Why do economists support carbon prices?
I’ve been a bit slow getting on to this, given the excitement of recent events, but my answer to this question is over the fold
The leader of the Opposition, Tony Abbott, is not easily embarrassed, but he showed a tiny bit of embarrassment when he had to concede that he could not find a single reputable economist to back his proposal for a ‘direct action’ scheme to reduce CO2 emissions. By contrast, large majorities back one or other of Abbott’s numerous previous positions on the issue, supporting a carbon tax, an emissions trading scheme, or some hybrid of the two.
An informal poll held at the Australian Conference of Economists found that only 11 per cent of attendees supported ‘direct action’, while 80 per cent favored price based mechanisms. From my discussions in the profession, I would say that the 11 per cent is an overstatement, and that those who responded this way fall into two groups:
(a) non-economists attending the conference on behalf of business organisations and other bodies tied to the conservative side of poltiics.
(b) the small minority of economists who reject the science of climate change and correctly judge that, whatever his current statements, Abbott has no intention of doing anything about it, let alone a wasteful and costly program of direct action
But why are economists so overwhelming in their support of market-based responses to climate change? Of course, economists support markets in general, but the great majority of the profession also supports direct government intervention in appropriate cases. The overwhelming support for a market based response to climate change reflects economists’ understanding of the nature of the problem.
Energy is essential to all aspects of modern life. On the other hand, our current methods of producing energy generate quantities of carbon dioxide too great for the atmosphere to absorb without producing a substantial disruption of the global climate.
So, we need to find a way to maintain the essentially uses of energy while reduce carbon dioxide emissions. This can be done by using alternative energy technologies, by using energy more efficiently or by changing our consumption patterns to focus less on energy-intensive items (such as lighting, heating, airconditioning and travel) and more on items that do not require so much energy (such as health services and telecommunications).
This problem raises a vast number of possible options, and the problem is to choose which will achieve the necessary reductions in emissions with the least possible disruption and economic cost. This is a difficult problem. For example, in reducing emissions from transport, the alternatives include the development of more fuel efficient private cars, expansion of public transport or the use of telecommunications (phone calls, email, Skype and so on) as a replacement for face-to-face meetings. It is not immediately obvious what mixture of these options is best, and there may well be other possibilities
One solution is for the government to appoint experts to identify the best methods of reducing emissions and then introduce regulations or other forms of ‘direct action’ to ensure that these methods are adopted. Sometimes, this is a sensible solution. Most of us are not very good at comparing the purchase price of household goods, from lightbulbs to fridges, with the lifetime energy costs they will generate. So, it makes sense for government to impose energy efficiency requirements, such as the phasing out of incandescent light bulbs.
But in most cases, no body of government experts has the information needed to make the necessary trade offs. The alternative solution is to make those responsible for carbon emissions pay a price, just as they do for goods and services of all kinds.
To see how this works, consider the government’s proposal for a price of $23/tonne. This will affect the decisions of businesses and households at a number of levels. First, consider electricity generators. They currently receive an average of about $40 for a megawatt-hour (MWh) of electricity (about 4c a kwh). Generating that MWh from brown coal emits about 1.3 tonnes of CO2, so a brown coal generator would have to pay around $30 MWh as the price of the carbon they emit. The corresponding figures are around $23/tonne for black coal, $10-15 tonne for gas and zero for most alternatives.
At these prices, new investment in brown coal power stations is no longer profitable, and existing brown coal stations are likely to close earlier than they would otherwise (the government is planning to help this along with some adjustment assistance). Where supplies are available, gas-fired electricity is usually the cheapest option followed by black coal and wind. As prices rise and the costs of relatively new renewable technologies fall, they will become competitive, even without regulatory measures such as the renewable energy target.
Given that the costs of coal-fired and gas-fired power will rise, the price of electricity will also rise, probably by around $23 MW/h or 2.3 c a kWh. That’s not huge, but it’s enough to provide businesses in particular with a stronger incentive to invest in more energy-efficient technologies. However, rather than governments specifying what investments companies should make, the imposition of a price lets them pick the option that is most cost-effective for their own business.
Finally, we can expect some changes in household consumption patterns. At the current carbon price these will be modest, but a rising carbon price will reinforce some trends that are already taking place, such as a reduction in the use of private cars, particularly among the young.
It is sometimes argued that, if the government compensates households for the increase in prices associated with a carbon tax, the incentive effects of the tax would be cancelled out. That’s an error (except if the compensation is conditional on continuing to use energy).
To see what’s wrong with this, think about the price of bananas, which has risen to around $12/kilo in the wake of cyclones and floods. Over the same period, most households have experienced wage increases that more than offset the higher price of bananas. But of course that doesn’t mean we keep on buying the same amount of bananas. Rather we switch to, say, apples, and use the money saved to buy other goods and services.
In thinking about the impact of the carbon tax on households, it’s worth doing some basic arithmetic. The total revenue raised by the tax is around $10 billion, which is a bit less than 1 per cent of national income, and most households will get a fair bit of that back in lower income taxes or higher pensions. So, the net impact, even for households that are net losers is unlikely to be more than 0.5 per cent of income. For the median Australian household, that’s around $7 a week, which is a lot less than the variation that arises from all kinds of other sources.
It follows that, although the carbon tax will have a significant impact on our aggregate emissions of CO2, mainly through its impact on electricity generation and energy use by business, the average household will barely notice it. This was true of the GST, which takes about $40 billion a year in revenue, and it will be just as true of the carbon tax at a quarter the size.