Uncharted Territory

December 8, 2009

Hansen vs. Krugman: Second (Third and Fourth Order Effect)s Out!

Yesterday’s NYT includes a right royal spat. Well, online it does, at least. In a piece titled Cap and Fade, James Hansen argues that carbon taxes would be more effective than cap and trade. Paul Krugman responds under the heading Unhelpful Hansen, by first telling Hansen to stay off his turf. Climate scientists shouldn’t dabble in economics, apparently. Tosh. Ideas have to stand on their own merits.

Having highlighted the intellectual ring-fencing which is at the root of many of the world’s problems, Krugman proceeds to un-blot his copy-book. He points out very convincingly that, from an individual consumer’s point of view, it matters not a jot whether gasoline is more expensive because of a tax or because of a cap and trade mechanism.

Krugman is right as far as it goes. But both Hansen and Krugman fail to mention the second, third and fourth order effects of pricing carbon emissions. And it is the second, third and fourth order effects that will determine the effectiveness of policy.

Let’s start at the end, because it’s more fun. The fourth order effect of pricing carbon will simply be a redistribution of spending power in the economy. I’m sure I’ve said it before, but I’ll say it again: money is just a means of distributing resources. The economic system will adjust so that the available resources are used.

Perhaps I should try to explain a little further. Money circulates. There is not a fixed quantity. Let’s imagine we put an astronomical tax on carbon. The money raised by that tax must be spent. Let’s say we decide to spend it on more doctors. Suddenly there will be more doctors to fly off to junkets round the world. Or maybe they’ll spend their money on art (or more expensive houses, or televised sport…). In which case the previous owners of the art (or houses, or sportsmen, their agents and other freeloaders) will be able to afford to fly more…

But before we even get to this unhappy state, we should consider, first, a second order effect of pricing carbon. Pricing carbon will tend to reduce the price of fossil-fuels. All that might happen is that the price of petrol at the pump remains the same, but less of the motorist’s money ends up going to the oil-producer and more goes to the government. Maybe a good thing in itself, but we’re trying to stop global warming here, not change the shares of unearned spoils divided with the Saudis. Sure, depressing the global oil price might have the desirable third order effect of reducing investment in the most expensive fossil-fuels for a while (until the lack of supply pushes prices up again), but we need to reduce consumption of fossil-fuels that cost virtually nothing: coal, in particular.

And unfortunately the second order effect of carbon pricing on the oil price is dwarfed by the third order effects of another second order effect. The second order effect (I’m trying to be rigorous, here!) is that taxes raise money. So does carbon trading. We need to consider the effects of how that money is spent.

Hansen argues that the money should be distributed to the population. This will, at least in the short-term, increase equality. And, unfortunately, when you’re trying to reduce consumption of mass-market products, equality is not your friend. Money will be taken from those whose consumption is not constrained by their financial situation and given to those who would like to spend more. Likely on heating, driving, flying and so on. Oh dear!

But there are problems with carbon trading, too. The precise outcome will depend on how carbon permits are distributed. If they’re given away to power companies, then any excess permits will accrue to these companies’ shareholders in the first instance. (Over time, these profits will encourage new market entrants, although this may not happen if only incumbents are able to access the permits). If permits are auctioned, though, then we reach a situation similar to the carbon tax. The outcome depends on what the government does with the revenue. Simply distributing it to the population would fall foul of the same equality problem as for the tax. Direct or indirect subsidies for renewable energy production would clearly be by far the best policy choice, in the hope that, once renewable energy has a huge cost advantage over fossil-fuels, everyone will switch to clean energy. Maybe.

In perverse support for Krugman’s argument that taxes and cap and trade are equivalent, government could spend tax revenues in the same way as those from auctioning permits. Very similar to Hansen’s position is the idea of tradeable personal carbon allowances. These would have the effect of transferring wealth from the rich to the poor. And remember, equality is not our friend…

Let’s make some tentative conclusions and observations:
1. The indirect ramifications of carbon pricing policies are more important than their immediate effects.
2. Carbon trading is philosophically preferable to carbon taxes, because it at least imposes a limit on total consumption. The problems arise from leakage (the concept is explained in a previous post). Unfortunately, these are very big problems – probably deserving a post of their own.
3. If there is a limit on the carbon price in a carbon trading system, then it becomes almost equivalent to a tax. However carbon is priced, governments must be prepared to push the price up indefinitely. Otherwise, I suggest, the economy will simply adjust to the price.
4. Carbon trading is a superior policy if you’re really serious about reducing fossil-fuel emissions, because government doesn’t have to set a tax at an eye-watering level. It can simply say: “this is all the fossil-fuel we can afford to burn, it’s supply and demand in the market-place which has pushed the price up.”

Unfortunately, I don’t see too many governments around the world that are about to bite the bullet and set an effective carbon price.

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November 19, 2009

The Nature of Money and the Consequent Likely Ineffectiveness of Carbon Taxes: Revisiting the Man in the Wardrobe Fallacy

Filed under: Carbon taxes, Concepts, Economics, Global warming, Markets, Oil price — Tim Joslin @ 12:56 pm

I’m very disappointed to see policy-makers trying to solve the problem of global warming by ineffective – and possibly even counter-productive – measures such as raising efficiency standards and imposing carbon taxes.

