Monday, November 21, 2005

Deeper Disincentives

Washington, DC, November 10, 2037 - Yesterday's Senate Energy Committee hearing on the exorbitant profits of the biodiesel industry was marked by controversy and a series of heated exchanges between senators and industry executives. Several senators accused the industry of collusion and price-fixing, while the biodiesel CEOs assured the panel that the recent doubling of biodiesel prices--and the resulting earnings bonanza for the industry--was entirely attributable to the summer drought and a persistent blight affecting canola and other oilseed crops. Suggestions that the provisions of the Energy Act of 2022 be waived temporarily to allow diesel cars and buses to fuel up with petroleum diesel brought Senator Jones to her feet. "My constituents have a right to purchase biodiesel at an affordable price, since it is the only environmentally safe fuel for their cars. Your high prices and excessive profits are a betrayal of the public trust granted to you."

This might seem like a highly fanciful scenario, but I think it illustrates an important argument concerning proposed Congressional action to tax the oil industry on its "windfall." As Ben Stein's Sunday NY Times column explained, and as I suggested in last Thursday's posting, this is bad policy with respect to the oil industry, but it also sends worrying signals to the alternative fuels industry that many hope will ultimately supplant a large portion of our currently petroleum dependence.

There is a notion at the heart of the criticism of the oil industry's recent high profits that should make us all nervous, although you'll never see it articulated in precisely this way, that in this country, only the government is entitled to earn more than a few cents per gallon on the sale of motor fuels to the public. Companies in this industry are viewed as performing a public service in a near monopoly, and thus should earn utility-like returns. You'll note that there's nothing in this idea that is specific to oil.

Now, as long as the ire of the public and its elected representatives is focused on oil companies, who deal with unpleasant foreign governments and operate on a scale beyond the comprehension of the average person, this may seem like a reasonable proposition. Fuel for your car is a necessity, not a luxury, after all. Why should someone be allowed to make huge profits at the expense of consumers on products they'd make anyway?

It's even harder to see how this could ever apply to the alternative fuels industry, because at present it is so small--and thus benign. It functions either as a cottage industry or as a semi-philanthropic or highly prospective sideline of big energy firms. But if alternative energy is ever really going to matter, relative to our challenges of energy security, trade imbalances, and climate change, it must eventually operate on a scale comparable to today's oil business. That means producing and selling not just millions, but billions, and ultimately hundreds of billions of gallons per year of fuel.

Now, perhaps the people who currently invest in startup companies in this area would be satisfied merely to break even, because they are motivated by impulses other than the allure of profits. But the alternative fuels industry, whether it is built on biofuels, coal liquefaction, oil shale processing or other technologies, will require enormous capital--probably hundreds of billions of dollars--to attain even a tenth of the scale of the present oil industry. You don't invest that kind of money to earn what you could make on a T-bill or a market index fund. And you won't invest it, if you are convinced that the first time you make a big profit, the government will swoop in and seize part of it, because you are selling the public something they can't do without.

While most of the executives of today's alternative fuels companies would probably think that growing large enough to get on the radar screen of a congressional committee would be a remarkable indication of success, I'd be surprised if the more thoughtful among them aren't squirming already, just a bit, because they recognize the magnitude of the profits they will need to make--in proportion to the tremendous risks they are undertaking--to grow as rapidly as they and we would like.

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