Energy Economics Archives - An Economic View of the Environment

The Future of U.S. Carbon-Pricing Policy

In 2007, I was asked by the leaders of the Brookings Institution’s Hamilton Project to write a paper describing a national emissions trading system to reduce U.S. carbon dioxide (CO₂) emissions to help address the threat of global climate change. I responded that I would prefer to write broadly about carbon-pricing instruments, including what I considered to be the symmetric instruments of a carbon tax and a carbon trading program. But the Hamilton Project leaders said no, they would find someone else to write about carbon taxes (which turned out to be Gib Metcalf), and they wanted me to “make the strongest case possible for” what is today called a cap-and-trade system. I did my best, and in the process I came to be identified – and to some degree may have become – an advocate for CO₂ cap-and-trade. For better or for worse, during the Obama administration transition, the design recommendations in my Hamilton Project paper became one of the starting points for efforts to structure the administration’s proposed CO₂ cap-and-trade system that became part of the failed Waxman-Markey legislation, H.R. 2454, the American Clean Energy and Security Act of 2009.

More than a decade later, I have written a new paper in which I seek to approach this question as I wished to in the first place, treating both instruments in a balanced manner, examining their merits and challenges, without necessarily favoring one or the other. On May 16, 2019, I presented this new paper at the National Bureau of Economic Research’s first annual Environmental and Energy Policy and the Economy Conference, held at the National Press Club in Washington, D.C. My topic was, “The Future of U.S. Carbon-Pricing Policy.” (It will be forthcoming in Environmental and Energy Policy and the Economy, volume 1, edited by Matthew Kotchen, James Stock, and Catherine Wolfram, published by the University of Chicago Press.) In today’s blog essay, I provide a very brief summary of the paper, based upon the presentation I made at the NBER conference. I hope you will find this of sufficient interest to download and read the complete paper.

Premises, Questions, and Conclusions

I began this research with two major premises: first, that economists and most other policy analysts agree that carbon-pricing will likely be a necessary (although not sufficient) part of any meaningful, long term U.S. climate change policy, because of: (1) feasibility – the necessity of affecting millions, indeed hundreds of millions, of decentralized decisions; (2) cost-effectiveness, given the tremendous heterogeneity of marginal abatement costs; and (3) the importance of providing incentives for carbon-friendly technological change. My second premise was that there is much less agreement among economists (and other policy analysts) regarding the choice of specific carbon-pricing policy instrument – carbon tax or cap-and-trade.

This prompts two questions: (1) how do the two major approaches to carbon pricing compare on relevant dimensions, including but not limited to efficiency, cost-effectiveness, and distributional equity? (2) Which approach is more likely to be adopted in the future in the United States?

Having carried out an exhaustive examination, two major conclusions stand out (among others). First, that the specific designs of carbon taxes and cap-and-trade are more consequential than the choice between the two instruments. And second, that political feasibility affects the normative merits of the two instruments, and vice versa.

Similarities & Symmetries

Of fourteen separate issues I examine, some appear at first to be key differences (in theory), but many of these differences fade on closer inspection, and depend on specifics of design.

First of all, carbon taxes and commensurate cap-and-trade turn out to be perfectly equivalent in regard to: (a) incentives for emission reduction (both can be upstream on the carbon content of fossil fuels); (b) aggregate abatement costs (both can be cost-effective, both provide the same incentives for technological change, and both can utilize offsets to further lower aggregate abatement costs); and (c) effects on competitiveness (both can lessen these impacts via appropriate border adjustment mechanisms).

Next, the two instruments are nearly equivalent in regard to possibilities for raising revenue (cap-and-trade can utilize auctions, but given the structure of Congressional committees, revenue recycling may be easier with taxes).

And these instruments are similar in regard to: (a) costs to regulated firms (cap-and-trade systems can freely allocate allowances, and taxes can provide inframarginal exemptions below a specified level of emissions); and (b) distributional impacts (the two instruments can be designed to be roughly equivalent in this regard).

Differences & Distinctions

Beginning with the least significant differences, there are relatively minor distinctions in terms of transaction costs (decreasing marginal transaction costs in cap-and-trade systems – such as with volume discounts on brokers’ fees – can violate the independence property, whereby the equilibrium allocation of allowances and hence aggregate costs are ordinarily independent of the initial allocation).

There are more meaningful, but still subtle differences with regard to: (a) performance in the presence of uncertainty (for this, I urge you to read at least this section of the complete paper, because new research suggests that the implications of the classic Weitzman rule in the presence of a stock externality are moderated – if not reversed – due to the persistent effects of technology shocks, which foster positive correlation between marginal benefits and marginal costs); and (b) linkage with other jurisdictions (it is easier with cap-and-trade systems, but tax systems can also be linked).