What, for example, will California’s TV owners do with the money they save on their electricity bills? Maybe they’ll upgrade their set more often which will likely lead to more emissions per dollar than would have been incurred had they spent the money on California’s partially decarbonised electricity!

I touched on the problem with efficiency – the rebound effect – when I summarised the various problems with policies which put a price on carbon with the aim of reducing CO2 emissions.

All these problems arise because we are so reliant on fossil fuels. Virtually everything we do – and in particular everything we spend money on – is likely to result in CO2 (and often other GHG) emissions to the atmosphere.

Today I just want to look at the problems with taxes on carbon. After all, now that the middle word has been dropped from “Copenhagen or bust”, it seems national policies, rather than a global emissions trading regime, are to be the focus, at least for the time being.

I worry whether my previous attempts to explain the Man in the Wardrobe Fallacy, here and then here, were too theoretical. So I’m going to try to work through the argument, step by step, with examples.

The Nature of Money

Too many people are failing to consider what money really is. One way of looking at money as a means of allocating resources. The price of a good is not, as many suppose, a fundamental quality, but reflects its supply and the demand for it.

Consider Geoge Monbiot’s recent piece on peak oil. Maybe its the late noughties zeitgeist, but again I feel obliged to express my disappointment, this time that George seems to think an “end is nigh” attitude to oil helps in the fight against global warming. Indeed, the first comment on his article, by NeverMindTheBollocks, has been deleted, but the second, by Daveinireland points out the problem:

“Isn’t the oil running out a simple so[lu]tion to global warming then? No oil means billions starve and the number of those pesky carbon footprints drops d[r]amatically.

Isn’t that what you want?”

In actual fact, if we want to stop catastrophic global warming, we can’t afford to use up oil the all, given that we’re also using all the gas we can find and most of the coal.

George’s predictions of chaos as oil output declines are also wide of the mark. For the activities that use oil – driving and so on – to decline globally, it would be necessary for oil output to decline faster than the rate of increase in efficiency in use of oil plus the rate of substitution of the use of oil, e.g. by the use of electric cars and (though it doesn’t help us on the GW front) the use of liquid fuels from coal (and indeed biofuels). Oil output would only decline by a few percent a year, max, which – given the EU thinks we can generate 20% of our energy supplies from renewable sources by 2020 – is of the same order as the rate at which we can replace it. And this doesn’t even take account of forced energy efficiencies.

Why do I say “forced energy efficiencies”? Because at some point, an individual’s spending on fuel is limited by the price. If they still want to get to work they’ll simply have to trade in the SUV for a hybrid. Money determines how the available fuel is allocated.

Of course, in a world of massive financial inequality, some will carry on driving their SUVs, whilst others are forced to use even cheaper means of transport, such as buses, trams or trains. But this is the fault of the economic system, not the oil supply. Since we’re using oil so inefficiently – maybe on average we get 50% fewer mpg than is possible with current technology – the supply could decline by at least 50% before it was necessary in energy rather than financial terms for anyone to reduce the distance they drive at all.

Monbiot oversimplifies by attributing economic problems to resource constraints. He suggests, for instance, that:

“a permanent oil shock would price food out of the mouths of many of the world’s people.”

If we assume the food supply does indeed decline, or at least fail to keep up with population growth, then it is indeed the case that food prices could rise if nothing else is done. But food, like gasoline, is being used unevenly and inefficiently. Many of the world’s people already have too little to eat, for economic reasons rather than because of limits on global resources. Further, many of those with least to eat are not part of the global market economy. Rather they are subsisting (or not) on small patches of land, relying very little on oil-based fertilisers and oil-powered machinery.

It’s the urban poor who are most likely to be affected. But in many countries, the prices of basic foodstuffs are regulated by the state, so problems will arise only when countries are no longer able to afford imports. Meanwhile the price mechanism will reduce consumption in developed countries, specifically those which are net importers of food. Here, though, minimum wages (and state pensions and benefits) are generally negotiable and index-linked, negating the effect of price rises.

Who would have to reduce their consumption, then? It’s a mixed, even slightly rosy picture, but it seems the burden will fall on two groups:
– those whose governments are no longer able to import sufficient food;
– those urban poor presently existing on slightly more than subsistence-level food supplies, who will become relatively poorer compared to those reliant on social or government safety-nets.

In other words, more people will be food-poor, but famines, as now, will be associated with collapsed governments and environmental or social crises.

The point I am trying to make is that money is simply a way of allocating resources. And there are other ways.

Food is so fundamental that you can’t naively apply simple supply and demand economics. In the UK, for example, food was rationed for a decade just over 50 years ago, well within living memory. In the event of a complete food-supply catastrophe (and actually I think a bigger threat than a slowly declining oil-supply is a major volcanic eruption which could reduce harvests for several years), I have no doubt we’d see rationing again.

