Carbon taxes

This is a response to a Twitter thread with Eric Lonergan and Max Jerneck about climate policy and the economics of externalities, which I am putting here because I am too lazy to write a Twitter thread in response.

I wrote that I couldn’t get my head around Max’s statement that “the externality frame may be true in some abstract philosophical sense but it’s hardly a useful guide to policy” and I still cannot. I think Max is wrong and “make things with negative externalities more expensive and things with positive externalities cheaper” is an important and useful guide to policy.

But what about Eric and Corine Sawers’ argument that externalities are the wrong place to start with climate policy? I reckon their arguments that the priority is to create green substitutes for dirty technologies is spot on, and that regulations will be needed to decarbonise electricity generation quickly enough, are true and important (and from what I can see in public debates the regulation argument is too often overlooked, although I don’t think the ‘create substitutes’ one is —everyone likes to subsidise green R&D). But I can’t follow their argument that concludes using taxes and subsidies to price externalities is the wrong thing to do today.

Eric and Corine write: “What is crystal clear is that you do not start with a carbon tax. It can play a role, but late in the game.”

I reckon the world would be in a better position today if we’d been taxing carbon emissions and subsidising green alternatives for decades. And I think the sooner we start, the better. Right now, for example, we need to replace gas-fired domestic boilers with electric heat pumps. I think that would happen quicker if taxes on gas (and gas appliances) went up and taxes on electricity (and heat pumps) went down. The same goes for bunker fuels for shipping, coke-fuelled steel furnaces, and so on and so forth.

Eric and Corine point out that demand for fuel is insensitive to prices, at least in the short run, which is true and important and an argument that we need more than carbon taxes. Fine by me, but I don’t think it’s an argument that carbon taxes are unhelpful. They write “carbon taxes have typically come at considerable political cost and little gain.” Kate Raworth is cited claiming taxes are “indeed leverage points … but they are low points of leverage”. I am not sure that’s correct. Here is some evidence that the UK’s carbon taxes have already helped accelerate the decarbonisation of electricity generation. Here is a paper that estimates a cross-price elasticity of demand for electric cars, with respect to the price of petrol, at 0.62 (in Norway, the authors caution estimates are market-specific).

Simple theory might apply taxes and subsides to the prices of goods and services, but the same idea can, and should, be applied to pricing the externalities of innovations (and there are other ways of increasing costs than taxes). We should subsidise innovations that create positive externalities and penalise those that create negative. If we’d started doing that decades ago, I think we’d be in a better position today. If we start doing more of it today, I think we will be in a better position tomorrow.

To my mind, changing the prices of green and brown goods and services complements policies to create green substitutes, and I don’t understand why Eric and Corine oppose it.

Eric and Corine write:

I’m with Gates on this one. I think the development of synthetic green aviation fuels would be accelerated if fuel producers and consumers faced higher taxes on fossil fuels and benefited from subsidies on green fuels. That is not a claim that taxes alone will decarbonise aviation fast enough.

I don’t know what to make of the claim Gates is “100% wrong in practice”, unless Gates is trying to claim taxing fuel is the only thing that needs to happen … but that’s not evident in the cited excerpt. I absolutely agree that, in the context of electric cars, charging infrastructure and other measures (regulations) to decommission the existing stock of petrol engines are crucial to decarbonising road transport, and the same doubtless goes for aviation fuelling infrastructure and decommissioning existing planes.

Eric and Corine describe how oil companies now face duel costs of capital, in part because of the expectation of future carbon taxes. They write: “But contingent taxes embed sequencing — they incentivise the creation of substitutes without cutting off the funding. Taxes are useful — indeed essential — but not in the context of correctly pricing externalities.” I don’t see how they arrive at that conclusion. Would higher taxes on oil today be a bad thing because it “cuts off the funding?”. I don’t see it. Why is “the future” always the right time for carbon taxes and not today? I can see how applying “correct” carbon taxes immediately could do more harm than good, if that’s too disruptive, but that’s just an argument for applying whatever level of carbon tax we think that economy can swallow without undue harm today and committing to an escalator. It’s adding adjustment costs to the theory of pricing externalities, not fundamentally altering it.

