The State of the Union may be strong, but the state of America’s energy policy is less clear

Filed Under (Environmental Policy, U.S. Fiscal Policy) by Don Fullerton on Jan 28, 2011

On Tuesday night, President Obama gave the State of the Union (SOTU) Address (transcript) before a joint session of Congress.  The speech drew upon imagery from the Cold War past in order to spur action regarding America’s energy policy.  “This is our generation’s Sputnik moment,” the President declared, and thus he will send a budget to Congress that invests “especially [in] clean energy technology, an investment that will strengthen our security, protect our planet, and create countless new jobs for our people.”  To deal with this “Sputnik moment”, the President set forth two goals: (1) become the first country to have a million electric vehicles on the road by 2015; and (2) get 80% of America’s energy from clean sources by 2035. 

(Not quite as inspiring as President Kennedy’s urging on May 21, 1961 that “this nation should commit itself to achieving the goal, before the decade is out, of landing a man on the moon and returning him safely to the earth.”  On July 20, 1969, Apollo 11 landed on the Moon and Neil Armstrong took his first step on the lunar surface.)

I have three issues with the President’s approach.  First, the wording of the goals in the SOTU Address needs to be parsed carefully in order to understand their meaning or lack of meaning.  For instance, does “electric vehicles” mean all-electric vehicles or do hybrids count towards that goal?  Similarly, what is the definition of “clean sources”?  Fortunately, in this case we have an answer later in the Address.  As the President admits, “Some folks want wind and solar.  Others want nuclear, clean coal and natural gas.  To meet this goal, we will need them all.”  However, ambiguity still exists because clean coal and natural gas technologies can be deployed with or without carbon capture and sequestration technologies.

Second, the President did not offer details about HOW to achieve these goals.  The Address includes references to investments in clean energy technology, but it specifies neither investment level nor investment horizon required to meet the stated goals.  He did not say, for example, $10 billion annually for 10 years.  If clean energy is really a priority for the President, and given concerns about the fiscal deficit, then clarity about the needed investment level would be helpful so that other programs can be identified for cuts in order to balance the budget.  Also, the President said that “clean energy breakthroughs will only translate into clean energy jobs if businesses know there will be a market for what they’re selling.”  I agree.  However, an efficient, well functioning market requires a price signal.  This brings me to my last point.

Third, the President did not directly address environmental policy when setting his goals.  If the President really means “low-carbon” or “no carbon” when he says “clean”, then the absence of a carbon policy in the Address becomes conspicuous.  Specifically, the President did not indicate if he would again push for a cap-and-trade bill.  Given the composition of the new Congress, a cap-and-trade bill or any other piece of legislation that puts either an explicit or implicit price on carbon emission seems politically infeasible.  To have a market for these clean energy technologies, where is the price signal going to come from?  

In their forthcoming book called “Accelerating Energy Innovation: Insights from Multiple Sectors”, Rebecca Henderson and Richard G. Newell look at lessons from the histories of innovation in other industries and implications for the energy industry.   The introduction says: “Taken together the histories point to three key factors as critical to accelerating innovation: (1) well funded, carefully managed public research that is tightly linked to the private sector; (2) rapidly growing demand; and (3) antitrust, intellectual property and standards policies that together promote vigorous competition and the entry of new firms.”

How many people would ‘demand’ electric vehicles at a high price, just out of the goodness of their hearts?  Or would that demand depend on the existence of a policy that raises the price of burning fossil fuels?

The President noted that when Sputnik was launched, NASA did not exist.  Yet, the Department of Energy has existed for many years, and America’s energy policy is still unclear and uncertain.

Without Climate Legislation, We Might Get More Regulations!

Filed Under (Environmental Policy, Finance) by Don Fullerton on Oct 22, 2010

On Tuesday October 19, the Center for Business and Public Policy (CBPP) presented a panel of experts on “Environmental Regulation: Building a Low-Carbon Economy.”  It was sponsored by the College of Business and the MBA Program with financial support from State Farm.  This blog may help tie our virtual audience to activities at the “brick and mortar” University, with a few reflections of my own.

