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Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy

For many years, there has been a great deal of discussion about carbon-pricing – whether carbon taxes or cap-and-trade – as an essential part of a meaningful national climate policy. It has long been recognized that although carbon-pricing will be necessary, it will not be sufficient. Economists and other policy analysts have noted that policies intended to foster climate-friendly technology research and development (R&D) will also be necessary, but likewise will not be sufficient on their own.

Some recent studies and press accounts, which I reference below, have identified these two approaches to addressing CO₂ emissions as substitutes, rather than complements. That is fundamentally inconsistent with decades of research, and so my purpose in this essay is to set the record straight.

Carbon Pricing: Necessary But Not Sufficient

First of all, why is there so much talk among policy analysts and policy makers – not simply among academics – about carbon‑pricing as the core of a meaningful strategy to reduce CO₂ emissions? Why, in fact, is this approach so overwhelmingly favored by the analytical community? The answer is simple and surprisingly pragmatic.

First, there is no other feasible approach that can provide meaningful emissions reductions, such as the 80 percent reduction in national CO₂ emissions by 2050 that was part of the legislation passed by the U.S. House of Representatives and proposed in the Senate and part of the Obama administration’s conditional pledge under the Copenhagen Accord. Because of the ubiquity and diversity of energy use in a modern economy, conventional regulatory approaches –standards of various kinds – simply cannot do the job. Only carbon pricing – either in the form of carbon taxes or cap-and-trade – can significantly tilt in a climate-friendly direction the millions of decentralized decisions that are made in our economy every day.

Second, carbon-pricing is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources. Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost.

Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time.

For these reasons, carbon-pricing is a necessary component of a truly meaningful national climate policy. [I’ve written about this in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”] However, although it is a necessary policy component, carbon-pricing is not sufficient on its own. This is because there are other market failures that dilute the impacts of price signals on decision makers.

Technology R&D Policies: Also Necessary, Also Not Sufficient

The most important of these “other market failures” is the public good nature of information. Companies carrying out research and development (R&D) incur the full costs of their efforts, but they do not capture the full benefits. This is because even with a perfectly-enforced system of intellectual property rights (such as patents), there are tremendous spillover benefits to other firms. Decades of economic research – much of it by my former colleague and co-author, Professor Adam Jaffe, now Dean of Arts and Sciences at Brandeis University – has analyzed with empirical (econometric) analysis the remarkable degree to which inventions and innovations by one firm provide valuable information that leads to new inventions and innovations by other firms.

So, firms pay the costs of their R&D, but do not reap all the benefits. The existence of this positive externality of firms’ R&D – or put differently, the public-good nature of the information generated by R&D – means that the private sector will carry out less than the “efficient” amount of R&D of new climate-friendly technologies in response to given carbon prices. Hence, other public policies are needed to address this “R&D market failure.”

New path-breaking technologies will be needed to address climate change, and public support for private-sector or public-sector R&D will be crucial to meet this need. But, at the same time, to address the climate-change market failure itself (that is, the externality associated with greenhouse gas emissions), carbon pricing will be necessary, for all of the reasons I gave above. This is an application of an important and fundamental principle in economics: two market failures require the use of two policy instruments.

Empirical analyses have repeatedly verified this crucial point – that combining carbon-pricing with R&D support is more cost-effective than adopting either approach alone. Included in this set of studies are the following: Carolyn Fischer (Resources for the Future) and Richard Newell (U.S. Energy Information Administration, on leave from Duke University), “Environmental and Technology Policies for Climate Mitigation”; Stephen Schneider (late of Stanford University) and Lawrence Goulder (Stanford University), “Achieving Low-Cost Emissions Targets”; and Daren Acemoglu (MIT), Philippe Aghion, Leonardo Bursztyn, and David Hemous (Harvard University), “The Environment and Directed Technical Change.”

Complements, Not Substitutes

An interesting, recent column, “Next Step on Policy for Climate,” by David Leonhardt in the New York Times (October 13, 2010, p. B1) might give some people the mistaken impression that technology policies are an adequate, even sensible substitute for carbon-pricing. That was not the intended message of the column. In fact, Leonhardt – perhaps the leading economic journalist writing today in the United States – indicates clearly in his column that he is skeptical of the notion of thinking of technology subsidies as an adequate substitute for carbon-pricing (in particular, cap-and-trade). And in a follow-up post at the New York Times’ Economix, he makes clear that “these two policies are not mutually exclusive.”

