Climate policies in a fossil fuel producing Country Demand versus supply side policies

Transcription

1 CREE Workng Paper 11/2013 Clmate polces n a fossl fuel producng Country emand versus supply sde polces Taran Fæhn, Cathrne Hagem, Lars Lndholt, Ståle Mæland and Knut Enar Rosendahl The CREE Centre acknowledges fnancal support from The Research Councl of Norway, Unversty of Oslo and user partners. ISBN: ISSN:

2 Taran Fæhn, Cathrne Hagem, Lars Lndholt, Ståle Mæland and Knut Enar Rosendahl Clmate polces n a fossl fuel producng country emand versus supply sde polces Abstract In absence of jont global acton, many jursdctons take unlateral steps to reduce carbon emssons, and the usual strategy s to restrct domestc demand for fossl fuels. The mpact on global emssons of such demand sde polces s found by accountng for carbon leakage,.e. changes n emssons abroad nduced by the domestc acton. Another domestc opton for fossl fuel producers, that s yet not well explored, s to reduce own supply of fossl fuels, agan accountng for leakages. We explore analytcally and numercally how domestc demand- and supply sde polces affect global emssons, contngent on market behavour n the fossl fuel markets. Next, we combne ths wth costs of demand- and supply sde polces to fnd the cost-effectve combnaton of the two types of polces. Norway s the case n our numercal analyss. Our results ndcate that gven a desre for domestc acton and a care for global emssons, a majorty of emsson reductons should come through supply sde measures,.e., by down-scalng Norwegan ol extracton. Keywords: clmate polces, carbon leakages, ol extracton, supply sde clmate polces, demand sde clmate polces. JEL Classfcaton: H23; Q41; Q54 Acknowledgement: We are grateful to Torbjørn Hægeland and Ådne Cappelen for comments on an earler draft. Whle carryng out ths research, the authors have been assocated wth the Oslo Centre for Research on Envronmentally frendly Energy (CREE). CREE s supported by the Research Councl of Norway. Address: Taran Fæhn, Statstcs Norway, Research epartment. E-mal: tfn@ssb.no Cathrne Hagem, Statstcs Norway, Research epartment. E-mal: cah@ssb.no Lars Lndholt, Statstcs Norway, Research epartment. E-mal: ll@ssb.no Ståle Mæland, Statstcs Norway, Research epartment. E-mal: stm@ssb.no Knut Enar Rosendahl, UMB School of Economcs and Busness and Statstcs Norway. E-mal: knut.enar.rosendahl@umb.no 2

3 Sammendrag I fravær av en nternasjonal klmaavtale har mange land satt verk nasjonale tltak for å redusere karbonutslppene. et vanlgste tltaket er å begrense eget forbruk av fossl energ. For å beregne den globale utslppseffekten av denne type etterspørselstltak må man ta hensyn tl karbonlekkasjen, dvs endrnger utslpp utlandet som følge av de nasjonale tltakene. Land som utvnner fossl energ har også mulghet tl å påvrke de globale utslppene gjennom redusert produksjon av slk energ. enne type tltak er mndre utforsket, og også her må man ta hensyn tl karbonlekkasjen for å beregne vrknngen på globale utslpp. For å fnne den optmale kombnasjonen av de to poltkkalternatvene undersøker v analytsk og numersk hvordan etterspørsels- og tlbudssdepoltkk påvrker globale utslpp. ette avhenger av markedsresponsen de fossle energmarkedene. e numerske beregnngene av kostnadene ved poltkkalternatvene er basert på tall fra Norge. Våre resultater ndkerer at dersom det tas hensyn tl globale utslppsreduksjoner, og det er ambsjoner om nnenlandske tltak, bør størstedelen av reduksjonene komme gjennom tlbudssdetltak, dvs. nedskalerng av Norges oljeutvnnng. 3

4 1. Introducton In a global clmate agreement, a cap on fossl fuel consumpton would have the same effects on global emssons as a cap on fossl fuel extracton, as consumpton must equal extracton on the global level. In ths frst best stuaton, demand and supply sde polces concde. However, wth lmted partcpaton n a clmate agreement, or wth unlateral acton by a sngle or a coalton of countres, demand sde versus supply sde polces matters. Many jursdctons show wllngness to restrct domestc demand for fossl fuels, even though economc reasonng calls for pckng the globally most cost effectve abatement optons. omestc supply sde polces are less frequently dscussed, let alone pursued. The purpose of ths paper s to assess what s the cost-effectve combnaton of the two types of polces, gven a country's target for own contrbutons to global emsson reductons. The result hnges crtcally on how domestc demand sde and supply sde polces affect global emssons. We explore analytcally and numercally how the optmal domestc clmate polces depend on market behavour n the fossl fuel markets, the emssons from extracton, and the costs of downscalng domestc fossl fuel demand and supply. Polcy measures that reduce fossl fuel demand lead to lower nternatonal energy prces, and may also reduce compettveness n the world markets for energy-ntensve goods. Both effects cause so-called carbon leakages,.e. ncreased consumpton of and emssons from fossl fuels among free-rders; see, among others, Markusen et al. (1993; 1995), Rauscher (1997) and Böhrnger et al. (2010). Leakages occur also through supply sde polces,.e. polces that reduce fossl fuel extracton. Such supply-sde leakages result from ncreased supply by countres outsde a clmate coalton as nternatonal fuel prces rse. Harstad (2012) shows that supply sde leakages can be completely avoded f the coalton buys margnal foregn fossl fuel deposts and conserve them. Ths renders the non-coalton s supply curve locally nelastc. Although ths s a promsng result, buyng deposts may face several practcal problems, such as asymmetrc nformaton, contract ncompleteness, and barganng falures. In our paper, we gnore the optons of purchasng both foregn fossl fuel deposts and nternatonal emsson quotas (e.g. EU ETS quotas or CM credts) and look at domestc measures, only. Our case n the numercal analyss s Norway, whch accounts for around 2 percent of global ol producton. Norway has an ambtous target for domestc emsson reductons by 2020 and has so far not consdered usng supply sde measures. Our fndngs ndcate that the global effect of the domestc demand sde ambtons s lkely to be around per cent lower than the domestc emsson 4

5 reductons, because of carbon leakages. The man concluson of our paper s that the most costeffectve domestc polces for obtanng these global reductons would be to substtute around two thrds of the planned domestc demand sde abatement wth supply sde measures, that s, reduced ol extracton. The lack of focus on supply sde polces has been questoned by NGO s and meda at home and nternatonally, see, e.g., The Economst (2009). Prevous lterature on optmal clmate polcy n the presence of carbon leakages through the nternatonal fuel markets has derved the optmal combnaton of producer and consumer taxes n a clmate coalton, gven a target for global emsson reductons. Hoel (1994) models the fossl fuel market as one aggregate market, and derves analytcal expressons for optmal tax levels. Golombek et al. (1995) extend Hoel s analyss by modellng three fossl fuel markets (ol, coal and gas) and provde a numercal llustraton of optmal producer and consumer taxaton for a coalton of OEC countres, gven compettve fossl fuel markets. They fnd that the optmal producer tax of ol should be negatve, due to terms-of-trade effects domnatng the leakage effects (OEC s a net mporter of ol). Hagem (1994) compares numercally the costs of pure demand sde polcy wth pure supply sde polcy for the case of Norway, gven a target for ts contrbuton to global emsson reductons n The calculatons assume compettve fuel markets and conclude that t would be less costly to reduce ol producton than to ntroduce unform taxes on fossl fuel consumpton. Our paper contrbutes to the theoretcal lterature by analysng how dfferences n emssons from fossl fuel extracton across countres affect the relatve performance of demand sde polces versus supply sde polces. Furthermore, t supplements prevous numercal analyses of demand versus supply sdes polces n several ways: Frst, we analyse the mpact of varous non-compettve ol market assumptons. Second, we take nto account emssons due to extracton of fossl fuels, and partcularly the dfferences n emsson ntensty across countres. Thrd, we ncorporate the fact that both producton costs and emsson ntenstes are relatvely hgh n the declne phase of an ol feld here we use detaled cost nformaton from Norwegan ol felds. Fourth, we revew the emprcal lterature on the relevant prce elastctes n order to assess lkely carbon leakage rates on the demand as well as the supply sde. The robustness of our calculatons s shown wth thorough senstvty analyses. Assumptons regardng supply and demand elastctes, as well as the compettve envronment on the fuel markets, are decsve for our results on the optmal dstrbuton of demand versus supply sde 5

