An Economic Analysis of Fracking

When people look at “fracking”—the production of natural gas through hydraulic fracturing techniques–they see different things. Critics see polluted wells, exploding houses, and earthquakes—an environmental disaster in the making. These anti-frackers have a simple solution: ban it. In contrast, industry supporters see hydraulic fracturing as a safe technology that drillers have been using for decades without controversy and that now promises a new era of energy abundance. The pro-frackers, too, have a simple solution: get the government out of the way and drill baby, drill.

As an economist, I see something still different: a familiar pattern of negative externalities and missing market signals, to which the appropriate response is unlikely to be either prohibition or laissez-faire.

Global externalities

In economic jargon, negative externalities are effects of production or consumption that have an impact on third parties who have no voice on either the supply or the demand side of a market. Some of the externalities of hydraulic fracturing are global in nature, others local. We will deal with the global first and then turn to local issues, including water use, contamination of aquifers, and others.

The most important global externalities are emissions of greenhouse gasses (GHGs) that feed into climate change. (Climate change deniers may skip to the next section.)The proper response to the negative externalities of energy production and use would be to introduce price signals proportional to the harm they cause. Doing so would put an end to the free lunch that producers and consumers have long enjoyed and would curb the resulting overconsumption.

As I have explained at length elsewhere, there are several ways to introduce the necessary price signal: A tax on GHG emissions, some kind of cap-and-trade system, or adequate measures to enforce the property rights of pollution victims through tort law are the most often mentioned. It is less important here to explore the pros and cons among these alternatives than it is to look at the general principles that lie behind all of them.

To begin with, price signals need to account for the differing GHG emissions from various fuels. For example, suppose the chosen policy is an emission tax of $100 per ton of CO2 equivalent. In order to apply the tax, we need to score various fuels according to their GHG emissions. Natural gas starts with an advantage, because burning an energy-equivalent quantity of gas produces about 40 to 45 percent less CO2 than coal and 25 to 30 percent less than oil.

If that were the whole story, it would imply that the tax per Btu would be much less on gas than other fossil fuels. Over time, the lower tax would lead to displacement of coal and, to some extent, oil, by natural gas. A recent study from MIT, “The Future of Natural Gas,” gives detailed projections. Under the assumptions of the MIT study, a system that priced in GHG emissions would cause gas to displace coal completely for electric power and make substantial inroads against oil as a transportation fuel.

Emissions from combustion are not the whole story, however. Accurate scoring of fossil fuels needs to take a lifecycle approach, including emissions in extraction, storage, processing, and transportation as well as in final use. For example, lifecycle assessment of liquid motor fuels gives a substantially higher GHG score to gasoline and diesel fuel derived from bitumen (oil sands) than from conventional oil. The same approach is applicable to natural gas. Robert W. Howarth and colleagues have argued that when leakages of methane are taken into account, natural gas produced by hydraulic fracturing has a GHG score that is not only higher than conventional gas, but higher than conventional oil and in some cases, even higher than coal.

Other researchers, including the authors of the MIT study and another group from the Energy Institute of the University of Texas in Austin, do not dispute that lifecycle assessment is the right way to measure the GHG impact of various fuels. However, they respond that methane leakages, while a real risk, can be minimized through proper drilling practices. I am not the one to resolve such technical issues. Whoever is right, though, we end up with two conclusions about the correct policy response.

First, we must begin now to implement a coherent energy policy that prices in environmental risks. It is simply disgraceful to limp along with the current mishmash of policies, all of them in one way or another based on the myth of affordable energy. Some of those policies make matters worse for both energy independence and the environment (ethanol). Others sacrifice the environment in a largely illusory pursuit of energy security (Canadian oil sands). Still others of which achieve results but only at needlessly high costs (automobile mileage standards). None of them provides a framework in which we can properly balance the pros and cons of various ways of producing and conserving energy against one another.

Second, we need to act now on what we already know. If unresolved technical issues mean that we cannot yet assign a precise lifecycle score to unconventional natural gas, let’s start with a policy that scores each fossil fuel according to carbon released in combustion, and move on from there. As additional data come in on methane leaks, on the land-use effects of ethanol production or on GHGs released in production of heavy oil, we can adjust the emission scores. Meanwhile, let’s remember one thing: The fact that we can’t measure something precisely is not evidence that its value is zero.

Local externalities

Climate change is far from the only environmental issue raised by hydraulic fracturing. The technology has the potential for causing a number of more localized externalities that are, for some people, a cause of even greater concern. The University of Texas study linked above provides a comprehensive list, including these effects:

•    Groundwater contamination in the immediate neighbourhood of wells
•    Contamination of aquifers on a wider, regional scale
•    Excessive use of fresh water
•    Health effects of undisclosed components of fracturing fluids
•    Spills and treatment of waste fluids
•    Blowouts, house explosions and flaming kitchen faucets

Both the MIT and Texas studies take all of these risks seriously. Unlike some fracking opponents, however, neither of them sees an outright ban as appropriate. Instead, they make three kinds of recommendations.

First, in a few cases, they recommend immediate action. For example, they favour immediate, mandatory disclosure of all chemical and other additives to the water used to carry out hydraulic fracturing, instead of allowing their composition to be protected as trade secrets as in the past.

Second, they recommend more research to establish the frequency and severity of environmental effects. Calls for further research can become a mere delaying tactic, but in this case, it does appear that the rapid growth of the industry has left the research community behind. One Australian politician, quoted in the Financial Times, describes the industry as “3,000 miles ahead of the regulators.” To cite just one example, some recent research shows high concentrations of methane in drinking water near drilling sites. However, that research would be more useful to regulators if there were better baseline studies of methane concentrations before drilling began.

