Discussion Papers No. 258, August 1999 Statistics Norway, Research Department

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1 Dscusson Papers No. 258, August 1999 Statstcs Norway, Research Department Lars Lndholt Beyond yoto: 2 permt prces and the markets for fossl fuels Abstract: Ths paper analyses the markets for fossl fuels gven that the lmts that the yoto Protocol sets on 2 emssons from Annex B countres extend beyond To our knowledge we are the frst to apply a forward-lookng model wth endogenous prces for fossl fuels n analyss of specfc 2 emsson targets, under dfferent assumptons concernng PE behavour. We calculate both the tme-path of the nternatonal permt prces needed for the yoto targets as well as the mplcatons through reduced demand and lower producer prces for fossl fuels. Irrespectve of the assumpton concernng PE behavour, the permt prce has to rse for the frst 3 to 4 years n order to fulfl the yoto targets n Annex B. The permt prce can be reduced substantally, dependent on when a backstop technology starts to replace ol. The yoto targets wll result n a loss of petroleum wealth for ol and gas producers by 15 to 2 % as long as PE acts as a cartel. If the developng countres are ncluded n the Protocol, PE wll lose much more of ther wealth. The compettve frnge has far more to lose f PE breaks down n the absence of these emsson targets, than the mplementaton of the targets wth PE as a cartel. eywords: The yoto Protocol, Internatonal 2 permts, Exhaustble Resources, Petroleum wealth. JEL classfcaton: H23, Q3, Q4. Acknowledgement: My thanks to Snorre verndokk and nut Enar Rosendahl for valuable dscussons, and to jell Arne Brekke for helpful comments. Address: Lars Lndholt, Statstcs Norway, Research Department, P.. Box 8131 Dep., N-33, slo, Norway. Phone: , Fax: E-mal: lars.lndholt@ssb.no

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3 1. Introducton The yoto Protocol to the Framework onventon on lmate hange (F) was completed n December The most promnent feature of the yoto Protocol s the quantfed emssons lmtaton and reducton commtments of greenhouse gases (GHGs) n Annex B countres 1. The combned result of ndvdual country targets s estmated to result n an overall reducton n Annex B partes GHG emssons by 5.2 % from the 199 levels by the commtment perod (averaged across the perod). The most mportant GHG s 2. The man source of anthropogenc 2 emssons s the combuston of fossl fuels, such as ol, natural gas and coal. The pont of departure n ths study s that emssons of 2 shall be reduced by 5.2 % n the Annex B area. As 2 accounts for most of the GHG emssons n the regon, t may be reasonable to assume that the reducton of 2 does not devate substantally from the emsson reducton targets for all sx GHGs. ne of the specfc features of the yoto Protocol s the explct ntroducton of emsson tradng among Annex B countres. The mplementaton of a tradng scheme s stll beng dscussed, but n our study we assume an effcent nternatonal tradable permt market. In the model we mpose a regonalwde tax, but we defne the shadow cost of reducng emssons as a permt prce. Wth an effcent nternatonal tradable permt market, assumed to be perfectly compettve, the permt prce wll correspond to the tax necessary to acheve the same reducton n emssons. In ths study, we look at the 2 -permt prces necessary n order to fulfl the yoto Protocol commtments. Ths has been done n varous studes, e.g., ED (1998). ur fndngs ndcate that rrespectve of the assumpton concernng PE s behavour, the permt prce wll rse from about $14-24 per tonne 2 n 21 up to $25-41 n 22, before t reaches $36-57 n 23. The lower fgures are ndcatng a stuaton where PE s actng as a cartel and the hgher fgures a stuaton wth perfect competton on the ol market. Rsng permt prces s necessary n order to reduce n partcular a steadly rsng consumpton of coal n Annex B. In comparson, estmates of the permt prce n nne dfferent models n ED (1998) were n the range of $ n 21. ur estmate s thus wthn the prce nterval provded by these studes, but n addton our study ponts to possble development paths after 21 under dfferent assumptons concernng the cartel s market power. We show that the permt prces can be reduced substantally as global ol producton begns to fall dependent on when the backstop starts to replace ol 3-4 years after the turn of the mllennum. Such a hump-shaped 2 -tax or permt prce over tme s n accordance wth studes lke Ulph and Ulph 1 Ths s ED-countres (except Mexco, orea and Turkey), Russan Federaton, Ukrane, Estona, Latva, Lthuana, Bulgara, roata, Romana, Slovaka, Slovena. 3

4 (1994) and verndokk (1994b). Ther startng pont s that the damage done s related to the stock of carbon n the atmosphere. They fnd that to combat global warmng the optmal tme path of a tax should rse over tme when the ntal stock of carbon s small, but fall later on when the stock of fossl fuels nears exhauston 2. In contrast to other analyss we focus on two mportant features of the markets for fossl fuels,.e., market power and dynamc behavour (see Salant, 1982, for an early numercal model). A long-term model for ol, natural gas and coal markets (PETR) s used n ths study n order to analyse the effect of the emsson targets on supply, demand and prces for fossl fuels, thereby allowng us to derve the mpact on the producers ol and gas wealth. The PETR model s a dynamc model where the producers take nto account future market condtons. All prces and quanttes are determned smultaneously n the model. We make the analyss under dfferent assumptons concernng PE s behavour. The study s a follow up of Berg et al. (1997b), who look at how a 2 tax of $1 per barrel of ol equvalents nfluences the petroleum wealth of ol and gas producers. In our new verson of the PETR model we nclude an addtonal regon on the demand sde n order to study the Annex B area. In addton to obtan the tme-path of the 2 -permt prces that are necessary to fulfl the specfed exogenous emsson targets, our man contrbuton s to derve the consequences for the fossl fuel markets. The dynamc aspect s often gnored n emprcal energy models. In dynamc models the ol prce s usually set exogenous makng t mpossble to determne how the burden of a permt or tax s shared between the producers and consumers. Some exceptons are however GREEN (Burnaux et al., 1992) and an extended verson of Global 21 (Manne and Rutherford, 1994). In GREEN the ol prce s endogenous, but the supply sde s not fully ntertemporal because t s modelled as beng ndependent of future expectatons. ne of the frst ntertemporal energy models, a general equlbrum verson of Global 21, s presented n Manne and Rutherford (1994). They focus on specfc stablsaton goals dfferent from the yoto targets and the ol market s modelled as a compettve market. hakravorty et al. (1997) also use an ntertemporal model wth endogenous prces for fossl fuels, and study the mpact of constant 2 -taxes on compettve markets. GREEN s among nne models n ED (1998), an analyss of the consequences of the yoto Protocol. GREEN and GLBAL 21 are n the portfolo of sx models n Dean and Hoeller (1992) that focuses on global emsson targets. These 2 Snclar (1994) argues that the optmal carbon tax should declne over tme to get the fossl fuel producers to postpone producton. Farzn and Thavonen (1996) also combne the stock externalty aspect of 2 n the atmosphere and the exhaustble nature of fossl fuel reserves. They fnd that the tme-path of an optmal carbon tax can have dfferent shapes dependent on, frst of all, how the stock of carbon decays n the atmosphere. 4

