Monday, July 23, 2007

Subsidizing Renewable Energy

As a pseudo candidate for the U.S. Hosue of Representatives, I am here today to announce my policy regarding renewable energy.

Before going into policy details, however, I want to set the context for this presentation.

First, as a pseudo candidate, I am blessed with the liberty that I do not have to announce a policy that will actually muster a majority of the votes in the House and Senate and be passed into law. Rather, I get to propose a policy that should earn a majority of the votes and be passed into law. The objection that my proposal could not pass because certain special interest groups would block it, in this context, implies only that those special interest groups are engaging in immoral practices – imposing suffering on others for their own benefit.

For similar reasons, it is not an objection against this policy that, if I was actually running for Congress, that this policy could not get me elected. I’m not going to be elected anyway. However, this is not an objection to the conclusion that this is the type of policy that moral and rational voters should support.

So, now, let me get into the details of my policy.

(1) I shall not support any subsidies for renewable energy – solar, wind, hydroelectric, geothermal, wave, biodiesel, ethanol, any of them.

This stand is not based on believing in some sort of pure capitalism ideal where subsidies are never permissible. Instead, there are particular types of situations that call for the use of a subsidy, and certain types of situations that do not. Renewable energy is one instance where subsidies do more harm than good.

The type of situation where we should use subsidies is a situation that generates economic free riders and there is no other cost-effect method for dealing with the free-rider problem.

A ‘free rider’ is a person who obtains a benefit from some activity without paying for it.

Standard examples of where activities generate free ridership include national defense. If national defense depended on voluntary contributions, we can expect that somebody living in the middle of Kansas to conclude that his home will be protected if any of the homes near his will be protected. He does not have to pay anything; he can obtain the benefits of protection as a free rider. Even if he does decide to contribute, his contribution will not make a significant difference.

The courts and legal system also produce free riders. The benefits of apprehending and confining a serial rapists are to be had by anybody who would become a future victim of that individual, or anybody who cares for somebody who would become a future victim. In this case, we cannot even identify who the greatest beneficiaries are, let alone ask them for payment.

The education system generates free riders that warrant government subsidies. Yes, it is true, that a person with a higher level of education can expect greater income. However, the benefits to society of being surrounded by educated people – particularly educated people who vote – far exceeds what the individual will obtain in terms of increased salary. Those who obtain these secondary benefits of having an educated population without paying for those benefits are ‘free riders’.

The idea in all of these cases is to have the free riders pay something, which can then be used to support the institution (military, courts, education) that they benefit from but otherwise would not contribute to.

Renewable energy does not fit this criterion. Renewable energy has no free riders.

The response here may be to say that everybody benefits from a cleaner environment, and there would be a whole lot of ‘free riders’ who would benefit by our attempts to avoid global warming.

However, these environmental and climatological effects are not ‘positive externalities’ generated from the use of renewable energy. They identify the negative externalities of using fossil fuels. The proper response to this type of situation is not to subsidize renewable energy, but to institute a pigelian tax against those activities that contribute to environmental damage and climate change.

Let us look at what happens when we use a subsidy rather than a pigelian tax.

We have an industry where those who consume a product pay, in our example, $3.00 per unit to consume that product. In doing so, the product generates another $2.00 per unit in costs on others – costs borne by those who suffer the effects of pollution used in creating or consuming that product. However, those victims of negative externalities are forced to pay this cost out of their own pockets. The person paying the $3.00 per unit only has to cover the costs the manufacturer passes on to the purchaser. It does not cover the costs that are not passed on, that are borne instead by the victims of these negative externalities.

If the consumers were required to pay the full cost, then they would be paying $5.00 per unit.

Let us assume that there is a use for the product that is worth $4.00 per unit to an individual. He would not use the product in this way if he had to pay $5.00. Because of the negative externalities, he is using the product in a way that realizes $4.00 worth of social benefit, but which inflicts $5.00 worth of social costs. Society would be better off if he did not use the product in these circumstances. However, he uses the product anyway because he only pays $3.00, and using the product provides him with $1.00 worth of benefit.

Now, we introduce a product that has a $4.50 social cost, but all of those costs are passed on to the consumer. So, now the consumer has a choice between paying $3.00 for a product that produces $5.00 in social costs - $2,00 of which are borne by the victims of negative externalities. Or he can pay $4.50 worth of costs for a product that produces $4.50 in social costs, but no negative externalities.

We have two policy proposals before us.

One is to impose a $2.00 pigovian tax on the first product – forcing the consumer to cover the entire social costs of his purchase.

The second option is to subsidize the second option. Here, the government says, “You cover $3.00 worth of costs for this new product, and we will cover the additional $1.50.”

Now, again, look at the optional use that produces $4.00 worth of social benefit. Because we have used a subsidy, the consumer has a choice between paying $3.00 for either the product with the $2.00 in externalities, or pay $3.00 where the government will cover the remaining $1.50 in tax revenue. In this case, we still have consumers engaging in activities that produce more social cost than benefit.

