Marc Guyot and Radu Vranceanu, Professors of Economics at ESSEC Business School, take a pragmatic look at the global warming debate and call upon stakeholders to accept a no-pain-no-gain approach.  

The Cost of Going Green: A focus on carbon tax, by Marc Guyot and Radu Vranceanu.

Fuelling the angst

It is widely agreed today that the major political, economic and technological challenge to come for humanity is climate change. Inevitably, this all-too-real challenge triggered the media machine into motion, hammering home an apocalyptic message meant to incite passions and provoke all sorts of reactions through accusing the wicked perpetrators behind it. Anxiety linked to a forthcoming end of the world is taking root, upsetting the minds of the young and not-so-young alike, and is prompting? companies and governments to undertake action that seems more aimed at calming this angst and bringing new business into the fold than taking effective decisions.

This nervousness is all the more distressing given that the diagnostic is indeed damning. The last two centuries of growth based on the use of fossil fuels – coal, petrol and natural gas – have resulted in an accumulation of CO2 in the atmosphere, which sends the sun’s rays back towards Earth, warming it at an alarming rate. While in 1750 the concentration in CO2 (or carbon) was 280 ppm, it was 413 ppm in 2018, and, if nothing changes, it is set to reach 700-900 ppm in 2100, bringing with it a 3°-5°C rise in temperatures in relation to the pre-industrial era. This should have truly dramatic consequences for life as we know it.

Of fossils and green populism

Insofar as carbon capture technologies are not yet fully developed, at this date in time there seems to be no other serious solution possible than the diminishing of CO2 emissions by a drastic reduction in the use of fossil fuels for the production of energy. As much as there is large consensus on this vital necessity, its tangible implementation remains extremely difficult. In effect, how can we decide on a common amount of reduction in their use? What power stations should be closed? In which countries? And from now onwards should fossil fuel-driven engines be banned? The absence of an answer from policymakers to these core questions are to the delight of the activists who strive to take on the role of saviour by proposing reductions that are as poorly well-grounded as unachievable. It also provides support to a new form of green populism. Accusations of climate indifference on the social networks leads to governments sidestepping the issue by highlighting a patchwork of spectacular, yet conflicting and ineffective measures.

It is not the market economy itself that is responsible for pollution and carbon emissions. It is a consequence of the methods of industrial production – whether this production takes place within the framework of a planned economy or that of a market-driven economy. However, a market economy offers a possibility of bringing necessary adaptation from the simple principle of the so-called law of supply and demand: the more expensive the product, the less it will be in demand and therefore the less it will be produced. As such, the hidden cost of a ton of carbon must be set – and those producing it made to pay. A while ago, A.C. Pigou (1920) indicated that a tax on pollution would enable governments to effectively correct – via price mechanisms – this form of negative externality. Applied to the present issue, this would mean a tax on every ton of carbon produced. This is the principle of the “carbon tax”.

A multi-disciplinary light on the matter

To measure the feasibility and the cost of the transition towards an economy that limits its carbon emissions, experts use integrated evaluation models (IMAs), in large part developed by Professor William Nordhaus, Nobel Prize for Economics 2018 (cf. Barrage, 2019), building on the early work of Tjalling Koopmans. A model of this type enables the integration of economic, demographic and physical mechanisms – the use of energy for production and how that production is used; and physical mechanisms – how production generates carbon, how technology contributed to higher efficiency use of energy over time, what the carbon cycle is, what share is absorbed and what share accumulated, and how the accumulation of carbon modifies the sea temperature and level – to be represented. The model then represents how in turn these changes impact the economy (floods, storms, acidification of the ocean, decrease in agricultural productivity, etc.). A model of this type presents many “loops” – or situations where A influences B, B influences C, and C has an impact on A.

