Wednesday, April 06, 2011

Politics, Economics and Climate Change

Following the idiotic controversy over the comments of Kevin Rudd on climate change it is time for some more analysis of the fundamentals.

Writing in the SMH today Jessica Irvine did a very good job of describing the difference between "income effects" and "substitution effects" of a tax on a specific good, and how you could both impose a tax and pay compensation and hence get a change in behaviour.

She notes that Tony Abbott has said "At best it's a giant money-go-round" but retorts "Sorry Tony, but good economists know better."

In this she is putting more economic theory around the straight-forward explanation that I praised the PM for in her appearance on Q&A.

But is the economics as simple as that? There are two ways of pricing carbon - one is the straight tax, the other is emissions trading. The latter is the ultimate economic orthodoxy on dealing with a negative externality. We lost that because the Greens didn't support it, not because of the coalition.

The Greens have preferred the tax route because they want to spend money directly on climate abatement programs. Gillard has been forced to go the direct tax route because that is the price of Greens support.

All of which makes the slagging off about the Greens and economics interesting. Gillard thinks they "wrongly reject the moral imperative to a strong economy", Albanese says they "tend to be a grab-bag of issues, tend not to have a coherent policy that adds up" while (M) Ferguson says they want to "sit under the tree and weave baskets with no jobs".

Yet the Greens are closer in their policies to the prescriptions of the Henry tax review than anyone else on death duties, health rebates,and higher taxes on super profits.

The criticism of either emissions trading or a carbon tax has a very wide support base - because people just don't understand how it works.

Frank Stilwell in a thoughtful piece outlined a very good reason for this lack of belief in response to price. He wrote;

In the real world market responses can operate quite differently. For example, you would expect to see a market disincentive incentive effect happening now as the price of petrol rises to $1.50 a litre and beyond. However, I don't observe less crowded roads. The availability of good, readily available alternatives to the car is a precondition for getting people to switch. And those alternatives do not just arise spontaneously.

To put it bluntly - for their to be a substitution effect there has to be a satisfactory substitute. In the case of carbon those substitutes will take time to be available.

Industry has argued that it won't make the investments in the alternatives until there is certainty on the price for carbon. But as Henry Ergas has neatly argued (yes I said that)there are reasons why investors should not have faith in the price for carbon being increased to reach the desired levels.

There is nothing in the mere fact of introducing an MBM that irrevocably commits to steadily and progressively increasing the implied tax on emissions. Moreover, it would not be rational for a potential investor in technology development today to assume such an increase in the implied tax rate would indeed occur.

This can be seen by considering two broad scenarios.

In the first, the technologies needed to dramatically reduce emissions do not become available in the relevant future. In that event, it is implausible that governments, merely so as to honour commitments made many years earlier, would increase tax rates on emissions to levels that would cripple their economies. Rather, the likelihood is that any commitments made would be revised or ignored, so that effective tax rates on emissions would remain low.

In contrast, in the second scenario new effectively decarbonised technologies become available at some relevant future date. In that event, governments could, if they so chose, abide by commitments to substantially increase the tax on carbon; however, it is still unclear whether they would do so.

This is quite simply because once those technologies are available, even a modest tax will suffice to create an incentive for their deployment in the marketplace.

While much of this is the kind of reasoning Jessica Irvine pointed out explains why an economist will not bend down to pick up a $100 note (if it were really someone would have already picked it up). But it does flag the fact that there are plenty of reasons why the tax MAY NOT (rather than will not) have the desired behavioural effect on R&D investment.

The error here is probably in thinking that the solution has to be exclusively one or the other - either pricing carbon or merely regulating industry, or regulating down output while compensating for investment in alternatives (the latter being as best I can understand the Abbott alternative).

It seems to me that the best outcome is a bit of everything.

Oh, and one final point for the "we shouldn't act unilaterally brigade". Irrespective of climate change the world's fossil fuel reserves continue to decline. Investing now in creating new energy industries from Australia's abundant resources is the way to building new comparative advantage for the future.

Novae Meridianae Demetae Dexter delenda est

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