A false choice: Carbon taxes and fuel efficiency regulations

I read Henry Paulson’s Sunday New York Times op-ed on the climate crisis and Paul Krugman’s response with interest—and frustration. Mr. Paulson called for putting a price on emissions of carbon dioxide, a carbon tax, as the best solution to the impending crisis. Mr. Krugman challenged him, as a prominent member of the Republican Party, which disavows all taxes and would certainly block any carbon tax proposal, to say whether he supports policies like fuel efficiency standards that, while technically “second best” options in the mind of an economist, are already in place or soon will be—and which conservatives also frequently oppose.

Both made excellent points, and both were accurate within their own framework. My frustration is that both missed the critical point, which is that carbon taxes and efficiency standards affect customers in different ways. It is not a question of taxes or standards, as their benefits are additive and are not affected by the implementation of the other.

Carbon (or fuel) taxes are important and effective. In the transportation sector specifically, they encourage people to drive less and to trade off size and performance for better fuel economy when they purchase a new vehicle. Carbon taxation helps encourage a shift to less energy-intensive travel modes and consideration of alternative, lower-carbon fuels. However, one thing taxes do not do very well is pull better efficiency technology into the vehicle fleet.

Driving less and buying smaller or lower-performing vehicles both reduce the upfront initial vehicle cost and the cost of driving, so the benefits are clear to the owner. Technology is different. The customer must pay more upfront, and the fuel savings occur slowly over a long period of time. Further, the upfront price paid is certain and the future benefits are highly uncertain. How long am I going to keep my car? How much will I drive? What if I move or change jobs? What will my real fuel economy be (“your mileage may vary” from the label values)? What will the future price of gasoline be? These vast uncertainties mean that the large majority of drivers severely discount the value of the future fuel savings.

Classical economic theory ignores the impact of uncertainty and says that customers fully value fuel savings over the useful life of the vehicles. If this were true, then efficiency standards might indeed be “second-best” in reality and not just in economics jargon. But behavioral economists, like Nobel Prize winner Daniel Kahneman, have cast doubt on this classical theory with studies of how people actually manage risk and uncertainty in real life. Future fuel savings are a textbook example of risky and uncertain benefits. Thus, most new vehicle customers only value about 2–3 years of future fuel savings when they make a new vehicle purchase decision. This large gap between the value of fuel savings to society and the value to the vehicle purchaser is precisely why standards (or feebates, which have the same impact on technology introduction) are needed and effective. (For a more comprehensive discussion of why the market for new cars generally undervalues fuel economy, see this paper by David Green.)

The effectiveness of efficiency standards in accelerating cost-effective technology use is confirmed by their use in countries that have fuel prices two to three times higher than in the U.S., such as Japan and in Europe. Despite their very high fuel prices, the efficiency technology used in vehicles is no more advanced than it is in the US. Efficiency standards or feebates are needed to fully draw all cost-effective technologies into production and can improve efficiency by 3%–5% per year, at a cost less than the fuel savings over the full useful life of a vehicle.

On the other hand, standards or feebates have little impact on the size or performance of the vehicles purchased by consumers and, by reducing the cost of driving, actually encourage people to drive more. This is where higher taxes excel.

It is important to recognize that fuel taxes or carbon fees affect fuel consumption in different ways than regulatory standards do. They complement each other, and we need both.