Wednesday, September 20, 2006

CBO on Global Warming

A just-released report from the Congressional Budget Office takes on global warming, framing the issue in a way that should be familiar to Ec 10 students. CBO points to a negative externality from carbon emissions and a positive externality from research. An excerpt:

The possibility of climate change involves two distinct “market failures” that prevent unregulated markets from achieving the appropriate balance between fossil fuel use and changes in climate. One market failure involves the external effects of emissions from the combustion of fossil fuels—that is, the costs that are imposed on society by the use of fossil fuels but that are not reflected in the prices paid for them. The other market failure is a general underinvestment in research and development (R&D) that occurs because investments in innovation may yield “spillover” benefits to society that do not translate into profits for the innovating firm. The first market failure yields inefficiently high use of fossil fuels; the second yields inefficiently low R&D.

Because there are two separate market failures, an efficient response is likely to involve two separate types of policies:

  • One type of policy would reduce carbon emissions by increasing the costs of emitting carbon, both in the near term and in the future, to reflect the damages that those emissions are expected to cause.
  • The other type of policy would increase federal support for R&D on various technologies that could help restrain the growth of carbon emissions and would create spillover benefits.

Policymakers could increase the cost of emitting carbon by setting a price on those emissions. That could be accomplished by taxing fossil fuels in proportion to their carbon content (which is released when the fuels are burned) or by establishing a “cap-and-trade” program under which policymakers would set an overall cap on emissions but allow fossil fuel suppliers to trade rights (called allowances) to those limited emissions. Either a tax or a cap-and-trade program would cause the prices of goods and services to rise to reflect the amount of carbon emitted as a result of their consumption. To the extent that a carbon tax or allowance price reflected the present value of expected damages, such policies would encourage users of fossil fuels to account for the costs they impose on others through their emissions of greenhouse gases.

It sounds like the CBO is angling for admission into the Pigou Club.