VoxEU Column Environment

Greenhouse gases: Demand control policies, supply and the time path of carbon prices

EU leaders don’t determine the pace of climate change. Demand reduction by some consumers only lowers fossil fuel consumption to the degree that resource owners decide to curtail their supply. Ultimately, the volume of fossil fuel burnt globally depends upon the rate of extraction and this is in the hands of oil producers who care about carbon’s intertemporal price path. Policies aimed at lowering carbon demand without concern for the price path of carbon may backfire.

To date, the public policy discussion of climate change has focused only on the reduction of demand for fossil fuel, neglecting the supply side. But both blades of the Marshallian scissors determine the evolution of fossil fuel prices – and therefore the rate of fossil fuel extraction and carbon emission into the atmosphere.1 Reducing fossil fuels’ contribution to global warming requires that policymakers stop neglecting the supply side.

The European Union’s consumption-reducing measures will be in vain if oil sheiks and other owners of fossil fuels do not cut back their supply. Without supply cuts, world energy prices fall by so much that other countries consume and burn exactly the quantities not demanded by the EU. Countries doing nothing with regard to climate protection enjoy an implicit subsidy on their energy demand, resulting from the restraint of the EU countries. The Chinese continue to step up their CO2-intensive expansion policies and the Americans drive even more SUVs than they otherwise would do.

The intertemporal profile of extraction and demand-management policies

The supply of fossil deposits that nature has made available is independent of the price reactions that the consumer countries can influence. The improvement in housing insulation, the conversion to biodiesel and the construction of cars with lower fuel consumption will be useless if the oil sheiks remain stubborn. Germany’s windmills and solar roofs and France’s nuclear reactors will make no meaningful contribution to addressing global warming if they are supplied only in addition to fossil energy. Thus, it is not EU leaders who will determine the pace of climate change but Hugo Chávez, Mahmoud Ahmadinejad, Putin's oligarchs, the Arabian oil sheiks and a few other potentates.

The supplier reactions that do occur depend on the temporal course of the demand restrictions that the suppliers expect. If today’s demand restrictions are not expected to continue in the future, then suppliers will defer extraction. If future restrictions are expected to be stricter, then suppliers have an incentive to extract more now. Suppliers’ decisions will depend on demand restrictions implemented in the present and the expectation of future restrictions.

To slow resource extraction today, EU policymakers would have to ease demand restrictions over time so that the fossil fuel suppliers would have an incentive to defer their extraction until a future date when prices were higher. However, the opposite evolution of demand restrictions is more likely. As global warming increases, the call for measures to address climate change will likely grow louder, resulting in increasingly strict demand reduction policies in the future. As resource providers anticipate this, they will intensify extraction today. This paradox may be one of the reasons that world consumption of fossil fuel and output of carbon dioxide has increased unabated in recent years, despite the expansion of EU environmental protection measures.

What might work?

In light of this ‘green paradox’ of environmental policies, the measures currently demanded by European governments have little in common with policy efforts that would be truly effective in reducing global warming. Meaningful measures would include the introduction of worldwide source taxes on capital income along with a closing of tax havens so that the resource owners would lose their investment alternatives. In addition, an emissions trading system with no loopholes that would unite all customer countries into a worldwide monopsony could force the desired amounts from the resource exporters. It would make particular sense to exploit the technical possibilities of sequestering carbon dioxide.

A top priority should be rebuilding forests, which are the largest absorbers of carbon under human control. Currently deforestation is leading to the release of more carbon dioxide than from the whole transportation sector. If reforestation were to replace forest destruction, global warming could be slowed down significantly.

The economics of climate change and the economics of exhaustible resources are closely intertwined, for in essence the problem of global warming is the problem of gradually transporting the available stock of carbon from underground into the atmosphere, with useful oxidisation on the way. Unfortunately, most policy proposals ignore this insight and seek to reduce carbon demand without concern for the price path of carbon and the corresponding supply reactions. This oversight may result in the green paradox of measures actually exacerbating the fossil fuel extraction they are intended to reduce. To find useful policies that mitigate the problem of global warming, we must remember that economics teaches us to pay attention to both demand and supply.




1 See Hans-Werner Sinn, “Public Policies Against Global Warming,” CESifo Working Paper No. 2087, August 2007; and http://www.nber.org/papers/w13453, http://www.nber.org/papers/w13454



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