That said, there are significant differences between the instruments in terms of: (a) carbon-price volatility (a problem only with cap-and-trade systems, but a problem that can be mitigated with price collars and banking of allowances); (b) interactions with complementary policies (a significant issue with cap-and-trade systems, which is much less severe with carbon taxes, because the “waterbed effect” is eliminated); (c) market manipulation (there is a need for regulatory oversight in cap-and-trade systems, but tax evasion is a parallel issue in tax systems, although presumably less severe in the U.S. context); and (d) complexity and administrative requirements (cap-and-trade is certainly more complex and has greater administrative requirements, but one might ask whether a simple tax will remain “simple” as it works its way through the Congress).

Hybrid Policy Instruments and a Policy Continuum

Many of the remaining differences can diminish further with implementation. Indeed, hybrid policies which mix features of tax and cap-and-trade blur distinctions. For example, auctioning of allowances and the use of price collars bring cap-and-trade closer to a tax system; and quantity formula employed to adjust a tax, and the use of tax revenues to mitigate emissions bring a tax closer to cap-and-trade. The result is that the dichotomous choice between a carbon tax and cap-and-trade can become a choice of design elements along a policy continuum, and the design of these instruments can be more consequential than the choice between the two.

Which is More Likely to be Adopted – Taxes or Trading? Positive Political Theory

Framing this question in terms of the metaphor of a political market, it is helpful to think about political demand and political supply of policy instruments. In terms of the demand from interest groups, first, regulated industry may oppose an ordinary tax approach, as it typically leads to greater costs than the simplest cap-and-trade (or than a performance standard, for that matter), because private industry is paying not only for compliance costs, but also for the tax on residual emissions. Second, regulated industry may favor cap-and-trade, because it conveys scarcity rents to firms, and can provide entry barriers for potential new entrants, which can make the rents sustainable.

Environmental advocacy groups favor cap-and-trade, due to the emissions certainty it provides, but also because presumably they have a preference for policies that help obscure costs, and cap-and-trade does a better job of sweeping discussion of costs under the rug than does a tax. However, in the era since cap-and-trade was demonized as “cap-and-tax,” this difference may be much less than it was!

Turning to the supply side (within the legislature), the revenue from either a tax or auctioning of allowances can be attractive to government. And because of the independence property of cap-and-trade, legislators can allocate allowances to build political support without increasing the costs or reducing the effectiveness of the policy. Of course, this important political advantage becomes an economic disadvantage if it invites particularly harmful rent-seeking behavior. Finally, environmental policy makers tend to think in terms of pollution quantities, not prices.

Experience with Carbon Pricing: Emissions Coverage & Price in Implemented Initiatives

There are some fifty carbon-pricing systems in operation worldwide, with equal numbers of carbon taxes and carbon cap-and-trade systems. A quick comparison of these policies reveals two striking realities. First, the highest carbon prices (the height of the bars in the figure below) are for carbon taxes (in norther Europe). Second, the scope of coverage (the width of each bar in the figure) of cap-and-trade systems greatly exceeds that of carbon taxes. Putting the two features (severity and scope) together, a reasonable measure of the relative importance of the policies is given by multiplying the carbon price (tax level or market price of allowances) by the tons of coverage, that is, the respective areas in the figure. On this basis, it appears that political revealed preference has been weighted toward cap-and-trade (at least up until now).

Carbon Price & Emissions Coverage of Implemented Carbon-Pricing Initiatives

Which Has Worked Better – Experiences with Trading and Taxes

Based upon more than thirty years of experience with cap-and-trade systems, including but not limited to CO₂ programs, lessons regarding the design and efficacy of these systems can be drawn. In brief, there is empirical evidence for the following: cap-and-trade has proven to be environmentally effective and economically cost-effective; downstream, sectoral programs have been common, but economy-wide upstream systems are feasible; transaction costs have been low to trivial; a robust market requires a cap below business-as-usual; banking has been exceptionally important, representing a large share of the gains from trade; price collars are very beneficial; free allocation of allowances fosters political support, with a likely transition to greater auctioning over time; competitiveness impacts can be mitigated with an output-based updating allocation; “complementary policies” are common, but in some cases can have perverse consequences, including no additional emissions reduction, an increase in aggregate costs, and suppressed allowance prices.

Turning to experiences with carbon taxes, two applications stand out. First, there are the northern European carbon tax systems, initiated in the 1990s in Norway, Sweden, Denmark, and Finland. Typically these were elements of broader energy and excise tax reform initiatives, and some are at the highest levels of any carbon-pricing regimes worldwide. However, fiscal cushioning has been common for industries expressing concerns. That said, these taxes have raised significant revenues to finance spending or to lower other tax rates, but unfortunately, there is little empirical evidence of their emissions impacts.

More striking is British Columbia’s carbon tax, initiated in 2008, which comes closest to that recommended by economists. Currently, it is an upstream tax of $27/ton of CO₂, but with important exemptions in place for key industries. Importantly, 100% of tax revenue was originally refunded through general tax rate cuts, but over time, there has been more focus on tax cuts for specific sectors and locations. Although there is some debate in the literature, it appears to have been effective in reducing emissions.

