Sunday, December 12, 2010

The Green Paradox

The green paradox is the idea that a policy to reduce global warming could instead accelerate the use of fossil fuels because owners extract more fossil fuels while they are still valuable. Of course, an actual cap on emissions should avoid this green paradox, but some other policies might lead to a green paradox in theory. Quentin Grafton, Tom Kompas, and Ngo Van Long have written a paper titled "Do Biofuel Subsidies Reduce Greenhouse Gas Emissions?" that argues that subsidies to increase biofuels could plausibly accelerate the use of fossil fuels and, therefore, climate change.

Importantly, the paper assumes that the production of biofuels does not use fossil fuels itself. In fact biofuels production requires large inputs of fossil fuels, such that there is a controversy as to whether some of them yield any net energy at all. So Grafton et al.'s paper shows an additional reason why encouraging biofuel production might be a bad idea besides the low energy return on investment of biofuels and their displacement of food production.

Grafton et al. assume that extraction costs of fossil fuels are constant and that biofuels and fossil fuels are perfectly substitutable. The supply of biofuels is increasing in the net price received by producers (market price plus subsidy). Given the assumptions the price of fossil fuels rises at the rate of interest. This results in a tractable problem where at some point in time the fossil fuel price will rise sufficiently high that all fuel demand will be supplied by biofuels. Fossil fuel producers must, therefore, extract all their resources by that time. Under certain conditions the greater the subsidy to biofuel production the sooner that time will come and the faster fossil fuels will be extracted. In other words, the supply response from fossil fuel producers overwhelms the substitution effect towards biofuels on the demand side.

Making the reasonable assumption that overall demand for energy does not fall to zero for a finite price they show that the green paradox is plausible for reasonable parameter values under both competitive and monopoly extraction of fossil fuels.

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