Monday, June 27, 2011

Incentivization, Externality Pricing and Coasian Economics

Debate over the method to tackle environmental issues has been under debate since the eighteenth century, when Adam Smith came out with the Bible of Capitalism "The Wealth of Nations" whereby he argued an absolute free hand to markets with the firm belief that the markets will find the solution to every problem. This can be argued to be a novel position with respect to environmental issues, as till then laws were passed in England for curbing pollution (or at least the visual aspects of it). Though Marx and Engels did believe in the absolute control of the State, a middle path alternative to incentives and State control really turned up in the nineteen twenties, with A.L. Pigou coming out with arguably the Socialis't Holy Book, "The Economics of Welfare". He argued consistently for both aspects, saying that while it is okay for enterprises to make profits, to tackle problems arising due to industrial activities, profits must be taxed and the monies turned around to health welfare and pollution clean up activities. While the argument has been supported strongly by influential thinkers like Amory Lovins and Paul Hawken, and has seen considerable success in the case of Denmark's energy policy on the carbon tax front (I talked about it here) there are adequate concerns of breeding corruption and nepotism that tend to arise due to such arrangements as well as the reluctance to cut down on profits while inviting too much 'interference' from the government.

A position that heavily relied on the Adam Smith argument of market being the best way was put forward by Ronald Coase as an alternative to Pigou's taxation ideas in the nineteen thirties, and said that if trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. This argument clearly supported by people like Milton Friedman in recent times, believes that incentives come out of the market's own operations if the externalities that arise are tradeable in nature. This has been the foundation for most cap-and-trade scheme that ultimately pose faith in the market's ability to rectify its shortcomings, particularly the Emissions Trading schemes for acid rain gases and the greenhouse gases. While the idea does appeal to business heads and corporate honchos as it gives them an incentive in reducing their externalities by helping them benefit from actions that are 'good', there are numerous cases where such benefits go to people who do not need it at all. A classic case is that of the HCFC gas flaring being a project eligible for carbon credits, even though it was well known that these gases would in any case have to be phased out under the Montreal Protocol's provisions.

Another example of incentivizing actions has been through direct financial benefits being offered by the government. Under this scheme, the government doles out financial incentives to industries to undertake corrective mechanism, but then has been considerable debate whether such incentives work or not. There are an equal number of success and horror stories on either side of the debate that can confound people into saying - What the hell is going on? A recent example of the incentive scheme having gone horribly wrong is the case of female infanticide in Rajasthan, where the government's idea of encouraging child birth in hospitals through cash dole outs has become a cruel joke on the girl child (more on that here).

Neither mechanism is perfect is well understood. However to think that none of them is needed is also taking a ridiculously negative stance. The way ahead is to actually find ways wherein we see a gradual shift in policy making towards solving environmental problems. The path has to be a mix of voluntary Coasian mechanisms, followed by direct financing and eventual hardening of laws with taxation of externalities. This not only sees short term benefits of the Coasian mechanism being achieved, it also helps in the long run raise money for clean up activities through funds gained from taxation. A definitive timeline of less than 20 years is the suitable path in my opinion for undergoing such an evolution, and no budging or extensions is the correct approach for tackling environmental issues, as it also brings seriousness into the issue over a period of time.

Friday, June 17, 2011

What Should be India's Energy Policy?

What should India's energy policy look like? There has been endless debate and countless number of posturings people on every corner of this quadrilateral have adopted. However, we all fail to miss the woods for the trees. History is a great teacher, and we should certainly look back at world history to look at the curious case of Denmark to understand where it succeeded while others failed.

I remember sitting in class when Mr. Benjamin Sovacool was passionately discussing Denmark's conscious shift towards renewable energy that started way back in 1973 after the oil shock caught them with their pants down. I confess to not having thought too much of it then. Since then, however, a lot of water has flown under the bridge, and looking at things as they stand now, Mr. Sovacool stands vindicated. One should look at the Denmark model of energy self reliance and how they consciously moved their national grid from being dependent on fossil fuels towards being one dominated by renewable energy resources generating energy.

