Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

Gas prices are back in the news, simply because gas prices are rising.  Reporters like to discuss WHY gas prices are rising, but who knows?  The price of gasoline or crude oil can vary with any change, either in supply or demand.  We can always point to shifts in demand (like the growing economies of China and India), and we can always point to shifts in supply (like the shutdown of production due to unrest in countries of the Middle East and North Africa).  But it’s very difficult to sort out the net impact of each such factor, since the price is affected daily by so many different changes.

Instead of trying to answer that question here and now, let’s take a step back and look at whether any of the current changes are really that unusual.  Is the price of gas really high by historical standards?  And how much of that gas price is driven by energy policy, taxes, and factors under the control of policymakers?  In other words, let’s just look at the facts for now, and then try to analyze them later!

Here are the facts, for the fifty years since 1960.  The first figure below is from the U.S. Energy Information Administration (EIA).  Look first at the BLUE line, where we see what you already know:  the nominal price of gasoline has risen from $0.31/gallon to what’s now $3.56/gallon.  It’s driving us broke, right?

Well, not so fast.  The RED line corrects for inflation, showing all years’ prices in 2011 dollars.  So both series stand at $3.56/gallon in 2011, but the red line shows that the “real” (inflation-corrected) price of gasoline back in 1960 was $2.33/gallon.  In fact, compare the red line from 1960 to 2009: over those fifty years, the real price of gasoline only changed from $2.33 to $2.42 per gallon – virtually no change in the real price at all! 

From 2009 to 2011 the real price increased beyond $2.42, rising to $3.56/gallon, but that may be temporary.  You can see that the red line bounces around for the whole fifty year period.   In 1980, the real price was $3.35/gallon, so the current price is not much different from previous upward blips in the real price of gas.

Now look at the U.S. Federal Gasoline Tax Rate, in the next figure.  The red line in the next figure shows that the nominal statutory tax rate was four cents per gallon for years, and then it was increased in various increments to 18 cents per gallon today.  But of course, inflation has changed the real value of that tax rate as well.  Using 2011 dollars again, both real and nominal tax rates are 18 cents per gallon today.  But in 2011 dollars, the 4 cents per gallon back in 1960 was really equivalent to 29 cents today.  In other words, the real gas tax in the green line has fallen from 29 cents per gallon fifty years ago to only 18 cents today.

The gas price may be rising, but not due to any increase in the Federal gas tax.  That Federal gas tax is falling in real terms.  In the next entry, we’ll take a look at the various State gas tax rates, and we’ll look at how many of those taxes are fixed per gallon – so that they fall in real terms as inflation reduces the real value of those State tax rates.

I would never ever want to be a macroeconomist charged with making economic predictions.  In fact, I’m sorry that anybody makes macroeconomic predictions, because they can’t always be right, and the fact that they turn out wrong gives all economists a bad name!   Yet I particularly like it when some non-economist friend of mine asks  “Do you think the economy is going to improve, or worsen?”  That just gives me a chance to respond, “YES!  That is, yes, I think the economy will improve or worsen.”

So I’m particularly reluctant to write any blog about the poor state of the macro-economy, what should be done about it, and when we are likely to see any turnaround.   But today’s article in the Washington Post is about macroeconomics and environmental policy!  It is called “Obama laments job losses, announces tax credits for clean energy”.   How are those connected to each other?   Only through rhetoric.

Basically, all of the points are valid, as presented by the article and even by the Obama Administration spokespersons.   The economy is bad, and we don’t know when it will improve.  We don’t even know what is the effect of last year’s stimulus bill, because we’ll never know what would have happened without the stimulus bill!  And it’s also true that we might need more stimulus.  And it is furthermore true (even if unrelated) that it might be a good idea to spend more money on green investments, to aid the transition away from burning fossil fuels that worsen global warming, and towards energy efficiency and alternative sources of energy such as solar power.

More specifically, the Washington Post article says:

“The unemployment rate was unchanged at 10 percent, the Labor Department said. Forecasters had expected zero net change in the number of jobs on U.S. payrolls, and some had had expected job growth to return. Those expectations were dashed by a report that — while not without bright spots — suggested that the long slog toward an improved labor market continued in December.”

