Solutions to Global Warming that Minimize Welfare Loss
A consensus has been reached that societies need to reduce the growth rate of carbon emissions to prevent the worst consequences of global warming. There remains no working consensus on how to accomplish this task and how quickly to do so. The larger debate is framed in terms of how much welfare today is worth compared to welfare in the future. Environmentalists are often dismissive about the needs of people living in contemporary poverty, and one need not be anti-environmentalist to be appalled by the talk of trying to reduce population growth in poor countries, or the industrial development therein, in order to preserve some vague idea of the climate’s future. What is often left out is the positive correlation between development and declining population growth rates, on the one hand, and the market’s remarkable ability to increase the efficiency of energy production on the other. This article takes up the problem by attempting to find a policy tool that mitigates welfare losses today, while still accomplishing the goals of reducing carbon emissions. After a brief survey of prominent commentators, the author recommends taxing industries based on their adaptability to price increases, that is their ability to maintain production levels via the adoption of more carbon efficient technologies. This system, explained below, would insure that welfare loss was as little as possible; it would reduce carbon emissions, while maintaining competitive industries that would vie for efficiency rents within their industry specific tax structure.
The Stern Review:
Last year’s Stern Review publicized a large and
unambiguously damaging cost to carbon emissions due to its role in warming the
earth’s atmosphere. A failure to decrease growth in emissions would lead to an
estimated cost of 5% of GDP per year from now until human eternity. This figure
comes from an estimated social cost of $85 per tonne of CO2. On the other hand,
the costs of reducing emissions are estimated by Stern and his co-authors at 1%
of global GDP each year. The authors set a goal of stabilizing green house gas
emissions somewhere between 500-550ppm CO2e (e is for equivalent). Current
levels are somewhere between 375ppm (Pacala and Socolow, 2004) to 430ppm (Stern
estimate), and their target level is the same as that advocated by the
influential atmospheric scientists Pacala and Socolow (2004) of
The Critics:
The Stern Review, however, has had many critics. The most prominent in the economics profession have been Martin Weitzman and William Nordhaus. Weitzman (2007) wrote a recent review of the report that details his primary concern, which is the value given to pure time preferences by the Stern team. A key issue in this debate is how to weigh future welfare. In order to do this, we need an interest rate. A formula for such an interest rate can be obtained from the economics literature. It equals growth in per capita consumption (g), multiplied by the responsiveness of utility to that consumption, plus the preference we have for the short-term as opposed to the future.
(1) r = ρ + ηg
Where η is the elasticity of marginal utility or the coefficient of relative risk aversion (Weitzman, p 4). Here, r is the interest rate, ρ is the time preference.
If people don’t respond to increases in income with any increase in utility, and we are indifferent between the present and the future, then there is no meaningful interest rate. The cost of capital or anything else would be the same today as 20 years from now, but since our welfare increases with increases in consumption (of health services for example), an interest rate of zero makes no sense. Stern doesn’t dispute this, but argues that our time preferences should not put more value in the present than in the future. The thinking goes that people today are no more inherently valuable than future generations. He makes ρ ~ = 0, according to Weitzman (2007), which levels the value of the present compared to the future. Weitzman (2007) argues that this is an absurd assumption, and would allow for such bizarre behavior as people saving 100% of their income, with the expectation that spending today is equivalent to spending at the age of retirement.
William Nordhaus’s (2006) criticism is along similar lines, and in a recent paper, he uses a few thought experiments to illustrate what he takes to be the flaws in Stern’s zero discounting. According to Nordhaus (2006), a Rawlsian ethical approach would aim to maximize the incomes of the poorest generation. Since GDP per capita will be higher in the future, that would mean maximizing the welfare of the current generation through consumption. To give equal value to the future clearly demeans the present and the urgent desires of everyone living in it, including everyone’s need for consumption, the most wretched of whom desperately need more consumption today.
More concretely, Nordhaus (2006) runs his own calculations using the Stern time preference of 0.1 and his preferred value of 3%, declining to 1% after 300 years. This model yields a social cost of emissions that is initially dramatically lower than the Stern estimate social cost of $85 per ton: $17.12 per tonne of carbon in 2005, rising to $84 in 2050, and $270 in 2100. This analysis would recommend that the world reduce emissions by 6% in 2005, 14% in 2050, and 25% in 2100.
