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Carbon Pricing vs. the Economy

It’s well established that the CO2 emissions from burning of fossil fuels represent an external cost not presently captured in the price of those fuels.  Carbon emissions pricing -- whether via direct taxes on fossil carbon or through some form of “cap and trade” permit system -- would capture at least a portion of those external costs.  By raising the price of fossil fuels toward what they “should” be if external costs were accounted for, realistic emissions pricing would encourage energy efficiency, conservation, and switching to non-fossil alternatives.  It would level the economic playing field for alternatives, and allow the best to compete without the market-distorting effects of legislated subsidies.  

To date, proposals for realistic carbon emissions pricing have made little headway in legislatures around the world.  Where measures have been adopted, they have been largely symbolic. The added price that they impose on fossil fuels falls short of even the more conservative estimates of the true external costs.  The chief argument used to kill consideration of anything more than token measures is that we can’t afford them. The world economy is already stressed by high energy prices, and increasing prices further through the imposition of fossil carbon taxes would surely scuttle it.

It’s an interesting thesis.  It’s saying that unless industries that burn fossil fuels are allowed to continue using the atmosphere as a free dump for CO2 emissions, the economy will suffer.  Or more generally, that economic prosperity is inversely proportional to the price of energy, and that we’re already operating near the limit of what we can afford to pay without incurring dire economic consequences.  

It sounds sort of plausible.  Could it be true?

The slope, not the value

The thesis can’t be dismissed out of hand as self-serving fabrication by fossil fuel interests.  Indeed, it featured prominently in the doomsday messaging on Jay Hanson’s old “” website.  It has resonance in today’s “peak oil” and “post carbon” communities -- though the intended message now is rather different.   It’s also supported, indirectly, by those who finger the extreme price that oil reached in 2008 as the root cause of the great recession that started then.  Gail Tverborg has posted in support of that view on her popular website, Our Finite World.

Those who blame high oil prices for the great recession and continuing economic malaise are not entirely wrong.  While not the whole story, oil prices certainly do have much to do with it. Even those who place the blame elsewhere -- e.g. reckless banking practices and collapse of the US housing bubble -- don't deny that oil prices played a role.  The plunge in housing prices that began in late 2006 got started in bedroom communities far removed from urban job centers, after gasoline prices began to soar. High gasoline prices undercut the tradeoff that these communities had long represented -- more house and land for the dollar in exchange for long commutes.  

Nearly all the posts blaming the recession on energy prices, in my opinion, miss a key point.  They peg economic effects to the absolute price of energy. But the absolute price, per se, is not what causes trouble.  Rather, it's the rapid increase in price.  More precisely, it's what's behind the increase that causes trouble.  The problem is loss of productivity at the margins for oil and natural gas.  

What do I mean by that wonky phrase "productivity at the margins"?  I'll explain in a moment. First, there's another key point to make about energy prices and the economy.  

The economic ecosystem

The economy is a form of ecosystem.  Job categories are ecological niches; new niches open up and others lose viability as conditions change.  And like natural ecosystems, the economy can adapt to a great deal of change -- so long as the change isn't too large or too sudden for the system to digest.  

If the rise in the price of energy had come smoothly and gradually, it would not have been a big deal.  Consumers would gradually have had to spend a larger fraction of their incomes for energy and transportation, and would have been left with less to spend in other areas.  That would have impacted those other areas. However the impact would ultimately have been offset by increased spending and more jobs in the energy sector. The shift in work patterns would have been disruptive and sometimes painful to those affected, but not substantially different than what happens in the everyday churn of the job market.  

Even had a slow steady rise led over time to a large net increase, it would not have mattered much.  Economies have flourished in the past when energy accounted for a much larger fraction of GDP. Given time, they could again.

That's not what happened, however.  Prices rose quickly. How come? And why is a quick rise so much more damaging than a long slow rise?  We're back to the meaning and implications of "productivity at the margins".  

Why oil prices soared

"Productivity at the margins" refers to what it costs in capital and labor to increase production of a product or service by an incremental amount.  For oil and gas, it would be the cost to produce an additional barrel of oil or an additional thousand cubic feet of natural gas.  

There's a basic rule in economics that the market price of a commodity is set by the cost of production at the margins.  The reason is simple. If the market price is less, then production at the margins is unprofitable. So, for example, the marginal barrel of oil that would be needed to meet demand simply won't get produced.  It will sit where it is until lagging supply drives up the market price enough to make extraction profitable.

The principle may be obvious, but it has some significant and not so obvious consequences.  Once a successful oil or gas well has been completed and put into production, its operational costs are low.  The "lifting costs" for oil from the aging giants in Saudi Arabia is estimated to still be only a few dollars a barrel -- even though the fields are nearing depletion and now require massive water injection and other means of "enhanced oil recovery" to sustain production.  So when production from conventional oil fields in the world peaked in 2005 and it became necessary to turn to expensive non-conventional resources to meet demand, it wasn't just the price of oil that soared. Profits from conventional reserves that were still producing most of the world’s oil soared as well.

