Question

Hydraulic fracturing (fracking) is a technique that extracts oil and natural gas from underground by injecting pressurized liquids to create fractures in bedrock formations. In recent (pre-COVID) years, the fracking industry has experienced a boom in the United States and worldwide (in China, Australia, UK). Supporters argue that fracking leads to economy-wide benefits by increasing the supply of natural gas and thus lowering gas prices (by almost 50% from 2000 to 2010). This has led to economy-wide benefits for energy consumers, including residential, commercial, industrial, and electric power sectors, at an amount of $74 billion per year. In contrast, producers of existing wells lost $30 billion per year in revenue from the price decrease, and this loss was only partially offset by the gains associated with new wells, which totaled $4 billion per year.

Studies have also pointed out the environmental and social externalities from fracking practices, both at a local level and at a global level. The local externalities include the pollution of groundwater supply and air quality, decreasing agricultural productivity, and the increasing prevalence of crime, sexual assaults, and sexually transmitted diseases. Economists have estimated that the local environmental and social impacts amount to -$1,400 per household annually. Fracking practices also lead to global externality in the form of greenhouse gases emission, from methane leaks during the production process and from the combustion of natural gas. The economic impact of that ranges from -$0.7 billion per year (if natural gas substitutes coal) to $28 billion per year (if natural gas substitutes renewable energy sources), under a social cost of carbon at $40/ton of CO₂.

You are hired by the environmental protection agency (EPA) as a consultant, and they want to formulate a policy with respect to fracking. Given the information above (and any additional information at your disposal), please answer the following question:

1) Use an appropriate economic framework to analyze this problem

2) Make a recommendation to the EPA administrator as to what the best approach should be to regulate hydraulic fracturing

Answer 1

1. Hydraulic fracturing is a high tech method of extracting natural gas from 1000s of feet below the earth's surface. Even though fracturing has economic benefits worldwide, the huge externalities caused by it can't be ignored. Externalities include pollution of groundwater supply, air quality, agricultural productivity, increasing crimes, etc. Negative externalities are the effects of the production and consumption of the goods on a third party. On a global scale, the most severe externality is the emission of greenhouse gases that lead to environmental changes. On the local level, groundwater contamination is the biggest problem fracturing causes. When the producers ignore the negative externalities and the pricing of gas doesn't include the opportunity cost and the social cost associated with it, it is an exploitation of the resources. This will lead to the underpricing of gas will leads to both increased expansion of the market share of gas and also increased consumption of energy as a whole. This will lead to the overexploitation of resources and environmental concerns. This can be considered as a market failure.

2. Solutions: Different recommendations that can be considered to avoid these externalities or value these externalities are given below.

1. The pricing of the fractured gas has to account for the changing greenhouse emission.

2. A lifecycle approach has to be taken to understand the levels of emission in extraction, processing, storage, transportation, etc to understand the level of externalities in each level and regulating policies according to that.

3. Carbon taxes, Cap and trade, Quota limiting, or other mechanisms can be used to reduce the growth of demand and thereby reducing the global impacts. A carbon tax is a direct tax regulation to reduce the production and consumption of the commodity that generates so much externalities

4. Local externalities can be dealt with the compensation and Valuation criteria. Private negotiations are one way of compensating for the externalities. The company can provide compensation to the parties that are harmed by local externalities. The amount of compensation can be set by negotiation between those parties. The compensation has to fall between the maximum the fracturing firm is willing to pay and the minimum the communities are willing to accept.