Countdown to Kyoto, Parts I-III

gained through the trade against capital but the gain is costly in terms of capital expended and hard to justify in terms of economics. This is the dominant theme of this paper."

Steinmeyer viewed capital in this industry as having two components: one component is fixed relative to other inputs, and the other component allows some substitutability relative to other inputs. This substitutability was defined by Steinmeyer as the trade of capital. For instance, Steinmeyer suggested that capital costs increase linearly with plant size. The intercept is large and "outside the trade of capital" and covers such costs as support facilities which vary little with scale. In this industry, the intercept accounts for feedstock and product storage. Steinmeyer estimated that the tradeable component of capital costs is about 20% to 40% of total capital costs.

He then undertook an analysis of the optimum share of (tradeable) capital and energy with an example of insulation, heat exchanges, and piping. The optimum thickness of insulation was obtained by assuming an increasing level of insulation until the incremental cost for insulation equals the lifetime cost for heat loss. If the price of energy were to rise, an optimum allocation would be made by adding insulation until the lifetime cost of energy and insulation were again equal at the margin.

Steinmeyer offered some generalizations about the effect of energy prices on input substitution, given reasonable assumed values for capital, energy and tradeable capital. Assuming that half of the capital is tradeable, a doubling in the cost of process energy would result in a 37 percent drop in process energy and a 9 percent increase in total costs. An extensive analysis of alternative input assumptions led Steinmeyer to conclude that higher energy costs would result in substitutions of capital for energy, but this occurs over a long time period and at high cost. However, the cost increases would enable much of the existing chemical industry to remain in business.

The application of the fuel price adders to some countries and not to others was considered by Steinmeyer (and by the panel) to be critical in the choice of future investment areas. Three of the four largest chemical firms in the world are located in Germany. As noted by Steinmeyer in Table 6A. these three German firms had sales of $62 billion in 1995. Germany once had large coal reserves that supported the industry, but these reserves have apparently been played out.

Steinmeyer offered an explanation of the continued location of these large firms in Germany by suggesting a large "information" content to the location decision. Such information includes the availability of technical and scientific information as well as political and economic stability. Although location economics is changing in the direction of the Middle East and developing countries, variables such as the science base, market size, and political stability all favor the U.S. and would enable the U.S. industry to survive a significant cost increase.

2. SUMMARY OF WORKING GROUP DISCUSSION

The working group members agreed on the major conclusion of Steinmeyer's analysis: that applying the fuel price adders to the developed countries and not to the developing countries would result in a significant increase in imports to the U.S. These imports would displace domestic employment and output. Steinmeyer's quantitative estimates of industry impacts of a $10 to $12 billion shift in trade balance were judged to be reasonable by the group. However, the overriding sense of the group, including Steinmeyer, was that the quantitative effects on the domestic industry are not known with precision. The industry is extremely diverse and produces more than 70,000 different chemicals; some are energy intensive, some are not. The impact of fuel price adders would vary across the industry, with the greatest effect on the high energy portion of the industry.

Even in the absence of new environmental restrictions, financial capital is expected to continue to migrate to the developing countries. With the assumed fuel price adders in effect, the rate of capital flow would increase. New investment that would have occurred in the U.S. and other OECD countries would be redirected towards less developed countries. Some older and less efficient plants may be retired prematurely.

The industry has some opportunities to improve energy efficiency in the short run, but they are highly limited. The recommended approach is to encourage capital investment that improves the overall productivity of the industry. Energy is not a discrete component of the production process that can be separated; rather, it should be considered as part of the entire production process that includes capital and labor.

Domestic Effects

The working group discussed the use of fuel by the industry in terms of process energy and as a feedstock. The group expressed considerable reservations about the feasibility of distinguishing among fuel uses and therefore about the ability to administer any policy based on such a distinction. One panel member asserted that carbon taxes are in effect in Denmark and the Danes have great difficulty in effectively administering this tax. The tax is apparently revised annually. The difficulty of distinguishing between feedstocks and process energy is one complication. Fuel combustion produces immediate emissions, but fuel used as feedstock produces emissions over the long term. The sense of the group was that it would be very difficult to administer fuel price adders applied only to process energy.

