Introductory Comment–The Green Paradox: A Supply-Side View of the Climate Problem

Abstract

Why have policies aimed at reducing the demand for carbon not succeeded in slowing down global carbon extraction and CO2 emissions, and why have carbon prices failed to increase over the last three decades? This comment argues that this is because
of the Green Paradox, that is, the anticipation of sales by resource owners who try to preempt the destruction of their markets
by green policies. Reviewing some of the conditions under which strong and weak versions of the Green Paradox may emerge,
it is argued that there is little hope that green replacement technologies will impose hard price constraints that would keep
long-run extraction within a fixed carbon budget and that, therefore, even strong versions of the paradox cannot easily be
avoided.

Full text

Introductory Comment
The Green Paradox: A Supply-Side
View of the Climate Problem
Hans-Werner Sinn*
The climate problem is one of mankind’s biggest challenges. Averting disaster requires nothing
less than worldwide collective policy action. However, policies that ignore the laws of eco-
nomics may prove futile, if not downright counterproductive. In particular, policies aimed at
reducing future demand for fossil fuels could backfire by inducing resource owners to bring
forward their extraction plans, thus accelerating global warming. I have called this behaviour
the Green Paradox.
Economists and policy makers alike long overlooked the possibility of a Green Paradox
because the behaviour of resource owners played no specific role in the economics of climate
change. Although it has long been recognized that the anthropogenic carbon accumulating in
the atmosphere is basically the same as the carbon taken from the ground and that, except for
sequestration,no technical devices exist that could change the proportions accumulating in the
sea, biomass, and atmosphere, this has rarely been incorporated into climate models or
addressed by policy makers in the past. Instead the focus was on the demand side of the
market.Itwasthoughtthattomitigatetheclimate problem, it would be effective and sufficient
to require better insulation of homes, to extract higher mileage from car engines, to subsidize
green energy through tariffs, to morally discredit fossil fuel consumption, to tax the use of fossil
fuels, or to subsidize the development of green technologies, because it was taken for granted
that supply would follow demand. Resource suppliers were perceived to be like car producers,
facing flat marginal cost curves and producing what is demanded at given prices. However,
unlike cars, fossil resources sold in the market are already there (i.e., in the earth’s crust) and
thus cannot be “produced”in the normal sense of the word. Extraction and exploration costs
are typically small relative to user costs. This means that we cannot assume that the supply
reactions of resource owners will be elastic.
Fortunately, the period of ignoring the obvious appears to be coming to an end. Although the
supply-side view of the climate problem is not yet widely recognized by the public, both the
Intergovernmental Panel on Climate Change and the literature on the economics of climate
change are now giving at least as much weight to the supply side as to the demand side. The
focus is on the intertemporal dimension of supply decisions, merging the traditional theory of
*President, Ifo Institute - Leibniz Institute for Economic Research, and Professor of Economics and Public
Finance, University of Munich, Germany; e-mail: hws-f2015@ifo.de.
239
Review of Environmental Economics and Policy, volume 9, issue 2, Summer 2015, pp. 239–245
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exhaustible resources with the theory of climate change. Exhausting the stock of carbon re-
sources in the ground and accumulating waste carbon in the atmosphere are now viewed and
modelled as a single decision.
The Hotelling View
In the spirit of Hotelling (1931), the new models typically assume that resource owners opti-
mize the composition of their wealth portfolios, with wealth consisting of both the physical
resource in the ground and the financial wealth that can result from extracting and selling some
of the resource. Ideally, resource owners will choose portfolios that equate the rates of return on
both the physical and financial assets. However, resource owners are blind to the carbon
externality they cause.
Under the Hotelling rule, it is essential that resource owners be forward-looking (i.e., that
they base their behaviour on expectations of future prices). This means that policies aimed at
limiting or reducing the possibility of generating resource-derived revenues in the future will
induce resource owners to bring their sales forward to the present. This, in turn, will depress
current market prices and increase resource demand, thus accelerating global warming.
