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What economists say about carbon pricing

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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

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

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