Chapter 12
Bjorn Lomborg, a young statistician who became famous for writing the book Th e Skeptical Environmentalist in 1998, which garnered contempt from many environmentalists and admiration from many politicians (especially on the Right of the political spectrum) and some economists, again managed to att ract attention in 2004, when he brought together eight famous economists in Copenhagen (three of them Nobel Prize laureates) and paid them $30,000 for the week to try to answer one question: what would you do with US$50 billion to benefit mankind? They were to forget about politics and personal preferences and concentrate on cost- benefit analysis to determine where the money would do the most good. Th ey ended up judging four projects “very good” from cost- benefit perspective: controlling of HIV/AIDS and malaria, addressing malnutrition by providing micronutrients, and liberalizing trade.2
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(W hy trade liberalization will cost money is a different issue.) Three out of the four projects judged “worst,” from a cost- benefit perspective, involved mitigating anthropogenic contributions to climate change. Two of the mitigation methods were based on taxing carbon products, which we will discuss shortly, and one was to enforce the Kyoto Protocol, discussed in the next chapter. In all these cases the benefits do not seem to justify the cost.
Before we go any further, it is important to clarify a concept used throughout the book central to the cost- benefit analysis: monetary exchange rates. If we use, as I have been doing since Chapter 2, GDP per capita as a global or regional measure of wealth, then we need to specif y the currency in which we measure GDP. As simple as it sounds, it is a problematic concept. The next section will outline this issue.
GDP is designed to measure the sum of economic activities in a country. It is natural that we measure these activities in units of the respective country’s currency. If we want to compare the activities of different countries, then we must compare their currencies. Th e simplest way to compare currencies is to use the official exchange rate. We did exactly that— we used the US dollar as the reference currency. We could then calculate global GDP by summing up the individual countries’ GDP after adjusting for the exchange rate. If we wanted to compare these numbers across time, we would have to correct for the inflation rate in the United States. Otherwise US inflation would distort the numbers. This produced values in what economists call “constant dollars,” which usually specify the year. All the original data sources I have used provide the numbers in this form; in the majority of the cases, the numbers are supplied by the individual countries. The IPCC uses these numbers for their input scenarios (Chapter 8). However, some economists have raised objections to the use of offi cial currency exchange rates for these comparisons and have suggested using a different concept called purchasing power parity (PPP) rates. This objection was important enough for the IPCC to promise to include the conversion in future reports. It is important to include the concept in our discussion because its omission reduces the credibility of the basis of this book’s observations.
W hat is PPP and why is it needed? PPP is a theory of exchange- rate determination that assumes the actions of importers and exporters, motivated by cross-country price diff erences, will induce changes in the exchange rate. It is an extension of the “law of one price,” which assumes that if there are no costs associated with transport, taxes, duties, and so forth, then identical goods should sell for identical prices in different countries. Otherwise, smart people will see the price difference and buy the items in the low-cost countries and sell them in the high- cost countries. In the process, demand will increase in the low-cost country, enabling merchants there to raise the local prices and, at the same time, increase supply in the high- cost country, forcing suppliers there to lower the prices until the equilibrium prices are same. Th ese kinds of transactions are known as arbitrage, and they underlie a great deal of economic thinking. Let us take an example that actually serves some good purpose: Big Mac hamburgers are now sold in over 200 countries. In the United States, an average price (taken from the prices in New York, Los Angeles, and Chicago) is $3. An identical hamburger in Paris, France, will cost 2.7 euros. The US$/euro exchange rate at the time we did this market research was 1.3 US$/euro. If we are tourists in Paris—we have only US dollars in our pockets—then we have to change 2.7 × 1.3 = US$3.50 to get enough money to buy the hamburger. This means that the euro is overvalued relative to the dollar to the extent of 3.5/3 = 1.17 or about 17%. If we wanted to make money and do arbitrage on this difference, then we should buy the Big Macs in New York, Los Angeles, and Chicago and sell them in Paris, making sure they stay fresh and transportation costs are zero. This influx of American hamburgers would force the price of hamburgers to go down in Paris and up in the United States until the prices reach equilibrium, where the PPP rate equals the actual exchange rate. This forms the basis of what Th e Economist calls the “Big Mac Index,” which the magazine publishes every year for some major countries. An obvious extension is to compile a typical basket of goods that a typical family purchases in various countries and get the average exchange rate that equalizes the various prices of the basket as measured in US dollars or any other currency. Conversion tables between PPP exchange rates and the more common spot exchange rates are available on the Internet. An example of such a comparison is given in Table 12.1.
