Mispriced CO2 — the great big subsidy and the unbalanced, overheating global economy

People respond to incentives.  For the economy, the most important incentives are prices.  The marvellous thing about a market based economy is the ability of prices to adjust in a way that induces us to behave in a way that elevates our societies from chaos into orderly, well functioning economies that produce wealth and a high quality of life.  This self-organising nature of the economy and the role that prices pay is an amazing thing that we take for granted.

But prices aren’t always right. There are some prices that markets can’t set properly. Carbon dioxide is possibly the most important example of a price that is not properly set by markets. The reason that CO2 is mispriced is simple: it is almost impossible to prevent people from producing it, so businesses, big and small, and households, rich and poor, treat it as free.  Its effectively a great big subsidy to the production of CO2.  Everyone therefore produces too much carbon dioxide – way more than what would be produced if the rest of the world could refuse to accept it (unless induced to do so by a payment that appropriately compensates them for the negative side effects that the emitter imposes).  This problem is well-known to economists as the tragedy of the commons, and TH fears that future generations will look back at today’s and say that it was the greatest tragedy to ever affect planet earth.

Because the production of carbon dioxide is treated as free, those industries that use carbon intensively have become too big.  And since they draw resources (labour and capital) away from other sectors of the economy, the zero price on carbon has encouraged other sectors of the economy to become too small.  So not only has cheap carbon dioxide led to too much CO2 in the atmosphere and fueled an unexpected type of economic overheating in the form of global warming, it has also distorted the global economy making it unbalanced.

To get an idea of which sectors have become overweight on CO2  and which sectors have been crowded out, you need to know which goods emit carbon dioxide most intensively in production.  TH poked around a bit and found some data for the United States (http://www.esa.doc.gov/Reports/u.s.-carbon-dioxide).  For a variety of reasons, carbon dioxide intensities would be a bit different for a country like Australia, but the data is good and comprehensive and it should give you a reasonable idea.

The following Chart ranks industries from low CO2 intensity to high.  There are no real surprises here.  The industries which use carbon dioxide most intensively in production are often in the mining sector —  iron ore mining, gold mining and coal mining are all big culprits (7 to  8 metric tonnes of CO2 per thousand dollars of output). Part of the reason that mining sectors get high scores could be technical – to measure intensity you look at the amount of CO2 per dollar’s worth of output.  Since inflation causes the dollar value of stuff to grow over time, the calculated CO2 intensity tends to decline over time.  To control for the inflation effect, the US Economics and Statistics Administration picked a year (2000) as a base year and measures the value of output using prices from that year in every year.  It just so happens that 2000 was a bad year for commodity prices.  If they used 2013, the story would probably be a bit different with the commodity producing sectors not looking so bad.

Other sectors that are CO2 intensive include the cement industry (cement is among the most intensive, producing around 12 metric tonnes of CO2 per $1000 of output using prices from the year 2000), metal production (producing between 1mt/$1000 and 3.5mt/$1000 for steel and aluminium respectively) and transportation (at 4mt/$1000, water transportation is particularly bad, worse that air transportation which produces almost 2mt/$1000 of output).   As you may expect manufacturing is worse than services. On average, manufacturing has a CO2 intensity of about 0.9 mt per $1000 of output compared to services (excluding transportation), which use less than 0.3 mt/$1000 (employment services, management consulting, sound recording, environmental, architectural and legal services all produce less than 0.15 mt of CO2 per $1000 of output).  Health care is low in CO2 too. As is movie production and banking.  Grain farming is somewhere in the lower to middle range.



So what can we learn from all this?  Well the last 20 years has seen some pretty drastic changes to the world economy.  Check out this graph from Arvind Subramanian and Martin Kessler’ neat blog post (http://www.piie.com/blogs/realtime/?p=3777 with links to their paper).  Look at what they call the period of hyperglobalisation in world trade, which saw global trade increase from around 20% to 30% of world GDP in about a decade starting in the mid 1990’s.  As you can see, merchandise trade (i.e. trade in CO2 intensive manufactured goods and commodities) accounted for nearly all of this increase, while services trade has increased slightly around the 5 percent of world trade mark).  And all this merchandise has to be shipped — mostly by sea.

At the same time, the process of industrialisation has promoted a rapid increase in the rate of urbanisation (the share of the world’s population living in cities has increased from less than 40 percent in the mid 1990’s to over 50 percent today).  Like manufacturing and transportation, urbanisation and the construction that goes with it is somewhat CO2 intensive.  It is not clear how much extra CO2 production, if any, has happened because of the effects of trade, but it seems intuitive that trade has contributed to increased manufacturing output and therefore increased CO2 production.



Source: Arvind Subramanian and Martin Kessler (http://www.piie.com/blogs/realtime/?p=3777)

It is almost impossible to say definitively that these changes have been due to free CO2, even in part.  But we can say that they wouldn’t have been quite so dramatic if CO2 emissions were constrained by the true cost of producing it.  International merchandise trade requires water transportation, merchandise must be manufactured, urbanisation – requires construction and infrastructure, which in turn requires cement and steel, steel requires iron ore.

It is also possible that because of the principle of comparative advantage, the hyperglobalisation of trade has helped production of CO2 intensive goods to shift to places that specialise in the manufacture of these types of goods.  Similarly, comparative advantage can help encourage specialisation in low emission industries. For example, using the US emissions data, which tells us not only about the emissions by growth in each of the 349 sectors that they collected data on, you can calculate that over the decade from 1996 to 2006, US manufacturing industries in the survey grew just 3 percent while services expanded by 24 percent. This no doubt reflects service biased technological advancement and factors such as population aging in the US, but trade could also have something to do with it.  Tradeable services like banking and management consulting expanded by 45 percent and 109 percent respectively, such as photographic equipment declined by 50% and printing machinery by 25%. This process can shift CO2 emission to rapidly manufacturing driven countries such as China (Australia for commodities), and free up resources for less CO2 intensive sectors in countries that import those goods (such as the US).

There are two points to be made on this.  First, if you look at data for a country such as the US, you find that CO2 per unit of GDP is falling.  But this is not necessarily reassuring.  It partly reflects that sectors that were high emitters of CO2 have shifted offshore and allowed low emitting industries to grow.  This process just shifts the emission of CO2 from one place to another. The second point is that the problem is not trade per se. Since comparative advantage is determined by the price of inputs into the production process, the freeness of CO2 has affected the location decision for these industries.  The problem is the effective subsidy to CO2.

The freeness of carbon is reshaping the global economy in a way that not only causes too much CO2 production and global warming, but encourages the production of too few goods such as health care, education, arts and entertainment, and too much stuff like cheap plastic toys. It also encourages firms to shift production to places to reduce cost pressures based on the wrong signal about costs, and ship those goods at effectively subsidised prices.

The solution to all these problems is to properly price carbon dioxide.


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