Will raising the minimum bid in federal oil and gas lease auctions boost auction revenue?

The short answer to the title question is probably not.

In the Department of the Interior’s rulemaking docket concerning the financial terms governing oil and gas leasing on federal lands, a handful of comments endorsed the idea of raising the minimum bid in lease auctions as a way to increase federal revenues. But, as explained below, under current law raising the minimum bid could increase or decrease total government revenue generated.

Raising the minimum bid can have the effect of increasing the winning bid on some properties, so generating a higher bonus payment from the successful bidder. Presumably this is the direct effect that proponents of the idea have in mind. At the same time, a higher minimum bid means that some properties will not attract bids in the auction and instead be offered for non-competitive leasing after the auction. Parties securing non-competitive leases do not pay a bonus, so these properties yield lower federal revenues. Under existing regulations, royalty rates and other terms are mostly identical whether the lease is sold at auction or the property is leased non-competitively. Depending on whether the increased revenues from higher bonus bids is greater than the lost revenues from more properties becoming leased non-competitively, total revenue will either rise or fall.

In any case, relatively few properties likely would be affected by an increased minimum bid. Good prospects already sell at auction for higher than the current minimum bid or any likely raised minimum bid—often much, much higher—so bonus payments on those properties would be unchanged. Marginal properties already do not sell in auction at the existing minimum bid and become offered non-competitively. Revenue from those properties would also be unchanged. Only in the narrow range between “good” and “marginal” as described will the higher minimum have an effect, sometimes increasing revenue and other times decreasing it.

The narrowness of the opportunity to increase federal revenues by raising the minimum bid can be emphasized by noting that revenues only increase for cases in which the minimum bid is increased to a point higher than the second highest willingness to pay among bidders but lower than the highest willingness to pay. In cases in which the existing minimum bid is below the highest willingness to pay but the increased minimum bid is higher than that value, revenue will fall. In other cases revenue is unaffected by the change in minimum bid.

We can pin down the various effects on revenue analytically.

Call the existing minimum bid “MB” and the proposed higher minimum bid “MB+”. Assume each potential bidder comes to the auction with a maximum willingness to pay in mind for each property. Call the bidder with the highest maximum willingness to pay bidder A and the bidder with the second highest willingness to pay bidder B. Assume non-strategic bidding (i.e., bidders A and B are willing to bid up to their maximum willingness to pay in any auction in which that maximum is greater than the minimum bid). Leases are offered in an ascending price auction.

Therefore, so long as bidder A values the lease at a value greater than or equal to the minimum bid, bidder A wins the auction at a bid fractionally higher than bidder B’s maximum willingness to pay or at the minimum bid level, whichever is higher. If bidder A wins the auction, then bidder A pays the winning bid (termed the “bonus payment”). If bidder A’s value is below the minimum bid level, the lease is not sold at auction and becomes available for non-competitive leasing and no bonus payment is made.

We can describe the possibilities in the following way (simplifying by using A to stand for the maximum willingness to pay of bidder A, and similarly for bidder B).

  1. If B < A < MB < MB+, then the lease is not sold by auction and becomes available for non-competitive leasing both under the existing minimum bid and under the higher minimum. Revenue is unaffected.
  2. If MB < MB+ < B < A, then the lease is sold at auction at fractionally above B, both with the existing minimum and with the higher minimum. Again, revenue is unaffected.
  3. If MB < B < A < MB+, then the lease would have sold at auction at fractionally above B under the existing minimum bid, but would be leased non-competitively at the higher minimum bid. These properties will yield less revenue.
  4. If MB < B < MB+ < A, then the lease would be sold to bidder A at just above B under the existing minimum bid, but will be sold to bidder A at the higher MB+ under the raised minimum bid. These properties yield higher revenue.
  5. If B < MB < A < MB+, then the lease would have sold to bidder A at MB but now will be leased noncompetitively. These properties will yield less revenue.
  6. If B < MB < MB+ < A, then the lease would be sold to bidder A at MB under the lower minimum and at MB+ under the higher minimum. These properties yield higher revenue.