Inspection of the table shows immediately that for rich countries such as the United States and Japan, the rate difference is very small. On the other hand, for poor countries such as India and Pakistan, the difference is very large. Shifting the calculation to PPP will make the GDP per capita in India not 50 times smaller than in the United States but instead only 10 times
Table 12.1.
Comparison of official exchange rate and PPP exchange rate
| Country | Official exchange rate | PPP exchange rate |
|---|---|---|
| Brazil | 2.3 | 1.2 |
| China | 8.1 | 2.1 |
| India | 44 | 9.2 |
| Japan | 112 | 126 |
| Pakistan | 60 | 17.5 |
| United States | 1 | 1 |
Source: World Bank.3
smaller. Qualitatively, it does not change any of the previous discussions, but quantitatively, the differences are significant.
PPP is a statistical concept because the conditions of the arbitrage are unrealistic for most of the items for one reason or another. However, it is a useful construct against the use of spot exchange rates because PPP rates are much less susceptible to government manipulation to encourage import or export or speculators who want to increase volatility in the exchange markets to maximize their profit opportunities. However, for our analysis they are too opaque as they rely on statisticians to come up with numbers that for ordinary people appear arbitrary. Th is difficulty is amplified because the statistical analysis is done in developed countries, whereas much of the political debate centers on the relative roles developed and developing countries must play to find a solution to the climate change issue. This issue will be further explored in the next chapter.
How do we cost the possibility that failure will turn the planet against us (remember Le Chatelier’s principle) through climate change, making the planet uninhabitable? Some of us believe that costing items such as life, death, freedom, love, or sustainability of the planet are meaningless. Others (many of them economists) maintain that costing mainly quantifies societal priorities and we do it all the time, whether we are aware of the process or not, so we must learn to be methodical. One can get the impression that the IPCC was not very happy with the costing requirements because for nearly every line that presented costing scenarios, 10 lines presented reservations about the accuracy of the estimates. Lomborg’s panel was asked about their preference for spending the money now, but economists are not enthusiastic about spending money now to reap the benefits 100 years from now.
Before we go any further and try to outline cost, let me summarize the issues covered so far. The issue of significant changes to the chemistry of the atmosphere resulting from reliance on fossil fuels is real. The issue is global and requires a global approach. The time scale for action is within the next 2 to 3 generations or toward the end of my definition of “now.” Within this time period it is likely that the world’s population will stabilize at a level approximately 50% higher than the present population. The population at that time will be dominated by the population of the current developing countries. Within this scenario, most of the contributions to atmospheric- chemistry changes will originate in developing countries. Th e contributions from the economic activities of the developed countries will be small irrespective of the political decisions they will make.
Over the last three chapters I was using the term “feeding transition” to indicate the present time period in which we should change from reliance on fossil fuels as our main energy sources to reliance on sustainable energy sources that do not contribute to atmospheric changes. Th e IPCC costing of the price of such transition and the Lomborg panel’s cost- eff ectiveness proclamations are concentrated on reduction of CO2 emissions with only occasional mention, without going into details, of the alternative energy sources that will replace fossil fuels. The only sure way to reduce CO2 emissions is to use less fossil fuel. If reduction of fossil fuels leads to a commensurate decrease in energy use without a compensatory fall in energy intensity, then GDP will decline. For most of the developed world with a relatively high standard of living, this is objectionable; for developing countries, some of them with a standard of living 100 times smaller than that of the developed countries, this is unacceptable and unfair. To do this we must replace fossil fuels with alternative energy sources that will also increase the standard of living.
Based on our discussion in the previous chapter, we are far from ready with alternative energy sources. The only alternatives currently on the map of global energy consumption are nuclear energy based on fission, solar energy in the form of hydroelectric power, and biomass relying on the burning of wood fuels without renewing the associated forests (Table 11.3). Other energy sources discussed in the previous chapter are in various phases of research and development with some local impact on energy use, but globally they are not yet in use in quantities significant enough to affect the overall energy picture. Nuclear energy has major problems, which were discussed in the last chapter and presently stand in the way of adopting it as a source for further expansion. Most of the promising sites for effi cient hydropower energy conversion are already in use, and the prospects for significant expansion are limited. Unsustainable use of wood fuel is not a real alternative fuel; it negates sequestration and is presently counted as an alternative only for energy- accounting purposes. A feeding transition without acceptable alternative food leads to death. Transition management should thus focus on two separate, related aspects: lengthening the transition time and using the time to develop acceptable alternatives. From a resource- availability and climate- change standpoint, lengthening the transition means reducing energy use and shifting to alternative sources whenever feasible. The big challenge for the developed countries is to use their resources to develop alternative energy sources so developing countries will be convinced that these sources are compatible with their desire to increase their standard of living. This will require some major changes in our lives. Some of these changes are political and will be explored in the next chapter. Some are economic and will require paying higher prices for the energy we use. Th ese changes will be explored in the remainder of this chapter.
