Pricing Carbon – Part One

[I am modifying this post on February 15th to reflect the fact that the official IPCC target for GHG concetntration is 550 ppm. The original post referred more vaguely to "most experts" proposing a 450 ppm limit.]

Emissions of greenhouse gases (GHGs, which include gases other than CO2 but which are normally measured in CO2 equivalent) will be reduced by a combination of technology, conservation, and lifestyle changes, but the incentive for all these efforts must be a price imposed on making those emissions. Only then can these “price signals” feed through the economy and influence the decisions made by consumers. The idea of holding the emitter responsible for the total cost to society is not new; economists call effects caused by a particular actor but incurred by society as a whole “externalities.”

But how to determine the appropriate price? There are two basic ways of looking at it: either we can try to calculate the cost of the damage done by the emissions; or else we can decide that we need to set a firm limit on GHG concentration in the atmosphere and then try to set prices in such a way that this is achieved. I will elaborate on each of these, but note that to have any effect the price charged needs to be more than the cost of reducing emissions, at least in some applications. This cost will vary according to circumstances both within and between industries, and the price mechanism will encourage the reduction of emissions in those places where it can be done most economically, while concentrating the remaining emissions in those industries where it is hardest to change. (For example, it is easier to build clean new power stations and to retrofit old ones.)

The first approach to setting the price, based upon the estimated cost if we do nothing, is the one taken by the Stern Review. There are a number of problems with this approach, including two ethical ones:

Firstly, the adverse effects of climate change seem to bear more heavily on the poorest countries. Sub-Saharan Africa is likely to see worse droughts, while much of Bangladesh and all the Maldives may be under water. Meanwhile Canada expects to benefit from an open Northwest passage, Russia will see better agricultural conditions, and prestigious Champagne houses are already considering planting in England. Counting the cost in dollars using current exchange rates does not adequately reflect the suffering of third world countries. Is the loss of a peasant’s house worth less to him than the loss of a tycoon’s mansion?

Secondly, if we do nothing the adverse effects of climate change will build up for ever. Using normal discount rates to discount the far future effectively disenfranchises our grandchildren. We may prefer to spend $1 now rather than $1.05 next year, but can we extrapolate this time preference to conclude that we have the right to spend a $1 now and deprive our grandchildren of $50 eighty years hence? (1.05 to the power 80 is about 50.)

Methods of social accounting exist to deal with these issues, but they rely on subjective assumptions and therefore put the end result in question.

(Incidentally, some argue that if we go all out for growth, emitting greenhouse gases without restraint, we will be much better placed to mitigate the problem however bad it becomes, but this is an act of faith. In any case, how can the Bangladeshi farmer rely on us actually doing what needs doing when the time comes?)

Setting a firm limit on GHG concentrations seems a better way to go, and the official IPCC goal is to stabilize this at 550 ppm. From this we can set targets for emissions each year and then decide either to issue tradable permits (a “cap and trade” system) for that amount of emissions or else set a “user fee” (a.k.a. a tax, though here it really is a user fee) which we estimate will result in the target amount of emissions. On its face, the cap and trade system seems more reliable, since in theory it guarantees meeting the target. On the other hand, the market for permits can experience wild swings which make it hard for industry to plan. User fees could well work better. Their effects would need to be monitored and the rates adjusted as necessary but these adjustments would be more gradual and predictable than market swings. And they could be revenue neutral if they replaced existing taxes. Suppose industry was taxed solely on its emissions?

Part Two will probably appear late next week and will discuss the range of carbon prices resulting from each of these methods (including the European cap and trade system) and what it means to the consumer. Topics for other postings planned for the next few days include personal experiences with CFLs, and the Tesla electric car.