David R. Henderson  

Uncertainty Can Go Both Ways

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In the latest issue of Regulation magazine is a symposium on carbon taxes. The lead article is by Bob Litterman and then four authors, including me, responded. Here's an excerpt from my piece.

On two other issues, I disagree with Litterman.

The first is the issue of the economists' consensus. He writes, "There is no disagreement among economists on the benefits of pricing carbon emissions." That is simply false; there is disagreement. I'm an economist and I am not sure of the benefits of pricing carbon emissions; in what follows, I say why. Perhaps he accidentally overstated his case because in the same paragraph, he writes, "Relying on prices to allocate scarce resources is vastly superior to the command-and-control approaches of current policies, which rely on public subsidies and mandates to use particular alternatives to fossil fuels." That is true, but to say that A is better than B is not to say that there is no disagreement on the desirability of A.

The second issue on which I part company with Litterman is the role of uncertainty, which is the main focus of his article. He admits that his reasoning about uncertainty does not lead to any firm conclusions about carbon policy. He writes, "The fundamental problem, of course, with the insights provided by the economics of risk management is that the answer depends, at its core, on something unknowable." And yet, in his last paragraph, he reaches a strong policy conclusion. He writes:

I believe that given that uncertainty, a cautious approach that weighs the cost of catastrophic outcomes above the potential benefits of hedging future economic growth is justified. It would be best to get started immediately by pricing carbon emissions no lower, and perhaps well above, a reasonable estimate of the present value of expected future damages, and allow the price to respond appropriately to new information as it becomes known.

I think that Litterman would be hard pressed to justify that conclusion. It seems to be more of a hunch than to be something he has established in his article.

But there is a more fundamental problem. For Litterman, the uncertainty is all in one direction. Go through his article and, in every case where he discusses uncertainty, it's about how bad the consequences of global warming will be. Will they be just moderately bad or will we have a catastrophe? Notice what's missing: He doesn't even entertain the possibility that global warming could be good. Nor does he entertain the possibility that not only could it be good, but also it could offset the potentially catastrophic damage that could result from global cooling. I am not a climate scientist, so I don't know how likely global cooling is. But I am enough of an analyst to know that if we are uncertain, as Litterman admits we are, then we need to entertain that possibility.


I also express my caution about the political system:
I am cautious not only about the science of global warming, but also about the political system. If the government imposes a tax, that tax will be difficult to end if our later information tells us that it should end. Some interest groups will lobby to keep the tax in place. Which groups? Perhaps the producers of alternative, non-carbon-based energies, a group that has shown particular power in recent years. Economists who pay any attention to the way laws are made and to the contents of those laws should be among the first to be cautious about advocating new programs and/or new taxes.


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COMMENTS (14 to date)

He also may be assuming that people are risk averse and that reducing carbon emissions reduces the degree of climate uncertainty.

pyroseed13 writes:

The problem that I have with a carbon tax, though I am open to it, is that it is not clear what its proponents hope to accomplish. Are carbon taxes supposed to raise revenues that will compensate for the destruction that global warming will supposedly wreak, or are they supposed to get us to reduce emissions by driving less? Given the nature of the political process, the former is highly unlikely, and the latter is unrealistic and probably undesirable. Either way, I still think the strongest argument against a carbon tax is that it falls mostly on the poor and middle class, and without pairing it with some other kind of tax relief this could be potentially. devastating.

Ryan P writes:

I concur with Predrag. Risk aversion & uncertainty are arguments for being cautious and reducing emissions relative to the case with the same expected impact but relatively little uncertainty. I believe Martin Weitzman has written pretty extensively on exactly this point.

Ryan P writes:

pyroseed13,

Definitely the latter -- it's a Pigovian tax. If the goal was just to raise money to reduce harm (or for any other revenue purpose), you wouldn't want to have a narrow tax that causes more deadweight loss and raises less revenue than a broader measure. I'm confused why it can't possibly be desirable. I certainly agree that if there's an externality, too high a Pigovian tax is a bad thing, but surely in general there exists some sufficiently small but still positive tax that makes the price incorporate the harm imposed on others.

MikeP writes:

...in general there exists some sufficiently small but still positive tax that makes the price incorporate the harm imposed on others.

And herein lies the tragic comedy of the whole exercise.

When William Nordhaus runs the numbers, he indeed finds that a modest carbon tax yields the optimum future benefit. But when he runs the numbers on every proposed alternative policy, from Kyoto to Stern, he finds that the second best policy is no carbon tax whatsoever.

And this of course makes sense. Wealth increases exponentially. Global warming gasses increase linearly with wealth. Temperature increases sublinearly with global warming gasses. The exponential simply dominates the problem. You can provide a modest improvement with a modest tax, but anything more is wealth destroying.

