Gernot Wagner | Writing

America.gov debate on low-carbon economic development

noreply@blogger.com (Gernot Wagner) — Thu, 14 Jan 2010 23:40:00 +0000

I'm debating AEI's Steve Hayward at the U.S. State Department's site, america.gov, arguing why low-carbon development will create economic opportunities all over the world.

Turn toward climate safety

noreply@blogger.com (Gernot Wagner) — Thu, 05 Nov 2009 06:20:00 +0000

The science is compelling. We are heading in the wrong direction, and we are running out of time. The critical period is from now until 2020, when global emissions must begin to decline. The sooner the turn, the greater is the chance that we can avoid the most dangerous consequences.

We know the turn toward safety must come soon. The clock is ticking.

We know that with clear economic signals we can redirect much of the capital we were preparing to spend on carbon-intensive infrastructure to financing the turn toward safety. And we know that within the next decade all major emitting countries must get on a downward trajectory in carbon emissions. The task before us now is to get to a global deal that makes this happen — without delay.

This paper sets forth the actions needed to start the turn toward safety.

Why a carbon cap should be the next US stimulus

noreply@blogger.com (Gernot Wagner) — Fri, 10 Apr 2009 21:32:00 +0000

Bridges vol 21, April 2009 / OpEds & Commentaries

The United States and many other countries' stimulus packages include provisions for green investments. That's good. After all, the economic and climate crises are intimately related. They share a similar structure - with greenhouse gas emissions and energy waste replacing toxic debt as the element that has gotten us into trouble. But green stimuli alone are not enough. A cap on carbon could provide the missing link.

President Barack Obama's stimulus package contains provisions to the tune of $100 billion in direct appropriations and tax breaks for green energy and energy efficiency. McKinsey, the management consultancy, estimates that the United States alone will require $1 trillion in added investment by 2020 to guide it onto a low-carbon pathway and meet climate policy goals. We cannot have one stimulus per year, every year between now and 2020, to meet the climate goals.

Similarly, we cannot depend on government spending alone to jump-start the economy. As a number of economists have argued, the key to pulling the US and world economies out of the Great Recession is what Larry Summers has called "the universal demand agenda." Where will that demand come from? Even if 10 stimuli might be out of the question, US lawmakers have already been talking about a second one. But government spending alone cannot be the answer.

A successful recovery will depend on massive investment by the private sector. That is where a cap on emissions comes in. The credit crunch obviously provides the biggest barrier to investment. But as the supply of credit begins to loosen up, we must also do everything we can to stimulate demand for investment. While the economy collapses, businesses - especially in the energy and manufacturing sectors - have held back investments in part because they are waiting for clear rules of what is going to happen in climate policy. By passing climate legislation that puts a cap on carbon, Congress can clear up regulatory uncertainty and help get capital flowing into clean energy.

Yes, consensus model estimates project that the economy would grow slightly more slowly under climate policy than under "business as usual" - although this effect amounts to only a few months of growth over two decades; and when you do an economic model that far into the future, the margin of error is likely too big to know if the cap will have any effect. Moreover, none of those models include the huge cost of allowing climate change to accelerate unchecked. Once you take the costs of inaction into account, it is far better, from an economic point of view, to act and act quickly.

Yet, most importantly, the "business as usual" path of these models is a Panglossian world with full employment of resources like labor, land, and capital. In such a world, any government policy is bound to be a drag on growth, since the modeled economy is humming along at full speed. This is clearly not the world we live in at the moment with skyrocketing unemployment, boarded-up homes, and shuttered factories. In the world of the Great Recession, a government policy that stimulates investment - like a cap on carbon - could well boost growth rather than slow it.

A carbon cap has another important feature that a carbon tax or other climate policies do not. A cap - even one that goes into effect in, say, 2013 - would help put assets on companies' balance sheets now. Businesses are holding back on investments in part because they need cash on hand to pay back their existing debt, since banks aren't giving out as many loans due to the credit crunch. The exact effect will depend on the detailed accounting rules, but give businesses additional assets and the financing equation will change in favor of increased spending and investment.

This holds true regardless of whether carbon allowances are given away for free or sold in an auction. Most businesses would, of course, prefer free allowances. Yet even auctioned allowances have benefits. The cost of these auctioned allowances would affect company balance sheets at the beginning of the program, while every incremental investment in low-carbon technology increases the value of carbon assets on the books now.

Of course, a carbon cap won't be a free lunch. Emitters will need to find ways to cut global warming pollution. There are lots of low- and even many no-cost opportunities available to do so, but some efforts clearly cost money and require additional investments. The point is that new investment is exactly what we want to have happen right now, when we face such massive underemployment of resources.

Dire economic headlines these days are only matched by equally worrisome news that our climate is changing faster than expected. The United States must lead in finding solutions to both crises. Deploying a cap-and-trade program to repower our economy should be an integral part of the way forward.

Docking into a global carbon market: Clean Investment Budgets to finance low-carbon economic development

noreply@blogger.com (Gernot Wagner) — Wed, 18 Mar 2009 03:12:00 +0000

by Gernot Wagner, Nathaniel Keohane, Annie Petsonk, and James Wang
Environmental Defense Fund
Forthcoming in: The Economics and Politics of Climate Change (Oxford University Press, 2009)

Financing the transition to low-carbon economic development must be the focus of any framework to encourage developing countries’ participation in the global carbon market. It needs to do so with the aim of eventual full participation in carbon markets while maintaining the core market’s integrity and meeting the environmental goal of avoiding long-term warming in excess of 2°C above pre-industrial levels. This paper proposes a mechanism to achieve these goals: Clean Investment Budgets (CIBs).

Under this proposal, emerging economies could adopt binding limits on greenhouse gas emissions, set above current levels but within economic and environmental constraints. Such a step would enable these nations to access carbon finance immediately and far more efficiently than existing and proposed mechanisms. Moreover, the growth increment – the portion of the CIB in excess of a nation’s actual emissions – provides a pool of readily available emissions allowances that could be leveraged in carbon markets, financing investments in renewable and low-carbon energy generation, energy efficiency, and technology transfer. CIBs would thus reward early action taken by emerging economies, providing them with a source of capital to enable a rapid transition to a low-carbon economic development path.