5 studes apply measures of welfare lke GNP, falng to take account of changes n terms of trade, whch can be especally mportant for fossl fuel producng countres. Petroleum wealth for an ol and gas producer s defned as the present value of future petroleum rent; equal to the dfference between producton revenues and the costs of ol and gas producton. l and gas extracton normally provdes an excess return to captal compared wth other economc actvty because they are non-renewable resources (Hotellng, 1931). In ths context the scarcty rent refers to the nature of exhaustblty of the resource. In addton, PE s market power on the ol market gves a cartel rent. If an nternatonal 2 tax (or a system wth tradable permts) results n a reducton n the prces of fossl fuels, petroleum wealth wll be reduced. From standard tax ncdence theory t s well known that the dstrbuton of the tax burden n terms of lower producer prces and hgher consumer prces depends on the relatve prce responsveness n supply and demand. If the supply vares substantally as a result of a change n prces, the effect on the consumer prce wll be greatest whereas the prce for producers wll be affected to a lesser extent. As fossl fuels are non-renewable resources, producers wll take nto account that extracton today wll reduce the avalablty of the resource n the future. The dstrbuton of the 2 tax burden between consumers and producers may therefore change over tme. PE s an mportant agent n the ol market. By reducng ts producton the cartel s able to obtan hgh ol prces. As a startng pont we model PE as a cartel, where the members have concdng nterests. To llustrate the mportance of PE s market power we also study an ol market wth perfect competton, where all producers consder the prce as gven. Ths s done because the assumpton concernng the stuaton n the ol market wll nfluence both the level of the 2 permt prce and the loss of ol and gas wealth as a result of a clmate treaty. The current stuaton can be sad to share features from both market descrptons, although modellng PE as a cartel clearly gves the most reasonable results. The developng countres were not subject to any commtments n the yoto Protocol, or on the subsequent conference n Buenos Ares. However, these countres may be facng emsson reducton requrements at a later stage. We wll therefore also look at a scenaro wth global emsson targets. In the scenaro nvolvng Global yoto targets, t s assumed that the entre world shall acheve the yoto targets by reducng the emsson level n 199 by 5.2 % n 21. In order to estmate the costs of mplementng emsson cuts n the commtment perod, assumptons are requred concernng the longer-term requrements n both scenaros, snce the model s ntertemporal. As the nternatonal negotaton process offers lttle gudance on ths ssue, we smply assume that emssons are held constant when the targets have been reached. 5

6 The structure of the paper s as follows. Secton two descrbes the model, and n Secton three we look at the reference scenaro wth no 2 tax n the model verson where PE acts as a cartel. We then examne the effects of an mplementaton of the yoto Protocol, before examnng the consequences of a Global yoto treaty n Secton fve. Ths s followed by a dscusson n Secton sx of the effects of perfect competton n the ol market. We turn to senstvty analyss and caveats n Secton seven, and a concluson ends the paper. 2. Descrpton of the model The model has a long tme horzon and descrbes the nternatonal markets for ol, gas and coal n an ntertemporal and determnstc way (see Appendx A for a more formal model descrpton, based on Berg et al. 1997b). ompared wth Berg et al., the model has been expanded to nclude Economes In Transton (EIT). The EIT regon on the demand sde conssts of the Russan Federaton, the Ukrane, and the former entral and Eastern European countres. Some central parameter values wll be mentoned n the followng (otherwse see Appendx B for numercal specfcatons). As fossl fuels are fnte and non-renewable resources, the extracton of one unt today wll reduce the avalablty of the resource n the future. Producers wll therefore demand a petroleum rent for sellng the resource today. It s assumed that producers have perfect (.e. model consstent) knowledge, and n the model they therefore take account of not only exstng prces and market condtons, but also future movements n these varables. Producers attempt to extract ther resources at a rate that maxmses ther petroleum wealth. onsumer demand, on the other hand, s assumed to depend only on ncome and prces n each perod. All prces and quanttes at each pont n tme are determned smultaneously n the model. There are four demand regons n the model: ED-Europe, Rest of ED, EIT and a regon consstng of the rest of the world (Non-Annex B). The model specfes three fossl fuels: ol, gas and coal. The demand for a fossl fuel declnes wth the prce of ths fuel and ncreases wth the prce of the other two fuels. The drect prce elastctes are set equal to -.9 and -.75 for the ED-regons and the Non-ED regons, respectvely. All cross prce elastctes are set equal to.1. Demand rses over tme due to economc growth, whch s determned exogenously for each regon. Annual GDP growth s hghest n Non-Annex B and lowest n ED-Europe. A certan relatve rse n ncome outsde the ED area results n a slghtly hgher relatve ncrease n demand than n the ED. A carbon-free alternatve energy source (backstop-technology) exsts at a specfc cost at any gven tme n all regons. Due to technologcal progress, ths cost s reduced over tme. It s avalable n 6

