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

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