Why would the Obama administration allow new drilling in U.S. coastal areas, and what will it mean for greenhouse gas reductions? My colleague Frank Ackerman has a posting on the TripleCrisis blog today on off-shore drilling, peak oil, and how they relate to a carbon tax:

Solving our energy problems, without a change in direction, will lead to increasingly costly and environmentally destructive production – either deep offshore, or deep in the rocks below existing communities and watersheds. We need a tax (or a fee resulting from an allowance system) on energy, to keep the cost to consumers high enough to encourage conservation, while holding the price for producers low enough to discourage the pursuit of the worst fossil fuel deposits.

This is another way in which the distributional consequences of carbon permit giveaways (i.e., who gets the revenue – see Alejandro Reuss’ Public Goods posting from earlier this week) differ from those of permit auctions. A cap and trade system will increase the price of oil exploration only if businesses have to pay for their permits; if permits are given to the largest polluters for free, there will be no incentive to limit fossil fuel extraction from areas where underground reserves are not very rich and the environmental consequences of extraction are enormous.

Most economic analyses of “cap-and-trade” policies – under which the government sets a target amount of emissions and then issues tradable permits totaling that amount – take it for granted that it would not make any difference, in the reduction of emissions, if the government were to sell the permits or give them away. A 2008 report on cap-and-trade climate policies from the MIT Center for Energy and Environmental Policy Research puts it like this: “Economic theory suggests that the method of distributing emission allowances, i.e., through grandfathering or auctioning, will not affect an individual source’s output decisions or emissions.”

If firms always make optimal decisions, maximizing their profits, as mainstream “neoclassical” economists assume they do, this conclusion should be correct. It shouldn’t make any difference to a profit-maximizing firm whether, by reducing its emissions, it avoids the cost of buying emissions permits or reaps the benefit of selling permits. Either way, it will reduce emissions as long as the cost of doing so is less than the price of the permit.

But are real-life firms really the perfectly rational profit maximizers of the neoclassical economists’ imagination? Some insights from behavioral economics suggest they may not be, and therefore that they may react differently to a policy that makes them buy emissions permits compared to one that gives them permits for free.

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An Obama administration task force has recently proposed that $21 per ton is an appropriate “social cost of carbon.” (The social cost of carbon, or SCC, is an estimate of the damage caused – both today and in the future – by the release of an additional ton of carbon dioxide into the atmosphere; it’s a topic that I’ve discussed frequently in this blog (see here, here, and here). A bigger SCC means that the federal government is willing to do more to more to slow greenhouse gas emissions; conversely, a smaller SCC means that fewer emissions abatement measures will be considered “economical.”) In an Economics for Equity & Environment white paper, released today, Frank Ackerman and I discuss the very serious errors and omissions that have led to EPA, OMB and other agencies’ promotion of what is a very low SCC.

As our paper demonstrates, the calculation of the SCC is less science than alchemy. It is also – like much of cost-benefit analysis – a very strange way of making decisions. Cost-benefit analysis sounds like common sense: weigh the costs of an action against the benefits. A good policy will have net benefits; a bad policy, net costs. Simple.

Well, actually, no, not so simple. There are (at least) three big problems:

Problem #1: When it comes to the greenhouse gas emissions (and many other environmental issues) we can’t measure the costs and benefits with any accuracy. We’ve never filled the atmosphere with CO2 before. We’ve never tried to remove large quantities of CO2 from the atmosphere before. Some of the important consequences of climate change, such as the loss of human lives and risks of extinction of endangered species, simply don’t have meaningful prices (although economists have at times made up dollar values for them). And many of the costs of halting emissions and benefits of averting damages will occur well into the future. That’s a lot of uncertainty, which doesn’t tend to increase the accuracy of economic predictions.

Problem #2: Many of the costs and benefits will affect not us, but our great-grandchildren, and there is a fair amount of disagreement (a least among economists) about how to weigh these future impacts in the decisions we make today. Some (like me) say we should weigh all damages equally regardless of whether it is us or our descendants that suffer the costs. Others feel that future costs (and benefits) are worth far less than those that take place today.

