Worthwhile Canadian Initiative

More reactions to the Liberals' carbon tax proposal

The Liberals have provided more detail on their carbon tax proposal (48-page pdf), and it has received generally positive reviews. The basic strategy is to take the existing gasoline tax, re-interpret it as a tax on carbon, and to extend it to other sources of greenhouse gases. As an exercise in electoral politics, introducing a carbon tax without increasing gasoline taxes is actually a pretty clever trick.

We also have a better idea of what the Liberals would do with the $15b or so in revenues that the carbon tax would generate: income tax cuts for the lower- and middle-income brackets, another point off the corporate tax, and targeted transfers for low-income households who wouldn't benefit from the income tax cuts. That's a pretty sensible list, although income tax cuts for those earning $100k/yr isn't exactly what I call a priority.

Reactions from the other two parties are continuations of their original talking points. For example, the Conservatives' theme of shrieking "Eeek! A tax!" has evolved into this. And the New Democrats are intent on showing to the world their singular inability - or refusal - to understand economics.

The standard NDP critique of the Liberal proposal takes two forms:

A) $10/kg (rising to $40/kg in four years) per tonne of CO₂ is not enough to make a significant difference in ghg emissions, and

B) The Liberal plan will impose an unacceptably large cost on consumers.

The latter point is of course the CPC's position. And the NDP can fairly make point A) - except that according to this page, emitters will have to pay at least $35 per tonne of CO₂ emissions. If an increase of $40/tonne is not enough to attain the announced policy goal, then the NDP's floor of $35/tonne is clearly too low; the appropriate price should be well north of $40/tonne. But if emitters are going to be paying significantly more under the NDP policy than they would under the Liberal plan, it makes no sense whatsoever to appeal to point B): there is no reason to think that emitters will try to pass along the costs of a carbon tax to consumers, but will not try to pass along the costs of an even more expensive carbon permit. The NDP is trying to suck and blow on this issue, but all it's doing is making unpleasantly incoherent noises. Cap-and-trade is not an indefensible policy (to a first approximation, cap-and-trade and carbon taxes are equivalent), and it will almost certainly be a part of the policy mix in the near future. But if the NDP wants to be taken seriously in this debate, it has to abandon the notion that its plan will not affect consumers, and it has to explain how it is going to protect consumers in low-income households.

My view is that a carbon tax is a good place to start, but it's not going to be the last word. If you're more concerned about hitting the emissions targets than you are about price uncertainty, then cap-and-trade is the best way to go. And it seems clear that this will be a good description of our priorities in the not-too-distant future.

But we're not there yet. Right now, there are a lot of people who are worried about the effects of climate change policy on prices and about the potential for economic dislocations; a radical cut in emissions runs the risk of generating severe economic disruptions and wiping out electoral support for climate change policy for a generation or more.

As far as revenues go, the Liberal plan amounts to rescinding the Conservatives' 2 ppt cut in the GST. Not insignificant, but not particularly profound, either. Once it's been demonstrated that a carbon tax does not mean the end of the world, then there will be less electoral opposition to climate change policies. And as we learn more about the relationships between ghg emissions and prices, we can start introducing cap-and-trade measures with more confidence.

Carbon taxes vs cap-and-trade

There are now several plans for reducing greenhouse gas emissions bouncing around the political landscape. The BC Liberals have implemented a carbon tax and the federal Liberals are also floating the idea. For their part, the federal NDP is talking about a cap-and-trade model, as are the premiers of Ontario and Quebec. And a cap-and-trade model also happens to be the federal Conservative government's policy.

It's important to remember that in almost every way that matters, the two approaches are equivalent. But since the various political parties are all trying to squeeze out as much torque as possible from their own proposals, this point is easy to overlook. So as a public service, here is the Econ 101 explanation of how the two policies work, and why they are equivalent.