The Green Paradox, Fossil Fuel Prices, and Overextraction
In my view, the Green Paradox is not simply a theoretical possibility. I believe it explains why
fossil fuel prices have failed to rise since the 1980s, despite decreasing stocks of fossil fuels and
the vigorous growth of the world economy. The emergence of green policy movements around
the world, rising public awareness of the climate problem, and increased calls for demand-
reducing policy measures, ranging from taxes and demand constraints to subsidies on green
technologies, have alarmed resource owners. In fact, while most of us perceived these devel-
opments as a breakthrough in the battle against global warming, resource owners viewed them
as efforts that threatened to destroy their markets. Thus, in anticipation of the implementation
of these policies, they accelerated their extraction of fossil fuels, bringing about decades of low
energy prices. In fact, as of this writing (April 2015), oil prices, in real terms, are at about the
same levels as just before the May 1979 price jump that led to the second oil crisis.
Concerns about the increasing influence of environmental activists may also explain the
strange behaviour of the owners of German lignite fields. While Germany’s lignite
resources rank tenth in the world and account for less than 2 percent of the available
global stock, its 17 percent market share makes it the world’s leader in terms of current
extraction. What else but fear of threats from Germany’s Green Party—arguably the world’s
most powerful environmental party—to close lignite mines and prohibit extraction can explain
this behaviour?
Of course there are probably other reasons for overextraction, including rising political
tensions in the Middle East, which have increased the threat of expropriation. However, this
only heightens the risk of global warming. For resource owners, it does not matter whether
expropriation occurs through a coup d’e
´tat in a particular country, or through pressure from
environmentalists to reduce dependence on fossil fuels. In either case, resource owners will seek
to protect their interests by bringing at least some of their extraction forward.
240 H.-W. Sinn
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This symposium on the Green Paradox and Climate Policy contains three important review
articles written by experts in the field (Jensen et al. 2015; Long 2015; and van der Ploeg and
Withagen 2015). The articles primarily present the theoretical literature because there has been
very little empirical research on the Green Paradox to date. Using different models of fossil fuel
extraction, they examine the impacts of a variety of announced or implemented green policies,
focusing on the roles of stock-dependent extraction costs, spatially differentiated policies, and
backstop technologies, in order to identify when well-intentioned policies are likely to backfire
and result in a Green Paradox outcome. Overall, they find that the literature confirms the risk of
Green Paradox outcomes and strengthens the case for taking a supply-side view of the climate
problem.
While it is not possible to review the symposium articles in detail here, I would still like to
comment on some of the key issues they raise.
The Price Wedge
My work on the Green Paradox (Sinn 2008a, 2008b, 2008c) focuses on the “price wedge”that
may be created by green policies. Consider a baseline scenario (with an intertemporal market
equilibrium and rational expectations) that is distorted by a green policy aimed at the demand
side of the market (e.g., subsidies for green backstop technologies, enforced technological
demand constraints, carbon taxes). This policy depresses producer prices during some periods
relative to what they would have been without the policy, resulting in a price wedge. More
specifically, I define the price wedge at a particular point in time as the difference between the
old, pre-policy price and the new producer price, which would arise if suppliers did not adjust
the fossil fuel extraction path to the new policy.
My analysis is based on the standard assumption made by traditional resource models
whereby rising prices will always stay above (and be bounded away from) rising stock-depend-
ent unit extraction costs due to increasing scarcity and on-going depletion. This assumption
implies that laissez-faire markets will exhaust the available stock as time goes to infinity.
Assuming marginal policy measures, I showed that producers will:
(1) Bring their extraction forward if the present value of the expected price wedge
(discounted using the rate of return on financial assets) increases over time; (2) not change
the extraction path if the present value of the expected price wedge remains constant over
time; and (3) postpone extraction if the present value of the expected price wedge decreases
over time.