Nevertheless, Leonhardt’s original column (which included a very nice profile of my colleague, Professor Michael Greenstone of MIT) focused attention on a recent report – a report that could give the false impression that technology policies would be a sensible substitute for serious carbon-pricing. The report in question – “Post-Partisan Power” – received significant coverage, primarily because of its sponsorship: a combination of a prominent Republican-oriented Washington think tank, the American Enterprise Institute (AEI), and an equally prominent Democratic-oriented Washington think tank, the Brooking Institution (and a third partner, the Breakthrough Institute, a California-based environmental think tank).

The report may well garner some bi-partisan political support, because it promises a free lunch of painless, win-win solutions, a promise that will resonate with many elected officials. Indeed, the report’s sub-title is “how a limited and direct approach to energy innovation can deliver clean, cheap energy, economic productivity, and national prosperity.” What’s not to like? And the authors are presumably smart and politically shrewd. I know that’s the case with the AEI author, Steven Hayward, who I debated last year in the pages of the Wall Street Journal.

To its credit, the report lays out a menu of policies intended to stimulate carbon-friendly technological change, ranging from $500 million of Federal government funding of K-12 curriculum development and teacher training to $25 billion annually of direct Federal funding of energy innovation.

For the reasons I explained above (the “R&D market failure” and the “carbon emissions externality”), both direct technology R&D policies and serious carbon-pricing are necessary, but neither is sufficient on its own. Unfortunately, this new report – and some of the press coverage surrounding it – makes the claim that such direct government funding of technology innovation is a sufficient and sensible substitute for meaningful carbon-pricing. That claim is both unfortunate and wrong, as it is supported neither by sound reasoning nor empirical research, as I have described above.

Again, many of the individual technology policy recommendations offered by the AEI-Brookings-BI report are worthy of serious consideration (as a complement, not a substitute for an economy-wide carbon-pricing policy). But the specifics – indeed, much of the meat – are missing. “Reform the nation’s morass of energy subsidies” – yes, but exactly which subsidies (all of which have important political constituencies behind them) will be eliminated? “Recognize the potential for nuclear power” – yes, and both the House and Senate carbon-pricing schemes would have provided tremendous incentives for nuclear power investment.

Overall, there should be concern about how all of this will be funded. Where will the $25 billion per year come from? The report appropriately states that this should not come from general revenues, and thus add to the Federal debt. “Phasing out current subsidies for wind, solar, ethanol, and fossil fuels” could be meritorious on its own, but how much does this generate, and does it even pass a political laugh-test? Interestingly, beyond this, despite considerable rhetoric about moving beyond debates about carbon-pricing, the report recommends that in order to avoid adding to the Federal debt, it would be necessary to impose new taxes, including increased royalties for oil and gas extraction, a tax on imported oil, a tax on electricity sales, and a “very small carbon price” (presumably from a modest carbon tax or unambitious cap-and-trade system).

The actual numbers would be helpful, and the political feasibility remains a serious question. The political challenges that emerged in the effort to pass cap-and-trade climate legislation will not magically disappear if there’s an attempt to induce Congress to approve $25 billion in funding. As Tom Friedman noted on October 12^th in the New York Times, Congress has not come close to fully funding the outstanding requests for about $4 billion for ARPA-E (energy) research.

More broadly, despite the attraction of the AEI-Brookings-BI proposal as a potential complement to carbon-pricing (and I am serious that the proposal is of value in that context), one has to be very careful about comparing proposed new policies in idealized form (for example, precisely the right subsidies eliminated and precisely the right new subsidies introduced) with real policies with all their warts (for example, the cap-and-trade bill that was passed by the House last year). Making such comparisons can lead to flawed analysis and misleading results.

This is not a new issue. Robert Hahn and I wrote about this generic problem nearly 20 years ago in an article (“Economic Incentives for Environmental Protection: Integrating Theory and Practice”) which appeared the American Economic Review Papers and Proceedings (May 1992). At the time, our concern was that this mistake was being made not by the opponents but by the supporters of cap-and-trade and other (then essentially untested) market-based instruments. We worried that “many analysts use highly stylized benchmarks for comparison that ignore likely political realities,” and suggested that an appropriate “comparison would be between actual command-and-control policies and either actual trading [cap-and-trade] programs … or a reasonably constrained theoretical … program.”

Likewise today, when carrying out comparisons of policy alternatives, it is fine to compare two theoretical, idealized alternatives, or to compare two real-world policies, but it is problematic and usually misleading to compare a theoretical, idealized policy of one type with a real-world example of another type of policy.

The Bottom Line

Carbon-pricing – whether carbon taxes or cap-and-trade – will be an essential part of any truly meaningful national climate policy. Likewise, to address the “R&D market failure,” direct technology innovation policies will also be required. Both are necessary. Neither is sufficient. These are complements, not substitutes.

