Partners, Not Rivals: The Power of Parallel Supply-Side and Demand-Side Climate Policy

This report examines how supply- and demand-side policies, when pursued in tandem, can help mitigate emissions leakage.

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Date

April 21, 2022

Authors

Brian Prest

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Report

Reading time

6 minutes

Introduction

Despite recent progress in securing international commitments to fight climate change, such as the Paris Agreement, current climate policies remain far from sufficient to limit global temperature rise to 1.5°C. While this indicates more aggressive steps are needed, many policy levers remain underutilized. By and large, the policies pursued thus far have focused on demand-side measures, such as fuel economy standards, that directly reduce the consumption of fossil fuels, whereas supply-side measures that directly reduce fossil fuel extraction have received relatively little attention. This lopsided focus is at odds with the International Energy Agency’s 1.5°C-consistent pathway, which entails “no investment in new fossil fuel supply projects” starting immediately. Similarly, Welsby et al. (2021) calculate that the same target would require leaving 60 percent of existing oil and gas reserves and 90 percent of coal reserves in the ground. Such reserves would seem to be a natural focus of climate policy. In the United States, greenhouse gas emissions associated with federally owned fossil fuels are equivalent to about 24 percent of annual US emissions (Merrill et al. 2018; Ratledge et al. 2022), giving the federal government direct control over the extraction of these resources. Abroad, even larger shares of fossil fuel reserves are directly owned by governments. Yet governments have largely eschewed policies that directly reduce fossil fuel extraction.

Climate mitigation policies can generally be classified as either demand-side, directly reducing the consumption of fossil fuels and hence greenhouse gas emissions, or supply-side, directly reducing fossil fuel extraction. Historically, policymakers have overwhelmingly focused on demand-side measures. For example, in the United States, the Obama administration primarily pursued demand-side policies such as fuel economy standards and power plant regulations but did relatively little to directly reduce the production of fossil fuels. That focus on the demand side may stem in part from a common perception by policymakers and economists that supply-side policies are vulnerable to emissions “leakage”—in which reduced domestic fossil fuel production (and hence emissions) is simply offset by increased production and emissions elsewhere—to which demand-side policies are supposedly immune. But is that truly the case? Are these types of policies fundamentally different? More specifically, what are the major differences between these policies with respect to key outcomes such as leakage and, ultimately, global emissions reductions? This paper explores those questions and shows that the two types of policies are not fundamentally different with respect to leakage concerns. Although both types of policies can induce leakage on their own, when pursued jointly, they are in fact complementary, mitigating or even eliminating leakage.

Critics frequently dismiss supply-side policies based on a notion that leakage undermines their effectiveness in reducing emissions globally. However, it is commonly overlooked that leakage is an issue for demand-side climate actions as well. For example, whereas analyses of the effects of federal oil and gas development frequently emphasize the potential for leakage of production to other regions, analyses of demand-side policies like fuel economy standards typically do not consider the analogous potential for leakage of consumption elsewhere.

On their own, demand-side policies generate leakage by reducing the price of fossil fuels, making it cheaper for other consumers, such as those in other countries, to burn them. Supply-side policies analogously generate leakage by increasing the price of fossil fuels, encouraging more production elsewhere. The climate benefits of either supply- or demand-side policies are each reduced by emissions leakage, or substitution, just via different mechanisms. Despite this symmetry, leakage concerns are disproportionately raised in the context of supply-side policies.

Leakage is not inevitable, though. Standard neoclassical economic theory shows that leakage can be avoided if supply- and demand-side policies are implemented in tandem and with equal ambition, in a quantitative sense in terms of the direct number of barrels of oil of consumption and production reduced. Intuitively, leakage is a problem either when demand-side policy suppresses global fossil fuel prices, making it cheaper for other countries to emit, or when supply-side policy boosts those prices and thereby makes it more profitable for other countries to produce more fossil fuels. But if both types of policies are implemented in parallel and in equal magnitude, these two effects can exactly offset each other: reduced supply is offset by reduced demand, muting or even eliminating the effect on global prices and hence the leakage problem. Conversely, a lopsided policy approach that addresses only demand or only supply will continue to generate leakage, demonstrating how the two kinds of policies can create synergies if pursued with similar ambition.

In this study, I consider leakage under both types of climate policies and argue that these policies are better thought of as partners that complement each other, and not rivals or alternative policies, as they are commonly seen. I demonstrate this point using standard neoclassical economic theory. This exercise demonstrates conceptually symmetric leakage effects from both demand-side and supply-side policies—if each type of policy is pursued alone. But when both types of policies are pursued in parallel, their individual weaknesses become synergies, mitigating leakage.

