The Earth’s atmosphere comprises 76 percent of nitrogen and 21 percent of oxygen. Water vapour constitutes 2.5 percent of the remaining portion. The rest is made up of several trace gases, of which carbon dioxide (CO2) has the largest importance.
The temperature of the Earth is stable in the sense that the amount of energy it receives from the Sun equals the amount of energy it radiates back into space. The greenhouse gases (carbon dioxide, methane, chlorofluorocarbons, ozone) make this process possible. They balance the incoming and outgoing radiation by absorbing the infrared energy radiated by the Earth and re-emitting it back to the planet (because the Earth is colder than the Sun). Without greenhouse gases, the average temperature would be around -6C and the planet would be inhabitable. A change in the greenhouse gases concentration may cause an imbalance in the overall energy that would result in the Earth warming or cooling. The greenhouse gases allow the mankind to proliferate but pose a serious threat to the sustainability of their lives.
1.2) Carbon dioxide
Carbon dioxide is a colourless, non-toxic greenhouse gas found in volcanoes, geysers, petroleum, and natural gas deposits. Before the industrial revolution, CO2 concentration was 0.028 percent (280 ppm = 280 part per million). CO2 is produced by the combustion of fossil fuels. Since the 18th century, with the discovery and the spread of new energy sources such as coal, oil and natural gas, the stock of CO2 in the atmosphere has increased causing, together with the other greenhouse gases, an increase in the average temperature from 13.5C to 14.5C. Calcination, a process that consists in heating calcium carbonate (the raw material for cement), is another source of CO2. Cement production is, indeed, a very polluting process because, in addition to the CO2 involved in calcination, more dioxide is created to fire up the kilns. Figure 1 (Boden, Marland and Andres, 2015) shows the contribution of the different sources of CO2 to the total emissions. In 2013, the Manua Loa Observatory in Hawaii recorded for the first time in history a CO2 concentration of 400 ppm. Since such a small increase in the concentration has been able to raise the temperature of 1C, it is extremely important to track the change in greenhouses gases concentration and to keep it as small as possible in order to avoid a calamity. Considering that the CO2 emitted today will remain in the atmosphere for around 30,000 years, timing is critical.
Figure 1. Contributors to the total carbon emissions. Boden, Marland and Andres, 2015.
1.3) CO2 and temperature
Prior to the mankind, volcanic eruptions were the only endogenous way for carbon emissions to increase. They now account for only 1.25 percent of the yearly anthropological emissions. Human activities have substantially increased the amount of carbon cycling through the atmosphere and the seas by burning carbon that was supposed to stay hundreds of meters below the ground level.
Figure 2 (Wight, 2010) is a graphical representation of the temperature increase in the last century.
Figure 2. Global average temperatures. Wight, 2010.
The extent of temperature increase varies among geographic locations, with greater changes in the areas far from the equator and the shores. The trend occurred in two boosts, one from 1900 to 1945 and one since 1975. The interval between them is a consequence of the sulphur dioxide emitted in the first period. In the atmosphere, sulphur dioxide turns into sulphate particles that reduce warmth by hindering sunlight. During the 1970s the first measures against greenhouse emissions – thus against sulphur dioxide too – were applied, reducing the softening of global warming and causing a second surge in temperature. This is a proof that global warming was not of public interest until 50 years ago.
It is clear how temperature and CO2 are correlated. Is this an evidence of the greenhouse effect?
No, because the changes in temperatures have always occurred before the changes in the atmosphere’s level of carbon dioxide. Instead, the correlation is explained by the fizzing effect and the permafrost effect. Contrary to the behaviour of water vapour, only a limited amount of CO2 can be naturally self-regulated (absorbed by the seas and stored by forests); a great part of the CO2 resulting from human activities accumulates in the atmosphere and in biomass. Furthermore, as the temperature of the seas rises, their capacity to absorb carbon dioxide gets lower and lower. This is the so-called fizzing effect, which is the most important factor concerning climate change. Together with the reduced capacity of oceans to absorb CO2, the temperature increase causes permafrost to melt (permafrost effect), thereby releasing CO2 either directly or indirectly (through methane).
