Partners, Not Rivals: The Power of Parallel Supply-Side and Demand-Side Climate Policy

Despite recent progress in securing international commitments to fight climate change, such as the Paris Agreement, current climate policies remain far from sufficient to limit global temperature rise to 1.5°C. While this indicates more aggressive steps are needed, many policy levers remain underutilized. By and large, the policies pursued thus far have focused on demand-side measures, such as fuel economy standards, that directly reduce the consumption of fossil fuels, whereas supply-side measures that directly reduce fossil fuel extraction have received relatively little attention. This lopsided focus is at odds with the International Energy Agency’s 1.5°C-consistent pathway, which entails “no investment in new fossil fuel supply projects” starting immediately. Similarly, Welsby et al. (2021) calculate that the same target would require leaving 60 percent of existing oil and gas reserves and 90 percent of coal reserves in the ground. Such reserves would seem to be a natural focus of climate policy. In the United States, greenhouse gas emissions associated with federally owned fossil fuels are equivalent to about 24 percent of annual US emissions (Merrill et al. 2018; Ratledge et al. 2022), giving the federal government direct control over the extraction of these resources. Abroad, even larger shares of fossil fuel reserves are directly owned by governments. Yet governments have largely eschewed policies that directly reduce fossil fuel extraction.Climate mitigation policies can generally be classified as either demand-side, directly reducing the consumption of fossil fuels and hence greenhouse gas emissions, or supply-side, directly reducing fossil fuel extraction. Historically, policymakers have overwhelmingly focused on demand-side measures. For example, in the United States, the Obama administration primarily pursued demand-side policies such as fuel economy standards and power plant regulations but did relatively little to directly reduce the production of fossil fuels. That focus on the demand side may stem in part from a common perception by policymakers and economists that supply-side policies are vulnerable to emissions “leakage”—in which reduced domestic fossil fuel production (and hence emissions) is simply offset by increased production and emissions elsewhere—to which demand-side policies are supposedly immune. But is that truly the case? Are these types of policies fundamentally different? More specifically, what are the major differences between these policies with respect to key outcomes such as leakage and, ultimately, global emissions reductions? This paper explores those questions and shows that the two types of policies are not fundamentally different with respect to leakage concerns. Although both types of policies can induce leakage on their own, when pursued jointly, they are in fact complementary, mitigating or even eliminating leakage.Critics frequently dismiss supply-side policies based on a notion that leakage undermines their effectiveness in reducing emissions globally. However, it is commonly overlooked that leakage is an issue for demand-side climate actions as well. For example, whereas analyses of the effects of federal oil and gas development frequently emphasize the potential for leakage of production to other regions, analyses of demand-side policies like fuel economy standards typically do not consider the analogous potential for leakage of consumption elsewhere.On their own, demand-side policies generate leakage by reducing the price of fossil fuels, making it cheaper for other consumers, such as those in other countries, to burn them. Supply-side policies analogously generate leakage by increasing the price of fossil fuels, encouraging more production elsewhere. The climate benefits of either supply- or demand-side policies are each reduced by emissions leakage, or substitution, just via different mechanisms. Despite this symmetry, leakage concerns are disproportionately raised in the context of supply-side policies.Leakage is not inevitable, though. Standard neoclassical economic theory shows that leakage can be avoided if supply- and demand-side policies are implemented in tandem and with equal ambition, in a quantitative sense in terms of the direct number of barrels of oil of consumption and production reduced. Intuitively, leakage is a problem either when demand-side policy suppresses global fossil fuel prices, making it cheaper for other countries to emit, or when supply-side policy boosts those prices and thereby makes it more profitable for other countries to produce more fossil fuels. But if both types of policies are implemented in parallel and in equal magnitude, these two effects can exactly offset each other: reduced supply is offset by reduced demand, muting or even eliminating the effect on global prices and hence the leakage problem. Conversely, a lopsided policy approach that addresses only demand or only supply will continue to generate leakage, demonstrating how the two kinds of policies can create synergies if pursued with similar ambition.In this study, I consider leakage under both types of climate policies and argue that these policies are better thought of as partners that complement each other, and not rivals or alternative policies, as they are commonly seen. I demonstrate this point using standard neoclassical economic theory. This exercise demonstrates conceptually symmetric leakage effects from both demand-side and supply-side policies—if each type of policy is pursued alone. But when both types of policies are pursued in parallel, their individual weaknesses become synergies, mitigating leakage.I first demonstrate this effect using a simple theoretical model that shows the effects of each policy type on the regional distribution of fossil fuel production and consumption. It shows how leakage can be reduced or eliminated, demonstrating that leakage can be eliminated by pursuing supply- and demand-side policies in tandem and with equal ambition.In addition to this theoretical exercise, I use an empirically calibrated model of US and global markets for oil and gas, developed in Prest (2022), to conduct a quantitative exercise of the synergies produced by pursuing supply-side policies (such as reduced development of oil and gas on US federal lands and waters) in parallel with the more commonly implemented demand-side ones (such as fuel economy standards). The results demonstrate how such policies complement each other by mitigating or even potentially eliminating leakage.Beyond the issue of leakage, I outline other benefits of pursuing parallel policies, from both economic and political economy perspectives. I also discuss how the demand-centric structure of existing emissions accounting systems inefficiently skews policymakers’ incentives away from supply-side actions and in favor of demand-side ones. Overall, supply-side policies represent underappreciated tools for reducing greenhouse gas emissions, given their complementarities with more commonly pursued demand-side policies. This underappreciation is a contributor to the disproportionate focus by policymakers and economists alike on demand-side policies like fuel economy standards and power plant emissions intensity regulations.