Despite these objections, there is much agreement that reducing carbon emissions should be a goal of public policy, and these reductions will impose costs. Given the urgency, it behooves policy makers to work with economists to come up with solutions that will minimize costs while maximizing reductions. The EU’s system of permit trading aims to do this by giving firms incentives to lower emissions, since they can then sell their excess permits on the open market to firms that are less able to adjust. While this system has many advantages and certainly creates the right incentives to spark innovation, it is not clear a priori how permits should be initially distributed.
Since the distribution of permits raises the same issue as the distribution of a Pigou tax, I will analyze only the latter in the final portion of this paper, under the assumption that assigning different industry tax rates would have roughly the same impact as granting different numbers of permits per industry. Such an idea was discusses by Weitzman in a famous paper, where he argued that a preference for quantity (e.g. cap and trade) vs. price regulation depends on estimates of the relative elasticities of supply and demand (Weitzman 1973). First, however, I will discuss a few actual examples of policy endeavors.
Contrasting Dutch and
Swedish Approaches to Regulation: Is
it “Rewarding Environmental Efficiency vs. Rewarding Environmental Pollution”
or “Exempting the Strong vs. Fostering the Weak”
I will mention two examples of how countries have dealt with this dilemma. In 1999, the Dutch government made a deal with industries that consume the highest levels of
energy in its economy called the “Covenant Benchmarking Energy
Efficiency” (Phylipsen,Blok, Worrell, de Beer, 2002). This voluntary agreement aims to push Dutch companies towards the top-of-the-world in terms of energy efficiency. Every
four years the company must determine which companies are in the most efficient
10% of global producers in their industry, and show that they are within that
range. If they are not, they must submit a detailed plan to move in that
direction. Their reward for cooperation is that that Dutch government will not
impose any tax requirements or other measures on emissions. This agreement
imposes constraints on the least efficient producers to take action to improve
efficiency, while allowing the most efficient producers to continue with
business as usual. Savings on emissions have been estimated to be roughly 5% (Phylipsen, Blok, Worrell, de Beer,2002).
The Swedish government has taken an approach that is almost the opposite
of the Dutch approach. In 1991 the government implemented a carbon tax at $100
per tonne. Consumers had to pay the full tax, but producers only had to pay 50%
(Osborn, 2001). In 1993, industries were granted even further relief after
making organized complaints -the tax was lowered to 25%, and the least efficient
industries were exempted from the tax on the grounds that they could not reduce
emissions enough to avoid the cost, and thus, they were put at a severe
competitive disadvantage (Osborn, 2001). A 1997 report by the
Swedish government forecasted that by the year 2000, the tax system would have
reduced 20-25% of more carbon emissions than the old regime would have (Osborn,
2001). A number of innovations have been made in biomass as an alternative fuel
source, but despite these advances many Swedish politicians had hoped the
results would be more robust, especially with regard to innovation in other
areas (Osborn, 2001). An Alternative Model
with Differential Taxation: The remained of this paper will analyze the impact of
imposing a carbon reducing tax regime on emissions that accounts for varying
levels of efficiency and adaptability across industries. The goal will be to
equalize the total costs of carbon emission across industries, adjusting for an
industry’s propensity to substitute out of carbon emitting technology. Figure 1 shows that some industries can afford greater
abatements in carbon emissions than others. Imposing stricter standards on
industries that can more easily adjust to new carbon-light technologies thus
allows for greater quantity of carbon reduction for any given level of marginal
harm. In the diagram, Industry 2 faces a higher emissions tax, pushing the MC2
curve out, but the cost measured by the Y-axis is still equal to that faced by
Industry 1. The result is that both industries face the same tax, but the
industries vary according to their ability to minimize carbon emissions,
without losing profits, since they have different marginal cost curves. Under a perfectly efficient system of carbon regulation in a
competitive economy, each firm would be charged exactly the price that would
maximize welfare gain, which would come not only from the reduction of
emissions but also through technological innovation that would increase the
efficiency of energy production. The perfect carbon tax would charge each firm
exactly the amount to induce that firm to invest up to the point where marginal
gains from additional investment in new technology (or R&D) compensate the
firm for marginal costs of the tax. The tax would adjust to equalize the gains
from investment with the losses from the tax. Under such a system each firm
