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 Timeseconomic 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.

  1. Norman Pfyster said:

    Scott Walker is governor of Wisconsin, not a senator from Massachusetts.

  2. Martin said:

    I think you should qualify some of your remarks.

    First, who ever said that one should make IAM based CBAs for temperature changes of 20 °C or more? Damage functions are completely ad hoc, so it is clear by construction that they can only be used for relatively small temperature changes. This seems like a red herring right there. The issue, if I am not mistaken, is that models do not capture catastrophic risk in a satisfactoty way, which has been a topic at lest since Weitzman publised his “Dismal Theorem.” But this is another issue than the question what an IAM does at +20 °C – the output of which is completely aritrary, and nobody – IAM modelers included – has ever suggested to take seriously. Now, several ideas have popped up how to incorporate catastrophic risk or how to account for (model runs with) larger temperature deviations more realistically (there has, for example, been much discussion between Nordhaus and Weitzman about the convexity of the damage function). Maybe you find them lacking. But you did not even touch the issue.

    Second, who exactly is “the rest of the academic community” who is “freaking out about an increase of two degrees?” As far as I know, this target has first been adopted by the German Bundesregierung as a suggestion by the PIK and has then become official policy of the United Nations. But this is different from “the rest of the academic community freaking out” over anything else. Who exactly, is “the rest of the academic community,” here?

    Then, I am not sure to understand your point about taxes and the question how they are used. CBAs try to measure marginal damage costs against marginal abatement costs. So, if some magical device makes fossil fuels cheaper, the tax having a lesser effect would – in this framework – be a feature, not a bug. You might disagree for other reasons. But again, you’d have to argue and quantify that. The choice is not between 2 °C and 20 °C, but rather between 2 °C and 2.3 °C, no? And the unnamed “rest of the academic community” freaking out notwithstanding, I don’t see how this is a crazy idea – especially as you treat this as somehow self-evident as such. So, in an optimization framework, can you explain me how your point about what to do with tax revenues matters? Also not that even if this magic device makes the (private) cost of fossils so cheap that a tax does not affect them “sufficiently’ (again, I do not understand how this matters in an optimization framework), emission levels would rise and the damage function is convex, too. That is, your initial carbon tax would, of course, rise. Not ‘sufficiently’, you might argue, but you didn’t.

    For cap and trade – you are referring to the US here. Note that Weitzman, for example, makes exactly the opposite point of yours in a global context: that an international cap fails for the lack of “focal points” and high transaction costs (for the initial distribution of national caps), and that we should therefore go for a carbon tax:

    To put it differently: Does your conviction about the superiority of a cap as a policy instrument have any other basis than your gut feeling? Notably, not even critics of IAMs suggest anything else than a tax: it is what the triumvirate of IAM modellers suggests (Nordhaus, Tol, and Hope), as well as the triumvirate of critics you refer to, or the FT (the three papers in the JEL are by Weitzman, Pindyck, and Stern, all of whom argue for a carbon tax, though Stern suggests R&D in addition). Also, economists like Acemoglu who argue that a tax that deals with the problem in a satisfactory way would be too high to be politically feasable, favor R&D investment on top of whatever is feasable as a tax (“Directed technial change.”) Now, I see that you might disagree, but I don’t really see much basis for your very strong claims here that seem entirely based on your perception of the US policial environment.

    • The point about the economic consequences of a large increase in temperature is that these models only work for very small changes where second order effects are less important. More generally, my attitude towards using these models to form policy is captured by the last paragraph.

      By rest of the academic community I meant the scientific community. If you read the stuff they write, especially for a larger audience, there is much more alarm than among economists looking at their models. And if not two, then four.

      I’m not sure what you’re trying to say regarding the use of carbon tax revenues. Has very little to do with an optimization framework (unless you agree that economic models of the climate are good and sound – which strikes me as a huge gamble). It is the very simple fact that if we suddenly discovered an infinite amount of oil, unless the revenues were being used to recapture the carbon (or undo it in some arbitrary way) we would be screwed (as the price of gas would drop to 25 cents).

      So revenues would rise, yes, but that’s hardly the point – and this doesn’t have much to do with optimization. I’m not sure what’s so difficult to see about this. Today, if you buy a carbon offset it either goes towards purchasing renewable energy credits or some form of green investment. A tax must ultimately be the same thing if it is actually correcting the externality.

      My support for a cap-and-trade comes from the US political environment, you are right. And while a permit auction and a tax can, under the right circumstances, be made equal, I think the former would be a superior Coasean bargain leading to a transfer of funds from rich, dirty countries to poorer, clean ones than a carbon tax. Yes, there are problems with initial allocation but only politically.

      But yes, my support for a permit auction goes beyond gut feeling, though I cede that the points you make will likely win out and we will end up with a carbon tax.

      • Martin said:

        Wait, your qualification of the “rest of the academic community” is based on your impression of what vocal scientists say on the internet?