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Postscript: Four years ago, the U.S. Congressional Budget Office (CBO) — widely recognized for its non-partisan, first-rate research — produced a study on the same topic as the AEI-Brookings-BI report, but did so with rigor and without ideology. The CBO report — Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide Emissions (September 2006) — was prepared by Dr. Terry Dinan, a long-time, respected CBO economist, and was peer reviewed by an impressive set of academic and other experts. Sadly, the CBO paper received little press coverage, despite its high quality and its relevance. For anyone interested in the topic of this post, particularly those who disagree with my theme, I hope you will read the CBO report.

Also, a reader of this blog post sent me a paper by David Hart and Kadri Kallas (from MIT’s Energy Innovation working paper series) that examines “Alignment and Misalignment of Technology Push and Regulatory Pull.” It’s worth reading in the context of combining carbon pricing and technology R&D policies.

Can Countries Cut Carbon Emissions Without Hurting Economic Growth?

In the September 21st issue of the Wall Street Journal, the editors pose the following question: can countries cut carbon emissions without hurting economic growth? In his introductory essay, Michael Totty frames the issues as follows:

“There’s little doubt: Cutting greenhouse gases will be costly. But that leads to two big questions. First, how costly? And second, can nations afford it? As policy makers around the world take action to avoid a predicted climate catastrophe, the debate is turning to the costs of reducing carbon-dioxide emissions. Energy-efficiency measures are often pricey, and alternative energy sources are more expensive than the fossil fuels they replace. A steep price on carbon emissions will ripple through the economy. Does that mean a serious effort to tackle global warming is incompatible with economic growth? Or can we make significant cuts in greenhouse-gas emissions without causing serious damage to the economy?

We put the question to a pair of experts. Robert Stavins, a professor of business and government at Harvard University and director of Harvard’s environmental economics program, says the answer to the second question is yes: Making the necessary cuts need cause little more than a blip in world-wide growth if smart policies are used.

Steven Hayward, a fellow at the American Enterprise Institute for Public Policy Research, says no: Energy use — and the carbon dioxide it emits — is so central to the world’s economy that major cuts can’t be made without significant damage.

Of course, the answers can depend in large part on how “significant cuts” and “serious damage” are defined. Many scientists, the European Parliament and the Waxman-Markey climate legislation approved by the U.S. House of Representatives have set a goal of cutting carbon emissions about 80% by 2050, so that was picked as constituting significant cuts.

As the accompanying essays show, such a definition leaves plenty of room for disagreement.”

I encourage you to read the entire Journal Report on Environment in the Wall Street Journal (there’s an excellent Q&A on carbon offsets by Bob Curran) and to check out my affirmative response, “Yes: The Transition Can be Gradual — and Affordable,” as well as Steven Hayward’s well-articulated negative response, “No: Alternatives are Simply Too Expensive.”

Understandably, the editors wanted to highlight differences between us in order to develop a concise and clear debate. I find it interesting, however, that in an audio interview/debate at the Wall Street Journal web site (Podcast: Crafting a Global Policy), which was by nature more free-wheeling and less limited by space constraints, there is a remarkable amount of agreement between Mr. Hayward and me on a number of key issues.

For now, in today’s post — liberated from space constraints — I want to expand a bit on my WSJ essay, in which I responded, yes, the transition can be gradual and affordable.

Can the nations of the world meaningfully address the threat of global climate change without inflicting unjustifiable damage to their economies? The answer that has emerged with increasing clarity is a resounding “yes.”

Although “The Day After Tomorrow,” the 2004 disaster epic about the greenhouse effect’s apocalyptic consequences, had less scientific basis than “The Wizard of Oz,” scientific reality is disturbing enough. Man-made emissions of greenhouse gases — including carbon dioxide (CO₂) from the combustion of fossil fuels — are very likely to change the earth’s climate in ways that most people will regret. World energy trends are unsustainable — environmentally, economically, and socially.

The global recession has slowed emissions growth, but the world is on a path to more than double global atmospheric greenhouse gas (GHG) concentrations to 1,000 parts per million (ppm) in CO₂-equivalent terms by the end of the century, resulting in an average global temperature increase of 6 degrees Centigrade. But increased temperatures — which might well be welcome in some places — are only part of the story.