1
The first of the three outcomes is a Green Paradox, in both its weak and strong forms. It is a
weak paradox because global warming accelerates at least for a while. It is a strong paradox
because it moves the economy further away from an intertemporal Pareto optimum, which
requires a slower speed of global warming than would occur in competitive markets.
2
1
This analysis draws on earlier work (Long and Sinn 1985) that examines the effects of exogenous price changes
on extraction, as well as analysis of nonconstant sales tax rates in a resource extraction model (Sinn 1982).
2
See Sinn (2007, 2008a) for a generalization of the Solow-Stiglitz efficiency rule (Solow 1974; Stiglitz 1974) to the
case of global warming due to the accumulation of carbon in the atmosphere.
The Green Paradox: A Supply-Side View of the Climate Problem 241
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Backstop Technologies
Two of the symposium articles (van der Ploeg and Withagen; Jensen, Mohlin, Pittel, and
Sterner) emphasize the impact of a backstop technology that produces a perfect energy sub-
stitute at a fixed unit cost, thus preventing the extraction of fossil fuels with extraction costs
above this unit cost. They also note that subsidies that reduce the unit cost of the backstop
would accelerate global warming for a while (weak Green Paradox) but would reduce the total
amount of carbon released into the atmosphere. For those who view reducing the carbon
budget as the primary goal of climate policy, this is a satisfactory outcome.
Unfortunately, I am less optimistic about the potential role of backstop technologies. First, it
is not clear to me why reducing the total long-term carbon budget should be considered more
beneficial to human welfare than postponing extraction. Focusing on the final carbon budget
would make sense in a hypothetical world with no time preferences and discounting. But
without discounting, a welfare analysis of resource extraction would be meaningless, even
in the absence of global warming, as the optimal rate of resource extraction would be zero.
I believe that even hard-core philosophers would agree that this problem excludes a
lexicographic ordering of social preferences for postponing versus avoiding climate damages
forever.
Second, I do not see anything in the real world that even comes close to being the perfect
backstop assumed in theoretical models. Wind and solar power, often considered the most
likely candidates, will be able to replace some fossil fuel, but certainly not all, because they are so
volatile. The economic cost of storage devices such as pump storage or methanization plants
that could smooth the supply of green electricity is extremely high.
3
For example, in 2013,
Germany would have needed 3,500 pump-storage plants, more than a hundred times the
number it had at the time, to smooth its energy from wind and solar power, although the
latter accounted for only 3 percent of final energy consumption. I fear that the only effective
smoothing strategy would be one that is based on the intermittent production of energy from
fossil fuel to cover periods when wind or solar is not available. But this smoothing strategy can
only work if the green energy supply is small enough to prevent production spikes from
exceeding aggregate demand, something that already occurs in Germany from time to time.
Thus, beyond a certain production level, wind and solar energy would switch from being
substitutes to complements of fossil fuels. This means that they cannot serve as the backstop
technology assumed in many Green Paradox models.
Thus, at best, subsidies for green energy would reduce the demand for fossil fuels at all points
in time but would not impose the hard ceiling on prices assumed in the models. The subsidies
would shift the (period-specific) resource demand curves downwards, creating the price wedge
discussed earlier. At worst, subsidies for wind and solar energy would increase the demand for
complementary fossil fuels if wind andsolar energy were already extensively used, thus reducing
thepricewedgeatthemargin.
Nuclear fission and nuclear fusion have the potential to serve as backstops that induce hard
price ceilings. However, the former has been discredited by the Fukushima accident and thus
does not appear to offer a politically feasible alternative. Nuclear fusion could potentially garner
3
See H.-W. Sinn, “Schafft es Deutschland, den Zappelstrom zu ba
¨ndigen?”, public lecture, Ifo Annual Meeting,
available at: http://mediathek.cesifo-group.de/iptv/player/macros/cesifo/mediathek?content¼3583749&idx¼
2&category¼2196209669.
242 H.-W. Sinn
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more political support. However, decades of promises of imminent breakthroughs have given
way to more pessimistic expectations. At best, the availability of a nuclear fusion backstop can
be anticipated with time-dependent probabilities, but such probabilistic expectations translate
into a mathematically expected price wedge that has implications similar to those discussed
earlier.
