Thursday, August 12, 2010

On Carbon Taxes Spurring Innovation

A few days ago, Megan McArdle wrote this:
responding to Ryan Avent:
who was responding to Jim Manzi:
Jim Manzi argues that carbon taxes aren't likely to solve our climate problems, and we need innovation more directly, while Avent and McArdle argue that a carbon tax (or equivalent cap-and-trade or fuel taxes, etc) can be what stimulates innovation.
Both sides make thoughtful arguments, but there's a structural problem involved that I've mentioned before but is worth rehashing.
This is a problem with three dimensions: Supply-side (how our energy is sourced), distribution (how our energy gets from source to end-user), and demand (how our energy is used).
Demand-side solutions like carbon taxes and cap and trade a) have big negative economic shocks, b) don't necessarily reduce carbon use because energy-intensive production shifts (a la Reliant moving steel factories from Britain to India, or even simply production of British goods decreasing and Chinese goods increasing - McArdle makes this latter point wonderfully), and c) are not, by themselves, permanent solutions, because we still haven't changed how energy is sourced.
In a two-dimensional process (supply and demand), demand-side programs would, by necessity, feed back into the supply side and give incentive for innovation.
The problem is that nasty distribution step can obfuscate or even remove the price-feedback effect due to both technical limitations and fixed cost investments with unsubsidized positive externalities.
To be more specific, two major areas that need upgrading are a smart grid (i've seen cost estimates at $1.5 Trillion to get the grid renewed over 20 years) and a system of battery-charging stations to help us transition away from gasoline-based motor vehicles.
Current infrastructure severely limits how much innovative energy can come in on the supply side because there's no distribution. A plug-in car would have to significantly outperform a gasoline-based car in order to even be considered for purchase by consumers, because the gasoline infrastructure is so well-developed and battery charging, right now, is very, very inconvenient.
Furthermore, the demand-side sees distribution costs as part of their end costs, so a weak distribution system functionally serves as the anti-carbon tax by increasing the cost of innovative energy.
Thus, the economic effects of a carbon tax (increasing the relative cost of dirty energy) and equivalent infrastructure improvement (decreasing the relative cost of innovative energy, which can now be delivered on equal terms), should be equal in terms of shifting consumption, but the latter drives economic development (as opposed to the former, which slows it down).
The problem, of course, is that a smart grid and battery charging stations have such high positive externalities that without significant subsidy, they don't get built because the builder sees too few of the gains.
For whatever fixed sum we have to spend on energy, isn't it counterproductive to be arguing about carbon taxes/cap-and-trade and targeted technological grants when the very obvious, potentially productive, and massive distribution investment exists? Carbon taxes and cap-and-trade have nasty second-order effects on the economy and are subject to some political favoritism, and targeted technological grants are subject to significant political favoritism. Building out infrastructure functionally lowers the price of innovative energy sources without actually having to pick the winners.
Furthermore, by reducing distribution problems, you actually do stimulate innovation on the supply-side (because some things are feasible that aren't anymore, either technologically or cost-effectively), which often leads to a virtuous cycle - a learning-by-doing situation in which we eventually develop energy sources that are efficient enough to export to developing countries that don't have the infrastructure we would have developed.
Think structurally, people! Instead of worrying about cap-and-trade, why not subsidies for battery-charging and smart gridding?

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