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Einav Henenson Chris Conway Guadalupe Candanedo Robby Sittman Justin Pfledderer

Hydraulic Fracturing: Seeking Economic Solutions to an Incomplete Market

As with many advanced and complicated technologies, the term ‘further studies are

needed’ is often the regulatory commonality linking the economic need for the technology with

surfacing environmental and health concerns well after the technology is in full blown

application. The use of hydraulic fracturing as a means of expanding gas production in shale

rock formations is one of these technologies.

The oil and gas industry claims hydraulic fracturing is an economic necessity and is safe

in its current application. However, many environmentalists believe that gas production from

shale formations and the intensive use of hydraulic fracturing will potentially lead to a major

source of ground water pollution, while producing more greenhouse gas emissions than does

our current use of coal. Although there are many competing voices and diverse views, few

would argue that the current hydraulic fracturing process, which lacks complete information

and does not internalize all the costs of ill effects to producers, represents an incomplete

market.

Hydraulic Fracturing – The Very Basics of a Complex Technology

The process of hydraulic fracturing, known simply as ‘fracking’, is a well stimulation

technique that results in creating conductive fractures in low porosity and low permeability

rock. The process increases the area, or void space, from which natural gas and oil can be

recovered, thereby increasing flow and production capability of gas and oil wells to create

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economically feasible rates. In the context of this discussion, hydraulic fracturing is currently

used in unconventional resources such as coal beds or shale rock formations that generally exist

deep below the Earth’s surface from 5,000 to 20,000 feet. In the hydraulic fracturing process, a

mixture of water, sand, and a mix of chemicals is blasted into the wellbore at pressures that can

reach 15,000 psi and flow rates up to 100 barrels per minute in order to break up the rock and

free the gas (Montgomery & Smith, 2010). In addition to the 1 to 7 million gallons of water

required to drill the original well, the hydraulic fracturing process requires an additional 1 to 7

million gallons. Wells have been known to be fracked up to 18 times during their productive life

(Montgomery & Smith, 2010). It is generally believed that over 80% of the wells drilled today

are not economically feasible without the hydraulic fracturing process.

Changes in the last 10 years – Under the Radar

Heralded has a tried, true, and safe technology by the oil and gas industry, hydraulic

fracturing has been used for 60 years to stimulate millions of wells across the country (Energy

In Depth, 2010). However, the hydraulic fracturing process used in the last few years differs in

many ways and bears little resemblance from historic fracturing. The modern technique uses

higher pressures with increased water volume, the ‘frack job’ has a longer duration, the

chemical cocktail used in the process has become much more complex, and the combination of

hydraulic fracturing and horizontal drilling has added a huge new aspect to the process so that

a much greater area can be fracked per given well (Fox, 2010).

Under pressure to discover the next economic mechanism that would positively drive

the national economy and create jobs, Congress and the Bush Administration passed the 2005

Energy Act that essentially removed hydraulic fracturing from regulatory provisions of the Safe

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Drinking Water Act and EPA oversight. With the removal of federal government oversight,

regulation of hydraulic fracturing was then left up to the individual state governments

(Wiseman, 2009).

Shale Formations – The Game Changer

Interest in developing America’s shale formations began to manifest itself only within a

recent time frame, beginning with the drilling of the first test wells in the prolific Texas Barnett

Shale formation in the late 1990s. Soon to follow was the first test well in the Pennsylvania

Marcellus Shale in 2004 (Energy In Depth, 2010). Since then, the development potential of

North America’s deep shale formations has become enormous, possibly contributing trillions of

cubic feet of natural gas and creating thousands of jobs. Experts for the oil and gas industry

have compared the shale formations available in 30 states to a Saudi Arabia of natural gas. With

energy provider spokesmen touting the discovery as a game changer for our nation, our

economy, and safe for our environment, arguments against anything short of full scale

development are hard to find inside industry and government circles, or with desperate job

seekers.

Environmental and Social Costs – Costs Externalized to the Current Market

When addressing hydraulic fracturing environmental concerns, the first consideration

involves the three primary issues surrounding water: the large amount of fresh water required

for the fracking process, possible ground water contamination, and proper disposal of

contaminated water (flowback).

