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The Argument for Cap-and-trade (Or why the IGM is wrong)

May 23, 2013
the Economy: Home and the World
4 Comments

There seems to be a settled consensus among economists that carbon taxation is superior to cap-and-trade with support from Jeffery Sachs, Nobel Laureate Gary Becker, Exxonmobil CEO Rex Tillerson, Sierra Club director Carl Pope, and Pigou Club founder Greg Mankiw. Or these three IGM polls of the biggest hotshots in econ. Any frequenter of this blog would know that this has been my preferred position as well. But I’m pretty sure I was wrong – at least to the extent climate change is our primary goal. And revenue potential of carbon permits wouldn’t be that much worse, just a bit more volatile, especially on an infinite horizon.

Evan Soltas aptly states the biggest problem with taxation (albeit reaching the conclusion that  a carbon futures market is the optimal solution):

There’s just one problem. Nobody knows how big carbon’s negative externality — if any — really is. Richard Tol, an economist at the University of Sussex and an expert on carbon-tax research, has compiled 588 estimates of this number from 75 different studies. In an e-mail he tells me that the interquartile range (which excludes the most extreme estimates) is approximately -$25 to $325 per metric ton of carbon (a negative number means a positive externality).

It’s well-acknowledged that estimating externalities is not easy. But here’s what we do know: eclipsing 2º C above preindustrial levels will be disastrous. Right now, we’re on track to a 6º C world. The World Bank doubts it can fulfill it’s mandate in anything more than a 4º C world. But scientists also know, with good probability, if we stabilize carbon at 400 parts per million (ppm) 2º C world. (And we’ve recently breached this limit, for the first time in history).

In the long-run, we also know approximately how many permits we can issue to be 50% certain that we won’t breach this threshold. (Ensure carbon emissions peak no later than 2016). That is, if there existed sufficient international will, we could solve global warming today, with great certainty, under a cap-and-trade regime.

But externalities are more complicated. What is the difference between the marginal social cost and the marginal private cost of carbon? It’s extremely tough placing a dollar value on the environment. We can more effectively calculate the public health cost thereof, but this will certainly undershoot any hope of averting tail risks with regard to climate change. The Clean Air Act handles most of that, without really touching carbon. That’s why I’m actually peeved that this ever passed – it’s kind of like removing ethyl mercaptan from your propane gas. What kind of an idiot would do that? Carbon, like natural gas, is the invisible and odorless gas that’s killing us.

So naturally, because we have no idea what the hell carbon “costs”, politicians will be unable to price it highly enough. Remember, we have a Congress where a rough half (Democrats included) don’t believe in climate change. And because any suggested tax has to be arbitrary, it will fall on the conservative side. In the future, as economic growth continues increasing demand for carbon-intensive activities will be met with both increased revenue and emissions.

In microeconomics, textbooks often cite an example of two factories polluting in a common river. In this far less complex system, the per-unit social cost can be determined, and internalized. And hence taxation will not be arbitrary. This is the most important point, politically if not economically.

If Congress can commit to averting climate change, we can non-arbitrarily argue the maximum acceptable number of permits for n-degree climate change. The insight here is that what’s keeping us from significant legislation isn’t the extent of political will, but the lack of will itself. Once we “make a move” – whether it be through taxation or cap/trade – it’s likely we’ll do the best we can with reasonable exceptions. Every major reform confirms this bias.

So it’s crucial we get the fundamentals right. Now, there are certain conditions under which taxation is superior. There’s been some fascinating work in carbon capture and storage. This can either be on-site (like at a coal factory) or, more complicatedly, from atmospheric air itself. Under current regulation, plants around the world think this is too expensive, because the technology is very nascent. But if scientists develop viable carbon capturing techniques, the government can very reasonable price each ton emitted at the cost of recapturing from the air.

The not-so-obvious implication of this argument is that carbon taxation is effectively revenue-neutral. If the government has to deploy a large-scale program to recapture emissions, all earned revenue is – by accounting identity – consumed.

