Climate Policies in a Fossil Fuel Producing Country Demand Versus Supply Side Policies

Transcription

1 Clmate Polces n a Fossl Fuel Producng Country emand Versus Supply Sde Polces Taran Fæhn Cathrne Hagem Lars Lndholt Ståle Mæland Knut Enar Rosendahl CESIFO WORKING PAPER NO CATEGORY 10: ENERGY AN CLIMATE ECONOMICS ECEMBER 2014 An electronc verson of the paper may be downloaded from the SSRN webste: from the RePEc webste: from the CESfo webste: Twww.CESfo-group.org/wpT

2 CESfo Workng Paper No Clmate Polces n a Fossl Fuel Producng Country emand Versus Supply Sde Polces Abstract In absence of jont global clmate acton, several jursdctons unlaterally restrct ther domestc demand for fossl fuels. Another polcy opton for fossl fuel producng countres, not much explored, s to reduce own supply of fossl fuels. We explore analytcally and numercally how domestc demand and supply sde polces affect global emssons, contngent on market behavour. Next, n the case of Norway, we fnd the cost-effectve combnaton of the two types of polces. Our results ndcate that gven a care for global emssons, and a desre for domestc acton, a majorty of emsson reductons should come through supply sde measures. JEL-Code: H230, Q410, Q540. Keywords: clmate polces, carbon leakages, ol extracton, supply sde clmate polces, demand sde clmate polces. Taran Fæhn Statstcs Norway Research epartment Oslo / Norway tfn@ssb.no Lars Lndholt Statstcs Norway Research epartment Oslo / Norway ll@ssb.no Cathrne Hagem Statstcs Norway Research epartment Oslo / Norway cah@ssb.no Ståle Mæland Statstcs Norway Research epartment Oslo / Norway stm@ssb.no Knut Enar Rosendahl Norwegan Unversty of Lfe Scences School of Economcs and Busness 1432 Ås / Norway knut.enar.rosendahl@nmbu.no We are grateful to Torbjørn Hægeland and Ådne Cappelen for comments on an earler draft. We would also lke to thank the research centre CREE (Centre for Research on Envronmentally frendly Energy) for fundng. The authors Fæhn, Hagem, Lndholt and Rosendahl are assocated wth the CREE-centre.

3 1 Introducton In the context of 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 at the global level. If fossl fuel markets were effcent, the global costs of reducng emssons would also be the same. In ths frst-best stuaton, demand and supply sde polces concde wth respect to effcency. However, wth lmted partcpaton n a clmate agreement, or wth unlateral acton by a sngle country or coalton of countres, demand sde versus supply sde polces matters. Many jursdctons show wllngness to reduce CO 2 -emssons by restrctng domestc demand for fossl fuels. omestc supply sde polces are less frequently dscussed, let alone pursued. The purpose of ths paper s to deduce the cost-effectve combnaton of the two types of polces, gven a target for a country's (or coalton s) contrbuton to global CO 2 abatement. The result hnges crtcally on how domestc demand sde and supply sde polces affect global emssons through nternatonal markets. 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. omestc polcy measures that reduce fossl fuel demand lead to lower nternatonal energy prces, and may also reduce the compettveness of domestc frms n the world markets for energyntensve 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 conserves 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 focus on the trade-off 2

