Towards the ideal CO2 price structure – Part 1: The McKitrick proposal

Summary:

  • Despite being the most efficient mechanism for climate change mitigation, CO2 pricing is proving to be very challenging to implement in the real world. 
  • This article discusses an interesting new framework with the potential to overcome these barriers.
  • The approach proposes to link the CO2 price to an objectively measurable effect of CO2 emissions (global temperature rise) and to establish a futures market for CO2 exemption certificates in order to incentivise truly objective and practically applicable forecasting. 

Introduction

It is almost universally agreed that a CO2 price is the best response to the global challenge of climate change, but the complexities of implementing such a market mechanism has thus far prevented meaningful action. Part of the problem is that there are so many different opinions on how a CO2 tax should be structured – both in terms of how it should be collected and how it should be utilized. This post will present one view on the topic that I think is pretty close to perfect, simply because it provides all the right incentives throughout the market. Ross McKitrick explains the foundation of his approach in the video below.

Most important aspects of the proposition

Three important aspects of the proposed CO2 tax structure will be briefly discussed below:

  1. It incentivises the market to find the most efficient CO2 abatement strategy
  2. It incentivises people on both sides of the debate to find truly objective information and to put their money where their mouths are
  3. It promises not to harm the economy of a nation that implements it before it is implemented in other nations

The most efficient CO2 abatement path

The efficiency of CO2 abatement through a well-implemented CO2 price is easily understood. A given price level will incentivise every player in the market to implement any of the very wide range of CO2 abatement solutions that has a lower cost than the current CO2 price in order to gain a competitive advantage. This is the purest and most efficient way in which to utilize the power of the free market to combat climate change.

McKitrick directs some harsh critisisms at the current “mish-mash” of highly inefficient policy mechanims that are supposed to, in some way or another, abate CO2 emissions. He also stresses that, if a CO2 tax is eventually implemented, the worst possible way in which to utilize these extra revenues is to subsidize the low-carbon solutions rejected by the market.

Complete objectivity on both sides of the debate

This is the most interesting aspect of the proposed CO2 tax mechanism. Basically, this highly desirable outcome will be realized by linking the price of CO2 to some measurable effect of CO2 emissions (McKitrick proposes the temperature in the tropical troposphere) instead of the emissions themselves. In addition, it is proposed that a futures market for CO2 exemption certificates is established so that players can buy and trade exemptions to future CO2 taxes based on the information they have on future temperature rises.

The reasoning behind this is easy to understand. Despite the general consensus that anthropogenic climate change is happening, the jury is still out on just how sensitive the climate really is to our greenhouse gas emissions. Specifically, the nearly 2-decade pause in global temperature increases we are currently experiencing has given the skeptic community plenty to talk about. See the graph below as an example.

Global warming pause

Yes, people who are truly concerned about climate change (myself included) can cite all kinds of reasons for this pause, but the fact is that the global climate modelling community has almost universally missed this persistent pause in the most direct measure of global warming. It should therefore come as no surprise that there exists a lot of opposition towards basing policy that could negatively affect a nation’s welfare on model predictions that have compared so poorly against observations. The natural result of this will simply be another decade or so of intense (and increasingly emotional) debate with virtually no tangible action.

This is where the McKitrick proposition becomes very interesting. By linking the CO2 price to the actual observed temperature rise and setting up a futures market for this price, it incentivises all players in the market to gather the most objective information about global warming available and then directly invest in this information. If such a mechanism is implemented, odds are that initial futures prices (10, 20 or 30 years ahead) would be fairly conservative due to recent observations. For someone who truly believes in model predictions, this would constitute an excellent buying opportunity that will lead to major profits in the future if his/her information proves to be accurate.

Because of the amount of money that would be at stake in such a market system, there would be a great incentive to all major players to really get hold of the most objective and cutting-edge information about future temperature rises available. In essence, climate modelling would evolve from the academic exercise it is today to being a forecasting tool directing the allocation of billions of dollars of investment capital. This paradigm shift will provide all the right incentives both to climate modellers and all those interested in their results.

And yes, as mentioned above, anyone who is frustrated at the current lack of action will be given the opportunity to act very directly on these frustrations by buying cheap future contracts as an investment. Not only can this be highly profitable, but, if enough people do it, the large demand for future exemption certificates will increase the price, thus indicating that the market expects major temperature rises in the future, thus potentially prompting more direct action today.

McKitrick makes these points more directly in the video below.

No harm in going it alone

One of the biggest hurdles to effective climate legislation is that any nation implementing these taxes on its own can hurt its competitiveness relative to other nations who are carrying on with business as usual, thereby hurting its own economy. McKitrick addresses this concern by explaining that energy is a very good thing to tax because it has a very low level of price elasticity (demand responds very slowly to price changes as with cigarettes in the figure below). Things with low price elasticity are good candidates for taxation because the resulting price increases will not prompt a large slowdown in economic activity through reduced demand.

elasticity of demand

However, McKitrick stresses clearly that this will only work if this CO2 tax comes instead of (not on top of) the existing mish-mash of inefficient policy mechanisms implemented throughout the developed world. In fact, if such a tax replaces the bureaucratic mess of inefficeint technology-forcing policies currently in place, it will almost certainly be beneficial to the economy of any country choosing to implement it. The establishment of the futures market and the large incentive for truly objective forecasting that this will create will also likely bring some additional economic benefits.

Possible further improvements

Part 2 of this post will cover two potential mechanisms through which the incentives provided by this framework can be further refined. In particular, these suggestions will address the following two potential weaknesses of the approach outlined above:

  1. The global temperature rise is not the effect of CO2 emissions that we are actually concerned about. That which we should measure (and link the prevailing CO2 price to) is actually the amount of economic damages caused by a disrupted climate system.
  2. Even though the futures market does bring some forward-looking action into the framework, this is possibly not enough. The framework therefore needs a more direct link in which the market’s expectations of future climate damages can incentivise proactive action today.

Stay tuned…

 

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