Discussion Note Commonwealth Finance Ministers Meeting 2017

Transcription

1 FMM(17)4 October 2017 Discussion Note Commonwealth Finance Ministers Meeting 2017 Can innovations in market instruments help achieve the Paris Agreement? Daniel Wilde and Travis Mitchell 1 Abstract An analysis of fossil fuel reserves, planned investments in oil exploration and projections of oil production, suggests that global fossil fuel supply will be well in excess of that consistent with the Paris Agreement s goals on climate change. Assuming that the market has already built in current and planned policy changes, it is apparent that larger disincentives and more climate financing will be required if the global community is to successfully respond to climate change. This paper presents a number of market instruments that could, if applied on a global scale, strengthen climate change policies and generate financing for climate change adaptation and regeneration. In particular, it discusses fossil fuel royalties; carbon emissions taxes; carbon content excise taxes on refined products; fossil fuel imports and production taxes; and cap and trade. It argues that the global implementation of these market instruments would slow climate change by raising the cost of the supply and consumption of fossil fuels. Use of these instruments would also lead to significant revenue that could be used to finance climate change adaptation and regeneration. Finally, while recognising that there are costs and challenges to the implementation of these market instruments, the paper asks Ministers to consider the feasibility of their use. Guiding questions: What major challenges could arise with the implementation of these market instruments, and how could countries address them? What practical steps would be required to arrive at such an agreement? Is the proposal for global fossil fuel market instruments an idea that the Commonwealth would champion? 1 This paper is based on Wilde, D. and Price, R. (2017) Can a Global Oil Royalty Help to Limit Climate Change? Discussion Paper 24. London: Commonwealth Secretariat, available at Daniel Wilde (d.wilde@commonwealth.int) is an Economic Adviser in the Commonwealth s Oceans and Natural Resources Division. Travis Mitchell (t.mitchell@commonwealth.int) is an Economic Adviser in Economic Policy and Small States. FMM(17)4

2 2 \ Commonwealth Finance Ministers Meeting Introduction Climate change is partly caused by greenhouse gas emissions (IPCC, 2013), which include carbon dioxide (CO 2 ). Restricting climate change to a specific level can only be achieved if the total amount of CO 2 (released through the burning of coal, oil and natural gas, for example) that enters into the atmosphere is limited (Clarke et al., 2014). The goal of limiting climate change to well below 2 C can only be achieved if CO 2 emissions are sharply reduced going forward. This is implicitly recognised in the Paris Agreement s commitment to rapidly reduce greenhouse gases in the second half of this century (UNFCCC, 2015). 2 It has also been recognised that achieving this target will require bespoke and effective public policies. An analysis of market expectations regarding future fossil fuel production raises important doubts about policy effectiveness. The expectations of market participants, which can be reasonably assumed to take account of current, and known future, public policies, suggests that larger disincentives will be required if the global community is to successfully slow the pace of climate change (Muth, 1965; McGlade and Ekins, 2015). In light of the above propositions, this paper discusses the prospects for innovation in market instruments that could potentially help to strengthen disincentives to supply and consume fossil fuels, while generating additional financing to help with countries climate change adaptation. In particular, it draws attention to the potential of a fossil fuel royalty; a carbon emissions tax; a carbon content excise tax on refined products; a fossil fuels imports and production tax; and cap and trade, if applied on a global scale. The next section briefly discusses market expectations for future fossil fuel production and the Paris Agreement. Section 3 talks about the potential for limiting climate change through market instruments, and Section 4 briefly presents some issues and challenges. The paper concludes in Section Fossil Fuel market expectations and the Paris Agreement Fossil fuel reserves include fossil fuels that are technically and economically recoverable. 3 Therefore, if current fossil fuel reserves are in excess of the level of total production consistent with achieving the Paris Agreement targets, then the price signals being given to companies in the fossil fuel market and their expectations concerning future production are not consistent with limiting climate change to well below 2 C. 2.1 Fossil fuel reserves A recent analysis demonstrates that, in order to have a 50 per cent probability of limiting climate change to 2 C, CO 2 emissions from 2013 to 2049 cannot exceed 1,075 GT (Carbon Tracker and Grantham Research Institute, 2013). The combined CO 2 emissions in current reserves of oil, gas, hard coal and lignite amount to 2,490 GT (see Figure 1). Thus, reserves of these fossil fuels are more than double the amount that can be consumed if the world can hope to achieve the Paris Agreement. Figure 1: CO 2 in reserves and carbon budgets (GT) Sources: Data on CO 2 emissions in current reserves are taken from McGlade and Ekins (2015). Data on the CO 2 budget consistent with a 50 per cent probability of limiting the rise in global temperatures to 2 C or less is taken from Carbon Tracker and Grantham Research Institute (2013). 2 The Paris Agreement commits 195 countries to combating climate change. Its overarching goals are to limit the increase in the global average temperature to well below 2 C above pre-industrial levels and to pursue efforts to limit it to 1.5 C. 3 A fossil fuel is economically recoverable only if at current and expected future market prices it is profitable to mine that resource. If fossil fuel companies expectations of future prices decline sharply, then some existing reserves would become uneconomical to recover, and would cease to become reserves.

