In my previous blog entry, I discussed how when each person or corporation maximizes their individual interests, it can easily end up with most of us losing, and how this is at the heart of major market failures, like those involving pollution and climate change. Economists have known for more than a century how, in principle, that can be fixed if we collectively set up an incentive system (i.e., via governments) to make the maximization of individual interests better aligned with the maximization of the common good. This can be done, for instance, via the taxation of socially nefarious behavior (like polluting) or rewarding socially beneficial behavior (like carpooling, using public transportation, or biodiverse reforestation). An external objective can thus be added to the natural objective of market participants, making it possible for them to internalize something which would otherwise not affect their behavior; this is called an externality in economics1. In this blog entry, I will focus on how to deal with the current problem at hand to make such a strategy effective: governments, for all kinds of political and cognitive reasons, are not willing to set a sufficiently high price for carbon emissions. In essence, what I am suggesting is that laws can be passed to make the price paid today by polluters depend on a rational bet about the social cost of carbon determined by future governments. In this way, future governments would become indirectly responsible for providing the signal determining the total price that emitters should pay today for each ton of greenhouse gas emissions (and other forms of pollution) they emit.
There may be several ways of implementing this idea. Consider the following simple carbon pricing2 scheme, with a levy on carbon pollution charged in part by current and future governments, giving the latter the power to charge for carbon emissions ex-post (only for years after the law is passed, of course)3. After the said law is passed, say in 2022, governments each year set a price for carbon emissions and charge for the carbon emitted that year and any carbon emitted since 2022. If companies have not paid enough in the past, they have to pay extra each year. To make this clearer, consider the following example, illustrated in the table below.
|Year||CO2 emitted||Cumulative emissions||Gov. price||Payment, this year’s emissions||Extra payment for past||Total paid this year||Cumulative paid|
|2025||80||370||$90||$7,200||$(2,900)||$4,300||$33,300 =370 x $90|
In 2022, Company X emits 100 tons of carbon, and the government price that year is $70, so they pay $7,000. In 2023, the government has more information about the social cost of carbon (and more will to charge for it) and increases the carbon price to $80. Company X has again emitted 100 tons of carbon, thus owing the government $8,000 for these emissions. However, an additional $1000 is due for the 100 tons of carbon emitted the previous year: 100 tons x ($80-$70) = $1,0004. Let us say that in 2024, Company X managed to reduce its carbon footprint to 90 tons of carbon for the year, but the government increased the price of carbon to $100 per ton. The company will now have to pay $20 extra for each of the 200 tons of carbon emitted since 2022. The company also needs to pay the current price for the 2024 carbon, $100, thus incurring a total cost of $100 x 90 + $20 x 200 = $13,000 that year. What would happen if the price goes down? Company X would get a refund. So let us imagine that in 2025, climate scientists find out5 that we had been too pessimistic and the price drops to $90. Company X then gets a refund of 290 x ($100 – $90) = $2,900 for the 290 tons of carbon emitted in the past, but also owes 80x$90=$7,200 for its 80 tons of 2025. This adjustment could continue indefinitely, or until a fixed date, e.g., 30 years into the future6. For example, 30 years from now, governments of 2052 could charge for all past 30 years of emissions from 2022 to 2051, but those of 2053 could only charge for 2023-2052, in addition of course to the current year’s charge. As a consequence, at the end of every year, polluters will have paid this year’s carbon price for all of the carbon they emitted since 2022 (or in the last 30 years, after 2052), as can be seen in the last column of the table.
The effect of such a law delaying penalties for each year’s pollution would be that companies would now have to consider the impact of their carbon footprint as estimated by governments in the future. If they try to be as rational as possible in their estimate of how future governments will price carbon, they will probably guess that it will be very much higher than current governments. The reason is that future governments and future citizens will have access to more certain information about the damage brought by climate change. Climate catastrophes will have happened in more places globally, making it all the more evident that climate change is threatening present and future societies. Citizens will have had more time to grasp the gravity of climate change, which will affect the price set by governments for carbon emissions. With companies knowing that they will have to pay a high environmental debt to future generations, they would likely change their behavior to reduce future payments and the uncertainty surrounding them. If they are large enough, companies would probably invest in R&D to find technological solutions to reduce their carbon footprint. In any case, they would probably be willing to pay other companies that may have developed technologies to reduce their carbon footprint. In the meantime, the prices of goods and services producing a large carbon footprint (like fossil fuels, beef, airplane tickets, etc.) would rapidly increase, which would very likely change the behavior of consumers. If beef became 10 times more expensive over the next five years, its consumption would likely go down drastically, and people would turn to foods with a smaller carbon footprint. If gasoline prices were similarly increased, it would accelerate the growth and market share increases of renewable energy producers. It would greatly increase the economic appeal of electric cars so long as you can buy electricity from renewable energy, because electricity produced from coal would become very expensive.