7 unlmted quanttes and s a perfect substtute for fossl fuels. Hence, there wll be no consumer demand for a fossl fuel f the consumer prce of the fuel s hgher than the prce of the backstop. The relevant consumer prce of a fuel n a regon s the sum of the producer prce, delvery costs (due to transport, dstrbuton and refnng) and exstng taxes and subsdes. The 2 tax comes n addton to delvery costs and exstng taxes. They are mposed on the consumpton of fossl fuels and vary wth the carbon content of the fuel. The prce of the backstop less these taxes and delvery costs represents a celng for the producer prce of each fuel at any gven tme, and wll n the followng be referred to as the maxmum producer prce. As a result of a more ntegrated world economy, we assume that exstng taxes and delvery costs for each fuel wll be harmonsed after 4 years to a global weghted average. When these costs and taxes are harmonsed, the maxmum producer prce for each fossl fuel wll be equal across the regons. The ol market s dvded nto two groups of producers: PE, whch has low costs, and a frnge of hgh-cost producers. In order to examne the mportance of market power, two dfferent stuatons are studed. In the frst model verson, PE acts as a cartel and takes nto account that ther own producton nfluences prces. They consder the producton from the frnge as gven, and ths entals a ournot approach (see e.g., Salant, 1976). The frnge s a compettve producer, decdng producton on the bass of the gven prce. In the second verson, the entre ol market s a compettve market. The prces and volumes that satsfy the maxmsaton problem of both types of producers are the equlbrum soluton. Intal unt costs are set equal to $3.3 and $1.9 per barrel of ol for PE and the frnge, respectvely. The unt costs of producers are assumed to rse as ol resources are gradually depleted. The parameters n the cost functons are determned so that the margnal cost of the last unt of the current reserves (BP, 1995) equals $2 per barrel. Moreover, technologcal progress ndependent of the producton lowers the unt costs. Ths means that dependng on the producton rate unt costs can ncrease or decrease over tme. The techncal progress s assumed to be hgher n the frnge for the frst 3 years. We assume a unversal dscount rate of 7 %. Both the gas and coal markets are modelled n a more smple fashon, and they are not analysed under varous market condtons. The market for natural gas s dvded nto three regons: ED-Europe, Rest of ED, and Non-ED. Because gas s costly to transport, no trade takes place between the regons. The producers cost structure s modelled n the same way as for the ol market. All three regons are modelled as compettve markets. Intal unt costs are set equal to $7., $5.45 and $5.53 per barrel of ol equvalents (boe) for ED-Europe, Rest-ED and Non-ED, respectvely. The coal market s modelled as a global compettve market. Due to substantal nternatonal coal reserves, extracton today s not assumed to ncrease costs at a later tme. Producers wll therefore 7

8 focus on each ndvdual perod. Technologcal progress results n lower costs over tme. Intal unt costs are set equal to $8.8 per boe. Due to dfferng carbon contents, a tax of $1 per barrel of ol wll correspond to $.71 per boe for gas and $1.24 per boe for coal. Smulatons are carred out up to 21 wth perods of 1 years usng the GAMS/MINS system (Brooke et al., 1992). For example, the result for the year 21 can be nterpreted as an average for the perod Reference scenaro wth PE as a cartel Fgure 1 shows the model s projectons of movements n the ol prce and unt costs for PE and the frnge, n the scenaro wthout emsson reducton targets and where PE acts as a cartel. The prce starts from $21 per barrel n the year 2. Ths s hgher than the current ol prce. In the current stuaton, t cannot be sad that PE s actng as a completely coherent cartel where partcpants have concdng nterests. In realty, members of the cartel wll therefore be somewhat less wllng to reduce producton to acheve a hgher prce. Moreover, the model provdes a long-term prce path, entalng that short-term changes are not captured. The current low prce of ol partly reflects the prevalng market, wth lower demand for ol due to the crss n Asa 3. The prce rses untl t reaches a peak of $41 n In ths perod, the producer prce s at ts maxmum level, determned by the prce of the backstop, exstng taxes and delvery costs. After ths tme, the producer prce s reduced due to technologcal progress for the backstop-technology. The fgure shows that unt costs ncrease faster n the frnge. The reason s that they produce more than the cartel n the frst perods whle, at the same tme, PE has greater resources that can be extracted at lower costs. 3 After PE's decson on new producton cuts n March-99, the ol prce reached $19-$2 n June and July. 4 The ol prce follows closely to the medan prce of a poll survey whch s presented for the perod 2-22 by the Internatonal Energy Workshop (Schrattenholzer, 1998). 8

9 Fgure 1. l producer prce and unt costs wth PE as a cartel 6 5 Prce wth no tax Max. prce wth no tax Unt cost PE Unt cost Non-PE 4 $/barrel Year Fgure 2 shows producton n the frnge and PE pror to the ntroducton of taxes. The frnge produces approxmately twce as much as the cartel n the frst perod 5. Because hgher producton n a perod ncreases costs n the future, both PE and the frnge have ncentves to lmt producton. In addton the cartel has market power and takes nto account that hgher producton results n a lower prce n the same perod. Ths s the reason why PE produces less than the frnge, even though costs are lower. The frnge produces the frst 5 years untl ts unt costs reach the maxmum producer prce between 24 and 25. Further extracton s then no longer proftable. PE also ncreases producton somewhat n the frst perods before the cartel takes over the entre market. The cartel stops extractng n 27 when t s no longer proftable for the cartel to produce ol, as the prce of the backstop has become lower than the cartels unt costs. Fgure 2. l producton wth and wthout clmate treates, and wth PE as a cartel Mtoe Non-PE producton wthout treaty Non-PE producton wth yoto targets Non-PE producton wth Global yoto targets PE producton wthout treaty PE producton wth yoto targets n Annex B PE producton wth Global yoto targets Year 5 PE s share of total producton s slghtly lower than ts real market share today of about 4 %. The reason may be that the cartel s more effectve n the model than n realty. 9

