Below is a summary of the proposal. Download the full proposal here. On June 2, Sylvain Chassang discussed the proposal in a webinar hosted by Princeton’s Bendheim Center for Finance. You can watch video from the webinar here.
Since its founding in 1960, OPEC has remained an imperfect tool for regulating global supply and prices of oil and natural gas. Oil price volatility remains excessively high. While the need to reform how these markets function is nothing new, the climate crisis as well as Russia’s war in Ukraine has cast a spotlight on the need for the global economy to move away from dependence on fossil fuels. A rethinking in favor of a more strategic solution is overdue.
This proposal discusses how a Joint Purchase Board for oil and natural gas can help member consumer countries work together to maintain stable and fair prices, counter OPEC’s influence in a cooperative way, and ensure a fair allocation of restricted supplies across members. The stakes of reforming the status quo are high as the current situation is suboptimal for both producers and consumers of energy—especially for low-income countries which suffer disproportionately in the face of higher energy prices. A Joint Purchase Board is a promising medium-term solution for reducing the dependence on oil and natural gas that continues to cripple political and economic goals on a global scale while working toward a green energy transition.
1. As the world adjusts to restricted oil and gas supplies, increases in the price of energy are both strengthening Vladimir Putin’s hand, and resulting in serious hardships to consumers, especially in the developing world.
2. Italian prime minister Mario Draghi has proposed to create a “cartel” of oil consumers, with the goals of keeping prices reasonable, and stable. Rethinking energy purchases in the light of recent advances in economics could be a way to lead to welfare gains and strengthen the role of the International Energy Agency or any other relevant organization.
History provides us with examples of successful purchasing boards (buying cartels).
a. The European Coal and Steel Community, which ultimately led to the European Union, proved an effective way to deploy limited resources from the Marshall Plan (Monnet, 1978), in the face of a cartelized coal and steel industry.
b. Medical purchasing boards are successfully run to reduce the cost of healthcare (Chown et al., 2019).
Criteria for a good solution
1. The primary objectives of a joint purchase board are:
a. To ensure that participating members can procure a significant share of their energy consumption at reasonable and stable prices;
b. To ensure a fair allocation of restricted supplies across members. The outcome in which richer countries end up satisfying their marginal needs by bidding up the price of energy out of the reach of poorer countries is not morally acceptable.
2. The policy should not come at the expense of emissions targets.
3. The means used to support such a purchase board should reflect the goal to maintain goodwill across countries. As far as possible energy producers should be treated as partners. Participation in the purchase board should be voluntary. Breaches from group discipline should be dealt with in a minimally conflictual manner. As a result, the functioning of the purchase board should be robust to reasonable breaches of discipline, lukewarm or slow participation by members, and remain functional and useful at every scale of operation.
1. Our policy proposal builds on the fact that the economics of cartelized markets are radically different from those of competitive economies. This cartel view of energy markets also informs other policy proposals in useful ways.
2. One useful insight from the cartel view is to recognize that OPEC+ recently went through a costly price war, suggesting that
a. Cartel threats are quite credible, and
b. OPEC may be justifiably cautious about deviating against its Russian partner.
3. In our view the policy goal should not be to go from volatile high prices to volatile low prices, but instead to maintain stable reasonably high prices. This view identifies a win-win-win solution to the current energy crisis. Consumers and suppliers benefit from co-insurance, while stable relatively high energy prices create a predictable environment for entry in the renewable energy market.
Policy Proposal: Strategic Purchase Board
1. We propose the creation of an oil and natural gas purchase board that participants mandate to ensure stable energy supplies at reasonable prices. The board will be empowered to manage advance purchase commitments (bespoke forward contracts) (Kremer et al. 2020) made by member countries. The board will have discretionary powers to use advance purchase mandates, and allocate procured resources in order to attain its goals.
