Decision analysis of the synthetic fuels commercialization program

Transcription

1 Decision analysis of the synthetic fuels commercialization program by STEVEN N. TAN I SRI International Menlo Park, California INTRODUCTION In his State of the Union Message in January 1975, President Gerald Ford called for the accelerated development of U.S. energy technology and resources and proposed a comprehensive set of energy supply and conservation measures to reduce U. S. requirements for imported oil. As one of these measures, the President proposed a federal incentive program hose goal ould be the commercial production of one million barrels per day of synthetic fuels by In such a program, the Federal Government ould provide suitable financial and regulatory incentives to stimulate private sector investment in commercial-scale plants to convert coal, oil shale, and other relatively abundant domestic resources into clean liquid and gaseous fuels. It as generally believed that ithout such incentives, industry ould be unlikely to undertake the large risks of synthetic fuel plant investments. The benefits to be achieved by the synthetic fuels program ould be the folloing: 1. An accelerated accumulation of experience and information on the technical, environmental, economic, and institutional aspects of commercial-scale synthetic fuel production for better-informed private sector investment decisions. 2. The development of an industry infrastructure to support subsequent expansion of the synthetic fuels industry. 3. Insurance against high orld oil prices and against early depletion of domestic sources of conventional fuels. 4. Protection against the losses of an oil embargo. 5. Improvement in the U.S. international bargaining position. These benefits, hoever, ould be counterbalanced by the possible costs of subsidizing synthetic fuels relative to less expensive energy sources such as imported oil and other domestic resources and by the environmental and socioeconomic costs associated ith rapid development of coal and oil shale reserves. In response to the President's message, the Interagency Task Force on Synthetic Fuel Commercialization as formed to evaluate the economic and environmental costs and benefits of the program and to recommend to the President a program of appropriate size and scope. The Task Force as chaired by the Office of Management and Budget and included members from the Federal Energy Administration, the Environmental Protection Agency, the Departments of State, Commerce, and Treasury, the Council on Environmental Quality, and the National Science Foundation. We, in the Decision Analysis Group at Stanford Research Institute (no SRI International), ere engaged to assist the Task Force in conducting an analysis of the program. STRUCTURE OF THE ANALYSIS The fundamental question addressed by this analysis as hether the U.S. should have a synthetic fuels commercialization program and, if so, ho large the program should be. The Task Force defined four distinct program alternatives to be evaluated: 1. No Program-No federal funding of synthetic fuels commercialization but continuation of research and development. 2. Informational Program~A minimal program designed primarily to generate technical, environmental, and economic data on various resource-to-fuel conversion processes, ith synthetic fuel production of about 350,000 barrels per day by Medium Program-A program designed to generate more complete information on a ider range of processes and to meet the President's goal of 1,000,000 barrels per day by Maximum Program-A program desig'ned to achieve the greatest amount of synthetic fuel production in 1985 possible ithout causing major dislocations in the economy: 1,700,000 barrels per day. The object of the analysis as to determine hich of these alternatives ould be of greatest net benefit to the nation as a hole, here net benefit includes both economic and noneconomic impacts. 23

