services.26 With economic development spreading across the world, particularly in China and India, additional supplies of energy will be necessary. 19 SEE, FOR ExAMpLE, U.S. LIBRARY OF cONGRESS, FEDERAL RESEARcH DIvISION, cOUNTRY STUDIES, “pERSIAN GULF WAR,” AT HTTp://cOUNTRYSTUDIES.US/pERSIAN-GULF-STATES/32.HTM. 20 ON THIS pESSIMISTIc OUTLOOK, SEE HUNTINGTON, SAMUEL p., THE cLASH OF cIvILIZATIONS AND THE REMAKING OF WORLD ORDER (NEW YORK: SIMON & ScHUSTER, 1996). 21 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, MONTHLY ENERGY REvIEW, MARcH 2008 AT TABLE 3.3A. 22 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, MONTHLY ENERGY REvIEW, MARcH 2008 AT TABLE 1.1. 23 NATIONAL ENERGY pOLIcY DEvELOpMENT GROUp, Op. cIT. AT vIII. 24 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY OUTLOOK 2007 WITH pROJEcTIONS TO 2030, AT 70. 25 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY OUTLOOK 2007 WITH pROJEcTIONS TO 2030, AT 10, AND TABLE 1. 26 WIRTH, T.E., c.B. GRAY, AND J.D. pODESTA, “THE FUTURE OF ENERGY pOLIcY,” FOREIGN AFFAIRS, JULY/AUGUST 2003 AT 138. 9

Page 10: The most recent projections of future energy needs predict that worldwide energy demand will be “well over 50% higher” than today by 2030.27 Developing countries are expected to account for 74% of this increased demand, with 45% of the increase coming from China and India alone.28 Coal suppliers are the primary beneficiaries of the development wave, with demand for coal expected to jump 73% by 2030.29 The upshot of burgeoning development in Asia is that China and India must look outside their borders to find new sources of energy supplies. China’s search has taken them to such international hot-spots as Sudan and Myanmar. China’s path to development offers an example of the new level of complexity that the future holds. Not only will increased demand squeeze resources, but energy policy will be forced to confront a new array of issues in the already highly-charged discourse surrounding energy security, the ownership of energy resources, and the ability of the U.S. to compete for scarce supplies. Stepping back from the specific implications of China’s path to development, the world as a whole is getting better at economic development. The rising incomes and wealth that come with development imply rising demands for energy. The developing world is bootstrapping itself toward what we would regard as minimal standards of living. Not only will we need supplies to fuel the economic development of the poorest nations in the world, but there is no sign that the developed world is about to give up its energy-driven lifestyles. The International Energy Agency projects that by 2030, world energy consumption will rise by 55% over 2005 levels.30 Where will all of this energy come from? To enable such strong increases in consumption, world oil production will have to rise from current levels by about 37% – to 116 million barrels per day by 2030.31 Notwithstanding all of the investment, all of the tax inducements, all of the technological change that can be projected for renewables development; notwithstanding all of the investment that can be projected for natural gas, coal, and nuclear power, oil will remain the single most important source of energy for the world, projected to comprise about 32% of all energy use in 2030.32 And the oil will continue to come from the Middle East. Supply sources in developed economies are both relatively depleted and declining, as is oil in the United States. Further development of supply resources in the developing world is impeded by both legitimate and hysterical environmental concerns, as well as weak capital markets and political insecurity in the developing world. It is the Middle East that has abundant supplies of oil. As the world’s use of oil grows by the projected 37% over the next two decades, more and more of it will come from the Middle East. OPEC countries currently account for 40% of US imports, and as US demand for foreign oil grows, OPEC is expected to be the primary provider of these new supplies.33 It is not just energy commodities that are affected by the pressures of rapidly developing economies. Non-energy commodities have also seen a significant increase in demand that has been largely fueled by the rapidly growing economies of India and Asia. Between 2001 and 2005, non-energy commodity prices increased by 9.2% annually.34 Notably, prices of base metals—materials such as iron ore, lead, cooper and zinc—have seen average annual growth rates of over 13%.35 27 INTERNATIONAL ENERGY AGENcY, “WORLD ENERGY OUTLOOK 2007: cHINA AND INDIA INSIGHTS,” ExEcUTIvE SUMMARY, AT 3. 28 INTERNATIONAL ENERGY AGENcY, “WORLD ENERGY OUTLOOK 2007: cHINA AND INDIA INSIGHTS,” ExEcUTIvE SUMMARY, AT 3 AND 4. 29 INTERNATIONAL ENERGY AGENcY, “WORLD ENERGY OUTLOOK 2007: cHINA AND INDIA INSIGHTS,” ExEcUTIvE SUMMARY, AT 4. 30 INTERNATIONAL ENERGY AGENcY, “WORLD ENERGY OUTLOOK 2007: cHINA AND INDIA INSIGHTS,” ExEcUTIvE SUMMARY, AT 4. 31 INTERNATIONAL ENERGY AGENcY, “WORLD ENERGY OUTLOOK 2007: cHINA AND INDIA INSIGHTS,” ExEcUTIvE SUMMARY, AT 4. 32 INTERNATIONAL ENERGY AGENcY, “WORLD ENERGY OUTLOOK 2007: cHINA AND INDIA INSIGHTS,” ExEcUTIvE SUMMARY, AT 4. 33 U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY OUTLOOK 2007 WITH pROJEcTIONS TO 2030, AT 70. U.S. ENERGY INFORMATION ADMINISTRATION, DEpARTMENT OF ENERGY, ANNUAL ENERGY REvIEW, 2006 AT TABLE 5.4 34 ASIAN DEvELOpMENT BANK, “ASIAN DEvELOpMENT OUTLOOK 2006” AT 103. 35 ASIAN DEvELOpMENT BANK, “ASIAN DEvELOpMENT OUTLOOK 2006” AT 110. 10

