How A Carbon Price Can Ease The Climate Shock

22 April 2016 | In their book “Climate Shock: The Economic Consequences of a Hotter Planet”, Harvard economists Gernot Wagner and Martin Weitzman offer a deep dive into the history of climate science and the rationale behind the drive to put a price on carbon. We caught up to Wagner in Vienna, and had a wide-ranging discussion on the rationale for embedding the destructive costs of carbon dioxide in the price we pay for emitting it. The interview forms the core of the inaugural episode of Bionic Planet, a new podcast launched by Ecosystem Marketplace publisher Steve Zwick and also available through iTunes, TuneIn, and Stitcher radio. You can subscribe as soon as it’s green-lighted on those systems, or click below to listen on this device.

Steve Zwick: Your core argument is that we should be paying at least $40 per ton of carbon dioxide emitted but the problem is instead we’re subsidizing emissions to the tune of about $15 a ton so we’re basically about $55 off. That’s your core argument?

Gernot Wagner: Yes, pretty much. To be fair, that $15 is global, so this is half a trillion dollars’ worth of subsidies globally. Now, they’re concentrated, so obviously the Saudis and Venezuela and Iran are subsidizing fossil fuels more than the US and the Europeans are. That doesn’t mean that there are no subsidies in the US and Europe, but most of them are in fact concentrated in oil rich, oil exporting countries.

Now that being said, if you average out half a trillion by how many tons we emit every year globally, it comes up to about $15 per ton of CO₂ going the wrong direction. It is a “negative externality”. It ought to have a positive price. This is, literally, the one law we have in economics, right? Economists like to be like physicists, but humans just don’t behave like atoms in a vacuum. We don’t.

But we do have one law. It’s called the law of demand. Technically it’s the law of compensated demand. I won’t bore you with the difference here, but really what it says is price goes up, the demand goes down. There are only two exceptions that we’ve ever discovered that actually are in fact exceptions. Those two exceptions are not CO₂. For CO₂, it’s the same as for almost every commodity out there. You increase the price and demand goes down. So, when we have too much CO₂, we need to price it. That’s the answer.

SZ: You also mentioned the challenge that former Nigerian president Goodluck Jonathon had, when he stopped fuel subsidies in 2012. What happened there?

GW: His good luck ran out, right? There were suddenly riots in the streets when he in fact decreased subsidies on petrol. Now of course, if your population is used to having just those subsidies and the price of gasoline goes up, overnight, in that case, which of course was not the most politically astute move, you will have protests, right? The same thing happens in Iran and the same thing would happen in Saudi Arabia. Now that doesn’t make it the right thing to do, right? It’s still a step backward to be subsidizing fossil fuels.

SZ: Or at least in the wrong direction because we should be paying for the damage we inflict on others and not getting paid to inflict it. But you’re not against subsidies in principle?

GW: Well, there’s also the economics 102, let’s say. Much like there is a negative spillover effect of CO₂ on everybody else. So you and I board a plane, 7 billion people pay for the cost. But then there’s also the flip side. There are positive externalities. There are learning-by-doing externalities. This is sort of economics 102, right? It’s not sometimes the most obvious thing to say, but it turns out that when you sit in your garage and you tinker with the next great innovation, you don’t consider the fact that you are creating shoulders for others to stand on. You only consider the benefits that accrue to you personally. You don’t consider the positive externalities, and there are positive externalities of new inventions. There are new technologies out there and renewables are, sadly, still very much new technologies at this point. They deserve a subsidy.

SZ: But then there’s also the Solyndra argument about the solar company that got massive subsidies and went bust because it couldn’t compete with the new solar technologies. There’s a school of thought that says subsidies of any kind distort the market and prevent it from working its magic. Any truth to that?

GW: Well sort of, right? Every time you mention Solyndra, I would mention Tesla – or SpaceX for that matter, whose story just came out and is actually pretty fascinating. NASA essentially saved SpaceX from certain demise, and the same with the Department of Energy loan that went to Tesla, which Tesla, or course has repaid by now.

So, yes picking winners is hard, it turns out, and venture capitalists are better at it that than the US government is. No surprise there. Solyndra demonstrated there is a lot of learning to be done when it comes to looking at these very new technologies that are, in fact, long shots, often. If it were a sure bet, there would be no need for subsidies. There would be plenty of money supporting that particular technology already.

By the way, what Solyndra really showed actually, was how fantastically cheap solar photovoltaic technology has gotten very very quickly.

