Alas, it turns out that I was not the first to point out the perverse dynamic supply-side effects of a carbon tax! (Well, I never really believed I was the first anyway.)
Hans-Werner Sinn wrote a whole book about it. It is called the “Green Paradox“. And there is some academic literature on it, although surprisingly little. (For instance, this recent paper on the role of oil reserves and marginal extraction costs).
Sinn also wrote this paper in 2007 which confirms my hypothesis that a rising carbon tax makes resource owners extract more fossil fuels in the short run. But he does so in a much more sophisticated dynamic general equilibrium model. The paper helps to answer one important objections I received in private conversations.
My good friend (and Graz Economics alumnus) Michael Schwarz points out that oil extraction can’t just be turned on and off like a water tap. There are extraction costs! Yes, indeed, and Sinns paper addresses this point:
„If extraction costs are assumed, the problem of moving the economy in the wrong direction is mitigated, and with sufficiently strong extraction costs, current extraction may even move in the right direction.“Sinn, HW. “Public policies against global warming: a supply side approach”, Int Tax Public Finance (2008), p. 21
But Sinn also points out:
„As marginal extraction costs are likely to be only a small fraction of the price of the extracted resource, the effect on the extraction path may be tiny. For instance, the average production costs of crude oil amounted to only about 15% of the average spot price in 2006.“Sinn, HW. “Public policies against global warming: a supply side approach”, Int Tax Public Finance (2008), p. 20
Since oil extraction is a high fixed cost, small marginal cost industry, the average production costs overstate the marginal costs which are relevant for the extraction path.
Recent empirical research throws more doubt on the importance of extraction costs. Here is a quote from the paper by Heal and Schlenker linked to above:
Using data from a large proprietary database of field-level oil data, we show that carbon prices even as high as 200 dollars per ton of CO2 will only reduce cumulative emissions from oil by 4% as the supply curve is very steep for high oil prices and few reserves drop out.Heal, GM and Schlenker,W, “Coase, Hotelling and Pigou: The Incidence of a Carbon Tax and Co2 Emissions” (July 2019). NBER Working Paper No. w26086
Sinn’s paper is interesting not just for its thorough analysis of the Green Paradox, but for suggesting a couple of alternative policies against global warming. The key to these policies is that they address the important point of the issue: the quantity of fossil fuels extracted.
Here are three of them:
- Capping fossil fuel production: Basically, we need to tell the oil sheikhs very gently and politely that they need to stop extracting oil. For example, we could agree a fixed quota for annual oil and gas extraction. Since the oil sheikhs are intelligent people, they might be pursuaded to do that if we offer some development aid in exchange.
- Emissions trading: We could set a global cap on carbon emissions and auction off carbon certificates to industries and households. The EU has already tried such a scheme, although the cap was probably too large and not enough industries were not included (e.g. airlines). The big advantage of emissions trading compared to a tax is that it directly addresses the quantity, not the price. The downside is that negotiating a global trading system opens up a huge can of worms: especially, which country gets how many certificates? How should the revenue be used, etc.
- Sequestration and afforestation: Another way to solve the problem would be to de-link carbon emissions from fossil fuel consumption. Sequestration, i.e pumping the emitted CO2 back into the earth is one way (how feasible this is techniqually, I have no idea). Growing more trees which absorb CO2 naturally is another. Again, there could be international agreements to subsidize both these things.
I think all these policy proposals should get at least as much attention as the carbon tax. Why is nobody talking about them?
I should also point out that the issue is broader than the carbon tax. Any policy that merely tries to shift the demand curve for fossil fuels down will fail achieve the objective of decreasing greenhouse gas emissions unless it avoids the perverse effect on the fossil-fuel supply curve. Subsidizing e-mobility, putting tarrifs on international shipping, shaming people into avoiding airplanes, incentivizing the installation of solar panels and wind energy – all those things merely change the demand side.
I think the demand side is the wrong side. Let’s talk more about the supply side!