Rejecting Keystone: The Importance of Incentives in Environmental Policy

Today, we're going to dive into the ugly world of U.S. petroleum imports, a long debated topic often stuck in the political rifts that continues to plague this country's reputation. Particularly recently, the passing of Keystone XL Pipeline bill onto Obama's desk has reignited the conversation over domestic oil product, the environmental effects of fossil fuel consumption, and energy independence in the United States. In the end, there hasn't really been an astute analysis of the subject with regards to all three topics, instead, the proposed pipeline is often dismissed as an old platitude of the rifts between climate change and energy policy, and no one seems to find a middle ground. Just a little while after the bill was passed to President Obama, his veto power killed the hope of it passing with little political and economic repercussion evident. What really did the Keystone Pipeline Project mean for the United States? The proposal had such a long appearance in Congress, and its nuances changed with the simultaneous shifts in both energy and climate agendas. I seek, in this article, to sift through the implications and re-analyze the potentials that this project could have provided with an emphasis on energy markets and policy and environmental externalities.

From Politico

In 2005, a Canadian company that specializes in the transportation infrastructure that moves crude products coming from the tar sands region, requested permission to build a pipeline from Alberta, Canada to Steele City, Oklahoma, TransCanada sought to build this line in order to bring more of the tar sand crude to the market based in Cushing, Oklahoma. At the time, high oil prices and increasing fossil fuel demand created a strong movement to support the proposal. Conversely, environmental opposition grew against the bill which was submitted to Congress for the rights to build on the land requested. There was no political shade pulled over the deal, but a clear divide was evident from the beginning of the controversial proposal. The bill was rejected twice in voting, but it was never totally stricken down as vote tallies were marginal (November 2014 vote was 59 for, 41 against, one short of passing). The main issue debated during the earlier attempts of passing was over the environmental effects of bitumin, the heavy, viscous substance that the tar sands produced. Climate change activists claimed that production and consumption of the heavy form of crude oil were more harmful to the environment than typical crude oil consumption. It is also worth noting that bitumin's heavy status was preferable to most U.S. refineries who were used to processing the heavy, sour Arab oil that is typically imported. Fast forward to late 2015 and the bill is placed in Obama's hands where the debate reemerged on the political scene once more. Even though we know that Obama killed the bill completely with his veto power, let's look at what the Keystone Pipeline could have done if it had been passed.

Besides the environmental effects, the construction of the pipeline would provide various economic benefits for both the United States and Canada. In fact, the oil trade would be considered a very healthy progression of free trade under NAFTA, and one that would help U.S. energy policy as well. In a Forbes article from 2014, the author cites that the pipeline would add approximately 444,000 jobs with 43,000 of those being permanent. On top of that, government fees would generate revenue of about $521 billion in the next twenty years. That does not sound like a bad deal for an economy with over $16 trillion worth of debt. On top of that, the oil and gas industry would benefit from lower transportation costs as more pipelines are opened to pump to refineries.These benefits looked especially enticing to energy firms, consumers, and investors who were looking for cheaper oil prices and lower revenue. But remember, those were the times before fracking had boosted domestic production to over 9 million barrels a day and unemployment had hit its natural level of 5%. In fact, something like the Keystone Pipeline Project, had it been passed, would have had a negative impact on the oil and gas market today. There's no doubt that the pumping of a new 700,000 to 800,000 barrels a day would have diluted WTI price further.When looking at the condition of energy firms with respect to current price trends, these production additions would have elongated the supply glut and caused most oil and gas companies to face higher probabilities of default. Yes, jobs could have been added with the need to keep up and maintain the pipeline, but most likely at the cost of oil majors shedding some of their workforces too. Another strong argument supporting this proposal is the hope of a waning need to depend on OPEC oil as the new Canadian influx could replace those imports. Many people might wonder why imports are so high, but they fail to understand that U.S. refineries are not capable of effectively processing WTI oil, they are built to refine heavier crude from the Arab states. Had the pipeline been built, Canadian tar sand oil could replace that need for heavy oil as the bitumin substance produces the kind of crude oil that U.S. refineries are set to process. Along with that, the U.S. energy sector gains a trading partner that is much closer and more stable than the Middle East nations which are ridden with conflict. These points were once strong but are quickly overshadowed by 2015 import data.