Before the policy, the intersection of the supply and demand curves for ghg-emitting products - point A on the graphs - will generate emissions equal to Q₀, and the price will be P₀. Suppose that the government wants to reduce the quantity to Q₁.

• Carbon tax: Suppose that a carbon tax π is added into the price. For a given quantity, the supplier's price will be the old price plus the amount of the tax, and the supply curve will shift up to S*. The new equilibrium is at point B, the quantity is the target Q₁, and the price will increase to P₁. Note that the price increase will be less than the tax, although if the demand curve is fairly steep (i.e., inelastic, or relatively insensitive to changes in price), the increase in the price will be pretty close to π.
• Cap-and-trade: Suppose that the government restricts emissions to a level consistent with Q₁. The new supply curve - denoted by S* - is now vertical at the target: no matter how high the price goes, supply will remain fixed at Q₁. The new equilibrium is again B: the quantity is determined by the cap at Q₁, and the price will rise to P₁.

So as far as prices and quantities go, the two policies are equivalent: as we go from A to B, quantities fall to the target Q₁, and prices rise to P₁. From the consumer's point of view, that's all that matters.

What distinguishes the two is what happens to π - the difference between the price the consumers pay at B and what it costs suppliers to produce at Q₁. In the case of the  carbon tax, the money goes to the government. But if output is capped at Q₁, that difference is pure profit: a permit to produce one unit of output allows its owner to collect a rent equal to to the difference between the selling price and the cost of production. If permits are traded, their price will be bid up so that their price will be equal to π. So where that money goes depends on how the permits are allocated in the first place. If the permits are simply given to existing emitters, then those profits are pocketed by the firms. If the permits are auctioned off, the price will be bid up to π, and the government gets the money.

So if permits are auctioned off by the government, then cap-and-trade and a carbon tax are equivalent: same quantities, same prices, and the government gets revenues equal to the area in the green rectangle in the graphs.

Update: Mark Thoma reminds us of a more sophisticated - yet still very accessible - analysis at Environmental Economics.

Reactions to the carbon tax: the good, the bad, and the ugly

The good: In addition to being good policy, there's some reason to be optimistic that the Liberals' carbon tax proposal will be good politics. According to one poll, more than 60% of Canadians approve of the general idea of carbon taxes. And even noted environmentalist David Suzuki endorses the idea. David Suzuki can't always be counted on to support sensible policies, but at least this time he's not going to be an obstacle.

The bad: As predicted, the Conservatives are spinning the carbon tax as, well, a tax. And since the CPC is unable to distinguish between smart and stupid taxes, they're coming up with stuff like this.

The ugly: The NDP's response is a confusing jumble of faulty analysis and short-sighted pandering.

Layton raises carbon tax alarm: NDP Leader Jack Layton launched a vehement campaign against carbon taxes yesterday and was quickly accused of alarmist pandering by prominent Canadian environmentalists.

Speaking to a fundraiser for an Ottawa homeless shelter, Mr. Layton said carbon taxes would raise home heating costs and hurt Canadians living on the margins. He said big corporations should bear the lion's share of Canada's climate-change tab and a federal ombudsman should ensure those costs aren't passed on to consumers.

"With energy costs soaring in Canada, we've got to ensure that the solutions to climate change don't aggravate an already dire situation for those who struggle to make ends meet," Mr. Layton said.

He said he supports a cap-and-trade system, which imposes penalties on industrial emissions above a certain level, or cap. Liberals, meanwhile, are preparing to announce a plan built around carbon taxes, which is expected to apply to a wider range of emissions and raise money for environmental efforts.

As far as the consumer is concerned, cap-and-trade will have exactly the same effect as a carbon tax, namely, to increase prices. The only potential difference is who is on the receiving end of that extra spending: with a carbon tax, the government gets the money, and with cap-and-trade, that money is rent for those who own the permits. If the permits are auctioned off by the government, the two programs are essentially equivalent.

