The Silver Bullet Of Climate Change Policy


By Bob Litterman and Gernot Wagner

Whenever the conversation turns to climate change, someone is sure to opine that there’s no silver bullet. The issue is simply too complex to have one solution. When you focus on all the changes that need to occur to reduce greenhouse gas emissions globally it seems like a multifaceted approach is the only way forward.

Most of the world’s vexing problems share that feature. Mideast peace, nuclear non-proliferation, Eurozone stability, and plenty of other national security problems have no single right plan of attack. Some past plans might have brought us tantalizingly close to a seeming solution, but then reality started interfering once again, reconfirming the complexity of it all.

Climate change must surely be in that category. No single country, no single technology, no single approach can seemingly solve this one for us once and for all. Picking a single technology will almost inevitably end in some form of disappointment. Bureaucrats, the saying goes, ought not to try to pick winners. Leave that to venture capitalists for whom failure is a way of life. For every Apple and Facebook, there are dozens who never make it out of the garage. And clean technology doesn’t yet even have a single Apple and Facebook as the standout approach revolutionizing the field.

It turns out, though, that how you frame the issue is crucial. If you think like an engineer there are dozens of challenges. If you think like an economist, there is one. It’s guiding the ‘invisible hand’. How can you create the appropriate incentive to decrease the pollution that’s causing climate change? For that, the government need not be in the business of picking winners at all. What it should—and can—do is identify the loser that’s been clear for decades: greenhouse gas pollution. And the solution is equally clear: create incentives to reduce emissions by pricing it. If we make this one change, most other actions that are needed will follow.

That’s what the European Union has done by capping carbon emissions from its energy sector, including large industrials, covering almost half of total carbon emissions. That’s what California is doing with over 80 percent of its total global warming emissions. It’s what China is experimenting with in seven city and regional trials, including in Beijing and Shanghai. All these systems put a price on greenhouse gas pollution.

On the other side of the ledger, there are still much larger incentives to consume fossil fuels in many other countries. The International Energy Agency estimates that global subsidies are well over $500 billion. These subsidies, which incentivize emissions, sadly dwarf the paltry incentives to reduce them. Free marketeers, small government advocates, and others who dislike distorting government subsidies should be appalled at the tax money poured into fossil fuels.

There’s one simple principle that’s been around in economics for so long that no economist worth his or her degree would question the conclusion: increase the price, watch the quantity demanded go down. It’s such a universal truism that economists call it the “Law of Demand.” Generations of graduate students have estimated the effects of price on demand for anything from the generic widget to demand for car miles driven. People may be irrational at times, but one thing that we know for sure is that they respond to incentives.

Everything we know from decades of the study of human behavior would lead us to believe that carbon pollution will go down as the price on emissions increases. The only interesting question is by how much.

The prescription then for anyone seriously concerned about climate change is simple: price carbon to the point where its now unpriced damages are incorporated into the price, and get out of the way. It’s simple. It works. It’s conservative to the core.

It’s also a silver bullet solution if there ever was one.

Bob Litterman is a Partner at Kepos Capital, LP. Gernot Wagner is a senior economist at the Environmental Defense Fund.

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  1. Posted January 24, 2014 at 4:51 pm | Permalink

    Massive reforestation has to be implemented. Reversing the trend of clear cutting over the most recent 175 ainyears, will help to process some of the carbon dioxide and create oxygen. When public policy is dictated by what can turn the most money rather than what will create a healthy and sustainable environment, we slide the slippery slope of a faux progress.

  2. Peter Fiekowsky
    Posted January 25, 2014 at 5:11 pm | Permalink

    In the carbon pricing choice between cap and trade and a carbon tax, a senior economist explained to me that cap and trade gives us known results in the face of unknown demand elasticity, while a carbon tax leaves future CO2 levels uncertain. Yet I'm a serious fan of a gradually increasing carbon tax at the point of first sale, with border adjustments.

    Given the Germany is already getting 25% of its electricity from renewables, as is the US state of Iowa, with Texas and California not far behind–it appears that the existing solar and wind technologies are sufficient to make serious dents into fossil fuel use. The natural evolution of those technologies–which they've demonstrated by halving costs every 8 years or so–will make getting the next 50% of energy consumption (and efficiency improvements) quite predictable over the next 10-20 years (or 30 years if you're very conservative).

    The big advantage of a gradually increasing carbon tax, increasing annually at 10 cents per gallon of gas, or 10 dollars/ton CO2, is that it is easy to implement, easy to adjust to by consumers and suppliers, and gives a compelling message to investors that now is the time to move investments from oil to renewables–that the future is clean energy. After 25 years of this slow increase, the cost of a barrel of oil will be $200-$400, depending on the extraction costs, which are now skyrocketing. Oil's competitor, renewables, meanwhile will decrease by 2-4x. Given that they're at parity now in many parts of the world, the 25-year demand for oil will be a small fraction of what it is now–assuming we have a gradually increasing carbon tax.

    This should make the trillion dollars per year that we spend on oil development quickly available for use in renewables development.

  3. Posted January 25, 2014 at 7:35 pm | Permalink

    It's truly gratifying to read that EDF — one of the largest, oldest, most trusted and successful organizations –embraces the action plan put forth by Citizens Climate Lobby — one of the smallest, youngest and — for it's youth — most successful organizations. The revenue-neutral carbon fee and dividend being pushed by CCL, along with such luminaries as George Shultz, Art Laffer, Gary Becker, Greg Mankiw — all conservatives — comes closer to your silver bullet than any other plan.

    Climate change is way too deep and complex a problem for governments alone to solve. Regulations simply can't do it. The most powerful and pervasive force in human affairs is money. (Sorry, it's not love, though that would help.) Unless and until we harness the economy to the task of pulling humanity out of the climate ditch it has dug for itself on its way to prosperity we don't have a chance. Once it is universally understood that carbon pollution is on its way to becoming unprofitable, everything will change, from top to bottom. Nature is yelling that we are out of time, so the relative simplicity and economic efficiency of a carbon tax is one of its greatest virtues. And by recycling the funds back to households so that people can still afford their needs, one has the political stability that industry requires for planning and investment. It's predictability compared to cap and trade's volatility wins the gold.

    The leaders who were burned by cap and trade's failure are waiting for cover from Big Green. Will EDF and it's hefty brethren throw their weight behind carbon fee and dividend? What are we waiting for? Superman is not coming.

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