Therefore, it is possible to conclude that changes in the concentration of carbon dioxide follow changes in the average temperatures. Nevertheless, this does not mean that there is no greenhouse effect. The reality is that variations in the concentration of greenhouse gases are less common and smaller than changes in the solar radiation. Fluctuations in the power of solar radiations cause changes in temperatures which alter the stock of CO2 due to the fizzing and permafrost effect. It must be said that before the industrialisation temperatures were already above the long-term average due to the geological cycles. The anthropological increase in greenhouse gases has only exacerbated the effect, leading to a vicious circle that has led too far from the previous equilibrium.
1.4) Non-renewable resources
Non-renewable resources are defined as those that do not regenerate quickly enough to fulfil human needs. The most common non-renewable resources are the fossil fuels such as oil, coal and natural gas. Among these, natural gas is the most efficient in terms of energy released, followed by crude oil and coal. The carbon emitted (burnt) is proportional to the energy released. Therefore, while efficiency gains and technical achievements do make fossil fuels more powerful, they also increase the amount of CO2 in the atmosphere.
Figure 3. OPEC share of world crude oil reserves. Organization of the Petroleum Exporting Countries, 2018.
Oil is the most used fossil fuel due to political reasons. Figure 3 (OPEC, 2018) shows where oil deposits are located. The majority of oil deposits are in the most unstable countries where the insecurity of property rights causes a shorter running time, as it will be discussed in section 4.3. The instability is reflected in the price of crude oil that has increased much more than the prices of gas and coal in the last 50 years (see figure 4, Sinn 2012). On the contrary, coal deposits are in very safe countries such as Australia, US, and China, and indeed it is the least extracted and the cheapest fossil fuel.
Figure 4. Real prices of fossil-fuels resources. Sinn, 2012.
2. The Hotelling’s Rule
In 1931 Harold Hotelling published his studies on the use of a non-renewable resource. He focused on the optimal extraction path in a multi-period model, its impact on social welfare and on the expected price pattern overtime, and the sensitivity to changes in the parameters. For the sake of simplicity, only a two-period model will be analysed here.
2.1) Two-period model with no extraction costs
In order to find the optimal quantity to be extracted today, the future benefits and costs must be discounted to the present.
Suppose there are no extraction costs, R0 is the total initial stock, and δ is the discount rate. Ut(qt) is the utility function which corresponds to the social welfare. Recall that social welfare is the sum of consumer and producer surpluses. The goal is to maximise present social welfare and future discounted social welfare to find the socially optimal extraction path:
max{U(q_0 )+U(q_1 )/(1+δ)}
subject to the limit of the initial stock R_0=q_0+q_1.
This problem shall be resolved by using the Lagrangian method. The constraint (stock limit) is expressed as an equation that equals zero (R_0-q_0-q_1=0 ) and multiplied by the Lagrange multiplier λ, then added to the social welfare function. Therefore, the Lagrangian function is the following:
L=U(q_0 )+U(q_1 )/(1+δ)+λ(R_0-q_0-q_1 ) .
The maximisation process consists in:
(i) taking the partial derivatives of the Lagrangian with respect to q0, q1, and λ;
(ii) equating them to zero.
{█(∂L/(∂q_0 )=0@∂L/(∂q_1 )=0@∂L/∂λ=0)┤ {█(U'(q_0 )-λ =0@U'(q_1 )/(1+δ)-λ=0@R_0-q_0-q_1=0)┤
The first two lines are two equations in two unknowns (q0 and q1) that can be written as
λ=U'(q_0 ) and λ= U'(q_1 )/(1+δ).
Therefore: U'(q_0 )=U'(q_1 )/(1+δ).
According to microeconomic theory, the marginal utility of the last good consumed equals the price paid to purchase it. Hence, substituting the utility functions with the prices in the respective periods:
p_0=p_1/(1+δ)
or,
p_1=p_0 (1+δ).
The latter formula is the Hotelling’s Rule in a two-period model with no extraction costs.
It says that the price of a non-renewable resource in period 1 is equal to the price of the resource in period 0, multiplied by the future value interest factor 1+δ.