Page 11: The surge in demand for base metals—the primary materials for steel, wires, and other building blocks of large construction and infrastructure projects—is driven by the rapid development of the Asian economies. China in particular has demonstrated a voracious appetite for industrial commodities. Iron ore shipments have increased at an average annual rate of 27% for the past four years, and China now consumes about a third of the world’s steel and over 25% of the world’s aluminum.36 Of course, the increased demand for industrial commodities has important supply-side implications as well. Rising prices are a signal of tightening supply relative to demand. Anticipating the strain on current resources, China has already begun to look for new sources of iron-ore, copper, zinc, and other minerals. Even in the face of tough international criticism, China has invested heavily in harvesting resources from such hot-spots as Sudan, Congo, and Myanmar.37 While China’s quest for new energy resources spreads development to these very poor countries, it comes with very real costs and highlights the political and security issues that will shape the future of energy and natural resources for some time to come. In the case of energy commodities, all of this adds up to a world in which the long range prognosis is one of increased scarcity of energy resources and continued reliance on oil from the Middle East. To meet the human race’s growth-driven demand for ever more power, it will have to be in an environment of higher prices that calls forth needed supplies. Even if prices vacillate around the trend, we still face an upward trend in energy prices. This is the reality of increased scarcity. To be sure, we can hope for further demand-softening conservation and the rise of renewable and exotic supply types. Yet, the data clearly indicate that fossil fuels will remain predominant for a generation or more. The basic reality is that where there is existing fossil fuel dependence – particularly on oil – in the world, that dependence is not going away. When I look in the domestic and international policy arena and ask what its future holds, I again find myself discouraged. From all quarters, the story is the “same ‘ol’, same ‘ol’”. In the mainstream, the right calls for more tax breaks for resource development, opening up ANWR, and finding more rational environmental controls. The left calls for draconian conservation policies, investments in renewables, subsidies for technological demand-side fixes. On the fringes, new agers call for changes in human nature and dream on about a post-modern world in which the two-thirds of the world that doesn’t live anywhere near the modern lifestyles of the new agers miraculously jumps from animal and human power to blissful rejection of the need for modern fuels, while enjoying huge progress in health and well-being. At the other extreme, militarists call for just taking control of the Middle East’s oil reserves. Regardless of what each of us may think is the “right” policy, I think the betting money goes on the status quo. Indeed, responsible selection from the mainstream of policy recommendations is advisable. Those are the useable tools at our disposal. Yet, we have heard the same calls from the same camps for three decades, and we still face a future that looks a lot like the past. In fact, it looks worse – rising consumption, predominant dependence on oil and other fossil fuels, and concentration of oil supplies in just about the most politically volatile points on the globe. Moreover, everyone’s alternative approaches have costs. It is only optimistic rhetoric that says we can solve any problem and come out the other end unscathed. But the realities are that the human race both needs and demands lots of energy. Naturally occurring sources of energy are scarce and often filthy, in both their extraction and their use. New inventions are hard to perfect, and they require other scarce resources – especially capital – to become commercialized. The policy status quo has some desirable features – at least as far as economic policy is concerned. For example, notwithstanding California’s remarkable backsliding on energy pricing when it coupled market-driven restructuring of wholesale electricity markets with government price caps at the retail level, nationally we seem to weather price movements without troglodyte regulatory responses – without imposing the kinds of price controls that sent us all into gasoline lines at the beginning and the end of the 36 “A RAvENOUS DRAGON”, IN A SpEcIAL REpORT ON cHINA’S qUEST FOR RESOURcES, THE EcONOMIST, MARcH 15-21, 2008. 37 SEE, FOR ExAMpLE, “NO STRINGS” AND “MUTUAL cONvENIENcE” IN A SpEcIAL REpORT ON cHINA’S qUEST FOR RESOURcES, THE EcONOMIST, MARcH 15-21, 2008. 11

