1 Approach to Estimating the U.S. Oil Security Premium for the Medium - and Heavy- Duty GHG/Fuel Economy Rule

Paul N. Leiby Oak Ridge National Laboratory (ORNL) September 8th, 2010 The Environmental Protection Agency (EPA) and the National Highway Traffic Safety Administration (NHTSA) (“the agencies”) are announcing a first - ever program to reduce greenhouse gas (GHG) emissions and improve fuel efficiency in the medium and heavy- duty highway vehicle sector in the U.S . This broad sector – ranging from large pickups to sleeper- cab tractors – represent s the second largest contributor to U.S. oil consumption and GHG emission s, after light - duty passenger cars and trucks. Setting GHG emis sions and fuel consumption standards for the medium and heavy- duty vehicle sector will improve the U.S.’s energy security by reducing the U.S.’s dependence on foreign oil , which has been a national objective since the first oil price shocks in the 1970s . World crude oil production is highly concentrated, exacerbating the risks of supply disruptions and price shocks. Tight global oil markets led to prices of over $100 per barrel in 2008, with fuel prices reaching as high as $4 per gallon in many parts of t he U.S., causing financial hardship for many families and businesses . Medium and h eavyduty vehicles account for about 17 percent of U.S. transportation oil use, which means that they alone account for about 12 percent of all U.S. oil consumption . 1 Background on Energy Security Methodology To provide a measure of the energy security implications of the Medium and Heavy- Duty GHG emissions/fuel economy Rule (“HD Rule”), an oil import security premium was estimated over the duration of the rule’s phase - in an d for years after its completion. The HD Rule will reduce U.S. oil consumption and, to a similar extent, oil imports. To estimate energy security benefits, ORNL focused on the benefits of the reduced U.S. oil import levels. The oil import security premi um is a measure of the marginal economic cost of oil imports to the U.S. economy beyond the private cost that is paid for oil, that is, beyond the market oil price. Since these costs exceed the market price, reducing them is a societal benefit. The import premium includes components that account for incremental costs during disrupted and normal oil market conditions. The definition and methodology for estimating the oil import premium are presented in Leiby (2008), 2 along with prior estimates. This pape r summarizes the

1 In 2009 Source: EIA Annual Energy Outlook 2010 released May 11, 2010 2 Leiby, Paul N. 2008. “Estimating the Energy Security Benefits of Reduced U.S. Oil Imports,” Final Report, Oak Ridge National Laboratory, ORNL/TM - 2007/028, revised March 14.2

differences between the premium analysis conducted in support of this HD Rule and that prior 2008 analysis. The principal difference was the re - benchmarking of reference oil market conditions through 2035 to conform to the latest Annual E nergy Outlook of the U.S. Energy Information Administration (AEO2010, Reference case). In addition, European Union (EU) oil demand assumptions are modified to account for recent EU policies related to the EU Emissions Trading Scheme (ETS). 1. Definition of Oi l Import Premium A useful measure of the energy security benefits of improved HD fuel economy is the marginal reduction in economic costs to the U.S. from reduced oil imports. The oil import premium is defined as the difference between the marginal econo mic cost to society for petroleum imports and the market price paid . This is measured and reported in dollars - per- barrel, for a small change in the number of barrels imported. 3 The approach estimates the incremental benefits to society, in dollars per barrel, of reducing U.S. imports. 4 This “oil import premium” approach identifies those energy- security related costs that are not reflected in the market price of oil, and that are expected to change in response to an incremental change in the level of oil imports. Omitted from this premium calculation are environmental costs and possible non - economic or unquantifiable effects, such as effects on foreign policy flexibility or milit ary policy. Also omitted are any spillover- benefits that may accrue to U.S. allies and trading partners who are similarly reliant on oil, and who would benefit from a reduction in the level or volatility of world oil price. 2. Methodology for Premium Calcula tion The estimation of security premium for the HD Rule closely followed the methodology used to support the RFS and Light Duty Fuel Economy/GHG emission rule regulatory analyses, as documented in Leiby (2008). For comparability and consistency, most of the assumptions were held unchanged. The primary assumptions made are: a) Supply/Demand E lasticities OPEC- supply behavior is treated parametrically, with a Monte Carlo simulation of possible future outcomes using elasticities of supply over a wide range (0.25 to 6.0, with a mean of 1.8) . Combining the Non - OPEC region demand and Non - U.S. supply elasticities implies a (mode) net elasticity of import demand from Non - U . S . /Non - OPEC regions of approximately - 1.6, with a wide random distribution . To account for the p ossibility, suggested by some but not yet definitively demonstrated or universally agreed upon , that the economy has become less sensitive to oil shocks over t ime , we applied

