November 5, 2018

A Coasean Rationale for a Carbon Tax

Ronald Coase’s famous paper on The Problem of Social Cost is a touchstone in the field of environmental economics. I was inspired to take a fresh look at it a few weeks ago when Jordan McGillis of the Institute for Energy Research sent me a link to a blog post he had written with the intriguing title: Toward a Coasean Approach to Coastal Property Damage. McGillis’s post led me to attempt a restatement of the case for a carbon tax in Coasean terms. Here are some of the main points of that undertaking, which are explored in more detail in a new Niskanen Center policy brief.

1. Coase himself was openly skeptical of pollution taxes – Pigovian taxes, as he calls them, in reference to the work of Arthur Pigou.

In his opening paragraph, Coase maintains that economists’ widespread impulse to slap a tax on anything they don’t like is “inappropriate,” and likely to “to results which are not necessarily, or even usually, desirable.” As McGillis notes, this skepticism “has provided the intellectual core of many an anti-regulation, anti-tax argument in the decades since Coase wrote his seminal paper.”

But Coase, who wrote his paper in 1960, was mostly concerned with environmental externalities of a much smaller scale than the problem of global warming, which motivates the carbon tax proposals of our own day.

 His skepticism regarding pollution taxes was not unequivocal. Rather, what Coase is really urging us to do is to think more deeply about what we are doing before we fire the tax bullet. As he put it:“A better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one.”

2. For Coase, the “better approach” starts by framing the problem not as one in which A harms B, and therefore, needs to be restrained, but instead, as a coordination problem in which the plans of two parties conflict.

McGillis’s example of climate change and coastal flooding makes a good case study, so I adapted it as a representative case: Party A is a coal-fired power plant that emits CO2 that causes global warming. The warming, in turn, raises the sea level, increasing the frequency of flooding that harms Party B, a coastal landowner or landowners.

The problem, then, is to coordinate the activities of the two parties in a way that jointly maximizes the value of the two properties, considering both the costs of mitigation and adaptation. Both converting to less carbon intensive power and building sea walls involve costs.

3. Transaction costs play a big role in Coase’s analysis.

These include costs of finding potential partners, negotiating a deal, monitoring compliance once a deal is reached, and resolving disputes. The Coasean approach first looks at how a given coordination problem could be resolved in a world without transaction costs. It then examines the barriers that transaction costs pose to optimal coordination and at ways of mitigating them so that coordination may be improved, even if not fully optimized, in the real world.

Without transaction costs, the parties to the coastal flooding problem would be able to find a mutually beneficial way of coordinating their activities through private bargaining, governed by common law principles of torts and property law. However, the specific resolution would depend on the initial assignment of property rights.

Suppose first that the power plant had unlimited rights to use the air for disposal of waste CO2. If the cost of abatement was less than the cost of adaptation, so coastal land owners would then find it worthwhile to subsidize installation of the carbon capture equipment rather than build more costly sea walls. If adaptation was cheaper than abatement, their maximum subsidy offer would be rejected by the power plant, and they would build the sea walls.

If, instead, coastal property owners had an absolute right to exclude pollution, they would threaten the power plant with an injunction. In response, the plant would attempt to purchase an easement allowing the CO2 emissions. If the cost of abatement was greater than the cost of adaptation, the plant would find it worthwhile to make an offer that induced property owners to build the sea walls. If abatement were the cheaper alternative, the plant would install the carbon capture equipment at its own expense to get out from under the injunction.

If the optimal solution is to undertake some abatement and some adaptation (as is usually the case), the solution is more complex. But, as explained in the Policy Brief, the bargaining process still reaches an optimal outcome if there are no transaction costs.

4. Bargaining under the guidance of common law courts can work in the real world where transaction costs are low and the numbers of parties are few, as they often are in purely local disputes.

However, transaction costs are insurmountable in large-scale pollution cases where the numbers of parties are great and there is no global court system to act as a backstop to private bargaining. In that case, calls will be made for a more active role for government.

Up to now, most government efforts to deal with climate change have taken a command-and-control approach, based on regulations that specify what pollution control equipment has to be installed at what sites, who can build where, how high buildings must be constructed to resist environmental damage, and so on. This strategy has long been criticized by economists as inefficient and prone to manipulation by special interests.

A better alternative is to facilitate coordination by using the price system to transmit information and decentralize decision making. In recognition of Friedrich Hayek’s work on the price system and the use of knowledge in society, we can call these Hayekian coordination mechanisms.

A carbon tax is one way to implement the Hayekian approach. In the simplest version, the tax would be assessed on carbon-based fuels at the point of extraction. It would then be passed along in the form of higher prices to users of carbon-based energy, including both industries and consumers, giving them an incentive to engage in cost-effective abatement measures.

Cap and trade is an alternative way to put a price on carbon. Under that approach, the government would issue a limited number of permits that would each allow emission of a specified quantity of carbon or other greenhouse gasses. The permits would be traded on an exchange in which the buyers would be parties whose costs of abatement were relatively high and the sellers would be parties whose abatement costs were relatively low

The brief explains that although the two Hayekian approaches can theoretically achieve the same degree of coordination, practical considerations lead many economists to prefer a tax rather than cap and trade. Some emphasize the relative administrative simplicity of a tax. Others worry that cap-and-trade is too vulnerable to the influence of special interests. Still others note that a tax would produce a more stable carbon price, less sensitive to business cycles and other transient market conditions, which would facilitate long-run planning for investments both in clean energy and in adaptation measures.

5. The brief also discusses the distributional and ethical dimensions of a carbon tax as a tool for dealing with climate changes.

It concludes that although issues of the ethical validity of property rights and the distributional consequences of alternative policies are certainly worthy of debate, they are issues on which compromise should be possible. It would be tragic if they stood in the way of practical measures to mitigate the threats of climate change. When due consideration is given to the Coasean admonition to examine each specific coordination problem from all sides, a carbon tax—not a punitive one, but one that aims to facilitate the coordination of conflicting interests—stands a good chance of making our situation better than the one we are in now, even if not perfect in all respects.

Follow this link to download the full policy brief.