US Refineries Under Cap & Trade

A new study confirms my previous suspicions that the allocation of free emission allowances in the Waxman-Markey climate bill would disproportionately disadvantage the US oil sector, with serious consequences for our energy security. In particular, it quantifies the impact on the refining sector, which was chosen by the bill's authors as the focal point for collecting the "tax" on all carbon emissions from the use of petroleum products. In the view of EnSys Energy Systems, Inc., based on their model of global downstream petroleum markets, US refineries would run much less crude oil and be able to invest much less in modernization. As a result, US imports of refined products would grow significantly, despite lower overall consumption, and employment in the US refining sector would fall, while the reductions in greenhouse gas emissions from domestic refineries would be largely offset by increases abroad. Such an outcome would benefit neither the global climate nor US national security.

When I examined the preliminary version of Waxman-Markey in early June, I concluded that because it doled out so many free emission allowances to the electricity sector, its main effect for at least the first two decades would be to function as a tax on the petroleum sector, though without the clarity and transparency of a gasoline tax. Those allocations didn't change materially during negotiations, with the final House bill offering roughly 2% of emission allowances to refineries that would be saddled with the responsibility for between 33% and 44% of all US GHG emissions, depending on how you slice them. Compare that to the electricity sector, which accounts for 39% of emissions but would get at least 35% of the free allowances.

Rather than going through the details of the EnSys study, which was commissioned by API, I'd like to approach this by considering how an evenly-distributed cap & trade system (or carbon tax) should reasonably be expected to affect the oil industry, which after all accounts for a major share of US emissions. You'd hardly expect it to get off scot-free. However, it's a fact that most emissions in the petroleum value chain occur when refined fuel is burned, rather than during production (extraction) or refining. The Ensys study puts the refining contribution at less than 10% of all emissions from well to wheels. Although refiners ought to see their operating costs rise under cap & trade, giving them further incentives to increase their already impressive efficiency of roughly 90% (energy out vs. energy in), the impact should properly be relatively modest. The bulk of the impact from cap & trade should manifest in the form of higher end-user prices for gasoline, diesel and jet fuel, putting commensurate pressure on consumers to use less. The outcome of that reduction would fall on the marginal suppliers of refined products to the US market: foreign refiners that sent us over 3 million barrels per day last year. EnSys concludes that Waxman-Markey would have entirely the opposite result, enriching foreign refiners at the expense of the employees and owners of US facilities.

I wouldn't be surprised if the EnSys study were greeted with the customary skepticism of a finding that supports the interests of the constituency that paid for it. API and its member companies have much at stake in this debate. But if you doubt the likelihood of the scenario it describes, you need only review the regulatory history of the US refining industry and the long-term trend of our refined product imports, which have increased at double the rate of our crude oil imports. Between 1993 and 2007--before the recession axed them--net US refined product imports (after subtracting out exports) grew by a compound average rate of roughly 6% per year, compared to an average increase of 3% per year for net crude imports over the same period. This coincided with increasingly strict regulations on permits for new facilities and on refinery emissions of criteria pollutants, along with ever-tougher rules on gasoline and diesel fuel specifications, culminating in the current reformulated gasoline and ultra-low-sulfur diesel specs. With the exception of a couple of years of stellar margins late in that interval, returns on refinery investments were very poor, and the major oil companies were steadily shedding refining capacity as a bad bet. Today, even the independent refining companies that created profitable businesses by purchasing these assets at a fraction of their replacement cost are suffering from low profits.

If anything, the economic impact on the US refining industry from regulating carbon emissions could be even worse than this recent history, since it hinges on the basic chemistry of combustion itself, rather than the removal of impurities that constitute only a small percentage of their feedstock inputs, even for the highest-sulfur crudes. That could happen even with an even-handed approach to cap & trade or a carbon tax, but it would be a certainty under a system that appears designed mainly to shield utilities and their customers at the expense of the entire existing transportation fuel system. The principal means of reducing GHGs from the latter is through cuts in consumption, not more efficient refining, and even our recent low level of product imports offers the opportunity to cut our emissions from petroleum products by roughly 7% with a minimal effect on US refineries. Instead, Waxman-Markey would effectively offshore many of those refineries--and their emissions. In a world transfixed by market failures, that would constitute a regulatory failure of the first magnitude.