3 Additi onal energy security benefits are derive d from reduced consumption, and from the resulting reduced oil intensity of the U.S. economy. This can be expected to reduce the sensitivity of the U.S. GDP to global oil shocks (e.g. Leiby 2008, Toman 1993, 2002, a nd Brown and Huntington 2009). As in the 2008 analysis, t his p articular component of potential benefits is not included here. 4 Technically, the oil premium is based on a “marginal” economic analysis (i.e. , a differential analysis of the rate of change of costs per barrel change in imports). At times the term “incremental” may be used in place of “marginal” here to avoid confusion with marginal in the more common sense of either “fringe” or “close to the limit of acceptability.”3

the reduced range for the elasticity of Gross Domestic Product (GDP) with respect to oil price shocks. That is, in the Monte Carlo simulation the GDP elasticity rang ed from -0.01 to -0.05 4, with a mean value of

- 0.03 2 . This approach was also taken in the main cases in the 2008 analysis. b) Changes from 2008 Estimation for the L ight - duty Vehicle Rule In these estimates of HD vehicle energy security premiums, the primary change from previous estimates is the development of a revised time path for the premium on a year- by-year basis over a long er horizon, from 20 11 to 2035, under the updated oil market projections embodied in the U.S. Energy Information Administration’s 2010 Annual Energy Outlook (AEO2010). Based on the AEO2010, evolv ing market conditions alter some of the factors influencing the oil import security premium . In particular : base oil price, U.S. import and consumption levels, U.S. GDP, and OPEC production s hares. These assumptions together also imply an assumption abo ut the value share of oil use in the U.S. economy. The following Table 1 compares keys assumptions that differ in these estimates compared to those used in th e prior fuel economy/GHG rulemaking.4 Table 1: Evolving Oil Market Conditions and U.S. Oil Use 2008 Report/LD Rule (AEO2007 Reference Case) Avg. for 2006 - 2015 Current Study/HD

Rule (AEO2010 Reference Case) 2011 Current Study/HD

Rule (AEO2010 Reference Case) 2015 Current Study/HD

Rule (AEO2010 Reference Case) 2025 Oil Price (2008$) $55.68 $66.63 $86.88 $104.42 U.S. Oil Imports 12.560 10.826 10.699 10.519 U.S. Oil Demand 22.190 20.210 20.668 21.560 OPEC Supply 34.430 35.590 37.382 40.862 U.S. GDP (bill 2008$) $15,193 $13,812 $15,494 $20.475 Oil Share of GDP 2.83% 3.56% 4.23% 4.01%

Evolving historical and projected oil market conditions influence the premium estimate. Note that all these parameters are positively related to the size of the import premium, to varying degrees. (Price is in $/bbl; imports, demand and supply are in mil lions of bbl/day; and GDP is in $billion per annum.) Another change to previous estimates of energy security premiums is to assume that for the OECD - Europe area , oil demand is inelastic wit h respect to the HD Rule . The European Union has committed to achieving a 20 per cent reduction in greenhouse gas emissions by 2020 from 1990 levels. Phase 3 of the EU program begins in 2013 and broadens coverage on GHG emitting sources and establishes E U -wide rules for allowance availability and allocations. Since the last time that ORNL estimated energy security premiums, the European Commission has proposed a Directive to alter the EU - Emissions Trading Scheme ( ETS ) structure for Phase 3 in January, 2008, and the Directive was amended and adopted by the European Parliament and by the Council of the EU in April 2009 . 5 While the Directive is for GHG commitments, it is likely that the mix of energy sources, and the use of oil, would change only by a limit ed extent under c hanged prices. In any event, EU GHG emissions, given the cap, would be unaffected even if oil demand changed by a small amount with the EU - ETS. c) Results Table 2 compares the premium estimates under the assumptions of the current analysis with those in the prior 2008 analysis. Following the approach of most oil security premium estimates, these are the long- run import premiums, reflecting marginal import c osts once the market has had

