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 won’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 government’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 government’s leading research agency in this area, the Australian Bureau of Agricultural and Resource Economics. Writing in AFR recently, ABARE’s Brian Fisher and Anna Matysek argued against carbon taxes and similar policies on the grounds that studies have shown ‘early action would be more costly than adopting emission pathways with lower near-term mitigation’. 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 ‘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?’ (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.

38 thoughts on “Prices and quantities in climate change

  1. Is NIMBY more powerful than hip-pocket? The only way you’re going to get me to shuffle around rugged up in a non-heated house in winter is to charge me $1 or more per kWh for electricity. At that price I suspect many people would find nuclear a lot more attractive.

    NIMBY is partly a function of people’s natural fears, and partly a function of the enormous disinformation that has been wilfuly disseminated by green groups in the past. That is now changing – some of the worst offenders are now actively promoting nuclear. If they’re half as good extolling the benefits of nuclear as they were when denigrating it, we could be in for quite a sea-change in public opinion.

    So it seems at least worth a try looking at a proactive nuclear policy in Australia. We need to do that in conjunction with any carbon tax system anyway, because simply introducing a carbon tax without setting people straight on the benefits of nuclear means we doom ourselves to very scarce, very expensive energy from renewables, which in turn means leaving my children far worse off than me.

    And where is the money from a carbon tax going to end up? To have a real impact on people’s behaviour it is going to have to be an enormous tax – potentially adding a significant amount to government revenues. If recent history is anything to go by, that money will simply end up in the same place as our current surpluses: down the gullets of federal public servants.

  2. “On prices and quantities”

    I’d like to add to my earlier post that the only price that changed (significantly) in the example given is the value of the US dollar in relation to some of the then many local currencies in Europe. The US dollar depreciated ‘significantly’ (ie enough for people to bother to review their consumption patterns).

    Apologies. I took it for granted that people who post on a thread headed ‘Environment – Economics General’ would all know about major events in international financial markets. It came as a total surprise to me that some people think ‘NIMBY’ has anything to do with it.

  3. Yes NIMBY is that powerful, especially while the general populous sees global warming as some far off threat that might happen next century. The nuclear power station scheduled to be built next *year* 10kms down the road would be far more alarming. Frankly, you’ve got Buckley’s of educating that fear out of people. Seriously, if a nuclear power station was to be built within 10kms of your house, would you be happy about it? Even if you felt comfortable about it, think what it would do to real estate values!

    Maybe we do need to be paying a dollar per kWh for coal-fired electricity, instead of the 10-15 cents we pay now. It might not make you turn off the heater, but it might make you insulate the house, invest in a more efficient heater, or get the gas connected. Four winters ago I used several electric heaters and froze. The following year I got the gas connected and bought a gas convection heater and was toasty warm. I did that mainly for greenie do-gooder reasons, and at considerable expense (a few grand). It didn’t make sense from an economic POV … I reckon most people faced with a similar situation would buy a few more electric heaters; they’re cheap to buy and electricity doesn’t cost much. Millions of these decisions are being made every day, and the only way to get people to make better choices is price.

    Where would the carbon tax go? Well, we could reform our idiotic income tax system for a start, pay for a few schools and hospitals, and invest in public transport … because we’re gonna need it.

  4. PrQ,
    Most of the equipment that produces carbon emissions is long lived, as you have pointed out. If the governmnet stated now something along the lines of “in 5 years we will have a carbon tax of $x per tonne of carbon emitted” the change would start happening now as the NPV of investments made now would change. Similarly with emissions trading – a statement that a system would be implemented (based on emissions at the current level) at a reasonably near date would also affect current decisions.
    If you believe we need to move in this way then this would be something that could be implemented now without major current costs.
    BTW, I cannot see any constitutional reason why the state governments cannot implement this. Blaming Howard for all of this (if you feel that appropriate) overlooks the possibility of the State Premiers actually doing something rather than whinging to the feds for more money.

  5. AR, the states are doing things, within the limits of their powers. For example, Victoria is promoting emissions trading.

    I would have thought that a state carbon tax might be regarded constitutionally as an excise. More importantly, it would be certainly treated by the Feds as a violation of the GST agreement, which Costello regards as prohibiting any state tax he doesn’t like.