2.2) Two-Period model with extraction costs
The assumption of no extraction costs implies that the cost of a resource in-land and the cost of the same resource wellhead (extracted) are the same. This is definitely a situation far from reality. A more truthful case clearly includes some extraction costs. In the real world, extraction costs are positive. The price of a resource wellhead is P while the price of a resource in-land is P – C , where C is the extraction cost (assumed to be constant). P – C is also known as rent or royalty because of the rights that kings used to have on subsoil resources in their reign. The rent increases in each period at the rate of interest, as price does. Consequently, the Hotelling’s Rule in a two-period model with constant extraction costs is:
p_1-MC=(1+δ)(p_0-MC)
and the Lagrangian function becomes:
L=p_0 q_0-cq_0+(p_1 q_1-cq_0)/(1+δ)+λ(R_0-q_0-q_1 )
2.3) Graphical representation
Pearce and Turner (1991) offer a visual representation of Hotelling’s Rule that is very helpful in understanding the functioning and the dynamics of it.
Figure 5. Graphical representation of Hotelling Rule after Pierce and Turner. Mádai and Földessy, 2011.
Figure 5 (Mádai and Földessy, 2011) is made up of four quadrants. The upper-right quadrant represents the relationship between price and time, this is the price path of the resource that is described by the Hotelling’s Rule. The initial price P0 increases by the interest factor until the depletion of the stock at time T. PB is the price of a backstop technology (a close substitute of the current non-renewable resource). A backstop technology may be either an alternative source of the same resource or a completely new technology. As the price of conventional oil rises due to scarcity, an alternative source of oil (light tight oil, ultra-deepwater, kerogen) becomes cheaper in comparison. It follows that P0 is the optimal initial price because any price higher than P0 would reach the price of PB before the exhaustion of the resource, leaving a part of the stock unused. Instead, any initial price lower than P0 would cause a “jump” in the price as the resource would end before reaching PB. In other words, it would mean that the backstop technology is either non-available or available at a much higher price than the current trend. In conclusion, P0 is the optimal initial price as it determines a price path (therefore, a usage rate) that allows for a gradual transition between the current and the alternative resource.
The upper-left quadrant is the demand curve mirrored with respect to the y-axis. The quantity demanded increases moving to the left. The lower-left quadrant relates quantity with time. It expresses the extracted cumulative quantity: the area under the curve. At P0 the area is 0, at PB the stock is completely exhausted and the area is “full”.
2.4) Comparative statics
It is now possible to understand what happens when one of the parameters changes. The parameters are:
a) discount rate, δ;
b) price of backstop technology, PB;
c) total resource stock, R;
d) extraction cost, C;
e) demand.
An increase in the discount rate δ makes the price path steeper because of higher prices in future periods. Then, the owner of the resource lowers the price at the beginning because he is aware of the fact that demand will drop in the future, as shown in figure 6 (National Environment Management Authority, 1996). The initial price changes also because the price path would reach PB before the end of the stock otherwise. Consequently, T decreases as well. A higher discount rate causes a quicker exhaustion of the resource. The greater exploitation of natural resources is counterbalanced by the lower demand for energy due to the higher discount rate that makes the overall effect on the stock ambiguous.
Figure 6. Effect of an increase in the discount rate. National Environment Management Authority, 1996.
New discoveries or faster development might cause a backstop technology to become cheaper. When an alternative technology is less expensive PB shifts downwards and the price path “touches” PB earlier (see figure 7, Pierce and Turner, 1991). This means that the stock is not fully exploited: the optimality is reached by lowering the initial price P0. As the new price path will be below the previous one, demand will be higher and the resource will be exhausted before. As backstop technologies become cheaper, the current resource is employed at a higher pace in order to exhaust it before the alternative technology comes into play.
Figure 7. Effect of a reduction in PB. Pearce and Turner, 1991.
It may seem weird for a resource stock to change, but it actually happens. On the one hand, new research techniques allow for the exploitation of oilfields and deposits thought to be non-exploitable. On the other hand, new seismic technologies imply an improvement of the discovery rate. Stock estimates change periodically also as a consequence of the increasing price of non-renewable resources. When the price increases, the deposits that were not economically sustainable due to high extraction costs becomes accessible. An example is the exploitation of the crude oil in The North Sea after the price increase of 1973-1974.
