Policy Debacle: Do we know how to implement climate policy?

In an effort to get serious about climate change, the leaders of the G8 countries agreed at a July 2009 meeting in L’Aquila, Italy, to limit the increase in global average temperature to no more than 2°C above pre-industrial levels. They would do this by reducing global greenhouse gas emissions by 50% and their own emissions by 80% or more by 2050. This target was agreed to despite lack of scientific evidence to suggest that a temperature rise of 2oC is somehow optimal – that it is preferred to current temperature levels or even temperatures higher than 2oC. There is also no empirical evidence to indicate that drastic actions by G8 countries to control their carbon dioxide emissions could actually reduce atmospheric CO2 and thereby impact climate. Further, it is a bold proposition to assume that non-G8 countries can be coerced into reducing their emissions by 30% or more from current levels (to achieve a global target of a 50% reduction in emissions)!

The European Union already has in place a ‘20-20-20 target’ – a 20% reduction in CO2 emissions from 1990 levels by 2020, with 20% of energy to be produced from renewable sources. Indeed, at the climate conference in Copenhagen in late 2009, the EU was prepared to impose a 30% reduction in CO2 emissions by 2020, if there had been some sort of climate agreement. The latter gesture was made because economic models indicated that the 20-20-20 target could be met at lower cost than originally anticipated because of the financial crisis. Since then, however, European experience with renewable energy is causing them to have second thoughts.

The United States has also considered legislation to reduce CO2 emissions dramatically. The House of Representatives passed the American Clean Energy and Security Act on June 26, 2009. It uses cap-and-trade to reduce CO2 emissions – by 42% below 2005 levels by 2030 and 83% by 2050. In the Senate, first the proposed American Power Act (which would have added carbon taxes of upwards of $175 per tCO2 to the House cap-and-trade scheme), and subsequently bill S.3813 to create a national ‘Renewable Electricity Standard’ (which required that 15% of the electricity sold by an electric utility be generated renewable, primarily wind, by 2021), failed because Senators feared a backlash from voters. Lobbyists and voters clearly saw these efforts as leading to much higher energy costs with little if any climate benefits.

But there is a more fundamental problem: To achieve the kinds of emission reduction targets envisioned, it is necessary to radically transform the fundamental driver of global economies. The main obstacle to so doing is the abundance and ubiquity of fossil fuels, which can be expected to power the industrialized nations and the economies of aspiring industrial economies (the so-called emerging and developing nations) into the foreseeable future. Realistically, global fossil fuel use will continue to grow and remain the primary energy source for much of the next century.

Should society regulate greenhouse gas emissions? Choosing a policy instrument

To date, Congress has passed no climate legislation. Yet, the environmental lobby did not despair, because, in 2007, the Supreme Court had ruled that the gas required to grow plants, carbon dioxide, was actually a pollutant! Consequently, the U.S. Environmental Protection Agency would be required to regulate CO2 emissions.

There are four policy instruments available for controlling CO2 emissions – taxes, cap-and-trade (i.e., emissions trading), subsidies (the flip side of taxes), and regulation. The economist is usually indifferent between a price (tax) and a quantity (emission cap) instrument. If chosen correctly, both achieve the desired level of emissions reduction. Only the resulting distribution of gains and losses varies greatly between the two, and depends on whether emission permits are grandfathered (large emitters gain a windfall) or auctioned (government collects the windfall).

Taxes and emission trading

Economists generally prefer a tax on emissions rather than a cap, especially in the case of climate change. When greenhouse gas abatement costs and the benefits of abatement (damages avoided) are uncertain, picking a carbon tax can lead to the ‘wrong’ level of emissions reduction, while choosing a quantity can result in a mistake about the forecasted price that firms will have to pay for auctioned permits. Such errors have social costs. If the marginal cost of abatement is steep while the demand curve for permits is relatively flat, then a small increase in the number of permits that are issued can have a large impact on their price.

With climate change damages are unavoidable for the most part and, in any event, are likely to increase slowly over time. In that case, the choice of a price or quantity instrument will depend on the marginal abatement cost function. The steeper the marginal abatement cost function, the more beneficial it will be, all else equal, to use a price (tax) rather than quantity instrument. Thus, a carbon tax is preferred to a quota – to cap and trade.

There are other problems with emissions trading that are sometimes overlooked, particularly in economic theory. Emissions trading is fraught with political maneuvering, corruption, questionable offset credits, high monitoring costs because of the variety of offsets that are already appearing in carbon markets, lack of revenue recycling (no ‘double dividend’), and difficulties in bringing all countries into the scheme. Political maneuvering is evident, for example, from the G8 meeting and in U.S. legislation where the pain of reducing emissions has generally been delayed to 2020 and later, well beyond the next round of elections. Further, in most countries large emitters are granted an enormous windfall in the form of free credits. In essence, therefore, large industrial emitters can tax energy consumers in lieu of government doing so, while large financial firms will reap huge benefits as intermediaries in the buying and selling of emission permits on financial markets. Again, it is little wonder that large firms not only favor cap-and-trade schemes, but actually promote and lobby for them. No wonder large industrial emitters and oil companies have backed away from funding climate research that contradicts the mainstream view – with emissions trading there is no financial incentive to contradict claims of anthropogenic warming. Whether global warming is occurring or not, large companies are better served by emissions trading that would be hard to stop even if the temperatures in the tropical troposphere were to indicate that a more prudent approach would be wiser.

