Wednesday, December 16, 2015

Central Points On the Tax Versus Cap And Trade Issue In The Paris Climate Agreement

I have already made several posts on this, but I want to focus on two  points regarding this and apologize that some of this will be repetition.   One is theory and one is on the views of economists.

The theory point derives from Martin Weitzman's 1974 paper in the Review of Economic Studies on Prices and Quantities.  I mentioned  this argument in my Pigou Club post, but again, in a world where we lack certainty about impacts of trying to clean up,  whether one focuses on fixing prices or fixing quantities depends on the potential threat from getting it wrong.  So, if one is more worried about overly high costs of cleanup from being wrong, then one wants to avoid that by fixing prices, which in the environmental policy debate means taxes or some similar mechanism.  If one is more worried about getting the benefits of cleaning up wrong, that is having a disaster because one did not keep the quantities controlled properly, then one should use a quantity limit approach.  Personally I think the latter is by far the biggest problem for the global warming problem, so a quantity approach is the better way to go, making it cost effective by adding cap and trade or tradable emissions permits to it.  I note that a hybrid policy is possible, allowing one or the other to  be dominant, but allowing a kick-in if things get too extreme on either side so as to allow the other policy to then also be used.

This would seem to be a strong argument, and I note that Weitzman has largely stayed out of being publicly involved in the debate over taxes versus cap and trade at Paris, although he is in the same department as Robert Stavins, who has supported cap and trade pretty clearly.   However, as many have  noted there are some very prominent economists in the Pigou Club, with Arrow, Schelling, and Stiglitz the most prominent, and with Mankiw also  very promient.  More than one observer has said, "how  can you disagree with these guys?"  Well, for starters, I do not think any of them have said that one should not or  never use cap and trade as climatologist James Hansen seems to have said after the Paris agreement tilted for cap and trade as I predicted it would based on past diplomatic and political history, although Paris certainly allows nations to use carbon taxes to achieve their national goals if they so  choose.  The  only favoritism is for international coordination, where the agreement suggests that trading permits is a useful  way to do that, which it certainly is.

As it is, I see this as partly a debate between very famous economists whose principal areas of research are not in the economics of global warming, although this topic has become Schelling's main concern in recent years, and I think that both he and Arrow also know a lot about the climate science involved, against some economists whose main field has been environmental economics, and thus are not as well known publicly as these Nobel Prize winners.  Stavins is one of those, and so is Weitzman (although he has publicly remained neutral). I shall name another, Tom Tietenberg of Colby College and J.H. Dales, whose current location I do not know.  Dales was the actually the first to propose tradable emissions permits, aka cap and trade back in the 1960s, getting the idea from the Coase Theorem, which was developed very much as a critique of Pigou's approach to taxing negative externalities. I may not be right on this, but I suspect that part of why Arrow and Schelling and Stiglitz have favored Pigouvian taxes is that it was the earliest approach formulated and the only one in all the textbooks for  years, dating back to the 1920s.

It was Tom Tietenberg in the 1970s who led the actual first implementation of cap and trade, the Wisconsin plan to limit BOD emissions into the Fox River, which I was peripherally involved with.  But Tom was the main person, and he is also the author  of the most  widely used environmental economics textbook.  He went from Wisconsin to be one of the main people advising EPA and the US government more generally on implementing the successful system for trading permits for lead in gasoline and SO2 emissions, much praised by Schmalensee and Stavins in their forthcoming JEP article.  But nobody outside of  environmental econ knows who Tom Tietenberg is, and, of course, the cap and trade system arose initially out of an effort to make cost effective the quantity limits laws that the US had put in place in the early 1970s against the advice of all the economists supporting Pigouvian taxes, many  of them signatories on this petition that went to Paris.

