ECONOMY

Assessment:

The economies of the world and of the United States are utterly dependent upon energy.  Energy powers our manufacturing plants, runs the computers of our information technology sector, underpins our research, keeps the lights on for financial companies, and keeps the transportation system moving. This is not to say that energy is a huge cost; on the contrary, the United States Bureau of Economic Analysis calculates that every $100 of GDP required $2.50 of energy input.i  Considering how ubiqitous energy is in the economy, this seems surprisingly minimal.  What this tells us is not that energy is unimportant in the economy; indeed, it is vital.  The point is that energy has been very, very cheap.

According to the Energy Information Agency of the US Department of Energy, in 2006, 62% of all energy used in the United States was generated from petroleum liquids or natural gas.ii 

San Francisco:  San Francisco’s economy has historically been extremely vibrant and independent.  Because of its strong trading ties, especially with Asia, San Francisco is less dependent upon the vagaries of the United States economy than many other places.  However, as other economies are damaged by peak oil, San Francisco will feel the effect.   

San Francisco’s economy is powered by three key sectors:

Experience Sector:   The “experience sector” refers to the business of hosting visitors to the city.  Currently, the experience sector employs approximately 72,000 people in San Franciscoiii, or about 10% of the city’s work force.  Visitors to San Francisco fall into four main categories: meeting attendees, business travelers, vacationers, and local leisure visitors.  Of these, convention/meeting travelers are the most important to the economy, because they spend approximately twice as much per person per day as the average visitor.

{pie charts types of visitors; Visitors: Meeting/convention 35.3%, Business travel 22.1%, Non-local vacationers 12.3%, Local visitors 27.4%.  }iii

About one in every four passengers at SFO arrives on an international flight.  Fourteen percent of visitors to San Francisco are foreign.  Short term, the foreign visitor trade may benefit from the expected decline of the dollar, particularly relative to the euro.  The euro is a very relevant currency, because the top five countries sending tourists to San Francisco are the United Kingdom, Japan, Germany, France, and Australia.  China may contribute more visitors in the future, as bureaucratic obstacles to leisure travel from China are removed.

Financial Sector:   In common with most cites, San Francisco is dependent on exports to pay for the food, energy, and goods it needs.  San Francisco’s premiere export is financial services of various kinds.  Securities sales and banking services make up 40% of the city’s export earnings.iv  As we know, this sector has been hit hard by US economic woes.
Knowledge Sector:  San Francisco is home to a growing concentration of technology-driven businesses. One is the biotech cluster centered around the new California Institute for Quantitative Biomedical Research (known as QB3). Also, in common with many cities, San Francisco is working to develop a local green energy business sector.  Among others, the Mayor’s Office of Economic and Workforce Development sponsors CityBuild, a training and internship program in conjunction with San Francisco City College.

Trade:  Since the end of World War II, there has been a revolution in the shipment of cargo. The cost of air freight has fallen precipitously, while the cost of water shipping has risen somewhat.v The introduction of containerized shipping was expected to lower costs, but that has not happened. This globalization has involved not only increasing shipments of finished goods, but also international sourcing of components.  “Just in time” inventory systems have put a premium on speedy delivery of parts.

Though there is no theoretical reason why it should be so, 80% of all international shipments have transport costs of no more than 4% of valuevi.  As long as there are huge differences in labor costs between countries, most trade will be relatively insensitive to fuel price changes.  This is a result of the extremely low cost of energy.   A study done in 2006 estimated that shipping costs would need to rise by at least a factor of ten before transportation costs would be the limiting factor on tradevi.  Shipping costs have been so low that the economic literature is full of papers questioning why there is not more international trade.

Oil tankers are one of every four large trading vesselsvii, and the third biggest commodity import processed through the Port of Oakland.ix  (Beverages are number one.)

San Francisco has historically been a port city. Though the physical port has declined in importance, San Francisco’s economy retains strong ties to international economies, particularly in Asia. This has shielded the city somewhat from American economic cycles.

Because San Francisco’s manufacturing sector is extremely small, the city is reliant upon imported goods. Long distance imports may come by ship to the Port of Oakland, or by air freight, but the last leg of travel to San Francisco is by truck, with few exceptions.  See the Transportation Section of this report for a more complete discussion of freight hauling.

