A Tale of Two Energy Policies: Germany vs. UK

Some people have recently pointed out that one of the many adverse effects of Brexit is the fact that it makes it much harder for the European Union to hit its carbon emissions target. The reason is that the United Kingdom has the lowest per-capita emissions of carbon dioxide in the EU. So if the UK falls out of the EU statistics and the target doesn’t get adjusted, other EU countries will have to step up their emission reduction efforts.

This is, of course, more a problem of political symbolism than a substantial one: If member states thought that their pre-Brexit climate policies balanced the cost and benefits of emission reduction, then why should Brexit make a difference? What matters for the greenhouse effect, after all, are global emissions.

But one might ask: how come the UK is the “green poster child” of Europe? What are they doing differently? Here I find it instructive to compare the UK to Germany.

As is well-known, Germany has embarked on an ambitious policy of “energy transition” (Energiewende) which consists of a combination of subsidies for renewables and legally mandated targets for fossil energy production. (For reasons that don’t really make sense except to those living in the bubble of German public opinion, they also see their shutting down nuclear power plants as a part of the green energy transition.) The question of how fast the government should shut down coal plants, and other aspects of the energy transition, are hotly debated issues in Germany.

The UK has taken a different approach. Rather than trying to regulate the energy mix directly, the British government decided to use the price mechanism: they implemented a special tax to create a price floor for EU emission certificates which British energy producers need to buy. The price floor increases every year according to a fixed formula, ensuring that the cost to energy producers of emitting carbon dioxide in the UK has been substantially higher than in the rest of the EU throughout the last decade.

OK. So how did the UK do compared to Germany?

Pretty impressive. True, the UK’s per-capita emissions were lower than Germany’s to begin with. But Germany has cut their emissions by 12% over the last decade, while the UK cut theirs by 33%!

What about the energy mix?

The UK started from a renewable share of only 1.6% in 2007. Now it’s 11%. By contrast, during the same time, Germany went from about 10% to 16.5%. That, too, is a pretty impressive difference.

But didn’t the UK policy lead to much higher energy prices for consumers?

Nope. In fact, energy is considerably cheaper in the UK than in Germany. One kilowatt-hour of energy costs only about 18 euro cents in the UK (accounting for purchasing power differences and including all taxes) compared to 29 euro cents in Germany.

I call this a big win for Pigou taxes as opposed to direct regulation.

(Ceterum censeo: I still think the demand side is the wrong side. Effective climate policy must restrict the supply of fossil fuel!)

Addendum: Patrick Mellacher wants me to include the size of the industrial sector in my comparison. I’m happy to oblige him. Of course, the industrial sector is smaller in the UK compared to Germany. But that only explains why the level of emissions per capita is lower in the UK, not why the decrease in emissions was larger. It doesn’t seem like the industrial sector has changed in size (compared to the economy as a whole):

Supply-side policies against global warming

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:

  1. 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.
  2. 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.
  3. 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!

Some unpleasant carbon tax economics

Every economist knows that a carbon tax is the correct solution to climate change. By correct I mean the solution that a perfectly informed, well-meaning dictator would choose.

But when I was recently brooding over some dynamic optimization problems, I made a discoverey that I haven’t seen anyone discuss. And I find it disturbing.

I’m going to develop the argument formally below, but I will give away the punchline. Brace for impact!

Theorem: A carbon tax that remains constant over time doesn’t change the extraction path of fossil fuel. A carbon tax that increases over time tilts the extraction path in such a way that more fossil fuel is extracted now, less later.

If this is obvious to you, you can stop reading and start freaking out. If you think that this must be wrong, I would like you to point out any error I made in the argument below.

Let’s start from the Hotelling rule which dictates how profit maximizing oil sheikhs exploit their resource over time:

P(1+r) = P’,

where P is today’s price for oil (or gas, or whatever), r is the real interest rate and a prime denotes future variables. The rule says that you want prices to rise over time at the rate of the real interest rate.

When I say P is the price for oil, I mean the price the oil sheikh gets. The price consumers pay is P(1+t) where t is the (ad-valorem) carbon tax.

Next we need to postulate a demand curve to translate the Hotelling rule, which is about the evolution of prices, into a rule about quantities. Let’s write the (inverse) demand curve as follows

P(1+t) = D(Q)

and let’s postulate that D is decreasing in Q. This should shock nobody: demand curves slope down.

I hope you agree with me that absolutely nothing about this is in any way controversial. But then you must agree with me that we can combine the Hotelling rule with the present and future demand curves to get the following equation:

D(Q)(1+r)/(1+t) = D(Q’)/(1+t’).

This, ladies and gentlemen, is the dynamic law of motion for fossil fuel consumption. It describes how the quantity of fossil fuel extracted from the ground evolves over time. Since everything that is extracted will be consumed in the end, it implies a time path of carbon emissions.

