Transcription
[Music] welcome to the political economy of the environment. Today's episode is about pricing carbon. It's the first of three episodes, really, all of which have to do with putting a price on our emissions of carbon dioxide into the Earth's atmosphere. And today, we're going to look at why and how to put a price on carbon.
The basic reason to put a price on carbon is to limit our emissions of carbon dioxide from burning fossil fuels, which is the main cause of global climate change. And there are several reasons why putting a price on carbon emissions is one important instrument in the policy mix of tools we can use to limit carbon emissions and thereby protect the stability of the Earth's climate.
The first reason is that putting a price on carbon is a cost-effective way to reduce emissions. It provides incentives to cut our use of carbon and to cut our use of carbon in the cheapest ways. So that's the reason that economists often think that carbon pricing is a really important element of the toolkit.
But another reason, which is equally important, maybe even more important, is that carbon pricing provides incentives for technological change. It helps to drive the cost curve for new technologies down, making things like solar and wind power cheaper than they would otherwise be. Because the fact that carbon prices are not zero anymore, but in fact are real and are going up, means that individuals and firms have an incentive to invest in R&D and new technologies in order to lower their own costs of reducing emissions.
A third reason to include carbon pricing in the policy mix is that it's not a standalone instrument, but can readily be combined with other important instruments in climate policy, including regulatory instruments and public investments.
A fourth reason, and to my mind actually this is the most important reason to put a price on carbon, is that while other policy instruments like regulations or public investment can do a great deal to limit our carbon emissions, we can never know for sure exactly how much emissions reductions we're going to get from any particular policy or mix of policies unless one of the policies in the mix is pricing carbon, and that carbon price is keyed to hard targets for quantity of emissions we're going to allow. If we limit the amount of emissions, put a hard constraint on that amount of emissions, and let there be a price on those emissions dictated by that restriction in supply of carbon in our economy, that's the way we can make sure that we stay within the emissions envelope that climate science and international negotiations of governments have agreed is necessary to maintain the Earth's climate stability.
And finally, another good reason to think about carbon pricing as part of the mix is that the money that firms and governments and individuals pay as a result of carbon pricing doesn't disappear. It's available for uses that could turn out to have beneficial effects both in terms of people's incomes and well-being, and in terms of the political durability of the climate policy. And this is what's called a protective rent, because by charging for use of the carbon absorptive capacity of the environment, we are in effect trying to protect the environment by charging a rent for its use rather than letting its use be free.
So I want to talk a little bit about each of these things today. First, short-run cost-effectiveness. We know that there are some ways to eliminate carbon emissions that are really pretty cheap, and others that are pretty expensive. About a decade ago, McKinsey and Company, the consulting firm, tried to look at different ways to reduce emissions and rank them in terms of their cost. And some of the ways were really cheap: lighting LED lights, insulation retrofits, for example, were very inexpensive ways to reduce our emissions of carbon. And others were pretty expensive. Way up at the top is what's called carbon capture and sequestration, where you go ahead and you burn the carbon, but then you try to capture it as it's coming out of the power plant smokestack or whatever, and pump it back into the ground. That's really an expensive way to do it. And so one of the attractions of putting a price on carbon is that you incentivize people to reduce emissions in the cheapest possible ways. Whereas with regulations, if you say, "Oh, you've got to do this or you've got to do that," you may not pick the cheapest ways to cut your carbon emissions. So if you want to get emissions reductions at lowest cost, a price is an attractive instrument to use.
Now, one thing that's worth noticing is that this line in the middle is a cost of emissions reduction of zero, which means that down here, you've got things that actually would save people money if they reduced their emissions. In other words, they would have what they call negative costs, right? And you have to ask yourself, what's going on here? If there are negative cost ways to reduce emissions, what that means is you or me, or firms, or governments could actually save money by cutting our emissions. We don't need to have a price on carbon to incentivize us to do it. We could save money today to do it. And the fact that people don't do it is one of the reasons why price alone may not be the only instrument we need in the policy toolkit.
A second attraction to carbon pricing is that it provides incentives for cost-saving technological change. The graph on this slide shows projections for the costs of wind power in years, both onshore and offshore wind power. And we can see that the price is projected to decline. But how much it declines is uncertain, and partly that'll depend on whether we put a price on carbon emissions from burning fossil fuels, and if so, how high that price is. If we do have a substantial price on carbon emissions, that's going to help to incentivize the research and development and deployment of alternative technologies that'll push that cost curve down.