10 Developments n gas markets vary between regons (as shown later n Fgure 5). The producer prce of gas n ED-Europe rses from a lttle less than $1 per boe untl t reaches ts maxmum level of $25 n 27 n the reference scenaro. Producton s relatvely stable untl gas producton s no longer proftable n 28, and the backstop takes over. The gas prce n Rest-ED also starts from about $1 and reaches $36 n 25. The producton s hgher n ths regon, but falls over tme untl t ceases n 26. The gas prce n Non-ED rses from $6.5 n 2 untl t reaches a peak of $15 n 29. In contrast to the other regons, the producton ncreases over tme untl t stops n 21. Natural gas s produced and consumed over a longer perod because the regon has consderable gas resources that can be extracted wth lower costs 6. oal s produced and consumed throughout the whole perod and wll not be replaced by the backstop due to low prces and low exstng taxes on coal. The consumpton of coal n Annex B s almost three tmes hgher n year 21 as n 2. Fgure 3 shows carbon emssons n Annex B n the reference scenaro wth no taxes when PE operates as a cartel. l s share of total consumpton s almost constant for the frst ffty years, whle coal s share has ncreased somewhat on the expense of natural gas. Total emssons rse from 3.92 bllon tonnes of carbon a year n 2 and reach a peak of 6.38 bllon n 25. The carbon emssons n the reference case are crucal n determnng the tax level needed to mplement specfc reductons. Among the key factors underlyng the reference scenaro are GNP growth rates, (autonomous) mprovements n energy effcency, technologcal progress, developments n relatve prces of fossl fuels and the avalablty and prce of the backstop. ompared to 199, the carbon emssons are about 1 % hgher n 21 and 21 % hgher n 22. Ths s n the lower range of Annex B emssons scenaros n the reference case n other studes, e.g., ED (1998). Part of the explanaton s that we have PE as a cartel that reduces ol producton compared to a stuaton wth a compettve market 7. However, opposed to our analyss, many studes estmate ncreasng Annex B (and global) 2 - emssons over the entre tme horzon due to lack of exhaustblty constrant and a fallng backstop prce. arbon emssons from coal more than double n the perod up to 25. The cost of the backstop falls over tme (and leads to a steadly lower maxmum producer prce for ol). As a result the emssons 6 Total accumulated producton of ol s greater than "proven" reserves n BP (1995), as ponted out n Berg et al. (1997b). Ths s also true for natural gas, and s ascrbable to the fact that technologcal progress and ncreasng prces expands the resource base n our model. 7 Another explanaton may be that we use a lower GDP growth n the EIT-regon compared to some other analyss. It should be mentoned that the US Department of Energy s Energy Informaton Admnstraton (EIA) has substantally reduced forecasts of world energy consumpton out to the year 22 owng to contnued economc troubles n Russa (and partly Asa) (Global Envronmental hange Report No. 7, 1999). 1

11 from ol are reduced after 25, untl global ol producton ceases n 27. Total emssons also declne n ths perod. The consumpton of gas n Annex B s reduced when producton n Rest-ED and ED-Europe ceases n 26 and n 28, respectvely. The consumpton of gas n Annex B (.e., EIT) stops n 21, and concdes wth the last perod of producton n Non-ED. Due to the harmonsaton of taxes and costs the long run regonal maxmum producer prce s equal, and all regons therefore consume a fuel as long as t s produced, except for the gas markets where no trade takes place between the regons. Emssons are almost constant after 27, wth a small drop n 21 when the backstop dsplaces gas. Fgure 3. arbon emssons n Annex B n the reference scenaro and tme-path of a 2 tax needed for the yoto targets Bt arbon emssons n Annex B wthout clmate treaty oal Gas l tax needed for the yoto targets $/boe Year 4. Effects of an mplementaton of the yoto Protocol In order to acheve the yoto targets, Annex B countres must reduce emssons to 3.77 bllon tonnes of carbon from 21. It s presupposed that emssons should be kept at ths level n subsequent perods. A 2 -tax s mposed on the consumpton of fossl fuels n each perod. We derve the tax profle that s just necessary for the targets to be reached. Due to the ntertemporal aspect of the model, the taxes must be ntroduced smultaneously n all perods. Fgure 3 shows the development n the 2 tax per boe over tme, whch s necessary f Annex B countres are to fulfl the commtments n 11

12 the yoto Protocol 8. It s assumed that the tax s frst ntroduced n In order to lmt steadly rsng emssons n the frst perods, as shown n Fgure 3, the tax wll frst rse. As emssons gradually declne due to the backstop technology, the taxes wll be reduced. The tax must ncrease from about $6 per boe n the year 21 to $15 n 23, thereafter rsng faster to a peak level of $27 n the year 24. The tax then declnes slghtly to just under $1 n 27. It s then no longer proftable to produce ol because PE s unt cost exceeds the prce of the carbon-free energy source. From then on the tax remans at ths low level. The reason s that the fallng backstop prce makes the unconstraned emssons almost constant and generally not much hgher than the target of 3.77 bllon tonnes of carbon. But why does the tax reach a peak n 24, one perod before the emssons n Annex B reach ts hghest level? To answer ths we have to look more closely at the ol market. Effects n the ol market Fgure 4 shows changes n the producer prce of ol after the tax has been ntroduced. Snce the maxmum producer prce s the prce of the backstop less taxes, the maxmum producer prce s reduced by the entre tax n each perod. Fgure 4. $/barrel l producer prce wth and wthout clmate treates, and wth PE as a cartel Prce wthout treaty Max. prce wthout treaty Prce wth yoto targets n Annex B Max. prce wth yoto targets n Annex B Prce wth Global yoto targets Max. prce wth Global yoto targets Year We see that the effect on the producer prce s mnmal at the begnnng. In the year 2 the prce s reduced margnally because the tax s not ntroduced untl 21. In the year 21 the producer prce s reduced by only $1.1. The tax s $6.2, whch means that the consumer prce rses by $5.1. onsumers wll thus bear almost the entre tax burden at the begnnng. The ntroducton of the tax entals that the ol prce reaches ts peak level n 23, one perod earler than n the scenaro wth no 8 In the scenaro wth yoto targets, the tax s not mposed on consumpton outsde Annex B untl 24. In order to study the drect effect of the yoto Protocol, we let Non-Annex B exst wthout 2 -taxes for as long as possble. In 24 the taxes must be placed outsde Annex B due to model techncal reasons, but t may nevertheless be realstc under a more global economy. Besdes, the development of a more global economy was the reason for lettng exstng taxes and costs be harmonsed across regons up to If the tax was ntroduced n 2, ths would have resulted n a margnally lower tax level n the frst two perods. 12