My final observation on this is that this reminds me a bit of what happened after the fall of the Soviet Union.  There were a bunch of comparative economists around, not well known outside of their field, who knew very well how difficult the transition processes would be and cautioned about overly ambitious plans brought in from the outside in a "one size fits all" manner.  But all the pizzazz of the fall brought all sorts of very well known economists who had not  studied comparative economics into the ball game, getting ahold of the policy apparatus and developing and enforcing the destructive Washington Consensus, which led to many disasters in Eastern Europe against the advice of many of the more established but less well known comparative  economists.  This reminds me of that a bit, the advocates of carbon taxes pushing a textbook ideal  against a policy actually developed by environmental economists that has much more going for  it, especially at the global level.

Barkley Rosser


Unknown said...

Cliff Russell and I wrote about exactly this problem, in a couple of venues (Issues in Science & Technology (2002) and the Harvard International Review. A short summary is printed below and the arguments apply equally to the push to use economic instruments in service of greenhouse gas reduction:
Most nations lack the infrastructure and expertise necessary to implement the market-based strategies being recommended by the international development banks.
Most developing countries have long since established laws and formal governmental structures to address their serious environmental problems, but few have been successful in alleviating those problems. The development banks, which control resources desperately needed by the developing countries, are promoting the use of economic incentives and other market-based strategies as the key to more effective environmental protection. However, the donors have rarely asked whether the approaches they are urging, which have recently had some success in Europe and the United States, can be implemented effectively in developing countries with limited resources and little experience with market-based policies of any kind.
We worry that these highly sophisticated instruments have been pushed too hard and too fast, and that those who promote them say little about the context and conditions in which they thrive. The targets of this advice should be better informed about everything they would need to do to make market-based instruments work. Otherwise, the cause of environmental protection itself may be dealt a blow when ill-conceived policies divert a country’s energies without producing the desired result. Developing-world regulators, already marginalized in their own countries, will have little to show for their efforts in terms of a cleaner environment.
Before imposing a regulatory strategy on the developing world, we should review the experience of the industrialized countries and others that have implemented market-based policies. How extensive is the experience? How successful? What have we learned about the conditions necessary for effective market-based policies? Then we will be ready to consider when and where these policies are likely to work in the developing world.

Peter Dorman said...

Good post, Barkley. I especially like your second point.

Let me add something more to the first, about uncertainty. Whenever you see a textbook demonstration of Pigovian taxes, or just about anything else for that matter, you see supply and demand curves drawn across P/Q space, end to end. Guess what? We have no idea where these curves are located, what their slopes are, or even (incredibly) whether they exist (due to interaction effects through which changes in P and Q can react back on the underlying functions). It's just a heuristic device, folks -- a good one, but little more.

What we do know, of course, are elasticities, the effects of small perturbations in the environment of each relationship. If the elasticities are stable we can use them to extrapolate a bit to larger perturbations. But the kinds of changes we are talking about with climate policy, phasing out fossil fuels in the space of a generation or two, are way, way beyond the zone of reasonable extrapolation. We really have no idea (a) what the P-Q relationships are going to look like down the road or (b) how nonconvexities in the underlying cost and preference sets are going to play out in tipping points and discontinuities.

This is Barkley's terrain far more than mine, but it needs to be voiced loudly and often. The uncertainty we are dealing with is truly immense.

Whether we go the P route (taxes) or the Q route (permits), or some crafty combination of the two, we will have to establish a framework of adaptive management with prompt feedback from the emerging consequences of policy back into recalibration of policy. said...

Thanks, Peter, completely agree.


A week ago today I had a long discussion in person with Thomas Schelling, one of the first (after Nordhaus) economists to seriously look at global warming as part of a NAS panel and since. He is an advocate of carbon taxes, but not hardline about it.

However, in connection with your point he noted to me that many maybe most developing countries are not really able to properly implement either one of these policies very well, so the debate is somewhat moot for them. These have all been implemented to the extent they have in higher income nations.

