The vast majority of world nations are not currently participating in agreements to limit global warming. Many countries cut down their rainforests in a way harmful to global social welfare. Even worse, attempts to improve things by the countries that do care can be self-defeating because of the problem of “leakage”, or what we economists just call supply and demand. Imagine Sweden cuts emissions by lowering domestic demand for oil. That lowers world demand for oil, lowering world price, hence increasing quantity demanded elsewhere. Boycotts may work in a similar way: when consumers in Canada stop buying some rare wood, the price of that wood falls, increasing the quantity of wood consumed in other countries.
What to do? Well, Coase tells us that externalities are in many cases not a worry when property rights are properly defined. Instead of trying to limit demand side consumption, why not limit supply? In particular, imagine that one set of countries (call them Scandinavia) imagines some harm from consumption of oil, and another set doesn’t care (let’s call them Tartary, after my favorite long-lost empire). Oil is costly to produce, and there is no entry, which isn’t a bad assumption for something like oil. Let there be a market for oil deposits – and you may have noticed from the number of Chinese currently laying pipe in Africa that such a market exists!
Let (q*,p*) be the quantity and price that clears the world market. Let h be the marginal harm to Scandinavia from global oil consumption. Let qopt be the socially optimal level of consumption from the perspective of Scandinavia, and popt the price that clears the market at that quantity. The Scandinavians just need to buy all the oil deposits whose cost of extraction is higher than popt minus h and lower than popt. Once they own the rights, they place an extraction tax on those deposits equal to the harm, h. With such a policy, no one exploits these marginal oil fields because of the tax, and no one exploits any more costly-to-extract fields because the cost of extraction is lower than the world oil price. There are many well-known mechanisms for buying the marginal oil fields at a cost lower than the harm inflicted on Scandinavia if the oil were exploited: the exact cost is particularly low if a few countries own all the world oil, since that country will benefit from Scandinavia’s policy as the world oil price rises following Scandinavia’s purchase of the marginal fields. Note that this policy is also nice in that oil, after the policy, costs exactly the same in Tartary and Scandinavia, so there is no worry about firms moving to the country with lax environmental policies. Another benefit is that it avoids the time inconsistency of related dynamic problems, such as using subsidies for green technology until they are invented, then getting rid of the subsidies.
There are some policies like this currently in place: for example, Norway’s environmental agency buys the rights to forest tracts and keeps them unexploited. But note that you have to buy the right tract to avoid leakage: you want to buy the tract that is worth exploiting, but just barely. This is great for you as the environmentalist, though, since this will be the cheapest tract to buy given the limited profit to be made if it is cut down!
This paper should also suggest to you other ways to enact environmental policy when facing leakage: political recalcitrance doesn’t mean we are completely out of options. The problem is that you want to decrease quantity consumed in your country – whose policies you control – without causing quantity consumed to rise elsewhere as price falls. The Pigouvian solution is to make the marginal suppliers unprofitable, or make the marginal demanders lower their willingness to pay. One way to do this without tax policy is to introduce products that are substitutes for the polluting good: clean energy, for instance. Or introduce complements for products which are substitutes for the polluting product. There are many more!
http://www.kellogg.northwestern.edu/faculty/harstad/htm/deposits.pdf (January 2012 draft – forthcoming in the Journal of Political Economy)
A Fine Theorem 