Carbon Confusion

Lately I’ve noticed a lot of misconceptions about how various policy instruments for GHG control actually work. Take this one, from Richard Rood in the AMS climate policy blog:

The success of a market relies on liquidity of transactions, which requires availability of choices of emission controls and abatements. The control of the amount of pollution requires that the emission controls and abatement choices represent, quantifiably and verifiably, mass of pollutant. In the sulfur market, there are technology-based choices for abatement and a number of choices of fuel that have higher and lower sulfur content. Similar choices do not exist for carbon dioxide; therefore, the fundamental elements of the carbon dioxide market do not exist.

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On the emission side, the cost of alternative sources of energy is high relative to the cost of energy provided by fossil fuels. Also sources of low-carbon dioxide energy are not adequate to replace the energy from fossil fuel combustion.

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The development of technology requires directed, sustained government investment. This is best achieved by a tax (or fee) system that generates the needed flow of money. At the same time the tax should assign valuation to carbon dioxide emissions and encourage efficiency. Increased efficiency is the best near-term strategy to reduce carbon dioxide emissions.

I think this would make an economist cringe. Liquidity has to do with the ease of finding counterparties to transactions, not the existence of an elastic aggregate supply of abatement. What’s really bizarre, though, is to argue that somehow “technology-based choices for abatement and a number of choices of fuel that have higher and lower [GHG] content” don’t exist. Ever heard of gas and coal, Prius and Hummer, CFL and incandescent, biking and driving, … ? Your cup has to be really half empty to think that the price elasticity of GHGs is zero, absent government investment in technology, or you have to be tilting at a strawman (reducing carbon allowances in the market to some infeasible level, overnight). The fact that any one alternative (say, wind power) can’t do the job is not an argument against a market; in fact it’s a good argument for a market – to let a pervasive price signal find mitigation options throughout the economy.

There is an underlying risk with carbon trading, that setting the cap too tight will lead to short-term price volatility. Given proposals so far, there’s not much risk of that happening. If there were, there’s a simple solution, that has nothing to do with technology: switch to a carbon tax, or give the market a safety valve so that it behaves like one.

To his credit, Rood does acknowledge the dual role of price and technology policy instruments:

Rather than taxes and technology being posed as choices in competition with a carbon dioxide market, they are part of an interrelated group that leads to a market. When considered together they provide a set of tools to address both near-term and long-term climate policy needs.

Here’s another bit of widespread nonsense that’s been bugging me:

If (a) you raise the costs to utilities of providing energy, and (b) the utilities then pass those costs onto consumers, and (c) then the government gives people money to then help pay those increased costs, guess what is going to happen to consumer behavior? Just about nothing. Some might argue that consumers could become more efficient and save some money, and this is true, but consumers already could become more efficient today with the exact same incentive. Balancing cost increases with direct payments does nothing to alter this incentive.

This is faulty economic reasoning for all proposed cap and trade variants I’m aware of. It is only true if rebates (’direct payments’) are directly proportional to individuals’ expenditures on carbon. Under any other allocation scheme (e.g., flat rebates to all citizens, benchmarked permit distributions, allocations based on grandfathered historic emissions, etc.), there is an incentive to change behavior.

Economists jumped on Obama when he said nearly the same thing:

So long as the government caps emissions, companies will see a price signal and be forced to act, Harvard University’s Robert Stavins said.

“If you give permits away for free or sell them, either way, allowances will be priced and the system will work,” Stavins said in an interview. “There may be sound arguments that the administration wishes to make for auctioning allowances, but the functioning of the price mechanism and the environmental performance of the system is not one of them.”

Dallas Burtraw, a senior fellow at the nonpartisan Resources for the Future think tank, agreed with Stavins’ assessment.

“The way that the allowances are distributed matters hugely for the success of the program,” Burtraw said. “But for the most part, it does not matter directly for the kinds of emission reductions you’re going to see. The primary influence is the existence of an emissions cap.”

Apparently bathtub dynamics is not the only widely-misunderstood aspect of climate science and policy. There’s a lot of room for simple tools to help clarify these points.

Update: I just found this cool piece on advanced market mechanisms for solving King Solomon’s Dilemma. In a similar vein, I think two-sided demand revealing auctions would be a cool mechanism for creating a GHG emissions market, simultaneously setting the cap somewhat democratically and creating price elasticity on the supply side (which would stabilize prices). But if people don’t understand current simple policy instruments, there’s no hope for such an approach. That makes things tough on the modeler as well as the decision maker:

Of course, this assumes that the people playing this game are “rational” in the sense that they understand the rules of the game and in the sense that they can anticipate how others are likely to play it. One of the great strengths of assuming rationality in this form is that the assumption can be applied as a general condition that prevails in any resource allocation problem. Its weakness is that people may not always possess this assumed degree of rationality.

But the alternative–the “behavioral approach”–suffers from an even greater problem. In particular, the policymaker must be aware of precisely how people are irrational in each and every given circumstance (a great loss in generality). There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of “behavioral rules” that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner. But if the theorist can identify this systematic pattern of irrationality, it seems hard to know why people cannot discover it for themselves too. But then, it seems clearly in the interest of aspiring philosopher kings prefer to think of themselves as being systematically more rational than the subjects they study.