Why are carbon taxes so low?

The recent announcement by Canada’s Minister of the Environment, Catherine McKenna, that there will be a national carbon price by the end of the year, is extremely welcome news. As someone who has spent a great deal of time trying to articulate to the public the basic rationale for carbon pricing (here, here, here and here), this is about as close to a “win” as anyone could reasonably expect. Let’s hope it happens.

Most of the time that I spent writing about it, I was trying to explain very basic features of the policy (what a collective action problem is, how the price system works, why it’s not a “tax on everything,” etc.) This was aimed primarily at a right-wing audience, of people who were inclined to do nothing about climate change. I have spent comparatively less time addressing a left-wing, or environmentalist audience, explaining why pricing is an appropriate policy measure in this case (although there was this and this).

(On the general issue, of when we should be using pricing, and when we should favor more “deontological” approaches to environmental policy, I continue to recommend John Braithwaite’s paper, “On the Limits of Economism at Controlling Harmful Corporate Conduct.”)

There is, however, a very reasonable question that arises about carbon pricing, which is not often enough addressed. The mainstream view on carbon pricing is that there should be a tax imposed of approximately US$30 per carbon-tonne (carbon-tonnes being the generic unit used to measure all greenhouse gases.) This is enough to raise the price of gasoline by approximately 10 cents per litre. The obvious question is how such a small increase could possibly be an effective response to the problem of climate change.

There is one version of this argument that rests on a failure to understand the idea that price changes affect behaviour at the margin (which I discussed here). But set that aside, and just consider the facts as they now stand. Two years ago, when the evil Harper Government was in power, gas cost more than $1.20 per litre. Now it’s selling for less than $1 (here in Ontario). So how is raising the price of gas to $1.10 per litre going to bring about an environmental utopia? If climate change is the big threat that it’s made out to be, shouldn’t the price of gas be going up to $3 or $4 per litre?

In other words, the question is, “why are the carbon taxes being proposed, and adopted in jurisdictions like BC, so low?” (see recent report by Ecofiscal Commission on relative stringency of carbon policies in Canadian provinces here).

That is a great question. It’s also one that has an answer (in fact, several answers), although it gets a bit complicated. The technical, but relatively uninformative answer is that the US$30 (actually, more like US$33) represents the best estimate of the “social cost of carbon” (SCC) which is to say, the value of the damage caused by the release of a single carbon-tonne of emissions. So a carbon price in that range “internalizes the externality,” making it so that the private cost of using energy derived from fossil fuels is approximately equal to the social cost.

However – and this is a big however – in that calculation of the social cost, an enormous number of judgements are being made about how much we should be concerned about the various consequences of our actions. What follows is a quick list of some considerations that speak in favour of doing less than the maximum possible to reduce our carbon footprint:

(These are, incidentally, each very complicated issues. I’ve sketched them out quickly here, in a very bloggy format, just to get them into the public discussion, because I notice that a lot of people are talking past each other.)

1. People in the future will be richer. Environmentalists sometimes fail to appreciate just how powerful a force economic growth is, and how much future people stand to benefit from increased growth. Climate change damage, while not exactly a geometric function, increases rather gradually, over the course of decades. Economic growth increases exponentially, annually, and so at the rates experienced in developing countries, with the right alignment of social, economic and political factors, it is possible to double per capita GDP in less than a decade. This has two consequences for climate change policy:

First, it means that we in the present can reasonably defer some of the cost of climate change mitigation/adaptation to the future, because people will have vastly more resources to confront the problem then (and, because they will be so rich, the “costs” will have less impact on their welfare). Even though climate change gets worse over time, the economic situation gets better at a much faster rate (under the most probable set of scenarios), and so it is rational to delay some action. For instance, in 1996, when the Kyoto Accord was being negotiated, the Chinese economy was only one-quarter the size that it is now. One of the arguments that the Chinese used, at the time, to exempt themselves from obligations under that treaty, was as follows: “why should we do this now, in 1996, when we are poor, when it would be so much easier to do it in 20 years, when we are four times richer?” In retrospect one can see that there was a lot to be said for this argument. But of course they can make the same argument now.

