Green energy paradox: Hotelling’s exhaustible resource and consequences of improving the alternatives

Michael Giberson

The “green power paradox” grabs Hotelling by the ankles, turns him upside down, and shakes the change out of his pockets.

Harold Hotelling’s classic article, “The Economics of Exhaustible Resources,” observes that the owner of an exhaustible resource stock always is making choices in the shadow of the future. If the owner produces and sells a bit today, that necessarily involves sacrificing the opportunity to produce and sell that bit in the future. Given that the resource is exhaustible, we expect the price to increase as the stock of resources nears exhaustion. The resource owner’s choice, then, is whether to sell at a low price today or a higher price tomorrow.

Hotelling’s mathematics says the resource price will tend to increase at the rate of interest, at least under certain conditions (The intuition: if the rate of price increase is below the rate of interest then it will pay to produce more quickly now; if the  price increases are any faster then it will pay to produce more slowly. The adjustments will tend to keep the rate of resource price increases in line with interest rates.)

The green paradox emerges when, in a world of exhaustible energy resources, a new renewable energy supply is introduced. Suddenly, the heavy hand of the future is lifted a little. Therefore, even as the exhaustible energy resource dwindles, no longer can the owner expect ever rising prices. In fact, as the technology of the renewable energy resource improves, the price of all energy resources should drop.

In a world of constantly improving renewable energy technology, the owner of an exhaustible resource may be choosing between a low price today and an even lower price tomorrow. The implication: produce and sell now, before the price drops again!

Paradoxically, government promotion of alternative energy technology as a means to fight global warming may be encouraging the rapid exploitation of fossil fuels!

(This is my optimistic, Julian Simon-esque version of the Green Paradox, with resources becoming cheaper over time. A similar pessimistic version can obtain if owners of an exhaustible energy resource expect that regulatory controls on production will become increasingly onerous over time. Produce now while the controls are light instead of keeping your resource in the ground where future regulations may insist it stay.

And finally, if you are a combination resource optimist and a regulatory pessimist, then you ought to stop reading this post right now and go drill, baby, drill!)

SEE: Hans-Werner Sinn, The Green Paradox, MIT Press (2012). Related Sinn: “Greenhouse gases: Demand control policies, supply and the time path of carbon prices.

HT: Marginal Revolution.

Highly recommended read on Waxman-Markey: The Cap-and-trade Bait and Switch

Michael Giberson

David Schoenbrod and Richard B. Stewart explain why the Waxman-Markey “cap-and-trade” bill isn’t, fundamentally, a market-based approach to regulating greenhouse gasses:

As a candidate for president in April 2008, Barack Obama told Fox News that “a cap-and-trade system is a smarter way of controlling pollution” than “top-down” regulation. He was right. With cap and trade the market decides where and how to cut emissions. With top-down regulation, as Mr. Obama explained, regulators dictate “every single rule that a company has to abide by, which creates a lot of bureaucracy and red tape and often-times is less efficient.”

… [Yet] Waxman-Markey is largely top-down regulation dressed in cap-and-trade clothing. It purports to set a cap on greenhouse gases, but the cap is so loose in the early years that through the use of cheap offsets the U.S. need not significantly reduce its fossil-fuel emissions until about 2025. …

The top-down directives come in three forms. First, electric utilities, auto makers and states get free allowances on the condition that they comply with regulations requiring coal sequestration, alternative energy sources, energy conservation, advanced auto technology and more. Second, many other provisions of the 1,428 page bill mandate outright regulation on subjects ranging from how electricity is generated to off-road vehicles and household lighting. Third, still other provisions provide subsidies for government-chosen technology “winners” such as alternate energy sources, plug-in vehicles and weatherization of old buildings.

Progress on most or all such fronts will be needed, but when, where and how should be decided principally by a cap-driven market, not the “red tape” that candidate Obama deplored.

The bill would impose dramatically lower limits in the future, but the authors see little reason to expect future politicians to allow them to go into effect. What would go into effect in the legislation are hundreds of pages of new energy mandates, more industrial policy directives from Washington and many more subsidies for politically favored technology choices.

The authors believe that cap-and-trade can be successfully applied to greenhouse gas emissions, and they much prefer the approach to the likely alternative (source-by-source EPA regulation of greenhouse gas emission). But Waxman-Markey isn’t going to do the job.

Cash for clunkers, economics of

Michael Giberson

Christopher Knittel, at UC-Davis, has run some numbers on the “Cash for Clunkers” program and concludes that it is an expensive way to reduce carbon dioxide emissions:

The Cash for Clunker program aims to stimulate the economy, provide relief for automobile manufacturers and reduce greenhouse gas emissions. In this research note, I present estimates of the implied cost of carbon dioxide reductions under the Cash for Clunker program. The estimates suggest that the program is an expensive way to reduce greenhouse gases. This is true under a wide range of assumptions regarding the increase in fuel economy of new vehicles purchased under the program, how long the clunkers would have been on the road if not for the program, and whether we account for reductions in criteria pollutants. Conservative estimates of the implied carbon cost exceed $365 per ton; best case scenario parameter values suggest a cost of carbon of $237 per ton.

