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9. The effects of CO2 reduction policies on energy markets

John P. Ferriter

1. Introduction

Numerous studies have now been completed on the macroeconomic effects of policies (mostly carbon taxes) to reduce greenhouse gas emissions.! These analyses show a range of economic effects that might be expected in the long term. But most long-term analyses are unable to give detailed descriptions of the next 10 to 20 years. This is the period for which governments have set CO2 reduction or stabilization targets. It is a difficult period for policy makers. The risks and costs associated with climate change may remain uncertain for at least 20 years to come, and these uncertain costs have to be balanced against the possible costs to the economy of early intervention to reduce CO2 emissions. In this context, policy makers have been eager to find "no-regrets" strategies, which reduce CO2 emissions but which would be fully justified by other policy objectives. Even a carbon tax, ostensibly aimed at reducing CO2 emissions, might be justified as a "no-regrets" strategy if it showed other benefits. These could include reduced dependence on imported fuel, the stimulation of technical progress in industry, reduced local pollution, and reductions in other taxation. Nevertheless, recent discussions about the BTU tax in the United States and the carbon/energy tax in Europe give an indication of the uncertainties about the timing and manner in which any tax might be introduced.

This paper examines some of the issues that might arise in energy markets during the next 20 years, using results from modelling by the International Energy Agency (IEA) of world energy markets over the period 1990-2010. Fuel markets will be the main focus of policies to reduce emissions of CO:. Most policy measures will aim either to limit or reduce the amount of energy consumed, or to change the form of energy used to acquire a given energy service.

As has frequently been stressed (Hoeller and Coppel, 1992; IEA, 1993b), carbon-based fuels are not currently priced or taxed to reflect their relative carbon content. Governments already intervene in energy markets for reasons including energy security, the local environment, social welfare, employment, and industrial competitiveness. Any policy to reduce energy demand or encourage fuel switching will be applied on top of a host of other measures and may have only marginal effects in some sectors. Without coherent action to deal with all of the policy objectives associated with energy use, we therefore start from a less than optimum position. Thus suboptimal economic efficiency of policy impact is to be expected and counter-intuitive consequences should not surprise us.

Approximations and simplifications are inherent in almost all modelling efforts and the IEA model is no exception. One of the most difficult areas to treat effectively in such models is the process of technical change, especially during times of rapid transition. Although we can use econometrics to relate energy efficiency to income and energy price, such a relationship cannot take account of the potential for technical breakthroughs or switching to fuels and energy sources that have not been widely used in the past.

It is similarly impossible to account in an econometric model for the uncertainties associated with the politics of fuel supply and for some of the unexpected results that may occur because of the way policy measures are implemented. World market prices for fuels in the IEA model are exogenously determined and these issues have been considered in choosing the price trajectories. Sensitivity analysis gives some idea of the effect of the variability of world market prices.

A further area that has been modelled at a minimal level of detail is the effect of changing market structure. Energy demand and prices, as well as the price elasticities of demand, are likely to be changed by the moves towards open energy markets and private ownership.

In analysing the results from the IEA model, this paper does not pretend to be giving a "correct" view of the effects of government policy in energy markets. It does give a view of the sectors and regions where different types of policy are likely to be most effective, and it identifies areas where further investigation is needed to improve our understanding of the effectiveness of policies.

2. Background - Energy markets and policies

Energy markets are dynamic, complex, interdependent systems, built on massive capital investments and relying on fuel supply systems that are in part commodity markets and in part dedicated transportation and conversion systems. Energy suppliers meet a constantly evolving and very broad spectrum of demand for energy services.

Markets for different energy forms are interdependent in a variety of ways. For example, gas and coal prices are often linked to the oil price in contracts; substitutable energy forms such as gas and electricity will have their prices linked through market forces; in other cases where energy products are co-produced, cross-subsidies can occur, one product having a highly variable price while the other's price is constant. These effects can confound efforts by governments to intervene in the market. To the extent that human behaviour is unpredictable, surprising effects can come from decisions made by fuel producers, commodity speculators, and energy service consumers.

The fuel mix in a regional market will depend greatly on the resource endowment of a region and the cost of extraction. It will also depend on the mix of demands for specific energy services, such as transport or refrigeration, where particular forms of energy are preferred. Thus, heterogeneity of energy markets is the point of departure for any analysis of their response to policy interventions.

