Ann McCampbellEconomics 398October 31, 2012Professor Guse

Capstone Proposal: The Effect of the Energy Policy Act of 2005 on Domestic Production of Fossil Fuels and Alternative Energy

Question

The fundamental question I hope to answer is did the Energy Policy Act of 2005

have an effect on domestic energy production. The Energy Policy Act of 2005 is the most

recent energy legislation; the act created a variety of new incentives or alternative energy

production and consumption. I hypothesize that the tax code treatment of the energy

industry has an effect on energy production; I hope to capture that with the use of time-

series data from the industry.

Background

Since the 1970s, US energy policy has attempted to reduce oil import dependence

and enhance national security through a variety of domestic energy investment and

production tax subsidies as well as subsidize a renewable and energy efficient technologies

via the tax code to account for environmental concerns. The tax code’s treatment of

different sectors within the energy industry has changed over time, reflecting changing

incentives and views on the best way to achieve the energy goals of the US. In 2007, the

United States domestic energy production total was 71.5 quadrillion BTUs; about one-third

of that energy came from coal, natural gas accounts for about one-quarter of production

and crude oil makes up one-fifth. Solar, geothermal and wind account for just one percent

of US energy production.

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The US has traditionally favored traditional modes of fossil fuel production, from

1948 to 1998 roughly 80% of U.S. Department of Energy appropriations for R&D went to

nuclear and fossil fuel technologies (Nayak 2005). The choice between fossil fuel/nuclear

and efficiency/renewable is a key policy debate moving forward. The efficiency/renewable

path recognizes permanence and environmental concerns as guiding principles. The fossil

fuel advocates prioritize resource extraction, profit making and national security. The

choice between energy technologies is about more than merely hardware; there is a

significant debate between new stakeholders and entrenched interests over what sources

of energy gain favor in the tax code. Questions over how best to manage power systems,

industrial utilities, and the energy use of businesses and firms; and a conflict over

competing conceptions of modern life and identity characterize the policy debate. The

implications within energy policy affect material and intangible concerns, institutions and

technology as well as consumers.

The paper is organized as follows. Section 2 clarifies provisions within the law and

their importance to this study. Section 3 provides an overview of the data used for analysis

and Section 4 and 5 discusses the model and specification used. Section 6 is a literature

review of relevant research and section 7 encompasses concluding thoughts and policy

implications.

Provisions in H.R. , the Energy Policy Act of 2005

The bill, which became Public Law No: 109-58, sets forth an energy research and

development program coving; (1) energy efficiency; (2) renewable energy; (3) oil and gas;

(4) coal; (5) Indian Energy; (6) nuclear matters and security; (7) vehicles and motor fuels,

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including ethanol; (8) hydrogen; (9) electricity; (10) energy tax incentives; (11)

hydropower and geothermal energy; and (12) climate change technology.

The law introduced 1840 new and distinct provisions, however for this paper I am

going to focus on the energy tax incentives associated with the law. I focus on energy tax

incentives to determine if government policy preferences and subsidies have an effect on

energy production. While the tax code may have the most direct impact on energy

production, many other provisions have important implications for energy policy. Title XIII

amends the IRS code to extend eligibility of renewable energies (biomass, geothermal,

small irrigation power, and landfill gas and trash combustion facilities) for tax credit for

producing electricity. The law also increases the credit period for renewable energy

facilities placed in service after the enactment of this Act from five to ten years.

US energy policy has traditionally favored the oil and gas industry through

production tax credits; however, EPA05 casts a great preference for renewables. Goals

within the bill such as giving incentives and credits for use of energy efficient appliances,

clean gasoline and hydrogen as well as providing funding for R&D in energy efficiency

could have a negative effect on fossil fuel production. Futher, R&D directed at fossil fuels is

appropriated towards reducing emissions, clean transportation fuels, fuel cells, carbon

dioxide capture technologies and the pulverized coal combustion units.

