The Green Paradox

When economists discuss climate change policies such as carbon taxes, cap-and-trade systems, and carbon intensity standards, effectiveness is a key question. Will these policies lead to the reductions in greenhouse gasses that we would like? The worst case scenario is usually thought of as an expensive policy that has zero effect on the global stock of gases, such as a tax that induces businesses to displace all the emissions they are “getting rid of” to other, untaxed regions. (The shifting of emissions across space like this is called carbon leakage).

So, we’re often considering whether climate policy might fail. But, could the outcome be worse? Could emissions increase due to climate policy? That is, could our policy backfire?

Since a 2008 article, there has been a discussion in the environmental economics community about the “Green Paradox”: the phenomenon of emissions increasing, at least temporarily, in response to climate change policy that is targeted at fossil fuel use.

How could this occur? Fossil fuels come from nonrenewable resource stocks. As famously theorized by economist Harold Hotelling in 1931, owners of nonrenewable resources will extract them when it is profitable to do so, compared to making other investments. Similarly, they will leave their resources in the ground when other investments are better deals. That means that the rate of extraction and the price of the resource is determined by the prevailing interest rate.

Climate policy changes that result a bit. Many policies work by increasing the price of fossil fuels to reflect the cost that society bears as a result of climate change. When a policy kicks in, consumers will demand less fossil fuel. This causes the price that suppliers receive to fall, and suppliers will make less of a profit than they otherwise would. If suppliers expect a policy to start sometime in the future, they may shift some of their extraction to before the policy goes into force to make up for the drop in profits they are anticipating. The schedule of extraction is simply moved up in time. This can mean that the same amount of greenhouse gases that would have been emitted without the policy is just emitted sooner. In the near term, more greenhouse gas is emitted today than would have otherwise been emitted.

This could be quite problematic if emissions released sooner result in greater-than-otherwise damages or damages for which we are simply unprepared. A paper published in the Review of Environmental Economics and Policy this year summarizes the current research on the Green Paradox. The authors walk through the theoretical models on the topic as well as the tiny bit of empirical evidence about whether the Green Paradox has occurred so far. Here’s what they say:

The classic model of resource extraction that led to Hotelling’s results also leads to the Green Paradox. If a climate policy [equivalent to a tax that rises with the interest rate] is announced in advance, fossil fuel suppliers will shift their extraction forward in time. This will also occur if a surprise climate policy is implemented and it is equivalent to a tax that rises faster than the rate of interest. Even a surprise climate policy that rises at the rate of interest may lead to more emissions sooner as suppliers might not really be a surprised at all, given the importance that climate change has taken in political debate.

But does the classic model tell us about what will really happen?

When we play with some of the assumptions of that model to make them match the real world more closely, we find that the Green Paradox becomes less likely.

For example, the model assumes that extraction costs are constant. But, if we consider the possibility that extracting more and more oil, for example, may become increasingly expensive, then suppliers will be less likely to shift production forward in time in response to a climate change policy. Similarly, the models assume that suppliers can adjust extraction decisions immediately. If extraction depends on building new oil rigs, however, these decisions can be delayed for years. This also makes the Green Paradox less of a concern.

The classic model, additionally, does not take into account the possibility of carbon leakage between countries or regions. When emissions can move spatially, things get complicated, to say the least, and whether suppliers extract more fuel now could depend on factors such as the price elasticity of fuel demand (how much demand for fuel changes when its price changes) and the difference in carbon prices between countries.

What about the fact that there are several fossil fuels out there? The classic model creates a world of one nonrenewable resource. When we plug in the fact that oil, natural gas, and coal all contribute to greenhouse gas emissions, we can have less hope: suppliers might substitute to using “dirtier” fuels before the cleaner ones. This is because clean fuels would be more valuable in the future when the climate policy is anticipated to begin.

So, our models predict that climate change policies might lead suppliers to move up their extraction of fossil fuels. This may be less likely when we include increasing extraction costs, suppliers shifting extraction slowly, and/or spatial carbon leakage. But with several types of fossil fuels out there emitting different amounts of carbon per unit of energy produced, the Green Paradox might be plausible. All this modeling is great, but, since we are getting mixed results, should we really be worried about this? Empirical studies of what suppliers have done in the past can answer this question.

Unfortunately, there have been only two studies conducted so far. And the Green Paradox could be difficult to capture, even if it was occurring, due to factors such as spatial carbon leakage. One study found that suppliers of coal did not shift up their extraction before the U.S. Acid Rain Program. Another study found that coal and natural gas prices increased after the U.S. carbon cap-and-trade legislation failed, which might point to a Green Paradox occurring. In short, we just don’t know if the Green Paradox is at work.

It might feel like all this buzz about a Green Paradox amounts to little more than gas. One important contribution of the idea is that it emphasizes the supply side of fossil fuel markets. Many carbon policies are targeted at the demand side—taxing, putting a cap on, or otherwise regulating emissions from the use of fossil fuels. Supply-side policies are oriented toward ensuring that fossil fuels stay in the ground. The thinking is that if those fuels are not taken out, they can’t pollute, right? Policy makers could employ the same economically efficient tools to keep fuels in the ground as they do to restraining emissions, such as taxes, cap-and-trade systems, and subsidies. Of course, we don’t just use fossil fuels for energy generation, the main source of greenhouse gas emissions. For example, plastic production relies on these fuels. Still, supply-side policies are usually not even on the policy table, and perhaps they’re worth considering.

 

Image courtesy of Flickr. Originally published by S&S on March 28, 2016.

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