JOINT TRANSPORT RESEARCH CENTRE
Round Table, 15-16 November, Paris

Discussion Paper No. 2008-5
February 2008

Oil Dependence:
Is Transport Running Out
of Affordable Fuel?
SUMMARY AND CONCLUSIONSContents

Executive Summary ....................................................................................... 3
1. Introduction .............................................................................................. 7
2. Oil Prices Drivers 1960 to 2007 ................................................................ 7
3. Oil Price Volatility and Cyclical Effects ................................................... 10
4. The Short Run Oil Price Outlook ............................................................ 12
5. Long Term Oil Supply Outlook ............................................................... 13
6. Non-Conventional oil .............................................................................. 14
7. Does a Price of $100 a Barrel Oil Matter ................................................ 16
8. Transport Sector Response to Changes in Oil Prices ............................ 18
9. Motivating Transport Policies – Market Failures ..................................... 19
10. Policy Instruments .................................................................................. 21
References .................................................................................................. 32© OECD/ITF, 2008

2

Executive Summary
The transport sector’s demand for oil is less price sensitive than any other part of theeconomy. This is partly because demand for transport services is relatively
insensitive to price and partly because substitutes for oil in road transport are
currently far from cost-effective. Evidence from the USA suggests that as incomesrise, transport sector oil demand becomes even less price sensitive. This implies thatoil consumption is set to become increasingly concentrated in the transport sector. It
also implies that relatively limited fluctuations in demand can have increasingly
significant effects on oil prices.

Figure 1. Spot crude oil price 1970-2007: real and nominal prices$/bbl

WTI Nominal

WTI Real, base = Dec 2007

120

100

80

60

40

20

0
1970

Notes:

1975

1980

1985

1990

1995

2000

2005

Price sources: Dow Jones for pre-Jan 1985 data, Platts monthly Cushing spotwest Texas intermediate (WTI) crude from Jan 1985; Deflated taking December
2007 baseline and using monthly OECD consumer price index data.

Source:IEA.

Oil prices approached their historical 1980 peak in real terms in November 2007,
when the Round Table convened (see Figure 1). Because of growth in incomes since1980 and the reduced oil dependence of OECD economies, the economic impact of3© OECD/ITF, 2008

high prices has been weaker than during earlier oil price peaks. Moreover, thecurrent high prices are a result of strong economic growth rather than a supply shockas was the case in the oil crises of the 1970s. Nevertheless, the transport sector isthe most exposed part of the economy to oil prices.

OPEC market power is expected to increase. OPEC, and particularly the Middle
East, will see its share world oil supply increase because production of conventionaloil from other parts of the world has either peaked and entered a phase of permanent
decline or reached a plateau for the foreseeable future. OPEC will therefore be in astrong position to defend high prices against a background of rising demand,
particularly from the emerging economies.

That is not to say prices will inevitably rise further or even stay at current levels. They
could also fall substantially if economic growth weakens, particularly in theincreasingly interdependent US and Chinese economies. Price instability is likely topersist. This creates uncertainties that delay major investments in new oil production
and refining capacity, as well as in fuel efficient car technology.

In the longer term, non-conventional oil resources could supply a large part of oil
demand at prices from around $40 a barrel. The conventional view is that reserves oftar sands, oil shale and coal are sufficient to provide for decades of further growth inoil consumption but this was challenged by some round table participants whobelieve coal supply has already peaked. As non-conventional oil sources become
more critical to world oil supply, a better understanding of their availability and theeconomics of production is increasingly important.

Policy responses to growing OPEC market power can seek to either promote nonconventional oil production in non-OPEC countries or reduce oil consumption.
Policies to promote alternative fuels are also relevant but of limited short term
potential as discussed in the conclusions of the JTRC Round Table on Biofuels:
Linking Support to Performance (OECD/ITF 2007). Non-conventional sources of oil© OECD/ITF, 20084

are associated with more than twice the emissions of greenhouse gasses fromconventional oil. Their development may therefore be constrained by climate policy.

Intervention to internalize the costs of CO2 emissions from transport serves to both
mitigate climate change and reduce oil consumption at the same time. Carbon taxes
are the preferred instrument of many economists to achieve this because they
provide incentives for attainment of the environmental target at least-cost. However,vehicle fuel efficiency or CO2 emissions standards have some advantages, not leastin terms of political acceptability. They are also able to correct the difference betweensocial and private discount rates at the point of vehicle purchase. Differences
between social and private discount rates, and imperfections in consumers’ decisions
on what fuel economy to buy, may justify standards even if taxes reflect externalcosts.
Standards are vulnerable to being undermined by the rebound effect – i.e. the costsavings resulting from increased fuel efficiency may be taken up by additional driving
or upgrading of the power or weight of the vehicles purchased. There is considerable
agreement that the rebound effect in terms of increased driving is small (around 20%,
maybe smaller1), so that standards do translate into substantial reductions in fuelconsumption. To the extent that the rebound effect is a problem, it indicates a failure
to price CO2 emissions and other transport externalities correctly. This suggests that
if a standard is the primary tool adopted for reducing transport sector CO 2 emissions
a secondary tax element is required – ideally in the form of a carbon tax oralternatively through fuel taxes or differentiation of taxes on vehicle purchase orownership. It also increases the urgency of introducing tools to manage congestion.

