Watch the price of Carbon!

Daniel Gros 21 December 2007

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World leaders have just finished discussing intensively how best to reduce emissions of the so-called green house gas CO2. The agreement reached at Bali represents only a ‘road map’, which should make it easier to attain the target of a new agreement on limiting CO2 emissions once the Kyoto protocol expires in 2012. Since the Kyoto protocol came into force in 2002, the scientific evidence for the need to curb CO2 emissions has strengthened even further, and in most industrialised countries public opinion strongly supports the goal of limiting global warming.

However, the first years of this century have also witnessed an important change in relative prices which will make it more difficult to achieve meaningful reductions in CO2 emissions. The key development over the last years is simply that the price of coal has fallen considerably relative to the price of crude oil as the chart below illustrates:

This chart documents that the relative price of coal (here measured as the average of the price of coal in Asia and Europe relative to that of crude oil) has halved since the turn of the century. This has occurred despite an increase in the nominal price of coal because the price of oil has increased much more, the most recent run-up in oil prices added a further leg to this trend, but most of the reduction in the price of coal had already occurred by the year 2000.

Carbon versus hydrocarbon

The relative price coal/crude oil is important for the debate about global warming because coal consists only of carbon, whereas crude oil (a ‘hydrocarbon’) contains also an important part of hydrogen atoms. For this reason, the use of coal leads to much higher CO2 emissions (per unit of energy created) than the use of crude oil. One needs about 1.5 tons of oil to generate the same amount of thermal energy as one ton of crude oil. The same argument applies, a fortiori, also to natural gas, whose calorific content is based to an even larger extend than oil on hydrogen atoms. The discussion here concentrates on oil, since its price is more widely known. However, oil is really just a shorthand for hydrocarbons since the price of gas has so far usually followed that of oil. Moreover, at least in Europe, gas prices are contractually indexed to the price of oil.

The current low relative price of coal presents a serious hurdle for the goal to reduce CO2 emissions since it encourages the substitution of oil for coal. This is already happening (and has happened in the past) as can be seen from the chart below which shows global consumption of coal relative to that of oil.

The evolution of relative coal consumption fits very well that of the relative price of coal. During the 1960s, when the price of oil was very low, consumers massively  substituted coal for crude oil. This changed when the price of oil shot up in 1973. The relative high price of coal during the 1980s illustrated in the first chart then led again to substitution away from coal starting towards the end of that decade. More recently the use of coal has clearly accelerated along with the decline in its relative price.1

The main area where this is possible (and indeed happening on a large scale) is in electrical power generation and to some extend in steel production. Any switch towards or away from coal on a large scale needs heavy capital investment, hence the mix of energy input determined to a large extent by the nature of the capacity already installed (coal-fired versus gas-fired power stations) in the short-run. However, for all new investment substitution can follow relative prices. This means that a long period of low coal prices (relative to hydrocarbons) will guide investment towards coal-intensive uses, which will be difficult to reverse later should the relative price change again (lock -in effect). Given that China is likely to install over the next decade more new power generation capacity than already exists in all of Europe, this implies that the current level of high oil prices provides incentive to make the Chinese economy even more intensive in carbon than it would otherwise be given the country’s vast reserves of coal. This will be very difficult to reverse even if China’s energy demand growth slows down once its income per capita comes closer to that of the OECD average.

Supply elasticities

The relative price of coal will thus have an important impact on the energy mix used by consumers. But the relative price of coal can stay low only if the increased demand can be satisfied by an elastic supply response. This should be the case since the known reserves of coal are worth hundreds of years of production and in reality the supply of coal has grown over the last 5 years by 30%, although the price of coal has increased rather less than that of oil. By contrast, production of crude oil has increased only by around 9% over the same period, indicating that the supply of crude oil is much less elastic than that of coal.

It is often thought that high oil prices could contribute to lowering CO2 emissions because they make energy more expensive, thus encouraging lower energy consumption. But this view overlooks that a high price of oil relative to coal encourages the substitution of a hydrocarbon with pure carbon, thus increasing the carbon intensity of energy use. The supply of coal is abundant, especially in the new emerging energy giants China and India, and relatively elastic. This implies that the price of coal is likely to stay low, thus encouraging an increase in the carbon intensity of energy use everywhere. Reaching the goal of reducing CO2 emissions will thus be even more difficult than generally assumed if oil (and thus also gas) prices remain at present levels.

The latest World Energy Outlook from the International Energy Agency already forecasts on a business-as-usual scenario an increase in the share of coal in global energy use. But over the last five years business has not been as usual as one half of the increase in global energy consumption has come from coal, prompting acceleration of global CO2 emissions. Sustained high hydrocarbon prices will intensify this trend, making it highly unlikely that the goal to reduce CO2 emissions can be reached.

Footnotes

1 Other factors have of course also been at work: during the 1960s private transport expanded strongly, and more recently electricity consumption has grown strongly as the service sector is now the main engine of growth.

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Topics:  Environment

Tags:  oil prices, coal burning, coal supply elasticity

Director of the Centre for European Policy Studies, Brussels

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