SZ: You go into a lot of detail on how we can quantify uncertainties and probabilities and how you believe these should influence the actual price on carbon. We’ll get into those details later but I would like to focus now on your doomsday scenario. You make a very strong case for there being a 10% probability that we’ll see a 6 degree Celsius increase, or about 11 degrees Fahrenheit, if we don’t change soon. But that means we also have a 90% probability that we won’t go higher than that. So why should we all be paying a price on carbon now?

GW: We take out homeowners insurance or fire insurance or life insurance for probabilities much much lower than 10%. There are some fairly involved complex scientifics of ventures out there, including one sponsored by the European Commission. It’s called HELIX. It’s basically climate scientists coming together trying to estimate what will happen degree by degree of warming. One degree is pretty easy, maybe because we’re already there. So we can already estimate the consequences of 1.5 degrees. We can wrap our heads around and figure out what should, what will happen. Then 2 degrees is already a lot harder but at least most of it is in fact quantifiable. 2.5, 3 degrees is already a lot harder. And frankly that project, basically ends at 6 degrees. And simply they throw their hands in the air and say, look, catastrophe is catastrophe. There’s not much more you can add. We just a) don’t know enough, frankly, and it’s going to be so bad anyway at 4 or 5 degrees, what point is there looking at 6 degrees? And we are, meanwhile, looking at least at 10% probability of hitting that amount of global point. That’s the shock in climate shock.

SZ: And you also go into a lot of detail on the history of climate science and how we’ve known about this for over a century. I won’t go into that here but I would like to get into the history of the economic thought behind all this, and specifically focus on a man named Arthur Pigou. I’ve never read his stuff directly but I’ve seen him sighted and paraphrased all over the place. I wanted to read your paraphrase here because it does get to the core of why you say we need a price on carbon.

First, you point out that the average American emits about 20 tons of CO₂ per year. You argue for a price of about $40 a ton and, again, we’ll get to the reasoning for that price later. But it translates into either $800 per person per year or 35 cents per gallon at the filling station on average.

Here is your summary of what Pigou says:

“Pigou’s crucial insight was that we ought to see and pay these costs right then and there at the pump. That’s the only way to create the right incentives and lead us to incorporate the full cost into our daily decisions and stop privatizing benefits while socializing costs.”

Can you tell us a little about Pigou and then explain why he argues it’s so important that you charge at the point of sale?

GW: Yeah. So, first of all, Pigou did not in fact talk about CO_2. He spoke about rabbits overrunning a meadow, right? This is actually the fascinating thing. The economist coming up with a solution for what to do about climate change is never going to win a Nobel Prize in economics because he died eight decades before the first Prize was given out. Much like climate science itself, it’s sort of 19^th century stuff. Even the solution has been known for over 100 years. Yes, it is in fact making sure that everybody pays for the full cost that his or her actions, in this case when it comes to climate change, global warming that they’re causing. One of these obvious concepts-there’s a Wikipedia page dedicated to privatizing benefits, socializing costs. Now that’s frankly, what led to the Great Recession last decade, not too long ago. And that’s exactly what’s going on here.

Nobel Prizewinner Milton Friedman also supported a “Pigouvian tax” to deal with pollution. For details, check out “Ghost Of Milton Friedman Materializes In Chicago, Endorses A Price On Carbon“.

So on a planetary scale, we are privatizing benefits, and we are socializing the cost. I receive the benefit of flying, but seven billion people are paying for the cost. That’s crazy.

Now, of course one can in fact voluntarily say, OK, well, let me spend the $20, $40 to offset my personal contributions, voluntarily. Of course, that’s possible. Now that’s not the point. We can’t rely on the 10,000 environmentalists who would voluntarily offset their emissions. It has to be the 1 million people every year who board flights to not voluntarily get the change to do that but to actually be compelled to do it. And of course that requires policy. And Pigou’s insight is in fact, that only makes it different when it happens right then and there, when you make that decision.

SZ: But will that actually reduce emissions or are people going to just pay and keep flying?

GW: What is then the solution if not a price?

Well, a ban may well be the solution. That’s literally saying there is an infinite cost of you boarding a flight, which is clearly not the right answer.

First of all, we have to acknowledge that there are life-and-death situations when it’s actually fine to board the plane. Let’s start with that. More importantly, there are not in fact infinite costs. There are probably much higher costs than the $40 per ton. That’s clear too, right? The right number may well be a lot higher if you take all these sort of unknowns and uncertainties seriously, then the right price may well be higher than 40 bucks. I don’t know whether it’s $400 or $4,000 but it’s certainly higher than 40 bucks. Now, banning flights is clearly not the right answer.