Data

The US Energy Information administration has both yearly and monthly time series

data for prices, reserves, production, consumption/sales, stocks and imports/exports for

crude oil by state. The data is available for every state from 1859-2011. I plan to use data

from 2005 onward in order to capture the effect of the law over time. Controlling for state

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fixed affects, this panel data allows analysis of changes in production that vary both over

place and time. Time-series data is also available on the price, exploration & reserves,

production, imports/exports, storage and consumption for natural gas and coal.

Further, the EIA also has historical data on alternative transportation fuel

consumption.

Possible Specification

Yit=γi + αit + βpost 2005

Where Yit is the capacity and/or production for a specific sector of the energy industry, γi is

the state fixed effect, αit is the state specification over time and βpost 2005 represents changes

since 2005, which is the year of interest for the policy.

Literature Review

Gravelle, Jane and Kotlikoff, Laurence. “Corporate Taxation and the Efficiency Gains of the 1986 Tax Reform Act” NBER Working Paper Series. October 1989.

While this paper does not address the Energy Policy Act of 2005, it is useful from a

methodology standpoint on possible ways of examining a law’s impact on an industry. This

paper develops an 11 industry – 55 year dynamic life cycle version of the Mutual

Production Model. This model is used to study the steady state of efficiency gains

associated with the new law. The authors identify steady state welfare gains as those that

arise from compensating transitional generation for the first order redistribution of income

associated with the Tax Reform. The authors use a two-sector model in which corporate

and noncorporate firms coexist within the same industry. These two sector models have

different structures but their common characteristic- a very high/infinite within-industry

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elasticity of substitution between corporate and noncorporate output- implies an excess

burden from corporate taxation that is many times larger than the predicted by other

models.

The model permits mutual production of the same good by corporate and

noncorporate sources and assumes constant returns to scale in the production function.

There are seven benefits the authors note to using their new model in examining industry

effects. First, the model also merges statistics with dynamics through a 55-year life cycle

model of intertemporal choice. Second, it uses a fixed coefficient input-output table to take

account of intermediate inputs. Third, it deals explicitly with depreciation. Fourth, takes

into account personal as well as corporate marginal taxation of capital income. Fifth, it

accounts for differences across industries in marginal corporate tax wedges. Sixth, it

models owner-occupied housing as a separate industry whose sole input is noncorporate

capital. Lastly, it takes into account the use and production of different types of capital

goods.

Sherlock, Molly. “Energy Tax Policy: Historical Perspective on and Current Status of Energy Tax Expenditures.” Congressional Research Service. May 2010.

Sherlock looks at the history of the US tax code and its two broad objectives in the

context of revenue losses. She is concerned with this question with the question of revenue

losses associated with special treatment of the energy industry. This paper is useful in that

it provides context for the history of how energy has been treated by the tax code and the

changes in incentives within the industry over time. In the 1970s and 1980s, fossil fuels

were favorably treated by the US tax code. With the major tax reform undertaken in 1986

by the Reagan administration pursued a more neutral approach to energy with a “free

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market approach” that attempted to clear any production incentives. In the 2000s the

federal government showed a renewed interest in renewable energy in an effort to balance

the need for domestic energy with environmental concerns.

EPACT05 was responsible for substantially increasing tax subsidies, the number

provisions for energy from 11 in the 1990s to 38 in 2007. New provisions coming out of the

EPACT05 fall under electricity infrastructure, domestic fossil fuels, energy efficiency, and

clean motor vehicles and fuels. The Emergency Economic Stabilization Act of 2008 contain

a number of energy tax provisions, primarily ones that extent existing provisions on

renewable energy. The Emergency Economic Stabilization Act of 2008 was fully paid for by

raising taxes (mostly reducing oil and gas breaks) on the oil and gas industry. Further, the

American Recovery and Reinvestment Act of 2009 modified incentives for renewable

energy production, energy efficiency, clean motor vehicles as well as a number of other

energy tax incentives.

