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Testimony of Mark Glickman, Director, Accurate Prices Program and
Kim Rodgers, Research Associate of Redefining Progress

Submitted Before the Committee on Ways and Means, Subcommittee on Oversight at a Hearing on the
Impact of Federal Tax Laws on Energy Supply and Prices, March 5, 2001

Mr. Chairman and Members of the Subcommittee:

We welcome the opportunity to examine the role of Federal tax laws in the energy sector. We could not agree more with the importance and timeliness of these hearings. Americans are presented with the opportunity to make critical choices about the future of our economy. We can make sacrifices now, and channel our creative talents towards a transition to sustainable energy use, or we can continue with the same old policies that will lead us down the primrose path to recurring and increasing energy shocks. Federal tax laws can continue to support fossil fuels at the expense of sustainability, or they can help Americans to make tough decisions that will benefit our future and the future of our world.

We represent Redefining Progress, a nonprofit research and policy organization based in Oakland, California. Redefining Progress develops policies and tools that reorient the economy to care for all people and nature first. The Accurate Prices program at RP advances market mechanisms and incentives to internalize the economy's hidden social and environmental costs.

Our priority is to encourage comprehensive, long-term policy solutions that accomplish economic efficiency and equity. While the policy discussion has so far emphasized increasing the supply of energy by increasing fossil fuel production, a comprehensive energy policy must encourage supply alternatives and equitable demand reduction. Oil and gas production alone is a myopic lens with which to look at energy policy.

The American economy depends heavily on fossil fuels, in part because federal policy has kept them cheap and abundant. But fossil fuels are finite, non-renewable resources, and their use causes significant harm to the environment and to human health. At long last, even the most skeptical admit the hard reality of climate change caused by the burning of fossil fuels. Although technology has stretched absolute supplies of oil and gas, the recognition that 1) world demand will at some point outpace world supply capacity, and 2) absolute supplies are ultimately finite, cannot be too far off.

Low-income, minority and tribal communities suffer disproportionate health and ecological impacts from the energy industry and from energy users, including coal and uranium mining, oil extraction and refining, power plant sitings, dirty and unsafe industrial practices, and vehicle pollution. Continued over-reliance on fossil fuel will disproportionately impact the poor and communities of color, forcing unacceptable trade-offs among basic necessities every time we hit another price shock. Make no mistake about it, the longer we continue down the fossil fuel path, the harsher and more widespread these impacts will become.

Federal policy has long subordinated these costs to the priority of keeping fossil fuel resources cheap and plentiful for Americans. The government has done this through spending on research and development, favorable tax treatment of fossil fuel industries, and allowing these industries to use public lands, resources, and atmosphere cheaply.

Federal taxes should improve price signals reflecting scarcity and environmental costs, not obfuscate them. In the case of energy, taxes need to reflect the real scarcity of resources and the significant social and environmental impacts of energy use. The numerous tax breaks that subsidize fuel energy prices need to be phased out. Energy tax laws should instead focus on leveling the playing field for renewable sources of energy, reducing demand through conservation and efficiency measures, and accounting for high health and environmental costs. Consumers, our environment, and our economy will benefit from these changes.

We offer several illustrative suggestions below. Our testimony is organized around the three areas of focus as described in the Subcommittee Hearing Advisory. We do not intend for this to be either an exhaustive list of the possibilities or a complete analysis of the impact of federal taxes on energy supply and demand, but rather a set of forth principles and reforms that would move the American economy onto a sustainable energy path for the future.

We have reason to believe that making this kind of turn in the economy is possible. Europe is far ahead of us in making this transition; most countries in the European Union have implemented various forms of green tax reform that discourage fossil fuels. And despite objections that Americans will not accept change, large cultural shifts are clearly possible when Americans understand the need and benefits of change-witness the sea change in attitudes towards tobacco smoke and recycling.

1) Adequacy of Current Tax Incentives for Production and Conservation

Conventional economic theory holds that as oil becomes scarce, rising prices will stimulate new, alternative resources to enter the market. Federal taxes however, have played a significant role in subverting market forces and have kept oil and gas prices artificially low, at the expense of competing industries and the American consumer.

Conventional economic theory also argues that it is the task of government to intervene when economic activities impose costs, or "externalities", on society that are not captured in the market, such as pollution and global warming. Again, federal policy, including federal tax laws, has failed to meet this task in the case of fossil fuel energy. In short, current Federal tax laws encourage over-production and over-use of fossil fuels.

Oil and gas industries have long enjoyed numerous tax breaks, including accelerated depreciation of assets, tax credits for production at marginal wells, and immediate expensing of intangible drilling and development costs. It is difficult to think of another American industry that is so heavily subsidized by our tax system.

These tax breaks are reinforced by the less obvious but equally potent absence of taxes on health and environmental costs imposed by the use of fossil fuels at no discernible cost to users and producers. Instead these costs are passed on in the form of health problems and a degraded environment (which create future health and cleanup costs), and are paid most often by the least well-off in our society and around the world. These costs will only continue to mount for future generations unless we make hard decisions now.

