On the Climate Change Effects of Oil Price Shocks
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On the Climate Change Effects of
Oil Price Shocks 1
Marc Vielle a and Laurent Viguier b,c
a CEA-LERNA, University of Social Sciences, Toulouse, France, mvielle@cict.fr
b REME-EPFL, Ecole Polytechnique Fédérale de Lausanne, Switzerland
c MIT Joint Program on the Science and
Policy of Global Change, Cambridge MA, USA, laurent.viguier@epfl.ch
Draft – 18 October 2005
Key words: Oil price, climate change, Kyoto Protocol, general equilibrium
modeling.
1 Introduction
Considering the difficulty of implementing the Kyoto Protocol (e.g. USA and
Australia withdrawal) and negotiating a post-Kyoto agreement that would
impose commitments for developing countries, one might be tempted to take
the current oil price shock as a good news. Indeed, high oil prices will have
a beneficial impact on climate change by forcing producers and consumers to
change their behaviors. Whatever the future commitments on climate change,
greenhouse gases (GHG) emissions might be lower than expected if we are
about to enter a new era characterized by the end of cheap oil. As an example,
Eberhard Rhein from the European Policy Center, writing in the International
Herald Tribune (31 August 2005), said that “the international community has
been laboring for 10 years under the Kyoto Protocol negotiations to agree on
a global reduction of energy consumption and carbon dioxide emissions of less
than 10 percent by 2012. So the market has achieved within a few months
what international bureaucrats - hampered by resistance from key consumer
1 Partly supported by the French Ministry of Ecology and Sustainable Develop-
ment, and the NCCR-Climate program of the Swiss NSF. For helpful comments
and discussions, we thank Alain Bernard and Jean-Marie Bourdaire.countries like the United States, China, Australia and India - have struggled
to obtain in a decade.” Is this argument valid? What might we really achieve
through high oil prices? What are the impacts on GHG emission baselines?
Can we count on the oil price shock to address the climate change issue and
mitigate GHG emissions worldwide? Do we still need to put forward on the
building of a post-Kyoto international regime on global climate change?
In this viewpoint we use a computable general equilibrium (CGE) approach
to assess the effects of the present oil price shock on global and regional
greenhouse gases (GHG) emissions. We use a dynamic-recursive CGE model,
GEMINI-E3, that represents the world economy in 21 regions and 14 sectors,
and incorporates a highly detailed representation of indirect taxation (Bernard
and Vielle (1998)). GEMINI-E3 is built on a comprehensive energy-economy
data set, the GTAP-5 database (Hertel (1997)), that expresses a consistent
representation of energy markets in physical units as well as a detailed Social
Accounting Matrix (SAM) for a large set of countries or regions and bilat-
eral trade flows. It is the fourth GEMINI-E3 version in this succession that
has been especially designed to calculate the social marginal abatement costs
(MAC), i.e. the welfare loss of a unit increase in pollution abatement (Bernard
and Vielle (2003)). The original version of GEMINI-E3 is fully described in
Bernard and Vielle (1998) 2 . Updated versions of the model have been used
to analyze the implementation of economic instruments for GHG emissions
in a second-best setting (Bernard and Vielle (2000)), to assess the strategic
allocation of GHG emission allowances in the EU-wide market (Bernard et al.
(2005c)) and to analyze the behavior of Russia in the Kyoto Protocol (Bernard
et al. (2005a) Bernard et al. (2003)).
In section 2 we briefly comment oil price forecasts that are commonly used
in CGE models designed for climate change policy analysis. We also present
the alternative “high oil price” reference case implemented in GEMINI-E3. In
the two next sections, we present the alternative baseline scenarios, and assess
the effects of oil prices on GHG emissions and the economy. In section 5, we
compare the impacts of departing from the original baseline case through high
oil prices or the implementation of Kyoto. In section 6 we conclude.
2 Oil prices Projections
In the last Annual Energy Outlook of the U.S. Department of Energy (EIA
(2005)), world oil prices are set in an environment where the members of OPEC
are assumed to act as the dominant producers, with lower production costs
2For a complete description of the model see our web site and the technical docu-
ment downloadable at: http://www.gemini-e3.net
2than other supply regions or countries. Non-OPEC oil producers are assumed
to behave competitively, producing as much oil as they can profitability extract
at the market price for oil. As a result, the OPEC member countries will be
able effectively to set the price of oil when they can act in concert by varying
their aggregate production. Alternatively, OPEC members could target a fixed
level of production and let the world market determine the price.
