EPICs v taxes

EPIC debates: a reply to The Economist’s Free Exchange

The Economist devotes the Free Exchange column to a discussion of some of the ideas in Supercharge Me. There is little we disagree with in this typically well-informed take, but a number of areas of nuance and substance merit a reply. 

One argument in Supercharge Me is that the economics of climate policy has been overly fixated on carbon pricing and taxes. We discussed this in more detail in our last post. To summarise, we think policy should be focused less on accurately pricing an externality, and more on altering the price elasticity of demand. Simply put, to get anywhere close to meet our climate objectives, we need to collapse demand for fossil fuels. Taxing an externality will not significantly reduce demand if it is price inelastic – which is the case in many carbon intensive activities, from steel to transport. If we target the price elasticity of demand, however, we are forced to focus policies on the creation and pricing of substitutes. Furthermore, if we can create close to perfect substitutes for carbon intensive goods and services, and then devise policies to target the relative prices, demand collapses.

We should be clear that our objective is not ‘an assault on carbon pricing’, as The Economist puts it, in its typically dialectical style. In the book we do not discuss cap-and-trade schemes in great detail (although we suggest business air travel could be capped and traded). Partly because the book is intended to be accessible to any reader, and partly because although carbon markets play a role, they are not the main game. Furthermore, carbon pricing schemes are most effective when they are focused on the price of substitutes. 

Some examples will clarify. How do we reduce the carbon intensity of the auto industry? The UK has very high fuel taxes by global standards, but very modest electric vehicle penetration. Taxing fuel does not target the relative price of a substitute: there is no zero carbon alternative to petrol or gas, so petrol is price inelastic. However, if we create a viable charging infrastructure, electric vehicles (EVs) are almost perfect substitutes to their gas-guzzling competitors. It follows that using the tax system to target the relative price of EVs will have a far greater effect on emissions than taxing fuel. The evidence overwhelmingly supports this conclusion. In the book we go further and argue not just that  policy should target the relative price of substitutes, but also that we should deploy EPICs – extreme positive incentives for change. We don’t want a modest change in demand for carbon intensive activities, we want demand to collapse. Norway and China have had astonishing success in electrifying the auto market by doing precisely this. Norway has used an EPIC – the 50% rule, where tolls and parking charges are 50% lower for EVs. But perhaps most importantly they used tax exemptions to ensure the list price of electric cars is below that of the fossil fuel alternative. Unsurprisingly, EV sales reached 90% of the total by the end of last year. Fuel taxes in the UK have yielded little benefit, other than raising tax revenue and engendering political opposition. A relative price strategy in Norway and a number of Chinese cities has transformed the market.

In Supercharge Me we argue that policy should be focused, sector-by-sector, on the relative price of substitutes. In simple form: make the green option cheaper. Carbon taxes should primarily be deployed as part of this broader approach.

There are two final considerations which strengthen these arguments. The core of any successful road to net zero is sustainable electricity and the electrification of transport, buildings and manufacturing. Electrification of these sectors, and provision of clean electricity can reduce emissions by 75%. So electricity is mission-critical. Electricity is also provided by regulated utilities. No chapter of any book on electricity regulation would start a plan to accelerate investment spending in newer technologies with a tax on the carbon emission of legacy assets. The Economist cites the role of UK’s Carbon Price Floor in the transition to wind. It is true that this form of carbon tax negatively impacted the profitability of coal generation and contributed to its declining market share – but this was only economically viable due to the favourable relative price of gas-fired substitutes, and an explosion of new investment in renewables. The two considerations which really dominate new investment in regulated utilities are the cost of capital and the return on capital. We do not need to disincentivise new investment in fossil fuel-based generation via a carbon tax – our regulators and governments should simply not approve them. The real heavy-lifting is to make sustainable electricity generation profitable at vast scale, and the effective levers directly target the cost of capital –  ‘carbon pricing’ is not really relevant. Consider some of the most successful examples, such as UK offshore wind. This is an example of extraordinary policy success. The latest data suggest that the UK has a pipeline for 86GW of capacity, more than China, and equivalent to a ten-fold increase in capacity.  To put this in context, total electricity capacity in the UK is currently 76GW. This astonishing achievement is not due to a carbon tax, but to rapid technological improvements due to the global scaling of offshore wind, supercharged by direct or indirect subsidies, and in the UK’s case, the provision of contracts for differences (CFDs) – which dramatically reduce the cost of capital. The expansion of the CfD regime to solar and co-located storage should be encouraged.

