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Making better regulations: a U.S. downstream industry perspective.



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Making Better Regulations:

a U.S. Downstream Industry Perspective Charles E. Sandler Vice President American Petroleum Institute

Abstract.

• The US downstream industry has spent billions of dollars complying with a wide range of government rules. Many of these rules have imposed unnecessary costs on industry and consumers.

• As a result of bad or inefficient rules, it is becoming increasingly more difficult for industry to keep consumers reliably supplied with affordable products. The solution is better regulation: scientifically sound, performance based, cost effective and properly coordinated with other regulations.

Government regulation is a fact of life for the downstream sector of the U.S. oil and gas industry. Over the past few decades, federal, state and local regulatory requirements have multiplied, increasingly affecting downstream investments and operations and petroleum markets.

Much of the regulation, such as rules requiring cleaner fuels to reduce emissions from automobiles, is aimed at lessening harm to the environment or improving safety. Some regulation focuses on competition and pricing.

Regulation is appropriate in certain areas—environmental protection is an example. However, even where regulation makes sense, some rules have unnecessarily hampered the free flow of energy to consumers and made energy less affordable.

The experience of the U.S. downstream industry holds lessons for improving the effectiveness and efficiency of regulation. With a sounder approach, regulatory objectives can be achieved with fewer adverse impacts on the industry, energy availability and consumers.

Highly competitive and heavily regulated Thousands of large and small independent businesses in the U.S. downstream industry ensure highly competitive petroleum markets. Some 150 U.S. refineries, owned

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by 65 different companies, refine most of the nation’s gasoline.1 About 8,000 fuel distribution companies2 help market this gasoline and other petroleum products, which are made available to consumers at more than 175,000 retail outlets.3 The major oil companies own and operate just over 7 percent of all retail outlets and lease another 8.5 percent to independent businessmen.4

On a national basis, the petroleum industry is less concentrated than many other industries.5 Regionally, concentration can vary, but multiple businesses compete in all parts of the nation. The U.S. Federal Trade Commission (FTC) and the states monitor petroleum markets and have required sale of facilities to ensure competition.

Every sector of the U.S. industry is extensively regulated, but none more than downstream. Downstream regulations control facility air emissions, water discharges, and waste disposal. They set standards for maintaining employee and community safety. They require information reporting to government and the creation of risk management plans. They mandate periodic equipment inspections. In some states, there are also rules requiring divorcement and prohibiting below-cost pricing.

A number of downstream regulations establish fuel specifications. Some help ensure fuel quality. Many others are aimed at making gasoline and diesel fuel cleaner. These rules have required the removal of lead from gasoline, the reduction of gasoline vapor pressure, restrictions on benzene content and toxic emissions, the addition of oxygenates, and other changes.

The total downstream regulatory burden is imposing. The U.S. refining industry, alone, must operate under more than 140 federal environmental regulations. This is in addition to numerous state and local environmental requirements as well as non-environmental rules. The investments needed to comply with downstream regulations are large. For example, during the 1990s, refineries spent $43 billion meeting environmental requirements—or $12 billion more than their dollar book value at the beginning of the decade.6

Benefits and costs of regulations The impact of regulations on the environment and safety has generally been salutary. However, these rules have contributed to significant changes in the industry and in some cases impaired its ability to reliably provide affordable fuels.

On the benefit side, the rules have played a major role in improving U.S. environmental quality. For example, according to data compiled by the U.S. Environmental Protection Agency (EPA), between 1970 and 1999 cleaner fuels and vehicles required by government regulations have accounted for more reduction in “criteria” air emissions7 than emission cuts from all other sources combined, helping trim

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overall U.S. criteria emissions by almost one-third.8 This achievement is especially impressive given that vehicle miles driven more than doubled over the same period.9

Employee safety has also improved. Although work in the petroleum industry is often physically demanding and involves heavy equipment and high temperatures and pressures, the job-related illness and injury rate declined during the 1990s and was well below that of the U.S. private sector as a whole. For example, between 1990 and 1999, the illness and injury rate for the refining sector declined 51 percent.10

The adverse impacts of the regulations stem in part from the huge investments needed to implement them. During the early 1990s, the ratio of refining and marketing environmental investments to investments in new capacity or efficiency improvements increased, and the return on capital declined.11 In the early 1990s, many refineries shut down (between 1981 and 1997 the number of refineries fell by half). (See figure 1.) By the late 1990s, overall refinery capacity had declined 2 million barrels per day since 1980.12 As a result, refiners have increasingly run “flat out” when demand for fuel is strong, lessening flexibility to address unforeseen events that affect supply.