As explained in the report, the behavior and ability of OPEC member coun-
tries to set the price of oil will be influenced by many factors about which
there is considerable uncertainty. These factors include the forces that will
drive world oil demand, such as the rate of economic growth in the developed
and developing world and the degree to which oil demand is linked to eco-
nomic growth. The behavior of each major non-OPEC producer, and changes
in technologies that use or find and extract oil, will also be important. Each
of these factors will also be influenced by the market strategy that the OPEC
members choose for OPEC in the aggregate or for themselves.
In Figure 1 we present historical oil prices from 1900 to 2005, world oil price
cases from the U.S. Department of Energy published in EIA (2005), and the
alternative high oil price case implemented in GEMINI-E3. These oil price
projections have been designed to address the uncertainty about the market
behavior of OPEC. They are not intended to span the full range of possible
outcomes. The DOEs cases are defined as follows:
• DOE-Ref: It corresponds to the reference case in EIA (2005). Prices in
2010 are projected to be about $10 per barrel lower than current prices
(2004 dollars) as both OPEC and non-OPEC producers add new production
capacity over the next 5 years. After 2010, oil prices are projected to rise
by about 1.3 percent per year, to around $28 per barrel in 2025.
• DOE-low: It is the low world oil price case in EIA (2005). Prices are pro-
jected to decline from their high in 2004 to $22 per barrel in 2009 (2004
dollars).
• DOE-high A: Prices are projected to remain at about $36 per barrel through
2015.
• DOE-high B: Projected prices continue to increase through 2005 to $46 per
barrel, fall to $40 in 2010, and rise to $43 per barrel in 2025.
Two oil price cases are implemented in GEMINI-E3:
• DOE-2003: The reference case defined in EIA/DOE (2003) is used as the
reference oil price scenario in GEMINI-E3.
• GEMINI-high: Oil prices are projected to be at $65 per barrel in 2005, and
then rise by 0.6% per year to reach $74 per barrel in 2015 (2004 dollars). We
assume an oil price indexation of gas at 0.75 (i.e. the price of gas increases
by 7.5% when the oil price increases by 10%).
390
80
70 GEMINI−High
60
50
$/bbl
DOE−high B
40
DOE−high A
30 DOE−ref
DOE−2003
DOE−low
20
10
Source: EIA/DOE (http://www.eia.doe.gov/emeu/aer/) and BP database.
0
1900 1920 1940 1960 1980 2000 2020
Fig. 1. World oil prices, 1900-2015 (2004 dollars per barrel)
3 Oil Prices Impacts on GHG Emissions
The original baseline scenario of GEMINI-E3 is calibrated on international
sources concerning projections of CO2 emissions, energy consumption, GDP,
and population as provided by the U.S. Department of Energy (EIA/DOE
(2003)), the International Energy Agency (IEA (2002a,b)), the World Bank
database, and the United Nations population division, respectively. Non-CO2
GHG emission projections and MAC curves per region and sector are from the
Energy Modeling Forum 21 (Stanford) (Bernard et al. (2005b)). As shown in
Figure 2, the oil price shock is expected to lower GHG emissions worldwide.
Global GHG emissions are expected to rise from 10.1 GtC-equivalent in 2005
to 12.2 GtC-equivalent in 2015 in the low oil prices case. These emissions are
around 10.7 GtC-equivalent in 2015 in the high oil prices case. That represents
a 12% reduction compared to the original baseline in 2015. This reduction in
GHG emissions might be considered as relatively limited as regard to the
magnitude of the oil and gas price shock. Why does this happen?
A first response to this question comes from a closer look at the regional emis-
sions pathways. In Figure 3, it is shown that the effects of high oil prices on
GHG emissions may greatly vary from one country to another. According to
GEMINI-E3, GHG emissions might be reduced by around 20% in the Former
Soviet Union, the Middle East and Latin America in 2015 as a consequence
of higher oil prices. In the meantime, they would decline by around -19% in
Europe and -13% in the United States, and increase by more than 2% in
China. The insight of Figure 3 is clear: An oil price shock is likely to be ben-
eficial for the climate but the respective contributions of the different regions
would largely differ, depending on adjustments and substitutions opportuni-
ties within the different economies. The global emission reduction would not
414
Reference case
12 Oil shock case
10
GtC−equivalent
8
6
4
2
0
2005 2010 2015
Fig. 2. World GHG Emissions in the reference and oil shock cases
be obtained in a cost-efficient way, and the allocation of the reduction effort
across countries would implement no equity principle of any kind.
