The Economy? Energy Policy!

Recently, I read a webpage on npr that discussed the American economy. I was shocked to see that it did not mention Climate Change or Global Warming. I personally believe that Human Induced Climate Change (HICC) is probably the biggest challenge that humanity has faced since before the bronze age, but I'm not here to discuss that. I'm here to discuss the HICC, Energy Policy, and the economy.

Why is energy so expensive?

No one can deny that the exorbitant price of energy is one of the largest factors in the current downturn. Some blame OPEC. Others blame speculation, but--and this is basic, people--it's supply and demand. There is too much demand and not enough supply. Thus the price has risen.

Simple, right? What does that have to do with HICC? Well ever since the late 90s, Europe has been introducing measures to curb greenhouse gas emissions as part of the Kyoto Protocol. In general, world policy has been shifting toward environmental regulation of greenhouse gases to curb HICC. This puts the world's large energy companies in a precarious position. The price of energy is high right now, but it is risky for them to increase capital investment in fossil fuels. Those investments might pay off in the short term, but could be burdensome over the long term--under a Carbon Cap and Trade or Carbon Tax. Thus, they are taking a wait and see approach. On the other hand, renewable energy can't quite make it off the ground just yet. The technology still has not improved enough that it can compete with fossil fuels in a totally free market.

Thus, the government should end all of this indecision and finally implement new policies to control climate change. Nothing hurts the economy more than uncertainty. Still not convinced? Look at Europe. $140/barrel oil has not hurt Europe nearly as much as the U.S. Why? Because it has implemented measures to reduce greenhouse gas emissions, thus reducing fossil fuel use. If the U.S. had increased the gasoline tax 4 years ago, demand would have decreased, U.S. automakers would be making efficient vehicles, and the price of oil might not risen as high as it is now.

What should we do about expensive energy and Climate Change?

But John McCain and Barack Obama have it right. We need to have a Carbon Cap and Trade system. Right? WRONG. Let me explain why. A Carbon Tax would place a price on the cost of emitting greenhouse gases, thus making non-emitting technologies such as wind and solar competitive. A Carbon Cap and Trade system would allow energy companies and others to emit CO2 (and other green house gases), but if they exceed a certain cap, they would have to pay a penalty. Companies that did not exceed that cap could sell their permits to pollute to the higher polluters. Additionally, other entities that reduced greenhouse gas emissions in other ways, could apply for permits to pollute which they could then sell. The problem with this scheme is the same as the problem with the energy market today: uncertainty. Energy infrastructure requires large capital expenditures and long term investments. If the carbon market is volatile (which could be due to technological changes, political uncertainty, or just the herd mentality), this will discourage capital investments and thus slow technological advancement. Consider this: Fred's Renewable Energy develops a new widget which allows the production of clean energy almost as cheaply as coal fired power plants. This will cause the price of carbon emissions permits to go down so that coal fired power plant owners can afford them and can then continue to pollute.

There are other problems with the system in Europe as well. The practice of grandfathering is particularly bad. Owners of old polluting technology are given free permits by the government. They can then sell these on the free market or use them themselves. This is just free money given out by the government. Another problem is the administration cost of a Cap and Trade system. In it, not only does the government have to verify the amount of emissions of all participants, but it also must verify that trading is done fairly and above board, that any new permits are for valid reasons (such as planting of trees or mechanical filtering of CO2 from the air). With a Carbon Tax, only emissions need be tracked.

Many fiscal conservatives have criticized the idea of any carbon regulation arguing that the energy markets should be free of such distortion. In his seminal work, Milton Friedman argued that the role of government in commerce should be diminished except to diminish negative "neighborhood effects"--effects on third parties for which it is not feasible to charge or recompense them. (from Capitalism and Freedom by Milton Friedman). What's climate change, but a big negative effect on many third parties? The carbon taxes are a way to recompense society for the pollution that is emitted and a way to discourage it from being emitted in the first place. A further benefit of a Carbon Tax is to make the price of energy somewhat predictable, thus encouraging long term investment in those technologies which are most cost-efficient.

But markets are efficient. Shouldn't then a Cap and Trade scheme be preferable? The problem is that the government should not be trusted with handing out pollution permits. Too many corrupt companies with political connections will be falsely rated as green and given free permits. Furthermore, if the markets are ever flooded, polluters will be able to stockpile cheap permits.

Won't all these schems hurt the economy?

But what about the effects on the economy? People will pay higher energy prices and this will tank the economy. Right? Not necessarily. If we offset the carbon tax burden that consumers face with income tax cuts so that it is revenue neutral, the only people who will be overly burdened will be prolific polluters. And that's exactly who should be. So Mr Obama and Mr McCain, please get this right. Save the planet and help the economy.