The Economic Costs of Kyoto: Straw Men and One-Sided Assumptions

A number of key critical points on the federal government’s “analysis” of the economic impacts of Kyoto –
http://www.ec.gc.ca/doc/media/m_123/toc_eng.html – have already been made, including by Erin.

http://progecon.wordpress.com/2007/04/20/inconvenient-truth/
A lot hinges on whether continued adherence to the protocol means that very large cuts have to be made to domestic emissions in a very short period of time – a key assumption of the study – or whether bona fide international credits can be purchased at reasonable prices. Also, we don’t absolutely have to meet our Kyoto commitment if we are prepared to undertake deeper emission cuts down the road, and it seems reasonable to think that other countries will cut us some slack if we make a serious start on a serious plan.

My view is that we should not abandon the Kyoto commitment – which is the logical but unstated conclusion of the government report. It is, after all, the only global framework we have to deal with the most pressing global issue of our times.

That said, as people like Mike McCracken from Informetrica have argued, it is hard for a reasonable economist to think that we could quickly and painlessly reach anything near a Kyoto-consistent domestic emissions level at no or even modest economic cost given years of Liberal inaction. To achieve a 6% reduction from 1990 greenhouse gas emission levels in 2008-2012 , current emission levels would have to be cut by about one third, starting next year.

The government study assumes – probably wrongly, but I’m no expert here – that three quarters of the emission reduction will have to be achieved domestically, and it models the impacts of achieving this target through a very high ($195 per tonne) carbon tax (hugely higher than the $30 per tonne level most frequently advocated by climate change activists.) This per tonne figure is derived from a Government of Canada “energy-technology” model, though how and why it was calculated at this very high level is not disclosed. (Note all that is publicly avaiable is a 29 page summary of the study.)

In effect, the study models the impact of a huge increase in primary energy costs (the carbon tax would raise $105 Billion per year) on the Canadian economy, using the TIM econometric model.

If you restrict yourself to this framework of assumptions, the model tells you that the hit to GDP is about 7% (6.7% in 2008 and 7.2% in 2009, and 276,000 lost jobs. One implication of that number, even taken at face-value, is that the economic impacts of the $30 or so per tonne carbon tax actually proposed by climate change activists would be quite modest, but this is un-stated for obvious reasons.

The hit to GDP, according to the study, would be concentrated on the most energy-intensive sectors of the economy, especially the tar sands. Oil production would fall by 30% as current operations became uncompetitive even at currently very high oil prices. Rather than force investment in new technology such as carbon capture and storage, the tar sands expansion would basically be halted. Natural gas net exports would also fall. Other industries would face big increases in electricity and natural gas input prices, as would consumers and commercial businesses. Natural gas prices are calculated to double, and electricity prices calculated to increase by about 50%.

To the best of my knowledge, climate change activists have never advocated a carbon tax at a level which would stop the tar sands in their tracks and devalue past investment, as opposed to a tax that would be calibrated in such a way as to slow expansion and force investment in greenhouse gas reduction measures. So, as widely noted, the government study is attacking a “straw man.”

However, even the summary of the study acknowledges that the hit to GDP and employment headlined by Baird and his media spinners is misleadingly high. This is because the study does not take into account the offsetting impacts of macro-economic policies. As stated explicitly “(t)his analysis does not account for a monetary policy and nominal exchange rate response that would be expected to mitigate some of this loss.. ” (p.18) Instead, the headline numbers cited to induce fear of huge economic dislocation assume that the exchange rate and the interest rate remain unchanged despite the carbon tax shock, and also that there is no fiscal policy response.

A plausible alternative monetary policy secenario is that a big hit to energy exports would depress the exchange rate of the Canadian dollar against US and other currencies, probably very sharply. Recent dollar appreciation has, after all, been driven mainly by high energy and other commodity prices. To the extent that this was true, the economic hit to the primary energy sector itself would be lessened, and there would be positive impacts on non energy based manufacturing sectors. Sectors like auto, aerospace and machinery and equipment manufacturing would probably benefit, since energy input costs are not large while the exchange rate is key to their to international cost competitiveness. At a minimum, there would be a major offset to energy cost increases for our hard-hit manufacturing sector.

In an alternative scenario, the Bank of Canada might not maintain interest rates unchanged as the economy was hit by a big economic shock. To be sure, consumer price inflation would rise, but the Bank could view this as a temporary transitional issue and feel the need to bring the economy back to its full production potential by stimulating domestic consumption and investment outside the primary energy sector.

Further, the study assumes that there would be no fiscal policy response to the economic shock. To be sure, carbon tax revenues would be recycled in the form of personal and corporate income tax cuts, but only after government fiscal balances were insulated from the economic shock. In practice, governments could lower surpluses or run deficits to offset a sharp increase in energy prices, rather than take up fully one third of the carbon tax revenues to maintain their fiscal positions as thr study assumes.

In short, this economic study sets up a straw-man and, even within the framework of its own logic, it sets out a worst-case macro-economic scenario. Read carefully, a possible conclusion is that there would be rather little economic cost from a more reasonable carbon tax which re-balanced our economy away from the primary energy sector and highly carbon intensive activities.