A few notes on the very novel solution Soltas suggests:

Nicolaus Tideman and Florenz Plassmann, economics professors at Virginia Tech and SUNY Binghamton respectively, have an ingenious solution. In a paper published in 2010, they say polluters should be made to buy a special 30-year, zero-interest bond from the government for every unit of pollution they emit. The government would set the principal at a reasonable upper-limit estimate of the per-unit cost of pollution. The bond’s redemption value, though, would be set in the future. Bondholders would receive what is left of the principal after subtracting the actual cost of the pollution as determined by an independent agency at the bond’s maturity.

Investors could trade the securities in a secondary market, creating a prediction market for the cost of emissions. Investors who think the bond market is overestimating future costs will buy the bonds. Those who think the market is underestimating the costs will sell them.

“If you’re going to deal efficiently with pollution, it’s appropriate to put an incentive on people to economize,” Tideman said in an interview. “But you’ve got to get the price right. Experience tells us that the best way to get information about the future is a futures market. Our proposal adapts a futures market to address climate change.”

Tideman’s and Plassmann’s insight is that policymakers don’t know the actual future costs of pollution and don’t need to guess. Their market would determine the actual liability of most polluters, except for those who chose to hold the bonds to maturity. This solution uses the ability of prediction markets to synthesize a price from disorganized, disconnected bits of knowledge.

It is ingenious indeed, but not ideal. The independent agency in question will have the same problem government has in pricing carbon (that is it will be underpriced, by political nature), though it benefits future correction from a prediction market. But the whole premise derives from the ability of investors to reasonably deduce what future costs might be. There’s good reason to believe climate change poses serious tail risks, which makes this a pretty futile effort. Reason is, understanding climate science requires a lot of expert knowledge. An effective futures market assumes that said experts are not so risk-averse as to avoid the market to maximize the discounted present value of their profits.

Irrationality may not be a big deal in gold futures because level of expertise isn’t as significant a barrier, and those with the most valuable information aren’t as risk-averse (they will probably be investing on behalf of a bank). The whole idea of prediction markets seems to fall apart if a select few won’t fully divulge information onto the market (that is, maximize their profits without any consideration of risk). Maybe if Al Roth put his mind to it, he’d design a market that fixes this failure. But, until he does, I must hold back my endorsement for Tideman and Plassmann, except perhaps for the most creative solution.

Or perhaps J.K. Rowling ought to write a new book on codfish and the environment…

P.S. Some interesting thoughts from the comment section. Evan Soltas says:

Ashok, something you should read — and the most convincing argument I’ve seen for cap-and-trade — comes from an old article called “Prices vs. Quantities.” http://www.jstor.org/stable/2296698. Weitzman’s reasoning is that at the point where the costs are both uncertain and highly nonlinear with quantity, you can minimize the deadweight loss with a quota rather than a tax. Note that the optimal carbon level is just as hard of a cost-benefits question as a carbon tax. And I think tax wins big points over cap-and-trade when you get into the nitty-gritty of it. If you do cap-and-trade for big firms only, that’s a distortion, and it doesn’t solve the whole issue; cap-and-trade for all firms would be a logistical nightmare. Much easier just to collect tax at the point of production!

Martin Weitzman is one of the most interesting environmental economists (you should check this scary article with a silver lining). Soltas’ point got me wondering, and I’m starting to think climate change is a fantastic real-world manifestation of the Ellsberg Paradox. Me:

Going through [Weitzman’s model] itself, climate change strikes me as the rather perfect example of uncertain costs. And it is at least ethical in the sense of accepting the social discount rate. It really seems like the real-life approximation of the Ellsberg Paradox. (And the Knightian uncertainty thereof is what makes pricing, and to a lesser extent futures, a challenging task). This suggests we should act on this sooner-than-later (even disregarding the scientific benefits of doing so).

And if we do anything at all, it seems it would be easier to legislate command by quantity than by price. I’ve thought a bit about the logistical issue, and wonder if a robust trading regime would spawn several large financial organizations that mediate allocation of permits to smaller firms. Perhaps allowing them to “borrow” a permit today and pay for it later.