Transport, environment and oil security policies interact in a number of ways andthere are trade-offs beyond the environmental impacts of developing non1

US data suggests that with rising incomes price elasticities for private road passenger
transport have declined. As a consequence, there has been a change in the way drivers
respond to higher fuel prices, with the vehicle-kilometres driven less sensitive to theprice of fuel than the fuel efficiency of vehicles.
5© OECD/ITF, 2008

conventional oil. Dieselisation of the car fleet, initially triggered by relatively low taxes
on diesel fuels, has been the cornerstone of progress in Europe to reduce CO 2
emissions from the transport sector. As a consequence, the market share of diesel
has grown strongly and has reached almost 70% of road transport fuels in the EU.
But there are limits to the degree to which the refining process can switch production
from one type of fuel to another without consuming large additional amounts ofenergy to convert oil products. The excess diesel demand in Europe is currently met
through trade, with diesel imported from Russia and the USA and gasoline exported
from Europe to America. If any other major car market were to follow the dieselization
path, diesel prices would rise sharply and CO2 emissions would increase.
Two important issues arise when the energy security and greenhouse gas emissions
from transport are viewed from a broader perspective. First, there is the question of
how to distribute greenhouse gas abatement efforts among different sectors. Costeffective CO2 abatement strategies should aim to distribute efforts over sectors
efficiently. The challenge is to minimize simultaneously CO2 abatement costs,
potential losses in the competitiveness of industry and the costs of energy importdependence. In this sense, the large share of transport in total CO 2 emissions in itself
provides little guidance on how large this sector’s contribution should be, although it
needs to be recognised that the political process very likely will request a substantial
contribution from transport to cutting overall emissions.

Second, intervention to reduce greenhouse gas emissions from the transport sector
needs to be integrated with policies to reduce the other external costs of transport –local air pollutants, accidents and especially congestion. Congestion costs greatly
outweigh the cost of CO2 emissions from transport according to most studies. The
large impact on CO2 emissions (-20%) of congestion charges in London andStockholm suggests that congestion management can facilitate the attainment of
CO2 reduction targets in congested areas.

© OECD/ITF, 20086

1.

Introduction

Crude oil prices were nearly 100 dollars a barrel when the Round Table convened in
November 2007. In real dollar values, this matched the historic peak in oil prices of1980 (Figure 1). The gradual rise in oil prices to these levels over the last five years
was driven fundamentally by growing demand, especially from China, in combination
with limited elasticities of supply. Whilst the outlook for supply and demand suggests
prices are likely to remain high in the next five years, any slowdown in world tradeand economic growth would result in a fall in oil prices, and probably a large fall.
Whether prices rise or fall, they are expected to continue to be characterized bysharp spikes and troughs.

The Round Table examined the factors that drive oil prices and those likely to be
most important over the next 25 years. It then reviewed recent evidence on the
response of road transport activity to changes in fuel prices in order to explore
linkages between transport and energy policies. The Round Table also examined theoutlook for oil supply, together with the implications for climate policy if very heavy
crude oils, tar sands, oil shales or coal-to-liquid fuels are developed on a large scale.
Discussions then turned to potential policy responses, on the supply side and on the
demand side, revealing some critical trade-offs between climate change and oil
security policies. If these interactions are ignored, energy policies in the transport
sector could result in large unnecessary costs.

2.

Oil Prices Drivers 1960 to 2007

The impact on oil prices of action by the Organization of Petroleum ExportingCountries (OPEC) to restrict oil supplies in 1973 and 1979 is obvious in Figure 1. The
motivation for restricting supply was in both cases political (the Yom Kippur War andthe Iranian revolution) rather than aimed at maximizing profits2 but coincided withpeaking of US oil production, which endowed OPEC with market power to control
2

Although the 1973 Arab-Israeli War and subsequent oil embargo was preceded by renegotiations of oil concessions and nationalisations of oil companies in the Middle East
and Africa and by OPEC coordinating oil production tax and price increases in response
to a weak dollar.
7© OECD/ITF, 2008

prices. OPEC subsequently used this power to defend high oil prices by setting
production quotas for its members. Although oil producers in the USA were unable toexpand supply, the high prices did drive exploration and rapid development of oil
fields in other non-OPEC countries. This gradually eroded OPEC market power until
the point in 1985/6 when prices collapsed.

This price collapse stranded high-cost investments made by the major oil companies.
The effects are still felt today, with a strong aversion to (over-) investing in oil
production, oil refining and fuel efficiency on the part of private oil companies and car
manufacturers. The consequence is that supply is not very elastic, even with strongly
rising demand. And uncertainty over future prices, as well as rising resource costs for
extraction and refining, further discourages major investments.

Even during periods of market dominance, OPEC decisions on production targets
have sometimes resulted in sharp falls in prices, underlining the uncertainties in themarket. The net effect is to increase upward pressure on oil prices.

David Greene traces these developments in price and market power in his report for
the Round Table (Greene, 2007), summarized in Figure 2. The graph plots upper andlower bounds for oil prices, assuming OPEC seeks to maximize profit, as a functionof short and long run oil price elasticities and as a function of conditions of supply
outside OPEC. The maximum price band is calculated on the basis of short run priceelasticities for oil demand, i.e. the potential for rapid oil substitution and demand
reduction in response to price increases, and short run elasticities for oil supply fromthe rest of the world. The lower band is based on the larger, long-run elasticities ofdemand and supply. These account for changes that take time to affect the market,
such as the introduction of more fuel efficient vehicles or oil substitution in otherindustries.

It should be underlined that the upper limit band is rather wide because short run
supply and demand elasticities are not easily calculated. It should also be noted that
© OECD/ITF, 20088

the band indicates a range for price trends and not an absolute limit. In particular,
given that the underlying model is deterministic, prices can substantially overshootthese bounds for short periods.

Figure 2. World Oil Prices Since 1965 in the Context of
OPEC’s Long- and Short-run Profit-Maximizing Price Functions
Cartel Market Share and World Oil Prices: 1965-2006
$100
$90

1979

$80

2006 $/Barrel

$70

2006

$60
$50

1974

1985
1990

$40

2000

$30
1986

$20

1998

$10

1965

$0
25%

30%

35%

40%

45%

50%

55%

OPEC 11 Market Share
Source: Greene 2007.

