Sunday, April 11, 2010

Must-read Article of the Day: Krugman on the Economics of Climate Change

Paul Krugman has an excellent primer on what environmental economics has to say about climate change and strategies to mitigate it: Building a Green Economy in NYTimes Magazine:

In what follows, I will offer a brief survey of the economics of climate change or, more precisely, the economics of lessening climate change. I’ll try to lay out the areas of broad agreement as well as those that remain in major dispute.

Here's an excerpt from the section on Pigouvian tax (and its cousin -- the Cap and Trade) to soften the impact of 'negative externalities' -- "costs that economic actors impose on others without paying a price for their actions":

... What Pigou enunciated was a principle: economic activities that impose unrequited costs on other people should not always be banned, but they should be discouraged. And the right way to curb an activity, in most cases, is to put a price on it. So Pigou proposed that people who generate negative externalities should have to pay a fee reflecting the costs they impose on others — what has come to be known as a Pigovian tax. The simplest version of a Pigovian tax is an effluent fee: anyone who dumps pollutants into a river, or emits them into the air, must pay a sum proportional to the amount dumped.

Pigou’s analysis lay mostly fallow for almost half a century, as economists spent their time grappling with issues that seemed more pressing, like the Great Depression. But with the rise of environmental regulation, economists dusted off Pigou and began pressing for a “market-based” approach that gives the private sector an incentive, via prices, to limit pollution, as opposed to a “command and control” fix that issues specific instructions in the form of regulations.

The initial reaction by many environmental activists to this idea was hostile, largely on moral grounds. Pollution, they felt, should be treated like a crime rather than something you have the right to do as long as you pay enough money. Moral concerns aside, there was also considerable skepticism about whether market incentives would actually be successful in reducing pollution. Even today, Pigovian taxes as originally envisaged are relatively rare. The most successful example I’ve been able to find is a Dutch tax on discharges of water containing organic materials.

What has caught on instead is a variant that most economists consider more or less equivalent: a system of tradable emissions permits, a k a cap and trade. In this model, a limited number of licenses to emit a specified pollutant, like sulfur dioxide, are issued. A business that wants to create more pollution than it is licensed for can go out and buy additional licenses from other parties; a firm that has more licenses than it intends to use can sell its surplus. This gives everyone an incentive to reduce pollution, because buyers would not have to acquire as many licenses if they can cut back on their emissions, and sellers can unload more licenses if they do the same. In fact, economically, a cap-and-trade system produces the same incentives to reduce pollution as a Pigovian tax, with the price of licenses effectively serving as a tax on pollution.