A new report from the IMF

Last week many representatives of the global business community gathered at UNESCO Headquarters in Paris for the Business and Climate Summit, a prequel of sorts to the main COP21 event in December, but with only the business community involved. The goal was to demonstrate the involvement of the business community in the climate change issue and to set the stage for the business response to whatever is agreed by the Parties to the UNFCCC in December.

The event had significant political backing, with President Hollande speaking at the opening session. His speech went straight to the heart of the issue, with very matter of fact references to the important role of carbon pricing and the need for carbon capture and storage. Even UNFCCC Executive Secretary, Christiana Figures, endorsed CCS, not something she is known to do very often. The remarks by the President were backed up by many speakers, but Angel Gurria, Secretary General, OECD was perhaps the most memorable with his call for “a price, a price, a big fat price on carbon.”

The opening on May 20th set the scene for a major session on carbon pricing the next morning, with the World Bank and various business leaders taking the podium. While these speakers were all in agreement on the importance of carbon pricing, the harmony of the day before wasn’t quite as strong, with something of an argument between Tony Hayward, Chairman of Glencore and Kerry Adler, CEO of Skypower (solar) over the respective role of solar and coal in the coming decades. Mr Hayward saw little possibility of solar filling the breadth of industrial needs currently fulfilled by coal (and other fossil fuels).

The economic purpose of a cost on carbon dioxide emissions (carbon price) is as a response to the externality presented by our collective use of fossil fuels. This externality (the impact related to rising levels of carbon dioxide in the atmosphere) was discussed on several occasions during the Summit with regular reference to a new IMF report which argues that fossil fuel subsidies now stand at $5.3 trillion per annum. The vast majority of this arises from unaccounted externalities, such as the emissions of carbon dioxide and the impact of black carbon. Given that global fossil fuel production is some 10+ billion tonnes of oil equivalent per annum, then $5 trillion of externality equates to a charge for each tonne of production of some $500. The IMF report says that about a quarter of this relates to carbon dioxide emissions.

The publication of this number caused some excitement at the Summit and of course it got picked up in the media very quickly, in many cases with very little explanation as to its meaning. The IMF paper dwells at length on the need to cost in the externality and argues that despite a huge rise in energy costs that would result from such a charge, there would be a net welfare benefit to society at large. The report discusses the work of 19th Century Economist Arthur Pigou, who introduced the concept of externalities and proposed that negative externalities could be corrected by the imposition of a tax, now known as Pigouvian taxation. In the case of the climate issue, a carbon tax or the need to purchase emission allowances from the government are examples of Pigouvian taxes. The IMF report notes;

When the consumption of a good by a firm or household generates an external cost to society, then efficient pricing requires that consumers face a price that reflects this cost. In the absence of a well-functioning market for internalizing this cost in the consumer price, efficiency requires the imposition of a Pigouvian tax equal to the external cost generated by additional consumption.

. . . . . . 

. . . . . .

Eliminating post-tax subsidies in 2015 could raise government revenue by $2.9 trillion (3.6 percent of global GDP), cut global CO2 emissions by more than 20 percent, and cut pre-mature air pollution deaths by more than half. After allowing for the higher energy costs faced by consumers, this action would raise global economic welfare by $1.8 trillion (2.2 percent of global GDP).

But it is also important to consider the current value that is delivered by the availability of energy, a point also made by Tony Hayward on the carbon pricing panel. From an economic standpoint, it is worth taking this a step further. After all, why would the world be producing and using a fuel that brings such apparent economic hardship to society (i.e $5 trillion per annum worth of hardship)? The answer to this question implies that a positive externality must be outweighing this factor.

Although the IMF report doesn’t mention it, Pigou didn’t just talk about externalities in the negative sense, but also in the positive sense. Someone creating a positive externality—say, by educating himself and making himself more interesting or useful to other people—might not invest enough in education because he would not perceive the value to himself as being as great as the value to society. Pigou even advocated for subsidies for activities that created such positive externalities.

Despite the issues associated with using them, fossil fuels have brought tremendous value to society and continue to do so. Almost everything we take for granted in modern society from the food we eat to the iPhone we constantly use are here because of fossil fuels. This wealth creation that is tied to their use but not reflected in the price is a positive externality. Such a positive externality should be apparent in the price of fossil fuels, but because of their relative abundance around the world and the dislocation that often exists between extraction and use, this may not be the case. The positive externality is potentially so large that it is likely the root cause of some governments offering real incentives and (Pigouvian) subsidies to promote additional fossil fuel production. The IMF report calls these Producer Subsidies, but notes that they are relatively small.

None of the above is meant as an argument for not dealing with the environmental externalities associated with fossil fuels use. As noted many times during the Summit and as I have discussed often in the past, a carbon price is essential. But as other forms of energy scale up to the level at which we use fossil fuels, new externalities will present themselves. There will of course be the ongoing positive externality associated with energy provision, but negative externalities will almost certainly make themselves known as new industries emerge and new materials are introduced into society for everyday use (e.g. very large scale use of lithium). Perhaps the lesson from the IMF report is to start dealing with externalities much earlier in the cycle of production, before they reach a level which challenges our economic system to correct.