Page 12: 1970s. At least we are no longer directly subsidizing our dependence on imported oil; and policy impediments to coal, gas, and renewables development have proven surmountable on net. On the environmental side, the picture may be a little more mixed, but we have had some successes. NIMBY continues to make it not worth investors’ while to spend much effort looking for nuclear alternatives, and the costs of environmental regulation of energy-caused environmental degradation can still be worked on. But, as I’ve noted, emissions trading now seems to be well ensconced and, overall, we seem to muddle through and avoid the extremes of shutting down all energy development and returning to an earlier time of no environmental controls. Yet, as we look into the environmental arena, the huge issue of global climate change policy still looms, unresolved. The science of global climate change is marked by at least one notably confounding problem: emissions of greenhouse gases have risen during a time of long-horizon cyclical warming. Teasing out the causal effects of greenhouse gas emissions on climate thus confronts what the statisticians and the economists call collinearity: natural, long-term cycles in climate are intersecting with huge increases in emissions of offending gases over the last century; and, as a result, causality is difficult to agree upon. This allows debate to rage. That debate should properly be settled by the scientists, rather than the politicians or political correctness. Even the most credible and thoughtful policymakers on the subject can’t seem to agree.38 I will leave it to others to debate the science of global warming at this point. But it seems salient to point out that insurance-creating action is rational in the face of uncertainty and, regardless of the state of scientific discussion, global warming will remain on the public’s radar screen. As this affects our energy future, the danger, as I see it, continues to lie in the thus far intractable problem of what economists call “public goods.” A public good arises when one person’s investment, or one nation’s investment, can benefit everyone. Under such circumstances, rational human beings have incentives for free riding: Proverbially, each farmer in the flood plain has strong and personally rational incentives to hope that the other farmers will contribute and build the flood control dikes, so no one does. As applied to global climate change policy: “let the other country take action to limit greenhouse gases. My country will get the benefit; and letting others bear the burden will save my country from having to invest its capital in such actions, thus making my country’s goods relatively cheaper to produce than theirs.” In these kinds of public good situations, the problem created by the incentives to free ride is that if everyone decides to be a free rider, then no one will make the necessary investments. Global climate change policy has precisely these kinds of problems. Slowing any human-induced climate change requires cooperation of the world’s governments. Actions taken unilaterally can have the effect of merely creating economic opportunities left on the table for non-cooperators (who, as suggested, can produce more cheaply if they eschew the costs of emissions controls designed to eliminate global climate change). In fact, if non-cooperators have particularly lax domestic environmental policies, the world’s emissions of greenhouse gases can even worsen by shifting production to those countries. The challenge in the U.S. is at least two-fold: to work for international cooperation and to avoid letting domestic politics pull us down a path of unilateral inanity. I am not sure we are going to do this. There is real danger that our domestic politics will lead us to take expensive, if not draconian, action to limit our greenhouse gas emissions. In the process, we may increase the prospects that others will feel the pressure is off of them, and in the end we may spend billions of dollars to limit our emissions but contribute not a whit to putting a dent in global climate change or the costs of adapting to that change. Try as I might, I am just as pessimistic about the linkages between the world’s energy future and international security. I have already indicated the grounds for a dire outlook here. Specifically, the energy resources for the whole world are overwhelmingly concentrated in only a small part of the world. Oil is in the Middle East, and the political winds there are hardly blowing our way. Coal is in the U.S. and some other 38 SEE, FOR ExAMpLE, THE ExpLIcIT NOTIcES OF DISAGREEMENT IN THE JOINTLY-AUTHORED AND BI-pARTISAN WIRTH, T.E., c.B. GRAY, AND J.D. pODESTA, “THE FUTURE OF ENERGY pOLIcY,” FOREIGN AFFAIRS, JULY/AUGUST 2003. 12

