Economic Surplus: Michaelmas 2021/22 Week 8
Economic Surplus by The Marshall Society
29 November 2021
"A nation is not made welathy by the childish accumulation of shiny metals, but it enriched by the economic prosperity of it's people" ― Adam Smith
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A Giant Cash Point in the Sky? - (mis)perceptions of Foreign Aid in the UK | 6 PM, 30th November 2021
CUID (International Development Society) and Marshall Society are co-hosting an event on foreign aid held in the Keynes Room of King’s College. All Marshall members are invited. We hope to see many of you there.
We will be asking the question: why is support for the aid budget so low?
Saleyha Ahsan - BBC and Channel 4 presenter, film-producer, humanitarian doctor and Captain of the British Army. She served and reported from Bosnia, Lybia, Syria and from the frontline of the Covid-19 pandemic. She is a trustee of numerous NGOs working in International Development.
Sam Nadel - Oxfam, Head of Government Relations
Jennifer Larbie - Christian Aid, UK Advocacy and Policy Lead
If you are interested in becoming a Marshall member, please go to: https://marshallsociety.com/join-us/
Marshall's Thoughts - Real Estate in China
This week’s Marshall’s Thoughts are written by Jeff Yang.
“All we hear is blah blah blah.” Some followers of Greta Thunberg may feel validated at the conclusion of the recent COP-26 summit. Neither Russian nor Chinese leaders turned up, and major countries like China, India and the US were absent from commitments to phase out investment in coal. Climate Action Network, an independent think-tank, has posited that the new 2030 targets will cause temperatures to rise by 2.4C by 2100, well above Paris Agreement’s red line of 2C. This provides us with food for thought: What is the “optimal” policy response to promote decarbonization? How can countries be incentivized to decarbonize?
With geo-engineering technologies in their infancy, most efforts against climate change are focused on reducing carbon emissions. Economists broadly agree that the best way to do so is through carbon-pricing solutions like carbon taxes and cap-and-trade schemes, which internalize the social externality of carbon emissions and hence remove the original market failure. While carbon taxes are Pigouvian taxes levied upon carbon emitters, cap-and-trade schemes uses a quantity lever. Essentially, emitters require a license to emit carbon, and a fixed number of licenses are issued annually, either via free distribution or auctions. Firms with surplus licenses can sell them to other firms buying more, hence the “trade”.
Both carbon taxes and cap-and-trade schemes are seen as efficient instruments as they achieve emissions reductions at the lowest cost burden for society. Firms facing a higher cost of abatement can obtain permits from other firms which can decarbonize more cheaply. Similarly, a carbon tax ensures that only firms with a sufficiently low cost of abatement will reduce their emissions, compared to emissions standards like fuel economy requirements which tend to be one-size-fits-all. This is useful given the heterogeneity in scale, energy intensity, and technological capabilities between firms – for example, small cement and steel producers are likely to find it much harder to reduce their carbon footprint than a large supermarket chain.
However, cap-and-trade schemes are often subject to price volatility, as their prices are determined by market demand as well. Prices in the EU’s Emission Trading Scheme were depressed for a significant period following the 2008 recession, due to a significant surplus of unused auctions. More recently, the surge of carbon prices from around 20 Euros/tCO2 during the pandemic to more than 50 Euros/tCO2, buoyed by hoarding behavior by significant carbon emitters and increased speculation by hedge funds and financial institution, could have contributed to the inflationary pressure on energy prices in the EU. Such uncertainty may weaken the signaling effect of the carbon price, dampening the incentive for firms to invest in carbon abatement. This may be further exacerbated for national or local carbon markets, which may be more illiquid and vulnerable to sudden price movements due to the smaller number of participants.
Nevertheless, these challenges are not insurmountable. To reduce price fluctuations, cap-and-trade schemes have created price floors such as the Carbon Support Price in UK, or a mechanism to absorb excess permits as in the case of the EU’s Auction Reserve Mechanism. Smaller emissions trading schemes have also been integrated, like in the case of California and Quebec, to deepen the market for permits and promote price discovery. Researchers have also proposed blocking access or implementing a tax for non-compliant entities trading permits, to discourage financial speculation.