The above scheme would probably have to be tweaked in several ways. The most obvious one is that companies do not like having an uncertain debt hanging over their head (what if future governments decided to charge a lot more for carbon emissions?), and governments would be sensitive to that risk aversion. It might also go against the fiscal principle of predictable taxes for each year’s behavior, before the year starts. Companies would prefer to pay a fixed price today and be able to plan their budgets without the uncertainty about the extras to pay in the future for past ecological debt. A natural solution to this is to have an insurance market absorb that uncertainty, and governments should allow or maybe even make such insurance mandatory, effectively creating an insurance market whose rational profit-maximizing behavior (if there is enough competition in that market) would lead to the best scientific prediction of the future social cost of carbon (and its uncertainty), as ascertained by governments 30 years into the future. Let us see how this could work.
The insurer would make the following deal with Company X: Company X pays a fixed premium for the current year’s emissions, in addition to the government’s price for the year. The premium covers future price changes for a predetermined carbon footprint, and it is the insurer that will pay them (for the next 30 years). The insurer thus has to estimate the future price of carbon carefully, and they will no doubt take advantage of the best scientific evidence about the future damages of climate change. Indeed, if they underestimate the future price, the insurer will lose money. If they overestimate it, they will be less competitive with their premium than a company with a better forecast, and lose market share. Interestingly, the premium will also contain a price for uncertainty like for any insurance contract. Since the insurer does not have a crystal ball, they have to make a probabilistic calculation that considers that uncertainty, and which will increase the premium. This will create a market value for better predictions about the future, stimulating innovation in climate modeling and public economics forecasting. Climate scientists, ecological economists and environmental scientists would be hired not just by governments and universities but also by insurers trying to make the most accurate predictions, both of future prices and of its uncertainty.
Paying for uncertainty about climate impacts is as important as accounting for the gap between current and future estimates of the societal cost of a ton of emitted carbon-equivalent greenhouse gases. Indeed, our scientific uncertainty about the future impact of climate change is highly asymmetric. In the best-case (but unfortunately unlikely) scenario, the consequences are mild and societies can easily adapt. In the worst-case scenario, the impacts are so catastrophic that a large fraction of humanity may die, leading societies to revert to a much more violent and less civilized state. Some even speak of existential risk where humanity disappears altogether, but that is hopefully very unlikely. Human misery and economic costs of such scenarios are difficult to even imagine, and we should rationally be ready to pay a large part of our revenues today and in the coming decades to avert such global threats tomorrow. Hence, relying only on the expected or average scenario is not sufficient to correctly value the societal cost of carbon emissions. The proposed insurance scheme would force the most rational decision to be made about both the expected future price of carbon and the uncertainty in that forecast. Consider an insurer who looks at the science and sees that there is an odd chance of really catastrophic climate events in the future. That insurer will have to build a reserve against that possibility, because if that catastrophic possibility starts unfolding, it is likely that the ex-post price of carbon would greatly increase7.
What motivates the above proposal is the hypothesis that an important cause for the current insufficient action of governments, even in the most democratic and developed countries, may have to do with cognitive biases and political influences. There may be multiple factors that explain this extremely concerning lack of sufficient government action. It could be that lobbying by the fossil fuel industry is influencing governments. On the other hand, other industries, which stand to lose just as much as the general public with drastic climate change, should ideally be able to counteract that. More fundamentally, especially in democracies, one would expect that the public would put sufficient pressure on governments to do the right thing. But that assumes the public sufficiently understands the gravity of the situation and that they can properly balance the long-term catastrophic impacts of insufficient carbon pricing with the short-term burden of increases in taxes or prices of goods and services8. The scientific consensus and the urgency of the message from the scientific community has been loud and clear for a long time, and has not been enough to sufficiently convince the public, the business community and governments. One factor at play here could be the high amount of uncertainty about future impacts of climate change, both in the minds of people (including politicians and other decision-makers) and in the state of scientific knowledge. It is difficult for one person to fathom and balance those uncertain and remote risks against the short-term certainty of higher costs of living, the danger of losing one’s job, etc. There is a psychological effect9 at play here, which makes it difficult for humans to picture and understand dangers that are remote, in space and time, and uncertain, as is the case for climate change. It is difficult to intuitively integrate the temporal inconsistency between our actions today and someone else’s (including our children and grandchildren) misery, decades in the future. The objective of the proposed legislative change is to make it easier for most people to immediately see the trade-offs between short-term and long-term costs because the long-term costs would come with a concrete price tag. Of course, no one has a crystal ball, but it would be in the best financial interest of companies emitting greenhouse gases, or of insurance companies selling them insurance against future carbon taxes, to estimate as correctly as possible the price tag that future governments will put on carbon emissions. Any bias (e.g. underestimating the costs) will cost them more money down the line with that financial burden inflicted year after year as governments increase their carbon price and other market actors come up with more accurate estimates, benefitting at the expense of the companies making poor predictions.