That paragraph seems unrelated to the prior one:

“As part of an effort to ‘close the clean-energy gap,’ he announced the awarding of $2.3 billion in tax credits to American manufacturers of technologies such as wind turbines, solar panels and cutting-edge batteries. The credits — destined for 180 projects in 40 states — will generate 17,000 jobs and help leverage $5 billion in private-sector investment that would create tens of thousands of additional jobs, while doubling the amount of renewable power over the next three years, Obama said.  …  Since there are far more qualified applicants for the credits than the federal funding will cover, he said, he is calling for investment of an additional $5 billion in the program.”

Yet the Administration might as well link the two, at least to appear to be doing something, and to make headway on another important agenda item.  Just as stated by Obama’s Chief of Staff, Rahm Emanuel, “You never want a serious crisis to go to waste — and what I mean by that is an opportunity to do things that you think you could not do before”.  You can even listen to it on You-Tube, if you click here!

Speaking of “unrelated”, I have another link to suggest.  If you are interested in hearing about progress in Copenhagen toward international agreements on climate change, in the style of Dr. Seuss, click here!

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.”

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.

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.

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.

This week the Senate began committee hearings on S-1733, the Kerry-Boxer Bill, with a mark-up expected within the next two weeks.  The authors modeled their Senate bill on the House’s Waxman-Markey Bill that passed the lower chamber in June.  The main component of both bills is a cap-and-trade system to limit greenhouse gas (GHG) emissions in the United States.  Although the Congress has a full agenda, legislative action is critically important at this moment due to the upcoming United Nations Climate Change Conference in Copenhagen, to prove the United States is willing to participate in global GHG mitigation.  (For more information visit: http://en.cop15.dk/)

When the U.S. negotiators sent by President Obama return from Copenhagen, any treaty they sign must be ratified by the Senate with a two-thirds vote, before it could take effect.  This check on the power of the Executive branch is enumerated in Article II, section 2, of the U.S. Constitution, which states the President “shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two-thirds of the Senate present concur.”  Thus, a treaty must gain the support of 67 senators in order to take effect, a number unrealistically high for an issue as contentious a climate change.

If any agreement in Copenhagen is not signed or not ratified, however, it does not mean that the U.S. cannot be a partner in a global climate solution.  Indeed, the U.S. can act as a de facto treaty member by passing domestic climate change legislation that can be harmonized with international standards.

To enable harmonization with an international treaty, domestic legislation requires three main features.  First, for fairness and competitiveness, the emission reduction targets must be comparable to those of the other industrialized economies such as those in Western Europe.  Second, to reduce the total cost of GHG reductions, it must allow for the sale and purchase of verifiable allowances across international borders.  Third, it must establish a mechanism for technology or monetary transfers to developing countries, lessening their mitigation burden and hopefully bring countries like China and India into the agreement.

The Senate proposal and the House bill demonstrate to the international community that the U.S. is serious about climate change mitigation.  Indeed, the framework in these bills provides a basis for U.S. negotiations in Copenhagen, and furthermore, any agreement at that international conference will influence the final form of the domestic legislation.

I’m a tad late to upload my Friday blog, since it’s already Sunday, and now Charlie Kahn has beaten me to the punch.  I’ll assume it’s better late than never, and still provide what I could have uploaded on Friday.  As I said last week, I was invited to speak about climate policy to the 27 Finance Ministers of the 27 countries in the European Union.  The EU has an “Emissions Trading System”, which is a carbon dioxide cap and trade permit system — an economically efficient way to cut greenhouse gas emissions.  But it only covers electric utilities and certain other industries, only 45 percent of emissions in Europe.  For some reason, they don’t want simply to expand that system to cover the whole economy, as they certainly could.  So the question is what to do in the “non-trading” sector.  Anyway, here is what I told them:

I’m greatly honored to be able to talk to you today, about the choice among policy instruments for pollution abatement.  It is a very difficult but important job you are undertaking, the planning for efforts to reduce emissions of carbon dioxide and other greenhouse gases (GHG).  I cannot help you with the details of policies in Europe, but I hope to be able to clarify a few of the conceptual issues in the choice of policy.

