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On Thursday, January 21, James Stock will join Markus’ Academy for a lecture on macroeconomics, carbon pricing, and climate policy. Stock is a Professor of Professor of Political Economy at the Harvard Kennedy School.

Watch the full presentation below and download the slides here. You can also watch the Markus’ Academy webinars on the Princeton BCF YouTube Channel.


Executive Summary

Climate change policies are rapidly changing. For example, on its first day, the Biden Administration rejoined the Paris climate accord, stopped the Keystone XL pipeline, reinstituted the Social Cost of Carbon (SCC), and embarked on a review of the Trump climate rollbacks. This is an opportunity for aggressive climate policy, and economists can help to make sure those aggressive goals are achieved effectively and efficiently. 

Current projections for aggregate CO2 emissions under existing policies show a decrease before ticking back up while missing the Paris target. The reasons for the recent decline in emissions are from reduction in GDP/capita from the financial crisis, decrease in CO2 intensity of energy, and decreasing population growth. The decline in coal use resulted from initial replacement by natural gas and now also by solar and wind.

There exist many challenges for an energy transition. To displace all natural gas and coal with solar and wind, we would need to build hundreds of wind and solar farms every year over the next 15 years. In addition, there are concerns over carbon tax bills regarding  jobs and economy, regressivity, the impact on coal mining and similar sectors, and that such taxes would not produce necessary emission reductions. 

Regarding the macroeconomic effects of carbon tax, standard calculations of the effects of carbon taxes on GDP are done using computable general equilibrium models, which indicate a small decrease in GDP per capita, along with some job displacement effects. The new work here is an empirical analysis of data from 15 European countries that adopted a carbon tax at different points and different levels, and 16 that did not. That analysis finds effects of an increase in the carbon tax on GDP and employment over the first six years of the tax – the years in which one would see the largest reallocation and displacement – that are both economically negligible and statistically insignificant. The EU carbon taxes were on the transportation sector, and there was only a modest effect (2-6% reduction) from a $40/ton tax, consistent with gasoline and diesel demand being inelastic. 

Projections by the US Energy Information Administration and others have shown that a modest carbon tax would help us hit the Obama-era Paris targets by 2025. These big emission reductions arise because a carbon tax increases the marginal cost of production from coal and, to a lesser extent, natural gas, leading to a large amount of substitution to gas and clean generation sources. Thus, the emissions impact of a carbon tax in the US would be substantially larger than in the EU data.. 

Alternative policies to economy-wide carbon tax include: a carbon tax on power sector only, clean electricity standard (CES) — where a certain percentage of electricity has to be from clean (renewable and nuclear) sources — and extending investment and production tax credits. All those require legislation. Regulatory options include regulating emissions under the Clean Air Act and ending the federal coal program.  Stronger state policies, such as strengthening state RPS’s, are also an option, but have very small national impact.

A carbon tax (or a proportional CES) is a key element of effective and efficient climate policy, but it isn’t enough on its own. The energy transition must tackle multiple externalities: the carbon externality, the R&D externality, and others such as the EV/charging station network externality. Each externality needs its own tools, and those tools need to work together. In a static world, a carbon tax only serves to postpone consumption of a finite resource, and will not leave fossil fuels in the ground, as we must. In a dynamic world, a carbon tax buys us time to innovate: to produce new technologies that will be cheaper than fossil fuels. We have seen that this is possible, since new wind and solar are cheaper than new fossil fuel generation in much of the US. We have, however, a very mixed track record on federal programs producing low-cost new technologies. Good economic research on those programs is badly needed, as it is on other climate policy tools that potentially dovetail with a carbon tax, such as supply side policies. Finally, there are important details to get right to allow market forces to respond to price signals, such as overcoming hurdles to transmission siting, installing EV charging infrastructure to help us jump from the internal combustion engine equilibrium to the EV equilibrium, allowing power demand management, and other weedy put important policies.