In this series, I'll game-out strategies of different anti-fracking groups. Should the environmental movement compromise on watered-down regulations, or instead take a radical stand against the fracking industry's very existence?
In November, the city council of Carbondale, Illinois voted unanimously for a resolution to join other cites across the state in advocating for a moratorium on fracking. "Carbondale has taken a stand for public health and the environment," said Bruce Ratain from Environment Illinois, "Now it's time for Illinois to stand up for them and communities statewide by passing a moratorium." [1] Environment Illinois is part of a coalition of groups, including the Sierra Club and SAFE, fighting for a fracking moratorium. Their bill is currently before the legislature. So far there have not been major fracking developments in the state, but Industry experts believe there are large gas deposits in Southern Illinois. [2] Will the Industry start fracking in Illinois, or be scared away from investing by the possibility that it could be banned in the near future?
We'll outline what would happen if the Environmental Activists said they will not negotiate on fracking regulations until a ban is in place. In Illinois, the anti-fracking bill would actually only establish a moratorium, which has an expiration date, rather than an indefinite ban. But for now, the consequences of a total ban are simpler to model, and will demonstrate the same principles (I'll game-out a moratorium in Part Four.)
Imagine a typical scenario in a state like Illinois, where the Industry is currently not fracking but it wants to start soon. Investing in fracking would require big up-front costs like finding gas deposits and drilling wells. It would be years before these wells were profitable. Before the Industry decides to make this investment, the Environmental Activists mobilize a movement to pre-emptively ban fracking. If the ban were to pass after the Industry had already invested a bunch of money into fracking, the Industry would lose everything it spent on the up-front fixed costs, but make none of the profit. So if the Industry thinks a ban would have a good shot at passing, they'd be less likely to invest in new fracking sites.
Here's the game tree:
Recall V represents the Gas Industry's potential profit from fracking without regulations. But in part one and two, we assumed the Industry was already fracking, so they'd already paid for the up-front costs, which the Industry hasn't yet paid in states like Illinois. Let's say these fixed costs are F dollars. So the most they can make is V - F dollars.
If the Industry decides not to invest, then obviously they make zero dollars, whether or not a ban passes.
If the Industry does decide to invest in fracking in the state, then the Activists' campaign to ban fracking will continue onward and we've said that they won't negotiate until after the ban passes. Let's say there's a probability of p that fracking will be banned in the next few years, before newly built fracking operations become profitable. So that means the probability is ( 1 - p ) that a ban will fail to pass. If fracking were banned, the Natural Gas Industry would offer the environmentalists any amount regulation to legalize fracking again, even though every new regulation would cost them money. Recall that C represents the cost the regulations impose on the Industry as a percentage of V, what they'd make from their investment without regulations. So C = 0 is total deregulation and C = 1 is a total ban.
The goal of these "frackitvists" is to have as little fracking as possible. Ideally they would ban it ( C = 1 ), or else impose the strictest -- and therefore costliest -- regulations they can get. Because the more it costs to frack, the less fracking they'll be. So we'll represent these environmentalists' payoff as equal to the regulatory cost C, which they want to be as close to C = 1 as possible. If the Industry never invested in fracking in the first place, then this would be a de facto ban, so the environmentalists' payoff would also be 1.
If the Activists accepted the offer, then the Industry will make V (1 - C ) - F dollars, which is their profit from fracking after regulatory costs have been imposed and they've paid for the all fixed costs. But after the ban is in place, the environmentalists would have no reason to agree to a compromise that allowed any fracking at all. So the Industry would expect that if a fracking ban passed, then they'd lose 100% of their initial investment, so their profit would be negative F dollars.
If, on the other hand, the fracking ban failed to pass before their wells became operational in Illinois, then the Industry would be free to extract natural gas without any regulations. So their profit would be V - F dollars, i.e. the return on fracking minus the fixed costs.
The Industry's expected profit from investing in fracking is the average of their profit in each of two possible outcomes, one in which fracking is banned and one in which it is not, weighted by the probability that each outcome will actually occur:
p ( - F ) + ( 1 - p ) ( V - F )
Multiplying this expression out, then canceling like terms gives us:
- Fp + V - F- Vp + Fp
V - Vp - F
V ( 1 - p ) - F
The Industry will decide NOT to invest in fracking if their expected profit from investing now is less than than their expected profit from not investing, which is zero dollars, so:
V ( 1 - p ) - F < 0
V ( 1 - p ) < F
So the higher the probability of a ban, the smaller the expected profit from investing in fracking. If this expected profit value becomes smaller than the fixed costs of investing, then the Industry won't invest. This result means that in an industry with such high fixed costs, if the probability of a fracking ban passing is great enough, the threat of passing a ban is in-and-of-itself enough to prevent the Industry from ever investing in fracking in the first place. This is important strategically, because as long as the Gas Industry hasn't started fracking in Illinois, the environmental movement still has time to push for a ban or moratorium. And if a fracking ban were actually passed, the Gas Industry would agree to whatever environmental regulations they had to in order to lift the ban.
Often environmentalists aren't able to put in place an indefinite ban, but succeed in establishing a temporary fracking moratorium. In part 4 of this series, we'll look at how the negotiations change after a moratorium is passed. Read part 4 >>