Empirical Evidence for Positive Assessment

Given that the normative differences between the two instruments are minimal, a key question becomes which instrument is more politically feasible, and which is more likely — in practice — to be well designed. Based on experiences with cap-and-trade and carbon taxes, the relative masses in the figure above suggest that political revealed preference has favored the former. Furthermore, after years of deliberation, China has chosen trading for its national program (although it appears to be a set of sectoral tradable performance standards, not a true, mass-based cap-and-trade system). In addition, the new “Transportation and Climate Initiative” in the northeast United States was first proposed in terms of fuel taxes but is gravitating toward cap-and-trade. Also, New Jersey is preparing to rejoin the Regional Greenhouse Gas Initiative, and Oregon is poised to enact an economy-wide CO₂ cap-and-trade system this year. On the other hand, Washington State has twice defeated a carbon tax.

But past may not be prologue. The demonization of the Waxman-Markey trading system as “cap-and-tax” may have reduced the political advantage of cap-and-trade (that it can hide the costs). And there is clearly increasing interest in a national carbon tax in the policy world, including several bills in Congress and the prominent Climate Leadership Council proposal. On the other hand, the “Green New Deal” is silent about carbon-pricing of any kind.

It is worthwhile focusing on the political economy of the British Columbia carbon tax. Its successful enactment has been attributed to “the confluence of political conditions ripe for carbon taxation”: untapped hydroelectric potential; a strongly environmentalist electorate (as in the case of California’s move to cap-and-trade with Assembly Bill 32); a right-center government with trust from the business community (as with the George H.W. Bush administration’s SO₂ allowance trading system in the Clean Air Act amendments of 1990); and a premier with institutional capacity to pursue personal policy preferences. There has been increasing public support over time, due to the perception of emissions reductions without severe economic impacts, but political pressures have caused the evolution of the system from using revenues exclusively to cut distortionary taxes to greater use of tax cuts to favor specific sectors and regions.

Clearly, political pressures can drive up social costs with either type of carbon-pricing instrument. On the one hand, politics may disfavor the auctioning of allowances in cap-and-trade systems, while, on the other hand, politics may disfavor cost-effective cuts of distortionary taxes in tax systems.

Does Either Carbon-Pricing Instrument Dominate in Normative or Positive Terms?

When carbon taxes and cap-and-trade are designed to be truly comparable, their characteristics and outcomes are similar, and in some cases fully equivalent (normatively), in terms of their: emission reductions, abatement costs, revenue raising, costs to regulated firms, distributional impacts, and competitiveness effects. But on some other dimensions, there can be real differences in performance. The tax approach is favored by administrative requirements, interactions with complementary policies, and effects on carbon-price volatility; whereas cap-and-trade is favored by linkage with policies in other jurisdictions, and possibly by anticipated performance in the presence of uncertainty. In the positive political economy domain, the evidence is also decidedly mixed. Hence, there is not a strong case for the blanket superiority of either instrument. Differences in design simply dominate differences between the instruments themselves.

Can Carbon-Pricing be Made More Politically Acceptable?

The track record of 50 carbon-pricing policies cited above should be contrasted with the 176 countries with renewable energy policies or energy efficiency standards, as well as another 110 national and sub-national jurisdictions with feed-in tariffs. Hence, carbon pricing has not in general been the favored approach to climate change policy. Why is this the case? Survey and other evidence indicates that public perceptions – some of which are inaccurate – are primary factors behind aversion to carbon taxes: “personal costs too great; policy is regressive; could damage economy; will not discourage carbon-intensive behavior; and government just want the revenues.” So, one way to improve public acceptance could be through better information, that is, education.

But another way forward could be through judicious policy design, which may well depart from first-best design, including: phasing in taxes/caps over time (which was effective in California and British Columbia); earmarking revenues from taxes/auctions to finance additional climate mitigation, in contrast with optimizing the system via cuts in distortionary taxes; and/or using revenues for fairness purposes, such as with lump-sum rebates or rebates targeted to low-income and other particularly burdened constituencies (a carbon tax with “carbon dividends” or a cap-and-trade system in the form of “cap-and-dividend”).

Has the Defeat of National CO₂ Cap-and-Trade Initiatives Provided Openings for Carbon Tax Proposals?

Political polarization has decimated the key source of Congressional support for environmental/energy action, the political middle. And the successful political battle against the Obama administration’s CO₂ cap-and-trade legislation featured the effective demonization of that instrument as “cap-and-tax.” Does the consequent reputational loss for cap-and-trade provide a meaningful opening for the other carbon-pricing instrument – a carbon tax?

It would seem that large budgetary deficits ought to increase the attraction of new sources of revenue, but existing carbon tax proposals have largely been revenue-neutral. That said, it is surely true that there has been increased attention to carbon taxes from the “policy community,” with support coming not just from Democrats, but also from prominent Republican academic economists and former Republican high government officials. But – finally – what about in the real political world of those currently holding elective office in the federal government?