5 See Parker, L., “Climate Change and the EU Emissions Trading Scheme (ETS): Looking to 2020”, Congressional Research Service, January, 20105

time to fully respond to any change in the level of imports. That is, they reflect the long - run elasticities of regional supply and demand. The current premium estimates are computed yearly, for 2011, 2012, and at 5 -year inte rvals between 201 5 and 2035. The oil import premium, measured in $/bbl of imports reduced, is not strongly affected by the estimated volume of oil imports displaced. In all cases the volume of reduction in oil use from the HD rule is under 0.5 per cent o f world demand, and 3 per cent of U.S. demand. The total current premium for 2011 is about 17 per cent larger than the prior premium in the 2008 analysis, which was calculated for average market conditions from 2006 - 2015. This premium increase reflects the mixed effects of changes in projected reference oil market conditions . Such changes include 26 per cent higher projected oil prices, slightly higher OPEC supply, and a higher value share of oil expenditures in GDP. Offsetting these drivers are proje cted oil consumption and import levels that are 9 per cent and 14 per cent lower, respectively, than projected in AEO2007. For years after 2011, the EIA projected real oil price, GDP, and OPEC supply, and oil value share continue to grow. Oil consumption grows slowly and oil imports are little changed. Together, these conditions yield a steadily increasing oil security premium through 2035.

Table 2: Summary Results – Comparison of Current and 2008 Report Effect / Study Prior Analysis: ORNL 2008 Report (2008$/BBL, average for 2006 - 2015) Current Analysis:

2010 HD Rule Analysis (2008$/BBL, for example year

2011) Monopsony Component $8.03 ($3.00 - $14.21) $9.58 ( $3.26 - $17.87 ) Macroeconomic Disruption/ Adjustment Costs $4.97 ($2.28 - $8.02) $5.63 ( $2.6 0 - $8.79 ) Total Mid - point $13.00 ($7.23 - $19.45) $15.21 ( $8.02 - $23.62 ) Results in 2008$. Columns report mean estimate and ranges. Results for 2008 report match those in Leiby 2008, in 2005$. The ranges include 90% of results from the risk - analysis simulation, with simulations done around the EIA Reference Outlook only.

For this proposed rule, ORNL also estimated energy security premium s fo r the years 2020, 2030 and 2040. These premiums are presented in Table 3 as well as a breakdown of the components of the energy security premiums for each of these years. Variations over time reflect changing reference oil price level s, U.S. import level s, and global market balances. There are no assumed changes in global oil market disruption risk.6 Table 3: Energy Security Premiums in 2020, 2030 and 2040

(2008$/Barrel) Effect 2020 2030 2040 Monopsony Component $12.28 ($4.16 - $23.74) $12.69 ($4.43 – 23.80) $12.68 ($4.41 – $23.41) Macroeconomic Disruption/ Adjustment Costs $7.39 ($3.39 – $11.92) $8.54 ($4.10 – $13.60) $8.99 ($4.48 - $14.08) Total Mid - point $19.66 ($10.27 - $30.90) $21.23 ($11.30 - $32.88) $21.67 ($11.54 - $33.11) Results in 2008$. Columns report mean estimate and ranges resulting from Monte Carlo Simulation.

The EU oil demand assumption doesn’t have a large impact on estimated energy security premiums estimated for the HD vehicle rule. For instance, for 2020, the total energy security premium with the inelastic EU oil demand is $19.66/barrel. If oil demand i n the EU is demand responsive, then the energy security premium is $18.88/barrel. The macro - disruption component of the energy security premium is unchanged at $7.39/barrel in 2020 with both cases. The disruption component is not sensitive to the assumptio n regarding EU demand elasticity since it is more a function of disruption risk, U.S. oil import level s and import elasticity, and U.S. GDP sensitivity to shocks. The main reasons for this limited effect of inelastic EU demand is that the EU comprises a limited and declining share of world oil demand outside of the U.S., and that the premium is largely determined by supply behavior in all world regions . Since the HD rule only counts the macro - disruption portion of the energy security premium when valuing the energy security benefits of the HD vehicle rule, whether EU oil demand is inelastic or demand responsive has only a relatively small impact on the overall energy security benefits of the rule. References Leiby, Paul N. 2008. “Estimating the Energy S ecurity Benefits of Reduced U.S. Oil Imports,” Final Report, Oak Ridge National Laboratory, ORNL/TM - 2007/028, revised March 14. Parker, L., 2010, “Climate Change and the EU Emissions Trading Scheme (ETS); Looking to 2020”, Congressional Research Service .7

Toman, Michael A. 1993. “The Economics of Energy Security: Theory, Evidence, Policy,” Handbook of Natural Resource and Energy Economics, vol. III, edited by A.V. Kneese and J.L. Sweeney, Chapter 25. (New York: Elsevier Science Publ ishers B.V.). Toman, Michael A. 2002. “International Oil Security Problems and Policies,” The Brookings Review, 20(2):20 - 23, Spring.