All pollution abatement polices can be grouped into two broad categories.  On the one hand, we have traditional regulations such as technology mandates or performance standards.  Examples include energy efficiency standards, building codes, mandated use of renewable fuels, scrubber requirements, and vehicle fuel efficiency standards.  On the other hand, we have market-based economic incentives that impose a price per ton of emissions.  Examples include a carbon tax or cap-and-trade permit system.

In the comparison among these alternatives, I will focus primarily on cost efficiency, by which I mean the ability to achieve the minimum total cost for any given amount of abatement.   In this regard, all of the policies listed above could achieve the same cost efficiency, if policymakers have full information about all the costs of all the technologies.  With only the use of regulatory mandates, for example, then legislative bodies would have to specify which areas should use wind or solar power, which areas have ready access to natural gas, and which areas have geology that might be favorable for carbon sequestration and storage.  Policymakers would have to identify the cost-effective technologies for each different product or activity.  If all this information were available, and the regulations required only the least-cost ways to cut greenhouse gas emissions, then this approach could be perfectly cost effective.

In contrast, the use of a carbon tax or permit system effectively imposes a price per ton of carbon or other greenhouse gas emissions.  For sulfur dioxide and other pollutants, such pricing requires measuring emissions that actually emerge from each smokestack.  Emissions of carbon dioxide do not have to be measured directly, however, because those emissions are directly related to the carbon content of the fuel being burned.  A tax or permit price can be imposed on each ton of coal at a rate that reflects the carbon content of that coal, and on each barrel of oil at a rate that reflects that carbon content.   In fact, this price is even easier to collect if it is imposed not “downstream” on each of the millions of businesses that burn fossil fuel, but instead “upstream” on the relatively few firms that produce such fuel (that is, at the mine mouth, oil well, or natural gas pipeline).   Either way, it raises the price of fuel that is carbon intensive, and therefore reduces the use of whatever fuel is the most carbon intensive.

So far, the various alternative policies could be roughly equivalent.   If a cap-and-trade system limits the total amount of carbon dioxide and drives the price of a permit up to €16 per ton, then that policy has the same effect as a carbon tax at the rate of €16 per ton.  With full information, the two “market-based” incentive policies are identical.  The difference between them is subtle, and it only arises with uncertainty or imperfect information about the costs of alternative abatement technologies.  In that case, a carbon tax places a clear and certain price per ton of carbon dioxide emissions, and it encourages all of the cheapest forms of abatement, but policymakers cannot be sure about exactly how much abatement will be undertaken.  In contrast, a cap-and-trade system places a clear and certain limit on the total amount of emissions, to achieve a certain amount of abatement, but we cannot be sure exactly what the price is going to be.

Either way, however, a price per ton of emissions achieves cost-efficiency, because it provides incentives to businesses and households to undertake any abatement that costs less than the price per ton of emissions, and it encourages them to forego any form of abatement that costs more than the imposed price per ton of emissions.

This discussion now brings us to the major difference between market-based incentives and the other more traditional forms of regulations like technology mandates or performance standards.  And this difference is large and important, not subtle.  In most cases, policymakers are never going to know the cost of each technology or method of pollution abatement.  That information may be very technical, and it is specific to each firm or each location.  Only the engineers within a firm may be able to figure out what are that firm’s most cost-effective technologies.  Any mandates imposed from outside are unlikely to require the cheapest technologies, and they may require some very expensive technologies.  Only omniscient policymakers could achieve cost-effective abatement.

Because this point is so important, let me elaborate by example.  The sector covered by the permit system includes many kinds of activities with many possible abatement projects, but consider just the six projects shown in the graph.  Each may have a very different cost per ton of abatement.   If a set of mandates were to choose imperfectly, it could require expensive technologies and miss some cheaper options.  With a single price of €16 per ton, however, then the various businesses could choose for themselves, knowing what they know about the costs of their own technologies.  All projects cheaper than €16 per ton are undertaken, and the expensive ones are not.