Climate legislation recently failed in this Congress, so the U.S. will not soon adopt any cap-and-trade policy.  To provide incentives for Congress to act, however, the Obama Administration had said that otherwise the EPA will act to reduce carbon emissions using other forms of regulation under the Clean Air Act.   The key question here is what can or should be done without climate legislation.  The Panel members were asked to discuss the future of energy use, its role in creating a low carbon economy, and what future energy policies and regulations will be needed.

The first speaker was William A. Von Hoene Jr., the Exelon Corporation’s Executive Vice President for Finance and Legal.  Exelon has 17 nuclear reactors at ten locations, as well as other plants powered by hydro, wind, solar, landfill gas, and fossil fuels.  Their electricity is relatively low in carbon emissions, with 5.4 million customers primarily in Illinois and Pennsylvania.  They favor carbon pricing because it reduces overall abatement costs relative to a patchwork of tax credits for certain technologies and mandates such as “renewable portfolio standards.”   Those policies might not target the cheapest form of abatement, whereas a carbon tax or cap and trade price would provide clear and crisp signals to reduce emissions in any of the cheapest ways.  He also talked about their “Exelon 2020” business strategy of greening their operations, helping customers reduce emissions, and producing more low-emission electricity.

A problem, of course, is that none of these other technologies are very cheap.  Protections for nuclear power may prevent any new plant, and the U.S. has no long term storage plans anyway.  Other renewable options like wind or solar are not cost-effective unless the cost of coal-fired electricity is raised by a carbon dioxide tax of more than $30 per ton.

The second speaker was Mark Brownstein, Deputy Director of the Energy Program for the Environmental Defense Fund.  He talked first about “what went wrong” with climate legislation in Congress.  Divisions were not just by party but by region, since the President’s plans were offset by a coalition of Republicans and coal-state Democrats.  The recession also added to perceptions that markets don’t work, which spills over to carbon permit markets.  He also talked about “what’s next”, including renewed effort to put climate legislation back on track, with eyes on state action and EPA regulations.   Finally, he discussed “what’s the focus” at EDF.  Besides continued discussion of climate policy and EPA, they are interested in energy market reform.  For example, smart grid technology that links various electricity markets can allow more people to buy power from areas that have newer and cleaner production.

The third speaker was Jon Anda, UBS Securities’ Vice Chairman and Head of Environmental Markets.  He also extolled the virtues of carbon pricing, because it would encourage new technology that could help the U.S. compete internationally.  It would “decarbonize” production at the least cost, minimize leakage, and realize various “co-benefits” (reductions in other pollutants).   In particular, he pointed out that a carbon permit system should not apply to utilities only, because reduced emissions among utilities would be offset by increased emissions elsewhere (“leakage”).  It needs to cover all use of all fossil fuels. 

For example, carbon pricing for utilities only would raise the price of electricity, but that could discourage the use of electric vehicles.  Carbon pricing also needs to apply to gasoline, for drivers to make the right tradeoffs between whether to buy an electric car or a fuel-efficient gasoline car.

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.

It’s Not a Simple Choice!

Filed Under (Environmental Policy) by Don Fullerton on Jan 16, 2010

A lot of research in environmental economics is all about the choice of environmental policy: a pollution tax, an abatement subsidy, tradable permits, or some regulatory mandate.  Economists have made two primary distinctions.  One distinction is between a price instrument (like a tax or subsidy) and a quantity instrument (like a fixed number of permits, or nontradable quota).  It’s a bit esoteric, but the choice between those two categories depends on uncertainty about the cost of abatement, and the slope of the marginal abatement cost curve.

A different key distinction is between a market based instrument (like tax OR tradable permits), as opposed to command and control regulations (like quotas or technology requirements).   This distinction is not so esoteric: having a tax or permit price per unit of pollution provides incentives to abate pollution in all the cheapest ways, and therefore minimizes the cost of abatement.  In contrast, regulators may easily require forms of abatement that are much more expensive.  Estimates suggest that command and control regulation can be six times as expensive as using market based instruments.