6 polces. There s a large lterature on OPEC behavour (see e.g. Grffn, 1985; Alhajj and Huettner, 2000; Smth, 2005; Hansen and Lndholt, 2008). Although the conclusons from ths lterature are rather mxed, one qute clear concluson s that OPEC does not behave as a compettve producer. In our man case, we model OPEC as a strategc player that seeks to maxmze ts ncome from annual ol producton, whle other producers are prce-takers. To check the robustness of our results, we also consder the compettve case, along wth stuatons where OPEC has prce or producton targets. As fossl fuels are non-renewable resources, there are mportant dynamc propertes of the market that our statc analyss does not capture. A fossl fuel producer s optmzaton behavour mples fndng an extracton path that maxmzes the present value of the resource, whch depends on the expected, future prce path (Hotellng, 1931). If they expect a gradual tghtenng of clmate polces, they may accelerate ther extracton; see Snn (2008) for a dscusson of ths green paradox. Thus, leavng out dynamc consderatons may have mplcatons for the results. On the other hand, Venables (2011) shows that although decreasng prces may speed up producton on exstng felds, t s offset by ther postponng effect on feld openngs; see also Österle (2012) for a smlar study. Furthermore, the government can control the avalable cumulatve producton through ther producton lcencng. Hoel (2013) consders supply sde polces and argues that conservng the margnal, most costly resources reduces both total and mmedate resource extracton. These studes show the relevance of analyzng fossl fuel polces n a statc framework as ours even f some ntertemporal redstrbuton s gnored. We restrct our carbon leakage consderatons to those stemmng from the fossl fuel markets, dsregardng carbon leakages through the market for energy-ntensve goods. Unlaterally ntroducng demand sde nstruments such as carbon taxes or permts reduces the nternatonal compettveness of domestc, emsson-ntensve frms and causes carbon leakages. These leakages can be mtgated or completely abolshed by compensaton schemes for exposed ndustres (e.g. free allocaton of permts) or by border tax adjustments (Böhrnger et al., 2012a, and Hoel, 1996). We therefore gnore ths channel of carbon leakages. 2. Theoretcal analyss 2.1. Unlateral clmate polcy We consder a fossl fuel producng and consumng home country that ams to contrbute to a certan reducton n global greenhouse gas emssons ( A ), through a combnaton of domestc demand sde and supply sde polces. The country s aggregate benefts from domestc consumpton of fossl fuels 6

7 are gven by B( yo, yc, y g), where y o, y c and y g denote domestc consumpton of ol, coal, and gas, respectvely. Wthout loss of generalty, all fuels =o,c,g are measured n unts of ther carbon content. We assume that the beneft functon s ncreasng n each of the fuels. Furthermore, let c ( x ) denote the home country s aggregate cost of producng fossl fuel, where x denotes home producton of ths fuel. We assume that the cost functons are ncreasng and strctly convex. Fossl fuels are traded n nternatonal markets at prces P o, P c and P g. The objectve for the regulator s to maxmze welfare (W), subject to the global contrbuton target, A, where W s utlty of consumng fossl fuels net of producton and net mport costs: (1) Max W B(y,y,y ) c(x ) P( ) (y x ) o c g y,x o,c,g o,c,g s.t. 0 E E A, 0 where E s the global emssons n absence of the unlateral, domestc polces. From the frst-order condtons for ths maxmzaton problem, we fnd that: (2) B P P ( y x ) E y y y (3) c(x) PP(y x) E. x x λ s the shadow cost of the emsson constrant, whle Ey and E x are the margnal effects on global emssons of ncreased consumpton and producton of fuel n the home country, respectvely. They depend on the mpacts of domestc demand and supply changes n the fossl fuel markets, whch we wll explore further n the next subsecton. P (y x ) and P (y x ) are the terms-of-trade effects. y If the country s a net exporter of a fuel, a hgher prce mproves terms of trade. Hence, the terms-oftrade effects for a fuel exporter wll tend to favour supply sde polces,.e. to reduce producton rather than consumpton. Note that ths effect occurs also n the absence of clmate polcy. In the followng we wll dsregard terms - of - trade effects, as welfare mpacts of the global fossl fuel prce changes can be consdered mnor for the small home country. Note that ths s not a suffcent condton for x 7

8 dsregardng the global emsson effects of the prce changes, whch must be compared to the home country s own emsson cuts; see next subsectons. From (2) and (3), we then fnd: By P P c(x ) (4). E E y x Hence, optmal clmate polcy mples that the margnal cost of global emsson reductons through By -P domestc demand sde polcy ( ) should equal the margnal cost of global emsson reductons E y P-c(x ) through domestc supply sde polcy ( ), across all fuels. Gven that domestc consumers and E x producers are prce takers and maxmze ther proft and net beneft, t s shown n Golombek et al. c (1995) that the optmal outcome can be acheved by ntroducng a consumer tax, t=λe, and a y producer tax, p t =λe, for all fuel types. x We wll proceed by dervng expressons for E y and E x n a partal fossl fuel market model. We dstngush between mpacts on global emssons stemmng from combuston of fossl fuel traded n markets and used as nput n extracton, respectvely, and explore them n each of the two subsequent subsectons Global emssons from combuston of fossl fuels traded n markets Let captal letters denote foregn producton and consumpton of the three fossl fuels (X and Y, =o,c,g). Total global emssons from combuston of fossl fuels, E, equals global fossl fuel producton, whch agan must equal global consumpton: x X E y Y. (5) o,c,g o,c,g o,c,g o,c,g To smplfy the analytcal dervatons, we treat domestc consumpton (y ) and producton (x ) as exogenous varables, set by the domestc regulator. In the numercal analyss, we derve the optmal consumer and producer taxes, gven proft maxmzng domestc producers and welfare maxmzng domestc consumers. 8

9 We assume that foregn consumers are prce takers, where demand for each fuel s a functon of all energy prces ( Y=(P o,p,p c g ), where <0 for =j and >0 for j). For each energy P P j market, foregn producton must equal foregn consumpton plus net mport from the home country: j (6) X (P,P,P o c g ) y x, o,c,g. We assume compettve behavour by foregn coal and gas producers. Ther aggregate supply functons are gven by: S (7) X S(P), 0, c,g. P The ol market s charactersed by a domnant producer (OPEC) wth a compettve frnge: (8) X o Z S o(p o ), where Z s output from the domnant ol producer, and S(P o o )s aggregate supply from the compettve frnge. From (6) (8), we wrte the equlbrum fuel prces as functons of net mport from the home country and supply of ol from the domnant ol producer: P P( yo xo Z,yc x c,yg x g ), o,c,g. (9) Our default assumpton s that the domnant ol producer maxmses net ncome. However, we also consder other objectve functons. In Appendx A we derve the equlbrum prce functons gven that the domnant ol producer a) operates as a compettve prce taker, b) keeps the ol prce constant, and c) keeps ts producton constant. If the domnant ol producer seeks to maxmze net ncome, Z s found from: (10) Max P Z C( Z ), z o where C( Z )s the producton cost. The frst order condton s gven by: (11) P P Z C(Z ) 0. o oz 9

10 From (9) and (11), we can wrte all prces as functons of net mport from the home country: (12) P f ( yo x o,yc x c,yg x g ), o,c,g. As nternatonal fossl fuel prces are functons of net mport from the home country, domestc clmate polces wll affect emssons abroad. We defne the margnal demand sde carbon leakage of fuel, denoted L, as the ncrease n consumpton abroad (measured n CO 2 ) followng from a unt decrease n domestc consumpton of fuel : (13) Y jo,c,g fk L jk. y jo,c,g ko,c,g (y x ) To smplfy the dscusson, we make the followng reasonable assumpton: 1 (14) 0 L 1. We defne margnal supply sde leakage of fuel ( L ) as the ncrease n total fossl fuel producton abroad (measured n CO 2 ) followng from a unt decrease n domestc producton of fuel. As total consumpton must equal total producton, and y s exogenous, we see from (6) that: S X j ( ) x S jo,c,g o,c,g fk (15) L 1 jk 1L. x x ( y x ) jo,c,g k o,c,g Hence, we can express the margnal mpact on total emssons of domestc clmate polces as functons of the demand sde carbon leakage: (16) E 1L, y E L. x We see from (16) that demand sde polces are more (less) effectve n terms of global emsson reducton than supply sde polces when the demand sde leakage rate s less (bgger) than (14) s satsfed when the followng three condtons hold for each of the fuels (see Golombek et al, 1995): 1) Increased net demand of one of the fuels leads to hgher prces of all fossl fuels, 2) An ncrease n the prce reduces the sum of demand of all fuels, measured n carbon content, and 3) Hgher net demand ncreases total producton of fossl fuels from abroad, measured n carbon content. (15) s satsfed n our numercal model. 10

11 ( E -E 0forL 05. ). We also notce that E E 1. If both domestc consumpton and y x y domestc producton decrease by one unt, there s no mpact on fossl fuel prces, and the fnal global mpact s one unt less emtted. x So far we have only accounted for emssons from the use of fossl fuels traded n markets. However, as argued above, there are also emssons due to extracton of the fuels, as fossl fuels are used as nputs n the extracton processes, and emsson ntenstes vary qute a lot across sources. Hence, the global mpact of domestc polces should be adjusted accordngly Includng emssons from fossl fuel extracton Let E denote total emssons (fossl fuel consumpton ncludng emssons from extracton): E E (x ) (X ). (17) o,c,g o,c,g Where α (x )and β (X ) are emssons as functons of extracton of fossl fuel n the home country and abroad, respectvely. We fnd (see Appendx A): (18) j(x j ) jo,c,g Ey E 1 y L X X l j j, y (X ) jo,c,g j j jo,c,g x x x x X X j j x jo,c,g E E L l, where l j s the demand sde leakage from fuel j (ncreased consumpton of fuel j abroad due to reduced consumpton of fuel at home): (19) f k lj jk. ko,c,g (y x ) 11

