Home > Economic policy, Environment, Oz Politics > Why do economists support carbon prices?

Why do economists support carbon prices?

July 14th, 2011

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.

  1. Hermit
    July 14th, 2011 at 14:34 | #1

    Some of the assumptions here need to be questioned. It is assumed the order of preference for brown coal substitution is gas, black coal and wind. What if there are quantitative and qualitative restrictions on these alternatives? Black coal fired electricity into Victoria would have to come from New South Wales and Queensland. I doubt if the current grid could handle another 6.3 gigawatts coming into the State. Gas in Victoria is quite expensive based on the quoted figure of $7 per gigagoule for the Morwell gas/b.c. hybrid plant. On the hand brown coal costs about $6 for 9.8 gigajoules, though gas has higher conversion efficiency. Wind can only be relied upon for 20-30% of its nominal capacity and requires backup including the higher emitting open cycle generators (gas turbine only, no secondary steam turbine).

    Thus the alternatives to brown coal have capacity constraints that would require major investment to overcome. Whether that investment would be prudent is unclear given uncertainties over the future price of gas in southern Australia (for both primary and wind backup generation) and the unknown carbon price after 2015. A prolonged spell of indecision seems on the cards.

    I note the 2,000 MW of coal to gas switch funding announced this week is a maybe, not a definite. That leaves another 4,300 MW of coal fired capacity in Victoria. Can gas, imported black coal power and wind replace that in any time frame?

  2. Rob
    July 14th, 2011 at 14:43 | #2

    Can anyone comment on the impact of the tax on people like myself who already buy 100% wind generated electricity, or perhaps those who (like our host) already have solar installation.

    My thinking is that this will shield us from the impact of the price increase on electricity. Or to put it another way, I’ve already been paying a premium for clean electricity, but now it will not be as much of a premium. Am I on the right track here?

  3. John Quiggin
    July 14th, 2011 at 15:18 | #3

    Hermit, I do mention supply constraints for gas in particular. But I can’t see much value in an analysis that takes the existing grid as given. Very large expenditures are already planned, and there are no obvious constraints to more. More generally, don’t you find relentless negativity a bit wearing? Based on your comments here over the years, the huge global expansion of wind capacity we’ve already seen should never have happened, nor the big decline in the costs of solar PV.

    Rob, you are right at least if the market works as it should.

  4. July 14th, 2011 at 15:21 | #4

    Rob.. Where does your electricity come from when the wind doesn’t blow?

  5. sam
    July 14th, 2011 at 16:04 | #5

    Another talking point I’m hearing a lot lately is that a tax that phases out these dirty power stations will cause grid supply failures. This is a particularly annoying fallacy, because it displays an ignorance of how the National Electricity Market actually works. Nevertheless, I hear this line repeated without question all the time. I suppose I should stop listening to Alan Jones.

  6. iain
    July 14th, 2011 at 16:24 | #6

    The actual cost of the carbon tax, and the perception of the costs (to the average punter), will be divergent.

    Many people will blame any increase in their electricity bill or fuel bill over the coming years as due to the carbon tax.

    It will be very hard to break this perception in the minds of many people.

  7. Hermit
    July 14th, 2011 at 16:29 | #7

    @John Quiggin
    Here’s a likely explanation for the growth of windpower; when the energy mix is 8% renewable and the mandatory target is 20% under threat of fines it’s an offer too good to refuse. Here’s an alternative explanation for PV costs; the Chinese knew wealthy westerners would get generous subsidies so they used their cheap labour and unrestrained coal power to swamp the market. Even if they can get PV cheaper we need 80% cheaper batteries for night time and winter storage. Can the share of renewables grow indefinitely? A dietitian may recommend eating more carrots but that doesn’t mean we should try to base most of our intake on carrots. It’s a finite niche.

    As to my relentless negativity I believe I’m entitled to it. For the last 6 years I’ve tried to limit my electricity consumption to match the daytime output of PV. All my cooking is microwaved or woodfired. I also make most of my car fuel from veg oil. It occurs to me that the vast majority of people are not in this position. I once thought renewables might make a big difference but I now see they are just a limited niche. I predict this view will become widespread in a few years both here and overseas.

