Price v's policy for reducing emissions

At the New Zealand Initiative, Matt Burgess makes an important point about the advantages of using price rather than policy to reduce emissions. Prices act like information signals that allocate resources to their best uses in the economy. This, as Matt points out, means that prices can do easily what policymakers find almost impossible, dealing with the trade-offs involved with choosing between different methods of reducing emissions. When should we stop investing in one particular method of emissions reduction and invest in other methods instead? Policymakers find this an almost insurmountable problem.

When governments want to reduce emissions, they have a choice between using policy or price.

Policy includes rules – for example, 100% of electricity must be generated from renewables – as well as incentive payments, such as electric vehicle subsidies.

Alternatively, governments can price carbon using cap-and-trade, or tax carbon directly.

The fact that emissions occur in millions of places in the economy strongly affects the relative performance of policy and price.

Consider the following question: At what share of renewable electricity does further investment in renewable electricity cease to be competitive with other ways of reducing emissions?

For policymakers, this is an astonishingly difficult question.

It is not just a matter of working out how the per tonne carbon abatement cost rises as the share of renewables approaches 100%. That is hard enough.

It is also about understanding the consequences for downstream users of electricity, who comprise the rest of the economy.

At a very high share of renewables, the cost of electricity will tend to increase. For downstream users, that affects emissions: If electricity costs more, they will be less willing to switch from petrol to electric vehicles, or to switch their industrial processes from coal or gas to electricity.

For policymakers, working out how the share of renewables affects overall emissions is impossibly complicated.

But for a carbon price, whether through cap-and-trade or a tax, discovery of the ‘right’ share of renewable electricity is easy.

Confronted with the relative cost of emissions-intensive coal and gas generation against green alternatives, buyers of electricity decide their willingness to pay.

For some users, green energy is attractive. For other users, coal and gas has real advantages and means a high willingness to pay.

For a problem like emissions, price enables discovery of the answer to non-obvious questions like how much coal and gas generation to retain. Price can access information that is lost to top-down policy.

Policy’s disadvantage is measurable. A survey of the literature on the performance of government emissions reduction programmes reveals governments spend perhaps $5 to avoid harm from emissions worth $1, on average.

Under cap-and-trade like an Emissions Trading Scheme (ETS), retaining coal and gas generation does not increase overall emissions. These high-emissions generators stay in business only by outcompeting alternative emissions sources for the right to emit.

The government recently calling the ETS its “main tool” for achieving its emissions targets is a step in the right direction.