Why a carbon tax is the best solution for climate change.
In his Nobel Prize acceptance speech, William Nordhaus stressed that, “Global warming is the most significant of all environmental externalities. It menaces our planet and looms over our future like a Colossus. It is particularly pernicious because it involves so many activities of daily life, affects the entire planet, does so for decades and even centuries, and, most of all, because none of us acting individually can do anything to slow the changes.” He concludes that abatement, the substitution of renewable for fossil fuels as a source of energy, is the only feasible and responsible solution. But that solution will be costly.
As one example, Morgan Stanley estimates that the global bill for decarbonization will be on the order of $50 trillion. Due to its scope and nature, the transition to an economy more reliant on renewable energy will involve a complicated compromise between continuing to use fossil fuels in activities where they remain necessary, such as air travel, while replacing them in activities where the external costs exceed the benefits, such as the generation of electricity. The question is how to balance the costs and benefits across the myriad of activities that require energy. In that regard, to quote Nordhaus one more time, “Economics points to one inconvenient truth about climate-change policy: for any policy to be effective it must raise the market price of CO2 and other GHG emissions.”
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The problem with climate change financing
But the one inconvenient truth of the economics of climate change involves a political catch-22. To draw an analogy, the basic science of weight loss is simple. Burn more calories than you digest, and you will lose weight. The problem is that many people are not fond of habitual exercise and are not willing to forego their favorite foods. The result is the proliferation of exotic diet programs and bizarre exercise machines that attempt, unsuccessfully, to circumvent the laws of physics.
he same is true of the transition to renewable energy. Following Nordhaus, the pathway for the transition was laid out in a statement signed by a great majority of the world’s economists (including the current author) and published in the Wall Street Journal on
January 16, 2019. The statement held that, “A carbon tax offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary. By correcting a well-known market failure, a carbon tax will send a powerful price signal that harnesses the invisible hand of the marketplace to steer economic actors towards a low-carbon future.” It is worth pausing for a minute to appreciate how rare such unanimity is among economists. This is a profession about which there are jokes such as “if all the world’s economists were placed end to end, they still would not reach a conclusion.”
My forty-five-year experience as a professional financial economist suggests there is much truth to such jokes, but climate change policy is an exception. The economist statement was signed by all living economics Nobel Laureates, all past Federal Reserve chairmen, and all the past heads of the Council of Economic Advisers. Given this unanimity, why was the statement largely ignored?
The fact that price is the powerful signal is not only the solution, it is also the problem. That is the catch-22. A significant increase in the price of carbon-based fuels would put pressure on people to do things like, drive smaller cars, fly less, live closer to work, eat more vegetarian meals and on and on.
A carbon tax and beyond
That is the way the market works – by sending price signals that lead people to alter their behavior in ways they otherwise would not. Unfortunately, it is natural to react to such pressure by asking isn’t there a less painful way to transition to a renewable world, like losing weight without exercising? That thought opens the door to a proliferation of politicians who offer plans, akin to exotic diets, that involve complex rules, subsidies, new government entities and so on as a means to a transition to a green economy without the accompanying personal and financial pain. The trouble with these plans, again like exotic diets, is that they are inefficient ways to attack the problem, often have a host of unintended consequences, and typically fail to work.
Nonetheless, the effort to find ways to move to a green world without countenancing the cost remains widespread. In this regard, it is no surprise that the delegates from almost 200 nations left Madrid after more than two weeks of discussion, agreeing only on the “urgent need” for countries to make deeper cuts to greenhouse gases. They shelved work on adding market mechanisms as a tool for countries to meet their goals and couldn’t agree about finance needed to fix the problem.
A carbon tax and risk models
What makes grappling with the costs of transition so difficult, in addition to their daunting size, is determining what the true costs of climate change are and deciding who should bear those costs. For instance, what costs should be borne now, and what costs should be paid by future generations? The ability to kick the can down the road adds to the catch-22 and makes it even more difficult to impose a meaningful, global carbon tax.
Further compounding the problem is the fact that developed nations exploited fossil fuels for more than a century to build their economies without paying the tax, so developing nations can rightly ask why they should pay such a tax today. We economists think we have the best solution for dealing with the externality of climate change in the form of a carbon tax. We have even developed so called DICE models (dynamic integrated climate-economic models) to estimate the size of the optimal tax. (The name has not been helpful in selling the models.) But we have been remarkably unsuccessful in getting the public to accept our such suggestions and governments to adopt them. That is the catch.