Wednesday, August 7, 2013

Litterman on carbon finance

I just read a very nice article by Bob Litterman in CATO's "Regulation" on the finance of carbon taxes. It includes a review of some of the recent academic calculations.

(Related, Ronald Bailey at takes on the Administration's latest cost of carbon estimates, and reviews Robert Pindyk's recent NBER working paper "What do the models tell us?" also covered by Bob.)

Like just about every economist, Bob favors a carbon tax or tradeable emissions right over the vast network of regulatory controls on which we are now embarked. I might add that getting rid of the large subsidies for carbon emissions implicit in many country's policies would help before we start taxing.

But let's get to business, how big should the carbon tax be?

It's a hard question. The economic costs of warming are hard to assess. Moreover, they come in a century or more, when presumably our descendants are much wealthier than we are, and hopefully have technologies we have not imagined. Or civilization will have collapsed so they have a lot more pressing problems. How do we trade off costs now and uncertain benefits in a century?  What discount rate should we use?

Bob has good points on this question that I hadn't thought of, and are good applications of finance thinking (as you'd expect from Bob) which is sort of my excuse for covering it here.

Carbon beta

First, climate costs are likely to have a strong negative beta, and thus climate investments have a large positive beta.

Here's the thinking. The rate of economic growth over the next century is a major uncertainty. Will the historically unprecedented growth of the post WWII era continue, say 2% real per capita? Or does our current scleroscis settle us into 1% growth? Or are the end-of-growth prognosticators right? When you compound over a century, these add up to truly major uncertainties over how wealthy our descendants will in fact be.

But they also add up to truly major uncertainties over how much carbon we will emit in the meantime. If growth stops, carbon emissions stop too. Yes, it's not one for one (a perfect correlation). Technology choice matters; everything from windmills to deregulated nuclear power to driverless cars and trucks makes a difference. But there is a strong positive correlation.

So, if carbon is a bigger problem, our descendants are more likely to have lots of money, technology, and resources to deal with it. If they are poorer, then carbon is likely to be a lesser problem. In finance language, projects with a strong positive beta require a much higher expected return, and a high equity-like discount rate. This consideration drives us to tax less now.


But, Bob goes on, how do you price catastrophe risk? Though the central tendency of the present value of economic costs of carbon emissions are surprisingly low -- even moving all of Florida up to the Georgia border is only money after all, and you have a century to do it -- there is a chance that things are much worse.

We're all thinking about "black swans" and "tail risk" these days. Shouldn't we pay a bit more carbon tax now, though the best guess is that it's not a worthwhile investment, as insurance against such tail risks?

The problem is,
Massachusetts Institute of Technology economist Robert Pindyck... argues that too many non-GHG-related low-probability, high-damage scenarios exist. He writes, “Readers can use their imaginations to come up with their own examples, but a few that come to my mind include a nuclear or biological terrorist attack (far worse than 9/11), a highly contagious ‘mega-virus’ that spreads uncontrollably, or an environmental catastrophe unrelated to GHG emissions and climate change.” He concludes that society cannot afford to respond strongly to all those threats.
Indeed. (Fun for commenters: come up with more. Asteroid impact. Banking system collapse. Massive crop failure from virus or bacteria. Antibiotic resistsance....) If we treat all threats this way, we spend 10 times GDP.

It's a interesting case of framing bias. If you worry only about climate, it seems sensible to pay a pretty stiff price to avoid a small uncertain catastrophe. But if you worry about small uncertain catastrophes, you spend all you have and more, and it's not clear that climate is the highest on the list.

This thought fits nicely into the modern research on "ambiguity" and "robust control" (for example see Lars Hansen and Tom Sargent's webpages for a portal). This line of thought often argues that you should pay a lot of attention to unlikely catastrophes, especially when it's hard to quantify their risks. And Pindyck's point (as I see it) gets to the central problem with that line of thought: you have to draw an arbitrary circle about which unlikely events you pay a lot of attention to, and which ones you pay no attention to.

If you worry about anvils falling from the sky, maybe you miss the piano falling from the sky. And if you worry about anvils, pianos, dynamite, and so on,  you just don't get out of bed in the morning.

It's also related to the tendency people have, in Kahneman and Tversky's famous analysis, to overweight some small probability events -- nuclear reactors, airplane crashes, terrorism -- and to ignore others -- coal dust, cab crashes on the way to the airport.

The same observation: One of my skepticisims of the current almost exclusive focus on carbon and global warming in the environmental community is that we may miss the real environmental problems. Most of the world breathes awful air and drinks awful water. Climate change is not even on their list of environmental problems. And the environmental effects of social or economic collapse or another war might dwarf warming.

All in all, I'm not convinced our political system is ready to do a very good job of prioritizing outsize expenditures on small ambiguous-probability events.

