0412 Executive Digest.IR 4

Bard Harstad, Kellogg School of Management

Environmental policy historically has been driven by a demand-side mindset attempting to limit consumption of fossil fuels through pollution permits, taxation and multinational climate change treaties. New research from the Kellogg School of Management at Northwestern University, however, suggests that buyingcoal, oil sand and other fossil fuel deposits still in the ground could be a better way to fight climate change.

 
The new study, “Buy Coal! A Case for Supply-Side Environmental Policy,” suggests that the best policy for a multinational climate coalition is to purchase the extraction rights of fossil fuels in nonparticipating countries (also called “third countries”) and then conserve rather than exploit the deposits. According to the study’s author, Bard Harstad, this would be a radical departure from the traditional view that focuses on reducing the demand for fuel.
 
“One of the biggest challenges for multinational climate agreements is the role of nonparticipating countries,” said Harstad, associate professor of managerial economics and decision sciences and Max McGraw Chair in Management & Environment at the Kellogg School of Management. “If a climate coalition reduces demand for fossil fuel, the world price of oil goes down and nonparticipating countries find it profitable to consume and pollute more. Similarly, if the coalition seeks to reduce the supply or extraction of fossil fuels, the world price increases and these countries find it optimal to supply more.
 
“Thus, both on the demand side and the supply side the result is carbon leakage, which is an increase in pollution abroad relative to the emission reduction at home. To limit carbon leakage, the coalition may set up tariffs or other border measures, but this will distort trade.
 
“In my analysis, I show that by letting coalition countries buy extraction rights in third countries  – and preserve rather than exploit the fuel deposits – climate coalitions can circumvent the traditional problems of a demand-side policy.”  
 
The most intuitive benefit from this policy, Harstad said, is that emission is reduced if one buys and conserves deposits. Furthermore, the coalition finds it cheapest to buy the marginal deposits (i.e., deposits that are not very profitable to exploit, but still quite polluting when consumed).
 
After selling its marginal deposits, a nonparticipating country’s level of supply will be less sensitive to changes in the world fuel price. Consequently, there is no longer carbon leakage on the supply side, and the coalition can limit its own supply without fearing that the nonparticipants will increase theirs.
 
“This does the trick,” Harstad said.
 
After purchasing marginal extraction rights, the coalition implements its ideal policy by reducing its supply, not its demand. Fossil fuel prices are then equalized across countries. Also, the resulting fossil fuel price seems high enough to motivate even nonparticipating countries to invest effectively in new technologies, such as renewable energy sources. For these reasons, the policy is socially optimal in the analysis, even if some countries do not participate.
 
“The analysis shows that progress on international climate policy is best achieved by simply utilizing the existing market for extraction rights,” Harstad said.
 
Multinational companies are already trading extraction rights.
 
“Climate coalitions should, as well,” Harstad said.  

The study will appear in a forthcoming issue of the Journal of Political Economy.
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0412 Executive Digest.IR 4

Bard Harstad, Kellogg School of Management

Environmental policy historically has been driven by a demand-side mindset attempting to limit consumption of fossil fuels through pollution permits, taxation and multinational climate change treaties. New research from the Kellogg School of Management at Northwestern University, however, suggests that buyingcoal, oil sand and other fossil fuel deposits still in the ground could be a better way to fight climate change.

 
The new study, “Buy Coal! A Case for Supply-Side Environmental Policy,” suggests that the best policy for a multinational climate coalition is to purchase the extraction rights of fossil fuels in nonparticipating countries (also called “third countries”) and then conserve rather than exploit the deposits. According to the study’s author, Bard Harstad, this would be a radical departure from the traditional view that focuses on reducing the demand for fuel.
 
“One of the biggest challenges for multinational climate agreements is the role of nonparticipating countries,” said Harstad, associate professor of managerial economics and decision sciences and Max McGraw Chair in Management & Environment at the Kellogg School of Management. “If a climate coalition reduces demand for fossil fuel, the world price of oil goes down and nonparticipating countries find it profitable to consume and pollute more. Similarly, if the coalition seeks to reduce the supply or extraction of fossil fuels, the world price increases and these countries find it optimal to supply more.
 
“Thus, both on the demand side and the supply side the result is carbon leakage, which is an increase in pollution abroad relative to the emission reduction at home. To limit carbon leakage, the coalition may set up tariffs or other border measures, but this will distort trade.
 
“In my analysis, I show that by letting coalition countries buy extraction rights in third countries  – and preserve rather than exploit the fuel deposits – climate coalitions can circumvent the traditional problems of a demand-side policy.”  
 
The most intuitive benefit from this policy, Harstad said, is that emission is reduced if one buys and conserves deposits. Furthermore, the coalition finds it cheapest to buy the marginal deposits (i.e., deposits that are not very profitable to exploit, but still quite polluting when consumed).
 
After selling its marginal deposits, a nonparticipating country’s level of supply will be less sensitive to changes in the world fuel price. Consequently, there is no longer carbon leakage on the supply side, and the coalition can limit its own supply without fearing that the nonparticipants will increase theirs.
 
“This does the trick,” Harstad said.
 
After purchasing marginal extraction rights, the coalition implements its ideal policy by reducing its supply, not its demand. Fossil fuel prices are then equalized across countries. Also, the resulting fossil fuel price seems high enough to motivate even nonparticipating countries to invest effectively in new technologies, such as renewable energy sources. For these reasons, the policy is socially optimal in the analysis, even if some countries do not participate.
 
“The analysis shows that progress on international climate policy is best achieved by simply utilizing the existing market for extraction rights,” Harstad said.
 
Multinational companies are already trading extraction rights.
 
“Climate coalitions should, as well,” Harstad said.  

The study will appear in a forthcoming issue of the Journal of Political Economy.