The Supply Side in the Economics of Climate Change

I already have written some entries about the economics of climate change. Today I would like to write about an aspect of this problem that is often ignored.

As an old joke goes: The only training a parrot needs to be a passable political economist is one phrase: “supply and demand, supply and demand.” And while the economics of global warming seems to concentrate on demand-side solutions for the most time, there are striking problems with the supply side as well. This aspect was analyzed in an interesting way by the German economist Hans-Werner Sinn in 2008, inter alia in his lecture (later expanded to a book) Das grüne Paradoxon. Warum man das Angebot bei der Klimapolitik nicht vergessen darf (English: The Green Paradox. Why Climate Politics Shouldn’t Forget about Supply).

Sinn’s key message is that ignoring the supply side in economic analyses of the global warming challenge causes solution proposals that don’t lead to any betterment of the situation and in some cases are even counter-productive. It is a fact that global emissions of greenhouse gases haven’t slowed down after the ratification of the Kyoto Protocol (until the recent recession).

Sinn recognizes the fact that climate change represents the biggest market failure in the history of economics. While concentrating on the relevant markets for carbon (i.e., for coal, oil and gas), he claims that, according to economic theory, there wouldn’t be any problems as long as there were perfect markets with perfect property rights and all externalities internalized. The so called Hotelling’s rule would “do it”.

But, as the author rightly notes – there are two important reasons why the carbon markets are not perfect. The first is the fact that property rights over especially oil reserves are not perfectly defined (and protected). Three fourths of the world oil reserves are in countries ruled by authoritarian regimes. They have an incentive to exploit the reserves much faster than it would be optimal in a perfect world with well-defined property rights.

The second reason why the supply side of the carbon markets isn’t working as it should is the climate change itself. Would prices of carbon products reflect the true costs (i.e., would these costs be internalized, as carbon emissions are a typical case of an external effect), the exploitation paths would have to be much flatter – what means that the carbon emissions would be much lower. But because we are not living in a perfect world, they are not.

These two phenomena lead, according to Sinn, to a much higher than optimal, price-inelastic supply of carbon. Because of the low price-elasticity cap’n’trade and other policy approaches to reducing the demand for oil, coal and gas in the developed world represent a kind of indirect price-subsidy for the other countries that have not ratified the Kyoto Protocol (as well as the so called Annex-II countries) – and thus don’t lower the overall consumption/emissions of carbon.

The problem of Sinn’s analysis and, at the same time, the main point of criticism by commentators, are his proposals what is to be done. The only ones he himself views as feasible are a tax on capital yields, imposed at source (for an explanation, which is not straightforward, see the link above (p. 42) or, for English, here (p. 27)), and/or a globally binding and rapidly implemented cap’n’trade scheme, including all countries of the world. And even these are problematic, as he claims.

All in all, the research by Sinn shows that what we do have to achieve is a (really) global post-Kyoto agreement aiming at reducing carbon emissions soon. Otherwise our effort won’t be of any benefit. This shows one more time the global dimension of global warming and the fact that we can’t cope it isolated. The response must be a global one.

[2012/02/03] P.S. There is one major weakness in Sinn’s argument: it rests to a considerable extent on the application of the so-called “Hotelling’s rule” for extraction of non-renewable resources. However, while the rule is a theoretically compelling application of the rationality principle under competitive markets, empirical studies have shown that the reality is all but different. This certainly is an important drawback of Sinn’s paradox.

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