Regulation and subsidies

Regulation and subsidies are the worst possible means of achieving greenhouse gas emission reduction targets. Elementary environmental economics textbooks provide a simple graphical analysis to demonstrate why regulation leads to higher mitigation costs than taxes or emissions trading. The reason is that emitters with the lowest emission abatement costs are not necessarily the ones doing the most to reduce greenhouse gas emissions – without a tax or emission permit price they have no incentive to reduce emissions beyond what the authority requires. The authority, on the other hand, must make a judgment concerning the types of regulations it will impose, and some of those decisions are simply wrong or misleading. In a growing economy, it is even possible that CO2 emissions rise even while mandates are met. Simply mandating automobile fuel economy standards on manufacturers does not result in lower overall emissions if the stock of automobiles and the amount they are driven increases. Forcing firms to employ the best available technology for reducing emissions does not prevent new firms from entering an industry and emissions from expanding.

Like regulations, subsidies are no more than an attempt by the authority to select the appropriate emission-reduction technology. Subsidies to wind manufacturers or biofuel producers end up promoting these renewable sources of energy over ones that are not subsidized. Perhaps the most dangerous course of action relates to biofuels, where subsidies to agricultural producers, agribusiness and fuel producers are combined with fuel content regulations to promote ethanol and biodiesel. Despite evidence indicating that biofuels do practically nothing to reduce greenhouse gas emissions while contributing to socially destabilizing food price increases, such policies continue to be promoted over alternatives, such as liquefied natural gas (LNG). Compared to oil, LNG can reduce greenhouse gas emissions and, in the case of the U.S., reliance on foreign imports of oil.

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There are other problems that plague any choice of instrument. It is well recognized in the economics literature that energy efficiency improvements lead to a ‘rebound effect’ that offsets the original reduction in greenhouse gas emissions. For example, the income saved from driving the same distance using less energy will be spent on activities that require inputs of energy, including driving greater distances. In some circumstances, there may even be a ‘backfire effect’ where emissions actually increase as a result of energy improvements

Congressional insouciance and rebound

From this vantage point, the U.S. Congress has failed to provide leadership, having failed its own citizens and the world at large. First, it has not taken seriously controversies regarding climate change, succumbing instead to the mantra that the ‘science is settled.’ The science of climate change is about as settled as the science of astrology – prediction is a difficult thing and is only possible, as economists have found out time and again, when a system is entirely deterministic and the equations governing it are known beyond a shadow of a doubt. That is not the case with climate systems. Too much remains to be discovered.

Second, Congress has failed to lead by passing climate legislation that makes sense – climate legislation that is promoted by almost all policy experts. At this time, given uncertainty, it makes sense to implement a small carbon tax with revenues to be used to fund a serious research effort into alternative fuels, ways of addressing climate change outside of emissions control (e.g., increasing sulfur dioxide in the upper atmosphere as proposed by the Nobel laureate in Chemistry, Paul Crutzen), alternative explanations for climate change, et cetera. Instead, Congress has defaulted its obligations to an unelected regulatory body, the Environmental Protection Agency, whose methods are likely to aggravate the overall situation with regard to global warming.

Finally, the principal argument for drastically reducing greenhouse gas emissions relates to our concern for future generations. This is a strange argument given that nearly every country has amassed enormous debts and is currently running huge deficits (the U.S. deficit is some $1.3 trillion, the largest since World War II). There is something wrong here. How is it possible to urge immediate action to save tomorrow’s generation from a possible temperature increase while, at the same time, consuming prodigiously at the expensive of the next generation?

Recently, the House Energy and Commerce Committee recently passed the Energy Tax Prevention Act, H.R. 910, which would prevent the EPA from regulating greenhouse gas emissions. Perhaps this will lead to a serious reconsideration by Congress of a major political decision that has a large impact on the lives of citizens. The only policy that makes sense at this time is a carbon tax that is small enough to prevent undue harm to the poor and yet provides R&D funds for unbiased research.

How large should it be? The accompanying table provides some indication. It is clear that any tax should probably stay well below $10 per metric ton of CO2 (tCO2).

Effect of Carbon Taxes on Various Fuels, United States, 2010

Item Coal Oil Natural Gas
tCO2 emissions 2.735 per t coal 0.427 per barrel 1.925 per m3×103
Average price $45.50/t coal $70.69/barrel $423.78/m3×103
Carbon tax per unit of fuel
$10 per tCO2 $27.35 $4.27 $19.25
$30 per tCO2 $82.05 $12.81 $57.75
$100 per tCO2 $273.50 $42.70 $192.50
% increase in price of fuel from carbon tax
$10 per tCO2 60.1% 6.0% 4.5%
$30 per tCO2 180.3% 18.1% 13.6%
$100 per tCO2 601.1% 60.4% 45.4%
Carbon tax as % of tax-adjusted fuel price
$10 per tCO2 37.5% 5.7% 4.3%
$30 per tCO2 64.3% 15.3% 12.0%
$100 per tCO2 85.7% 37.7% 31.2%

Source: Own calculations

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