12 We see that E E =1. If both domestc consumpton and producton decrease by one unt, y x x there s stll no market leakage, but as domestc fuel producton causes emssons from extracton, global emssons decrease by more than one unt. Comparng the mpact on global emssons wth and wthout ncludng the emssons from fossl fuel extracton, we fnd that: (20) E E l, y y X X j j jo,c,g (21) E E l. x x x X X j j jo,c,g We cannot n general say whether ncludng emssons from extracton makes demand sde polces more or less effectve than supply sde polces, n terms of global emsson reductons. Ths depends on the leakages ( l j ), the dfferences n emsson ntenstes across fossl fuels abroad ( β X j ) and across countres (home ( α ) versus abroad ( x β X )). Gven that emssons from extracton of fossl fuels abroad are dentcal, ( β =β =β =β ), we fnd: Xg Xc Xo X (22) E E 12L 2 ( 1L ). y x X x We see that for any gven leakage rate L, ncludng emssons from extracton makes demand sde polces more effectve relatve to supply sde polces the larger s the foregn emsson ntensty ( β X ), and the smaller s the domestc emsson ntensty ( α ). Furthermore, the emssons from foregn extracton has the larger mpact on the dfference between x E y and E x, the larger the supply sde leakage (1- L ). Moreover, f foregn and domestc ntenstes are the same ( β X = α ), we notce x that E- E=(1+α )(1-2L ), whch s equal to zero f L 05.. y x X 12

13 3. Numercal analyss We estmate margnal costs of Norwegan unlateral reductons n fossl fuel demand and supply n Secton 3.1. Ths means quantfyng By -P and P-c(x ), respectvely; see Eq. (4). emand sde abatement s assessed by means of a CGE country model. Supply sde measures are quantfed by dentfyng representatve, margnal cuts n ol producton. Norway s also a sgnfcant producer of gas. In 2011, Norway accounted for 2.3 percent of global ol producton and 3.1 percent of global gas producton (BP, 2012). Gas s, however, a fossl fuel wth relatvely low emssons and wth larger substtutablty aganst the hgh-emttng coal. Hence, t s not clear whether reduced Norwegan gas extracton would decrease or ncrease global emssons. Thus, we do not consder ths supply sde opton n our analyss. 2 In Secton 3.2 we analyse the effects on global emssons, by explotng a partal model of the global fossl fuel market effects, where we also take nto account emssons from extracton of fossl fuels. These computatons wll provde the values of the denomnators n Eq. (4), Ey and E x. In Secton 3.3 we combne the fndngs n the two precedng sectons to derve the optmal combnaton of demand and supply sde polces for Norway as expressed n Eq. (4) Unlateral clmate polcy emand sde polces The startng pont for our polcy analyss s the ambton on domestc greenhouse gas (GHG) abatement set by the Norwegan Parlament. 3 By 2020, unlateral acton correspondng to a 30 per cent reducton from Norwegan 1990 emssons s pledged, and about two thrds of the reductons relatve to a defned 2020 reference level s to be taken domestcally through demand sde measures. The offcally apponted expert group Clmate Cure 2020 (2010) carred out macroeconomc computatons of necessary, cost-effectve demand sde measures. (Clmate Cure 2020) derves what we may term a reference scenaro, whtch ncludes polces already mplemented, approved, or promsed for the years up to To obtan a margnal cost functon for demand sde measures, we compare ths reference 2 We abstract from the techncal challenges of separatng ol and gas extracton, but return to ths ssue n secton The agreement s avalable at 13

14 scenaro wth a unlateral clmate polcy scenaro where demand sde polces are only mposed on sectors outsde the EU ETS. Ths choce s consstent wth our assumpton that the home country (Norway) s concerned wth global emssons; as there s a cap on total emssons n the EU ETS, addtonal cuts n Norwegan ETS sectors would merely dsplace emssons to ETS-regulated nstallatons n other European countres. 4 Fgure 1. Margnal costs of foregone fossl fuel consumpton for Norway US/t CO mlon tonnes CO 2 The reducton of CO 2 emssons from fossl fuel consumpton compared wth the reference scenaro amounts to 15 per cent of total GHG emssons n 2020, correspondng to a domestc abatement of A = 8.4 mllon tonnes (Mt) of CO 2. 5 The estmated margnal costs n terms of foregone fossl fuel consumpton (the value of B -P for all fuels) to acheve the domestc target s US 576 per ton CO 2, y whch are consderable as vrtually all abatement wll have to take place wthn transportaton. In road transportaton, the abatement amounts to more than half of the reference emssons. The cuts almost exclusvely take place as reduced ol consumpton. 4 Ths comparson of scenaros s dentcal to comparng scenaros B and C n Clmate Cure 2020 (2010). The scenaro C used as our reference ncludes partcpaton n the EU ETS, a dfferentated carbon tax system n the non-eu ETS sector, deployment of CCS technologes on all gas power nstallatons, and consderable energy effcency mprovements. In scenaro B, the dfferentated carbon tax system s replaced by a unform GHG tax. 5 The Clmate Cure 2020 computatons also allows for forest conservaton and other GHG abatement, whch we dsregard here. Total abatement s therefore 21 per cent n 2020, where 15 percentage ponts represent demand sde CO 2 abatement. 14

15 Based on a number of smulatons usng the same hybrd CGE model and assumptons as Clmate Cure 2020 (see Fæhn et al., 2013), we have estmated the followng margnal cost curve for Norwegan demand sde measures: 6 (23) B P. A. A.. 2 y The curve s depcted n Fgure 1; the marked pont s the Clmate Cure 2020 unlateral polcy scenaro, where A = 8.4 Mt of CO 2. Supply sde polces The costs of supply sde measures n our statc framework are the forgone profts by not extractng the ol, correspondng to P-c(x o o o ); see nomnator of the second fracton of Eq. (4). We need to sngle out ol felds whch can be characterzed as margnal, n the sense that reducng or termnatng extracton nvolves as small proft loss per unt CO 2 extracted as possble. Ol felds n the declne phase generally have hgher costs than felds n the plateau phase. Explanatons are that margnal operatng costs, ncludng energy nput, are ncreasng as remanng ol declnes. In addton, IOR actvtes (Improved Ol Recovery) can nvolve new nvestments. Typcally, these felds also have hgher emsson ntenstes. For the years , we have sngled out nne Norwegan felds where ol consttuted a major or total part of the petroleum producton. In addton, these felds were n, or close to, the declne phase. For some of these felds nvestment costs for drllng purposes were ncreasng durng one or more of our covered years, whch may be characterzed as IOR-actvtes. We have data from Statstcs Norway on producton volume and varable costs, costs that would not accrue f ol producton were reduced or termnated. Based on these data we can construct the margnal producton cost curve shown n Fgure B1 n Appendx B. To calculate margnal forgone profts by reduced ol producton, we apply the average ol prce over the perod (US 84.5 per barrel of Brent Blend), subtracted by the producton costs n Fgure B1; see Fgure 2. 7 The supply sde cost curve, where A S s reduced extracton measured n CO 2, s: 6 The ntersecton pont wth the vertcal axs s the unform tax rate that yelds the same abatement as obtaned wth the dfferentated tax system n the reference scenaro. 7 Whle costs and producton are measured n US/barrel and mllon Sm 3 n Fgure B1, respectvely, we now measure these varables n US per ton CO 2 and Mt of CO 2. One mllon Sm 3 of ol leads to 2.65 tonnes of CO 2 emtted when the ol s combusted. 15

16 (24) P c (x ). A. A.. 2 o o o 07 S 196 S 61 We see that t s actually proftable to reduce 0.3 Mt of CO 2, rrespectve of clmate benefts, due to hgh producton costs of some of the smaller felds. Fgure 2. Margnal foregone profts of reduced ol extracton for Norway US/t CO mllon tonnes CO 2 As we only have ncluded varable costs n the declne phase of the felds, and not feld development costs n the ntal years (due to lack of data), we have probably underestmated the total costs of producton,.e., overestmated the costs of reducng producton. Moreover, we do not have specfc nformaton about costs of IOR projects, whch are often projects wth lmted profts per unt of extracton. Most probably ths contrbutes to overestmate the costs of the supply sde measures depcted n Fgure 2. In our study we are more nterested n future abatement optons. Thus, the relevant queston s to what extent the cost functon depcted n Fgure 2 s representatve for comng years such as On the one hand, the future ol prce may be hgher than the average for the years (84.5 US per barrel), suggestng that forgone profts of reduced ol extracton may be hgher. However, extracton costs have tended to be postvely correlated wth the ol prce, meanng that the effect of a hgher ol prce on forgone profts could be moderated. Several of the felds we have studed for the years wll stop producng before On the other hand, some felds that are now n ther plateau phase wll be n ther declne phase by 2020, suggestng that ther costs per unt producton wll 16

