Document ID: EPA-HQ-OAR-2010-0162-0286
Agency: epa
Document Type: Supporting & Related Material
Title: 
Posted Date: 2010-11-30T05:00Z

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  -  represents the second largest contributor to U.S. oil consumption and GHG emissions, after light-duty passenger cars and trucks. 
	Setting GHG emissions 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 the U.S., causing financial hardship for many families and businesses.  Medium and heavy-duty 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.
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 and 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 premium 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), along with prior estimates.  This paper summarizes the 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 Energy 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 Oil 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 economic 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.  The approach estimates the incremental benefits to society, in dollars per barrel, of reducing U.S. imports.  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 military 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 Calculation
	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 Elasticities
	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 possibility, suggested by some but not yet definitively demonstrated or universally agreed upon, that the economy has become less sensitive to oil shocks over time, we applied 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 ranged from -0.01 to -0.054, with a mean value of 
-0.032.  This approach was also taken in the main cases in the 2008 analysis.
   b) Changes from 2008 Estimation for the Light-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 longer horizon, from 2011 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, evolving 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 shares.   These assumptions together also imply an assumption about 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 the prior fuel economy/GHG rulemaking.

           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 millions of bbl/day; and GDP is in $billion per annum.) [Source: "Mapping and Testing OilPrem1997_to_2007 - Ver2.xls"]	

   	Another change to previous estimates of energy security premiums is to assume that for the OECD-Europe area, oil demand is inelastic with 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 EU-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.  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 limited extent under changed 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 costs once the market has had 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 intervals between 2015 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 of 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 projected 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 
                                ($2.60 - $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 premiums for 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 levels, U.S. import levels, and global market balances.  There are no assumed changes in global oil market disruption risk. 
      	

           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 in 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 assumption regarding EU demand elasticity since it is more a function of disruption risk, U.S. oil import levels 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 Security 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.

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 Publishers B.V.).

Toman, Michael A. 2002. "International Oil Security Problems and Policies," The Brookings Review, 20(2):20-23, Spring.