  8. Rob
    July 14th, 2011 at 17:28 | #8

    @chrisl
    It doesn’t. The lights go out and I go to bed early.

  9. July 14th, 2011 at 17:53 | #9

    Rob You win!

  10. July 14th, 2011 at 17:58 | #10

    The problem with the $14! banana / switch to apples analogy is that the apples are still being genetically engineered by a start -up company. Using seed capital. They haven’t had their first generation cross yet. And they may never bear fruit!

  11. quokka
    July 14th, 2011 at 17:59 | #11

    An unanswered question I posed on the previous thread:

    Page 24 of THE AUSTRALIAN GOVERNMENTS CLIMATE CHANGE PLAN seems to be projecting that something like 2/3 of emissions savings will come from “abatement sourced overseas”. Does this mean what it looks like – that it mostly depends on buying foreign carbon credits?

  12. John Quiggin
    July 14th, 2011 at 20:02 | #12

    @quokka
    I plan a post on this soon, but need to do some work

  13. Ikonoclast
    July 14th, 2011 at 21:44 | #13

    @Hermit

    Hermit says; “I once thought renewables might make a big difference but I now see they are just a limited niche. I predict this view will become widespread in a few years.”

    I used to be a much more relentlessly negative gainsayer than Hermit. And yet, it’s a funny thing, whilst I once thought renewables would be a very limited niche, I now think they will make some difference, at least in the energy sphere. The whole issue will be what is physically possible.

    If it comes to pass, as well it may, that the best transport I can afford is an electric moped, and if my solar cells can recharge it daily, and if I can still independently bring home my groceries this way at age 70, will I disparagingly call this technology “niche” or will I say, “It’s a ruddy life-saver mate!”?

    I can guarantee you it will be the latter.

  14. Roberto
    July 14th, 2011 at 22:06 | #14

    At the expense of sounding like Andrew Bolt, what impact will all of this have on global temperatures? i.e. what is the cost-benefit analysis of this not in terms of emissions but in terms of temperature?

  15. Ken Miles
    July 14th, 2011 at 22:45 | #15

    Because of Australia’s small overall CO2 contributions, it won’t have a significant direct effect on temps.

    But (at least in my mind) the big benefits is extra incentives for the development of low emission technologies. These technologies can flow out of Australia into larger emitters – which in turn can potentially have an extremely large effect on future climate change.

  16. crocodile
    July 14th, 2011 at 23:07 | #16

    Ken, and also income.

  17. Rich Puchalsky
    July 15th, 2011 at 06:42 | #17

    I criticize this post (using it as a proxy for all ETS/carbon tax support) here. You might be interested in it.

  18. BilB
    July 15th, 2011 at 08:35 | #18

    Quokka@11,

    In a global market it cannot be predicted where credits will be sourced. So it is a false to make such a prediction. Furthermore from our current view point it is impossible to predict the effect that technological development will have on our need to buy credits. it is far more likely, given Australia’s land mass, that Australia will become the carbon sink for many other countries, and profit hugely from such trade.

  19. quokka
    July 15th, 2011 at 09:30 | #19

    @BilB

    It’s not my prediction, it’s the governments. We can seek comfort in soothing stories about Australia becoming a huge carbon sink and lots of dosh to be made in the process but it has no connection at all with current reality. Apparently the government doesn’t think so either, judging from the chart I referenced. Well before such fantasies have any connection with reality, 450 ppm CO2 will be just a memory.

    The overwhelming priority is to stop emitting the stuff – not to seek “indulgences” as Hansen calls them, nor to sell indulgences to others.

    Australia’s biggest contribution to emissions avoidance internationally? – selling a low emission fuel by the name of uranium. It’s hard to see than changing any time soon.