Now consider the second part of the graph, showing some projects in the sector not covered by the permit trading system.  With no policy in the uncovered sector, then none of these projects may be undertaken by firms there, even cheap projects that cost less than €16 per ton.  Again, policymakers could try to “pick the winners”, but perhaps without the inside information required to know which are really the most cost-effective methods of abatement.  Imperfect mandates could require some expensive options, and skip some of the cheapest ones.  Finally, consider a carbon tax in the uncovered sector.  If the tax is set at a rate of, say, €10 per ton, then the firms have incentive to undertake any project that costs les than €10 per ton of abatement, and not the more expensive ones.  In this case, abatement is cost-effective within the uncovered sector.

Unless the rate of tax in the uncovered sector is the same as the permit price in the covered sector, however, the overall effort is not really efficient.  In the example of the second graph, where the permit price is €16 per ton and the tax is €10 per ton, then the uncovered sector would not undertake the two projects that cost €11-14 per ton, even though those projects cost less than some of the €16 projects undertaken in the covered sector.  In fact, overall efficiency is improved by making the tax rate in the uncovered sector closer to the actual permit price in the covered sector.

I usually upload a new blog each Friday, but this week I traveled from Illinois to Sweden, where I am honored to be invited to address the collected Finance Ministers of all 27 nations in the European Union.  They are meeting in Sweden, because that nation currently holds the rotating presidency of the European Union.  They are having meetings about the economic downturn and other financial matters, but one of their meetings is about climate policy.  This meeting is intended to prepare for the December negotiations among all the nations in the world in Copenhagen.  Already the European Union has an Emissions Trading System (EU-ETS) that places a price on carbon dioxide emissions in the trading sector, but the trading sector includes only about 45 percent of carbon dioxide emissions.  Thus they wonder what policy could be used to reduce greenhouse gas emissions in the non-trading sector.  As one option, they are considering a carbon tax.  I’ll write more about these policies later, when I’m back in the United States, but meanwhile I thought I would upload a copy of the interview that was published on their website.

“The most important thing is an agreement in Copenhagen”

“The single most important action to reduce carbon dioxide emissions is for all nations of the world to agree to binding emission limits when they meet at the Climate Change Conference in Copenhagen.” So says Professor of Finance Don Fullerton from the University of Illinois, who is one of the speakers at this week’s meeting of finance ministers in Göteborg.

On Thursday and Friday the EU’s finance ministers and governors of central banks will meet in Göteborg. Don Fullerton, an expert on taxation and environmental economics, has been invited to speak about cost-effective policies for reducing carbon dioxide emissions.  “I consider that the sectors not under the EU Emissions Trading System could also be made to face a tax on carbon dioxide emissions. This policy is cost effective because it is expected to provide incentives for businesses to cut emissions by any of the cheapest ways possible”, says Don Fullerton.

Don Fullerton’s work aims to find the cheapest ways to reduce emissions. The cheaper the methods, the more likely that they will be accepted by the public and implemented by policy.

Cheaper to act now

“It is not realistic to believe that we can cut carbon dioxide emissions without any costs at all”, says Don Fullerton.  “But the world still gains by cutting emissions now, because the cost of doing so is less than the cost of global warming if we don’t act.  The longer we wait, the greater the consequences in the form of sea level rise, loss of biodiversity, etc.  The cost of stopping global warming later on will be higher.”

Strength in numbers

In Don Fullerton’s view, all countries of the world must act together to reduce emissions and reach an agreement in Copenhagen.  “A small set of nations cannot do it alone, because one set of emission cuts could be more than offset by increases in carbon dioxide emissions elsewhere. When the governments have reached an agreement in Copenhagen and each nation has to cut emissions, then the most important policy for each nation is to put a price on emissions, either by an emissions trading system or a tax on greenhouse gas emissions”, concludes Don Fullerton.

Speakers

Besides Don Fullerton, a number of other economists are coming to address the finance ministers and governors of central banks at the ministerial meeting in Göteborg. These include Lars Nyberg from the Riksbank (Swedish central bank) who will speak about financial supervision and crisis management, Jean Pisani-Ferry, Director of the think tank Bruegel in Brussels, Francesco Giavazzi, from Bocconi University and MIT, who will speak about ‘exit strategies’, and Stephen Nickell from Nuffield College in Oxford who will speak about employment policy.