Fracking: Anatomy of a Free Market Failure

A recent New York Times article reported that rural landowners who had signed leases with gas and oil companies exchanging drilling rights on their property for royalty payments have discovered that they may have been misled. Many are now experiencing buyers regret. A review of more than 111,000 leases, addenda and related documents by The New York Times revealed:

• Fewer than half the leases require companies to compensate landowners for water contamination after drilling begins. And only about half the documents have language that lawyers suggest should be included to require payment for damages to livestock or crops.
• Most leases grant gas companies broad rights to decide where they can cut down trees, store chemicals, build roads and drill. Companies are also permitted to operate generators and spotlights through the night near homes during drilling.
• In the leases, drilling companies rarely describe to landowners the potential environmental and other risks that federal laws require them to disclose in filings to investors.
• Most leases are for three or five years, but at least two-thirds of those reviewed by The Times allow extensions without additional approval from landowners. If landowners have second thoughts about drilling on their land or want to negotiate for more money, they may be out of luck.

If all this sounds reminiscent of ex post revelations about predatory lending in the housing market that contributed to our recent housing bubble and crash, it should. It is the classic tale of fast-talking salesmen working for well-heeled companies taking advantage of  disadvantaged individuals who are less than fully informed about the options presented to them.

A follow-up article in The Times detailed the battle between town and state governments over who will, or will not police the exploding market in fracking leases. “As energy companies move to drill in densely populated areas from Pennsylvania to Texas, battles are breaking out over who will have the final say in managing the shale gas boom. The fight, which pits towns and cities against energy companies and states eager for growth, has raised a fundamental question about the role of local government: How much authority should communities have over the use of their land?” A second interesting question addressed in the article is what communities are opposing fracking and why? “Only a small minority of towns in Pennsylvania’s Marcellus Shale area — about 80 of approximately 1,800 — had, or were developing regulations, and most of them were affluent.” The spectacle of only the wealthy proving capable of protecting themselves from predatory businesses is as old as capitalism itself.

A Living Experiment in Economic Decision Making

Social scientists often cite the handicap that we are not permitted to conduct experiments on humans as an excuse for why social science advances more slowly than the physical sciences. But fracking provides an interesting social experiment playing out right before our eyes. In Pennsylvania, gas and natural resource companies have been sufficiently powerful to prevent passage of a statewide ban on fracking; as a result 8000 permits have been issued and 4000 wells dug since 2008. Just across the Delaware River, New York State has issued a temporary ban on fracking in Marcellus Shale pending release of a study and new regulations by the New York State Department of Environmental Conservation. The issue has become so controversial that the NYSDEC report may now be delayed until 2013.

As a result, south of the Delaware River in Pennsylvania some private landowners are signing fracking leases with gas companies, some are refusing to do so, and where the latter outnumber the former, some towns have begun to pass their own local, anti-fracking laws putting them on a collision course with the state over who has the legal right to regulate. North of the Delaware River in New York there is no fracking, some residents are pleased that what they consider to be an environmental and health hazard has been prevented, while others are complaining that their freedom to contract however and with whomever they please has been stolen from them. We have a classic case of government regulation in one state vs. market freedom in another state. Which arrangement for making decisions is proving to be more democratic, more efficient, more fair, and last, but not least, more environmentally sustainable?

The Economics

Many cite economic theory to support claims of market efficiency. The fundamental theorem of welfare economics states that markets allocate scarce resources and distribute goods and services efficiently – but only under very restrictive conditions. As is often the case, the devil is in the details. As the market for fracking leases reveals, we neglect the necessary assumptions behind “fundamental theorems” at our peril. What any economist can tell you is that the efficient markets theorem is true only if: (1) All markets are in equilibrium. (2) All buyers and sellers have perfect knowledge. (3) All buyers and sellers behave rationally. (4) All markets are perfectly competitive. And last, but not least, (5) there are no “externalities” in any markets. The real world conditions that satisfy these conditions are the exception not the norm. Moreover, the first theorem of welfare economics says nothing about whether or not outcomes will be fair. Even if an outcome is “efficient”, it still may well be grossly unfair if efficiency gains are distributed inequitably.

