The Green Paradox

Hans-Werner Sinn, professor of economics at the LMU in Munich is one of the most influential and undoubtedly controversial German living economists. He is particularly well-known for having introduced a supply- side view of the climate change problem. Sinn argues that “the climate problem is one of mankind’s biggest challenges”. However, he also argues that policies that ignore the laws of economics risk being worthless and ineffective. Particularly, policies that seek the reduction of future demand for fossil fuels could actually induce resource owners to anticipate their extraction plans, thus accelerating global warming. H.-W. Sinn called this behavior ‘das Grüne Paradoxon’ or the Green Paradox. The Green Paradox explains why policies aimed at reducing the demand for carbon didn’t succeed in slowing down global carbon extraction, and why carbon prices failed to increase over the last decades.1 If policy makers wish to decrease the amount of carbon output that goes to the atmosphere, two possibilities exist. The first one is to push carbon consumers to use less of it. The second one, is to target carbon producers directly by forcing them to produce less. That is, the first is a demand policy and the second is a supply policy. Sinn argues that in public debate, over the past years, economists and policy makers have typically focused themselves on demand-side approaches: they thought that to mitigate the climate issue, it would be advisable to subsidize green energy/green backstop technologies, or even to tax the use of fossil fuels (e.g. carbon taxes), i.e. to reduce the demand for carbon. Other demand-side approaches include requirements on better insulation of homes, tighter regulation on mileage in car engines, or even “morally discrediting of fossil fuel consumption”. But economists know that both supply and demand matter. One should thus look more carefully at the supply-side of the market. Indeed, we cannot think of supply as being a flat curve (i.e. perfect elastic supply). In Sinn’s words: “[…] resource suppliers were perceived to be like car producers, facing flat marginal cost curves and producing what is demanded at given prices. However, unlike cars, fossil resources sold in the market are already there and thus cannot be “produced”. Extraction costs are typically small relative to user costs. This means that we cannot assume that the supply reactions of resource owners will be elastic […]”2. The curious thing is that if the supply of carbon was flat, and demand decreasing in price as usual, a demand reducing policy would work: when demand contracts in the market, equilibrium quantity decreases and price would remain the same. This would be accurate if we were, say, in a car production market. But the carbon market is a different one. In the carbon market, Sinn notes, nothing has to be produced, the oil and the coal are already there in the ground! Thus, we should rather consider supply as a vertical line, perfectly inelastic. Now, if we reduce demand in such a scenario, nothing will happen to the equilibrium quantity of carbon. Prices of carbon, however, will decrease to clear the market. Why is this important? H.-W. Sinn invites us to think of measures taken by an isolated group of countries. He proposes the following experience: let us split the world into two groups of countries, those who sign the Kyoto protocol and those who don’t. They both have demands for carbon at time t. We also have carbon producers offering a certain fixed amount of carbon at time t (the width of the box in the figure is the total carbon supplied). The world price of carbon (p*) will be reached when the sum of demands exhausts the supply. If we suppose the Kyoto countries impose a demand restriction in order to reduce demand, these countries will now have a kinked demand. The new market price for carbon is now lower at p**. But the domestic price for carbon is actually higher than p*. Sinn called the difference between those two prices (between p** and the new domestic price) an ‘altruistic wedge’ because according to him, this policy helps non-Kyoto countries get their carbon at lower prices. He called this problem the ‘leakage problem’. If Kyoto countries don’t buy the carbon, someone else will. The dramatic issue is that the leakage problem gets worse because of the Green Paradox.

Source: Hans Werner Sinn, How to Fight Climate Change: economic and technical challenges

The Green Paradox argues that one cannot even take for granted that carbon producers will choose to produce a fixed amount of carbon over time regardless of policy measures. It is quite possible that producers would actually produce more. Promises to make the economy greener and less dependent on fossil fuels would lead to an anticipation effect. As the argument goes, policies seeking to reduce ‘resource-derived’ revenues in the future will cause resource owners to bring their sales forward to the present. Indeed, owners of fossil fuels enjoy scarcity rents and maximize profits by deciding when to extract their coal or oil reserves3. Thus, the problem arises because scared oil and gas producers anticipate a future fall in the prices they charge for their products and try to extract more now, causing an acceleration in global warming. More recently, some authors have made the distinction between a weak green paradox and a strong green paradox4. On the one hand, the fact that when faced with tighter regulation fossil fuel owners decide to extract less in the future and more today instead is known as the weak green paradox (‘weak’ since global warming accelerates at least for a while). If, despite policy changes, fossil fuel owners can still extract a fairly large amount of their resources profitably, then the anticipation of extraction could actually increase cumulative damages, such outcome is known as astrong green paradox. All in all, Sinn believes that only through ‘binding global agreements on quantity constraints’ one can successfully reduce the pace of global warming. To illustrate his theory with a practical example, Sinn notes that ‘Germany’s lignite resources account for less than 2% of the available world stock, but its 17% market share makes it the world’s leader in terms of current extraction’. This weird behavior could only be explained by a fear of the threats of the German Green Party to prohibit extraction in a near future. Although it seems like a compelling theory, one can make a couple of remarks to Sinn’s argument. First, an important assumption of the Green Paradox is the existence of an exogenously given resource stock that firms are endowed with. In the real world, however, firms have to invest in exploration before extractions can proceed5. Second, Sinn assumes the non-existence of a ‘backstop technology’: “[…] unfortunately, I am less optimistic about the potential role of backstop technologies […]”6. William Nordhaus, Nobel Prize laureate in Economics, defined a backstop technology as a technology that constitutes a substitute to the fossil fuel energy resource and is not constrained by exhaustibility7. The point is that if an alternative technology is available it is at least possible that demand for fossil fuels will be partly replaced by the backstop technology. This could potentially leave some fossil fuels un-extracted. In fact, in 2010, Michael Hoel pointed out that the introduction of a backstop technology makes the appearance of a Green Paradox unlikely8. 1Cf. Hans-Werner Sinn, The Green Paradox: A Supply-side View of the Climate Problem, CESifo Working paper no.5385, June2015. 2 Cf. Review of Environmental Economics and Policy, Volume 9, Issue 2, summer 2015, The Green Paradox: A Supply-Side View of the Climate Problem, Hans-Werner Sinn, p. 239. 3 See for example: Svenn Jensen, Kristina Mohliny, Karen Pittelz, and Thomas Sterner, An Introduction to the Green Paradox: The Unintended Consequences of Climate Policies, Review of Environmental Economics and Policy, July 2015, p.1. 4 See for example: Svenn Jensen, Kristina Mohliny, Karen Pittelz, and Thomas Sterner, An Introduction to the Green Paradox: The Unintended Consequences of Climate Policies, Review of Environmental Economics and Policy, July 2015. 5 Ines Österle, The Logic behind the Green Paradox, – Bocconi, May 31, 2012 6 Cf. Review of Environmental Economics and Policy, Volume 9, Issue 2, summer 2015, The Green Paradox: A Supply-Side View of the Climate Problem, Hans-Werner Sinn, p. 242. 7 Cf. William Nordhaus, 1973, “The Allocation of Energy Resources.” Cowles Foundation, Paper 401. 8 Cf. Michael Hoel, 2010, “Is there a Green Paradox?” CESifo, Working Paper 3168.

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