One of the most serious issues is simply information, knowing what emissions are, which is necessary for any of these schemes, including just plain old quantity emissions limits without any trading. I remember hearing that this would be a big deal when took public finance in grad school from Burton Weisbrod, which was where externalities got discussed, back before there were any "environmental economics courses" (I have never taken one, I started the one on my campus that I teach), and this was also just before the main Clear Air and Clean Water Acts were passed. He made a big deal out of it that much impressed me at the time, but since most people seem to just take this for granted.

However, even now this is a problem in China, where we just learned that they are burning 17% more coal than we thought they were. One fo the few things that came out of Copenhagen, which Stavins (and I) praised at the time was a commitment to improve data gathering, clearly then a problem for China. And I note that some of the problems for the ETS in Europe has been that when they set it up they did not have accurate information on emissions, which is part of why they set the limit wrong. This is one of the messes that they have been trying to fix ever since. But such issues are just as serious for carbon tax systems as they are for cap and trade systems. If you do not even know what the emssions are, all these schemes are just hot air.

Peter Dorman said...

Barkley and Ruth, isn't the feasibility/state capacity problem a function of downstream regulation? What if, unlike ETS for instance, you had a perfectly upstream system, either taxes or permits, right at the entry point of fossil fuels? If the country has mines or wells, get them at the minehead or wellhead. If they have pipelines or LNG or oil tankers or whatever, get them at the ports. I realize you will miss the odd artisinal coal mine, but we can live with that.

The problem is that, largely for political economic reasons, these systems are introduced at the sectoral level, which commits you to many more agents as well as the need to assess gaseous emissions rather than the fuels themselves. said...

There are people pushing the so-called "fee and dividend" system, which many of my local climate activists like, which does something like this, especially for trade at national borders. This may be what Hansen is really supporting, based on some off the cuff remarks in some of his interviews, but I am not sure he even knows what on earth he is talking about precisely.

This sounds nice when people present it, but it seems not to have been remotely on the table at Paris, with it probably facing greater political resistance than either of the other two systems, although that may mean it really is preferable. It certainly sounds nice in some presentations.

Thornton Hall said...

This strikes me as one of those moments where economics brings a forest to the discussion that was previously in an open field. Thus the debates ensue about the arrangement of the trees and the missing of the forest. And no one notices the failure that was once sitting exposed in an open field.

Go back a step, before all the stuff about caps and taxes and Coase. Would a physicist opine about the evolution of frogs? And if he did, would an observer of below average intelligence (eg a reporter) notice a problem?

No and yes.

What makes economics different?

The answer, I suspect, goes to the heart of the soul sickness that afflicts the entire endeavor.

Myrtle Blackwood said...

The possible solutions are being presented without a true awareness of our predicament. And what the 'development banks' want (or demand) is now - and should have always been - irrelevant.

There's no way to describe the precipice we now confront. There is (as Hunter S Thompson said) "no honest way to explain it because the only people who really know where it is are the ones who have gone over.” Economists are not there yet. They've never been the stewards of life on earth, after all. We're about to lose our home.

For the little time we may have why don't we try using money to feed and clothe ourselves. We could help widows and orphans and provide for our real needs. Some very respectable economists have long said it's a fraud to apply money for other purposes. said...


I have said nothing about what the development banks say, and I do not care what they say. I shall also say that there were a lot of people in Paris, both in the streets and in the negotiation rooms who are aware of the seriousness of the situation. That there is such widespread awareness is why they finally managed to pull off getting a truly international agreement signed, inadequate as it is, with 195 nations signing, and 186 offering initial plans of action, which clearly need to be further tightened over time.

Only the Republicans in the US fail to recognize how serious this is, and we need to use multiple policies to get at this, not just hone in on one in particular, as a particular climate scientist has said we much or else the entire negoatiations were a fraud. But I shall not again name this scientist, even though many of his fellow scientists are dissing him hard for his latest paper that has not passed peer review, but he has been publicly trumpeting its results inappropriately.