13 tax. The prce s then $6.5 lower than t would have been wthout a tax. It s not untl 24 that the producer prce s reduced by the entre tax of $27. Ths means that n the frst 4 years the consumer prce shows the greatest change as a result of the tax, whereas t s the producers who bear the entre tax burden after ths tme. The reason for ths s found on the ntertemporal aspect of the supply sde n the model and from PE s behavour, whch we wll now examne more closely. Fgure 2 n the prevous secton shows how the producton profles of PE and the frnge change as a result of the necessary 2 tax for the yoto targets. PE takes the producton of the frnge as gven. PE take nto consderaton that reduced producton gves a hgher ol prce now (the "cartel effect"). Because the costs stay farly constant n the frst perods, t s not so essental for the cartel to weght reduced producton versus lower future costs (the "scarcty effect"). PE reduces producton by 11 % n 21 and by 18 % n 22. The cartel reduces producton to mantan ol prces at about the same level that prevaled before the tax was ntroduced. The frnge consders the ol prce as gven. For the hgh-cost frnge t s crucal to weght ncreased producton versus hgher future costs. The frnge fnds t optmal to ncrease producton n 2, 21 and 22 when the reducton n the producer prce s less than n 23. When the prce s reduced by the entre tax n 24, t s no longer proftable for the hgh-cost frnge to produce ol, and so the producton ceases one perod earler than n the reference case. l wealth outsde PE s reduced by about 15 % (as measured by the present value of future petroleum rent). Begnnng n 24 t s optmal for PE to charge as hgh a prce as possble that s the maxmum producer prce, and the cartel produces as long as ts unt costs do not exceed ths prce. In 27 the backstop has become cheaper than ol, and t s no longer proftable for PE to extract. PE's total producton s reduced by only 8 %, but the ol wealth by as much as 19 %. The reason s that the bulk of PE producton comes n the last perods, when PE can t prevent the drop n producer prces. Effects n natural gas markets When taxes are ntroduced, the producer prce of gas s reduced somewhat over the entre horzon n the three producton regons, as shown n later n fgure 5. As n the ol market, however, most of the burden falls on consumers n the frst perods (and for a longer perod than n the ol market). The level of extracton s reduced almost over the whole producton perod n the three regons. The reducton n extracton ncreases up to 24, when the tax leads to the hghest consumer prce. From 24 the tax s reduced and producton ncreases n all three regons. As for the frnge n the ol market a slower rse n the producer prce compared to the reference scenaro wll gve an ncentve to move producton nearer n tme. Stll, producton s lower wth the emsson targets compared to the reference case for all gas producers. Some of the declne n producton can be explaned by a substtuton effect from gas to ol that wll be commented on later. Total producton s reduced by 7 % n ED-Europe, 5 % n Rest of ED and 7 % n Non-ED. Gas wealth n the three regons s 13

14 reduced by about 18, 15 and 17 %, respectvely, followng the ntroducton of the 2 tax. (The reducton n ol and gas wealth s summarsed n Fgure 1, at the end of Secton 6). Effects on consumpton n Annex B The effects on the consumpton of fossl fuels n Annex B are shown n Fgure 6. As the 2 -tax ncreases up to 24, so does the reducton n gas and coal consumpton from the reference stuaton. l consumpton s only margnally reduced n 21 and 22, and s actually hgher than n the reference scenaro n 24, as s the case wth global ol producton. We see from Fgure 6 that t s partcularly the consumpton of coal that s reduced after taxes have been ntroduced. In 22, coal consumpton has already been reduced by half n relaton to the reference scenaro. The explanaton for ths s of course partly due to the fact that the tax on coal s hgher than on ol and gas (measured n energy content). The reason for the larger reducton n gas than ol consumpton s due to the fact that the consumer prce of gas (and also coal) s lower than on ol, so that the relatve prce ncrease due to the 2 -tax s hgher. Ths occurs even though gas s a cleaner fuel. When the tax reaches a peak n 24, Fgure 2 showed that the frnge stops producng ol and the cartel takes over the whole market and ts ol producton starts to declne (as s the case wth consumpton n Annex B). In 24 the ol producers bear the whole tax burden, as the taxes have no effect on the consumer prce. The consumer prce of gas and coal, on the other sde, has ncreased n 24 compared to the reference case. As a consequence, the ntroducton of the 2 -taxes ncreases ol demand from the reference stuaton. In the followng perods t s optmal for PE, as n the reference scenaro, to charge as hgh a prce as possble whch s the maxmum producer prce. But due to a rsng producer prce up to 26/7 t s not optmal for the cartel to satsfy all demand. Ths leads to a faster ntroducton of the carbon-free backstop technology than n the reference scenaro. 14