City Revenues: 

{pie chart of city revenue sources: Revenues (excluding agencies with proprietary funding, such as MTA, Hetch Hetchy, the airport):
	Sales tax = $108 million (4% of general fund revenues)
		In 2006, sales taxes on gasoline sales accounted for approximately $15 million
			 (0.5 % of general fund revenues)
	Hotel tax = $143 million (5.4%)
	Payroll tax = $337 million (12.7%)
	Property taxes = $888 million (33.5%)
	Utility users tax = $79 million (3%)
	Parking tax = $36 million (1.4%)
	Garages - parks and rec = $9 million (.3%)
	Revenues from Federal and CA governments = $663 million (25%)
		Total revenues = $2.6 billion  (06-07 fiscal year)}x

 The biggest single source of income to the city is property tax revenues, currently one-third of the total.  Property taxes move with real estate prices and level of activity.  Though prices have fallen less than 20% in the current downturn, fewer sales are taking place, resulting in lower transaction tax revenues.xi

The second biggest source of general fund revenues, transfers from the state and federal governments, are already falling, in response to declining revenue at higher levels of government.  It remains to be seen what the federal government will do in the way of fiscal stimulus.  For now, the loss of this revenue is pinching the city’s budget.

The San Francisco Convention and Visitors’ Bureau estimates that its industry generates $473 million in city tax revenues, 18% of the total city budget.  This is comprised of sales tax, payroll tax and hotel tax, including transfer tax on sale of hotels.iii

Note that sales tax on gasoline sales makes up less than 1% of city revenues.

San Francisco International Airport (SFO):  The airport is a major gateway to San Francisco.   For a discussion of freight and passenger travel, see the Transportation Section. This section will consider the airport’s financial stability.

Following the construction of the new international terminal, the airport has $3.8 billion in bond debt.xii  SFO is required to achieve a balanced budget.  The main source of revenues is landing fees, which are based on tonnage landed for both cargo and passenger travel.  Cargo traffic is a minor part of San Francisco’s revenues, less than 6%.  Air cargo is split pretty evenly with Oakland Airport.  Through June, 2008, SFO has not seen a decline in landing fees, as international flights have held up, and 2008 saw  three new carriers begin service from San Francisco.  

The airport was expecting significant growth in the future. The renovation of Terminal Two is in the early stages.  Terminal One is also slated for major rebuilding.

Port of San Francisco:  The Port of San Francisco is an enterprise department of the city.  Like the airport, it is required to be financially self-supporting. Most of its annual revenue of $60 million is from lease revenues.  It has little ability to issue bonds. The Port has prepared a $1.5 billion capital plan, much of which involves strengthening the substructures of the piers.  Two-thirds of this plan are unfunded. Several piers have already crumbled into the bay.xii
Funds will be difficult to find to develop the port’s commercial and industrial potential, but it must be done. If the Federal government makes capital available for infrastructure improvements, this would be an ideal use of such funding.

Vulnerabilities:

General:  When it comes to rising oil prices, this much is clear:  Oil prices have a strong negative effect on the economy in all oil-importing countries. Economists estimate that a spike in oil prices drives the economy lower, with a lag of approximately 12-18 months, but has no statistically significant effect on inflation.  In other words, the demand reduction due to a damaged economy overrides the price effect.  We can expect the negative effect of this spring’s price spike to hit in 2009.  Of course, oil is only one factor influencing the economy, though it is an important one.   Sadly, it is likely to reinforce the current recession.

“The empirical evidence suggests that a 10 percent increase in the price of oil is associated with about a 1.4 percent drop in the level of U.S. real GDP.  Interestingly, increases in oil prices have no significant effect on U.S. inflation.”

			-- Keith Sill, Senior Economist, Federal Reserve Bank of Philadelphiaxiv

Even more striking, the effect of oil price is “asymmetric”:  History shows that an increase in price generates a big negative effect, but falling prices don’t have a positive effect.  Price volatility is a drag on the economy.  In an energy-constrained world, economic growth will increase demand for oil, driving up oil and gas prices.  Rising energy costs will curb economic growth, reducing energy demand and bringing prices back down in a damaging cycle of volatility.

Though the inflationary effect of rising oil prices may be modest, the contribution of increasing oil imports to the trade deficit is a major concern.  Because demand for oil is not very price sensitive, demand does not decline as fast as prices go up.  For instance, from 2005 to 2006, the average price of a barrel of crude went up 19.5%, but the number of barrels of oil imported to the US declined a mere .05%.  The total cost of imported oil rose over 19%, though the volume was down.xv  Another example: in April, 2008, the US balance of trade deficit rose 7.8%, and the increase was entirely due to a jump in payments for oil imports, though the number of barrels was down.xv By increasing our trade deficit, rising oil prices put downward pressure on the dollar.

Despite the volatility of oil prices, the trend has been and will continue to be upward.  Even at the recent low, the price of oil was 79% above its 2002 level, and 230% above its 1998 trough.  As the price of energy rises, market forces will move us toward more efficiency.  At some point, when the easy efficiency measures have been taken, the economy will begin a painful and protracted adjustment.  When will that be?  It’s hard to predict, given the state of the economy.

The future could see the perfect economic storm.  Expensive and scarce energy and the need for capital to mitigate the effects of climate change will put intense pressure on our financial system.  As the economy begins to recover, rising oil and gas prices will constrain it again. See chart, Figure x.

[Vicious cycle chart]

Even if the economy as a whole is not pushed into an extended recession, there will be dislocations because some sectors will be more strongly impacted than others.  Trucking and air travel will feel the pinch directly.  Food production is also highly dependent upon oil to power equipment and as feedstock for pesticides, and upon natural gas for fertilizer.  Food and personal transportation issues are discussed in separate sections of the report.  Tourism will be affected by rising travel costs, and globalized trade may have seen its apex.

San Francisco:  San Francisco’s existence as a city is dependent upon the broader global and national economies.  As they are damaged by the cycle of price volatility described above, San Francisco’s economy will suffer too.  In addition, San Francisco’s economic drivers have their own vulnerabilities.

Experience Sector:  The spike in oil prices in 2008 makes clear that high fuel prices wreak havoc with the airline industry. There is no effective substitute for oil in making jet fuel. Though it is possible to brew it from coal or from biological sources, this would be too expensive for general use. In short, it appears that the age of cheap air travel is coming to an end. Between 1981 and 2006, US passenger air travel tripled.xvi  But now that trend may be reversing. Following just a few months of high oil prices, United Airlines, which carries almost half of all passenger traffic at SFO, cut 17% of its flights.  American Airlines, which carries 10% of SFO passengers, is cut 12%.xvii  The tradeoff between rising oil prices and growing GDP will continue to put increasing pressure on airline profits and probably result in a continuing downward trend in air travel.

Travel by individual auto will also be increasingly costly.  In short, leisure travel will be one of the first casualties of peak oil.  The market for the remaining travelers will be extremely competitive.

One mitigation will be the probable increase in local visitors.  Of the 16 million visitors to San Francisco in 2007, 4 million came from the surrounding areaiii.  As long distance travel becomes more expensive, one would expect to have more local visitors.  However, local tourists spend 40% less per visit, and are less likely to stay in a hotel, thus contributing less to San Francisco’s economy.iii

In sum, the days of affordable long-distance travel are coming to an end.  Though various factors will mitigate the decline, the handwriting is on the wall.  In the low-carbon future, visitors will be primarily local and/or wealthy.  San Francisco is very well positioned to capture a large share of the market, but it will definitely be a shrinking pie.

Knowledge Sector:  Technology, engineering, and consulting are not energy intensive, but they are sensitive to economic trends.  As energy decline progresses, tax revenues to fund research may fall off.  Capital expenditures could also be down.

Financial Sector:  As we know, this sector has been hit hard by US economic woes.  Even when the financial markets begin to recover, a continuing loss of confidence in the dollar is likely.  

Both the financial sector and the knowledge sector are dependent upon regular interaction with the rest of the world.  As physical travel becomes more expensive, high-speed, reliable internet connectivity will become even more vital than it is today.  To keep our service sectors competitive, San Francisco needs to make this a priority.

Trade:  Many commentators believe that rising oil prices will cause international trade to decline.  Since both water and air freight are dependent on oil, this will eventually happen - how soon is unclear. Going forward, the historic decline in relative cost of air freight compared to rail and water shipping will reverse.  Air freight will surely decline rapidly, because its fuel use per ton of cargo is approximately thirteen times as high as that of water freight.  Because of its dependence on air travel, “just in time” inventory may very soon be unmanageable.

The vast majority of San Francisco’s exports are services. On the one hand, service businesses are relatively impervious to fuel issues. On the other hand, they depend upon the general economy.

City Revenues:  In general, San Francisco will have to do more with less.  Demands on the city budget will rise at the same time as revenues fall.  The city is seeing something like that now, with the difference that the squeeze on city finances due to peak oil and gas will be indefinite, if not permanent.

It seems likely that rising fuel prices will lead to an influx of new residents escaping the car dependence of the suburbs, so expect property taxes, the city’s biggest source of revenue, to hold up relatively well.  In the past year, for example, San Francisco real estate values have gained as much as 30% in value relative to suburban real estate.  (Suburban values have fallen less than San Francisco.)xi

On the other hand, transfers from the state and federal governments will be ever more pinched. San Francisco itself has far more non-fossil-fuel resources than the rest of the state and nation. The same factors that will impact the city’s municipal budget will have an even greater negative impact elsewhere. Long term, the city’s fortunes are tied to the future of the region, state and nation, but the better  San Francisco prepares itself for the era of expensive and possibly scarce energy, the more people will be attracted to it, and the better it will fare as a metropolis.

Another big vulnerability is the 18% of San Francisco’s revenues that come from the experience sector. Peak oil will reduce both the number of visitors and the amount they spend.

Meanwhile, as revenues fall, urgent needs for infrastructure projects to cope with the coming shift in transportation modes will require massive capital investment.  The Municipal Transportation Agency will especially need funds to prepare for an influx of passengers.  There may be Federal funds available as part of the stimulus package in 2009.

San Francisco International Airport (SFO):  If air travel undergoes a protracted decline, the airport will be in the unenviable position of needing to raise landing fees to cover debt payments and other expenses, even as airlines struggle to survive.  Currently, the airport pays $22 million into the city’s general fund each year.  This payment is calculated as a percentage of the airport’s revenue, which may decline.

As air travel becomes increasingly a luxury affordable only to the wealthiest elite, it will be increasingly difficult for SFO to manage its debt.  In the worst case scenario, CCSF may be called upon to bail it out in order to avoid default.

Port of San Francisco:  The Port of San Francisco is an enterprise department of the city, but also is subject to oversight by the state. If the city allows the port to continue to deteriorate, the cost of bringing its maritime facilities into working condition will be higher and harder to raise.

Strategies

Constricting oil and gas supplies will cause three bad results simultaneously: a faltering economy, declining city revenues and a need for additional spending. In addition, trade will fall off. San Francisco lawmakers need to treat this situation as the structural issue it is, and not a temporary problem.  The basic conceptual framework for coping:

City planning should take rising oil and gas prices into account: San Francisco uses a purchased econometric model of the city’s economy.  In this model, energy prices move with general inflation.  In fact, the model cannot consider fast-rising energy prices.  Until the recent downturn, the increase in the price of crude oil averaged over 25% per year since 2002.  The model needs to be upgraded to be more realistic.  If the model cannot be revised, then a separate calculation needs to be made when evaluating the effect of potential legislation.

Quite aside from the use of the econometric model, evaluations of policies and plans generally do not adequately consider energy use.  San Francisco has a plethora of commissions and agencies, nearly all making plans based on past energy prices.  This was a reasonable thing when energy was cheap.  That assumption now needs to be changed.  All city plans need to include a section explicitly assessing the effect of expensive and scarce energy.

Look for new revenue sources that encourage conservation.  Enact a carbon tax. San Francisco will face declining revenues from the hotel tax and from state and federal revenue-sharing.  MTA will need large infusions of cash to cope with increasing ridership at a time of rising fuel prices. Politically, it will be difficult to enact a carbon tax large enough to be a major revenue source, but we should attempt it. This is no time to reduce city revenues.

Another possibility would be to set a floor under gasoline and diesel prices in the city.  If the market price of vehicle fuels dropped below the floor, the difference would go toward public transit. See below for a discussion of the business tax.

Other possible revenue sources include:  variable parking charges, city car tax, congestion pricing tolls, impact fees on new parking spaces and garages.

Prioritize high-speed internet thoughout the city.  As physical transportation becomes more expensive, electronic transmission of data will be necessary to maintaining our economic functionality.  A well-functioning broadband network will facilitate telecommuting, virtual conferencing, and so on, to replace face-to-face communication.  Overnight letter and package services will fast become impractical due to rising air freight costs, so without an efficient on-line “shipment” system, productivity will be constrained.  This will be extremely important to San Francisco, with our location on one coast and many overseas customers.  The proposal to lay fiberoptic cable each time a street is dug up should be seriously considered.

Develop the southeast waterfront to take advantage of the coming rise in short haul water freight.  As discussed above and in the Transportation section below, the redevelopment of the port is both a challenge and an opportunity.  Should Federal infrastructure funding become available, this project is ideal for submission.  It needs to be a priority.

Formulate a plan to build a modern freight rail facility in San Francisco.  A modern city needs a modern freight rail yard. One example is the tunnel through which trains approach the southeast waterfront. The inadequate size of the current railway tunnel is a choke point for our ability to replace trucks as virtually the only method of moving goods into San Francisco. Fixing it is the first step toward a functional freight system.  Federal funds could become available for this sort of infrastructure improvement.  Our plans need to make it a high priority.

Beyond the enlargement of the tunnel, CCSF needs to formulate a plan to revitalize rail access to the city.  When oil and gas are prohibitively expensive, electric rail will be the major cargo transport mode.  Cities and regions with well developed rail will be at a competitive advantage, but such development takes time.  Start now.

Avoid orphan infrastructure. San Francisco’s infrastructure plans need to take the long-term view.  There will not be enough funding to handle all important projects, so priorities will have to be carefully set.  For example, while the airport is busy today, its future prospects are murky.  Upgrades to the airport could fall into the category of orphan projects.  The best plan is to wait and see, because improvement funds probably would be better spent elsewhere.  

Expand and strengthen programs for local small businesses.  Establishing local control over our economy will become more important than ever as Peak Oil hits in order to protect our residents from the bad stuff happening in the broader economy. To a certain extent, market forces will push toward localization, but there may be dislocations.  Also, cities and regions that act now to prepare will fare better in the transition time.

The City needs to create local sources of key resources. The Board of Supervisors should direct the Controller’s Office to begin studying the city’s balance of trade to identify pivotal imports. Then the Economic Strategy Report needs to be expanded to include a strategic plan to locally source vital inputs to our economy. Local control over two of the most important ones, food and energy, is top priority. These items are discussed in subsequent chapters of this report. However, these are far from the only inputs to look at. If we knew the composition of San Francisco’s balance of trade, we could identify other vulnerabilities and begin to plan to mitigate them.

There is a great opportunity for small, local business to gain in importance as trade declines.  This is not a bad thing, because small business generate new jobs.  According to a 2006 study by Kent Sims, a former city economist, small businesses are more reliable employers in bad economic times than large companies.xviii  They also keep profits local. San Francisco should take advantage of the changing economy to become more economically sustainable.

City government could push much harder to promote small businesses.  San Francisco could use its financial might to pressure its own bankers to invest in and loan to local businesses.  There is already legislation on the books, the Community Reinvestment Act, which requires that banks that do business here devote a portion of their lending to the local community. This legislation needs to be strengthened -- and enforced.

San Francisco could also use its own purchases to give market support to local business. Such a policy is in place, but is not enforced.

The City could also make it easy to invest in local businesses. Banks who want to do business in the city could be required to support a local venture capital fund, including a local micro-finance fund. This fund could also accept direct investment from local small investors, allowing neighbors to invest in neighborhood businesses. [Here’s one example of an opportunity San Francisco is missing: The California Clean Tech Open Competition is a contest held right here in San Francisco for putative clean tech startups. Most of the winners are local; many are students at the Presidio School of Management. The 2008 winners got seed money -- and free rent for a year in San Jose.]

San Francisco needs to orient the business tax toward small businesses by making it progressive, based on gross receipts, not payroll, with an exemption for micro businesses. Such a tax change could raise needed revenue too.

**Recommendations**

Require the Controller’s Office and other departments to consider rising energy prices when evaluating potential policies and legislation.

Direct the Office of Economic and Workforce Development to revise the Economic Strategy Report in light of increasing fossil fuel prices.

Direct the Controller’s Office to prepare a report on San Francisco’s balance of trade, with attention to identifying key imports.  Follow this with the creation of a strategic plan to find or develop local sources of these inputs.

Expand and enforce the City’s own policy of sourcing locally for city purchases.

Resume development of a project to make high-speed internet available to all residents throughout the city.

Establish local venture capital and micro-lending funds.

Revise the City’s business tax to be assessed on gross receipts as it used to be, and to be progressive, with an exemption for the smallest businesses.

Look for new revenue sources for city government to fund the transition despite declining revenues from current sources:
    Carbon tax
    Progressive business tax
    Demand-sensitive parking fees
    City vehicle tax
    Gasoline tax based on price floor

Develop the southeast waterfront to take advantage of the coming rise in short haul water freight.

Evaluate plans for new or improved infrastructure to avoid “orphan” projects which will lose their rationale in light of Peak Oil and Gas.

Enlarge the railway tunnel giving access to the port.  

Formulate a plan to build a modern freight rail facility in San Francisco.

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Endnotes:

i  2002 Commodity Flow Survey, a partnership between the U.S. Department of Commerce, Bureau of the Census, and the Bureau of Transportation Statistics of the Department of Transportation, quoted in East-West Gateway Council of Governments Data Center, http://www.ewdateway.org/DataCenter/STLRegData/Trans/FreighShare/freightshare.html

ii Energy Information Agency, United States Department of Energy, US Energy Consumption by Fuel, Forecasts and Analysis of Energy Data, http://www.eia.doe.gov/oiaf/forecasting.html 

iii San Francisco Convention and Tourism Bureau, San Francisco Fact Sheet, 2006 and 2007

iv Mayor’s Office of  Economic and Workforce Development, Sustaining Our Prosperity: The San Francisco Economic Strategy, November, 2007

V Hummels, David, Have International Transportation Costs Declined?, University of Chicago, 1999

vi  Glaeser & Kohlhase, 2004, quoted in Disdier, Anne-Celia, and Head, Keith, The Puzzling Persistence of the Distance Effect on Bilateral Trade, July 29, 2006

vii Lloyd’s Register World Fleet Statistics Tables, London, 2000

ix Port of Oakland, Maritime Facts, http://www.portofoakland.com/maritime/facts_comm_02.asp

x City and County of San Francisco, Financial Statements, June 30, 2007

xi “Bay Area Home Prices Still in Free Fall”, San Francisco Chronicle, December 19, 2008

xii Airport Commission, San Francisco International Airport, Financial Statements, June 30,2007

xiii San Francisco Planning and Urban Research (SPUR), Hard Choices at the Port of San Francisco, April, 2008

xiv Sill, Keith, Senior Economist, Federal Reserve Bank of Philadelphia, The Macroeconomics of Oil Shocks, Business Review, First Quarter, 2007

xv  Energy Information Agency, United States Department of Energy, Monthly Energy Review

xvi Research and Innovative Technology Administration, Bureau of Labor Statistics,http://www.bts.gov/programs/airline_information/air_carrier_traffic_statistics/airtraffic/annual/1981_present.html

xvii San Francisco Chronicle business section, June 6, 2008

xviii Sims, Kent, Economic Impact of San Francisco Small Businesses in the Recession, 2000-2004, June, 2006, http://www.cal-insure.com/SmallBusinessImpactReport.pdf

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