It is presumably good news for carbon tax proposals that they are not “cap-and-trade.” Perhaps that helps with the political messaging. But if conservative opposition could tarnish cap-and-trade as “cap-and-tax,” surely it will not be difficult to label a tax as a tax! And in addition to such opposition from the political right, it is – as of now – questionable whether the new left will want a carbon tax to be part of its “Green New Deal.”

Hence, in the short term, national carbon pricing of either type will likely continue to face an uphill battle. Therefore, in addition to considering second-best carbon-pricing design (as I recommended above), economists can work productively to catch up with political realities by considering better designs of second-best non-pricing instruments, such as clean energy standards.

But, at some point the politics will change, and it is important to be ready, which is why – for the longer term – ongoing research on carbon-pricing is very much warranted, particularly if it can be carried out in the context of real-world politics, and focus on policies that are likely at some point to prove feasible.

Economics of the Environment

The seventh edition of Economics of the Environment: Selected Readings has just been published by Edward Elgar Publishing, and I’m pleased to bring this new volume to your attention. The book is a compendium of some of the best and most timely articles by a dream team of environmental economists. Previous editions have served as a valuable supplement to environmental economics text books or as a stand-alone reference book of key, up-to-date readings from the field. In addition to being valuable for anyone studying environmental economics, environmental policy, or climate change policy, the book can be a useful resource for practitioners in government, private industry, as well as advocacy groups and other NGOs working on environmental policy.

In today’s essay, I first describe the background and motivation for the book, summarize its contents – chapter by chapter, highlight its key messages, and then conclude with some reflections and an invitation.

Background and Motivation

Environmental and natural resource problems are both more widespread and more important today than they were 100 years ago when the discipline of modern economics was marking its emergence with the publication of the first volume of the American Economic Review. A century of economic growth and globalization have brought unparalleled improvements in societal well-being, but also unprecedented challenges to the carrying capacity of the planet. Increases in income and population that would have been inconceivable 100 years ago have greatly heightened pressures on the natural environment.

The stocks of a variety of renewable natural resources – including water, forests, fisheries, and numerous other species of plant and animal – have been depleted below socially-efficient levels, principally because of market failures. Open-access – whether characterized as externalities or public goods – have led to the degradation of air and water quality, inappropriate disposal of hazardous waste, depletion of stratospheric ozone, and the atmospheric accumulation of greenhouse gases linked with global climate change.

Over the same century, economics as a discipline has gradually come to focus more and more attention on these problems, first considering natural resources and subsequently environmental quality. Economic research within academia and think tanks has improved our understanding of the causes and consequences of excessive resource depletion and inefficient environmental degradation, and thereby has helped identify sensible policy solutions.

Despite the generally positive influence economics has had on policy, the problems have overall not diminished, and the lag between understanding and action can be long. While some environmental problems have been addressed successfully, others continue to emerge. Some, such as the threat of global climate change, are both more consequential and more difficult than problems of the past. Fortunately, economics is well positioned to offer better understanding and better policies to address these new and ongoing challenges.

The Book

Approximately six years have passed since the previous edition of this volume was published, and it is now close to 50 years since the first edition appeared in 1972, edited by Robert and Nancy Dorfman. I have had the pleasure of editing the fourth (2000), fifth (2005), sixth (2012), and now the seventh edition (2019) of this book. Whereas the first six editions were published by W.W. Norton & Company, the new edition has been published by Edward Elgar Publishing Limited.

Over this span of time, environmental economics has evolved from what was once a relatively obscure application of welfare economics to a prominent field of economics in its own right. The number of articles on the natural environment appearing in mainstream economics periodicals has continued to increase, as has the number of economics journals dedicated exclusively to environmental and resource topics.

There has also been a proliferation of environmental economics textbooks. Many are excellent, but none can be expected to provide direct access to timely and original contributions by the field’s leading scholars. As most teachers of economics recognize, it is valuable to supplement the structure and rigor of a text with original readings from the literature.

With that in mind, this new volume consists of 34 chapters that instructors will find to be of tremendous value as a complement to their chosen text and their lectures. The scope is comprehensive, the list of authors is a veritable “who’s who” of environmental economics, and the articles are timely, with more than 94 percent published since 1990, and well more than a third published over the past five years. Overall, more than half of the chapters are new to this edition.

In order to make these readings broadly accessible, one criterion I used in the selection process is that articles should not only be original and well written – and meet the highest standards of economic scholarship – but also be non-technical in their presentations. Hence, readers will find little or no formal mathematics in the book’s 688 pages.

The 34 chapters are grouped into nine parts of the book: (1) Overview; (2) Costs and Benefits of Environmental Protection; (3) Assessing the Goals of Environmental Policy: Economic Efficiency and Benefit-Cost Analysis; (4) The Means of Environmental Policy: Cost-Effectiveness and Market-Based Instruments; (5) Economics of Natural Resources; (6) Global Climate Change; (7) Sustainability, the Commons, and Globalization; (8) Behavioral Economics and the Environment; and (9) Economics and Environmental Policy Making.

Overview

Part I of the volume provides an overview of the field and a review of its foundations. Don Fullerton and I (Chapter 1) start things off with a brief essay about how economists think about the environment. This is followed by the classic treatment of social costs and bargaining by Ronald Coase (Chapter 2).