HT to Keith Johnson at the WSJ’s Environmental Capital, who adds that the government estimates Waxman-Markey to reduce carbon dioxide for only $28 per ton. Knittel acknowledges that the Cash for Clunkers program was intended both as a stimulus program and an environmental program, and he limits his attention solely to analysis of the environmental program.

Robert Hahn, back in the early 1990s, analyzed some early “cash for clunkers” efforts in California and concluded that a program targeted to high-pollution areas could produce net benefits. (Published as “An Economic Analysis of Scrappage,” Rand Journal of Economics, 1995.) Key parts of the analysis, Hahn says, are assumptions about the remaining life of retired vehicles – are you avoiding four years of future clunker-emissions or just two? – and the stringency and effectiveness of existing automobile inspection and maintenance programs, which may already be capturing the ‘low hanging fruit’ (i.e., forcing repair or scrappage of high-emitting vehicles that would otherwise enjoy a long life).

UPDATE: For the interested reader, Political Calculations offers a Cash-for-clunkers tool by which you can calculate how long it would take for taxpayers to obtain environmental benefits equal to program costs, and if you don’t like their assumptions you can easily substitute your own.

A problem with market-based approaches to emission reductions

Michael Giberson

Market-based approaches to regulating emissions are the new conventional wisdom, according to Robert Stavins, and it would be hard to disagree. Among proponents of regulating greenhouse gasses in the United States, the big debate is over which of two market-based approaches to regulating emissions should be pursued: emission tax or cap-and-trade. Is anyone proposing “best available control technology”? Market-based approaches have become favored in part because of some high profile successes, notably the cap-and-trade program for SO2, seen as achieving its goal at a considerable cost savings compared to alternative approaches to regulation.

The primary strength of market-based approaches comes from the decentralizing of compliance decision-making, which enables each entity responsible for compliance to pursue the lowest-cost means of meeting the requirement. This strength, though, may also be the biggest problem with market-based approaches, at least when proponents of regulation hope to achieve goals beyond efficiently addressing externalities associated with emissions.

At TNR’s THE VINE, Bradford Plumer asks, “If Carbon Caps Are Coming, Why Mandate Renewables?“, and reports some of the responses he received.  Rich Sweeny asked the same question at Common Tragedies a while back.  In both cases it appears to be the case that proponents of greenhouse gas regulation are worried we might achieve the targeted reductions too easily, i.e. while still burning a lot of coal, not cutting back on consumption, and not garnering enough market share for renewable power. That is to say, some proponents of regulating greenhouse gasses hope to not only to reduce externalities, they have additional preferences about other people’s future energy choices that they want to control through the public policy process.

From Plumer:

Hummel explained that in wholesale electricity markets, the price of carbon would need to get very high—around $60/ton—before pushing dirty coal out onto the margins. So a renewable standard is a good way to manage a steady transition away from coal long before reaching that point.

In the comments responding to Sweeny’s discussion:

Cap and trade purists don’t seem to understand that there is something out here in the real world called an electricity market, and that under any politically viable national cap, coal use is barely touched.

Once we get beyond “internalizing the externality” in economists’ language, or more plainly, once the third party effects of actions are taken care of, the further ambitions of these regulation proponents sound like a bad mix of industrial policy and meddlesome preferences. The problem with market-based approaches, from the point of view of some folks, is that they don’t help enforce these further ambitions for social reform.

Actually, in my view, this “problem” is another great strength of the market-based approach.

Falling carbon permit prices in Europe: Threat or menace?

Michael Giberson

At Environmental Capital Keith Johnson notes that the financial market meltdown is driving down carbon permit prices in Europe, and as a result it is harder to fund clean-energy projects in the developing world.

Johnson calls this change in prospects for clean-energy developers “a negative side effect” of falling permit prices.  I can see how this change might be a negative side effort for investors in these projects, but for the rest of us falling permit prices are a good thing. After all, if the permit price reflects approximately the cost of reducing carbon emissions (a big “if”, but approximately justifiable*), then falling permit prices mean that the cost of reducing carbon emissions is going down.  If reducing carbon emissions is a worthy public policy goal, then attaining that goal is becoming cheaper.

To the non-investor, worry about the economic prospects of clean-energy projects seems to mix the ends of policy and one particular way of attaining those ends.  One advantage shared by both cap-and-trade and carbon tax proposals is that they do not wed the attainment of a goal to specific means (i.e. particular technologies or approaches), but rather let the market sort those things out in a least-cost way.

