4 minute read
By Simran Panesar, Deputy Editor
When William Nordhaus won the Nobel prize for Economics earlier this year, his pioneering work ratified climate change into mainstream economics, effectively providing a roadmap for a future where the world’s economic health would be linked to its environmental one.
Climate Change is perhaps the greatest externality that the world has ever faced. Many economists state that the most effective response to an externality is to internalize it, by ensuring that decision makers have to pay for the damages arising from harmful activities. According to this, the solution to the environmental problem of climate change lies in a Pigovian Tax-a tax that equals the social marginal damage from emissions, so that households and businesses choose an amount where the harm from emissions is just offset by the extra benefit derived from the polluting activity. While this policy seems economically sound and a fix-all solution, there has been a disappointing cleavage between theory and practice. Real world climate policies have not been very successful and historic conventions such as the Kyoto protocol have reported a sudden spike in emissions immediately after introduction of the policy.
Such unintended consequences have been described using the term ‘Green Paradox’- an outcome in which conventional climate policies aimed at reducing carbon emissions have the opposite effect-emissions increase, at least in the short run. ‘Green Paradox’, the brainchild of economist Hans-Werner Sinn focused on one specific reason for this paradoxical outcome: the effect of climate policies on the long-run profits that owners of fossil resources expect to earn from selling their resources over time. Because fossil fuels are nonrenewable resources, their prices reflect not only the cost of extraction but also their scarcity. Hence, owners of fossil fuels enjoy ‘scarcity rents’ and maximize their profits by deciding the best time to extract their coal, oil, or gas reserves.
Now, suppose policy makers announce today that a carbon tax would be imposed in a few years in order to reduce emissions and damages from climate change. This pre-announcement divides the resource owner’s planning horizon into two periods: before and after the tax is introduced. The resource owner will still maximize profits over all periods, but the producer price after the introduction of the tax is now the consumer price minus the tax. The resource owner will now equalize the present value of the resource rent by extracting more of the fossil resource today (pre-tax) and less tomorrow (post-tax). The owner will still extract all of the resource because each unit still yields rents, hence the cumulative production and emissions are unchanged. A carbon tax that is implemented immediately might also result in a green paradox if the tax rate starts low and increases fast over time. This policy is equivalent to imposing new additional taxes every year, thus creating incentives each year to extract scarce resources immediately rather than in later years.
In the simple model discussed, taxation does not prevent resource owners from exhausting resources over time. Assuming that extraction costs are the same for all units produced and that taxation is not prohibitively high, fossil fuel extraction is profitable down to the very last unit of the resource. The implication of the above analysis is that the sole impact of taxation is on the time profile of resource extraction. The only way in which a carbon tax could actually reduce total fossil fuel use and emissions would be if the tax were high enough to completely choke demand and reduce the scarcity rents to zero. The green paradox implies that at some point, we must make fossil energy unprofitable. In order to significantly reduce the risks of harming the delicate balance of the environment, we must rethink policies to focus on reducing the cumulative amount of resources extracted and ensure that the major share of currently existing coal, gas and oil reserves remain unexploited. Ultimately, what we need is a cap on cumulative emissions, also known as a carbon budget.
Interestingly, we may already be experiencing the green paradox today. Fossil fuel companies anticipate stringent climate policies in future not only due to actual policy announcements but also from following the scientific and political debates on climate change. Some anecdotal support for this phenomenon can be found in predictions of a “new normal” of low oil prices combined with constant levels of production, explained by banks and business analysts as resulting from fossil fuel owners trying to sell their resources before stricter climate policies are enacted.
The green paradox has sometimes been thought to suggest that climate policies per se are ineffective or even harmful. However, this would amount to misinterpreting the debate. Rather, the literature on the green paradox seeks to broaden the discussion on climate policy to go beyond the current and almost exclusive focus on demand side responses and to consider how supply side reactions might determine policy outcomes. Ever since the term was first coined, a broad debate has emerged in environmental economics literature concerning the validity of the theoretical arguments supporting the green paradox as well as about its importance and relevance in solving current climate change issues. While the phenomenon of the green paradox is relatively recent, the unintended effects of taxation on the timing of resource extraction have been studied before. The extent of the policy challenge posed by the green paradox is yet to be determined, but there is a need to call attention to both- the complexities of identifying an optimal carbon path, as well as the unforeseen, harmful consequences of well-intended but naive policies.