This is the story of how textbook examples of environmental taxation and emission trading came to life and the obstacles they face, all from the perspective of CERE Research Director Bengt Kriström. Complete with bubbles, dragons, yin and yang. Grab a coffee or tea and enjoy.

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When textbooks come alive

As an economist fresh out of graduate school, my first assignment for the Government was to work in a Commission on environmental taxation. Rather than drawing curves on (in those days) a blackboard as a teacher, I was part of a team that translated the curves into numbers, i.e. taxes per kg of whatever emissions we were looking at. The Commission published its final deliberations in 1991 and the Parliament later introduced a suite of environmental taxes. Later evaluations have shown that these taxes work exactly as how we thought they would do in theory. Success!

We had more ideas from the textbooks for the Commission to ponder, i.e. using markets to trade pollution. However, the time was not ripe for emission markets in Sweden, although they had already had been around for some time in for example the US. They were considered too complex and, after all, the Commission’s task was a piece of a larger puzzle; a significant tax reform involving a whole array of taxes. Somehow the reform had to be financed and a partial answer was the new taxes the Commission came up with. Yet, a daring reform it was.

At the time, I was interviewed by a foreign newspaper and, naively, I confidently exclaimed that we will “bubble” Europe and much of the modern world. A “bubble” is, the nickname given to emission markets, whence the emissions is constant in an imaginary bubble that hosts the emission units (who emits is determined by market forces, the total being given). At the time, a strong argument against the idea was “who would want to leave important decisions about environmental quality to a market?” (in those days, emission taxes were considered by some as a way of “buying oneself free”, not the least by the Green Movement. Today they have a diametrically different position. We all learn).

Well, time went by and magic happened. Lo and behold, today the world is being “bubbled” big time. The EU-ETS in Europe that began in 2005 is the most impressive program with more than 10000 installations participating in emission trading. China is just starting off and there are several programs going on elsewhere. This development is nothing but incredible. How such delicate textbook ideas came to life and went straight into the law in many countries is a testament to the power of economic ideas. It is a lasting success for environmental economics (or economics depending on your predilections), and it is hard to imagine a bigger success for our, after all, relatively small field.

Enter the dragons

To watch this development from the sidelines (and also being right in the lion’s den) has been extraordinary and I, again somewhat naively, thought that the sun would keep shining and all will be well. But no. A quite vigorous part of the modern environmental economics literature now argues that the permit markets “are not enough”. Beware the dragons, here they come firing on all cylinders (or is that from all noses?) with all sorts of arguments. Thus, “the price is too low in the EU-ETS” and “we must subsidize renewable energy and install all sorts of complementary measures to help out”. These kinds of arguments would have been perfect ammunition for the Commission politicians to back their position in 1990.

One (big) dragon is sometimes called “second best” and is invoked to motivate anything under the sun (and more). Useful party tip: if you meet an economist at a party and she explains some wonderful economic theory and its implications, you can always say “well, not necessarily in a second best world”. If her theory happens to be about second best, you can always say “well, not necessarily in a third best world”. Of course, second best theory is perfectly fine, the thing is that it is just too convenient to tailor second-best arguments to a certain sector; this dragon typically lives in the “green sector”. For example, “..in a second best world, subsidies could increase innovations in the green sector”. True, but there are other sectors in the economy.

Fighting the dragons

I think the critique is insufficiently backed by hard evidence and is not at all convincing, not the least because the critique seldom answers the question “relative to what?”. The price is “too low”, but relative to what? For example, twist and turn as we might, the emissions in the EU covered by the system will decrease by (at least) 2.2% per year. Sooner or later the price will go up, depending, however, e.g. on how much money is spent on subsidies. If we subsidize ourselves out of fossil fuel electricity, nobody will buy permits, so one cannot consider these issues as independent. So, if you say “subsidize because the price is too low”, you have to face the fact that this subsidy will contribute to the perceived problem of a “low price”. In addition, one has to understand the problem in a bigger context: up until now, the EU has been alone in pricing CO2 in this way and one cannot shy away from the fact this affects the relative costs on certain export markets. I am not going to write a thesis on how big the “leakage problem” is, but suffice it to say that one must pay attention to it. I think it would be irresponsible for the EU leaders not to consider it and of course they do.

Yin and yang

“Ademonai, Kodemonai” is a Japanese phrase that translates to “On the one hand, on the other hand”. You might have heard Captain Corcoran on the H.M.S Pinafore say it (in the Gilbert & Sullivan blockbuster). It is a favorite economist phrase, because, after all, many of our assertions depend on the assumptions made. You can, quite correctly, say that consumer demand will increase or decrease when the price of a good increase. It all depends (on the income/substitution effect). Can we say that: on the one hand, permit markets work perfectly well and on the other hand, they really don’t? In the case mainly under discussion, i.e. the EU-ETS, I am quite confident that the market work just like textbooks tell us they would do. Let’s be one-handed about this. The EU-ETS is a perfect illustration of the old adage: “Big bubbles, no troubles.” Well, since I am an economist, let me modify this to “Big bubbles, not really too many troubles, there are some, but we should not worry about them too much.”