Optimally Rewarding Countries for Reducing Fossil Fuel Supply and Demand: A Time Consistency Problem

Abstract

Consider a world with complete information in which a global institution receives an exogenous flow of funding which it can use to curb fossil fuels by rewarding countries for reducing supply or reducing demand. I show that the ex ante optimal path of reward payment schemes is not time consistent. The global institution will in the future have incentives to partly shift its budget from the supply side towards the demand side relative to what it initially announced. If the global institution cannot commit at all then a version of the Weak Green Paradox always arises. However, I show that the Strong Green Paradox is highly implausible. I argue that the the time consistency problem will also arise to some extent in the more realistic setting with endogenous funding if there is a separate institution for each of the approaches and donors can flexibly earmark their flows of contributions. I discuss potential approaches to mitigating the time consistency problem.