Second, it means that any policy that could negatively impact growth needs to deliver huge benefits in the future, in order to justify its opportunity cost. For example, if you plot out life expectancy in China, or infant mortality, look at the correlation with GDP, and project that out into the future, you can see the anticipated decline associated with current growth rates. Now suppose you depress that growth rate by adopting an aggressive carbon abatement program (e.g. not building any new coal-fired electricity plants). This is going to get you lower life expectancy, and a slower rate of decline in infant mortality. So you are going to be “killing” a certain number of people with this policy. On the other hand, you are going to be “saving” a bunch of other people, by mitigating climate change, and thus reducing exposure to extreme weather events, crop failure, etc. To justify the policy, the number of people you are “saving” should be at least in the ballpark of the number you are “killing.” Unfortunately, the amount of “bang for the buck” that you get out of climate change mitigation is not enormous, when compared to economic growth in underdeveloped countries. (This is, of course, not true in developed countries, where growth does not make much of a difference. But climate change is a global problem, and so you have to look at the big picture.)

2. Technological change. Underlying disagreements over climate change policy there are often differences of opinions about what the “end game” picture of the policy looks like. Some people have a view of climate change policy as being like a standard pollution problem, such as dumping mercury into waterways, where the projected ideal outcome is that you pass a law saying “you can’t do that,” and firms still have an incentive to do it, but they refrain from doing so because it is now illegal, and they are being threatened with fines, etc. This is, in my view, unrealistic, simply because of the global nature of climate change and the impossibility of an international enforcement regime. The idea that all this fossil fuel is going to just sit there, underground, untouched – this amazing source of incredibly cheap energy – and that all the nations of the world are going to cooperate to ensure that it stays that way, is to me totally unbelievable. So like many other people, I see the “end game” of policy as simply correcting a negative externality, eliminating the price distortion that it created, then relying upon the combined efforts of both governments and market actors to find a technological solution to the problem, which will eliminate the underlying incentive to burn fossil fuel.

From this perspective, the basic problem is that because fossil fuel is too cheap (due to the externality), there has been significant underinvestment in energy research. Green energy can’t compete with brown energy, because the latter is being tacitly subsidized (by the victims of climate change). If one compares the amount of technological innovation that we have seen in computing, over the course of the 20th century, and compare it to the amount of technological innovation in energy systems (which is practically zero, we still use predominantly 19th century technology), there is reason for optimism that we will be able to find zero-carbon energy sources. The world, after all, is awash with energy. At any given point in time, the earth is being struck by over 15,000 terawatts of solar energy. Total human energy usage at any given point in time is roughly 17 terawatts. Furthermore, most of that energy is not being captured directly by humans – it comes from solar energy captured and transformed millions of years ago by plants. We should be able to do better than that!

So from this perspective, the goal of carbon pricing is not actually to achieve some huge amount of carbon abatement, it is to correct the price distortion, in order to direct a much greater portion of human ingenuity to the solving of this problem.

3. Canada is not going to be doing the bulk of mitigation. The ballpark figure for the level of sustainable per capita carbon emissions is 2 carbon-tonnes per person (depending, of course, upon global population). Canada, as we know, is at about 20 right now (although our national average is brought up by the 80 or so carbon-tonnes per person being generated in Alberta and Saskatchewan). In any case, the scenario in which we actually drop to 2 per person is neither likely nor desirable. Because we’re a northern country, as well as a wealthy industrialized country, it will always be the case that it is more efficient for us to pay other people to reduce their emissions than it will be for us to reduce our own. This is not true right now. In the absence of a carbon price, there are areas in our economy where the marginal cost of abatement is zero, or even negative (e.g. lighting). So a carbon tax is intended to pick off the low-hanging fruit. But it is not intended to drive our per capita emissions down to 2. Furthermore, there is no moral requirement that we do so. The moral requirement is that we pay the full cost of the emissions that we generate. Under the ideal policy regime, lots of people in temperate climates are not going to need their full 2 tonnes (e.g. no home heating needs), while we are going to need more, so we can “buy” the space from them (which is to say, it will be better for us to exceed our nominal quota, and then compensate those affected).