Our definition of CO2 reduction policies covers a broad range of government interventions. Parts of the energy industry are regulated to a greater or lesser extent, involving significant government ownership and/or direction in some countries. However, the focus in analysis of CO2 reduction policy has been on market measures such as carbon taxes or energy efficiency standards rather than on measures to alter institutional factors. Market measures are more easily modelled than institutional changes and we view carbon taxes, or other price signals, as the most efficient way to induce the optimum response. Yet a broad spectrum of policy measures must ultimately be considered. Those most often mentioned in the CO2 reduction context are: fuel-use restrictions; taxes and other fiscal instruments (including changes in fuel and technology subsidies and in R&D spending); regulations such as energy efficiency standards; and voluntary agreements with industry. Companion policies, such as emissions trading or joint implementation, are often advocated to improve the economic efficiency with which national or regional emission targets are met. Other policies of an economic reform nature, such as opening up access to electricity or gas transmission, have been mentioned in the context of climate change as "no-regrets" strategies. OECD countries already have considerable experience with all of these approaches to energy policy.

Policies to reduce emissions from the energy sector can do so by causing: (i) a reduction in fuel used without altering the quality of energy service (increased efficiency); (ii) a reduction in fuel used through a reduction in the service or in its quality (conservation); and/or (iii) a switch to a fuel with less or no carbon content while delivering the same service. Using carbon-stripping technologies is another response, but one that is currently not commercially available. See the appendix at the end of the chapter for a summary of the main policy types discussed in relation to CO2 emission reduction.

3. The World Energy Outlook: A reference scenario

The IEA has updated its World Energy Outlook (WEO) using its medium-term energy econometric model (IEA, 1993a). Simultaneously we decided to use the model to investigate the effects of certain CO2 reduction policies on energy markets. To do this we used the WEO model itself as a reference case and then created three policy scenarios: two carbon tax cases and one efficiency-driven case. The reference case assumes no major policy changes. We describe this case in some detail below.

Our results are similar to those from other models for energy and emission trends. In the WEO model, world energy demand grows by 48 per cent from 1990 to 2010. Three regions are defined in the model: (1) the OECD member countries (OECD); (2) the newly independent states and the Central and Eastern Europe economies in transition (NIS/CEE); and (3) the rest of the world (ROW). Over the period modelled, both OECD and NIS/CEE shares of energy consumption fall vis--vis ROW: OECD drops from 53 per cent to 46 per cent, NIS/CEE drops from 21 per cent to 15 per cent, and ROW rises from 26 per cent to 39 per cent (see fig. 9.1).

The use of fossil fuels grows significantly over the period: coal consumption rises by 44 per cent, oil by 33 per cent, and gas by 66 per cent. Of the increase in total fuel use, coal represents 27 per cent in energy terms, oil 39 per cent, and gas 30 per cent. Fuel shares change less dramatically than they did over the period 1971-1990 (see fig. 9.2).

Fig. 9.1 World total primary energy demand, 1971-2010 (Source: TEA, 1993a)

Fig. 9.2 World primary energy shares, 1971-2010 (Source: IEA, 1993a)

World trends mask some opposing trends in the three regions. For example, ROW and OECD coal growth is somewhat offset by reductions in coal consumption in the NIS/CEE. About 85 per cent of the net growth in coal demand occurs in the ROW. Oil growth is 72 per cent ROW and 26 per cent OECD. Gas growth is 48 per cent ROW and 44 per cent OECD. World electricity production grows 73 per cent. Electricity's share of primary energy continues its growth (from 25 per cent in 1971 in both the OECD and the World to 42 per cent and 38 per cent respectively in 2010). The shares of fuel for electricity generation continue to change between 1990 and 2010, with oil down 5 percentage points, gas up 8 percentage points, and nuclear down 5 percentage points.

Growth in OECD energy demand is greater in 1990-2000, slowing down during 2000-2010. The highest growth rate is in the OECD Pacific region, followed by OECD Europe and then North America. Although growth in ROW energy demand shows a similar slow-down in 2000-2010, the absolute growth rates are over three times higher in ROW than in OECD. Energy intensity declines worldwide, more in OECD than elsewhere and less where economies are in transition. Increasing electrification leads to a decrease in total final consumption (TFC) in relation to GDP, e.g. electricity demand growth is faster in North America during 2000-2010 than in 1990-2000. Lack of infrastructure in ROW retards the penetration of gas, and limited financial resources in both the ROW and NIS/CEE limit the uptake of more efficient technologies. Continued growth in the transport sector accounts for almost all of the incremental oil demand in the OECD.

Under the reference case assumptions, annual world carbon emissions rise from 5,880 million tonnes in 1990 to 8,600 million tonnes in 2010, or 46 per cent (see fig. 9.3). OECD carbon emissions rise from 2,830 million tonnes to 3,600 million tonnes by 2010, or 28 per cent. Increases vary among the OECD regions, rising 25 per cent in OECD North America, 48 per cent in the OECD Pacific region, and 24 per cent in OECD Europe. The faster rise in the OECD Pacific is due to a higher expansion of energy demand, occurring through a higher rate of economic growth than in North America and Europe, and despite the significant further addition of nuclear power plants in Japan.