A third attraction of carbon pricing is that it can be readily combined with other policy instruments in our efforts to reduce carbon emissions. For example, we can include smart regulations and public investment in the policy mix, as well as carbon pricing. These things are complementary; they're not substitutes for each other. Why do we need these other policies apart from carbon pricing? Well, for one reason, we have a problem of imperfect information, shortsightedness or myopia, inertia, which is why you've got that low-hanging fruit, actually fruit lying on the ground, that I showed in the earlier slides, ways of saving money today by cutting our carbon emissions that still go unexploited.
A second reason to include regulations in the policy mix is that, like pricing carbon, regulatory instruments can turn out to be very powerful tools for bending the cost curve. And in addition, public investments in research and development can help to drive cost-saving technological change. Indeed, many of the greatest innovations of the 20th century came about in part, at least, as a result of public investments.
Thirdly, public investments are needed to provide public goods like mass transit systems. Simply putting a price on carbon isn't going to allow me to stop driving my car to work if I don't have any other way to get to work. And public investments are needed to provide those other options.
And finally, another good reason to have regulation in the policy mix is to prevent the emergence of what are called "hotspots" for co-pollutants. Co-pollutants are things that are emitted along with carbon dioxide when we burn fossil fuels, things like sulfur dioxide, nitrogen oxides, particulate matter, that are hazardous to human health, particularly in the neighborhoods near the locations where the pollutants are emitted, near power plants or petroleum refineries or cement plants or whatever. And in order to control emissions in those specific spots, it's not enough to put a price on carbon emissions; you also have to have some other instruments in the policy toolkit.
An example of complementary policies is what we do in the case of parking. How do we deal with the congestion problem in parking lots for automobiles? Well, we use a combination of prices and regulations. We have a charge on parking in the lot or parking in the street, but we also have rules like, "You have to park between the lines," "You can't park in a way that blocks other cars from getting in or out of the parking lot," "You can't park on the street in front of somebody's driveway or in front of a fire hydrant." These kinds of rules complement the pricing, and together they result in a solution to the congestion problem that would occur in the absence of rules and in the absence of prices on parking. What we're talking about in terms of carbon emissions is parking the wastes from burning fossil fuels in the global atmosphere, and the same congestion problem, in a way, is what we're trying to address.
A fourth attraction of carbon pricing, as I mentioned earlier, is that it can ensure that we hit that emissions target in a way that other instruments in the policy mix, like public investment and regulations, can't guarantee. We can hope that those other instruments will do a lot to reduce our emissions, but if we really want to make sure that we get the amount of emissions reductions that we need to hit our targets for climate stabilization, we need to put an absolute constraint on how much carbon enters our economy. We need to just say no to any carbon emissions above that level. And carbon prices are the result of putting that constraint on the amount of carbon entering our economy.
There are two ways to put a price on carbon. One is to use a carbon tax, and the other is to use a cap-and-permit system. And the two are more or less equivalent; they're about the same thing. The only difference is that a tax sets a fixed price and lets the quantity of emissions adjust, and a cap sets a fixed quantity and allows the price of the permits that are issued up to the level set by the cap to adjust. If we want to hit the target, and if our target is to limit the amount of emissions to a trajectory that's consistent with climate stabilization, there are good reasons to think about putting a quantitative limit there and letting the price adjust rather than fixing the price and just hoping that that price is going to be sufficient to do the job. I'll return to that point.
First, where to put the price on carbon is also an important question from an administrative standpoint. How do we go about doing this? Carbon emissions are coming out of every tailpipe from every vehicle on the road, at least every non-electric vehicle. They're coming out of power plants. They're coming out of many different sources. How do we put the price on? Well, administratively, the most straightforward way to do it, and the least expensive way to do it, is to put the price on where the carbon enters the economy, where the fossil fuels enter the economy. That is to say, at the pipeline terminals, at the coal mine heads, at the natural gas pipeline collection points, where the fuels coming into the economy. That's where you charge the price, where you charge the tax, or require one permit to be surrendered for each ton of carbon embodied in the tons of coal, or the barrels of oil, or the cubic feet of natural gas that are coming into the economy. That price that's put on upstream, as they say, will then be passed along to consumers in the as part of the cost of production. And that's a lot simpler than charging a price at the point where the carbon's actually burned, which is called an end-of-pipe, as opposed to upstream pricing system.
