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Market-Based Solutions to Vital Economic Issues


Kenan Institute 2024 Grand Challenge: Business Resilience
Market-Based Solutions to Vital Economic Issues
Jan 12, 2023

Use Carbon Taxes to Solve the Short/Long Fossil Fuel Investment Dilemma

Energy policy is widely suffering from gridlock. Energy price inflation has erupted, fueled by suppression of new hydrocarbon development, and further stoked by war in Ukraine. European electricity and natural gas prices clock in at 5 to 10 times U.S. rates. Incentivizing new oil and gas production would seem a natural policy response. Yet, strong opposition continues to block steps for lifting fracking bans and permitting new pipelines. Environmental groups resolutely oppose such actions on the grounds that they’re incompatible with a transition to a low-carbon future. The resulting gridlock has delivered control of the oil and gas markets back to unreliable suppliers. Energy consumers thus face a dilemma – how can they assure reasonably priced supplies for the short/medium term without “locking” into oil and gas supplies long term?

One answer is to introduce carbon taxes as part of a larger political bargain. The bargain trades the introduction of carbon taxes for a less hostile oil and gas regulatory regime. The carbon taxes would have three important features. First, they would apply only to the emissions of new oil and gas projects. Second, the taxes would be customized by different project types such as fracking, pipelines, or refining. Third, they would be backloaded. The taxes would be low for the first 10-15 years, then escalate sharply.

This approach would accomplish several desirable things. First, it would lead to the adoption of carbon taxes on a much broader scale. For the first time in the U.S., there would be national carbon pricing. Second, it would give oil and gas firms a more predictable fiscal and regulatory environment in which to make the investment decisions that will provide near-term supplies. Third, it would also put them on notice that these new projects will need to be decarbonized or else face steep carbon taxation. Said differently, the firms will have 10-15 years to earn project returns while figuring out how to decarbonize their assets to extend them.

This last point takes advantage of the industry’s use of “life extension economics.” Many oil and gas assets see their project lives extended well beyond initial scope. Life extension economics are often very favorable. They not only preserve existing capacity, but also often add growth at a fraction of initial investment cost while deferring shutdown and remediation expenses. As such, they constitute a highly favorable context within which companies may consider the added costs of decarbonization.

Sealing the political bargain will require concrete steps that assure the industry that regulatory hostility is in remission. However, climate policy will benefit greatly from the “ice being broken” on carbon pricing and by the knowledge that new oil and gas projects will either be decarbonized or shut down. Once national carbon pricing comes into being, possibilities for its extension will also be significant.

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