Carbon emissions from the NIS/CEE region follow the same path as energy consumption, first falling and then returning to the 1990 level of 1,300 million tonnes by 2010. Carbon emissions from the ROW countries increase from 1,750 million tonnes to 3,700 million tonnes of carbon in the same period, or a rise of 111 per cent. By the end of the projection period, therefore, more carbon originates in ROW countries than in the OECD region. The major reason for this is the much faster rate of growth in energy demand in ROW countries cited earlier. Moreover, the major energy input into power generation in two of the most important and fastest-growing non-OECD countries - India and China - is coal, the most carbon intensive of the fossil fuels. In the absence of the improvement in efficiency of power generation that has been assumed in the reference case for these countries, their growth in emissions could be even faster. These two countries also account for 45 per cent of the world's population additions by 2010.

Fig. 9.3 World carbon emissions, 1971-2010 (Source: IEA, 1993a)

The robustness of the carbon emissions in the reference case was tested against alternative economic growth assumptions and lower oil and gas prices. Even under rather pessimistic economic growth assumptions, world carbon emissions over the projection period grow by at least 38 per cent. Under a scenario of low oil and gas prices (based on flat US$20 per barrel to 2010), emissions from OECD exceed those of the reference case by only about 3.7 per cent. Emissions from the ROW countries rise by some 5 per cent above the reference case if lower prices prevail.

4. Two carbon tax cases

Two carbon tax sensitivity cases (US$100 and US$300 per tonne of carbon emitted) were simulated with the WEO model. In both cases, nearly one-third of the tax is imposed in 1993 with the remainder added in annual increments of almost US$4 in the US$100 case and US$12 under the US$300 case. These taxes are in addition to any excise or other taxes currently in place (see fig. 9.4) and are applied to final energy prices in the model. It must be emphasized that we are using these two cases to investigate the effects of large carbon taxes, not to represent any existing government policies. In the real world, carbon taxes are not likely to be introduced so soon, or with such high starting levels.

Fig. 9.4 Implicit carbon taxes, 1988 (Note: Coal is taxed only in Sweden)

Fig. 9.5 OECD carbon emissions: Carbon tax cases relative to reference case, 1990-2010

Figure 9.5 illustrates the emissions growth for the two tax cases and the reference case described above. Emissions in 2010 under the US$100 tax reach 3,300 tonnes, compared with 3,620 tonnes in the reference case (a 9 per cent reduction). This is still well above the 1990 level of 2,830 million tonnes per year. Under the tax of US$300 per tonne of carbon, emissions reach 2,990 tonnes in 2010, somewhat above the 1990 level and 17 per cent below the reference case.

The use of all fossil fuels is reduced in both tax cases (except natural gas under the US$100 tax), as shown in table 9.1. The reduction in contribution to total primary energy supply (TPES) is greatest for coal, then oil, and finally gas. Reductions in final energy use are greatest for oil, then coal, then electricity, and then gas. Contributions to CO2 emission abatement follow the same ranking, as shown in table 9.2. Tripling the level of carbon tax only doubles the emission reduction, reflecting the diminishing scope for substitution between fuels in the medium term and implying that the effectiveness of the carbon tax is reduced as the tax gets higher.

5. An efficiency-driven scenario

An "efficiency-driven" scenario (EDS) has also been constructed. Under this scenario, the efficiency of energy conversion and use improves faster than in the reference case. The improvement rates are exogenous to the model and are based on the introduction of commercially available technology over the period (IEA, 1991, 1992a). In the reference case, the rate of take-up of technology is based on historical trends. Waste heat in power generation is also assumed to be utilized to a much greater extent than at present in all OECD regions. Table 9.3 details the efficiency assumptions used to construct this case. It is not suggested that these improvements would arise exogenously or that they would follow naturally from market factors. Implicitly these accelerated efficiency gains are achieved through some form of regulation or behaviour changes, which we have not specified.

By 2010 energy use is reduced relative to the reference case by 25 per cent in the residential/commercial sector, 7 per cent in the industrial sector, and 10 per cent in the transport sector. By our own assumptions, the EDS's effects involve no fuel switching in the industry or residential/commercial sectors. We have assumed some switching from gasoline to diesel cars in the transport sector.