2 24 National Computer Conference, 1978 We defined four components of net national benefit for the evaluation of the program alternatives: economic impact on consumers, economic impact on producers, embargo protection, and environmental and socio-economic impacts. To measure the economic impact on consumers, e utilized the concept of consumer surplus. Consumer surplus is the difference beteen the value of a good to consumers and the amount of money they must pay for it. This is shon graphically in Figure 1. The demand curve, by definition, is the most consumers ould pay for each unit of the good, hich is the value of that unit. If the market price is p, then q units ill be purchased. For every unit except the last one, the value of the good exceeds the price paid for it. The shaded area beteen the price line and the demand curve represents the total excess value the consumers receive from this good; this is called the consumer surplus. In the case of the synthetic fuels program, it as felt that a demonstration that synthetic fuels could be produced cheaply, if achieved, ould have the effect of holding don the price of imported oil. The resulting increase in consumer surplus ould then be credited as a positive benefit of the program. To measure the impact on producers, e used a concept analogous to that of consumer surplus-producer surplus. This is the difference beteen the amount producers receive for a good and their marginal cost of producing it. Clearly, producer surplus is directly related to the idea of profitability. Figure 2 shos producer surplus graphically. The supply curve represents the marginal cost of producing each unit of the good, hich is the least amount of money the producers ould accept for it. The shaded area beteen the price line PRICE LONG-TERM SUPPLY CURVE I- e.> ~~ p ~~~77TT~~7777~~~~~~~---- <0... I ~ I I I POSITIVE CONTRIBUTioN TO PRODUCER SURPLUS i I QUANTITY Figure 2-Producer surplus q SYNTHETIC FUEL CAPACITY and the supply curve is equal to the total producer surplus for that good. We assumed in this analysis that synthetic fuel ould be a substitute for imported oil. Therefore, if the cost of the synthetic fuels turned out to be less than the cost of imported oil, the industry ould accrue positive producer surplus, hich ould be credited to the program as a benefit. Ho- SHORT-TERM (EMBARGO) DEMAND CURVE. EMBARGO EQUILIBRIUM POINT u a: P 0... CONSUMER SURPLUS ~ EQUILIBRIUM POINT u a: a. LOSS DURING EMBARGO AMOUNT OF EMBARGO q QUANTITY Figure I-Consumer surplus qo QUANTITY Figure 3-Embargo loss

3 Decision Analysis of the Synthetic Fuels Commercialization Program 25 ever, if synthetic fuels turned out to be costlier than imported oil, producer surplus ould be negative and industry ould require a subsidy from the government to cover its losses. The amount of this negative producer surplus ould be charged as a cost of the program. The algebraic sum of consumer and producer surplus is a measure of the total economic impact of the program on the nation assuming normal market conditions. Hoever, it does not include the impact of the program in the event of an oil embargo. The situation during an oil 'embargo is illustrated in Figure 3. The pre-embargo price and quantity of oil are established on the long-term demand curve. If an embargo occurs, the quantity of oil available for consumption decreases abruptly. Because of short-term inflexibilities in consumption patterns, the marginal value (or shado price) of oil is much higher than the long-term demand curve indicates. Here e use a linear short-term demand curve to sho this effect. The economic cost of the embargo is the loss of consumer surplus during the embargo and is represented by the shaded trapezoidal area. The synthetic fuels program, by providing a substitute for some of the imported oil, ould reduce this embargo loss by increasing the amount of fuel available for consumption during the embargo. This reduction of embargo loss, eighted by the probability of occurrence of an embargo, is credited to the program as a benefit. Finally, the synthetic fuels program ould result in noneconomic costs in the form of environmental damage (e.g., increased air pollution) and socio-economic disruption (e.g., "boom tons" near mining and conversion facilities). These costs, to the extent that they are not internalized in the producers' costs (e.g., pollution control costs), are charged to the program. The sum of these four components of program impact is the measure of net national benefit e used in the analysis to evaluate the alternatives. Clearly, to determine the net benefit of each program alternative, e need to kno something about the energy supply and demand situation in the future. There as, of course, considerable uncertainty about the future energy picture, so e used probabilistic modeling techniques to quantify and incorporate the uncertainty in the analysis. Figure 4 shos the decision tree structure that e ultimately developed for this analysis. We treated the dynamics in a simple manner by looking at three discrete time periods. In 1975, the government ould make its program decision, Strategic Program Decision Forecast of 1995 Co~t of Synthetic Fuels State of Cartel Foreign Oil Price Corporate Synthetic Fuels Synthetic Fuels Price Decision 5 MM bbls/d State of Cartel Foreign Oil Price Domestic Energy Po$ition: Supply Relative to Demand Maximum Program (0 MM bbls/d) Capacity Figure 4--Decision tree

