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What Economists Believe About the Economic Tools We Can Use to Respond to Climate Change

This is where economists are really the only experts. Economists believe that economic tools can help reduce consumption, divert investment to creating alternative energy systems, and reduce energy demand.

This is not surprising: economists believe that prices affect people. That is probably the central insight in economcs. A surprising amount of the relevant economic theory is summed up in the simple graph of a downward-sloping demand curve. That image is just a way of presenting the general principle that when the price of something rises people generally buy less of it.

As a result, all economists believe that putting a price on carbon will reduce consumption of fossil fuels. If you don’t believe this, you don’t believe the most basic observations in economics and you aren’t an economist.

Corrective taxes
If prices affect how much people buy, then it is possible for prices to encourage people to buy too much or too little. Make machine guns free and there will be too many machine guns in school yards. Make milk expensive and children may grow up with weak bones.

But what is the right price for fossil fuels? It is easier to talk about what the wrong price is. When we burn any fossil fuel we dump CO2 into the atmosphere. Another way to say this is that we are getting garbage removal for free. Whenever price charged by fossil fuel companies leaves out important costs like garbage removal, climate change, pollution and nasty health effects, consumers are not paying the full price of using fossil fuels.  The price is too low, so they burn more than they should.

When important prices are too low, markets simply cannot be efficient. They are broken. Economists call the results “market failure.”

With fossil fuels the scale of the inefficiency is actually startling. Burning one ton of coal with a carbon content of 78 percent and a heating value of 14,000 Btu per pound to produce electricity adds a roughly 2.25 tons of CO2 to the atmosphere.  A common estimate of the appropriate carbon tax is about $70 per ton, which means the carbon tax on a ton of coal should be in the range of $167. One pound of coal produces roughly one Kilowatt hour of electricity so a ton of coal produces roughly 2000 kWh which, at the higher of Ontario’s residential rates, has a retail value of about $200.   This suggests that electricity from coal should cost almost twice as much as electricity currently costs in Ontario. Households are paying only half the economic price for electricity generated form coal plants.  At that rate they consume vastly more electricity than they should.

A similar calculation tells us that we should be adding a carbon tax of $23 for each barrel of oil (and at least $27 for oil from Alberta’s bitumen mines)

A. C. Pigou, showed that when prices are wrong the public can correct them using taxes or subsidies. These “corrective taxes”  or Pigovian taxes” actually make the economy more efficient. Most economists believe that the fossil fuel industries should be subject to corrective taxation. To be more specific, most economists believe that a carbon tax would promote economic efficiency. This conclusion is a necessary result from basic economic theory.

Economists who support a carbon tax
Conservative American economist Greg Mankiw, author of one of the most popular introductory economics texts, and chairman of the economics department at Harvard University,  has listed members of what he calls the Pigou Club, “an elite group of economists and pundits with the good sense to have publicly advocated higher Pigovian taxes, such as gasoline taxes or carbon taxes.” Included in the list are

  1.    Greg Mankiw (Fortune 5/24/99, WSJ 1/3/06, 5/31/06)
  2.    Bill Nordhaus (Foreign Policy in Focus 3/27/06)
  3.    Martin Feldstein (WSJ 6/4/92)
  4.    Gary Becker (Businessweek 5/27/02)
  5.    Robert Frank (NY Times 2/16/06, 6/8/06)
  6.    Andrew Samwick (his blog)
  7.    Ted Gayer (Regulation)
  8.    Mike Moffatt (about.com)
  9.    Ken Rogoff (Project Syndicate)
  10.    Paul Krugman (Slate 4/18/97)
  11.    Greg Easterbrook (NY Times 5/25/04)
  12.    John Tierney (NY Times 10/4/05, 5/23/06)
  13.    Jonathan Rauch (National Journal 2/9/02)
  14.    Thomas Friedman (NY Times 9/21/05, 2/8/06, 6/16/06)
  15.    Joe Klein (Time 5/7/06)
  16.    Andrew Sullivan (Time 4/11/04)
  17.    Jane Galt (her blog)
  18.    Christopher Farrell (Businessweek 8/19/05)
  19.    William Baldwin (Forbes 6/19/06)
  20.     Clive Crook (National Journal 6/2/06)
  21.     Al Gore (Charlie Rose Show 6/19/06 at 42:45)
  22.     Alan Greenspan
  23.     George Schultz,
  24.     Tony Lake,
  25.      Nicholas Stern,
  26.     Hal Varian,
  27.     Larry Summers,
  28.      Richard Posner,
  29.      Nouriel Roubini,
  30.      Joe Stiglitz,
  31.      Brink Lindsey,
  32.      Tim Harford,
  33.       Rob Stavins,
  34.       Ray Magliozzi,
  35.       Robert Samuelson,
  36.       Dan McFadden,
  37.       Charles Krauthammer,
  38.       Paul Mulshine,
  39.       Kevin Hassett, Jason Furman,
  40.       Anne Applebaum,
  41.       Paul Volcker,
  42.       Bill Frenzel,
  43.       Isabel V. Sawhill,
  44.       Charles Stenholm,
  45.       William Hoagland,
  46.       Robert Shapiro,
  47.       David Leonhardt,
  48.       Morton Kondracke,
  49.       Gilbert Metcalf,
  50.       Fred Foldvary,
  51.       Arthur Laffer,
  52.       and a majority of economists.