Under these assumptions, emissions in Europe and North America by 2010 return almost to 1990 levels while in OECD Pacific some growth in emissions still occurs. Emissions for the OECD grow on average by less than 0.4 per cent per annum, compared with 1.2 per cent per annum in the reference case (see fig. 9.6). Whereas emissions in the reference case grow almost in line with primary energy, under this scenario they increase at just over half the energy demand growth rate of 0.6 per cent per annum. This is due to the growing proportion of non-fossil fuels in electricity base-load: non-fossil capacity grows at 1.6 per cent per annum in all cases, so that reduced electricity demand results in a reduction in fossil fuel use only.

Table 9.1 The effects of tax cases on fuel use relative to reference case

Fuel

In TPES

In TFC

US$100

US$300

US$100

US$300

Mtoe change

% of reference case use

Mtoe change

% of reference case use

Mtoe change

% of reference case use

Mtoe change

% of reference case use

Coal -230 -20 -306 -26 -57 -22 -100 -39
Oil -96 -5 -250 -13 -96 -5 -233 -13
Natural gas +6 0 -148 -12 -36 -5 -94 -13
Electricity - - - - -41 -5 -96 -12


Table 9.2 The effects of tax cases on CO2 emissions associated with fuel use (MtC change relative to reference case)

Fuel

Emission change

US$100

US$300

Coal in TFC -62 -109
Oil in TFC -81 -196
Natural gas in TFC +23 -60


Table 9.3 Efficiency assumptions for reference case and efficiency-driven scenario

 

Reference case

Efficiency-driven scenario

Use of heat produced as co-product in power generation
North America 6% 12%
OECD Europe 6% 12%
Japan 1% 7%
Residential/commercial sector energy efficiency improvement
All regions   1.5% p.a. energy savings (extra 25% in 2010)
Industrial sector energy efficiency improvement
All regions   0.4% p.a. energy savings (extra 7% in 2010)
Transport sector energy efficiency improvement
Air transport
All regions 1% p.a. 2% p.a.
Freight transport
North America and OECD Europe 0.5% p.a. 1% p.a.
Japan 1% p.a. 1.5% p.a.
New ear improvement by 2010
North America 19% 43%
OECD Europe 15% 47%
Diesel share in passenger transport
OECD Europe 14% 28%
North America 1% 14%

Fig. 9.6 OECD carbon emissions: Efficiency case relative to reference case, 1990-2010

6. Regional and sectoral differences in the three policy cases

Regional differences

Primary coal and gas prices and the taxes on energy products are lower in North America than in other regions, so that a given level of carbon tax leads to larger percentage increases in end-use prices. Prices combine with other factors such as economic structure, current fuel use patterns, and growth rates in their effect on carbon emissions. Nevertheless, under the US$300 tax, emissions stay close to 1990 levels in North America, rise slightly in Europe, and are about 13 per cent higher in OECD Pacific, reflecting the assumed, sustained higher growth rates in that region.

In all three sensitivity cases using the IEA model, over 50 per cent of the OECD emissions reductions occur in North America, about one-third in Europe, and the rest in the Pacific region, mainly Japan (fig. 9.7). These are roughly the regional shares of primary energy use in 1990. The EDS is more effective in reducing energy use than the US$300 carbon tax, although the US$300 case is slightly more effective than the EDS in achieving emissions reductions (see figs. 9.8 and 9.9.)

In the carbon tax cases there is more regional variation in energy savings than in emissions reductions. The US$300 tax leads to 17 per cent final energy savings in North America, but only 6 per cent in Europe. The Japanese savings are slightly more than in Europe. The OECD's GREEN model and other modelling produce generally the same results. The reasons for these regional differences are examined below.

Fig. 9.7 Carbon emission reductions, OECD 2010: Three cases regional breakdown

Fig. 9.8 Carbon emission reductions, OECD 2010: Three cases sectoral breakdown

Figure 9.10 shows a comparison between the Commission of the European Communities' (CEC) model, looking at the effect of the CEC's proposed energy/carbon tax, and the IEA model output for Europe. The CEC tax has much less effect than any of the WEO cases because the tax is much lower (equivalent to roughly US$70 on oil per tonne of carbon), and is introduced gradually over the period to 2000. The tax is disproportionately higher on gas and nuclear, but lower on coal, than a pure carbon tax. In the CEC model, gas use decreases with the tax, with gas for power generation going down as well as in end use. With the US$100 tax, the WEO produces increases in gas use for electricity generation in all regions. It produces a decrease only in the higher tax case.

Fig. 9.9 Energy use reductions, OECD 2010: Three cases breakdown by fuel

Fig. 9.10 Energy use reductions, OECD Europe 2010: The three cases and the CEC carbon tax case

Sectoral effects

In examining the responses of energy consumers to policy measures, there are important distinctions between individuals such as car drivers and home-owners making personal decisions, and industrial or corporate decision makers. For personal decisions, lifestyle and personal values can often have more influence on fuel-use decisions than price signals, whereas industry is generally expected to be more price responsive. Industrial consumers generally have better access to information about alternative technologies and to the capital needed to invest in them.

