Hill Heat

From the Wonk Room.

Accusing Massachusetts Institute of Technology economist John Reilly of using “fuzzy math” and “fuzzy logic,” the Weekly Standard has further distorted an MIT study of the economics of carbon regulation. By making an economically unsupportable assumption, Weekly Standard editor John McCormack transforms a $3100 fabrication promulgated by House Republicans into a $3900 fabrication:

While $800 is significantly more than Reilly’s original estimate of $215 (not to mention more than Obama’s middle-class tax cut), it turns out that Reilly is still low-balling the cost of cap and trade by using some fuzzy logic. In reality, cap and trade could cost the average household more than $3,900 per year.

In reality, the energy economist from the Massachusetts Institute of Technology who co-authored the “Assessment of U.S. Cap-and-Trade Proposals” report does a better job of interpreting “reality” than McCormack. It’s McCormack’s logic that is “fuzzy.”

$3100?

The MIT study estimates the average value of the carbon market over a thirty-five year period to be $366 billion per year. If you were to divide that value by the number of households in America, you get $3,128 per household. Asserting that the value of the market is equivalent to the economic cost of the policy – which one has to do to claim that the cost of cap and trade is $3100 per household— requires the assumption that this revenue stream magically disappears somewhere. Reilly attempted to explain this to the Weekly Standard:

It is not really a matter of returning it or not, no matter what happens this revenue gets recycled into the economy some way. In that regard, whether the money is specifically returned to households with a check that says “your share of GHG auction revenue”, used to cut someone’s taxes, used to pay for some government services that provide benefit to the public, or simply used to offset the deficit (therefore meaning lower government debt and lower taxes sometime in the future when that debt comes due) is largely irrelevant in the calculation of the “average” household. Each of those ways of using the revenue has different implications for specific households but the “average” affect is still the same.

For example: Exxon Mobil became the largest corporation in the world by raking in $442.9 billion in revenue in 2008, “costing” the average American household $3,785.

Is the existence of Exxon Mobil a $3,800 tax on American families? No, because most of its revenues are redistributed in the economy—as oil rig employment, petroleum products (which fuel transportation and trade), and of course, multimillion-dollar salaries for its top executives and massive profits for its shareholders.

$3900?

The MIT study of the economic effects of cap and trade did estimate the “welfare cost” of the transition from an unsustainable pollution-based economy to a clean-energy economy. As Reilly explained to McCormack (to no avail), this cost to the economy involves all those actions people have to take to reduce their use of fossil fuels or find ways to use them without releasing [greenhouse gases]>

So that might involve spending money on insulating your home, or buying a more expensive hybrid vehicle to drive, or electric utilities substituting gas (or wind, nuclear, or solar) instead of coal in power generation, or industry investing in more efficient motors or production processes, etc. with all of these things ending up reflected in the costs of good and services in the economy.

The MIT study found that this “welfare cost” is tiny with respect to the size of the economy, even with strong reductions in global warming pollution and a very high price for carbon permits. The change in total welfare is less than one-tenth of one percent in 2015, never rising above two percent for the forty-year run of their model. Averaging out the “price” of a clean-energy economy versus the status quo over those forty years, Reilly found the cost for “the average household just in 2015 is about $80 per family, or $65 if more appropriately stated in present value terms,” and the “present value cost per average current household through 2050” is “about $800.”

McCormack decided to add $3100 to $800 and get $3900, even though Reilly told him one has to assume the carbon market value gets flushed down the toilet:

If you took the revenue and flushed it down the toilet or burned it, the cost would then be the Republican estimate plus the cost I estimate. But that is quite unrealistic, as the auction revenue will be recycled into the economy some way.

Using McCormack’s logic, we could take our $3,800 Exxon Mobil “tax” and then add in, say the $855 per household per year spent on the war in Iraq (given a lowball estimate of $100 billion in total expenditures per year) as the welfare cost of the existence of Exxon Mobil. Adding $3785 to $855 returns a figure of $4640 per average household.

Saying “Exxon Mobil is a $4640 tax” would be silly and intellectually irresponsible. But that’s essentially what McCormack is doing, as is the once-respected Heritage Foundation, who is promoting McCormack’s nonsensical $3900 figure.

THE AVERAGE HOUSEHOLD?

The actual costs and benefits to individual consumers is dependent on how the policy is constructed. As Reilly explained in his April 14 letter, “the burden on lower income households can be offset through the use of auction revenues.” The cost of building a green economy could be paid entirely, in fact, by the richest one percent of the United States, for example – those whose income has nearly tripled in the last thirty years of our pollution-based economy while the bottom 80 percent has seen an increase of only 20 percent.

A cap-and-trade market involves only the corporations who own the power plants, oil refineries, and large factories that are responsible for the covered emissions. Any “cost” for the “average household” can only be derived from a model of how corporations pass costs onto consumers. This is not a simple one-to-one process, as both the House Republicans and McCormack assert. For example, the MIT study found that oil companies enjoy significant economic “rent” – in other words, undeserved profits – because of factors like the inflexibility of production with respect to consumption, the lack of fuel switching in the transportation sector, and the existence of oil cartels. Carbon regulation acts “in effect like a monopsony buyer that extracts some of the producer rent,” substituting the undeserved profits of companies like Exxon Mobil with public revenues.

To calculate the macroeconomic cost of carbon regulation, economists compare a model of the economic status quo with a model that implements the effects of a cap and trade system. As the MIT study warns, pulling out “precise numerical results” from these models is dangerous:

Given the many assumptions that are necessary to model national and global economic systems, the precise numerical results are not as important as the insights to be gained about the general direction of changes in the economy and components of the energy system and about the approximate magnitude of the price and welfare effects to be expected given alternative features of cap-and-trade design.

Reilly’s $800 estimate does not explain how, say, a family earning $36,000 in Toledo would be affected in 2015, or how their electricity or gas bills would change. What this figure does indicate, however, is that the cost of rebuilding our economy to end our dependence on Exxon’s oil and avoid catastrophic global warming is on the order of a dollar a day per person.

THE SAFE STATUS QUO?

The biggest lie of McCormack’s piece, putting aside the deliberate refusal to accept economics 101, comes from the assumption that staying on a pollution-fueled path is cost-free. The MIT study, like other economic models of the cost of new policy, fails to factor in the significant health benefits of reducing fossil-fuel pollution, and most significantly ignores that the level of greenhouse gas emissions in the reference case would lead to catastrophic global warming, with out of control floods, storms, wildfires, droughts, and sea level rise, mass extinction and international insecurity.

Furthermore, no attempt was made to model the economic benefits to either the nation at large or to individuals of the mandate for technological innovation. The shift from a pollution-based economy requires the widescale deployment of modern technologies. The new pathways of economic growth that follow are difficult, if not impossible, to model accurately. The cost of being left behind in the race to develop twenty-first century technologies by clinging to nineteenth-century fuels is similarly difficult to model. So most economists don’t make the attempt.