15 15 Producton wth Global yoto targets Producton wth Global yoto targets Producton wth Global yoto targets Producton wth yoto targets n Annex B Producton wth yoto targets n Annex B Producton wth yoto targets n Annex B Producton wthout treaty Producton wthout treaty Producton wthout treaty Year Year Year 1 5 Mtoe 15 Mtoe Mtoe Producton n ED-Europe Producton n Rest-ED Producton n Non-ED Prce wthout treaty Max. prce wthout treaty Prce wth yoto targets n Annex B Max. prce wth yoto targets n Annex B Prce wth Global yoto targets Max. prce wth Global yoto targets Prce wthout treaty Max. prce wthout treaty Prce wth yoto targets n Annex B Max. prce wth yoto targets n Annex B Prce wth Global yoto targets Max. prce wth Global yoto targets Prce wthout treaty Max. prce wthout treaty Prce wth yoto targets n Annex B Max. prce wth yoto targets n Annex B Prce wth Global yoto targets Max. prce wth Global yoto targets $/boe 3 2 $/boe $/boe Producer prce of natural gas n ED-Europe Producer prce of natural gas n Rest-ED Producer prce of natural gas n Non-ED Fgure 5. Producer prce and producton n the natural gas regons wth and wthout clmate treates, and wth PE as a cartel

16 Backstop consumpton n Annex B ncreases from 12 % n 24 to over 2 % of the ol consumpton n The reducton n ol consumpton after 24 and the ntroducton of the backstop are the reasons for the 2-tax to reach ts maxmum level n 24, one perod before the emsson level peak n the reference scenaro. Inasmuch as ol producton falls untl t comes to a complete halt n 27, the 2 -tax s also reduced n ths perod. Fgure 6 shows that from 25 coal consumpton begns to ncrease n lne wth the declne n the 2 -tax. Gas consumpton n Annex B moves along approxmately the same path as n the reference scenaro begnnng n 25. Gas consumpton falls gradually from then on because gas producton becomes unproftable and s phased out n the three producton regons. Fgure 6. Effects on ol, gas and coal consumpton n Annex B wth yoto targets, and PE as a cartel Mtoe l wth yoto targets l wthout clmate treaty Mtoe Year Gas wth yoto targets oal wth yoto targets Gas wthout clmate treaty oal wthout clmate treaty 1 It s assumed that the relatve amount of backstop consumpton s equal nsde and outsde Annex B. Because the backstop s a perfect substtute for ol, just small shfts n the tax lead to relatvely large shfts n demand between the two energy goods n 25 and 26. Ths makes t dffcult to fnd the exact 2 -tax needed for the emsson target. As a consequence the emssons n Annex B n 25 are margnally hgher and n 26 margnally lower than the target. A correct tax would only have to be slghtly hgher for 25 and lower for

17 A key pont s that f only the ED had been subject to emsson reducton targets n yoto, the 2-tax (or permt prce) would ntally have to be hgher. If an effcent tradable permt market s assumed, the model shows that the ED can actually ncrease emssons by 2.4 % from 199 to 21 due to substantal emsson reductons n EIT. As a result of the collapse and dssoluton of the Sovet Unon at the begnnng of the 199s, emssons from ths category of Annex B were about 26 % lower n 1994 than n 199. These countres have thus been allocated commtments they may be able to fulfl by a wde margn n 21 wthout havng to mplement measures (wth ths phenomenon referred to as hot ar ). The magntude of ths "hot ar" n varous models s crucal n determnng the costs of the yoto emsson targets. 5. onsequences of Global yoto targets Global emssons rse from 6.15 bllon tonnes of carbon n 2 and reach a peak level n the reference scenaro of bllon n 26, as shown n Fgure 7. The estmated emssons are n accordance wth other long term studes to the mddle of next century, see, e.g., Dean and Hoeller (1992) 11 and lne (1992), and are n the lower range of IP scenaros (IP 1992, 1996). In our model the emssons rse more rapdly outsde Annex B due to stronger economc growth and hgher ncome elastcty for fossl fuels. In partcular, the consumpton of coal rses faster outsde Annex B. The Global yoto targets refer to a stuaton where the entre world reduces emssons by 5.2 % n 21 compared wth the level n 199. In order to acheve these targets the global emssons have to be reduced to 5.59 bllon tonnes of carbon from 21. The global tax s mposed on consumpton from 21. As a result of these reducton targets, the tax must n all perods be hgher than the tax level n the case wth commtments only for Annex B. Ths s partcularly due to the much hgher consumpton of coal nasmuch as we are consderng consumpton n Non-Annex B. The tax now rses sharply from $1.5 per boe n 21 and up to an almost steady level of $17-18 n 22 and 23, before t reaches a maxmum level of $32 n 24; ths tme two perods before the emsson level peaks. For PE, t s now proftable to reduce producton twce as much n 21 and 22 to mantan ol prces, compared to the stuaton wth yoto targets n Fgure 2. In 23 PE actually reduces producton wth 45 % compared to the reference case. The cartel producton s lower than wth yoto targets n Annex B throughout the whole extracton perod. Even f the tax s hgher, the producer prce s almost the same as wth yoto targets n Annex B up to 23. Ths leads to almost the same producton profle for the 11 ur estmated global emssons up to 21 wth PE as a cartel are actually n the lower range of the scenaros n Dean and Holler. Ths study that uses standardsed values for exogenous varables across the dfferent models. But the reference scenaros that were calbrated to match the actual 199 levels, ndcates an overshootng of the level of global emssons already n See also footnote 7. 17

18 frnge n the three perods t produces. Wth global reducton targets, the frnge s ol wealth s reduced wth 17.5 %, compared to 15 % wth targets for Annex B. PE's ol wealth s reduced wth as much as 32 %, an ncrease of about two-thrds of the loss wth yoto targets n Annex B. Wth regards to the natural gas markets as shown n Fgure 5, the producer prce s reduced further compared wth the case wth yoto targets, and producton s lower. Gas wealth n ED-Europe, Rest-ED and Non-ED s now reduced by 27 %, 24 % and 33 %, respectvely. Whle the wealth loss n the two ED regons ncreases wth 5-6 %, the loss n Non-ED s almost doubled compared to loss wth yoto targets n Annex B. Non-ED now experences the largest reducton n wealth frst of all because ths regon ncludes Non-Annex B and ths regon s not ncluded n the yoto Protocol. The wealth effects are summarsed n Fgure 1. Fgure 7. Global carbon emssons and tme-path of a 2 tax wth Global yoto targets, and PE as a cartel Bt Global carbon emssons wthout clmate treaty oal Gas l 35 $/boe tax wth yoto targets 2 tax wth Global yoto targets Year We now turn to the effect of the ntroducton of 2 -taxes on the global consumpton of fossl fuels, as shown n Fgure 8. We see that the hgher tax leads to a larger reducton n the consumpton of fossl fuels compared to the yoto targets. Fgure 4 shows that the ol producer prce s almost the 18