I first demonstrate this effect using a simple theoretical model that shows the effects of each policy type on the regional distribution of fossil fuel production and consumption. It shows how leakage can be reduced or eliminated, demonstrating that leakage can be eliminated by pursuing supply- and demand-side policies in tandem and with equal ambition.

In addition to this theoretical exercise, I use an empirically calibrated model of US and global markets for oil and gas, developed in Prest (2022), to conduct a quantitative exercise of the synergies produced by pursuing supply-side policies (such as reduced development of oil and gas on US federal lands and waters) in parallel with the more commonly implemented demand-side ones (such as fuel economy standards). The results demonstrate how such policies complement each other by mitigating or even potentially eliminating leakage.

Beyond the issue of leakage, I outline other benefits of pursuing parallel policies, from both economic and political economy perspectives. I also discuss how the demand-centric structure of existing emissions accounting systems inefficiently skews policymakers’ incentives away from supply-side actions and in favor of demand-side ones. Overall, supply-side policies represent underappreciated tools for reducing greenhouse gas emissions, given their complementarities with more commonly pursued demand-side policies. This underappreciation is a contributor to the disproportionate focus by policymakers and economists alike on demand-side policies like fuel economy standards and power plant emissions intensity regulations.

Literature

Although academic research commonly focuses on demand-side climate policies, a growing literature has promoted the value of supply-side policies. In a seminal study, Sinn (2008) noted that demand-side policy is effective only if suppliers actually react by reducing production, and further, a “green paradox” can arise if producers actually accelerate production in response to anticipated weakening demand in the future. This suggests a role of supply-side policy to target fossil fuel production directly, rather than indirectly through the channel of demand. Harstad (2012) made the case for climate coalitions to engage in supply-side policies by buying up foreign fossil fuel deposits and retiring them.

Countries can also reduce supplies domestically. In most countries, this policy approach is theoretically straightforward to implement because mineral rights are commonly owned by the government, although naturally the prospect of forgone revenue can create political disincentives to reducing production. Even though mineral rights ownership is more dispersed in the United States, about one-quarter of fossil fuels are nonetheless extracted from lands and waters owned by the federal government. Recent studies suggest that these kinds of US supply-side policies could indeed lead to substantial emissions reductions, even after accounting for potential production leakage (see, e.g., Prest 2022; Prest and Stock 2022; Gerarden et al. 2020; Erickson et al. 2018; Erickson and Lazarus 2014, 2018). These are frequently discussed supply-side policies, but other examples of demand-side and supply-side policies are shown in Table 1. Both IEA (2021) and Welsby (2021) find that substantial declines in fossil fuel production are needed globally to have even-odds of limiting global warming to 1.5°C, suggesting that supply-side policy can play a substantive role in reducing emissions.

Table 1. Examples of Fossil Fuel Supply- and Demand-Side Policies

Some argue that supply-side policies may also be easier to implement, both practically and politically (see, e.g., Green and Denniss 2018). Practically, supply-side policies may have lower monitoring costs to the extent that there are fewer producers than consumers, reducing administrative and implementation costs. Politically, supply-side policies place the focus on fossil fuel production, which many people closely relate to the full suite of negative externalities, such as air pollution and land degradation. By contrast, the end goals of demand-side climate policy (reduced environmental harms) may be commonly perceived as only indirectly connected to a consumer’s energy use. It is also likely that consumers perceive supply-side policies to primarily burden fossil fuel producers rather than consumers (Green and Denniss 2018).

The literature on supply-side policies has frequently focused on supply-side policies alone; relatively little focus has been given to the appropriate balance of supply-side and demand-side policies. One notable exception is Fæhn et al. (2017), who find that in Norway, optimal policy calls for a relatively balanced mix of supply- and demand-side policies (about two-thirds supply, one-third demand).

This paper contributes to the literature by demonstrating in a general model the conditions under which leakage can be eliminated. One such case highlights the benefits of pursuing, in tandem, supply- and demand-side policies with similar levels of ambition. The next section demonstrates the economic complementarities of these two kinds of policies, first through a theoretical model and second through an empirically calibrated, dynamic simulation model of US and foreign oil and gas supply and demand. That simulation compares two real-world supply- and demand-side policies: 1) an end to oil and gas leasing on federal lands and waters, and 2) fuel economy standards for light-duty vehicles. Finally, I discuss other benefits and complementarities of pursuing parallel policies and the diverging incentives for demand- and supply-side policies under existing emissions accounting systems.

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