Common Tragedies

Thoughts on Environmental Economics

Convincing arguments, bad economics

Posted by Rich Sweeney on September 21, 2007

This is the first in what will probably be a long string of installments describing (and hopefully debunking) arguments that sound reasonable to the lay person, but that fly in the face of widely accepted economic theory. I was originally going to call this series “Arguments rent seekers make”, but I decided to be less cynical. However, it is important to note that this is more than just some snotty academic exercise. Voters’ and policymakers’ susceptibility to these types of arguments leads to suboptimal policy outcomes and inefficient transfers of wealth. At RFF we spend a lot of time explaining (and re-explaining) the fact that “common sense” and a rational examination of actors’ incentives do not always yield the same conclusions. Maybe documenting examples of this will save all parties involved time in the future.

Ok. Today’s example is a simple one, and it has been explained many before in the popular press and blogosphere. Nevertheless, a lot of intelligent, well intentioned players in the carbon regulation arena still don’t quite get it. Do you?

Several eastern states have agreed to cap carbon emisions and now they’re working out the details of the program (it’s the Regional Greenhouse Gas Initiative, in case you’re interested). One of the main points of contention is whether pollution permits should be auctioned off or given away for free to electricity generators. Generators have been telling politicians that if they have to pay for permits, this cost will be passed on to end users. Therefore, they argue that if politicians want to keep electricity prices down, they should give the permits away for free.

Why is this line of reasoning incorrect? Assume competitive, deregulated electricity markets. And, for now, ignore any considerations of what the states could do with the auction revenue they receive. I’ll give my explanation in the first post.

One Response to “Convincing arguments, bad economics”

  1. Rich Sweeney said

    The short answer is that in competitive markets the electricity price resulting from capping carbon emissions will be exactly the same regardless of whether or not permits are given away for free. This is because rational actors are concerned with opportunity cost, not just actual or nominal cost. To illustrate this point, my boss sometimes uses the Beverly Hillbillies as an analogy. Before anyone knew it was sitting on oil, Jed Clampet paid practically nothing for his land. Then, while hunting, he suddenly discovered oil and decided to sell. What did he charge? The going market rate, not what he paid for it originally.

    Coming back to carbon permits, let’s assume that the price of carbon is $20 and that a hypothetical plant is given enough permits to cover its generation. Let’s also assume that its marginal cost of generation is $40/MegaWattHour, which is also equal to the price it charges before the cap. If the generator has to use one permit to generate one MWh, what does it set the price at once the cap is in place? Since it got the permits for free, “common sense” would tell you that the answer is still $40, because the generator’s costs haven’t changed. However, the correct answer is $60. Anything less than that, and the generator would be better off not producing electricity at all, and simply selling its permit for $20.

    Ok. For many of you I know that was an obvious point. However you wouldn’t believe how hard it is to explain that to some people. Anyways, going forward I’ll try to make these posts more interesting.

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