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Pricing Carbon Isn’t Enough

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.CarbonPriceIsntEnoughFig4The 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.CarbonPriceIsntEnoughFig1

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.CarbonPriceIsntEnoughFig2

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?CarbonPriceIsntEnoughFig3

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.

I’m still tweeting energy news stories/research/blogs most days @BorensteinS

Keep up with Energy Institute blogs, research, and events on Twitter @energyathaas

Suggested citation: Borenstein, Severin. “Pricing Carbon Isn’t Enough.” Energy Institute Blog, UC Berkeley, April 15, 2019, https://energyathaas.wordpress.com/2019/04/15/pricing-carbon-isnt-enough/

Severin Borenstein View All

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.

42 thoughts on “Pricing Carbon Isn’t Enough Leave a comment

  1. So tell me again – based on the extended comments by Jim Lazar and Carl Wurtz (below) – why we are wasting time, effort and political capital on a carbon tax as a cornerstone for energy policy? To paraphrase Elizabeth Warren – the game is rigged. Lazar’s comment would suggest that the energy markets largely don’t even meet the requirements for when a tax/pricing policy is even plausible. My only addendum to his list is that all of this is being done under the duress of trying to catch up to (which may not be possible) or at least trying not to fall further behind the climate change effects of GHGs. I don’t think any of us should be sanguine about the outcome. I’m beginning to side with those who think our only way out of this is a Manhattan-project-style energy effort (on both the demand and supply side). The outcome is clearly too important to be left to economists alone…

  2. surprised there is not more discussion of Gen.IV nuclear, my understanding no risk of melt down and able to use nuclear waste for fuel

  3. Thanks, your post opened new paths! Still if part of the solution is to further make alternatives cheaper, my question is how much cheaper. If we look at fex pv:s their price/watt has come down in ten years from c 3 $ to under 1$. And to make the point clear, the pv module price was 20 years ago under 5$. How much lower we need to go to make alternatives more valuable for investors? Where comes the push?

  4. Severin, even if a carbon tax is passed in the U.S., it will change nothing if recent deregulatory changes aren’t addressed first. Since 2005, they’ve provided a multi-$billion incentive for energy holding companies to generate electricity by burning gas – one so lucrative, a tax couldn’t be steep enough.

    The incentive relied upon what were once known as affiliate transactions, or (in 21st–century parlance) vertical monopoly self-dealing. Proscribed under the Public Utilities Holding Company Act of 1935 (PUHCA), the practice again became legal when PUHCA was repealed in 2005. The basic premise is simple: when both electricity and gas subsidiaries exist under the same holding company, the electricity subsidiary purchases fuel from the gas subsidiary to generate electricity. The electricity utility, authorized by its public utility commission, then passes its expense along to ratepayers as a legitimate cost of doing business.

    In a competitive environment such a relationship is both proper, and prudent. Competition keeps a lid on the price of electricity – if it exceeds market value, customers simply switch to another provider. But when the electricity provider is a monopoly, the result is toxic for both ratepayers and the environment. Incentives for keeping the price of gas low are non-existent; any incentive for the electricity subsiiary to conserve fuel is replaced by one to consume as much as possible. All profits flow through to the parent holding company, and end users – electricity ratepayers – have little recourse other than to go without electricity.

    What’s the potential for energy holding companies? In a 2017 filing, California energy conglomerate Sempra Corporation revealed electricity subsidiary San Diego Gas & Electric (SDG&E) had spent $95 million for natural gas to generate electricity that year. Gas was purchased from Sempra subsidiary Southern California Gas Company in Texas, and transmitted via the El Paso Pipeline to its customers in California. Whether the price SDG&E paid for gas was reasonable is unknown; that it wasn’t competitive is known for certain. There was no competition.

    In 1935 New Deal Democrats enacted PUHCA specifically to address the same conflicts of interest confounding energy regulators today – yet its recent repeal was justified by claims the Act had outlived its original purpose. Others weren’t so sure. In 2004 prepared testimony, Federal Energy Regulatory Commission (FERC) attorney Lynn Hargis wrote:

    “In my thirty-odd years of electric utility regulatory practice, I have come to believe that PUHCA is the most important piece of federal legislation relating to electric and natural gas utilities…if PUHCA is repealed the consequences to electric and natural gas utility consumers and to our national economy may be catastrophic.”

    Soon after PUHCA was repealed the following year, FERC recommended Congress amend its replacement, The Energy Act of 2005, to give the commission greater enforcement authority over gas subsidiaries. Congress has yet to act on FERC’s request.

    David Littell, of the non-profit Regulatory Assistance Project:

    “In the United States, we see utility holding companies owning up to eight regulated energy businesses in different affiliated corporations. Opportunities for self-dealing abound…utilities by their very nature have “captive customers” who can be forced to pay for a service procured from an affiliate, regardless of whether that service is provided at an economical cost.”

    With the prevailing anti-regulatory mood in the White House, most analysts believe the sun has set for re-instating PUHCA. Though nuclear has been excluded from state subsidies offered to wind and solar developers, several states now offer a “zero emission credit” to utilities in acknowledgement of nuclear’s role as clean baseload generation. Whether the credits will allow either nuclear or renewables to compete with the obscene profits available from gas self-dealing is an open question.

  5. Indeed, many of us in the economics profession have recognized the three-legged stool of Policies, Pricing, and Programs.

    Forget China and India for a moment. Even in the USA, pricing carbon is not enough.

    Efficiency under competition requires meeting some important prerequisites that are not found in the energy sector:

    a) Goods must be perfect substitutes; efficiency and electricity are not perfect substitutes;
    b) All buyers and sellers must have perfect information about the market; far from true in energy efficiency;
    c) No buyer or seller can be big enough to move the market; there are some very larger players in the electricity market;
    d) Capital must be fungible, able to be redeployed without friction; it’s hard to transform a coal-fired power plant into efficient windows;
    e) There must be free entry and exit from the market; state-protected monopolies prevent some competition (for a reason).
    f) All goods are priced at their relevant marginal costs;

    Renters have short time horizons, and will not make efficiency investments. Low-income folks do not have access to capital on reasonable terms. Most small businesses are tenants, and will not make efficiency investments that may take a decade or longer to produce a meaningful return.

    We have learned that consumers have implied discount rates over 20%, in a market where borrowing costs are 5% – 10%. Just yesterday, I was in a commercial building with a mix of incandescent and magnetic ballast lighting; two and three technologies ago, compared with modern LED lighting. The average standard of efficiency is much higher in China — if only because so much of the building and vehicle stock is much newer than in the US.

    So, yes, we need policies and programs, in addition to needing prices. This is why under AB32 the lion’s share of carbon reductions are anticipated from “complementary policies” like efficiency mandates and required investments in renewable energy. Only a small portion is left to the uncertainties of the market.

  6. According to Aghion’s estimates, carbon taxes do induce significant innovation. Nonetheless, “optimal policy makes heavy use of research subsidies as well as carbon taxes” (Acemoglu et al., “Transition to Clean Technology”). But since emission abatement is a global public good, its proper locus is the world, or at least a sizable Nordhaus club of countries. This leaves a controversy concerning the correct domestic SCC and innovation subsidy for a smaller jurisdiction (see e.g. Fowlie’s Nov 2017 blog and related comments). Another promising research area regards the optimal design of research subsidies.

  7. For a future article: if the price of electricity from the grid in N. California goes up 50% next year, and stays there, to pay for wildfire damages, how will that affect demand for natural gas and residential solar+storage (as substitute sources of energy and/or electricity).

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