Fig. 9.11 Carbon emission reductions, OECD 2010: Three cases sectoral breakdown

Figure 9.11 presents breakdowns by sector of carbon emissions reductions for the three cases. The sectoral emissions reductions in the two tax cases are in more or less the same proportions. Changes in power generation provide roughly 50 per cent of emission reductions, final fuel use in industry roughly 25 per cent, and the transport and residential/commercial sectors the rest.

The EDS differs significantly in its sectoral effects from the carbon tax cases. Changes in electricity generation account for roughly 55 per cent of emissions reductions and there are significant differences in end-use sectors. Excluding electricity, the transport and domestic sectors each account for roughly 40 per cent of the reduction in emissions from final energy use, while industry provides the rest (20 per cent). The EDS is far more effective in the "problem" residential/commercial sector.

Figure 9.12 shows the breakdown of emissions reductions by sector for each region in the US$300 tax case. The differences in the sectoral contribution to each region's emission abatement are mostly explained by differences in the sectoral shares in emissions in the reference case. Even the percentage changes in transport energy use are similar in North America, Japan, and Europe, which may seem surprising given the higher reference case fuel price in Europe and Japan to which the tax is added. Different turnover rates and saturation of vehicle-miles travelled in North America account for the closeness of the reductions. Fuels are affected differently according to sector. Faced with carbon taxes, industry tends to reduce electricity use more than gas, whereas the residential/commercial sector reduces gas more than electricity.

Fig. 9.12 Carbon emission reductions, OECD 2010: Regional and sectoral breakdown, US$300 tax case

The relationship between primary energy prices and consumer energy prices

One reason for the apparent insensitivity of energy demand in the transport and residential/commercial sectors to high levels of carbon taxes is the relatively modest impact of the taxes on the prices that consumers actually pay. Whereas the imposition of a US$100 carbon tax is likely to increase gasoline prices by about 20 per cent in the United States, prices would increase by less than 8 per cent in Europe and Japan. Similarly, the impact on the price of residential gas is around 22 per cent in the United States, 12 per cent in Europe, and less than 6 per cent in Japan. Whereas a US$100 carbon tax is greater than the primary coal price by 2010, its impact on the price of electricity, by far the largest consumer of coal, would be less than 10 per cent in Europe and Japan. Thus, unless carbon taxes are set at a very high level, the reaction of energy consumers is expected to be moderate.

Fig. 9.13 Indices of real energy end-use prices: Total OECD (Note: 1985 = base year for "total energy" price; further moving averages of 4 quarters are used. Source: International Energy Agency, Paris)

7. The effects of CO2 reduction policies on energy commodity markets

The nature of energy commodity markets

Crude oil is the largest single commodity traded on world markets in dollar terms. It represents 75 per cent of the world trade in fossil fuels partly because of its ease of transport, storage, and use. Markets for gas tend to be organized regionally; in the case of coal, sources are linked to particular users. Although the coal industry has made great strides in developing preparation and blending techniques to increase the number of potential buyers, improved coal products make up a very small percentage of coal in international trade. Because of its ubiquitousness and flexibility of use, oil tends to be the price leader, with coal and natural gas following (see fig. 9.13).

Energy commodity markets are not entirely distinct, but major regional markets are recognized in North America, Western Europe, Central and Eastern Europe and the newly independent states, and the Asia/Pacific region. Some national economies are virtually self-sufficient in energy, especially for gas and coal.

There is a high degree of government ownership in many regional markets, whether developed countries, economies in transition, or developing countries. Government control is especially prominent in the utility sector but it is also significant in natural gas and oil production and transformation. Government control generally inhibits the efficient functioning of the markets for these fuels, for example in limiting market access and competition among suppliers or by ensuring cross-subsidies to certain consumer sectors.

Concurrently it will be important to understand the strength of other changes that have been set into motion in energy commodity markets. Examples are the effects of a global trend (particularly in a number of large ROW and NIS/CEE greenhouse gas emitters) to eliminate energy subsidies and to open up markets to greater competition.

The effects of removing subsidies should not be overestimated. In competitive situations, producers may not be able to raise prices to cover the loss of former subsidies. In situations with other types of government control, the removal of subsidies alone might not "free" the producer from other regulations that constrain fuel choice.