Costs and Benefits of Environmental Protection

Part II examines the costs and benefits of environmental protection. It begins with an article by Antoine Dechezleprêtre and Misato Sato (Chapter 3) that examines an often-controversial area, namely the theory and empirical evidence regarding the relationship between environmental regulation and so-called “competitiveness.” The remainder of Part II focuses on the other, more challenging side of the analytic ledger – the benefits of environmental protection. This is an area that has been even more contentious, both in the policy world and among scholars. Here the core question is whether and how environmental amenities can be valued in economic terms for analytical purposes. Trudy Cameron (Chapter 4) provides a valuable guide to a concept that is both important in assessments of the benefits of environmental regulations and is also widely misunderstood – the value of a statistical life. Then we turn to a provocative debate on the stated-preference method known as “contingent valuation,” including two supportive essays – by Richard Carson (Chapter 5) and by Catherine Kling, Daniel Phaneuf, and Jinhua Zhao (Chapter 6) – followed by a critique by Jerry Hausman (Chapter 7).

Assessing the Goals of Environmental Policy: Economic Efficiency and Benefit-Cost Analysis

There are two principal policy questions that need to be addressed in the environmental realm: how much environmental protection is desirable; and how should that degree of environmental protection be achieved?

In Part III, the criterion of economic efficiency and the analytical tool of benefit–cost (net present value) analysis are considered as ways of assessing the goals of environmental policies. In an introductory essay, Kenneth Arrow and his co-authors (Chapter 8) ask whether there is a role for such analysis to play in environmental, health, and safety regulation. Then, Lawrence Goulder and I (Chapter 9) focus on a key ingredient of benefit–cost analysis that non-economists often find confusing or even troubling – intertemporal discounting. Next, Kenneth Arrow and another set of co-authors (Chapter 10) focus on the possibility of a declining discount rate, which can be very important for analyzing long-term phenomenon, such as climate change. Finally, Ted Gayer and Kip Viscusi (Chapter 11) provide a critique of what they perceive to be the ways in which the principles of benefit–cost analysis have been abused in some regulatory impacts analyses carried out by the federal government.

The Means of Environmental Policy: Cost Effectiveness and Market-Based Instruments

Part IV examines the policy instruments – the means – that can be employed to achieve environmental targets or goals. This is an area where economists have made their greatest inroads of influence in the policy world, with tremendous changes over the past 30 years in the reception given by politicians and policy makers to so-called market-based or economic-incentive instruments for environmental protection. Richard Schmalensee and I (Chapter 12) start things off by identifying lessons that have been learned from three decades of experience with cap-and-trade systems in Europe and the United States. In the next chapter, Schmalensee and I (Chapter 13) examine the ironic history of one particularly important application – the SO₂ allowance trading system, enacted by the Clean Air Act Amendments of 1990. The following article, by Karen Fisher-Vanden and Sheila Olmstead (Chapter 14), recognizes that virtually all prominent applications of emissions trading systems have been for air pollutants of various types, and examines the opportunities and challenges of using such instruments to address water quality problems.

Economics of Natural Resources

Part V consists of four essays on the economics of natural resources, beginning with Robert Solow’s classic, intuitive explication of Harold Hotelling’s seminal contribution to the economic theory of nonrenewable natural resources (Chapter 15). A natural extension is provided by Thomas Covert, Michael Greenstone, and Christopher Knittel (Chapter 16) in an article in which they ask whether market forces of supply and demand will lead to severe reductions in the use of fossil fuels. Then Sheila Olmstead (Chapter 17) applies similar thinking to the management of water resources, and Severin Borenstein (Chapter 18) examines the economics of renewable electricity generation.

Global Climate Change

The next four sections of the book treat a set of timely and important topics and problems. Part VI is dedicated to analysis of economic dimensions of global climate change, which appears to be the most significant environmental problem that has yet arisen, both in terms of its potential damages and in terms of the costs of addressing it. First, a broad overview of the topic is provided in a survey article by Joseph Aldy, Alan Krupnick, Richard Newell, Ian Parry, and William Pizer (Chapter 19). Next, William Nordhaus (Chapter 20) critiques the well-known Stern Review on the Economics of Climate Change, and Nicholas Stern and Chris Taylor (Chapter 21) respond. Following this, Richard Newell, William Pizer, and Daniel Raimi (Chapter 22) examine what was accomplished with the use of carbon markets in various parts of the world in the 15 years after the global climate agreement known as the Kyoto Protocol. Of course, after Kyoto, the next major global agreement in this realm was the landmark Paris Agreement of 2015. Daniel Bodansky, Seth Hoedl, Gilbert Metcalf, and I (Chapter 23) analyze how linking heterogeneous national policies can lower the cost of achieving national targets and thereby facilitate increased ambition under the Paris Agreement. Finally, Richard Tol (Chapter 24) turns from the cost side to the benefit side of climate policy by examining the anticipated economic impacts of unabated climate change.

