The Creative Destruction of Climate Economics

In the 70 years that have passed since Joseph Schumpeter coined the term "creative destruction," economists have struggled awkwardly with how to think about growth and innovation. Born of the low-growth agricultural economies of 18th century Europe, the dismal science to this day remains focused on the question of how to most efficiently distribute scarce resources, not on how to create new ones -- this despite two centuries of rapid economic growth driven by disruptive technologies, from the steam engine to electricity to the Internet.

There are some important, if qualified, exceptions. Sixty years ago, Nobelist Robert Solow and colleagues calculated that more than 80 percent of long-term growth derives from technological change. But neither Solow nor most other economists offered much explanation beyond that. Technological change was, in the words of one of Solow's contemporaries, "manna from heaven."

Climate economics until recently was similarly oriented. Economists mostly treated global warming as a challenge of distributing scarce resources (e.g., the right to pollute), not of creating new ones (e.g., cheap zero carbon energy sources). Climate models treated technological innovation as a given, not as a dependent variable.

That's starting to change. Over the last few years, economists have modeled ways to accelerate the innovation of zero carbon power sources. The boldest of these entries to date comes from one of the discipline's rising stars, MIT's Daron Acemoglu, along with Philippe Aghion, Leonardo Bursztyn and David Hemous, in a paper published last February in American Economic Review. The paper argues that conventional climate models have overstated the importance of carbon pricing and understated the importance of public investment to encourage technological innovation.

The Economist's Ryan Avent praised the paper, noting, "economics is clearly moving beyond the carbon-tax-alone position on climate change, which is a good thing." In fact, Acemoglu and his colleagues went further than Avent suggested. "Optimal policy," they found, "relies less on a carbon tax, and even more so on a direct encouragement of clean energy technologies."

This technological turn within the economics profession comes at a time of three big events in the energy sector.

First, more than thirty years of government funding for unconventional gas research, demonstration, and tax credits have contributed to a glut of cheap natural gas, making everything from solar to wind to nuclear uncompetitive, at least in the near-term, while also driving America's shift from coal to gas.

Second, the tripling of public and private sector investment in clean tech over the last five years has resulted in the price of solar panels declining by 75 percent and wind turbines by 25 percent, after no price declines in the prior five year period.

Third, carbon pricing, which many analysts and policy makers believed would be the central mechanism through which nations reduced emissions, has had no measurable impact. If Europe's Emissions Trading Scheme (ETS) has had any impact on the continent's emissions, it has been too small to measure with any certainty against falling energy consumption during the recession and large direct subsidies for renewables. Today, the ETS is being used to justify Europe's reversion to coal.

All of this has sent those who believe carbon pricing should be the highest climate policy priority scrambling. Harvard economist and former Environmental Defense Fund (EDF) Chief Economist Robert Stavins claims that the low carbon prices of the ETS, and its little sister cap and trade system in the US Northeast, known as RGGI, prove not that they're failing but rather that they are working as planned. The economist Charles Komanoff insists that a carbon tax would not suffer from the same problems as the ETS. And Paul Krugman asserts that a carbon price is still the most important climate policy because... well, because he's Paul Krugman and he says so.

One of the most detailed defenses of a carbon pricing-focused response to climate change comes from the economist Gernot Wagner of EDF, who in a debate with us at Breakthrough Journal credits pricing for the phase-out of leaded gasoline, and for the control of acid rain-causing sulfur dioxide pollution.

But history tells a very different story. In the case of leaded gasoline, eighty percent of the phase-out of leaded gas had already occurred before the establishment of a trading system, due to the ban on the sale of cars that could run on leaded gasoline after 1975, along with local air pollution rules. And the lower-than-expected cost of sulfur dioxide regulation mostly resulted from technological changes that occurred well before the establishment of pollution trading: rail deregulation allowed for the economic shipment of low-sulfur coal, and the development of cheaper scrubbers.

In the end, Wagner implicitly concedes our point, writing, "Yes, acid rain was mostly about deployment--which is/was my point." In fact, that wasn't his point. Wagner's point was that it was the market-based pollution trading mechanism (again: the efficient allocation of a scarce resource) that resulted in the lower costs.

"Similarly," Wagner writes, "we can achieve US emissions reduction goals for 2020 and possibly even 2030 through deployment of existing technologies."

But US emissions are today declining not because of cap and trade -- it died in the Senate two years ago -- but because we are awash in natural gas. And we are awash in gas neither because of caps nor taxes nor regs but because of a government technology push started by Presidents Ford and Carter.

Out of real-world evidence, Wagner falls back on economic theory. "[C]arbon is a pollutant; we need make polluters pay... Price goes up, demand goes down. Economists typically call it the 'law of demand'--one of the very few laws we've got."

But no exceptions to the law of demand are required to acknowledge that it is the pace and scale of innovation, not the efficient allocation of existing emissions mitigation options, which will most determine the overall cost of mitigating and adapting to climate change.

In the end, Gernot summed up our disagreement well:

It is, in fact, economics 101 that tells us to cap or tax pollution. It's economics 102 that teaches us about the process of technical progress, a place where Breakthrough could serve a very useful purpose. Denying economics 101 while trying to make an economics 102 point, though, isn't the way to go.

But when economics 101 was created in the 18th Century, there were one billion humans on the planet, mostly living on farms, using animals, wood, and dung for energy -- about 20 exajoules of it a year. Today, there are seven billion humans, mostly living in cities using electricity and liquid fuels, consuming 430 exajoules of energy annually.

Over the next century, global energy demand will double, and perhaps triple. But even were energy consumption to stay flat, significantly reducing emissions from today's levels will require the creation of disruptive new technologies. It's a task for which a doctrine focused on the efficient allocation of scarce resources could hardly be more ill-suited.