Although the elimination of consumer subsidies is expected to lead to a reduction in demand for some fuels, greater competition in energy markets could reduce prices and raise demand. In some regions, including parts of OECD Europe, protection of indigenous coal production is being reduced, allowing cheaper imports into the market. Coal prices could be reduced relative to those of oil and gas, resulting in a shift towards a fuel mix with a higher carbon content. Conversely, open access to electricity grids for power producers, especially small suppliers, could lead to an increase in co-generation and renewable energy use. Furthermore, the move away from government ownership and control could result in higher discount rates being used for energy-related investment. In electricity systems this might result in a move away from nuclear and coal toward less capital-intensive capacity such as oil- or gas-fired plant.

In an energy commodity market such as the Japanese market, even without direct fuel-use requirements, a considerable amount of "administrative guidance" creates a "price wedge" that keeps the prices of fuels higher than the world price although the fuels are not actually taxed. Although either the European or the Japanese case has the effect of a tax on demand, it is not clear what would happen if other policies were superimposed in order to reduce greenhouse gas emissions. One could easily imagine the wedge reducing somewhat in the face of new taxes, with the net result being a lower price than one might calculate taking the actual price and simply adding the tax to it.

Coal market issues

In all three CO2 reduction policy cases using the IEA model, coal in OECD primary energy supply falls relative to the reference case. The 2010 level is below the 1990 level in the US$300 tax case. Carbon taxes are likely to have more effect on coal than on other fuels because coal contains more carbon per unit of energy. However, coal is also at a disadvantage relative to oil and gas in that it is mainly used in non-premium applications. Although some oil products (mainly heavy fuel oil) are sold in these non-premium markets, oil companies may be able to pass on most of the carbon tax to consumers of premium fuels in the transport sector. Similarly gas producers may be able to raise residential gas prices more than commercial contract prices. Fuel suppliers are likely to cross-subsidize their customers in this way to some extent, regardless of whether taxes are imposed on primary fuels or on final energy products. Thus, not only is coal more affected than other fuels by a carbon tax, it is also likely to be disproportionately more affected in the markets where fuel switching is easiest.

OECD carbon taxes could affect the coal market in the rest of the world. Reduced OECD demand could lead to a fall in the pre-tax price. However, if the tax is applied only in the OECD, rising demand in other regions may stabilize the market. Meanwhile the movement in the OECD and former Comecon countries away from domestic coal subsidies will increase demand for imported coal.

Countries typically have energy systems (especially electricity generation) based largely on their indigenous resources even when these take the form of relatively highly polluting coal. Most of the world's very large CO2 emitters are also very large energy producers. Included in the top 10 CO2 emitters are the United States, Russia, China, India, Ukraine, and Canada, which are large energy producers although some of these are not exporters (IEA, 1992b). Some governments might be expected to continue to shield certain fuels from the effects of carbon taxes, offsetting some of the demand-dampening effect of the CO2 reduction policy.

Oil markets

It is not possible to predict how major oil-exporting countries would react to an OECD-wide tax. To date they have criticized such proposals as being an incursion on the rent that should be theirs as owners of the oil resources. They correctly point to the existing taxes on fossil fuels and note that premium oil products in most OECD countries already bear high taxes. Producers may attempt to increase volume to offset the revenue losses stemming from a carbon-tax-driven lower demand, or they may prefer to reduce exports to the OECD, given that markets are growing elsewhere.

Natural gas markets

Gas is the only fuel for which consumption is increased overall under any of the CO2 reduction policy cases and electricity generation is the only sector in which this occurs for the OECD as a whole. There are some regional variations, and increases in gas used for electricity generation in Japan and Europe are masked by larger decreases elsewhere.

The trend towards the use of natural gas, particularly in Europe and Japan, leads to questions about the speed and cost at which fuel substitution could be achieved. In the European and Japanese markets, significant incremental gas supplies would have to be imported and preceded by major investment in production and transportation systems. Policies intended to encourage switching away from high carbon fuels could be frustrated, or their effects delayed, by a lack of infrastructure for natural gas, the regional concentration of resources, and the expense and time-lags to build the infrastructure to connect them to distant new users.

The Pacific gas market, where rapid growth in energy demand exists, will remain dominated by liquefied natural gas (LNG) for the next two or three decades at least. LNG markets are only beginning to go into their "second era": the first of the early 1970s' contracts are being renegotiated and, unlike the first contracts, formal contract re-opener or price review clauses have been introduced. In future there is likely to be more competition between LNG suppliers than in the past 20 years. As more markets open for LNG, and given variations in demand in different countries, there are greater prospects of lower-priced spot cargoes. Against this, LNG depends on large investments in terminals and no new projects are assured at current prices.

