Limit-Pricing and the (Un)Effectiveness of the Carbon Tax

All existing studies on the design of the optimal carbon tax assume that such instrument can effectively curb current carbon emissions. Yet as this paper argues, the effectiveness of a carbon tax is very limited when limit pricing arises on the oil market. Demand for energy, for fossil fuels like oil in particular, is notoriously very price inelastic, even in the long run. Facing such demand, an extractive cartel may increase its profits with higher prices, as long as those prices do not destroy its demand. The demand for oil features kinks, each corresponding to the entry price of one competing substitute. Some substitutes may be tolerated by an oil-extracting cartel (e.g. other fuels, including existing biofuels, solar and wind sources of energy...). However, when a substitution possibility has the potential to drastically deteriorate its market share, the cartel maximizes its profits by inducing the 'limit price' that deters its entry. Limit-pricing equilibria of non-renewable resource markets sharply differ from the conventional Hotelling outcome; for instance, taxes on the cartel's resource become neutral regardless of their dynamics. Environmental policies may still reduce current extraction quantities when limit pricing occurs. For that, policies must support the production of existing substitutes, i.e. those not deterred by the cartel's pricing. Unlike it, a carbon tax may increase current oil extraction: while its direct application to the oil (carbon) resource may be neutral, its application to oil's (carbon) substitutes induces higher oil production. (authors)