Number of Refineries Decreasing -- Environmental Expenditures Increasing

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Figure 1

The high cost of regulations has also affected consumer prices, although efficiency improvements reduced operational costs, masking the impacts. Through the 1990s, gasoline prices have trended downwards.

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More than ever: a need to regulate better The regulatory burden continues to increase. (See figure 2.) During the next few years, U.S. downstream companies will be making changes to comply with new stationary source and product specification rules, including new requirements to reduce sulfur content in both gasoline and diesel fuel. They already involve substantial new investments. In addition, the U.S. Congress could enact requirements to blend more ethanol in gasoline as part of new energy policy legislation now under consideration. Some state and local governments continue to consider rules or laws that would affect gasoline marketing and pricing. There is also the prospect of an overlay of regulations relating to facility security in the wake of the terrorist attacks on September 11, 2001.

Figure 2

Figure 2

Because of existing and potential regulations, the future for the downstream sector will be challenging and uncertain. Unnecessary, excessive or poorly coordinated regulations will magnify the challenges, further increasing costs, reducing flexibility, and subjecting consumers to more price volatility. However, by heeding the lessons of the past

Regulatory Burden

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and regulating more wisely, it should be possible to mitigate these impacts and still achieve regulatory objectives.

Failure of economic regulation When product prices rise, consumers complain. Government hears those complaints and proposes legislative or regulatory remedies, some of which are implemented. But the remedies have failed to achieve their objectives. Part of the reason is that they do not make good economic sense. Equally important, competitive markets do a very good job of bringing products to consumers as efficiently as possible. Government rules do not enhance, and often interfere with, the efficient performance of markets. They do not help consumers.

The facts argue for faith in markets—and avoidance of economic regulation. In the United States, gasoline is an affordable commodity for virtually all Americans. It has become more attractively priced over the years. U.S. government data show that gasoline prices—adjusted for inflation and net of taxes—reached their lowest average in the 1990s. At the end of 2001, prices for regular grade gasoline averaged about $1.10 per gallon including 42 cents in taxes (or .56 Australian dollars per liter).13 That is close to the bottom of the range of prices throughout the last century.

Price and allocation controls. Although competitive markets bring consumers the lowest average prices, government may take action during times of rising or high prices. Such was the case in the 1970s when price and allocation controls were imposed. However, in controlling prices, government created higher demand for gasoline, discouraged conservation and reduced incentives for companies to explore for and produce oil. Also, imports rose because of an entitlements program that required companies with more domestic reserves to pay firms that had to import more expensive foreign oil.

The allocation controls—based on historical demand—caused distribution problems, which created gasoline lines. For example, in 1974 the Federal Energy Office diverted gasoline to Vermont based on records that showed many in New York City had gone to Vermont the previous year to ski. However, owing to higher prices and concerns about allocation controls, the skiers stayed home in 1974. Thus, Vermont storage tanks were filled with product for which there was no demand, while New York City motorists experienced a shortage.14

The controls lasted eight years, until early 1981. For about a year prices held constant at the high level they had been in 1980 during the Iran-Iraq war and then steadily declined through most of the 1980s, even as the nation was coming out of a recession and demand for energy was growing.

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It is hard to find anyone who disputes the failure of the controls, which were amended several hundred times to little benefit. They caused enormous inconvenience and discouraged the production of new supplies. Had the market been allowed to work freely, the high prices would have encouraged companies to produce and market additional supplies. That would have put downward pressure on prices and left consumers far better off in the long run.

Divorcement and below-cost selling laws. Other forms of economic regulation of the downstream industry in the United States have also failed to help the consumer, including divorcement and below-cost selling laws.

Gasoline divorcement statutes restrict—and, in their most extreme form, proscribe—the vertical integration of gasoline refiners and gasoline retailers. At least six states have divorcement laws, and advocates frequently tout their alleged benefits to state legislatures when supplies are disrupted and prices rise.

Some proponents of divorcement legislation argue that it prevents refiners from driving rival dealers out of business in order to reduce competition for refiner-operated outlets. According to the theory, such legislation protects dealers from predatory pricing and results in a higher level of competition that benefits consumers. But according to U.S. Federal Trade Commission economist Michael Vita, the theory is “difficult to reconcile with economic analysis” because it presumes that a refinery would want to eliminate efficient dealers selling its products.15 More important, experience demonstrates that divorcement laws do not increase competition or reduce prices.