4. Many other ways of helping the future. It is important not to compartmentalize the climate change issue, and to look at it in isolation from other policy questions. For instance, people sometimes talk about “climate change justice” as though it were first and foremost a distributive justice issue, of the rich world harming the poor. Climate change mitigation is then presented as an issue of justice – something that we owe to them. But because of the inertia in the climate system – the 80-year lag between actions taken now and effects experienced – any policy we could adopt is going to be pretty inefficient at addressing these justice issues. For instance, one might argue that the damage Bangladesh is going to suffer from sea-level rise is a terrible injustice, and we should adopt an aggressive carbon abatement program in order to correct this. But think what this means. Canada could spend literally billions of dollars on such a program, in order to deliver benefits to the people of Bangladesh 80 years in the future. Apart from the fact that, at current rates of growth, the average citizen of Bangladesh will be 6 times richer in 80 years than he or she is now, there is a sense in which helping people in the distant future just doesn’t seem like the best way of responding to the issues of justice that exist in the world today. Aren’t there any better ways of helping Bangladeshis? (Imagine the federal government announcing a program to improve living conditions in First Nations communities in Canada, with the first benefits being felt sometime in the early 22nd century.) It just seems like there must be better ways of helping people. What about pure redistribution, right now? Or what about making sure that people right now have clean drinking water? As soon as you look at it in context, you start to realize that there are a lot of different ways of helping people, and climate change mitigation is not obviously the most effective. What about investing in malaria eradication research?

Just to be clear, I am not taking Bjorn Lomberg’s line, arguing that we should be doing these other things instead of fighting climate change. I am simply saying that there are a lot of competing options in the policy space, and a lot of uncertainty about what the best thing to do is. There is, however, one thing that we can be certain of – that the correct price of carbon is not zero. As long as there is an atmospheric externality associated with fossil fuel consumption (and a few other things), then we should internalize it. And that means a carbon price, based on our best current estimate of the SCC. After that, though, we should let the chips fall where they may, without prejudging the question of what kind of policies towards future generations will be best.

5. Reasonable partiality for the present. Finally, there is the most controversial question, which is whether it is permissible for us to show some degree of partiality for people alive today over those who will live sometime in the future. I just wrote a long article arguing that we can and should (gated here, early MS here). The idea that we can’t is, I think, the sort of view that people are attracted to because it seems like the moral high ground, but that when you think about it, has totally crazy consequences. The big problem with giving future people equal moral standing to actual, living people, is that they vastly outnumber us. So refusing to show any partiality toward existing people (or toward people in the present) can generate all kinds of absurd scenarios, in which you wind upon constantly having to favour non-existent people over existing people (because there are so many of them!), and so as a result, no actual person ever gets any actual benefit from the policies adopted.

So part of the reason carbon taxes are low is that, when the SCC is calculated, a discount rate is applied to it – just as it is to every other major public investment or spending program – which expresses, among other things, a measure of reasonable partiality toward the present.

In summary: Why are carbon prices so low?  Because the costs associated with climate change — both doing something about it and not doing something about it — are going to be spread over the next 200 years at least, and there are several reasons why we are not obliged to shoulder more than a moderate share of these burdens right away.


Why are carbon taxes so low? — 6 Comments

  1. While I’m totally in favour of a carbon price, and given in the ground realities think it’s the only practical way of getting ourselves moving in the right direction, I think you’re maybe dancing around some issues a little here and that there are some big chinks in the armour of some of those arguments.

    Firstly I’m not sure you’re perhaps giving the discount rate the prominence it deserves when it comes to how important it is in determining the carbon price. Indeed, along with assumptions about the damage function, the discount rate dominates so much that it’s pretty much the sole determining factor in setting your carbon price. Difference in discount rates basically explains the difference between sterns price and Nordhaus’s price, which is a difference of orders of magnitude! Furthermore, Nordhaus’s rate suggests that when the native Americans sold Manhattan for $24 they got a good deal! There really needs to be a pretty strong argument for going for a specific discount rate, but I’ve seen few that appear deeply convincing.

