External Effects of Hydraulic Fracturing: Risks and Welfare Considerations for Water Supply in Germany

FCN Working Paper No. 4/2014 (revised August 2015)

51 Pages Posted: 25 Aug 2015

See all articles by Sebastian Loucao

Sebastian Loucao

RWTH Aachen University

Reinhard Madlener

RWTH Aachen University

Date Written: August 2015

Abstract

In this paper, we investigate the externalities related to hydraulic fracturing (‘hydrofracking’) in Germany, based on a detailed analysis of hydrofracking risks and potentials, and a stylized social welfare analysis related to adverse impacts of unconventional gas production on both surface and ground water resources and water supply. Natural gas is extracted by a profit-maximizing monopolist. Society faces several kinds of negative externalities, including additional water purification costs. The results of our sensitivity analysis show that the maximized welfare is in any case higher than the welfare resulting from the profit-maximizing quantities, as is predicted by our model. Also, the regulator always has to pay a subsidy in order to maximize welfare, which shows that the monopolist has an incentive to exercise his market power in order to keep the prices up for profit maximization. The monopolist’s profits are always non-negative, whereas the welfare-maximizing shale gas production generally reduces his profits. As profits do not drop below zero, however, there is no need to employ a second-best approach. We conclude that increasing costs and/or an increasing price sensitivity will lead to reduced profits and to reduced social welfare, while for an increasing choke price it is the other way around.

Keywords: Natural gas, Fracking, Externalities, Water supply, Germany

JEL Classification: L71, Q31, Q34, Q42, Q53, Q58

Suggested Citation

Loucao, Sebastian and Madlener, Reinhard, External Effects of Hydraulic Fracturing: Risks and Welfare Considerations for Water Supply in Germany (August 2015). FCN Working Paper No. 4/2014 (revised August 2015). Available at SSRN: https://ssrn.com/abstract=2650311 or http://dx.doi.org/10.2139/ssrn.2650311

Sebastian Loucao

RWTH Aachen University ( email )

Templergraben 55
52056 Aachen, 52056
Germany

Reinhard Madlener (Contact Author)

RWTH Aachen University ( email )

School of Business and Economics / E.ON ERC
Mathieustraße 10
Aachen, 52074
Germany
+49 241 80 49 820 (Phone)
+49 241 80 49 829 (Fax)

HOME PAGE: http://www.eonerc.rwth-aachen.de/fcn

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