4 between domestc demand and supply sde measures. We, thus, reserve a gven unlateral contrbuton to global abatement to domestc acton; the optons of purchasng foregn fossl fuel deposts or nternatonal emsson quotas are excluded. Our case n the numercal analyss s Norway, whch has an ambtous target for domestc demand sde measures for 2020, but has so far not consdered usng supply sde measures. The Norwegan 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). Whle the country accounts for around 2 per cent of global ol producton, t contrbutes to less than 0.3 per cent of global ol consumpton (BP, 2013). The global combuston of fossl fuels extracted n Norway leads to CO 2 emssons that are about ten tmes hgher than total emssons of CO 2 wthn Norway. Even though leakages are lkely to be larger wth supply sde measures than demand sde measures, we conclude that t s cost-effectve for Norway to let most of the contrbuton to global emsson reductons be acheved through supply sde measures. In our benchmark scenaro, only one thrd of a gven global reducton should be realsed through demand sde measures; the remanng two thrds should come through supply sde measures, that s, by reducng ol extracton. 1 Prevous lterature on optmal (second-best) 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 an aggregate fossl fuel 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). 1 In practcal polcy the domestc acton to meet a gven global target wll have to concur wth other exstng clmate ambtons and commtments. For nstance, Norway has demand sde commtments n the EU Emssons Tradng System and n the Kyoto agreements. Chapter 3 explans how these are accounted for n the computatons. Note that to the extent that these commtments are not met by the domestc actons studed here, ther fulfllment may mply extra costs. However, Norway has already shown wllngness to do more than smply complyng wth nternatonal commtments, e.g., through over-fulfllng the Kyoto oblgatons n , fnancng technology transfer and engagng n ranforest preservaton n RE+. 3

5 Hagem (1994) compares numercally the costs of pure demand sde polcy wth pure supply sde polcy n 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, prevous estmates on cost and emsson effects are outdated. In our updatng of the nformaton base we have ncluded a revew of the emprcal lterature on 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 checked 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 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 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 depend on 4

6 the expected, future prce path (Hotellng, 1931). If producers 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 analysng fossl fuel polces n a statc framework as ours even f some ntertemporal reallocaton 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. 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 (GHG) emssons ( A ), through a combnaton of domestc demand sde and supply sde polces. The country s aggregate benefts from domestc consumpton of fossl fuels 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. 5

7 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: 0 E E A, o c g Max W B y, y, y c x P y x y,x o,c,g o,c,g s.t. (1) where E s global emssons and 0 E s the global emssons n absence of the unlateral, domestc polces. From the frst-order condtons for ths maxmzaton problem, we fnd that: y y y B P P y x E (2) c x P P y x E (3) x x λ s the shadow cost of the emsson constrant, whle E y 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. If the country s a net exporter of a y x fuel, a hgher prce mproves terms of trade. Hence, the terms-of-trade 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 the prce changes and consequently the welfare mpacts of ths can be consdered mnor for the small home country, relatve to the other terms n eqs. (2)-(3). Small prce changes do not mply, 6

8 however, that global emsson effects of these prce changes can be gnored consumpton effects abroad may well be of the same order of magntude as consumpton effects n the home country; see next subsectons. From (2) and (3), we then fnd: B P P c x E E y y x. (4) Hence, optmal clmate polcy mples that the margnal cost of global emsson reductons By -P through domestc demand sde polcy ( E y ) should equal the margnal cost of global emsson P -c (x ) reductons through domestc supply sde polcy ( ), across all fuels. Gven that domestc E consumers and producers are prce takers and maxmze ther net beneft and proft, t s shown n Golombek et al. (1995) that the optmal outcome can be acheved by ntroducng fuel-specfc c p consumer taxes, t = E, and producer taxes, t = E. y We wll proceed by dervng expressons for E y and x x E x n a partal fossl fuel market model. In the followng subsecton we dsregard emssons n the fossl fuel extracton processes, but return to ths n subsecton Global emssons from demand and supply sde measures Let captal letters denote foregn producton and consumpton of the three fossl fuels (X and Y, =o,c,g). As all fuels are measured n unts of ther carbon content, total global emssons from combuston of fossl fuels, E, must equal 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 7

9 To smplfy the analytcal dervatons, we treat domestc consumpton (y ) and producton (x ) as exogenous varables, set by the domestc regulator. 2 In the numercal analyss we derve the optmal consumer and producer taxes, gven proft maxmzng domestc producers and welfare maxmzng domestc consumers. We assume that foregn consumers are prce takers, where demand for each fuel s a functon Y = P,P,P, where < 0 P of all energy prces ( o c g j for =j and > 0 P j for j). For each fuel market, foregn producton must equal foregn consumpton plus net mport from the home country: o c g X P,P,P y x, o,c,g. (6) We further assume compettve behavour by foregn coal and gas producers. Ther aggregate supply functons are gven by: S X S P, 0, c,g. P (7) (Non-OPEC): The ol market s charactersed by a domnant producer (OPEC) wth a compettve frnge o o o X Z S P, (8) where Z s output from the domnant ol producer, and S o P 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: o o o c c g g P P y x Z, y x, y x, o,c,g. (9) 2 For a small country such as Norway, ths s a reasonable smplfcaton. 8

