The oil market and international agreements on CO2 emissions

According to most scientists, greenhouse gas emissions must be reduced significantly relative to current trends to avoid dramatic adverse climatic changes during the next century. CO₂ is the most important greenhouse gas, so any international agreement will certainly cover CO₂ emissions. Any international agreement to reduce emissions of CO₂ is going to have a significant impact on the markets for fossil fuels. The analysis shows that it is not only the amount of CO₂ emissions permitted in an agreement which matters for fossil fuel prices, but also the type of agreement. Two obvious forms of agreements, which under certain assumptions both are cost efficient, are (a) tradeable emission permits, and (b) an international CO₂ tax. If the fossil fuel markets were perfectly competitive, these two types of agreements would have the same effect on the producer price of fossil fuels. However, fossil fuel markets are not completely competitive. It is shown that, under imperfect competition, direct regulation of the ‘tradeable quotas’ type tends to imply higher producer prices and a larger efficiency loss than an international CO₂ tax giving the same total CO₂ emissions. A numerical illustration of the oil market indicates that the difference in producer prices for the two types of CO₂ agreements is quite significant.