Market Bubbles: Right now everybody knows that energy sources are key to our economic future, but nobody knows what sources will turn out to be the “winners” or “losers” in the short, medium, or long-run. Unless renewable sources dominate in the long-run, most knowledgeable observers believe we are in a lot of trouble. But what energy sources will dominate in the medium and short-run is very much up in the air. Again, scientists may tell us that unless renewables are playing a dominant role in the medium-run, and a much more important role in the short-run than they currently do, we are in more trouble than we should find comfortable. But betting odds on whether that will prove to be the case are much less certain than scientific opinion about what needs to happen.

What role does natural gas play in this scenario? To make a long story short: Oil has peaked, coal is plentiful but most likely to lead to cataclysmic climate change, and natural gas is cleaner than coal but a fossil fuel nonetheless. Which is what makes betting odds on the role natural gas will – as opposed to should play – in our energy future so difficult to predict. If wise political forces seize control over energy policy it will play a limited role, and only as a “bridge technology” as renewables replace all fossil fuels ASAP. If the fossil fuel industry continues to exert as much political power as it has over the past hundred years, natural gas may become the new “king” for many decades.

This is the stuff that market bubbles – and crashes – are built on. So, get ready for a roller coaster ride! The odds that we will see a great deal of volatility in the natural gas market are high. Economics tells us that market bubbles and crashes leave a great deal of economic inefficiency in their wake.

Perfect Knowledge: Perfect knowledge means actors know what all relevant prices are and will be, and correctly predict what the consequences of any choice they make will be for them. In light of the uncertainty explained above about what role natural gas will play in the short, medium, and long-run as a source of energy, clearly energy companies as well as landowners must operate with less than perfect knowledge about key prices. It is also surely the case that energy companies can predict more accurately what the consequences of drilling will be than landowners can. So we not only have imperfect knowledge about prices for both buyer and seller in the market for fracking leases, we have asymmetric knowledge about consequences of drilling as well. Economic theory predicts that imperfect knowledge creates inefficiency and asymmetric knowledge creates additional inefficiency along with inequity.

Rational Behavior: Many take economic theory to task for assuming actors will behave rationally – defined as behavior that best serves a decision maker’s own interests – when sometimes it is obvious they do not. I believe we can rely on large energy companies to more consistently behave in accord with their own self interest than small rural landowners always do. However, in this situation I suspect that when landowners fail to act “rationally” they do more good than harm! The most prevalent irrational behavior rural landowners are exhibiting in Pennsylvania is refusing to sign fracking leases out of solidarity with their neighbors who would be harmed, even though a lease would benefit them individually. Such individually irrational behavior promotes more, rather than less efficient outcomes by preventing leases with negative expected net social benefits from being signed – as explained below.

Market Power: Landowners in rural New York and Pennsylvania are often hard pressed to make a go of it as farmers, and alternative employment in the rural Northeast is hard to come by, particularly since the onset of the Great Recession. In Eastern Oregon where many farmers are also hard pressed, there are energy companies offering to pay royalties to farmers to allow them to erect wind turbines on their property. In both cases powerful corporations who will play a big role in tomorrow’s energy markets are negotiating via an army of smooth talking salesmen with landowners, many of whom are desperate for income and know far less about the true market value of what they are selling than energy companies do about the true market value of what they are buying. In both cases large corporations will more than likely get the better of many deals, which will generate inequities — like the buyer’s regret stories reported in the New York Times.

Both wind turbines and fracking operations disturb what we might call a landowner’s rural solitude to some extent, albeit in different ways. However, in the case of fracking the downside risks for landowners are greater since fracking can also pollute one’s own well water. Presumably, any negative personal consequences are what landowners weigh in the balance when negotiating and deciding whether or not to sign leases. So we would expect landowners to require somewhat greater compensation to allow fracking than wind turbines on their property. But if the knowledge and market power asymmetry is the same in Oregon and Pennsylvania one would expect roughly the same degree of inequity in the contracts negotiated in both cases.

The importance of knowledge and power asymmetries is illustrated by the fact that most of the communities in Pennsylvania attempting to ban fracking through local regulations are affluent. Affluent communities can afford the time and money to investigate the risks of fracking more thorougly to reduce knowledge asymmetry. Affluent communities are also not so desperate for additional income that they are willing to risk damaging their health and high property values.