10 Our default assumpton s that the domnant ol producer maxmses net ncome. However, we also consder other objectve functons n the numercal analyss 3. If the domnant ol producer seeks to maxmze net ncome, Z s found from: Max P o Z C Z, (10) z where CZ s the producton cost. The frst order condton s gven by: o oz 0 P P Z C Z. (11) From (9) and (11), we can wrte all prces as functons of net mport from the home country: o o c c g g P f y x, y x, y x, o,c,g. (12) 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 carbon unts) followng from a unt decrease n domestc consumpton of fuel : Y jo,c,g fk L jk. y jo,c,g ko,c,g y x (13) To smplfy the dscusson, we make the followng reasonable assumpton: 4 0L 1. (14) 3 In Fæhn et al. (2013b), 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. 4 Equaton (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. (14) s satsfed n our numercal model. 9

11 We defne margnal supply sde leakage of fuel ( L ) as the ncrease n total fossl fuel producton abroad (measured n carbon unts) 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 1 fk 1 L jk L. x x y x (15) 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: E 1L, y E L. x (16) 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 0.5 ( E E 0 for L 0. 5). We also notce that E E 1. If both domestc consumpton y x and domestc producton decrease by one unt, there s no mpact on fossl fuel prces, and the fnal global mpact s one unt less emtted. So far we have dsregarded emssons due to extracton of fossl fuels. Fossl fuels are used as nput factors n the extracton process, and emsson ntenstes vary qute a lot across sources. Hence, the global mpact of domestc polces should be adjusted accordngly. y x 2.3 Includng emssons from fossl fuel extracton Let E denote total emssons (fossl fuel consumpton ncludng emssons from extracton): o,c,g E E x X, (17) o,c,g 10

12 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): 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, (18) 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): f (19) k l j jk. k o,c,g y x We see that E E =1. If both domestc consumpton and producton decrease by one y x x unt, there s stll no 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: E E l, (20) y y X X j j jo,c,g E E l. (21) 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 11

13 depends on the leakages ( l j ), the dfferences n emsson ntenstes n extracton across fossl fuels X j abroad ( β ) and across countres (home ( α ) versus abroad ( we fnd: x β X )). Gven that emssons from extracton of fossl fuels abroad are dentcal, ( β =β =β =β ), X g Xc Xo X E E 1 2L 2 1 L. (22) y x X x We see that for any gven leakage rate L, ncludng emssons from extracton makes demand sde polcy more effectve relatve to supply sde polcy the larger s the foregn emsson X ntensty ( β ), and the smaller s the domestc emsson ntensty ( α ). Furthermore, the emssons from foregn extracton have 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 that Ey E x = 1 αx 1 2L, whch s equal to zero f L 05.. x 3 Numercal analyss We now turn to the comparson of demand and supply sde polces n the case of Norway. In Secton 3.1 we estmate margnal costs of Norwegan unlateral reductons n fossl fuel demand and supply. Ths means quantfyng B P and P c x, respectvely; see Eq. (4). emand sde y abatement s assessed by means of a computable general equlbrum (CGE) model for Norway. Supply sde measures are quantfed by dentfyng representatve, margnal cuts n Norwegan ol producton. Norway s also a sgnfcant producer of gas, accountng for around 3 per cent of global gas producton (BP, 2013). 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 12