Existing integrated models of evaluation can be relatively compact, with twenty or so key relationships, and delve into the details of the process taking into account hundreds of relationships and hundreds of thousands of variables. What sets this model apart is that (1) its dynamic optimization framework, and (2) its interactive character consumption and carbon emissions – are interconnected. Such models allow us to simulate future developments by using scenarios for population growth, revenue growth, and productivity. And, most importantly, they enable us to simulate how public policy can modify the trajectory of consumption and GDP, carbon emissions and temperatures.

However, IAMs are not infallible tools in as much as the impact on climate and policy costs depends on hypotheses linked to parameters and mechanisms such as productivity growth rate, demographic growth rate or even the discount rate for the future generations well-being. Moreover, there are also uncertainties regarding the relationships themselves and the “tipping points” because global warming can trigger catastrophes and irreversible crises. But the debate on their sources and margins of error (see Gillingham et al., 2018) is in itself useful for improving policies. For example, thanks to integrated evaluation models, we now realise that the objective to limit the rise in temperatures to a 2°C maximum by 2100 is almost unreachable; whether an unachievable goal is useful for its signaling effect or not, it is open to debate. On the other hand, an objective of 2.5°C would be quite realistic.

The cost of going green: The now or the future

The integrated evaluation model, through its construction – constrained inter-temporal optimisation (in general with an infinite horizon) – enables us to assess in a rigorous way the “social cost” of an extra ton of carbon released in the atmosphere. Today, an additional ton of carbon is linked to more consumption in the present, thus higher benefit for the current generation. However, it also carries costs on the future generations having to compensate for the harmful effects, by consuming less than they could in their time. In the case of a massive increase in temperatures, these costs can be very high. The social cost of carbon can be seen as the total costs imposed on humanity of today from letting out an extra ton of carbon into the atmosphere. Obviously, the more importance we give to the future generations, the larger this discounted cost of a ton of carbon and inversely. The importance to us of the consumption of future generations is modelled by a discount factor equal to one (or a zero discount rate) if the future counts as much as the present, or less than one if it counts for less. The debate on the correct discount rate is far from settled.

Turning back to the rationale by Pigou (1920) a tax on carbon emissions would increase the cost of fossil energy and would create the incentive to reduce its use. The IAMs allow an “appropriate” carbon tax to be determined. Indeed, a carbon tax identical to the social cost of carbon as determined within the IAMs framework should set economic growth on a path in line with the objectives of reducing emissions and controlling the rise in temperatures.

According to William Nordhaus, who published a summary of the most recent IAMs results in the American Economic Review in 2019 (Nordhaus, 2019), if we make the hypothesis that the discount factor of the future generation consumption is very close to one and we accept the target of limiting the increase in temperature to 2°C maximum, most integrated models reach a carbon social cost in a range of $500 per ton to $900 per ton, which is obviously a very significant figure. We should keep in mind fo instance that today a Paris-NYC flight generates approximately one ton of carbon per traveler, or that a Big-Mag generates some 3kg of CO2 emissions. With discounted factors closer to those of private investment and a more realistic objective set at a 2.5°C rise in temperatures, the social cost of carbon would be around $200 per ton. In its latest report, the World Bank (2019) is more optimistic – it estimates that a tax at around $100 per ton towards 2030 would be enough to reach the COP21 objective.

It is worrying to see that today governments are very far from this optimal level. In 2019, out of the thirty or so countries which implemented such a tax, its amount rarely surpassed $30 per ton – with the notable exception of Sweden ($129 per ton) and Switzerland ($96 per ton). However, even in these “virtuous” countries, carbon tax covers less than 50% of CO2 emissions – which is also the case for most other countries. In France, in 2019 the government gave way when faced with the “yellow vests” movement and renounced on the increase in carbon tax it wanted to implement at €44.6 per ton (the French tax being already “hidden” in an older tax on fuels). Implementing too low a carbon tax with only partial cover of emissions virtually means trying to put out a fire with a single drop of water.