Figure 8. Effect of an increase in the stock. Mádai and Földessy, 2011.
Figure 8 (Mádai and Földessy, 2011) shows the effect of an increase in the available stock: it causes the stock itself to last more. As long as the discount rate does not change either, the price path lies below the previous one.
Empirical data show that prices have been decreasing overtime, contrary to what Hotelling’s Rule says. As it can be seen from the figure 9 (Mádai and Földessy, 2011), if the discoveries are frequent, price keeps adjusting to the increasing stock by getting lower every time. The price path with increasing stock is therefore characterised by a discontinuity every time a new discovery occurs. Thus, the overall price trend might be negative, if supported by a large increase in R.
Figure 9. Effect of repetitive discoveries. Mádai and Földessy, 2011.
An increase in a resource stock causes the price of that resource to decrease, and the stock to last more.
If the extraction cost decreases, P0 – C (royalty) increases at the discount rate, causing PB to be reached before the exhaustion of the resource. Then, P0 decreases as well, but less than C. As a consequence, a larger quantity is extracted in the first period. Thus, the new price path is steeper and the stock is depleted earlier, as illustrated in figure 10 (Mádai and Földessy, 2011). The price path is steeper despite the constant discount rate due to the higher royalty.
Lower costs increase the pace of extraction and reduce the duration of the stock.
Figure 10. Effect of cost decrease. Mádai and Földessy, 2011.
Demand changes in the second quadrant do influence the price path in the first quadrant. Demand might increase because of demographic growth or as a consequence of higher incomes (GDPs). Demand might decrease if close substitutes of the resource are found. When demand increases, the new price path lies above the previous one, as the standard demand/supply relationship explains. If the price stayed the same, the stock would finish before PB. The higher price means a lower duration of the stock.
Figure 11. Effect of an increase in demand. Pearce and Turner, 1991.
Higher demand causes higher prices and a faster depletion of the stock. Simply, higher demand pushes price and quantity up. But since quantity is limited by the stock, the resource is exhausted earlier. Figure 11 (Pearce and Turner, 1991) is a graphical representation of that.
2.5) Monopoly
The extraction and price path under monopoly is of historical interest. Between 1971 and 1983 OPEC enacted a cartel. It fell apart during the 1980s due to new non-OPEC oil production and economic recession.
Microeconomics says that in a monopoly price equals marginal revenue. Therefore, the Hotelling’s Rule in a monopoly is:
〖MR〗_1=〖MR〗_0 (1+δ)
In addition, the extraction path is not (is less than) socially optimal because the monopolist restricts quantity in order to increase price. Hence, the same quantity spread over a longer period of time results in a longer duration of the stock. In other words, a higher initial price means a lower rate of extraction and therefore a lower extent in the use of the stock.
A monopoly is more conservative than firms in a perfectly competitive market are, as shown in figure 12 (Mádai and Földessy, 2011).
Figure 12. Resource conservation when the market is a monopoly. Mádai and Földessy, 2011.
2.6) Remarks
The Hotelling’s Rule is a theoretical model that predicts the behaviour of the owners of resources in terms of price and time frame of extraction. As every model, it has limitations as far as an actual validation in the real world is concerned. The take-home message is that Hotelling forecast an increasing price of exhaustible resources overtime. The lower the price is in the present, the quicker the depletion and the greater future price increase. The higher the price is today, the smoother the price increase and the longer the stock lasts.
3. World Market for Fossil Fuels
As already discussed, the common trait of fossil fuels is carbon emissions. When coal, natural gas, and oil are burnt, they release carbon that is supposed to stay underground. In order to simplify the economic analysis of the market for fossil fuels, supply and demand will represent the whole fossil fuels, disregarding their origin.