3 October 2017 \ Investments in oil exploration In addition, many listed fossil fuel companies continue to invest in exploring for new reserves, when an optimal strategy in a low carbon emissions future would be to maximise profits and to increase dividends by cutting back on exploration and development expenditure. For example, Wood McKenzie (2017) recently reported that the first six months of 2017 saw 15 large conventional upstream oil and gas projects given the green light, compared with just eight projects approved in the whole of The market, therefore, seems to be pricing in future oil production that is above the amount consistent with achieving the Paris Agreement goals. 2.3 Oil production projections These market signals are also reflected in recent oil production forecasts. Current projections signal oil production well in excess of the level 80 million barrels per day (MMbbl/d) consistent with a 60 per cent probability of meeting the Paris Agreement (McGlade and Ekins, 2015). As Figure 2 shows, the US Energy Information Administration (EIA) forecasts oil production in excess of 100 MMbbl/d of oil by 2027, indicating that such production is not anticipated to stay within the range consistent with limiting the increase in global average temperatures to 2 C. Figure 2: Oil production forecasts (MMbbl/d) MMbbl/d Sources: Data on forecast oil production are taken from the reference case for oil and other liquids production in EIA (2016). This paper adjusts the EIA (2016) forecast downwards to account for the fact that the EIA s forecast includes other liquids (such as biofuels, coal to liquids fuel and gas to liquids), which are not included in this paper s definition of oil. Data on oil production that is consistent with global temperatures increasing by 2 C are taken from McGlade and Ekins (2015), who use the TIAM-UCL model under a 2 C scenario with carbon capture and storage. 3. Potential market instruments to help achieve the Paris Agreement The above analysis suggests that, should market forces prevail, oil production is likely to significantly exceed that consistent with achieving the Paris Agreement. Missing the Paris Agreement s target could cause severe ecological damage and result in significant economic costs. It would also complicate climate change mitigation and adaptation efforts, and affect the required amount of climate financing. On this basis, in the run-up to COP23, leaders should consider further disincentives to climate change, which could strengthen policy signals and also generate additional climate financing. This paper focuses on the potential for market instruments to limit climate change and help achieve the Paris Agreement s target. More specifically, it discusses a global fossil fuel royalty; a global carbon emissions tax; a global carbon content excise tax on refined products; a global fossil fuel imports and production tax; and global cap and trade. Many countries are already implementing one or more of these instruments at the domestic level, albeit with mixed success. Thus, one of the main innovations of this paper is that it proposes that the global application of one of these market instruments is considered. All these market instruments work by increasing the costs of supplying fossil fuels. The global implementation of any of them would result in a new equilibrium between demand and supply, whereby the price is higher and the amount of fossil fuels produced and consumed is less. It should, however, be noted that the relative impact on price and quantity depends on the slope (elasticity) of demand for fossil fuels. The steeper (more inelastic) the demand, the larger the impact of any given market instrument on prices, and the lower the impact on production. In addition, for a targeted decline in production and consumption of a fossil fuel, more inelastic demand implies higher tax/market instrument rates, higher prices and high revenue collections. As fossil fuel demand is inelastic and significant reductions in their supply and consumption are required to achieve the Paris Agreement, there is scope for substantial revenue collection from market instruments. This revenue could be used to finance climate change mitigation and regeneration. The following paragraphs discuss each market instrument in greater detail.