Sherlock notes that the primary economic justification for intervening in energy

markets via the tax code is to address market failures, when markets fail resources are not

allocated efficiently. Both production and consumption of energy can generate negative

externalities. Part of the rationale for intervening in energy production is to subsidize

activities that may generate fewer externalities, like renewable energy. However, energy

subsidizations that deal with changing incentives does not necessarily achieve allocative

efficiency. Subsidizing renewable energy may reduce the average price of energy, which

would theoretically increase demand and ultimately consumption and that works against

the goal of energy efficiency. Further, to pay for these subsidies, the government must raise

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revenue in a distortionary way. High barriers to entry and the need for domestic energy

work to ideologically justify subsidies for oil and gas production.

Metcalf, Gilbert. “Investment in Energy Infrastructure and the Tax Code.” Tufts University. October 2009.

Gilbert Metcalf estimates the marginal tax rate’s effect for different energy capital

investments as of 2007. Metcalf finds that wind investment is strongly responsive to

changes in tax policy. The American Recovery and Reinvestment Act of 2009 that provides

over $60 billion in funds for clean energy investment is the piece of legislation that is of

primary interest in Gilbert’s analysis.

Like Sherlock’s paper, Metcalf addresses the structural changes in the tax code over

the last decade that may have altered incentives for energy production. A recent study by

the US EIA (2008) estimates that producers of fossil fuels received approximately two-

thirds of tax-subsidies for energy production in 1999 in contrast to the one-third for

producers of renewable energy. By 2007, the tax code changed so that renewable energy

producers received about 40 percent of tax subsidies while the share given to fossil fuels

has fallen to about 50 percent.

Metcalf addresses the cost of infrastructure in energy production, because the direct

dollar benefits of the tax code for the energy industry are largely known.

The mining, utilities petroleum and coal manufacturing sectors are subject to

corporate income tax; this production usually falls under the top federal marginal tax rate

of 35 percent. The tax provisions Metcalf notes as having the most significant impact on

production decisions are the additional depreciation benefit for oil and gas drillers from

the ability to expense a dry hole and differing rates for depreciation of assets across sectors

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in the energy industry. Also, percentage depletion allows oil and gas producers to take a

depletion deduction based on a percentage (15%) of the revenue, rather than the actual

cost, for us to 1,000 barrels a day. An example to clarify the implications of this follows: if

an independent firm owns an oil reserve and sells 100,000 barrels of oil pumped in the first

year for $60/barrel, assuming no taxable income limits, the firm could deduct 15 percent of

the revenue from the sale, equal to $900,000. If the same firm were to sell the entire

reserve of oil at $60/barrel its cumulative depletion allowance would be $18 million, 80

percent greater than the depletable cost of the field. The CBO estimates this provision will

cost $4.4 billion between 2009 and 2013. According to the US EIA, roughly half of domestic

crude production in 2007 came from independent producers that were potentially eligible

to take percentage depletion productions.

Intangible drilling costs are another factor that significantly contribute to

production decisions. Intangible drilling costs are all the costs for which no salvage value is

possible. Intangible costs may include site improvement, construction costs, wages, drilling

mud and fuel.

Sovacool, Benjamin. “The Problem with the “Portfolio Approach” in American Energy

Policy.” Policy Sciences. Springer. Vol. 41, No. 3 (Sept 2008)

Sovacool uses this paper to show the flaws in the implementation and policy that

push for a renewable energy portfolio in the US. He finds inconsistencies in policy and high

social costs associated with the US energy approach. He begins the paper by making the

argument that in order for an energy portfolio to make senses, four assumptions must be

made:

