Prices and quantities in climate change
My piece in last Thursday’s Fin (over the fold) was on the economics of climate change. Paul Krugman in the NYT was writing on the same topic.
Pricing a change of climate
Prices and quantities are the bedrock of economics, yet confusion about the roles they play, and the way they are determined in markets, continues to bedevil government policy. This is obvious in relation to the water crisis, where continued resistance to any serious role for prices has brought the National Water Initiative to a standstill Water rules wonâ€™t wash AFR 20/4/06
There are, at least, some signs that the Howard government, and particularly the Parliamentary Secretary to the Prime Minister, Malcolm Turnbull, are ready to move in the right direction on water. But on the even more important issue of climate change, the governmentâ€™s resistance to an appropriate role for prices seems to be hardening.
With the recent release by the US government of a draft of the Fourth Assessment Report of the International Panel on Climate Change, it is apparent that scientific debate over the issue has come to a firm conclusion that human activity is causing damaging climate change. Unfortunately, the economic debate is nowhere near as advanced.
Understanding of the issues has not helped by the recent contributions of the governmentâ€™s leading research agency in this area, the Australian Bureau of Agricultural and Resource Economics. Writing in AFR recently, ABAREâ€™s Brian Fisher and Anna Matysek argued against carbon taxes and similar policies on the grounds that studies have shown â€˜early action would be more costly than adopting emission pathways with lower near-term mitigationâ€™. Greenhouse quick fixes sure to backfire, AFR 1/5/06.
This argument gets the roles of prices and quantities precisely backwards. If short-term action is costly, this will be reflected in the pattern of adjustment to an increase in prices. The adjustment will be slow to begin with, and more rapid as old capital stock is scrapped and new, less emissions-intensive technology is developed in response to the price change.
But the fact that emissions adjust slowly to price changes is not a reason for delaying those changes; precisely the reverse. The fact that responses will be slow means that the longer we delay getting prices right, the greater the buildup of emissions in the atmosphere and the greater the eventual cost.
Much of the ABARE analysis, and of the rhetoric surrounding the Asia-Pacific Climate Pact, seems to be premised on the assumption that the development and adoption of new technology will resolve the problem of excessive emissions. But as Brett Janissen of Allen Consulting observes â€˜what is going to stimulate the development and uptake of these technologies? Rhetoric, tax dollars and an army of bureaucrats – or opportunities to profit from emission reductions, backed up by a carbon price?â€™ (It’s time to adjust to the realities of climate change, AFR 19/5/06).
A more sensible observation based on the fact that quantities are going to adjust slowly to any price change is that there is little benefit in raising the price of emissions rapidly. Much the same adjustment can be achieved by a gradual increase in carbon prices, based on a preannounced commitment. But again, if prices are to be increased gradually rather than rapidly, it is necessary to start sooner rather than later.
The other central lesson of economics is that prices and quantities are two sides of the same coin. Under conditions of full information, it does not matter whether governments specify a gradually declining path for aggregate emissions and let a market for emissions permits determine the corresponding equilibrium price or impose a steadily increasing carbon tax sufficient to reduce emissions to a sustainable level.
The first approach is that represented by the Kyoto protocol, which combines modest initial quantitative targets with the establishment of markets for emissions rights. These markets are now in existence, and despite some teething problems, appear likely to be firmly established in the next few years.
The second approach is that advocated by Australian economist Warwick McKibbin and his American colleague Peter Wilcoxen. It has the advantage of being more transparent. In particular, it is easy to ensure that the selected price path incurs only modest social and economic costs. So far, however, this proposal has failed to win much political support. Signatories to the Kyoto Protocol have argued that, whatever its limitations, Kyoto is, in effect, the only game in town.
The members of the Asia-Pacific Climate Pact have the opportunity to disprove this claim by adopting a price-based plan to reduce emissions gradually. So far, unfortunately, they have preferred to rely on wishful thinking.