Full paper in PDF.

Carbon cap beats tax

noreply@blogger.com (Gernot Wagner) — Thu, 05 Mar 2009 02:48:00 +0000

Response to "Obama’s chance to lead the green recovery" by Joseph Stiglitz and Nicholas Stern (Financial Times, 2 March 2009) in the Financial Time's Economists' Forum.

Joe Stiglitz and Nick Stern are exactly right to emphasize the role President Barack Obama can play in leading the green recovery. They are also right to calling for a “stable, strong carbon price.” But it matters how that price is set. In the United States in particular, the right environmental, political and economic answer is a cap-and-trade system.

A cap guarantees the environmental outcome; a tax does not. A cap has hope for passage in US Congress; a tax does not. A cap would not only provide the basis for the necessary long-term restructuring of the US economy, it would also act as a short-term stimulus, much more than would a tax.

A cap delivers far more innovation than a tax. The cap – even one that goes into effect in, say, 2013 – would help put assets on companies’ balance sheets now, which would immediately change the financing equation in favour of increased spending and investment. This holds true regardless of whether allowances are given away for free or sold in an auction. The cost of auctioned allowances would affect company balance sheets at the beginning of the program, while every incremental investment in low-carbon technology increases the value of carbon assets on the books now.

Innovation is where the true potential of a cap becomes apparent. If we think of research and development as creating options, a future cap signed into law this year would make the “call option” on clean energy research and development significantly more valuable. This would help unleash much-needed energy investments that have been placed on hold while companies have been waiting for clear rules.

Options theory also provides direction for market design. A price ceiling for carbon allowances, like a tax, would be poisonous to the innovation process and the atmosphere alike. An initial price floor would help both. It would also counteract the dampening effects of an uncertain price on green energy investments: downside risk looms large for investments in alternative energy sources. Similarly, a well-designed cap calls for banking and limited future borrowing of allowances to smooth prices and create investment certainty and continued asset values.

Of course, the carbon market also requires utmost transparency as well as patently enforceable – and rigorously enforced – oversight rules. Any regulatory framework must start from the premise that a carbon allowance is not simply just another physical commodity and must not be regulated as such. Rather, the overarching goal of market oversight must be aligned with the fundamental goal of reducing emissions.

Finally, a US cap is the key step toward a truly global solution to our shared climate problem. The United States must lead, but it – and Europe – cannot solve the problem alone. At the very least, the largest emerging economy emitters and tropical forest nations need to limit their pollution as well. A global cap-and-trade market would encourage all nations to seek the lowest-cost solutions and provide incentives for others to join.

If you want to limit carbon emissions, do exactly that

noreply@blogger.com (Gernot Wagner) — Wed, 07 Jan 2009 13:06:00 +0000

Letter to the Editor, Financial Times, January 7, 2009.

Sir,

You are absolutely right to argue for prices and against too much direct government meddling within the set of "Green options for US energy policy" (editorial, January 2). You then go on to say that an explicit carbon tax would be best. Yet cap-and-trade is much more than an "implicit carbon tax".

Both sides of the debate have good arguments in favour of their positions. I myself wrote an editorial on these pages (April 26 2007) throwing the FT's support behind a tax, but I have since changed my views, for several reasons.

Most significantly, the US and the European Union cannot solve this problem alone. At the very least, the largest emerging economy emitters need to limit their pollution as well. A carbon market can make these commitments in the economic self-interest of all parties involved; a tax cannot. Second, smart market design - including provisions for banking and borrowing of allowances - would dampen feared price volatility, and well-known market instruments can iron out the rest.

Third, the most important missing link in turning climate change from a problem into an unprecedented market opportunity is innovation. A cap taxes entrepreneurs to look for breakthrough technologies at any price. A tax caps innovation.

Lastly, almost all new scientific evidence over the past two years has shown that the climate problem is worse than previously feared. We do not have time to experiment with tax rates to achieve the desired results. If you want to limit emissions, do exactly that: cap them.

Gernot Wagner,
Economist,
Environmental Defense Fund,
New York, NY, US

The world can (and must) innovate its way out of this slowdown

noreply@blogger.com (Gernot Wagner) — Thu, 31 Jul 2008 12:39:00 +0000

Response to "The world cannot grow its way out of this slowdown" by Kenneth Rogoff (Financial Times, 30 July 2008) in the Financial Time's Economists' Forum.

I agree with Ken Rogoff’s analysis (and Martin Wolf’s interpretation) of the global imbalances leading to the current crisis. One point I do not agree with is that high commodity prices are “prima facie evidence that the global economy is still growing too fast” and that “it will probably take a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil, down from the current $124).”

High oil prices are not a sign that we have grown too fast, they are a sign that demand for oil has gone up. Yes, the two are closely related, but there’s a crucial degree of freedom in play: energy intensity.

High oil prices in the 1970s prompted a decrease in oil per unit of output, a trend that has continued to a lesser extent since then. It is no secret that climate change, one of the other major crises facing the world at the moment, will require us to make large strides in that direction. (McKinsey introduced the useful concept of “carbon productivity” and shows why it needs to – and, crucially, how it can – rise tenfold by 2050.)

Energy prices – and oil in particular – have risen so dramatically for a deep underlying reason, albeit one that’s possible to express in simple terms: demand has gone up, while the resources themselves are becoming ever scarcer.

The best answer to high oil prices is using less oil, not scaling back the use of capital and labour to bring oil prices down to “trend.”

Environmental economics blogging

noreply@blogger.com (Gernot Wagner) — Wed, 30 Jul 2008 21:53:00 +0000

I began contributing to the Environmental Economics blog on a semi-regular basis a couple of weeks ago. So far, I have written about White House scrubbing of EPA rules, doled out some unsolicited investment advice (since confirmed), thought about fancy titles, and -- the all-time blogger's favorite -- provided some uncommented links.

