Whenever I criticize economists I get yelled at by economists because I’m no economist and what do I know. So I’m trying a different approach: I’m going to compare and contrast two economic perspectives on climate/energy policy. See if you can guess which one I prefer!

Textbook economics

Representing what he calls the “textbook economics preference” we have Harvard economist Robert Stavins. The textbook economist advocates for an upstream carbon tax, with the revenue used to reduce other distortionary taxes (income and/or payroll). In a pinch he’ll take an economy-wide cap-and-trade system with some mix of auctioned and free permits, which is close enough. But — and this is important — that’s it. Additional, complementary policies (renewable energy standards and tax breaks, efficiency codes, etc.) only distort the effect of the carbon price and raise the overall cost of the program. For instance, Stavins says the non-cap-and-trade portions of Waxman-Markey (fully two-thirds of the bill) are …

the worst parts of that legislation — the smorgasbord of regulatory initiatives. As I’ve written previously, those additional elements of the legislation are highly problematic. When implemented under the cap-and-trade umbrella, many of those conventional standards and subsidies would have no net greenhouse-gas-reducing benefits, would limit flexibility, and would thereby have the unintended consequence of driving up compliance costs. That’s the soft under‑belly of the House legislation.

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Complementary policies, on this view, are the dirty secret of climate policy, something no upstanding economist would countenance. What’s behind this perspective?

invisible handThe semi-invisible hand of the market.Its roots are in Chicago school, laissez-faire economics, which holds that humans are rational actors who seek to maximize their own welfare; the sum total of those welfare-maximizing decisions is an optimal distribution of resources — the “Invisible Hand” of the market at work. Then came neoliberal economics, which acknowledges that certain commercial activities produce social costs (“externalities”) that aren’t reflected in market prices; these social costs can be addressed by public policy. The field of environmental economics — in which Stavins is a noted authority — is a branch of neoliberal economics concerned specifically with environmental externalities like climate change. According to the neoliberal textbook, the proper course of action when faced with an externality is to determine the size of the social cost and incorporate it into the market via prices. Price-based policies, also know by the more familiar term “market-based mechanisms,” are tweaks that effectively make the market more perfect.

That is the appeal, to economists, of putting a price on carbon: it incorporates the social costs of climate change into energy markets in a clean, elegant way. It is the minimum intervention necessary to correct a market failure. It follows that any additional regulatory intervention in the economy only mucks things up, reducing economic efficiency and raising overall costs — and that’s just what Stavins thinks about the energy portions of Waxman-Markey.

The problem with textbook economics is that it clings too tightly to its libertarian roots. (The conceptual elegance of free market economics is incredibly attractive to both rationalist academics and businesspeople who see themselves as proto–John Galts.) In practice, though, people with those ideological predispositions have a troubling tendency to overlook existing market imperfections, to conflate the status quo with the Will of the Market. It’s always the new regulation or subsidy that threatens the sanctity of the market, not the existing skein of market distortions that protects incumbents.

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Thing is, when we descend from the lofty heights of macroeconomics to look more closely at actually existing markets, the picture becomes much messier; it becomes clear that a livable climate is only one of many social goods markets are failing to maximize. As the burgeoning field of behavioral economics is documenting, market (and cognitive and behavioral) failures are ubiquitous, particularly in and around energy.

Bottom-up economics

To take one example, consider a hot topic these days: energy consumption in the built sector. Textbook economics would tell you that people optimize building energy efficiency based on current energy prices; if you want to make buildings more efficient (and reduce their carbon footprint), raise the price of energy. Done and done.

It turns out, though, there is already a panoply of cost-negative (i.e., profitable) investments in efficiency going unexploited; resources are not being optimally distributed. A closer look suggests a market suffering from multiple, endemic flaws, which can be addressed with active public policy.

Support for this basic view on energy efficiency can be found in McKinsey and Co.’s “Pathways to a Low-Carbon Economy.” On the built sector more specifically, see the World Business Council for Sustainable Development‘s magisterial Energy Efficiency in Buildings project. In a policy brief based in part on those two reports, “The Economics of Energy Efficiency in Buildings,” Trevor Houser of the Peterson Institute for International Economics reviews the various gaps, failures, and misaligned incentives in building efficiency markets, along with some smart policy recommendations for overcoming them. Here are his two most significant conclusions for our purposes:

• Given barriers to action by building owners and occupants, a carbon price of $25 per ton alone would not catalyze the necessary transformation. New approaches to efficiency financing are critical, but these must be coupled with new codes and standards.

In other words, the potential for low-cost carbon abatement in the building sector will not be maximized merely by pricing carbon; unpriced carbon is but one market failure among many. Fully exploiting the potential will require a suite of complementary policies — financing, codes, and standards — of the sort found in, say, the Waxman-Markey bill.

Far from “driving up compliance costs,” as Stavins charges, these complementary policies would lower them:

Failure to overcome barriers to efficiency improvements in buildings would raise the cost of meeting emission-reduction goals considerably. Making up the 8.2 billion tons in buildings sector emission reductions outlined by the IEA via emission reductions in other sectors would impose an additional economic cost of at least $500 billion per year globally.

The presumption here is that human analysts can identify profitable investments that are going unexploited by current markets. Some economists simply reject that notion entirely; it violates their core dogma. But unless one’s faith in markets is adamantine and impenetrable, it’s hard to argue with the considerable evidence mounted by McKinsey and WBCSD, and the conclusions Houser draws from that evidence.

Now, that’s just buildings. Maybe other energy-related markets are closer to Adam Smith’s ideal?

Um, no. Consider electricity: at the center of America’s power generation and distribution system are electric utilities — some regulated monopolies, some in various stages of semi-deregulation. Where’s the Invisible Hand in a market almost completely dominated by quasi-public entities governed by state regulatory boards? (Hint: nowhere. There’s a reason the average power plant today is no more efficient than the average power plant 50 years ago.) Or consider oil, a global market dominated by state-owned companies and cartels — is that what Adam Smith had in mind?

The fact is, energy markets are always and everywhere regulated, subsidized, flawed, and politicized. They are constructed by humans to serve particular interests and achieve particular ends. They can be regulated and subsidized differently to serve different interests and achieve different ends. Putting a price on carbon is an important part of that process, but it is not sufficient in and of itself. Revolutionizing energy going to be a much more hands-on effort than that.

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