Environmental policy: Monopoly, oligopoly, (shale) oil and climate change

Combustion of fossil fuels (oil, gas, and coal) contributes to climate change by generating carbon emissions. Because the effect of fossil fuels on climate change is not taken into account by the free market, government policy is needed to reduce carbon emissions. Optimal climate policy is simple, at least in theory: carbon emissions should be priced, for example by introducing a global carbon tax. The optimal carbon price is equal to the social cost of carbon (SCC), representing the marginal damages of emissions.

Green paradox

For political reasons, introducing such a carbon tax in practice turns out to be problematic. Politicians often prefer alternative, suboptimal climate policies, such as subsidies for renewables (e.g., solar and wind). However, these well-intended suboptimal policies may lead to perverse effects. Forward-looking oil barons foresee that the future oil price will be lower, due to renewables subsidies. It becomes more attractive for them to start pumping oil faster. As a result, current oil supply goes up, which lowers the price and increases demand. In this way, a subsidy for renewables causes an increase in current emissions: a ‘green paradox’.

OPEC

The occurrence of this green paradox has been demonstrated in theoretical models that assume perfect competition on the markets for fossil fuels. However, especially for oil this assumption is unrealistic, as the global oil market has been dominated by the OPEC cartel since its foundation in 1960. The member states of OPEC coordinate on restricting oil supply in order to influence the market price. In our papers, we examine the role of market power for the effectiveness of suboptimal climate policies. We first focus on the extreme case of monopoly (one big supplier with full market power) and subsequently move on to the more realistic, but also more complex, case of oligopoly-fringe (a small number of big suppliers with market power and a large number of small suppliers without market power).

Green ‘orthodox’

A monopolist sets a higher price and responds differently to climate policies than price-taking oil barons operating under perfect competition. We show that, if the initial oil reserve is large enough and if marginal profits are positive, a monopolist increases the initial oil price upon the introduction of a subsidy for renewables. Hence, initial oil use goes down: a green ‘orthodox’! Still, the monopolist chooses – similar to the price-taking oil barons – to deplete his oil reserve faster if a renewables subsidy is introduced. The reason is that the monopolist eventually (as soon as the remaining oil reserve is small enough) chooses a limit-pricing strategy. This strategy consists of setting the oil price such to just undercut the production costs of renewables, in order to outcompete producers of renewable energy. A renewables subsidy lowers the consumer price of renewable energy, and therefore lowers the oil price during a limit-pricing regime. As a result, oil use increases and depletion will occur sooner.

Speculators

We also investigate what happens if the monopolist sells oil to two different regions in the world: one region with (the West) and one region without climate policies (the East). Both regions will switch from fossil fuels to renewables if the oil price becomes too high. Due to the carbon tax or renewables subsidies, this switching point will be reached sooner in the West than in the East. As long as the remaining oil stock is large enough, the monopolist will sell oil to both regions. As oil reserves dwindle, the oil price will increase over time. At some point, the price will be reached at which demand from the West vanishes: due to climate policies, from that moment onwards renewables there become cheaper than oil. We show that, ideally, the monopolist would like to let the oil price jump upwards at this switching instant. However, if there are speculators on the market, a price jump cannot occur in equilibrium. After all, merchants would arbitrage away this jump by building up a reserve before the jump and selling it off afterwards. Accordingly, the monopolist is forced to choose a continuous time path for the oil price. We demonstrate that, as a result, it takes longer for the monopolist to deplete his oil stock. Moreover, the presence of speculators implies that a renewables subsidy does not only lead to a decrease in initial oil use (the mentioned green orthodox), but also to postponement of oil depletion. Hence, speculators on the oil market slow down the speed of global warming and increase the effectiveness of suboptimal climate policies.

Shale revolution

Just like the extreme case of perfect competition, the other extreme of monopoly is unrealistic as well. Especially after the recent shale revolution in the US and Canada: due to improved fracking techniques, is has become cheaper to extract shale oil and the technically recoverable shale oil reserves have gone up substantially. This development has reduced OPEC’s market power. At this moment, about a quarter of the proven global oil reserves are owned by non-OPEC countries. Moreover, recent empirical evidence has shown that the cohesion between the members of the OPEC cartel has declined. The current situation on the global oil market can best be described as a group of big oil owners with market power (the individual OPEC countries) that face competition of a large number of small price-taking oil owners without market power (including the shale barons in the US and Canada). Our oligopoly-fringe model resembles this market structure, and takes into account that shale oil has higher extraction costs and generates more carbon emissions per unit of energy than conventional OPEC oil.

The results of our calibrated model indicate that the recent shale revolution not only has adverse implications for climate change (due to larger cumulative carbon emissions), but is also detrimental to global welfare. The reason is that the relatively expensive shale oil (marginal extraction costs of about 60 US$ per barrel, compared to about 30 US$ per barrel in OPEC countries) crowds out the cheaper OPEC oil, because due to OPEC’s market power, the oil price does not fall sufficiently to completely drive the shale barons out of the market until OPEC’s cheap oil is depleted. Furthermore, we show that the partial collapse of the OPEC cartel has an ambiguous effect on climate change. On the one hand, an increase in competitiveness lowers prices and therefore causes an acceleration of global warming. On the other hand, the weaker cohesion between the OPEC members results in back-loading of relatively dirty shale oil extraction, which slows down climate change. Our calibrated model shows a mountain-shaped relationship between the cohesion within the OPEC cartel and climate damages. Finally, we demonstrate that a subsidy for renewables only induces a weak green orthodox if the cohesion within the OPEC cartel is sufficiently strong and if OPEC’s reserve is large enough compared to the oil reserves in the rest of the world.

Hassan Benchekroun
Gerard van der Meijden
Karolina Ryszka
Cees Withagen

 

Further reading

BENCHEKROUN, H., G. VAN DER MEIJDEN AND C. WITHAGEN, “On OPEC’s evaporating market power and climate policies”, mimeo.

VAN DER MEIJDEN, G., K. RYSZKA AND C. WITHAGEN, “Double Limit Pricing,” Tinbergen Institute Discussion Papers 15-136/VIII, Tinbergen Institute, December 2015.

VAN DER MEIJDEN, G. AND C. WITHAGEN, “Limit Pricing, climate policies and imperfect substitution,” Tinbergen Institute Discussion Papers 16-089/VIII, Tinbergen Institute, December 2016.

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