4 26 National Computer Conference, 1978 choosing one of the four alternatives. Then, in the mid- 1980's, the program ould result in information about the ultimate cost of synthetic fuels production. Based on this information and on the prevailing and projected price of imported oil, the industry ould make its decision on further investment in synthetic fuel plants. The price of imported oil ould, of course, depend on hether or not the oil producers' cartel remained effective in controlling prices. Finally, in the mid-1990's, hen the ne synthetic fuel plants are on-stream, the program impacts can be determined by looking at the cost of synthetic fuels, the price of imported oil, hich again depends on the current state of the cartel, and the U.S. energy supply and demand balance. The year 1985 as used to typify the decade of the 1980's and the year 1995 to typify the decade of the 1990's. Program cost and benefits ere measured in constant 1975 dollars and ere discounted in 1975 using a discount rate of ten percent. The decision tree in Figure 4 shos ho uncertainty as explicitly incorporated in the analysis. Uncertainty about each of the factors shon as quantified in the form of probabilities. Then, for each combination of factors, hich defined a unique scenario of the future, both the probability of occurrence for that scenario and the discounted net national benefit associated ith it ere calculated. Finally, for each alternative, the expected net benefit as calculated by eighting the outcome of each scenario by its probability and summing. Note that the decision tree in Figure 4 defines 5,832 different scenarios for each of the four program alternatives. The industry decision in 1985 of ho much further investment to make in synthetic fuels plants required special treatment. While the government decision ould be made on the basis of overall national benefits, the private sector decision ould be made on the basis of corporate profits only. Therefore, in the analysis, the level of corporate investment that maximized expected future producers surplus as selected. Figure 5 illustrates the techniques e used to quickly 1985 STATE OF CARTEL 1995 STATE OF CARTEL EXPENSIVE 19 $/bbl NOMINAL 15 $/bbl CHEAP 11 $/bbl Figure 6-Probabilities of 1985 imported oil prices EXPENSIVE 10 $/bbl NOMINAL 8 $/bbl CHEAP 6 $/bbl encode uncertainty in the various factors. The probability distribution shon represents uncertainty in the 1985 imported oil price given that the cartel is strong. According to this distribution, it is equally likely that the price ill be above or belo $15 per barrel (the median value). Also, there is a ten percent chance that the price ill be belo 1985 STATE OF CARTEL FOREIGN OIL PRICE IMPORTED 01 L PRICE GIVEN A CARTEL (Dollars per barrel) Figure 5-Simple encoding technique Figure 7-Probabilities of state of cartel

