Yes, Virginia, prices really will work
Posted by Daniel Hall on December 5, 2007
Evan Sparks requests analysis from “the environmental economists at Common Tragedies” on what the EPA should do in response to a request from some states that EPA regulate airline emissions. I get an occult thrill from being referred to as an economist (despite having disclaimed my pedigree as a mere policy wonk, even if one who prefers the tools of economics), so I am impelled to respond. First, an excerpt from the relevant AP article, via the Washington Post:
A coalition of states and environmental groups is urging the federal government to curb global warming pollution from planes and other aircraft.
California, Connecticut, New Jersey, New Mexico, Pennsylvania and the District of Columbia plan to file a petition Wednesday asking the U.S. Environmental Protection Agency to regulate greenhouse gas emissions from domestic and foreign aircraft departing or landing at American airports. …
The petition asks the EPA to develop rules to reduce aircraft emissions by requiring operators to boost fuel efficiency, use cleaner fuels or build lighter, more aerodynamic airplanes.
I’m skeptical there’s much room in the aircraft market for efficiency standards that are economically justifiable. The typical market failures that occur for many consumer products — asymmetric information, principal-agent problems, irrational discounting — are essentially non-existent in the market for aircraft. Airlines want the most fuel-efficient planes they can get; they know exactly how efficient their fleets are and what they are getting when they buy a new plane; and they are willing to pay value for fuel economy — fuels costs are a significant percentage of the operating costs for any airline. It’s conceivable that you could concoct rationales for supporting infrastructure for cleaner fuels — network externalities and whatnot — but not with the current generation of biofuels, at least not in terms of greenhouse gas reductions (as any regular reader of this blog knows).
Evan missteps, however, when he postulates that the best climate policy response for reducing airline emissions is to “stimulate aerospace R&D without penalizing airlines today.” Indeed, in a longer piece at TCS Daily, Evan — who is an editorial assistant at the American Enterprise Institute — repeats what is apparently the latest conservative meme on climate change policy: that reducing emissions through a carbon tax or a cap-and-trade system will be far more economically costly than innovating our way into emissions reductions.
I’ve already spent the majority of today’s blogging disputing this idea and praising the beauty of prices in theory, so I thought I would try to bring the argument to a practical level. For an activity such as airplane travel, there are broadly three ways to reduce carbon emissions: reduce the carbon content of the fuel input, increase the efficiency of the airplane, or reduce the number of miles traveled. (This is essentially true throughout the transportation sector more broadly, including among passenger vehicles, which are a much larger percentage of GHG emissions, around 15% in the U.S.)
The ability to reduce emissions through new technology sounds attractive, but one of its fundamental weaknesses is that it can work at most on two of those margins: fuel input and aircraft efficiency. Further, improvements in efficiency will inevitably produce a rebound effect: by reducing the cost per passenger-mile, they incentivize more travel, thus eliminating a portion of the emissions reductions the efficiency gains were designed to achieve. (Not all of them by any means, but certainly a portion.) Pricing emissions, on the other hand, works on all three margins at the same time, incentivizing substitution towards lower-carbon fuels, stimulating efficiency innovations, and encouraging passengers to economize on trips.
Evan does acknowledge that higher prices will work on this third margin and lead to less flying. Oddly, however, he argues that an emissions price will depress, rather than encourage innovation:
…it’s critical to remember that profit helps drive innovation. Only if aerospace companies are profitable can they fund the arduous and expensive aircraft development process. Profitable manufacturers depend on profitable airlines.
This strikes me as naive. It’s not past inter-industry profits that drive innovation; it’s the promise of future returns that leads investors, both inside and outside an industry, to pour in investment funding to encourage innovation. An emissions price will increase the returns to innovation by giving fuel-efficient aircraft a larger edge over their more highly polluting brethren. Under any standard economic story this will lead to more innovation.
As we seem to repeat around here ad nauseam, there are strong economic rationales for government support of fundamental R&D. But these exist for all types of R&D — medical, energy, etc. — and are quite independent of the question of how to reduce the externalities from excess greenhouse gas emissions.
Relying on government support for technology development sounds initially like a nearly free lunch — wait for innovation to make emissions reductions cheap, and then reduce. But to believe that it is truly cheaper than the alternative of an emissions price you must believe that the government, in the absence of a market signal, will more wisely direct research investments than the private market could if given a price signal about the value of emissions reductions. Further, you have got to somehow solve the problem that a technology policy works on only the intensive margin — the intensity of an activity — rather than the extensive margin, where both the intensity and the amount of an activity are impacted. In reality support for technology seems cheap now because it obscures what the near-term costs are and who are paying them. Pricing emissions may involve some economic pain, but it remains the most cost-effective — to say nothing of transparent — approach to addressing greenhouse gas externalities.