3.1) Demand
The demand for fossil fuels is affected by several factors like GDP, population growth, and climate. Price has a role as well because when it is higher, citizens cut consumption by avoiding vacations overseas and by commuting less. In addition, greater prices leave space for alternative technologies that become more affordable. High prices are the reason why people in developed countries insulate houses and switch to more efficient cars (=lower demand for fossil fuels). If prices were lower, world’s population would not care as much about using less non-renewable energy. If prices were even higher, cars would probably be much more efficient, nobody would go overseas and solar power would be much more spread. The curves in figure 13 (Sinn, 2012) illustrate the behaviour of consumers (energy saving strategies) when price changes.
Figure 13. Possible price-quality scenarios. Sinn, 2012.
According to the Hotelling’s Rule and the steadily increasing prices of fossil fuels, in the future the equilibrium is expected to climb up to the left. No movement to the right is awaited because prices cannot go down (at least in the long run) due to limited stocks. This means an escalation in consumers’ energy saving strategies that progressively become more and more efficient. The curve is asymptotic with respect to the vertical axis because, regardless of the price, consumption of non-renewable resources cannot be completely stopped as there are no perfect substitutes for the time being. The upper line is the demand with no government intervention whereas the lower curve involves some sort of environmental policy enacted by the government, being them tariffs, carbon taxes or any instrument that gives a competitive advantage to green technologies. The lower curve shows that green technologies are cheaper. That does not mean that non-renewable resources are cheaper too. Instead, the same price of fossil fuels allows for higher energy saving as the threshold is now lower. Therefore, demand for fossil fuels goes down without any change in price when the government successfully implements green policies.
One important remark must be made though. When considering green policies and the choices of governments, the analysis is limited to a specific country or geographical area. But the world demand is derived from the average behaviour of consumers all around the planet. What happens to demand in the Asian developing countries when Germany and Europe successfully reduce consumption? The answer depends on whether the supply of carbon is elastic or inelastic.
3.2) Supply, green policies and carbon leakage
Policymakers’ assumption is that the supply of fossil fuels is elastic. If supply is elastic, reducing demand does help in reducing CO2 emissions and environmental policies work as expected because less carbon is extracted. But if supply is inelastic, green policies are completely useless. If Europe demands less carbon but the supply of carbon is unchanged, it means that somebody else in Asia can consume more. When consumption is reduced somewhere, world prices go down and stimulate all countries’ demand, regardless of their policies. With a rigid supply, all the efforts of developing countries in saving energy are vain. Sinn, the author of ‘The Green Paradox’ (2012), calls it ‘The Neglected Supply Side’. Before Sinn, there were almost no academic publications and scientific literature dealing with the supply side of global warming.
“It isn’t the EU Commission President […], or the EU Parliament that sets emissions
levels, it is oil and gas potentates […]. It is they, together with the other owners of fossil-
fuel resources, who will ultimately determine how much carbon will be extracted and burned” (Sinn, 2012, p.128).
Figure 14. How Kyoto countries subside the world’s carbon consumption. Sinn, 2012.
Sinn (2012) explains ‘how Europe subsides the world’s carbon consumption’, a process known as carbon leakage, in figure 14. There are two group of countries: ‘Kyoto’ (those who signed the Kyoto Protocol and committed to restrict emissions: EU27, Australia, Canada, Russia, Japan) and ‘Non-Kyoto’ (those who signed but without commitments: US, India, China, Iran, Korea). The demand of Kyoto countries is shown left to right, the demand of non-Kyoto countries is shown from the right. Equilibrium is at point A, with Kyoto countries consuming a quantity that equals the distance between the left vertical axis and point A, and non-Kyoto countries consuming a quantity that equals the distance between A and the right vertical axis. When Kyoto countries enact green policies, their demand is reduced, thus it is shifted to the left. The new equilibrium is at point B: the lower price has given an incentive to the non-Kyoto countries to consume more. Not only the non-Kyoto countries are responsible for 70 percent of the global emissions, but they also benefit from the commitment of Kyoto countries to lower consumption. Thanks to the latter, the former can purchase cheaper fossil fuels. ‘The Europeans subsidise American and Chinese consumers without doing anything for the climate in the process’ (Sinn, 2012, p.146). The only positive side effect is that Kyoto countries may buy cheaper oil too. Anyway, it often results in a higher consumer price (B’) due to the taxes used to reduce demand. The proceeds from taxes and carbon tariffs are a source of revenues for the governments, this is a rationale for environmental policies from the point of view of policymakers that can do nothing for carbon pollution. When it comes to saving the planet instead of saving the economy, punitive tariffs are pointless and the problem is much bigger than it may look like. It goes beyond politicians and policymakers and it involves much more influential figures.
