Review of Environment, Energy and Economics - Re3 The Debate of the Green Paradox


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The Debate of the Green Paradox
by Yuting Li

The theory of  the “Green Paradox” subverts the traditional theoretical foundation of the environmental policies. The crucial question is whether the green paradox holds and how large the impact is in reality, which has provoked heated debate among economists. This article identifies and reveals the virtues and weaknesses of the green paradox theory through a comparative literature review. Both theoretical studies and empirical work are covered. It is found that the theory is at least logically sound, though it can be extended and modified in different ways. In addition, the evidence from data and empirical studies is mixed. 

This work was supported by a grant from the Major Program of National Social Science Foundation of China (No. 11&ZD009).

Key words: Environmental Polices, Carbon Leakage, Green Paradox, Resource Extraction, Greenhouse Gas Mitigation

JEL Classification: F18, Q31, Q38, Q42, Q54, Q58

Suggested citation: Yuting, Li, The Debate of the Green Paradox (September 18, 2014). Review of Environment, Energy and Economics (Re3),

At the end of the 20th century, many economists started to investigate the undesirable effects of well-intended climate policies. The theory of the “Green Paradox” can be traced back to these studies, which apply the Hotelling rule of exhaustible resource extraction to evaluate climate policies. For example, some researchers find that increasingly greener carbon taxes can actually worsen the global warming crisis (Sinclair, 1994; Strand, 2007). The mechanism can be explained as follows: due to the greener policies, the owners of the exhaustible resources rationally expect their assets sitting in situ to depreciate over time, thus bring forward their extraction plans which in turn accelerate carbon emissions and global warming. Later, this abnormal phenomenon, i.e. climate policies intensify rather than mitigate the global warming problem, is coined by the German economist Hans-Werner Sinn as the “Green Paradox” (Sinn, 2008, p. 380). Whether the “Green Paradox” holds in reality is so important for the outcomes of the climate policies, thus it has received great attention and raised intense debate among scholars over the past decades. This article tries to provide an unbiased evaluation of the “Green Paradox” theory by referring to the latest theoretical and empirical results.

1. Evidence from Theoretical Derivation
One of the most famous demonstrations of the green paradox is conducted by Sinn (2008), who takes the greener carbon tax as an example. An exhaustible extraction model is constructed under the assumptions of no backstop technology (a perfect substitute for the non-renewable energy) and exogenous stocks of the oil. If the Hotelling rule is satisfied for the oil market, it can be easily seen from the mathematical equation that the price falls faster with a growing tax, which implies a steeper extraction routine. In other words, it means there are more energy and carbon supplies in the near term. The results are confirmed by many economists. Several researchers have repeated Sinn’s procedures and gained the same results following the typical assumptions and the Hotelling settings, such as Hoel (2010). In addition, under similar deduction framework, other policies such as subsidies for the renewable energy have been shown to raise the green paradox (e.g. Grafton et al., 2010; Gerlagh, 2011) as well. In a word, the concept of the green paradox holds at least theoretically.     

However, the applicability of the green paradox theory is limited as it is drawn from strict assumptions. By relaxing these assumptions and modifying the model, researchers show theoretically how the green paradox of climate policies could be avoided. Firstly, as pointed out by Perman et al.(2003), the hypothesis of “no backstop technology” seems to be true only in short or medium term. In the case with a backstop technology, a transition to an alternative energy will happen before the physical exhaustion of the non-renewable resources. Therefore, low-carbon policies can encourage less extraction and even accelerate the transition to the non-carbon economy, if the price of the clean alternative is cheap enough (Hoel, 2010; Van der Ploeg and Withagen, 2012). 

Secondly, the restrictions and features of production are not taken into account. Researchers stress that the firms have to invest in exploration and development activities, which usually incur not only large costs but also great risks of losses(Cairns, 2009;Zimmer et al, 2010; Bhattacharyya, 2011). As a result, carbon-pricing policies can reduce the profit and incentive of the extraction projects. In return, the supply of energy and carbon will decrease. Moreover, it is claimed by Cairns (2009) and Zimmer et al. (2010) that the firms cannot rearrange their production freely even if it is profitable to do so. The reason is that there exist technological and geological restrictions on the production at any time. 

Finally, the Hotelling rule itself is worth questioning. The results of the empirical tests do not provide strong support for it (Livernois, 2009). Therefore, some economists built different models to evaluate the effects of climate policies and found that the possibility of the green paradox is less likely. This is the case for instance of Osterle (2012) who extends the Hotelling model by adding various exploitation costs or of Cairns (2014) considering longer-term technological transitions-type models as he believes that the Hotelling model is only suitable for short-term analysis. 

