The visible hand in economics

Supply siders on climate change

Posted on: November 6, 2007

Most debate surrounding climate change focuses on the best method of suppressing demand for carbon intensive technologies. However, as Hans-Werner Sinn points out at VoxEU, reductions in demand for carbon could result in perverse incentives on the supply side. In particular, the suppliers of oil, coal and other non-renewable, carbon rich resources could face an incentive to increase their rate of extraction.

This arises because of the special nature of exhaustible resources: since there is a finite quantity of the resource to make profits from, the extractor tries to sell it when the price is highest. If carbon reduction policies are successful then we should observe declining demand for these resources over time. Decreasing demand will cause prices to fall and, since the extractors of oil can anticipate the price drops, they’ll try to sell as much now as possible. The increase in supply will cause prices to drop straight away which will trigger countries who have not signed up to Kyoto to consume more carbon rich fuels now.

The two ways this could be avoided are to either force the entire world to conform to the same Kyoto-type standards, or to forcibly restrict the supply of carbon rich fuels. Failure to do either of these things could result in global carbon emissions actually rising as momentum builds behind the environmental movement. Sinn thinks that the only way to cope is to invest heavily in afforestation to offset the extra emissions. Given the rate of global deforestation it can only be hoped that political pressure and reputation effects will be enough to prevent cheap oil flooding the world market. Thankfully oil prices show no signs of diving since the advent of the Kyoto protocol. So far at least…

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