These six cases exhaust the possibilities. We can conclude that revenue will increase if added revenues from cases 4 and 6 are greater than the reduction in revenues from cases 3 and 5.

That is to say, revenue will increase in cases in which MB+ is greater than B but less than A, but revenue will decrease in cases in which MB is less than A but MB+ is greater than A. Or, restating the “narrowness” conclusion from above, revenues increase only in cases in which the minimum is raised to a level that is higher than B but below A—in all other cases revenues are unchanged or reduced.

We can estimate the net revenue effects of a higher minimum bid.

Or rather, if we had detailed auction data from recent lease auctions, then we would be in the position to estimate the net revenue consequences of a higher minimum bid. With sufficient information from auctions values for A and B could be estimated for various properties and the effects of higher minimum bids could then be simulated.

NOTES

Related earlier posts

Information on the rulemaking process

DOT’s airline price gouging investigation and a political economy-based prediction

On Friday, the U.S. Department of Transportation announced it had launched an investigation into possible “unfair practices (e.g., price gouging) affecting air travel during the period of time that Amtrak service along the Northeast Corridor was delayed or suspended as a result of the May 12th derailment.” Five airlines received letters from the agency seeking information on prices for travel between airports most affected by the derailment. CBS News in New York had the story, as did many other media outlets.

In the statement released by the DOT Transportation Secretary Anthony Foxx said, “The idea that any business would seek to take advantage of stranded rail passengers in the wake of such a tragic event is unacceptable. This Department takes all allegations of airline price-gouging seriously, and we will pursue a thorough investigation of these consumer complaints.” The DOT was responding to consumer complaints and a letter from U.S. Senator Chris Murphy (D-CT).

Pure political theater.

The law DOT cites, 49 US Code § 41712, allows the department to investigate whether an airline “has been or is engaged in an unfair or deceptive practice or an unfair method of competition in air transportation or the sale of air transportation.” In the event the department finds price gouging, the sole remedy present in the law is to order the airlines to stop. Given that rail travel was restored after five days, prices have already returned to normal. No meaningful remedy is possible…

…unless DOT wants to go big: rather than finding the prices constituted unfair practices, the DOT could conclude that the airlines’ computerized pricing algorithms constitute unfair practices and order airlines to cease employing them. The airlines’ dynamic pricing systems are not popular with consumers, so they might make an appealing political target. Such a response would be meaningful, in that it would impose significant costs on airlines to reform their systems, but is such a conclusion likely?

The word “unfair” is not defined in the law; the DOT said it relies upon the U.S. Federal Trade Commission’s Policy Statement on Unfairness for a working definition. The policy statement provided a three factor approach to fairness. considering: (1) consumer injury, (2) violation of public policy, and (3) unethical or unscrupulous conduct. In practice the FTC relies only on the first two factors.

Under the policy, apparent consumer injury is judged against the commercial benefits associated with the trade practice. While dynamic pricing is unpopular with consumers, it is profitable for airlines. In addition, it likely produces prices and service quality that are, on average, better for consumers than otherwise. A balancing of apparent harms and apparent benefits should tilt in favor of dynamic pricing.

Here is my political economy-based prediction:

After a month or two the DOT will report finding that airline prices did jump suddenly after the derailment as demand for air travel jumped up. They will observe that initial price spikes resulted from airlines’ computerized pricing mechanisms and did not reflect an intent to “take advantage of stranded passengers in the wake of such a tragic event.” They will note that airlines responded by adding flights and pressing larger aircraft into service. The report will conclude temporary price spikes reflected the ordinary workings of supply and demand under short-lived extraordinary circumstances. No finding of unfair practices will result, and no trade practices will be condemned.

While the announcement of the investigation produced a lot of press, the release of the report will produce little press. A finding of “ordinary workings of supply and demand” is not newsworthy.

What is more, the DOT already knows this answer. It already believes there is nothing to find in the data it is requesting. Still, a Senator wrote a letter — by the way Senator Murphy sits on the Senate subcommittee that oversees the DOT budget — and the DOT responded.

