The problem with economics is that it often uses a language that non-economists do not speak.
Take “externalities”, for example. If you are not an economist, you are unlikely to know the meaning of the word. That is hardly your fault because in everyday language, no-one ever talks about externalities.
And yet, “externalities” is an important concept because the whole of environmental economics circles around the question of how to deal with them.
Though we cannot expect lay people to understand this, economists should know better. Especially if they hold a PhD in Insurance and Risk Management, an MA in Applied Economics and Managerial Science, an MBA in Money and Finance and honours degrees in law and economics.
Which brings us to Rod Carr, chair of the Climate Commission. In a post of just 636 words, published on the Commission’s website, Carr just threw out the entire approach of environmental economics in one fell swoop.
Carr writes that “New Zealanders deserve better than just the least cost pathway to a low emissions future.” That sounds caring and ambitious. Unfortunately, it is just a decoy for a covert attack on economic logic.
Non-economists would not appreciate just how far Carr deviates from mainstream economics. To give an example, he writes that one cannot put a price on things such as future generations, land and resource use or our personal relationships. Once again, that sounds nice. But it is still wrong. Resources are scarce. Choices and trade-offs are inescapable.
We must put an implicit price on all matter of things to make decisions. We constantly weigh alternatives. We sometimes do this implicitly. An hour spent with a friend is an hour unavailable to go to the gym, work or sleep.
We also make choices about how much to care for today – and how much for the future. We balance different goods and services within our means, and we allocate our time, money and attention accordingly.
Economics has formalised such thinking. It is called utility theory. In the extreme, economists even put a price on the value of life itself. Though it sounds harsh, it is useful. For example, it allows governments to figure out how to spend budgets to save the maximum number of lives. Should the Government rather fund a new drug through Pharmac or improve road safety on highways?
And, by the way, it is not just economists making such life-and-death calculations. Skydivers also weigh the risk of death against the pleasure of jumping.
Therefore, for Carr to claim that some things cannot be priced is misleading. Determining the utility of different options may be hard, but that is no excuse for not trying. It is even less of an excuse to reject least-cost strategies.
Carr has his problems with utility theory, but his failure to grasp the externalities issue is even more astonishing. So what, then, are these fabled externalities?
Briefly put, externalities are the effects one’s actions impose on others. The rubbish you dump in the sea, the exhaust gases from your car, or the even the strong smells from your neighbour’s kitchen are examples. Environmental economics is about internalising externalities in the most efficient way.
In the first instance, that means determining an optimal level of pollution. To non-economists, this probably sounds outrageous. How could any level of pollution be acceptable, let alone optimal?
But again, this is the kind of calculation people make when they face the full costs and benefits of their decisions. Hence there is a need to internalise such externalities.
In his piece, Carr claims that the price New Zealanders pay for emissions certificates does not reflect the true cost their emissions inflict on society. Except how would he know?
The statement is even stranger since the Zero Carbon Act puts New Zealand on a path to net-zero emissions by 2050. The end point of “net-zero” means that the negative externalities of a net tonne of carbon are deemed to exceed any benefit derived from emitting it.
That is quite an assumption. In their Economics textbook, the two Nobel laureates Paul Samuelson and William Nordhaus explain that: “Cost-benefit analysis will show why extreme “no-risk” or “zero-discharge” policies are generally wasteful.”
To make it even clearer, they write: “Reducing pollution to zero would generally impose astronomically high clean-up costs, while the marginal benefits of reducing the last few grams of pollution may be quite modest.”
By the way, Nordhaus won his Nobel Prize for his work on the economics of climate change. Never mind, zero-emissions are what New Zealand’s Zero Carbon Act prescribes.
Once Government has decided on the desired level of pollution, the second question in environmental economics is this: How do we reduce the level of pollution to that level?
Economists try to achieve such goals in the most efficient way. That means: at least cost to wellbeing.
Carr, meanwhile, does not accept this approach. “We know that the least cost option often creates poor outcomes,” he writes. But what follows from that claim?
The problem with Carr’s rejection of least-cost reductions is that he throws out the yardstick by which climate policies could be judged.
If cost-efficiency is no longer the criterion, anything goes. We could remove carbon from the atmosphere by afforestation for $10 a tonne, by installing solar panels for $40 or by replacing coal boilers in schools for a few hundred dollars. But we would not have a way to determine which way is best.
For over a century, economists have thought long and hard about how to best deal with reducing externalities. Arthur Pigou did so in his seminal work The Economics of Welfare (1920), in which he proposed environmental taxes. In The Problem of Social Cost (1960), Ronald Coase then developed ways in which negotiations between affected parties can lead to efficient outcomes.
Since the 1960s, many government agencies and economists have worked on cap-and-trade schemes with the goal of reducing emissions in the most efficient way.
With this long history of economic thought, the basics of environmental economics are literally textbook stuff. Still, Carr claims that efficiency and least-cost are bad ideas. And why? Because “pursuing the cheapest path fails to consider impacts on individuals, communities, workers, businesses, families, and the principles of Te Tiriti o Waitangi,” he says.
What it means is that there will not be constraints on any policy that Carr and his Commission come up with. They no longer need to justify them on economic terms. They do not need to assess their costs and benefits for New Zealanders. All it takes is for them to assert that a specific policy works well for communities, families or the Treaty regardless of their cost implications.
Economically speaking, Carr’s approach is nihilistic. His Commission’s proposals are not open to checking because there no longer is a framework for evaluating them.
Deep down, it is also an admission that the Commission’s proposals will not get us to net-zero emissions in the most cost-efficient way. It is the replacement of the goal of efficiency with political values, but for no environmental gain.
The net zero goal will be achieved regardless because total emissions are capped anyway. The whole exercise will just be several times more expensive. And that will be money no longer available for other things that people will value. It is a colossal waste of resources, based on shoddy logic.
The one point I would concede to Carr is that there may be outcomes resulting from internalising externalities that are politically unpalatable. Indeed, Carr himself mentions rapid afforestation and undue social burdens on groups of people.
But even such political problems should not justify, let alone require a departure from efficient solutions. It is possible to regulate for land use or compensate social inequities – even more so once revenue from the Emissions Trading Scheme becomes ringfenced.
To reject least-cost solutions just because there are some other related problems you wish to solve would be to throw out the baby with the bathwater. None of these issues require a departure from the principle of internalising externalities in the most efficient way. In fact, the more efficient we are in dealing with externalities, the more resources we would have left to deal with other issues.
As an economist, I have every sympathy for non-economists finding our discipline confusing, intimidating and hard to understand. Which is why us economists have a duty to explain ourselves better – ideally without the jargon but firmly standing on the foundations of our discipline.
The trained economist Rod Carr, meanwhile, does not do this. Surely, he knows full well about utility theory, environmental economics and efficiency. But to pursue eminently political goals, he is willing to discard or at least deviate from economics.
From a political perspective this is understandable. From an economics perspective, it is disingenuous.
We will need to evaluate the final proposals from Carr’s Climate Change Commission, to be released to the public on Wednesday, by using the tools of sound environmental economics.
– Dr Oliver Hartwich is the Executive Director of The New Zealand Initiative (www.nzinitiative.org.nz).
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