5 Decision Analysis of the Synthetic Fuels Commercialization Program 27 $11 per barrel (the 10 percent fractile) and a ten percent chance that it ill be above $19 per barrel (the 90 percent fractile). We divided the distribution into three sections having areas of 25 percent, 50 percent, and 25 percent and used the median value to represent the middle section and the 10 percent and 90 percent fractiles to represent the to tails. Thus, as shon in Figure 6, e said in the analysis that there is a 25 percent chance that the 1985 imported oil price ould be $19 per barrel, a 50 percent chance that it ould be $15 per barrel, and 25 percent that it ould be $11 per barrel, given that the cartel is strong. The imported oil price given that the cartel is eak is assessed to be much loer $10, $8 and $6 per barrel, respectively. U sing this simple technique, e encoded the uncertainty of the Task Force members about each of the factors shon in the decision tree. Of particular interest are the assessments of the future state of the oil producers' cartel. As shon in Figure 7, the chances of the cartel remaining strong through 1985 ere assessed by the Task Force to be Given that it is strong in 1985, the probability that it ould remain strong through 1995 as assessed to be 80 percent, hile if it is eak in 1985, the chance that it ould become strong by 1995 as assessed to be only 20 percent. RESULTS OF THE ANALYSIS After e had structured the problem ith the decision tree, constructed a computer model to calculate the net national benefit for each of the thousands of scenarios in the tree, and encoded the uncertainties of the Task Force, e ere ready to compute the analytic results. Figure 8 summarizes these results. The total expected discounted net benefit (in billions of 1975 dollars) is shon, along ith its components, for each of the three synthetic fuels program levels relative to having no program at all. These results indicated that, on balance, the synthetic fuels commercialization program as not in the best national interest and that the bigger the program, the greater the national loss. The small informational program had an expected impact on minus $1.65 billion. The larger program had expected impacts of minus $5.41 billion and minus $10.98 billion, respectively. We can get more insight by looking at the components of total net benefit. While the synthetic fuels program is expected to have positive impacts on consumer surplus --Informational Program ---Medium Program - -Large Program OL-~L- ~ -L -L -L ~~~~=-L-~ DIFFERENCE IN DISCOUNTED EXPECTED NET BENEFIT FROM NO PROGRAM (billions of 1975 dollars) Figure 9-Uncertainty in program impacts through the possible moderation of future imported oil prices and on embargo losses through a slight reduction in oil imports, these benefits are far outeighed by the negative impact on producer surplus. Basically, it as far more likely than not that synthetic fuels ould be more expensive than imported oil and therefore need a subsidy. The negative impact of environmental and socio-economic costs is relatively minor. The results shon in Figure 8 are the expected values of program impacts. There is, of course, considerable uncertainty about the impact of the program, as shon in Figure 9. While the expected impact of the informational program is $1.65 billion, there is a 30 percent chance that the net impact ill be positive and a 10 percent chance that it ill be as much as +$7 billion. On the other hand, there is a 10 percent chance that it ill be as negative as -$9 billion. It is equally likely that the impact ill be orse than or better than -$4 billion. The uncertainty in the impact of the larger program is even greater. Figure lois a partial expansion of the decision tree that shos ho to of the factors affect the results of the analysis. The -$1.65 billion expected impact of the information program consists of a 50 percent chance of -$4.86 billion if the cartel in 1985 is eak and a 50 percent chance of +$1.55 billion if it is strong. Note that a eak cartel, hich leads to generally loer imported oil prices, is bad for the syn- STATE OF CARTEL IN 1985 PROJECTION OF SYNTHETIC FUEL COST IN 1985 EXPENSIVE Expected Discounted Net Benefit (billions of 1975 dollan) Consumer Producer Embargo Environmental Program Alternative and Total Surplus Surplus Protection Socioeconomic No Program Information Program (0.35 mm bbl/day) Medium Program (1 mm bbl/day) Maximum Program (1.7 mm bbl/day) Figure 8---Expected program impacts NOMINAL, c~ CHEAP EXPENSIVE NOMINAL ' <J Figure to-partial expansion of tree CHEAP '