The Senator himself, too, either already knows this answer or simply has not thought too hard about it. But why should he think about a future no-news report? The announcement of the investigation and the press that the announcement garnered, that was the goal. The rest is noise.

[Thanks to Tom Konrad for bringing the story to my attention.]

Dallas Morning News on competitive retail power market fees and rate designs in Texas

At the Dallas Morning News James Osborne reports on the controversy over minimum use fees in the competitive retail power market that includes most Texas households. As discussed here at Knowledge Problem last week, retail suppliers sometimes design contract offers to be especially cheap for consumers using 1000 kWh per month. The state’s powertochoose.org website defaults to presenting offers from low to high by the average cost of power at exactly 1000 kWh per month. Minimum use fees can be used to help boost an offer to the top of the ranking.

Minimum use fees are sometimes controversial — consumers feel penalized for conserving resources — and the Texas state legislature looked into the issue earlier this year. Osborne wrote:

During this year’s legislative session, Rep. Sylvester Turner, D, Houston, introduced a bill banning retailers from charging customers for using too little power. Power companies quickly lined up against the bill, arguing the fees were essential to the financial health of the retail industry, which must navigate wide swings in wholesale power prices. The legislation never made it onto the House floor.

But Osborne noticed, “For some companies, the controversy presents an opportunity.” He explains retailers offer an increasing variety of plans – some with free nights and weekends for example, others designed to accommodate solar panels, and still others that reward conservation over consumption.

A Houston Chronicle analysis in January 2015, link below, concluded over 70 percent of the contract offers for the Houston area included minimum use fees, but then nearly 30 percent of the offers did not. Consumers simply need to understand a bit about their own power consumption and shop accordingly.

Related:

Gaming the rankings on the Texas Power to Choose website

To help provide consumer information on competitive retail offers in the Texas electric power market, the Public Utility Commission of Texas maintains a website at www.powertochoose.org. Enter your zip code, click a button, and it will display the top ten (out of nearly 300) offers.

Because the table shows the lowest priced offers first, with the average calculated assuming 1000 kWh of energy consumption, companies can compete for the front page by minimizing their average price at exactly 1000 kWh. But as it turns out, the low cost offer at exactly 1000 kWh of consumption may not be the low cost offer for consumers using a little bit less or a bit more than 1000 kWh.

For example, when I search for downtown Houston (zip code of 77002) the website tells me there are 290 plans available. Click “View Results” and at the top of the table is Texans Energy’s “12 Month Texans Choice” plan at an amazing 4.3¢ per kWh (for comparison, the U.S. average residential power price is around 11¢ or 12¢ per kWh).

But check the offer’s “Electricity Facts Label”: Texans Energy obtains the top spot via a rate design of 10.8¢ per kWh but tossing in a $65 credit if usage falls between 999 kWh and 1200 kWh during the billing cycle. The usage credit creates a low-price sweet spot at 1000 kWh. (The second result is Texans Energy’s similarly designed “6 Month Texans Choice” plan.)

The rest of the first 10 results work similarly to blend in a bill credit kicking in around 1000 kWh to create a low-price sweet spot at that consumption level:

  • Power Express’s “#Super6” rate at an amazing 4.4¢ per kWh, which they produce via 12.4¢ per kWh rate with an $80 bill credit for consumers using more than 999 kWh.
  • Pennywise Power’s “Wise Buy Conserve 6 Plus” also showing 4.4¢ per kWh. Their rate includes a usage credit of $25.00 per cycle for consumption between 999 and 2001 kWh.
  • Discount Power “Prime 24” showing at 4.5¢ per kWh, obtained with an 11.04¢ per kWh and a bill credit of $65 for consumers using more than 999 kWh in a billing cycle.
  • Gexa Energy’s “Gexa Choice 6” showing at 4.5¢ per kWh. The rate includes a “monthly service fee” of $14.95 for consumption of less than 1000 kWh and a “residential usage credit” of $25 for consumption of more than 999 kWh.

Also showing on the first page of the Power To Choose results: The Frontier Utilities “Frontier Credit Back 3” plan similarly offers a $60 credit for usage of more than 999 kWh per month. Our Energy “Our Optimal Residential Plan” also offers an $80 credit for usage greater than 999 kWh per month.