From EIA

Above is annual data plotted over the past twenty years with an emphasis on data from 2005 to 2015. In the year that the Keystone bill was proposed, U.S. imports from OPEC measured about 2 billion barrels a month. Because of that many economists and politicians complained of how dependent the great U.S. superpower was on OPEC production. For the past half of a century, gas prices were subject to the whims of prices that were negotiated far away from U.S. consumers, and for that reason, they saw gas prices as an uncontrollable force that would have to be tolerated as long as the United States depended on oil from oil exporting nations. From Venezuela to Saudi Arabia, the very life support of the largest economy was bought, sold, and transported to the large oil majors that owned most of the downstream operations (and still do). The Keystone pipeline was Canada's play into our extensive demand which was inelastic when it came to most fossil fuels. This year, though, when the bill was placed on the desk of President Obama, monthly production statistics were on track to post an annual total of just 1 billion barrels imported from OPEC, about 60% lower than a peak in 2008 and 50% lower than numbers in 2005. This data shows the clear demise of OPEC's hold over the United States because of the frenetic spread of the fracking revolution. Allowing the creation of the Keystone pipeline would be an ineffective way of combatting U.S. energy independence because it is happening on its own (Canada's import share is slowly growing as well). Because of the lack of economic support for the implementation of the pipeline, those who wanted to see the bill pass have let it go. In fact, TransCanada had actually asked for a delay of the proposal before Obama made a decision over the bill. Instead of improving infrastructure for oil and gas firms, energy investment should focus on converting refineries to light, sweet crude refiners so that upstream and downstream operations can be combined into providing energy cheaply, efficiently, and with a healthy flow of revenue. Many consumers and even politicians want to see oil prices as low as they can be, but that is not healthy for a domestic energy industry who needs a stable level of prices to grow. The U.S. government would never let corn farmers go out of business if they produced so much corn that prices choked revenue growth. Why should the same be done to the energy industry? In conclusion, the failure of the Keystone pipeline was a win for the energy sector and avoided unhealthy and irrelevant economic benefits that are currently being overshadowed by growth in production and exploration operations.

With the striking down of the Keystone bill, many climate change activists praised the President for a small victory against the oil and gas industry which has been notoriously against environmental impetuses imposed by the government and activist groups. President Obama, who has often quoted his desire to be a politician to change things before he leaves, used this rejection to fuel the movement for more green policies in both domestic and foreign settings. As he meets with the United Nations over international climate change policy, this "victory" will be used to validate his green credentials. Coupled with his initiative to phase out coal consumption (due to its extremely dirty nature), Mr. Barack Obama has made it clear that no carbon emission will go unnoticed by him. On the other hand, a WSJ reporter made an interesting comment about how the Keystone pipeline could have been used as an example of how carbon emissions could be penalized with new credits and taxes imposed on the guidelines of those using the pipeline. The suggestion was an interesting use of an incentive structure that could be used to push firms towards greener operations in the future. President Obama and other climate change enthusiasts want to eventually see fossil fuel use phased into an alternate cleaner fuel to which  transportation and electrical infrastructure can convert, and oil and gas companies want to maximize profits using these "dirty" fossil fuels and typical cost optimization incentivizes an apathetic attitude towards the environment. The golden question is how to do politicians create a proper incentive system where green operations are encouraged? Using the Keystone pipeline as an example, those using the pipeline would have to pay a carbon tax to offset the negative externalities which would create incentives to find cleaner ways to transport oil. While the tax won't force all oil to be transported by Teslas, it should spark firms to increase R&D spending on cleaner and more effective solutions. The problem is, in most cases, the oil and gas firm can just pass those costs on to the consumers through price increases. Nevertheless, the opportunity to establish such measures was there but passed up. Although, the failure of the Keystone pipeline was overall a good thing considering weak economic benefits and the avoidance of appropriate environmental externalities. On the other hand, President Obama could have taken an opportunity to show the desire to cooperate with energy firms who often seem alienated by a "radical" approach to forming environmental guidelines. Canadian officials reported that the administration never even made attempts to negotiate over the environmental terms which appeared to set this bill up for failure from the beginning. Politically and economically, the incoming President will have the prickly job of incentivizing cleaner business operations in every sector including that of energy producers. For that reason, energy and climate policy will become key issues going forward into the presidential race, the political mentality of our future congressional leaders, and how business and markets optimize their profits.