The third and broadest response of both the MIT and Texas studies is that the worst problems are due to departures from best practices. Undoubtedly, more work needs to be done to develop a catalogue of best practices, ideally with the participation of industry representatives, independent engineers, and the regrettably fragmented system of state regulators.

Compensation and valuation

Moving beyond the geological and engineering problems, what economic issues do local effects of hydraulic fracturing raise? In some cases they turn out to be similar to those raised by global effects, but in other ways, they are different.

The main similarity is that when producers are free to ignore negative externalities, whether local or global, the price of gas from hydraulic fracturing does not reflect its full opportunity cost. Underpricing of natural gas, in turn, leads both to excessive expansion of the market share of gas relative to other energy sources, and to excessive energy consumption in general. In that regard, any price-based energy policy at all would be an improvement over the current situation. Carbon taxes, cap and trade, or any other mechanism, even if motivated primarily by climate change, would at the same time slow the growth of demand and thereby mitigate local as well as global impacts. To repeat, there is no need to wait for more research to begin putting a price-based policy in place. We already know that the correct price is not zero. Fine-tuning can come later.

At the same time, local pollution raises new issues of compensation and valuation that remain in the background when discussing climate change, if they arise at all. It may be helpful to begin our discussion of compensation and valuation with an overview of the way externalities would be resolved in an ideal market-based system.

Ideally, we would resolve all negative externalities by private negotiation, as outlined by Ronald Coase in his famous article on social cost. For example, suppose a gas company wanted to drill a well in the middle of a North Dakota wheat farm. Assume that the farm is large enough that all local externalities can be contained within its boundaries. In that case, either the company offers the farmer a fair royalty on the gas, plus enough to compensate for spills, ground water pollution, and so on, or it does not get to drill.

This approach to resolving local externalities has three key features:

1.    It generates a price signal to the producer through the compensation paid for harmful local impacts. The producer then passes the signal along to buyers of the gas.
2.    It provides compensation to the parties harmed by the local externalities.
3.    It solves the valuation problem. Since the amount of compensation is set by negotiation between the parties actually paying it and receiving it, the payment has to fall between the maximum the driller would willingly pay and the minimum the farmer would willingly accept, or no drilling will take place.

Use of a carbon tax or similar policy to control climate change falls short of this three-part ideal. It preserves only the first of these features, the price signal, but not the second, compensation, or third, valuation. That is probably inevitable. It is difficult to imagine any practicable scheme that would allow direct negotiations or payment of compensation between individual polluters and their individual victims on a global scale. When dealing with local externalities, however, we do need to consider paying compensation and obtaining the consent of those who bear the harm.  There are several ways that could be done.

Sometimes the ideal of direct negotiations really works. It is commonplace for Kansas or North Dakota farmers to allow construction of wind turbines on their property in exchange for negotiated compensation. Wildlife organizations buy conservation easements from ranchers. These are real business deals, not something out of an economics journal or a work of libertarian science fiction.

In crowded areas, the numbers of parties involved and property rights that may be poorly defined or hard to enforce make completely voluntary resolution of externalities difficult. Even in such cases, though, practicable mechanisms are available that go at least part way toward resolving the issues of compensation and valuation.

One possibility is a court-administered compensation pool to which harmed parties can apply for restitution. The resolution of damages from the Deepwater Horizon oil spill is a case in point. This approach may not be perfect, but it is better than letting the responsible parties escape the duty of compensation altogether, and it puts others on notice that pollution has a price.

Individual or class action lawsuits under tort law are another possibility. As discussed earlier, it may be possible to control the externalities of hydraulic fracturing by following best practices. If best practices are properly codified, courts can consider departures from them as evidence of negligence. That would increase the probability that plaintiffs will prevail. If the threat of compensation pools or class action suits makes fracking in densely populated or geologically sensitive areas prohibitively expensive, so be it. Not all resources are economically worth recovering when the full value of externalities is included in costs of production.

In still other cases, it may be possible for producers to negotiate with communities, rather than individuals, and offer compensation in the form of tax payments, support for local schools, or whatever. That is not quite the equivalent of voluntary negotiations with individuals, but it may be better than nothing both in terms of putting a price on pollution and providing at least indirect restitution to victims.

Finally, at least one of the local externalities of hydraulic fracturing, excessive use of fresh water, has a clear market-based solution. The solution is to price water properly in the first place. David Zetland’s recent book The End of Abundance describes how proper water pricing can resolve what he calls the “water-energy nexus.” Because the economic value of water varies greatly from place to place, the problem of water use can only be resolved locally, on a case-by-case basis.

The bottom line

The bottom line is that the environmental impacts of fracking are a real problem, but one to which neither prohibition nor laissez faire seems a sensible solution. Instead, we should look toward mitigation of impacts using economic tools that have been applied successfully in the case of other environmental harms. Three principles are especially important:

First, the controversy over hydraulic fracturing would be far easier to resolve against the background of a coherent national energy policy that prices in environmental effects. It is important to begin setting the framework for such a policy in place now, on the basis of what we already know, even if pricing and scoring are initially imprecise.

Second, although the existence of a price-based national energy policy would help to resolve local environmental impacts by reducing overall energy demand, it does not represent a complete solution. In the case of local harms, we also need to consider mechanisms for compensating victims and getting their input into the valuation process.

Third, we really don’t yet know everything we would like to about the frequency and severity of negative externalities from hydraulic fracturing. We need more research on the extent to which environmental harms can be mitigated through best practices and how to integrate best practices into state, local, and federal regulations, as well as into tort law. However, the need for further research is not a justification for delay. We know enough to begin taking action now.

By. Ed Dolan

"This post originally appeared on Ed Dolan's Econ Blog at Economonitor.com, and is reprinted here with permission."