Clearly rates are being designed for prominent position on the Power To Choose website. No doubt these offers are good deals for consumers who regularly consume at or a little above the 1000 kWh level and watch their usage. But because the consumer bill will jump significantly at consumption levels just below 1000 (and in some cases above either 1200 or 2000 kWh), they could be surprisingly expensive contracts for consumers who are not so careful.

The power to choose

But the consumer has the “power to choose.” On the results page the viewer can select estimated use levels of “500 – 1,000 kWh,” “1,000 – 2,000 kWh,” and “more than 1,000 kWh.” The selection re-sorts the results based on average price estimates at the 500, 1,000, and 2,000 kWh usage levels. (The middle is the default.) Consumers who use less than 1000 kWh monthly can easily find a contract good for them, perhaps the Infinite Energy “Conserve and Save 3-month” offer that includes a $9.95 credit for consuming less than 1,000 kWh and averages just 4.2¢ per kWh at 500 kWh!

A little different deisgn is 4CHANGE ENERGY’s “Value Saver 6,” which has a per kWh rate that drops between 500 and 1000 kWh usage, but jumps by nearly 5¢ per kWh at 1001 kWh. The effect is that of a rolled-in billing credit that grows in size with usage from 500 to 1000 kWh. The average rate is 8.6¢ per kWh at 500 kWh, drops to 4.9¢ per kWh at 1000 kWh, but rises to 7.6¢ per kWh at 2000 kWh. Unlike many of the above rate designs, however, the “Value Saver 6″ does not have sharp jumps up or down.

Don’t like complications? Maybe Discount Power’s “Saver – No Gimmicks No Minimum Usage Fee – 24″ plan is for you. Just as described: no minimum usage fee, just a fixed flat rate that averages about 8¢ per kWh.

Gaming is good

Overall, the competition is good for consumers. These supplier games may create traps for unwary customers, but consumers in Downtown Houston currently have 290 contract offers from over 50 different suppliers to choose among. Most residential consumers in the competitive retail part of Texas have a similar number of opportunities. It is easy to avoid the traps!

These suppliers offer contracts that differ across many margins: fixed price vs. variable, flat price vs. time-of-use, different levels of renewable content, pre-paid or not, terms ranging from 1 month to several years. On the other hand, Texas residential consumers outside of the competitive region (either because outside of ERCOT or because served by a municipal or coop utility in ERCOT that opted to stay out) are lucky to see more than two or three different options from their local monopoly utility. These offers might include a fuel cost adjustment tracking wholesale costs to a degree, and might get adjusted annually. But dynamic? No. Competitive? No.

The competitive retail electric power market for residential consumers in Texas is probably the most dynamic one around. With a little care consumers can avoid the gimmicks and find a pretty good deal.

HT: Big thanks to the economically-savvy anonymous tipster who brought the gamesmanship to my attention.

Al Roth’s new book on matchmaking and market design

Alex Tabarrok reviews Al Roth‘s new book, Who Gets What — and Why: The New Economics of Matchmaking and Market Design, in the Wall Street Journal. An excerpt:

Most economic theory focuses on commodity markets, in which anyone willing to pay the price gets the good and anyone not willing to pay the price doesn’t. In matching markets, price isn’t the only determinant of who gets what. Willingness to pay the price is one determinant of who gets into Harvard but not the only one. Willingness to accept a certain wage is one part of who gets a job but not the only one. In some cases, such as assigning kidneys to dialysis patients, price isn’t part of the equation at all—at least in the United States.

Mr. Roth’s work has been to discover the most efficient and equitable methods of matching and implement them in the world. He writes with verve and style, describing many market malfunctions—from aboriginal tribes in Australia arranging marriages for children not yet born to judges bending every rule in the book to hire law clerks years before they have graduated from law school—and how we ought to think about them.

Mr. Roth’s approach contrasts with standard debates over free markets versus government regulation. We want markets to be thick, quick, timely and trustworthy, but without careful design markets can become thin, slow, ill-timed and dangerous for the honest. The solution to these problems is unlikely to be regulation legislated from on high. Instead what Mr. Roth practices is nuanced market design created mostly by market participants.

