Carbon Pledges

If Coca-Cola, Apple, and Facebook promised to take a stand on climate change, would you believe them? Would their commitments matter?

President Obama thinks so. On October 19, 81 major U.S. companies, many of whom are multinational, signed the American Business Act on Climate Pledge. The Obama Administration announced the pledge as an important action towards mitigating climate change as well as a step toward successful negotiations at the 2015 Paris Climate Conference this December.

This might feel like progress in the challenge of coordinating reductions of greenhouse gas emissions, but are pledges how we should be addressing climate change? As an economist might ask, what policies actually move society toward reducing emissions at the lowest cost and optimal rate? As a political scientist might chime in, what actions will actually help international climate negotiations arrive at an agreement and inspire greenhouse gas reductions? Do pledges from private business fulfill this dual role? In short, what do the economists and political scientists have to say about pledges?

In this first part of a two-article series, we’ll think about how economists might respond to the pledge announcement.

Economists often think of environmental policy, including climate change policy, in terms of “cost-effectiveness.” If a policy is cost-effective, it will meet a given goal at lowest possible cost. For example, if we decide to limit the amount of greenhouse gases we spew into the atmosphere to the amount that would cause, at most, a 2°C increase in the average global surface temperature, a cost-effective policy would get us to that goal by spending as little as possible. Generally, “market-based” policies can do this.

Market-based policies, such as taxes, subsidies, and tradeable permit systems (including cap-and-trade systems) send signals through a market that incentivize polluters to change their behavior. They induce the entire market (say, power producers in a given region) to meet a specified environmental goal (such as emitting 20% less CO2 per MW of power produced compared to a base year) at lowest cost by incentivizing those who can clean up their pollution cheaply to do the most clean-up.

So, if the U.S. wants climate change policy to make “business sense,” as it is often put, we should use a market-based policy. At first blush, pledges seem attractive because they allow businesses to make the same set of flexible abatement decisions that market-based policies use. Both pledges and market-based policies allow firms to choose: 1) whether they’re going to emit less greenhouse gas, 2) the way they’re going to emit less, if they do, and 3) how much less they’re going to emit than they would otherwise. Under a market based policy, these choices, for all participants, are simply based on the tax or permit price. However, with pledges, there is no way for businesses to automatically coordinate their decisions to ensure that those with the lowest costs of pollution abatement clean up the most.

For example, Goldman Sachs’ American Business Act pledge contained a commitment to use 100% renewable power to meet its global electricity needs by 2020. Similarly, Facebook set a goal to have 50% of its energy come from clean and renewable sources by 2018, with an eventual commitment to have all of its energy from such sources. By the nature of these pledges, companies are both reducing the demand for fossil fuel-fired energy and bearing the cost of subsidizing renewable energy. There is no way for Goldman and Facebook to compare their costs for doing so—unless they decide to get on the phone and talk about these things.

We know then that pledges are not as cost-effective as a tax or cap-and-trade system. Economists would be quick to point out that the pledges just made by businesses are more costly to society than necessary for two additional reasons: they do not involve the companies most able to make cost-minimizing decisions regarding energy generation, the activity largely responsible for greenhouse gas emissions, and they may not be on track with the optimal timing of emissions adjustment.

First, what businesses are best able to make decisions regarding energy generation? Energy generators. That is why economists are generally in favor of “upstream” climate change policy, which puts a price on greenhouse gas emissions for those responsible for producing them.

The idea is that, when power companies feel the price of carbon through taxes or a cap-and-trade system, they make cost-minimizing decisions in response, whether it be through fuel substitution, investment in renewables, or other means. If market-based policies are locked in for these companies with predictable rates or goals for the long-term, they should incentivize these companies to make optimal, business-sense investments in line with climate goals. Note, however, that if there are other objectives in addition to cost-effectiveness, such as reducing health damages from pollutants in specific areas, we might want to consider using other types of policies or modifying the market-based tools.

Now, how do we know the optimal timing of emissions adjustment? Well, it’s a bit complicated. This timing is determined by Integrated Assessment Models (IAMs), described here. The end result of IAMs is that emissions reductions should start modestly and ramp up over time. While economists might be grateful that large companies in the U.S. are recognizing the need to get going on this ramp, they would still insist that governments use the pricing or quantities suggested by the IAMs to incentivize abatement in the energy generation sector.

Thus, climate policy pledges may not make business sense after all. They also may not lead to any reductions in greenhouse gas emissions. Why? The “counterfactual problem”: there’s no way of knowing what these companies would have done had they not made a pledge. And, to boot, even if the companies that pledged climate action do make change, their changes may not translate to reductions in emissions. For example, if Goldman and Facebook decrease their demand for fossil fuel-fired energy and this dip in demand is felt by generators, the price of energy will fall, and other consumers may simply use more energy.

Now that we’ve established that economists would mostly rain on the pledge parade—given that it disregards the most efficient methods, sources, and timing of reducing emissions, we should recognize that economists are keenly aware of the political importance of actions like this. But we’ll save those thoughts for part 2 in this series, which will cover what the political scientists were likely talking about at their water coolers in response to the pledge announcement.

Image courtesy Wkimedia Commons.

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