Nevertheless, Figure 2 suggests a strong positive relation between OPEC market
power and prices. Plotting historical prices on this framework reveals that until 1973
oil prices were below the lower bound. In 1979, OPEC raised prices to the level ofthe upper band and had sufficient market power to defend prices in this band through1985. The cartel was able to increase profits by cutting output until a point where
their market share fell below 30% of world oil supply. At this point longer term
demand and supply responses started to be felt, discipline broke down in the cartel,
9© OECD/ITF, 2008

production quotas were exceeded and the oil price collapsed, falling close to thelower bound of the model. OPEC nevertheless continued to control the bulk of lowcost oil production capacity and gradually recovered market share.

What does the analysis tell us about more recent history, and about the near future?
Production of conventional oil in non-OPEC countries is not expected to expand
rapidly in response to current high oil prices. Some analysts foresee continuous
decline and most expect a prolonged plateau in overall production levels. Extraction
rates from existing oil fields cannot be accelerated beyond the limits imposed by thephysical characteristics of each reservoir and the development of new sources is
uncertain and slow. The bottom line is that in the near future the Middle East is
expected to produce a rising share of world oil supply, which will tend to increase
OPEC’s market power.

In terms of Figure 2, current oil prices and OPEC market share are close toconditions that prevailed in the second oil shock. With a tendency for both oil demand
and the cartel’s market share to increase, OPEC is likely to be able to defend prices
and maintain large economic rents for several years, until longer term responses
begin to be felt.

3.

Oil Price Volatility and Cyclical Effects

In addition to the overall supply and demand balance and OPEC production rates, alarge number of other factors can have a significant influence crude oil and oil
product prices in the short term. On the supply side these include wars, politicalunrest, strikes, storms and hurricanes, accidents and unexpected maintenance.
Refining is vulnerable to a similar set of problems. Crude oil and oil product stocks
provide a buffer between supply and demand but stock changes can also have astrong influence on prices. On the demand side the most significant factors arecolder or milder than average winter heating periods and economic downturns. Both
crude and products are traded on international exchanges that have developed
forward contracts to manage the price risks. Interaction between contract, spot and© OECD/ITF, 200810

forward markets, between crude and product markets and between different types oftrader increases the complexity of price behaviour.

At the time the Round Table took place crude oil prices on the spot market werehigher than on futures markets. This had been the situation for some weeks, withforward prices falling the further into the future the date for settlement, despite ageneral expectation that oil supplies would remain tight. With this configuration ofprices3 there is pressure for traders to sell on the spot market and buy on the futures
market until prices even out. However, the gains to be made this way have to beassessed against supply security, oil quality and timing of delivery risks. Refiners,
which are an important part of the market, can only sell part of their inventory as theyneed to hold stocks for refining. The size of the gap between spot and futures prices
is sometimes taken as a measure of the tightness of supply, but the situation isunstable and eventually there is a readjustment of prices, often a sharp fall in spot
prices.

Although oil product prices are dependent on the price of crude oil they are also
subject to trading pressures of their own. At the time of the Round Table oil refinersand distributors held sufficient stocks of products that competition between them tosupply the end user markets coupled with a fear that further price increases would
suppress demand prevented them fully passing on increases in the cost of crude oil
to consumers. This ended a five-year run of unusually high refining margins and is
now expected to squeeze investment in new refining capacity.

Cuts in refinery investment will affect the supply and price of products in the future.
This lagged effect is characteristic of both refining and crude oil production, driving
cycles of over and under supply. Cycles initiated by the oil crises of the 1970s andthe subsequent oil price collapse of 1985-86 continue to have an influence onmarkets today.

3

Known as ―backwardisation‖.
11© OECD/ITF, 2008

4.

The Short Run Oil Price Outlook

There are a very large number of factors that drive oil prices in the short term but
their impact depends ultimately on the fundamental balance between supply anddemand. Sustained expansion of global economic activity is the underlying reason oil
prices have risen to current levels, with consequent demand for oil expanding aheadof supply. Continued strong demand, particularly from China, is expected to maintainthese oil market conditions for some time. China’s economy is vulnerable, however,to any slowdown in demand for its exports. The difficulties in financial markets thatbegan with the sub-prime mortgage crisis in the USA in 2007 illustrates the downside
risks; China’s industry Minister has warned of the potential for a sharp downturn inChinese output as a result. (Financial Times, 16 October 2007).

Above ground constraints currently play a greater role in determining oil supply andprices than the long term dynamics of oil reserves, exploration and production. The
most important is cost escalation in the oil services industry (drilling, oilfielddevelopment and pipeline construction) due to shortages of skilled labour andincreases in the costs of raw materials.

Social and political tensions have depressed production in a number of regions,notably Nigeria and Venezuela, and war in Iraq has taken a large part of thatcountry’s potential output out of commission. In the medium term, output from theseregions is expected to be restored, albeit under arrangements that allow for profit
maximizing under OPEC coordination. More generally, it was noted that oil
production concession agreements that provide lower rents (after adjusting for
production costs) than in OPEC and other countries are inherently unstable, leading
to renegotiation and eventually adjustment of the agreements.

Changes in the taxation of oil field development and production also have an impact.
This concerns not only renegotiation of concession conditions in countries like
Venezuela but also OECD countries where, for example, tax changes in the UK
sector of the North Sea have depressed exploration and development activity.
© OECD/ITF, 2008

12

The refining investment cycle mentioned already above could also affect prices fortransport fuels over the coming five years. The oil majors lost large amounts ofmoney in refining in the period 1996 to 2003 and as a result cut investment. The
consequence was a shortage of capacity in the period 2004 to 2007 that helped drive
up prices. New capacity is now coming on stream, particularly in the Middle East andIndia. More generally there has been investment in converting heavy fuel oil into
diesel and other higher value products. This could result in over-supply of the market
and falling prices in the medium term, although opinions are divided as to how likely
this is.