17 ncrease. It s dffcult to know whether the net effect of these consderatons wll push the cost curve n Fgure 2 up or down. To help assessng the relevance of the margnal foregone proft curve n Fgure 2, we have also gathered nformaton on a future, not yet started, ol feld named Ivar Aasen. Here we have access to nformaton about both expected annual development and operatng costs, as well as producton (The Norwegan Ol Company, 2012). Investments for ths feld wll start n 2013, wth producton expected to set off n Based on the reported data we calculate a break-even ol prce of US 60 per barrel for ths feld, usng a dscount rate of 6 per cent whch the ol company uses. 8 Wth an average producton of 1.4 Sm 3 over the perod and a break-even ol prce of US 60 per barrel, ths s comparable to the data behnd Fgure B1 n Appendx B for the years (.e., the upper thrd part of the curve). 9 To sum up, we beleve that Fgure 2 could be qute representatve for the year 2020, although the uncertantes are rather large. From the dscusson above, t seems more lkely that the supply sde abatement costs le below than above the curve shown n Fgure Numercal analyss of global fossl fuel markets The partal fossl fuel market model Based on the exposton n Secton 2.2, we construct a smple numercal model that makes t easy to dentfy and adjust the basc assumptons drvng the results. The man drvers are ) prce responsveness on the demand sde (ncludng substtuton effects between ol and other fossl fuels), ) prce responsveness of Non-OPEC supply, ) OPEC s response, and v) dfferences n emsson ntensty n ol extracton. We consder so-elastc demand functons (.e., wth constant drect and cross prce elastctes), so-elastc supply functons for compettve fossl fuel producers, and constant unt producton costs for OPEC (when behavng as a domnant producer). As we are focusng on a permanent cut n ol supply as a potental clmate measure, we are mostly nterested n the long-run effects n the market,.e., we consder long-run elastctes. Fnally, we model fxed emsson ntenstes n ol extracton, but these should be nterpreted as emsson ntenstes of margnal producton. Appendx C contans a detaled dscusson of the man drvers, n partcular a revew of 8 The break-even ol prces wth 4 and 10 per cent dscount rates are US 58 and US 65, respectvely. Note that these estmates must be seen as approxmate as the nformaton s gathered by lookng at graphs. The future ol prce used n the mpact assessment of the Ivar Aasen project seems to be around US 90 per barrel. 9 Accordng to Aftenposten (2013), several other undeveloped felds have break-even prces around US per barrel. 17

18 exstng demand and supply elastcty estmates from the lterature. Here we only present our benchmark assumptons, whch are motvated n the appendx. Ol prce ncreases may reduce ol consumpton n varous ways. Ol consumers may reduce ther total energy use, or they may swtch to other energy goods such as coal, gas or renewables. Swtchng to other energy goods requres that there are vable alternatves, whch wll vary across sectors. Reducng total energy use may ether nvolve reduced use of energy servces (e.g., drvng fewer mles, producng/consumng less energy-ntensve products), or usng more energy-effcent vehcles (or transport modes), captal, or equpments. In the long run, hgher prces may also stmulate the development of more ol-effcent technologes. In prncple, long-run prce elastctes should capture all these effects. Based on the lterature revew, we apply a drect prce elastcty of -0.5 n the long run, and cross-prce elastctes for coal and gas of However, we report the effects of other estmates, as well. Hgher prces of ol ncrease the proftablty of ol exploraton, new felds developments, and projects to ncrease ol recovery (IOR) rates of felds n producton. Ol resources that are relatvely cheap to extract wll not be nfluenced by moderate ol prce changes t s merely a matter of tme when these resources wll be extracted. 10 Thus, an ncrease n the prce of ol wll mostly affect extracton of socalled margnal resources, such as exploraton and feld development n ultra-deep waters, developments of smaller felds and unconventonal ol, and IOR projects. Hgher ol prces may also lead to mproved technologes n the long run, smlarly to ol-effcency mprovements on the demand sde. Based on the lterature revew, we use a supply elastcty of 0.5 for Non-OPEC. Ths mples that ol demand and Non-OPEC supply are equally prce elastc. However, due to substtuton between ol and other fossl fuels, the fossl fuel demand elastcty (wth respect to the ol prce, and measured n carbon unts) becomes around As dscussed n Secton 2, our default assumpton s that OPEC behaves as a domnant producer. The unt producton cost of OPEC then has to be calbrated so that our reference smulaton s consstent wth base year data (2011). In our benchmark case, the unt margnal producton cost of OPEC turns out to be 45% of the ol prce, whch s wthn the range of producton costs reported by IHS CERA 10 The tmng of extracton may of course be affected by prce changes, cf. the dscusson n Secton 1. 18

19 for OPEC countres (see e.g. Fgure 3.9 n Mnstry of Petroleum and Energy, 2011). 11 When we model OPEC as a compettve producer, we assume the same supply elastcty as for Non-OPEC. Although the lon s share of carbon emssons from ol use takes place as the ol s combusted, emssons from ol extracton have to be counted as well. Accordng to OGP (2012), the average greenhouse gas (GHG) emssons per unt producton worldwde n 2011 were 159 tonnes CO 2 e (CO 2 equvalents) per 1,000 toe hydrocarbon produced. However, the margnal emsson ntenstes wll typcally exceed the average. Emsson ntenstes for the Mddle East are much lower than the global average, whch s also the case for Norway. Hence, average Non-OPEC emssons are hgher than the global average. As explaned n appendx C, we set the benchmark emsson ntenstes n Norway, OPEC and Non-OPEC equal to respectvely 90, 76 and 300 tonnes CO 2 e per 1,000 toe. 12 For comparson, emssons from consumng (.e., combustng) 1,000 toe of ol s about 3,070 tonnes of CO 2. Although of mnor mportance here, we also account for emssons from extractng other fossl fuels, and assume that emsson ntenstes for coal and gas are equal to the emsson ntensty for ol n Non-OPEC (outsde Norway). Effects on global emssons of demand- and supply sde polces We frst report the smulaton results of exogenously reducng Norwegan ol extracton or consumpton by one unt of carbon. We are nterested n the net effects on global emssons,.e., the denomnators E x and Ey n Eq. (5). As shown n Secton 2, the sum of E x and E y should equal one plus α x,.e., the emssons from domestc extracton (relatve to emssons from consumpton). Table 1 dsplays the net global emsson reductons when OPEC acts as ether a compettve or a domnant producer. The table also shows the varous components of the emsson reductons. Note that the leakage rate L defned n Secton 2 s equal to mnus the sum of Ol market leakage and Coal/gas market leakage under emand sde polcy (and also equal to the sum of the three frst components under Supply sde polcy). 11 Note that the calbrated unt cost for OPEC s ncreasng n the absolute value of the resdual demand elastcty. When the resdual demand s more elastc, OPEC s less nterested n cuttng supply to ncrease the ol prce, and hence unt costs must be hgher to obtan a reference case consstent wth base year data. We return to ths ssue below when we do senstvty analyss wth respect to elastctes. 12 It could be argued that the emsson ntensty of Norwegan ol extracton should be set to zero, as these emssons are regulated by the EU ETS, whch has a cap on overall emssons (cf. the dscusson of ETS sectors n Secton 3.1). As seen n the followng subsecton, however, these emssons are of less mportance. 19

20 We frst notce that leakage through the ol market s around 50 percent for both demand sde and supply sde leakage. Ths s certanly the case f OPEC acts compettvely, and follows straghtforwardly from the assumpton of equal (absolute values of) supply and demand elastctes. If OPEC acts as a domnant producer, t s optmal for the producer group to adjust ts supply slghtly more to changes n Norwegan supply or demand compared to n the compettve case, but the dfference s not bg. Stll, supply sde leakage through the ol market s 55 percent, compared to 45 percent for demand sde leakage (gven the benchmark assumptons). Next, we see from Table 1 that overall market leakage s substantally lower under demand sde polcy than under supply sde polcy, whether OPEC behaves compettvely or as a domnant producer. Ths s due to substtuton between ol and other fossl fuels, whch obvously goes n dfferent drecton dependng on whether the ol prce drops (demand sde) or ncreases (supply sde). When ol demand abroad ncreases (decreases) due to reduced Norwegan ol consumpton (extracton), coal and gas consumpton s somewhat reduced (ncreased). Ths effect alone accounts for almost 10 percent of the gross emsson reducton. Fnally, we see that the mportance of emssons from fossl fuel extracton s more modest, as these emssons account for less than ten per cent of total emssons from extractng and consumng ol. The effects are hghest for demand sde polcy, as under supply sde polcy emssons from ol extracton only matters to the degree that emssons outsde Norway exceed Norwegan emssons. Table 1. Net global emsson reducton from reduced Norwegan ol extracton or consumpton by one unt of carbon. Benchmark assumptons. OPEC: omnant producer OPEC: Compettve producer Supply sde emand sde Supply sde emand sde Gross emsson reducton Ol market leakage Coal/gas market leakage omestc extracton Foregn extracton Net emsson reducton Obvously, the net emsson reductons depend heavly on the assumed elastctes, whch affect leakage through the fossl fuel markets. In the compettve model varant, we can freely alter any elastcty and recalbrate the model to base year data. In the domnant producer model, however, a change n elastctes wll typcally alter the calbrated producton costs n OPEC that are consstent wth base year data. Hence, n order to keep OPEC producton costs unchanged whle checkng the effects of dfferent elastctes, we search for combnatons of elastctes that comply wth ths 20

