A GHG tax alone doesn’t solve the global need for low-cost alternative technologies
Economists seldom discuss climate change without someone opining that it is simply an externality that can be solved by putting a price on GHG emissions. In fact, a couple months ago a bi-partisan group of nearly 50 superstar economists released a statement in support of a U.S. carbon tax that would rise each year “until emissions reductions goals are met.” The statement says that this price on carbon will harness “the invisible hand of the marketplace to steer economic actors towards a low-carbon future.”
I’m as big an advocate of pricing GHGs as other economists working on climate change. Adding the cost of negative externalities to the price users pay is a very powerful way to bend consumption in a more responsible direction. That goes for GHGs as much as for traffic congestion, fine particle emissions, or plastic disposal. But when it comes to global climate change, pricing carbon isn’t a complete answer.The idea that we can ratchet up the tax until we hit the desired emissions doesn’t recognize that most of the global emissions are now coming from relatively poor countries. Politically, they are even less likely than the developed world to accept a large carbon tax. And economically, a big tax, given current technologies, would significantly slow their climb out of poverty.
Economists on the “just price carbon” train argue that the tax will encourage technological innovation that helps displace fossil fuels. That’s just straightforward economics. But straightforward economics also tells us that even if emissions are priced, there is a second market failure that the price won’t address: inefficient markets for innovation. Successful innovators typically can only capture a small share of the value they create for society. Most of the value of innovation is enjoyed by others in society. That is great for the many who get the benefits — and it generally increases the total benefits derived from a new idea — but it still reduces the incentive to create new ideas.
Most developed countries try to address this market failure with intellectual property (IP) laws that reward inventors by giving them a monopoly over the product for years or decades. The inventor can then profit by charging high prices and restricting sales of their product. That might be the best option for the latest mobile electronics, but it’s not a good approach when we need rapid diffusion of GHG-reducing technologies in poor countries. Furthermore, IP protection is complex and costly to use, and IP laws are weakly enforced or non-existent in most of the developing world.
All of which is why the U.S. and most other advanced economies explicitly subsidize knowledge creation – for instance, through grants to researchers and innovative entrepreneurs, creation of freely accessible data and libraries, and tax breaks for research and development expenditures by companies. Knowledge creation generates huge positive externalities that are not reflected when we simply “get the prices right” for goods and services in the economy.
Economists widely agree that this imperfection in the knowledge market leads to sub-optimal levels of innovation, but at this point in a climate change conversation, someone will ask whether this problem is any bigger in technologies to reduce GHGs than in any other market. If we got the prices right, wouldn’t markets at least have as much incentive to solve climate change as other challenges, such as curing diseases or creating more realistic video games?
Unfortunately, no. At least, not if other nations — particularly the low-income, developing countries where GHG emissions are growing fastest — don’t also get the prices right. The whole planet benefits when developing economies follow a low-carbon path, but most of those benefits do not go to a country that chooses that path. So, the most viable path to decarbonizing the developing world must include pushing the cost of reducing GHGs ever lower. Pricing up carbon (and other greenhouse gases) in wealthier countries helps, but if much of the world is unlikely to take that road, then we also need to be focused on innovating down the cost of alternatives.
Subsidizing innovation effectively is not easy. It means some degree of administratively picking winners among the many creative, or just crazy, ideas that are out there for eliminating GHG emissions. The process will be imperfect, mistakes will be made, and corruption can easily work its way in. Those are good reasons to do it carefully and monitor the programs closely. But they’re not good reasons to conclude that pricing emissions alone has the Good Economics Seal of Approval. The world we live in is nothing like the setting in which that would be true.
There is a lot of cheap fossil fuel left on the planet – and likely to get cheaper as some economies move to alternatives and reduce their demand. We need not just the wealthy developed countries to stop using it, but also the poor less-developed countries to grow out of poverty without it. Maybe those countries will voluntarily forgo the cheapest energy sources, but there isn’t much indication of that. Maybe wealthy countries will pay poor ones to get off the carbon path, but that also seems unlikely. So, policies that support innovation to lower the cost of carbon-free energy should be an explicit part of fighting climate change. Working in tandem with a robust carbon tax wherever it is politically possible.
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Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business and Faculty Director of the Energy Institute at Haas. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. He chaired the California Energy Commission's Petroleum Market Advisory Committee from 2015 until its completion in 2017. Currently, he is a member of the Bay Area Air Quality Management District's Advisory Council and a member of the Board of Governors of the California Independent System Operator.