The Copenhagen Game

Written by Maximilian Held | December 10, 2009 | 1 Comment | Category: Opinion

The Big Ask is on: These days, the leaders of the world convene in Copenhagen for the 15th time to address that “greatest and widest ranging market failure ever seen“: Climate Change.

Will they ward off that Tragedy of the Commons of our time? We don’t know.

They are playing games in Copenhagen. Not of the entertaining kind, but of the intricately interdependent kind.

The Green Paradox is one of those intricacies: are we reckoning without our fossil-fuel supplying hosts? What are their stakes?

Let’s get the rules straight. Then let’s see what we can do to improve our collective odds for a cooler planet.

And while we’re at it, let’s level out this playing field.

We have long known that agreeing to avoid climate change can be an unhappy game: those who do not participate in the effort can still free-ride on its benefits, a cooler planet. And still, conventional ethics have it that everyone can make a difference. That is indeed the essence of traditional, unilateral green policies, from ecotax to EU-ETS and renewables: depressing or substituting carbon demand will make us better of, even if not everyone plays along.

The Green Paradox

Economist Hans-Werner Sinn warns us that this may not be so. If we ignore the supply side of fossil fuels, we’re just acting as inconsequential if naive fools.

Together with my colleagues Makaio Witte and Rasmus Relotius I recently presented Sinn’s argument in our public choice seminar, taught by Hans-Peter Grüner. Here’s the gist of it, and here’s the entire expose.

Mind the Sheiks (et al.).

Sinn looks at the decisions that owners of fossil fuels make in determining their extraction paths. In other words: when to transform how much of oil in the ground into dollars in their Sovereign Wealth Fund (or, in a more sinister version, their Swiss bank accounts).

Given a finite stock of resources, their mixture of oil in the ground and money in the bank is optimal when the two interests rates are same. Trivially, for the mathematically inclined, the optimality condition of their intertemporal portfolio allocation is .

Future Oil Price Expectations Matter …

The interest on capital is simply the long-term, risk-free capital market interest.

The interest on oil in the ground stem from the expected price development. If future prices are higher - due to increased scarcity, or demand, or both - the interest is positive. If prices are expected to fall, so does the oil interest rate.

Advise for a Sheikh: “As structural alternatives become more fully realized you need new strategies to maximize every penny of your existing resources.”
Fictitious derivatives trader Bryan Woodman advises the Emir’s family in the 2005 thriller “Syriana“.

… A Lot

A couple of unsettling implications arise from this rationale of resource owners.

For once, unilateral demand reductions will be offset by additional consumption from other countries. Prices will be depressed by the reduced demand, but, given that resource owners care only about the future development of resource prices, they will not change their extraction path. Instead, they will just sell some additional oil to the non-green consumers, initially at cheaper prices. These countries benefit from more oil at lower prices.

What’s more, if resource owners anticipate tightening green policies with the resulting falling prices in the future, they will frontload their extraction. The interest rate of oil in the ground, in that case, falls. The Sheik’s will pump more today and less in the future.

Extraction Paths: Slower is Better

A this point it may be helpful to restate the relatively obvious: to slow down global warming, the extraction path of fossil fuels matters. Global warming is a function of the stock of CO2e in the atmosphere. Resorption (biomass, deep ocean water) of CO2 doeshappen, but relatively slowly. To avoid an increase in the stock, our extraction must be smaller or equal to the rate of resorption. It follows that while me may, in the very long-term, extract all carbon (and we may be compelled to do so), it matters a lot when we extract. The slower, the later, the better.

How do we stop them from smoking?
(Ok, this one is for cheap visual effect. The water vapor from these cooling towers, of course, is harmless).

How to Respond?

Sinn of course provides the solution for his paradox, too.

The most obvious - if crude - solution is to create an effective, “carbon”tight demand cartel, that will set global emission levels, leaving the suppliers with no one to sell their cheaper oil or front-loaded extraction to.

Sinn also provides some creative ideas to change the parameters of the intertemporal portfolio optimization of resource owners. One way to tilt the Sheik’s rationale in favor of prolonging the extraction would be to reduce the specific capital market interest rate of resource owners. Sinn suggests a source-based capital gains tax on incomes generated by “oil money” in OECD capital markets.

Better Be Safe Than Sorry

Granted, Sinn’s arguments are empirically and logically contested: is the supply of fossil fuels really price inelastic? How, then can we explain the colossal fuel price fluctuations? Won’t the insatiable carbon demand of emerging market cancel out any Green Paradox effect, anyhow? Aren’t we at peak oil already?

First, we argue in our expose that actually, these criticism fall short of negating the dynamic suspected by Sinn: in saving the climate, the question is not whether extraction is not going to be expanded. It would be bad enough if it were not slowed as much as it could, absent a Green Paradox.

Secondly, and more broadly, fighting climate change is one of these issues where we should rather be safe - with some of Sinn - than sorry without him (german pun intended). In other words, even if there is only a slight chance that Green Paradox dynamics may arise, we must address them.

A Global “Kyoto” Will Partly Expropriate the Sheiks - A Deal Breaker?

But there is more to Sinn. If resource owners behave as he predicts (optimizing their extraction based on future capital market interest and fuel price), a contracting emissions trading regime will de facto expropriate the resource owners of part of the welfare they would have otherwise enjoyed. Resource owners loose welfare by realizing lower prices and depressed price expectations over all periods. This welfare is, in part, redistributed to net-importing countries who can raise revenue by auctioning off permits.