The effect of a decline in global food supply is complex, but one tentative conclusion might be that it would be governments rather than the individuals themselves who ensure their populations have an adequate food supply. Or not.

The Likely Ineffectiveness of Carbon Taxes

Let’s now consider the policy of taxing carbon, as is being implemented in France, for example. The idea is to tax gasoline, heating oil and so on. Fine, but the critical question is what happens to the money:

“But things get tricky. The €4.3 billion ($6.39 billion) raised annually by the tax would actually be returned to taxpayers in the form of tax reductions or ‘green checks.’ A family living in an urban area, for instance, would get a break of €112 ($166.53) on their income taxes. A family living in the country, which presumably would mean higher carbon taxes because of the lack of public transportation, would get an even bigger reduction of €142 ($211.14).”

What amuses me most is that the French have decided that carbon consumption because of a rural lifestyle is somehow legitimate! Apparently we should subsidise those who have profligate lifestyles in rural areas – a ludicrous position that is also taken for granted on this side of La Manche. An intelligent policy would instead pass on the various extra costs arising from their inefficient lifestyle to those in rural areas to encourage more to adopt a less costly urban lifestyle.

But the real problem is that the money raised by the carbon tax is simply redistributed. Only two things have happened:
– the spending power of the poor has been increased at the expense of that of the wealthy;
– the price of highly carbon-intensive activities has been increased relative to less carbon-intensive activities.

The first effect could actually make the situation worse, as some of those who could not afford to (say) use their car often or heat their homes as much as they’d like, can no afford to do so. This could (in fact very likely will) outweigh the effect on the wealthy, who may simply save less of their money!

The whole policy therefore rests on the magnitude of the second effect. Will people switch to less carbon-intensive technology? There are at least two reasons why they might not and even if they did, this would not necessarily reduce global or even French carbon emissions:
– first, it’s often difficult to tell which option is least carbon intensive;
– second, there may be insufficient supply of renewable energy;
– third, consuming less fossil fuel will simply allow its price to fall, allowing others to consume more.

Let’s explore the third problem a little more. Take the example of the oil price which is set globally in dollars. If the French purchase less oil, its price will drop slightly and someone else – China, say – will be able to purchase a little more of it. France acting on its own cannot reduce global oil production.

But it’s worse than this. France can afford a certain level of imports, over a long period of time equivalent in value to their exports. So, if France earns on average $100bn a year in exports (let’s assume imports and exports are all priced in dollars), then, on average, it will import an annual $100bn worth of goods. Money can store value but ultimately must be spent – in itself it has no intrinsic utility.

The carbon tax has no effect on France’s trade position – if anything it will help them increase their exports, by promoting more efficient use of fossil-fuel imports – so they still have (at least) the same hypothetical figure of $100bn to spend each year.

Likely a similar proportion of the $100bn will be spent on fossil-fuel such as oil. But let’s suppose France succeeds in reducing oil consumption. What else might they buy? If they buy manufactures, the “embedded carbon” in each $1bn worth will very likely be higher than in $1bn worth of oil! Why? Because manufactures require energy which will likely come from cheap indigenous (or Australian) coal, in China, say. Oil has a scarcity value because it is so useful. $1bn worth of oil might therefore contain less carbon than $1bn worth of manufactures!

And it gets worse. Whatever France buys, even if it’s software, they’ll give their dollars to the producers, let’s say in India. And the producers will then be able to import oil. Or manufactures.

The Man in the Wardrobe Fallacy

The Man in the Wardrobe Fallacy is simply that an internal change in an economy – a redistributive tax on carbon, say – has no direct effect on the external effects of that economy, its ability to import fossil-fuels, for instance.

At the present time, supply-side constraints – the rate at which low-carbon energy is being rolled out – are limiting our ability to reduce fossil-fuel consumption and hence carbon emissions. When gigawatts of wind energy capacity are held up in the planning system, all carbon taxes will do is act as a redistributive tax, increasing economic equality (all else being equal).

And, mirroring the case of the likely effect of production capacity constraints on food consumption, economic equality is, sadly, not your friend when you are trying to reduce consumption of a resource. Think about it. Consumption of any resource is surely minimised when the poor majority are constrained by their finances (or access to the resource), and the wealthy minority by their appetites!

In the example of food, the response to a drop in supply would be to increase the numbers of the poor majority, that is, those constrained by their finances. The number able to eat as much as they want, whenever they want, would tend to decline.

In the example of fossil-fuels, redistributive effects – such as from taxes – tend to increase consumption, the reverse effect. Indeed, we can see on a global scale how the spurt of development over the last couple of decades, and especially since the start of the millennium – a massive equalising of global spending power – has led to an increase in, for example, demand for oil.

Successful strategies to reduce global carbon emissions must involve a limitation on overall emissions. Kyoto – with crucial terms dictated by the hyperpower of the time, the USA – was intended to lead to such limits. Copenhagen, forged in the new multi-polar world, will consist of no more than a series of unenforceable, and, in many cases, vague, national undertakings, and will be entirely ineffective.

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