• Economists widely consider putting a price on carbon to be the ideal, "economically optimal" climate change policy. Unfortunately, real-world political constraints mean carbon pricing rarely lives up to this ideal (see Part 1 in this series).
  • Careful attention to several political economy constraints on carbon pricing can yield improved policy designs and better environmental and economic outcomes.
  • In particular, as discussed in the final installment of this seriessmart use of the revenues generated by a carbon tax could be just as (if not more) important than the carbon price itself.

Full Spectrum: Energy Analysis and Commentary with Jesse Jenkins

The repeal of Australia’s carbon tax last week put the political obstacles to establishing a substantial price on carbon in stark relief. Yet the news from Canberra is just the most dramatic manifestation of a set of powerful political economy forces that can fundamentally constrain efforts to put a price on carbon, as I explained in Part 1 of this series (and detailed in a new paper published in the peer-reviewed journal Energy Policy here; email me for a copy).

Economists typically envision tackling climate change by putting a price on carbon equal to the cost of climate-related damages caused by CO2 emissions — also known as the “social cost of carbon.” That’s the “optimal tax” T* in Fig. 4, from my paper, below. Typical estimates of the social cost of carbon range from roughly $15 to $150 per ton of CO2 in 2012 dollars, with economists envisioning prices rising steadily each year.

Figure 4. Politically constrained carbon price and the opportunity space for improvement. 

Politically constrained carbon pricing policies

Source: Jenkins (2014). Click image to enlarge. 

While pricing carbon sounds simple in theory, in the real world, several political economy constraints can prevent policy makers from enacting such a price, including: opposition of industrial sectors with a concentration of assets that would lose considerable value under such policies; the collective action nature of climate mitigation efforts; principal agent failures; and a low willingness-to-pay for climate mitigation by citizens (see Part 1).

Evidence on public support for climate policy in the United States indicates that political constraints might limit any carbon price to the range of just $2 to $8 per ton of CO2. That’s anywhere from 60 percent to two orders of magnitude below the full social cost of carbon!

In general then, efforts to price carbon will result in a politically constrained tax TC well below T*. This constrained carbon price can only reduce emissions to QC in the figure above. This constrained carbon price thus fails achieve the optimal equilibrium emissions level, Q*, leading to excess CO2 emissions and remaining external damages that exceed the marginal social benefits (the shaded area in Fig. 4, equal to Q* QC).

In short, these political economy constraints mean that carbon pricing proposals don’t work as planned and can’t deliver either the economic efficiency or environmental efficacy envisioned by economists.

Fortunately, that’s not the end of the story! 

While simply trying to “put a price on carbon” is likely to fall far short, alternative policies may capture the “opportunity space for improvement” labeled in Fig. 4. That is, any policy that can achieve reductions in CO2 emissions in the range QC to Q* without imposing social costs in excess of the optimal social cost of carbon (equal to MSC–MPC) will be welfare-improving relative to both the absence of policy intervention (P, Q) and the implementation of a politically constrained carbon price (PC, QC). (A note to economists: this relates to the “general theory of the second best,” as discussed in my paper). 

Thus, while a classic “Pigouvian” carbon price may be “economically optimal” in theory, in real-world practice, there is a significant opportunity space to improve upon the constrained implementation of carbon pricing policies.

How to improve on a politically-constrained carbon price?

How are policy makers to capitalize on this opportunity space for improvement and pursue creative climate policy instruments with superior political feasibility, economic efficiency, and environmental efficacy relative to the constrained implementation of carbon pricing policies? My Energy Policy paper outlines several key implications for climate policy making in the face of political economy constraints…

First, we have to recognize that political economy considerations present an additional key constraint on the design and implementation of climate policies. Recognizing this constraint, policy makers should therefore strive to mitigate climate-related externalities while ensuring (1) that the policy is welfare-improving (i.e., the social costs of mitigating climate-related externalities do not exceed the social benefits) and (2) that the policy does not violate one or more political economy constraints (i.e., the private costs of mitigating climate-related externalities do not exceed the various political economy constraints on policy making). These political economy constraints may take multiple forms, including: limits on welfare losses for industrial constituencies with high asset specificity; limits on initial increases in household costs or in perceived price increases in particularly salient goods or services (e.g., gasoline prices or heating or cooling bills); and/or limits in net increases in household costs after offsetting tax reforms, rebates or government expenditures. (We’d all benefit from further research exploring the operation of each of these potential constraints and the manner in which they may bind climate policy design as well).