One of the biggest uncertainties in the European energy commodity market is the stability of the supply of oil and gas from Russia and other newly independent states. These countries are strongly motivated to export gas and oil to obtain Western currency, but political instability and poor infrastructure lead to uncertainties about the availability of the fuels. Deep economic recessions in recent years have led to declines in fossil fuel use, potentially freeing up supplies for export. Many of these countries are in the process of raising domestic energy prices, which will continue to have some dampening effect on demand. The European Energy Charter, with its emphasis on opening and improving the technical aspects of energy commodity trade, is also an important step in stabilizing the European energy commodities markets.

Other factors mitigate against the availability of oil and gas from the former Comecon region. Carbon taxes are not likely to be introduced by these countries in the near future, but some may move away from existing coal and nuclear energy use for environmental and safety reasons. In this case, domestic demand for gas, which is already significant, could increase rapidly. Oil demand is also likely to increase rapidly as a result of increasing car use.

8. Areas for further study

There is clearly a need for more work on the analytical base from which we make conclusions about the costs and effects of CO2 reduction policies. For example, further elaboration of the IEA model could take account of the technical possibilities, including the introduction of non-fossil fuels and the retrofitting of existing energy-using equipment, especially in electricity generation, to use low-carbon fuels.

More importantly, several different analytical approaches are needed to comprehend the full range of effects on the economy, including the energy sector. Econometric modelling is only one of these tools one that is particularly suited to examining the effects of policy measures in the short to medium term.

Linkages with other modelling efforts must continue. This will allow the analysis to incorporate the impacts of CO2 reduction policies on economic activity and the important feedback effects of changes in economic activity on energy demand and prices, on fuel commodity markets, and on the rate of carbon leakage.

More questions have been raised than answered in this paper, but this was by design. More attention must be given to in-depth analysis of CO2 reduction policies and energy markets. At the OECD/IEA Conference on the Economics of Climate Change in June 1993 in Paris, participants raised a number of questions for further analysis.

• How will the costs of carbon taxes be distributed between fuel producers, suppliers, and consumers? How is this affected by moving the point at which the tax is levied?

• How might OPEC react to carbon taxes or other CO2 reduction policies?

• What does the historical relationship between crude oil prices and oil product prices tell us about the way carbon taxes would be passed on to consumers?

• How will changing government intervention in coal markets modify the effects of carbon taxes?

• What are the financial implications of the capital costs associated with switching to natural gas on a very large scale vis--vis interest rates and the financing of energy investments in general? On what time-scale?

• What are the options for moving natural gas to key markets, and what are the economic and political constraints on various source and/or transportation options?

• Will exporting countries (again) wish to retain significant natural gas supplies for domestic consumption, for both environmental and trade-competitive reasons?

• In choosing fuels for power generation, will utilities be able to select among fuels freely, taking into account not only price (including tax) but also supply security and other factors, or will price be the only determinant allowed by the regulators?

• How do emissions trading, power-wheeling, and other efforts to find least-cost approaches affect the cost-effectiveness of CO2 reduction policies?

9. Conclusions

The IEA's energy modelling work has shown, within the assumptions applied, that a US$300 per ton carbon tax might be able to reduce OECD carbon emissions in 2010 nearly to 1990 levels. This level of tax is far beyond any that has been seriously discussed in international forums, yet governments already intervene to a greater extent, and in some instances at considerable cost to national budgets, in parts of the energy market. Institutional and transitional issues require careful consideration on a national and regional basis. Opening up energy markets and reducing subsidies could reduce the economic costs of applying CO2 reduction policies. The degree and timing of the implementation of a policy could be fine tuned to divert future investment toward more environmentally friendly fuels and technologies without resulting in excessive disruption in the economy.

The reader is strongly cautioned against concluding that either a regulatory approach, or the use of fiscal or financial incentives, could achieve CO2 stabilization at little or no cost. Considerable further work should be done to develop a better understanding of the possible economic impact of regulations, taxes, and other fiscal measures before such a judgement is made.

The analysis presented here does suggest that a mix of policies may be the most effective, although not the most cost-effective, approach to reducing emissions. In the foreseeable future, it appears unlikely that OECD governments will adopt substantial carbon taxes. Voluntary agreements with industry are receiving increasing attention. All measures attempting to bring emissions back to 1990 levels by reducing demand or improving efficiency have to be continually strengthened to hold emissions at 1990 levels. The effects of achieved improvements in efficiency could lead to increased energy use elsewhere in the economy. Decreased GDP might suppress gains in energy efficiency through reduced capital replacement.

A hedging strategy would contain a balance of measures to improve the efficiency with which we use energy (e.g. through voluntary agreements, performance standards, and incentives), with a much heavier emphasis on R&D to make renewable energy sources competitive earlier. Two major questions brought out in an OECD/IEA model comparisons project relate to the rate of autonomous energy efficiency change and the availability of backstop technology. These both depend on clear policy signals such as encouragement of R&D and the creation of necessary market conditions.

