If you put a price on GHG emissions, will it raise the cost of energy?

That question goes to the core of carbon policy. Unfortunately, many people inside and outside the environmental community consistently get it wrong, with potentially disastrous results.

Consider: if the answer is yes, then we don’t need any incentives for GHG reduction. The costs of carbon-intensive energy will rise, giving we energy users the incentive they need to lower consumption.

But if the answer is no, we will find ourselves with a tax on dirty energy but no incentive to reduce its use. That is, we will end up with a greenhouse-gas policy that fails to do the one thing it’s supposed to do above all else: lower our greenhouse-gas emissions.

The answer, more often than not, is no.

Ironically, this fact is understood by people individually even as they misunderstand it globally. When you get hit with sudden medical bills, does your salary increase? If you lose your job, do your costs suddenly fall to maintain a constant bank balance?

Of course not. Our individual costs vary independently of our individual revenues, and whatever’s left — our individual profit — bounces accordingly. And it’s not at all clear that it levels out in the long run. Some people with low incomes are fantastically thrifty, and die with money in the bank. Some people with enormous incomes fall in love with fancy cars and drugs and die in debt.

And what’s true for individuals is no less true for businesses. If Ford Motor Company negotiates a new deal with the UAW that leads to a 20 percent rise in labor costs, they don’t suddenly get to charge more for their cars — they either reduce their profits or figure out a way to conserve those costs somewhere else. If they don’t, they’re going to find that folks who wanted to buy a Ford like the price on the Toyota better.

Is cost a factor in pricing decisions? Of course — but it’s only one among many, and it’s easily trumped by other considerations. Prices of alternatives (like the aforementioned Toyota) must be considered. Your customer’s willingness to pay matters (which is why Ford makes more money on leather seats than on gas caps). The quality of your marketing factors in.

This is no less true for big companies than it is for small ones. Try offering your $10/hour babysitter $12/hour if you disagree. I’m guessing you won’t get a $2/hour rebate at the end of the night!

As another example, try buying your next airline ticket at the airport on the day of your trip instead of a month in advance. The airline’s cost is identical, but I’ll bet they charge you a lot more — not based on the costs you’re imposing on them, but because of your apparent willingness to pay. The flip side of this is that they really can’t raise prices on the person who buys the ticket a month before on Expedia. Thus, the airline earns much higher margins on some customers than others.

So why does this matter for GHG policy?

The exact same disconnect between prices and costs exists in the energy industry. If energy companies can pass along costs by raising prices without compromising their bottom line, they will. But if in raising those prices they find that their revenue starts falling faster than margins can keep up, they will accept lower per-unit margins to protect revenues. This doesn’t make them nefarious — it just makes them human.

And watch what else they’ll do: Just like the airlines, they will find it much easier to pass along price increases to customers who have no other options. Big industrials that can invest in efficiency or other fuel supply options will probably end up seeing little movement in their costs of energy — they are the Expedia customer in this example. On the other hand, small residential consumers with little free cash and less technical savvy will probably see price increases. Which means that those sectors of the economy that have the most capability to lower their energy consumption will have the least incentive to do so. Again, this isn’t suggestive of any nefarious behavior — it’s just how pricing works.

All of this is precisely why we need carrots as well as sticks in an effective GHG policy. Without them, there is simply no guarantee that the resulting policy will impose any economic incentive to lower GHG emissions.