Putting a price on carbon directly by taxing carbon directly may circumvent price instability, but it is not a straightforward process either due to the difficulty of determining the social cost of carbon (SCC). Integrated Assessment Models developed in the early 1990s seek to calculate SCCs by incorporating the effect of climate change into macroeconomic modeling but produce very different results based on the choice of parameters. Robert Pindyck, an MIT economist, argued that such models “create a veneer of scientific legitimacy” by assuming arbitrary values for core parameters like climate sensitivity and damage functions, and neglecting the unquantifiable – such as catastrophic risk. Another area of controversy is how much to value the welfare of future generations. William Nordhaus, who won the Economics Nobel, for his pioneering DICE model, calculated an SCC of about 37 USD/tCO2 in 2020 using a 4.5% discount rate. However, with the same model and the discount rate of 1.4% used in the Stern Review, the optimal SCC would come to about 277 USD/tCO2!
Despite these flaws, the most important issue with both measures today is that they are not being taken up by most countries. According to the IMF, four-fifths of global emissions remain unpriced, with the average global carbon price being about 2 USD, far below the range of estimated carbon prices. This stymies the implementation of national carbon taxes and cap-and-trade schemes by creating the risk of carbon leakage, through the substitution of domestic goods for cheaper, more carbon-intensive imports and firms relocating to carbon havens. Ultimately, countries are less ambitious in their carbon taxes and cap-and-trade allowances to remain competitive, encouraging a race-to-the-bottom.
This pervasive inaction in the face of the climate threat boils down to free riding. Every country reaps the benefits of keeping global warming in check, regardless of their Nationally Determined Contributions, and whether it is adhered to. Nordhaus suggests that a climate club could deter free-riding – membership in the club is conditional on reducing emissions but provides countries with certain benefits. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership operates on a similar concept, offering reduced barriers to trade while mandating stringent environmental and labor protections. However, the CPTPP only contains about 13% of global GDP (following the departure of the US) and its provisions are not explicitly focused on the climate. If a few major economies could start a similar agreement with strict emission reduction requirements, then it is likely that other countries would be attracted to join as well, with potential network effects as the club expanded.
Ultimately, global warming is a wicked problem, but various market-based tools are available to policymakers. Not only are these policies cost-efficient, they also boost government revenue which can then be used to fund subsidies for clean energy or redistributed to households as ‘carbon dividends’, offsetting any increases in prices of final goods and making them more politically palatable. However, with a 2C limit on temperature increases, emissions trading schemes which directly impose a quota on carbon emissions may be a better instrument than carbon taxes. Interestingly, to deal with the lack of international coordination, the EU ETS has proposed a Cross Border Adjustment Mechanism to reduce leakage by charging a comparable price for carbon embedded in imported goods. Its effect on global carbon emissions will be closely watched.
In Case You Missed It:
This article considers the implications of the pandemic and long-term structural changes on labour supply and examines differences in the labor market between countries. Fascinatingly, it suggests that a large factor driving the current labor shortage in the US and the UK is excess early retirements, driven by broad-based gains in wealth.
This brilliant piece describes the effect of climate change on labor and capital markets in the short and long-run due to changes in economic productivity. It takes an interesting look on the knock-on effects on labor demand in other sectors like manufacturing and services, and in other regions with close financial linkages and communal networks with affected areas.
This article discusses the recent move of the US to tame inflation by tapping its oil reserves, along with the possibility of international coordination, and whether these measures are adequate to deal with rising energy demand.
Given the post-Brexit preoccupation with trade and the more recent focus on levelling up, this illuminating article provides insights on the UK’s use of free trade zones. It sheds light on the interesting phenomenon of tariff inversion in freeports, allowing businesses to avoid taxes on imported inputs and instead obtain a lower tax on final products. Can freeports generate employment and boost trade for Britain? Read this article for The Economists’ evaluation.
That's it from us for now!
The Marshall Society