We have discussed Roth’s work and market design topics many times here at Knowledge Problem (link to links). Tabarrok mentions the review at Marginal Revolution. Al Roth’s Market Design blog is here.

NOTE: If the WSJ link does not work for you, here is a link to review on the Mercatus website.

Social costs of oil and gas leasing on federal lands, carefully considered

OVERVIEW: A report filed with the US Department of the Interior recommended that terms governing the leasing of federal land for oil and gas development be updated to reflect social costs associated with such development. While such costs may be policy relevant, I suggest social costs are smaller than the report indicates and the recommended policy changes are not well focused.

The U.S. Department of the Interior (“Interior”) has begun an effort to update financial terms for oil and gas leases on federal lands. These financial aspects – royalties, minimum acceptable bids, annual rental rates, bonding requirements, and penalty rates – are collectively referred to as “government take.” One issue raised in the effort concerns social costs associated with oil and gas development on federal lands. (As noted earlier, Shawn Regan and I have filed a comment with Interior on the issue.)

THE HEIN REPORT

Social costs of such development are also among issues addressed in a report filed in the Interior rulemaking docket by Jayni Foley Hein of New York University’s Institute for Policy Integrity. The report provides an overview of the legal requirements governing government take and recommends Interior’s regulations be revised to reflect option value and social costs. Here I focus on social costs.

Hein said social costs are imposed by oil and gas development on federal lands both during development and during production. She wrote:

America’s public lands offer millions of people a place to hike, camp, hunt, fish, and enjoy scenic beauty. They provide drinking water, clean air, critical habitat for wildlife, sites for renewable energy development, as well as natural resources including timber, minerals, oil, and natural gas. As soon as energy exploration begins, competing uses of federal land such as recreational enjoyment, commercial fishing, and renewable energy development are impaired, and continue to be foreclosed for the duration of production.

Hein listed the following social costs of oil and gas activity on federal lands*:

  • Loss of use values (including loss of recreational value, renewable energy development potential, timber value, scenic value, and wildlife habitat)
  • Local air pollution (local effects of methane leakage, emissions from diesel or gas-fueled pumps and other engines)
  • Global air pollution (methane leaks, carbon dioxide)
  • Induced earthquakes from disposal of hydraulic fracturing wastewater
  • Potential oil or wastewater spills and subsequent water contamination from wastewater stored in pits and tanks
  • Noise pollution
  • Increased traffic (wear and tear on roadways, traffic-related fatalities).

She recommended increasing rental rates and royalties to reflect social costs associated with development and production of oil and gas on federal lands.

GETTING SOCIAL COSTS RIGHT

Naïve application of Hein’s list would likely produce significant over-counting of social costs. Regan and I described social costs as “the sum of all future benefits foregone by one or more persons due to oil and gas development activity on federal lands.” We were imprecise. We cannot simply sum up all possible future foregone benefits, but rather we should focus on the difference in benefits between two specific cases: one case with oil and gas resources leased for development, and a second case in which the land is not leased.

The social costs of oil and gas leasing is the sum of the specific incremental differences in the stream of future benefits associated with the land leased for oil and gas development as compared to the best alternative use. Specification of the second case is key. Assume, for example, that if the property is not leased for oil and gas development, then it would be leased for PV solar power development. Leasing the land for PV solar power also involves some loss of timber value, wildlife habitat, recreational value, and so on. In counting the social costs of oil and gas leasing associated with, say, wildlife habitat, we need to focus on just the difference in wildlife habitat between the two cases. If recreational use is impaired equally, the loss of recreation value is not properly counted as a cost of oil and gas leasing.

Consequences, or rather, the differences in consequences beyond the property itself matter too. It is likely holding a specific tract of property out of oil production has no effect on total world oil production and consumption, and therefore there would be no difference in total air pollution, traffic, potential for oil leaks, and so on. Withholding a particular property out of development primarily would affect the location, not the total amount, of these costs. Location can matter: we likely do not want to increase traffic and local air pollution in already crowded areas. But location does not always matter: the greenhouse gas implications are the same whether a methane leak arises from development on federal land or elsewhere.