14 extracton would decrease or ncrease global emssons and we do not consder ths supply sde opton n our analyss. 5 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). 3.1 Unlateral clmate polcy emand sde polces The Norwegan parlament has announced hgh ambtons for ts contrbuton to global (demand sde) emssons reductons, correspondng to a 30 per cent reducton from Norwegan 1990 emssons by Moreover, t has emphassed that the lon s share of the reductons s to result from domestc acton. To obtan a margnal cost functon for demand sde measures n Norway, we use Statstcs Norway s technology-rch CGE model for the Norwegan economy, MSG-TECH (see Fæhn et al., 2013a). We smulate costs of unform emssons prcng, gven dfferent demand sde abatement levels. The effects are measured from a reference scenaro that ncorporates clmate polces already mplemented, approved, or promsed for the years up to From 2008, ths ncludes the partcpaton n the EU ETS. 6 Snce we assume that the demand sde abatement ams to contrbute to global emssons reductons, we only consder emssons prcng n sectors outsde the EU ETS. Wth the cap on total 5 We abstract from the techncal challenges of separatng ol and gas extracton, but return to ths ssue n Secton The same smulated scenaro s used n Clmate Cure 2020 (2010), the report of an offcally apponted commsson tasked wth preparng the ground for evaluatng Norway s clmate polcy. 13

15 emssons n the EU ETS, addtonal cuts n Norwegan ETS sectors wll merely dsplace emssons to ETS-regulated nstallatons n other European countres. Fgure 1: Margnal costs of foregone fossl fuel consumpton n Norway. Based on a number of smulatons, we fnd a margnal cost curve for Norwegan demand sde measures as expressed by Eq. (23) and depcted n fgure 1. For all the smulated emsson targets, vrtually all abatement takes place as reduced ol consumpton, mostly wthn the transport sector. B P. A. A.. (23) 2 y A denotes the level of domestc emsson reductons (measured n mllon tonnes 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 ; see the numerator of the second fracton of Eq. (4). o o o We sngle out ol felds whch can be characterzed as margnal, n the sense that termnatng extracton nvolves small proft losses per unt extracted. 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 n the reservor declnes. In addton, IOR (Improved Ol Recovery) actvtes to prolong the lfetme of maturng felds can nvolve new costly nvestments, mplyng that the proft losses of not undertakng an IOR project may be modest (not always though). 14

16 Typcally, these felds also have hgher emsson ntensty. Unfortunately, we have lmted nformaton about IOR costs (see below). For the years we have sngled out nne Norwegan felds where ol consttuted a major part of total petroleum producton (several were pure ol felds). In addton, these felds were n, or close to, the declne phase. We have feld data from Statstcs Norway on producton volumes and varable costs, costs that would not accrue f ol producton were termnated. 7 Based on these data we have constructed the margnal producton cost curve. 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), and subtract the margnal producton costs. The results can be consdered as the margnal costs of forgone ol extracton n Norway, and are shown n Fgure 2. The supply sde cost curve, where A S s reduced extracton measured n mllon tonne s of CO 2, s: 2 P c x 0. 7A 19. 6A (24) o o o S S We see that t s actually proftable to reduce 0.7 Mt of CO 2, rrespectve of clmate benefts, due to hgh producton costs of some of the smaller felds. 7 See Fæhn et al. (2013b), Appendx B 15

17 Fgure 2: Margnal costs of foregone ol extracton n Norway. US/t CO mllon tonnes CO2 In our study we are nterested n abatement optons n the near future such as Thus, the relevant queston s to what extent the cost functon depcted n Fgure 2 s representatve for comng years. 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 around 2020, suggestng that ther costs per unt producton wll ncrease. It s dffcult to know whether the net effect of these consderatons wll push the cost curve n Fgure 2 up or down. However, there are several reasons why we may have underestmated the total costs of producton,.e., overestmated the costs of reducng producton. Frst, we do not have specfc nformaton about the costs of IOR projects, whch are often projects wth lmted profts per unt of extracton. 8 Second, we have only consdered advanced termnaton of maturng felds, n whch case development costs are sunk. A cost-effectve downscalng of ol producton may also mply that some felds wth lmted proftablty are not developed at all. Then development costs, that ncur durng the frst ntal years and can be consderable, are not sunk. To help assessng the relevance of Fgure 2 for comng years, we have also gathered nformaton on an ol feld named Ivar Aasen that s decded to be developed. Here we have access to 16