I will start with a relatively well- defined issue, lowering gasoline consumption, because of the interdependence of national security issues inserted into our collective consciousness during the oil crisis of the 1970s and early 1980s.
Lowering Gasoline Consumption
From the time of the oil shocks of the 1970s, finding ways to lower gasoline consumption, and more recently to lower consumption of fossil fuels, has been at the center of an ongoing public debate. In 2002, few members of the US Congress asked the Congressional Budget Offi ce (CBO), a nonpartisan consulting arm of the US Congress, to investigate alternative policies that would decrease gasoline consumption. Here I describe the outcome of this inquiry in some detail because it illuminates the available options for the more general reduction of fossil fuel use. The main rationale for the request was national security. The United States, like much of world, is unsettled by its own dependence on foreign energy suppliers. Th e aft ereff ects of the Arab oil embargo in the 1970s are still not far removed from the collective memory. For many purposes the steps suggested to satisf y both the security concerns and the concern about anthropogenic climate changes are the same, but not always. The proposed search for oil in Alaska’s Arctic National Wildlife Refuge (ANWR) is an example of diverging methodologies between the two objectives.
In its report, the CBO identifies three options for encouraging the public to use less gasoline:
CAFE Standards
CAFE standards were mandated in 1975 in response to the oil crisis. Manufacturing output was divided into four categories: imported and domestic passenger cars (two separate categories) and two and four wheel drive light trucks, which includes sport utility vehicles (SUVs). The four categories then were reduced to two: passenger cars and light trucks. A standard of average fuel consumption was mandated for each category. The standards for imported and domestic vehicles were the same, but the averaging was done separately. One could get credit for alternative fuels and for averages that exceeded the mandated average. CAFE took eff ect in 1978, and the standard for passenger cars was set at 18 miles/gallon (MPG). In 1999 it was raised to 27.5 MPG. In 2002, the standard for light trucks was set to 20.7 MPG. Actual gas mileage followed the mandated standards very closely. Once the mandated standard was reached, research efforts were directed at improving power for a given gas mileage instead of the more traditional goal of improving gas mileage for a given power.
Gasoline Taxes and Prices
In 1932 the US government levied its first tax on gasoline— 1 cent/gallon. This was about 6% of the price of gasoline at the time. The tax was raised in 1950 to 15 c/gallon and it is now
18.6 cents/gallon. With an average price of gasoline of $2.0/gallon, this amounts to about 9% of the price. US legislators have refused to use a percentage in the law for a variety of reasons. Revenues from these taxes go to the Highway Trust Fund created to finance the interstate highways system. In 1983 the fund’s mandate was extended to finance public transportation. At the end of 2001, the balance of the fund stood at $27.7 billion, of which $20.4 billion went to highways and $7.4 billion went to public transportation. In addition to federal taxes, state and local governments add taxes that vary among localities. In New York, the tax is 35 cents/ gallon and in Alaska it is 8 cents/gallon. For comparison, in Italy the tax per gallon is $2.43 and in the United Kingdom it is $3.29. In the United Kingdom it constitutes nearly 77% of the price of gasoline. In real terms, the US price (adjusted for inflation) of gasoline was approximately constant from around 1987 to 2002, after which it climbed and then fell.
Caps and Trade
Trading in pollution rights (or emission allowances) appeared in academic publications around 1968. It was used to achieve various environmental objectives such as lowering the amount of lead in gasoline, phasing out ozone- depleting chemicals, and meeting federal mandates on electrical generators for sulfur dioxide emissions that cause acid rain. Essentially, the government will set a cap on the total amount of carbon contained in all the gasoline consumed in the United States and enforce it by issuing a limited number of allowances. Th e government can sell the allowances or distribute them for free to gasoline manufacturers and importers. After the distribution, people will be able to trade them— the net effect will be a rise in prices.
