-- John Kemp is a Reuters columnist. The views expressed are his own --
By John Kemp
LONDON, Dec 8 (Reuters) - China's decision on Friday to link domestic fuel prices to the international price of crude oil, but increase consumption taxes on gasoline and diesel sharply to spur more efficient use of energy in the medium term, raises the question whether the incoming Obama administration might be tempted to do the same.
China is taking advantage of a cyclical pull back in energy to push through a permanent structural increase in taxes and prices. The aim is to combine a short-term boost to the economy with longer-term and more consistent incentives for improving energy efficiency.
By consolidating a series of tolls and administrative charges into a single, easy to collect consumption tax, the government is simplifying the tax system, creating a new source of revenue, and ensuring the change will have no impact on the politically sensitive inflation rate.
More importantly, it creates a fairly simple mechanism for raising energy costs further in future to spur additional efficiency gains, irrespective of cyclical changes in the crude oil price.
Once short-term economic weakness is past, the government can easily raise the consumption tax progressively over the next few years.
In effect, the tax breaks the link between the government's energy efficiency programme and short-term oil-market movements.
NEW ADMINISTRATION PRIORITIES
Across the Pacific, the incoming Obama administration has made clear improving energy efficiency is also one of its highest priorities.
The president-elect's future national security adviser, General James L. Jones, has been working on energy issues for an affiliate of the U.S. Chamber of Commerce since retiring as NATO's supreme allied commander in Europe. He made clear in a recent interview improving energy security would be one of his central objectives, marking an unusual extension of the adviser's traditional role.
The incoming administration faces several related challenges, however:
-- It needs to maintain the recent trend towards smaller and more fuel efficient motor vehicles, even though retail gasoline prices have halved in less than six months.
-- It needs to find a way to increase the volume of ethanol blended in the gasoline supply, even though ethanol is now more expensive than fossil-fuel gasoline, and mandated volumes are running up against the technical limits of the U.S. car fleet (the "blending wall").
-- And it needs to find a way to continue providing incentives for developing alternative energies (such as advanced biofuels and oilsands) as well as alternative power sources (fuel cells, electric vehicles).
VOLATILITY DEGRADES PRICE SIGNAL
The common problem is that short-term price volatility threatens long-term strategic planning by both energy producers and consumers.
Adam Smith's theory of the "invisible hand" has price changes acting as a signal to ration demand and encourage supply.
Policymakers have long accepted that inflation can interfere with these signals by making it hard for consumers and producers to distinguish between a relative change in prices and incomes (to which they should respond) and a general rise in the price and income level (to which they should not).
Inflation introduces "noise" into the price mechanism, making it hard to extract signals correctly.
Extreme price volatility can have the same impact. Large price movements and repeated price reversals leave producers and consumers uncertain about the correct response.
The problem is worse in sectors such as energy where changes in consumption and production involve long-time lags and costly investment.
The oil price surge in 2006-2008 was widely interpreted as a response to the threat of a long-term shortfall in supply (since there was no actual shortage of physical crude oil in the near term). It appeared to send a strong signal about the need to develop substantial new oil reserves, invest heavily in alternative fuels, and achieve massive increases in energy efficiency.
The subsequent collapse, including long-dated prices, seems to be signalling that these long-term high-cost investments will not be needed.
Producers and consumers are struggling to work out whether the market was right in JulY 2008; whether it is right now; or whether the world really has changed that much in less than six months.
A HELPING HAND FOR ADAM SMITH?
The incoming administration's public announcements indicate senior policymakers believe all these new and alternative fuel supplies will be needed. The question is how to maintain the efficiency drive and incentives for long-term investment during a period of price weakness.
Following China's example and raising fuel taxes is probably the most attractive mechanism.
By raising the long-term floor for domestic gasoline and diesel for any given level of international crude prices, it sharpens efficiency incentives and would maintain the pressure towards smaller and more fuel efficient vehicles.
Crucially, it could solve the problem of the blending wall. Most U.S. vehicles are able to run on a maximum 90-10 gasoline-ethanol blend (E10) that will limit the overall amount of ethanol blended into the fuel supply to around 12-13 billion gallons per year, and is likely to become binding in the next 18 months.
To meet the longer-term objective of blending as much as 36 billion gallons into the fuel supply by 2022, the administration will need to increase the number of vehicles taking higher 15-25 percent blends, or shift an increasing proportion of the car fleet to flexible-fuel vehicles running on a 15-85 gasoline-ethanol blend (E85).
The problem for policymakers is whether to go for a big-bang approach (pushing for widespread adoption of E85-adapted vehicles) or a gradualist one (increasing the standard blend to 15 percent, then 20 percent, etc).
Widespread adoption of E85 requires investments in an expensive pipeline infrastructure and new cars. Neither is likely unless distributors, pipeline companies and motor manufacturers can be guaranteed sufficient minimum demand for the fuel and associated cars.
The question is how to promote widespread adoption of higher 15-20 percent fuel blends and E85. One possibility is to make production of E85 vehicles a condition of any government rescue package for the major auto makers.
But rolling out E85 vehicles does not guarantee they will actually be filled up using E85 fuel. Federal agencies have been obliged to buy E85-capable vehicles since the early 1990s. Most are filled up with regular gasoline, owing to the lack of filling stations carrying E85 in most areas outside the Midwest. And at low gasoline prices, there is no guarantee ethanol will be competitive.
There must be a temptation to impose a sharply differential tax rate on the fossil fuel and ethanol components of gasoline to encourage higher blend rates or E85 vehicles, creating clear long-term incentives for switching to more ethanol use.
The main factor restraining policymakers is fear of advocating any tax increases at a time when households are struggling with mortgage payments and falling employment.
But the big pull back has created some headroom to raise tax rates and long-term energy costs while still allowing pump prices to fall in the short term.
Raising fuel taxes will therefore be a very tempting option for the new administration. It could be presented as part of an integrated energy efficiency, climate change and national security strategy, raising useful revenues to pay for some of the massive stimulus and speed the return to fiscal discipline in the medium term.
The question is less whether fuel taxes will rise substantially, but when.