The divorcement law in the state of Maryland is a case in point. Maryland enacted its law in 1979. Since then a number of economic studies have evaluated the impacts. Only one—an analysis by a state of Maryland contractor—concluded that the law reduced prices. Moreover, when Maryland’s Department of Fiscal Services conducted a review of all economic studies of divorcement in Maryland a year after its contractor report, it agreed that “divorcement has resulted in higher gasoline prices for consumers….”16

According to Michael Vita, “previous empirical studies of divorcement not only fail to show that such policies result in lower prices, they indicate strongly that divorcement results in prices significantly higher than would have obtained had no such restrictions been imposed.”17 After examining state-level data for the mid-1990s, Vita found that “divorcement regulations increased the retail price of unleaded regular gasoline by more than 2.7 cents per gallon.”18 He also concluded that if national divorcement legislation were imposed, “the annual consumer welfare loss could come to approximately $2.5 billion per year.”19

Fifteen states have enacted below-cost selling or minimum markup laws. Proponents of such legislation initially argued that major refiners were using company

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operated retail outlets to drive competitors out of business. More recently, support for below-cost selling laws has sprung from concern about low prices at so-called “hypermarts.” (Hypermarts are supermarkets, mass merchandisers, and discount chains with club memberships that have entered the gasoline retailing business.)

API’s analysis of below-cost selling laws suggests that they marginally increase prices and the number of gasoline retail outlets. Prices rise slightly because these laws intimidate low cost sellers, discourage temporary price cuts to shed inventories or promote specific products or locations, and discourage selling gasoline as a “loss leader” at food convenience and department stores. The number of outlets rises slightly because, by eliminating some low pricing, some marginally profitable outlets are able to continue in business.20 Thus, though below-cost selling laws are perhaps helpful in keeping marginal marketing outlets in business, they are anti-consumer.

Improving environmental regulations The U.S. downstream industry is prepared to do its part to further environmental progress. However, new regulation should be cost-effective, scientifically sound, performance-based, coordinated with other regulations, and attuned to the complexity of the existing distribution system. Reasonable regulation eliminates unnecessary costs and hurdles that can hamper the ability of the industry to reliably bring supplies of affordable energy to all Americans.

Setting performance standards. Setting environmental performance standards and allowing industry to meet them as efficiently as possible is common sense, but government has sometimes prescribed to industry where and what kind of pollution controls or methods should be used. For example, when the 1990 Clean Air Act Amendments were passed, they included a requirement for a cleaner-burning “reformulated” gasoline to be used in many larger cities. The law set a performance standard for emissions, but also gave the industry a recipe for making the new fuel. Reformulated gasoline had to contain a certain percentage of oxygenate in each gallon produced.

The oxygenate requirement added to the cost of the fuel without increasing its environmental effectiveness, which was already assured by the emissions performance standard. While the oxygenate mandate created business for ethanol producers and other manufacturers of oxygenates, it penalized consumers, who purchase more than 40 billion gallons of the costlier-to-manufacture gasoline each year.21

Government has regulated prescriptively in other areas, with the same inefficient results, as an examination of benzene controls at an Amoco refinery in the state of Virginia illustrated some years ago. The regulations required the refinery to operate an enclosed canal and water treatment system to trap benzene emissions from wastewater. The cost of

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the system was about $31 million. Had the refiner had to meet a performance standard for the same amount of benzene reduction—however and wherever he could achieve it—he could have installed benzene controls at the facility’s loading docks for a cost of about $6 million.

Assuring adequate benefits. Regulations do more harm than good if benefits fail to equal or exceed costs. In 1996, the economist Robert W. Hahn, now Director of American Enterprise Institute-Brookings Institute Joint Center for Regulatory Studies in Washington D.C., calculated that only 23 of 54 federal environmental, safety and health regulations issued between 1990 and 1995 could pass a cost-benefit test based on the government’s own numbers and that eliminating those regulations could save $115 billion, money that could go to consumers or be more productively invested in other environmental projects.22