The three alternatives can extend to fossil fuels to reflect the three available alternatives: reducing fossil fuel use through price increase, regulation, and taxation based on the amount of carbon in the fuel (carbon tax) and emission allowances based on set caps of fossil fuel use that allow for trade in the allowances. The last topic will be further discussed in the next chapter in the context of the Kyoto Protocol.
Price Elasticity
Raising prices does not guarantee decreased use. The concept of price elasticity deals with the correlations between prices of products and services and the corresponding demand. Numerically it indicates the extent to which a 1% increase in price would affect the demand for a good or a service (measured in % compared with the base level). Estimates for gasoline price elasticity vary widely, but in the United States they converge to a short-term elasticity at – 0.26 and a long- term elasticity at – 0.86. Based on these numbers, a 10% increase in price results in a 2.6% short- term decrease in the use of gasoline and an 8.6% decrease in long- term use. Th ere are also indications that the elasticity varies between periods of rising and declining prices. Customers adapt faster in times of increasing prices as compared to periods of falling prices. The adjustment of consumers and industry to rising energy prices is one of the main driving forces to an increase in energy efficiency and a decrease in energy intensity, which plays such an important role in our attempt to maintain and increase our collective well- being during the transition period. Most differences in the short-term and long-term price elasticity result from the capital expenditures needed to adapt. As a business we will not invest heavily in research, development, or implementation of energy-saving policies if we believe the high prices are not here to stay, and as consumers we will not try to change our lifestyle through relocation to places with shorter commuting time and greater availability of public transport unless we assume the high prices are here to stay.
Money
Lengthening the time of the feeding transition often involves imposing, through one mechanism or another, higher prices for fossil fuels and allowing the market to find cost- eff ective mechanisms to accommodate them. Our discussion on price elasticity made it clear that short- term policies will have minimal effects whereas long-term policies can be very effective, leading to nearly a 1:1 correspondence between price increase and reduced use. I will assume here that the decrease in use of fossil fuels will be induced through direct or indirect (cap and trade) pricing policies and not simply through regulations. Here I will discuss three related issues: First, who will collect the taxes? Second, what should we do with the money? Third, if the proposed money expenditures will prove effective in making the feeding transition as painless as possible, then can we justif y other forms of taxation not directly related to short- term reduction in consumption of fossil fuels but rather to building the infrastructure for alternative fuels?
Who Will Collect the Money?
There are two obvious options for who receives the money: energy companies and the government. If the objective is to search for new energy supplies (fossil fuels), then we can make the case that the energy companies can do it more efficiently than the government. This is more or less the rationale for allowing drug companies to charge high prices to facilitate research on new drugs. If, on the other hand, we want the money directed at the development of infrastructure and technology needed to expand the use of alternative energy sources, then the government is probably the better bet. This method is similar to the federal gasoline tax: create a trust fund to use the resources for the stated objectives.
What Should We Do with the Money?
This is similar to the question Bjorn Lomborg asked his panel, but with much more money at stake. We will change the emphasis here from his emphasis on lengthening the transition through reduced use of fossil fuels to working on developing the technology and implementing the infrastructure for the alternative energy sources. This will be consistent with the “high priority ” questions that got favorable review from the panel. Remedies that will facilitate the transition to renewable energy sources include the following:
These suggestions do not imply that every problem can be solved with money. Many attempts will end in failure, but such is the nature of exploring unexplored areas. Almost all these activities are currently being investigated on one scale or another, but we should not come with fixed ideas about the future mix of sustainable energy sources but should develop alternatives without competitive price criteria with respect to the present energy mix. At this stage we are ignorant of the competitive environment that will exist at the end of “now.” Some of these expenditures will result in major resource transfers from developed to developing countries. I strongly believe that this is essential for the successful management of the transition. There is no solution to this issue without such a transfer.
Other Forms of Taxation
At this stage I can think of one other form of taxation. I live in an apartment building constructed in the 1930s in New York City. Not unexpectedly, we periodically face major repairs such as fixing leaks, roof rebuilding, major elevator repairs, and so forth. Normally, when a major repair is needed, the necessary funds are collected to pay for the repair. At one meeting to discuss a needed repair, one of the tenants raised the following issue: Right now tenants pay for the deterioration that partially took place when previous owners were occupying their apartment. Similarly owners do not pay for amortization until a repair is needed that might well be after they sell their apartments. There exists an accounting alternative to ensure owners pay for their share of the amortization in which depreciation tables are used that are issued by the tax authorities for businesses that generate income from dwellings. We can then calculate each tenant’s share of the monthly depreciation and add it to the normal maintenance fee that pays for regular upkeep. This money is then used as a reserve fund to pay for major repairs. Th is way we ensure that present tenants pay for their share of the depreciation.