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A diversified portfolio of electricity technologies is needed to response to different

sets of challenges and problems

All energy technologies, including those on the demand and supply side from energy

efficiency and renewables to fossil fueled generators and nuclear power plants,

deserve support

Energy research and development should push breakthroughs on all technological

fronts

Nuclear and coal have an important future role to play in American and global

electricity policy

Sovacool argues the energy portfolio in the US has traditionally favored nuclear and

fossil fuels, this fits with historical facts and other relevant literature. He also notes that

legislation to change the nature of government subsidies has been largely inconsistent and

internally divided on how to best promote renewable energy systems. The recent Energy

Policy Act of 2005 heavily favored supply-side options and barely made a dent in reducing

energy consumption and improving energy security. Senator John McCain remarked that

"this bill does little to address the immediate energy crisis we face in this country. The

handouts to big business and oil companies are irresponsible and will be disastrous for

people" (Quoted in Sovacool 2006a). This prompts the question of whether the country

sees greater changes to energy policy from alteration to supply side or demand side

alterations.

The Energy Information Administration (EIA) estimates in the next 12 years clean coal

and natural gas will gain much more of a market presence than renewable sources. In its

2007 Annual Energy Outlook, the Energy Information Administration (EIA 2007) projected

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that oil, coal, and natural gas will provide the same 86-pecent share of total energy supply

in 2030 that they did in 2005. Even though the coal, gas and nuclear energy industries are

relatively mature sectors (electricity has been produced from coal for more than a

century), federal R&D expenditures continue to favor these industries at the expense of

funds for newer renewable technologies. In fiscal year (FY) 2006, for instance, the federal

government allotted $580 million in R&D funds to fossil fuels and $221 million to nuclear

(The FY 2008 budget calls for expanding this figure to an astonishing $547 million). But the

wind industry, in contrast, received only $38.3 million or 4.8% the amount given to

conventional technologies (Levesque 2007). These discrepancies in spending cause

Sovacool to question the federal government’s commitment to subsidizing renewable

energy and a diverse energy portfolio in general.

Sovacool examines social cost associated with energy production through the levelized

costs of electricity (LCOE) he presented in a previous paper (2007). This estimation

attempts to take into account the social cost now while controlling for historic costs and

accounting for differences in construction, operations, maintenance, technical feasibility

and environmental performance.

More than 90% of the $90 billion spend on public and private capital flows towards

new power plants from 1994-2001 in the developing world were directed towards large

scale coal and natural gas projects. The US could play a leadership role in promoting clean

coal in places like China. The EIA projects coal and natural gas use will increase

dramatically over the next two decades. Despite prior willingness for US firms to export

fossil fuel technologies, recently firms have been reluctant to share innovations in clean

coal because of weak global intellectual property rights. This may imply a roll for public

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policy in the US to drive the protection of R&D innovation globally; this could substantially

increase both the public and private benefits of R&D.

Hultman et al. (2007) investigated the financial risks for new nuclear power plants

utilizing a three-decade historical database of delivered costs from each of 99 individual

nuclear reactors operating in the U.S. Their study found a significant fraction of plants

(16%) with extremely high costs. They point out two unique attributes of new nuclear

power plants that make them prone to unexpected increases in cost: (a) their dependence

on operational learning (a feature not well suited to rapidly changing technology and

market environments subject to local variability in supplies, labor, technology, and public

opinion, and the risks of capital cost escalation); and (b) difficulty in standardizing the

manufacturing of new nuclear units (or the idiosyncratic problems of relying on large

generators whose specific site requirements do not allow for mass production). Further,

nuclear power plants contribute to greenhouse gas emissions.

Energy Projections

The 2011 Annual report from the Energy Information Administration provides

updates for current energy production and consumption status. This information is useful

to show how the energy industry has changed since 2005 and what the goals and

projections are moving forward. One of the most important features of the report is the

emphasis on the influence of technological improvements in building the energy sector.

With respect to renewables in particular, the report provides four different tracts energy

use could take depending on the technology available.