Cost-benefit analysis is not easy or without controversy, but in Hahn’s view it is “ a highly worthwhile analytical tool that can and should be used to improve decision making and set better regulatory priorities.”23 Unfortunately, government is often reluctant to employ cost-benefit analysis or avoids it completely. For example, the federal Clean Air Act requires setting the nation’s air quality standards without regard to cost. Thus, the U.S. Environmental Protection Agency (EPA) set the new federal air quality standard for ozone close to background levels, requiring the elimination of virtually all man-made emissions at huge potential cost. At the same time, there was no reasonable expectation of substantial benefits. Dr. George T. Wolff, the director of the U.S. EPA’s own Clean Air Scientific Advisory Committee, advised the agency before it acted that the research showed that the new standard would not be “significantly more protective of public health.”24

Ultimately, regulations must not only meet a cost-benefit test, they must make sense in the broader scheme of social investments. Resources are limited. Prioritizing their use is necessary to get the biggest bang for the taxpayer’s buck. Bjorn Lomborg, author of The Skeptical Environmentalist, warns that a failure to prioritize “means that we abandon the opportunity of doing the best we can. A lack of prioritization, backed by however many good intentions, can in the final analysis result in the statistical murder of thousands of people.”25

Coordination and streamlining of rules. The quantity and complexity of new overlapping regulations could affect the reliable flow of products to consumers. Simultaneous implementation of regulations can involve enormous investments over a relatively short term. For example, the U.S. downstream industry estimates that capital investments to reduce sulfur in gasoline and on-road diesel fuel will total about $16 billion (in addition to possible other large investments) over the same period.26 These costs could affect supplies. According to a study conducted by Charles River Associates on the

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impact of the diesel sulfur rule, some refiners may choose to shut down facilities rather than make the investments. The study projected that the production of on-road diesel could temporarily fall short of consumption by 12 percent nationally, potentially leading to sharp, regional price increases.27

Overlapping regulations also threaten the reliability of supplies in a second way. A generation or two ago, refineries made few different types of products. Gasoline made anywhere in the United States could be marketed anywhere in the United States, making it easier to adjust to local supply disruptions. Today, because of increasing federal, state and local fuel regulations, product types have multiplied and markets have become isolated. The United States has become a nation of boutique fuels, with 17 different varieties on sale (not counting different octane grades). (See figure 3.) This balkanization of the motor fuel market was an important factor in the price volatility experienced in parts of the Midwest in the late spring of 2000.

The cleaner burning reformulated gasoline that was being introduced in the region then had to contain ethanol, making it harder to manufacture. When refineries configured to produce it experienced difficulty making adequate quantities, it was not easy to find alternate sources. As a result, supplies became very tight, pushing up prices. Some consumers and elected officials accused the industry of misconduct. However, as subsequent investigations determined, the causes of the price spikes, including the introduction of the hard-to-make new fuel, related to the market and other factors beyond the ability of companies to control.28

Allegations of collusion or other misconduct have often followed periods of price volatility in the United States, but more than 20 government investigations of U.S. companies over the past two decades have failed to find any illegal behavior.

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U.S. Gasoline Requirements

Federal, state and local gasoline specification requirements have created a patchwork quilt of boutique fuels

Figure 3

Conclusion In an increasingly regulated world, the need to regulate more wisely is of paramount importance. This is demonstrably true for regulation of the energy industry, which bears major responsibility for fueling economic progress. Energy is a vital input to economic growth. Affordable, available energy facilitates that growth, increasing the well being of all, making it easier for society to achieve its goals, including a cleaner environment, healthier population and safer workplace.

The best regulation accomplishes its objectives while minimizing costs. It is both effective and efficient. The best regulation of the energy industry should stand on a foundation of sound science, be performance-based, and return benefits equal to or greater than its costs. It may never be possible to achieve all goals all the time, no matter how sensibly we regulate. However, despite the real progress regulation has brought, it has too often fallen short of good sense. We need to do better, and we can.

