Some Myths of the Economics of Climate Change

Tyler Cowen links to a brief, frank symposium on the economics of climate change. Many of the responses, particularly from Lomborg and Tabarrok are fascinating. But, unfortunately, there are a few big myths about the economics of climate change that seem so obviously true but are dangerously false. Take Otaviano Canuto, Senior Advisor to the World Bank, for example:

The economist’s solution to climate change can be summarized in a single statement: “get the prices right!” This means taxing fossil fuels proportionately to the amount of carbon they release, in order to correct the problem that corresponding negative spillovers of their use are not reflected in their market prices. Incentives in favor of more climate-friendly technological innovations would also be reinforced. Subsidies to these innovations, as well as to avoid deforestation would also help, as potential benefits of these mitigating factors would in turn become appropriately embedded in their reduced costs.

First of all, one would imagine that the World Bank could put its money where its mouth is and stop flying its officials in first class on taxpayer dime. Second of all, “taxing fossil fuels proportionately to the amount of carbon they release” is only enough under the assumption that the revenues will be spent on undoing the damage of the initial emission. (There are a few exceptions to this which I’ll get to later). If Canuto noted this as a start he would be on sound economic footing, but like so many in this debate he misses a nuance in the way externalities work.

To see why imagine the effect of a $25/ton tax on carbon. We know this would increase gas prices by just over 25 cents. If $25 was the “spillover cost” of carbon, the climate would be robust to large increases in drilling efficiency. But let’s say there’s a breakthrough in refinery technology and a substantial increase in available petrol, putting a strong downward pressure on costs such that the tax becomes a majority of the price itself. Would the carbon tax be enough in this case? Well, it depends what you’re doing with it. A good, if brute, measure of spillover may be the cost of recapture. Therefore, the tax is enough if and only if the government is spending the money on a large scale recapture program undoing the ills of the initial emission. Otherwise, the decrease in costs of production would increase supply and hence emissions beyond a sustainable level.

It is always useful to consider various parametric limits in assessing the validity of one’s claim. In doing so we discover hidden assumptions that never make their way to public consciousness. Textbook economics is tricky. Whether a spillover is intimately connected with your definition of social costs and the implications for your revenue thereof.

Of course, this assumes that the socially optimal level of carbon is effectively zero. In fact, there is a carrying capacity and the optimal level, economically speaking, probably exceeds this carrying capacity. The initial capacity emerges from the Earth’s innate ability to absorb emissions along with uncertainty that more is always worse. That the optimal capacity exceeds this level is a result of a positive discount rate along with the fact that future generations – due to improvements in technology – will be richer than us. Therefore, under perfect generational smoothing, we endow our children with superior technology and a shittier earth.

But neither of these change the fundamental premise that pricing carbon “at its cost” will hardly ever be enough (unless, as other more intuitive commenters noted, green technology becomes competitive in its own right). For one, the last sentence in the previous paragraph should make uncomfortable your moral sensibilities – for axiomatic reasons. More importantly, the economic models that are needed to quantify such ambiguous statements are really crappy.

As Robin Harding writes in the Financial Times, economic models of climate change fail the limit test with flying colors. Standard models suggest output would only be reduced by half for warming over twenty degrees Celsius in magnitude. To get some perspective, the rest of the academic community is freaking out about an increase of two degrees. Therefore, by the rule of seventy, our kids will be better off than us if the Earth warms twenty degrees and we grow at a measly 2% a year. You would be right to laugh.

Of all the answers that actually say something of substance, Larry Summers has the one that I find most practically challenging. I think he misjudges the political landscape of the United States. Cap-and-trade failed in 2009 – truly a “moment of great opportunity” – not because of deep forces against its passage but primarily because the Obama administration decided socialized healthcare was its priority and secondarily because of the Massachusetts mistake that is Scott Walker. Permit trading has something a carbon tax does not. That is, it’s not a tax. In America, that gets you very far. It’s why second best alternatives like banning incandescent bulbs or regulating fuel efficiency work, but simple taxes do not.

But I think he misses one more thing. Practically, we are more likely to have a system that both subsidizes and taxes carbon before we have one that does neither. Yes, we should phase out fossil fuel subsidies and tax breaks. This is a bit like the problem with sugar subsidies. Mancur Olson’s The Logic of Collective Action is a must-read for this. Oil subsidies have very low average costs but remarkable concentrated benefits that make “big energy” a powerful lobby in both parties. Big energy will also loose more from a repeal of our most inefficient subsidies than it will from a broad based carbon tax. Therefore, one is distinctively easier to fight. In fact, big business in general may yield to a carbon tax if they know a larger decrease in subsidies is not immediately to follow. Poor Americans loose out on this one but it is hard to argue that subsidy without tax is better than subsidy with tax.

Therefore while Summers is unimpeachable in his economic logic, public choice concerns dominate. Here’s to the second best.

Permit trading has many benefits a tariff does not. For one, we are far better at estimating the effect of carbon than calculating its price (and, as noted above, we would not use the revenues from a carbon tax appropriately to begin with). But more importantly, it isn’t a tax, and it isn’t as “leaky”. A relatively important component of a broad carbon tax at the level we need it (probably around $100 to the ton) is subsidizing the poor. Under a carbon tax, this ends up undoing part of the tax and is counterproductive. On the other hand, under a permit trading system, the government can guarantee a fixed number of permits to each household from its initial “stock” which would simply increase the cost of luxury carbon.

But ultimately, economists need to step up on climate change. It is more than a textbook example of externalities and far more nuanced than many simple accounts make it to be. It is also far more harmful than many of their models suggest (consider the limits). Economic logic sometimes fails. It was, if I recall, Larry Summers who prevailed over Gore and Browner, convincing Bill Clinton not to follow a more aggressive reduction in carbon emissions wary of economic consequences. (Not a criticism of Summers – just one of his decisions).

Lomborg makes a lot of sense in the snippet of the linked symposium. Subsidizing basic research and hoping for the best is our only real option. But, in general, he doesn’t acknowledge scientific realities that clash with his optimism and occasional myopia. Indeed, climate change hurts the poor more than anyone and, when the water runs dry, probably more than anything else he worries about. But, even within his economic frame, an ideal, international, permit trading system would be the most beneficial. Think about what would happen if each of us were limited to some level of carbon output. The west would need far more than this limit, and poor Africans would need far less. Money is going to flow in one direction and, given the need for carbon in the west, would be enough to replace the inefficient foreign aid already in place. An international carbon marketplace is the ideal cash transfer – something economists should be killing for.

I believe in economics and, indeed, the value of economists. They are unfortunately neglected in important policy decisions which – independent of any political affiliation – may be cited as a cause for much hardship over the past thirty years. But if an astroid was about to crash into New York City, we wouldn’t ask economists to create a poorly-founded model of its costs. We would tell NASA to do whatever it can to save us. Economists need to stop telling us what the program for change should be, but rather identify the most efficient means of implementing a program scientists already deem necessary. Otherwise we’ll end up with nonsense like CAFE standards and Cash-for-Clunkers. Otherwise, we’ll end up with an absolute mess of leftism that is Greenpeace and organic, anti-GMO activism claim climate change for its own. Now that is scary.