Nobel Prize winners are in bold type. This list is not complete, and it does not include the Canadian and other non-American economists that support a carbon tax. In fact, most economists around the world believe that a carbon tax is needed  and a carbon tax is the best tool available. Period. Support for a carbon tax is actually a reasonable test of how well trained an economist is. If someone says they don’t support an carbon tax it generally means they are not an economist, and if the person has some credentials as an economist, it means they are not a very well trained economist. It might be possible for someone with a training in economics to argue that carbon taxes would not promote a more efficient economy, but it would be an intellectual strain, like a physicist arguing the earth is flat.

Most economists recognize the obvious fact that carbon taxes can raise stable revenues: existing carbon-related taxes, like gas taxes, have been raising sizeable revenues for years. Raising them significantly would therefore both achieve environmental improvements and allow other taxes to be lower. This isn’t just theory, by the way: British Columbia has shown that a carbon tax does reduce the use of carbon and raises revenue. British Columbia has shown that  governments can use carbon revenues to lower taxes.  Many economist argue for a carbon tax because it allows other taxes to be reduced.

Economists believe that a carbon tax will be resisted because people see all taxes as directly reducing their purchasing power and do not fully recognize the benefits generated by those taxes.

Many economists believe, however, that the public can be won round to green fiscal reform.

A number of polls show majority public support in Britain for a green tax shift, and support  increases when people are persuaded that the green taxes will be used to reduce other taxes .See the UK Green Fiscal Commission Report a thttp://www.greenfiscalcommission.org.uk/images/uploads/GFC_FinalReport.pdf) The existence of the  Canadian Ecofiscal Commission} headed by Dr. Chris Ragan demonstrates the confidence of at least a significant group of Canadian Economists in the political feasibility of carbon taxation. The Environmental Commissioner for Ontario notes that Research has shown that public support for a carbon tax hinges on how the revenue is used. In one American poll, he notes, the public supported a carbon tax most when the revenues would be used to fund renewable energy.

Cap and Trade and Carbon Offsets
Most  economists believe that  in theory cap and trade could work as well as carbon taxes. We like clever theories. Many of us like the idea of creating a market to solve a problem.

Some economists believe that cap and trade will actually work in practice. A few believe it has worked in Europe.

Most economists understand that cap and trade is a bureaucratic approach that requires measurement, reporting, and verification to be effective.   It does create a market, and  is technically a `market-based’ approach,’ but it requires the creation of an agent or collection of agents to issue rights and monitor compliance. It require a government decision about the amount of emission permits.

Most economists believe that Cap and Trade might be easier to implement politically than a carbon tax because the economic incentives are positive for the companies involved while the costs are hidden for consumers:  with Cap and Trade you buy off companies with additional property rights and hide the cost of the implicit subsidy from consumers.

Most  economists recognize that  Cap and Trade is a form of privatization — the rights to emit are transferred to private corporations.