    You also appear to be treating the issue largely as an exercise in consumption maximisation, whereas others might look at it more as an exercise in risk management/buying insurance. If you treat the economy and climate as smoothly varying systems then, depending on assumptions and parameters you input, it can of course end up making sense to emit more carbon to make people richer through growth. This would seem to ignore the fact that the climate system is strongly nonlinear and that there is strong geological evidence that it can go through extremely rapid state shifts. Since we only have evidence that large scale intensive agriculture (for example) works within an extremely limited temperature range, perhaps we should be willing to pay an exaggerated risk premium to avoid potentially ruinous situations, which anything above 3-4C might potentially be. Climate change damage functions may be fat tailed, which can substantially alter the risk profile you’re looking at. The fact that some analysis seems to suggest climate change may have been a contributing factor to the collapse of Syria should at least give pause for thought.

    As for energy, the 15,000 to 15 ratio is one of those superficially optimistic sounding facts which doesn’t stand up to much scrutiny. When you start chopping out oceans, mountains, areas for agriculture, reflection from clouds and so on you start losing orders of magnitude very quickly and things get a lot tighter. Using realistic numbers you need to solar panel areas that are the size of fairly big countries, which is not a trivial task. Plus electricity is only about 20% of emissions. Other industrial processes (coking steel, haber Bosch) might not substitute away so easily, to say nothing for emissions from land use change and agriculture. As someone whose background is physics and who has spent a fair bit of time working in energy, there is a lot of wishful thinking in this area. Yes, there is lots of solar energy, and we’re awash with wind too, but these are inherently low quality energy sources. They’re intermittent, diffuse ananof a low temperature. Coal, oil and gas, by contrast, are energy carriers par excellence. Easy to store, high energy density and available on demand. Current gen renewables and storage are miles behind and it is far from obvious that they’ll catch up any time soon. Outside renewables fusion research has been a money pit for decades and current gen nuclear is insanely expensive and unpopular and expanding it to take a much bigger share of global generation seems unrealistic, so to me it is far from immediately apparent that human ingenuity will be sufficient to solve the problem in a realistic timescale.

    Issues of lock in also abound. China is still rapidly building out coal capacity, and I struggle to imagine them turning off their coal plants halfway through their useful lives. The UK is edging closer to just building out lots more gas capacity as we need to get something done before the lights go out and the USA will soon have to replace large amounts of aging plant. Again it seems like these assets will be fully depreciated. Unless signals are in place to strongly drive towards lower carbon alternatives, we risk countries getting locked into carbon intensive infrastructure built to last for decades.

    • Sam: Thanks for making most of the points that I would have made, only a lot better!

      But perhaps the biggest “chink in the armour” is in plain view, right at the beginning: “People in the future will be a lot richer”. This is a remarkably bold prediction, and is presumably based on the experience of the past century or so — about 2% of human history since the beginning of the Bronze Age. However much we might wish this to be true, because it melts away the need for many difficult choices, it’s quite a leap of faith!

    • Thanks for the thoughtful comment Sam. Regarding your first point, my “reasons” numbers 1 and 5 are the ones that go into determining the social discount rate, with 1 being the most important. So I was giving the discount rate prominence, I just wasn’t referring to it as such. Regarding your second point, I never know what people mean when they suggest approaching the issue from an “insurance” perspective, rather than as a matter of calculating the social cost of an externality. Insurance is an arrangement under which multiple individuals facing similar risks create a pool of resources/funds, which they use to indemnify those who suffer the loss. This is inapplicable in the climate case, since there is just one planet, so there is no one to “pool” with. So the idea that the cost involved in carbon abatement can be considered analogous to the cost of buying an insurance policy doesn’t make sense to me. What we are really doing, when we engage in carbon abatement, is reducing the chances of harmful climate change, and of certain catastrophic scenarios from materializing (unlike with insurance, which does not reduce the chances of the insured-against loss from happening). The question then is one of optimal risk-reduction, i.e. how much does it make sense to spend now to reduce the chances of the catastrophe from occurring? But the calculation involved in that, it seems to me, is the same as the cost-benefit calculation involved in determining the SCC, so I don’t see how the two approaches (optimal consumption vs. insurance) are any different.

