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You can't conduct an orchestra with an invisible hand: The problem with carbon taxes

Jason D Scorse agrees with the Reason article arguing that the way to phase out fossil fuels is to tax them -- to make their price reflect some or all of their social costs (referred to by economists as "Pigovian" tax). Fossil fuels will become more expensive, low-carbon technology will become competitive, and everybody will do the "happy happy joy joy" dance.

Unfortunately, a strategy based mainly on price increases will work ineffectively, if at all -- a position for which we have both historical evidence and good theoretical grounding. (This is not to say that Pigovian taxes have no place, but as a supplementary measure, not a primary one.)

Historically, large-scale infrastructure changes take place only via hands-on government involvement -- involvement that not only subsidizes technology but helps shape its deployment. This can consist of public works, or grants of land and rights of way that help shape where infrastructure is placed. You can find examples in List 1 at the bottom of this post, ranging from canals and railroads to the internet.

J.S. cites Synfuels and the original Apollo project as counter-examples. I note that both these involved "picking winners," not deploying mature technologies. List 2 at the bottom of this post offers examples of mature technologies we could subsidize and deploy through a combination of public works, subsidies, and regulations, ranging from railways to insulation to solar water heaters.

What's wrong with price signals as the primary mechanism to induce change? In economic terms, certain kinds of energy infrastructure tend to have low long-term elasticities (PDF). In English, that means large price increases result in small reductions in energy use.

For example, price increases that produced (among other things) much greater levels of insulation would cost consumers more than a simple public works program that raised taxes and used the revenue to pay for insulation upgrades (among other things). That, basically, is the meaning of inelasticity -- that prices must rise a great deal more than the cost of the behavior we are trying to change.

There have been a great many elasticity studies, which come to widely varying conclusions. But those that show low elasticities conflate source substitution (e.g., natural gas for coal) with capital substitution (e.g., insulation for natural gas). The study linked above is one of the few to separate the two kinds of elasticity.

Fossil fuels have inelasticities of ~20%, when substitutes considered include other fossil fuels or biofuels. When one takes into consideration uncertainty and the capital and transaction costs of switching, that really is extremely low. The main market failure there really is social costs, for which price increases are a reasonable remedy.

But efficiency measures substitute capital costs for operations. You are making long term investments to reduce an operating loss. And there, you have an inelasticity of around 60%. That means doubling the price of energy only reduces use by around 40%.

This a huge problem if you want to reduce carbon at the lowest price. As has been extensively documented by the Rocky Mountain Institute, and touched on by me in a previous post, efficiency is essential if you don't want to greatly increase the percentage of the GDP energy consumes. Relying primarily on price signals will bias any change toward sources over efficiency, and toward biofuels over more capital-intensive sources (like wind, which is cost competitive with natural gas and "clean" coal up to a limit we are not anywhere near).

Again, this doesn't mean we don't need carbon prices in addition to regulations and public works. But it means carbon pricing needs to be supplementary rather than primary, and (I would argue) to begin a few years after major infrastructure work begins.

Why the high inelasticity between capital and operating costs? The macro answer is that price signals tend to produce local and short-term optimizations. Optimizing individual components of a system in isolation tends, as Amory Lovins puts it, to "pessimize" the system as a whole. It is difficult to conduct an orchestra with an invisible hand.

On the micro and smaller-scale macro levels this takes a number of documentable forms:

  1. Split incentives: These include obvious split incentives, like insulation in rental apartments, but also differential access to capital. Consumers and various industrial sectors pay differing prices for capital, but they also have varying alternative uses for it. For example, even if you offer a homeowner a low-interest loan for insulation or solar upgrades, she still may want to avoid using up so much of her credit in case she needs it for emergencies or job loss.
  2. Still more split incentives: You can't overlook split incentives in firms. Cost accounting evolved under circumstances in which direct labor was the overwhelming cost driver. As other costs play an ever-increasing role in industry the trend is toward ABC accounting, which seeks more appropriate drivers than labor to allocate these costs. However, flow costs -- energy, water, in some cases even raw materials -- are often allocated in proportion to labor or departmental drivers. That means the person in a position to make decisions that save energy will often see the savings allocated to other departments or divisions.
  3. Noise: When we talk about "markets setting prices" we are making a necessary simplification. You have to remember that there is a price giver and a price taker. That is, someone offers a good or service at a price they think the market will bear, and someone else decides whether to pay the price. Other factors in a purchase will affect a decision more than energy efficiency.

    Think about buying a home. Good insulation is better than poor insulation. But if you are selecting between two otherwise good houses, are you going to select the one with a poor location but good insulation over the one with a good location but poor insulation? What if the problem is layout rather than location? Seldom are two homes identical, and most factors that distinguish them will outweigh insulation.

    Now, this is not completely true. Builders can get a "green building" premium on the upper end. But you will note that most green homes (excluding owner-built) are in one of two sectors: upper-end or subsidized. You don't see a lot of ordinary, unsubsidized, middle-class housing with extensive green features. Home builders aren't confident they can recover the price of such changes in a mass market, even though there's little doubt such features would pay for themselves over the life of a 15-30 year mortgage.

