Common Tragedies

Thoughts on Environmental Economics

An emissions price won’t leave the airline industry grounded

Posted by Daniel Hall on December 10, 2007

Evan Sparks remains skeptical that an emissions price really is the best policy option for reducing aviation emissions, as I averred previously. He maintains that the aviation sector has some unique characteristics that make it particularly susceptible to economic dislocations from a pricing policy. I encourage visitors to go over and read his whole post — he knows a lot about aviation and I found it very educational. I want to work through the basic narrative he tells about why an emissions price won’t sufficiently encourage innovation, because I think it’s a story that sounds like it might apply to many economic sectors. I’m going to argue that although there is some potential for the type of economic dislocation that concerns Evan, in practical terms the problem is not that big. Further, I’m going to argue that you can structure a pricing policy wisely to reduce these dislocations. Evan sums up his story in his last paragraph:

Daniel is right that under standard theory, emissions pricing would lead to more innovation, and it will probably do so in the long run. But in the short run, effective emissions pricing or caps will probably cause massive dislocations in the industry and set it on a poor footing, leaving airlines with fewer resources to invest in the very planes they need to escape the dislocations, in turn forcing aerospace companies to delay or shelve innovative new technologies. We need to take the high transition costs of emissions cuts into consideration when designing policies to ensure that we don’t threaten future innovation.

So the basic story is the carbon tax (or the price of emissions permits) causes a short-run negative shock to profits, depresses investment, and locks the airline industry into a cycle where it isn’t ever able to develop or deploy the new planes it needs to more cost-effectively cope with emissions prices, now or in the future.

First, this story presumes that industry is bearing the brunt of higher emissions prices. So, quick econ lesson: when the price of an input for a good rises, whether the consumer or producer bears the cost depends on the demand elasticity for the good. If demand is perfectly inelastic, producers can pass the entire cost of the input on to consumers, who therefore pay the higher cost. If, on the other hand, demand is perfectly elastic, the producer pays most of the cost, in the form of fewer sales.

Demand elasticity for air travel is an empirical question. This summary of studies from Canada’s Department of Finance suggests that air travel demand is slightly more than unit elastic: a 1% increase in fares will reduce air travel by about 1.1%. This suggests that producers and consumers would roughly split the cost of a carbon tax, with producers bearing slightly more.

One thing that would help mitigate against the near-term dislocation that most concerns Evan is that short-run elasticities are lower than long-run elasticities, meaning that producers would bear fewer costs in the first few years. So, for example, over the long run under emissions prices we might expect rail service to become better and more available, allowing travelers to substitute away from air travel for some trips; in the near term, however, that’s not a widely available option.

The second part of the story is that reduced profits leave firms unable to invest in developing and deploying new technologies. Evan includes quite a bit of useful detail about the history of investment in the airline industry in his post, and it does sound like it is prone to boom-and-bust cycles of investment.

My guess is that this is partially a function of having only two major aerospace firms. Why are there only two? Well, to start with there are large natural barriers to entry. But I also wonder if that Boeing and Airbus are somewhat protected by competition by the perception that the U.S. and European governments won’t let them go bankrupt. True, these are not nationalized firms — but do we really think they would be allowed to fail? I suspect there may be a moral hazard problem here that is making it more difficult than it should be for smaller competitors to enter the aerospace industry. We have a hard time imagining a world with a variety of smaller “boutique” aerospace firms competing to create innovative new designs, but I wonder if that’s largely because there haven’t been sufficient returns to innovation previously.

Even with this problem, however, one of the lessons that I take from Evan’s post is that the two aerospace firms that are out there are managing to respond to the market demand for more fuel-efficient planes. It may have taken a few years after 9/11, but the new generation of planes that both Boeing and Airbus are now rolling out are much more fuel-efficient than previous generations.

This provides lessons about ways to intelligently structure policy to minimize dislocations. First, give sufficient notice of coming policy. Most of the cap-and-trade proposals in Congress — including the Lieberman-Warner bill now on the floor of the Senate — don’t begin until 2012, giving industry plenty of lead time to prepare for regulation. Further, start small — with a less aggressive cap, or a smaller tax — and gradually ratchet up the emissions price. This structure starts incentivizing emissions reductions from the start of the policy, while minimizing transition costs by giving advance warning of what the policy will be and how it will ramp up, thus allowing time for a cycle of innovation and new design to occur that will ease the costs of higher emissions prices in the future.

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