4 4 \ Commonwealth Finance Ministers Meeting Global fossil fuel royalty A fossil fuel royalty is a payment from a mining company to the government of the country where the mining site is located. The payment is set at a fixed percentage of gross revenues. Applied at a global level, the fossil fuel royalty would be applied at the same rate by all countries with reserves. 3.2 Global carbon emissions tax This is a tax levied on the actual amount of carbon emissions. It requires that the tax authorities accurately measure and/or audit carbon emissions made by companies and households. Ideally, the tax is collected from all emitters. 3.3 Global carbon content excise tax on refined products A carbon content excise tax on refined products is a tax levied on domestic producers and importers of refined/processed fossil fuels, with the tax rate positively varying with the likely carbon emissions of the refined/processed fossil fuel. The tax rate should account for not only the carbon emissions of the refined/processed product, but also the emissions associated with its production and transportation. 3.4 Global fossil fuel import and production tax A global fossil fuel import and production tax is self-explanatory. If implemented globally, the tax must be implemented at the same rate by all countries, to avoid arbitrage and smuggling. This would also require monitoring of whether mined fossil fuels are for export or for domestic consumption. 3.5 Global cap and trade Cap and trade involves licences that set an absolute limit for emissions. Within this overall limit, companies buy and sell emission licences as needed. It is not practical for a cap and trade scheme to cover all emitters. Households and small commercial emitters are therefore normally excluded. The system requires monitoring and verification of actual emissions for each emitter compared with their licences. If allowances are initially distributed for free, then revenue from selling licences accrues to companies that can reduce historically high emissions at a low cost. Alternatively, the government can sell licences to generate revenue. 4. Issues and challenges Application of one or more of these market instruments at the global level could be useful in limiting climate change and raising additional climate financing. Global co-ordination in the design and implementation of any of these market instruments would be important for two main reasons. First, implementation of a market instrument such as carbon emissions tax by one country in isolation may have only a moderate impact on climate change, as most countries emissions are relatively small as a proportion of global emissions. Second, if a country implements a market instrument in isolation, this may simply result in production or consumption of fossil fuels shifting to lower tax jurisdictions, with little overall reduction in global emissions. Deciding which of the market instruments should be used to reduce CO 2 emissions to a level consistent with the Paris Agreement s goals also requires consideration of issues around tax administration, economic efficiency, distribution of revenues, fairness and equity. 4.1 Tax administration The global fossil fuels royalty would arguably be relatively easy to administer, as fossil fuel production can be easily monitored, production takes place at a limited number of sites normally operated by large companies and international benchmark prices for fossil fuels are publically available. In contrast, the global cap and trade and global carbon emissions tax are more difficult to administer, as they require the monitoring of emissions from many households and firms. 4.2 Economic efficiency To be economically efficient, the market instrument should increase the price of the fossil fuel in relation to its carbon content (including the carbon used in its transportation and storage). From this viewpoint, the global fossil fuel royalty might be regarded as inefficient, as it would increase the price of refined products, such as lubricants, which do not result in CO 2 emissions. A carbon emissions tax and a cap and trade scheme are arguably more efficient, as these market instruments increase costs according to the amount of carbon emitted. However, it is difficult to monitor the emissions of all firms and households, and this often means these market instruments are not applied to smaller emitters.