Water is an essential component of shale gas development. It is used for drilling where a

mixture of clay and water is used to carry rock cuttings to the surface, as well as to cool and

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lubricate the drill bit (Chesapeake Energy, 2010). With the amount of fresh water used to first

drill the well requiring up to 7 million gallons, and then to frack it which requires an additional 1

to 7 million gallons (Fox, 2010), it has become a major concern that gas production wells are

beginning to compete with local municipalities for precious ground water, especially in shale

formation areas of arid Texas. Although this extensive water use is permitted by and within

state regulations, many environmentalists and the concerned public are starting to question if

the sheer amount of water used in the process - which cannot be recycled - is the best and

most wise use of available water.

In a geologic sense, the deep underground shale formation areas where hydraulic

fracturing takes place are separated from aquifers by thousands of feet of permeable rock, thus

leading to the theoretical unlikelihood that hydraulic fracking fluid could directly contaminate

ground water sources. However, poor cementing jobs near the surface or near the wellhead are

of grave concern for drinking water contamination. Proper cementing of the well is one of the

trickiest and critical parts of the drilling process (Walsh, 2011). If done incorrectly, the pressure

from the fracking process and the gas can leak into the surrounding area, with the potential to

contaminate ground water. This was determined to be the case in Dimrock, Pennsylvania when

methane contaminated the water wells of 19 families. Although Cabot Energy claimed that the

methane was naturally occurring, they none the less compensated the families for the water

contamination damage. It should also be noted that a bad cement job around the wellhead was

one of the leading factors in the Deep Water Horizon rig blowout and subsequent BP Gulf oil

spill last year (Walsh, 2011).

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The initial fracking process produces millions of gallons of waste water, with an

additional 1 million gallons of toxic and briny wastewater produced over the lifetime of a

fracked well. Waste water retrieved from the well can contain highly corrosive salts,

carcinogens like benzene, and radioactive elements like radium that the fracking fluid comes in

contact with. This contaminated fracking water solution can never be used again by humans,

animals, or plants. Determining what to do with the waste water becomes the biggest challenge

to drilling (Walsh, 2011). In many of the western states like Texas, the geology allows for the

contaminated fracking water to be pumped back underground and stored. Pennsylvania’s

geology makes storing fracked water underground difficult (Walsh, 2011). As a result, drillers

often have to rely on municipal wastewater treatment plants to process the water. Often these

plants are not set up to process all contaminates from the fracking water, resulting in releases

of toxic water from the plants into surface water systems.

Much of the current concern with hydraulic fracturing surrounds the chemicals used in

the process. The Committee on Energy and Commerce launched an investigation to examine

the practice of hydraulic fracturing in the United States. They asked the 14 leading oil and gas

service companies to disclose the types, volumes, and chemical content of the hydraulic

fracturing products they used in their fluids between 2005 and 2009. It was discovered that the

14 companies use more than 2,500 hydraulic fracturing products containing 750 chemicals and

other components, not including the large amount of water added at well sites (Waxman,

Markey & DeGette, 2011). Some of these chemicals include benzene, lead, arsenic, copper,

vanadium, and adamantine, which have been known to cause cancer, kidney failure, anemia,

and fertility problems among other things. However, the most widely used chemical is

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methanol, which is a hazardous air pollutant and is on the candidate list for potential regulation

under the Safe Drinking Water Act (Waxman, 2011).

In addition, between 2005 and 2009, the oil and gas service companies used hydraulic

fracturing products containing 29 chemicals that are known or possible human carcinogens.

Studies have shown that anywhere from 20-40% of these fluids may remain underground,

contaminating the surrounding area for many years to come (Waxman, 2011).

There has been an array of complaints of toxic water pollution starting within the same

time frame as hydraulic fracturing events. People living in these areas are experiencing severe

headaches, loss of hair, breathing problems and other health issues due to toxins in drinking

water sources likely caused by nearby hydraulic fracturing processes that are not closely

monitored (Foxx, 2009). Wildlife near hydraulic fracturing sites has also been harmed as they

are exposed to toxins in both the air and water.

The exemption of hydraulic fracturing from the Clean Drinking Water Act externalized

many of costs and consequences of the process onto the shoulders of the environment and

society.

Correcting the Missing Market – Internalizing Costs

Through the analysis of the environmental and social issues, the hydraulic fracturing

process presents a missing market that allows for market inefficiency. The many potential social

costs and environmental damages that could result from produced water spills and

contamination are currently fully externalized to producers. Asymmetric information regarding

hydraulic fracturing has put more weight on the benefits of a “cheap” energy source than on

the costs of potential negative externalities. The result of any cost-benefit analysis undertaken

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in order to find an efficient level of fracking will have to combine the total costs internalized to

the industry, along with costs externalized to the environment and society. Any true cost-

benefit proposal would likely suggest higher internalized costs to hydraulic fracturing producers

and will result in a reduced amount of total fracking altogether.

