Evan Soltas
Aug 9, 2012

Prices, or Prizes?

When it comes to global warming and pollution, the conventional wisdom among economists is to say that we've developed a set of public policy solutions -- among them, cap-and-trade, carbon taxation, and research-and-development subsidies -- but note their implementation is restrained by unfortunate political realities.

A cap-and-trade program would set a ceiling on emissions of greenhouse gases -- most importantly, carbon dioxide -- creating emission credits for polluters, and establishing secondary spot and futures markets for credits which establish individual rights to pollute. A carbon tax follows a similar approach: polluting activity would be subject to tax. There would be no solid cap of emissions, but a tax could align more exactly with the marginal external costs of pollution and thus be more economically efficient. And research-and-development subsidies in energy technology are a no-brainer, as they should bring clean tech to market more quickly and open up new channels for pollution reduction.

The economists' viewpoint on these questions can be distilled to three goals: shift demand for resources to less pollutive ends, make polluters pay for the full social cost of their actions, and support the expansion of supply of clean energy.

The economists' proposals, I contend, have also failed -- both politically and in light of new economic arguments. It is time for a new conventional wisdom on global warming, a new playbook of policy proposals.

Cap-and-trade programs worked well in the reduction of chlorofluorocarbons (CFCs), sulfur dioxides, and nitrogen oxides. That has not proven quite as true in the extensions of cap-and-trade programs onto carbon dioxide. Europe's Emissions Trading System has struggled to gain traction, with rising coal use and an unstable and illiquid market for carbon credits. The UN's system has resulted in the diversion of pollution from one pollutant to another, according to a recent story in The New York Times. Legislation to establish federal cap-and-trade program, known as Waxman-Markey, died in the Senate in 2009. Carbon taxation has shown some promise through a tax-shifting plan enacted in British Columbia which used the revenues from a carbon tax to reduce its personal and corporate income taxes. And yet it will go nowhere politically.

More importantly, schemes which increase the price of polluting are more likely to shift pollution to where those activities go untaxed rather than shift production into less pollutive practices. Noah Smith put it well in a recent post, writing that "[c]arbon taxes are undermined by free trade...[polluter location-shifting] will not completely cancel out the effect of a U.S. carbon tax, but they will work against it substantially. The only way to stop this would be to tax both carbon exports and the implied carbon content of imports. This would lead to big rises in tariffs...And you know what the U.S. can't tax? Cheap-carbon Chinese-made products replacing expensive-carbon U.S.-made products in global markets." Smith also writes that "[g]lobal carbon taxes present a basically insoluble coordination problem," given that lack of an international governing body to enforce pollution property rights leaves the problem in "tradegy-of-the-commons" mode.

Noah writes that the hope of environmentalists should go with natural gas for the medium run and subsidies for energy research-and-development in the long run. I agree with the first. But I think plain-old research subsidies are unlikely to work in speeding the introduction of clean energy technologies.

The problem is that both the short- and long-run supply of research are highly inelastic. This means that an increase in the demand for research, as subsidies would achieve, will go almost exclusively to increasing the price of research rather than the quantity thereof. More to the point, subsidies will increase the pay of the researchers, but better pay alone is unlikely to increase the research produced. This is the unfortunate conclusion of a 1998 paper by Austan Goolsbee, who was more recently the Chairman of the Council of Economic Advisers. Goolsbee found that conventional estimates of the effectiveness of public R&D subsidies may be 30 to 50 percent too high, and that there are strong crowding-out effects of public subsidies on private research.

Another study from Paul Romer in 2001 finds that the institutional arrangements of higher education restrict long-run elasticity of supply for research -- basically, if we made the education system more responsive to price signals, then we could produce significantly more scientists. This is one of the reasons why petroleum engineering has to pay six-figure entry-level salaries to convince students that the field will be lucrative -- it takes extreme price signals to shift any significant number of students among potential courses of study.

All three major policy proposals -- cap-and-trade, carbon taxation, research subsidies -- are either politically dead, economically ineffective, or some unfortunate combination of the two.

Therefore we need a new, sound policy to tackle pollution and global warming. I suggest a tournament approach for energy science research, paired with education reform to establish more science and technology charter schools and infrastructural development to facilitate a switchover to natural gas.

Tournaments revise how government finances innovative research and development. Instead of giving a team of researchers a grant to pursue research in a given field, government sets a goal -- say, a car which runs on conventional gasoline, costs less than $40,000 when produced at scale, and gets over 110 miles to the gallon on the highway and 67 in the city. (The Prius and Volt both get somewhere in the 90s and 50s in each respective setting.) Teams of researchers from around the world compete for a large cash prize. Sometimes they receive patent rights also; in other times the body of research has gone into the public domain.

Why are they superior to vanilla subsidies? For one, they create externalities inherent to the tournament set up -- more research is produced, and the reward is greater due to the effects of recognition. Experimental tests of research tournaments find powerful effects; it turns out that researchers are competitive enough that they will organize themselves better and generate an effective increase in supply under the incentive structure established by tournaments. Other historical studies find that several major innovative advances, including sea, train, and plane travel, were achieved under tournament structures. Related work in medical research also suggests that, given the extreme risk-reward profile in disruptive research, conventional subsidies are unsuited to the task, and tournaments with large prizes are better.

Prizes, rather than subsidies and patents, seems to be the right way forward for alternative energy research and development. "A modern R&D prize system could focus innovative efforts on important societal problems where the answers are not obvious, and which does not rely on a proprietary approach to knowledge," another study reports. (See also here for the particulars on climate technology.)

Addendum: Yichuan Wang, who turns out to know a lot about the state of space research, discusses here public/private involvement and the prize paradigm for technological advances.