They conclude:

“There is a role for smart taxes, but the purpose is very different. They are not aimed at correctly pricing an externality. Taxes, exemptions and credit guarantees, should serve one purpose — accelerating the depreciation of carbon-intensive assets, financing the creation of carbon free alternatives, creating substitutes at scale, and targeting the relative price of substitutes.”

I fail to understand how this is “very different” to using taxes and subsidies to internalise externalities, especially the last part about targeting the relative prices of substitutes. We wouldn’t need to accelerate the depreciation of carbon-intensive assets if they weren’t generating negative externalities [1]. We wouldn’t need to subsidise the creation of carbon free alternatives if that didn’t generate positive externalities.

I find it baffling how so many people who want to accelerate decarbonisation and see the need for more than tax carbon taxes, somehow end up arguing against making emitting carbon more expensive, today (or at least, appear to).

Addendum!

What all this makes me wonder is how standard economic theory, which says that pricing externalities will result in socially optimal outcomes, deals with demand elasticities and innovation.

I would have thought the simple theory of pricing externalities ought to come from a model with multiple goods, which are substitutes to varying degrees. As far as I know, the prescription to price externalities is not conditional in theory on own-price and cross-price demand elasticises, which, if so, suggests they are unimportant (in theory). Of course, those elasticities will determine how the consumption of various goods changes after externalities are priced in, but if pricing externalities is sufficient to yield a socially optimal allocation than that simply means whatever those elasticities are, and whatever the resulting pattern of demand looks like, it’s socially optimal (in theory).

If that’s right, I’d like to understand why. For example, if demand for petrol is price-inelastic, that could be because people bloody love driving and don’t have any good substitutes, so if they keep driving after carbon taxes include the cost of externalities in petrol prices and the world subsequently burns, that is optimal because people evidently value driving more than an unburnt world. Whereas if demand for petrol is price-elastic, and people have good substitutes, so they stop driving after carbon is taxed and the world does not burns, that is also optimal. Because what’s optimal depends on 1. how much people like stuff and 2. what substitutes exist. And if you don’t like these conclusions, you must revisit how you’ve priced externalities (or introduce the idea that people aren’t rational, or anything else that breaks the theory). Is that how it works?

(I am interpreting “socially optimal” to be equivalent to “will decarbonise the economy quickly enough to keep the harms of global heating within acceptable limits” and if that’s not correct I have questions about the concept of social optimality being invoked in theory. The concept of “acceptable” must include some idea of how to aggregate preferences across people).

As you have probably realised, this raises the question of whether standard theory takes the existence of substitutes to be exogenous, or whether the result that pricing externalities is optimal extends to a setting in which substitutes are endogenous and must be created by innovations that incur upfront costs. I would guess that in such a model, with no “frictions” and rational forward-looking agents, then pricing externalities into existing and any future goods might be sufficient to steer innovation in socially optimal directions, but I don’t know. Perhaps even standard theory agrees with the need for policies to influence innovation, in addition to the pricing of externalities? Or perhaps standard theory would agree with that need only after frictions, such as entrepreneurs’ uncertainty around future taxes and subsidies, are incorporated. And what happens if the theory is extended to include durable capital goods in a dynamic setting?

What you should infer from this is that I don’t know enough about the standard economics of externalities to be pontificating on the topic. And I should go read a textbook.

[1] I having been telling anyone who will listen, in my development finance circles, that promoting green substitutes in “hard to decarbonise” sectors is not enough, we also need to persuade people to replace carbon intensive fixed capital before the end of its useful economic life, and that development finance institutions, such as my employer, should be thinking about how we can help there.