Carbon Tax and the Theory of Second Best

Paul Krugman wrote yesterday that a carbon tax would be an ideal “economics 101” policy solution to correct for the externality of carbon emissions. Krugman argues that, despite a carbon tax being the most efficient solution, “second-best” approaches that are less efficient will be the likely outcome. This need to settle for second best is due to political intransigence in Congress. Krugman’s assessment of the politics sadly may be correct, but his analysis of the policies leaves out important details.

First, Krugman says that policies like fuel economy standards and net-metering are inefficient compared to a clean and clear carbon tax. A fuel standard is inefficient in the pure economics sense because the government dictates the outcome, rather than allowing the market to determine the most efficient level of emissions reductions (as theoretically happens with a carbon tax). But net-metering is not at all like a fuel standard. Net-metering, the policy of mandating utilities to buy solar power generated on rooftops, actually opens up and expands electricity markets. Net-metering can be viewed as an extension of the electricity market deregulation of recent decades. Net-metering allows anybody that can produce power to sell it into the grid. Yes, the price the utility pays for that power is important and is worth debating, But there is no debate on the notion that open access to markets is a good thing and actually increases market efficiency.

Krugman’s second point worth closer examination is his assumption about investment. Krugman says that creating a carbon tax will send a clear signal to investors of where they should now invest, eliminating the need for subsidies or loan guarantees for clean energy. While a carbon tax itself might be clear, the outcomes and new market realities produced by that carbon tax would be incredibly challenging to predict. Yes, a carbon tax will increase the price of carbon-based electricity, but by how much? Is it enough to make clean electricity cheaper than the carbon-based electricity? This change in market prices will play out in an incredibly complex and perhaps unpredictable way in every single power market in the country. This tremendous uncertainty will likely slow investment in carbon-based power, but it will not immediately drive investors to clean energy alternatives. More likely, investors will see looming uncertainty in power prices and hold their money on the sidelines until markets stabilize under the new carbon tax. In the meantime, clean energy alternatives that warrant investment will be left waiting.

A carbon tax is indeed a clear and crisp policy tool that comes straight out of “economics 101.” But the reality of how that tax may play out is far harder to predict. Green Banks, publicly-capitalized financing entities that offer low-cost and long-term capital for clean energy, must be created to fill the clean energy financing gap. Green Banks can ensure that clean energy technology is deployed where it is economically viable, and that uncertainty around subsidies and tax policy does not sink clean energy markets just as they are about to take off.

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