Cap and Trade schemes are usually associated with a system of carbon offsets. You can pay someone to plant a tree to offset the carbon released when you fly to the Bahamas. Economists recognize that under the Clean Development Mechanism of the Kyoto  Protocol, carbon offsets tend to transfer income to less developed countries, as they were intended to do. Some economists approve of the transfer, others don’t. (Prime Minister Harper, who has an MA in economics, called it a form of socialism when he worked for  the self-styled Canadian Tax Foundation.) Some think it is an effective mechanism, others don’t.  Carbon offsets  create a market for sequestration that most economists probably  think could work in principle. that has worked to some extent but is prone to fraud,  hard to verify, and complex. The offset market is market trading an asset that only exists if a public agency says it does.

I think all economists understand that a carbon tax will favour consumers  and that Cap and Trade favours existing producers by giving them an additional property right. I think that most economist would think it obvious that  for carbon taxes to be fair, however, low-income households would need to be protected from energy price rises while their homes were being made energy efficient. The Britich eco-fiscal commission suggeested that a massive  programme to improve the energy efficiency of existing homes for social as well as environmental reasons would be necessary. Such a program would provide an economic stimulus according the the economic theories most economists believe. It would probably pay for itself according to most energy accountants.

Most economists don’t believe that  Canada is doing a good job of getting ready for the new economy because of commitments to the energy industry.

Economists believe that, in general, subsidies are a bad idea and that reducing subsidies is a good idea.  Subsidies for fuel consumption or for producing fossil fuels encourage the production of more carbon dioxide.

Most economists believe that petroleum  and tar sands  production in Canada is heavily subsidized – and some, like the analysts at the International Monetary Fund in ENERGY SUBSIDY REFORM: LESSONS AND IMPLICATIONS  (Available at (http://www.imf.org/external/np/pp/eng/2013/012813.pdf), argue the effective subsidy is in excess of  of 30% of the price ( If there is a technical word for encouraging people to do bad things, it is “stupid.”  We do have some very stupid policies in Canada.  The paper warns that “These estimates are likely to underestimate energy subsidies and should be interpreted with caution.”).

Using Regulations
No economists believe that regulation is an efficient tool  in general, although most believe that regulations can help cut carbon in specific ways, and most believe regulation will be necessary. Mandating fuel efficiency for automobiles in California, for example, forced technological developments that did reduce emissions. The reason it worked is that California was such a large market that automakers couldn’t afford to be excluded. Once that tooled up to produce cars for California, it was cheaper to produce the same cars for the rest of the USA.

Regulations generally require oversight, enforcement, prosecution and penalties, all of which involve costs. When observing behaviour is imperfect, regulation will usually be incomplete as well as costly.

Reducing Carbon Intensity
The Canadian government’s preference for regulating carbon intensity is a non-market approach that does not provide a direct incentive for reducing emissions. It seems attractive because it encourages emitters to reduce emissions per unit of output. It also seems to be good for economic growth because it does not influence output. This is in fact a misunderstanding of the economics involved.

Total Carbon emissions from any sector can be represented as a box. The width is the amount of output and the height is the intensity. Reducing Carbon Intensity reduces the height but allows the width to increase. In Alberta’s bitumen deposits, for example, even though producers emit less carbon dioxide per barrel, they are producing so many more barrels that emission have risen and will continue to rise.

A carbon tax encourages people to reduce both height and width. Here is where a deeper understanding of economics helps. If you just look at one market, the carbon tax seems to reduce production, and this seems to mean it reduces growth. Looking at one market this way is called `partial equilibrium analysis.”

A carbon tax doesn’t reduce total growth in the whole economy, however. Instead it encourages  growth to move to sectors that use less carbon. Studying how the effect of a policy spreads to other markets is called ``general equilibrium analysis.” Economists developed general equilibrium analysis because it is more accurate that partial equilibrium analysis.

Adding it up
To summarize, most economists would accept the conclusion of the UK green Fiscal commission in 2009:

  1. Carbon taxes work
  2.  Carbon t axes are efficient
  3.  Carbon taxes can raise stable revenues
  4.  The public can be won round to carbon taxes
  5.  Carbon taxes would stimulate investment in the low-carbon industries of the future
  6.  Carbon taxes can mitigate the impact of high world energy prices
  7.  The impacts of Carbon taxes on competitiveness can be mitigated

In other words, most economists would assent to the view that carbon taxation will help get Canada on a low-carbon trajectory, help develop  new industries, provide competitive advantage, and contribute to fiscal stability.


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