COVID as a natural experiment for climate policy

MUNICH — The world is divided over how, and how aggressively, to respond to climate change. While only a small minority of countries have committed to implementing rigorous fossil-fuel bans and reducing their carbon dioxide emissions, most others are doing little or nothing. The big question, then, is whether unilateral measures implemented by the minority can contribute to mitigating climate change or whether a global climate club with truly binding constraints is needed.

The COVID-19 crisis points to the likely answer. The pandemic, it turns out, served as a real-world experiment for assessing the mechanics of multilateral and unilateral climate policies.

In theory, the 2015 Paris climate agreement adopted a multilateral approach. But only 60 of the 195 signatory countries, representing 35 per cent of global CO2 emissions, committed to quantitative emissions constraints. China and India, the world’s most populous countries, did not accept measurable constraints, and while the United States committed to constraints, the US Senate has not yet ratified the agreement.

The standard view in those countries that did commit to quantitative constraints is that they can reduce global CO2 emissions by curtailing fossil-fuel demand if they switch to green energy or nuclear power. The effect on curbing world-wide emissions will be small, as their consumption is small. But a small contribution is better than nothing; the argument goes, similar to making a charitable donation.

A closer look reveals a severe problem with this view: It neglects the role of markets for internationally traded fuels such as oil, gas, and hard coal. Consider the oil market. When demand for oil in green industrialised countries declines, so will the world price, enabling consumers in other countries to buy and burn more than they would have otherwise. The reduction in oil demand by green countries thus may be at least partly offset by others’ purchases. This problem is particularly relevant for the European Union, which recently decided to phase out the use of fossil fuels in passenger cars by 2035, and for Germany, which is preparing legislation to ban the implementation of oil heating in private dwellings as early as 2024.

Whether unilateral demand restrictions for oil will curb global use of fossil fuels and slow the pace of climate change ultimately will depend on how global suppliers react. Only if they extract less would less be consumed, because every bit of fossil fuel extracted will be burned somewhere. What has not been extracted cannot be used. This is the fundamental truth of climate policy. Abstracting from sequestration and reforestation, which have negligible effects, the power to mitigate global warming rests entirely with the owners of fossil-fuel resources, including the governments that control the territory where they are found.

It is unclear, however, how resource suppliers such as OPEC will react to unilateral demand-reducing measures by the green countries. Suppliers might sell less because marginal storage sites become unprofitable. They might sell the same amount as before because royalties or user costs of marginal sites would fall with the market price of the fuel. Or they might even sell more because they want to anticipate further reductions in demand (the so-called green paradox), or simply because they are living hand to mouth and must offset the price reductions by selling more.

In the two latter cases, restricting demand for fossil fuels in some countries could have the unintended consequence of accelerating extraction and climate change. The non-abiding countries would be able to consume what the green countries do not, as well as whatever additional quantities the source countries extract. Unfortunately, economic research offers no clear guidance as to which scenario is most likely, so we must rely on empirical analysis.

Here, the results are surprisingly clear-cut, at least with respect to crude oil. From the end of the second oil crisis in 1982 to the beginning of the COVID crisis in 2020, world oil extraction followed a linear, slightly upward trend with minimal fluctuations in volumes extracted. Prices, on the other hand, were extremely volatile, ranging from around $10 to $130 per barrel. Whenever an economic downturn somewhere in the world reduced demand, consumers elsewhere responded to the fall in prices by increasing their purchases correspondingly. Likewise, when an economic boom somewhere boosted demand, consumers elsewhere reduced their purchases sufficiently to offset the price increase. Either way, oil suppliers in the aggregate did not respond to these patterns. Instead, they pursued a rigid supply strategy, not allowing themselves to be distracted by price fluctuations.

This changed only with the pandemic’s arrival. During the initial global reaction to the crisis, oil prices fell, as lockdowns and quarantine measures sent industrial production plummeting. To prevent prices from going into freefall, OPEC reduced output, which quickly produced the desired effect: prices bounced back immediately and even exceeded their initial levels. Then, when the end of the crisis came into view, prices and supply gradually normalised, eventually reverting to their usual trend.

The lesson is simple: when fossil-fuel demand declines only in some parts of the world, resource-owning countries do not extract less, because other parts of the world will absorb the supply at lower prices. The demand restrictions promised by some of the world’s industrialised countries in the Paris agreement do not even have the slightest effect on climate change. Only if all, or nearly all, oil-consuming countries unite to reduce demand, can they gain leverage over OPEC and other resource owners, forcing them to leave more oil in the ground, slowing down global warming.

These empirical findings about the natural COVID experiment, which were published last year, turn many longstanding tenets of global climate policy on their head. For example, in the absence of a global climate club, the EU’s forthcoming ban on cars with internal combustion engines will be useless from a climate perspective, because the fuel no longer consumed will be burned elsewhere in the world. In fact, it could actually increase global CO2 emissions by forcing drivers to buy electric cars that will rely on power generated by burning more domestic lignite, which could otherwise have been kept in the ground.

Similarly, Germany’s planned ban on oil heating will force homeowners to use electric heat pumps, thus inducing more burning of lignite without reducing the quantity of oil extracted and burned worldwide.

As frustrating as these findings may be, they at least imply that consumer countries are not entirely powerless. If enough buyers come together, they can force resource owners to leave oil in the ground, thus mitigating climate change.

The difficulties of achieving effective coordination through global agreements should not be overlooked, of course, particularly in view of rising geopolitical tensions. For example, there is no hope that China, merely out of a sense of climate solidarity, will offer measurable demand restrictions for fossil fuel, as long as the Taiwan crisis remains unsolved. Internalising the greatest negative externality in human history will be impossible in the absence of a peaceful and stable global order.

Hans-Werner Sinn, professor emeritus of Economics at the University of Munich, is the author of “Casino Capitalism: How the Financial Crisis Came About and What Needs to be Done Now” (Oxford University Press, 2010). Copyright: Project Syndicate, 2023. 

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