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Subsidies and Puppies.

A nuanced look at politicians’ favorite policy tool.

Everyone likes a puppy. You get a puppy you’re immediately in love. You never want to get rid of it. Puppies also come in all sizes. Look at that face!

The same is true for energy subsidies. The government essentially decides on what type of behavior (e.g., using public transport instead of your personal car to go to work) or purchase (e.g., electric vehicles instead of gas guzzling SUVs) to encourage and then hands out monetary incentives. Everyone loves them! Politicians and regulators can hand out “free” money to firms and consumers, who will be happier, and more likely to vote for them later. Everyone wins! It’s like the Oprah show, but at scale.

Even Chicago economists should like puppies, I mean subsidies, in some settings. Econ 101 tells us that there are some good reasons to subsidize certain activities.

Reason 1 is if there is a public goods nature to a firm’s activity. Research and development (R&D) of low carbon technologies is a good example. R&D is risky, as success is not guaranteed (if you would like a list of my failed ideas, email me. Make sure you have room for big attachments in your inbox.). Firms, if left alone, could engage in too little R&D for two reasons. If intellectual property rights are not perfectly enforced, firms do not get the full returns on their R&D investment as other firms “rip off” the invention. Second, even if property rights are enforced, there could be learning that spills over to other firms, which is socially beneficial. In order to ensure the optimal amount of R&D, the public sector should hence step in and subsidize such efforts or engage in public R&D.

Reason 2 is if there are externalities. We have written extensively about the case of negative externalities and how one corrects these (e.g. via a tax or cap and trade). Subsidies play an important role here too. Often, instead of properly taxing the source of the negative externality (e.g. coal), we subsidize substitute cleaner technologies. It’s easier to hand out puppies than to tame a wolf. This is imperfect. It’s sort of like instead of yelling at the kid that drew on your living room wall with markers (who in response would change his/her behavior to the better – in theory), commending the other kid that did nothing for his/her good behavior. There are reasons for doing both! Then there is the case of positive externalities. In the textbook, if a firm’s production has positive spillover effects, which that firm is not getting any profit from, the firm chooses to produce too little relative to what is socially optimal. For example, carbon free power generation in jurisdictions where carbon is not priced, provides a benefit to society by reducing damages from climate change and local pollution that the owner of the plant does not receive. They should get a free puppy! I mean subsidy.

Reason 3 for a subsidy is when we try and push a new technology, which we think has significant social benefits, into the market. This is especially true if such a technology requires a platform – such as EV chargers. In order for this technology to catch on, we need enough EVs around so that making charger ubiquitous makes sense. Having chargers everywhere, makes it more likely that folks will buy into the new technology. Subsidies hence can help “push” technologies. So overall, you should subsidize goods and tax bads.

But in reality, there are many settings where we, via subsidies or inefficiently low taxation, encourage bad behavior. In the US, we massively subsidize the production of corn, which (in its sugary form) has turned us into probably the fattest nation on earth. Globally, the combustion of fossil fuels receives implicit and explicit subsidies every year. How much do you ask? A team of IMF economists (including one of my grad school heroes, Ian Parry) estimates that the implicit and explicit subsidies to fossil fuels amount to 5.3 trillion dollars per year! That is 6.5% of global GDP!

But, Max, you say, you are being hysterical. No, I am not. You may argue that we should only count direct monetary payments from the government to the producers of fossil fuels as subsidies. Nope. Failing to charge a firm for the full cost of its activities, such as climate damages and local pollution externalities is an implicit subsidy. If you dump your trash in the public park, a cost is imposed on everyone. You should have to pay for it. Replace trash with CO2 and park with atmosphere in the previous sentence and you get my drift.

So, if I wrote an energy campaign platform, it would be centered around subsidies and leveling the playing field. (It still may never get my candidate elected, but bear with me.)

  • I would phase out explicit subsidies that encourage the production of fossil fuels. Let these fuels compete on a “level-ish” playing field. Coal, which is subsidized, is losing this battle even now. Without subsidies, this would look even more bleak.
  • Remove the implicit subsidy on fossil fuels by properly pricing carbon. I would shoot for a tax that starts where permits are trading now in places with a cap (e.g. California!) and ramp up the price at announced steps. You would still be able to drive your car, but you and manufacturers would be encouraged towards a mix of more efficient vehicles.
  • I would use tax revenue to subsidize low probability, high return research and development for carbon mitigation technologies by private and public research institutions.
  • I would attempt to address as best we can any attributable environmental justice consequences of market-based environmental policies (which we do not understand very well so far, so grad students, get to work).

(Image Credit: Elektrek)

But, after that it gets hard. There are lots of subsidies out there that sound good on the surface but may not be as effective as you’d think. I did enjoy the $5,000 rebate for my (I wish it were a Tesla) PHEV ski mobile, which I am going to take up to Tahoe to talk to some snow soon. So did my friends driving the $90,000 Teslas. Why am I struggling here? Last week, my ninja smart colleague Jim Sallee, whom we incentivized away from the University of Chicago, gave a talk about how hard it is to correctly redistribute tax revenue from a gas tax. This made me think about how difficult it is to target subsidies. A blanket $5,000 subsidy, even with a per manufacturer limit, has led to a significant increase in the purchase of high end electric vehicles by people who would have bought them anyway. We have the same story, well documented by Lucas Davis and Judd Boomhower in Mexico for refrigerators – the number of free riders in appliance rebates is significant. I think it’s time to have a frank debate about our current use of these rebates and subsidies, and whether they have a measurable effect on the adoption of new technologies and the ultimate use of the new technologies. Getting at free riding empirically is hard. But all the causal evidence I have seen points to massive free riding of “anyway adopters.”