Problem #3: While climate policy will benefit humanity as a whole, the costs of reducing emissions and the benefits of avoiding a climate catastrophe will impact different people differently. Most people will be net gainers from climate policy (more benefits than costs), but some will be net losers (more costs than benefits). This is true both across generations – future generations are the biggest net gainers from climate policy – and among the Earth’s population today. As a broad generalization, poorer people have more to gain from climate policy. The more one weighs the interests of the net losers compared with the net gainers, then, the less one will conclude that we should do to avert climate change.

In short, cost-benefit analysis is complicated, and its results are open to a lot of interpretation. Regrettably, that is how the U.S. government makes decisions about environmental issues. In a cost-benefit analysis of emission reducing policies, the social cost of carbon is the benefit from each one-ton reduction in carbon emissions (it’s the damage that doesn’t happen, and thus, a benefit). A bigger SCC means a bigger benefit from reducing emissions, making it more likely that any particular carbon reduction policy will pass muster as delivering greater benefits than costs.

There is no way to truly measure the SCC. (Seriously, all climate damages throughout time reduced to one figure in today’s dollars? If you really have faith in such a figure, I have a bridge in Brooklyn that I’d like to sell you.) The Obama administration should consider looking at the problem of emissions abatement from an entirely different angle: For example, by how much do we need or want to reduce U.S. emissions, and what’s the cheapest way to do that? Alternatively, how much can we afford to devote to insuring ourselves against the danger of catastrophic climate change? Decisions made from starting points like these are far more likely than cost-benefit analysis to result in a climate policy that is both effective and economical.

Those following U.S. climate policy will have run into talk of the “discount rate” this week. A discount rate, for those not in the know, is the flip side of an interest rate. Where an interest rate allows us to calculate how much something we have today (like money in the bank) will be worth in the future, a discount rate tells us how much something we will have in the future is worth to us today.  The idea is that we prefer pleasure now to pleasure later (and pain later to pain now). Imagine, for example, that someone owed you $100 in a year. What’s the least you would accept now rather than wait a year for the $100? Supposing it is $90, then we say that your discount rate is 10 percent.

Many environmental economists, including me, are troubled by the use of almost any discount rate greater than zero to calculate the current worth of values (future benefits and harms) that will occur more than a generation from now – an issue of especially importance in climate economics. Here’s what all the kerfuffle is about: When used in long-term analyses of environmental impacts – climate change, the storage of nuclear waste, etc. – the discount rate quantifies our ethical judgment regarding the importance of the welfare of future generations (compared with our own). When we say that the discount rate is zero, we mean that we consider the health and well-being of future generations to be just as important as our own health and well-being. The larger the discount rate, the more we value our own lives and livelihoods over those of our grandchildren.

The current conventional wisdom calls for discount rate that is something like the short-term  “risk-free” interest rate (3 to 5 percent) for calculating the worth today of values that will exist at sometime within the next 20 or 30 years, and slightly lower discount rates for values that will exist in the more distant future. The idea is that the interest rate on the safest investments is what people require to compensate them for waiting (getting their payment later, rather than now).

But people routinely put savings away at very low interest rates. To my mind, this strongly suggests that, even within a single generation, the discount rate can be very low. We save money because it will have a value to us in the future. That we’re willing to put it in savings accounts that often have a less than 1 percent annual interest rate after adjusting for inflation means that it’s worth it to us to put $100 away today to secure about $100 in the future. It would surprise us to hear that our neighbors – unable to find an investment with a 10 or 20 percent rate of return – chose to spend all their money today. We put money away because the future (our own, and that of our families) is important to us. That we can earn some interest on that money is just a side benefit.

Reasonable people can and do disagree about the most appropriate discount rate to apply to long-term problems, although the use of discount rates above 5 percent has become much more unusual in recent years, and a discount rate over 3 percent on values that will occur in 2050 or later certainly would raise the eyebrows of many (most?) climate economists.

