Deepish Thought

Mark Thoma has published a detailed rebuttal of the idea that the the Waxman-Markey (carbon permits) bill is a massive corporate giveaway.  Mr Thoma’s reasoning is that:

The split over the entire period from 2012 to 2050 is 53.4% for consumers and public purposes, and 20.1% for private industry.

Assuming you believe Mr Thoma’s math, Waxman-Markey is actually a massive giveaway to consumers, special interests and private industry.  This is not exactly a compelling defense.

The problem with the bill is not the manner in which the giveaways are divided.  It’s the existence of giveaways.

The whole point of a cap and trade system is to price carbon emissions and thus incorporate the cost of CO2 emissions into the price of everything those emissions produce. Price signals can then drive innovation to minimize the carbon use and ensure that maximum economic benefit comes from the level of emission we believe is acceptable.   If carbon permits are given away, regardless of who exactly the giveaways are intended to benefit, this price mechanism is undermined.

The fundamental problem here is that American public would apparently like to believe that the transition to a low carbon economy can somehow be achieved without carbon based energy becoming significantly more expensive.   Unfortunately, there is no free lunch to be had here.  A major restructuring of the US economy isn’t going to occur unless the financial incentives surrounding energy use are significantly realigned.

What Congress should have done is create a fully auctioned cap and trade system, then used the resulting revenue to lower and simplify income taxes.  This would have shifted the burden of taxation from a earned income (generally considered a social positive) to a negative externality without increasing the overall tax burden on the economy.  Energy would get more expensive while labor gets cheaper.  It would also likely have created a broad base of political support for cap and trade.

Tragically, this is not what happened.  The administration, somewhat naively, expected their fully auctioned program to become a new and fruitful source of revenue to fund its ambitious spending plans.  When this proved politically unfeasible, the congressional leadership was allowed to use carbon credits giveaways to buy off opposition to the bill.  In its desperation to achieve legislative success, congress has not flinched at undermining the bill’s original objectives.  The revised bill is more politically palatable in that it apparently won’t really affect energy costs.  Of course, if energy costs aren’t affected there is very little chance the thing will actually work.

It is revealing that Congress choose to lard the bill with energy use regulations.  If the bill were going to effectively price CO2 emissions the regulations would be redundant.  Market forces would drive change without the need for mandates from Washington.  Clearly, even Congress doesn’t really believe that the cap and trade portion of the bill will drive change.

To be fair, the successful SO2 cap and trade scheme, on which the bill is based, gave away rather than auctioned SO2 emission rights.  The prospect of selling surplus SO2 credits, or the threat of having to buy extra credits, encouraged enough companies to find ways to limit SO2 output.  So Waxman-Markey may not be completely hopeless.

However, SO2 was a relatively minor problem that could be minimized without a wholesale restructuring of the US economy.  It is extremely difficult to believe that a similarly low key approach will yield the changes required to move us towards a low carbon economy.  For those of us who believe in harnessing the power of markets to solve environmental issues Waxman-Markey is a profound disappointment.

I just watched Thomas Friedman, in a particularly insightful interview with Jim Lehrer, give an excellent explanation of why putting a price on carbon is important if the US is even remotely serious about addressing global warming. It went a little bit like this:

Imagine I came to you 25 years ago (before cell phones) and said, “I have this brilliant new product. For just a $1000 I’ll sell you a phone with no wires that is small enough to carry around in your pocket. It’ll change your life.” You might say something like, “Well a $1000 is a lot of money, but you know what, this will change my life – I’ll buy one”. I could then take your $1000, do some more research, and then come back a year later and say, “You know that phone I sold you, well now I have a smaller, better one – only $850” and so on. Pretty soon everyone would have a cell phone.

Now imagine I came to you and said, “You see these lights in the ceiling here. They cost you about $100 a year to run. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would be your likely response?

Unlike for the cell phone, the low carbon power supply won’t improve your life in any obvious way (unless global warming is actually keeping you up at night), so there is very little incentive to pay extra for the low carbon alternative.

Now imagine that the cost of carbon externalities were being included in the price of energy and I come to you and say, “You see these lights that cost you $160 a year. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would your response be now?

Of the two scenarios, which is more likely to result in a low carbon energy infrastructure in the US?

There are a couple of ways we might include the environmental costs of CO2 in the price of energy. A carbon tax or a system of tradable carbon credits.

A carbon tax is politically difficult for any politician to advocate because it would (obviously) raise the price of energy. However there is an approach that might make a carbon tax politically viable. Harvard economist Greg Mankiw has suggested that the US could replace FICA taxes (payroll taxes that fund Social Security and Medicare) with a carbon tax. This might work politically because the total tax burden wouldn’t increase. It is particularly attractive economically because it would shift the burden of taxes from an economically positive activity (work) to a negative externality (global warming).

The main problem with a carbon tax is that it falls evenly across all CO2 producing activities. The result of such a tax is likely to be a modest reduction in emissions, through higher prices reducing demand and motivating efficiency improvements, across the whole spectrum of CO2 generating activities. This is not an economically optimum result.

From an economic perspective we would like to maximize the economic value we get from utilizing the limited resource that is the environment’s ability to safely absorb CO2. In other words, we would like for whatever CO2 emissions we find acceptable to be associated with those high value activities where avoiding emissions is either difficult or prohibitively expensive.

In order to achieve this result we need a system for allocating our carbon emissions around the economy. This is the genius of tradable emissions credits. By creating a market for trading CO2 emissions we would also be creating a mechanism that allowsthe economy to reorganize itself in order to to achieve maximum output for the allowable level of CO2 emissions.

This is not simply pie in the sky economic theory. A cap and trade system has been used very successfully to control SO2 emissions in the US. Under this system the government allocated a fixed supply of pollution permits amoung SO2 emitters. Permit holders that managed to reduce their emissions at reasonable cost were then able to sell their excess credits to organizations that faced more expensive constraints. The system led to a rapid reduction in SO2 emissions in the US at very little overall cost to the economy.

Despite its success, the SO2 system is not without issues. Simply allocating emissions credits to existing polluters is a somewhat questionable approach. It distorts the market in favor of existing SO2 generating activities, which receive credits for free, over possibly higher value new activities, which would have to buy them. This wasn’t a big issue for SO2, which is created by a limited number of activities, but would be a significant problem if the same approach were applied to CO2. In addition, the system potentially created an incentive for companies to increase SO2 output prior to the start date so as to receive higher emission allocations when the system got under way.

Quite apart from these criticisms, an SO2 style cap and trade system for CO2 would not generate any new sources of government revenue, which would mean foregoing the non-environmental benefits of Mankiw’s tax approach.

Fortunately, there is a way of combining both approaches in order to achieve maximum economic benefit. Instead of simply allocating CO2 credits to existing polluters, the government could have an annual auction of credits for the coming year (the credits being subsequently tradable). The revenue from this auction could then be used, as carbon tax revenue would have been in Mankiw’s proposal, to replace FICA taxes.

In addition to being economically sound, this proposal combines six great political selling points, adding up to across the spectrum political appeal:

1. No net new taxes
2. Higher employment (through eliminating tax on employment)
3. Harnessing the power of the market
4. Rewarding innovation
5. Punishing polluters
6. Aggressively combating global warming

The question is whether there are any politicians out there, especially viable presidential candidates, who would be willing to champion such a radical approach?