Sweet sweet rationality

My undergrad was double-honours economics and politics at one of the few places in the world where the economics department sat very far to the left of the politics department. Manitoba was a strange place in the 90s, and it sure wasn't as though a farm kid would have been able to do due diligence about it.

But there were still occasional oddities over in the pols honours seminars. A mature student in our political economy course, on the pols side, really liked to dismiss anything from economics with a slogan: "Economics assumes ceteris paribus, but ceteris is never paribus." I don't know if she just liked saying Latin things to sound clever, but she seemed to think it was a knock-down argument for just about anything in econ. 

It was nonsense in any case. Econ runs comparative statics to see what the isolated effects of a change might be, but then it runs general equilibrium models where everything can move. And comparative statics can be really really useful in tracing out first-order effects. It isn't that we assume that nothing else in the real world moves. 

Anyway. 

Pattrick Smellie over at Business Desk uses a different version of the same argument.

The NZ Initiative, an economic rationalist think-tank, argues that all NZ needs is the Emissions Trading Scheme to spur action. Virtually no one apart from other economists, with their sweetly rational assumptions, believes that. People and industries need active spurs beyond a fluctuating carbon price to act.

Well, the ETS (as tweaked with the usual set of things we've argued for as improvement) is only enough for the covered sector, and we want a carbon dividend to go with it. But let's leave all that aside.

Within the covered sector, do conclusions about the merits of the ETS require a whole pile of strong assumptions about sweet sweet rationality?

It's pretty darned hard to see how. 

Here's my counterfactual scenario which looks nothing like actual-NZ, for sake of argument.

Most New Zealand businesses that don't need to compete in international markets satisfice. They aren't profit-maximising, but instead are kinda cruisy. 

They will make changes when it becomes really important to make changes, but competition in New Zealand is slack-as.

The Overseas Investment Office bans foreign companies from coming in and competing with Kiwi businesses. If they got OIO approval, they'd never get Council consent to set up premises that competed with local lazy well-to-dos who are buddies with everyone on Council anyway. And in lots of sectors, entrants would have to get around regulatory barriers that seem almost designed to protect cosy cruisy incumbents against competition.

All of it means competition is slack-as. Remember when Ikea tried to enter to break up cosiness in furniture retail? And the furniture retailers convinced Auckland Council that Ikea would be too popular so it would be a traffic issue so no consent should be issued and furniture retailer slack-rents should be protected? And how Ikea then didn't even bother setting up in Christchurch after the quakes when there was plenty of land near the airport and everybody was rebuilding? That, across almost everything, almost always. We now have one (1) Costco for 5.1 million people; let us all celebrate our benevolent government for this tiny tiny morsel of newly-allowed competition. Hooray.

In the US, if a business is cruisy and has moats against competition, it doesn't matter as much. There are sharks who will swoop in, buy the company, replace the management, and transform x-inefficiency slack-rents into profits. But if you run securities legislation just-so, you can make sure that hostile takeovers are just too hard. Securities legislation can also ensure that companies have incentive to stay private rather than be listed. 

Because government stifles competition, and because the market is small, talented managers flee the country for places where the vigour of competition plus larger market size means they are far more handsomely rewarded. And we're left with crappier managers who could barely respond to incentives if they wanted to. They just haven't the ability to do it: neither the drive, nor the capacity. Not the ones who are left and who age their way into senior positions while being competitive on the margins that drive appointment rather than the ones that drive profitability. 

Government only auctions a set volume of carbon credits each year in the covered sector.

Suppose that a business, Company X, has a coal-fired boiler that has a decade of life left in it, at which point it's due for replacement. The timing was all set when the thing was purchased, and they put a notification in Outlook reminding them "Look at boiler replacement options in 2030 so we can have a new one in place in 2032." They won't think about replacing that boiler until the Outlook notification pings, because they're slack-as, unless their running costs have absolutely gone through the roof.

Carbon prices have quadrupled since they bought the boiler and set that Outlook notification. And they're expected to double again before that notification pings. When it comes time to replace the boiler, they'll go with a low-carbon option. Given rising carbon prices, it would make sense for them to scrap that boiler today and put in a new one: they'd save money, even though there's life left in the current boiler. 

But they have tons of slack: x-inefficiency everywhere. So they're not going to even think about it until the notification pings, unless they're hitting real problems due to input costs. They have other priorities, and not enough talented managers to handle everything that might make sense in a more competitive environment. 

And suppose most businesses are like this. 

Just suppose that's the case. It certainly isn't; it looks nothing like the New Zealand we all know and love. [There is actually a hell of a lot more going on in decarbonisation than anybody notices, do check out some of the case studies that Energy Resources Aotearoa points to here.]

We're just here trying to give Pattrick the strongest possible case. 