That’s why reports last week – now said to be erroneous – that the Office of Management and Budget (OMB) was recommending discount rates of 25 or even 50 percent for use in environmental analyses got a lot of people in a lather (these outrageous rate recommendations are now said to have originated with a staffer in another agency and were posted online, but not advocated, by OMB).

Similarly, the Obama administration’s recommendation of a social cost of carbon based on a 3 to 5 percent discount rate, for an analysis that stretches hundreds of years into the future, puts a surprisingly low value on the next generations’ welfare. Here’s an example: An event with the magnitude of material damages of Katrina (which some estimates put at $300 billion) occurring 500 years from now would be worth just $110,000 today at a 3 percent discount rate, or $8 at a 5 percent discount rate. Personally, I think the future is worth more than that.

It’s nice to win, now and then, in the battle against really bad economics.

Back in 2006, California adopted an ambitious state climate policy, known as AB 32. It will require higher fuel efficiency standards for cars and trucks, better insulation and energy efficiency in homes, and more vigorous promotion of renewable energy. Careful analysis by the state’s Air Resources Board and analysts at the University of California-Berkeley showed that AB 32 will have neutral to slightly positive effects on California jobs and incomes – a conclusion that was unacceptable to some of the bill’s opponents.

Last year, two reports trashing AB 32, and state regulation in general, were released by Sacramento State College business professors Sanjay Varshney and Dennis Tootelian (click here for the first, here for the second).  They projected that AB 32 would reduce the state’s overall income by 10 percent, and that regulation in general would shrink California’s output by one-third. Released with great fanfare, these super-sized critiques started showing up in media discussion of AB 32.

I did a report called “Daydreams of Disaster” for the California Attorney General’s office, evaluating the Varshney-Tootelian (V&T) studies. V&T assumed that all benefits of AB 32 were too speculative to include; in effect, they estimated benefits at exactly zero. The costs caused by AB 32, on the other hand, are treated with expansive generosity. Housing costs surge upward, based on the cost of converting homes to zero net energy consumption (but with no resulting savings on utility bills). The projected fuel savings from new, high-mpg cars are treated as a cost imposed on owners of older cars (but not a savings to new car owners). Food cost increases are estimated in an entirely data-free manner. V&T then multiply everything by 2.8 to account for indirect costs.

Even worse is the V&T critique of regulation in general. They estimate a single equation explaining state GDP, across the 50 states, based on six different rankings of state business climates from Forbes. Those rankings give every state a number from 1 (best) to 50 (worst); in the V&T equation, every one-point increase (worsening) in the “regulatory climate” ranking decreases state GDP by a bit more than $4 billion. California comes in at number 40 in the Forbes scorecard for regulatory climate, so V&T project losses to the state of more than $160 billion. And don’t forget to multiply the result by 2.8!

The worst mistake here, although not the only one, is this: State-by-state differences in the size of the economy are – surprise! – primarily determined by the population of the state, a factor left out by V&T. (Why does California have a bigger economy than Rhode Island? Because California is a bigger state with more people, not because of either state’s business climate or rankings in Forbes.) When I reran V&T’s analysis taking state population into consideration, the Forbes rankings had no correlation with the size of the state economy per capita.

My report was one of three independent evaluations of the V&T work, all reaching entirely negative conclusions. The word is starting to get around: the Legislative Analyst’s Office of the California legislature released its own analysis of the shoddy quality of the V&T reports; the head of Small Business California asked that the studies be removed from public websites, due to “deeply flawed methodologies and useless conclusions”; the story even made the San Francisco Chronicle last Friday, which quoted my summary remarks: “The losses they [V&T] project would be serious economic impacts – if they were real. They are, however, entirely unreal; they should be viewed merely as daydreams of disaster.”

There’s plenty more bad economics out there to do battle with. But it’s gratifying to see that there are some limits to what you can get away with in public debate.