Sustainability, the Commons, and Globalization

Part VII examines another important area of exploration in environmental economics: sustainability, the commons, and globalization. Robert Solow (Chapter 25) begins with an economic perspective on sustainability. This is followed by Elinor Ostrom’s development of a general framework for analyzing sustainability (Chapter 26), and my own historical view of economic analysis of problems associated with open-access resources (Chapter 27). Then, we turn to the topic of corporate social responsibility and the environment, discussion of which has too often been characterized by more heat than light. Forest Reinhardt, Richard Vietor, and I (Chapter 28) provide an economic perspective by examining the notion of firms voluntarily sacrificing profits in the social interest. The essays in the book can apply in the context of a diverse set of countries, but developing countries face a special set of challenges. So, this section closes with Michael Greenstone and Kelsey Jack (Chapter 29) providing a broad examination of the relationship between economic development and environmental protection.

Behavioral Economics and the Environment

Next, in Part VIII, we feature applications of the emerging area of behavioral economics to environmental issues, beginning with an overview of this terrain by Jason Shogren and Laura Taylor (Chapter 30). Then, Cass Sunstein and Lucia Reisch (Chapter 31) examine the implications of behavioral economics for the types of public policies that are most likely to be effective. Lastly, a specific application of behavioral economics to environmental questions is considered by Todd Gerarden, Richard Newell, and myself (Chapter 32), as we examine potential explanations for the so-called “energy paradox” or “energy efficiency gap” – the apparent reality that energy-efficiency technologies that would more than justify their upfront costs through life-cycle energy-cost savings are nevertheless not adopted.

Economics and Environmental Policy Making

The final section of the book, Part IX, departs from the normative concerns of much of the volume to examine some interesting and important questions of political economy. It turns out that an economic perspective can provide useful insights into questions that might at first seem fundamentally political. Myrick Freeman (Chapter 33) reflects on the benefits that U.S. environmental policies have brought about since the first Earth Day in 1970. And Robert Hahn (Chapter 34) addresses the question that many of the articles in this volume raise: what impact has economics actually had on environmental policy?

Key Messages

Preparing the various editions of this book has caused me to review hundreds of articles, and this has allowed me to identify some common themes that have emerged. First, there is the value – or at least, the potential value – of economic analysis of environmental policy. The cause of virtually all environmental problems in a market economy is economic behavior (that is, imperfect markets affected by externalities), and so economics offers a powerful lens through which to view environmental problems, and therefore a potentially effective set of analytical tools for designing and evaluating environmental policies.

A second message, connected with the first, is the specific value of benefit–cost analysis for helping to promote efficient policies. Economic efficiency ought to be one of the key criteria for evaluating proposed and existing environmental policies. Despite its limitations, benefit–cost analysis can be useful for consistently assimilating the disparate information that is pertinent to sound decision making. If properly done, it can be of considerable help to public officials when they seek to establish or assess environmental policies.

Third, the means governments use to achieve environmental objectives matter greatly. Different policy instruments have very different implications in terms of both benefits and costs, including abatement costs in both the short and the long term. Market-based instruments can enable the minimization of these costs.

Fourth, an economic perspective is also of value when reflecting on the use of natural resources, whether land, water, fisheries, or forests. Excessive rates of depletion are frequently due to the nature of the respective property-rights regimes, in particular, common property and open-access. Economic instruments – such as ITQ systems in the case of fisheries – can and have been employed to bring harvesting rates down to socially efficient levels.

Fifth and finally, policies for addressing global climate change, linked with emissions of carbon dioxide and other greenhouse gases, can benefit greatly from the application of economic thinking. On the one hand, the long time-horizon of climate change, the profound uncertainty in quantitative links between emissions and actual damages, and the possibility of catastrophic climate change present significant challenges to conventional economic analysis. But, at the same time, the ubiquity of energy generation and use in modern economies means that only market-based policies – essentially carbon-pricing regimes – are feasible instruments for achieving truly meaningful emissions reductions. Hence, despite the challenges, an economic perspective on this grandest of environmental threats is essential.

Reflections and an Invitation

Environmental economics is a rapidly evolving field. Not only do new theoretical models and improved empirical methods appear on a regular basis, but entirely new areas of investigation open up when the natural sciences indicate new concerns or the policy world turns to new issues. Therefore, this volume of collected essays remains a work in progress. I owe a great debt of gratitude to the teachers, students, and other readers of previous editions who have sent their comments and suggestions for revisions. Thanks are also due to Patrick Behrer, who provided superb research assistance in producing this Seventh Edition. Looking to future editions, I invite all readers – whether teachers, students, or practitioners – to send me your suggestions for improvement.

Climate Negotiations in Poland Advanced Implementation of the Paris Agreement

During two weeks of sometimes boisterous plenary sessions and equally energetic backroom discussions, the 197 Parties of the Twenty-Fourth Conference of the Parties (COP-24) of the United Nations Framework Convention on Climate Change (UNFCCC), meeting in Katowice, Poland, sought to reach consensus on rules and guidelines for implementing the Paris Agreement. That landmark 2015 accord came into force in 2016, and is scheduled to begin operations in earnest in 2020. The fault lines at the Katowice negotiations were, as usual, largely between two groups: the 43 industrialized countries, and the 154 developing nations.

