Friday, September 30, 2011

Externalities in energy production

OK - today a slightly non-finance post.

There has been much hand wringing recently over the Solyndra Solar scandal in which it is alleged that the solar company received government support without proper controls.  Solyndra filed chapter 11 and is now being investigated by the FBI.

In the same way that I don't think subsidies for agriculture make sense, I don't think that subsidies for certain industries make sense either.  The government shouldn't subsidize solar power.  But it also shouldn't subsidize fossil fuels either.  Turns out that fossil fuel subsidies are a lot larger than the solar subsidies.  A whole lot larger.  This of course, doesn't get Solyndra, its management or the government off the hook in the current scandal.

(graphic from the Environmental Law Institute )

But the Solyndra case is a distraction to the bigger issue.  Even ignoring federal subsidies of fossil fuels, these industries are able to provide low cost energy because they impose negative externalities on other parties.  These externalities are primarily airborne pollution which have a very significant effect on the economy overall.   A recent paper published in the American Economic Review (the very top journal in Economics) finds that the magnitude and costs of these externalities are huge.  If the article is a bit dense, Paul Krugman gives a nice summary of the article.

The solution is to impose a Pigovian Tax - a tax on carbon.  A carbon tax works by raising the cost of carbon fuels towards a point that more accurately reflects their true cost (externalities included).  The key element of such a tax is that it is revenue neutral.  This means that all proceeds are rebated back to tax payers.  The most obvious way of doing this would be to reduce payroll taxes.  Greg Mankiw, the noted Harvard economist, who will admit to being on the opposite side of many debates to Paul Krugman, is a huge fan of a Pigou Tax.

With such a tax in place, and the removal of federal fossil fuel subsidies, the playing field would then be fully leveled for alternative fuels to compete based purely on their merits.