Supply‐ versus Demand‐Side Policies in the Presence of Carbon Leakage and the Green Paradox

• Published date: 01 January 2019
• Date: 01 January 2019
• DOI: http://doi.org/10.1111/sjoe.12277

Scand. J. of Economics 121(1), 379–406, 2019

DOI: 10.1111/sjoe.12277

Supply- versus Demand-Side Policies in the

Presence of Carbon Leakage and the Green

Paradox*

Cathrine Hagem

Statistics Norway,NO-0177 Oslo, Norway

cah@ssb.no

Halvor Briseid Storrøsten

Statistics Norway,NO-0177 Oslo, Norway

hbs@ssb.no

Abstract

We consider a climate coalition that seeks to reduce global emissions in the presence of carbon

leakage and resource exhaustibility. We show that a credible announcement of future unilateral

supply-sidepolicies delays foreign emissions, and we derive the optimal combination of consumer

taxes and producer taxes when we consider leakages from free riders, both within periods and

across periods. The tax shares generally differ over time. A decline in the present value of the

social cost of carbon over time supports a time path where the consumers’tax share of the total

carbon tax also declines over time. We illustrate our findings with a numerical model.

Keywords: Carbon leakage; climate coalition; demand-side climate policy; green paradox;

supply-side climate policy

JEL classification:H23; Q41; Q54

I. Introduction

The Paris climate conference (COP21) in December 2015 led to an

ambitious global agreement on the goal for global warming; it should

stay well below 2 ◦C. However, the emission pledges made by the

signatories are far from sufficient to reach this target of 2 ◦C. Furthermore,

the commitments are not legally binding.1It is therefore reasonable to

*The financial support of the Norwegian Research Council is highly appreciated. Valuable

comments by Taran Fæhn, Michael Hoel, Bjart Holtsmark, Knut Einar Rosendahl, and two

anonymous referees are gratefully acknowledged.

1The agreement refers to the intended nationally determined contributions (INDCs) submitted

by the parties before the meeting. However, the targets specified in the INDCs are not legally

binding, and there is no enforcement mechanism to ensure that the pledges are met. Moreover,it

is not clear to what extent the targetsspecified in the INDCs always represent emission reductions

compared to a business-as-usual (BAU) scenario.

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The editors of The Scandinavian Journal of Economics 2017.

380 Supply- versus demand-side climate policies

suspect that the non-binding promises for emission reductions will not be

implemented by all countries.

Hence, there is a need for knowledge about how to construct more

ambitious agreements in a world where the willingness to contribute is

very unevenly distributed across countries. The starting point of this paper

is that a group of countries (home countries) establishes a climate coalition

that seeks to reduce global emissions, whereas the rest of the world

(foreign countries) pursue their self-interest (free riders). We assume that the

coalition can perfectly control consumption and production of fossil fuels in

its own region. However, both reduced consumption of fossil fuels (demand-

side policies) and reduced supply of fossil fuels (supply-side polices) within

the climate coalition affect the world market prices, and thereby emissions

from the free riders (carbon leakages). The climate coalition must take these

responses into account when designing its climate policy.

Most studies of carbon leakages have so far been carried out in a

static framework. Furthermore, these studies typically target consumption

of fossil fuels (i.e., demand-side policies); see Zhang (2012) for an

overview. To counteract the carbon leakage following from demand-side

measures, supply-side policies have been suggested (see Bohm, 1993).

A lower supply of fossil fuels causes the prices to rise and leads to

lower consumption among the free riders (negative carbon leakage). In a

static model, Hoel (1994) theoretically derived the (second-best) optimal

combination of producer and consumer taxes in a climate coalition, given

a target for global emission reductions.2

In the present paper, we analyze carbon leakages following from both

demand-side and supply-side policies. Furthermore, we analyze how the

climate coalition’s policy in one period affects carbon leakage, both in

the same period (within-period carbon leakage) and in other periods

(intertemporal carbon leakage).

Intertemporal carbon leakage follows from the fact that fossil fuels

are non-renewable resources. This was recognized early on by Sinclair

(1992), who pointed out that attempts to curb the use of fossil fuels trigger

a response from the producers of fossil fuels. In particular, the present

value of carbon taxes should decline over time, as an increase in carbon

taxes accelerates emissions. This is because an increase in taxes decreases

the future value of the fossil-fuel resource, making it profitable to move

extraction forward in time. Using similar reasoning, Sinn (2008) argues

2Fæhn et al. (2017) provide numerical illustrations of the optimal combination of demand-side

versussupply-side policies in a static setting. Harstad (2012) shows that leakage can be completely

avoided by purchasing fossil-fuel deposits and preserving them. Although this is a promising

result, buying foreign deposits for internal conservation might face several practical and political

problems. Therefore, wedo not consider that option in the present paper.

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The editors of The Scandinavian Journal of Economics 2017.