Climate Policy as Wealth Creation, Part 1

James K. Boyce

This is the first installment of a five-part series on climate policy by regular Triple Crisis contributor James K. Boyce, professor of economics at the University of Massachusetts-Amherst and director of the Program on Development, Peacebuilding, and the Environment at the Political Economy Research Institute (PERI).

The series is adapted from Prof. Boyce’s March 31 lecture, part of the Climate Change Series at the Honors College of the University of Pittsburgh. The lecture explores how to turn the atmosphere (heretofore treated as an “open access” resource, into which greenhouse gases can be dumped at no cost to the emitter) into a common-property resource. This requires the establishment of a set of public property rights over the atmosphere’s capacity to absorb and recycle carbon, the imposition of costs (as through a carbon tax or sale of carbon permits) on those who use this finite resource, and a determination of how the rents will be distributed.

The remaining parts of the series will appear once a week for the next four weeks. The full lecture and subsequent discussion are available, as streaming video, through the University of Pittsburgh website. Click here or on the image below.

Demand and Supply

Broadly speaking, there are two types of policies to reduce carbon emissions from fossil-fuel combustion. One set of policies operates on the demand side of the picture, on the need for fossil fuels. These are policies that include investments in energy efficiency, investments in alternative sources of energy, public investment in mass transit, etc.—investments that reduce our demand for fossil fuels at any given price. Even if the prices of fossil fuels were to remain unchanged, people would consume less of them, thanks to these investments in efficiency, alternative energy, alternative modes of transportation, etc. That’s an important set of policies, but it’s not the only one that is relevant.

I’m going to focus on the complementary set of policies that operate not on the demand side of the equation, but the supply side—policies that raise the price of fossil fuels at any given level of demand. Those policies operate by raising the price in either of two ways which are more or less equivalent, either by instituting a tax on carbon emissions or, alternatively, by putting a cap on emissions and thereby restricting supply. In the same way, OPEC restricts supply when it wishes to increase the price of oil and increase profits—it raises the price. Well, that’s how a cap works to raise the price, too.

There are two main reasons why I think a supply-side set of policies is an important part of the policy mix. The first is that those policies can achieve very quick and immediate reductions in the use of fossil fuels. The policies that involve shifts in demand—investments in mass transit, building up clean and renewable energy, investments in energy efficiency—those policies take time—in some cases, a lot of time, possibly decades—in order to be fully implemented. In the short run, if we want to see immediate reductions in fossil-fuel consumption, we need policies in the mix that operate on the price today, and reduce consumption today without waiting for the shift in the demand curve. So that’s one reason I think that price-based policies can and should be part of the policy mix.

The other reason is that the price-based policies themselves are critical for engendering the shifts in demand that we’ve been talking about. If people know—if consumers, households, firms, and public sector institutions know—that over the next decade or two, the price of fossil fuels will inexorably rise due to having policies in place to make that happen, they will have an incentive to make those investments in energy efficiency and renewable energy sources. They will have price signals to push that investment along. In an economy where roughly three-fourths of investment operates in the private sector, and only about one-fourth in the public sector, having those price signals as a motivating incentive for guiding private investment is absolutely critical to moving the energy transition forward as quickly as needs to be done.

The easiest way to put a price on carbon emissions is through an “upstream” pricing system, which means that the place at which you put the price on is where the carbon enters the economy, not where it comes out the tailpipe. So that would mean at the tanker terminals, the pipelines, the coal-mine heads, where fossil fuels are entering the U.S. economy.

That’s a lot more efficient and administratively simple to implement than having a tailpipe solution, which is at the other end of the process, where you’re trying to price the carbon as it is burned as opposed to coming into the economy. The Congressional Budget Office estimates than an upstream system in a cap-and-trade or carbon tax regime would involve 2,000 compliance entities—that’s the name for the folks who have to either pay the tax or surrender a permit for each ton of carbon they bring into the economy. You can contrast that to what it would be like to monitor the emissions coming out of your tailpipes and send you a bill at the end of the month for the amount of carbon you’ve emitted. If you tax carbon or price carbon upstream, those price increases come as part of the price of the fuel and are passed along to business and consumers are thereby create incentives for reducing emissions over the longer haul.

Basically, there are two instruments that one can use to price carbon—one is a tax and the other is a cap. A tax sets the price and allows the quantity of emissions to fluctuate. A cap sets the quantity and allows the price of emissions to fluctuate. Other than that, they’re basically the same thing. You can think of them both as involving permits—a tax says here are permits, as long as you pay the price for them, you can have as many permits as you want, while a cap says here are the number of permits, we’re going to let the price be determined at an auction or in a market.

One way or another, what’s important is to get a price on carbon. If we had a tax to try to do that, I would be all for it. One of my worries about a tax, apart from the political unpopularity of the “T-word,” though, is that there would be a temptation on the part of the government to lowball the level of the tax that’s necessary based on over-optimistic assumptions—“Well, we don’t need that much of a tax to get the reduction in emissions that we’re looking for.”

In the case where the main policy objective is to hit the target, the quantity target—to reduce the quantity of emissions—it seems to me that targeting the quantity rather than the price makes a lot of sense. We don’t know for sure exactly what the relationship is between quantity and price. We know that, in the short run, roughly a 10% increase in prices results in a 3% reduction in demand, but that relationship isn’t precise. It can change over time, particularly as more technologies are discovered. So if you want to hit the quantity target, it seems to me that setting a cap has advantages over setting a tax.

Triple Crisis welcomes your comments. Please share your thoughts below.