Scenarios that Avoid the Green Paradox
Of course, there are model assumptions that would eliminate the risk of a Green Paradox
outcome. For example, it is possible that mankind would, under laissez faire, not exhaust the
entire resource stock, because, with the passage of time, the marginal willingness to pay for
dwindling fossil resources rises more slowly than the unit extraction costs resulting from the
depletion of the better fields. In this case, any permanent demand-reducing measures of the
kind discussed earlier would eliminate some of the stock that could be profitably extracted and
hence put a limit on the earth’s maximum temperature (see Withagen and van der Ploeg 2015).
However, we cannot know today whether the underlying conditions for this optimistic scenario
will hold because this all depends on technologies and preferences in a far distant and uncertain
future.
Alternatively,wemightwanttodesignastrategy that ensures a gradual decline in the present
value of the price wedge over time, thus giving resource owners an incentive to extract later.
However, I doubt that it will ever be politically possible to fine-tune such a policy and to
commit to its implementation over the long term. In the real world, there are no commitment
devices that bind successive generations. New generations of policymakers will reoptimize, and
when the world does get warmer, they may face increasing political pressure to intensify their
green policies, thus increasing the price wedge more than originally envisaged. In any case,
resource owners are likely to anticipate such policy changes and react by bringing forward their
fossil fuel extraction.
Carbon Leakage
The efficacy of demand policies may deteriorate further if only some resource-consuming
countries implement green policies, since their demand restraint would be outweighed by
additional consumption in other countries. In this case, the Green Paradox would be reinforced
by carbon leakage, rendering any unilateral actions toward solving the climate problem futile.
To illustrate this point, let’s assume that the green policy consists of implementing a
cap-and-trade system in a subgroup of countries, with quantity constraints tightening over
time. Let’s also assume for a moment that resource owners do not react by changing their
extraction path. Under these conditions, at each point in time, the world market price for fossil
fuels will be lower than it would have been without the policy because the cap reduces world-
wide demand. Consumers in countries not participating in the emissions trading system would
enjoy the lower world market price, and their energy demand would increase, while consumers
in participating countries would be forced to pay a higher energy price and consume less
because they would also have to pay for the emissions certificates. Consider now the possibility
of an adjustment reaction affecting the extraction path and suppose that, without such an
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adjustment, the tightening of the cap would be fast enough to cause the present value of
the world-market price wedge to increase over time. In this case, the price signal would
again induce resource owners to bring forward extraction to the present to minimize revenue
losses.
These green policies carried out by only a group of countries are inefficient for two reasons.
First, the energy no longer consumed by these countries will be consumed by non-participating
countries instead. Second, the nonparticipating countries will also consume the additional
quantities of energy that resource owners extract and sell because of the Green Paradox. In
an initial phase, this would lead to more than 100 percent leakage because nonparticipating
countries would consume more carbon than the countries introducing the cap-and-trade
system would cut.
4
Conclusions
My pessimistic conclusions about the efficacy of green demand-reducing policies have no
doubt disappointed many environmental activists. However, the climate problem is too
important to be left to ideologues. The purpose of green policies is not to provide the public
with a warm glow from charitable actions but rather to cool the earth.
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
reoptimization by successive generations of policy makers.
The first step toward imposing quantity constraints should be to extend the existing UN
emissions trading system (initially introduced through the Kyoto agreement) to the entire
world and to add national or supranational cap-and-trade systems similar to Europe’s. If the
United States, China, and India could be convinced to sign such a treaty, 71 percent of world-
wide CO
2
output would be covered. In a second step, we should attempt to convince most of
the rest of the world to participate. By definition, such a global system would be safe from
international leakage and would not fall victim to the Green Paradox. In my opinion, this
approach offers the only potential solution to the world’s climate problem, which, as Stern et al.
(2006) have remarked, is the world’s greatest market externality ever.
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