Published July 26, 2019
On the Importance of Pricing Carbon
Economists are famous for their contentiousness. One of the ever-popular jokes about economists asks “What happens if you put 10 economists in a room?” Answer: “You get 11 opinions.” Yet there is one subject on which economists overwhelmingly agree: the single most important thing to do about climate change is to put a price on carbon emissions. Yale’s William Nordhaus was awarded the Nobel Prize in 2018 for his decades of work on carbon pricing. In 2017, a carbon price was advocated by a group of conservative economists including George Schultz (former Secretary of State), Greg Mankiw (chairman of the Council of Economic Advisors (CEA) under President George W. Bush) and Martin Feldstein (chairman of the CEA under President Reagan). Even Trump’s CEA Chair, Kevin Hassett, has endorsed the idea.
Lest you fear economists have been spending too much time taking Ecstasy and singing kum-ba-yah, don’t despair: they do still argue heatedly about whether a carbon tax is preferable to a system of tradable permits (“cap and trade”). But in the bigger picture, both approaches put a price on carbon emissions, so this is a disagreement over the tactics of implementation, not of fundamentals.
The basic logic is simple: if you want people to do less of something undesirable, tax it. Want people to smoke fewer cigarettes? Slap a couple dollars of taxes on every pack. Want people to drink less booze or sugary soda? Tax it by the bottle. Want companies to emit less carbon dioxide? Tax their emissions! The prescription follows directly from the Law of Demand, which says that quantity demanded varies inversely with price.
There is also a subtler argument for carbon pricing that emerges when one compares this policy to other options like fuel economy standards. Fuel economy standards affect only new cars, but do nothing to change the behavior of drivers whose older cars are already on the road. Even for new cars, there is a “rebound effect”: if a car gets more miles to the gallon, people will drive more. (This effect does not fully offset the gains from greater efficiency, but it does reduce them somewhat.) In contrast, a carbon tax raises the price of gasoline, making driving more expensive for drivers of both new and old cars. As a result, the behavior of both groups changes—without any rebound effect. As an added bonus, pricing carbon creates incentives for companies to innovate and find ways to cut their carbon tax bill by cutting emissions.
Most economists will add that a carbon tax by itself is not enough—we also need government funding for research and development (R&D) into cleaner and greener energy sources. For-profit companies don’t do enough R&D because they can’t capture all of its benefits; knowledge tends to spill over to rivals who didn’t do the research. Thus, governments everywhere are typically responsible for most fundamental research. But when it comes to carbon policy, economists find that a carbon price is the one policy to have if you’re only having one. R&D subsidies alone will help to create new low-carbon technologies, but without a price on carbon, consumers lack incentives to adopt them. In contrast, a carbon price (even without R&D subsidies) creates incentives for entrepreneurs to develop low-carbon alternatives and for consumers to adopt them.
On the Importance of Technology Policy
So, to be clear, I strongly support putting a price on carbon. The challenge posed by climate change is monumental and will require us to consider every available lever if we are to come close to addressing the targets laid out in the Paris Accord. Whether via a tax or a cap and trade system, a carbon price can be a critical component of a comprehensive policy mix to address climate change. There are certainly sectors, for example industrials like cement and petrochemicals, that will be hard to decarbonize without incentives provided by a carbon price to capture and store greenhouse gases produced in situ.
However, I would like to take issue with the near blind devotion to carbon pricing at the expense of other policy interventions. In the dogged pursuit of a carbon price, I fear that we have not sufficiently pushed many other policy options that could be equally, if not more, important than a price on carbon. How can this be? Is not a carbon price the preferred solution? My argument is two-fold.
First, while carbon pricing may be theoretically first best, it is not necessarily the second best solution. By this I mean, given political realities, it is highly unlikely that a successful carbon price will be adopted – one that brings about the changes needed in the distressingly short time frame available. Take the United States, a significant number of our elective officials are doubtful of the existence of anthropogenic climate change let alone appreciative of the severity of the problem and the need to act. Serious discussion of a carbon price seems unlikely in the current political environment.
But let’s say that carbon legislation could magically be put on the table. While I am not cynical by nature, you can be assured that numerous special interests will be behind the scenes working feverishly to lessen the impact of a carbon price. In the worst case scenario, a carbon tax passes – and has modest economic impact on business because the price of carbon is too low. Also note, that depending on how crafted, implementation will likely require a significant regulatory apparatus to measure carbon emissions and to punish violators. This would most certainly be the case in a cap-and-trade system. It is not hard to imagine an administration coming in and loosely enforcing the carbon price. Now let’s take these issues and multiply them across the 200 plus nation-states in the world. I’ve been waiting for an effective price signal in the U.S. around greenhouse gases my entire professional life. I suspect the wait will have to continue.
