Discussion Paper

The Effects of Transport Regulation on the Oil Market: Does Market Power Matter?

Sep 3, 2010 | Snorre Kverndokk, Knut Einar Rosendahl


Popular instruments to regulate consumption of oil in the transport sector include fuel taxes, biofuel requirements, and fuel efficiency. Their impacts on oil consumption and price vary. One important factor is the market setting. We show that if market power is present in the oil market, the directions of change in consumption and price may contrast those in a competitive market. As a result, the market setting impacts not only the effectiveness of the policy instruments to reduce oil consumption, but also terms of trade and carbon leakage. In particular, we show that under monopoly, reduced oilconsumption due to increased fuel efficiency will unambiguously increase the price of oil.

In the United States and Western Europe, reducing oil consumption is a growing priority due to concerns about climate change, energy security, and the recent oil spill in the Gulf of Mexico. The first place to turn should be the transport sector because it accounts for more than 50 percent of global consumption, a share that will only increase.

Several policy instruments—including fuel taxes, biofuel shares, and fuel-efficiency requirements—have been proposed (if not already introduced) for the transport sector. In a new RFF discussion paper, authors Snorre Kverndokk and Knut Einar Rosendahl show how the effects of different instruments depend on oil market structure.

In a competitive setting, a fuel tax and a biofuel share requirement will always reduce oil demand, whereas a fuel-efficiency standard will have an ambiguous effect as it will be cheaper to drive if cars are more efficient (a rebound effect). The rebound effect may dominate and lead to more oil consumption if oil prices are high, as consumers are usually more responsive to prices in this case. In a monopoly setting, the effects of regulations become more ambiguous; a required share of biofuel may in certain cases increase oil consumption.

In an open economy with both oil-producing and oil-importing regions, taxes and biofuel shares will reduce consumption if they are introduced in the importing region (with no regulations in the exporting region). Again, the effects of increased fuel efficiency are ambiguous. When the price is high the rebound effect may be strong and lead to higher oil consumption.

Oil price changes are important due to distribution effects between oil producers and consumers, terms of trade, and carbon leakage. The producer price always moves in the same direction as consumption if there is a competitive market, so a lower consumption level yields a lower producer price. With monopoly, the effects are more ambiguous and depend on the demand and cost functions. For instance, a fuel tax potentially increases the producer price of oil. With a biofuel requirement, the producer price will decrease; with a fuel efficiency standard, the price will increase if oil consumption decreases.

According to the authors, if the main objective of transport regulations is to reduce oil consumption, a fuel tax is the safest alternative. In a competitive market, lower consumption always goes hand in hand with a lower price.

The existence of market power complicates the picture. If policymakers are concerned about the mark-up for big oil producers or terms of trade effects, say Kverndokk and Rosendahl, they should avoid fuel efficiency standards. But if they worry about carbon leakage, the conclusions are different.