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Hannah Ryder

Hannah Ryder

Senior Economist

What economics can (and can’t) tell us, part 1: carbon taxes

Posted 12 July 2011

On my first day as a civil servant, my new boss asked, “So, Hannah, what would you say are the three key concepts in economics?”  I was tongue-tied – it felt like a trick question. What three concepts could I possibly pick to impress him?   

Over the next few weeks, I’m going to do a short series of blog posts about the three concepts I settled on. The first was 'equilibrium'.  

Equilibrium features in a lot of sciences – chemistry, biology, physics, etc. It’s generally meant to describe a 'balanced' or steady state of affairs. For example, we might think of the equilibrium of a factory – where there is a lot going on, but there is an underlying 'order' associated with it. Equilibrium is very much associated with macroeconomics - i.e. how economies – whether that’s whole countries or just a village – function.  

Some people think the world works like a factory. Credit: DFID, 2010

Economists use equilibrium all the time. Take yesterday, when Australia announced that it's going to bring in a carbon tax from July 2012. It was fantastic and well-overdue news for the world. Australia signed up to the Kyoto Protocol just before the Copenhagen Climate talks in 2009. But only now has it managed to bring in new policy to tackle climate change.  

In all the news reports about the carbon tax, people have been quoting hotly contested numbers about the sorts of effects the tax might have on prices, businesses, people’s incomes, jobs, and the economy – neatly summarised in this infographic. The numbers are mostly derived from economic reports, the most important by Australia's Treasury in 2008, and by Professor Ross Garnaut – Australia’s equivalent of the UK’s climate change guru Lord Stern.    

If you look closely at this economic analysis, you’ll see that equilibrium is at their core. Most of the numbers were calculated using computable general equilibrium models – models that use historic data and mathematical formulae to predict how an economy might react to changes in policy, technology or other external factors. I described these models briefly in a previous blog post. 

Australia isn’t unusual in using equilibrium analysis. In the Stern Review, we used a dynamic stochastic general equilibrium model. Applied general equilibrium models and partial equilibrium models also exist. Such models are also used in developing countries. For example, a 2010 study for South Africa (pages 78-98) suggested that a carbon tax – especially if revenues were re-distributed to the poorest households or investment was increased – could have positive effects on the economy and poverty reduction. A 2007 study in Indonesia suggested similar outcomes. The analysis has been persuasive: South Africa’s Treasury have now announced plans to bring in a carbon tax.  

But I have to admit that I’ve always found equilibrium to be one of the most difficult concepts to get my head around, partly because the world doesn’t really seem to function like one big factory. We see big, irreversible shifts that change the entire structure of factories or economies all the time – from natural disasters, to mobile phone revolutions, to internal practices like the Ford assembly line. These – and their effects – are unlikely to be predicted by equilibrium models. Indeed, physical scientists have been progressively moving away from the concept of equilibrium, now examining ideas like the “Anthropocene” – which focuses on the profound effects that humans are having on the planet - as explained in this Tea with the Economist Video:

Luckily, I’m not alone in feeling somewhat uncomfortable with equilibrium.  The Origin of Wealth by Eric Beinhocker, a Senior Fellow at the McKinsey Global Institute, sets out ideas for how policy might look different if we based our thinking on “complexity economics” instead of ordered equilibrium thinking. This amusing short video, discovered yesterday by a fellow blogger Oxfam International's Duncan Green, provides an even easier-to-digest idea of the potential differences. 

I’m not saying equilibrium models are useless. Not at all! They can tell us a lot and, crucially, prepare us for change. But, for example, there have been some effects of UK climate change policy that models didn’t predict – such as the ease with which companies would be able to reduce their emissions when the UK Emissions Trading Scheme was first introduced. So much so that almost a third of the emissions credits had to be cancelled two years later.   

That’s why it’s crucial that equilibrium models are complemented by other types of analysis. For example, in a paper for the DFID-funded International Growth Centre, economists Duflo, Greenstone, Pande and Ryan have suggested that a pilot Emissions Trading Scheme in India should be rigorously monitored and evaluated. This could be done by comparing the emissions over time of a number of randomly selected factories that are involved in the pilot scheme, to the emissions of a random selection of factories not involved in the pilot, and perhaps another random selection of factories regulated in a different way.

I do hope that Australia, South Africa and all the other countries implementing carbon management policies will take the opportunity to monitor their outcomes too, so that we can learn from our real-world actions. 

Comments

1. Alex
13 July 2011, 3:29 pm

Hello,

So taxes are leviedon carbon intensive producers. The goverment conceeds this will be passed on to the consumer. Revenue is diverted in the form of tax benefits for housholds under the earnings threshold.

Does the environmental benefit of this depend on the path of least resitance i.e. whether it is more cost effective to increase price or reduce carbon?

Support for reducing poor households' energy consumption may help frame this as a greener tax.


2. Louisa
20 July 2011, 11:03 pm

Hi thanks for this article,

As someone who has worked in the travel industry, I welcomed the idea of carbon trading, however having studied at goldsmiths for a masters in anthropology, I came across a girl who is writing a phd about the problems with carbon trading, namely that there is no solid proof that it is actually effective.

What this comes down to is that people do not want to change their lifestyles, and governments don't want to change their economic models, but climate change is going to continue to be a big problem until this is seriously looked at.

Furthermore the addition of a carbon tax on flights again does not solve the problem, firstly as I understand it the money gained from the tax does not go into actually improving the country's green footprint. People will still travel although perhaps the poorer people will not be able to afford it as much. This will not mean a significant reduction in flights, but is merely in effect another tax to the poor.

I agree that people need to fly less as one of the many changes we all need to make, but adding a tax is not the solution.

Alex makes a good point that the tax should be used to actually improve our footprint. But I find it hard to believe that we will make a significant difference without industry being targeted, before the average consumer - but this goes against the free market economics strategy that seems to be the guide for politics in most capitalist countries.

Thanks for your post.


3. Hannah Ryder
24 July 2011, 6:57 pm

Alex and Louisa - thanks for two really thought-provoking replies.

Both of you raised some really crucial points about the pros and cons of carbon taxes, emissions trading and the use of their revenues. Many of these were explored in Chapter 15 of the Stern Review - see http://www.hm-treasury.gov.uk/d/Chapter_15_Carbon_Pricing_and_Emissions_Markets_in_Practice.pdf. And your points about the special nature of aviation, Louisa, were explored on Page 18 of Chapter 22 of the Stern Review - see http://www.hm-treasury.gov.uk/d/Chapter_22_Creating_a_Global_Price_for_Carbon.pdf.

But you are also both right that other measures beyond trading and taxes are needed. In some cases, regulation to change behaviour – whether of industry or consumers – is necessary and very cost-effective. In others, technological improvements are crucial. I believe that all three will be needed in most situations, and in all societies because climate change is a global problem. But many developing countries need support to deliver these – and that’s why countries like the UK need to be able to offer such support, as well as taking action at home.


4. James Hewitt
31 July 2011, 5:58 pm

What support can the UK give which the people and habitats of will benefit from? Their greatest need is for us to greatly reduce our greenhouse gas emmision footptint from consumption.

The second most important cheap and assured measure we can take is to stop procuring products from the few enterprises in Brazil and Indonesia which are known to account for most GHG emissions from deforestation - namely soy-based animal feed, cattle products, products based on wood pulp, and products which contain palm oil. Their production tends also to be associated with immiseration of peoples locally (not the supposed benefits of economic growth) and illegality / poor governance (stultifying economic development)


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