21 restrcton. 13 Intutvely, hgher supply elastcty must then be accompaned wth less elastc demand (to keep the resdual demand elastcty qute unchanged). Fgure 3 shows the results of ether more elastc supply and less elastc demand, or vce versa. 14 We see that when supply s twce as elastc as demand, net emsson reductons from supply sde polces drop to 20 percent of the gross emsson reducton, whle for demand sde polces net emsson reductons are around 80 percent. On the other hand, f demand s twce as elastc as supply, supply sde polces are slghtly more effectve n reducng global emssons than demand sde polces. These fndngs apply both n the compettve settng and when OPEC acts as a domnant producer. We notce, however, that OPEC tends to adjust ts supply somewhat more n the latter case, mplyng slghtly hgher supply sde and lower demand sde leakage n the domnant producer varant. Fgure 3. Net global emsson reductons (per cent) wth demand or supply sde polcy when OPEC acts as domnant or compettve producer 1,2 1,0 om.prod. Supply-sde om.prod. emand-sde Comp.prod. Supply-sde Comp.prod. emand-sde 0,8 0,6 0,4 0,2 0,0-0,2 0 0,5 1,0 2,0 nf. Supply elastcty dvded by demand elastcty If OPEC decdes to keep the ol prce fxed at the BAU-level, there s of course no demand sde leakage through the fossl fuel markets. Hence, net global emsson reductons under demand sde polcy equal the gross reductons n Norway, plus reduced emssons from extracton, whle supply sde polcy has neglgble mpacts on global emssons. 13 If we relax ths restrcton, and multply all elastctes wth a factor k > 1 (k < 1), the calbrated OPEC unt costs ncrease (decrease). Ths leads to hgher (lower) emsson reductons wth demand sde polcy and lower (hgher) emsson reductons wth supply sde polcy. In the compettve settng the results are unchanged. 14 All fossl fuel supply and demand elastctes are adjusted, except for OPEC n the domnant producer model. 21

22 On the other hand, f OPEC decdes to keep ts ol extracton fxed at the BAU-level, net global emsson reductons are about half of the gross reducton n Norway both under supply- and demand sde polcy. The explanaton s that the prce response by Non-OPEC s qute smlar to the net prce response for fossl fuel demand (coal and gas demand change n the opposte drecton of ol demand). We notced above that emssons from ol extracton have relatvely modest mpacts on the net emsson reductons from reduced ol extracton or consumpton. Stll, t mght be useful to see the consequences of changng the benchmark assumptons about emsson ntenstes of ol extracton. If we e.g. assume that Norway cuts back on ts most emsson-ntensve extracton actvtes (e.g., mproved ol recovery projects), we may be talkng about felds wth emssons of 300 tonnes of CO 2 per 1,000 tonnes of ol (cf. Fgure C1). Then the net emsson reducton from supply sde polcy ncreases to (0.448) when OPEC behaves as a domnant (compettve) producer. If we nstead assume that the margnal ol extracton outsde OPEC has emssons around 500 tonnes of CO 2 per 1,000 tonnes of ol, whch could be the case f ol sand n Canada consttutes a major share of margnal extracton, then net emsson reducton from supply sde polcy drops to 0.33 (0.358) when OPEC behaves as a domnant (compettve) producer. Net reducton from demand sde polcy, on the other hand, ncreases to (0.671). Hence, emssons from ol extracton should not be gnored, and ther mportance depends qute much on whch ol resources that are (not) extracted Optmal balancng of demand and supply sde polces The equlbrum soluton When we account for the net global emsson effects dsplayed n Table 1 (wth OPEC beng a domnant producer), the demand sde measures n Clmate Cure 2020 (2010),.e., reducng domestc emssons by A = 8.4 Mt of CO 2, correspond to a global emsson cut of A = 5.7 Mt of CO 2. The margnal cost of reducng global CO 2 emssons (.e., λ n Eq. (4)) s then 850 US per ton. The correspondng margnal abatement cost curve for demand sde measures s depcted n Fgure 4, along wth the correspondng margnal abatement cost curve for supply sde measures (also accountng for net global emsson effects). The ntersecton pont n Fgure 4 reveals that the optmal combnaton of demand and supply sde abatement for Norway, gven a global emsson reducton target of A = 5.7 Mt, nvolves 35 per cent demand sde measures, whle the remanng emsson cuts should be carred out as reduced ol 22

23 extracton. The correspondng margnal costs of reducng global CO 2 emssons are 367 US per ton,.e., less than half of the margnal cost wth only demand sde measures. Fgure 4. Leakage-adjusted domestc demand sde margnal abatement cost curve and the margnal supply sde abatement cost curve US/t CO Margnal cost, demand sde Margnal cost, supply sde mllon tonnes CO 2 Implementng ths combnaton of demand and supply sde measures would mean that domestc CO 2 emssons should be reduced by almost 3 Mt of CO 2, e.g., through a domestc CO 2 tax on non-eu ETS sectors of 248 US per ton CO 2 (cf. Fgure 1). 15 Almost 90 per cent of the measures that are proftable to carry out relate to transportaton, of whch reduced prvate transport accounts for 20 per cent and transton to clmate frendly vehcles accounts for the rest. Moreover, Norwegan ol extracton should be reduced by 3.8 mllon Sm 3, whch s 3.4 percent of total Norwegan ol producton n Ths reducton can be acheved n dfferent ways, e.g., through a producton tax on Norwegan ol extracton. The optmal margnal cost of reduced CO 2 emsson estmated above corresponds to a producton tax of US 53 per barrel, 16.e., around half of the current crude ol prce. As mentoned n Secton 3.1, the break-even prce of the Ivar Aasen ol feld, whch can be characterzed as relatvely proftable, s around US 60 per barrel. 15 The domestc CO 2 tax s found by multplyng the margnal cost of reducng global CO 2 emssons (367 US per ton) wth the net effect on global emssons of reduced Norwegan consumpton (0.676 see Table 1). 16 The producton tax s found by multplyng the margnal cost of reducng global CO 2 emssons (367 US per ton) wth the net effect on global emssons of reduced Norwegan extracton (0.353 see Table 1), and then multplyng ths wth the CO 2 content of a barrel of ol (0.42). 23

24 Below we dscuss the pros and cons of mplementng a producton tax. Here we want to emphasze that a producton tax of around US 50 per barrel could potentally lead to a much bgger reducton n ol extracton than the 3.4 percent calculated above. The reason s that, as underlned n Secton 3.1, we most lkely overestmate the costs of reducng ol extracton. There are other uncertantes n our calculatons, too, especally the effects n the fossl fuels markets of reduced ol extracton or consumpton n Norway. In Table 2 we present a number of senstvty analyses where we adjust our benchmark assumptons. Note that to be consstent wth the domestc emsson reducton target n Clmate Cure 2020 (2010), we have to adjust the global emsson reducton target A n the same way as before. Ths adjustment n the global target has small mpacts on the dstrbuton between demand and supply sde measures, but obvously affects the optmal tax levels. We notce from Table 2 that assumng compettve behavour by OPEC gves more or less the same results as above. Besdes that, we see that the shares of supply and demand sde measures depend qute a lot on what we assume about the ol market. If we thnk that OPEC keeps ts supply fxed, or f demand s twce as elastc as supply, cuts n ol extracton are more effectve n reducng global emssons, and the share of supply sde measures ncreases to around 90 percent. Nevertheless, the optmal producton tax does not change much. On the one hand, the global emsson effects of reduced ol extracton ( E ) are ncreased, shftng the supply sde curve n Fgure 4 downwards. Moreover, the x global target has been reduced due to hgher demand sde leakages. Ths reduces the shadow prce of reducng global emssons ( ), even though the demand sde curve n Fgure 4 shfts upwards. On the other hand, the optmal producton tax s proportonal to E x (cf. Secton 2), and (as just stated) ths rate has ncreased. The domestc CO 2 prce drops qute substantally, though, due to a combnaton of lower and lower E. y If we thnk that supply s twce as elastc as demand, cuts n ol extracton s less effectve and the share of supply sde measures drop to 36 percent. Agan, we see that the optmal producton tax s less affected, whle the domestc CO 2 prce has ncreased qute a lot. If OPEC for some reason chooses to keep the ol prce fxed, reduced ol extracton gves no clmate benefts at all, and we are back to the conventonal choce of only dong demand sde polces. If we have overestmated the costs of reduced ol extracton, we should undertake even more supply sde measures than depcted n Fgure 4. Moreover, the optmal domestc CO 2 prce and the optmal producton tax for Norwegan ol extracton should then be reduced. For nstance, f we scale down the 24