There is only one solution to slow down global warming to an effective extent. It is not on the demand side, but it is on the supply side. It is not to enact tens of policies and regulations aimed at saving energy, but it is to convince the owners of resources to leave them underground.
Of course, supply is neither perfectly elastic nor perfectly inelastic (in the short run). Results might be not as strong as those of the theoretical curves, but still significant. The point is that it is not possible to forget about the supply side. As the empirical International Energy Agency’s data show in figure 15 (Sinn, 2012), there has been no decrease in carbon emissions since the Kyoto Protocol commitments and the EU emission trading system.
Figure 15. The world’s CO2 emissions. International Energy Agency, as cited in Sinn, 2012, p. 129.
4. The Owners of the resources
Sinn (2012) asserts that the search for the right exploitation path is the greatest task for humanity in the next centuries. Oil sheikhs, Russian potentates, multinationals such as Shell, Exxon, BP are those who decide when and how much to extract. Two variables are determined by their decision. On the one hand, GDP growth. With no fossil fuels, it is very hard to imagine a growth like the one the world is witnessing nowadays. On the other hand, global warming. The hardest trade-off ever is between human survival and social welfare. A more in-depth analysis involves future generations as well: do people want to bequeath them capital above ground or underground? How does global warming affect this decision?
4.1) Drivers
Choosing the exploitation path is a problem of wealth maximisation. Indeed, it has much to do with finance and capital markets. Leaving resources underground means betting on their higher prices as they become scarcer. Extracting now means monetising and investing the proceeds in the present. Then, the decision is a comparison between:
1) interest rate – the amount that can be earned by investing cash in the present;
2) expected appreciation rate of deposits – the amount that can be earned leaving the resources underground.
When the interest rate exceeds the expected appreciation of deposits, a larger quantity is extracted today. When the opposite happens, more is left for future extraction. Therefore, the equilibrium implies today’s interest rate to equal the expected future appreciation rate. This is what Hotelling’s Rule says. Of course, expectations differ from reality and price jumps are more common than what Hotelling predicted. From the point of view of the owners, a pure profit-seeking strategy is consistent with the conservation of resources because extracting everything today implies no revenues when the overall supply will be scarcer and more profitable. Then, postponing exploitation means bequeathing natural capital to the heirs.
4.2) Ethical considerations
The introduction of The Stern Review on the Economics of Climate Change deals with ethics as a matter of rights. ‘Future generations should have a right to a standard of living no lower than the current one’ (Stern, 2006, p.87). He claims that the environment, together with health, consumption, and education is one of the consequences policymakers should consider in the design and choice of future actions. In this light, all the policy decisions should be judged in relation to their consequences ‘(i) within generations, (ii) over time, and (iii) according to risk’ (Stern, 2006, p.88).
From a more analytical perspective, inheritance decisions might affect the rate of extraction by changing the rate of interest. The more altruistic people are, the more they save, the lower the interest rates. Lower interest rates mean that owners prefer to leave resources underground. Whether current generations are bequeathing too much or too little to future generations is hard to tell. Anyway, if people are not altruistic enough, it is very hard that governments behave differently. Both the politicians that represent future generations and voters do live now. The conflict between present and future consumption should be discussed with both present and future generations. But there is no way to make future generations decide because they are not here yet. According to Sinn, ethical considerations cannot reach any resolution.
4.3) Speed of extraction
Global warming does not enter in the economic calculations. According to the High-Level Commission on Carbon Prices, which was born after the Paris Agreement in order to sustain the attainment of the Sustainable Development Goals, this is the greatest market failure ever.