Over the last decade Congress has instituted or broadened several tax-based incentives for alternative energy sources. Although a positive step, the approach has too piecemeal to induce the scale of change required. Tax incentives to date have been small scale, only partially targeted towards renewable energy, and continue to be outpaced by tax breaks to oil and gas. The "Section 29" credit for non-conventional fuels, for example, supports oil produced from shale and tar sands, synthetic fuels produced from coal, and gas from biomass while providing no benefits to wind or solar energy.

Last year, the Joint Committee on Taxation submitted testimony to the Senate that examines the impact of federal taxes on energy policy. It lists ten new tax breaks proposed for oil and gas production, as compared to only five tax incentives for alternative fuels proposed in the 106th Congress. All five alternative fuel proposals related to alternative fuel vehicles. In other words all five proposals benefited methanol, which requires almost as much fossil fuel to produce as it replaces in end use, and which has been shown to reduce overall vehicle fuel efficiency.

Federal research and development spending has been equally stingy when it comes to renewable energy. Only 11% of all federal R&D money goes to renewable energy, less than half that spent on fossil fuels and less than a fifth of the widely discredited nuclear power program. Strikingly, energy efficiency, although receiving only 7% of research dollars, generated the greatest return. The United States now uses 42% less energy per unit of gross domestic product than in 1970.

For too long, these subsidies have allowed oil and gas companies to maintain high profit margins. Subsidies have also kept retail prices low enough to sap consumers' incentives to conserve energy and make it difficult for renewable energy sources to enter the market. Tax policies, by providing accurate signals regarding oil and gas, can play a powerful role in stimulating change that places the consumer and the economy as a whole ahead of the oil and gas industries.

Recommendations:

  • Reduce and phase out tax breaks that benefit oil and gas exploration and production, particularly at marginal wells and on federal lands.
  • Reject new subsidies for so-called "clean coal technology" and nuclear power, and eliminate existing subsidies.
  • Impose a market-based approach to impose charges on emissions. This would be fairer, more efficient and more effective than the structure of the currently proposed caps on NOx, particulate matter from electric generation, CO2, and SO2.
  • Require that polluters pay for their greenhouse gas emissions through either auctioned emissions permits or pollution taxes. Redefining Progress strongly believes that the United States should not give away rights to pollute the atmosphere. Revenues from taxes or permits can be recycled into the economy in several ways that improve economic efficiency and ensure distributional equity.
  • Provide additional tax incentives for renewable energy, conservation and efficiency, such as:
    • Tax credits to individuals who buy clean and efficient advanced-technology vehicles employing hybrid gasoline-electric drive;
    • Incentives for smart-growth development patterns that conserve land, discourage sprawl, and reduce dependence on car travel;
    • The extension of the renewable energy production tax credit, which encourages greater reliance on emerging renewable energy sources;
    • Incentives for advanced energy-efficient buildings and appliances;
    • Expansion of credits to employers who provide public transit benefits.
  • Ensure that tax incentives favor renewable energy sources. Current tax breaks, for example, provide benefits to ethanol fuel, which requires almost as much fossil fuel in its production as it replaces in end use.

Tax Provisions in the Proposed Senate Energy Bill:

  • The tax provisions in the Energy Security Bill introduced by Senator Frank Murkowski (R-Alaska) reinforce current tax bias in favor of fossil fuels. The most recent versions of his bill include continued tax credits for production from marginal oil and gas wells. Royalties from offshore production would also be reduced when oil and natural gas prices fall below a certain threshold level. These provisions are economically inefficient, fail to move the U.S. economy towards a rational energy policy, and provide large benefits to select industries.
  • Senator Murkowski's bill currently includes provisions to extend and expand the tax credit for renewable energy sources to wind and closed-loop biomass. Tax credits for energy efficient hybrid vehicles may also be included. These measures are a positive step, but are not sufficient to rectify the imbalance of tax credits favoring oil and gas. These should be the primary thrust of the legislation, rather than an afterthought.

2) Causes of current shortages and high prices

The bottom line is that oil and gas are finite resources in which the United States has little domestic production capacity relative to its demand. U.S. demand for oil has exceeded domestic production for more than 30 years. Our relatively meager supply-total U.S. production potential represents only about three percent of known world oil reserves-means that no matter how much we step up drilling on federal lands we are not going to come up with enough oil to actually influence prices. We remain dependent on foreign oil powers, and subject to unavoidable market fluctuations, as long as we remain dependent on oil, whatever its source.

In addition, current forecasts estimate that world demand will exceed worldwide production capacity within the next 2 to 17 years. The world already consumes more than three times as much oil as is discovered each year, and demand in Asia (which still uses dramatically less energy per capita than the United States) is rising rapidly. The critical point in energy markets is not when the world runs out of oil, but the much more imminent point at which world demand exceeds supply capacity. At that point, the costs of importing supplies and maintaining world economic stability will increase exponentially.