The point of this blog, however, is that these choices are too simple.  They do not encompass actual policy choices that are not only more complicated, but that cannot even be so categorized.   The “tax” is usually not on pollution itself, but on gasoline or on a car.  Also, virtually every “reform” is a package, and should be considered as a package!  I’ve shown in earlier research that the combination of a subsidy to abatement plus a tax on output can be functionally equivalent to the ideal tax on pollution.

Another “combination” is in the European Union, where a cap-and-trade carbon permit system applies to about half the economy, including electricity generation and major industries, but which does not cover small industries, residences, and transportation.  So they are now considering a carbon tax for the “nontrading” sector.

And anything done in the United States is likely to be a hybrid.  The Congress seems to want a cap-and trade permit system, or at least to call it a cap-and-trade permit system.  But that variable price may have a ceiling, and it may have a floor.  At the extreme, in a hybrid system as the ceiling and floor get closer to each other, the system converges to the single price of a carbon tax.  In other words, it’s not really one or the other.

Despite the complications, it may be worth our while to think about the ideal combination of policies, not the choice among distinct alternatives.

The Glass is Not 90% Empty; It’s 10% Full!

Filed Under (Environmental Policy) by Don Fullerton on Dec 22, 2009

Happy Holidays, everybody.  I’ll keep this short, since we’re all out of school and busy with family.  I just had a few thoughts on the further deliberations about climate change in Copenhagen.

Some observers might be disappointed about how little was achieved there, but I think that such a view would be based on expectations that were entirely unrealistic.  It would seem impossible to get 193 different nations to agree on anything!  The process is long and difficult, and we could not have expected more than a step or two in the right direction.

Certainly we could not expect a major leap into stringent mandatory reductions of all greenhouse gas emissions.   The world does not yet have enough experience with climate policy, in order to know how it works, how expensive it will be, what are the abatement alternatives, and how the permit trading will operate.   Only some of the nations of the world agreed to the Kyoto Protocol in 1998, and that was viewed as a major achievement.  Even that agreement delayed the first major mandatory cuts by ten years, to 2008-2012.  To prepare for that mandatory phase, the European Union instituted a Phase I of permit trading to meet its own voluntary reductions during 2005-2008.  This “emissions trading system” (ETS) became the largest pollution trading market in the world, and it offers several lessons to the rest of us.  It started with only moderate emission reductions, and a price of only 10-15 Euros per ton of carbon dioxide.  The businesses and other institutions gained experience with permit trading and are now ready to participate in Phase II.

Similarly, it would be a great achievement to involve more nations of the world, even with only slightly more stringent emissions reductions, to gain more experience before leaning on the rest of the nations to participate.

Much of the debate is about whether the U.S. should enact legislation unilaterally, without any new international agreement.  It might be dumb to give everybody else a major advantage in term of production costs.  Again, I would point out the difference between initial small steps, as opposed to the large steps that are needed eventually to deal seriously with climate change.  If we all wait until all nations agree to major cuts, it may never happen.  An important and viable alternative is for the U.S. to lead the way with some small steps, even by ourselves – to establish a climate policy, to impose some moderate emissions reduction, to set an example for the rest of the world, and to proceed then to lean on other nations to join an agreement.

I’d recommend reading the blog by Robert Stavins of Harvard.   He provides a very useful summary of the Copenhagen agreement and some analysis of it.  As inducement to click on his link, I’ll paste just his concluding paragraph here:

“The climate change policy process is best viewed as a marathon, not a sprint.  The Copenhagen Accord – depending upon details yet to be worked out – could well turn out to be a sound foundation for a Portfolio of Domestic Commitments, which could be an effective bridge to a longer-term arrangement among the countries of the world.  We may look back upon Copenhagen as an important moment – both because global leaders took the reins of the procedures and brought the negotiations to a fruitful conclusion, and because the foundation was laid for a broad-based coalition of the willing to address effectively the threat of global climate change.  Only time will tell.”

