The fossil endgame: strategic oil price discrimination and carbon taxation

Abstract

This paper analyzes how fossil fuel-producing countries can counteract climate policy. We analyze the exhaustion of oil resources and the subsequent transition to a backstop technology as a strategic game between the consumers and producers of oil, which we refer to simply as ‘OECD’ and ‘OPEC’, respectively. The consumers, OECD, derive benefits from oil, but worry about climate effects from carbon dioxide emissions. OECD has two instruments to manage this: it can tax fuel consumption and decide when to switch to a carbon-neutral backstop technology. The tax reduces climate damage and also appropriates some of the resource rent. OPEC retaliates by choosing a strategy of price discrimination, subsidizing oil in its domestic markets. The results show that price discrimination enables OPEC to avoid some of the adverse consequences of OECD's fuel tax and its switch to the backstop technology by consuming a larger share of the oil in its own domestic markets. Our results suggest that persuading fossil exporters to stop subsidizing domestic consumption will be difficult.

Keywords:

• dynamic games
• stock externalities
• carbon tax
• energy subsidies

Acknowledgments

We would like to thank Michael Hoel, Matti Liski, Stephen Polasky and two anonymous reviewers for constructive comments on earlier drafts of the paper. Funding from Göteborg Energi Research Foundation, Mistra Indigo, FORMAS COMMONS program and the Swedish Energy Agency is gratefully acknowledged, as is the support from the Swedish International Development Cooperation Agency (Sida).

Notes

1. For a World Bank analysis along similar lines, see Larsen and Shah (1992).

2. In December 2007, when international bulk prices for gasoline in Rotterdam were US 105¢/gallon, the retail consumer prices in some oil-producing countries were as follows: Iran, 18.4¢/gallon; Libya, 19.8¢/gallon; Kuwait, 41.9¢/gallon; Qatar, 32.8¢/gallon; and Saudi Arabia, 22.2¢/gallon.

3. Most analysis on how OPEC behaves concludes that it is not behaving as a textbook cartel, but that it still has an important influence on the world oil market price; see for example Smith (2005).

4. The choke price is the minimum price that brings down the demand in an area to zero.

5. Some major oil exporters, such as Norway, do not engage in price discrimination.

6. We assume that OPEC has less technology and easier access to oil, and therefore does not develop any backstop technology.

7. A tax levied on agents or market activities that pollute (adversely affect) the environment or that generate negative externalities.

8. For more in-depth studies of the carbon cycle, a multitude of different time constants are needed to reflect the different time scales at which carbon dioxide equilibrates between atmosphere, oceans, biomass, soil, sediments, and rocks (Archer et al. 2009).