2. Data and Empirical Results
Considering the above analysis, it can be said that the green paradox may not necessarily show up and that there are several ways to avoid the paradox theoretically. But does it really exist in real life? Does it happen frequently or is it a rare phenomenon? To answer these questions, data probably speak louder than theoretical analysis. Empirical studies do exist , although they are quite recent and much less than the theoretical research. Results are mixed and presented below.

More in favor of negative evidence are Kemfert (2009) and Michielsen (2011). Kemfert (2011) quotes statistics from the calculations of OPEC and International Energy Agency (IEA) to show that oil supply cannot continue to increase sufficiently to meet the demand. OPEC estimates an increase in the oil supply to be up to no more than 116 million barrels per day by 2025 while IEA calculates a maximum of 100 million barrels a day. Additionally, less overall investment in oil exploration may be made due to the current global economic status and the increasing marginal cost of production. Altogether, these factors seem to make the increase in extraction responding to climate policies a rare case. Michielsen (2011) estimates the inter-temporal carbon leakage (green paradox) of the carbon tax by simulation method using the estimated elasticity of demand for oil from five previous researches. The value of the inter-temporal carbon leakage, defined as the amount of increase in current emissions over reduction in future emissions, is estimated between -22% and 13% increasing with the rates of tax. The predicted inter-temporal carbon leakage rates are negative and small in absolute value for most of the elasticity values except for using Serletis et al. (2010) ‘s estimates, i.e. 13%. Given the present level of taxes in most countries, the inter-temporal leakage is not a concern. Based on these figures, they conclude that the chance of the green paradox to show up in reality is small, thus it should not be worried.

Positive evidences were provided by Di Maria et al. (2013) and Grafton et al. (2013), they investigated the green paradox effects of two specific climate policies using econometric methods with the data of US. Four implications of green paradox theories regarding the implementation of the Acid Rain Program have been tested by Di Maria et al. (2013), two of which are strongly supported by data: the price of coal dropped significantly (around 9%) and the sulfur premium increased substantially (roughly 40%). However, the two results for the quantity implications are weak or even reverse. They found a few plants had increased their heat input while no evidence was found for an increase in the sulfur intensity of coal. In general, these results provide some indirect evidence for the possibility of the green paradox. Instead, Grafton et al. (2013) conducted a direct test for the green paradox effects of the US biofuels’ subsidies using annual data from the US over the period 1981-2011. Results show that the elasticity of US oil production with respect to US biofuels production is 0.04 in the short-run and 0.09 in the long-run. It implies that 1 percent increase in the US biofuels production would boost US oil production by 0.04 percent soon and 0.09 percent in the long-run. In a word, subsidies that increase biofuels production do also promote more US oil production which means the existence of the green paradox is supported.

3. Conclusions
The theory of the green paradox does not mean that climate policies are not important or useless. On the contrary, it warns of the undesirable effects of the well intended climate policies and requires better design of the policy measurements. Many researchers have examined the conditions for its appearance by theoretical analysis. It has been demonstrated by serious research that theoretically the theory holds for several different policies if certain assumptions are satisfied such as the Hotelling rule and no backstop technology (see e.g. Sinn, 2008; Hoel, 2010; Gerlagh, 2011). However, under any of the following situations, the green paradox is less likely to happen if a backstop emerges and it is cheap enough (Perman et al., 2003; Hoel, 2010; Van der Ploeg and Withagen, 2012), the production of firms are subject to risky exploitation investments, technological and natural restrictions (Cairns, 2009; Zimmer et al, 2010; Bhattacharyya, 2011), or other factors resulting in the failure of the Hotelling rule exist (Livernois, 2009; Osterle, 2012; Cairns, 2014). The theoretical studies do help us understand the virtues and limits of the green paradox theory. However, in order to determine the existence and relevance in practice, further research, especially data and empirical research are needed. Kemfert (2009) and Michielsen (2011) quoted and calculated estimations for the oil market to show that the chance and impact of the green paradox are almost negligible. Yet some supporting evidence were found by Di Maria et al. (2013) and Grafton et al. (2013) by performing empirical tests with US data for two specific climate policies. Overall, the results are controversial and cannot terminate the debate.

Up till now, no consensus is reached about the existence and the relevance of the green paradox theory. Further researches are needed and can work in the following aspects. First, the research methods are out of date. Researchers mainly rely on the Hotelling model and static equilibrium methods. Thus, the relevance of the conclusions to the real world is often doubted. Moreover, the description of the energy market is too simple. Usually, only one type of fossil fuel i.e. oil is discussed. In reality, however, the attributes and uses of different types of energy differ greatly. Last but not the least, there are too few empirical work, due to which it is quite difficult (if not completely impossible) to evaluate the influences of the green paradox.


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Yuting Li, School of Finance and Economics, Graduate School of Chinese Academy of Social Sciences