Catallaxy Files

as an AGW policy sceptic, I would very much welcome serious debate and commentary that seeks the truth w.r.t the existence of AGW and, then, what if anything to do about it.

Tom N

Last year I was asked to speak at a conference on the CPRS and prepared some slides. The conference got cancelled at the last minute so I never got around to writing the paper. I suppose I should at some point, but the heat has gone out of the debate. Anyway in response to Tom’s point I’m posting a decision tree and some talking points that I had relating to the tree. It might be a bit wonkish for some tastes.

I sure we can all imagine more complicated trees, but that’s what I came up with. Basically a set of questions and possible outcomes. I look at the costs. Costs of incurred in three stages of the decision making process:
First, should ‘we’ do anything?
Second, what should ‘we’ do?
Third, how should ‘we’ do it?

Should ‘we’ do anything? This question involves answering four sub-questions:
Is global warming occurring?
Is anthropogenic global warming occurring?
Can we fix it?
Should we fix it?
These four questions range from scientific through to ethical questions.
It is important to note that despite all the debate and controversy that we run out of science by the second question.
‘Can we fix it?’ is a question of technology.

What should ‘we’ do?
This question involves answering two sub-questions
Should Australia do anything? Australia could free-ride
Should Australia follow the Rest of the World or go alone? If Australia goes alone should it follow a market or non-market approach?
If Australia follows a market approach, which approach should it take?
Carbon Tax
Cap and Trade (ETS)

What do we know?
IPCC says AGW has > 90% probability.
Technology solutions are not currently available and are forecast to appear over the next 40 years.
Ethical questions are hotly disputed:
Per capita emissions or total?
Social discount factors?
Do we care about the unborn?
Compensation?
Signalling doesn’t have a good track record in diplomacy.

Very little is known about the magnitude of any of the costs.
Type II errors are assumed to be small (because the economic costs of mitigation are thought to be low).
Little is known about the adaptation costs.
The White Paper admits that ‘Work on adaptation in Australia is in its infancy’.
It is assumed that adaptation costs are greater than mitigation costs.
Delay Costs are assumed to be high.
But recently some have argued that due to the GFC that some delay can be tolerated.
This argument is doubtful: CO2 is a stock pollutant not a flow pollutant.
Regime Uncertainty Costs are likely to be high.
Maladaptation Costs may be high or low.
Socialist Calculation Costs are high.
Type I Error are assumed to be high.
Net Program Costs are arguably low.
The Stern Report, Garnaut Paper and Treasury Modelling all suggest that the costs of climate mitigation are low.
The Australian government asked Treasury to model the economic impact of reducing emissions on the Australian economy.
Four scenarios, a free-riding scenario, and a reference case are presented.
This thought-experiment provides a guesstimate of the magnitude of the costs imposed on the economy from introducing an ETS.
The actual government proposal is not modelled.

How should ‘we’ do it?
Fix a price: Tax?
Fix a quantity: ETS?
Under perfect market conditions these two policy instruments will deliver the same outcome.
The choice between a price control and a quantity control depends on the elasticities (slopes) of the marginal cost and marginal benefit functions.
The marginal benefit elasticity is most important. If the marginal benefit curve is shallow, then a price instrument imposes fewer deadweight costs on the economy than does a quantity instrument. If the marginal benefit curve is steep, then a quantity instrument will impose lower deadweight costs on the economy than does a price instrument. Australia is a small polluter; if acting alone, the marginal benefit elasticity will be close to perfectly elastic.

Theory and simulations suggest a tax dominates an ETS.
W.A. Pizer Journal of Public Economics 85 (2002) 409 – 434

The resulting welfare analysis indicates that taxes are much more efficient than permits for controlling GHG emissions – by a factor of five to one ($337 billion versus $69 billion in net benefits). This derives from the relatively flat marginal benefit curve associated with emission reductions.

M. Hoel, L. Karp Resource and Energy Economics 24 (2002) 367–384

Even though we chose parameter values from the plausible range in such a way … making it more likely that quotas dominate taxes … our calculations indicate that taxes lead to higher welfare. Even if the larger (based on Reilly) estimate of g is too small by a factor of 1000, … taxes would still dominate quotas if the firm and the regulator were “reasonably flexible”. If the estimate of g is too small by a factor of 100, taxes would still dominate quotas even if the firm and the regulator are inflexible. Consequently, in spite of the data limitations, our results support the use of taxes rather than quantity restrictions to control greenhouse gasses

What about Coase?
White Paper invokes a Hayekian argument to support the ETS.

If the Government had full information about the relationship between carbon prices and the quantity of emissions reductions that such prices would induce, a carbon tax and an emissions trading scheme could deliver similar economic and environmental outcomes. However, while the Government can make estimates, it does not have complete information about that relationship.

But this applies in either case.
If government doesn’t know enough to set an equilibrium price, how do they know enough to set an equilibrium quantity? Due to a lack of information, the government will allocate property rights and let the market decide. Is that the Coase Theorem? Coase actually made methodological contribution, not a policy contribution.

Economic Consequences
Treasury have used different models to evaluate the various scenarios
They do not provide an overall framework to evaluate what their results may mean. I use Austrian Capital Theory to provide a framework for evaluating the introduction of an ETS. This involves combining Hayekian triangles that show the relationship between Production Time and Consumer Goods, the market for loanable funds, and a production possibilities frontier.

Applying the model to an ETS.
Increase in the Cost of Capital. Shifts the supply of loanable funds function to left. Reduces Investment. Increases current consumption. Reduces Production Time. High Risk, Long Production Time economic activity is restricted.
But intertemporal preferences are unchanged. At higher market interest rates, lenders expand the supply of loanable funds. Reduce consumption. Idle capital (S > I). Shrinks the overall size of the economy. Government induced long-run disequilibrium. Leads to unemployment.

The Treasury modelling assumes no unemployment. In their modelling Real Wages adjust to clear the Labour Market. The Treasury also say “Capital is allowed to retire and the economy experiences capital shallowing”.

Conclusion
It is not at all clear what the answers to many questions are.
It is not at all clear that any analysis has been undertaken on the various options.
The economic costs of the ETS are likely to be very high.
It is not clear why an ETS has been chosen relative to a carbon tax.
Neither the neoclassical school, Coasian analysis, or Austrian school seems to favour an ETS.
Taxes in theory would raise more revenue than an ETS.
The economic costs of an ETS are so high it is unlikely that government would be able to pay compensation.

All that is a bit rough and ready – but comments, thoughts etc are welcomed (as always).