5.

Long Term Oil Supply Outlook

Kjell Aleklett’s paper for the Round Table examines the production history of oil fields
around the world stressing the inevitable eventual decline in output from all fields.
Aleklett’s paper also makes the important point that there are physical limits to therate at which petroleum can be extracted from oil fields, determined by thecharacteristics of the reservoir and the oil. This limits the rate at which extraction fromfields already in production can be increased in response to increasing demand or in
response to supply disruptions. Based on work at Uppsala and Reading Universities,
which models oil field development field by field around the world, the paper
suggests non-OPEC production is already in irreversible decline and that the peak inproduction of conventional oil globally will arrive in only a few years, with anirreversible decline setting in thereafter.

This contrasts to analyses by the US Energy Information Administration (EIA) and theInternational Energy Agency (IEA), which foresee a prolonged plateau in non-OPEC
production levels and do not rule out increases in production from new fields and as
a result of technological innovation. With strong growth in oil demand, either adecline or a plateau in non-OPEC production indicates increasing market power for
OPEC in the future.

13© OECD/ITF, 2008

Views on potential production in the Middle East diverge sharply, largely because
data on reserves in the region are poor. The Association for Peak Oil foresees animminent peak and Aleklett’s paper incorporates new data from Saudi Arabia
reinforcing this view. The view is supported by a number of other analyses, reviewed
in Boyle and Bentley 2007 contrasting with the conventional view that the peak is far
enough away, or that sufficient non-conventional oil reserves can be developed atprices above $40/bbl, to ensure oil-based energy for transport for the foreseeable
future.

The models on which the peak oil analyses are based are no more uncertain, andrather less complex, than models of climate change and merit similarly serious
consideration. One implication for climate policy is that the rate at which fossil fuels
are burnt and the rate at which the stock of carbon dioxide in the atmosphere
increases in the near term may merit more attention than the total accumulation ofcarbon dioxide over the very long term.

Aleklett sees most scenarios for the growth of oil supply, including those employedby the IEA and the Inter-governmental Panel on Climate Change (IPCC), as overoptimistic, and there was some support for the view that they tell us more about
where demand ―would like to go‖ than where supply will be able to meet demand.

6.

Non-Conventional Oil

Oil can be produced profitably at current prices from a range of unconventionalsources. The Orinoco Belt in Venezuela is estimated to contain 230 to 300 billion
barrels of very heavy crude oil. This is around the size of Saudi Arabia’s oil reserves.
Canada holds a similar amount of very heavy oil in its tar sand deposits in Alberta.
Both deposits are already in production and profitable at prices above $40/bbl.
Extraction is expanding rapidly, and the main constraints are environmental, nottechnological. Canada produced 1M bbl/day in 2005 and expects to produce
2M bbl/day in 2010. The USA, Russia and the Middle East also have large tar sanddeposits.
© OECD/ITF, 2008

14

Oil shales hold even larger quantities of potentially recoverable oil, estimated ataround 3000 billion barrels. There are deposits in many countries with large
quantities located in the USA, Russia and Brazil. Oil shale is used to fire power
generation in a number of countries. It would probably be profitable to produce oilfrom shale at current prices with currently available technology. Costs would fall
substantially with expansion of production.

Coal has been converted to oil by SASOL in South Africa since 1955 and China iscurrently building two South African designed plants. There are large coal deposits ina wide range of countries around the world4, with the USA holding the largest
reserves. 2007 saw several bills presented to the US Congress for subsidies tofinance coal to liquid fuel plants. Operating costs for such plants are covered at oil
prices above $40/bbl.

If these non-conventional sources hold the promise of very large quantities of oil tobe produced at today’s prices they pose serious environmental challenges.
Extraction and processing into refinery grade oil requires a lot of extra energy,
resulting in more than twice the CO2 emissions associated with conventional oil(Greene 2007). Because of this, the potential of using nuclear power to provide
process energy is being considered for Canadian tar sands. Stripping the forest andsoil cover overlying the Canadian tar sands deposits also releases large amounts ofgreenhouse gases. Production of shale and coal requires large amounts of water,and many of the potential mines are in areas with water resources under stress.

Carbon capture and storage might be employed to reduce the CO 2 emissions
associated with tar sand and shale oil production to levels closer to conventional oil
but it is as yet an unproven technology. It is difficult to envisage a large scale retrofit
programme in Venezuela and Canada if it were to prove viable. Coal-to-liquid fuel4

Though Aleklett believes that coal production, like oil, has peaked.
15© OECD/ITF, 2008

production is somewhat more suited to carbon capture as the Fischer-Tropsch
process employed produces a very pure waste stream of carbon dioxide.

Aleklett argues (Aleklett 2007b) that applying a peak-oil type analysis to coal andnon-conventional oil reserves demonstrates that there are insufficient hydrocarbon
resources to produce the CO2 necessary to increase concentrations in theatmosphere to the levels envisaged by the Inter-Governmental Panel on Climate
Change (IPCC). The majority of participants at the Round Table, however, viewed
greenhouse gas emissions rather than oil supply shortages as the key long termissue for oil demand from the transport sector. At the same time, as governments
begin to develop policies to guard against catastrophic climate change despite large
uncertainties in climate modeling, the precautionary principle suggests they might
give similar consideration to peak-oil arguments despite uncertainty over the extent
of their conservative bias.

7.

Does a Price of $100 a Barrel of Oil Matter

Oil price shocks destroy demand for oil and have repercussions for activity across the
economy. They reduce economic activity to the extent that short run substitution andefficiency responses are unable to prevent the cost of production of goods andtransport services rising to levels that exceed the willingness of consumers to pay forthem. This reduces economic output and results in business failures andunemployment.