  4. Chicken/egg situations come in two types:
    • Solar photovoltaic power is an example of the first type. We've known how to make reasonably inexpensive solar cells for some time. The problem is that because they are currently so expensive, the market for them is limited. Because the market is limited, no one wants to risk investing in a big enough factory to take full advantage of the economies of scale in mass production. One proposal to overcome this was made by a consultant to Greenpeace back in 1999 (PDF): invest about a billion (in today's dollars) in two factories, one to produce silicon cells on a large scale, the other to produce silicon on a large scale, so the solar industry is not dependent on computer waste for raw materials. That probably would have lowered the price of solar cells to the point of power at 5 or 10 cents per kWh. Once the market was established, other players could come in with higher quality and lower prices and crush the early adopter - probably with better technology such as thin film. In effect, government intervention would produce a sacrificial lamb to break the deadlock.
    • CyberTran, described in an earlier post, is an example of the second type. It is not a fully mature technology, but it is as mature as a technology can be without real-life test deployment. It has had full-sized, fully functional working models, quarter-sized working models, and massive multiple simulations that answer every objection that's come up. But we will only know for sure that it works when someone deploys -- in other words, when we have publicly funded beta test. If the test is successful, it will be a proven technology and should be part of massive infrastructure funding. Other PRT systems would be candidates for similar tests.

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List 1: Historical infrastructure that required extensive U.S. government non-market involvement:

  • Canals
  • Railroads
  • Electric power plants and lines
  • Gas and oil pipelines
  • Water and sewer
  • Telephone lines
  • Rights of way for the internet backbone and cable television

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List 2: mature technologies that could be implemented with a combination of regulation, public works, and public subsidies:

  1. Require every new residential building to reduce climate control energy by 90% or more compared to current average in its region. Similarly require every new commercial building to reduce total climate control, lighting, and office equipment consumption by 70% compared to the current average. "Passivhaus" construction has demonstrated that this is a conservative number for residences. (Many passive and green buildings have exceeded this by a fairly large margin.)
  2. Require existing commercial buildings to meet the same standards within 20 years -- commercial buildings typically require a major rehab over time, and can easily fit in new efficiency measures as they replace windows and compressors.
  3. An efficiency upgrade for all existing residential buildings that need them (i.e., most of them). This would include insulation and reduction of air-exchange losses (being careful not to seal any existing building so well as to cause sick building syndrome). It would also include free shutters, insulated curtains, or some other way to reduce window losses until replacement.
  4. Efficiency requirements for new windows, so that all window replacements were of a fairly high standard.
  5. Higher efficiency standards for all appliances. I would use the Japanese dynamic scoring method: you look at the most efficient appliance of a particular type on the market for which the additional price is worth the savings. If it beats existing standards, that becomes the minimum standard for all new appliances the following year. You determine whether the savings is worth the cost increase by whatever value you have assigned carbon.
  6. Installation of water efficiency measures in all buildings (new and existing): low flow toilets, water heads that gave you choice of reduced flow, sink aerators, foot-pedal controls for kitchen sinks, on-demand water heaters to supplement the solar heaters listed below.
  7. Solar space- and water-heating for existing buildings, supplying at least 65% of demand. If district heating or natural zeolite storage happens to prove itself, this could be upgraded to 90% or better. For commercial buildings, solar chillers could be added. These would be phased in as existing heaters and chillers needed replacement.
  8. Efficiency requirements for new automobiles strong enough to make PHEV the de facto minimum standard for full-size cars. However, automakers would be free to meet the standards in other ways -- with fully electric cars, Lovins' Hypercars, or just very small cars.
  9. A massive increase in heavy rail infrastructure for freight -- track, locomotives, freight yards, switch yards -- whatever is required to allow freight rail to massively displace long-distance freight trucking.
  10. Utilization of organic waste to build and fertilize soil for agriculture, as a source of fiber to displace other raw materials, and as an energy source. At some point there will be a post on this.
  11. A massive increase in wind deployment where it can be done for 4 cents per kWh or less, up to the point where it supplies around 20% of the grid (or whatever portion of the grid it can supply without compromising stability and reliability).
  12. Require industry to gradually (over the course of 20 years) upgrade equipment to Best Available Technology in terms of energy efficiency for the 100 types of equipment and processes responsible for the highest proportion of energy consumption. At some point, there will be posts on this. For instance, there are widely known techniques for increasing efficiency in pumps and motors. Other examples include waste reduction in compressed air plants, increases in insulation of furnaces, ovens, kilns, and other refractories, and reduction of excess thermal mass and air space in those same refractories. There is also tremendous room for boiler improvements.
Editorial Notes: Gar Lipow has started writing an interesting series of articles on energy at Gristmill. About himself, he writes:
As a long time environmental activist and sometime journalist with a strong technical background I've spent years immersed in the subject of efficiency and renewable energy.
He has a book proposal online: Cooling It! No Hair Shirt Solutions to Global Warming. Some other articles by Lipow (not as technical as this one): Concentrating solar thermal Wind, sun, storage, and efficiency Freight trains: 19th century technology due for a 21st century revival CyberTran: Ultra-light rail for cities and suburbs -BA

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