Doing the maths on Copenhagen

Copenhagen is dead. Hurrah! And I say that as someone convinced that climate change is happening, we're causing it, and we need to do something about it. However, what we don't need to do is the ghastly mess that was being cooked up in Denmark.

They've essentially agreed to, um, well, try - and they'll think a little bit more about what they're going to try sometime later. And that's the best result we could have hoped for. We already know what needs to be done, as the economists have worked it out. It is true that economists are not exactly the flavour of the month right now, but they are still the experts here.

We are trying to change people's behaviour, and long experience tells us that the way to do that is to change the incentives people face. We might make it illegal to burn coal, for example - as we largely have done in British cities - and the motivation people would have for doing so would be an incentive not to.

Yet observation of humans over the past couple of centuries has shown that the carrot tends to provide a better incentive than the stick. Being shot for failing the Five Year Plan should concentrate minds more than the alternatives of bankruptcy or hot and cold running lingerie models which our own system provides for failure or success, but which has been better at producing economic growth? Quite.

So economists have thought long and hard about how we might alter incentives to change behaviour and avoid boiling Flipper. There are essentially two options. The first reaches back to Arthur Cecil Pigou and his publication in 1912 on welfare economics. He note that markets are very good things indeed, but they are not perfect. They have periods when they do not act as advertised. The most obvious of these is when there are externalities: things which affect others but which are not included in prices and thus are not in the calculations that market participants make when deciding how to act.

Externalities can be positive or negative: if they're positive then this means that markets unadorned will not provide enough of these nice things. The fact that knowledge is a public good and has positive externalities is the reason that the taxman asks us to pay for basic research in universities and the like. The correct thing to do with positive externalities is to subsidise them.

Pollution is a classic example of a negative externality. My factory polluting the river has costs for those downstream. If I'm not forced to pay those costs then they're not included in my prices, so I'll be making a profit while harming others. We should tax negative externalities, and with climate change, this leads us simply to taxing emissions. Alternatively, we could tax fossil fuels when they're dug up: a suggestion recently made by James Hansen which might be his most intelligent contribution to the debate so far.

So, solution 1) from the economists: slap on a carbon tax and we're done. The tax should be at whatever the damage done costs and we should reduce other taxes to make it revenue neutral. We might want to study what the actual cost of that damage is: current estimates range from around $5 a tonne CO2 from William Nordhaus to $80 a tonne from Lord Stern - the differences stem from technical points such as the length of the technological cycle and discount rates, which is not stuff we have room to explain here.

However, the economists agree that we should slap on the tax and then let everyone get on with it. But when this simple idea meets the world of politics and Copenhagen, one subtlety gets missed which makes a mess of the entire theory.

The economists insist that the tax should be what the cost of the pollution is. Not a high enough tax to stop people polluting at all, but rather just the cost of the pollution. This is an offshoot of welfare economics and what we're trying to do is maximise the welfare of everyone, current and future. We only want to stop people doing things where the cost is greater than the benefit. We don't want to stop people doing something where the benefit is greater than the cost.