On the other hand, if we use the piqovian tax, the consumer has the option of paying $4.50 for a unit of the unsubsidized Product B, or the full $5.00 social cost of Product A. Since he obtains only $4.00 worth of benefit, he does not engage in the activity at all.

Now, at this point a bunch of Republican politicians will likely stand up and shout that, because we have prevented $4.00 worth of activity, that this is bad for the economy.

That is false. Not only is it false, but it is one of those maliciously deceptive pieces of propaganda used by people who want to get away with harming others for their own benefit. What is ‘bad for the economy’ is having people pay $3.00 to obtain $4.00 worth of benefit from an activity that inflicts $4.50 or $5.00 worth of costs on others. The social cost is still greater than the social benefit. Overall, the activity makes people worse off. Overall, the claim that cutting off this activity is bad for the economy is at best an intellectually reckless claim, and is probably most commonly an outright lie.

Now, having said all of this, even though subsidizing renewable energy is not a good option, it is also not the worst. As your pseudo representative in Washington I would try first for a carbon tax so that the price of using fossil fuels more accurately reflects their true costs. Failing that, there is some merit for moving society from an activity that generates $2.00 worth of externalities on the poorest people in the world, to an activity that generates $1.50 worth of additional costs born substantially by the American taxpayers (who, we may assume, can afford the cost far better than the African desert-dweller or the poor family living in the river deltas in South East Asia whose land will be consumed by sea-level rise).

Now, obviously, there is some risk involved. We do not know what the actual costs would be. Again, it makes no sense to argue, “We do not know what the full costs will be; therefore, the victims have to suffer those costs.” This would be as absurd as arguing that we do not know how much damage you will inflict on others from your next automobile accident, so the victim of that accident will be required to suffer the cost. Or, worse yet, we do not know how much money you will take in your next armed robbery, so armed robbery should not be illegal. The fact that we do not know what the costs will be does not argue that the victims are responsible for coving those costs. It is still the duty of those who do harm to compensate the victims for the harm done.

So, as your phantom representative I could be coerced into supporting a subsidy. If it appears that the fossil fuel companies are capable of preserving its ‘right’ to impose death, disease, destruction of property, and other costs on others for the sake of profits, I may be forced to support subsidies for renewable energy as a way of reducing those costs and shifting them to those more able to pay. However, I will not pretend that it is a good thing. I will not stand before an audience and tell them that this is a great plan. I will only tell them that this is not the worst plan. The worst plan is what we would get if I did not vote for these subsidies.

2 comments:

ADHR said...

Alonzo,

If we accept the principle that subsidies are only justifiable in order to solve free-rider problems, then it seems you are correct that the presence of a positive externality is necessary for subsidies. (It's not sufficient, of course, but it is necessary.) When it comes to issues of climate change, though, there are obvious positive externalities. Reduced emissions, for example, are a positive externality: they are a benefit which can be enjoyed by those who contribute nothing to them. They are a benefit because of the known costs associated with increased emissions -- climate change, air and water pollution, respiratory ailments, and so on. Free-riders are produced, though, because while some members of high-emissions industries may reduce their emissions, thus incurring greater costs, others may not and thus free-ride on the benefits of reduced emissions.

(I note in passing that there's a looming prisoner's dilemma here, as the best outcome for everyone is not the rationally best outcome for each individual. This sort of collective action problem could provide a ground for subsidies that differs from the one you're considering here.)

One might want to claim reduced emissions are the lack of a negative externality, but given that emissions (and associated penalties) are continuing to rise, reducing emissions clearly generates a benefit relative to other possible outcomes. I don't see any in principle reason, though, for denying that someone can free-ride on a reduced negative externality just as easily as on a positive externality.

The problem for your argument is that there are obvious connections between renewable energy sources and reduced emissions (with the possible exception of ethanol). Wind, solar, hydro, geothermal, et al generate fewer emissions than current petroleum, coal and gas technologies. Fewer emissions are a positive externality. By your principle, if there is a positive externality, then subsidies are justified.

Personally, I think you're overlooking a third option, in addition to taxes and subsidies, which is to institute a cap on emissions (which could be extended to other social burdens as well) that industries must either meet or trade allowances with each other in order to meet. Then, generally, industries will meet the cap, even though particular companies may be well under the cap while others are well over. This solution will also internalize social costs, and it does so in a way that doesn't bear the administrative burdens of a tax (and, for that matter, a subsidy) and also places the cost directly on the heads of those who create it.

daniel said...

Fantastic info...I have been very interested in geothermal energy as of late, especially after Gov. Schwarzenegger formed a bill into law that set a CO2 limit on coal plants as a future source of electricity in the West Coast market. This is a good (early) time for geothermal energy production.

I would also recommend this report to everyone...

Geothermal Energy Special Report

-Cheers!