The case for considering fuel surcharges

Last week over in Newsroom, I laid out the case against subsidising fuel use during a supply shortage. 

That case is sufficiently obvious that you wouldn't think it would need to be made. But the New Zealand Taxpayers Union really disgraced itself by urging those kinds of subsidies via reductions in petrol excise. Petrol excise already is inadequate to cover the cost of the roading network. Taxpayers already subsidise road use. The NZTU wanted even larger subsidies from taxpayers to road users when it is manifestly unclear that we will be getting more fuel shipments. 

The piece also made the case for just letting fuel prices rise rather than contemplating various kinds of rationing. Letting prices rise automatically culls the lowest-valued uses of fuel. Governments concerned about equity implications can transfer money to poorer people. This point ought to be obvious to any economist who's done intermediate micro and the welfare theorems. Always surprised to note which bank economists might have missed the lecture on the welfare theorems. 

And it then made a point that I don't think I'd seen others make. I think it's also obvious. Real option value matters. 

But I also worry about the Commerce Commission’s insistence that prices should only reflect current supply costs.

Consider an analogous problem faced by hydroelectric generators.

The ‘cost’ of running water through a hydroelectric dam in February is that the generator cannot run that bit of water through the dam again in July. Rain is always uncertain. Holding storage back, in case inflows are lower than expected, has value.

If fuel storage tanks might not be replenished because import routes are disrupted or exports are restricted, the ‘cost’ of fuel is not whatever notional price fuel companies contract with overseas suppliers. A litre used now might mean a litre that cannot be used in June. It is possible that everything resolves itself before then. But it is also possible that things turn considerably worse. The Strait of Hormuz is less predictable than hydro lake inflows.

The commission’s messaging risks confusing today’s sourcing cost with the value of fuel in storage. If replenishment is uncertain, the relevant cost of selling a litre today is not just what it cost to source, but the value of keeping it in reserve. That is like telling hydro generators to run the sluices in February despite the risk of a dry winter.

And that gets us to the case for fuel surcharges. 

I do not think it's any kind of knock-down case. I certainly don't have the background figures to be able to tell. And if the government is confident that its agreement with Singapore and alternative sources of supply are secure enough, then none of it's needed. But it can be worth thinking through in advance, just in case.

Suppose the storage tanks are at their normal levels. Prices have increased, mainly reflecting increased price of fuel being loaded onto transport ships. But each ship now carries some risk of being diverted before it reaches New Zealand. That risk means each litre in storage carries some real option value: there is some chance that using a litre from storage today means that there will not be a litre to use in May or June. 

All going well, fuel companies price this in. If the transports stop arriving, fuel in storage is far more valuable than the current price. Every fuel company ought to be weighing the price it can get for a litre of fuel today against the potential price that litre could get in future if kept in storage, weighted by the likelihood that future prices are higher. 

It'll be complicated, and there aren't great numbers to throw in as probabilities. But it's in-principle doable. Fuel companies should have strong incentive to get that right. If a litre of diesel is worth $20+ in June if transports stop arriving, then selling today for $3 would be a mistake if the risk of the bad scenario is high enough.

And in the first best, government is in constant communication with the fuel companies about the negotiations it's having with foreign suppliers, and fuel companies are always weighing that up alongside their own market intelligence (and odds at Polymarket etc). 

There is no case for surcharges in that first-best world. Everyone's already weighing up real option values and they're priced in.

Here are a few ways that can go wrong. 

1. Suppose companies think that they will be punished by the government for increasing prices today to reflect real option value, ahead of the risk materialising. They are not crazy to think that, given the kind of messaging that our populist Commerce Commission provided. In that case, they will choose some price lower than would otherwise be optimal. Their optimisation would be 'what is the highest price we can charge, below the actual optimal price, without drawing ire from the government?' 
2. Suppose companies think that they will be punished by the government for increasing prices to very high levels in future if transport stops. In that case, a company holding fuel back against that future risk (and potential future returns) isn't able to realise those future returns. The social value of holding fuel back for future use would be high, but the private return would be expropriated through government seizure of stored supplies or other forms of de facto expropriation. 
3. Even if the government were sensible, consumers may not be. Suppose one fuel company runs real-option-value pricing and another does not. The one charging higher prices today will be damned today for charging higher prices. The one that does not, will not. The one that charges higher prices today will be further damned if the bad state of the world obtains and they charge very high prices in June. The one that runs out will not be blamed for running out. How could they be blamed for running out? The Straits are closed. It isn't their fault. The one that really deserves blame is the one that 'profiteers' in June. Running real option pricing when others aren't means taking a hit to revenues today in expectation of higher returns in future if the bad outcome obtains. But the brand damage could be far higher than can be recouped, because approximately nobody is willing to think in real option value terms. This underlying mechanism is what drives populist government responses too.

I do not know what fuel prices reflecting real option value should be. But $3/litre diesel feels low when thinking about those risks. 

And that gets to the case for surcharges. If companies fear backlash for using real option pricing, government could set a surcharge reflecting the difference between actual prices and prices that incorporate that real option value. 

I'm not convinced by that case. And I have little confidence that government could get to the right number on it, even with smart people making their best efforts. But it seems worth thinking about. 

At a minimum, the government really shouldn't be saying anything that could be read as discouraging fuel companies from increasing prices. 

And the Commerce Commission's public messaging ought to be more around real option pricing. Saying the words 'real option pricing' would be a mistake. But I think enough people understand the hydro lakes to get the point? The generators hold water back when the lakes are high, resulting in higher electricity prices at that time of year, if they worry that the lakes will otherwise be too low mid-winter. If they didn't do that, we'd risk winter blackouts. And that's worse than higher prices when the lakes are high.