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Putting a price on carbon is a fine idea. It's not the end-all be-all.

Three reasons to temper your enthusiasm.

holy grail
A carbon tax is not this.
(Shutterstock)

What is the most important policy tool for fighting climate change? Ask just about any economist and the answer will be the same: a price on carbon emissions.

Not only is there a robust consensus among economists, but they have been remarkably successful in spreading the gospel to the wider world as well. Climate activists, wonks, funders, politicians, progressives, and even conservatives (the few who take climate seriously) all sing from the same hymnal. It has become conventional wisdom that a price on carbon is the sine qua non of serious climate policy.

But it is worth keeping carbon pricing in perspective. It has become invested with such symbolic significance that it is inspiring some unhelpful purism on policy and magical thinking on politics.

Slowing climate change will require a suite of policies, regulatory reforms, and investments. Carbon pricing will be an important part of that portfolio. But only a part. It is not the only legitimate climate policy, the one true sign of seriousness on global warming, or a substitute for the difficult and painstaking political work that will be required to transition to a sustainable energy system.

I have no interest in a carbon-pricing backlash. But maybe a sidelash — a reality check.

This post will be a two-parter. Tomorrow I'm going to get into politics, how it shapes carbon taxes, and what's to be done with the revenue.

But first, I want to take a step back. In this post, I'll have a quick look at why carbon pricing has become so central to climate economics and raise some questions about its primacy in policy and political circles.

First, a word on cap-and-trade versus carbon tax

The most straightforward form of carbon pricing is a carbon tax, which, in its simplest version, imposes a fee on every ton of carbon that enters the economy ("upstream," on fossil fuel producers and importers, as opposed to "downstream," on fossil fuel consumers).

But taxes are not the only "price-based instrument" used to control pollution. In the 1980s and '90s, a new policy called cap-and-trade started to catch on. Rather than imposing a fee, it caps the total amount of a pollutant and issues tradable permits under that (declining) cap. The market for those permits sets the price of the pollutant.

Cap-and-trade was successfully used by the Environmental Protection Agency to control, for example, the pollutants that cause acid rain. A national carbon cap-and-trade bill failed in 2010, but the policy has taken hold regionally in the Northeast, California, and numerous other places around the world.

Depending on how they are structured, the economic impacts of the two policies are equivalent. They raise the price of fossil fuels. There are interesting debates to be had about their relative merits, but that's for another post.

For now, I'm mostly going to focus on a carbon tax, because a) many of the same considerations apply to both policies; b) cap-and-trade has fallen out of favor in the US, both among conservatives, who are convinced it's secretly a tax, and liberals, who are angry it isn't a tax; and c) it's just simpler.

Why economists love carbon taxes

Ever since the early 20th century, mainstream economists have had a favorite policy for dealing with pollution. It's called a Pigouvian tax, after British economist Arthur Pigou.

The idea is simple. Sometimes markets produce negative impacts that are not accounted for in market prices. The market participants who produce the impacts do not pay for them; society absorbs the costs. (Air pollution is a good example.) These "externalities," costs external to markets, are considered a form of market failure.

The most efficient remedy for this kind of failure is to price the externality in to the market via a Pigouvian tax. A tax raises the prices of polluting products to reflect their true costs. Markets respond accordingly.

Theoretically, if the tax is set at the correct social cost of the externality, the market becomes more efficient, with better information; it inexorably finds the "right" level of pollution, based on full costs and benefits. In this way, markets, not meddling regulators, will find the economically optimal way to address pollution.

When it comes to climate change, economists have turned en masse to this familiar tool; thus the carbon tax. If carbon emissions are causing damage, the solution is to tax them at the level of that damage. The market will do the rest.

This has an undeniable logic, and has captured the wonk imagination. Many environmentalists are thrilled at the idea of a green policy that passes muster with real economists and even some conservatives.

And for various reasons (some legitimate, some deeply muddled), a carbon tax has come to be seen by the green left as a simpler, more virtuous, more authentic alternative to cap-and-trade.

But four things about the case for carbon taxes give me pause.

1) Skepticism toward activist government is baked in the cake

In the early 1990s, Bill Clinton declared that "the era of big government is over." The idea was that Democrats had abandoned their vestigial socialist tendencies, their knee-jerk preference for more regulations and more spending, and embraced the power of markets.

They would pursue liberal goals, based on liberal values, they said, but use the power of markets to keep costs down. This was an alleged "third way" between heartless conservatism and spendthrift liberalism.

This kind of thinking is sometimes referred to as "neoliberalism," tracing back to Charles Peters's original 1983 manifesto in Washington Monthly. The term has been mangled and overused lately, to the point that it probably ought to be abandoned, but it does seem to apply here.

The broader (and especially younger) left has, of late, rejected neoliberalism with great vigor. It has seen that markets are not always great at solving social problems, that market-based policies are often a veneer for steering public money into private hands, and that markets, unrestrained by vigorous progressive governance, generate huge inequalities of wealth and opportunity. That's part of what the Sanders insurgency is about.

So the new left fixation on a carbon tax is at least facially peculiar, since, it seems to me, the policy issues from classically neoliberal instincts. It is a way of achieving a social goal (less carbon) while minimizing interference in markets.

The impetus for minimizing interference is a deep-seated belief that attempts to meddle in markets via industrial policy, "command and control" regulations, and targeted spending tend to backfire, distorting the economy and slowing growth. A (politically conservative) skepticism toward activist government is baked into the neoliberal cake.

Reinforcing that skepticism is not a wise long-term strategy for climate hawks, because I can guarantee that climate change is eventually going to require activist government. No market-based policy is going to equitably resettle the residents of Miami.