6 28 National Computer Conference, 1978 thetic fuels program hile presumably very good for the nation as a hole. Conversely, a strong cartel, ith higher imported oil prices, makes the program look good hile being bad for the nation. This emphasizes that the synthetic fuels program is a hedging strategy-it pays off hen other things are going badly. Note also that if the cartel is eak, the program looks bad even if synthetic fuels turn out to be cheap to produce. On the other hand, if synthetic fuels turn out to be expensive, the program looks bad even if the cartel is strong. That is hy, on balance, the program looks bad. The assessment of a chance that the cartel ould remain strong through 1985 turned out to be pivotal and more than a little controversial ithin the Task Force. To sho the implications of different probabilities for this factor, e performed a sensitivity analysis, hich is shon in Figure 11. This gives the expected net impact of each program level relative to no program as a function of the probability of a strong cartel in It assumes that ith 80. percent probability, the cartel ill remain in the same state from 1985 to Figure 11 shos that only if the probability of a strong cartel in 1985 exceeds 75 percent does the information program look better than no program and that the probability must exceed 82 percent for the medium size program to be the best alternative. An interesting result is that the maximum size program is never optimal for any value of this probability. So far, the analytic results have been presented only in terms of expected values. It might be argued that the dedsion should not be made on the basis of expected values but rather on the basis of values that are adjusted for risk. To sho ho various levels of risk aversion ould affect the ASSUMES THAT THE PROBABILITY OF PERSISTENCE IN THE STATE OF THE CARTEL FROM 1985 TO 1995 IS 80% Figure II-Sensitivity to cartel probabilities 1.0 ROBABI LlTY OF CARTE L IN 1985 ~ «a: (!) o a: a. o Z ~ o a: -1 LLCi) I-~ ~:g -2...J"C «1.0 ~~ :::> '0 en zc: <! ~ -4 ~ ~ -5 z () z a: LL LL Q -6-7 REASONABLE RANGE OF NATION'S RISK AVERSION MAXIMUM PROGRAM ASSUMES RISK TOLERANCE OF $5 BILLION FOR THE PRIVATE SECTOR CAPACITY EXPANSION DECISION Figure I2-Sensitivity to nation's risk aversion results, e prepared the sensitivity profile shon in Figure 12. Here, e have assumed that the nation's risk attitude is expressed by one of the family of exponential utility curves. The degree of risk aversion expressed by this curve is given by its one parameter, called the risk tolerance; the smaller the risk tolerance, the greater the degree of risk aversion. In personal terms, an individual's risk tolerance is the largest amount of money he ould illingly risk in a gamble that is equally likely to halve or double that amount. Figure 12 shos the value to the nation of each program level relative to no program as a function of the nation's risk tolerance assuming an industry risk tolerance of $5 billion for the private sector capacity expansion decision. Note first that the value of the program increases as the nation's risk aversion increases: This is characteristic of a hedging strategy, since it reduces overall uncertainty. Hoever, the nation's risk tolerance must be less than $67 billion for the information program to be better than no program and it must be less than $56 billion for the medium size program to be the best alternative. We believe that a reasonable range for the nation's risk tolerance is from one-fourth to one-half of annual GNP, or about $300 billion to $600 billion. As Figure 12 shos, for any risk tolerance in this range, the ranking of program alternatives is the same as in the expected value case, ith the best alternative being no program at all. EPILOGUE As far as e can determine, this is the first decision analysis to be presented in the White House. The chairman

7 Decision Analysis of the Synthetic Fuels Commercialization Program 29 of the Task Force presented it to the President's Energy Resources Council in July Citing benefits of the program that ere not quantified in the analysis, such as the international leverage gained by the U.S. in asserting positive leadership in developing alternate fuel sources, as ell as the "relatively small risk and expected cost" of the small program, the Task Force recommended that the government undertake the informational program alternative ith a possibility that it could sitch to the medium size program pending additional information on crucial factors. The Administration's bill incorporating this recommendation ultimately failed to pass through Congress. For this analysis, e rote a FORTRAN program for use on a commercial time sharing system. The program, hich e created from scratch rather than use off-the-shelf routines, required approximately 400 lines of code and cost roughly fifteen dollars to run a complete evaluation of the decision tree. One feature of the time sharing service that e found to be especially useful as the accessibility from different locations. We did most of the model development at SRI headquarters in Menlo Park, California, but e used the program extensively hile orking ith the Task Force in Washington D.C. Indeed, one of the most valuable aspects of our assistance to the Task Force as our ability to anser almost immediately their many questions about the effect of changes on the assumptions and assessments in the analysis. COMPUTER UTILIZATION REFERENCE Recommendations for a Synthetic Fuels Commercialization Program, report submitted by Synfuels Interagency Task Force to The President's Energy Resources Council, November Volume I: Overvie Report. Volume II: Cost/Benefit Analysis of Alternate Production Levels.

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