Uncertainty – Variables that Paralyze Policy

With recent advances in hydraulic fracturing and horizontal drilling, secretive chemical

mixes, and changes in oversight policy, uncertainty surrounding all major aspects of hydraulic

fracturing is at an all time high. The current uncertainty manifests itself in a variety of forms

which can affect our society, environment, and the economy. Uncertainties include

technological advances, environmental damage, policy design and evaluation, and the costs

policies.

Technological advances – A great deal of uncertainty about future technological

advances within the hydraulic fracturing industry exists. The public should expect a

significant amount of technical advances associated with shale gas production that can

significantly improve the efficiency of the production process, as well as reducing the

environmental impacts (Kerr, 2011). As time passes, technology will develop that will

reduce potential environmental damage and social costs, as well as increase market

efficiency

Environmental damage - We as a society, our government, as well as the firms involved

in hydraulic fracturing, have no true idea of the adverse effects that can take place

within the environment due to the hydraulic fracturing process. Although negative

environmental and social events have already happened, understanding complete long-

term effects are currently out of our reach

Policy and design evaluation – With large uncertainty surrounding potential

environmental damage and societal costs, it becomes nearly impossible to design and

develop sound policy and determine evaluation and monitoring criteria that will best fit

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the hydraulic fracturing process. Poor policy design and development, evaluation, or

monitoring may have unintended consequences that make matters worse than better

(Keohane & Olmstead, 2007)

Costs of policy – Government policy at the level needed for authority over the

development of shale gas reservoirs will be costly in the least. It will be difficult for the

government to determine the necessary cost to monitor potentially hundreds of

thousands of gas wells. Transaction costs are sure to be large, given the large number of

people who could possibly suffer damages from externalities

It should be noted and highly understood that we are more uncertain about the affects

of hydraulic fracturing than we are certain. The high level of uncertainty combined with the

interweaved intricacies of any system, suggest that we currently lack sufficient information to

make sound economic, environmental, and social suggestions associated with hydraulic

fracturing.

Quasi-Option Value – A Precautionary Principle

Cost and benefits are rarely known with certainty, but uncertainty can be reduced by

gathering information. Any decision made now that commits resources or generates costs

which cannot be subsequently recovered or reversed, is an irreversible decision. In this context

of uncertainty and irreversibility it may pay to delay making a decision. The value of the

information gained from that delay is the option value or quasi-option value (OECD Library,

2011).

Although not a solution in itself, exercising this precautionary principle would allow for

uncertainty to be reduced by allowing time to gather information on the potential

environmental and social cost of the fracturing process, thus avoiding a decision that could

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potentially cause irreversible damage. Many states have utilized such a measure under the

terminology of ‘moratorium’ to halt hydraulic fracturing.

Concerned that the hydraulic fracturing process in the Marcellus Shale formations could

potentially endanger the New York City and Syracuse watersheds, the state of New York put

such a moratorium in place while the state’s Department of Environmental Conservation

studied the subject further (Navarro, 2010). Before the legislature agreed to lift the moratorium

in April of 2011, many new regulations were put in place, limiting the land areas where

hydraulic fracturing can occur, thereby protecting watersheds and aquifers (Hall, 2011). A

similar moratorium is still in place today within the state of New Jersey protecting the Delaware

River watershed and the drinking water supply of some 15 million people. Other states are

looking at the New York and New Jersey moratoriums and considering similar actions under the

guise of allowing the necessary time to clarify uncertainties.

With the EPA releasing an extensive time studied report that will likely clarify many

hydraulic fracturing uncertainties, along with suggesting national regulatory policy in early

2014, there is no better time than the present for natural gas development and hydraulic

fracturing players to consider exercising a quasi-option principle. However, it could be quickly

argued that the political will for such an approach does not exist at a national level.

Potential Economic Solutions – Seeking Sound Polices to Reduce Risk and Uncertainty

This report seeks policies that will address the current market failure and will benefit all

parties involved in shale gas production. It is hoped that regulators will have more complete

and accurate information, industry will achieve more efficient operations, and the public will

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see continuous, measurable improvements limiting negative externalities in shale gas

production activities.