Take a look at www.env-econ.net for more posts to come.

Economics can smooth path towards global climate deal

noreply@blogger.com (Gernot Wagner) — Wed, 09 Jul 2008 18:02:00 +0000

Response to "Why obstacles to a deal on climate are mountainous" by Martin Wolf (Financial Times, 9 July 2008) in the Financial Time's Economists' Forum.

Martin Wolf is right to point to the difficulties inherent in any global deal on climate. Yet there are ways to smooth the path, and smart economics can play an important role.

First though, it is important to keep the distinction between efficiency and cost-effectiveness clear in our minds. Mr Wolf implicitly makes that distinction. Let me restate it more explicitly: efficiency is about weighing the costs and benefits of policies and setting a target; cost-effectiveness is about finding the best way to achieve that target. It is good to have economics on our side to address the former, but given the nature of the problem, economics has a lot more to say about the latter.

The first step is to set a global cap on emissions, which progressively tightens over time. As Martin Weitzman’s paper on the uncertainties around catastrophic climate change makes clear, traditional benefit-cost analysis is an inadequate tool to set the right target. Instead, this debate needs to center first and foremost around climate science. Again, it helps to have economic analysis support the agreement to limit emissions (current science centers around avoiding 2 degrees centigrade of warming, which translates roughly into progressively limiting pollution to arrive at around 20 gigatons of CO2 equivalent greenhouse gas emissions by 2050), but that agreement must be born from scientific necessity and political will.

Economics really enters the picture once that cap is set. For one, markets – in particular a cap-and-trade system – are an important tool to reaching the goal at minimum cost. Another aspect is when it comes to divvying up the room left under this global emission reduction pathway. How do we get countries to agree to individual limits that ensure the integrity of the cap?

One such economic tool could be so-called “premium emissions budgets.” Faced with the prospect of having to cap its emissions in the future, a country could gain significant financial advantage by adopting that exact same cap early. So instead of adopting a cap set at 2017 emissions levels, for example, a country could adopt that exact same cap in 2012 before it has reached the projected emissions levels. In the intervening five years, it could then sell off excess allowances to areas like the EU (and likely the US) with already binding caps, or it could ‘bank’ them itself for later use. The financial gain increases exponentially with every year that the cap is adopted earlier.

Of course, there would only be a limited number of these Premium Budgets to go around under a global cap, which would create an even larger incentive to act early. The first countries to sign on will have larger budgets available to them than the laggards. Early action pays. The sooner a country adopts a certain cap, the larger its financial advantage, and surely also goodwill in international negotiations.

Smart tariffs can help towards goal of lower emissions

noreply@blogger.com (Gernot Wagner) — Mon, 07 Jan 2008 11:00:00 +0000

Letter to the Editor, Financial Times, January 7, 2008.

Sir,

You argue against imposing any form of carbon border tariffs by invoking "slippery slope" reasoning ("The greening of globalisation", editorial, January 4): such tariffs, you say, could result in tit-for-tat restrictions. Possible, but most reactionary tariffs would and probably should be struck down by the World Trade Organisation. Yet the WTO would likely allow carbon tariffs combined with domestic caps or taxes, for good reasons. They provide a unilateral solution to an inherently global and complex problem without violating trade rules.

The system would enable globalisation to work for the environment - not, as you fear, prevent it from doing so. Current information deficits encourage consumer backlash against flowers grown in east Africa and flown to London, despite them being more carbon-efficient than those grown in energy-intensive greenhouses in Europe. A smart tariff system would be far preferable to consumers shifting en masse to products labelled "locally grown" - from both an environmental and a free trade perspective.

The economically ideal solution is a global cap or tax scheme, but smart tariffs come in as a close second. In addition, they would ease the transition by inducing poor exporting nations to move towards a path of lower emissions sooner.

Andreas Vogel,
Vice President, SAP Research

Gernot Wagner,
Consultant, Boston Consulting Group

The worth of nations

noreply@blogger.com (Gernot Wagner) — Sat, 01 Dec 2007 23:43:00 +0000

Worth Magazine, December 2007.

Imagine a business with an annual report containing nothing but revenue figures—and for only some of its operations. That is what happens when we focus on GDP as an indicator of how national economies are doing.

Revenues matter, but costs are equally important in figuring the true health of a business or a country. In a company, materials must be bought, machines lose their usefulness over time, and buildings require repair. Similarly, the economy of a country includes depreciation and the costs of doing business. National accountants adjust GDP to arrive at a net figure that accounts for worn-down roads and bridges, but there is more to a country than its physical infrastructure.

We are aware that trees are important to the environment, for example, but a tree doesn’t factor into GDP unless it is part of a commercial transaction. The sale of a Christmas tree appears in the GDP. An identical tree in the forest does not—at least not until it becomes plywood—and its contribution to a healthy environment does not appear on the country’s balance sheet.

If these factors were included, the adjustments to nearly every country’s GDP could be enormous. The cost of environmental degradation and pollution in China is equal to about 8 to 12 percent of the country’s GDP per year. That wipes out most of China’s impressive annual GDP growth, lately in excess of 10 percent.

China announced earlier this decade that it would start to calculate its green GDP, only to backtrack once the first numbers revealed some bad news. That turn of events is not new. The United States followed a similar path in the 1990s. It first started to measure subsoil assets, such as coal still in the ground. The coal industry did not like the results, and Congress soon bowed to lobbyists and included a line in the appropriations bill barring any such future activity. That ban has since disappeared, but national income accountants are still wary of doing anything too public.

Simon Kuznets—the father of U.S. income accounting who won the 1971 Nobel Prize in economics for his work—was the first to point to the limitations of calculating GDP without factoring in costs. On one hand, it is innocuous if the GDP feeds on a deteriorating environment: Companies produce, which adds to the gross domestic product, and other companies clean up their pollution, which again increases the GDP.