Externalities: But far and away the most important reason the free market solution to fracking yields undesirable outcomes is because there are significant external costs unaccounted for in the market for fracking leases:

• As a fossil fuel, natural gas contributes to global warming even if it is cleaner than burning coal. And if methane, which is a more potent greenhouse gas than carbon dioxide, leaks from wells as new studies suggest, the effects on global warming may be even worse.
• Fracking has also been associated with earthquakes.
• The risk of contaminating well water is not confined to the land of the lease, but extends to neighbors’ wells and can potentially damage an entire aquifer. A major reason the NYSDEC report is delayed is concern over contaminating the water supply for New York City.

In contrast, when leases for wind turbines are signed in Oregon there are significant positive externalities associated with substituting a clean renewable source of energy for a dirty fossil fuel. So while there are positive externalities associated with erecting wind turbines there are multiple negative externalities associated with fracking, and consequently when all the external effects are taken into account wind turbines yield more social benefits than the market signals, whereas fracking yields less social benefits than the market would lead us to believe. Therefore, economic theory predicts that when we leave the decision about fracking to individual negotiations between energy companies and landowners many deals will be struck with expected negative net social benefits. (Economic theory also predicts that absent any subsidy, when we leave the decision about leasing wind turbines to individual negotiations between energy companies and landowners, many deals will fail to be struck even though they have expected positive net social benefits.)

If economic theory predicts that because of asymmetries in information and market power the free market solution to fracking will lead to inequitable outcomes; if economic theory predicts that because of multiple externalities the free market solution to fracking will lead to inefficient and possibly dangerous outcomes; if economic theory predicts that numerous external parties with significant interests at stake will be disenfranchised by the free market solution to fracking, what are we to do instead? Common sense would suggest we should proceed as New York State has thus far.

Common Sense Solutions

(1) Undertake more research to investigate how great the negative consequences from fracking may be, how high the probability of damage is, and place the burden of proof on those who argue that dangers are minimal. In other words, apply the precautionary principle. This is a situation where there is no need to rush. The gas trapped in the shale is not like a crop that could rot in its silo, but will only become more valuable with time.

(2) Only if it turns out that the dangers are minimal and the benefits of natural gas as a transition fuel are substantial, should the technology known as fracking be allowed. Otherwise – as is quite likely the case – fracking technology should remain banned just as we ban other technologies where the risk to the public interest is simply too great.

(3) If, after careful research and testing the state determines that fracking should be permitted, it should be strictly regulated by government to ensure that it is done safely. The safety of fracking operations should be guaranteed by the state, not left to be negotiated by energy companies and individual landowners since landowner ignorance about possible consequences is too great, and many more than the landowner will be affected if something goes wrong. And of course, to avoid moral hazard energy companies should be held fully liable for any and all damages due to unforeseen events.

(4) If fracking is permitted standard leases should be negotiated between the state government and energy companies specifying that most of the royalties go to the state treasury, with only enough to compensate for inconvenience going to individual landowners and affected communities. This is the only lease individual landowners should be free to sign or not sign. Moreover, if local communities wish to pass ordinances banning such contracts they should be free to do so.

In the case of fracking the resource we are talking about possibly exploiting — if and only if we are sure it can be done safely — is gas trapped in shale rock deep under tens of thousands of square miles of land owned by hundreds of thousands of landowners. Hydraulic fracking on a piece of property is drilling into this vast shale formation to insert pressurized water and chemicals to break open pockets of trapped gas for capture. Increasingly “horizontal drilling” extends past property lines, and even when drilling is “vertical,” much of the gas captured is gas released from an area extending far beyond the property lines of the lease. Moreover, the amount most owners paid for their property does not reflect its potential value as a fracking site because this possibility was not widely foreseen when the land was purchased. An unforeseen technology has generated a large potential windfall gain for any who happen to own land through which a hole can be punctured. There is no reason the public at large should not seize this windfall. Capturing this windfall for the citizens of the state is not unfair to property owners and generates no perverse incentives. One could even make a good case that the bulk of the royalties should go to the national rather than state treasuries, but we can leave that to be debated later.

In conclusion, New York State, which has chosen to ban a dangerous new technology with very large potential risks to the environment and human health until such time as it is proved safe beyond reasonable doubt, is pursuing a much more equitable, efficient, and environmentally sustainable course than is Pennsylvania, which is allowing fracking to proceed under free market conditions that a careful reading of economic theory predicts will lead to unfair, inefficient, and quite likely dangerous outcomes that are irreversible.

Robin Hahnel is Professor Emeritus at American University and Visiting Professor of Economics at Portland State University.