Three key economic approaches are suggested:

Repeal the 2005 Energy Act clause that excludes the hydraulic fracturing process from

the Clean Drinking Water Act. This would also include oversight of the hydraulic

fracturing process under additional EPA acts designed to protect the environment and

public from adverse effects. This would be accomplished under the 2012 FRAC Act

Development of an ‘output based performance standard’ designed to limit potential

damage from production water

Development of a performance bond system allowing for clean-up in the case of

harmful surface spills and potential aquifer contamination

2012 FRAC Act – An Avenue for National Oversight

In Congressional policy circles, the future 2012 Fracturing Responsibility and Awareness

of Chemical Act (FRAC Act) represents the most prominent potential policy legislation to

address fracing concerns at the national level. The act would ultimately amend the Safe

Drinking Water Act, putting hydraulic fracturing and the chemicals used with the technology

back under the regulatory authority of the EPA. This authority was essentially stripped away

with the passing of the 2005 Energy Act. This would, in effect, take the issue away from the

fragmented state systems and bring the concern under one federal authority (Wiseman, 2008).

Currently the act is held up in the Committee on Environment and Public Works, but will either

be assured new attention in the upcoming Congressional legislative session, or held off until

2013 after the national election due to concern of not passing during the current Republican

control of the House of Representatives. Eventually the act will be addressed.

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The 2012 FRAC Act is, of course, highly opposed by the oil and gas industry on the

grounds of lost jobs and lost economic revenues. The preferred policy adjustment sought by the

industry would only include state level oversight and monitoring. With many states seeking

economic fixes to ongoing budgetary dilemmas, states are in need of tax dollars and are hoping

such a fix will come from the oil and gas industry through the expansion of shale gas

production. Authority held at the state level would allow the industry to retain greater control

over future policy utilizing the tax dollar argument as leverage.

Passing of the FRAC Act will also be economically advantageous to the public by

providing a judicial avenue for internalizing the external costs in third-party situations

(Tietenberg & Lewis: 2008: 504). Third parties are defined by Tietenberg & Lewis as victims who

have no contractual agreement with a potential polluter. In the case of hydraulic fracturing, a

third party would be any entity that is affected by point source or non-source point pollution,

and cannot bring any direct market pressure to bear on the source (Tietenberg & Lewis: 2008:

504). Since the hydraulic fracturing process is currently not under EPA authority, government

support and organization for third-party liability suits is limited at best. This leaves the affected

party on their own, facing the ‘lawyered-up’ oil industry with no government support for

proving wrongdoing. In principle, a judicial liability law avenue can force pollution producers to

choose efficient levels of precaution (Tietenberg & Lewis: 2008: 504) and can also act has a

third source of enforcement outside of the typical state and federal government agencies.

Output Based Performance Standard - Seeking Pollution Prevention while Utilizing ‘Best

Practices’ Technologies

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An output-based regulation (OBR) is a tool that can be used as part of a regulatory

strategy that encourages pollution prevention and the use of innovative and efficient

technologies. Typically, an output-based regulation, as it has been used in the past, is more

suited to an air emission regulation approach associated with electrical energy generation.

However, the concept can easily be converted to industrial water pollution and the hydraulic

fracturing process in general. An output-based performance standard utilized within the

hydraulic fracturing process would potentially reduce point source and non-point source

pollution. According to the EPA, output-based regulations are gaining greater attention as the

EPA, states, and regional planning organizations strive to find innovative ways to attain today’s

water and air quality goals (EPA, 2004).

The major benefit of an output-based pollution concept is that they encourage cost-

effective, long-term pollution prevention through the process of efficiency (EPA CHP, 2008).

Under an output-based pollution standard recognizing and rewarding efficiency within the

hydraulic fracturing process, benefits would include:

Reduced fracking fluid inputs – Encouraging water input efficiency will reduce the use

of fracking chemicals in volume and therefore total pollutant output

Multipoint emission reductions – Simply, less individual fracking chemical inputs result

in reduced overall chemical mix of pollutant outputs

Multimedia environmental reductions – By encouraging reduced fracking chemical and

water use, an OBR reduces water, air, and solid waste impacts that result from the

production, processing, and transportation during the shale gas development process

Technology innovation – Encourages more efficient, environmentally friendly, and

innovative fracturing technologies such as the recent industry innovations Chesapeake’s

Green Frac (Chesapeake, 2011), and Halliburton’s CleanStim Formulation (Halliburton,

2011)

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Compliance flexibility – Supporting the use of water efficiency as part of a pollution

control strategy provides regulated sources with additional compliance options by

allowing operators to determine internal variables that comprise the most cost-effective

way to reduce pollution output

Performance bonds – Insurance against the Inevitable

It is inevitable that even under the most stringent precautions, spills and contamination

during the hydraulic fracking process are likely to occur. In the past, when it came time for the

cleanup of toxic substance spill situations, responsible parties often either utilized the lengthy

and costly court system to alleviate costly damages, or declared bankruptcy to isolate

themselves from cleanup costs altogether. This approach externalizes the cleanup cost onto

society through taxpayer funds and government agency facilitators.