A large problem arises, however, with the way that GDP figures are used. The press, the public and even some economists equate them with statements about a nation’s overall well-being. And, up to a point, material wealth does mean better living conditions. China in the last two decades pulled more people out of poverty faster than any other country in history. Yet the enormous deterioration of its environment is equally unprecedented.

The United States provides another case in which GDP growth and overall welfare might no longer go hand in hand. Recent studies on childhood obesity conclude that children today might not live as long as their parents.

Ideally, we would develop an entire dashboard of indicators—economy, health, environment—and accord them all equal or similar weight in policy decisions. In practice, however, economic decisions often dominate. That is why it is essential to create monetary measurements of the environment or health and education, and integrate them with existing GDP measures.

When it comes to balancing 50 jobs against 50,000 trees, logging companies are able to point to hard economic data while environmental activists must plead for the sympathy vote with pictures of virgin forests and perhaps a fuzzy baby animal. But it is indeed possible to calculate the economic worth of trees left standing. They are natural water and air filters. Providing clean drinking water and removing carbon dioxide from the atmosphere add real value to society. Another sizeable part of the equation is the recreational value of forests and their contribution to the tourism industry.

Green GDP is not the result of green accounting; it is simply good accounting. The more data that the policymakers have to steer a country’s economy, the better. It is technically feasible to create such monetary measurements of our environment. What remains to be done now is the actual counting.

Gernot Wagner, a consultant in New York, served as the 2007 Peter Martin Fellow on the editorial board of the Financial Times.

Response to "Is Energy Independence the Answer?"

noreply@blogger.com (Gernot Wagner) — Sun, 30 Sep 2007 15:10:00 +0000

This week's NPR show Living on Earth aired some listener responses to the commentary, "Is Energy Independence the Answer?":

GELLERMAN: We got an earful about our recent commentary from Gernot Wagner who made the case that energy independence for the United States is not only unachievable, but undesirable.

Wes Tator, who listens to LOE on New Hampshire Public Radio, emailed to say, 'I thought your speaker was right on.'

But Cat Givens from Portage Lakes, Ohio sent us 'a resounding yes' to energy independence. She tunes in to WKSU and writes: 'The war on terror would be a thing of the past if we close down our dependence on oil and use the energy resources already available to us—like...ethanol, solar, wind, and battery-powered cars. There are green alternatives we can utilize right now.'

For the record, I agree with Wes Taylor, and with Cat Givens. The war on terror could well be a thing of the past if we became independent from oil. But there is an important difference between independence from all oil and independence from imported oil or energy in general.

Total oil independence might well be desirable. Becoming independent from imported energy alone, though, is not. None of this, of course says much about whether either would be achievable.

Is Energy Independence the Answer?

noreply@blogger.com (Gernot Wagner) — Sat, 15 Sep 2007 15:41:00 +0000

Living on Earth, National Public Radio's environmental news show, Week of September 14, 2007. (Radio-version of Chicago Tribune op-ed: "Energy goal should be to diversify," June 24, 2007.)

[CURWOOD:] Rudy Guiliani is not the only one talking about energy independence. It seems to be the mantra of just about all the presidential candidates, not to mention other politicians in Washington. For some, the goal is lower gas prices. For others, it's concern that oil-rich regimes hold sway over foreign policy. But commentator Gernot Wagner argues either way, energy independence gets us nowhere.

[WAGNER:] Talk of energy independence misses the point. The goal must be energy security. This is most often achieved by diversifying dependence, not by calling for independence.

President Richard Nixon started the craze with Project Independence in 1973. It has been a losing battle from the start. At the launch of the project, the U.S. imported a third of its oil. Now it imports over 60 percent.

Without draconian measures, energy independence is unachievable. The cheapest available oil, at the moment, is from the Arabian Peninsula. Meeting all need for oil domestically would come with a hefty price tag.

And those willing to pay a higher price in order to extricate foreign policy from perceived oil grip would do well to remember that the regimes they seek distance from will be enriched by that higher price. The market for oil is global. That makes it pointless to try to wean ourselves off particular suppliers.

The U.S. can declare today that it will not import any oil from Saudi Arabia. There is enough oil on the market to avoid shipping directly from Saudi to American ports. Someone else will gladly take the shipments from Saudi Arabia. But as long as there is no universal boycott of Saudi oil, we will be dependent on it – and we will still have U.S. tanks in the Middle East, if not U.S. tankers.

It is even more dangerous to link energy independence with environmental goals. We need to get away from oil and promote alternatives, but decreasing pollution is not the same as decreasing energy imports. Ethanol, for example, can deal with pollution but, for the most part, should not be used to address independence.

At the moment, the best source for ethanol is sugar cane. On environmental grounds, cane beats corn by a long shot. The most sensible environmental policy would be to drop all ethanol tariffs.

But slashing tariffs on ethanol increases our reliance on foreign fuels. Ethanol production shifts to Brazil, which could, at some point, replace Saudi Arabia as the lowest cost producer of the world's fuel of choice. Energy independence would decline. At the same time, energy security would go up. A democratic Brazil is clearly a better energy supplier than an autocratic Middle East. Even so, relying too heavily on Brazil could undermine supply security just as well. The goal should be to diversify.

Calls for energy independence undermine what really matters. The distinction with energy security is subtle, but important. Not only is energy independence unachievable, it is not even desirable.

Financial Times editorials

noreply@blogger.com (Gernot Wagner) — Fri, 17 Aug 2007 15:26:00 +0000

For the past four months, I have served as Peter Martin Fellow on the editorial board of the Financial Times in London. There I wrote about economics, energy and the environment.

I cannot post any editorials here, but I will gladly confirm having written well-received ones and will disavow any knowledge of the occasional dud.

Energy goal should be to diversify

noreply@blogger.com (Gernot Wagner) — Sun, 24 Jun 2007 18:30:00 +0000

Chicago Tribune, June 24, 2007.