Way back in March 2008, Monica Prasad had written an article in the run up to the Copenhagen Summit (memorable for all the wrong reasons)in which she had written the following about Denmark (the whole article can be viewed here

"The one country in which carbon taxes have led to a large decrease in emissions is Denmark, whose per capita carbon dioxide emissions were nearly 15 percent lower in 2005 than in 1990. And Denmark accomplished this while posting a remarkably strong economic record and without relying on nuclear power.

What did Denmark do right? There are many elements to its success, but taken together, the insight they provide is that if reducing emissions is the goal, then a carbon tax is a tax you want to impose but never collect.

This is a hard lesson to learn. The very thought of new tax revenue has a way of changing the priorities of the most hard-headed politicians... But if we want lower emissions, the goal of a carbon tax is to prompt producers to change their behavior, not to allow them to continue polluting while handing over cash to the government.

How do you get them to change? First, you prevent policy makers from turning the tax into a cash cow. Carbon tax discussions always seem to devolve into gleeful suggestions for ways to spend the revenue. ...

Denmark avoids the temptation to maximize the tax revenue by giving the proceeds back to industry, earmarking much of it to subsidize environmental innovation. Danish firms are pushed away from carbon and pulled into environmental innovation, and the country’s economy isn’t put at a competitive disadvantage. So this is lesson No. 1 from Denmark.

The second lesson is that the carbon tax worked ... because it was easy for Danish firms to switch to cleaner fuels. Danish policy makers made huge investments in renewable energy and subsidized environmental innovation. ...[T]he tax gave companies a reason to leave coal and the investments in renewable energy gave them an easy way to do so... The key was providing easy substitutes. ...

[A] carbon tax has been promoted almost as a panacea — just pop in the economic incentives and watch them work their magic. But unless steps are taken to lock the tax revenue away from policymakers and invest in substitutes, a carbon tax could lead to more revenue rather than to less pollution.

An increase in gasoline taxes ... would likewise be the wrong policy for the United States. Higher gas taxes would raise revenue but do little to curb pollution.

Instead, if we want to reduce carbon emissions, then we should follow Denmark’s example: tax the industrial emission of carbon and return the revenue to industry through subsidies for research and investment in alternative energy sources, cleaner-burning fuel, carbon-capture technologies and other environmental innovations."


In the field of energy policy there are two paths, as Amory Lovins had put forward - The Hard Energy Path and the Soft Energy Path. The Hard Energy Path, consisting of the conventional fossil fuel based resources and nuclear energy is made for a scenario where energy demands increase exponentially, and this path will eventually lead to a collapse. On the other hand, the soft energy path is predominated by renewable energy and energy efficiency measures, and in the long run looks towards decreasing the load on our grid. Its a pity that even today we have per unit of production industrial energy demands three times that of USA and five times that of Japan. Nuclear energy is not the answer, because even if the whole world were to shift towards nuclear energy, we would consume our nuclear energy resources within 30 years, forget the waste management fiasco that shall follow.

This clearly underscores the need to a) invest even more in energy efficiency both in the form of laws and technical and financial support, something started with the Electricity Act 2003 and the Energy Conservation Act 2001; and b)Invest big time for local development of renewable energy technology as it is expensive to buy gear boxes for turbines, high grade silicon for solar cells and turbines from Chinese and American companies, when our own research institutions and industrial capability can easily do the same at much lower costs of production.

Moreover, incentives for industries to power themselves through renewable energy should be pushed beyond the tax breaks followed by mandating about 10% of their demand through renewables to reduce consumption of diesel and heavy fuel oil by industry. There is great business sense in doing so, as shown by Bajaj Auto and several textile mills in Tirupur and Coimbatore.


Lastly, we should be working actively in promoting amongst our own people the spirit of energy conservation by reviving the good traditional values of saving resources and not blindly follow the west and indulge in wasteful behaviour. In a world looking for answers, India can certainly be the solution provider and thus truly achieve the greatness it really deserves.

Tuesday, June 14, 2011

I am a Fool

I am a fool for believing that people should care about each other. Truth is, we always were a selfish lot of creatures, and will always be. Helping each other is of no use, as we all look for ways to benefit from each other and go our separate ways. Being an idiot to believe that people can be good to each other, can come forward to help each other is just loads of bullshit.

The Economic Slowdown Needs Immediate Address

The Buck Stops With the Duo (Courtesy: Bloombergquint) The fracas in Maharashtra notwithstanding, things are at a critical juncture ...