19 same for the frst three perods as wth yoto targets n Annex B, whle the producer prce of gas and coal s reduced further. An extenson of the yoto targets to the whole world wll therefore lead to a relatvely larger ncrease n the ol consumer prce. As a consequence the substtuton towards ol consumpton that was present wth yoto targets s reduced. Begnnng n 24 the ol consumer prce s the same as n the reference case, whle the consumer prce of gas and coal has ncreased. Ths leads to a larger reducton n gas and coal consumpton than for ol n 24. As wth yoto targets n Annex B, the relatvely large demand after ol n 24 s partly satsfed by the backstop and at an ncreasng rate n the followng perods. The backstop replaces gas consumpton n Rest-ED n 25, and n 26 the reducton n the ol consumpton s actually larger than for coal. After ol consumpton s phased out n 27 the 2 -tax reaches a level of about $1 to keep the global coal consumpton low (compared a level of less than $1 wth Annex B targets). Fgure 8. Effects on ol, gas and coal consumpton wth Global yoto targets, and PE as a cartel Mtoe l wth Global yoto targets l wthout clmate treaty Mtoe Gas wth Global yoto targets oal wth Global yoto targets Gas wthout clmate treaty oal wthout clmate treaty Year 19

20 6. Perfect competton n the ol market The ol market s probably best descrbed wth PE as a cartel. But the dscusson of who shall reduce producton may, for example, result n such consderable strans that the varous member countres completely dsregard the producton quotas. If PE s dssolved and the ol market becomes a compettve market, the calculatons show that ths wll have major consequences for prces and producton, see Fgure 9. PE no longer restrans producton n order to mantan ol prces. They now quadruple ther producton n the frst perod, brngng the ntal ol prce down to about $11 n the year 2. The ol producer prce does not reach the maxmum producer prce untl 26, two perods later than when PE acts as a cartel. The low ol prce entals that hgh-cost countres fnd t optmal to postpone producton untl a later perod, and t s not untl the thrd perod that these countres acheve the same producton level that they have when PE operates as a cartel. Due to hgh producton ntally, PE halts producton one perod earler, whle Non-PE produces one perod longer compared wth the cartel case. The dssoluton of PE has major negatve consequences for the other producer countres. Non-PE s ol wealth s reduced wth as much as 71 % before any emsson targets are ntroduced. The reason s that the producers outsde PE now cannot enjoy the benefts from a hgher ol prce. The change n producton profle towards more producton n later perods contrbutes also to the large reducton n wealth because of dscountng. PE loses about 15 % of ts wealth, and so Non-PE has far more to lose from a dssolvement of the cartel (see also Berg et al. 1997a). PE does not have to reduce producton to keep the ol prce hgh, and actually moves some of ts producton to earler perods. Wth perfect competton n the ol market, both Annex B and global 2 -emssons are n the range of the scenaros from other studes, also up to 22. Hence, the costs of reducng emssons from the reference stuaton n ths perod s also probably more comparable wth other studes than n the case wth PE actng as a cartel. We see from Fgure 9 that global ol producton s hgher n the case wth perfect competton n the frst four perods compared to the cartel stuaton n the reference case. It also appears that ol consumpton n Annex B s hgher n ths perod. For ths reason the 2 -tax n Annex B must be hgher up to 23 wth perfect competton. The tax must ncrease from about $1 n 21 to a peak level of $23 n 23. Fgure 9 also shows that the 2 -tax declnes after 23, and s lower than n the cartel case from 24 to 26. 2

21 Fgure 9. 6 Effects of clmate treates on ol producer prce and producton, wth a compettve ol market Prce wthout treaty $/barrel Max. prce wthout treaty Prce wth yoto targets n Annex B Max. prce wth yoto targets n Annex B Prce wth Global yoto targets Max. prce wth global yoto targets Mtoe Non-PE producton wthout treaty Non-PE producton wth yoto targets n Annex B Non-PE producton wth Global yoto targets PE producton wthout treaty PE producton wth yoto targets n Annex B PE producton wth Global yoto targets tax wth yoto targets n Annex B $/boe Year 2-tax wth Global yoto targets In a stuaton wth perfect competton the ntroducton of a tax necessary for the yoto targets n Annex B results n a further reducton n the producer prce. We see from Fgure 9 that the relatve mpact s margnally greater up to 23 than n a stuaton wth PE actng as a cartel. The tax s hgher and PE countres do not fnd t optmal to lmt ther producton to the same extent n the frst four perods as n the cartel case. Ths leads to a hgher loss for Non-PE because ths regon 21