5 October 2017 \ 5 This reduces their economic efficiency as it encourages carbon intensive activities to shift to smaller households and firms that are not party to the carbon emissions tax or cap and trade scheme. 4.3 Distribution of revenues The different market instruments also have implications for the distribution of revenues. The global fossil fuel royalty would be administered by, and the revenue would accrue to, fossil fuel-producing countries. In contrast, the other market instruments would be administered by, and the revenue would accrue to, fossil fuelconsuming countries. This implies that, for a market instrument implemented globally to reduce CO 2 emissions to a level consistent with the Paris Agreement s goal, fossil fuel-producing countries may favour a global fossil fuel royalty over the other market instruments. If the global fossil fuel royalty was implemented, it could be argued that there should be some redistribution of revenues from fossil fuelproducing to fossil fuel-consuming nations. For the other market instruments, there could be some redistribution of revenues from fossil fuel-consuming to fossil fuel-producing nations. This suggests that it may be useful to use a combination of instruments and to establish a global fund to redistribute revenues to aid global agreement. This global fund could then be used to finance climate change mitigation and regeneration activities. Table 1 contains a more detailed discussion of the strengths and weakness in terms of tax administration, economic efficiency and distribution of revenues of each of these market instruments. dependence on fossil fuels are compensated for the higher fossil fuel prices stemming from the implementation of the above instruments. The challenge with this approach, however, is that producer countries could be thrice affected, discouraging them from entering such a global agreement in the first instance by the increased cost of fossil fuel production and challenges with competitiveness; secondly by a potential fall in fossil fuel demand; and thirdly by loss of revenue. Finding some compromise would be important to moving discussions forward. 4.5 Fairness There are potential ethical challenges as well. Countries that are new producers of oil, for example Ghana and Uganda, would be subject to the same level of taxation as entrenched producer countries. An argument of fairness could therefore arise, especially given the potential contribution of these new oil industries to poverty reduction and, more broadly, to these countries accomplishment of the Sustainable Development Goals. Arguably what matters, however, is not whether a country is a new or established producer, but where its fields are located on the oil supply curve. For example, Uganda s oil reserves are large and onshore. As such, they are relatively low cost, so that a higher oil royalty or tax, for example, would result in higher tax revenue per barrel and a limited decline in production. The question of fairness will be more of a challenge for high-cost producers. 4.4 Equity A further question relates to how the revenues raised from a global market instrument should be distributed between countries. In the spirit of the Paris Agreement, the more popular argument would be to focus resources on climate-vulnerable countries. These countries are largely those that have not historically contributed significantly to climate change. In this way, the global fund would redistribute revenues from major fossil fuel producers and emitters to countries with historically low contributions to climate change. This would ensure that climate-vulnerable countries and developing countries with high

6 6 \Commonwealth Finance Ministers Meeting Conclusion The realisation that it will be challenging to accomplish the Paris Agreement is not new. However, the market information on renewables, investments and production makes this premonition real. When countries meet during COP23 in November, they will have an opportunity to reflect on what has been agreed, and to assess progress toward implementation. This paper suggests taking market instruments into account, and promotes new thinking on how to further disincentivise fossil fuel production and consumption. It advocates for the implementation of existing market instruments on a global scale. In particular, a fossil fuel royalty; a carbon emissions tax; a carbon content excise tax on refined products; a fossil fuel imports and production tax; and cap and trade should be considered. Based on their theoretical properties alone, this paper finds that these can be helpful in further limiting fossil fuel production and consumption, albeit not without some challenges. As to the rates that these market instruments would have to be set at to reduce fossil fuel production and consumption to a level consistent with the Paris Agreement s goals, more detailed technical analysis is required. Additional work is also required to compare the advantages and disadvantages of these market instruments in terms of tax administration, economic efficiency and the distribution of revenues. Detailed discussion is required with regard to how revenues would be distributed across countries and used to finance climate change mitigation and adaptation. Such work could be undertaken by the Commonwealth if there is appetite among countries for introducing the proposed or similar types of market instruments. With COP23 on the immediate horizon, however, more urgent is to decide on whether more needs to be done, and what practical steps are necessary to promote increased ambition to achieve the Paris Agreement s goals. There is the obvious hurdle of polarisation among producer and consumer countries, but countries reactions to the USA s withdrawal from the Paris Agreement implies that commitments on both sides are strong. Hence, potentially divisive issues around equity and feasibility can be discussed and resolved. References Carbon Tracker and Grantham Research Institute (2013) Unburnable Carbon 2013: Wasted Capital and Stranded Assets. London: Carbon Tracker and The Grantham Research Institute, LSE. Clarke, L. et al. (2014) Assessing Transformation Pathways, in O. Edenhofer et al. Climate Change 2014: Mitigation of Climate Change. Contribution of Working Group III to the Fifth Assessment Report. Cambridge and New York: Cambridge University Press. EIA (2016) International Energy Outlook Washington, DC: DOE/EIA. EIA (2017) Annual Energy Outlook Washington, DC: DOE/EIA. IEA (2016) Key World Energy Statistics. Paris: IEA. IPCC (2013) Climate Change 2013: The Physical Science Basis. Contribution of Working Group I to the Fifth Assessment Report. Cambridge: Cambridge University Press. McGlade, C. and Ekins, P. (2015) The Geographical Distribution of Fossil Fuels Unused When Limiting Global Warming to 2 C, Nature 517: Muth, J.F. (1961) Rational Expectations and the Theory of Price Movements, Econometrica: Journal of the Econometric Society 29(3): Wood McKenzie (2017) A Big Year for FIDs: 2017 Marks a Turning Point. Available at upstream-oil-and-gas-a-big-year-for-fids marks-a-turning-point , accessed 13 September UNFCCC (2015) Adoption of the Paris Agreement. 21st Conference of the Parties. Paris: UN.

