The tax that might just save the world

24th May, 2008

The Financial Times has been calling for a credible price to be put on carbon emissions, either through a carbon tax or a serious cap-and-trade scheme. Most economists – including this one – would agree.

The textbook argument is that putting a price on carbon would raise the cost of everything we consume that contributes to carbon dioxide emissions. The result would be that consumers and businesses would waste less energy and would switch to lower-carbon alternatives, while businesses would develop new low-carbon technology.

That is all fine in theory.

In practice, would it happen? It’s important to find out. For one thing, politicians remain unconvinced, often insisting – probably because of political cowardice – that consumers do not respond to such taxes.

And there are other reasons beside politicians’ feebleness to indicate that a carbon tax might not be as effective as economists would hope.

Behavioural economists have shown that we sometimes procrastinate. This could be a real problem: a carbon tax could make it rational to install double-glazing, insulate the loft and buy an energy-efficient fridge. Yet as frail human beings, we might put off all of those rational investments, perhaps indefinitely. Or we might waste energy because we are ignorant of our energy-saving options. (How much money, for instance, could you save, each year, by buying a more efficient fridge? I haven’t a clue.)

Perhaps businesses are more rational, but even there, a carbon tax is not guaranteed to inspire the kind of carbon-saving innovation we need. The problem is the vagaries of innovation: not all spending on new ideas produces a patent, and not all patents produce profits – even if society as a whole stands to gain.

That’s why textbook assumptions can’t be waved through without question. We need some evidence as to what consumers and businesses would actually do if faced with a carbon tax. The main evidence comes from analogies with previous energy price spikes or regulatory efforts.

David Popp, an economist at Syracuse University, used patent data to evaluate the response to the energy crisis of the 1970s. He found some cause for optimism: as oil prices rose and rose, more and more energy-saving patents were applied for (and eventually approved) in every field from heat exchangers to solar panels. The process wasn’t automatic, and patent applications seemed to peter out before oil prices reached a maximum – perhaps all the obvious ideas had been applied for. But Popp’s analysis suggests that high prices do inspire an innovative reaction.

So too does research by Suzi Kerr of Motu, a New Zealand think-tank, and Richard Newell, of Duke University. They looked at the response to gradually more rigorous standards on the lead content of petrol in the US. Refineries brought in the latest technology as the standards tightened, and appeared to be rational about the timing of their investments.

Even Joe Public, the regular consumer, is not as stupid as he seems. One study, by Alexander Brill, Kevin Hassett and Gilbert Metcalf, asked whether ignorance might explain our unwillingness to invest in energy-saving home improvements. It seems not: more educated consumers make the same decisions as less educated ones. But the return on such improvements is closely correlated with consumers’ willingness to make them.

Metcalf is convinced that any sustained rise in the price of carbon emissions would be rewarded with lower pollution. In the long run, simple energy saving should trim energy demand by 3 to 5 per cent for each 10 per cent rise in the price of energy. That is a worst-case scenario, ignoring the possibility of technological improvements and switching to low- or no-carbon fuels.

The textbooks seem to be at least partially right. To find out for sure, all we need is some backbone in our politicians.

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