The results of the IEA World Energy Outlook model also point to the need for realistic and palatable policies not only for the OECD but also for relations between the OECD and the rest of the world. This may include examining the potential for investment in clean energy supply and industry, but also programmes to facilitate local initiatives for the efficient and clean use of energy. For the OECD, energy efficiency standards or voluntary agreements may be needed to address energy use in the residential/commercial sector and for transport. Where taxes are effective, such as in industry and in affecting the electricity fuel mix, these might be the preferred route. Meanwhile we should not forget that governments themselves are a major wild card in the design and implementation of CO2 reduction policies. Subsidies and fuel-use restrictions are still widespread inside as well as outside of the OECD. Thus, much reform of local and regional energy policies is required within countries, which could go a long way to reducing the severity of any eventual national or international policy actions needed to reduce CO2 emissions.

Appendix: Commonly proposed CO2 reduction policies

Instrument

General purpose Specific GHG application
Economic or quasi-economic
Taxes (carbon, BTU, or combination) Induce behaviour changes Reduce CO2 emissions, or reduce energy use, or both
  Raise funds for programmes R&D or grants for efficiency or renewables
Subsidies Induce behaviour changes or provide funds for specific behaviour or R&D Efficiency or renewable investments and development
Price supports Increase use of "desirable" fuels Increase use of non-fossil fuel
Other (regulatory and quasi-regulatory)
Fuel-use requirements and restrictions Force users to move to more "desirable" fuel or prohibit use of "undesirable" fuel Increase nuclear and renewables
Performance standards Force greater efficiency or fuel switching Decrease emissions
Voluntary programmes(for industry or individuals) Induce beneficial actions, often by "carrot" (financial incentives) or "stick"(possibility of regulation or fines) Allow end-user to choose means for emission reduction
Regulatory planning approaches Require consideration of social good of fuels in supply planning Shift fuel choices to less polluting fuels and give efficiency a better chance to compete
Joint implementation and offsets/credits Reduce costs of compliance and accelerate beneficial actions Induce action in non-OECD countries as well as within OECD countries


Notes

1. This paper is based on a study prepared by Mr. Robert Skinner, Director of the IEA Office of Long-Term Co-operation, with contributions from Ms. Connie Smyser, Head of the IEA Energy and Environment Division, and Mr. Laurie Michaelis, Administrator, Energy and Environment Division, and presented to the OCED/IEA Conference on the Economics of Climate Change, 14-16 June 1993 in Paris. It is further derived from research conducted by Mr. Robert Reinstein, consultant, and Ms. Christina Shhle, IEA Energy and Environment Division. Much of the discussion of the World Energy Outlook and the policy cases is derived from IEA (1993a). For more details on the IEA's model, see Vonyoukas (1992).

2. The results obtained from the IEA econometric model differ from those derived from the OECD GREEN model and from other models. This is because of the very different structures of the different models, the different time-periods considered, and the degree to which existing capital stock and capital stock turnover rates are explicitly modelled. The IEA model was designed to analyse the world energy markets. It was not designed to assess macroeconomic questions and there is no feedback link for evaluating the impact of taxes such as those examined here on GDP.

The two carbon tax sensitivity cases differ from the reference case only in the taxes incrementally applied as described. GDP and fossil fuel supply costs were kept as in the reference case. The ability to resort to non-fossil alternatives such as hydro and nuclear was also constrained as in the reference case. The sensitivity analysis did not include effects on the NIS/CEE region or China.

3. The rise in emissions between 2001 and 2008 in the US$100 case is caused by a change in the merit order in the electricity generation submodel for Europe. This occurs as coal becomes cheaper with the opening up of European markets and increasing use of imported coal. Although in practice this effect might be smoothed, it draws attention to the possibility of unexpected changes in market conditions resulting in rises in emissions.

References

Hoeller, P. and J. Coppel. 1992. "Carbon taxes and current energy policies in OECD countries." The Economic Costs of Reducing CO2 Emissions. Paris: OECD Economic Studies No. 19, Winter.

IEA (International Energy Agency). 1991. Energy Efficiency and the Environment. Paris: OECD.

IEA (International Energy Agency). 1992a. Cars and Climate Change. Paris: OECD.

IEA (International Energy Agency). 1992b. Climate Change Policy Initiatives. Paris: OECD.

IEA (International Energy Agency). 1993a. World Energy Outlook to 2070. Paris: OECD/IEA.

IEA (International Energy Agency). 1993b. Taxing Energy: Why and flow. Paris: OECD.

Vouyoukas, L. 1992. Carbon Taxes and CO2 Emissions Targets: Results from the IEA Model. Paris: OECD Economics Department Working Paper No. 114.


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