This redistributive dynamic is key to understand what may be at play in Copenhagen. If Sinn is right, it adds yet another fault line to the interaction: net carbon-importing countries than stand to win from a global carbon regime versus the net carbon-exporting countries, who stand to loose.

Abandoned gas station close to Merced, CA. Summer 2008.

What do resource owners stand to lose from decarbonization?

The Copenhagen Game

In what we call the Copenhagen Game, we model this fault line of the international climate negotiations. For those who like Game Theory, here’s the payoff matrix:

In this game, we assume the international green political economy to occupy some middle ground between Sinn, and the traditional view. We assume that net fossil fuel importers will be able to establish an effective, if imperfect demand cartel. They are able to depress CO2 consumption and carbon prices, even though not entirely. The net fuel exporters, conversely, suffer from lower prices, when a green policy is adopted, but are able to consume some of their surplus oil themselves, at a cheaper price.

As argued in the above, they will not join an international carbon demand cartel for fear of the redistributive effects, even though that would be collectively beneficia. For the climate, everyone should save carbon. Given the sharp concentration of costs at net exporters, however, the net importers will, in the net, benefit disproportionately from universal green policy.

If there is indeed a Green Paradox and a game with these incentives, prospects for a global CO2 regime and maximum climate change abatement are dim: in the above game, it will be individually rational for the exporters not to adopt a “new Kyoto”. The net fuel importers will best respond by adopting an incomplete ETS (this is formally referred to as a Nash Equilibrium, specifically an equilibrium in dominant strategies).

Sidepayments, Please

How do we get around this?

How do we make sure that in Copenhagen and beyond, everyonecommits to CO2 reductions, to abate climate change as much as possible at all?

In the logic of this game, we have to pledge the net exporters sidepayments, extra rewards to accept the losses incurred by lower fuel prices. The redistributive effect of a global ETS would then be offset, and it would be individually as well as collectively rational for everyone to adopt CO2-reducing policies.

How would this work in practice? Within a cap-and-trade regime, the net-exporting countries could just be allocated a greater number of emission rights which they could then sell.

A personal Green Paradox. Southern California, Summer 2008.

Sidepayments to Whom?

Who are these countries?

First, a note of caution: determining who stands on which side of this game is not straightforward, and positions are actually continuous rather than dichotomous. They depend on the ratio of costs and benefits from abating climate change and carbon demand reductions, respectively.

For oil, some countries are obvious net importers: the Gulf States, Venezuela, Iran, Norway, Russia, Mexico, or arguably, China.

Many of these countries, particularly the rich ones, already blessed by nature, may not easily warrant further redistribution from an ethical point of view.

Oil extraction in the Niger Delta. Via Flickr, originally uploaded by Sven.

No Oil, No Development?

And yet, for many of these, the revenues raised from selling of oil are the one hope for economic development and prosperity. These countries will not easily accept a deal that would negate these opportunities.

In addition, foregoing an additional unit of CO2e may be much harder for transition economies, with their insatiable demand for fossil fuels, that are so direly needed at their stage of development, resting on heavy industry, manufacture, and a massive expansion of infrastructure (think China).

Oil is in fact a very unique substance. No other material readily available has such a high energy density. Sinn even argues that it is the very discovery of oil which enabled economic modernization, saving humanity from a Malthusian world of linearly constrained resources, always outstripped by geometric population growth.

Getting the Genie Back in the Bottle

Is oil then the only way to prosperity and modernity?

For all our sakes, we can only hope that it is not. This planet surely would not endure another development path fueled by exploitation and waste - that road that the industrialized world was free to choose, and has learned to take for granted.

But for the time being, and given the technologies we command today, we cannot exclude the developing world from the carbon-fueled growth that we have enjoyed. At the least, if we, the rich world, have already exhausted our ecosystem’s ability to absorb CO2 without damage, we have to compensate those, who have not enjoyed that privilege.

The Case for Per-Capita Emission Rights: It’s What’s Right, and What Will Work.

From this inequity alone, we believe, emerges a strong rationale for per-capita-emission rights. Particularly if complemented by intelligent development policy, per capita-emission rights could help to also tackle gross inequalities unrelated to global warming, but enabled, in part, by a carbon-fueled industrialization.

But per-capita emission rights may also be the one solution to solve the cooperation problem towards a universal emission reduction regime, much like a redistribution between net importers and exporters of fossil fuel. Ethically, a redistribution based on the inherent equality of human beings seems more justifiable than instrumentally rational redistributing resources to fossil fuel-rich societies, some of which are generally affluent, too (Saudi Arabia).

To see how per-capita emission rights may also help to largely solve the cooperation problem with oil-exporters, consider again the above list of countries. Of these, some of the largest also stand to potentially benefit from per-capita emission rights: China, Venezuela, South Africa, other African countries, Iran and possibly also Russia.

What remains is a small, and potentially negligible set of rich gulf states, whose carbon consumption may be deemed suciently negligible so as to create a de-facto demand cartel, powerful, fair and well-equipped to save the planet’s climate.

Let’s not forget to distribute the chips equally in Copenhagen. For a fair play. But also, to make everyone a winner.

You can download the entire expose here, also including references.