Of course, it's entirely possible to support carbon taxes without buying into the larger neoliberal worldview. And, hell, maybe some climate hawks really do have that kind of faith in markets. But I get the sense that lots of carbon tax enthusiasts, especially on the left, haven't really thought through all the implications.

2) There are no free markets

Even if you accept the premise that free, competitive markets are always or almost always better at allocating resources than legislators or regulators, it's questionable just how far that gets you on energy policy.

Carbon taxes are meant to remedy one market failure: unpriced carbon emissions. But those familiar with US energy markets will attest that they are ridden with such failures. They bear virtually no resemblance to idealized neoclassical markets.

The US electricity sector, for instance, is a Rube Goldberg contraption of overlapping jurisdictions, regulated monopolies, and quasi-markets. Coal, oil, and gas are extracted from public land and transported over public right-of-ways, leaving behind an array of local pollutants. At every stage from extraction/production to transportation to consumption, all forms of energy are heavily regulated and dependent on public subsidies and public infrastructure.

In fact, there are so many market failures in energy, one almost wonders whether beginning with an idealized market and working backward through its "failures" is a fruitful way to approach policy thinking. Hmm.

Unpriced carbon is a market failure, if you want to look at it that way. But real-life markets, not just in energy but in transportation and agriculture, are failures all the way down — irrational behaviors, asymmetrical information, barriers to entry, monopoly control, and more. Then layer on top of that complicated regulatory systems, legacy policies and infrastructure, and the distorting influence of status quo interests, and you've got quite a mess.

One can look at the task ahead as painstakingly correcting an almost endless series of market failures. Or one can look at it as actively shaping and designing new markets to produce better social outcomes.

Either way, the "set it and forget it" schemes of hardcore tax advocates are a fantasy. It's a blunt-force tool. It will do wonders in some sectors (driving coal out of electricity) but very little in others (driving oil out of transportation). It will not do all the necessary work in any sector. Different markets are different; they have their own idiosyncrasies, their own failures.

Believing a single tool will accomplish everything requires seeing the economy as a frictionless machine, a spreadsheet, not what it is: a path-dependent accretion of past decisions and sunk costs, to be tweaked and unwound.

One other thing: The neoclassical model of a perfectly efficient economy depends on full employment, which hasn't been the case in the US for a very long time. Resources are being left slack, capital is cheap, and deficit spending is likely to boost growth. But when it comes to carbon and clean energy, many economists default to the knee-jerk stance that government spending is distortionary and only price-based instruments are legitimate.

3) Marginally reducing carbon emissions is one thing; mounting a high-speed Industrial Revolution is another

It is somewhat misleading to describe the goal of climate change mitigation as "reducing carbon emissions." Reducing carbon emissions is easy; lots of policies can do that.

We need to reduce emissions a lot — to zero, or close to it — as fast as possible. That's going to require more than changes at the margins. It's going to require phasing out virtually our entire installed industrial base and replacing it with new, low-carbon technologies and practices. It's going to require an explosion of innovation and building, the likes of which hasn't been seen since the Industrial Revolution — only much, much faster, constrained by a tight carbon budget.

We know price-based policies like Pigouvian taxes (and cap-and-trade programs) can efficiently generate marginal changes. Economists don't just love them because of theory; they work, especially in bounded markets where demand is elastic or substitution is cheap. The economic literature on that score is copious.

But carbon isn't just one pollutant from one product category. It's the whole economy. The whole world economy. Can price-based policies drive economy-wide energy transitions?

History doesn't seem to offer any examples. Large-scale energy transitions of the past have generally been driven by industrial policy and technology innovation; none have been driven by increases in the prices of existing energy sources. (Vaclav Smil is the go-to scholar on this.)

In a recent critical review of the new book from economist Nicholas Stern, Alex Trembath puts it nicely:

History reveals that prices and scarcity have rarely, if ever, driven large-scale energy transitions. We transitioned away from whale oil after discovering much more abundant and useful petroleum-derived kerosene, not because we were running out of whales. Electricity and the internal combustion engine emerged after decades of technological toiling and created whole new uses for energy. War, perhaps the most state-directed of all enterprises, accelerated the diffusion of several key energy technologies, most notably the internal combustion engine, jet turbines, and nuclear reactors. Today, hydraulic fracturing in shale emerged from government-funded labs and has diffused because of its usefulness in cost-effectively accessing previously hard-to-reach natural gas deposits. This is the work that governments have done since Alexander Hamilton invented industrial policy, not as a corrective to proliferating market failures, but as foundational and continuous policy to create and shape markets themselves.

Note the difference in perspective: not gingerly correcting markets, striving to return them to their edenic state of perfect efficiency, but creating and shaping markets that work better to achieve outcomes chosen (ideally) through democratic deliberation.

It has been proactive government, developing and diffusing technologies, sculpting markets through regulations and investments, that has sparked industrial shifts in the past.

Maybe we can engineer such a transition, faster than all the previous transitions, using a price-based instrument as our primary tool. But that is a very big gamble, not something we can confidently predict based on economic theory. At the very least, it seems novel and uncertain enough that we might not want to put all our eggs in that basket.

It is entirely possible to share all the reservations I describe above and still support putting a price on carbon. (I do!) It is, after all, one way of proactively shaping markets.

But it is dangerous to believe that a carbon price, or any single market-based policy, will do the work for us, rendering other efforts superfluous or unnecessary. There's a lot of messy, frustrating work ahead, involving any number of political compromises and kludged, suboptimal policies. No way around it.

Creating a whole new world is hard. Tax or no tax, our children and their children will still be working at it. And they will need every tool they can get their hands on.