Monday, July 7, 2014

Climate Misconception #11: Done right, climate policy can be nearly costless

The politics are straightforward.  Forces representing business interests and the free market crowd resist climate policy every step of the way, complaining that the economic cost is too high.  The environmentalists fire back: wrong, they say, if we use the right tools we can achieve our carbon objectives at minimal cost.  Some, invoking the Porter hypothesis, even claim that getting off fossil fuels can be a net economic boost—this without taking into account the economic costs of climate change itself.

It’s obvious why environmentalists would say this.  I truly wish they were right.  But they are not, and their evasion damages their credibility and muddles their politics.

Why does this big-payoff-at-little-cost meme persist?  If you look at the arguments of people who promote it, they generally cost out programs that fall well short of meeting carbon budget constraints like the one proposed by the IPCC.  They look at small carbon taxes or modest caps whose goal is to slowly ramp up to an annual emission target in 2050 or so.  Recall, however, that it’s the area under the emission path, not its eventual settling point, that tells us how much greenhouse gas accumulation we’re going to have.  If you do the calculation, you’ll see that these paths come in way over budget.

Here’s a demonstration.  A clever website is you enter the maximum amount of global warming you’d like to allow and the amount of uncertainty you’re willing to accept, and the engine spits out the date on which the corresponding carbon budget is maxed out under business as usual, as well as the annual rate of emissions decline necessary to meet the budget constraint if we start right now.  So let’s pick two degrees celcius and “cautious” with regard to uncertainty.  The engine tells us a straight-line emissions path that adheres to these stipulations requires an annual decline of somewhat over 2.5%—this year, next, year, and essentially forever.

Now for some economic arithmetic.  Obviously it won’t do to have every country in the world cutting its emissions at the same rate.  Some, like the US, have immense legacy emissions that tip the scales against them, and it’s reasonable that poor countries, where energy use per capita is a small fraction of what it is in the rich ones, should have much looser carbon caps.  To make things simple, suppose this means that, rather than reduce at the rate of 2.5% per year, the US has to cut back by 5%.  To simplify further, let’s just look at oil.  (Each fossil fuel needs to be considered separately, since the mix will change over time.)  Suppose its use has to go down at this average rate, with coal going down faster and natural gas slower.  There is great uncertainty over the long run price elasticity of demand for petroleum, but .5 is a plausible point estimate.  Put it all together, and you have gas prices in the US needing to rise at 10% a year in real terms.  Using the handy rule of 70, that’s results in about a seven year doubling time.  If gas is $4 a gallon at the pump today, by 2028 it needs to be $16, not factoring in inflation.

But this is a low-end estimate.  First, the US will not immediately begin to follow this reduction path, and the longer we delay, the faster we have to reduce.  Second, a factor of two for the US compared to the global average is probably much too low.  A large majority of the world’s population lives in low income countries, and their standard of living needs to rise.  Barring some disaster, it is inconceivable that their combined fossil fuel consumption will actually fall over the next decade or two.  Third, reduced consumption has to apply to all fossil fuel sources, not only oil, simultaneously.  Fourth, there is no guarantee that elasticities will remain constant as we cut ever more deeply into fossil fuel use; on the contrary, they should probably go down, driving up costs that much more.

This will not be cheap.

It’s possible that increased investments in renewable energy can cap these costs.  Perhaps substitutes can be found that will enable the US and other industrialized countries to convert to other energy sources at a less-than-astronomic price.  It could happen, but at this point we don’t know.  When it comes to energy costs, environmentalists should fess up.

There is another dimension to this problem, however, that is largely off the radar.  We have inherited a capital stock predicated, directly and indirectly, on relatively low-cost energy supplies.  If energy prices begin to rise rapidly, what will happen?  Economists usually assume that capital items will amortize according to plan, and that costs will be incurred only when new, possibly more expensive investments are needed to replace the old ones.  That would be nice, but don’t count on it.  Logically, there is a tipping point at which it becomes uneconomic to operate or maintain a capital investment when the costs of inputs go up or the value of outputs go down.  In other words, serious carbon policy will require a portion of our capital stock to be written off.

How big a problem is this likely to be?  It’s hard to say.  If you want historical antecedents, one place to look is the oil price hikes of the 1970s.  These were very large in percentage terms, but they were also temporary, one-time events and applied only to one energy source.  They did trigger a pair of intense business cycle downturns, although capital stock replacement was mostly orderly.

Possibly a more relevant case is the Eastern European experience post-1989.  For decades capital investments in that region were based on a closed trading system.  If you wanted a car, and you lived in the Soviet Bloc, you had to buy a Trabi or a Škoda or a Lada; that’s what there was.  Then the walls came down, and suddenly Eastern European automakers had to compete with western products.  Quickly, it became apparent that the price cut needed if consumers were to buy one of their cars rather than a VW or a Ford was too great to justify any further production; so they shuttered their factories and laid off their workers.  It’s not too far off the mark to say that the massive recessions of the early 1990s in the ex-Soviet Bloc, which cut output by 20-50% depending on the country, was the result of widespread capital writeoff of this sort.  (Now some of these cars are back on the market, but produced with completely different technology.)

Question: how much of the capital stock of today’s industrialized countries would become uneconomic if the world were to shift to a fossil fuel path that adhered to the IPCC’s carbon budget?  As far as I know, there are no economists at all studying this.  They are all too busy debating whether the hypothetical social cost of carbon is a few dollars more or less per ton (and therefore whether we should try to meet the IPCC’s carbon target or not).  There is scope for a change in priorities.

As we’ll see later, when we look into the political economy of climate policy, industrial interests are aware of this problem and intensely motivated by it.  When they look at their own operations, they think they’re at risk.  They are probably better placed than environmentalists to know their exposure.  Meanwhile, it doesn’t make the political job of getting tough climate policies enacted any easier if supporters underestimate the sources of resistance.

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Lord said...

It isn't very useful to compare the costs of doing something while neglecting the costs of doing nothing though and a lot of capital, potentially more, will be made obsolete by that also.

Peter Dorman said...

Clearly. As you may have noticed, I'm something of a climate überhawk. But one cost doesn't make the other go away.

john c. halasz said...

I think I told you so.