  20. Rosscolie
    July 15th, 2011 at 12:46 | #20

    On quokka’s question about foreign carbon credits – the graph on p4 of the Gov’s summary doc “Securing a clean energy future” shows Australian domestic emissions staying broadly flat to 2050 at 600 Mt CO2-e (+ or -) but reducing by c. 80% over the same time span taking abatement sourced overseas into account. This would presumably require domestic economic growth to be underpinned by clean energy sources, but would allow substantial domestic energy requirements to continue to be drawn from fossil fuel sources. Raises a lot of questions, particularly the continued availability of abatement projects overseas (from developing economies) and the integrity of the governance regime. How often will avoided deforestation figure in the mix? We need real reductions, not only the avoidance of increasing emissions. If the developed countries( US, Europe, Aus etc) , and the industrialising developing countries (China, India, Brazil etc) don’t actually reduce gross emissions (not just emissions intensity) then hello to plus 4 degrees (or more) of temperature increase. Raises the question, is the government’s plan an “emissions containment plan” rather than an “emissions reduction plan”?

    On the Andrew Bolt theme, Australia is the driest continent with a lot to lose from extreme weather events, and with c. 60,000 km of coastline (including islands) we also have a lot to lose from sea level increase (as well sea temperature increase and salination). We also are the highest per capita greenhouse gas emitters in the developed industrialised world. We generally pride ourselves on punching above our weight but there seems to be a strong freeriding culture being promoted by Andrew Bolt, Bob Katter and others. There is a moral issue here – as we are amongst the worst of the perpetrators, and having a huge amount to lose from global warming, is short term economic gain sufficient to move us to exploit the efforts of the other economies by letting them pay all the price of addressing anthropogenic climate change? I would think that the majority of Australians want to be part of a country that accepts its due responsibility in matters of global welfare.

  21. Jason
    July 15th, 2011 at 13:34 | #21

    I don’t think Stephen King falls into either of your two groups. http://economics.com.au/?p=7757

  22. July 16th, 2011 at 07:39 | #22

    Pr Q said:

    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.

    I listen to 3 MTR whilst driving, just to keep my blood pressure up, and if I had a dime for the number of callers who latched onto this fallacy then I would have a lot of dimes. Why has the Right abandoned basic economic theory, which used to be its most reliable scientific ally?

    The price elasticity of demand (PED) for carbon-tax goods consuming households exceeds the income elasticity of demand (IED) for carbon-tax compensated households. The value for the (negatively sloping) PED function will exceed the value of the (positively sloping) IED function.

    Carbon-energy is a normal good, That assumes that there are available and affordable non-carbon energy substitutes for carbon-energy goods, implying a negative sign PED with a slope value greater than zero (totally elastic) but less than infinity (totally inelastic).

    Thus the IED effect off-sets the PED effect, but probably not by much. Households facing a higher price for carbon-taxed goods consumption and enjoying a higher-income through carbon-tax compensation will in net reduce their consumption of carbon-taxed goods.

    Not to try and teach my grandmother how to suck eggs but it would be helpful to introduce some basic micro eco 101 theory here – illustrating this example of consumer demand theory by means of graphs and some elementary algebra.

  23. July 16th, 2011 at 09:20 | #23

    Pr Q said:

    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….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.

    This is the pure Hayekian “dispersed distribution of knowledge in society” justification of market mechanisms. The information required to both know and make calculated trade-offs for scarce resources is generally not present in a single mind. Therefore a plurality of minds, both co-operating and competing, will be better placed to do the job. Welcome aboard to the Hayek Fan Club!

    And so true, the price rankings found in trade publication for various goods are to the economy as page rankings found in google for various keyword searches are to the “epistemy”[1]. Both are examples of how the wisdom of crowds, operating according to transparent and accountable rules, can sort out the core signal from the peripheral noise.

    Or more generally, there is an economy of knowledge that applies to all things of value, both material and mental. No one has a monopoly on this economy which is why decentralised acquisition and distribution mechanisms (liberalism) generally out-perform centralised ones (“corporalism”[2]).

    Of course post-modern elites have subverted traditional liberalism for their own deconstructive and derivative purposes, its what happens when the WASPs aren’t around to provide adult supervision. But I won’t bore you with that story yet again.

    [1] Strocchilogism coinage,
    [2] Another Strocchilogism, begging your pardon

  24. BilB
    July 16th, 2011 at 15:47 | #24

    JS,

    One thing that your theory does not allow for is that by far the largest part of the Carbon Price will be absorbed by business with no cost to the consumer. This is because the increase is only a very small cost to most businesses, so small as to not require a change is product pricing. Relatively few businesses have dynamic pricing structures that allow for day to day reaction to costs, and for most businesses changing prices is a rare event tigered mainly by accumulated cost pressure.

