Monday, September 5, 2011

Pricing Carbon

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." - Frederick Hayek

A basic application of climate economics:

What economists must do is take consensus science into account, and approximate what the price of carbon should be to limit economic damages from CO2. This level will be achieved where the marginal cost of reducing carbon emissions is equal to the benefits of decreased damages from climate change in the future.  

Nordhaus ( Using the DICE-2007 model, and based on the science of the IPCC Fourth Assessment Report) prices carbon at about $30/ ton, with the average person in the US generating about 5tons/yr, for a total of about $150/year, or .09 /gallon of gas and .01/kwh for electricity. However, the Stern Proposal(proposed by another economist in the U.K) estimates the damage from global warming to be closer to $300/ton carbon for the next two decades. In this case we are looking at increasing gas prices by about $1.20/gallon. (read more)

How can economics narrow the gap between these approaches? Should we question the idea of 'pricing carbon' or the assumption that the impacts of climate change (manmade or not) fail to be captured in market interactions? 

Carbon taxes and the climate change knowledge problem
The idea of pricing carbon is that given the assumption that CO2 production has a negative impact on climate change and so many goods and services are carbon intensive, if we can put a price on carbon (paid by corporations that trade carbon permits or a carbon tax)  to capture the value of the negative externality, this will 'trickle down' to the mirco level, such that when you buy an ice cream cone, gasoline, or a pencil, the impact of your choice on the climate will be captured in the price you pay for it.  This is the climate change knowledge problem. We have to get the initial price of CO2 correct so that the 'trickle down' economics works at the micro level and we ward off catastrophic climate change.

The correct price for carbon will balance the marginal cost of reducing carbon emissions with benefits of decreased damages from climate change in the future.  As Armstrong points out, there are few scientific forecasts related to these future damages. And technological change allows us to continually respond the volatile effects of climate change. Advances in biotechnology are allowing us to produce more climate resilient crops, all the while reducing our carbon footprint in agriculture.  How can we incorporate this knowledge into our calculus? When it comes to the costs of reducing carbon emissions, it isn't any easier. What are the opportunity costs of resources invested in emissions mitigation (voluntarily vs. those mandated or incentivised by government administered prices for carbon)?   
Tradeable Permits
Some will argue that instead of a tax, you can get similar or superior results by defining property rights in the form of carbon credits or tradeable permits. Then markets can solve the information problem via the price mechanism that manifests in the trading of permits. The problem still stands. Someone has to initially assign some quantity of permits to 'polluters.' This quantity has to be based on some determination of an 'optimal' quantity of CO2 emissions. This also requires the information necessary for determining the marginal benefits and costs of each associated unit if CO2.  The knowledge problem has not been solved, just reformulated in a way that is equivalently intractable for planners to solve. Unless planners get this quantity right, the price that 'trickles down' at the micro level for all goods and services will be too high or too low, based on the artificial scarcity or excess created by the planners' miscalculation. The classic exampleof the Coase Theorem solves the externality of pollution of common property like a lake by clearly assigning property rights. The optimal level or quantity of pollution is a separate problem solved by the price mechanism via subsequent exchanges of property rights or contracting. In the case of CO2, the assignment of property rights and the optimal quantity of pollution both have to simultaneously be determined. You have to determine some initial quantity of pollution in order to create the permits (which a are then traded to establish a price).

From the Capitalism Today Blog at Western Kentucky University there was recently adiscussion regarding macroeconomic equilibrium and the difficulties of knowing the micro-level equilibrium for something (seemingly) as simple as ice cream:

"They act as if not only there is equilibrium, but that they know where it is.  If anyone knows exactly how many ice cream cones the US needs to produce tomorrow, please raise your hands.  What no hands?  No one can know the "appropriate" amount of ice cream cone production for today let alone for tomorrow.  The $15 trillion US economy makes a lot more than just ice cream cones."
I think this analogy may also apply to pricing carbon. Ice cream comes in lots of varieties and flavors, produced and marketed various ways (natural, conventional, biotech, hormone free, organic, home made, store bought, ice cream trucks, retail outlets). Ice cream is pretty differentiated when you think about it. What about carbon?Noone knows how to set a 'national' or even a 'local' price for pencils, or the correct quantity of pencils that our complex world requires.  Why do we expect carbon to be any different than ice cream or pencils? Even if economists like Nordhous and Stern were in agreement, their solutions would not sufficiently deal with climate change's knowledge problem. 

Some will agree that planners are no match for markets in determining prices and quantities, but because we currently have no established property rights to the atmosphere there is no 'price' for carbon. As such, there are going to be consequences if we do nothing, and the next best solution is an attempt, even if not perfect, to price carbon because it is not considered in market transactions. 

Is that really the next best solution and is it true that the price mechanism totally ignores CO2? 

What is carbon really? 'Carbon' in an economy manifests itself in how we heat and cool our homes, how we manufacture goods and services, how we respond to emergencies, how we travel and transport goods, how we store and retrieve information. Leonard E. Read's essay I, Pencil demonstrates  the complexity involved in an economy that thrives on disaggregated information and processes with numerous feedback loops and interactions.  In a complex society, carbon is no different, and while it may not be explicitly and directly priced, it is hard to believe that its role is not part of the pool of knowledge characterized by the partial bits of information held by all individuals in society. 

In fact, while politicians and special interests argue over the politically optimal arrangement of regulatory protections and subsidies to 'combat climate change' markets have responded in much more meaningful ways without any bureaucratically administered price of carbon or cap on CO2.

As Dr. Don Boudreaux of George Mason University points out in a recent piece in the Wall Street Journal, in response to climate alarmists' connecting violent storms and climate change (and obviously calling for centralized solutons to combat it): (read more)

 "...because of modern industrial and technological advances—radar, stronger yet lighter building materials, more reliable electronic warning devices, and longer-lasting packaged foods—we are better protected from nature's fury today than at any other time in human history."

Perhaps the innovations in green technologies in agriculture provide the greatest example of mitigating climate change:

Total decreases in carbon dioxide as a result of using biotech crops was equivalent to removing 6 million cars from the road in 2007. The carbon footprint for a gallon of milk produced in 2007 was only 37 percent of that produced in 1944. For every 1 million cows, the reduction in global warming potential from rBST supplemented cows is equivalent to removing 400K cars from the roadways or planting 300 million trees. The use of grain and pharmaceutical technology in beef production has resulted in a nearly 40 percent reduction in greenhouse gases (GHGs) per pound of beef compared to grass feeding. Intensive agriculture has actually has a mitigating effect on climate change with a reduction of 68 kgC (249 kgCO2e) emissions relative to 1961 technology. (read more)


We are not really sure how to price carbon, and what we observe in all of these instances is that despite the absence of a centrally planned price or quantity of carbon, people are making choices that optimize its use or production. Because we don't have the knowledge to price carbon, we don't know that the resources expended in 1) lobbying lawmakers to tweak the proposed rules and regulations 2) mitigating the costs of a centrally planned price or quantity, would not have higher valued uses mitigating climate change in other ways (like investment in green technologies like biotech). T
he best approach for dealing with climate change or any environmental problem is to develop resilient market based economies that are able to invest in the technology necessary to adapt to ever changing resource constraints.