But there's more to the NDP's position than a second-order difference of opinion on mechanics; there's also this sentence:

He said big corporations should bear the lion's share of Canada's climate-change tab and a federal ombudsman should ensure those costs aren't passed on to consumers.

It is at this point that one begins to despair of the NDP.

Could someone please explain to Jack Layton that corporations don't pay taxes? Only people pay taxes, and corporations are not people. And the people who pay corporate taxes are not the owners of the corporation, either: the people who really pay those taxes are workers (in the form of reduced employment opportunities) and consumers (in the form of higher prices).

The Liberals and Conservatives understand this point. The CPC is targeting the people who don't want to pay those costs, and Stéphane Dion is going after those who do. The NDP's niche appears to be voters who want someone else to pay the costs of reducing greenhouse gas emissions.

The Liberals' carbon tax proposal

Stéphane Dion and the Liberals are floating the idea of a carbon tax:

Liberals say carbon tax will be revenue-neutral: [I]nternal policy discussions are still underway and a number of proposals are under consideration. One proposal under study would replace the federal fuel excise tax - which applies to gasoline and diesel used for vehicles - with a more broadly based "environmental tax" to include other fuels such as natural gas, heating oil and coal-generated electricity.

That plan, proposed by economist Jack Mintz and Nancy Olewiler of the Sustainable Prosperity Institute, would leave the existing excise tax of 10 cents per litre of gasoline and four cents per litre of diesel unchanged. The authors estimate that applying the excise tax to other fuels would increase tax revenue by between $12 billion and $15 billion annually. The revenue could be used to substantially lower personal and business taxes and to fund tax credits related to climate change technologies.

If the Liberals follow through on this, they will have the distinction of being the only major party that has a sensible position on reducing greenhouse gas emissions: the Conservatives are unable to distinguish between smart and stupid taxes, and the NDP is busy pandering to those who think that gasoline prices are already too high (h/t to Paul Wells).

But I don't see why they have to make such a big deal about it being revenue-neutral. $12b-15b is a significant chunk of change - roughly the equivalent of the two GST percentage points that the Conservatives frittered away to no apparent purpose. A carbon tax will be regressive, so a good portion of those revenues should be used to compensate lower-income households. The Liberals seem to understand this point:

[Liberal finance critic John] McCallum said the Liberals are working out a plan where tax credits or some other mechanism will be necessary to ensure pensioners and other Canadians with fixed incomes, low wages or who are otherwise in zero or low tax brackets must also receive compensation.

"You may be sure that we would be acutely aware of people who have lower incomes or more difficult times and you could be certain we will do everything to look after those people," McCallum said. "Some of the lower-income people don't pay tax, so that would be a feature of any such program if we were to have one."

I don't know how it happened, but the Liberal Party of Canada has found a way to be relevant again.

The best response to John Baird's report on the cost of meeting the Kyoto targets...

...is right here. Go read it.

Economics and climatology: Why perfect markets are like a dishpan

Brian Ferguson at A Canadian Econoview makes an interesting point:

Ever wonder why so many economists are sceptical about man-made global warming? It's because we've had a lot of humbling experience with just how quickly large scale computer models can go very badly wrong. Remember when we had inflation and unemployment under control through Keynesian fine-tuning?

There are some interesting parallels between the atmospheric sciences (climatology and meteorology) and economics: they study highly complex systems, the available data are non-experimental, and their results have significant policy implications. Not surprisingly, both rely heavily on models as tools for understanding what is going on and why. Of course, models need not be based on a computer simulation, or even mathematics. As Paul Krugman notes, you can put one together using some ordinary household appliances:

Dave Fultz was a meteorological theorist at the University of Chicago, who asked the following question: what factors are essential to generating the complexity of actual weather? Is it a process that depends on the full complexity of the world -- the interaction of ocean currents and the atmosphere, the locations of mountain ranges, the alternation of the seasons, and so on -- or does the basic pattern of weather, for all its complexity, have simple roots?

