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The Price is Wrong
Cost of climate change missing from energy prices

Guest Blogger @ 11:25 AM

By Dave Warren

Economic studies of the impacts of weather events are nothing new. However, it is now difficult to go even a week without reading about new research that attempts to quantify the economic costs associated with global climate change. Such research has already produced a mind-boggling flurry of estimates adding up to hundreds of billions of dollars.

These economic analyses provide the impetus for advocacy groups of all stripes to push new policy recommendations to combat climate change. Vegetarians say eating meat is driving up emissions. Smart growth organizations say sprawl must be stopped. Promoters of public transportation say we must reduce auto use. Economics is often part of the rhetoric, with claims that a dollar spent now on a particular policy will save many dollars down the road.

Dan Stillman's Forecast

** North and West of DC: Frost Advisory From 3 AM to 8 AM Monday **

Forecast Confidence: High-Very HighToday: Mostly sunny and windy (near 15 mph from the north, gusts to near 25 mph). Highs in the low 60s.
Tonight: Clear with diminishing winds. Lows in the low 40s in town, 32-37 in the burbs.
Monday: Sunny with light winds. Highs near 60.

The full week ahead forecast will appear in tomorrow's post.

The truth is, the many well-meaning advocacy groups are at once both absolutely correct and completely wrong. Most of their suggested measures -- and many others --would likely reduce the carbon emissions that drive climate change. And it's a decent bet that the long-run benefits of the policies would outweigh costs. But advocating for specific, piece-meal approaches fails to address the underlying cause of climate change and clouds attempts to do so in an economically efficient manner.

Compare the approach of typical U.S. interest groups with that of Bjorn Lomborg, author of "Cool It: The Skeptical Environmentalist's Guide to Global Warming." Three weeks ago, Lomborg offered his own recommendations in a much talked about Washington Post op-ed.

I couldn't help but agree with many of Lomborg's statements, which may have put me in the minority of those who commented on the column throughout the blogosphere. He is not an economist, but approaches the climate change problem from an economist's perspective by proposing economically efficient responses to the problem. This is a refreshing perspective, especially considering the extraordinary complexity of the climate change challenge.

The real reason we are faced with climate change is not because we drive too much or leave too many lights on. It's not because we don't spend enough money on energy-related research and development. Yes, these activities (or lack thereof) contribute directly to climate change, but they do so only because their prices do not fully reflect all costs (or benefits).

In economics, this is called a market failure, and climate change is the result of arguably the greatest market failure of all time. Over many decades, we have driven cars and powered homes and factories, thereby releasing carbon dioxide into the atmosphere. The price of the gasoline or electricity used covers the capital costs of the refinery or power plant, the costs of transmission, and a host of other expenses. However, one thing the price does not include, whether it's the price at the pump or the price on your monthly electric bill, is the full environmental cost (or in economic jargon, a negative externality) of the fossil fuel combustion. The result: the price of energy is too low, resulting in over-consumption and a level of atmospheric carbon that is far from ideal.

While this is the major market failure contributing to the problem, it is not the only one. The Congressional Budget Office recently published an excellent report on emissions reduction strategies that elegantly identifies two market failures hampering efforts at cutting emissions. One involves the lower-than-optimal price of fossil fuel use. The other is an under-investment in research and development.

The latter occurs because the total benefits of innovation are not fully captured by those that produce the innovation. A company's technological advancement that would dramatically reduce auto emissions, for instance, would generate huge social benefits (positive externalities), such as reduced climate change impacts and cleaner air, but the company would not capture any of the value of such benefits. Thus, such technological innovations are under-produced.

Correcting these market failures means getting the price of carbon-based energy right and subsidizing research and development activities. (In fact, correcting the energy price market failure would go a long way toward increasing energy-related research and development, but for now let's just assume the two are somewhat mutually exclusive.)

Why is this the approach preferred by economists? Because it avoids making potentially costly -- or wrong -- judgments about which policies would reduce the greatest amount of carbon emissions per dollar. Getting prices right, and increasing energy-related research and development, would automatically make public transit more desirable, energy-efficient automobiles and appliances more economical, and alternative-energy research more viable. Individual consumers and producers -- responding in concert to incentives -- would determine the cheapest, most effective package of solutions, maximizing carbon dioxide reduction at minimum cost.

Of course, if mitigating climate change was as easy as adjusting energy prices and increasing research and development, we would have done it by now. Politics certainly gets in the way, as does uncertainty about the potential costs of climate change. After all, what is the "right" price if we don't know exactly what the consequences of doing nothing would be?

Nevertheless, thinking of the problem in terms of the market failures that caused it is instructive. If anything, such thinking can guide the eventual response by requiring policymakers to ask the question, "Will this policy correct the market failure?" If the answer is no, then both our planet and pocketbooks will suffer.

The author has a master's degree in environmental economics from Ohio State University and is a research analyst for the Brookings Institution's Metropolitan Policy Program.

Andrew Freedman's Undercast Column will return next week.

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