Why Low-Carbon Technology Innovation is Not Enough

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Mar 19, 2010

Nobody likes new taxes.   When policy wonks like me talk about addressing the problem of global warming by introducing a carbon tax, nobody listens (even though all of the tax revenue could be returned by cutting OTHER distorting taxes on labor or on investment!).  Instead, policymakers like to use the Manhattan Project analogy, essentially saying that we can solve the whole global warming problem just by research and development (R&D), innovation and diffusion of new technology.  We’ll just throw money at the scientists, and they will solve the problem for us.  Policymakers want to subsidize or require wind power, solar power, and other low-carbon technologies.

Here is why that idea will not work, for reasons based on some new research in a book called “Accelerating Innovation in Energy: Insights from Multiple Sectors”, edited by Rebecca Henderson and Richard G. Newell.     To see what might work for energy, they look at technology innovation in all the other sectors where R&D has been successful (the internet, chemicals, agriculture, and semiconductors).  They find that three elements were key in ALL of those success stories: “(1) the substantial, differentiated, end-user demand that enables private firms commercializing the technology to anticipate healthy returns; (2) the sustained funding and effective management of fundamental research; and (3) the development of an institutional environment that includes robust mechanisms to promote the widespread diffusion of both knowledge and technology and that favors vigorous private-sector competition.”

My point is all about #1: there has to be demand in the market for the technology.  No matter how much money Congress throws at the problem of research into new energy technologies, the program will not be successful unless people want to USE those new technologies.  And people will not particularly want to use those new low-carbon technologies, unless they face a carbon tax!  The researchers and developers of new low-carbon technologies might have great ideas, but those ideas will not come to fruition unless people are chomping at the bit to get those new technologies and use them to increase their profits or reduce their carbon tax burden.

My own thinking about this problem relates to the fundamental reasoning for any government policy intervention: the private market works fine unless you can point to a fundamental market failure.  One market failure is the pollution externality from carbon emissions, and that can be addressed by a carbon tax.  A different market failure is that any private firm might not have sufficient incentive to undertake R&D if they don’t capture all the benefits from it.  Patents only last for 17 years, not all ideas can be patented, other firms can see those ideas, and other firms can get similar patents for similar technologies.  These “knowledge spillovers” are a possible justification for government intervention to subsidize basic research, the kind of research that private firms would not undertake sufficiently.

But we still have two different market failures!  Two different market failures require two different policies to address them.  Subsidies for research might help address the knowledge spillover problem, but we still need a carbon tax to get people to want to use those technologies.

That is why we can’t solve the global warming problem by just throwing money into research.

Who Bears the Burden of Energy Policy?

Filed Under (Environmental Policy) by Don Fullerton on Sep 4, 2009

Economists have tools to analyze the distributional effects of income taxes, payroll taxes, property taxes, and corporate income taxes.  Some existing research even looks at distributional effects of environmental or energy taxes used to help control pollution or energy consumption.  Yet most pollution policy does not involve taxation at all!  Instead, we use permits or command and control regulations such as technology standards, quotas, and quantity constraints.  Existing studies of energy policy are mostly about effects on economic efficiency, addressing questions such as: how to measure the costs of reducing pollution or energy use, how to measure benefits of that pollution abatement, what is the optimal amount of protection, and what is the most cost-effective way to achieve it.

Yet environmental mandates do impose costs, and an important question is who bears those costs.  Moreover, those restrictions provide benefits of environmental protection, so who gets those benefits?  Full analysis of environmental policy could address all the same questions as in tax analysis.  Perhaps it could use the same tools to address distributional effects – not of taxes, but of these other policies that are used to protect the environment.

Thinking about the distributional effects of environmental policy is interesting and difficult.  For example, a standard tax analysis would point out some complex implications of an excise tax: not only does it affect the relative price of the taxed commodity, and thus consumers according to how they use income, but it also impacts factors intensively used in the production of that commodity, and thus individuals according to the sources of their income.  Yet an environmental mandate can have those effects and more!  Consider a simple requirement that electric generating companies cut a particular pollutant to less than some maximum quota.  This type of mandate is a common policy choice, and it has at least the following six distributional effects.