25 supply sde cost curve by 50 percent, supply sde measures should account for 84 percent of total abatement, wth the optmal domestc CO 2 prce and producton tax beng 131 US per ton CO 2 and 29 US per barrel; see Table 2. On the other hand, we have gnored the challenges of separatng ol and gas extracton, whch may suggest that we have underestmated the forgone profts of reduced ol extracton. However, the share of gas n total ol and gas producton for the nne felds studed above was merely 5 percent. Moreover, for 8 of the 13 felds currently under development on the Norwegan shelf, more than 90% of recoverable reserves are ol (Mnstry of Petroleum and Energy, 2013). The hgher ol prce, the less proftable s the supply sde polcy. However, t s very unlkely that t s cost effectve to rely only on demand sde measures. Gven the benchmark estmates of E x and t s optmal to mplement some supply sde measures as long as the net revenue of the least proftable ol feld s less than 126 US per barrel. Table 2. Senstvty analyss. Effects of reducng Norwegan extracton or consumpton of ol by one unt of carbon Net emsson Target Supply- vs. demand Optmal taxes reducton * ( A ) sde E x E y Mt of Supply emand Prod. tax CO 2 tax CO 2 $/barrel $/ton Benchmark case % 34% Compettve OPEC % 28% Fxed OPEC supply % 13% Fxed ol prce % 100% Supply two tmes more elastc % 64% than demand emand two tmes more % 10% elastc than supply 50% lower supply sde costs % 16% * Net global emsson reducton from reduced Norwegan ol extracton (supply sde) or consumpton (demand sde) by one unt of carbon. E y, Polcy alternatves and dscusson So far we have taken for granted that the Norwegan government wll mpose suffcently strong measures to reach the global target A. A reasonable frst step towards ths goal could be to mplement supply sde polces comparable to the demand sde polces already n place n Norway. The current CO 2 tax mposed on Norwegan non-ets sectors s 66 US per ton CO Usng the benchmark value 17 The Norwegan CO 2 tax s dfferentated across fuels and sectors. The hghest tax level n non-ets sectors s on petrol, at 393 NOK (66 US) per ton CO 2 (n 2013), cf. Mnstry of Fnance (2012). 25

26 of E y (see Table 2), ths translates nto a shadow prce of global emsson reductons ( ) of 98 US, whch further translates nto a correspondng producton tax of 14 US per barrel (when usng the benchmark value of E x ), cf. Eq. (4). That s, supplementng a domestc CO 2 prce of 66 US per ton CO 2 n non-ets sectors wth an ol producton tax of 14 US per barrel would mply a cost-effectve combnaton of demand and supply sde clmate polces. Naturally, the global target A would not be reached wth these moderate measures global emssons would declne by a lttle more than one mllon tonne. A more ambtous alternatve could be to spend as much on an optmally balanced demand and supply sde strategy as would be the total cost of the demand sde polces announced by the Parlament. As shown above, the margnal costs of reducng global CO 2 emssons are more than halved when the optmal combnaton s chosen nstead of a pure demand sde strategy. These savngs could alternatvely be nvested n further global emsson cuts. We stll restrct the analyss to domestc measures, despte that allowng for offset or depost purchases abroad would render abatement cheaper. Calculatons then show that spendng the same total amount on abatement as foregone n the demand sde strategy, would yeld a total global abatement of more than 10 Mt of CO 2, of whch 3 Mt would be optmally abated through demand sde measures and the remanng through contracted ol producton. In our benchmark case, the derved margnal costs of emsson reductons translate nto a shadow prce on ol producton equal to 53 US per barrel. Ths shadow prce can n prncple be mplemented through a correspondng producton tax on all ol producton n Norway. However, mplementng such a large tax overnght s not wthout drawbacks. Frst, we have already noted above that we may have overestmated the costs of reducng ol extracton. As a thought experment, assume that half of Norwegan ol producton becomes unproftable wth the ndcated tax level, and that the forgone profts amount to on average 25 US per barrel,.e., half of the tax. Usng the producton level of 2012, total costs would then be 17 bllon US, compared to 1.1 bllon US n the benchmark soluton and 2.7 bllons US wth demand sde polces, only. Although ths thought experment may be somewhat extreme, t llustrates that there s a substantal downsde rsk by mplementng such a large producton tax for such a bg sector. Second, Norwegan authortes have, for good reasons, been cautous about changng the taxaton rules, at least for already developed felds. Implementng addtonal taxes could be seen as changng the rules of the game, ncreasng the rsk of dong busness on the Norwegan contnental shelf. Hence, 26

27 t s easer to make a case for mposng a large producton tax on extracton from undeveloped felds, unexplored areas and even developed felds requrng upgradng through IOR projects, than on planned extracton from developed felds. An alternatve supply sde polcy, e.g., combned wth a more lmted producton tax, could be to have a more restrctve practse when t comes to openng new areas for ol exploraton. At least t seems reasonable to take a global perspectve smlar to the one n ths paper when undertakng mpact assessments of openng new areas for exploraton. Moreover, ths global perspectve should be ncluded when the authortes are consderng measures to ncrease the recovery rate on the Norwegan shelf Conclusons The conventonal way of mplementng polces to reduce CO 2 emssons s through the demand sde, that s, ntroducng measures or nstruments to reduce the consumpton of fossl fuels. In a closed market such as the global economy, demand and supply sde measures may be equvalent. Ths s not the case, however, when only one or a group of countres mplement clmate polces. emand and supply sde measures wll then have dfferent effects dependng, n partcular, on the prce responsveness on the demand and supply sde of the market. In ths paper we have derved analytcal expressons for the optmal combnaton of demand and supply sde polces for a fossl fuel producng and consumng country that has a fxed target for ts contrbuton to reducng global emssons. We have also accounted for emssons from the extracton of fossl fuels, whch comes n addton to emssons from the use (.e., combuston) of the fuels. Based on ths analytcal framework, we have analysed the optmal combnaton of demand and supply sde clmate polces for a small ol producng country, Norway, usng data for domestc abatement costs and forgone profts from Norwegan ol producton, as well as a transparent model of nternatonal fossl fuel markets. We fnd that a majorty of the measures should be mplemented on the supply sde, that s, by reducng Norwegan extracton of ol. Gven our benchmark assumptons, the optmal combnaton of demand and supply sde measures nvolves annual cuts n Norwegan ol 18 Norwegan authortes are generally concerned about ncreasng recovery rates of Norwegan ol extracton. For nstance, the Norwegan Petroleum rectorate (NP) states on ts webste that The NP shall be a drvng force for realsng the resource potental by emphassng long-term solutons, upsde opportuntes, economes of scale and jont operatons, as well as ensurng that tme-crtcal resources are not lost. ( Moreover, ncreasng recovery rates was the man objectve of the so-called Utvnnngsutvalget, ntated by the Mnstry of Petroleum and Energy (2010). 27

28 extracton of around 3.8 mllon Sm 3 (3-4 percent of current Norwegan ol producton), and annual domestc reductons n CO 2 emssons of almost 3 mllon tonnes of CO 2 (6-7 percent of current Norwegan CO 2 emssons). Ths combned polcy wll gve the same global emsson reductons as the domestc emsson reductons suggested by the Norwegan government, but at a cost of only one thrd of usng only demand sde measures. However, t should be noted that our numercal nformaton s not ntegrated n a common model framework. As we focus on the long run, transacton costs of reallocatng resources to the new equlbrum are not assessed. These can be sgnfcant, and 2020 s most lkely too short a horzon to dsregard transacton costs. The optmal polcy combnaton s, at least n prncple, a tax per ton domestc CO 2 emssons and a tax per barrel of domestc ol extracton. The tax levels we derve n our benchmark calculatons are hgh, drven e.g. by the hgh costs of reducng Norwegan emssons from sectors that are not regulated by the EU s Emssons Tradng System. Implementng such hgh taxes overnght s not wthout drawbacks, especally on the supply sde, and we have dscussed alternatve ways of mplementng the desred cuts n Norwegan ol extracton. We emphasze that there are a number of uncertantes n our calculatons. However, the concluson that a majorty of the global emsson reductons should be taken through supply sde measures, s qute robust. 28