  25. Brendan
    July 17th, 2011 at 22:10 | #25

    @chrisl
    Enter solar thermal. It can already provide baseload power — Spain is rapidly becoming a world leader in the technology owing to the favourable political conditions. http://www.beyondzeroemissions.org/blog/spain-now-producing-24-hour-solar-power-110708 No doubt with future investment the technology for heat storage will get even better.

    Check out the Zero Carbon Australia Stationary Energy Plan by Beyond Zero, it’s really encouraging http://www.beyondzeroemissions.org/zero-carbon-australia-2020

  26. July 20th, 2011 at 15:25 | #26

    Haven’t visited for a while. Plenty to chat about here. The next decade has been called the critical Decade as, to have any realistic chance of holding global warming to around 2ºC the scientists by and large seem to agree that the world must halt and begin to strongly reduce its emissions by 2020.

    @ Brendan. Much as we all love Beyond Zero Emissions and the ZCA Stationary Energy Plan I wouldn’t be too confident about the role of concentrating solar thermal with storage as a means of achieving substantial baseload power production in the near future. Given the fatal attraction of all governments outside of China to the power of the market to solve all problems, new energy technologies are unlikely to become widespread, let alone dominant, before they achieve something like price parity with competing technologies. ESTELA, the European peak body for the baby Concentrating Solar thermal generating industry, (thus with a vested interest in gilding this particular lily, reckons that CSP will be price competitive with combined cycle gas generation between roughly 2016 and 2022 and coal sometime after that. BZE’s figures have been widely criticized by people who know much more about this sort of thing than me.

    @Ken Miles and others
    I applaud this ETS and fervently hope it is put in place and that we are able to hang onto (and strengthen) it. However the world’s only other substantial carbon market in the EU has been spectacularly unsuccessful so far. Green peace Europe produced a careful and damning assessment of the EU-ETS. They claim that they have now fixed the problems (most of which the Gillard government has also built into its proposal) and that everything will go better from now on. Nevertheless working together with a suite of other policies European emissions have slowed but much much more is required. Anyone who thinks the problem is solved if only we get this ETS in place is deluded it is a tiny but vitally important first step. However there must be many more and much larger steps in this direction if we are to have a recognizable future.

    There are two excellent ways to describe the task for Australia so that its urgency and scale become apparent. First, if a green-house gas burden commensurate with holding the global temperature increase to 2ºC is equitably distributed among the world’s population. Australia’s per capita greenhouse gas burden must fall from around 20tonnes/capita/annum to around 2 in four decades. This is India’s current per capita greenhouse burden.

    The second way to look at it is that if a green-house gas burden commensurate with holding the global temperature increase to 2ºC is equitably distributed among the world’s population Australia’s share at current rates of production will be exhausted around 2016 – five years. With better technology and our economic strength we might be able to manage this given the political will and the necessary leadership but there is the rub. No time to waste, no political consensus, no leadership – what are our chances do you think?

    This is a flawed proposal with too-modest goals but it is our last chance to save our bacon. If it works it will reduce global emissions by about 160 million tonnes annually, Australian emissions by between a third and half of that. If we get to 2020 still with these goals we are almost certainly toast. Between now and then we will need to see at least two solid tightenings of this belt as the world inevitably moves to more and more serious action.

    This proposal also deals out a large sum of money to renewable technologies thus giving a powerful investment signal and an attempt has been made to separate the disbursement of these funds from Canberra. If it works this is a very valuable measure.

    People who persist in asking how much the temperature will decrease as a result of this package are either mischievous or don’t understand the problem. This package will only begin to slow the growth in emissions, reductions will come later. Still it is a first step that we must take.

    Hope this rant is useful the words ran away with me somewhat.

  27. July 20th, 2011 at 20:17 | #27

    Brendan. Probably not a good idea to use Spain as an example.When the subsidies stop, so do the grand schemes.
    A quote attributed to Margaret Thatcher goes along the lines of

    “The problem with socialism is that eventually you run out of other people’s money”
    Do you think that when Spain’s creditors want their money back these solar projects will continue?

Comments are closed.