While the U.S. Congress debates the latest energy bill, the eventual outcome amid intense lobbying by all sides is anybody's guess. One part, however, is certain: Calls for energy independence will be aplenty. These pleas will be as passionate as they are misguided. The goal must be energy security. This is most often achieved by diversifying dependence, not by calling for independence.

President Richard Nixon started the craze with Project Independence in 1973. It has been a losing battle from the onset. At the launch of the project, the U.S. imported a third of its oil. Now it imports more than 60 percent. That has not prevented George W. Bush and most major candidates vying to succeed him from pursuing the issue. But regardless of who takes it on, it will be a lost cause.

Energy independence is unachievable -- barring Draconian measures. Economic forces are aligned to exploit the cheapest available energy source, which is not located in the U.S. or in any other major energy-consuming nation. Oil from the Arabian Peninsula comes in second to none.

Moreover, the global nature of oil markets makes weaning ourselves off particular suppliers pointless. If the U.S. uses some oil -- any oil -- produced anywhere in the world, the price it pays will be determined, in part, by potentially hostile regimes. Moreover, U.S. demand for oil will increase that price and -- at least indirectly -- hand money to these regimes.

It would be desirable to shift from oil to alternative sources of energy, but here again, talk of energy independence muddles the issue. Some environmentalists like to link energy independence with the fight to combat climate change. We do indeed need an appropriate, predictable and consistent price on emissions of greenhouse gases, which would tip the balance away from oil and other carbon-intensive energy sources toward cleaner fuels. But decreasing pollution is not the same as decreasing energy imports. Ethanol can deal with the former, but, for the most part, should not be used to address the latter.

Currently the best source for ethanol is sugar cane. Neither the U.S., with its emphasis on corn-based fuel, nor the European Union, with rapeseed and sugar beet as its homegrown sources, can compete with Brazil and some Central American countries, where sugar cane thrives naturally. Cane beats corn, beet and rapeseed by a long shot on environmental grounds. The most sensible environmental policy would be to drop all ethanol tariffs. Given the powerful corn lobby in the U.S. and increasingly strong domestic ethanol lobbies in the EU, this is unlikely to happen. Talk of energy independence only exacerbates this boondoggle. Farm lobbies can now cloak their arguments for maintaining subsidies and import tariffs in the language of environmental concerns and of national security.

Yet slashing tariffs on ethanol would increase U.S. reliance on foreign fuels. Ethanol production shifts to Brazil, which could replace Saudi Arabia as the lowest cost producer of the world's fuel of choice. Energy independence would decline. At the same time, energy security would go up. A democratic Brazil is clearly a better energy supplier than an autocratic Middle East. Nevertheless, relying exclusively on Brazil could undermine supply security just as well. The goal should be to diversify.

Most countries already diversify to some extent in another dimension. The U.S. imports around 10 million barrels of oil directly per day. In addition, the U.S. imports about 1 million barrels a day indirectly, embedded in manufactured goods. China imports oil, burns it to fuel its plants, and the U.S. and others import the final products. If China and other poor manufacturing countries did not produce these goods for export, the U.S. and fellow rich consuming nations would have to import most of the oil or other forms of energy directly to produce the same goods.

Calls for energy independence undermine what really matters. Those arguing for it risk making the nation less secure. Sadly, energy independence is a powerful rallying cry for campaigns. It polls well and motivates people to put energy on top of their political priorities. That agenda-setting factor should not be underplayed. Yet the ends do not always justify the means. Here, the end would be unachievable and, more important, undesirable.

Dissertation

noreply@blogger.com (Gernot Wagner) — Wed, 09 May 2007 13:33:00 +0000

Essays on Environmental and Natural Resource Economics: Introductory Chapter

Informed policy circles no longer question whether to use economic instruments to solve environmental problems. Domestic European debates on global climate change focus on whether to use carbon markets or taxes. Even calls for banning incandescent light bulbs are wrapped in arguments of induced technological change and similar economic language. That is part of the problem. Economics is used to justify virtually everything, making it an extremely powerful tool – and increasing the stakes for economists producing environment-related research.

The United States imports around 10 million barrels of oil per day. That number is known and of much concern in the energy and national security communities. It also forms the basis of many studies concerned with macroeconomic effects of foreign energy dependency. Other important research areas in economics are the “pollution haven hypothesis,” based on the fear that dirty industries may migrate to poorer countries in search of lax environmental standards, and the “environmental Kuznets curve,” the conjecture that pollution follows an inverse-U-shaped pattern in relation to income. Demonstrated anecdotally, large-scale studies generally find no support for the pollution haven hypothesis and empirical results for the environmental Kuznets curve are by and large fickle. Research leading to my first paper shows that all three areas may have overlooked an important aspect of the data.

In addition to direct oil imports, the United States imports 0.8 million barrels embedded in manufacturing goods. That number has important national security implications. It also enables a direct way of studying both the pollution haven hypothesis and the environmental Kuznets curve. Relatively richer countries consume more energy-intensive products than they produce. Trade accounts for the difference. Future research needs to show whether that translates into a large-scale pollution haven effect. But at the very least, it shows the importance of choosing the correct model and data, especially since the data are not complicated. Careful accounting can produce the necessary figures and highlight important yet previously overlooked details.

Conventional wisdom says that negative environmental externalities dampen growth. Sick workers are less productive. That is certainly true and an important problem to study. Numerous economic papers have made seminal contributions in this area. The general conclusion seems clear: pollution hampers growth. The second chapter of my dissertation indicates that the opposite could be the case as well. Measured output might grow because of environmental externalities: pollution decreases the availability of previously free environmental services such as clean air. Households satisfy their demand by purchasing air purifiers. This transaction increases economic activity: GDP goes up. But households need to work more to pay for previously free environmental services: welfare goes down. In many ways, this is a problem of mismeasured welfare. A proper welfare indicator, such as comprehensive or “green” Net National Income (NNI) would decrease in this economy, but I do not argue for scrapping GDP altogether. Economic activity goes up, as it should. Welfare in this model does not keep pace with output because people value the environment and their leisure. Green NNI would go down.