As a matter of fact, there are some economic gains from postponing exploitation. In addition to the future GDP growth, deferring extraction reduces current GDP expenses that would occur to repair the damages of global warming. If extraction is postponed by say, 10 years, it means that for 10 years there will be fewer costs associated with floods, storms, and cooling. Then, the optimal extraction path implies an equivalence between the interest rate and the sum of the appreciation rate of resources and the saving from postponing global warming. But the last item is not taken into account by Hotelling’s Rule. This insight suggests that bequeathing natural capital is preferred to bequeathing man-made capital by the climate change that can be circumvented with the deferral of extraction. Then, by exploiting resources more slowly, society can make future generations better off without hurting the current generation (a Pareto improvement). On the one hand, future generations will enjoy more carbon in the subsoil and less CO2 in the atmosphere. On the other hand, current generation could increase consumption because savings from global warming would exceed the reduction of GDP from extracting less.
Figure 16. Market behaviour relative to the social optimum – too cheap today, too expensive tomorrow. Sinn, 2012.
Figure 16 (Sinn, 2012) shows that the Pareto optimal path is flatter than the market path (Hotelling’s Rule, the curve in the middle). In the latter, the initial price is too low so that the higher demand leads to faster depletion and quicker price increase in the future. A policy that reduces the pace of extraction is preferable in terms of inter-temporal social welfare.
What happens in reality is far from both the optimal (Pareto) path and the market (Hotelling) path. The majority of fossil fuels deposits (especially oil) are located in countries with a precarious social situation and high political risk. Political revolts may quickly cause owners to lose their property rights on deposits. Therefore, owners’ fear of expropriation makes them extract quicker than expected. The consequences of this quick exploitation are a very low price in the present (lower than market price) and very high price in the future because of higher scarcity (the steepest curve in figure 16). Protection of property rights must be a priority to ensure a conservative approach to carbon deposits depletion.
In summary, the Pareto optimal path does not exist in the real world due to the neglect of the benefit from deferring global warming and due to the costs of expropriation risk.
5. The Green Paradox
5.1) Policy challenge
The previous sections outlined that current green policies focus on reducing demand which can do nothing to slow down global warming. The ideal policy should involve the owners of carbon deposits and should convince them to reduce the supply of carbon, then the speed of extraction. A supply-side approach is the only effective approach.
‘The current environmental policies of many countries are expensive, inefficient, inhumane, and in many cases entirely useless’ (Sinn, 2012, p.187).
The current policies are not only useless but often counterproductive. The reduction in demand of European countries in the last 10 years produced an increase rather than a decrease in the supply of fossil fuels due to the carbon leakage overseas. The commitment to further reduce future demand (Kyoto Protocol, Paris Agreement) has been seen by the owners of resources as an announcement of future expropriation of their deposits. Therefore, they reacted accordingly by increasing the supply and extracting faster. The ineffectiveness of the green policies and their side effect is what Sinn named ‘The Green Paradox’.
‘The mere announcement of intentions to fight global warming made the world warm even faster. That is the Green Paradox’ (Sinn, 2012, p.189).
The owners feel threatened by the lower and lower demand. Indeed, what the majority of developed countries are doing, is to aim to gradually cut consumption in the next 50 or 100 years by a specific amount. The tendency toward green technologies and alternative energy is stronger and stronger. New laws and directives progressively tighten the consumption of carbon. In the mind of the landlords, this means that one day demand would be so low that nobody will need fossil fuels anymore. The result is that they extract as much as they can today in order to deplete the deposits as fast as possible, because they will be worthless in the future. The immediate effect is a huge increase in the concentration of CO2 in the atmosphere. Thus, demand affects supply on the basis of the timing of the expected cut in consumption. An expected cut in consumption in the future increases the speed of extraction today. This is what happens now, countries become greener and greener by gradually demanding less energy. But as countries become more environmental-friendly, they unwittingly increase global warming by increasing the supply of fossil fuels that less environmental-friendly countries can consume: The Green Paradox.
5.2) Empirical evidence and Hotelling
Figure 17. Oil price trend. Macrotrends.net, 2018.