In the 1970s, OECD economies were highly vulnerable to external shocks becauseof widespread government intervention in prices and rigidities in labour and financial
markets. Growing inflation meant a sharp downward adjustment was probably
inevitable, and this was precipitated by the 1973 oil embargo. Many of the immediate
responses of OECD governments exacerbated the crisis: additional price controls on
domestic oil production in the USA; restrictions on domestic oil production topreserve resources in Canada.

© OECD/ITF, 200816

Today, OECD economies are much less oil intensive and exhibit fewer rigidities.
OECD economies are not exposed to inflation (although it is rising) and markets aremuch freer to adjust to changes in energy prices. The countries where oil prices are
determined by governments rather than markets lie in the Middle East and Asia,
including China, with artificially low prices one of the factors contributing to strong
growth in oil demand in these developing economies. More generally, incomes haveincreased substantially in most parts of the world and energy costs account for asmaller part of disposable income. Most of the world’s economy is therefore much
more resilient to price shocks than it was in the 1970s.

The current low level of the dollar against other major currencies is also significant,as oil prices are quoted in dollars throughout the world. The dollar was trading at 0.68
euros in November 2007 compared to 0.99 euros in January 2000, i.e. one third
lower. The price for crude oil in euros is thus only two thirds what it might have been
if dollar parity had been maintained over the period of steady oil price increases since
2000. Though the yen/dollar exchange rate has only moved 8% since 2000,
compared to 1973 the Japanese yen is now worth three times what it was in dollars.

For all these reasons the economic impact of $100/bbl oil is much less than it was in
1979. That said, some economies will feel the effects of today’s high oil prices morethan others will. US consumers have experienced a bigger impact on prices,
especially for transport fuels, because oil is priced in dollars and because excise
taxes are a relatively small part of prices at the pump compared to most other OECD
countries.

If high oil prices eventually contribute to an economic slowdown in the USA, imports
from China will fall. China’s growth is highly dependent on its exports, and the USA
accounts for the largest part of its trade by volume, although the weak dollar has put
Europe in first place in trade by value (Financial Times 10.12.2007). China is also
exposed to high international oil prices because the government controls domestic oil
product prices at levels currently below cost. It will be forced to pay refiners large
17© OECD/ITF, 2008

sums in compensation so long as prices stay high. This combination of factors could
contribute to falling prices in the next few years.

8.

Transport Sector Responses to Changes in Oil Prices

Transport is the one sector of the economy where substitution with other fuels has
been negligible. Consumer responses to changes in fuel prices are often measured
through elasticities. There is considerable agreement that the price elasticity of fueldemand is fairly low, meaning that prices have no big impact on demand – but ―no
big impact‖ is different from ―no impact‖. The long run elasticity of fuel demand hashistorically been in the range of -0.4 to -0.6. Since the absolute value of the elasticity
is below one, fuel consumption declines when prices rise but expenditures increase.
The resulting shifts in allocation of expenditure to travel from other goods andservices depress consumption in other parts of the economy, and result in a transfer
of wealth to domestic and foreign oil producers.

Higher fuel prices affect fuel demand through two main channels. First, consumers
respond by driving less. Second, they invest more in fuel economy, i.e. in more fuelefficient vehicles. Recent evidence for the US (Small and Van Dender, 2007)
suggests that the relative importance of those two effects has changed as incomesincreased: the responsiveness in terms of reduced driving has become substantiallysmaller, so that a bigger share of the total response comes through improved fueleconomy.

Note that smaller responses in terms of driving imply a more limited overall fuel priceelasticity of demand, around -0.24 instead of -0.36 for the US in 2000-2004; andprice effects are counteracted by the income effect, which implies growing
consumption as incomes rise.
It should be emphasized that elasticities of demand refer to consumer prices of fuel.
Gasoline and diesel are taxed at much higher rates than oil products for use in othersectors, especially in Europe and Japan. Prices for gasoline after tax currently
equate to over $300/bbl in many European countries. The higher consumer prices in© OECD/ITF, 200818

Europe and Japan are one reason why elasticities in these parts of the world may behigher than those in the US. Another reason is that more European and Japanese
drivers have access to alternative transport modes than US drivers. Slightly lower
real incomes contribute to higher elasticities as well. On the other hand, more US
households have access to several vehicles, providing the opportunity to switch to amore fuel efficient vehicle when oil prices are high. Although differences in elasticities
between the US and Europe or Japan are likely to be small, it will not be entirely
clear that the finding of declining elasticities in the US is transferable to othercountries without empirical studies in those countries.

Freight transport is less affected by oil price increases than private car use as fuelaccounts for only a small part of the total cost of producing most goods. Salaries,
vehicles and tax are larger items of expenditure than fuel for transport companies. In
France it is estimated that the cost of crude oil would have to increase eight fold to
double the cost of road freight transport (Chevroulet 2007). The difficulty for freighttransport companies is primarily the delay in passing on fuel costs to clients inperiods when prices rise rapidly; contracts cover extended periods and do not always
provide for fuel costs to be passed on until renegotiation of the contract itself.

9.

Motivating Transport Policies – Market Failures

Transport generates a range of social costs that are not taken into account byconsumers or firms when they decide on how much and what kind of transport touse. Such external costs sometimes justify policy intervention because market
outcomes are less than optimal. The main external costs are related to accidents,
climate change, congestion and local air pollution. Some of these costs(e.g. congestion) are fairly well understood and relatively accurately measured.
Others, notably the costs of climate change, are poorly understood and theirmeasurement continues to generate controversy. 5
5The consequences of climate change are at best understood in a probabilistic sense. In
addition, since some of the more catastrophic consequences are likely to take place in thefar future, there is the problem of converting these costs to present values. Such
conversion inevitably requires judgments on intergenerational equity, and it was pointed
19© OECD/ITF, 2008

Debate at the Round Table highlighted the substantial uncertainty about the futureavailability of oil and the prices at which it will be sold. Part of the price uncertainty
relates to OPEC’s market power. But are uncertainty and import-dependency a basis
for government intervention in energy or transport markets?