Hanging over the negotiations was the reality that U.S. President Donald Trump announced in June 2017 that the United States would withdraw from the Paris Agreement (in November, 2020, the soonest that any Party can actually withdraw). Since Trump’s announcement, the former co-leadership by the United States and China, which had been critical to the passage of the Paris Agreement, has evolved into something between sole leadership by China and co-leadership by China and the European Union.

Not long before midnight on Saturday, December 15^th, a full 24 hours after COP-24 was scheduled to conclude, consensus was reached on the 156-page Rulebook, with considerable credit due to the Polish presidency of the Conference (not to be confused with the presidency of the Polish nation), in the person of Michał Kurtyka, Poland’s Deputy Minister of Energy. As Jean Chemnick wrote in E&E News, the Rulebook represents a transition from an “idealized expression of world solidarity” in the Paris Agreement to a “set of mechanisms that countries hope will deliver results.”

But was COP-24 Really a Success?

A simple “yes” or “no” response to this question would be misleading. There were literally dozens of aspects of the Paris Agreement on which the delegates to the Katowice meetings wanted to make progress by filling in details in the 29 articles of the skeletal Paris Agreement. In my mind, two areas stood out. One is referred to as “transparency,” and other is characterized (somewhat inaccurately) as “markets.” Combining the achievements and lack thereof on both fronts, I assess the outcome of the Katowice talks to be more than a half-full glass of water (or wine, if you prefer).

First of Two Key Issues: Transparency

Transparency refers to the credibility of each nation’s measurement of its own performance – in terms of its emissions and its policies. The Paris Agreement gave significant wiggle room to the vast majority of countries – the 154 developing countries – by granting them flexibility in meeting the transparency requirements (which were to be established for the industrialized countries). The U.S. delegation – consisting of civil servants led by long-time State Department official Trigg Talley – again worked closely with the Chinese delegation to foster a remarkable consensus that all countries must follow uniform standards for measuring emissions and tracking the achievement of their respect targets (Nationally Determined Contributions or NDCs). This was a significant achievement, and a major step forward toward a level playing field among the countries of the world.

Conceivably, it could make it easier for the Trump administration to remain in the Paris Agreement (if the President were to become convinced that such action would be politically advantageous in the run-up to the November 2020 U.S. presidential election). And, likewise, it will make it easier for a future (Democratic or Republican) administration to rejoin the Paris Agreement if the current President follows through on his promise to withdraw. That is a significant success.

Second of Two Key Issues: Article 6.2 and Carbon Markets

Turning to the second key set of issues at COP-24, I have frequently written that there are two necessary conditions for ultimate success of the Paris Agreement: adequate scope of participation, and adequate ambition of the individual national contributions. The first condition has surely been met, with 97% of global emissions associated with countries taking on responsibilities under Paris, compared with 14% under the current commitment period of the predecessor international agreement, the Kyoto Protocol of 1997. But the factor that brought about such broad participation – namely, that each country’s target is anchored in its own national circumstances and colored by its domestic political reality – suggests that the individual contributions will not be collectively sufficient (due to the global commons nature of the problem).

Because of this, a key question has been whether there are ways that the Paris Agreement itself, as it is fleshed out, can enable and indeed facilitate increased ambition over time? One answer, on which I have carried out extensive research with colleagues, can be provided by the linkage of regional, national, and sub-national policies – connections among policy systems that allow emission reduction efforts to be redistributed across systems.

Heterogeneous Linkage

Linkage is typically framed as between cap-and-trade systems, but regional, national, and sub-national policies will be highly heterogeneous, including a variety of types of emissions trading systems, carbon taxes, and conventional performance and technology standards. As my research in this area with Michael Mehling (M.I.T.) and Gilbert Metcalf (Tufts University) has found, linkage among such heterogeneous policies is not trivial, but is – in many cases – feasible.

This is important because linkage fosters: cost savings by allowing firms to take advantage of lower cost abatement opportunities in other jurisdictions; improved functioning of markets by reducing market power and price volatility; political benefits to linking parties; administrative economies of scale; and – perhaps most important – the possibility of satisfying the UNFCCC’s key criterion of distributional equity – “common but differentiated responsibilities” – without sacrificing cost-effectiveness.

Fortunately, such linkage can be consistent with the Paris Agreement, under the authority of its Article 6, focused on international cooperation. In particular, Article 6.2 provides for cooperative approaches among Parties, with Internationally Transferred Mitigation Outcomes (ITMOs) potentially serving as an accounting mechanism to ensure that international linkages do not result in double-counting or other errors when comparing each country’s emissions to its stated target.

So, What Happened in Katowice?