One hopes that this issue has not been studied before because broad empirical investigations deemed the effect negligible, but I am afraid one reason is mathematical tractability. The model is extremely complicated, even by growth theory standards, and leaves much room for future theoretical work. But that is not the highest research priority. Instead, further work ought to investigate this phenomenon empirically. An important approach might be to look at natural experiments or case studies where pollution has sparked the adoption of new products or services to defend against negative environmental impacts. While important as a first pass, it will always be possible to find particular cases where consumer products replaced free environmental services. It would be particularly valuable to demonstrate the relative importance of negative externalities in economic growth by using cross-country or cross-regional growth regression, the tools of empirical growth economists, or engage in a large-scale accounting exercise in an attempt to account for defensive expenditures in national income accounts.

My third paper, joint work with C.-Y. Cynthia Lin, underscores some of the same points of theoretical modeling and empirical investigation. In many ways, this paper has the typical format of an economic paper. (It is also the only one of the three papers that has already been accepted for publication in the Journal of Environmental Economics and Management, the top field journal.) The paper revisits the basic Hotelling model of natural resource extraction, which uses the arbitrage condition to show that the value of natural resources in the ground rises at the rate of interest. The basic model assumes no technological progress, no stock effects, no new discoveries, no demand changes, and no market imperfections. None of these assumptions is realistic. We relax the first two and calibrate the model to fit data from 1970 through 2004. I feel fortunate to have co-authored this paper but am fearful that it taps into the same potential fallacies I highlight in my first two chapters.

The modeling choice was largely driven by mathematical feasibility. The choice of time periods was entirely driven by data availability. Our model – like most others looking at the same phenomenon – is silent as to whether the two theoretical extensions are indeed the most important ones in the list. Putting full faith in the model, one can conclude that technological progress had been a powerful force, keeping resource prices constant over long periods of time. Another equally potent force might have been new discoveries. We acknowledge as much throughout the paper, but by virtue of our model’s focus on technological progress are not able to say much more. The same goes for the empirical analysis. Since 2004, prices for most minerals have increased dramatically, defying our observation that prices have remained constant over long periods of time. Is it because technological progress has suddenly stopped? That is what our model seems to suggest. Or does it relate to a host of other factors including rapid demand increases in China and India, which lay outside of our model?

Economic work on the environment wields enormous influence. My brief experience writing for the editorial board of the Financial Times has shown me how decisions with significant public policy consequences are often based on a single economic study. Striving to have one’s work be as inclusive as possible is not merely an academic exercise. Being able to draw conclusions unbound by data availability and modeling choices should be the starting point, not the end result of good economic research in general. It is all the more important in an area where economists answer questions linked to a system much larger than the one we are used to studying. After all, in the words of Senator Tim Wirth, “the economy is a wholly-owned subsidiary of our environment.”

Full dissertation.

Energy Content of World Trade

noreply@blogger.com (Gernot Wagner) — Wed, 09 May 2007 13:28:00 +0000

Abstract: I construct a comprehensive dataset of oil and total energy embedded in world trade of manufacturing goods for 73 countries from 1978 to 2000. Applying this dataset to debates on the dependency on foreign energy sources makes clear that achieving complete energy independence in the foreseeable future is unlikely to be feasible and may not be desirable. Applying it to the discussion of environmental Kuznets curves (EKCs) highlights an important distinction between production and consumption of energy. Richer countries use relatively less energy in their industrial production yet still consume relatively large amounts of energy indirectly. A further investigation largely excludes structural shifts of production in and out of the manufacturing sector as an explanation for the downward-sloping portion of the EKC. Country-level analyses add caveats but show tentative support for the cross-country conclusions.

Paper, data, and program files.

Green Accounting in a Ramsey Model: Undesirable Growth Fueled by Environmental Degradation

noreply@blogger.com (Gernot Wagner) — Fri, 13 Apr 2007 14:10:00 +0000

Abstract: Green accounting can take on various forms of adjustments to standard output measures. In a Ramsey model it highlights the importance of defensive expenditures and their role in output and welfare calculations. If both labor and environmental quality are included in a standard Ramsey growth model with two kinds of consumption goods, negative externalities increase the steady-state path of per capita output. At the same time, per capita utility – as well as societal welfare – decline. Economy-wide technological progress and population growth further widen this discrepancy between per capita output and utility. Accounting for defensive expenditures in this context enables an accurate description of welfare in that economy.

Full paper

Economics Focus: Bayesian Asset Pricing

noreply@blogger.com (Gernot Wagner) — Wed, 21 Feb 2007 16:24:00 +0000

The less we assume we know, the smaller the asset pricing puzzles

When physicists test their theories against the real world, they are frequently correct to five decimal places after the comma. Economists tend not to be as lucky. Approximating within an order of magnitude is often all they can hope for when applying their theories to the data. However, even that has proven to be elusive in a quest to explain asset pricing phenomena with economic theory.

This inability to match theory with data has given rise to three related failures of neoclassical economics applied to financial markets: the equity premium, the risk-free rate, and the variability mismatch puzzles. Given historic trends, neoclassical theory for plausible risk parameters predicts that stocks ought to pay less than 0.1% more annual return than the safest assets. In reality, equities pay a premium over 6% above short-maturity U.S. treasury bonds – a discrepancy by a factor of more than 60 – much more than an order of magnitude. Reversing the logic, the risk-free rate for bonds is much too low compared to theoretical predictions. Lastly, the observed variability in the stock market is much higher than reasonable expectations about the economy itself. Yet theory says the two should be the same. Worse still is that attempts to solve one puzzle frequently exacerbate at least one of the others.

A defining characteristic of neoclassical economics is its adherence to the frequentist school of statistics. Frequentists believe that there is an underlying, true structure of asset prices. Their distribution is known; only the correct parameters are uncertain. With enough observations, we can approximate the correct mean and variance around it and act as though the parameters are known.