The empirical evidence of The Green Paradox can be found in the price behaviour of fossil fuels. Figure 17 (Macrotrends.net, 2018) represents the oil price trend in the last 10 years. The Paris Agreement was drafted and signed on December 2015 and April 2016 respectively. Oil price fell in that period from more than $50/barrel to $29. This reaction is a bridge between the Hotelling’s Rule and the Green Paradox. Indeed, Hotelling said that lower initial prices cause a steeper price trend and a faster depletion of resources. In this case, the price drop is a sign that resource owners feel threatened by the announcement of the new policies and react by extracting more in the present to exhaust the resource earlier. The market reacts to the higher supply with lower prices.
Hotelling explained the Green Paradox 80 years before Sinn actually discovered the Green Paradox. He said that low price in the present and a fast price increase causes the resource to be exhausted earlier. But what he did not take into consideration is that fossil fuels are different to other exhaustible resources in that they emit CO2 when burnt. Sinn found out that reducing the time frame of depletion causes a higher stock of carbon in the atmosphere and therefore, a stronger contribution to global warming. The behaviour of the price path is the one in figure 18 (National Environment Management Authority, 1996).
T
Figure 18. Changes in price path and time frame of extraction due to the Green Paradox. National Environment Management Authority, 1996.
5.3) The solution
Suppose the opposite happens. Assume countries are incredibly green today and they gradually increase the demand for energy. In that case, owners would not bother to extract a great quantity now because they would be better off leaving extraction for the future, when consumption will increase. Therefore, a curb that reduces demand more today than in the future causes an increase in supply in the future, slowing down global warming. Is such a policy a realistic outcome? Not at all. It would not be credible. It is very hard to imagine a drastic change in consumption in the present because it would create too large costs on the current generation to the benefit of future generations. Politicians who propose this kind of policies could never be supported by enough voters. And even if they were, resource owners would still be sceptical about whether the new policies will become laxer. Nevertheless, the problem of carbon leakage might make even the perfect policy useless.
Then, the suggestion of Sinn to slow down global warming is to create a demand cartel. There must be no ‘Kyoto countries’ and ‘Non-Kyoto countries’. If demand is the same everywhere, then future expectations do not matter anymore and lower demand causes less quantity of carbon burnt, as economic theory would predict. But again, a surprise effect is needed in order to prevent owners to react to the announcement of a future demand cartel by accelerating the extraction paths today.
“It is hard to imagine China or India being willing to stifle its economic growth
committing to a cap on its own CO2 emissions. It is equally hard to imagine the West
making the major concessions that would have to be made to get the emerging economies
on board” (Sinn, 2012, p.210).
The analysis gets more and more complicated considering the possible reactions of the countries that own the resources and the following counterstrategies, but that falls outside the scope of this dissertation.
6. Conclusion
In the 1930s, Hotelling foresaw the optimal extraction path and the behaviour of prices of a non-renewable resource. As it can be seen from Pearce and Turner’s price curve (1991), he understood that a low price means a steeper price increase and therefore a faster depletion. A high price in the present instead translates into a more conservative approach that makes extraction slower and the price increase smoother. More than 80 years later, the supply side of an exhaustible resource is taken into consideration for the first time by Sinn (2012). He suggests that the inefficiency of the current green policies in slowing down global warming is due to the ‘neglected supply side’, or the fact that they aim only at reducing demand for fossil fuels, without acting on the supply. The transition to green technologies and the lower consumption of oil increase rather than decrease global warming and climate change. He calls it ‘The Green Paradox’. The constant increase in CO2 emissions in the last century is an empirical evidence of the Green Paradox and how the recent green policies have been counterproductive because of their focus on the demand side. The price response to the Paris Agreement is a proof of the Green Paradox in the Hotelling’s Rule. The purpose of this dissertation is to link the insights of Hotelling (1931) with the more recent Green Paradox (2012). Hotelling forecast the behaviour of prices and Sinn added the climate change in the equation. The quick time frame of depletion is not only of economic interest, but also of public interest as it affects the extent of climate change. Not only mankind will be lacking fossil fuels earlier, but also the Earth will be warmer sooner.
The relationship between the international agreements and global warming is more complex than the public opinion thinks. It does not only involve the green countries and their cuts in consumption but rather the behaviour of the resource owners and their willingness to increase their wealth. Global warming depends on those who can control the supply of fossil fuels.