Eye on the Prize

Filed Under (Environmental Policy) by Don Fullerton on Dec 15, 2009

Recently, somebody hacked into servers at the Climate Research Unit at East Anglia University, and they posted stolen emails on the internet.  From these emails, climate change skeptics claim to have proof that anthropogenic (i.e. man-made) climate change is not occurring.  With the climate summit in Copenhagen underway, some say that this  “climategate” scandal could derail the process.  Instead, I believe this situation allows us a moment to remember the facts regarding climate change.

To be clear, however, I am not writing to judge the contents of those emails sent between a small set of researchers using one method of analysis.

First, the Earth always has had a natural greenhouse effect that depends on CO2 and other “greenhouse gases”.  Without this natural process, the Earth would be unable to trap solar radiation and warm the surface.  Fortunately, so far, the Earth has had a stable carbon cycle that regulates the concentration of greenhouse gases in the atmosphere.  In contrast to Earth, Venus has a runaway greenhouse effect due to its lack of carbon cycle, resulting in a mean planet temperature of 461 degrees Celsius.

Second, the CO2 concentration in the Earth’s atmosphere is increasing.  Over the last 150 years, CO2 concentrations have risen from 280 to nearly 380 parts per million (ppm), and the concentrations are still increasing.  While the exact concentration is an empirical matter, the trend is clear.

Third, humans have been burning fossil fuels in large quantities since the industrial revolution.  Carbon dioxide is emitted by the burning of these fuels (coal, oil, wood, and natural gas).

Those three facts are not in dispute.

The only potential room for debate is the causal connections between human activities including those emissions, and the observed rise in CO2 concentrations.  Since climate scientists cannot perform an experiment to test the causal link, the conclusion that humans are causing climate change can never be proven in the same way as results in other branches of science.

However, many scientists using many different methods conclude that enough evidence exists to prove beyond a reasonable doubt that humans are causing climate change.   Moreover, this climate change is very dangerous and damaging.  It is predicted to disrupt agriculture around the world, change ecosystems in ways that endanger biodiversity, increase extreme weather events like hurricanes and droughts, and raise sea levels enough to cover several island nations, much of Florida, other U.S. coastal cities, and about half of the nation of Bangladesh.

Therefore, it is our responsibility to devise a reasonable strategy to limit the effects of climate change.  I don’t mean that the U.S. should or could do it all alone!  Perhaps a small step by the U.S. might encourage other nations to get on board.  The meeting in Copenhagen this month is another, hopefully productive, step in developing a global plan.

The situation in East Anglia should not distract from the facts.  We need to keep our eye on the prize.

Does a Carbon Tax need a “Border Tax Adjustment”?

Filed Under (Environmental Policy) by Kathy Baylis on Dec 4, 2009

When our colleague Don Fullerton was in Brussels this week speaking at a conference on climate change, he voiced support for border adjustments for carbon policies. This idea was promptly rebuffed with cries of ‘protectionism’, particularly from the business participants. Now, a border adjustment is just a friendly way of saying ‘an import tariff,’ so it’s understandable that people might see them as a harbinger of protectionism. Like most trade economists, I’ve seen many examples of trade policies that were reputedly intended to ‘level the playing field’, e.g. countervailing duties and anti-dumping tariffs, promptly get co-opted and used as a means to protect the loudest domestic industries, so I am sympathetic to this concern. That said, I think there are a number of compelling arguments for introducing some border controls along with a stringent domestic carbon policy.

Think of a carbon tax or cap-and trade system like a Value-Added Tax (or VAT), where border-adjustments are common. Most countries that tax the value-added in production of each good also tax imported goods at the same rate. They do this to ensure that imported goods aren’t given an unfair advantage over the taxed goods produced domestically. The same logic applies to a carbon tax, or a cap-and-trade system on emissions. The idea is that we would like to tax imports at an equivalent rate as domestic production. Thus, we would impose a tax based on the average carbon content of the equivalent domestic product. This approach conforms with the WTO rule of equivalence – that a country doesn’t favor its own producers over producers in another country.

Is designing a border adjustment going to be harder to do for carbon than for a VAT? Definitely, because carbon content is harder to measure than value-added, which is just a price. It also means using domestic carbon content as a proxy for the carbon content in imported goods, which is not going to be accurate. The problem is that the alternative is trying to estimate specific carbon content for all imports, which is not only impossible, but also generates the potential for problems with the WTO.