Although certain policies such as the deregulation of electricity generation in California have amplified world price volatility, underlying price increases are a result of world events and policies outside of our control. Our ability to avoid future price shocks therefore depends largely on our ability to reduce our dependence on oil.

Current power shortages in California have been blamed on progressive health and environmental protections. This is a smokescreen. The lack of generating capacity is a result of poor planning and industry forecasts based on recession-level demand. Uncertainty over the fate of deregulation legislation also contributed to industry reluctance to invest in new generating capacity. Currently there are nine approved power plants in the pipeline and a total of 12 new power plants have been approved within the last year.

California is just the tip of the iceberg. Virtually all Western states have outgrown their electrical systems. According to the Los Angeles Times, "almost none of the West save Montana has increased its power production at anything like the pace of its population growth during the last decade. Despite the long economic boom of the 1990s, which smiled especially on the West, several, such as Arizona, have failed to complete a single new power plant." California's problems have been blamed on a regulatory structure that stifles new plants, yet its neighbors, some of them with much more lenient standards, find themselves in the same boat. Finally, transmission bottlenecks have exacerbated local supply shortages. American power generation currently comes from a system of large, centralized generators. Relying on a system of large transmission lines carrying power over long distances introduces another level of potential instability to power consumers.

Recommendations:

  • The inequitable tax treatment of fossil fuels over renewable energy sources undermines the beneficial market forces of energy competition. Deregulation will only produce benefits if federal tax laws are made to facilitate competition rather than thwart it.
  • A full and fair accounting, including social and environmental costs, would likely reveal that states and localities are better off developing local energy supplies, which most often means renewable energy like wind and solar power. Tax policies should explicitly encourage rather than hide the full accounting of energy and transmission costs.
  • Insurance against world energy supply shocks requires that we reduce our demand for fossil fuels. Tax policies should encourage conservation through direct financial incentives.

3) Impact of shortages and high prices on consumers and businesses

In California, efficiency and conservation responses to shortages and price increases have been impressive, but have been hindered by retail price caps. Although the crisis has spurred new state-level incentives for efficiency and conservation, the capping of retail prices to consumers is undoubtedly slowing more widespread conservation and efficiency responses.

The sudden, sharp nature of the price increases also makes it difficult for consumers to adjust. In general, energy consumers are more risk-averse to price volatility than to the absolute price of power. Consumers are also less likely to believe that short-term shocks reflect long-term price conditions and therefore have less incentive to change their long-term consumption.

Repeated price shocks over the past thirty years reflect the increasing fragility of a regulated system that tries to cover up honest accounting of scarcity and environmental costs. Regulation, however, did provide the benefit of protecting consumers from price shocks, much as retail price caps are doing today. While competitive prices should fluctuate to reflect scarcity, policies should aim to equip consumers, particularly low-income consumers, and businesses with the knowledge and choices they need to reduce energy demand and insulate themselves from shocks.

As we have seen from anecdotal evidence of households unable to afford sudden sharp rate increases, price volatility hits low-income Americans particularly hard. Not only do low-income Americans suffer disproportionate health impacts of fossil fuels, they also bear a disproportionate amount of the financial risk associated with reliance on oil.

Assistance programs, such as the Low Income Heat and Energy Assistance Program (LIHEAP), and block rate price structures, can help low-income households deal with long-term energy price increases, but these programs are less well-equipped to deal with the types of crises we are now experiencing in both the West and Northeast.

Recommendations:

  • Prices should be allowed to reflect scarcity and health and environmental costs. It is possible for prices to more accurately reflect condition of scarcity without forcing Americans to choose between heat and food. Lifeline assistance to low-income households can be provided through a block rate pricing structure-recently authorized in California energy markets, and used in water markets. This structure guarantees a base amount at a lower rate, insulates necessity level of power usage, and implements higher prices above a base amount. Programs such as LIHEAP can be expanded.
  • Energy conservation and the promotion of renewable energy choices should become a high priority in electricity deregulation efforts. Deregulation must also include measures that protect consumers and businesses from extreme price volatility and that ensure access to necessity level energy use.
  • Redefining Progress research shows that, combined with reductions in other taxes, it is possible to raise fossil fuel energy prices - through a carbon tax or auctioned permits, for example - with little and possibly even positive impacts on economic growth and distribution.
  • Over 2,500 economists, eight Nobel Prize winners among them, have stated that the United States can most effectively implement climate policies through market-based mechanisms, such as carbon taxes or the auction of emissions permits. The revenue generated from such policies can be used to pay down interest on the deficit or to lower existing taxes, and may in fact improve U.S. productivity in the longer run.

Mr. Chairman, and Members of the Committee, there are no easy answers to the energy problems facing our nation today and in the future. Tough choices need to be made, and we welcome the opportunity to discuss the details of the recommendations we have made in the future.