I actually have possibly a simpler answer: plastic bags. We know they have a cost. We know that every single plastic bag is useful, up to a point, which is of course part of the point in fact. But of course, there are in fact costs to producing the plastic bag that are included in the price, and frankly to disposing – and more often than not improperly disposing the plastic bag. Ask the seagull, right, that’s caught in one what he or she thinks about the plastic bag.

Now what’s the cost of the plastic bag? Again, it’s probably not infinitely much. Should we have back taxes? Should we have fees every time you walk into a store and basically, mindlessly, just get the plastic bag? Of course we should. It turns out these things work beautifully. Ireland was among the first that introduced a “plastax”, 15 euro cents initially. Well, bag demand went down something like 80%.

SZ: But price isn’t the only thing that changes peoples’ behavior. You talk about the “Copenhagen Theory of Change”, which is more about doing the right thing for its own sake.

GW: Well, basically, sort of two broad and very much competing theories in how to evoke social change. So, one is what we somewhat glibly call the Copenhagen theory of change. So a simple observation: over half of residents in Copenhange’s bike to work. Now why in the world is that the case? First of all, it’s pretty damn cold up there in the winter so it’s night like Copenhagen is such a pleasant place to work in the dead of winter.

So why do so many people bike to work? Well, it turns out it is one of these things that has taken decades to develop but frankly, it’s this virtuous cycle, virtuous cyclists if you will but certainly virtuous cycle. Basically, initially there were a few individual bikers as there always are, right? The guys in the spandex suits and eventually it became sort of easier and cheaper in sort of all senses of the term to start biking. So more people started biking and then the first bike paths came into being and that meant you didn’t have to take extra life insurance just to be able to bike to work. Eventually, there were more bike paths and more people started biking, this virtuous cycle were individual steps leading to small social steps that again lead to more individual steps and so on.

In many ways, we see that in New York City now. When it comes to biking, Mayor Bloomberg put in something like 500 miles of bike paths in New York City. You can go up and down 5^th avenue a couple times to get to 500 miles. Pretty amazing change and yes we see many more people biking in New York City now because it turns out you can actually bike now without getting killed. Yes, it’s one thing leading to the next and that’s sort of the hopeful story of how you get from individual action, individual steps taken very often by environmentalists in, sort of, the name of public good, leading to public policy changes which then lead to ever more individual changes. You get this virtuous cycle that could potentially and sort of, I’d say in extreme form, lead from a bunch of people cycling-the environmentalists on the one end-and on the other the price on CO_2, the kind of policy that we know is necessary.

Here’s the opposing theory to this and frankly, one that economists are more inherently more comfortable with. So turns out day has only 24 hours, right? There are trade-offs. There are finite numbers of dollars going around so everyone’s budget is constrained in one way, shape or form-what economists call budget constraints. They are real. We don’t have infinite sums to spend on everything we like. We need to make decisions. We need to take individual steps sometimes that lead in one direction and not in the other. That, frankly, leads to the very real, I would say fear in a sense. It’s a personal fear of mine that frankly, individual steps of doing good won’t actually lead to more but in fact akin to a step backward to what is actually necessary.

Again 24 hours in a day, right? For example, my wife is a gynecologist. She works on few women dying in childbirth, an enormously difficult issue. She works on family planning issues, very important issues. I spend maybe three minutes a week thinking about that particular problem. She’s a better human being so she spends four minutes a week thinking about what I do for a living. But that’s about it. We all have lives or we have kids, so there are constraints.

That one thing doesn’t in fact lead to the next, but that one thing sort of sometimes is the last or only thing you do and basically you refuse the plastic bag at the checkout counter and you basically declare global warming solved for the day. You go on about your life and not worry about everything else.

That’s a real problem. I don’t know which of these theories will prevail. In fact, both of them are very valid in certain situations. The big, big question is: under which circumstances is which of these two theories going to apply? That’s question one. Of course, the second question is how do you get potential for this crowding out buyers toward this Copenhagen theory of change where basically, you have these virtuous cycles? How does the political economy work out to get from where we are today to where we need to be? And what do we need to do to make that happen?

SZ: There’s a famous experiment they did in Israel where kindergartens or it might have been preschool, I forget which. They started charging parents who were late to pick up their kids and it backfired because parents just started coming late and they figured; hey I’m paying for it, no guilt.