China
ROW
India
Brazil
World
USA
Asia
Japan
CANZ
Europe
Latin America
Middle East
FSU
−25 −20 −15 −10 −5 0 5
% change in 2015
Fig. 3. GHG Emissions by region (% change from the reference case in 2015)
A second explanation comes from Figure 4 that presents the oil price impacts
on CO2 emissions in the different economic sectors. Globally, the oil price shock
is projected to have a strong impact on the emissions from the transportation
sector and the chemical industry. In contrast, CO2 emissions are expected to
increase in the electricity sector as a result of fuel mix changes. Indeed, in
a baseline scenario without any climate change policy, the electricity sector
reacts to higher fuel prices by shifting from oil and gas to coal. Since the lower
abatement costs are probably in the electricity sector, the resulting global
GHG emission reduction is thus far from the allocation that would result
from an efficient climate policy that would equalize marginal abatement costs
across sectors.
This adverse substitution effect in energy consumption is depicted in Figure 5.
Because of the higher fossil fuel prices, gas and oil consumption are reduced
worldwide by 33% and 32% in 2015, respectively. The electricity consumption
5Electricity
Mineral industry
Paper industry
Other goods
Metal industry
Agriculture
Total
Chemical industry
Road and Rail
Sea transport
Air transport
−30 −20 −10 0 10
% change in 2015
Fig. 4. CO2 Emissions by sector (% change from the reference case in 2015)
is also reduced by 9% compared to the original baseline. But these reductions
in fossil fuel and electricity consumption are partly compensated by an increase
in coal consumption (+20% in 2015). The reduction of global emissions is thus
limited by the opportunity to substitute fossil fuel by other energy inputs that
might have greater carbon content coefficients (i.e. coal). This result illustrates
why the substitution of an energy tax for a carbon tax provides a far less
efficient policy instrument for achieving the goal of reduced GHG emissions.
30
20
10
% change in 2015
0
−10
−20
−30
−40
Natural gas Oil Electricity Coal
Fig. 5. World energy consumption (% change from the reference case in 2015)
4 Macroeconomic Impacts of the Oil Shock
There is an extensive theoretical and empirical literature on the macroeco-
nomic effects of oil price shocks (Jones et al. (2004)). Rotemberg and Wood-
ford (1996) developed aggregated simulations models to assess the magnitude
of effect on the economy. They found that a 1 percent reduction in oil usage
reduces gross output by a percentage amount corresponding to the cost share
of oil. This share of oil in input is though to be no larger than 4 percent; with
6a unit elasticity of substitution between oil and value added, a 10 percent
increase in oil prices, for example, will result in a less than 0.5 percent reduc-
tion in gross output. If the elasticity of substitution is less than 1, the drop in
gross output is even smaller. Barsky and Kilian (2004) identifies a number of
mechanisms that might provide a causal link from oil prices to recessions, in-
flation, and economic growth. Oil prices shocks have a stagflationary effect on
the macroeconomy of an oil importing country (Roubini and Setser (2004)):
they slow down the rate of growth (and may even reduce the level of out-
put i.e. cause a recession) and they lead to an increase in the price level and
potentially an increase in the inflation rate. An oil price hike acts like a tax
on consumption; for a net oil importer like Europe or the United States, the
benefits of the tax go to major oil producers rather than the oil-importing
government. According to Roubini and Setser (2004), the size of the output
growth/level effect and inflation rate/price level effect of an oil shock depend
on many factors: the size of the shock, both in terms of the percentage in-
crease in oil prices and the real price; the shocks persistence; the dependency
of the economy on oil and energy, the policy response of monetary and fiscal
authorities.
In CGE models like GEMINI-E3, welfare effects of an oil price shock can be
assessed through the indirect utility function that may distinguish (i) the “im-
ported costs” due to the change in the prices –or the quantities– of foreign
trade (the “terms of trade” effect) and (ii) the “domestic cost” interpreted
as the indirect change in revenue arising from the change in price. As an ex-
ample, CGE approaches used in climate change economics have shown that
the deadweight losses of climate policies under the Kyoto Protocol may be
partly outweighed by positive terms of trade effects in energy-importing re-
gions (Bernard and Vielle (2003), Babiker et al. (2004)). In the case of an oil
price shock, one should expect a high cost for oil-importing regions due to
the combination of deadweight costs and losses from a terms of trade deteri-
oration. Backus and Crucini (1998) show that the increased volatility in the
terms of trade since Bretton Woods is largely due to the increased volatility
in the relative price of oil rather than the increased volatility of nominal or
real exchange rates.