Uncertainty is pervasive throughout the economy, and not in itself a source of market
failure. As long as both firms and consumers make decisions on the best available
information markets respond optimally to uncertainty. Despite large uncertainties, oilcompanies do invest in exploration and production and in refinery capacity. The
clearest rationale for government intervention is thus ensuring high quality
information is widely available.6

Oil dependency is primarily an issue of market power. Concentration of oil productionin the hands of a cartel that explicitly aims to control prices is a clear case of market
failure. Despite government and private sector efforts to diversify sources of oil
supply, concentration of market power in the Middle East is expected to grow rather
than diminish.

There is also an externality dimension to oil dependence. The USA is a very large
consumer and importer of oil so probably enjoys a degree of monopsony power on
the world oil market; lower US demand reduces world prices. Individual US
consumers ignore this effect when deciding on their purchases of oil and of vehicles
and other oil consuming equipment. This potential monopsony effect is therefore
external to the market. Without government intervention its potential benefits will beforegone.

out that the well-known Stern report implies substantial sacrifices by current generations
to improve the welfare of more wealthy future generations.
6

While the private sector produces large amounts of oil market information on acommercial basis, the data and analysis of the IEA and of national administrations, suchas the EIA in the USA, is essential in providing a complete and authoritative picture; the© OECD/ITF, 200820

Another dimension to oil import dependency is the transfer of resources fromimporting to exporting countries. In strict economic terms transfers are not of
particular concern because oil revenues will eventually be recycled to the oil
importing countries through purchases of goods and services and throughinvestment. But with high oil prices the transfers are very large, politically highly
visible and they can create large temporary imbalances.

Policies to reduce market power through oil substitution and fuel efficiency are themost relevant responses to oil dependency although it would be possible to transfer
some of the economic rent from oil production to the importing countries throughadditional taxes on oil product consumption, albeit at the risk of pushing prices evenhigher.

10.

Policy Instruments

Fuel excise duty and carbon tax
Excise duty on transport fuels is widely used in OECD countries as a reliable sourceof government income because of the relatively low price elasticities of demand. The
overall effect on oil prices of simultaneous attempts by OPEC to maximise its profitsand by oil importing countries to increase fuel taxes is not easy to predict. It isconceivable that higher fuel taxes in the USA would increase welfare if accompanied
by reductions in taxes on labour and capital. In addition, such tax increases would
reduce some of the rent from oil production accruing to oil exporting countries,
because reduced consumption in the USA eases pressure on world prices. Note thatat present the reverse situation applies. Fuel excise taxes have been stable innominal terms in the US and many other OECD countries for the last 5-10 years,
eroding their value in real terms.

A number of governments have responded to oil price increases with small cuts infuel excise tax. The potential to shield consumers in this way is, however, limited bywork of university researchers on peak oil has been invaluable in improving theunderstanding of data on oil reserves reported by oil companies.
21© OECD/ITF, 2008

the size and the duration of the impact on government finance. It is alsocounterproductive as it reduces incentives for fuel conservation and dampens
consumer response to oil price increases. Not only does this interfere with the
response but it also reduces the price elasticity operating on the oil exporting
countries and thus increases their market power.

Governments are not likely to increase fuel taxes when oil prices are rising as thiswould exacerbate the short run impacts of high oil prices. It might, however, bepossible to increase excise taxes when prices fall.

A tax on carbon would have a very similar effect to fuel excise duty in transport
markets, as non-carbon based fuels are not likely to gain a large market share soon.
The main difference is that a carbon tax would apply equally to all sectors of theeconomy whereas current taxes on oil products differ enormously between sectors.
For example, domestic heating oil is normally taxed at very low rates in comparison
to auto diesel, which is a very similar product, just put to a different use. Tax
subsidies for diesel compared to gasoline would also disappear, as on a volumetricbasis diesel would attract a slightly higher carbon tax than gasoline.

A pigouvian carbon tax to internalise the social costs of CO2 emissions, applicable atthe same rate to all sectors of the economy and applied in a large number ofcountries, would be the most efficient policy response to the threat of climate change.
Setting the rate for such a tax is a political exercise because of the very real
uncertainties in estimating the costs of climate change through its physical impacts
on sea level and the weather and consequent effects on crop production, river flows,
ecosystems, health and the frequency and intensity of natural disasters related to theweather. Proxies have been calculated from the expected costs of expenditures toreduce emissions to rates that would stabilise the accumulation of CO 2 in theatmosphere at a level believed sufficient to avoid catastrophic climate change.
The most influential recent report on climate policy, the Stern Report (Stern 2006),
estimated total damage costs from future warming at 5—20% of world GDP in© OECD/ITF, 200822

perpetuity and recommends a current social cost equivalent to $311 per ton ofcarbon (Euros 60 per ton of CO2) according to calculations by Resources for the
Future (Harrington et al 2006). This is much larger than some other values
frequently employed, such as the average level of trading for carbon permits in thesecond session of the European Trading System (around Euro 20 per ton)7 but it isstill much lower than the level of fuel excise tax in any European country. For
example, UK fuel excise duty, at the top of the range in Europe, of Euros 0.70 per
litre equates to Euros 304/ton CO2 for gasoline and Euros 270/ton CO2 for diesel;
French excise duty on gasoline of Euros 0.60 per litre equates to Euros 259/ton CO 2
and excise duty on diesel of Euros 0.43 per litre equates to Euros 163/ton CO 2.
This begs the question of what fuel excise duties are for. In the USA federal fuelduties are earmarked for the Highway Trust Fund, which finances road and transit
projects, and which sees real revenues declining because of falling real gas taxes.
Fuel taxes are not hypothecated in most other countries, but instead contribute to
general revenue. As long as sophisticated road-pricing systems are the exception
rather than the rule, a reasonable system of road charges would see the fixed costsof road provision covered from general revenue8 and the variable costs of road use
paid through variable charges, such as fuel tax. The variable costs include roadmaintenance (as far as related to use and not the weather) and the external costs ofgreenhouse gas emissions, local air pollution, accidents and congestion9. In high fuelexcise tax countries such as the UK research has estimated that charges currently
roughly balance costs, even if there are mismatches in their differentiation by type of
vehicle, location and time of use (Sansom 2001). Parry and Small (2005) found UK