In Katowice, the delegates sought to write guidelines for Article 6 that could make its promise a reality. Negotiators had an opportunity to define clear and consistent guidance for the accounting of emissions transfers under Article 6.2. My view in advance of the Katowice talks was that a robust accounting framework for ITMO transfers could foster better linkage of climate policies across jurisdictions, but that if the guidance extended much beyond basic accounting rules, restrictive requirements could actually impede effective linkage, and be counter-productive.

In precisely this regard, two potential impediments arose in Katowice. Proposals were introduced to place an explicit tax on ITMO transfers under the rubric of “Share of Proceeds,” meaning a payment by the transferring parties to a fund intended to help vulnerable developing countries meet their costs of adaptation to climate change. Whereas the objective of financing adaptation has great merit, it is well covered and belongs in other parts of the Paris Agreement, not as a tax on trading.

The other potential impediment was in the form of proposals for an implicit tax on transfers, known as “Overall Mitigation in Global Emissions,” meaning that each transfer must result in a net reduction in overall emissions. Again, increasing ambition over time is important, but that is dealt with appropriately in other parts of the Agreement, not by making it an implicit tax on market activity.

Last-Minute Maneuvers

As the end of the second week of negotiations approached, it appeared that both of these potential impediments might be finessed, if not completely avoided. But then a single country – Brazil – decided to hold up the talks all night on the final Friday by insisting that it would not let there be any progress on rules for Article 6.2 unless the Conference agreed to state – under Article 6.4, viewed by most as an extension of the Kyoto Protocol’s Clean Development Mechanism (CDM) – that it could use its large surplus of CDM credits (of questionable credibility) to help meet its Paris commitments in a manner that would have resulted in double-counting. The Brazilian delegation refused to budge, and the result was that Article 6 was not included in the Katowice decision. Rather, it was punted to COP-25, to be held next year in Santiago, Chile.

So, the outcome with this second issue was clearly not a great success, but was it a complete failure, or was it something in between? This gets quite interesting. On first blush, a lack of agreement on the rules of the road for Article 6.2 would seem to render ITMO transfers impossible – and hence reduce the scope for bilateral international linkages.

Does the Cloud Have a Silver Lining?

As Nathaniel Keohane (Environmental Defense Fund) has pointed out, countries can move ahead with international transfers even without guidance under Article 6.2, because that article is explicit that countries may use transferred mitigation outcomes toward meeting their national targets whether or not additional rules have been written. The crucial phrase is that any transfer must be “consistent with guidance,” meaning that if guidance exists, it must be followed, but meaningful action does not depend on the existence of guidance. Keohane indicates that this language was intentionally written into the Paris Agreement precisely because the United States and others feared that Brazil would try to hold Article 6.2 hostage to Article 6.4 — exactly as they did in Katowice.

I hope very much that Dr. Keohane’s interpretation is correct. My lingering concern, however, is that in the absence of knowing what some potential future guidance and rules might bring, Parties may be very hesitant to pursue bilateral linkages (and try to justify those in the context of their national targets via ITMO transfers). Only time will tell.

A Sideshow: The IPCC 1.5^o C Report and U.S. Schizophrenia

There were several sideshows at the climate talks. One revealed the schizophrenia that has marked U.S. participation in the annual negotiations during the Trump years. The State Department civil servants who continue to represent the United States in the climate negotiations, again played a helpful role, working constructively with other delegations, and in some cases, even played a (admittedly diminished) leadership role, as in the work on transparency I described above. But, in addition, the White House again sent a group of political people to make symbolic statements supporting the use of coal and doubting the urgency of action on climate.

This resulted in the bizarre reality of the United States joining Russia, Saudi Arabia, and Kuwait to block language that would have endorsed the findings of the recent Intergovernmental Panel on Climate Change (IPCC) report on the Paris Agreement’s aspirational target of limiting warming to a 1.5^o C increase this century. All other countries wanted to include text that would “welcome” the IPCC report, which would indeed have had the effect of endorsing it. The group of four countries maintained that the report should simply be “noted.” In what has become classic climate diplomacy, the final language said that the Conference “welcomes the timely completion” of the report, not necessarily its findings.

The Bottom Line

Any sound judgment of the ultimate success or failure of the Katowice climate talks – and more important, the success or failure of the Paris Agreement – will depend upon future climate negotiations and upon the domestic policy actions of the key countries of the world. For that, it remains too soon to observe or even predict the long-term outcome.

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A Few Additional References:

For a much more succinct assessment of the Katowice climate negotiations, see my column in The Conversation: “An Economist’s Take on the Poland Climate Conference.”

For a summary of the outcomes of the Katowice meetings, see this report from the Center for Climate and Energy Solutions.

For a detailed summary and assessment of the Katowice outcome, see Axel Michaelowa’s slide deck.

For an assessment that focuses on the process and outcome of the Katowice negotiations with regard to the role of carbon markets, see the COP24 Summary Report of the International Emissions Trading Association (IETA).

For a detailed description of the processes and outcomes on transparency, finance, and stock taking, see Jean Chemnick’s story in ClimateWire.