22 has the lowest petroleum rent ntally. A certan reducton n the producer prce wll gve a relatvely hgher loss of wealth when the extracton costs are closer to the prce,.e. a lower petroleum rent. A larger burden therefore falls on producers n hgh-cost countres, and the reducton n Non-PE s ol wealth as a result of the tax s greater, about 3 %. PE loses about 15 % of ts wealth from the reference case under perfect competton. Fgure 9 also shows that because the producer prce s hgher n 26 than n 25, t s proftable for both PE and Non-PE to postpone ol producton so that they produce one perod longer than n the case wthout a tax. 12 The hgher tax and the lack of substtuton effect from gas to ol up to 23 lead to a larger reducton n ol consumpton n Annex B than n the cartel model. The 2 -tax now peaks n 23, two perods before the maxmum emsson level n the reference scenaro. The tax s lower than n the cartel case from 24 to 26, because the reducton n ol consumpton n Annex B now s greater n ths perod. The reason s that n the cartel case the tax dd not have any effect on the consumer prce from 24, but t s not untl 26 that the producers bear the whole tax burden wth perfect competton. The relatve backstop consumpton n Annex B s twce as large n 24 compared to the cartel case (and n 25 t s three tmes as hgh). Emssons, and thereby the tax, are the same n the case wth perfect competton as wth PE operatng as a cartel when ol producton ceases n 27. We now defne the shadow cost of reducng emssons as a permt prce. A 2 tax of $1 per barrel of ol wth an effcent nternatonal tradable permt market wll be equvalent to about $2.5 per tonne 2. If we sum up the consequences of the yoto Protocol, t may generally be sad that rrespectve of the assumpton concernng PE s behavour, the permt prce wll rse from about $14-24 per tonne 2 n 21 up to $25-41 n 22, before t reaches $36-57 n 23. The lower fgures are ndcatng a stuaton where PE s actng as a cartel. In comparson, estmates of the permt prce n nne dfferent models n ED (1998) were n the range of $ n 21. ur estmate s thus wthn the prce nterval provded by these studes, but n addton our study ponts to possble development paths after 21 under dfferent assumptons concernng the cartel s market power. As n the case wth a cartel stuaton, Global yoto targets ental that the tax, and thus the permt prce, must be hgher n all perods than the tax level n the case wth the yoto targets. The producer prce of ol s now lower durng the whole producton perod compared wth the stuaton wth perfect competton and emsson targets for Annex B, as shown n Fgure 9. Ths leads to a further reducton n the producton of both PE and Non-PE through the entre perod. As a result, Non-PE s ol wealth s now reduced wth as much as 55 %, aganst 3 % wth the current yoto targets. PE 12 Ths s n lne wth Snclar's argument that a carbon tax should declne over tme to get producers to postpone extracton (see footnote 2). 22

23 looses 29 % compared to 15 %. In a stuaton wth perfect competton n the ol market the emsson targets wll lead to a relatve loss for Non-PE about twce as hgh than for the low-cost producers that belonged to the cartel. Even though a larger tax burden s born by the producers, the relatve loss n wealth for PE s margnally less than n the cartel stuaton. The reason s that PE does not reduce producton n the frst perods as much as n the cartel model. Therefore, market structure s not so mportant for PE when t comes to the relatve mpact of emsson targets, whle for Non-PE t s of great mportance. To sum up the consequences of ncludng developng countres n the Protocol, the permt prce rses from $33-35 n 21, up to $52-59 n 22 before t reaches $49-81 n 23. The hgher fgures are ndcatng the permt prce wth perfect competton n the ol market. ur estmates are n the lower range of about $5-85 n 22 n Dean and Hoeller (1992) 13. As n our study, the avalablty of the backstop after 23 s a major factor n determnng possble tme-paths of emssons and permt prces after 23. Ths secton has been focusng on the ol market because the results n natural gas markets are approxmately the same as n the cartel model. The gas wealth n the reference case s slghtly smaller than n the cartel case, because the lower ol prce leads to a substtuton from gas to ol before targets are ntroduced. The relatve effects n the gas market of the emsson targets are not substantally dfferent from the cartel case. Fgure 1. Reductons n ol and gas wealth from the reference case wth PE as a cartel and no clmate treaty -1 yoto targets n AnnexB Global yoto targets Wthout clmate treaty yoto targets n AnnexB Global yoto targets PE's ol wealth -2-3 Non-PE's ol wealth Percent -4-5 PE as a cartel ED- Europe's gas wealth -6-7 Rest- ED's gas wealth Perfect competton n the ol market Non- ED's gas wealth 23

24 7. Senstvty analyses and caveats There s consderable uncertanty assocated wth the value of several parameters. Some senstvty analyses have been carred out to examne the degree to whch the results depend on specal numercal assumptons. The smulaton results apply to the ol market n the cartel case (see also senstvty analyss n Berg et al., 1997b). Technologcal growth has been remarkable n many Non-PE countres. More rapd technologcal progress n the frnge for the frst 3 years wll result n lower unt costs, hgher producton and ths leads to a lower ol prce. Inasmuch as PE s producton s almost unchanged, total producton and thereby emssons also ncrease, and the permt prce must be hgher f the emsson targets are to be acheved. More rapd technologcal progress for the backstop technology wll clearly change the tmepath of the permt prces. When the backstop prce falls faster, total producton wll ncrease for the frst perods but the producton perod wll be shortened. Ths wll ncrease the permt prce for the frst perods, but eventually lead to a lower permt prce as ol producton s phased out. All cross-prce elastctes are set equal to.1. Hgher cross-prce elastctes, whle keepng the drect prce elastctes unchanged, makes total energy demand less senstve to prce changes. The permt prce must then be ncreased to get the same ncrease n consumer prce (and fall n demand). In general wll lower substtuton elastctes between fossl fuels lead to an overestmaton of the costs of mtgaton, because ths makes swtchng between fossl fuels more dffcult. Stll, dfferent consumer prces of fossl fuels n our model are an mportant factor n determnng substtuton. Dfferences n exstng prces determne "the leverage" of any partcular tax rate, and hence nduce fuel swtchng. It s uncertan whether there should be an even larger substtuton between the fuels than n our smulatons. Several developng countres ncludng major PE members face severe budget crses (see, e.g., Salameh, 1997). Ths can mply that the need for current money may be overwhelmng. Hence, the dscount rate for PE may be hgh. A hgher dscount rate n the model ndcates that the future counts less, but the producton profle for PE (and the frnge) shows mnor changes n the frst perods. Wth a hgher dscount rate, the emsson targets makes the cartel ncrease ther producton n the mddle of ther producton perod. Due to low extracton costs the ntertemporal aspect s not so mportant for PE durng the frst decades of the next century. 13 These permt prces are roughly estmated through nterpolaton of dfferent reducton scenaros n 22, and by lookng at graphs. 24