Alternative investments

Once we reduce things to money, which is what economists do, a bunch of unconventional and unsettling analysis opens up. (This isn't in Bob's piece, mea culpa only.) The economic case for cutting carbon emissions now is that by paying a bit now, we will make our descendants better off in 100 years.

Once stated this way, carbon taxes are just an investment. But is investing in carbon reduction the most profitable way to transfer wealth to our descendants?  Instead of spending say $1 trillion in carbon abatement costs, why don't we invest $1 trillion in stocks? If the 100 year rate of return on stocks is higher than the 100 year rate of return on carbon abatement -- likely -- they come out better off. With a gazillion dollars or so, they can rebuild Manhattan on higher ground. They can afford whatever carbon capture or geoengineering technology crops up to clean up our messes.

Put that way, though, the first question might be why we are leaving our descendants with $18 trillion of Federal debt, and a bill for $70 trillion or so of unfunded liabilities. Once we reduce the question to investment now to benefit the economic well-being of our descendants, it's not at all clear that investing in carbon reductions is the best place to put our money.

The greatest thing we can invest in for the economic well being of our 100 year descendants is strong, decades-long  economic growth. Needless to say, the overall economic policy mix and especially the environmental policy mix is not pointing in that direction. A lot of environmental policy actively discourages growth.


Bob points out one good case against this analysis. It is possible that carbon abatement is a very special investment with very special state-contingent rate of return.
There is a very small chance that climate effects may not just reduce subsequent growth, but may cause it to plummet catastrophically. Such scenarios require positive feedbacks; for example, warmer temperatures cause the release of methane from the currently permanently frozen tundra, triggering catastrophic warming impacts beyond the ability of future generations to adapt. How should society today rationally price the possibility of such unknown, very-low-probability outcomes in the future?
In my investment context, reducing carbon emissions now has a very special property that alternative ways of investing money don't have -- it turns off this low probability but huge negative-return scenario.

That's a good point -- but it means the entire case for a strong carbon tax now relies on how likely such extreme nonlinearity is.

Economics after all? 

I suspect this sort of analysis will be profoundly unsettling -- how about infuriating -- to people who worry about carbon and other greenhouse gases. It's not just about money, I suspect they might say, it's not about giving our descendants wealth; it's about giving them a healthy planet. The economist might say, so what's that worth to you? Some finite number, no? Sure, we inundate Florida, but our descendants are $100 trillion richer, so they can afford to rebuild Florida on higher ground. Problem solved with $90 trillion extra in the bank. Somehow I doubt Greenpeace will go back to saving whales even if that argument were decisively proved.

As much of a died-in-the wool economist as I am, I have to admit some sympathy. (Or maybe "ambiguity?") Consider species extinction. Our short time on Earth coincides with a greater mass extinction than the asteroid that killed off the dinosaurs. And the extinction rate is not abating.

Now, I can't point to an economic cost, and people who hold up development projects to save some small species have a hard time doing the same. The best arguments I have read (admittedly not an expert) is of the sort that there might be some snake in the rain forest has a medically useful venom. More generally, "biodiversity is good." These is again, the  small probability of huge but unquantifiable benefit option-value argument.

Really, is that the best we can do when staring at the K-T boundary, and realizing that future alien geologists will see a more dramatic layer, with far more interesting chemistry, where we lived? The feeling nags that it can't be a good thing for us to move on from the dinosaurs to see if we can beat the Permian-Triassic extinction in the spectacular-geology department. (Global warming is a is a tiny component of extinction -- we got megafauna with spears.) I welcome suggestions on how to voice this view in economic terms.

Perhaps systematically worrying about small and unquantifiable probability events isn't such a bad thing. But paying attention to vague unquantifiable worries leads to a lot of stupidity, like banning genetically modified crops.

Back to carbon taxes

With all that in mind, where do I stand on carbon taxes? Usually, when something is this muddy, it means we're asking the wrong question, and I think that's the case here.

I think we're way too focused on the amount of the tax and way too unfocused on its operation.

I think we should be talking about a carbon tax in place of  all the rest of our rather calamitous energy policy. Subsidies for windmills, for rich people to buy Tesla cars, HOV lanes, fuel economy standards, subsidies for photovoltaic roofs, tax credit for energy efficient appliances, certified buildings, ethanol, high speed trains, low speed trains, and on and on. Throw out the whole department of energy, the EPA's ability to regulate climate emissions, and every other nagging energy regulation, and give us a carbon tax instead (and real-time tolling to eliminate congestion). Set the level of the carbon tax at the cost of all this other junk, and achieve better results at a fraction of the cost.

The first-order issue is the monstrous inefficiency and increasing corruption of our energy regulation. Get the clean carbon-tax system in place, then we can talk about the level of the tax. In that world, a tax rate twice or even three times too high will have much fewer distortions than what we have now, and will produce both better growth and a cleaner environment.

Alas, as with the consumption tax and any other perfectly obvious policy, we can't seem to trust that the deal will be kept.