We've made sure, in this little toy verbal model, that nobody is running differential equations in their heads and optimising that way. Not that standard models require that anyway, it's just a stupid caricature of how economists think about rationality. But let's rule it out explicitly. 

Does the ETS fail to work?

Company X buys more carbon credits than it would if it were optimising rather than satisficing. They use more coal for longer than would make sense on a profit-max basis. That pushes up demand for carbon credits in the ETS. The government only auctions off so-many credits. Net emissions are determined by the number of ETS credits auctioned or allocated by government. 

So prices go up.

Prices going up does two things. 

Some folks will try to generate credits through forestry, because trees can suck up carbon very cost-effectively at current ETS prices. But remember: they're slack-as too. They'll also be slow to respond, and will mainly be spurred to do so if they were already at a decision point about land use because some other Outlook notification pinged. But we do get more trees. More carbon credits are then available, but each one of these credits is backed by a tonne of emission removals by trees. Net emissions remain the quantum set by the ETS cap. 

At the same time, there isn't just Company X around. There are lots of other ones. Outlook notifications will be pinging on all kinds of decisions around investments where carbon prices affect long-term costs. 

ETS prices are higher than they would be if Company X had been profit-maximising. Some companies whose notifications aren't pinging will hit trigger points where rising carbon prices force an out-of-sequence decision even if they hadn't wanted to think about it. And on all of the Outlook notifications that are pinging, there won't just be catch-up where firms invest in things that they maybe should have done a year or two ago. There will also be some overinvestment in low-carbon tech by firms who are pulled into making their shift ahead of when they might have, if Company X and others like it hadn't pushed up demand for credits. 

And the quantum of net emissions remains determined by the number of credits issued and allocated by the government. 

All that's then happened is that the cost of adapting to rising carbon prices has risen relative to a first-best profit-maximising world. We get some firms flipping tech later than they would in a first-best world, and potentially some flipping earlier too. That sort of thing affects cost, but not quantity. And it also means that the least irrational firms do best: by being sharp and watching for points at which they should flip, they get a cost advantage over their lazier competitors. 

You can even imagine a limit case where there's no rationality at all around carbon investment decisions and they're all just random. A sequence of bad random decision-draws leads to bankruptcy. Lucky companies make the right investments and don't have to purchase as many expensive carbon credits; unlucky ones make horrible decisions and then either have to purchase far more expensive carbon credits than they might have, or are unable to afford them and go bankrupt. The costs of adjusting to higher carbon prices, in that world, will be very high.

But net emissions are still determined by the number of credits auctioned and allocated by the government. 

The simplest way of thinking about all of this is a game of musical chairs. Ten people circle nine chairs. When the music stops, they could have an auction to decide who misses out, or they could all scramble around to see who finds a chair. An auction, with everyone bidding well, makes sure that the one sitting out is the one who least wants to keep playing. But even if they're all just scrambling around, with many of them utterly confused about what a chair even is, there are still only nine chairs and one person will wind up without one. Anyone not sitting on a chair when the music starts again is out of the game. 

Regulation targeting the covered sector will not affect the quantum of net emissions. If it targets and cost-effectively eases a real additional market failure, it can reduce the cost of reducing net emissions. 

But if you're trying to pull something like EECA's GIDI Fund and encourage companies to bring forward investments in low carbon tech, it just can't reduce net emissions. If EECA has gotten things right, it's encouraged a company to make the flip at a time that makes sense, before the notification pings. It doesn't solve any particular market failure, but it might reduce some x-inefficiency losses. 

And you may have noticed something. We've made an assumption about the bureaus' abilities to spot these opportunities. We assumed at the outset that companies are really slack. If we assume that companies are all stupid and lazy, and that the bureaucrats know better, we've put something of a thumb on the scales. 

Harold Demsetz should be whispering in your ear here, warning you that you need a comparative institutional analysis that has realistic businesses and realistic bureaucracies. You can't just assume that businesses are lazy and need to be prodded by things other than rising carbon prices and then conclude that benevolent and wise officials will make the right calls. The officials we have are ones who'll call it a big win for the climate if they've gotten a company to bring forward a carbon-related investment by a year at the cost of that business pushing back other projects. Surely that should give us pause. 

If you're going to assume that bureaucrats are better motivated and more rational about getting businesses to do what's profitable than those businesses are themselves, because business in NZ is slack, think for a minute about who sets, enforces, and fails to change the sets of rules that result in any business slackness in that purely hypothetical world. 

The best objection I can think of to my position here is that high carbon prices make it harder for the government to reduce the cap more quickly. And that view isn't crazy. But holding that view, without simultaneously arguing for a carbon dividend so that the median voter wants prices to rise faster over the next several years, doesn't seem like clear thinking. It seems like motivated reasoning designed to justify interventions that somebody wants for reasons other than GHG reductions. And it should also be accompanied by a strong requirement that any regs prove themselves to be cost-effective relative to ETS prices. We don't have that either.