Bayesian statistics provides an alternative school of thought. Bayesians are not only uncertain about the correct parameters; they also do not know the true structure of the problem. Instead of setting out to accumulate massive amounts of data to approximate an unbiased sample, Bayesians rely on appropriate “priors,” pre-existing assumptions. Reverend Thomas Bayes first presented these ideas in eighteenth century England. Frequentists have managed to sideline them for most of their existence, but Bayesian statistics has experienced a renaissance of late, particularly in areas where data are sparse. Bayesians can draw inferences with as little as one data point.

Asset pricing is not an area that comes to mind in the context of paltry data. Hardly any field in economics can rely on as many observations. With decades of publicly available minute-by-minute pricing information from various stock markets around the world, equities are a fertile ground for frequentist statistical study. This abundance of data seems to have been the demise of theoretical economists trying to explain the asset pricing puzzles in the past. Many economists have suspected that Bayesian structural uncertainty may play a role in explaining these puzzles. Now Martin Weitzman, an economist at Harvard, has carried this idea much further. His paper* shows that all three asset pricing puzzles may be reversed when relying solely on Bayesian statistics. Some added mathematical wizardry brings us to a happy middle ground, where the puzzles disappear into the realm of statistical curiosities rather than massive failures of the theory.

Uncertainty is worse than risk

Mr Weitzman’s argument relies on the fundamental difference between risk and uncertainty. Risk refers to the frequentist worldview of unknown outcomes given known distributions. Uncertainty is linked to the Bayesian idea of unknown outcomes and unknown underlying structures. Poker players face risk. The distribution of a deck of cards is known. The risk of the game comes with not knowing the exact outcome of the next draw. Investors, according to Mr Weitzman, face risk and uncertainty. They do not know the exact outcome. More importantly, though, the underlying structure of the distribution is likewise unknown to some degree.

This distinction is not new to economics. It traces back to Frank Knight’s Ph.D. dissertation**. Mr Knight was a towering figure in early twentieth century economic thought. He went on to lead the Economics Department at the University of Chicago for two decades beginning in the 1920s. Most economists would recognize his distinction between risk and uncertainty. Few have known what to do with it.

Compared to the standard normal distribution often assumed by frequentists, a pure Bayesian analysis results in a “Student-t” distribution with significantly thicker tails. Cataclysmic crashes and miraculous price rallies now have a much larger chance of occurring than neoclassical theory allows. By putting a slightly higher probability on these extreme events, the asset pricing puzzles are even reversed. Pure Bayesian theory would predict a larger equity premium than is seen in reality. At the very least, it is no longer clear what puzzle needs to be explained: excessive equity premiums claimed by frequentists or overly modest premiums observed by Bayesians.

[Insert graph here: Student-t, “Bayesian-t learning”, and standard normal distributions shown in one graph, with decreasing thickness of tails.]

Mr Weitzman creates a hybrid dubbed “Bayesian-t learning” distribution with characteristics of both the frequentist and Bayesian approach. In fact, both are special cases of this more general theory. That is always a good way to find acceptance for one’s research. Instead of declaring past approaches wrong, simply sell your own idea as a generalization subsuming previous work. Most importantly, the task for economists now becomes a matter of model calibration to fit the data, rather than searching for the correct model in the first place.

As with every path-breaking piece of research, the question of why nobody has considered this previously remains. In this case, that question is the real puzzle. Economists needed only to take the ubiquitous warning for stock investments seriously: past performance does not guarantee future results. It appears that investors have stuck to that mantra all along.

* “Prior-Sensitive Expectations and Asset-Return Puzzles”. January 2007.

** “Risk, Uncertainty, and Profit”. 1921. Boston, MA: Houghton Mifflin.

Steady-State Growth in a Hotelling Model of Resource Extraction

noreply@blogger.com (Gernot Wagner) — Mon, 11 Dec 2006 22:38:00 +0000

Abstract: This paper re-examines the Hotelling model of optimal depletable resource extraction in light of stock effects and technological progress. We assume functional forms for cost and demand so that the solution to the Hotelling problem is a steady-state consistent with the empirical observation that the growth rates of market prices have remained zero over a long period of time. We use data on 14 minerals from 1970 to 2004 to estimate the supply and demand functions using SUR and 3SLS and to test the model. We validate the model for 8 of 14 minerals.

Paper, data, and program files.

Green accounting instead of Green GDP

noreply@blogger.com (Gernot Wagner) — Sun, 14 May 2006 21:36:00 +0000

Letter to the Editor of the Financial Times

Sir,

Patrick Hubert interprets your article on China scrapping its "green GDP index plan" (May 10) as a potential case of "breaking the thermometer in order to deny the evidence of rising fever" (May 12). I interpret it as a potentially misleading headline.

After quoting a Chinese government official as saying that green GDP is "virtually impossible to calculate", your article goes on to say that China will still pursue green accounting. In other words, China will create a second thermometer measuring the state of its environment -- a set of "environmental satellite accounts" in the green accounting lingo. That should have been done all along. It will provide much more information than one single index number.

Gernot Wagner

Repsol YPF-Kennedy School of Government Fellow in Energy Policy,
Harvard University,
Cambridge, MA 02138, US

'Energy tax' is a non-starter – rebrand it 'price stabilisation'

noreply@blogger.com (Gernot Wagner) — Mon, 06 Feb 2006 13:52:00 +0000

Letter to the Editor, Financial Times, US Edition, p. 14, February 6, 2006.

Sir,

A high oil price is good for the environment, but it does not have to be good "for the totalitarians in Saudi Arabia," as Jacob Weisberg argues ("A Union address that ran on empty", February 2). The solution is simply a variable tax on all crude oil imports aimed to stabilise the final price. Oil price volatility creates a heavy cost for American industry and consumers.

Under the name of an "energy tax", this proposal has been a political non-starter for decades. Re-branding it as a "price stabilisation" measure aimed at lessening our addiction to oil should have something for everybody.

