Tame oil's wild price ride with a tax

Volatile oil prices keep energy companies from investing in alternatives.

With the onslaught of high oil prices, war in the Middle East, an increasingly bellicose Iran, and the aftermath of hurricane Katrina, energy security has reemerged as a major public policy priority.

We have been here before, and the responses from elected officials have been quite predictable: find scapegoats (usually the oil companies), demand subsidies for the energy technology of the month, and point out that the country lacks a coherent national energy policy.

Give it a few years, however, and the sense of urgency will fall in tandem with the price of oil and we'll go back to business as usual. Presidents from Richard Nixon to Jimmy Carter to George W. Bush have all made similar pledges and yet progress in many of these areas over the past 30 years has been paltry at best. Why?

The answer is quite simple: Oil prices can rise rapidly and fall rapidly. The price of oil skyrocketed in 1980, but a decade later it was 50 percent less. In 1998, the average world price was $12.53 per barrel. Today it is five times more.

A company or a bank looking to put its money behind new technologies or alternative energy fuels is not going to base its investments on today's price, but rather on conservative assumptions about how far the price of oil might fall three to five years from now.

Further, the lure of government subsidies is not as enticing as one might think. The financial landscape is littered with the remains of bankrupt companies who counted on government programs to help them market cutting-edge energy technologies, only to see those programs vanish when oil prices fell. If the price of gasoline drops by 40 percent, what are the chances that government support for alternatives to gasoline - such as ethanol from cellulosic grasses - will be as avid as it is today?

It is true that the oil market in the next two decades may be burdened with many more dangers to our economy and our security than in the past. Compounding this threat is the looming reality of climate change and its implications for US energy systems. If we are serious about these problems, we need to accept the reality that the end of the era of cheap oil may be upon us. We can allow OPEC (the Organization of Petroleum Exporting Countries) to dictate the consequences or we can gain greater control of our energy destiny. This will require us to resurrect the "T" word. Yes, I mean taxes. We can choose from a growing menu: higher gasoline taxes, energy taxes, carbon taxes, or taxes on imported oil.

At first glance this may seem politically naive. With gasoline prices hovering around $2.73 a gallon and predictions of even higher prices to come, the chance that our political leaders will pass a gasoline tax in an election year is nil. An alternative would be for the government to set a floor price for oil and then tax the difference between that floor price and the actual price. If oil remains above the floor, there is no tax, but if oil prices drop below it, investors, entrepreneurs and inventors all will know that there will be a market for their products at the floor price. Revenue from the taxes can either be used to accelerate the development of new energy technologies or to offset other taxes.

For this to be successful, a tax needs to be designed so that elected officials do not get cold feet and revoke the bottom price at the last minute. At a minimum, this will mean designing the floor so that it mirrors our best guess as to the security, environmental, and economic premiums that we now pay for imported oil.

The United States has avoided addressing its "addiction to oil" for 30 years. To continue to do so may be flirting with severe political and economic consequences. We need to get serious about the problem. This means creating a marketplace that is receptive to alternatives to our present oil addiction.

Alternative energy companies that will be making our future energy investments are inhibited by oil price volatility. Unless the US can induce these institutions to invest in new energy technologies, the country is doomed to live through a continuing cycle of oil spikes, economic dislocations, and energy insecurity. We have an opportunity to take a step toward reasserting control of the oil marketplace. We would be wise not to squander it.

• Henry Lee is the director of the Environment and Natural Resources Program in the Belfer Center for Science and International Affairs at Harvard University's Kennedy School of Government.