Developments in energy markets over the last eight years have offered an interesting and, I think, instructive contrast between the effects of government regulations and those of the (mostly) free market. Now that EPA has finally gotten around to specifying biofuels volumes for the years 2014 – 2016, it’s an opportune time to assess the performance of Government Regulation v. Adam Smith’s invisible hand in achieving the objectives of U.S. energy policy: reduced dependence on petroleum imports and reduced carbon dioxide emissions.

Government regulation

In 2007 the U.S. Congress passed the Energy Independence and Security Act (EISA) to reduce the amounts of petroleum imported into the U.S. and to reduce the net amount of carbon dioxide emitted to the atmosphere from the combustion of transportation fuels. EISA would accomplish these objectives by replacing petroleum fuels with renewable fuels such as ethanol and other plant-based fuels. EISA mandated that transportation fuels should contain specific amounts of renewable fuels including specific amounts of renewable fuels made from cellulose (rather than food crops). However, the technologies to make cellulose-based renewable fuels on a commercial scale did not exist in 2007. This “technology-forcing regulation” rested entirely on the belief that a government mandate would provide sufficient incentive for innovators to create the necessary technologies.

Now, checking our progress after eight years, we find that we have not been able to replace as much petroleum as EISA mandated and virtually none of the renewable fuels have come from cellulose. That failure has been accompanied by the following unintended consequences:

  • Complex rules and regulations to implement an unrealistic mandate have turned out to be unworkable;
  • Imported ethanol made from sugarcane is preferred over U.S. produced ethanol;
  • The commodity introduced by the regulations to ensure compliance (RINs) has its own supply and demand balance which can increase consumer costs if supply is restricted.
  • Consumer preferences for incumbent fuels are not aligned with government regulations.

The Invisible Hand

In spite of EISA’s failure to make a meaningful reduction in petroleum imports, the U.S. is now much less dependent on imported petroleum than it was in 2007. Innovation in oil production technologies in response to market signals has resulted in an almost unimaginable increase in U.S. oil production. In each of the past four years, the U.S. has increased crude oil production by 1 million barrels per day (bpd). Each year. The total increase of 4 million bpd for the past four years would rank sixth among the world’s oil-producing countries. Just the increase. Oil production technology innovations have accomplished more in one year than government mandates have accomplished in eight.

In spite of EISA’s failure to make a meaningful reduction in carbon dioxide emissions, these same technology innovations have also reduced carbon dioxide emissions in the U.S. by approximately 10%. The dramatic increase in natural gas production that has followed the introduction of new technologies has resulted in the economic displacement of coal as the low-cost fuel for electrical power generation.

These technologies have also reduced U.S. petroleum refiners’ feedstock costs which have enabled U.S. refiners to become a refined products export powerhouse making a substantial positive contribution to the U.S. trade balance.

Because these innovations are the result of economic decisions made by hundreds of oil and natural gas producers and dozens of petroleum refiners, they are aligned with consumers’ interests rather than being at odds with what consumers want (low-cost fuels that fully utilize existing retail infrastructure). On the other hand, experience has shown that government mandates and regulations can be stymied if they are not aligned with consumers’ interests. The invisible hand of the market has done more to promote energy independence and lower carbon dioxide emissions than having the U.S. Congress mandate which fuels to use or deciding for us which technologies to develop.