I think as a global society, while this Oprah style policy makes us feel good, it’s time to ask the harder questions about the real implicit subsidies and seriously leveling the playing field for fuels. Before long, that would turn fossil fuels into what they really are – fossils.

 

 

 

 

 

Maximilian Auffhammer View All

Maximilian Auffhammer is the George Pardee Professor of International Sustainable Development at the University of California Berkeley. His fields of expertise are environmental and energy economics, with a specific focus on the impacts and regulation of climate change and air pollution.

5 thoughts on “Subsidies and Puppies. Leave a comment

  1. I agree with Bruce above. Avoiding free riders zealously does result in hopelessly complicated and expensive programs that no person (or business) wants to participate in. I’ve seen it reduce involvement in programs. Customers decide not to do an upgrade on a building, because the paperwork and EM&V is so daunting that it overwhelms the original interest in participation.

  2. Ian Parry is a hero of mine, too. I was inspired the powerful review of global energy subsidies by his group at the IMF. As an “bottom-up” energy efficiency analyst, I became interested in starting to think about energy subsidies received for specific energy services. The area I initially focused on was off-grid lighting with kerosene for 1+ billion people in the developing world. I broadened this out to other uses of kerosene and found that the cooking end use receives $2.0B/y in direct kerosene subsidies, lighting $7.1B/y, and heating and other residual uses $9.3B/y. These values roughly double when adding externalities (as defined by Parry’s group at the IMF).

    More info in the journal article.
    https://drive.google.com/file/d/0B1s8219SGDIjeVAwcUU2STRoSUk/view

  3. We love our 2 kittens! They are a lot of fun as they wrestle then groom each 0ther.
    Why do subsidies make renewable energy so expensive?! In total dollars wind and solar together have received more than all other energy sources combined. And in terms of subsidies per kWh solar energy has received about ten times the subsidies of all other forms of energy combined!
    As I have complained before, as a PGE customer I am paying twice the rate [~24 cents] per kWh that my brother-law pays in the Chicago area, and twice the average the rest of the nation pays ! A guy in WA bragged that he gets paid 7 cents per kWh for using his solar array!
    Despite “cap”, etc., taxes and energy mandates, CA CO2 emission-reductions have been smaller that the national average! This piece proposes all sorts of additional economic penalties! I understand the need for R&D funding. But shouldn’t economics, buttressed by real-world measurements, play an important role in the timing and degree of these burdens!

    The positives of warming and increased CO2, as well as negatives, need to be recognized. Crop yields have increased 4-fold since 1961, and warming and CO2 have played an important role in this annual Trillion dollar bonanza! Similar amounts for heating and cold-weather deaths have been saved in the cold dry north of the continents! No balance in positives and negatives is given, and in whether or when additional burdens should be imposed.

    Most agree that global warming is no hoax; but neither does it portend a climate crisis! Current scientific consensus based on climate-model predictions is that at the rate we are going, the average global temperature will increase at least another 2.0 deg. Celsius] this century. The median [climate-model] forecast is a rise of 3.2 C.

    However, real-world measurements show that global surface temperatures have increased on-average about 0.12 C per decade, and continuing will increase only 1.0 C [1.8 F] this century, far less than the 2.0 or 3.2 C.

    IPCC’s on-line “Climate Change 2014 Report”, page 3, Figure SPM 1, top panel (a) shows the 0.12 deg. C per decade rise since 1950 when CO2 emissions began rising rapidly [Panel (d)]. Panel(b) projects a further 10-inch sea-level rise this century, and (c) shows that nearly 60% of CO2 emissions go, not into the atmosphere, but into our greening Earth and the oceans.

    Satellite data also show similar moderate warming rates. Professor John Christy summarized these in Congressional Testimonials, and compared them to climate-model predictions, showing the large over-warming rate that models predict! See on-line reports: J Christy, Climate, House-testimonies, 2016 and 2017.

    Fossil-fuel use is unlikely to grow at present rates for many more decades, and will eventually be economical only in limited uses. Subsidy-free renewables will become economical. CO2 emissions are now peaking in China where huge solar arrays, nuclear plants, natural-gas pipelines to Russia and LNG terminals are allowing the present and future replacement of coal. India is following China! The US and EU have reduced emissions almost 10% in the last decade. It seems very likely that global cooling will begin well before the end of this century!

    Nevertheless, some scientists and the media continue to use alarmist [and wrong] climate-model predictions to beget more funding and more attention! Politicians use these phony, alarmist, predictions to justify unproductive energy taxes and mandates that burden citizens with high costs!
    Paul Brady
    Davis

  4. I think we need to rethink our aversion to free riders. What gets lost in the conversation is the need to leverage private capital investments. There’s no way on earth we can make all the investments required to reduce and reverse climate change relying only on public resources. We need to leverage private capital, probably at a ratio of 10:1 or higher. So when we think about free ridership, we should also think about leverage. If a 10% subsidy produces 50% free ridership, then we’re still getting a 5:1 leverage on our public investment. Maybe we can do better but at least we have a framework for thinking about the optimum level of free ridership. On a related note, we should also consider the marginal costs of squeezing out the next increment of free ridership versus the marginal savings. I’ve seen it over and over in the energy efficiency arena where our zeal to avoid free riders results in hopelessly complicated and expensive programs that no ordinary human wants to participate in.

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