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OPEC's Pricing vs. the Carbon Tax

by Saraly Andrade de Sá and Julien Daubanes on Wednesday April 1, 2015

Most experts share the same explanation for last year’s oil price drop. Faced with rapidly improved and abundant competing resources, the OPEC cartel was protecting its market shares. In the words of The Economist (December 6, 2014), the tactic was to “let the price fall and put high-cost producers out of business”.

Indeed, an oil price sufficiently high, for sufficiently long, triggers huge investments in other fuels’ development, a fact already experienced in the 1970s. Today’s long-run unit cost curve for liquid fuels becomes flat around $60. At this price, not only Canadian, Russian and Venezuelan resources start to break-even, but also most of U.S. shale oil, and virtually unlimited capacities of synthetic fuels; production flexibility further confers a special role to shale oil.

For many analysts, OPEC makes the oil price, determining the profitability of other energy sources. The reason is that despite its less-than-40-percent market share, the cartel controls the quasi-entirety of currently exploitable production capacities. Therefore, the everyday balance of oil supply and demand relies on the “call on OPEC”, and the oil price strongly responds to the cartel’s production.

In a recent CEEPR working paper, Saraly Andrade de Sá and Julien Daubanes combine empirical estimates to establish that the demand for OPEC’s oil exhibits a less-than-one demand elasticity, in contradiction with the widely-used approach to OPEC’s market power.1 This very low demand elasticity implies that OPEC’s profits increase with price, yet to the extent that it does not trigger the entry of aforementioned competing resources; those resources would largely eat into OPEC’s market shares. When the oil price was higher, OPEC Secretary General Abdalla El-Badri already referred to the potential “destruction as far as demand [was] concerned” (May 3, 2012).

In the jargon of industrial economists, OPEC practices “limit pricing”: it seeks, albeit through trial and error, to induce the highest price that deters resources like shale oil, setting extraction accordingly. The authors’ model shows that “limit pricing” is not only a short-run strategy, but may be optimal in the long run for OPEC, despite the cartel’s reserve constraint.

The oil price drop initiated by OPEC in June 2014 is often celebrated as good news by business analysts. However, OPEC’s limit-pricing behavior is bad news for environmental policy makers; the authors point out that the effect of carbon taxation does not obey the usual logic in the face of “limit-pricing” suppliers. For example, taxing OPEC’s oil leaves unaffected the cartel’s supply level which deters competing resources. Surprisingly, this is so despite the fact that the organization’s revenues may be eroded. Yet carbon taxation also penalizes carbon substitutes to OPEC’s oil, causing two effects of opposite directions.

The good effect concerns the aforementioned resources (shale oil, liquefied gas…) that largely threaten OPEC’s market shares: as those resources are penalized, the cartel can afford a price rise, hence cutting its oil supply.

The bad effect concerns all other carbon substitutes to OPEC’s oil, which currently meet some fraction of the energy demand (non-OPEC oil, coal and gas for some uses…). Their market shares are limited because their production exhibits rapidly decreasing returns to scale; for OPEC, they are not worth deterring. When penalized, these substitutes’ market shares are abandoned to OPEC, which takes them over with more oil. A limit-pricing OPEC completely replaces these carbon resources, implying ambiguous effects on total carbon emissions.

While the ability of the carbon tax to reduce carbon emissions should be expected to be largely weakened by OPEC’s pricing, one basic environmental policy remains very effective: it is to promote non-carbon substitutes to eat into the cartel’s business.

1Andrade de Sá, S., and J. Daubanes (2015), “Limit Pricing and the (In)Effectiveness of the Carbon Tax.” CEEPR WP-2015-004, MIT, April 2015.