In Figure 6 we present the welfare effect of the oil price shock obtained from
GEMINI-E3. Globally, the oil price shock has the effect of reducing the welfare
by around 2% in 2015 compared to the original baseline case. As shown on the
graph, high oil prices impose a significant welfare cost in oil-dependant regions
like India, Asia or Europe (-6%, -5%, -4%, respectively). At the opposite, oil-
exporting countries –in particular the Middle East (+10%), the ROW (mainly
Africa, +6%) and the Former Soviet Union (+4%)– would of course gain a lot
from an appreciation of oil prices.
7Middle East
ROW
FSU
Latin America
CANZ
China
World
USA
Japan
Brazil
Europe
Asia
India
−10 −5 0 5 10 15
% change in 2015
Fig. 6. Welfare effects by region (% change from the reference case in 2015)
5 Climate Policies and the Oil Shock
In this section we compare the climate and economic impacts of an oil price
shock with the effects of implementing specific climate policies. In Figure 7,
we present two climate policy scenarios. The first one is designed to reach
the -12% reduction rate obtained in the high oil price case through a uniform
world GHG emissions tax (world tax). The second one corresponds to a “kyoto
forever” scenario where Annex B countries (except the United States) are
assumed to reach their Kyoto targets by 2010, and to stabilize their GHG
emissions in the 2010-2015 period, through uniform domestic taxes without
international emission trading (Kyoto+).
The Figure shows how costly is the reduction obtained from the oil price
shock. We find that a -12% reduction of world GHG emissions in 2015 would
require a uniform GHG emissions tax of 16 dollars (of 1997) per ton of carbon
equivalent in 2015. This efficient tax policy would reduce global welfare by
only 0.05%, and the higher costs would range from -0.6% and -0.5% in the
Middle East and China, respectively. In the oil shock scenario, the global cost
of the world GHG emissions reduction (-12%) is far higher (-2%) and very
unfairly distributed across the different regions, in particular for developing
countries.
Figure 8 provides GHG emissions in each Annex B region compared to the
Kyoto targets 3 . It appears that the oil price shock allow to go below the
Kyoto commitments without any additional measure (i.e. climate policies),
except in the United States, Canada, Australia and New Zealand (CANZ). It
is thus right to say that the Kyoto emission targets might be achieved through
3 CANZ, CEA, and FSU are for Canada+New zealand+Australia, Central Euro-
pean Associates, and the Former Soviet Union, respectively.
8drastic changes in the oil market. However, the welfare cost of the Annex B
emissions reduction is -0.09% in the GHG tax case compared to -2.6% in the
oil shock case.
13.0
GHG emissions (in GtC−equivalent)
12.5
Reference
12.0
Kyoto+
11.5
11.0
Oil shock
World tax
10.5
10.0
0 0.5 1.0 1.5 2.0
Welfare costs (in % change)
Fig. 7. World GHG emissions and welfare cost in the reference, oil shock, world tax,
and Kyoto+ cases (in 2015)
Total Annex B
Germany Reference case
France Oil shock case
UK
Italy
Spain
Netherlands
Belgium
Switzerland
Rest of Europe
USA
Japan
CANZ
CEA
FSU Kyoto = 100
50 60 70 80 90 100 110 120 130 140 150
Fig. 8. GHG emissions in the reference case and the oil shock cases compared to
Kyoto commitments (Kyoto=100)
6 Conclusion
One might be tempted to consider the current oil price shock as a good news for
the environment, in particular for the objective of reducing GHG emissions
worldwide. Indeed some positive effects of high oil prices can be expected
from the observation of historical trends: evidence of price-induced energy
9conservation in response to higher world energy prices beginning in 1973;
reductions in energy-output ratios induced by the successive energy crises of
the 1970s and 1980. High oil prices may change agent’s behaviors as regard to
energy consumption and force technological change. Wishful thinking would
lead us to think that oil price should stay high to deal with climate change,
and to mitigate GHG emissions worldwide. The present paper raises 4 major
objections to this argument:
• The impacts of high oil prices on GHG emissions would be far lower than
expected because of fuels substitutions effects (oil/gas to coal);
• The GHG emissions reduction obtained from higher oil prices would be
inequitably distributed across regions and sectors;
• The global welfare cost of the GHG emissions reduction would be very
high compared to the cost of the same reduction obtained from an efficient
climate policy (i.e. acarbon taxes or a global emission trading system);
• The distribution of the welfare costs across regions would be very unfair,
and would put a high burden on oil-dependant developing countries.
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