Many variations on the above scheme should be considered. For example, to deal with the issue of predictability of the fiscal charge, the insurance could be mandatory and the amount paid to the insurer considered like a responsibility insurance. The amount paid for this year’s emissions is a tax, while the extras in the table are considered to be a payment for civil responsibility in a damage to a public good (the climate), with the government representing the parties losing something because of the pollution of earlier years by the company. Yet another scheme would replace the insurers by a betting market on the future government prices, along with an options market to buy and sell protection for the uncertainty about these predictions. The government could then simply declare each year’s tax based on the futures and options prices at the beginning of each fiscal period. The government would also need to intervene as a player in that market to make its size large enough in order to avoid market manipulation by large polluters trying to keep the price low. With a large enough market, such manipulation would be doomed to lead to great losses on the part of those trying to do it, in effect losses equivalent or larger than the amount of tax saved by manipulating the price down.
To conclude, I believe that there are existing legislative and fiscal tools at the disposal of governments that could be engineered to force us to confront our best rational guess about the future impact of the collective decisions we take now as well as the uncertainties associated with them. The same types of tools described in the context of carbon emissions could be used to address other market failures, such as the threat of antimicrobial resistance. How much would future governments, say in 2050, be willing to pay in 2021 to increase investments in research and development and absorb the costs associated with banning or greatly reducing the use of antibiotics in livestock? How much would they be willing to pay us (the humans of today) so that we act to protect society in the coming years from impending pandemics, where our healthcare systems are overrun by drug-resistant and potentially deadly bacteria, fungi or viruses?
Another non-negligeable detail is what to do with the taxes collected. Governments should invest in research and innovation in technologies and projects that can accelerate the transition and carbon drawdown. I intend to discuss this kind of societally motivated public investment in a future blog entry. The main point being that governments must stimulate publicly beneficial research and innovation where the commercial incentives remain scant. Besides, climate change and its mitigation will hurt some people more than others, potentially increasing inequalities within and across countries. The increase in prices (e.g. of gasoline) will be most hurtful for those with lower incomes, for example. For them, the net effect of carbon pricing and government tax refunds should not yield a reduction in buying power (or else strong political opposition to carbon pricing will mount!). The people losing their jobs in the fossil fuel industry should be helped financially and offered free reskilling. Governments should thus return the collected money to the economy, help climate refugees (including people losing their homes to floods and fires, inside the country and abroad), help underprivileged individuals most affected by the economic changes, and reduce wealth inequalities. Note that the above proposals mostly return money in the pockets of individuals as opposed to cap-and-trade markets, which create a zero-sum game among companies, but not among individuals, and cause significant business uncertainty. Finally, all the above are mere suggestions. Many more such proposals should be discussed, involving experts from many disciplines, to steer our collective public policies towards our future collective survival and well-being.
Needless to say the above proposal is just a sketch that requires many details to be worked out, such as the implementation of a short transition period to avoid an overly strong economic shock to the potentially rapid carbon price increase. Still, we have seen with Covid-19 that society can sustain such shocks. The dangers associated with the pandemic pale in comparison to the catastrophic impacts, potentially extended over centuries, inextricably linked to unbridled climate change.
- See https://www2.deloitte.com/xe/en/insights/economy/spotlight/economics-insights-analysis-02-2021.html for a discussion of economic impacts, still probably underestimating the risks.
- Carbon pricing is “the method widely agreed to be the most efficient way for nations to reduce global warming emissions” (Wikipedia entry).
- This may sound like retroactivity and contrary to common legal and fiscal practice, but it would only apply after the law takes effect, so it would not come as a surprise, and it would be consistent with the legal philosophy of penalizing the authors of a reprehensible action many years after the action, when the evidence for that misdeed has become sufficient, and the author of that action was aware of the possible consequences.
- Below we discuss how, instead of having to calculate themselves how much money to set aside as a reserve for future levies, companies could buy insurance and pay a fixed price for each year’s emissions.
- To minimize political colour, the influence of lobbies on carbon pricing and rapid price variations depending on the party in power, the government should probably eventually delegate the pricing to an independent body constituted by scholars and scientists tasked with coming up with the most precise and fair estimation of that social cost. However, if such was the way carbon price was set, the whole scheme proposed here would not be as necessary. The ex-post pricing is a kind of insurance policy in case the government or its agency deciding on carbon pricing is underestimating the social cost of carbon emissions.
- There are relevant precedents to the requirement to keep tax documents for such long periods, e.g., in the case of safety chemical exposure records, precisely in case the government decides to punish a misdeed whose consequences are only revealed decades later. See https://www.icpas.org/docs/default-source/tax-practice-procedures-files/records-retention-guidelines1a841fdf38106fba827cff0000493078.pdf?sfvrsn=dd94701d_0
- To avoid a market failure of the insurance market, the regulator should force insurers to put aside sufficient reserves, which would have the effect of increasing the insurance premium to match the forecasted risks.
- Governments could use some of the tax money as subsidies, to bootstrap and derisk the transition, especially R&D efforts. In addition, a large part of the tax revenues should be returned to those with lower incomes, as argued here, or else the tax may increase inequalities.
- See Weber, E. U. (2006). Experience-based and description-based perceptions of long-term risk: Why global warming does not scare us (yet). Climatic change, 77(1), 103-120.