Let us take a simple example: The tax authorities set a recovery period for various properties over which time the business is allowed to recover its original investment. For a rental property it is 27.5 years. Let us assume that the market value of my apartment is set at $100,000. Under the straight- line method of depreciation, I divide the $100,000 by the 27.5 years to get the yearly depreciation of $3636/year or about $300/month added to my maintenance fee to cover major repairs. In calculating the depreciation, the US tax authorities ask you to remove the price of land from the asset’s price, as land does not depreciate. However, we now know better, so let us expand the thinking globally. Suppose that we buy the world for the price of its present (2003) GDP of $36 trillion (remember the discussion on PPP for this kind of exercise). Generously assume that the recovery period is 100 years—way beyond our requirement to complete the transition. We again use the straight- line method to calculate the depreciation: $360 billion will go to our environmental trust fund to provide the resources on an equitable basis for what must be done. The number seems very big, but any number connected to the global GDP is bound to be big. In the US it will amount to an average tax of less than $400/person per year. In the rest of the world, it will be considerably less. I hope that we will gladly pay.
The most important driving forces for consumer preferences are quality and prices. Th e price elasticity of energy was discussed at some length. The other option of regulating and legislating behavior was also discussed to a more limited degree. This allows the market and research and development activities to develop to accommodate the priorities in the most effi cient way. Legislation and regulations assume legislators and regulators know the best way how to achieve stated objectives. This is almost always based on yesterday ’s technologies and alternatives. There are two additional driving forces that determine evolution of economic and environmental policies: good citizenship and fear of litigation.
Good Citizenship
One of the major driving forces to pursue policies compatible with minimizing potential climate change derives from citizens’ and businesses’ concern for the long-term well- being of the planet. Many businesses also consider it a long-term smart business practice. Th e form that such concern takes varies. Regardless of governments’ approval or disapproval of the Kyoto Protocol, many businesses throughout the world are announcing independent eff orts to reduce emission of greenhouse gases across their activities, such as by using environmental labels from credible certification programs. An example of such a label in the context of climate change is the Forest Stewardship Council (FSC) label described in some detail by Jared Diamond in his book Collapse and briefly mentioned in the previous chapter. Another example will be discussed in detail in Chapter 15. The FSC was formed in 1993 by a coalition of businesses, governments, and environmental organizations. The membership consists of the timber industry, environmental groups, and the general public. The council draws up a list of criteria for sound and sustainable forest management practices and certifies any particular forest that satisfies those criteria. It then traces products from such certified forests through the complex supply chain all the way to consumers and labels such products as FSC approved. In a controlled experiment in collaboration with one of the largest home improvements stores, when two piles of identical wood products with identical prices were placed in front of consumers, one certifi ed and the other one not certifi ed, a signifi cant majority of customers chose the certified products. W hen the experiment was repeated in another store where the certified stock was more expensive by an average of 2%, the majority of customers chose the less- expensive, uncertified products, but a very significant minority (around 35%) chose the more- expensive certified product. Like most other commodities, good citizenship has its price.4
Fear of Litigation
Following the litigation concerning Big Tobacco, asbestos, and drugs shown to have unexpected side eff ects after release to the general public, business became very sensitive to legal liabilities. Some of this litigation resulted in the transfer of billions of US dollars, leading to bankruptcy declarations and massive employment losses for large, established companies. Climate change seems at present too controversial and long term for successful litigation. Currently (2005), there are lawsuits all over the world demanding multibillion- dollar compensation from energy companies and government agencies for not taking preventive steps. Th ese suits include the following:
Though many consider most of these legal actions a nuisance, many lawyers and scholars think they rest on established legal precedents. No credible claim exists that will directly tie the 2003 heat wave in Europe with a particular business practice. However, the Big Tobacco legal wars and other litigation based on epidemiological findings lend credence to “fractional attributable risk” in which one does not need to prove a specific cause- effect relationship but simply a contributory role maintained with full awareness of the consequences. This is oft en compared to shifting the odds with loaded dice. (I will return to this analogy in the last chapter.) One does not need to prove the direct cause- effect relationship between loading the die and the result of one throw. It is sufficient to show the overall odds are affected by the loading. One of the major tools used to quantif y the “fractional attributable risk” is computerized climate simulations (Chapter 8). The more confident we get with climate simulations, the more credible legal actions become.