GW: Yes, this infamous study of basically, sort of, behavioral psychologists or behavioral economists, even, studying what happens when you start introducing fees. The story goes there was this social norm that you pick up your kid at say, 5pm in the afternoon or in the evening. While they observed that sometimes parents were late and that was a pain, so they started charging for every minute that the parent was late. Let’s say a buck a minute. What did they observe? They observed the social norm suddenly broke down. It was no longer the cast that most people picked up their kid at 5:00. And on occasion, sometimes somebody was late. What happened now was that lots of people started being late. They just paid the dollar.

When I look at this, I’m sort of two minds on it. So, yes, of course, that social norm just broke down. First of all, what that really means is you’re not charging enough. Second thing to say, frankly, is so what?

So I have a five year old and a two in a half year old. I appreciate flexibility when it comes to childcare. I would like to pay for the privilege to sometimes be flexible. In other words, on occasion, I’m not able to leave when I thought I was able to and I appreciate the extra 5, 10, 15 minutes of finishing up that one paragraph, one email, one tweet, whatever the case may be and pick up my kids late. Frankly, there are costs of that behavior so I should be paying the childcare provider for that.

In other words, really what this particular study observed was that parents appreciate flexibility. They are willing to pay for it if the cost to the daycare of keeping the kid one minute longer is in fact not covered by the fee that they’re charging. Well, they’re doing it wrong then. They should charge a higher fee. But if that’s the case, once that’s the case and you create the possibility for parents to be more flexible, show up a minute later, pay a buck a minute or whatever it was to show up a minute late, fantastic. Social welfare, social wellbeing just increased because you’re creating that added flexibility.

In other words, econ 101 once again: price goes up, demand goes down. That works. If you increase the price to infinity, if you ban late pickups, you’re not even creating the option, then yes people tend to be on time. And if you start charging for pickups that’s in fact a lower price than infinitely much, well, sometimes people appreciate the flexibility.

SZ: To me, this is also a reminder that we need to make a distinction between creating an incentive, which sounds like a cold calculation, and creating awareness or a focus like the plastic bag fee does. This is actually something we found at Ecosystem Marketplace when looking at corporate behavior in the voluntary markets, the voluntary carbon markets. We looked at companies that buy carbon offsets voluntarily, meaning not because they have to and we found that contrary to popular belief, they weren’t “buying their way out of their obligations” or using a get-out-of-jail-free card, but they were for the most part, companies that had already reduced their emission dramatically and they were using offsets exactly the way they’re supposed to. Namely, they were using them to get to zero net emissions or to create an internal price on carbon explicitly to make their divisions and managers and everybody along the line more consciously aware of the emissions.

GW: Absolutely. I would sort of call this the sort of frying pan effect, right? You whack someone over the head and they become aware of the decision to start thinking about what it takes to internalize the cost of CO₂. It’s a c-level decision. This is not something the lowly plant manager says let’s make that happen. It is of course a much broader decision with much broader reverberations throughout the company.

Then there’s a question of how do you send the right signal throughout every level of the company and frankly, pricing works beautifully that way. Microsoft is a good example of a place that has an internal cap and trade system and yes, they are offsetting their remaining emissions, not because they have to. They don’t, but because they are trying to be good corporate citizens and basically, saying we are trying to minimize our CO₂ footprint as it is. What we can’t minimize, what we can’t in fact eliminate, we are offsetting by spending tens of millions of dollars that it takes to buy voluntary offsets in order to offset our emissions completely and essentially be carbon neutral. But then there’s also while a) the question of what price do the company’s pay. That’s a big question and it turns out in fact, Microsoft is buying renewable credits which turn out to be very cheap per ton of CO₂-a buck or two. Frankly, it’s still $2 more than what most others are paying so that’s good too.

SZ: There internal price was a lot higher.

GW: Which is of course good too. All that said, even someone as big as Microsoft or even someone as big as Wal Mart, let’s say, or Apple or whoever it is, they themselves are not going to solve climate change either. You and I can’t solve it with our individual actions. Well, Microsoft and Wal Mart can’t either. Now, they are now more ready than their competitors to be facing an environment where carbon is in fact priced nationwide. Because of taking these voluntary steps makes them more likely to be advocating for a national global price on CO₂, fantastic.

Be sure to check back next week for Part 2, where we look at the factors that determine a fair and effective price on carbon, as well as the relative pluses and minuses of a carbon tax vs cap-and trade.

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