The distortion then, of course, is rents earned by said organizations!

Malaria, DDT, and Affluence

February 25, 2013
Uncategorized
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American and European agencies that regulate “organic” food, obviously, require said crops to be DDT-free. This makes a lot of sense.

There’s a big fight out in Uganda now between organic farmers making tons of cash on European supply chains and the real humanitarians that want to get rid of malaria (which decreases, as Jeffrey Sachs has demonstrated, GDP by 30% controlling for all other factors).

There are many ways to treat rid of malaria (bed nets being a prime example), however DDT is remarkably cost-effective. The organic farmers in Uganda have pretty much put a stop to all activities that would cripple malaria, thereby subjecting their countrymen to another generation of poverty, disease, and malnourishment – in hopes of meeting American and European standards.

This is just another example of how the well-intentioned crusaders for an all organic world ignore that for anyone that isn’t rich, organic food is irrelevant, and probably harmful (with second-order effects).

I’d bet every dollar of foreign aid (which is a mess by itself) that goes towards malaria relief has been counteracted by Greenpeace spreading exaggerations across the world. You don’t have to give any money to help those afflicted, just stop giving to various, “eco” groups that make the situation far worse than it is.

 

Addendum: I have nothing against real, substantive environmental policy. I’m a fan of high carbon tax rates, higher efficiency standards on air travel, awareness of depleting fossil fuels, etc. I’m just allergic to much of the crap that dominates “eco-talk”, like Greenpeace asserting Google and Cloud computing are a threat to the environment when video-cons reduce the need for carbon-intensive executives to be in Australia in the morn and DC in the eve. 

The Whole Foods Whoax

December 11, 2012
Uncategorized
3 Comments

So I live in India – where the “Green Revolution” really started. Many people – here and elsewhere – have a very critical opinion of the work of M.S. Swaminathan and Norman Borlaug (the fathers of the revolution). This criticism is usually presented along with a general criticism of genetically modified foods and other “unnatural” endeavors.

Broadly, the criticism levied falls into several categories:

  1. Socioeconomic: The Monsanto/Cargill empires are breaking down the “small farm” community that once thrived. Labor exploitation is on the rise and the corporations are reaping the profits from the poor farmers.
  2. Health: The pesticides in Green Revolution food are not healthy to eat and is a broad cause of lifestyle distress (I’ve heard claims/speculations as far reaching as that non-organic foods cause cancer from “reputable” news sources).
  3. Environmental: Modern agricultural practices are water-intensive and unsustainable at best – a means of “converting petroleum into food”.

There is some truth to each of the arguments made above. But to what extent does this justify a revolution to the past? To what extent has “modern agriculture” the devil that many make it out to be (and there are many such people here, especially in India).

Socioeconomics From a socioeconomic perspective, I agree that modern farming might be resulting in greater income inequality between large farmers and the actual laborers. However, this is largely a structural flaw of any scaled enterprise. When the Industrial Revolution to foot in Europe and the United States the inequality between the robber-barons and the laborers skyrocketed. However, the general wealth of the population increased. Inequality, per se, is not bad, it can even be a great motivating force (I say this carefully, having fallen on the “right” side of inequality). I’m not trying to throw a free-market, Milton Friedman argument here – but I am saying that the effect on inequality per se is not justification enough.

Government regulation to ensure fair treatment of laborers through prevention of monopsonies is one partial solution. India is largely unmechanized (due to backward government policy encouraging manual work) – the number of agricultural workers in the future will hopefully decrease the need for there to be such a large disconnect between the “owners” and the “workers” in which mechanization allows the “owners” to work their own soil.

The day Facebook had its IPO, the income inequality in California (and the country, and the world) ever so slightly increased. Are we the worse of? Scalability and efficiency even if not ultimate goals benefit all of us.