So we need to ask the question: Given that the second best policy is to do absolutely nothing, can we seriously hand control over carbon policies to political processes? Every proposal that political processes have produced so far is worse than second best. Why does anyone imagine they would pick the one optimal policy in the future?

Daublin writes:

There is also uncertainty about the economic effects of carbon policies. That element of uncertainty weighs in exactly the opposite direction, but for some reason people keep leaving it out of their analysis.

In more detail, we live in a time of technological change. It's entirely plausible that higher CO2 regs, including a simple carbon tax, would be the last straw that stops innovation well before it peeks. If that happens, then the effects on humanity will be much larger than any environment disaster. Nobody really knows how much regulation would stop innovation; nobody really knows swhat innovation lies in the future to begin with. The safe thing to do is to keep exploring, but that means we need to take a light hand on people who innovate.

On the Pigovian effect, I weep inside to think of a world where taxes are so high that people reduce energy usage by half or more. Energy use pervades almost everything that makes modern life so wonderful. The reason we do less by hand, is because we harness nature's forces to do things for us.

Are we really going to turn off all the Christmas lights forever? Just in case? Even if it's right in some actuarial sense, which I don't think it is, that would be a cold, soulless vision of humanity.

Cimon Alexander writes:

Given scientists' track records at predicting global temperature, how would you use their models to create an estimate of risk? Global Climate Models have been utterly wrong, and the error is all in one direction (predicting a hotter world than has actually happened). Every single global climate model is wrong significantly in the positive direction.

Relevant Charts:

http://media.economist.com/sites/default/files/imagecache/290-width/images/print-edition/20130330_STC334_1.png

http://www.drroyspencer.com/wp-content/uploads/CMIP5-global-LT-vs-UAH-and-RSS.png

Tom West writes:

Energy use pervades almost everything that makes modern life so wonderful.

Except those who are *most* likely to drastically suffer (as in die) are those who gain very little from carbon usage - namely heavily populated low lying lands like Bangladesh.

Give them a bunch of nuclear weapons that get fired at us if as they suffer catastrophic losses and let's see if we're just as complacent as we are now - after all, surely if their lives are worth risking for "innovation" or merely a more comfortable lifestyle, then ours are as well.

If not, then we can acknowledge the reality: A risk to their lives are not worth a change in our lifestyle, but ours are most certainly are.

Tom West writes:

Urk. Sorry for my failure to proof my post.

Andre Mouton writes:

It was a good response to the article - bravo.

Ryan - who is assessing the risk? Who is it that is risk averse? What bearing do these generalities have on the case -- on the fact that some scientists have argued there is a risk, some pundits have found it convenient to agree with them, and the public could largely care less? The incentives on every side are bad; we cannot eliminate risks but can only choose between them; and the effects of a low-to-medium carbon tax would be inconsequential with respect to global warming. If this is risk management, it's the sloppiest kind I ever heard of.

Predrag - it would be a poor assumption. People take risks all the time. We are not risk averse, we are risk selective.

Paul Geddes writes:

One (admittedly small) benefit of the carbon tax in British Columbia was that the government promised to reduce other tax revenues by every dollar collected by our carbon tax. http://www.fin.gov.bc.ca/tbs/tp/climate/carbon_tax.htm and seems to have done this --so far. The tax cuts were given to lower income individuals and rural residents. The economics exercise then becomes one of determining which type of tax is more distortionary or complicated and costly to collect and administer. Since fuel demand seems relatively inelastic and the administration costs relatively low -- tacked onto already taxed gasoline, home heating and electricity bills --- our carbon tax might cause a little less damage than what we had before. This however is a very, very weak argument in support of our carbon tax -- and it also involves improper comparisons of the values of different people.

Daublin writes:

@Tom, it's not plausible that rising sea levels will literally kill anyone. It's at most an economic loss as people have to dig up and move away from the coast over a period of decades. This already happens all over the world as coast lines wander in and out.

Tom West writes:

@Daublin, 80% of this country of 115 million is river delta. There isn't anywhere for them to go.

Moreover, they don't have the resources for disaster relief, and *no* relief effort is going to handle more than a fraction, and not when it's occurring 2-3 times a year.

Now, maybe AGW won't cause this sort of problem, and maybe it might. But I'll tell you, if we were engaged in something that had a decent chance of making the East coast more or less uninhabitable over the next few decades, our first thought would probably not be "how awful for our lifestyle".

The reality is that global warming isn't that big a concern for us because we're not the one's that are going to be hit extraordinarily hard.

Jason O writes:

The focus on uncertainty on the 'bad' side is correct because if we are wrong about climate change and it turns out to be worse than expected the effects will be very very high cost and the moderate efforts we take to stop it now will be (retrospectively) seen as a very good decisions. However, if it turns out that it is not as bad as expected then taxes will be seen as wasteful but not a disaster.

Put yourself in the shoes of your future self and wonder which action you would 'regret' most.

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