He was able to show the essential simplicity of the weather's causes with a "model" that consisted of a dish-pan filled with water, placed on a slowly rotating turntable, with an electric heating element bent around the outside of the pan. Aluminum flakes were suspended in the water, so that a camera perched overhead and rotating with the pan could take pictures of the pattern of flow.

The setup was designed to reproduce two features of the global weather pattern: the temperature differential between the poles and the equator, and the Coriolis force that results from the Earth's spin. Everything else -- all the rich detail of the actual planet -- was suppressed. And yet the dish-pan exhibited an unmistakable resemblance to actual weather patterns: a steady flow near the rim evidently corresponding to the trade winds, constantly shifting eddies reminiscent of temperate-zone storm systems, even a rapidly moving ribbon of water that looked like the recently discovered jet stream.

What did one learn from the dish-pan? It was not telling an entirely true story: the Earth is not flat, air is not water, the real world has oceans and mountain ranges and for that matter two hemispheres. The unrealism of Fultz's model world was dictated by what he was able to or could be bothered to build -- in effect, by the limitations of his modeling technique. Nonetheless, the model did convey a powerful insight into why the weather system behaves the way it does.

The important point is that any kind of model of a complex system -- a physical model, a computer simulation, or a pencil-and-paper mathematical representation -- amounts to pretty much the same kind of procedure. You make a set of clearly untrue simplifications to get the system down to something you can handle; those simplifications are dictated partly by guesses about what is important, partly by the modeling techniques available. And the end result, if the model is a good one, is an improved insight into why the vastly more complex real system behaves the way it does.

Popular usage notwithstanding, climatologists have not 'proven' a link between human production of greenhouse gases and global warming. Rather, according to the models that - in their best judgment - best reproduce the main features of the available climate data, the most likely explanation for the increases in the average temperatures we observe is the warming effect of greenhouse gases. That doesn't mean there isn't a more likely explanation - just that no-one has yet been able to think of one.

Although the idea of making important - and possibly very costly - policy decisions based on a modeling exercise doesn't seem to bother many people when atmospheric scientists do it, economists have a harder time getting away with it:

When it comes to physical science, few people have problems with this idea. When we turn to social science, however, the whole issue of modeling begins to raise people's hackles. Suddenly the idea of representing the relevant system through a set of simplifications that are dictated at least in part by the available techniques becomes highly objectionable. Everyone accepts that it was reasonable for Fultz to represent the Earth, at least for a first pass, with a flat dish, because that was what was practical. But what do you think about the decision of most economists between 1820 and 1970 to represent the economy as a set of perfectly competitive markets, because a model of perfect competition was what they knew how to build? It's essentially the same thing, but it raises howls of indignation.

Why is our attitude so different when we come to social science? There are some discreditable reasons: like Victorians offended by the suggestion that they were descended from apes, some humanists imagine that their dignity is threatened when human society is represented as the moral equivalent of a dish on a turntable. Also, the most vociferous critics of economic models are often politically motivated. They have very strong ideas about what they want to believe; their convictions are essentially driven by values rather than analysis, but when an analysis threatens those beliefs they prefer to attack its assumptions rather than examine the basis for their own beliefs...

The problem is that there is no alternative to models. We all think in simplified models, all the time. The sophisticated thing to do is not to pretend to stop, but to be self-conscious -- to be aware that your models are maps rather than reality.

There are many intelligent writers on economics who are able to convince themselves -- and sometimes large numbers of other people as well -- that they have found a way to transcend the narrowing effect of model-building. Invariably they are fooling themselves. If you look at the writing of anyone who claims to be able to write about social issues without stooping to restrictive modeling, you will find that his insights are based essentially on the use of metaphor. And metaphor is, of course, a kind of heuristic modeling technique.

In fact, we are all builders and purveyors of unrealistic simplifications. Some of us are self-aware: we use our models as metaphors. Others, including people who are indisputably brilliant and seemingly sophisticated, are sleepwalkers: they unconsciously use metaphors as models.

