Buy Coal?

Harstad, an associate professor of managerial economics and decision sciences at the Kellogg School of Management, has been casting an economist’s eye on the successes and shortcomings of multinational climate change treaties. Some of his previous work has suggested that short-term climate treaties were harming efforts to curb global carbon emissions more than no treaties at all. Adding to his catalog on climate change legislation, Harstad now has another counterintuitive proposal. Buy coal, he says. Lots of it.

The fatal flaw in most multinational climate agreements lies in the role of nonparticipating countries, Harstad notes. In the short history of major climate change initiatives, countries that agree to help reduce carbon emissions begin by tackling demand. Emission caps, carbon taxes, and alternative forms of energy are all pursued in an effort to lower the amount of carbon entering our atmosphere by making it financially appetizing to decrease the amount of fuel we consume. The trouble is, Harstad says, those efforts soon become counterproductive, thanks to the countries that do not sign on.

“If the coalition reduces its demand for fossil fuel, the world price declines and nonparticipating countries find it optimal to purchase more oil or fossil fuels,” he explains.

Fixing the Leak
The International Panel on Climate Change has dubbed this phenomenon “carbon leakage,” and it proves unavoidable in attempts to address climate issues from what economists like Harstad call the “demand” side of the problem. Not only do fossil fuels get cheaper, resulting in increased consumption by nonparticipating countries, but the prohibitive regulations enacted to curb demand in coalition countries can push industries to more accommodating nations where carbon emissions are not regulated.

“Up to now, most of the literature and political strategies have focused on demand. And a lot of problems arise if you focus on the demand side,” Harstad says. “What I show [in my research] is that those problems disappear when you focus on the supply side, including the supply of other countries.”

In Harstad’s supply-side model for a global climate treaty, coalition countries would essentially create a market for coal and oil deposits. To do this, they would first buy up the marginal sources of fossil fuels, i.e., deposits that are very costly to exploit. Once they owned the rights to these coal mines or natural gas deposits or oil fields, they would simply decline to develop them. They could also sell or lease the rights to produce fuel from them under the condition that any country buying the rights would be subject to the parameters of the treaty.

Eventually, nonparticipating countries would have developed all of their fossil fuel deposits and coalition countries would own the rest of the marginal deposits. By reducing the supply of fossil fuels available on the market, the coalition countries could then ensure that nonparticipating countries would not have the fossil fuel resources to drastically increase their own carbon emissions.

By employing supply-side policies only without limiting demand, the coalition would create a market in which the fossil fuel “consumption price” would be equalized across all countries. At this point the market would clear, Harstad says, as no two countries could make transactions of fossil fuels that would lend unqualified benefit to both. In other words, someone would have to pay. And in the absence of cheap, readily available sources of fuel, carbon leakage would no longer derail global carbon emission reduction efforts.

Under these conditions, the first-best outcome is reached and, regardless of full participation or not, Harstad writes, “the coalition implements its ideal policy simply by reducing its supply of fuel. There is no need to regulate trade or consumption and there is thus no consumption leakage. The fossil fuel price is equalized across countries, which induces optimal investments in technology.”

The key is that, by limiting supply, coalition countries could in effect set the price at a point that would encourage energy conservation and make investments in alternative fuels more alluring.“Whether the right to exploit fossil fuel deposits is for sale or rent,” he says, “the outcome is efficient.”

Money Can’t Be Everything
This may seem at first like wishful thinking at first. It makes no financial sense to pay for something only to ensure that it is not used. But to address global warming, the world needs to be motivated by more than financial considerations. And Harstad’s supply-side logic is not as improbable as it might seem. In fact, both the United Nations and the World Bank are already addressing one facet of climate change through the supply-side paradigm. In this case, the market is the world’s tropical timber.

In the past few decades, consumers and governments in developed countries have become aware of the rapid deforestation of some of the world’s most bountiful and biodiverse ecosystems. As environmental awareness rose, the price for tropical timber dropped, thanks to reduced demand caused by both consumer reluctance and government-imposed boycotts. However, other countries that had been unable to afford timber then increased their consumption. This “timber leakage” became a huge threat to efforts to save tropical rainforests.

Deforestation is a major cause of climate change, according to the United Nations. It estimates that tropical deforestation and the resulting land use changes account for nearly 20 percent of the world’s carbon emissions. Much like fossil fuel deposits, demand-side approaches to the problem were not working, so the UN developed a program called Reducing Emissions from Deforestation and forest Degradation, or REDD.

The plan, says the UN, is to “create a financial value for the carbon stored in forests.” What that translates into is paying developing countries to preserve their rainforests, to leave a marketable resource untouched. Currently, Norway, Denmark, and Spain are financing forests in southern hemisphere countries like Bolivia, Vietnam, and the Democratic Republic of the Congo.

Harstad believes a similar market for carbon deposits could be successful. As he points out, he is not trying to invent a whole new way of doing business. “In reality, a market for exploiting fossil fuel deposits already exists, since countries frequently sell, auction, license or outsource the right to extract their own oil and other minerals to international companies, as well as to major countries like India and China.”

Admittedly, there are complications. For example, nonparticipating countries might be inclined to search for new deposits of fuels to get around the prohibitive costs of existing supplies or to sell them to the climate coalition, which intends to conserve them. (The latter motivation for exploration is considered an economic inefficiency—the countries would be searching for deposits for the wrong reason.) And some scholars point to the “green paradox,” which predicts a short-term rise in carbon emissions as countries scramble to “use it now if it will get harder to do so in the future,” Harstad says.

Besides, perhaps participation is no longer such a big problem. In December 2010, 194 countries signed the Cancun Agreement that came out of the UN’s 16th Conference of the Parties of the United Nations Framework Convention on Climate Change. In 1997 only 37 countries signed the Kyoto Protocol. Surely concerns about nonparticipation should be alleviated.

But Harstad is quick to point out, the Cancun Agreement is nonbinding and will rely essentially on goodwill and voluntary cooperation. And that brings it all back to participation. Undoubtedly, many countries will not “chip in” at the level of others. There will also be haggling over specifics of cap and trade systems or carbon taxes or whatever demand-side approach the coalition takes to reduce carbon emissions.

The beauty of Harstad’s supply-side model is that positive outcomes could still be achieved even if the world’s leaders are not all on the same page. Countries may be unwilling to sign on to multinational climate agreements or drag their feet at taking the steps needed to reduce their carbon emissions, but when it comes to joining a market for the fossil fuels currently needed to power our world, they cannot simply sit on the sidelines.

Related reading on Kellogg Insight

Timing Is Everything: The duration of climate agreements influences their success

And the Poor Get Poorer: The economics of higher global temperatures