2. The reason a purchase board is attractive is that it can use its purchasing power strategically.
a. Importantly, the measures would only be activated if the price of energy exceeds a certain threshold. This would encourage members of OPEC to act as partners in the price stabilization effort.
b. One first use of advance purchase mandates is to encourage new entrants in the oil, gas, and electricity markets who are currently delaying their production decision because of market uncertainty. For instance, opening up a new oil well, or building barrages to store renewable energy involves high initial fixed costs that cannot be justified unless long-term demand is locked in. Advance purchase mandates would be used to de-risk entry by providing stable prices for targeted entrants. The difference to a standard futures contract is that it targets specially new entrants and does not raise the overall price of oil on open markets. The board may also be given a budget for foreign direct investment supporting new infrastructure.
c. A second use case for advance purchase mandates arises in the event OPEC members choose not to support the mission of the board. Then, advance purchase mandates can help weaken cartel discipline among oil producers through bilateral offers of medium-term supply contracts to plausible deviators.
3. While this does not seem like orthodox market policy, it is in fact consistent with economic theory. There are three reasons for it:
a. First, encouraging entry increases efficiency in an environment when entry involves substantial fixed setup costs. (This is the rationale for patent rights in R&D intensive industries.)
b. Second, in the presence of an existing cartel (OPEC), we are in the theory of the second best.
c. Third, elasticities are very low in the short-term so that reduced supply may lead to large welfare shifts. Managed demand can help achieve distributive imperatives.
4. We suggest that a small share of the board’s purchase mandate (say 10%) should be activated regardless of oil price, and used to provide advance purchase commitments to renewable energy suppliers, especially sources of electricity, or electricity transport and storage infrastructure that allows to directly displace the consumption of natural gas. The ideal strategy should also include a long-run perspective that makes countries less dependent on fossil fuel energies.
5. In addition to strategically using its energy purchasing mandate, the board would also allocate its supply strategically.
a. First, the procured advance supply would be allocated in priority to sectors of the economy with inelastic demand and high willingness to pay. This would increase the elasticity of the residual demand curve and lead to lower prices on the open market.
b. Second, the board will allocate access to its supply to encourage early commitment at scale by members. One possibility is to give greater access to the board’s purchased supply to members that have sourced a greater share of their consumption through the board.
Connection with other policies
1. The cartel view of energy markets informs other policy proposals. At the onset of Russia’s invasion of Ukraine, Ricardo Hausman proposed setting a punitive tax on Russian oil and natural gas. The proposal builds on the view that Russian supply may be inelastic since current prices are much higher than marginal cost. This is true in a competitive economy, but not in an environment with strategic price-making players. Realistically, Russia may significantly reduce exports to the West as retaliation. In addition there is no guarantee that OPEC would accommodate the West’s increased demand.
2. Proposals to set price caps on the price of oil, which are often decried as misguided, actually make sense under cartel supply. Such a strategic environment is much closer to a bargaining scenario than to a competitive market, and price caps play a role equivalent to reservation prices in auctions.
3. The cartel view also suggests that setting price floors (i.e. minimum prices) could be beneficial (Chassang and Ortner, 2019). Indeed, price floors encourage entry, reduce the cartel’s ability to wage price wars, and encourage a more productive cooperative relationship between producers and consumers. In addition the goal of maintaining stable reasonably high prices supports the entry of renewable energy suppliers.
4. A complement of all these policies is to support demand management measures,(as mentioned in point 6. above). One aspect of our proposal is to disproportionately assign supply guarantees to consumers with inelastic demand. This increases the elasticity of demand on the open market. We believe that there is also a significant opportunity in deploying energy saving incentives and information tools seeking to reduce peak electricity consumption driving demand for gas power plants. This is made possible by the growing penetration of smart-meters throughout the world (above 70 % in China, and the US, 50 % in Europe) allowing a precise timing of consumption reduction incentives.
Chassang, S. “Strategic Energy Purchases” Webinar at Markus Academy https://bcf.princeton.edu/events/sylvain-chassang-on-strategic-energy-purchases/
Chassang, S. and J. Ortner (2019): “Collusion in auctions with constrained bids: Theory and evidence from public procurement,” Journal of Political Economy, 127, 2269–2300.
Chown, J., D. Dranove, C. Garthwaite, and J. Keener (2019): “The opportunities and limitations of monopsony power in healthcare: evidence from the United States and
Canada,” Tech. rep., National Bureau of Economic Research.
Kremer, M., J. Levin, and C. M. Snyder (2020): “Advance market commitments: insights from theory and experience,” in AEA Papers and Proceedings, vol. 110, 269–73.
Monnet, J. (1978): Memoirs: Jean Monnet.