7

Note the price is determined by the amount of carbon allowed to be emitted by theparticipants in the scheme, currently determined largely on the basis of what they emitted
prior to the scheme. Such ―grandfathering‖ of emissions rights weakens the effectivenessof the system to cut emissions and illustrates the artificial nature of the price of carbon that
results. The EU plans to reduce the cap on the amount of carbon traded in the system,
which will force the price up.

8

Or possibly from fixed transport charges, such as annual circulation taxes.

9

Though fuel tax is not the best targeted instrument for some of these costs.
23© OECD/ITF, 2008

fuel taxes to be too high and those in the US too low, taking this ―second-best‖
approach to relating fuel taxes to external costs.

At the same time, most studies of the external costs of road use find CO 2 emissions
to be small relative to other types of externality, especially congestion (Figures 3 and
4). This is not to say that the cost of climate change is not large, rather there areother more pressing market failures in transport.
Figure 3.

CO2 Relative to Other External Costs(US cents/mile)

40
35
30
25
Climate change

20

Oil dependency
15

Congestion
Air pollution

10

Noise, Water
5

Accidents

0
Low

High

Low

High

(US & Europe)

(UK)

(US)

Harrington-McConnell

Sansom et al.

Parry et al.

Source: Small and Van Dender (2007).

Taxes on transport fuels can perform three functions:
The Pigouvian objective of internalising external costs;© OECD/ITF, 2008

24

The Ramsey objective of providing public revenues in the least allocatively
distorting manner. Since fuel taxes are changed in a context of pre-existing taxes,
the relevant concern here is how the change exacerbates or relieves the
allocational distortions of these pre-existing taxes. Labour taxes are particularly
distorting, so the issue becomes whether higher fuel taxes lead to higher or lower
real wages, and this depends as much on how revenues are used as on the tax
change itself.
A distributional objective by attempting to transfer rents from governments in oil
exporting countries to governments in net oil importing countries.

If a fuel excise duty were to be employed to achieve all three objectives, how should
its rate be set? In general, this depends on the weights given to the various functions,which in turn reflects policy objectives. When government cares strongly about
revenues, high fuel taxes seem justified to the extent they offset increases in labourtaxes. This may reflect European practice.

25© OECD/ITF, 2008

Figure 4
Overview of MC for Inter-urban Car Travel (Euro per vkm )Global w arming/Diesel

Cost/ context category

Global w arming/Petrol
Noise costs/ Nighttime
Noise costs/ Daytime
low er
Air pollution/ Diesel

upper

Air pollution/ Petrol
Accident
Congestion
Infrastructure
0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

0.04

Euro per vkm

Source: Nash (2003).

Vehicle efficiency regulations
In relation to oil import dependency it is not clear from the discussion above that
taxation is an appropriate instrument to address either market power or the externalbenefits of reducing fuel consumption. Alternative policies to promote fuel efficiency
are indicated, primarily fuel efficiency regulations.

Intervention to promote fuel efficiency is frequently argued for on the basis that
consumers undervalue fuel savings when they purchase cars (and other equipment)
because they employ higher discount rates than socially optimal (their planninghorizon is shorter than that of the government). Consumers make decisions on how
much fuel economy to buy in a context of combined uncertainty and risk aversion.
This leads to lower fuel economy compared to a risk-neutral environment but is not in
itself a market failure if we assume consumers are adequately informed of the cost of
running a car (and there is a wealth of car magazines available to inform car buyers© OECD/ITF, 200826

on this point). However, there is a case for government intervention effectively to
substitute a social discount rate for the shorter, typical private discount rates appliedby consumers in making decisions on car purchase.

Regulatory emissions limits have been employed fairly successfully to address local
air pollution externalities. They can also be employed in the case of CO2 emissions
and equivalent regulations were introduced in response to the oil price rises of the
1970s in the USA as Corporate Average Fuel Efficiency (CAFE) regulations.

Compared to a pure carbon tax, regulations have the drawback that they are sector
specific and tend to favour one technology over another according to the level atwhich they are set and the way in which they are measured. Regulations have to be
designed carefully to avoid perverse effects. For example, differentiating CO2
emissions standards according to vehicle class or weight in an attempt to avoid one
manufacturer facing higher costs than another can provide perverse incentives thatfavour high emission vehicles. This was the case with the US CAFE regulations inforce until 2007, where weaker standards for light trucks were instrumental instimulating a shift in demand from conventional cars to SUVs. Curvilinear rather thanstepwise differentiation can reduce the problem, but can still reduce incentives for
cutting emissions through weight reduction – where there is a large, relatively low
cost potential for savings (see Plotkin 2007 and OECD/ITF 2008 for a more detailed
discussion). Differentiation according to vehicle ―footprint‖ (wheelbase x axle width) isa somewhat less distorting approach because there are larger costs for
manufacturers associated with changing wheelbase. Allowing weight to increase canactually cut costs. Other constraints also make it difficult to increase vehicle footprint,
for example the size of typical parking spaces in underground garages and multistorey car parks.

