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What economists say about carbon pricing

The views expressed are those of the author and are not necessarily those of Scientific American.


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A natural gas drilling rig in Colorado. Photo: Reuters

I last raised the issue of a carbon price in “What Unconventional Fuels Tell Us About the Global Energy System”, which added several data points to Charles C. Mann’s already thorough discussion of fossil fuels for The Atlantic. My conclusion is: a carbon price is needed to induce large-scale changes of how we produce and consume energy. It’s only part of the solution, but one that many experts say is needed to reduce carbon emissions.

A more in depth discussion of carbon pricing will have to wait, but in the meantime, I direct the reader to several resources that I personally have found useful for understanding the economic rationale of a carbon price.

There are several points I hope you take away from the readings:

  • Economists largely agree that assigning a price to carbon is one of the least intrusive means for reducing carbon emissions.
  • The resistance is largely lack of political will/public understanding.
  • There are views in favor of pricing carbon across the political spectrum. It’s not simply a liberal/conservative or Democrat/Republican issue.

I’ll save a discussion of the political aspect for later. For now, the economics of carbon pricing.

The first is a paper by Gregory Mankiw, currently a Professor of Economics Harvard University, making the case for Pigouvian taxation to address carbon emissions (as opposed to a permit trading scheme). Here is what he says in a 2009 paper titled “Smart Taxes: An Open Invitation to Join the Pigou Club”:

The economics here is straightforward: emitting carbon into the atmosphere entails a negative externality. In absence of any policy, people will emit too much. The Pigovian policy response is to impose a tax on carbon emission. This will induce households and firms to internalize the carbon externality when deciding, for example, how much to drive, what kind of car to buy, how much electricity to use, what kind of electric power plant to build, and so on.

On implementing a carbon tax in a global environment:

A global carbon tax would be much easier to negotiate [than cap and trade]. All governments require revenue for public purposes. The world’s nations could agree to use a carbon tax as one instrument to raise some of that revenue. No money needs to change hands across national borders. Each government could keep the revenue from its tax and use it to finance spending or whatever form of tax relief it considered best.

Continuing:

But the United States is a big oil consumer — in fact, we use almost a quarter of the world’s production. As a result, we have substantial market power. Our tax policies can have a significant impact on the world price of oil. This means that, in the long run, part of a US gasoline tax gets paid by the producers of oil, not the consumers.

Full PDF here. In reference to the third bullet point above, Mankiw is a conservative, previously serving as Chariman of the Council of Economic Advisors under President George W. Bush and later as economic advisor to Mitt Romney’s presidential campaign.

The second piece is by Nicholas Stern, who released an influential report 2006 for the British government. The review goes into detail about the economics of climate change and reaches these conclusions:

Three elements of policy for mitigation are essential: a carbon price, technology policy, and the removal of barriers to behavioural change. Leaving out any one of these elements will significantly increase the costs of action.

The report continues:

Establishing a carbon price, through tax, trading or regulation, is an essential foundation for climate-change policy.

The first element of policy is carbon pricing. Greenhouse gases are, in economic terms, an externality: those who produce greenhouse-gas emissions are bringing about climate change, thereby imposing costs on the world and on future generations, but they do not face the full consequences of their actions themselves.

Putting an appropriate price on carbon – explicitly through tax or trading, or implicitly through regulation – means that people are faced with the full social cost of their actions. This will lead individuals and businesses to switch away from high-carbon goods and services, and to invest in low-carbon alternatives. Economic efficiency points to the advantages of a common global carbon price: emissions reductions will then take place wherever they are cheapest.

The report is lengthy, but short and long executive summaries are available (short PDF, long PDF).

Another worthwhile read is “Critical Assumptions in the Stern Review on Climate Change” Bill Nordhaus, Professor of Economics at Yale. Here, Nordhaus takes issues with the carbon price in the Stern Review, but the overall points remain:

A standard way of showing the stringency of policies is to calculate the “carbon tax,” or penalty on carbon emissions. A recent study by the author estimates an optimal carbon tax for 2005 of around $30 per ton carbon in today’s prices, rising to $85 by the mid–21st century and further increasing after that. A similar carbon price has been found in studies that estimate the least-cost path to stabilize CO2 concentrations at two times preindustrial levels. The sharply rising carbon tax reflects initially low, but rising, emissions reduction rates. We call this the climate-policy ramp, in which policies to slow global warming increasingly tighten or ramp up over time.

Full PDF here.

