High Oil Prices Can Help the Environment

Prices of fossil fuels rose sharply in October. The European price for natural gas hit a record peak early in the month. The price of US crude oil is above $80 a barrel, the highest it has been in seven years. Prices for thermal coal in China have also reached record highs. Heading into the northern winter, consumers in many parts of the world are understandably worried.

1. Explanations for high prices

Why the rise in prices?  To be sure, a variety of factors are at play in individual countries:

European inventories of natural gas are unusually low, and Europeans fear that Russian President Vladimir Putin will use gas supplies as a political weapon.

German demand for fossil fuels has been higher than it needed to be, ever since it decided in 2011 to shut down its nuclear power plants, in the wake of Japan’s disaster at Fukushima.

Britain has shut down coal and nuclear capacity, leaving high demand for natural gas in the power sector. Meanwhile, a shortage of truck drivers, exacerbated by Brexit, has raised the retail price of gasoline.

In Brazil, a severe drought has curtailed hydroelectric power.

In China, a history of subsidies for coal and price controls for electricity has discouraged conservation.

Despite such idiosyncratic factors in individual countries, however, the recent rise in fossil fuel prices must have some more fundamental cause. Just as with fuel prices, indices of mineral and agricultural commodity prices, have recovered from a low six-year period and have now re-attained their levels of 2014. The longstanding correlation across prices of different commodities suggests a common macroeconomic explanation.  In 2021, the rise in fossil fuel prices, and commodities in general, is readily explained by rapid growth in the global economy, recovering from the recession of 2020.  To that extent, it is a good thing.

2. Are high fossil fuel prices good for the environment?

The Biden Administration in August called on OPEC and other major oil-exporting countries to increase production and so reduce prices. Many of Biden’s predecessors had done the same.

But what about the implications of high prices for the global environment?   The question is particularly salient, as officials from 197 countries will meet in Glasgow over the next two weeks, for the 26th Conference of Parties to the UN Framework Convention on Climate Change (UNFCCC).  They are expected to declare their intent to reach net-zero carbon emissions by 2050.

Are high prices for oil, gas, and coal good or bad for the fight against climate change?  On the one hand, their effect on consumers is good for the environment, as they discourage demand for fossil fuels. On the other hand, their effect on producers is bad for the environment, as they encourage supply.

Past warnings that low prices would leave oil companies with stranded assets would seem less relevant when prices are high. (“Stranded assets” refer to reserves of fossil fuels that their owners would find unprofitable to bring above-ground because environmental exigencies would choke off the demand for them.)

Currently, however, the stimulus to private-sector investment in the fossil fuel sector that would normally be expected from higher prices has been attenuated.  Firms may have reached a tipping point in how seriously they take the realities of climate change.  They know that an energy transition has begun, away from hydrocarbons and toward renewable sources.

American frackers, whose tremendous expansion transformed the US natural gas industry not long ago, have since 2014 suffered losses and bankruptcies. They appear to have had “the fight knocked out of them.” (If natural gas still wants to be a bridge fuel – that is, to substitute for dirtier coal until the time when renewable resources like wind and solar energy can fully do so —  its methane emissions must be regulated.)

3. Time for a carbon tax?

This might be the right time in the US to reconsider a carbon tax or a (largely equivalent) system of tradable emission permits, also known as “cap and trade”.  Currently, revenue from higher oil and gas prices goes to Russia, Saudi Arabia, and other foreign producers. Why not keep the revenue at home? The proceeds of the tax or permit auction could be returned as a dividend to citizens, by cutting other taxes, thereby maximizing political acceptability.

The important point is that putting a price on carbon would be the most efficient way, by far, to achieve the carbon reductions necessary for goals like capping temperature rise at 1.5 degrees Celsius. In the US, cap-and-trade has been considered politically impossible, since the failure in Congress of the McCain-Lieberman Climate Stewardship Act in 2007 and the Waxman-Markey American Clean Energy and Security Act in 2009.  But perhaps the failure this month of President Joe Biden’s attempt to get a Clean Electricity Program through Congress offers an opening for a sensible carbon tax alternative.

4. Who is the free-rider?

Among the reasons for the strong political resistance for effective regulation of greenhouse gases such as a carbon tax or system of tradable emissions permits, in any country, is the question, “why should we impose this extra cost of operations on our own manufacturing firms, if it would hurt them in competition against foreign firms that aren’t subject to a similar burden?”  The feared result is leakage: a relocation of carbon-intensive activities to countries that are not imposing a comparable price on carbon.

But, logically, the US is perhaps the last country that should worry about other countries free-riding on its efforts.  Most other countries subscribe to the Paris Agreement. The free-rider problem discouraging them from full implementation currently takes the particular form of justifiable fears that the US will not take strong action to cut emissions of greenhouse gases and that China’s emissions will continue their rapid growth.  If the US takes leadership, others are more likely to follow.

The US has historically been the biggest emitter. By now, China emits far more, but the US still emits over twice as much per capita as China (and over seven times as much as India).

European countries have perhaps done the most to cut emissions — despite such missteps as Germany’s closing of nuclear power plants, which resulted in an increase in coal consumption. Or the ill-fated push for diesel.

It is ironic that Europeans, who are usually considered more statist, have adopted market mechanisms to curb emissions, while in the market-oriented US, they have been considered less feasible politically than direct regulation. Europe has two particularly important market mechanisms. The first is high taxes on gasoline (petrol). They have the incidental advantage of reducing the percentage volatility in domestic consumer prices in response to changes in the global oil price like the current one. The second is the European Union’s Emissions Trading System (ETS), which currently puts a substantial price of 59 euros (69 dollars) on a tonne (a metric ton) of emitted carbon dioxide, a price that is credibly expected to rise over the decade.

5. Carbon Border Adjustment Tariffs

What about countries that don’t do their fair share?   The European Union is already moving forward with a Carbon Border Adjustment Mechanism, a tax on imports of carbon-intensive steel, aluminum, cement, fertilizer, and electric power from countries that are not imposing a price on carbon comparable to the EU’s.

In general, there is an acute danger that such border adjustment tariffs could be protectionist and violate the WTO.  But they need not necessarily do so, in my view, if implemented under rules that are multilaterally worked out as an adjunct to a UNFCCC climate agreement like the Paris Agreement. An elementary requirement of such a regime is that the country, or group of countries, that wishes to impose a Carbon Border Adjustment Tariff (CBAT) must be a participant in good standing under the international agreement.

The United States would not currently meet this requirement. It would need to do its share to fight climate change first before it would qualify for a US CBAT to assure domestic industry of continued international competitiveness. The US should tax carbon, incidentally reducing the need to import oil, instead of paying as much money to OPEC and Russia as it effectively does now.