The Power of Prices

In his new book, Adapt, economic journalist Tim Harford tells the story of ‘Geoff’, a man who is determined to reduce his carbon emissions. As he goes through his day, Harford shows Geoff making a series of well-intentioned mistakes: going out of his way to wash his dishes by hand rather than use the dishwasher (Harford argues that the dishwasher has a smaller carbon footprint), but then choosing to tumble-dry rather than line-dry his clothes (which uses significantly more carbon). Geoff buys energy-efficient lightbulbs, but then decides not to install them until his existing ones pop (which will cost him more). He switches off his mobile phone charger, but leaves his desktop computer on standby (Harford tell us that the computer uses 100 times as much energy).

The point of Harford’s story is that solving climate change through personal action alone is hard. Even if we had a sophisticated computer program that could tell us the carbon intensity of a particular decision, how many of us would bother to check it?

Thankfully, there’s a simpler solution. The effect of putting a price on carbon is to change prices so that they reflect the carbon emissions embodied in them. Under a carbon price, an environmentalist doesn’t have to know precisely how a product was made – you just need to look at the price tag. By modestly changing prices (overall price impacts will be just 0.7 percent), carbon prices will change consumption patterns. As any marketer can tell you, customers already flock to cheaper brands. With a carbon price, there will be an incentive to choose the low-carbon option.

This incentive will exist for both firms and households. For firms, carbon pricing will encourage them to think hard about how they can reduce emissions. A recent Economist article gave the example of the potato chip firm Walkers, which discovered its carbon footprint was unexpectedly high.

‘It turned out that because Walkers was buying its potatoes by gross weight, farmers were keeping their potatoes in humidified sheds to increase the water content. Walkers then had to fry the sliced potatoes for longer to drive out the extra moisture. By switching to buying potatoes by dry weight, Walkers could reduce frying time by 10% and farmers could avoid the cost of humidification. Both measures saved money and energy and reduced the carbon footprint of the final product.’

With carbon pricing, we can expect to see simple changes like this taking place inside each of the 500 large polluters, as managers and workers look together for ways to reduce emissions. The better companies succeed, the more that business assistance can be used to grow the firm and increase employment.

Changing prices and providing assistance is the Labor way of achieving reform. As Paul Keating pointed out on Lateline, this is precisely why we floated the dollar. But it’s also a simple description of trade liberalisation (which reduced prices of imported vehicles and clothing, and provided industry assistance for textile and car workers), as well as the Accord itself (which kept real wages constant in exchange for improvements in the social safety net).

Unlike previous Liberal Party leaders – and conservative leaders in Britain and New Zealand – Tony Abbott refuses to accept that the market can be used to solve environmental problems. (Perhaps this suspicion of markets isn’t so surprising from a self-confessed admirer of the late BA Santamaria.) What Mr Abbott fails to realise is that a government that won’t use price signals has to fall back on heavy-handed alternatives like regulation, mandates and bans. That’s why the Coalition’s ‘Direct Action’ plan is so much more expensive – and less effective – than the Gillard Government’s Clean Energy Future approach. We’re now in the ‘Bizarro World’ in which Tony Abbott is the proponent of highly interventionist solutions, while Labor favours the market-based approach of pricing carbon.

Little wonder that a poll of members of the Economic Society of Australia, released at last week’s Australian Conference of Economists, found that 79 percent agreed with carbon pricing, while only 12 percent supported direct regulation. When it comes to reducing carbon pollution, a carbon price is the only sensible way to go.

(Cross-posted at the ALP blog)

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