Now what can we deduce about that time path from this equation?

  1. Hold the carbon tax constant over time by setting t=t’, and you will see that the equation reduces to
    D(Q)(1+r) = D(Q’),
    which is exactly the same equation that would hold if no carbon tax existed at all. It follows that with a time-invariant carbon tax, the sheiks will go on extracting oil and carbon emissions will continue at the exact same rate as if there were no carbon tax.
  2. It gets worse.  Suppose the carbon tax increases over time, i.e. t<t’. The effect of this will be the same as if the real interest rate would increase: it will make fossil fuel prices rise at a faster rate. But how do sheikhs make the sure the price path is steeper? By extracting more today, thus lowering the price today, and less in the future, thus increasing the future price.

Quod erat demonstrandum!

Now, of course you can refine the argument. What if, for example, the carbon tax eventually becomes so high that even the most fanatical SUV lover will refuse to pump gas? I don’t think this changes the argument. All this means is that oil producers will tilt the extraction path even more towards the present.

After all, there is a fixed and finite reserve of fossil fuels in the ground. All a carbon tax can change is when it will be extracted and the price consumers will pay for it.

If my argument is correct, why exactly are we sure that a carbon tax is the correct solution to climate change?

Addendum: If you want to me more concrete, assume fossil fuel demand is iso-elastic with elasticity e. In this case it is almost trivial to derive the equilibrium quantity: If R is the current stock of oil reserves, the quantity extracted now is

Q = (1-1/s)R with s = [(1+r)(1+t’)/(1+t)]^e

Notice that the extraction share Q/R is increasing in s which is increasing in the ratio of future to present carbon taxes (1+t’)/(1+t).

Zum Pariser Klimaabkommen

Am Sonntag letzter Woche war Karl Steininger „Im Zentrum“ um über das Pariser Klimaabkommen zu diskutieren. Ich fand die Diskussion, gemessen an dem, was man sonst von diesem Format gewohnt ist, sehr wohltuend: sachlich, unaufgeregt, informativ.

Für alle, die das Abkommen verschlafen haben: Die 195 Staaten haben vereinbart, dass die Erderwärmung auf unter 2° (relativ zu 1880) begrenzt werden soll. Wie wollen sie das schaffen? Indem jedes Land sich selbst Emissionsziele setzt, über deren Einhaltung sie dann regelmäßig Bericht erstatten müssen. Was hat die Entwicklungsländer, die ja beim Kyoto-Protokoll nicht dabei waren, diesmal dazu gebracht zuzustimmen? Sie bekommen für ein paar Jahre (von 2020 bis mindestens 2025) 100 Milliarden Dollar jährlich um die Anpassungskosten abzumildern. Wie viel Geld ist das? Eine ganze Menge: Im Jahr 2013 betrugen die Ausgaben für offizielle Entwicklungshilfe ca. 160 Milliarden Dollar. Was passiert, wenn die nationalen Emissionsziele nicht eingehalten werden? Nichts. Die Berichte über die Einhaltung der Klimaziele sind rechtlich verpflichtend, nicht aber die Einhaltung der Klimaziele selbst.

Nun gut, die große Revolution, von der Francois Hollande gesprochen hat, ist das nicht. Aber sicherlich ist die Tatsache, dass Russen und Türken, Iraner und Israelis, Nord- und Südkoreaner hier miteinander an einem Verhandlungstisch saßen und ein gemeinsames Abkommen unterzeichneten, ein Riesendurchbruch.

Wem wird das Abkommen nützen? Dazu gehören sicher die Erzeuger von erneuerbarer Energie, die in Zukunft wohl noch stärker subventioniert werden. Die heimische Landwirtschaft wird es sicher verstehen, das klimapolitische “Momentum” (© Andrä Rupprechter) in mehr staatlichen Schutz vor bösen (weil klimaschädlichen!!!) Agrarimporten umzumünzen. Die Klimaforscher dürfen sich höchstwahrscheinlich über eine gesteigerte staatliche Nachfrage nach ihrer Expertise freuen.

Im besten Fall wird die Klimapolitik dazu führen, dass perverse Anreizsysteme abgebaut werden. Dazu gehören all die Dinge, die Karl Steininger genannt hat: das Pendlerpauschale, die steuerliche Begünstigung von Dienstautos, die Subventionierung ineffizienter Energieerzeugung. Und vielleicht wird Österreich ja wirklich zu einem “Silicon Valley” der grünen Energie, einem Hotspot Zentrum energietechnologischer Innovation.

Leider halte ich das für einen frommen Wunsch. Ich fürchte Klimapolitik wird das bleiben, was sie ist: ein sehr effektives Schlagwort, das gut organisierte Interessengruppen in der politischen Debatte benutzen, um sich auf Kosten der Allgemeinheut zu bereichern.