With apologies to Little Milton.

Good news: With the incoming Obama administration, we are finally going to get some sort of a greenhouse gas (GHG) bill.

Bad news: We are still having an inane, economically uninformed conversation about GHG policy.

Many of the ideas that pass for Serious GHG Policy are silly, not because they aren’t serious but because they are based on economic theories that are as widely believed as they are at odds with the way all of us (economists included) actually behave.

The crux of the problem lies in the fact that policymakers, economists, and, yeah, some bloggers completely misunderstand the link between costs and prices.

There are a host of GHG models based on upstream carbon pricing, wherein GHG emissions are priced not at the point of GHG release (i.e., where the fire is), but at the point of fuel purchase. This was innate to Lieberman-Warner and is still found in many current cap & somethin’ and carbon tax proposals. The theory is that if you put a cost somewhere in the upstream end of the system, it will cascade downstream to affect point-of-use decisions. The idea is nonsense, worthy of Wolfgang Pauli’s famous put-down: it’s so bad it’s “not even wrong.”

The crazy thing is that outside of idle economic theorizing, no one really believes the idea. When gasoline prices go up, do you expect trucking companies profits to stay the same? When health insurance costs rise, does your boss give you a raise so that your take home pay will be unaffected? When your local phone company outsources directory assistance to some dude in Bangladesh, do their rates fall to reflect their lower cost structure?

Of course not. Yet we assume that if we put a price on carbon at the point of fuel purchase, it will diffuse perfectly through the system, affecting everyone downstream who burns fuel and release GHGs. It won’t. And to the degree that it doesn’t, an upstream GHG price is an economically flawed GHG price, disproportionately shifting the burden of GHG abatement away from those actually releasing GHGs into the atmosphere — and, therefore, failing to provide an effective incentive to reduce GHG emissions.

Obvious as it may be, it bears noting that companies set prices based on a wide number of variables, only one of which is cost:

  1. Some customers are more profitable than others, reflecting the reality that it is easier to pass costs along to some customers than others. For example, fuel providers commonly make more profit on small businesses than large businesses, because the small guys have a harder time changing suppliers. Should those fuel providers have to pay carbon taxes on their fuel, they may well decide to “stick it to the little guys,” leaving the biggest users agnostic on GHG emissions.
  2. While economics tends to assume that all prices are variable (e.g., $X per widget), many pricing schemes have much more complicated structures, with set-up fees, membership fees, and use fees all combining to (intentionally) hide the full cost of service and make the decision to incrementally use a product appear relatively cheap. (Think of your gym, or your ATM.) In the energy sector, many gas and electric rates have a fixed monthly fee for the contract plus a low variable cost for use. If the cost of upstream GHG emissions is borne in the fixed cost, it will have no more effect on the decision to reduce fossil fuel use than your gym’s initiation fee does on your decision to work out tomorrow.
  3. In many cases, much or all of the impact of a change in cost is not borne at all by a company’s customers, but by their owners. When oil prices fall, refinery profits tend to rise, as falling costs boost their profitability. Conversely, when fuel costs rise, airline profits tend to fall, for the opposite reason. It is quite reasonable to assume that a world with upstream GHG pricing will lead to lower profits for fossil fuel producers and distributors (many in the environmental community would very much like to see this). But if it does, that necessarily means that fossil fuel users are not seeing the full price signal. Corporate profits would fall, but day-to-day emission-causing behavior would not change.

None of this is complicated. But it is far too frequently glossed over with grossly simplistic economic theory utterly at odds with the reality of price-setting. And to the extent we base GHG policy on these flawed theories, there is a very real danger that we will craft a GHG policy that won’t work. The stakes are too high to get this wrong.