Carbon Prices, Not Monetary Policies, Are the Tools to Fight Climate Change

Everyone agrees that Climate Change is at the top of the list of most important policy issues that we face – everyone, with a few exceptions such as Trump supporters who call it a hoax.  Identifying the problem, however, is not much use unless we also identify the appropriate tools to address the problem.

Financial institutions

In my field of specialization, central bankers have caught Climate Change fever.  Perhaps the first was Governor Mark Carney — recently departed from the Bank of England.   Christine Lagarde – newly arrived at the ECB from the International Monetary Fund —  has declared the global environment to be “mission-critical” for her institutions.

Financial institutions do indeed need to fundamentally re-think some things.  Consider a bank or insurance company calculating risks to real estate loans, for example.  It would go seriously wrong to follow the standard methodology by plugging into its formulas the probability of a flood based on data from the last 100 years, rather than estimates of the increasingly elevated probabilities of such disasters entailed in a forward-looking approach.

Central banks and international financial institutions simply are not the agencies that have the tools needed to have first-order effects on greenhouse gas emissions, however, or even second-order effects.  Maybe not even third-order effects.

What policy tools will have first-order effects?   Green New Deal?  Solar power?

Green New Deal

Although “Green New Deal” is a catchy bumper-sticker slogan to signal a commitment to the issue, I fear that the US legislative proposal may do more harm than good.  It includes extraneous issues, for example, a federal job guarantee.  The jobs guarantee is an exercise in shooting oneself in the foot.  It takes a lie that opponents have long been telling – the claim that climate change is a hoax that Democrats pursue to achieve their “real objective” of expanding the size of the government – and for the first time creates a factual basis for the lie.  A sure way of generating votes for Donald Trump.

Technological innovations in areas such as solar power will play a big role in the solution.  But technology is not a policy.  Subsidies are a policy.  There is a good argument for the government subsidizing research in climate science and relevant technologies.

There is also a good argument for allowing free trade in solar panels, wind turbines, and other equipment used in renewable energy generation.  It would lower the cost of renewable energy and thereby expand the share, at no cost to domestic taxpayers.  The US and the European Union currently go out of their way to target imports of such equipment, through tariffs and so-called trade remedies.

Raise the price of carbon

In any case, the first-order policies to address climate change lie elsewhere, rather than in technology policy or trade policy.  As environmental economists never tire of explaining, the one policy that comes by far the closest to achieving environmental targets such as those in the Paris Agreement, at relatively modest economic costs, is to raise the price of carbon (more precisely, to raise the price of emitting carbon dioxide and other greenhouse gases).  If it is true, for example, that solar power or other renewables can meet most of our energy needs at a reasonable cost, a high carbon price will incentivize that result.  If some other technology or approach is needed to help maximize environmental benefits or minimize economic costs, the carbon price will also reveal that.

Carbon tax vs. cap-and-trade

The price of carbon can be raised via either one of two policies: (1) a carbon tax or (2) cap-and-trade, that is, a system of quantitative emission limits accompanied by the trading of the resulting emission permits.  Which is the better approach, a tax to raise prices or limits on quantities?

In a simple theoretical world, the two are equivalent:  the quantity of carbon permits is calculated carefully so that the resulting price when they are traded is the same as the price that would be achieved by the tax.  In the real world, there are important differences between regulating prices and quantities.  The two most important have to do with uncertainty and political economy.

It would be great if policy-makers could commit to a century-long rising path for the carbon price.  People could then plan ahead.  Firms would then know with certainty the penalty for building long-lived coal-fired power plants.  But even assuming a miraculous outburst of multilateral cooperation, today’s leaders cannot bind their successors 50 years into the future.  Thus there can be no precise certainty over the future price or quantity.  But what is critical is to establish today a credible certainty that the price of carbon will follow a generally rising path in the future.  Getting started today can achieve that credibility.  Neither lofty statements from public officials nor optimal calculations from climate modelers can achieve it.

Predicting the political economy is extremely difficult.  In the climate change arena, everything is reasonably judged “politically impossible,” and it was so even before Donald Trump.  Nevertheless, my personal judgment on balance is that, at the global level, countries may more likely be able to agree to quantitative emission targets – the Kyoto Protocol of 1997 and the Paris Agreement of 2015 were two versions of this – than to agree on a global carbon tax.  The latter is considered too great an invasion of individual nations’  sovereignty.

When it comes to implementation at the national level of any global effort to limit carbon emissions, however, I lean toward a carbon tax over emission permits.  The history of attempts to implement tradable emission permits, such as  Europe’s Emissions Trading System in the case of carbon, shows a political temptation to mollify industry by printing more permits than originally intended and also by giving too many to the legacy firms.  The logic is to “make them whole,” but the result can be a windfall gain when the firms sell the permits.

In any case, getting the price of carbon on an upward path, via either a carbon tax or cap-and-trade, is the right tool for the job.

Individual action

What can the individual citizen do?  No single individual can expect to solve the problem alone.  (How could it be otherwise?)  But some individual actions are mainly symbolic or feel-good while other actions can have an effect that is at least proportionate to the number of citizens undertaking them.  For a frustrated young person, one piece of advice is clear.  While it is fine to go to a Greta Thunberg-inspired demonstration, registering and voting is critical.  If Americans age 18-24 were to turn out and vote in the same proportions as elder voters, that would almost certainly prevent Donald Trump from being re-elected.  This calculation allows for the fact that some young voters are Trump supporters, but in lower proportions than their elders.  With Trump gone, the US could re-join the Paris Agreement and adopt effective measures; and other countries would lack an excuse that they now have to delay action.