Now you might well be thinking, you’re suggesting imposing an imperfect, potentially arbitrary tariff on billions of dollars of imports. How can this be a good thing? Let me walk through a few arguments.

1) If you don’t have a border adjustment, other countries have an incentive not to sign on to an international carbon agreement. By imposing a carbon policy domestically, we are raising the marginal cost of production inside the United States, so it gives firms the incentive to move to a lower-cost location as long as they continue to have access to the US domestic market. From the perspective of, say, Indonesia, a US carbon policy might make the US look quite tempting as a potential market. And the last thing they want to do is to get rid of this advantage by imposing a carbon policy themselves.

2) In contrast, a border adjustment means that a country like the US or Europe does not have to wait for an international climate agreement before implementing a carbon policy. In short, because it neutralizes the potential negative trade effects of a carbon policy, it becomes easier for a country to ‘go it alone’ and not have to wait for other developed and developing countries to sign on to a Kyoto-like agreement.

3) Similarly, if you do have a border adjustment, it can be used as an incentive to get other nations to implement a carbon policy, particularly developing countries with a large export base. Only those countries without a carbon policy would be subject to a border adjustment, and the revenue from the border adjustment accrues to the importing country. So an exporting country faces the choice of letting their firms pay the tariff to someone else, or collecting that revenue themselves in the form of a carbon tax or (auctioned) cap and trade permits. So even if the border adjustment is imperfect, one can hope it’s temporary.

I can see my trade colleagues wincing at their computer screens while they read this. Yes, we have had loads of trade measures that were supposed to be temporary that ended up becoming enshrined by the interests that they benefit. So my last argument is for them.

4) Without a border adjustment, import-competing industries will demand special treatment in the form of free permits, or, of more concern, outright exemptions from the carbon policy. Why do I claim this? We’ve seen it in Europe. Under the European Trading System for carbon, each country was allowed to exempt certain industries from the cap-and-trade system, and they particularly targeted those firms in ‘trade-sensitive’ industries. Along with generating concerns about environmental efficiency, such exemptions generate potentially large economic inefficiencies domestically and are incredibly arbitrary. Thus we tend to see the most politically-sensitive industries often identified as the most ‘trade-sensitive’. At least a border adjustment could be designed to be neutral across domestic industries, reducing the potential gains for firms in politically-powerful positions. As an aside, note that industry-specific subsidies could include exemptions to costly general environmental regulations and are subject to countervailing duties (CVD). Thus, I wonder if we might see such exemptions generating a cascade of CVD cases.

OK, I always find it frustrating when people from other disciplines pretend to be economists, so let me be clear that I’m not in any way a trade lawyer, so I can’t speak convincingly on the trade legality of these ideas. That said, we know that border adjustments for VATs are allowed under the WTO. You might also be concerned, however, that any border adjustment policy might spark a trade war, which our anemic global economy certainly does not need. In response, let me note that when the Uruguay round of the GATT was concluded, countries signed on to a ‘peace clause,’ where they agreed not to take trade actions against their fellow countries on agricultural subsidies as long as those subsidies conformed to the Agreement on Agriculture. To facilitate carbon policy, I wonder if there might be the potential to negotiate a similar peace clause for environmental subsidies and/or border adjustments as long as those border adjustments conform to some internationally-agreed upon rules. For example, these rules might try to ensure that countries treat importers no differently than they treat their domestic industries, and that the border adjustments be transparent and apply equally across industries.

In conclusion, border adjustments might help make domestic carbon policy both more palatable and more efficient, and could, in fact, be less harmful to free trade than allowing one-off industry exemptions.

Geoengineering: A Reasonable Solution to Climate Change?

Filed Under (Environmental Policy) by Don Fullerton on Nov 13, 2009

In SuperFreakonomics, the new book by Steven Levitt and Steven Dubner, the authors suggest geoengineering as a possible solution to climate change.  Their assertion has been so controversial that they devoted a long blog entry to its defense.  What is geoengineering, and how should economists think about it?