Fortunately, all is not lost. I take it is a base assumption that for us to achieve a decarbonized future will require substantial disruptive innovation across a wide number of sectors. While we’ve been waiting for a carbon price, an interesting number of developments have been taking place. Electric vehicles, while still a small percentage of new sales, have made great progress in performance and costs. Every major automaker is bringing electric vehicles (either battery or fuel cell) to the market, not to mention the inroads made by a number of intrepid entrants like Tesla and BYD. In the energy sector, wind and solar have made great gains and are now cost competitive with natural gas in an increasing number of regions. These developments have come about through a complex mixture of policy interventions – such as subsidies for R&D and the creation of renewable portfolio standards — and the pursuit of private business interests. What is interesting is that the market shifts we are seeing are less about the “internalizing of a negative externality” as it is alternative technologies providing superior performance on the current dimensions of merit in the marketplace. I don’t need to value climate change to adopt the low cost electricity option. I don’t need to be an environmentalist to see value in a Tesla Model 3.
Now, I don’t mean to go all Pollyanna on you. I do not believe for a second that the natural progress of technology will usher in a sustainable future. Modeling work done at MIT suggests that we will need to completely decarbonize the global economy by roughly 2060 if we are to limit global warming to 2 degrees Celsius. This is a very tall order. We are not talking about raising automobile fleet efficiency. We are talking the 100% electrification of transportation either by batteries or fuel cells. We are not talking about electric utilities adopting some pilot solar projects. We are talking about a grid that is 100% renewable (or at least some combination of renewables and other decarbonized sources like nuclear). Policy plays an absolutely critical role in driving the rate and direction of technological advance. Time is of the essence if we are going to address our climate change challenge.
So what can be done? Lots. Greater subsidies for R&D would be top of my list. For example, the continued penetration of electric vehicles and renewable energy are highly dependent on cost effective storage. Significant innovation in batteries can be a game changer. Check out Bill Gates’ Breakthrough Energy for some of the exciting technologies on the horizon. While we are at it, let’s continue to provide tax subsidies for the early adopters of green technologies. These can be critical in the early stages of development to ensure new technologies are price competitive before they have the chance to march down the learning curve or achieve economies of scale (at which point a price on carbon would be theoretically unnecessary). How about better enforcement of antitrust laws? Disruption is often led by entrepreneurial entrants challenging entrenched incumbents. Too much concentration of market power can hinder this important fountain of innovation. How about regulating the pollutants from hydraulic fracking? Raising the production costs of natural gas helps improve the comparative cost advantage of renewable energy. How about a massive infrastructure spend to deliver a smart electrical grid for the 21st century? The future of renewables may very well be in a massively distributed system – solar panels on every home, an electric vehicle in every driveway, all tied into an integrated smart grid creating incredible economic efficiencies in electricity production.
So in conclusion, what we need is a comprehensive technology policy that pursues clean technologies that are price competitive, if not superior, to existing technologies. So while many wait for a price on carbon to solve the problem (and seriously more power to you – let’s make it happen!), I am going to use my voice to advocate for pulling a bunch of other complementary levers that, dare I say, may be more likely to bring about fundamental transformation.
On Not Waiting for Carbon Pricing
We are basically in agreement: both carbon pricing and government R&D funding for clean technology are needed. Moreover, when politicians refuse to enact the first-best policy (carbon price + R&D), we agree that it makes sense to push forward as fast as possible with the second-best policy.
Carbon pricing clearly remains a heavy lift for many US politicians. Senators Lisa Murkowski (R-AK) and Joe Manchin (D-WV) published a joint opinion piece last week in the Washington Post entitled “It’s time to act on climate change—responsibly.” To their credit, they clearly acknowledge that anthropogenic climate change is important. This is fairly mainstream for Democrats, but requires a bit more spine for Republicans, whose party has become a “self-parody” on climate change, in the words of The Economist. But what do they mean by “responsibly”? That it’s important for the US to lead in developing new clean technologies—we don’t want to cede the space to China. And that a price on carbon is apparently too “irresponsible” to even be worth mentioning, at least from the perspective of senators who represent oil and coal states.
I am all for increased funding for clean energy R&D. And I support other tools, such as subsidies for early adopters, stricter antitrust policy, regulating fracking, and building out the smart grid. But I also believe we cannot afford to give up on our political system—we need to work to reform it. With regard to climate, we must continue to advocate for a carbon price, and work to expose the influence of the fossil fuel lobby on US climate politics. We need much greater transparency around corporate political spending and lobbying. The Center for Political Accountability supports full disclosure of corporate political spending and AFSCME and Walden Asset Management support full disclosure of corporate lobbying activity. These organizations are doing great work, and there is a growing roster of companies that are disclosing their political activity. Transparency is an essential part of making our institutions work again, and will help us move toward a first-best climate policy.
Here, here. This is where our arguments converge. I agree wholeheartedly on the need to continue to push for federal carbon legislation as well as other pursue other policy levers. Technology policy or carbon pricing, both require robust democratic institutions that identify pressing societal problems and work towards comprehensive solutions. Our political system must rediscover the ability to inspire and lead. The fate of the world may depend on it.
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