        Well, I said nothing at all with regard to revenues. You did. I said exactly that I do not understand how this matters. No sure why we are ‘screwed’ if we find an infinite amount of oil. With further emissions, marginal damage costs would rise – and as a consequence, so would the correpsonding Pigou tax (which would be set at, or slightly below, the marginal damage costs). So while a cheap source of fossils would have total emissions rising, I have no idea how you can come to the conclusion that we are ‘screwed’ without an attempt of quantification of the effect. Please point me to any literature that suggests that revenues of a Pigou tax must be directed to alternatives to internalize the externality. I have never heard that before, but perhaps I missed out.

      • No. Mainstream scientific literature is far scarier than economic literature. Again, given the standard economic models, climate change isnt even really a problem given modest growth.

        Yes, if we found an infinite amount of oil, the Pigou revenue would increase. But lets say we used this to finance soup kitchens in Harlem. The increase in emissions would become effectively infinite and we would, thereby, be screwed.

        A tax that corrects for the externality is effectively a requirement to purchase an offset. But offsets would not work if they were used for anything but some form of a green endeavor. A carbon tax would help in any form, but it would not be a perfect correction if those revenues arent used for relevant purposes.

      • Martin said:

        OK, could you point me to an example that not only demonstrates that there are scientists that think that the sotry is far scarier (which I do not doubt; there are also economists), but what you actually claimed, namely that “the rest of the academic community is freaking out about an increase of two degrees.” ?

        I do not understand the argument with revenues. What is obvious is that if the government simply gives the tax revnue back to where it came from it would have no effect. Why, exactly, should we do that (or the thing with soup kitchens)? Does anybody expect anything the like? Otherwise, one can talk about an uncertainty in quantity vs. an uncerstainty in price if it’s a tax as compared to a cap. This is also something Weitzman has discussed decades ago. Still, it seems as if each and every economist in the field seems sure about a tax as appropriate first-best instrument. I’d really like to see a reference for the plausibility of your claim.

  3. Reed Hundt said:

    Very sad that no one commented on the most obvious fact: low cost finance can support clean energy generation and consumption at prices to consumers that are lower than actual delivered prices today. Since as in all other cases, consumer demand is a function primarily of faster, cheaper, better services drawing that demand, it is far better to deliver clean energy solutions at prices below today’s prices than to rest the solution solely on a pigou tax system translated through a monopoly distribution market (generally pretty tough). If everyone or anyone supports an infrastructure bank, why not support a green bank, which is just a version of an infrastructure bank.
    In addition, interesting to see the economists back away from cap and trade after they spent nearly two decades pushing the environmental community to adopt this failed strategy in 2008-9. Sorry is not just a word appropriate for personal relationships.

  4. We are a bit beyond this, now. Climate change is increasing the frequency of hot days in the growing season, and most food crops are up against their productivity limits. If an increase in aver. temp. increases the number of hot day spikes, we may see global crop failure for a year or two — occurring only a few decades from now. Thus, panic and mayhem across world civilization. Our biggest intellectual problem is that economists have led us down the primrose path of believing that complex systems can be made computationally tractable, though of course economists couldn’t even predict the financial crisis, and argue over utter nonsense like the size of gov’t budgets, and still almost entirely avoid a central, primary concern: the subject of policy capture by industry. After all, it’s their bread and butter. Thanks, economists! Learn this instead: Climate wobbles:

  5. Bryan Willman said:

    I think a better line of thought would be “some myths about the real world geo-politics of climate change”.

    You present a notion that big carbon emitters should tax themselves to send money to (mostly not very developed) low carbon emitters.

    I would like to point out this is pretty much in direct contrast to most of human history, which can be largely summarized as organized theft and organized murder.

    It seems more likely we would see Wars of Suppression, in which Great Powers inflicted horrible immoral suppression on the carbon producing acitivities of the developing world, so as to “secure” some “safe volume” of carbon emissions for themselves. Probably combined with climate geo-engineering to preserve the weather, but always in a way that mostly favors the advanced nations and more or less screws over everybody else. As a US citizen I prefer that the US have a commanding lead in climate engineering. As a mildly hopeful human I prefer that energy technology changes.

    If you find the overreach, arrogance, and stunning cost of such misadventures implausible, I invite you to compare:
    * The current defense budget of the USA versus the budgets listed above to finding better energy supplies.
    * The current actual international aid budget of the USA versus anything else in the US budget, in particular, annual cost of US foreign AID versus annual cost of the wars in Iraq or Afghanistan.

    The one thing I think most of us can agree on is that development of vastly better energy sources, and/or vastly better energy using devices, such that they have huge economic leverage, is the only real out. And the “skip generations catch up” model widely used in the developing world can help. (So having all the unlit dwellings in the developing world skip all sorts of nasty intermediate schemes and go direct to daylight balanced LEDs will save them money, energy, carbon, and a host of other headaches they don’t need.)

    But I view any theory that the US, or most of the rest of the developed world, will somehow tax itself to buy “carbon favors” from the developing world about as plausible as the Easter Bunny.

    The weather is going to change, it is probably gonna get hot, prepare yourselves.

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