29 References Aftenposten (2013): Flere oljefelt er faresonen etter skatteøknng, Aftenposten June 6th 2013, Alhajj, A. and. Huettner (2000): OPEC and World Crude Ol Markets From 1973 to 1994: Cartel, Olgopoly, or Compettve? The Energy Journal 21(3), Askar,H. and N. Krchene (2010): An ol demand and supply model ncorporatng monetary polcy, Energy 35, Bohm, P. (1993). "Incomplete Internatonal Cooperaton to Reduce CO 2 Emssons: Alternatve Polces." Journal of Envronmental Economcs and Management 24 (3): Böhrnger, C., C. Fscher, and K.E. Rosendahl The Global Effects of Subglobal Clmate Polces. The B.E. Journal of Economc Analyss&Polcy 10(2) (Symposum): Artcle 13. Böhrnger, C., B. Bye, T. Fæhn and K. E. Rosendahl (2012a): Alternatve desgns for tarffs on emboded carbon a global cost-effectveness analyss, Energy Economcs 34 (suppl. 2), Böhrnger, C., J.C. Carbone, and T.F. Rutherford. 2012b. Unlateral clmate polcy desgn: Effcency and equty mplcatons of alternatve nstruments to reduce carbon leakage. Energy Economcs 34, Supplement 2 (The Role of Border Carbon Adjustment n Unlateral Clmate Polcy: Results from EMF 29): S208 S217. BP (2012): BP Statstcal Revew of World Energy 2012, London: BP. Brons, M., Njkamp, P., Pels, E., Retveld, P., A meta-analyss of the prce elastcty of gasolne demand. A SUR approach. Energy Economcs 30 (5), Clmate Cure 2020 (2010): Tltak og vrkemdler for å nå norske klmamål mot 2020, Klma- og forurensnngsdrektoratet, Norges vassdrags- og energdrektorat, Oljedrektoratet, Statstsk sentralbyrå, Statens vegvesen. Rapport TA2590 ahl, C. (2006): Survey of Econometrc Energy emand Elastctes Progress Report, August 2006, Unpublshed report. ahl, C. (2012): Measurng global gasolne and desel prce and ncome elastctes, Energy Polcy 41, ahl, C. and T.E. uggan (1998): Survey of Prce Elastctes from Economc Exploraton Models of US Ol and Gas Supply, Journal of Energy Fnance & evelopment 3, Number 2, Ells, J. (2010): The Effects of Fossl-Fuel Subsdy Reform: A revew of modellng and emprcal studes, Internatonal Insttute for Sustanable evelopment (IIS), March Fæhn. T, E. Isaksen, K. Jacobsen and B. Strøm (2013): MSG-TECH: Analyss and documentaton of a general equlbrum model wth endogenous clmate technology adaptatons, forthcomng Reports, Statstcs Norway. Farzn, Y.H The mpact of ol prces on addtons to US proven reserves 23 Resource and Energy Economcs

30 Fourner, J. I. Koske, I. Wanner and V. Zpperer (2013): The Prce of Ol Wll t Start Rsng Agan? OEC Economcs epartment Workng Papers, No. 1031, OEC Publshng. Golombek, R., C. Hagem and M. Hoel (1995). "Effcent ncomplete nternatonal clmate agreements." Resource and Energy Economcs 17 (1): Grffn, J.M. (1985): OPEC behavor: a test of alternatve hypotheses, Amercan Economc Revew 75, Hagem, C. (1994). "Cost-effectve clmate polcy n a small country." Energy Journal 15 (4): Hansen, P.V. and Lndholt, L. (2008). The Market Power of OPEC Appled Economcs 40(22): Harstad, B. (2012). "Buy Coal! A Case for Supply sde Envronmental Polcy." Journal of Poltcal Economy 120 (1): Hoel, M. (1994). "Effcent Clmate Polcy n the Presence of Free Rders." Journal of Envronmental Economcs and Management 27 (3): Hoel, M. (1996). "Should a carbon tax be dfferentated across sectors?" Journal of Publc Economcs 59 (1): Hoel, M. (2013). Supply sde clmate polcy and the green Paradox, CREE Workng Paper 2/2013 Hotellng, H. (1931): The economcs of exhaustble resources, The Journal of Poltcal Economy 39, Internatonal Energy Agency (IEA). (2007). World Energy Outlook Internatonal Energy Agency: Pars. Krchene, N. (2002): World crude ol and natural gas: a demand and supply model, Energy Economcs 24, Markusen, J. R. (1975). "Internatonal externaltes and optmal tax structures." Journal of Internatonal Economcs 5 (1): Markusen, J. R., E. R. Morey and N.. Olewler (1993). "Envronmental Polcy when Market Structure and Plant Locatons Are Endogenous." Journal of Envronmental Economcs and Management 24 (1): Markusen, J. R., E. R. Morey and N. Olewler (1995). "Competton n regonal envronmental polces when plant locatons are endogenous." Journal of Publc Economcs 56 (1): Mnstry of Fnance (2012): Skatter, avgfter og toll /11/9/2.html?d= Mnstry of Petroleum and Energy (2010): Økt utvnnng på norsk kontnentalsokkel. En rapport fra utvnnngsutvalget. 30

31 Mnstry of Petroleum and Energy (2011): An ndustry for the future Norway s petroleum actvtes, Meld. St. 28 ( ) Report to the Stortng (whte paper). Mnstry of Petroleum and Energy (2013): Facts 2013 (Faktaheftet 2013). The Norwegan Petroleum Sector. Mohn, K., Osmundsen, P., Exploraton economcs n a regulated petroleum provnce: the case of the Norwegan Contnental Shelf. Energy Economcs 30, NHO (2009): Offshorendustren. TEMAHEFTE. Oktober NHO. Nærngslvets klmapanel. f OGP (2012): Envronmental performance ndcators data, Report No. 2011e, October 2012, Internatonal Assocaton of Ol & Gas Producers. Ramcharran, H., Ol producton responses to prce changes: an emprcal applcaton of the compettve model to OPEC and non-opec countres. Energy Economcs 24, Rauscher, M. (1997), Internatonal Trade, Factor Movements, and the Envronment, Oxford: Oxford Unversty Press. Rnglund, G. B., K. E. Rosendahl and T. Skjerpen oes olrg actvty react to ol prce changes? An emprcal nvestgaton 30 Energy Economcs Snn, H.-W. (2008). "Publc polces aganst global warmng: a supply sde approach." Internatonal Tax and Publc Fnance 15 (4): Smth. J. (2005): Inscrutable OPEC? Behavoral tests of the cartel hypothess. The Energy Journal, 26 (1), The Economst (2009): Norway and the envronment - Bnge and purge. The Norwegan Ol Company (2012): Konsekvensutrednng for Ivar Aasen (Impact study for Ivar Aasen (n Norwegan). Venables, A. J. (2011) : epleton and development: Natural resource supply wth endogenous feld openng, CESfo workng paper: Resource and Envronment Economcs, No. 3608, World Bank. (2008). Clmate Change and the World Bank Group: Phase I: An Evaluaton of World Bank Wn-Wn Energy Polcy Reforms. World Bank: Washngton, C. Österle, I. (2012). Fossl Fuel Extracton and Clmate Polcy: A Revew of the Green Paradox wth Endogenous Resource Exploraton. FEEM Workng Paper Seres

32 Appendx A OPEC operates as a compettve prce taker: If OPEC operates as a prce taker, we fnd aggregate supply of ol as a functon of the prce of ol: (25) X o S(P). o o It thus follows from (6), (7) and (25) that all equlbrum prces are functons of net demand from the home country: (26) P g ( yo x o,yc x c,yg x g ), o,c,g. OPEC keeps ol prce constant: If ol prce s kept constant at a level equal to P o, OPEC must set Z, such that (27) Po P( o yo xo Z,yc x c,yg x g ). Hence, (28) Z Z( yo xo Z,yc x c,yg x g ), and prces of coal and gas are functons of net mport from the home country: (29) P h( yo x o,yc x c,yg x g ), c,g. OPEC keeps producton constant: Z constant( Z Z ), gves (30) P q( yo xo Z,yc x c,yg x g ), o,c,g. 32

33 ervaton of equatons (18): (31) j(x j ) jo,c,g Ey T y 1L X y j jo,c,g fk 1L X ( 1 k ) (y x ) ko,c,g k k Xs sk Xh hk ko,c,g ko,c,g 1L l, s,h,s h, X X j j jo,c,g X y f f ( ) ( ) (y x ) (y x ) and j(x j ) jo,c,g X E x T x x L x X j x x fk L x 1 X ( k ) (y x ) x X X j j jo,c,g ko,c,g j jo,c,g fk fk X ( s sk ) X ( h hk ) k o,c,g (y x ) k o,c,g (y x ) L l, s,h,s h. j 33

34 Appendx B Fgure B1. Varable costs and correspondng producton for nne Norwegan ol felds $/barrel mllon Sm 3 Source: Statstcs Norway 19 The felds are Gltne, Gungne, Gyda, Jotun, Norne, Sygna, Ula, Varg and Veslefrkk from 2009 to Hence, we have 27 observatons of costs and producton. We arrange our observatons accordng to cost level. We fnd no connecton between vntage and the cost level,.e. the cost level of a feld n 2011 s generally not hgher than n We downscale producton n each year to one thrd, so that the fgure represents an average year n We are not allowed to dsclosure operatng costs for sngle felds n 2011, and therefore we only show the ftted curve and not how the sngle felds are placed n the fgure. The margnal cost curve s 1.5x x , wth R 2 =0.98. The producton volume for these felds s 5.3 per cent of total Norwegan lquds producton n

