The Environmental Protection Agency (EPA) announced earlier this month that greenhouse gases “threaten the public health and welfare,” and are thus subject to inflexible command-and-control regulations under existing law. The move could pressure Congress to pass a new law containing a cap-and-trade program for greenhouse gases. The EPA should have no illusions about the economic costs that will result from reducing greenhouse gases with these regulations.
Arguing in favor of cap-and-trade, Paul Krugman recently wrote that “cutting greenhouse gas emissions is affordable.” He reasons, correctly, that there will be cost savings stemming from the financial incentives for emission reductions provided by a cap-and-trade system relative to command-and-control. Cap-and-trade is relatively effective at keeping costs down to the extent that it relies on decentralized market forces. Once the cap is set, firms should have complete flexibility on how to meet their quota of emissions, whether through switching fuels, lowering production, investing in more fuel efficient equipment, or even paying other firms to reduce emissions.
But Krugman oversells the affordability claim by linking to a widely cited report by McKinsey & Company. The main point of the McKinsey study is provided in their Exhibit B, which illustrates a rather peculiar finding that there are a significant number of pollution abatement options that can be achieved at “negative cost.” This finding violates the basic principles of economics. If firms (or consumers) could reduce emissions at negative cost, then they would do so. To say otherwise is to say that they are willingly or ignorantly passing up profits.
What, then, can explain a finding of negative cost? There are four possibilities:
First, the estimated costs of abatement are simply incorrect. Even for something as straightforward as an improvement in energy efficiency for an appliance, it is no easy feat to estimate the cost of production, installation and maintenance, let alone the cost savings that will result from lower fuel bills over the long term. A top-down calculation is difficult as it involves many different decisions and inputs, and also depends on forecasted energy costs and behavioral responses. The economics discipline takes a more modest approach of assuming that prices incorporate all of the information pertaining to private (not social) costs, and firms – motivated by profits – respond accordingly.
So if a firm does not buy a more fuel efficient appliance, it is because the costs outweigh the benefits to the firm. Of course, there are costs imposed on society by greenhouse gas emissions, which is why economists favor increasing the price of carbon-intensive activities, which could be accomplished with a carbon tax.
Second, the costs of abatement are incompletely estimated. Consider again a cost estimate of upgrading to a high-efficiency appliance. Even if one correctly estimates the cost of the appliance and the cost saving of reduced energy use, this still omits other relevant costs for the firm. For example, an energy-efficient commercial clothes washer might hold fewer clothes or clean less effectively, both of which would be real costs that any firm will consider in its purchase decision.
Third, the private discount rate is incorrectly estimated. The discount rate measures the tradeoff between having a dollar today vs. a dollar in the future. The higher the discount rate, the less the firm values a dollar saved in the future relative to today. A top-down analysis might impose a discount rate, which may be inconsistent with the tradeoffs that firms actually make in practice. Economics, again, takes a more modest approach of assuming that prices – in this case the interest rate – incorporate the relevant information concerning the private (not social) tradeoffs made by firms over time.
The fourth possible reason for the negative cost finding is that firms do indeed irrationally forego profit-maximizing activities, or they are ignorant of such activities. Economics takes the profit-maximizing motive as a premise. This assumption, like all economic assumptions, is used to simplify the complex economic world in order to make manageable inferences. It is an approximation of reality, not a physical law met with certainty. But to assume that negative cost opportunities exist because firms are irrational, people must also assume that the analysts who identify negative costs are more knowledgeable about profit-making activities than the firms. They must also assume that firms continue in their irrationality even after the analysts show them that profit-making opportunities exist. Finally, they would wonder why the analysts don’t act on their superior information and rationality and reap all the negative costs they have identified.