First, it raises the cost of production like a tax, so it may raise the equilibrium price of output and affect consumers according to spending on electricity.

Second, it may reduce production like a tax, reduce returns in that industry, and place burdens on workers or investors.

Third, a quota is likely to generate scarcity rents.  For simplicity, suppose pollution has a fixed relation to output, so the only “abatement technology” is to reduce output.  Then a restriction on the quantity of pollution is essentially a restriction on output.  Normally firms want to restrict output but are thwarted by antitrust policy.  Yet in this case, environmental policy requires firms to restrict output.  It allows firms to raise price, and so they make profits, or rents, from the artificial scarcity of production.  Just as tradable permit systems hand out valuable permits, the non-tradable quota also provides scarcity rents – to those given the restricted “rights” to pollute.

Fourth, if it cleans up the air, this policy provides benefits that may accrue to some individuals more than others.  The “incidence” of these costs and benefits usually refers to their distribution across groups ranked from rich to poor, but analysts and policy-makers may also be interested in the distribution of costs or benefits across groups defined by age, ethnicity, region, or between urban, rural, and suburban households.

Fifth, regardless of a neighborhood’s air quality improvement, many individuals could be greatly affected through capitalization effects, especially through land and house prices.  Suppose this pollution restriction improves air quality everywhere, but in some locations more than others.  If the policy is permanent, then anybody who owns land in the most-improved locations experience capital gains that could equal the present value of all future willingness to pay for cleaner air in that neighborhood. Similar capitalization effects provide windfall gains and losses to those who own corporate stock: capital losses on stockholdings in the company that must pay more for environmental technology, and capital gains on stockholdings in companies that sell a substitute product.

Capitalization effects are pernicious.  A large capital gain may be experienced by absentee landlords, because they can charge higher rents in future years.  Certain renters with cleaner air might be worse off, if their rent increases by more than their willingness to pay for that improvement.  Moreover, the gains may not even accrue to those who breathe the cleaner air!  If households move into the cleaner area after the policy change, then they must pay more for the privilege.  The entire capital gain goes to those who happen to own property at the time of the change, even if they sell it at the higher price and move out before the air improves.  Similarly, new stockholders in the burdened company may be “paying” for abatement technology in name only, with the entire present value of the burden felt by those who did own the stock at the time of enactment, even if they sell that stock before the policy is implemented.

Sixth, strong distributional effects are felt during the transition.  If workers are laid off by the impacted firm, their burden is not just the lower wage they might have to accept at another firm.  It includes the very sharp pain of disruption, retraining, and months or years of unemployment between jobs.  These effects are analogous to capitalization effects, if the worker has large investment in particular skills – human capital that is specific to this industry.  If the industry shrinks, those workers suffer a significant loss in the value of that human capital.  They must also move their families, acquire new training, and start back at the bottom of the firm hierarchy, with significant psychological costs.

The challenge here is that many of these effects of environmental policy are likely to be regressive.  Consider the six categories just listed.  First, it likely raises the price of products that intensively use fossil fuels, such as electricity and transportation.  Expenditures on these products make up a high fraction of low income budgets.  Second, if abatement technologies are capital-intensive, then any mandate to abate pollution likely induces firms to use new capital as a substitute for polluting inputs.  If so, then capital is in more demand relative to labor, depressing the relative wage (which may also impact low-income households).  Third, pollution permits handed out to firms bestow scarcity rents on well-off individuals who own those firms.  Fourth, low-income individuals may place more value on food and shelter than on incremental improvements in environmental quality.  If high-income individuals get the most benefit of pollution abatement, then this effect is regressive as well.  Fifth, low-income renters miss out on house price capitalization of air quality benefits.  Well-off landlords may reap those gains.  Sixth, transition effects are hard to analyze, but could well impact the economy in ways that hurt the unemployed, those already at some disadvantage relative to the rest of us.

That is a potentially incredible list of effects that might all hurt the poor more than the rich.  The challenge for those of us who want to claim to do policy-relevant research, then, is to determine whether these fears are valid, and whether anything can be done about them – other than to forego environmental improvements!