How Does the Cost of Capital Affect Oil Production?

Environmental Economics Seminar with Associate Professor Julien Xavier Daubanes, DTU.

Over the past decade, a rapidly growing number of investors have committed to ceasing their financing of oil production. Now more than ever, in the spirit of the green finance taxonomy, it is hoped that an augmented cost of capital will discourage environmentally unsustainable activities such as the production of carbon-intensive resources. Our analysis captures how the cost of capital affects the profitability and production of real resource exploitation projects. We also look for a normative benchmark: the returns that investors should forgo to align with the internalization of the carbon externality.

We develop a model of the oil market in which the industry's cost of financial capital – isolated from the cost of physical capital – affects drilling decisions and oil production. The model is calibrated using data covering all US oil assets. We use it to simulate the dynamic competitive equilibrium under various counterfactual policy scenarios for the period 2000-2030, including carbon pricing and "green finance," modeled as an augmented cost of financial capital.

Our results suggest that an augmented cost of capital by up to a few percentage points is counterproductive in the short run, because it encourages industry short-termism. Green finance becomes effective at deterring oil production only over longer horizons or under greater capital penalties. The returns that financial markets would need to forgo to replicate the effect of a $100 carbon price are unrealistically high.

Contact person: Rasmus Kehlet Skjødt Berg.