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.

27 thoughts on “Why do economists support carbon prices?

  1. 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.

  2. 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?

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