The working group indicated that, given the complexity and diversity of the industry, an extensive analysis would be required to understand the effects of any policy action on the different segments of the industry. The effects of the assumed fuel price adders would impact the most energy intensive segments of the industry, while other segments (pharmaceuticals) may be relatively unaffected. Furthermore, outputs of the chemical industry are inputs in other industries

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and therefore cost increases in this industry would be reflected in other industries. The total macroeconomic effects are much larger than the industry impact.

There was considerable discussion about the adjustment process that the industry would undertake in response to significantly higher energy prices. Steinmeyer concluded that short run substitutions of capital for energy are generally not feasible. A long run adjustment period would be required, where the normal turnover of capital stock would occur, with a limited trade of capital for energy. There is some view in the panel that markets adjust faster then the normal turnover of capital and the industry would therefore adjust more quickly to higher energy prices. The end result would be an increased cost of chemical production.

The discussion of adjustment processes evolved into a discussion of substitution possibilities, both fuel substitution in chemical manufacture and product substitution away from chemical products. First, with natural gas the predominant fuel used for non-feedstock purposes in the chemical industry overall, there is a limited possibility of substituting gas for coal. Second, the limitations in undertaking substitutions in the short run indicate that total costs would increase as a result of the fuel price adders, which could encourage a substitution of other products for chemicals. For example, wood or steel could be substituted for plastics. This type of substitution is not all that likely on a large scale because the manufacturers of these other products would also be subject to the price adders and because a more feasible substitution is between imports and domestic production.

A large share of capital used in this industry is in fixed proportion with energy. Only a small amount of capital is tradeable with energy and the cost is high. The chemical industry has experienced a decline in energy intensity over the last two decades, which is due in part due to a change in product mix but also to new investments in more efficient capital. The theme of Steinmeyer's paper, which was confirmed in the discussion, was that effective substitution of capital for energy in response to an increase in energy costs, such as from the assumed fuel price adders, would require a large amount of capital and require a long period of time. The costs of the assumed fuel price adders would therefore not be offset by investing in more productive capital.

International Effects

Even in the absence of new climate change commitments, growth in the high energy segments of the chemical manufacturing industry will occur most rapidly in the developing countries. The availability of low cost natural gas in the Middle East, especially in Saudi Arabia, makes this region attractive for new investments. In the base case of no new environmental constraints, the U.S. industry will remain economically healthy, but will obtain a declining share in the world market.

With the assumed price adders affecting only developed countries, they would lead to a migration of capital and energy use to non-OECD countries. With higher domestic costs relative to other countries, there would be a lower return on capital invested domestically relative to capital invested in non-participating countries. As a result, over the long run, about 20% to 30% of the domestic industry might move abroad.

The assumed fuel price adders may impact the U.S. more heavily than Japan or OECD Europe because the chemical industry in the U.S. is relatively more energy intensive. The chemical industry in Germany produces a large share of pharmaceuticals, which are not energy intensive.

Panel's Advice to DOE

The panel felt that the view that an increase in energy prices would reduce energy use and thereby reduce emissions was, according to one panelist, "...a very flawed model." Energy cannot be dealt with in isolation, but must be considered as a component of the investment decision of the firm. Fuel price adders are "not the right tool". Instead, policy should emphasize R&D and encourage investments in clean technologies at the normal rate of turnover of the capital stock.

Alternative strategies need to be considered. The panel felt that the strategy of increasing the competitiveness of the electricity market could significantly reduce greenhouse emissions. The assertion was that if the chemical industry had increased access to the electricity grid it would increase its cogeneration, which would reduce emissions.

THE CHEMICAL INDUSTRY IN THE USA

The Role of Energy and the Impact of Energy Price Increases