18 nformaton about both expected annual development and operatng costs, as well as producton (The Norwegan Ol Company, 2012) 9. Investments for ths feld started 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. 10 Wth an average producton of 1.4 mllon Sm 3 over the perod and a break-even ol prce of US 60 per barrel, ths s comparable to the data behnd Fgure 2 for the years (.e., the lower thrd part of the curve). 11 In addton, Rystad (2013) ponts to several Norwegan (undeveloped) ol felds wth break-even prces above US 72 per barrel. These observatons support our belef that the costs of reducng ol producton are lower than what we assume n our analyss. The ol prce around 2020 may be hgher than t was n , whch for gven costs suggests 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 hgh ol prce on forgone profts could be moderated. In addton, a hgher ol prce would ental hgher ol producton n the reference case,.e., a stuaton wthout new polces. We are nterested n the margnal costs of reducng ol producton compared to ths reference case. Hence, t s not certan that a hgher ol prce wll lead to hgher costs of reducng ol producton from a level endogenously determned by the ol prce. To sum up, although the uncertantes are rather large, t seems more lkely that the margnal costs of supply sde measures around 2020 le below than above the curve shown n Fgure 2. 8 The varable costs for the nne felds reported above also nclude some nvestment costs for drllng purposes, whch may be characterzed as IOR-actvtes. We do not have complete nformaton about the IOR projects, however. 9 Ths was the only ol feld wth suffcently detaled offcal data to calculate approxmate break-even prces. 10 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. 11 An ol prce of US 84.5 per barrel, and a break-even prce of US 60 per barrel, mples a cost of US 24.5 per barrel forgone ol producton, correspondng to US 58 per tonne CO mllon Sm 3 of ol leads to 3.7 mllon tonnes of CO 2 when t s combusted. 17

19 3.2 Numercal analyss of global fossl fuel markets The partal fossl fuel market model Based on the exposton n Secton 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 supply-sde measure, we are mostly nterested n the longrun 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 B contans a detaled dscusson of the man drvers, n partcular a revew of exstng demand and supply elastcty estmates from the lterature. Here we only present the assumptons of our benchmark case, 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 equpment. 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. 18

20 Hgher prces of ol ncrease the proftablty of ol exploraton, new felds developments, and IOR projects. 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. 12 Thus, an ncrease n the prce of ol wll mostly affect extracton of so-called 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 n our benchmark case 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 per cent of the ol prce, whch s wthn the range of producton costs reported by IHS CERA for OPEC countres (see e.g. Fgure 3.9 n Mnstry of Petroleum and Energy, 2011). 13 When we model OPEC as a compettve producer, we assume the same supply elastcty as for Non-OPEC. Although the lon s share of CO 2 -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 GHG emssons per unt producton worldwde n 2011 were 159 tonnes CO 2 e (CO 2 equvalents) 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 The tmng of extracton may of course be affected by prce changes, cf. the dscusson n Secton 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. 19

21 to be 60 tonnes CO 2 e per 1,000 toe. 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. 14 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, see Fæhn et al. (2013b), Appendx C. 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. Smlarly, ncreased supply from other Non-OPEC producers could mply hgher-than-average emsson ntenstes. For nstance, Canadan ol sands are consdered relatvely costly and thus margnal resources, wth average emsson ntenstes around three tmes the world average. When t comes to OPEC supply, however, ncreased producton may come from ncreased extracton of developed felds n countres lke Saud Araba, and thus to a lesser extent nvolve hgher emsson ntenstes. Our benchmark case assumpton s that margnal emsson ntenstes are 50 per cent above the reported average fgures above. For Norway and (other) Non-OPEC ths s related to the margnal supply most lkely beng more emsson-ntensve than average supply. For OPEC the ncrease s partly related to less comprehensve reportng and relance on Mddle East fgures (see above) and partly to margnal supply possbly beng more emsson-ntensve than average supply. Thus, we set the emsson ntenstes n Norway, OPEC and Non-OPEC equal to respectvely 90, 76 and 300 tonnes CO 2 e per 1,000 toe. 15 For comparson, emssons from consumng (.e., combustng) 1,000 toe of ol s 14 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. 15 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 3.1.1). As seen n the followng subsecton, however, these emssons are of less mportance. 20