The alternative to carbon tax, implemented in thirty or so other countries (sometimes in parallel to the carbon tax) is the setting up of a market for carbon permits, associated with regulations limiting the total amount of the emissions per country in line with the planned reduction in emissions. The price of carbon on this market would be equal to the social cost of carbon. As such, carbon market or carbon tax amount to being equivalent instruments, the second providing the advantage of being less prone to manipulation by lobbies and less sensitive to electoral cycles.

It seems, then, that while there is a possible solution to act on climate change via the carbon tax, governments and the public are not ready to assume the cost of this effective action. Their problem evidently comes from political fear at the idea of announcing to their citizens the level of cost that society should have to bear today and the way in which this cost will be distributed. Whether governments choose a tax or restrictions on emissions, it would push up the price massively for every good that is intensive in carbon – transport, heating, air conditioning – but also, all those goods whose production requires energy would see their price increase. And this would then spread rapidly to the goods that use them as intermediary inputs. While this could set emissions on a sustainable path, today’s consumption loss will be significant. Yet, there is no “miracle” solution, where the goals could be achieved only by changing consumption habits at the margin.

A Focus on Carbon Tax: The bottom line

The slowness of government action coupled with media pressure focusing on reproaches and accusations rather than on carbon tax make some companies communicate on their plans to become carbon-neutral. Unsurprisingly, these are especially companies selling mass market consumer goods (and therefore dependent on the positive image they provide) whose technical characteristics make them use low levels of energy. Their green strategy is more of a communication tool, while the impact on carbon emissions is small. Companies in the energy or steel sector are technologically unable of presenting such plans, which is easy to understand. This does not mean that we do not need steel or energy and we must shut down these firms. The application of a carbon tax would however have an extremely strong sectorial effect on the price of electricity and steel, yet this cost rise will be transmitted to energy users proportional to their use of energy.

Governments are not only slow but also inconsistent with what they say and what they do. When French authorities focused on limiting particle pollution in the cities, they purely and simply forget climate change and instead incited drivers to change from diesel-driven cars to petrol-driven cars – although the latter produce more C02 per kilometer than diesel cars. A country like China has given itself an objective to become the leading producer worldwide of electric cars to reduce urban pollution, but it is also the principal country to use coal to produce electricity. The transition towards electric vehicles will aggravate climate change if coal remains to be used as a source of electric energy.

To date, and in the actual state of technological progress, there is no viable solution other than massively taxing carbon and accepting the strong increases in costs that come as a result. This observation and this way forwards does not seem to be on any government’s agenda, and still less that of voters. In the meantime, however, the climate issue will not be solved by one more Sunday market organised by green vests, by one more plate of vegetables, or by a handful of small, daily eco-gestures.

References

• Barrage, L., 2019. The Nobel Memorial Prize for William D. Nordhaus. The Scandinavian Journal of Economics, 121, 3: 884-924.
• Gillingham, K., W. Nordhous, D. Aanthoff, G. Blanford, V. Bosetti, P. Christensn, H. McJeon, and J. Reilley, 2018, Modeling uncertainty in integrated assessment of climate change: A multimodel comparison, Journal of the Association of Environmental and Resource Economists, 5, 4: 791-826.
• Nordhaus, W., 2019. Climate change: The ultimate challenge for Economics, American Economic Review 109, 6: 1991-2014.
• Pigou, A. C., 1920. The Economics of Welfare, Macmillan, London.
• World Bank. 2019. State and Trends of Carbon Pricing 2019.  Washington, D.C.: World Bank Group. http://documents.worldbank.org/curated/en/191801559846379845/State-and-Trends-of-Carbon-Pricing-2019

Useful links:

• Link up with Profs Marc Guyot and Radu Vranceanu on LinkedIn
• Read a related article: Four Scenarios for the Future of Global Energy
• Study at ESSEC Business School
• Discover the new ESSEC MSc in Sustainability Transformation.

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