More on “Negative Costs” of Reducing Greenhouse Gases

There was a spirited response from the left side of the economics blogosphere to my Forbes article (see Brad DeLong, Paul Krugman, Ryan Avent, and Ezra Klein). My article pointed out the peculiar finding in a report by McKinsey & Company that purports to show “negative costs” for many greenhouse gas abatement activities. I appreciate the attention, welcome the criticisms, and with respect offer some responses to my critics.

Brad DeLong states: “That McKinsey and Company exists and that businesses regularly pay it money to identify $100 bills lying on their sidewalks strongly suggests that any half-competent economist should not immediately dismiss its analytical conclusions.” The fact that businesses “pay money” to acquire cost-saving information from a consultant is not evidence against the profit-maximizing assumption. Ironically, the McKinsey report’s cost estimate excludes the cost of acquiring information about potential energy efficiency investments. 

This falls under my explanation #2 for McKinsey’s peculiar finding: i.e., “the costs of abatement are incompletely estimated.” Perhaps if McKinsey’s report included the cost of hiring consultants to gather information, their marginal abatement cost curve would not cross the x-axis, and all would be good in the state of economics. 

Ryan Avent states of my claim that it is peculiar to assume “negative costs”: “This is kind of like saying that it was foolish for people to point out that housing prices appeared to be unsustainably high back in 2005, because that would violate basic principles of economics.” I share Avent’s concern that markets can be susceptible to bubbles. But I would caution against abandoning economic principles to quickly. For one, the bubble critique can be applied inconsistently. To take just one example, just a few weeks ago, Avent responded to a report on “A Call to Action to Stem the Mounting Federal Debt,” saying “there was no good explanation for the absence of evidence that markets are worrying about American borrowing.”  No good explanation? In criticizing me, Avent wrote: “You’d think we’d have learned by now to approach market results with at least some caution. Not everyone has gotten the message.” My goal isn’t to point fingers, or to claim that bond prices are exhibiting a bubble. But I don’t think citing the housing bubble is strong evidence that firms are forgoing profitable energy-saving projects. (I do believe, as I stated in the article, that firms are not internalizing the full societal cost of their emissions.)

If Avent is right that firms are behaving irrationally, then we have bigger problems on our hands with respect to the policy response. There are a number of academic studies on the optimal carbon tax (none of which, to my knowledge, assume negative marginal abatement costs). These studies assume that firms will respond rationally to a change in prices. If firms are not rational, then we need to re-think how we compute (and design) an optimal carbon price.

This relates to the main point of my article, which is that assuming negative marginal cost can lead to perverse policies. I fear that this point was misunderstood by Avent (perhaps because I stated it, as Avent suggests, in a manner that was “too clever by half”). I am not arguing that there is “no point in having” a cap-and-trade program. Quite the opposite (although I prefer a carbon tax).

Cap-and-trade and carbon tax are known as “market-based regulations” because they rely on market mechanisms to reduce pollution. They are substantially lower cost than prescriptive command-and-control regulations because they give firms (and consumers) flexibility in how to achieve reductions. If one discards the profit (or utility) maximizing assumption, then market mechanisms are not cost-saving relative to command-and-control. As I said in my article, if firms are irrational enough to forgo profitable abatement activities, then “we cannot rely on them to find innovative way to reduce emissions under a cap-and-trade system.” I don’t think firms are, by and large, acting irrationally, so I do think market-based regulations will work to lower cost. My concern is that policymakers will abandon market-mechanisms and EPA will instead pursue greenhouse gas reductions through command-and-control regulations, using McKinsey-like “negative cost” assumptions to justify their regulations.

Ezra Klein helpfully provides the McKinsey figure, so readers can judge for themselves whether a marginal cost curve that crosses the x-axis looks peculiar. Klein says I am arguing “theory” instead of “reality.“ He’s of course right to imply that profit maximization is an assumption, which is why I wrote of it as “an approximation of reality” that is “used to simplify the complex economic world in order to make manageable inferences.” But I’m really arguing for one theory (firms are better at identifying profit-making abatements) over another theory (regulators are better at identifying profit-making abatements). My theory suggests that market-based regulations are lower cost than command and control; the competing theory suggests otherwise. And surely we agree that the empirical – not just theoretical – literature supports the cost-saving advantage of market-based regulations. (And, at the risk of sounding “too clever by half,” surely we also agree that a “negative carbon tax” would increase emissions, not decrease emissions, as suggested by negative marginal abatement costs.)

Finally, Paul Krugman, says: “Now, there are some questions about how to interpret the whole thing. But I think it’s fair to say that there’s a lot of evidence for cheap conservation, at least in the early stages.” If cheap means non-negative, then I agree!