35 Appendx C Prce responsveness on the demand sde There s a large emprcal lterature on drect prce elastctes. However, the estmaton results vary qute substantally. Usng a meta-analyss of 43 prmary studes of gasolne demand from dfferent countres, Brons et al. (2008) fnd a mean long-run prce elastcty of However, all the prmary studes were publshed before the year Carol ahl has developed a large database wth nter ala 247 studes of gasolne and desel demand studes from around the world. Accordng to her summary statstcs, the medan long-run prce elastctes are and for gasolne and desel, respectvely. 20 In ahl (2012) she presents an analyss based on the statc studes n her database, reportng medan elastctes of and for gasolne and desel, respectvely. These may be nterpreted as ntermedate elastctes,.e., between short and long-run elastctes. 21 ahl fnds that elastctes tend to ncrease wth both prces and ncome. Ells (2010) revews emprcal lterature on prce elastctes, and refers e.g. to studes by the World Bank (2008) and the IEA (2007). Whereas the World Bank estmates long-run prce elastctes for gasolne and desel at and -0.67, respectvely, the IEA estmates the long-run prce elastcty for crude ol demand at Fourner et al. (2013) estmate the average medum to long-run prce elastcty n OEC and BRIICS (Brazl, Russa, Inda, Indonesa, Chna and South Afrca) countres to be around Askar and Krchene (2010) fnd very low elastctes: Ther estmates of long-run demand and supply elastctes are both around 0.01 n absolute value. Most emprcal studes of ol demand focus on gasolne and desel demand. As stated by Ells (2010), demand tends to be less elastc n the transport sector than n other sectors due to fewer vable alternatves. Ths s confrmed by an unpublshed survey by ahl (2006), based on the database referred to above, reportng a mean long-run elastcty for fuel ol at The database contans studes datng from the 1970 s up untl today. The standard devaton for the long-run gasolne elastcty s 6.37! See 21 ahl refers to them as long-run elastctes, but notes that dynamc models, estmatng both short and long-term elastctes, tend to fnd long-term elastctes % above the elastctes found n statc studes. 22 It s reasonable to assume that prce elastctes for crude ol are lower than for ol products, as ol products are hgher prced than crude ol (Fourner et al., 2013). At least ths s the case f the markup,.e., the dfference between the product and the crude ol prce, s ndependent of the crude ol prce tself. Own estmatons suggest that the markup and the crude ol prce s somewhat correlated, but a 1% ncrease n the crude ol prce wll n general ncrease the product prce by less than 1%. 35

36 As s evdent, a consensus estmate of the long-run prce elastcty of ol demand s dffcult to nal down. As mentoned n Secton 3.2.1, we use -0.5 as our benchmark estmate. However, we use other estmates, as well, n the senstvty smulatons. Whereas estmates of drect prce elastctes vary qute a lot, estmates of cross-prce elastctes are rarely reported (none of the studes mentoned above do so). Instead, we wll rely on smulatons on a large-scale CGE model buldng on the extensvely used GTAP database and usng benchmark GTAP parameters for crucal elastctes n producton and consumpton of goods and servces. 23 By smulatng an exogenous ncrease n the crude ol prce, we fnd that global consumpton of coal and gas (measured n carbon) ncreases by respectvely 0.10 and 0.09 unts for every unt reducton n ol consumpton. 24 Ths corresponds to cross-prce elastctes of around 0.08 for both fuels, whch we use as our benchmark estmates. Prce responsveness of Non-OPEC supply As opposed to ol demand prce elastctes, there exst rather few emprcal studes of ol supply prce elastctes. Ths s also ponted out by Fourner et al. (2013), who set the prce elastcty of supply equal to the (absolute value of the) estmated demand elastcty (-0.2) n ther smulatons. Above we referred to a study by Askar and Krchene (2010), who estmates long-run demand and supply elastctes around 0.01 n absolute value. In an earler study, Krchene (2002) reports a long-run supply elastcty of 0.1 for the perod Importantly, however, all these studes consder world supply of ol, not Non-OPEC supply. Ramcharran (2002) fnds an average prce elastcty of 0.11 for Non-OPEC over the perod In a study of OPEC behavour, Alhajj and Huettner (2000) fnd support for a model where Saud Araba acts as a domnant producer wth ths specfcaton ol supply prce elastcty from the rest of the world (Non-OPEC + OPEC mnus Saud Araba) s found to be In a smlar study, Hansen and Lndholt (2008) fnd a long-run supply elastcty of 0.38 for the perod Emprcal studes that focus on ol drllng tend to fnd hgher prce elastctes. For nstance, Rnglund et al. (2008) fnd an average long-run elastcty of 0.99 for olrg actvty n Non-OPEC, wth elastctes rangng between 0.51 and 1.86 n dfferent regons. ahl and uggan (1998) fnd elastctes for ol exploraton n the U.S. above one, whereas Mohn and Osmundsen (2008) fnd a 23 The model has been used n e.g. Böhrnger et al. (2010, 2012a,b). The GTAP database s avalable at 24 Obvously, from the same smulatons we can derve the mplct drect prce elastcty for ol, whch turns out to be for crude ol,.e., qute close to our benchmark estmate. 36

37 long-run elastcty of 0.41 for exploraton drllng n the Norwegan Contnental Shelf. Farzn (2001) fnds even lower elastctes for reserve addtons of known felds n the U.S. (0.16 n the long run). Agan, t s dffcult to pn down the exact prce elastcty of Non-OPEC supply. As a benchmark estmate, we wll use 0.5,.e., the same absolute value as for the demand prce. OPEC s response OPEC s response to a change n supply from a Non-OPEC producer depends on how OPEC explots ts market domnance n the ol market. As dscussed n the theoretcal part n Secton 2, our default assumpton s that OPEC behaves as a domnant producer, but we also consder alternatve assumptons. As seen n Eq. (11) OPEC s response as a domnant producer depends on the resdual demand functon (.e., global demand mnus Non-OPEC supply) and the producton costs of OPEC. The resdual demand has been dscussed above. The producton costs of OPEC are calbrated n our model so that our reference smulaton s consstent wth base year data (2011). fferences n emsson ntensty n ol extracton When t comes to emssons from ol extracton, there are qute large dfferences across extracton felds. Accordng to OGP (2012), the average greenhouse gas (GHG) emssons per unt producton worldwde n 2011 were 159 tonnes CO 2 e per 1,000 toe hydrocarbon produced. The fgure for the Mddle East s only 51 tonnes CO 2 e, but the coverage s less comprehensve for ths regon hence the real average could potentally be hgher. The European fgure s 84 tonnes CO 2 e. OGP (2012) does not report fgures for Norway, but based on data from Statstcs Norway we calculate the average Norwegan emsson ntensty n 2011 to be 60 tonnes CO 2 e per 1,000 toe. 25 A closer look at Norwegan felds shows that CO 2 -emssons from ol felds were n fact 4-5 tmes hgher than CO 2 -emssons from gas felds both n 2011 and 2012, see Fgure C1. Ths s partly because the two largest Norwegan gas felds use electrcty rather than gas, and partly because ol felds n Norway to a larger degree are n ther fnal phases of extracton. Energy use per unt ol or gas extracted typcally ncreases as the natural pressure n the reservor declnes. Fnally, the average ol feld n Norway tends to be smaller than the average gas feld, and smaller felds have hstorcally had hgher emssons than larger felds (at least n Norway, cf. NHO,

38 2009). The average CO 2 -emsson ntensty at Norwegan ol felds n 2012 were 95 tonnes CO 2 per 1,000 toe. In addton comes CH 4 -emssons amountng to around 5 tonnes CO 2 e per 1,000 toe. Fgure C1. Producton and CO 2 -emsson ntenstes n Norwegan ol and gas felds n 2012* Source: Own calculatons based on Norwegan Petroleum rectorate (O) and Norway s Clmate and Polluton Agency (Klf) * An ol (gas) feld s defned as producng at least 50% crude ol (natural gas) n In some cases t has been necessary to group several felds n the calculatons of emsson ntenstes. In those cases producton from the largest feld s shown. Two small ol felds wth emsson ntenstes above 400 kg CO 2 per toe s not shown. For the rest of Non-OPEC we make a rough calculaton based on the OGP (2012) fgures for the Mddle East, Europe and the world, arrvng at around 200 tonnes CO 2 e. 26 The average fgures reported above wll typcally devate from the margnal change n emssons of ncreased or reduced ol producton. Reduced ol producton n Norway could e.g. nvolve reduced IOR actvty or advanced termnaton of a feld. In both these cases, energy use per unt extracton wll tend to be hgher than average, cf. the dscusson and Fgure 1 for Norway above. The same could be true for reduced ol exploraton or feld developments, at least n aggregate, as the margnal areas or felds wll tend to be less proftable, whch often means that more costly energy s needed per unt producton. 26 OGP (2012) reports both emssons and producton data for seven regons of the world. We deduct emssons and producton from the Mddle East and half of those from Europe (.e., Norway), and calculate the emsson ntensty for the remanng regons, whch we then assume s representatve for Non-OPEC. 38