Gernot Wagner

Repsol YPF-Kennedy School of Government Fellow in Energy Policy,
Harvard University,
Cambridge, MA 02138, US

World's Toughest Briefs: Hybrid Cars

noreply@blogger.com (Gernot Wagner) — Sun, 15 Jan 2006 14:44:00 +0000

The Financial Times challenged all creative minds to design an ad campaign to broaden the appeal of hybrid cars. I teamed up with Michael Saji. Here is a sample of our entry.

Hybrids mean freedom from pollution, from high gas bills, from foreign oil. That is common knowledge. Our campaign associates hybrid technology with a new kind of freedom. The freedom associated with SUVs and race cars. "Free to Roam" and "Free to Accelerate" emphasize these aspects. "Free to breathe" shows that the campaign is flexible enough to tie these new-found freedoms back to commonly held believes about hybrid technology. The campaign can be adapted to fit any car company that is currently working on hybrid SUVs, Toyota being only one of many.

Free to Roam

"Next gas, 500 miles." Not a problem if you get 50 miles to the gallon. Even if it is an SUV. Now that I have a hybrid, I'm free to go wherever I please, as far as whim or fancy takes me. And I can take comfort in traffic knowing that.

Free to Accelerate

As I zoom down the tunnel, I enjoy the power of a hybrid V6 engine. People don't realize that with a hybrid, you just get more—more acceleration, more torque, more power, without the poor mileage of a turbocharger. No wonder they're developing hybrid engines for F1 racers.

Free to Breathe

Imagine a world with pollution cut in half. Suddenly your breaths are cleaner, crisper. Freer. Now imagine your cost of gas cut in half. Take a deep breath and enjoy. Hybrid technology gives you both, and much more.

Website launched

noreply@blogger.com (Gernot Wagner) — Mon, 17 Oct 2005 14:06:00 +0000

This website was launched on October 17, 2005. Any weblog entries prior to this day were, in fact, not posted on the date indicated in the time stamp, but sometime over the past three months.

Even now, though, this page is not a typical weblog, with daily musings on the latest chatter in cyberspace. It is rather a place for my writing, which is mostly intended for other media. The weblog format makes it very easy to publish all my pieces in one place and solicit reader comments.

For another experiment to turn the idea of weblogs upside-down, please see my green accounting bibliography, also published in form of a blog.

The Case against Happiness

noreply@blogger.com (Gernot Wagner) — Sat, 13 Aug 2005 02:57:00 +0000

Opinion piece written with fellow Ph.D. student Joe Mazor.

Ask yourself a question: On a scale of one to five, how happy are you?

What did you consider when you assigned yourself a number? According to the latest studies, the average person thinks about family relationships, their financial situation, work, community and friends, and health, in that order - with some thoughts about personal freedom and personal values mixed in. What do we leave out? A comfy bed, three meals a day, central heating, all the creature comforts our mothers kept telling us to be grateful for because somebody somewhere does not have them. We simply take them for granted as the status quo.

Our personal well-being depends on two factors. The first is the daily pleasures that we come to take for granted. This includes not only our creature comforts, but other pleasures - social and mental - which are part of our status quo. Psychologists call this our "adaptation level."

The second is the emotions resulting from the relative comparisons we constantly make to this status quo: what we have relative to what we used to have, what our neighbours have, what we believe we ought to have. When prompted to state their happiness, people focus on the second factor. They do not report the part of well-being that they take for granted.

Confusion around these two factors and how we should measure well-being has sparked a fundamental debate within economics. On one side are traditional economists who focus on consumption as a proxy for well-being. Our spending affords us a certain level of daily pleasures that we quickly get used to. Thus, consumption as measured by gross domestic product (GDP) is an important component of the first factor, the pleasures of the status quo that we take for granted.

On the other side of the debate is a new breed of "happiness economists" who want to wean the economics profession away from an admittedly unhealthy obsession with GDP. They advocate using stated happiness instead as the measure for well-being. Lord Richard Layard's book Happiness: Lessons from a new Science (2005) is only the latest example in this literature. By focusing exclusively on stated happiness, however, they only capture the second component of well-being, emotions associated with comparisons to the status quo.

To understand the distinction between the two components of well-being, think of Lord Layard's central heating, an example he uses in his book. A higher income allowed him to install central heating to keep his house warm. Initially, his well-being increased for two reasons: First, he was happy because this new situation was an improvement over the status quo. Second, he experienced the comfort of his pleasantly warm house.

After many years, Lord Layard has come to take the pleasures of the warmth for granted. Central heating has become part of his status quo, and so no longer makes him happy. Lord Layard clearly recognizes that if we take the heating away, he would be unhappy. What he fails to recognize is that even though his central heating no longer makes him happy, his pleasantly warm house still contributes to his well-being on a daily basis.

A groundbreaking book on well-being edited by psychologist and economics Nobel Laureate Daniel Kahneman formalizes this argument. Even these experiences we are used to contribute to our well-being without adding to our happiness.

It is worth mentioning that not all pleasures are equally easy to adapt to as a warm house. In particular, as Lord Layard recognizes, the pleasures we get from our relationship with family, friends, and God are more complex. Their complexity makes them harder to take for granted. Thus, factors like a good family life can be a continual source of both pleasure and happiness.

If well-being is a combination of our status quo pleasures and our happiness, focusing on either one alone will result in misguided policy. Should we have a higher income tax? If we overlook happiness, as many traditional economists do, we would answer with a resounding no. Higher income taxes create distortions, which lower our GDP. If we overlook the pleasures that we take for granted, as Lord Layard does, the answer is yes. Discouraging work would mean more free time to pursue what truly makes us happy, like a good family life. Since higher income would not make us happier in the long run, nothing is lost.

The truth lies somewhere in the middle. Both the pleasures we take for granted as well as happiness are important to our well-being, and there is often a trade-off between the two. In order to make informed policy such as setting the proper income tax, we need to create a more comprehensive welfare figure than GDP; one that includes both our central heating systems and the quality of our family lives. But we certainly should not abandon GDP altogether and rely on happiness surveys alone.