I had a small epiphany the other day when I went to eat at a chai-kadai for lunch (something that is of questionable sense for someone who has lived in the US for fifteen years, as I have). I had a full, hearty, meal for Rs. 20 (eggs, tons of rice, beetroot – nutritious and healthy) as well as a cup of, well, chai. Rs. 20 is equivalent to less than 50 cents. Such affordable meals have allowed the Indian masses to put food on their tables. So yes, inequality has increased, but so has the ability for the common man to feed his family (a very patriarchal society indeed).

Naysayers of the revolution point to the fact that the Food Corporation of India wastes over half its grain each year – a result of India’s Green Revolution. This is probably a good example of reverse causality. We must a priori assume that India cannot store its food because there has been no investment in the technology needed to do so. A terrible cold-chain, no silos, etc. Therefore the Green Revolution has allowed a large portion of India to eat despite its terrible ability to preserve food.

In 1968, Ehrlich argued that millions would starve and die because “India couldn’t possibly feed two hundred more million people by 1980”. No, not without science it could not. As a result of Borlaug’s dwarf wheat, India became self-sufficient in cereal production by 1974. You find that many of the pro-organic crowd here and elsewhere fall near the top of the socioeconomic spectrum – they’re not the ones who would pay the price when the country doesn’t have enough food. They’re not the ones for whom a lunch means three more hours worked, for whom putting food on the table means migrating away from the kids for maybe over eight months.

Health Organic sounds a lot healthier. And is a lot healthier if you don’t properly take care of the fruits and vegetables you are eating (washing it, etc.) However, thelargest scientific study on this issue – which used data from over 50 years of nutritional studies – noted that there is a negligible positive effect when one consumes organic food. This is not to say that organic is less healthy or that one should not consume organic food – there might be other reasons to do so. For example, animal welfare is generally a more important concern for organic farms than it is for conventional farms. However, this is again a tangent to the real question at hand.

Environment This is the big question, isn’t it? Now, let’s start with the facts. If we revert to Organic Farming, as Norman Borlaug has calculated, the world would be able to sustain ~4 billion people. Before we even consider organic farming, we should accept a priori that we are willing to pay the social cost of a Malthusian catastrophe. Indeed there is something deeply unsettling to me that the millions paying for this do not include those paying seven dollars for a gallon of milk.

I am the first to accept that the status quo, too, is unsustainable. There are states and farms in India that will probably loose the ability to remain fertile in about ten years, a result of modern agricultural practices. However, there do exist ways to sustainably farm using industrial methods. Can we not have major, scientific, research schemes that find ways to increase the productivity while at the same time decreasing the environmental cost? When there is large-scale investment in science (likely in times of war) we find that great advances do happen. We should inject warlike funding to such programs to allow for a more sustainable world.

A common question ignored is that modern farming allows you to receive a greater yield rate per acre, which allows you to till a lower surface area and thereby allowing you to conserve a greater portion of your total land. We would certainly have to increase our “area farmed” (and cut into untouched, pristine areas of nature) were we to abdicate efficient farming practices.

We must first make the steps that have the greatest impact per dollar spent. This means, for a country like India, to invest in high-quality silos, to teach farmers about the proper way to use herbicides, develop a high-quality cold-chain. This would do far more for the environment per dollar spent than investment in organic farming.

There are also simple steps we can take. Eat locally, from your farmers market… Don’t buy Kiwis (sorry New Zealand!) In fact there is some irony in the fact that Whole Foods imports from overseas (at great carbon cost) much of its organic produce in the winter when “conventional” food is available next door.

This post is already too long – and I don’t want to end on a negative note. I understand the merits of organic farming just I’ve heard too much lately about how modern agricultural has ruined the world and I don’t believe that is by itself true. Are we “borrowing from tomorrow”? Maybe. But with organic agriculture you would be borrowing from the many people that would not have existed today or be living on below-subsistence levels of food. To become better we do not need to look back, but look forward. What works about organic farming? How can that be incorporated into a modern and industrial model.

As a final note, when we for reasons of intuition and gut reject science – an evidence-based system – I think we are doing a disservice to our future. To question and challenge science in a rational and critical manner is one thing, but to damn it as a pawn of “big ag” is quite another.