Second, it’s time for economists, climate advocates, and policymakers to get more creative. It’s ok to compare a climate proposal to a perfect carbon tax in order to evaluate how close to the theoretical economic ideal the policy might get. But it’s time to put aside a single-minded focus on carbon pricing as the “optimal” climate policy in the real world. Policies that improve economic welfare beyond the status quo without violating relevant political constraints should not be dismissed simply because they are not “economically optimal.” Neither, in point of fact, are the politically constrained carbon pricing instruments most prevalent in the real world! In practice, there might be several policy measures that exhibit superior economic efficiency and environmental efficacy compared to both doing nothing and simply trying to implement a carbon price that will inevitably run right into binding political constraints.

Third, there’s evidence that the choice of policy measure itself can affect consumer and industry support for climate policy measures. For example, MIT’s Valarie Karplus explored how the visibility and distribution of the costs of complying with policy measures impact the way consumers and voters respond to energy policy proposals. For example, consumers pay for gas on a frequent basis and are well attuned to the fluctuations of prices at the pump, while they only infrequently purchase new vehicles and capital costs may be amortized over monthly payments. This difference in visibility helps explain the political durability of U.S. Corporate Average Fuel Economy (CAFE) standards for vehicle fuel efficiency relative to fuel taxes designed to provide market incentives to induce fuel efficiency. So while economists roundly prefer fuel taxes, which are much more economically efficient than fuel economy standards, consumers greatly favor CAFE regulations, even though they impose higher total costs for a given amount of benefit. Paying careful attention to the way voters and other constituents view the the costs of different policy measures is therefore essential. The choice of policy instrument itself may either relax or tighten political economy constraints, impacting the final economic efficiency and environmental performance of any policy proposal.

Fourth, policy makers should pay careful attention to industrial structure and related political economy dynamics. For example, trying to minimize energy cost increases resulting from climate policies, say by subsidizing low-carbon energy adoption rather than penalizing CO2-intensive fuels, could neutralize opposition from energy-intensive manufacturers who do not directly emit CO2 during production. Likewise, opportunities to expand markets for lower-carbon natural gas could win the gas sector to the side of policy action, undermining collective action within the oil and gas industry associations. Providing technology or transition assistance (and thus reducing asset specificity or providing compensation for lost asset value) to specific sectors may also neutralize or weaken industry opposition. Again, there are economic and political feasibility tradeoffs here, as policy makers try to balance the two constraints discussed above. At the same time, the ideal policy is unlikely to be one that ignores the political constraints arising from industry structure, and thus runs into fierce political resistance. 

Fifth, policies that deliver near-term co-benefits salient to consumers and citizens could help reduce the temporal and geographic mismatch between climate mitigation costs incurred today and climate damage avoided in the future. For example, policies that can be credibly linked to public health co-benefits (which can be very large), energy security benefits, or economic development and employment benefits for key constituencies could improve public support for such policies.

Sixth, both the economic and political constraints on the optimal climate policy are not static, but rather change over time. That opens up temporal considerations for adaptive policy design. One clear opportunity is to reduce CO2 abatement costs through technological innovation. This can increase the amount of CO2 reductions at any given cost, effectively relaxing both the economic and political constraints. Another option is to try to strengthen industries that stand to benefit from climate policies (low-carbon technology sectors such as renewable or nuclear energy, energy efficient technologies, biofuels, etc.) before directly impacting incumbent industries. For example, clean energy deployment subsidies and innovation policies designed to effectively reduce the costs of low-carbon energy alternatives and build stronger political interests around clean energy sectors can potentially launch a self-reinforcing cycle: stronger industries and lower technology costs yield greater demand for low-carbon policy and lower compliance costs which in turn yields even stronger industries and lower costs, and so forth. At the same time, public campaigning that can raise support for climate policies in key constituencies can relax political constraints, although such campaigning must be pursued in a way that doesn’t simultaneously increasing opposition in other constituencies (i.e. doesn’t backfire). 

Finally, and perhaps most importantly, the use of the revenues generated by a carbon price may ultimately be just as important as the level of carbon tax itself (if not more so). How revenues are used can dramatically impact both the political support for the carbon price itself and improve the environmental efficacy and economic efficiency of the policy. However, there is much more to say on this front, which I have to save for Part 3, which will conclude this series. Stay tuned on Monday…