22 about 3,070 tonnes of CO 2. Although of mnor mportance here, we also account for emssons from extractng other fossl fuels, and set emsson ntenstes for coal and gas equal to the Non-OPEC emsson ntensty reported above 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. (4). As shown n Secton 2, the sum of x E and E 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 domnant or a compettve 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). We frst notce that leakage through the ol market s around 50 per cent 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: Supply sde leakage through the ol market s 55 per cent, compared to 45 per cent for demand sde leakage. 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 y 21

23 (extracton), coal and gas consumpton s somewhat reduced (ncreased). Ths effect alone accounts for almost 10 per cent of the gross emsson reducton. Fnally, the mportance of emssons from fossl fuel extracton s modest, accountng for less than 10 per cent of total emssons from extractng and consumng ol. The effects are hghest for demand sde polcy, as under supply sde polcy ncreased emssons from ol extracton outsde Norway are modfed by reduced emssons from ol extracton n Norway. Table 1. Net global emsson reducton from reduced Norwegan ol extracton or consumpton by one unt of CO 2. Benchmark case. 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, net emsson reductons are senstve to a number of assumptons such as prce elastctes and OPEC behavour. Hence, n subsecton below we present a detaled senstvty analyss. We now use the fndngs n Table 1 to analyse the optmal balancng of demand and supply sde polces, focusng on the case wth OPEC as a domnant producer. 3.3 Optmal balancng of demand and supply sde polces The cost-effectve soluton By combnng the demand sde and supply sde cost curves and ther net effects on global emssons derved above, we can fnd the optmal composton of domestc acton for any global 22

24 contrbuton target, A, as expressed n Eq. (1). We pck a target of 5 Mt of CO 2 by In Fgure 3 we show a bath tub dagram wth length equal to A 5, and where the margnal costs of demand (supply) sde measures are shown from left to rght (rght to left). The ntersecton pont between the two curves shows the optmal combnaton of demand and supply sde measures. We notce that about 2/3 of the global contrbuton target should be met through reduced ol extracton. The correspondng margnal costs of reducng global CO 2 emssons are 336 US per ton. If the global reductons were to be met through demand sde measures alone, costs would more than double. Fgure 3: Combnng leakage-adjusted demand and supply sde margnal cost curves Implementng ths combnaton of demand and supply sde measures would mean that domestc CO 2 emssons should be reduced by 2.5 Mt of CO 2, e.g., through a domestc CO 2 tax on non-eu ETS sectors of 228 US per tonne CO 2 (cf. Fgure 1). 17 Almost 90 per cent of the measures 16 5Mt of global CO2 emsson reductons by 2020 s n lne wth the global emssons reductons (ncludng leakages) that can be acheved by fulfllng the Norwegan target for domestc emssons reductons by ncreased abatement n Norwegan non EU-ETS sectors, see Fæhn et al. (2013b). 17 The domestc CO2 tax s found by multplyng the margnal cost of reducng global CO 2 emssons (336 US per ton) wth the net effect on global emssons of reduced Norwegan consumpton (0.676 see Table 1). 23

25 that are proftable to carry out relate to transportaton, of whch reduced prvate transport accounts for 20 per cent and transton to more clmate frendly vehcles accounts for the rest. Moreover, Norwegan ol extracton should be reduced by 3.5 mllon Sm 3, whch s 3.1 per cent 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 50 per barrel, 18.e., around half of the current crude ol prce. As mentoned n Secton 3.1.2, the break-even prce of the Ivar Aasen ol feld, whch can be characterzed as relatvely proftable, s around US 60 per barrel. 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 3.1 per cent calculated above. The reason s that, as underlned n Secton 3.1.2, we most lkely overestmate the costs of reducng ol extracton Senstvty analyss 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 assumptons from our benchmark case. 19 The global contrbuton target s held fxed at 5 Mt CO 2. We notce from Table 2 that assumng compettve behavour by OPEC gves more or less the same results as above ths s not surprsng gven the results n Table 1. Besdes that, we see that the share between supply- and demand sde measures depends 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 even more effectve n reducng global emssons, and the share of supply sde measures ncreases to around 90 per cent. Nevertheless, the optmal producton tax does not change 18 The producton tax s found by multplyng the margnal cost of reducng global CO2 emssons (336 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). 19 The senstvty analyss s dscussed n more detal n Fæhn et al. (2013b), Appendx C. 24