  6. Costello has a point: despite record revenues mainly due to the GST, it now costs something close to 2 years average weekly earnings (gross) to pay the taxes when buying a new house in South Australia (median price).

    I dare say New South Welshmen hock themselves for closer to half a decade to their government for the privelege of owning their own home.

    Oh yeah, except for the baby boomers. They already got their houses on the cheap. Now they want my generation to pay through the nose for a shoebox for “environmental reasons”.

  7. David Michie, I have a idea to help deal with the NIMBY factors with regards to nuclear – pay the neighbours money from a levy (say about 0.2 cents a kilowatt, about a 5% impost on the wholesale price) on nuclear-generated electricity. If you put one nuclear power station in the Latrobe Valley and gave each of the 90,000 residents (at a rough estimate) an equal share of the compensation, it works out to about $170 per year. If you replaced the entire coal-generation capacity of the Latrobe Valley with nukes in the same spot (which wouldn’t be a bad spot to put them, as there is already ample water and lots of electricity grid there), each resident would receive on the order of $1000 per year.

    How much money does it take to keep NIMBYs sweet? I don’t know, but it’d be an interesting experiment to find out…

  8. “Where would the carbon tax go? Well, we could reform our idiotic income tax system for a start, pay for a few schools and hospitals, and invest in public transport … because we’re gonna need it.”

    Apart from the public transport (Australian cities are fundamentally not designed for it), I was hoping for all of that in the last budget. What did we get instead? A miserly shaving of the top marginal rate and a huge great dollop in the “future fund” – ie public service pensions.

    It feels really good knowing my 46.5c in every extra dollar is paying for the comfortable retirement of a 55 year old public servant with a house bought long before governments taxed or restricted such things out of the reach of anyone under 35.

  9. Dogz, no arguments from me about our tax system … the CGT and negative gearing rorts, the chasm between the top marginal rate and the company rate, and the handout given to retirees while working people still pay tax on their super contributions … but while we may whinge and gripe about these things the world will keep turning, if we don’t act soon on climate change the planet’s climate will be stuffed for 100,000 years.

    BTW, since when were Australian cities “designed”? (Canberra excepted)

  10. Robert Merkel, I dunno about you but I would find $170 a year rather inadequate compensation for having a nuclear power station plonked in my district.

  11. Honestly, I reckon a one-off payment in the tens of thousands, and an on-going yearly payment in the thousands. I know that may sound absurd (not to mention completely unaffordable) but that’s what I reckon you’d have to pay residents to stay within 10kms of a nuke. Even that may be inadequate for homeowners who would likely have ~30% wiped off the value of their properties.

    The feds would have to spend millions (perhaps billions?) shifting people who wanted to move and paying off those who wanted to stay. This kind of thing….

    Sydney Airport Noise Amelioration Program

    Reducing air traffic noise
    A range of measures have been introduced by the Commonwealth government to reduce or mitigate some of the noise impact associated with Sydney airport, including:

    a noise amelioration program that includes insulation and acquisition of the most affected properties, including houses, schools, child care centres, nursing homes and hospitals. As of 31 January 1997, $64,326,000 had been spent on insulation (the average cost for a house is $38,000) and $31,900,000 on land acquisition (data supplied to EPA by Commonwealth Department of Transport & Regional Development 1997)

    There are very few political forces more powerful than NIMBY!

  12. The solution to NIMBY is to put the reactors in as few BYs as possible.

    How about this: with carbon taxes many existing coal-fired power stations will be uncompetitive.The economies of some towns, like Port Augusta in SA, are completely dependent upon the local coal-burning power station. If the power station goes, the town will all but disappear. So I dare say the good citizens of Port Augusta would rather see a nuclear power station in their backyard than have no backyard at all.

    Closing the coal fired power stations near more densely populated areas would probably have a positive impact on property prices in those areas, because the economy clearly has other stuff going on (that’s why they are populated). So one can imagine replacing all the coal-fired generators in all areas with large amounts of nuclear generating power in the regional centers that need it for their economy, to the point where the expansion of the local economy would actually drive property prices higher, offseting any negative NIMBY effects.

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