The National Academy of Sciences defines geoengineering as “options that would involve large-scale engineering of our environment in order to combat or counteract the effects of changes in atmospheric chemistry.”  The specific geoengineering that Levitt and Dubner analyze calls for injecting sulfate aerosols into the stratosphere.  The idea is that the aerosols form a shield to reflect sunlight, thus lowering global temperature.  A similar cooling effect occurs naturally after large volcanic eruptions.  Paul Crutzen, the Nobel Prize winning chemist, estimates that $25-50 billion could be enough to construct a sulfate aerosol shield to counteract a doubling in the current atmospheric concentration of greenhouse gases (see “Albedo Enhancement by Stratospheric Sulfur Injections: A Contribution to Resolve a Policy Dilemma”, Climate Change 77: 211-200).

The traditional solution to climate change calls for limiting greenhouse gas (GHG) emissions that cause global warming.  In a “meta-analysis” discussed in the Stern Review (p.242),  a 50% reduction in worldwide greenhouse gas emissions could cost 2% of world GDP or more.  Let’s see,  world GDP is about $70 trillion, so a 2% reduction in GDP costs $1.4 trillion.   While the comparison here is not exactly apples-to-apples, the point is that these mitigation cost estimates are significantly higher than geoengineering cost estimates ($25-50 billion).  Thus, it superficially appears that geoengineering is the “correct” economic solution to climate change.

However, geoengineering is an ex post solution, where society waits for the symptoms of climate change to become so severe that geoengineering is the only remedy to treat the symptoms.  In contrast, GHG mitigation tries to prevent the symptoms from ever occurring by trying to correct the root cause.

Many present the geoengineering solution as an insurance policy against the disaster of runaway climate change.   Shall we rely on the theory that temperatures can be reduced later, while we continue unlimited burning of carbon?  What if that insurance doesn’t work.  What if geoengineering doesn’t cool the planet as theorized?  What if the sulfates cause other environmental problems?  In addition, geoengineering cannot necessarily counteract the economic effects of severe climate change.  Imagine that society waits for “proof” of climate change, such as waiting for large sections of Arctic ice sheets to break off and raise sea level by a few feet.  At that point the economic damage is irreversible – regardless of the geoengineering temperature correction – with millions of people displaced from low-lying areas, billions (if not trillions) of physical capital submerged, and severe disruption to economic activity.  Then would GHG mitigation look like the bargain solution?

Betting on American Innovation over EPA Mandates

Filed Under (Environmental Policy) by Don Fullerton on Nov 7, 2009

In 2007, the Supreme Court ruled that the Environmental Protection Agency (EPA) has the authority to regulate greenhouse gas (GHG) emissions under the Clean Air Act (link).  This fall the EPA announced its plan to regulate GHG emissions, including carbon-dioxide, by requiring large emitters to adopt state-of-the-art, best-practice pollution abatement technologies (link).  Yet the EPA’s new regulatory plan may rely upon costly methods of reducing GHG pollution.

Under the Clean Air Act, the EPA can only promulgate rules or “mandates” to control pollution.  Requiring every emitter to adopt best-practice pollution abatement technology is an example of a mandate, where the regulator dictates how the emitter must reduce its pollution.

In contrast, economists have long advocated market based approaches to pollution abatement – either a carbon tax or a cap-and-trade system.  Indeed, it is a cap-and-trade policy that passed the House during the summer and is currently being debated in the Senate.

The “cap” sets a hard limit on total pollution, and it then gets tighter and tighter over time, reducing emissions gradually.  Meanwhile, the “trade” part of the policy allows private markets to allocate pollution rights (permits) efficiently among thousands of emission sources.  Capping emissions causes pollution rights to become scarce, and thus the ability to pollute has economic value.  This value is the price at which permits are bought and sold.  If a company holds permits and can reduce GHG emissions more cheaply than the prevailing price, then it sells permits and makes money on the difference; otherwise it may buy permits.  This allows for companies with only expensive pollution abatement options to buy the right to emit at a price lower than they would otherwise incur, thus reducing the cost to society.