would be contributing its utmost to reduce carbon without losing profits. This could never work at the firm level, however, for a
number of reasons. One is simply the fact that firms would want not want to
take the risk of investment on the premise that there would be no corresponding
gain in profit. If this tax operated at the industry level, however, each firm
within the industry could gain efficiency rents by producing energy at lower
prices than its competitors, without a subsequent increase in its input costs
(including the tax), and thereby reap higher profits. Figure 2 analyzes the implications of my proposal to tax
industries at different levels. MP is the market price to producers under
laissez faire, MH is the marginal harm with a Pigou tax. Here Industry 1 has a
relatively inelastic supply curve. A uniform Pigou tax at the level of marginal
harm would decrease its output from Q1.MP to Q1.MH and decrease value in the
economy by the area represented by trapezoids 3 and 4. Industry 2, however, has
a relatively elastic supply and would see a much smaller loss in revenue with
the uniform Pigou tax. The total loss in value would be 2+3+4. With tax
differentiation, on the other hand, Industry 2 could be taxed at a higher rate
and Industry 1 at a lower rate such that net carbon emissions were just as low
as under the uniform Pigou tax. The total loss in economic value, however,
would be lower, -only 1+2+4, since 3>1. This outcome may depend on
unrealistic assumptions about within industry competition, but I believe it’s a
useful framework to discuss more efficient policy options. Industry 1 would
emit more CO2 under this model, but Industry 2 would make up for it by emitting
less. This is essentially the same principle behind international negotiations
on climate change that require steeper emissions from rich countries, due to their
greater ability to invest in new carbon reducing technologies. It operates on a
principle along the following lines: from the strong, much is demanded; for the
development of the weak, less impeded. The difference in this case is that the
most adaptable industries are allowed to make just as high of profits as any
other, since the premise of the discriminatory taxing is that they can absorb
the extra costs via innovation. There are a number of potential problems with this approach
that need to be addressed. The two most salient, information and political
economy, interact with one another. First, there is a great deal of uncertainty
for the regulatory agency as to the true costs to firms from carbon regulation,
especially once relative technological adaptability is considered. One must
consider the ensuing political economic negotiations upon the announcement of
the regulatory system. One would predict that firms will invest resources in
persuading politicians to limit the tax for their specific industry, by arguing
that they have a low capacity to adjust. Yet, when one considers that some
firms within a given industry will be more apt to lead the way in carbon
reducing technology, and thus be able to collect temporary rents as other
lagging firms adjust later to the tax, these firms will have an incentive to
allow for high taxation. Technology firms producing carbon-reducing innovations
would join environmental groups in lobbying for high taxes as well, which would
make for a strong constituency in favor of taxation. These players might also
exaggerate the potential capacity for firms to adapt, which means that more
neutral sources of industry capabilities would be desirable. I believe the uncertainty problem can be partially
ameliorated by a market analysis of the relevant industries. Empirical data on
R&D and changes in efficiency from recent years will be suggestive in
determining the ability of industries to adapt to price changes in energy
inputs. An industry’s marginal adaptability into carbon reducing technology
could be estimated based on such data. Of course, these historic trends must be
considered alongside new developments, and potential new developments, in
technology to accurately reflect adaptability. Nevertheless, even with the
inherent uncertainty of innovation, regulators could still rely on historic
data, and if they made their tax-level calculations on a recurrent basis, accounting
for the emergence of new technologies as they come into the market, they could
still achieve something close to the correct relative tax. -J.T. Rothwell, Editor
Nordhaud, William (November
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the energy efficiency of Dutch industry: an assessment of the expected effect
on energy consumption and CO2 emissions.”Energy Policy, V 30.8. Osborn, Gareth (2001). “Can
eco-taxation be effective in reducing carbon emissions?” Colby College http://www.colby.edu/personal/t/thtieten/eco-taxation.htm Pacala, S. and Socolow, R.
(August 13, 2004). “Stabilization Wedges: Solving the Climate Problem for the
Next 50 Years with Current Technologies” Science,
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26, 2007). “The Stern Review of the Economics of Climate Change” Weitzman, Martin (1973). Price vs. Quantities, MIT, Working
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