Image of Nicholas Stern: AP

David Wogan About the Author: An engineer and policy researcher who writes about energy, technology, and policy - and everything in between. Based in Austin, Texas. Comments? david.m.wogan@gmail.com Follow on Twitter @davidwogan.

The views expressed are those of the author and are not necessarily those of Scientific American.





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  1. 1. Owl905 3:08 am 06/4/2013

    Cap n trade works best where there is no alternative or innovation, and the best solution encourages straight reduction. Punitive tax works best where there are possible technology or alternative solutions available. In the case of GHG pollution, Kyoto’s cap n trade (modeled on the US SO2 cap n trade success) was the right answer … and it died a very very cruel death.

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  2. 2. sault 10:51 am 06/4/2013

    Owl,

    A cap & trade mechanism also fosters innovation. If there’s a price on carbon, people will innovate to minimize that price. Whether the price signal comes through buying permits or paying a straight tax. The main benefit of cap & trade is the cap part, meaning that an emissions ceiling is put in place. This gives us certainty on emissions reductions and the permit auction price responds accordingly. Oh, and a side benefit is that you don’t call it a “tax” because some people have a kneejerk reaction against taxes…at least when rich people have to pay them, that is.

    The benefit of a carbon tax is price certainty on carbon emissions. The carbon tax starts at a determined level and slowly raises to indirectly drive greater emissions reductions. The downside is that if a certain level of emissions reduction is more expensive than predicted, the program may stall in delivering those reductions for a few years until the tax rate rises to the appropriate level.

    Either way, we have to start with something to reduce the chances of climate disruption.

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  3. 3. Sisko 11:59 am 06/4/2013

    The idea of adding a carbon tax is a very interesting discussion, but not nearly as simple or likely to be adopted worldwide as David Wogan suggests.

    The relative ability of a carbon tax to reduce consumption of fossil fuels will vary greatly depending upon the nation in which the tax is applied. Add $4.00 per gallon to the price of gas in the UK and consumption will be reduced by a much lower percentage than if you add that tax to the US. Add that same tax to the people in India or China and it would reduce consumption to an even greater percentage. The term is elasticity in economics. Some markets are very sensitive to changes in price while others have already taken steps to reduce consumption and are far less sensitive.

    Imo, what David Wogan hasn’t addressed several key issues.
    1. How much of a worldwide tax does David believe should be applied? How much would such a tax lower consumption and as a result how much would CO2 emissions be lowered and probably most importantly what would be the benefit? If CO2 concentrations are at a different level as a result of the tax in 2060 what will be the benefit other than the increased revenues that governments collected? (which btw are certainly needed in the USA if our government wishes to continue to want to provide the services it has already passed into law)
    2. Is it really likely that such a worldwide tax could be agreed upon? There are 3 billion people in less developed countries that have no access to electricity or personal transportation today. The nations that these people reside in will undoubtedly be trying to provide electricity and personal transportation over the next couple of decades. If such a tax was applied then these people would be greatly harmed. If you don’t apply the tax, then CO2 emissions continue to rise.

    David concludes: “The economics here is straightforward: emitting carbon into the atmosphere entails a negative externality. In absence of any policy, people will emit too much.”
    What David concludes is most certainly not a fact, but his (and others opinion). It is not a fact that the net long term impact to humans of more atmospheric CO2 is negative, or to what amount it is negative.

    BTW- Cap and trade is economically really dumb as it is a highly inefficent process and very expensive to administer.

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  4. 4. phalaris 1:03 pm 06/4/2013

    Cap and trade has not been looking good in Europe recently:
    http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/20/europes-cap-and-trade-program-is-in-trouble-can-it-be-fixed/

    Somehow a carbon tax seems more transparent and less open to political manipulation once it’s introduced and at an effective level, but admittedly getting that far is not going to be easy.

    Link to this
  5. 5. sethdayal 2:28 pm 06/4/2013

    Ok lets take nuke power. Already cheaper LCOE than its rival gas at current prices only 50% the cost of production, but losing the battle – why?

    Unfortunately fascist business interests would rather spend a small amount of capital on gas plant and collect a lucrative gratuity on future fuel sales paid for by the taxpayer, than a large amount of capital and no gratuities. They pay a lot of graft to our corrupt politicians and media to keep that scam going.

    As long as corruption exist it will overrule silly things like economics.

    No need for carbon taxes. Just tell the power companies and regulators to replace the coal/gas power and the petrol refineries with nuke based plant or face jail time. No more gas furnace sales. Rate of return on investment to the nation as whole would be 40% per annum. Like France did in the 80′s when it went from zero to 80% nuke in 15 years, it’d be pretty well done in a decade.

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