One proposed solution (Russell, 1988; Costanza and Perrings, 1990) would require the

posting of a dated performance bond as a necessary condition for disposing of hazardous

waste, or in the case of hydraulic fracturing, contamination, spills, or disposal of production

water. The amount of the required bond would be equal to the present value of anticipated

damages. Any restoration of the site resulting from a produced water leak or contamination

could be funded directly and immediately from the accumulated funds; no costly and time-

consuming legal process would precede receipt of the funds necessary for cleanup. Any unused

proceeds would be redeemable, with interest, at specific dates if the environmental costs

turned out to be lower than anticipated. Although performance bonds are similar to liability law

in their ability to internalize costs, performance bonds are different in that they require the

money for damages be available up-front (Tietenberg & Lewis, 2008, 519).

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A performance bond approach shifts the financial risk of damage from the victims to the

producers and by doing so, provides incentives to ensure a safe process (Tietenberg & Lewis,

2008, 520). Internalizing the costs of fracking fluid contamination and produced water spills

would sensitize producers not only to the risks posed, but also to the amounts of fracking fluid

used. Utilizing performance bonds also provides an incentive for fracking firms to monitor the

consequences of their choices because they will then bear the ex post burden of proving that

the processes utilized were safe.

Conclusion – Completing the Market

There is no doubt that hydraulic fracturing is economically necessary and that

development of shale gas formations is necessary in order for America to meet its future

energy needs. Due to the many recent events outlining and bringing awareness to hydraulic

fracturing, it can be ascertained that policy will be addressed at the federal, state, and local

levels moving into the future. As the U.S. considers how to address concerns with shale gas

exploration and production, it is crucial that our approach is grounded in a clear understanding

of the risks involved, the drivers of risk, and the many different interests that must be balanced.

New policy will ultimately lead to regulation that will carry more weight toward internalizing

the costs to producers, creating a more complete market.

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Keohane, N. & Olmstead, S. (2007). Markets and the Environment. Washington: Island Press Kerr, R. (2011, August 11). Federal Committee: Shale Gas Needs Openness, Better Data. Science Insider http://news.sciencemag.org/scienceinsider/2011/08/federal-committee-shale- gas-need.html?ref=hp Montgomery, C. & Smith, M. (2010, December). Hydraulic Fracturing: History of an Enduring

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OECD. (2006) Cost-Benefit Analysis and the Environment: Recent Developments, OECD Publishing. doi: 10.1787/9789264010055-en

Tietenberg, T. & Lewis, L. (2008). Environmental and Natural Resource Economics. New Jersey: Prentice Hall. P. 463-522.

U.S. Environmental Protection Agency. (2004, August). Output-Based Regulations: A Handbook for Air Regulators. Retrieved from http://www.epa.gov/chp/documents/obr_final_9105.pdf U.S. Environmental Protection Agency. Combined Heat and Power Partnership. (2008, March 8). Output-Based Environmental Regulations: An Effective Policy to Support Clean Energy Supply. Retrieved from http://chpcenternw.org/NwChpDocs/4_Factsheet_EPA.pdf

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Walsh, B. (2011, March 31). Could Shale Gas Power the World. Time Magazine. Retrieved from: http://www.time.com/time/health/article/0,8599,2062331-4,00.html Wilson, W. (2007, October 4). Letters from EPA Fracking Study Whistleblower. Earthworks: Protecting Communities and the Environment. Retrieved from: http://www.earthworksaction.org/publications.cfm?pubID=372 Wiseman, H. J. (2008, September 23) Untested Waters: The Rise of Hydraulic Fracturing in Oil and Gas Production and the Need to Revisit Regulation. Fordham Environmental Law Review. Vol 20. P. 115, 2009. SSRN: http://ssrn.com/adstract=1595092