Regulations also entail monitoring and enforcement costs that are avoided withsimple taxes. Regulations do, however, have some advantages compared to taxes,
not least in terms of political acceptability.
27© OECD/ITF, 2008

Using a standard instead of a tax also has the advantage of reducing uncertainty forvehicle manufacturers in the sense that they can be relatively certain how bothconsumers and competitors will respond to a standard, compared with much larger
uncertainty under a tax policy. This certainty facilitates the large investments required
to introduce new generations of fuel efficient technologies.

Regulatory standards for CO2 emissions are undermined to some extent by therebound effect. By reducing average fuel consumption they reduce the costs ofdriving, other things being equal, which will provide an incentive to drive more often
and further, partially off-setting the impact of the regulation. To correct for this effect it
is possible to combine regulatory standards with a carbon tax designed tocompensate for the fuel cost savings otherwise engendered by the standard. A
combination of vehicle standards and carbon tax is also indicated as regulations
alone risk simply postponing emissions of CO2 rather than restricting the ultimate
quantity of CO2 emitted from the world’s stock of crude oil to an acceptable (efficient)level, which a pigouvian tax should achieve if the price can be based on reasonably
accurate damage estimates.

A note of warning was sounded at the Round Table, however, over combining too
many instruments to achieve greenhouse gas mitigation and oil security objectives. A
proliferation of instruments results in a lack of transparency and difficulty in tracing
the effects of interventions and increases the cost of implementation andenforcement, ultimately undermining cost-effectiveness. This does not rule out using
complementary instruments but underlines the need to understand how transport,
environment and energy policies interact. Effective and efficient combinations of
instruments are examined in a companion publication (OECD/ITF 2008).

Designing transport policies: the need for integrating transport, environment
and energy dimensions
There are potential trade-offs to be made in addressing the failures that affect oil andtransport markets. The current structure of oil supply, with production concentrated in© OECD/ITF, 200828

the hands of a cartel, suppresses oil demand and in this respect contributes tomitigating CO2 emissions. Some policies to weaken OPEC market power and reduce
oil prices could undermine policy towards climate change.

Promoting non-conventional oil, through subsidies for oil shale or coal-to-oil plants,
as demanded by a number of bills presented to the US Congress in 2007, could
reduce OPEC market power if a large enough part of US oil supply was provided
from these plants but it would massively increase CO2 emissions. It should be notedthat with non-conventional oil production on a smaller scale, OPEC would continue tocontrol prices and the non-conventional oil would be priced at the level of OPEC oil.
Support for non-conventional oil would simply represent a transfer of resources from
US tax-payers and oil consumers to oil shale and coal-to-oil producers.

Transport, oil and environmental policies also interact in more subtle ways. Fuelspecifications have played a significant part in the costs of oil refining, the availabilityof oil products and the price of oil products in recent decades. For example,
California’s fuel specifications related to environmental protection isolate the local
market from world oil products markets. Local refiners enjoy the protection that thisprovides and gasoline trades in Singapore at $10/bbl below the wholesale price in
California. Mismatches in product standards fragment markets and even if the effectis not as marked in other parts of the world this adds significantly to oil product prices
everywhere.

Environmental regulations have sharply reduced the sulphur content of gasoline anddiesel to reduce tailpipe emissions of sulphur dioxide, particulates and CO 2. Current
engine technologies increase NOx emissions when optimized to reduce fuelconsumption. This requires NOx reduction catalysers for the exhaust that are
extremely sensitive to sulphur poisoning. Stripping sulphur out of oil at the refinery
requires a lot of energy, resulting in additional emissions of CO2 from the refinery
itself. The balance in CO2 gains and losses between car exhaust pipe and refinery
emissions is shifting as sour (high sulphur) crudes account for an increasing share of29© OECD/ITF, 2008

the refining slate. Demand for low sulphur diesel is one of the factors promoting
production of biodiesel in Europe, as it is completely free of sulphur. Current
biodiesel production may be associated with an increase rather than a decrease ingreenhouse gas emissions compared to conventional diesel, taking into account N 2O
emissions from the cultivation of feedstocks (OECD/ITF 2007).

Two thirds of the progress in reducing CO2 emissions from new cars in the EU since
the voluntary agreement with car manufacturers entered into force (in 1998) havebeen the result of a shift from gasoline to diesel engines. This has seen diesel
consumption rise inexorably and it now outsells gasoline in Europe. The shift hascreated a large imbalance in Europe’s refining industry, with excess gasoline sold to
the USA and diesel imported from Russia. This has implications for CO2 emissions
as well as prices. Crude oil contains a mixture of different hydrocarbons. The mix ofuseful products that can be separated out with minimal energy input is determined by
the nature of the crude. There is a degree of flexibility in the product mix produced,
but shifting the mix requires large amounts of additional energy input. An increasing
number of refineries in Europe convert heavy fuel oil (for which the market is weak
most years) into diesel, but at the cost of additional CO2 emissions from theserefineries. The diesel-gasoline balance has been pushed to its limits in world refining
markets. If the US government were to adopt policies to promote diesel cars10 diesel
prices would rise significantly and CO2 emissions would increase as additional crudeoil, with deeper conversion processing, would be required to supply the market. It
would not be possible to achieve the European degree of dieselization in any othermajor car market.

Regulatory standards or taxes intended to internalize the costs of greenhouse gas
emissions thus need to be designed not only to avoid bias towards promoting
particular technologies (in this case diesel engines) but also to avoid simply shiftingemissions from one point (tailpipe exhaust) to another (refinery smoke stacks) and10

Policies adopted initially in Europe to promote producers of diesel engines.

© OECD/ITF, 200830

exacerbating other external costs - in this case NOx emissions, as diesel engines
produce higher levels of NOx than gasoline engines and are generally subject toweaker emissions standards. These are basic tenants for the design of interventions
to protect the environment but they are frequently overlooked in practice. Fuel taxes
in Europe, to the extent they are intended to curb CO2 emissions, clearly fail the test.

31© OECD/ITF, 2008

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33© OECD/ITF, 2008