Soaring profits from conventional oil were good news for a few.  For world GDP and the economy as a whole, they were a disaster. Money that finds its way into the accounts of the already wealthy will, for the most part, rest there doing nothing productive for a long time.  What the wealthy spend on goods and services -- the things that move economies -- is tiny, relative to holdings. Their funds may turn over rapidly in investment trading, but those are sum-zero paper transactions that have nothing to do with jobs or creation of wealth. 

The transfer of large chunks of the money supply from lower and middle income workers to wealthy portfolio holders is a problem.  Little of the additional money that consumers must spend on energy, transportation, and more costly goods finds its way into the hands of energy sector workers.  It effectively vanishes from the economy, like air leaking from a punctured tire. Jobs lost in other sectors are not quickly balanced by new jobs in energy and transportation.  The negative economic stimulus sends the economy into a tailspin of less discretionary spending leading to job loss and still less discretionary spending. The problem is compounded when the change is quick.  It triggers a loss of confidence in the future and attendant drop in both consumer spending and business investment. Despite lowered interest rates and other stimulus efforts by the government, recovery is difficult.

Since oil prices peaked in 2008, the long economic recession and the consequent drop in consumption, coupled with new oil and gas production from non-conventional resources, have been holding a lid on oil prices.  And a decade of comparative price stability has allowed the economic ecosystem to begin adapting. Jobs in the energy sector are up as an increasing fraction of oil and gas production shifts to the new, more costly resources.  Windfall profits for the holders of declining conventional reserves are down, and renewed spending seems to be easing the recession. That’s well and good, but the recovery has been fueled by money borrowed at near-zero interest rates; it feels very fragile.

Implications for the future

The difference in effects between the absolute cost of energy vs. rapid change in the cost of energy is not an academic distinction.  The case against carbon emissions pricing rests on the implicit assertion that it’s the absolute price paid for fuel that matters to the economy.  I’ve explained why I feel that it’s a rapid increase in price that causes trouble, rather than the price per se.  

Now I’ll go further, and say that even a rapid increase in the price of fuels would not be a problem -- so long as the price increase were due to some form of emissions pricing and not a cost increase for production. Tax-driven price increases have fundamentally different economic consequences than cost increases due to reduced productivity.  The former requires no new capital investment and involves no increase in labor costs. The revenue collected can be quickly cycled back into the economy.

Depending on how the revenues are cycled, the economic effects from adoption of an emissions pricing system could well end up positive.  The simplest and most economically efficient approach would be the “fee and dividend” approach advocated by former NASA climate researcher James Hansen and others. I.e, direct redistribution or carbon tax revenues in the form of a monthly rebate check to every adult citizen.  

The fee and dividend system provides no net revenue to the government.  It would not enable expansion of the government, and thus avoids the chief objection of the "no new taxes" crowd.  At the same time, it does not harm the working poor. The smaller cars and limited mileage that they typically drive means that lower income workers purchase less fuel than average.  Their carbon dividend checks would therefore more than offset the added cost of fuel at the pump.

As noted  earlier, funds going to lower income earners turn over more quickly, on average, than those going to the wealthy. The redistributive aspect of a rebated carbon tax would thus increase consumer spending and provide a net boost to GDP.  

But what of the long term effects, after fossil fuel consumption begins to taper off?  Carbon tax revenues will taper off as well. By then it's possible, and even likely, that the expanded market for non-fossil energy will have reduced its cost enough to make it cheaper than fossil energy is now.  That would be good for everyone. However, If cost reductions don’t materialize it will leave us paying higher prices for energy, with less income from redistribution of carbon tax revenues to offset it. Won't that hurt the economy?

The answer, again, is not necessarily.  If the transition happens gradually, the economy can and will adapt.  Since the transition we're speaking of will likely take several decades, there will be ample time for production and jobs to adjust.

But what of China?

At this point in the discussion, the issue of international cooperation arises.  Critics contend that any talk of a serious carbon tax is stupid; a carbon tax would increase the cost of its exports, so any nation that adopted one unilaterally would be shooting itself in the foot.  At the same time, there is no realistic possibility for an international agreement, because China and other developing nations would never agree.

Predicting what China will or will not do is a hazardous occupation.  Most pundits seem to get it wrong more often than right. It’s true, though, that China -- or any nation heavily dependent on exports -- is an unlikely candidate for unilateral adoption of a serious carbon tax.  The goods that China exports are mostly low cost, in relation to the energy invested to make them. Hence raising the price of energy to businesses would disproportionately impact the price of those goods.  