The higher the price we put on, the more pollution reduction or abatement we're going to see. But the precise relationship between prices and quantities isn't known. If it were perfectly known in advance, one could simply set the price and get the desired quantity reduction. But we don't know exactly how much quantity reduction we're going to get. These marginal abatement cost curves show how much the cost of reducing emissions is expected to go up as we tighten up the emissions reduction target, but they're uncertain. They're subject to uncertainty.
There have been studies done that look at how consumption responds to price increases for fossil fuels. And in a recent meta-analysis of those studies, it was found that there are a wide variety of estimates of what's called the long-run price elasticity of energy demand. That is to say, how much reduction in quantity demanded comes with a certain increase in prices. And the mean, the average price elasticity of demand that was estimated was about minus 0.6. That is to say, a 10% increase in prices leads to about a 6% reduction in the use of fossil fuels. But the thing I want to point out here is that you've got a wide range of estimates around that, and we don't know precisely what it is. And it's because of that that in order to hit the target, it makes sense to specify that target and let the price adjust.
There are two ways to do that. One is to set a cap on the total amount of carbon you're going to allow into your economy and issue permits up to the level determined by that cap and auction those permits off. Alternatively, if you wanted, you could give away the permits to the importers of fossil fuels and let them trade among themselves. But if you want to make sure that the revenue is available for other uses and doesn't result in windfall profits for fossil fuel firms, it makes more sense to auction them. That's one way to do it: a cap-and-permit and auction system. The cap sets the limit on emissions, the permits are issued up to that limit, and the price adjusts in the auction.
The second way to do it is to use a tax, to set a carbon tax. But if you're going to do that, and you want to be sure you hit the emissions reductions target, what you need to do is index that tax. You need to key that tax to the quantity of emissions. And so every year, the tax rate would adjust as needed in order to achieve the emissions reductions objectives. Either one of those is a way to use the price to ensure that you stay within that emissions envelope.
What price it should be? What prices are we talking about? Well, I'll discuss that more in the next episode. A good conversion factor to bear in mind is that one dollar per ton of CO2 translates into one cent on a gallon of gasoline, or a gallon of petrol, as it's called in other countries outside the United States. So a $30 per ton of CO2 charge would mean 30 cents on a gallon of gasoline. A $100 per ton of CO2 charge would mean a dollar on a gallon of gasoline. And a $1,000 on a ton of CO2 would mean $10 on a gallon of gasoline.
Who pays the price? If we put a price on carbon emissions, where does that money come from? At the end of the day, it comes mainly from consumers, from people like you and me, people who consume energy, who consume it directly in the form of gasoline, for example, for our automobiles, or electricity in our homes, and indirectly through our consumption of everything that's produced and distributed using fossil fuels, which is most things in our economy. Consumers pay in proportion to their direct and indirect use of fossil fuels. The carbon price imposed upstream, where the fuel enters the economy, gets passed along to consumers as part of the cost of providing them with energy.
In absolute terms, richer households tend to use more fossil fuels than poorer households because they consume more. They consume more of just about everything. That's what it means, or one of the things that means, to be rich. On the other hand, as a share of their income and expenditure, in many countries, including the United States, poorer households, lower-income households, pay more than richer households because fuels are a necessity, not a luxury. So the percentage of their income and expenditure that goes to fuels is higher in low-income households than in upper-income households. In other words, putting a price on carbon is equivalent to a regressive tax. It's a tax that hits low-income people harder than middle-income people, and it hits middle-income people harder than upper-income affluent people.
And so a critical question in carbon policy is, where does the money go? That's the trillion-dollar question, and we'll return to that in a subsequent episode as well. But to preview that, there are three broad options. One is, we can let the money go to energy companies. A second option is, we can let it go to the government. And a third option is that we can return it to the people, to you and me, to ordinary folks, on the principle that we're the owners of the Earth's limited ability to absorb carbon emissions safely, and if we're going to charge for using that scarce resource, the money ought to come back to us.