I understand, of course, reducing carbon emissions is becoming cheaper at the margin because the scale of overall economic activity is down.  That falling level of overall economic activity is a negative factor worthy of public policy attention, but the investment-worthiness of clean energy businesses is per se of no more public policy interest than the growth of dingus makers or widget manufacturing.

(*”Approximately justifiable” because companies coverned by the requirements must choose between reducing carbon emissions or buying a permit, so at the margin the price should reflect the cost of abatement.)

ASIDES:

Just because the falling level of economic activity is appropriately a matter of public policy attention doesn’t mean that public policy makers have a clue. On this topic, see Mario Rizzo’s ThinkMarkets blog post, intelligently named “The Macroeconomic Knowledge Problem.” (Around here we usually focus on microeconomic knowledge problems, so it is nice to know someone’s got our back.)

The comments by Rob Stavins comparing cap-and-trade and carbon taxes at the National Journal site (noted in my post yesterday) have now been supplemented by a number of other responses.

Rob Bradley reminds us that the policy choice isn’t just between cap-and-trade and carbon taxes.

Generally speaking, Johnson’s post at Environmental Capital provides an illustration of the mild counter-cyclical effects of a cap-and-trade approach that I mentioned briefly in yesterday’s post.

Carbon tax vs. cap-and-trade, again

Michael Giberson

The U.S. Climate Action Partnership report, mentioned by Lynne last Friday,  has stimulated a spate of new newspaper stories comparing cap-and-trade and carbon taxes as ways to regulated greenhouse gases.  A story by Tom Fowler in the Houston Chronicle looks pretty good as an overview of “carbon tax vs. cap-and-trade.”

One thing to notice about some of the points raised on one side of the argument or the other is that they apply pretty strongly to both.  Rice University’s Amy Meyers Jaffe is right to be worried about “aberrations that can be created when you design a market through the political process” – see the initial California ISO power market design for an example – but the carbon tax would similarly be designed and imposed through the political process.  I don’t see much reason to believe that the tax code is less susceptible to lobbying than other parts of the political process.

According to the Chronicle, “many are skeptical that the government would make good use of tax proceeds,” but the same people should also be skeptical that the government would make good use of permit auction proceeds. Similarly, emissions will have to be monitored under both programs, either to ensure sufficient taxes are paid or that sufficient permits are acquired.

S. David Freeman is worried that a permit system would be unpoliceable.  The example quoted refers to offset programs, not the cap-and-trade system itself, and design of offset credits raise separate issues.  Freeman worries about manipulation of a permit market, but I’d say manipulation of a permit market (which would be show up in market prices and be accomplished through registered market participants) is likely to be more transparent than manipulation of the tax code by lobbyists and their Congressional  pals in Washington (which could be snuck into obscure tax code amendments inserted during late-night conference committee mash-ups).

Craig Pirrong is quoted as saying “just like any large commodity market, CO2 prices could be highly volatile.” In a Washington Post story, Rob Shapiro also suggests that cap and trade would introduce “enormous volatility” and would allow “a lot of mechanisms for gaming the system.”   Yes, if badly designed, then a cap-and-trade market could be volatile and susceptible to gaming.  A well-designed CO2 market would not likely pose significant problems on volatility or gaming.

The RGGI market appears reasonably well designed and carefully monitored; if Shapiro knows of ways to game the RGGI design, then why didn’t he raise them during design of that system?  It will be a few years before the RGGI cap begins to bite and the market is really tested, but it looks like a reasonably sound design.

Pirrong is also quoted in the Chronicle saying, “Banks like the volatility and complexity, because the more volatile and complex, the more money they could make.  But volatility may make companies put off investing in cleaner technology because they can’t get an accurate estimate on the costs.”  On the other hand, volatility raises the value of options, which may increase the value of investing in cleaner technology.

Perhaps it bears mentioning that while a carbon tax would vary more or less directly in proportion to macroeconomic activity, a cap-and-trade approach would likely have a modest counter-cyclical effect.  The cap would become less binding during recessions – permit prices would fall – and the cap would become more binding during economic booms.

I may sound like a cap-and-trade advocate, but not really. I don’t have a hard conclusion on whether cap-and-trade or carbon taxes would work best.  But like Rob Stavins, I am opposed “to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.”

Stavins also writes:

Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects.  Hence, they said, the two primary questions to use in deciding between them should be:  (1) which is more politically feasible; and (2) which is more likely to be well-designed?

Stavins answers the two questions in favor of cap-and-trade, citing “real world political forces” as the reason to think cap-and-trade would be better designed.  For more by Stavins on the topic, see “A U.S. Cap-and-Trade System to Address Global Climate Change.”

On the carbon tax side of the issue, Greg Mankiw is probably most prominent among economist-advocates.

At Environmental Economics, John Whitehead advises: the “economic case for cap-and-trade (or a carbon tax) is clear.”