Notes

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1 Petroleum Supply Annual 2000, Volume 1, U.S. Energy Information Administration. 2 Petroleum Marketing Association of America. See opening page of their website at http://www.pmaa.org/. 3 Market Facts, 2001, p. 114. 4 Financial Reporting System Public Data, S5212.xls, U.S. Energy Information Administration, at http://www.eia.doe.gov/emeu/finance/frsdata.html. The data, which are taken from reports from 32 companies, are for 1999. 5 Stephen P.A. Brown and Mine K. Yucel, writing in the Federal Reserve Bank of Dallas’ Economic and Financial Review, third quarter 2000 (“Gasoline and Crude Oil Prices: Why the Asymmetry,” p.25), say “there does not appear to be much evidence of monopolization in any segment of the gasoline market…. The market share claimed by the four largest gasoline refiner/marketers (37.7 percent), as well as a relatively low Herfindahl-Hirschman Index of 650, suggests that U.S. gasoline production is competitive when viewed at the national level.” The U.S. Department of Justice at http://www.usdoj.gov/atr/public/testimony/hhi.htm advises, “Markets in which the HHI [Herfindahl-Hirschman Index] is between 1,000 and 1,800 points are considered to be moderately concentrated, and those in which the HHI is in excess of 1,800 points are considered to be concentrated.” 6 National Petroleum Council letter to U.S. Secretary of Energy, 8-30-93. 7 Volatile organic compound, carbon monoxide, lead, nitrogen oxide, sulfur dioxide and particulate emissions. 8 National Air Quality and Emissions Trends Report, 1999, U.S. Environmental Protection Agency, March 2001 (see emissions tables in Appendix A). The data show cuts in on-road highway emissions account for about two-thirds of the total reduction. 9 Latest Findings on National Air Quality: 2000 Status and Trends, U.S. Environmental Protection Agency, September 2001, p. 2. Vehicle miles increased 143 percent 1970-2000. A comparable number for 1970-1999 was not available but should be about the same. 10 These figures were calculated using U.S. Bureau of Labor Statistics data. 11 U.S. Petroleum Refining: Assuring the Adequacy and Affordability of Cleaner Fuels, National Petroleum Council, June 2000, p. 33. 12 Annual Energy Review 1999 (Table 5.9, Refinery Capacity and Utilization, 1949-1999), U.S. Energy Information Administration. 13 How Much We Pay for Gasoline: April 2001 Review, American Petroleum Institute, May 2001, pp. 13-14. The conversion to Australian dollars was based on an exchange rate on 1/14/02 of 1.936 Australian dollars per U.S. dollar. 14 The American Petroleum Institute: An Informal History (1919-1987), American Petroleum Institute, March 1990, p. 60. 15 Regulatory Restrictions on Vertical Integration and Control: The Competitive Impact of Gasoline Divorcement Policies, Michael G. Vita, Deputy Assistant Director, Bureau of Economics, Federal Trade Commission, July 21, 1999, p. 1. 16 Letter from William S. Ratchford, II, Director, Department of Fiscal Services, to the Maryland General Assembly, November 30, 1988. 17 Vita, p. 22. 18 Vita, p. 23. 19 Vita, p. 23. 20 The Impact of State Legislation on the Number of Retail Gasoline Outlets (Research Study #062), American Petroleum Institute, October 1991, p. 8. 21 Approximately one-third of the eight million barrels of gasoline Americans consume each day is reformulated gasoline. 22 Risks, Costs, and Lives Saved: Getting Better Results from Regulation, Robert W. Hahn, Washington D.C., 1996, p. 239. 23 The EPA’s True Cost, Robert W. Hahn, The Wall Street Journal, June 27, 1996, p. A18.

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24 Letter from Wolff to Carol Browner, Administrator, U.S. Environmental Protection Agency, November 30, 1995, p.3. 25 The Skeptical Environmentalist: Measuring the Real State of the World, Bjorn Lomborg, Cambridge University Press, 2001, p. 350. 26 Assuming a five-year investment period, this equals the refining sector’s recent capital spending levels. Examples of other investments that could add significantly to this total include (not a complete list) possible requirements to reduce sulfur in off-road diesel, to phase out the oxygenate MTBE (methyl tertiary butyl ether), and to blend large amounts of ethanol in gasoline. 27An Assessment of the Potential Impacts of Proposed Environmental Regulations on U.S. Refinery Supply of Diesel Fuel, Charles River Associates, Inc., August 2000, p. 6. Premcor, Inc. shut down its Blue Island, Illinois refinery in January 2001, citing the high investments needed to make lower sulfur fuels. The company said its facility “does not generate a return sufficient for us to justify the additional investment.” See January 17, 2001 Premcor news release, “Premcor to Close Blue Island Refinery” at http://www.premcorinc.com/press/newsrelease. 28 In a June 16, 2000 memorandum, the U.S. Congressional Research Service cited steadily rising crude oil prices, the difficulty of making the new gasoline, pipeline problems, low crude and gasoline inventories, and concern about infringing a cleaner-gasoline patent held by one refiner.