The most important consequences of climate change will be changes in precipitation (causing, for example, 75 to 250 million people in Africa to be exposed to increased water stress due to climate change by 2020, with rain-fed agriculture yields falling by as much as 50%), disappearance of glaciers throughout the world (and decreased snowpack in areas ranging from the western United States to Asia), droughts in mid to low latitudes (with severe effects in Australia), decreased productivity of cereal crops (at lower latitudes, especially in tropical regions), increased sea level, loss of islands and 30% of global coastal wetlands, increased flooding (in all parts of the world, but greatest in Asia), greater storm frequency and intensity (both typhoons and hurricanes), risk of massive species extinction (20 to 30% of all species, including massive coral mortality), and significant spread of infectious disease. On the other hand, climate change will also bring some health benefits to temperate areas, such as fewer deaths from cold exposure. But such benefits will be greatly outweighed by negative health effects of rising temperatures (cardo-respiratory, diarrhoeal, and infectious diseases, and increased morbidity and mortality from heat waves, floods, and droughts), especially in developing countries.

These impacts will have severe economic, social, and political consequences for countries worldwide, ranging from malnutrition and mass migration (hundreds of millions of people displaced) to national security threats. Bottom-line, comprehensive estimates of economic impacts of unrestrained climate change vary, with most falling in the range of 2 to 5% of world GDP per year by the middle of the century. The best estimates of marginal damages of emissions (again, by mid-century) are in the range of $100 to $175 per ton of CO₂(in today’s dollars).

The world is already experiencing the adverse effects of increasing concentrations of GHGs in the atmosphere, with concentrations already about 60% above pre-industrial levels, greatly exceeding the natural range over the past 600,000 years. Just one example: the Greenland ice sheet has been losing mass at a rate of 179 billion tons per year since 2003.

To have a coin toss’s 50-50 chance of keeping temperature increases below 2 degrees Centigrade — the level at which the worst consequences of climate change can be avoided — it will be necessary to stabilize atmospheric concentrations at 450 ppm. (Even this would result in significant sea-level rise, species loss, and increased frequency of extreme weather, according to the U.N. Intergovernmental Panel on Climate Change.) Consistent with the 450 ppm goal is a long-range target of cutting U.S. emissions 80% below 2005 levels by 2050, which happens to be the target of legislation passed earlier this year by the U.S. House of Representatives, H.R. 2454, the so-called Waxman-Markey bill.

Now, to the heart of the WSJ question: will a serious effort to tackle global warming is incompatible with economic growth? My response was and is that the nations of the world do not have to wreck their economies to avert the crisis. If appropriate and intelligent policies are employed, the job can be done at reasonable and acceptable cost.

Critics argue that the Waxman-Markey legislation — to cut U.S. emissions 80% below 2005 levels by 2050 — will mean big, disruptive changes to our infrastructure and untold economic damage. But they make a couple of basic errors. For one thing, they seem to think we’d have to replace the entire infrastructure quickly, paying trillions of dollars to shift to cleaner power. They also seem to assume that we have to choose between much more expensive energy and no energy at all.

The move to greener power doesn’t have to be completed immediately, and it doesn’t have to be painful. The right transition plan will increase consumers’ bills gradually and modestly, and allow companies to make gradual, well-timed moves.

How would this work? One way is via a combination of national and multinational cap-and-trade systems. Companies around the world would be issued rights by their governments to produce carbon, which they could buy and sell on an open market. If they wanted to produce more carbon, they could buy another company’s rights. If they produced less carbon than they needed, they could sell their extra rights. What’s more, companies could earn more rights by creating appropriate “offsets” that mitigated their carbon use, such as planting forests. Nations could add carbon taxes to the mix.

The effect would be to send price signals through the market — making use of less carbon-intensive fuels more cost-competitive, providing incentives for energy efficiency and stimulating climate-friendly technological change, such as methods of capturing and storing carbon, as well as safe nuclear power.

[NUKES_STAVIN]

Julian Puckett

Robert Stavins

More Efficient

True, in the short term changing the energy mix will come at some cost, but this will hardly stop economic growth. As economies have grown and matured, they have become more adept at squeezing more economic activity out of each unit of energy they generate and consume. Consider this: From 1990 to 2007, while world emissions rose 38%, world economic growth soared 75% — emissions per unit of economic activity fell by more than 20%.

Critics argue we can’t possibly increase efficiency enough to hit the 80% goal. In a very limited sense, that’s true. Efficiency improvements alone, like the ones that propelled us forward in the past, won’t get us where we need to go by 2050. But this plan doesn’t rely solely on boosting efficiency. It brings together a host of other changes, such as moving toward greener power sources. What’s more, making gradual changes means we don’t have to scrap still-productive power plants, but rather begin to move new investment in the right direction.

