Analysis

Healthy markets remedy energy and climate crises

March 23, 2022

issues: Energy and Environment, Energy Subsidies, Fossil Fuels, Fracking, Natural Gas

Months before Russian tanks rolled into Ukraine, global oil and European natural gas markets were undergoing sharp price increases. Predictably, crisis escalation prompted calls for “fuel fixes” like replacing Russian oil with renewable energy and the familiar “drill, baby, drill” call for domestic oil and gas expansion. Yet fuel-picking interventions have an abysmal legacy, whereas policies that cultivate healthy markets maximize economic, security and environmental outcomes.

Healthy markets are transparent, are liquid, possess few entry and exit barriers, and internalize all benefits and costs. These include environmental and security costs, which are often perceived to be at odds. For example, senators in a recent hearing were “overtly hostile” on economic and security grounds to a new Federal Energy Regulatory Commission (FERC) policy to scrutinize the climate impact of natural gas pipelines.

Energy and climate anxiety must be resolved by cool, evidence-based discourse. This requires clear terminology, verifiable data and systems thinking around global energy markets. For clarification, this piece defines “energy security” as the protection against price spikes and the continuity of physical supply to meet demand.

Given the current debate, it is worth correcting three misconceptions and emphasizing three opportunities to yield healthy markets:

Misconception: energy security risks of crude oil imports. Two oil market facts are critical. First, prices are principally determined by global supply and demand. Second, the market is highly integrated with fungible flows, meaning supply lines remain available from alternate sources in the event of a disruption. Thus, the proportion of crude oil a country imports has almost no bearing on its exposure to price spikes nor its vulnerabilities to securing supply, contrary to protectionist claims of “energy independence.” One caveat is that less prevalent oil grades can have unique geographic supply constraints with distinct price ramifications. Advances in domestic oil production means the United States can modestly affect global oil prices and the market power of the Organization of Petroleum Exporting Countries (OPEC). Nevertheless, all countries are primarily “price takers,” as evidenced by the tight correlation between West Texas Intermediate (U.S.) and Brent (European) light crude oil prices. Countries can use price controls to set domestic prices below market levels, but that creates bigger problems.
Opportunity: reduce or avoid consequences of oil market interventions. A classic pattern in energy politics is that surging prices induce claims of corporate price gouging. Recent Senate hearings have confirmed this. Such theater has no evidentiary basis; no oil firm has sufficient market power to drive prices—in contrast to a cartel like OPEC. Creating corporate reputational harm is one thing, but policies like punitive taxes or price controls harm everyone. For example, price ceilings imposed below the market price result in shortages, as was most famously seen in the oil crisis of the 1970s. This type of outcome is a self-inflicted wound that is often mistakenly attributed to an import supply shortage.
Misconception: energy security benefits of nuclear, renewables, coal and other electric fuels. Oil is a trivial player, by volume, in power generation, accounting for 1 percent of generated electricity in Europe in 2019 and half of 1 percent domestically in 2021. Alternative electric fuels do not directly substitute for oil meaningfully. Electric fuels can substitute for natural gas, which held 21 percent of European electric generation share in 2019 and 38 percent of domestic share in 2021. However, substitution provides meager price relief because it hardly displaces the role of natural gas at the margin, which determines prices in natural gas and electricity markets. Domestically, gas supply continuity is not so much a function of market share; it is more about the quality of its storage and pipeline network. For example, a grid with 20 percent gas dependency concentrated on one congested pipeline may have worse fuel security than a 60 percent gas dependent-system with a robust pipeline and storage network. The same is true in Europe, with the added condition that supply continuity depends on the fungibility of the regional natural gas system.
Opportunity: benefits of reduced barriers to liquefied natural gas (LNG). Natural gas is far less globally fungible than oil, creating energy security risk from imports. In 2021, Europe relied on imports for 80 percent of its natural gas supply with few alternative supply options. Russian gas pressures drove stark geographic price spreads, unlike oil markets. The most liquid virtual natural gas hub in Europe averaged $29/one million British thermal units (MMBtu) from September 2021 to February 2022, while the U.S. Henry Hub averaged below $5/MMBtu. Fortunately, markets route supply toward high prices, and the United States accounts for 60 percent of expected gains amid a frothy LNG market outlook trending toward global commodification. Unfortunately, infrastructure constraints severely restrict rapid market responses, underscoring the economic and security value of permanently enabling robust LNG infrastructure and trade. This is also likely to benefit the environment. A new paper by the Citizens for Responsible Energy Solutions Forum noted that Russian natural gas shipped to Europe had lifecycle greenhouse gas emissions 41 percent higher than U.S. LNG shipped to the same location.
Misconception: climate value of strict regulatory review of infrastructure projects. Efficient permitting processes help minimize local environmental impacts, such as endangering wildlife habitats. But inefficient processes create more harm than good, especially when they deter projects that are net environmentally beneficial. Determining the direction and magnitude of climate impacts of oil and natural gas projects depends on complex lifecycle analyses of global conditions, making project-by-project scrutiny highly prone to regulatory error, delays and litigation. Large swings in executive agendas and extensive legal uncertainties, such as recent court decisions on how agencies use the social cost of carbon, further deter investment. Depoliticizing and streamlining climate reviews for oil and gas infrastructure to be consistent with the law is the interim path forward. Ultimately, policies that enable markets to internalize climate effects should displace regulatory micromanagement.
Opportunity: climate value of emissions transparency and differentiated commodities. Tens of trillions in private capital accounts for climate impact in investment decisions and voluntary investment spearheads emissions reductions. This is pushing the oil and gas industry into a global environmental race to the top. For example, a new report examines how trust, transparency and digital transactability across the methane supply chain can enable markets to differentiate natural gas products based on environmental impact. Cleaner commodities hold great potential but remain constrained by poor information, transactional frictions and reputational and legal risk of “greenwashing.” A variety of agencies are involved in addressing these issues, such as energy bodies that facilitate granular emissions transparency in dynamic power markets. Financial reforms to climate risk disclosures could improve clarity, reduce liabilities and foster “private ordering” to improve the depth and quality of environmental reporting. Poor reforms risk doing the opposite.

The crisis warrants emergency action to liberate natural gas exports. The Biden administration’s approval of LNG exports should reduce European bleeding. But mitigating future energy crises requires transparent, fungible and liquid markets before supply shocks hit.

Barriers to infrastructure development and trade should be removed across all fuels. Expanding market institutions and letting price signals drive investment enables natural fuel substitution and financial hedges to manage future risk. These strategies align with the implementation of a sensible climate agenda that prioritizes emissions transparency and legitimizes pathways for commodity markets to internalize environmental effects across global supply chains.

In energy crises past and present, the wise assess market conditions. The naïve think they know the “right” resource allocation. But the “right” mix of future energy resources depends on increasingly complex global conditions beyond any authority’s ability to predict or control. If policymakers focus on market health, new solutions to energy and environmental crises will emerge organically.