7 7 \Commonwealth Finance Ministers Meeting 2017 October 2017 \ 7 Appendix Table 1: Assessment of potential market instruments Market instrument Administration Economic efficiency Distribution of revenues Global fossil fuel royalty This market instrument would be relatively easy to administer. Upstream fossil fuel production can be easily physically monitored and production takes place at a relatively small number of sites normally operated by large companies. International prices for most fossil fuels are publically available. There is some degree of inefficiency, as some fossil fuels may have alternative uses that do not result in CO 2 emissions. For example, a global oil royalty would be levied on each barrel of oil produced globally and therefore increase the costs of production and reduce the consumption of refined oil products, such as lubricants, that do not result in CO 2 emissions. However, in reality, the vast majority of oil is used to create refined oil products such as petrol, which do result in CO 2 emissions. The global fossil fuel royalty would be collected by, and result in revenue accruing to, countries producing fossil fuels. Fossil fuel-producing countries should thus favour the global fossil fuel royalty over other market mechanisms, such as a global carbon emissions tax, which would result in revenue accruing in countries that consume fossil fuels. Global carbon emissions tax This market instrument is complicated to administer. It requires that tax authorities accurately measure and audit carbon emissions made by companies and households. Ideally, the tax is collected from all emitters. As many households and companies emit CO 2, the tax is relatively complicated and expensive to administer. The tax could be levied on large emitters only but this would reduce its efficiency. In order to simplify tax administration, this tax would likely be levied only on large emitters. If levied only on large emitters, its economic efficiency will be reduced, as there is an incentive to shift carbon-intensive production to small firms. Revenue would accrue to countries where carbon emissions occur. Global carbon content excise tax on refined products This market instrument is relatively complicated to administer, as it implies the monitoring of importers and domestic refineries/processing plants. Theoretically, the rate on different refined/processed fossil fuels should account for all the carbon emissions associated with the product, including emissions associated with their transportation and processing. In reality, this complicates administration of the tax, as it requires that tax authorities have detailed information on the carbon content of production and transportation processes. The efficiency of the tax is reduced if the tax rate does not account for the carbon content of processing and transportation of the processed fossil fuel. More specifically, fossil fuels where processing and transportation have high carbon content would be overconsumed. Revenue would accrue to countries where processed fossil fuels are purchased. Global fossil fuel import and production tax This market instrument is relatively complicated to administer, as it requires monitoring of whether fossil fuels are for export or domestic consumption. The efficiency of the tax is reduced if it does not account for the carbon content involved in the transportation of the fossil fuel. Accurately measuring carbon content involved in transportation would be difficult/ impossible and would complicate tax administration. Revenue will accrue in those countries where fossil fuel consumption takes place. Global cap and trade This market instrument is complicated to administer as it requires the monitoring of emissions compared with licences for all households and firms covered. It is not practical for all emitters to be covered. Households and small commercial emitters are therefore normally excluded, which reduces the economic efficiency of such schemes, as there is an incentive to shift carbon-intensive production to small firms. Revenue will accrue in those countries where carbon emissions occur.

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