Don’t forget supply effects when considering pricing carbon emissions

Economists and journalists tend to focus mainly on the effects of higher prices in restricting socially excess demands. There are also effects on supply that are positive. For the global warming externality the supply effects induced by carbon charges will substantially limit the economic damage policies impose on energy users.

As I posted in February firms motivated to make money out of climate change will, by their self-interested actions, help to reduce the adjustment costs imposed by climate change as a consequence. Carbon taxes or carbon emission prices created by emission quotas will encourage such firms. Other firms will punt that the threat of climate change is exaggerated and will pursue status quo policies that will save us all should the forecasts of the climate change pessimists prove overly pessimistic.

The Economist this week shows that firms are falling over themselves to prove their ‘greenness’:

Global investment in renewable power-generation, biofuels and low-carbon technologies rose from $28 billion in 2004 to $71 billion in 2006, according to New Energy Finance, a research company. The stock prices of clean-energy companies have been rocketing up. Silicon Valley's venture capitalists are piling into the business, convinced that they can design revolutionary technologies, bring down prices and turf out incumbents in the energy business just as they did in the software business. Oil firms, carmakers, power generators, nervous of being outmanoeuvred, are jacking up their investments in renewables and biofuels.

As the likes of General Electric and BP put money into cleaner technologies, costs will fall. The price of a watt of solar photovoltaic capacity dropped from around $20 in the 1970s to $2.70 in 2004 (though a silicon shortage, caused by rocketing demand as a result of madly generous German subsidies, has pushed it up since). The price of wind power has fallen from $2 per kilowatt hour in the 1970s to 5-8 cents now, compared with 2-4 cents for coal-fired power. More investment will bring prices down further; and, as the gap shrinks, so the costs of switching from dirty energy to the clean sort will fall……. (my bold)

Moreover, the Economist makes the obvious point about encouraging investments:

The best way for governments to encourage investment in cleaner energy is to make the polluter pay by putting a price on CO2 emissions. According to the IPCC, the body set up under the auspices of the UN to establish a consensus on global warming, a price of somewhere between $20 and $50 per tonne of CO2 by 2020-30 should start to stabilise CO2 concentrations at around 550 parts per million (widely reckoned to be a safeish level) by the end of this century. A $50 price tag would raise petrol prices in America by around 15% and electricity prices by around 35%—hardly draconian when set alongside recent fluctuations. The IPCC reckons that stabilising at 550ppm would knock around 0.1% off global economic growth annually. (my bold)

A carbon price can be established either through a tax or through a cap-and-trade system, such as the one Europe adopted after signing up to Kyoto. A carbon tax would be preferable, because companies would then be able to build a fixed price into their investment plans; but businesspeople and politicians are both strangely averse to the word “tax”. A cap-and-trade system can be made to work, but the price has to settle at a level that affects commercial decisions. Europe's hasn't: the price has been too volatile, and, for much of its existence, too low, to shift investment patterns much.

Europe has tightened its system up, and the carbon price has risen to a level which could start to make a difference. But Europe, by itself, will not save the planet. It
is America that matters, not just because it is the world's biggest polluter, but also because without its participation, the biggest polluters of the future—China and India—will not do anything.

The best news in the fight against climate change is that business is starting to invest in clean energy seriously. But these investments will flourish only if governments are prepared to put a price on carbon.

There are many good points here including an interesting argument for carbon taxes rather than 'cap and trade' schemes as we will adopt in Australia. Of course Australia mudst learn from the difficulties of the European scheme.

A series of other Economist articles on the same issue are here.