In addition, the explicit price on pollution induces profit-maximizing firms to research and implement new and cheaper ways of reducing GHG emissions.  This is a key difference when comparing cap-and-trade vs. mandates.  The price signal of the market based approach induces innovation.  Individual entities acting in their own self-interest will have the incentive to find new and cheaper forms of pollution abatement.  Those future innovations cannot be foreseen, and thus the cost projections of current legislative proposals cannot take them into account.  The costs of reducing GHG emissions are real, but under a cap-and-trade system, U.S. ingenuity and innovation will lower the cost of compliance relatively to current projections.  Why am I confident?  It has happened before.  The cap-and-trade policy to reduce sulfur dioxide pollution from coal-fired power plants cost one-fourth of the project price tag precisely due to unanticipated adaption and innovation by U.S. businesses (link).

Recognizing the Costs and Benefits of Climate Change Policy

Filed Under (Environmental Policy, Uncategorized) by Jeffrey Brown on Nov 4, 2009

I am posting a day later than usual this week because I spent a good part of yesterday participating in a fascinating discussion about U.S. policy towards climate changes sponsored by the Center for Business and Public Policy, the Institute for Government and Public Affairs, and the Environmental Change Institute (all at the University of Illinois).  Three highly accomplished experts on climate change (Charlie Kolstad, Don Fullerton, and Nat Keohane) discussed the various approaches to tackling this global policy priority.  The conversation was refreshing for its analytical clarity, its recognition of both the benefits and costs of alternative policies, and for the fact that it was good economics set against a backdrop of political realism.  It left me wishing that more of our policymakers in Washington would have such high quality conversations when making their decisions.   

 

In preparing my own thoughts for this event, I read through some of the material from two of the many “sides” in the debate over climate policy legislation – the views of the U.S. Chamber of Commerce and the views of the Obama Administration.  Doing so brought back memories of my own days in the White House (in 2001-02 under President Bush).  Specifically, it made me remember the constant struggle between the economists and policy wonks who want to have honest and nuanced discussions about complex issues, and the “spin masters” whose job it is to effectively communicate to the public in a simple way.  I understand the value of simplicity for communication, but all-too-often, the truth gets “simplified away.”

 

Economics is fundamentally about trade-offs.  Perhaps no phrase is more famous for capturing this idea than “there’s no such thing as a free lunch.”  But to listen to the opponents and proponents of climate change legislation – at least after they have been filtered through the communications shops – one could be forgiven for thinking that our policy makers do not understand this.    

 

Let me give two examples – one from each side.

 

The U.S. Chamber of Commerce has an official position on climate policy that states:

 

“Our position is simple: There should be a comprehensive legislative solution that does not harm the economy, …”

 

What is remarkable about this statement is that they do not say that the legislative solution should be one in which “the benefits clearly outweigh the costs.”  Rather, they are imposing a truly impossible standard – that the solution “does not harm the economy.”  The most straightforward interpretation of this is that they are unwilling to accept any cost or slowdown in economic growth in order to reduce emissions.  Unless you believe that there are no costs to climate change and/or no benefit to any solution, this cannot possibly be an optimal – or even rational – policy.  

 

Proponents of climate change often make equally vacuous statements.  To hear many in the Obama Administration speak of climate change, you would think that environmental regulation is good for the economy rather than a cost.  They focus their attention on the number of “green jobs” that will be created, while largely ignoring the large number of jobs in other industries that will be destroyed.  I’ve yet to see a single study showing that environmental regulation is a NET positive for economic growth or job creation in the U.S. 

 

What we need – on this and so many other issues – is a “grown-up conversation” about the costs and benefits.  Of course we know that reducing emissions levels will be costly.  Of course we know that it will require changes in the way we consume and produce energy.  The question is not whether climate policy can be done at no harm to the economy or can even benefit the economy – the question is whether the benefits of reducing emissions is worth the cost. 

 

Fortunately, even if the “talking heads” are not having these discussions, serious thought leaders like those at our forum yesterday are.  Let’s just hope that policymakers listen.