We argue in Supercharge Me that these kinds of policies need to be scaled globally and replicated across high emitting sectors. We suggest additional policies to further reduce the cost of capital, such as repurposing central bank targeted lending schemes (h/t Stan Jourdan), which The Economist oddly dismisses, asking ‘to whom would they [the central bank] be accountable’? Targeted lending schemes already exist. The Bank of Japan, and others are already targeting these programmes at renewable electricity, and ECB board member Isabel Schnabel has revived the idea at the European Central Bank. Accountability is not a major barrier in these cases. They are being implemented or proposed to operate consistently with national, or EU frameworks. The pandemic has shown that independent institutions can and should cooperate, without compromising their mandates. Indeed, Schnabel raises an extremely important systemic challenge for policy, which favours the ‘making green cheaper’ framework we advocate. If draconian carbon taxes result in inflationary pressures, central banks will respond with tighter monetary policy. If policy rapidly accelerates investment in electricity and subsidises a collapse in the price of green alternatives via EPICs, disinflation should be one’s prior. We make no apologies for a ‘kitchen sink’ approach, as The Economist describes it – as long as each policy is proven to work rapidly and effectively.  

Let’s conclude with an example from another important sector – cement, which accounts for as much as 8% of global emissions.[1]  The approach described by The Economist, which is not dissimilar to EU’s emissions trading scheme (ETS), would go something along these lines: target a decline in emissions consistent with viable technological improvement, set quantitative targets and combine a cap-and-trade system of emissions with a carbon price. Cement companies will then buy carbon credits to cover their emissions, and the price of cement should rise, potentially a lot. This sounds like an appealing solution to economists because it is ‘market-based’. But the incentives are mixed, and at worst it encourages incumbents to underplay the scope for rapid substitution – after all they own the assets which need to be written-off. Inevitably, the targeted emissions reductions are the result of industry consultation and lobbying. Incumbents understate technological change, and favour specific technologies – in particular carbon capture – which preserve the value of existing assets. The cement industry’s report on the ETS is a case in point. 

One feature of Supercharge Me, is relentless pragmatism – about individual, corporate and political behaviour. Given Europe has gone far down the emissions pricing and trading route, we want to be supportive and propose policies which complement the ETS and enhance the probability of success.[2]  The ETS is reducing emissions, but do not expect rapid emissions reduction at the speed we need. Cement demand is price inelastic, and it is a relatively small share of the cost of buildings. There will be no collapse in demand. Producers can expect to pass on higher costs of the carbon tax and that this will be absorbed. Now, an advocate can always argue that the carbon price should be higher, and at some point it becomes so expensive it is impossible to use. But that isn’t really a market-based solution – it’s effectively prohibition. If prohibition is politically viable, just do it. In reality, of course, it isn’t. Nor is it a good policy. We need cement, but we need to make it as green as possible.

Importantly, the policy approach we choose affects the rate of technological progress. This is the evidence from the success stories. Consider how a policy based on an EPIC targeting of the relative price of low emission cement would look. First you need to identify close substitutes – some lower emissions alternatives exist, and technologies are evolving rapidly given the amount of capital and innovation being thrown at the problem. The challenge is that none of the current substitutes are fully competitive at scale, even after the introduction of carbon pricing, or they are blocked by the regulatory capture of incumbents. So there is really no reason to expect a collapse in demand in response to a tax on the emissions. Most of the really interesting technological breakthroughs are also not being developed by the firms which dominate this market. 

We need a relative price strategy. The only way this industry will change at the speed and scale we require, is if the green alternative is significantly cheaper and a close substitute. Taxing the emissions of incumbents is one side of the policy, the other is extensive tax exemptions and almost certainly huge subsidies. The goal is a relative price advantage for the green(er) substitute. The world needs a cement market where a combination of taxes, tax exemptions and outright subsidies ensures that green(er) cement is a close substitute and 30% cheaper than the carbon alternative. Ditto for steel.

In summary, emission-reduction targets for producers help, but we need market share targets for green substitutes. That is the lesson from all the success stories – solar, wind power, and battery technology. Only by supercharging these industries with huge subsidies to producers and consumers did demand at scale emerge. The good news is that most of these technologies are now independently viable, and often cheaper than the carbon alternative. 

In his excellent and detailed review of Supercharge Me in this weekend’s Irish Times, President of the Eurogroup of finance ministers, Paschal Donohoe highlights our optimism: “We need books like this,” he says. Our optimism is in part premised on the fact that the policies we advocate are already being adopted. The challenge we address in Supercharge Me is to learn from the successes, clarify our framing, and accelerate globally an investment challenge which will benefit us all.

[1] The same arguments can be made for the other major industrial culprit, steel.

[2] California’s auto sector cap-and-trade scheme (and China’s) are also forms of EPIC aimed at relative prices. In California’s case it involved taxing incumbent auto makers and paying Tesla. This kind of model would absolutely help with accelerating change in the cement industry – but to be clear it’s efficacy will hinge not on accurately pricing the externality of a price-inelastic good, but on targeting the relative price of a substitute.