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In the No Sunset and Extended Policies set (compared against the base reference) in

place beginning in 2005, renewable energy generation is set to more than double from

2010 to 2035.1 The most rapid growth in renewable capacity occurs in the very near term,

largely through projects that are already underway. Further, the increased utilization of

energy efficient appliances and cars with greater fuel efficiency are significant in the

increased demand for renewable energy. Analysis of the results in the study suggests that

the total levels of energy consumption are close to the reference level; improvements in

energy efficiency lead to reduced consumption but also relatively lower aggregate energy

prices led to higher relative consumption.

For determining global oil market projections and prices the AEO2012 reference

case assumes current practices, politics and levels of access will continue at least in the

mid-term. The reference case also assumes non-Organization for Economic Cooperative

Development (OECD) nations, including China and India, will more than offset the slower

growth projected in many OECD nations. In the reference case, non-OECD fossil fuel

consumption is about 21 million barrels per day higher in 2035 than in 2010; this contrasts

sharply with the less than 2 million barrels per day growth in OECD countries over the

same period.2 When thinking about policy conclusions and domestic production, which is

the focus of this paper, it is essential to keep in mind the role of other countries. The rapid

increase in energy production and consumption, especially in non-OECD countries will

have an effect on global environmental and safety concerns regardless of US domestic

energy policy.

1 http://www.eia.gov/forecasts/aeo/pdf/0383(2012).pdf 2 http://www.eia.gov/forecasts/aeo/pdf/0383(2012).pdf page 24

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Concluding Thoughts and Policy Implications

Relevance of this study and policy implications: In the presidential debate on

October 3, 2012 the state of the economy was the key issue of contention between the

candidates. Energy policy is one of the key points of departure when thinking about the

economic future of the country. Obama said Romney would continue to favor tax breaks for

the oil industry and Romney criticized Obama for supporting over $90 billion in renewable

energy projects in four years, which is “about 50 years’ worth of what oil and gas

receives.”3 Further, Chris Edwards of the Cato institute recently wrote: “The Republican

charge that eliminating these tax preferences will increase prices at the pump is for the

most part nonsense. Given stable demand, oil prices are determined by whatever factors

increase or decrease production anywhere in the world. So the relevant question is

whether elimination of these tax provisions — i.e. decreasing the profits of those producers

who enjoy these tax deductions — will decrease production.4” While there is healthy

debate over what source of energy is best for the country and how we should finance the

cost of energy, there is no question that the United States needs energy to continue to

function on both a micro and macro level.

References

Balz, Dan and Gardner, Amy. “Romney goes on offense, forcing Obama to defend record.” The Washington Post. October 4, 2012.

3 http://www.washingtonpost.com/politics/decision2012/romney-obama-debate-could-be-pivot-point-in-campaign/2012/10/03/74fad02c-0d98-11e2-bd1a-b868e65d57eb_story_2.html 4 http://www.cato.org/publications/commentary/eliminating-oil-subsidies-two-cheers-president-obama

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Congressional Budget Office. Cost Estimate. S.10 Energy Policy Act of 2005. Reported by the Senate Committee on Energy and Natural Resources. May 26, 2005.

Gravelle, Jane and Kotlikoff, Laurence. “Corporate Taxation and the Efficiency Gains of the 1986 Tax Reform Act” NBER Working Paper Series. October 1989.

The Library of Congress. CRS Bill Summary & Status. 109th Congress (2005-2006). H.R. 6

Metcalf, Gilbert. “Investment in Energy Infrastructure and the Tax Code.” Tufts University. October 2009.

Sherlock, Molly. “Energy Tax Policy: Historical Perspective on and Current Status of Energy Tax Expenditures.” Congressional Research Service. May 2010.

Sovacool, Benjamin. “The Problem with the “Portolio Approach” in American Energy Policy.” Policy Sciences. Springer. Vol. 41, No. 3 (Sept 2008)

http://www.jstor.org/stable/pdfplus/4102229.pdf?acceptTC=true

Current economic forecast of 2012: http://www.eia.gov/forecasts/aeo/pdf/0383(2012).pdf

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