This doesn't mean that conclusions based on models are always right; quite the opposite. Models are approximations, and approximations are 'wrong' pretty much by definition. The problem is that it's hard to know if the model is wrong in a way that significantly affects its usefulness for policy analysis. Indeed, many advances in economic thought have occurred because a model-based policy went wrong in an unexpected way. A good economist will always make a clear distinction between a model and reality.

Since I personally know nothing about climatology, I'm willing to defer to the judgment of those who do. But there's always the risk that climatologists - being human - have gotten it wrong. Greenhouse gases may not turn out to be that big of a deal. On the other hand, they may be even more of a problem than even the worst of the model-based scenarios would predict.

When it comes to climate change policy, the most important question may be: Do we feel lucky?

The price of Kyoto

A voting majority of the House of Commons has passed a resolution calling upon the government to "honour the principles and targets of the Kyoto Protocol in their entirety". Now, we already know that Canada cannot and will not reach its target for greenhouse gas emissions. If we go by the - admittedly questionable - hypothesis that the opposition parties have thought through the implications of their resolution, then they must be thinking about complying with the penalties for missing the Kyoto targets:

In the case of compliance with emission targets, Annex I Parties  have 100 days after the expert review of their final annual emissions inventory has finished to make up any shortfall in compliance (e.g. by acquiring AAUs, CERs, ERUs or RMUs through emissions trading).

So we're supposed to buy greenhouse gas emission (GGE) permits. How many? As I noted before, GGEs have been growing at the fairly steady rate of 1.7% a year between 1990 and 2004, a trend that has almost certainly continued to 2007. This means that Canadian GGEs are running around 797mt in 2007. If the trend continues to 2012, they'll be at 866mt, but it will presumably be the case that stronger environmental legislation will be brought in before we get that far. If we can cut the rate of growth of GGE by half over the next 5 years - and this would be quite an achievement - then 2012 emissions would be in the neighbourhood of (say) 825mt. Canada's Kyoto target (96% of 1990 emissions) is 575mt, so we'd be looking to buy emissions for 250mt. How much would it cost?

The short answer is that we don't know: the market hasn't opened yet. But there have been many attempts to predict what will happen when it does. Here is a summary from a recent survey:

If we take the median forecast of $US 19/tonne at 2000 prices, add inflation and convert to CAD at current exchange rates, that works out to about $C 25/tonne. Multiply that by 250mt, and the Kyoto penalty works out to something like $6.25b/yr.

Now if paying $6b a year were the price of actually reducing greenhouse gas emissions to the Kyoto levels, it would be a bargain. But it's not: we'd still be producing greenhouse gases at levels well above the Kyoto targets.

Of course, if the emissions market were to function as it is supposed to, then it would make sense to buy permits from countries that have a comparative advantage in GGE reduction. But without the participation of the US, Canadian purchases of permits would have at best a symbolic value.

$6b/year is a lot to pay for a symbol.

We can't get to Kyoto from here, and there's no point in pretending that we can

All of the opposition parties in Ottawa say that they support the Kyoto accord, and they insist that any climate change policy must be aimed at achieving the Kyoto targets for greenhouse gas emissions.

But this is simply not going to happen. There is no feasible way we can achieve the Kyoto targets.

Why does Luxembourg have such high levels of greenhouse gas emissions?

I don't understand this at all.

Tonnnes of CO2 equivalents per person in 1990:

1. Luxembourg: 35.5
2. Australia: 25.7
3. US: 23.8
4. Canada: 21.5

In 2003:

1. Australia: 26.1
2. Luxembourg: 24.9
3. Canada: 23.9
4. US: 23.4

I can understand why Canada, Australia and the US are in the top four. But Luxembourg?

The politics of climate change policy in Canada

Convincing Canadians of the need to make significant sacrifices in order to slow global warming was never going to be easy.