Eco-nomics: Carbon Tax

Why do most economists favor a carbon tax as a way to address the harmful consequences of carbon emissions? Efficiency.

Here is a smart and succinct defense of carbon taxes over cap-and-trade by Ted gayer of the Brookings Institution, it was his testimony before the U.S. Senate Committee on Energy and Natural Resources on December. It is all about the incentives... [HT: Greg Mankiw]

1202 Carbon Tax Gayer

That said, cap-and-trade is a heck of a lot better than nothing, and a pretty good second best: I am not that convinced that the incentives problem Gayer talks about is going to be that important (the plant a tree so you can say you saved a tree - you are still creating one more tree which in this case stands for carbon reduction). Here is Paul Krugman's defense of cap-and-trade:

A tax puts a price on emissions, leading to less pollution. Cap and trade puts a quantitative limit on emissions, but from the point of view of any individual, emitting requires that you buy more permits (or forgo the sale of permits, if you have an excess), so the incentives are the same as if you faced a tax. Contrary to what Hansen seems to believe, the incentives for individual action to reduce emissions are the same under the two systems.

This is true even if some emitters are “grandfathered” with free allocations of permits, as will surely be the case. They still have an incentive to cut their emissions, so that they can sell their excess permits to others.

The only difference is the nature of uncertainty over the aggregate outcome. If you use a tax, you know what the price of emissions will be, but you don’t know the quantity of emissions; if you use a cap, you know the quantity but not the price. Yes, this means that if some people do more than expected to reduce emissions, they’ll just free up permits for others — which worries Hansen. But it also means that if some people do less to reduce emissions than expected, someone else will have to make up the shortfall. It’s symmetric; there’s no reason to emphasize only one side of the story.

The key is reduced carbon emissions, cap-and-trade gets you there and appears to be the only thing politically feasible. The world is getting warmer as we speak, it is time to act.

Oh, and one last thing, if we are really going to address this problem, the wealthy countries are going to have to help out emerging economies.

Eco-Nomics: France Gets Serious About a Carbon Tax

Hooray for France! The Washington Post reports on this very good proposal by Nicolas Sarkozy. The economics of the thing is simple: a Pigovian tax is one that equates the market price of an economic activity equal to its private and social cost resulting in an efficient market outcome.

From the WaPo article:

The tax would be initially based on the market price for carbon dioxide emissions permits, which is now euro17 ($24.74) per ton of carbon dioxide, Sarkozy said. At that level, the government expects to raise euro3 billion, which will be entirely returned to households and businesses through a reduction in other taxes or repaid via a so-called "Green Check," Sarkozy said.

[HT: Greg Mankiw]

Eco-Nomics: Carbon Taxes and Cap-and-Trade

An excellent primer on the similarities and differences and where the current legislation falls by Greg Mankiw in Sunday's New York Times. Here are the highlights:

During the presidential campaign of 2008, Barack Obama distinguished himself on the economics of climate change, speaking far more sensibly about the issue than most of his rivals. Unfortunately, now that he is president, Mr. Obama may sign a climate bill that falls far short of his aspirations. Indeed, the legislation making its way to his desk could well be worse than nothing at all.

Let’s start with the basics. The essential problem of climate change, scientists tell us, is that humans are emitting too much carbon into the atmosphere, which tends to raise world temperatures. Emitting carbon is what economists call a “negative externality”— an adverse side effect of certain market activities on bystanders.

The textbook solution for dealing with negative externalities is to use the tax system to align private incentives with social costs and benefits. Suppose the government imposed a tax on carbon-based products and used the proceeds to cut other taxes. People would have an incentive to shift their consumption toward less carbon-intensive products. A carbon tax is the remedy for climate change that wins overwhelming support among economists and policy wonks.

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What Mr. Obama proposed was a cap-and-trade system for carbon, with all the allowances sold at auction. In short, the system would put a ceiling on the amount of carbon released, and companies would bid on the right to emit carbon into the atmosphere.

Such a system is tantamount to a carbon tax. The auction price of an emission right is effectively a tax on carbon. The revenue raised by the auction gives the government the resources to cut other taxes that distort behavior, like income or payroll taxes.

So far, so good. The problem occurred as this sensible idea made the trip from the campaign trail through the legislative process. Rather than auctioning the carbon allowances, the bill that recently passed the House would give most of them away to powerful special interests.

The numbers involved are not trivial. From Congressional Budget Office estimates, one can calculate that if all the allowances were auctioned, the government could raise $989 billion in proceeds over 10 years. But in the bill as written, the auction proceeds are only $276 billion.

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How much does it matter? For the purpose of efficiently allocating the carbon rights, it doesn’t. Even if these rights are handed out on political rather than economic grounds, the “trade” part of “cap and trade” will take care of the rest. Those companies with the most need to emit carbon will buy carbon allowances on newly formed exchanges. Those without such pressing needs will sell whatever allowances they are given and enjoy the profits that resulted from Congress’s largess.

The problem arises in how the climate policy interacts with the overall tax system. As the president pointed out, a cap-and-trade system is like a carbon tax. The price of carbon allowances will eventually be passed on to consumers in the form of higher prices for carbon-intensive products. But if most of those allowances are handed out rather than auctioned, the government won’t have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans, leading to lower real take-home wages, reduced work incentives and depressed economic activity.

Most people I talk to don't really understand Cap-and-Trade and think it just represents a loophole for polluters. No, but I agree with Mankiw that these permits need to be auctioned and not given away. In fact this article described the sentiment of most economists I talk to (of all political persuasions). The differences in opinion among my conversants are in how much they are willing to compromise in the face of political reality. Has the Obama administration bowed too much? I think the most unfortunate reality is that people just don't understand what it is and what giving the permits away v. auctioning them means and for this I applaud Mankiw for a lucid description. I think if people really understood what was going on, the energy industry would not be able to hijack this process and we would see auctioning.

Eco-nomics: Renewable Energy and Carbon Taxes

[Wind, wave and solar power all in one! Photo/graphic credit unknown]

In my previous post I discussed how wind power does not necessarily displace carbon emitting power generation, but, here in the Northwest, often displaces clean hydro power. In the comments, reader Brian talks about the problem more generally. Here are his comments in their entirety:

The problem with the wind tax credit is that it is an indirect approach toward reducing coal generation. The direct impact of the credit is to make wind more profitable, but the indirect desired result is really uncertain, and if you re-read the WW article you will notice that it is completely silent on the success of the system on reducing coal generation, and the dependence on the hydro system isn't mentioned at all.

A tax credit for wind is far more politically palatable than increasing the tax burden on coal generation, but we risk the possibility that we are picking favorites, and we are not allowing the market to find the right mix of conservation and alternative sources. It is highly likely, from an economics perspective, that the resulting outcome is inefficient.

Spoken like a true economist, and absolutely correct. The point is that supporting one particular type of clean energy circumvents the markets ability to reward the most cost effective and cleanest energy source. It also poses the risk of substantial public investment in a technology that ends up not being the most successful and thus has the potential of being wasteful.

Which leads us right back to a carbon tax. If we tax carbon appropriately, we 'get the prices right' and the market can be expected to produce an efficient outcome, just as Brian says. This is also part of the point I have made a number of times about the Governor's plans to create a 'green economy' for the state: it can't be based on particular businesses or industries, but rather creating an environment that is attractive for whatever firm has the next great idea. This means high quality schools and research institutions, a good infrastructure and a efficient and flexible government that is ready to support any new business.

And, of course, revenue from carbon taxes can fund such investments...