The Market Is Responding to the Oil Shock

By Rod Hunter
Tuesday, July 8, 2008

The leaders of the G-8 and of major developing countries will discuss how to respond to energy security and climate change tomorrow. Their first instinct will likely be to propose new regulations. Yet market forces may already be solving these problems, as high oil prices drive a shift away from the polluting, petroleum-fueled internal combustion engine to cleaner forms of transportation.

That's a change worth cheering, even if oil prices are painful in the meantime. Oil is the United States' principal transportation fuel, and the source of a third of the country's greenhouse gas emissions. Other major countries are similarly dependent on oil for transportation. As prices have risen, worries about energy security and long-term climate effects have reached a fever pitch.

History teaches that innovation directed by markets can solve problems such as these. In New York at the end of the 19th century, horses were the main form of transport – and a major source of pollution. As many as 200,000 horses each produced 15 to 35 pounds of manure per day. Manure piles along the roads and in stables produced vast numbers of flies, an important vector for infectious diseases such as typhoid fever. Horses became increasingly expensive, thanks to rising prices for hay, oats and the urban land required for stables.

Initially the automobile wasn't much competition for the horse. Then, around the turn of the century, a series of innovations involving the internal combustion engine and manufacturing (mass production, assembly lines and interchangeable parts) improved performance, reliability and costs. As car prices fell, the horse, the manure and the "typhus fly" were done for.

The same thing may be happening today. This March, American entrepreneur Elon Musk started production of his electric sports car, the Tesla. This car accelerates from 0 to 60 miles per hour in four seconds, tops out at 125 mph, and has a range of 220 miles. The $110,000 price tag limits the Tesla to the wealthy, but mass-production models are in the works. General Motors has committed itself to rolling out its electronic vehicle, the Volt, by 2010. Toyota plans a successor to its popular Prius hybrid.

Recent cost comparisons by Deutsche Bank's auto analysts suggest electric cars will be cheaper to operate than conventional vehicles. Fuel costs per mile for gasoline-fueled cars are $0.27 in Germany, $0.24 in Britain, $0.17 in Brazil and $0.11 in the U.S., with differences driven by local fuel taxes. For electric vehicles, the cost per mile is a mere $0.02. Adding in a battery amortized over the life of the car, the cost is still only $0.10. Batteries will be expensive, at least in early years, but electric cars won't need costly engines or complex transmissions like today's autos.

Cost differentials like those could drive a quick transition to energy-efficient forms of transportation. There would surely be failures along the way – even Henry Ford had a couple of flops and an encounter with bankruptcy before making it big with the Model T. And it would take a while to replace the existing transportation fleet made up of cars that last 15 years.

Nonetheless, incremental effects on oil demand could be powerful. Developed countries would grow less dependent on oil producers, and transportation-related greenhouse gas emissions could ease (even coal-fired power plants are better than millions of gasoline-powered autos). As costs fall, electric vehicles could be adopted in developing countries, amplifying energy security and climate benefits.

The transition would reduce the world's dependence on regimes run by thugs and theocrats. More than 80% of proven reserves are controlled by national oil companies and Russian firms, which don't operate like normal profit-maximizing businesses. (Witness Russian threats to turn off gas supplies to Ukraine and Eastern Europe.) High oil prices have corrupted countries with weak institutions and reinforced misbehavior of international miscreants such as Iran and Venezuela.

Regulation and taxes can of course shape market incentives. But regulation comes with unintended consequences – the more complex the regulation (think cap-and-trade), the more scope for undesired consequences. High oil prices, as unpleasant as they are, are making a lot of alternative energy and transportation technologies look attractive. The petroleum-powered auto has provided affordable independence to millions for a century, but has brought its own problems. Innovation and markets could well send the internal combustion engine and its oil-related worries the way of the horse and buggy.