      • Joe,

        I understood you were referring to the discount rate, I just think that given the huge sensitivity in the carbon price to one’s choice of rate that it needs some pretty serious support, since otherwise it becomes easy to tune your iam to get out a carbon price that you like. Especially given that the rate itself can also be affected by fairly subtle assumptions about various parameters. The inclusion of both uncertainty about the rates we should use and structural uncertainty about the shape of the probability distributions into the equations is also a big deal and can totally blow assumptions that lead to a low carbon price completely out of the water because thick tails start to dominate. I just don’t really think a low price is necessarily a slam dunk just yet. To be clear I’m totally with you that a zero discount rate can lead you to some insane places though. Here’s my favourite recent example of this: http://www.vox.com/2015/8/10/9124145/effective-altruism-global-ai

        Related to the above, and to the (probably correct) argument that everyone will be richer in the future, there’s also the fact that much of the damage of climate change will be borne by nature, some of which we will feel in terms of impacts on ecosystem services and some which will be felt in things like reduced biodiversity. To my knowledge, none of these things are currently captured in the considerations required to calculate a carbon price, and indeed whether such things can be meaningfully priced. To me it still seems entirely possible to have an economically neutral pathway in which a great deal is still lost. I recognise that there are things like the natural capital approach, but these seem underdeveloped and, given the fact that many ecosystems are nonlinear and subject to rapid state shifts, a price may be an inadequate mechanism to capture this behaviour.

        When I made the insurance vs consumption argument I was trying to emphasise the conceptual difference, though perhaps it’s not the best way to frame it. In my understanding, the IAMs tend to use various averages and expected values to compute an optimal carbon price. However when people buy insurance they do so because they have a preference to ameliorate the very worst and least likely of life’s outcomes, such as premature death, a house fire. People are clearly happy to pay more than the expected losses to insure against these risks (if they didn’t the insurance industry couldn’t exist, let alone turn a profit). In general people seem prepared to pay a significant premium to avoid worst case outcomes, so there is perhaps an argument that policy should be more focused on avoiding the very worst outcomes as opposed to maximising expected value.

  2. Where does the $30/ton estimate of the social cost of carbon come from? Is it from the US government?

    Google turns up an EPA document from December 2015, describing a range of values estimated by an US interagency working group. It looks like the $30/ton estimate may be assuming a 3% discount rate. A discount rate of 2.5% gives a higher estimate (more like $50/ton). These are in 2007 dollars; they also rise over time.

    “… the SC-CO2 should increase over time because future emissions are expected to produce larger incremental damages as physical and economic systems become more stressed in response to greater levels of climatic change. …

    “The 2009-2010 interagency group recommended a set of four SC-CO2 estimates for use in regulatory
    analyses. The first three values are based on the average SC-CO2 from three integrated assessment
    models, at discount rates of 5, 3, and 2.5 percent. SC-CO2 estimates based on several discount rates are included because the literature shows that the SC-CO2 is highly sensitive to the
    discount rate and because no consensus exists on the appropriate rate to use for analyses spanning multiple generations.”


  3. I had a couple of questions that maybe someone here can clarify.

    In the post you say:

    Even though climate change gets worse over time, the economic situation gets better at a much faster rate (under the most probable set of scenarios), and so it is rational to delay some action.

    My understanding is that most studies that try to estimates the damages due to climate change assume continued economic growth. Has anyone considered how climate change might impact economic growth itself? Clearly, if economic growth continues as it has, climate change would have to do extensive damage this century if people in future are to be poorer than we are today. On the other hand, it would seem to really be a coupled system in which economic growth may depend on the climate change impacts and so the picture may not be as simple as it seems. Is this right, or am I misunderstanding something?

    You also say

    But think what this means. Canada could spend literally billions of dollars on such a program, in order to deliver benefits to the people of Bangladesh 80 years in the future. Apart from the fact that, at current rates of growth, the average citizen of Bangladesh will be 6 times richer in 80 years than he or she is now, there is a sense in which helping people in the distant future just doesn’t seem like the best way of responding to the issues of justice that exist in the world today.

    My understanding (which, again, could be wrong) is that the SCC is computed on the basis of the global damage/cost due to the emission of 1MtC today (obviously discounted to today). So, surely an alternative way of looking at this is that we are paying, today, for damage that will be done to others in the future. So, why is it appropriate to think in terms of us paying to help people in the future?