Ryan Avent and Paul Krugman are ripping Ted Gayer over his recognition of the costs of energy efficiency investments. Here is Krugman:
Ryan Avent takes on Ted Gayer so I don’t have to. Mr. Gayer tries to dismiss some of what I’ve said about the cost of climate-change policy by mocking a McKinsey study showing that a substantial amount of conservation would actually save money, that is, have a negative cost.

The criticism is a bit unfair. Here is what Gayer says:

But Krugman oversells the affordability claim by linking to a widely cited report by McKinsey & Company. The main point of the McKinsey study is provided in their Exhibit B, which illustrates a rather peculiar finding that there are a significant number of pollution abatement options that can be achieved at “negative cost.”  This finding violates the basic principles of economics. If firms (or consumers) could reduce emissions at negative cost, then they would do so. To say otherwise is to say that they are willingly or ignorantly passing up profits.
The rest of Gayer’s piece is a reasoned analysis of the issue, pointing out that business firms, households and government aren’t stupid, they rationally weigh the benefits and costs and choose the option that generates the most net benefits.

Critics of this sort of analysis look at the numbers and conclude that since many energy efficiency investments will pay off over time, the institutions that don’t adopt them are “morons.” I agree that people are morons. How else could you explain the faithfulness of University of Kentucky football fans (pass the ball downfield dangit!)? However, in this situation it makes sense to give them the benefit of the doubt. Consider a couple of situations. First, suppose there is a five dollar bill on the sidewalk. Only a moron would fail to pick it up. This is the analogy given when economists suggest that profit maximizing business firms usually are better able to find profit opportunities than government regulators, university professors and think tank researchers.

Second, suppose there is five dollar bill on the sidewalk and you bend over to pick it up. Before you do another pedestrian grabs it first and offers you a deal. If you give him $20 then he’ll give you the $5 and another $5 bill annually for the next four years. What would you do? Obviously, I’m trying to illustrate the decision faced by those considering energy efficiency investments. There is a substantial upfront cost that pays off over a number of years. The energy efficiency advocates seem to look at the above situation and say, heck, the cost is only $20 and the benefits are $25. The “negative costs” are $5. Only a moron would turn that deal down, right?

Wrong. There are a number of reasons to turn down the deal. The most obvious is the timing of the benefits and costs. The benefits occur in the future which most people (in the words of one of my commenters: “morons”) discount. We require the payment of interest to induce us to save and we must pay interest to borrow. Interest rates reflect the market activity of buyers and sellers of loanable funds and measure social discount rates.

In the example above, suppose the decision maker has a discount rate of 10%. The $5 received next year is discounted so that the value today is only $4.55 (the present value is equal to the future value divided by one plus the discount rate to the power of the years away). The sum of the present values is only $19 so it doesn’t make sense to invest $20 to receive the stream of benefits. On the other hand, if the decision maker’s discount rate is 5% then the present value of the stream of benefits is $22 and the decision maker should take the deal. The net costs are negative (i.e., $20 - $22 = -$2).

So, when economists point out that there are costs associated with energy efficiency investments this simply means that there are … costs! In the example above the costs are $20. The decision maker could use that $20 today to do a number of useful things. Firms considering energy efficiency investments have other things they could do, such as adopting other new technologies or investing in the human capital of their employees. Economists call these other alternatives “opportunity costs”, the recognition of which is often misunderstood and mocked by noneconomists (e.g., here is David Roberts at Grist).

The claim made by Krugman that cap-and-trade will actually have negative costs involves imposing a social discount rate on firms that they don’t use in their own private decisions. Gayer puts it like this:

A top-down analysis might impose a discount rate, which may be inconsistent with the tradeoffs that firms actually make in practice. Economics, again, takes a more modest approach of assuming that prices – in this case the interest rate – incorporate the relevant information concerning the private (not social) tradeoffs made by firms over time.   
I’m not saying that from society’s point of view that these might be been involved. The analysis of energy efficiency investment from society’s point of view involves additional factors. For example, the pollution control benefits must be included. And perhaps individual decisions are made with a discount rate that is too short-sighted. That’s what Gayer is saying too:
So if a firm does not buy a more fuel efficient appliance, it is because the costs outweigh the benefits to the firm. Of course, there are costs imposed on society by greenhouse gas emissions, which is why economists favor increasing the price of carbon-intensive activities, which could be accomplished with a carbon tax.
So, I think the criticism made by Avent and Krugman is a bit unfair. It seems that all three players in the spat reach the same conclusion about the economics of climate change: that government action is necessary to provide incentives to firms to adopt energy efficiency investments. The best government action could be cap-and-trade or a carbon tax. I’m always surprised at the intensity of the debate among economists who basically agree over their disagreements about the minutiae of the issue.