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Rossi-Hansberg on the effects of a carbon tax

I was inspired to think again about climate economics from Esteban Rossi-Habnsberg's excellent presentation at the  Hoover Economic Policy Working Group. Link here in case the above embed does not work. Paper here, (with Jose Luis Cruz Alvarez), slides here. Previous introductory post here. There is a lot in this paper and presentation, and I'm going to ...

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I was inspired to think again about climate economics from Esteban Rossi-Habnsberg's excellent presentation at the  Hoover Economic Policy Working Group. Link here in case the above embed does not work. Paper here, (with Jose Luis Cruz Alvarez), slides here. Previous introductory post here. 

There is a lot in this paper and presentation, and I'm going to try to stick to one topic per post. 

Like most economists, my knee jerk reaction to climate change is "carbon tax." In particular, a carbon tax instead of extensive regulation. Given that we're going to have a climate policy that discourages carbon emissions, a uniform price on carbon emissions is the only sensible and effective way to do it. (Whether tax, tradeable rights, or other mechanism doesn't matter for this purpose.) I would add remove barriers to alternatives, such as nuclear power, and a healthy expenditure on basic science of alternatives. 

With that in mind, I was stunned by these graphs:

Rossi-Hansberg on the effects of a carbon tax
Rossi-Hansberg on the effects of a carbon tax

Carbon taxes do not stop climate change. They just postpone it. They do postpone it substantially. In the bottom graph, we get 4 degrees rather than 6 by 2100. But still, we're at the same place by 2300. 

Rossi-Hansberg on the effects of a carbon tax

Here are the GDP effects. (In this model, warming does hurt GDP, quite a lot, which I will return to in the next blog post.) Cutting out carbon costs a lot of GDP now, in return for mild increases later. 
At impact, the implementation of a uniform proportional carbon tax reduces the use of fossil fuels, which makes energy more expensive overall, and thus reduces income and welfare...initially, carbon taxes reduce firm innovation since potential current profits decline, and therefore reduce the growth rate of the economy. Of course, as time evolves, the flattening of the temperature curve has beneficial effects on amenities and productivities, leading to higher real income and welfare, as well as higher growth rates. Eventually, the curves in Figure 19 cross one, meaning that the implementation of the carbon tax is, on average, beneficial after that period. In the long-run, real GDP and welfare keep increasing due to a larger global population.
Since there is no long-run benefit to the climate, the only long run benefit flows through their assumptions on population size. Endogenous fertility is something we know very little about, so I would not put too much weight on costs and benefits of carbon policy that work through encouraging larger fertility, and I'm not sure climate advocates regard larger population as an unalloyed benefit. 

For standard cost-benefit analysis, using currently popular very low discount rates, that fact really cuts down the benefits. 
we chose a baseline discount factor of β = 0.965. For this value, carbon taxes are not desirable today....However, if we increase the discount factor to β=0.969, a carbon tax of 200% or more maximizes welfare and real GDP. This large sensitivity of the optimal carbon tax is natural given the path shown in Figure 19 and cautions us not to rely too heavily on PDV statistics that dependent specific values of the discount factor.  
If you think that global warming is a "crisis," an "existential threat," the prelude to the end of civilization or life on earth, such a postponement is not worth much at all. "Let's postpone climate change" doesn't really get the young activists out to the barricades, does it? 

Unlike many black-box climate models, the intuition here is straightforward and compelling, in the "why didn't I think of that?" sort of way. We sit on a pool of fossil fuels, which cost more and more to drain.

Rossi-Hansberg on the effects of a carbon tax
(Actually, I think this is mostly coal.) We can use fossil or "clean" energy, which are good but imperfect substitutes. This is an important point. The time of day and weather sensitivity of "clean" energy, means that for the moment we still need fossil backup. Completely substituting away from fossil fuels is harder than using a little bit. There are also uses for which fossil fuels are much harder to substitute. Airplanes, for example, are a lot harder to electrify than cars, since batteries are heavy. Shooting billionaires into space will be hard to electrify. Don't forget fossil fuels and other carbon emissions of making windmills, electric cars, and biomass. 

Thus, we use fossil fuels, they get more expensive, and we start to substitute to clean energy. The more expensive the fossil fuels, the more we substitute, but we always keep using them a little bit until we have used up all the fossil fuels. (Their meteorological model apparently does not remove carbon that quickly, because that is one mechanism by which postponement would lower overall quantity.) 

In this mechanism, a carbon tax just makes extraction more expensive. We use less energy overall, contributing to the short term decline in GDP, and substitute more to "clean" sources. But we still drain the pool. 

You may say, this proves those silly economists were wrong all along, damn the carbon tax bring out the regulations. But this point holds equally no matter the mechanism. If regulators (and now central banks) achieve the same substitution out of fossil fuels via mandates, regulation, de-funding, and so on, the amounts burned and GDP effects are the same. We just hide the costs and do it much less efficiently; burning fossil fuels in economically less valuable but politically privileged activities and substituting away from them in extremely costly other activities. The carbon tax still dominates regulations, by doing the same thing more efficiently, burning the carbon we do burn in places where it does the most good. 

So, really, this graph is a damning indictment of all anti-carbon policy. 

How can we undo it? Where are the hidden assumptions? Fortunately, they are not hidden! 

The first central assumption is the substitution elasticity between carbon emitting and clean energy, set here at 1.6. That's quite elastic, but not infinitely so.  

Rossi-Hansberg on the effects of a carbon tax

with epsilon = 1.6. 

The standard vision in policy discussions assumes infinite substitutability. As soon as the cost of clean energy is lower than the cost of carbon-emitting energy, everyone substitutes completely to the latter and the oil and coal stay in the ground. This is the key question. What the graphs make clear is that the majority of carbon must stay in the ground (or go back there) if we want to avoid a large temperature rise. (Again, I do not quibble with the climate side of the models here. Whether the large temperature rise actually hurts GDP is a separate issue, which I'll return to in the next post.) But as long as the elasticity of substitution is finite, as here, then the carbon comes out of the ground. As you use less and less, the remaining uses become more and more valuable, so it's worth it, privately and to society, to keep using it although at lower scale. 

So I learn from this that a key focus for R&D is not so much on lowering the cost of alternatives, but increasing their substitutability for fossil fuels. Just because the cost of solar cells is plummeting does us little good. We need to increase their substitutability.  This consideration once again points to nuclear and carbon capture and storage as really important technologies. We're really talking about how to replace coal-fired base-load electric plants in parts of the world that badly need electricity. Nuclear and capture and storage, though they might not be the least expensive, seem to offer much better substitutability options.   That both are forbidden topics in climate debates is sad. 

This thought emphasizes a point that Bjorn Lomborg hammered away on in many different ways during a previous presentation. Simply making carbon more expensive will not work.  
The second assumption is this static cost curve. Again, I won't dig into the sources, but you see the obvious objection. Fracking. There has been a lot of technical change in fossil fuel extraction. I see more of that in oil than coal, but it has been true in coal too. (I went back a few years ago to the coal mine exhibit in the Museum of Science and Industry in Chicago, a childhood favorite, and the tour leader explained that this is really now an exhibit of coal mining history -- nothing is done this way anymore, rather by machines 10 times the size. Recommended before they take it out in the name of climate.) 

Rossi-Hansberg on the effects of a carbon tax

Here is the real price of oil. Not much trend. Innovation that reduces costs can reduce fossil fuel costs as well as reduce the cost of alternatives. 

On to the big question, how much is the GDP cost of climate change... 

John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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