26 much. The global emsson effects of reduced ol extracton ( E ) are ncreased, shftng the supply sde curve n Fgure 3 downwards. Lkewse, the demand sde curve n Fgure 3 shfts upwards. Stll, the ntersecton pont drops down, meanng that the shadow cost of the emsson constrant (cf. eqs. (2)-(3)) declnes. However, the optmal tax on ol extracton s proportonal to E x (cf. Secton 2), whch has ncreased. The domestc CO 2 prce drops qute substantally, though, due to a combnaton y of lower and lower E. 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 25 per cent. 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 suggested by Fgure 3. 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 supply sde cost curve by 50 per cent, supply sde measures should account for 83 per cent of total abatement, wth the optmal domestc CO 2 prce and producton tax beng 126 US per tonne CO 2 and 28 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 per cent. Moreover, for 8 of the 13 felds currently under development on the Norwegan shelf, more than 90 per cent of recoverable reserves are ol (Mnstry of Petroleum and Energy, 2013). Hence, ths may be of lmted mportance. The hgher the ol prce, the less proftable t s to restrct extracton from a gven ol feld. As explaned n subsecton 3.1.2, however, a hgher ol prce does necessarly mean that supply sde measures become more costly, as more expensve resources wll then be extracted n the reference x 25

27 case. Anyway, t s very unlkely that t s cost effectve to rely only on demand sde measures. Gven the benchmark case estmates of E x and E y, t s optmal to mplement some supply sde measures as long as the net revenue of the least proftable ol extracton s less than 116 US per barrel. Table 2. Senstvty analyss. Effects of reducng Norwegan extracton or consumpton of ol by one unt of carbon. Net emsson Supply- vs. Optmal taxes reducton * E x demand sde E y Supply emand Prod. tax $/barrel CO 2 tax $/ton Benchmark case % 34% Compettve OPEC % 28% Fxed OPEC supply % 13% Fxed ol prce % 100% Supply two tmes more elastc than demand emand two tmes more elastc than supply 50% lower supply sde costs % 75% % 10% % 17% * Net global emsson reducton from reduced Norwegan ol extracton (supply sde) or consumpton (demand sde) by one unt of carbon Polcy alternatves and dscusson So far we have taken for granted that the Norwegan government wll mpose suffcently strong measures to reach ts global contrbuton 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 26

28 Norway. The current CO 2 tax mposed on Norwegan non-ets sectors s 66 US per tonne CO Usng the benchmark case value 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 case value of E x ), cf. Eq. (4). That s, supplementng a domestc CO 2 prce of 66 US per tonne 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 tonnes. In our benchmark case, the derved margnal costs of emsson reductons translate nto a shadow prce on ol producton equal to 50 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. 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, 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 sanctoned extracton from developed felds. 20 The Norwegan CO2 tax s dfferentated across fuels and sectors. The hghest tax level n non-ets sectors s on petrol, at 393 NOK (66 US) per tonne CO 2 (n 2013), cf. Mnstry of Fnance (2012). 27

29 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 4 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 for Norwegan ol producton, as well as a transparent model of nternatonal fossl fuel markets. We fnd that a majorty of measures should be mplemented on the supply sde, that s, by reducng Norwegan extracton of ol. In our benchmark case the optmal combnaton of demand and supply sde measures nvolves annual cuts n Norwegan ol extracton of around 3.5 mllon Sm 3 (around 3 per cent of current Norwegan ol producton), and annual domestc reductons n CO 2 emssons of 2.5 mllon tonnes of CO 2 (almost 5 per cent of current Norwegan CO 2 emssons). In contrast, the Norwegan Government suggests usng demand sde measures, only. We 28