SUMMING UP

A careful identification of the social costs of oil and gas leasing associated with specific federal properties would reveal these social costs to be smaller than a naïve application of Hein’s list may suggest. Federal oil and gas policies governing the government take primarily affect the distribution of social costs, not the total amount. Most relevant social costs are highly localized to the area of development, a feature which should make them easier to manage.

Other issues arise with Hein’s proposal to increase rental rates and royalty rates to account for social costs. While charging a higher royalty rate, for example, would discourage development of federal lands at the margin, it would not encourage operators to minimize social costs on properties that are developed. Other policy levers may be more useful.

*NOTE: The list of social costs is my summary drawn from Hein’s report. We might dispute aspects of the list, but for purposes of this post I am more interested in the social cost concept rather than the particular items listed.

How should the BLM reflect social costs when leasing federal lands for oil and gas development?

In April the U.S. Department of the Interior issued an advanced notice of proposed rulemaking (ANPR) seeking comments on a handful of economic issues surrounding the leasing of federal lands for oil and gas development. Most of the questions raised in the ANPR concern aspects of the “government take” – the royalty rates, minimum bids, annual rental rates, bonding requirements, and non-compliance penalties – arising from the leasing program.

One of the questions asked raises a broader point: “Should the [U.S. Bureau of Land Management (BLM)] consider other factors in determining what royalty level might provide a fair return, such as life cycle costs, externalities, or the social costs associated with the extraction and use of the oil and gas resources? If the BLM should consider such factors, please explain how it should do so.”

In a public interest comment recently filed in the ANPR docket, Shawn Regan of the Property and Environment Research Center and I suggest an answer to this question on social costs. Quoting from our comment:

Federal lands offered for oil and gas leasing often contain a wide range of non-energy characteristics. If the BLM could accurately determine the full social cost of developing energy resources for each property, in principle the value could be employed as a property-specific minimum acceptable bid in the lease auction. Such a change would ensure that properties are developed only when the value of the energy resources produced is expected to be greater than the value of the environmental benefits sacrificed.

Two problems arise. First, under current federal law BLM is constrained to employ a single minimum acceptable bid nationwide. Second, and more importantly, federal lands are potentially valued for a wide variety of use and non-use values, some of which values complement each other and some of which conflict. No method reliably integrates the variety of diverse, predominantly subjective, and sometimes conflicting values into a single, uncontroversial auction reserve price.

We suggest that these subjective and conflicting values could be incorporated into federal land practices by direct participation of recreation, environmental, and conservation groups in oil and gas auctions. Should these groups desire that a property be held out of development, they simply need to outbid oil and gas developers in the lease auction.

In this system, the highest bid from a conservation group serves as a reserve price. An oil and gas developer would have to bid higher than the highest conservation group bid to obtain the lease. Should a conservation group bid the highest, it obtains the rights to either develop oil and gas resources or hold the property out of development. The greater the conservation values at stake, the greater would be the likely bids from conservation groups. The process would at least in part mimic a system in which the BLM could measure the social costs of oil and gas development and employ that measurement as a minimum bid price in the lease sale.

We do not claim our suggestion would work perfectly, only that it provides an approach to bringing social costs into the leasing system and no administrative system would do a better job. Our proposal is not fully developed in the comment filed, but we do address a few obvious questions.

Feedback appreciated, so take a look and let us know what you think.

So far only one other “academic-y” comment filed in the docket. Jayni Foley Hein of the NYU School of Law submitted a detailed report, “Harmonizing Preservation and Production: How Modernizing the Department of Interior’s Fiscal Terms for Oil, Gas, and Coal Leases Can Ensure a Fair Return to the American Public.” (Have not had a chance to read it yet.)

By the way, the deadline for comments in response to the ANPR has been extended to June 19, so if you have a view on social costs or the government take associated with oil and gas leasing on federal lands, feel free to let the Department know how you feel.

Related Knowledge Problem posts include: