Repost: Resolving The Green Paradox
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Estimated reading time ~ 7 mins
The conventional argument behind the introduction of climate policies (such as carbon pricing, subsidies for renewable energy, and energy efficiency), is that consumers of energy will respond by switching over to lower carbon energy sources and becoming more energy efficient. Meanwhile, producers of fossil fuels, who now expect demand for their product to decline in the future, will respond by cutting production and instead, invest in alternative, low carbon sources of production.
But is that really how the market works? There is an argument that climate policy announcements could have exactly the opposite impact to that intended, at least when looking at it from a global perspective, and considering carbon emissions are a global problem that is the only perspective that matters.
Let’s dive in.
First, lets have a look at the demand response. Introducing climate policies intended to decrease demand for fossil fuels will not lead to a global decline in emissions if participation is limited to a certain low percentage of the global economy. The reason why is that demand restraint (and lower emissions) from those countries introducing green policies is likely to be outweighed by the additional consumption (and higher emissions) from those countries that have not introduced green policies - the latter benefiting from lower fossil fuel prices.
As I note in Harnessing the invisible fuel, the knock-on effect of successful energy efficient measures introduced in North America, Europe and other developed economies will be a drop in the price of coal, oil and natural gas. For developing nations hungry for affordable energy, the drop in the price of fossil fuels will only fuel demand for gasoline consuming vehicles and fossil fuel-fired generation plants.
Secondly, there will be a reaction on the supply side from fossil fuel producers, but maybe not the one that you expect. The ‘Green Paradox’ theory suggests that to avoid the negative consequences of future climate policies fossil fuel owners will seek to frontload production. This way they can maximise the rent they receive from their reserves, while also seeking to reduce the risk that those same reserves are rendered ‘stranded’, i.e. no longer able to generate an economic return, when climate policies become overwhelming in the future.
The assumptions underpinning the Green Paradox are consistent with those of Hotelling’s rule, i.e. that resource owners are forward-looking, revenue maximising, and base their production decisions on expectations of future prices. Hotelling’s rule states that the most socially and economically profitable extraction path for a non-renewable resource (one blind to the externalities of carbon dioxide emissions) is one along which the price of the commodity, determined by the marginal net revenue from its sale, increases at the rate of interest. If an oil producer believed that prices were not going to keep up with higher interest rates, then they would be better off selling as much as possible for cash and then purchasing bonds. Conversely, if they expected prices would increase faster than the prevailing interest rate, they would be better off keeping the oil in the ground.1
The Green Paradox theory was originally put forward by German economist, Hans-Werner Sinn in 2008, who argued that if the announcement of climate policies “reduce the discounted value of the carbon price in the future more than in the present…resource owners will have an incentive to anticipate the price cuts by extracting the carbon earlier.” That’s exactly the opposite of what climate policies set out to achieve. Instead of cutting production, the rational decision by individual fossil fuel producers is to increase output, monetising more of their reserves now.2 3
In reality, there are three key reasons why the Green Paradox may not be as strong as the theory suggests. First, demand is typically highly price inelastic and so if producers frontload supply excessively the price drop may be too steep to bear. Second, rigidities in expanding hydrocarbon production capacities (infrastructure, reservoir decline rates) limit the ability of producers to expand supply. Finally, the sensitivity of fossil fuel prices to expected future carbon prices varies - relatively small for crude oil, but much larger for coal.
As I explain in Big Oil's bigger brothers, when it comes to channelling the ire of environmental campaigners, the five major energy companies - BP, Shell, Total, Exxon and Chevron - tend to get all the attention despite only accounting for 15% of global oil and gas output. But it’s the state-led national oil companies (NOC’s) - the so-called “hidden half” of the oil and gas industry - that account for the majority of global fossil fuel related emissions.
And while some NOC’s have recognised that they will not be able to compete in a carbon constrained world, others are doubling down, betting that only the lowest cost, least emissions intensive oil and gas producers will win the prize to supply the “last barrel”. It’s these producers (as well as an increasing number of oil and gas majors) that are economically rational enough to see that they should be investing in increasing their productive capacity, not scaling back to meet net zero.
How can we resolve the Green Paradox? Carbon taxes are ineffectual since they only raise the marginal cost of fossil fuel extraction, resulting in a small but unpredictable impact on emissions. There is also the risk that subsequent governments decide to water down or remove the carbon tax entirely if it suits their political needs. According to Sinn, only by expanding the use of cap-and-trade systems such as the European emissions trading scheme (ETS) across the globe, will we bind all countries and industries (but especially the fossil fuel business) into only producing what is consistent with meeting net zero:
“I would argue that nothing short of binding global agreements on quantity constraints can successfully reduce the speed of global warming. Measures that simply work through price signals are not sufficiently reliable to do the job, as it is the changes in prices, rather than their levels, that will determine success; and it is easy enough to get the price changes wrong through re-optimization by successive generations of policymakers.”
At the moment the world is falling well short of this ideal. Almost one-quarter (24%) of global carbon emissions are covered by ETS’s or carbon taxes, according to the World Bank’s State and Trends of Carbon Pricing 2024 report. Approximately 18% of emissions are covered by an ETS, carbon taxes cover 5.5%, while 0.5% is covered by both an ETS and carbon taxes.4
Nevertheless, the scope of global GHG emissions covered by carbon pricing is expected to grow substantially over the next decade, although not fast enough to meet the 60% by 2030 goal underpinned by the Global Carbon Pricing Challenge (GCPC). However, as I outline in It's the carbon price, stupid!, it’s unlikely to cover more than 40% by the end of the decade.
Governments seeking to introduce an emissions trading scheme must signal three things to the market to avoid the Green Paradox: rapid introduction (not decades), high participation rates (little or no free allowances), and high ambition (big emission reductions and an appetite for high carbon prices). Unfortunately, this tends to be the opposite of what occurs. Instead governments seek to introduce cap-and-trade schemes gradually, softening the blow for industry via free permits and low prices.
Resolving the Green Paradox is probably the greatest challenge we face if we are to decarbonise the global economy.
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https://www.hanswernersinn.de/dcs/2008_ITAX15_Public_Policies_Against_Global_Warming.pdf
http://links.jstor.org/sici?sici=0022-3808%28193104%2939%3A2%3C137%3ATEOER%3E2.0.CO%3B2-G.
Sinn’s book, The Green Paradox: A Supply-Side Approach to Global Warming, was published by MIT in 2012.
https://openknowledge.worldbank.org/entities/publication/b0d66765-299c-4fb8-921f-61f6bb979087