As for how much this will cost, the best economic analyses — including studies from the U.S. Congressional Budget Office and the U.S. Energy Information Administration — say such a policy in the U.S. could cost considerably less than 1% of gross domestic product per year in the long term, or up to $175 per household in 2020. (As the Obama administration is fond of saying, that’s about the cost of one postage stamp per household per day.)

In the end, we would be delaying 2050’s expected economic output by no more than a few months. And bear in mind that previous environmental actions, such as attacking smog-forming air pollution and cutting acid rain, have consistently turned out to be much cheaper than predicted.

The best economic experts have validated the wisdom of adopting climate policies: from Yale’s William Nordhaus, who has supported moderate carbon taxes to cut emissions as an “insurance policy” against the most serious consequences of climate change, to MIT’s Richard Schmalensee and Columbia’s Glenn Hubbard, who have endorsed the climate policy recommendations of the bipartisan National Commission on Energy Policy, to Harvard’s Martin Weitzman, who has argued for much more aggressive policies because of the risk of particularly catastrophic outcomes. And a diverse set of CEOs, including the heads of some of the largest U.S. corporations, acting as part of the U.S. Climate Action Partnership, have called on the government “to quickly enact strong national legislation to require significant reductions of greenhouse gas emissions.”

Critics are wary of raising energy prices, arguing that no nations have grown wealthy with expensive power. But historically, it is the scarcity and cost of energy that have prompted technological changes as well as the use of new forms of power. What’s more, critics challenge the price estimates the experts have set out. They say that the predictions depend on extensive — and unrealistic — cooperation among nations. In particular, they say, developing nations won’t sign onto plans for curbing emissions, for fear of losing their economic momentum.

Indeed, we do need a sensible international arrangement in place to achieve low costs, and the economic pain will be much greater if we don’t set up an international carbon market. But it can be done. Many nations have already initiated such emissions-control policies. And the world can be brought together in a meaningful, long-term arrangement that is scientifically sound, economically rational and politically pragmatic.

Road to Cooperation

Because the benefits of any single nation taking action to address global climate change are spread worldwide, unlike the costs, it may never be in the self-interest of a single country to take unilateral action. This is the nature of a global commons problem. For this reason, international cooperation is required; this is the point of climate negotiations among some 190 countries, which will continue in Copenhagen this December. It is also the motivation for the U.S. administration’s Major Economies Forum, which brings together the 17 largest economies, accounting for 80% of GHG emissions.

Europe has already put significant climate policy in place, and Australia, New Zealand, and Japan are moving to have their policies in place within a year. But without evidence of serious action by the U.S., there will be no meaningful future international agreement, and certainly not one that includes the key, rapidly-growing developing countries — Brazil, China, India, Indonesia, Mexico, South Africa, and South Korea. U.S. policy developments can and should move in parallel with international negotiations.

Understandably, developing countries have a very different perspective than the currently industrialized world regarding climate policy. After all, the vast majority of the accumulated stock of man-made greenhouse gases in the atmosphere is due to economic activity in the richer countries over the past century and more. But the share of global emissions attributable to developing countries is significant and growing rapidly. China surpassed the United States as the world’s largest CO2 emitter in 2006. And developing countries are likely to account for more than half of global emissions by the year 2020, if not before. China, Korea, and others are beginning to take action.

Most important, all of the key countries of the world can be brought together in a meaningful and pragmatic arrangement. Such a post-Kyoto international agreement can expand the scope of action to include key developing countries, but with targets linked via an appropriate formula with economic growth, so that emissions can be reduced around the world, while emissions (and job) leakage from the industrialized to the developing world is avoided, and economic growth continues in all parts of the world.

Reducing Costs

The longer we put off serious action, the more aggressive our future efforts will need to be, as greenhouse gases and carbon-spewing capital assets continue to accumulate. Plants built today will determine emissions for a generation. In the steel sector — where plant lifetimes typically exceed 25 years — more than half of all plants in the world are now less than 10 years old. The picture is similar in the cement industry, as well as more broadly throughout the economy. For every year of delay before moving to a sustainable emissions path, the global cost of taking necessary actions increases by hundreds of billions of dollars.

Critics argue that we can afford to wait because the world of tomorrow will be wealthier and better able to absorb the costs. But acting sooner, such as by adopting the emission caps proposed in the U.S. House legislation, will lower the ultimate costs of achieving the target, because there will be more time allowed for gradual transition — which is what keeps costs down. Perhaps most important, the costs of failing to take action — the damages of climate change — would be substantially greater.

Getting serious about climate change won’t be free, and it won’t be easy. But if state-of-the-science predictions about the consequences of continued delay are correct, the time has come for sensible and meaningful action.