Of course, there are ways to avoid that problem.  The exporting nation could impose a carbon tax to shift domestic consumption away from fossil fuels, while exempting businesses whose products are exported.  If charged with a violation of fair trade practices by unfairly subsidizing exports, they could simply point to Germany or the many other nations where industrial users buy power at rates heavily discounted over those available to residential users.  Still, it does seem unlikely that China or any developing nation with a strongly export-oriented economy would choose to take the lead in enacting serious carbon taxes. That role is a much more natural fit for the U.S.

Because export of manufactured goods has become a relatively minor part of the U.S. economy, the U.S. could more easily afford to act unilaterally to burden fossil carbon with its external costs.  It would not devastate the economy, even if no particular action were taken to “level the international playing field” for businesses that do export products.  For the most part, the things we export are not especially sensitive to the price of energy.  However, that’s a moot point, because there are simple measures that would level the international playing field quite effectively.  It’s hard to imagine that such measures would not be enacted in parallel with a carbon tax, were we to enact the latter unilaterally.

The leveling measures I’m thinking of would be some form of what I dub a “YCOWC” (Y-COW-C) policy. That stands for “You Collect, Or We Collect”.  It means that any product coming to this country will be taxed in proportion to its embodied fossil carbon content.  The exporting nation may enact a suitable carbon tax and collect the revenue itself; otherwise we will collect it, in the form of import duties based on what we judge the product’s embodied fossil carbon content to be.  Instant level playing field.

It’s pure speculation on my part, but I suspect that China might secretly welcome a U.S. initiative to establish a worldwide standard for fossil carbon pricing.  It wouldn’t disadvantage their export industries so long as the policy applied equally to all competitors.  

No nation has more to gain than China from cleaning up its coal-fired power plants.  Air pollution from coal is a severe problem that takes a daily toll on Chinese lives and health.  The problem has been that the cost of remediation would harm their export industries and limit economic growth.  China’s leaders see economic growth as essential for political and social stability. They’re likely correct.   

A worldwide policy for carbon pricing would enable China to fund cleanup measures without leaving it at a disadvantage relative to other exporters.  As the world’s premier supplier of solar cells and panels, with strong positions in wind turbines as well, China stands to profit handily from accelerated adoption of renewable energy.  But it can’t afford to lead the charge for carbon pricing when competitors might hold back and thereby gain an advantage. China doesn’t import enough for a YCOWC policy at its end to exert the leverage it would have coming from the U.S.

The shape of adaptation

Let’s return briefly to the question of adaptation. If competition and an expanding overall market fail to bring down the cost of non-fossil energy, what would the consequent adaptation to higher energy prices look like? 

I can’t do justice to that topic in the few lines remaining here, but here are some tidbits for readers to chew on: 

There’s far more “fat” in the current economy than most realize. Trimming that fat would likely leave us better off, should a larger fraction of GDP really need to go toward energy. We should also view any energy-related changes in the context of changes that will have to come anyway. Changes that might be needed to adapt to higher energy costs are very likely to be eclipsed by those stemming from advances in automation and computer intelligence.

I’ll try to expand on those points in a future column. For now, I’ll conclude by reiterating the key points of this discussion, as I see them:

  • CO2 emissions are a large external cost for use of fossil fuels that should be priced in to those fuels, but currently aren’t;

  • Appropriate carbon pricing would encourage smarter, more efficient use of energy, and ease the necessary transition away from fossil fuels;

  • The overall impact of carbon pricing, after economic adjustment, would very likely be positive;

  • The U.S., through an announced “you collect or we collect” trade policy, could drive the worldwide adoption of carbon pricing without significantly hurting its own economy.

I recognize, of course, that not everyone will agree. But I hope that readers will at least be encouraged to think about the issue. It's important that we question the reflexive “we can’t afford it” arguments against policies that are vitally important if we care at all about the kind of world we’ll be passing to future generations.


Roger Arnold's picture

Thank Roger for the Post!

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Bob Meinetz's picture
Bob Meinetz on Feb 18, 2020 7:38 am GMT

Great article, Roger. I feel the last sentence raises the question at the center of all others:

"It's important that we question the reflexive 'we can’t afford it' arguments against policies that are vitally important if we care at all about the kind of world we’ll be passing to future generations."

Though most of us care about climate change, the actions we take in coming decades will tell us whether we care enough to make the changes in our own lives and in public policy that will allow us to leave a habitable world to future inhabitants.

It wasn't until I read James Hansen's book "Storms of my Grandchildren" that I realized how brutally different life will look on a 22nd-century Earth unless we take concrete steps to end consumption of fossil fuels now. Convincing others is a tall order, thanks in part to prophecies of other Armageddons, large and small, which never materialized. But if more understood the scientific certainty and severity of what our descendants will face we might see more of a commitment to work on the problem. Right now, I don't think many people do.

Gerard Reid's picture
Gerard Reid on Feb 18, 2020 10:26 am GMT


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