July 22, 2010
Economic Doctrines and Climate Change
Last week, the Information Technology and Innovation Foundation (ITIF) released an important new report that explores the ideological origins of different policy responses to climate change, and helps clarify why there has been a lack of consensus (and lack of progress), on tackling climate change or nearly two decades.
The report, "Economic Doctrines and Approaches to Climate Change Policy," examines three competing economic doctrines--neoclassical economics, neo-Keynesian economics, and innovation economics--and describes how the doctrines shape different policy responses to climate change.
Neoclassical economics emphasizes the need to get prices right, and has provided the intellectual basis for the dominance of carbon pricing as a solution to reducing carbon emissions. Neo-Keynesian economics is most concerned with managing the demand for goods and services, and has led to clean energy policies that seek to boost the demand for low-carbon sources of energy, including regulations and mandates like renewable portfolio standards. Innovation economics recognizes the limitations of both pricing and regulation to drive the adoption of clean energy technologies, and argues that dramatic innovation is needed to reduce the cost and improve the performance of clean energy technologies before they can be adopted around the world at a scale that can significantly impact carbon emissions. Innovation economics therefore concerns itself not only with prices but also with developing and strengthening the institutions and public-private collaborations that drive technological transformation.
The full report is well worth the read, and can be accessed here.
In the last two years, we've seen the collapse of two distinct but related paradigms: the Pollution Paradigm and the Neoclassical Pricing Paradigm.
The Pollution Paradigm to the idea that global warming is the same as other conventional pollution problems, and that therefore the solutions to climate change will be the same as with prior pollution problems. The Neoclassical Pricing Paradigm is the idea that if we want to discourage the use or production of something, we can just put a high price on it or tax it out of existence.
Cap and trade, which is the most common climate policy mechanism around today, is the love child of the Pollution Paradigm and the Pricing Paradigm, with the cap ostensibly serving as an overall limit to carbon pollution and the trading element creating a price for carbon emissions.
Today, climate policy, informed by these two paradigms, is everywhere in collapse.
At the global level, the collapse of the Copenhagen climate negotiations spelled the end of the idea that we will ever have a comprehensive global agreement centered on reducing pollution. It was also the end of the fantasy held by many neoclassical economists, that we will have a harmonized global carbon price, which is required for maximizing "allocative" efficiency.
In the United States, the failure of cap and trade for the fourth time in ten years, as well as similar failures of carbon pricing policies in Australia, France, and elsewhere, laid bare the political problems with conventional climate and energy policy based primarily around increasing the cost of dirty energy.
Both the Pollution Paradigm and the Pricing Paradigm were successfully applied to earlier environmental issues. In the 1970s the United States passed the Clean Air Act and the Clean Water Act, which were successful in curbing harmful pollutants. At the international level, the Montreal Protocol succeeded in getting countries to restrict the use of ozone-depleting chemicals. Montreal became a model for the Kyoto framework to reduce carbon emissions.
Cap and trade was successfully applied to the problem of acid rain in the United States and helped meet pollution reduction goals at a low cost.
In each of these cases, however, the common mechanism that made both policies successful was that cheap and reliable replacement technologies existed prior to the policy taking effect. In the case of CFCs, low-cost alternatives to ozone depleting chemicals were invented before the Montreal Protocol was enacted. Acid rain legislation regulated a single pollutant emitted by a relatively small number of power plants, and inexpensive smokestack scrubbers, as well as low-sulfur coal from Wyoming enabled the cap and trade system to operate at relatively low cost.
But the issue of climate change mitigation is orders of magnitude more complex and much larger than acid rain. Let's just look at the numbers. In 2007, humans consumed roughly 15 TW of energy. This number is likely to double or even triple over then next 50 years, and the bulk of his new demand will come from the developing world. Virtually all of that new energy will have to be low-carbon.
To give a sense of scale, providing 20 TW of energy would require building the equivalent of 20,000 new 1GW nuclear reactors, or a new reactor every day for the next 50 years.
The enormous disparity in the scale and complexity of the climate change problem in relation to acid rain should dispel the notion espoused by people like Paul Krugman that "the logic of how to respond to global warming is much the same."
In reality, we don't have low-cost and effective substitutes for fossil fuels the way we did for CFCs and acid rain. And this is why conventional climate policy fails the "reality test." Without low-cost clean energy substitutes, the cost of reducing emissions will be prohibitively high.
This fact has led to an incoherent climate policy. Policymakers at once view a high price on fossil fuels as the main mechanism for mitigating climate change, and at the same time seek ways to make sure that the price of fossil fuels remains low.
This is why you don't actually get a firm cap, you get a cap shot through with loopholes like carbon offsets, over-allocation of allowances, borrowing from the future, and other accounting tricks that, by design, constrain the cost of the policy. Cap and trade in theory is really visor-and-trade in practice.
Conventional climate policy misclassifies the task of mitigating climate change as an "allocation" problem. According to the theory, once the carbon price is set, opportunities to emit carbon dioxide will be allocated efficiently throughout the economy, returning the economy to an optimal equilibrium.
In reality, mitigating climate change is an innovation challenge. Dramatically reducing carbon emissions will require that new, reliable, and cost-effective clean energy technologies be developed and widely commercialized.
Unfortunately, conventional climate policy is not optimized to drive innovation.
Both neoclassical and neo-Keynesian policies, such as carbon pricing and renewable portfolio standards will, by design, favor the least-cost and most mature clean energy technologies, while stranding higher-cost technologies that, while currently less mature, may show more promise in becoming less expensive over the long-term.
So where do we go from here?
Innovation Economics points us in the right direction. Politically, we can't rely on increasing the price of fossil fuels, and even if we could, many other market failures and infrastructure hurdles prevent the large-scale commercialization of innovative new technologies. We can't subsidize higher-cost clean energy technologies in perpetuity, particularly as they become larger shares of the electricity mix. Countries in the developing world will be particularly loathe to do either of these things.
Rather, we need to focus on making clean energy technologies cheaper in real, unsubsidized terms. We need fundamental breakthroughs in areas like solar panels, advanced biofuels, and batteries, to improve performance and reduce cost. And that means we need a technology-focused innovation policy.