Page 13: areas of deposit, but coal is the dirtiest of fuels (or at least the most expensive to clean up when processed). The political logjam over nuclear power that has existed since the 1970s, in my view, shows no sign of breaking up. It has withstood shocks ranging from military crises to skyrocketing fossil fuel prices. I believe the reasonable conclusion is that nuclear power is not going to save our energy future. Newer technologies, such as solar, wind and/or hydrogen power, are showing promise, and we should continue to pursue their development. However, the sheer quantity of alternative energy supplies that would be needed not only to displace our current levels of fossil fuel use but also to meet the net increases in worldwide energy demand over the coming decades means that, in my view, it is wishful thinking to see those alternative technologies as being our saviors. All of these considerations suggest a future that looks to me like the present: hostile controllers or would-be controllers of indispensable energy supplies are getting richer as they restrict those supplies, while their increasing wealth makes them increasingly capable of unthinkable acts. With additional supplies of energy needed by the world economy and sought most intensely by the poorest of the world’s citizens, and with Middle East petroleum remaining so critical, I find myself pessimistic not only about our energy future, but also about the likely recurrence of those unthinkable acts. CONCLUSION: ARE THERE ANY GROUNDS FOR OPTIMISM? I would like to conclude by exploring grounds for optimism as we look to the future – but I won’t. As I look across the landscape, at its dominant features, I do not find compelling grounds for anything other than the sour view I have set out here. In fact, I think if we take the long view of history, what we see is that over the last 30 years things have been getting worse along exactly the lines that I have laid out. After 30 years of debate, action by administrations and congresses of both political parties, and numerous international conventions, protocols and agreements, the United States today is still more, not less, dependent on imported oil to meet its energy needs. Today, notwithstanding all of the efforts and all of the rhetoric to the contrary, it remains the case that oil supplies are overwhelmingly concentrated in the Middle East. Today, crude oil prices, even after adjusting for inflation, are more than double what they were 30 years ago. Today, unlike 30 years ago, the United Stated has more than 150,000 troops deployed to and in combat in the Middle East. Whereas at the beginning of the modern era of energy crises we might have seen terrorism and other anti-Western movements as isolated in the Middle East and focused on the Arab-Israeli conflict, today terrorism is spread across a network from Bali to Manhattan. While the pessimism I have expressed is uncomfortable and not characteristic of the American psyche, I think the evidence for this outlook is compelling. I wish it were not so. ABOUT THE AUTHOR Joseph Kalt is a senior economist with Compass Lexecon, a division of FTI Consulting, and is based in Cambridge and Tucson. Dr. Kalt is also the Ford Foundation Professor of International Political Economy at the John F. Kennedy School of Government at Harvard University, and visiting professor of economics at the Eller College of Management, University of Arizona. He is a world-renowned expert on antitrust economics and regulated industries, with special emphasis on the energy sector and regulated industries. ABOUT FTI CONSULTING FTI Consulting is a global business advisory firm dedicated to helping organizations protect and enhance enterprise value in an increasingly complex legal, regulatory and economic environment. With more than 2,200 professionals located in most major business centers in the world, we work closely with clients every day to anticipate, illuminate, and overcome complex business challenges in areas such as investigations, litigation, mergers and acquisitions, regulatory issues, reputation management and restructuring. fticonsulting.com ©FTI Consulting, Inc., 2008. All rights reserved. The views expressed in the article are held by the author and are not necessarily representative of FTI Consulting, Inc.