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Why raise interest rates to tackle cost-push inflation?

We have examined inflation in several blogs in recent months. With inflation at levels not seen for 40 years, this is hardly surprising. One question we’ve examined is whether the policy response has been correct. For example, in July, we asked whether the Bank of England had raised interest rates too much, too late. In judging policy, one useful distinction is between demand-pull inflation and cost-push inflation. Do they require the same policy response? Is raising interest rates to get inflation down to the target rate equally applicable to inflation caused by excessive demand and inflation caused by rising costs, where those rising costs are not caused by rising demand?

In terms of aggregate demand and supply, demand-pull inflation is shown by continuing rightward shifts in aggregate demand (AD); cost-push inflation is shown by continuing leftward/upward shifts in short-run aggregate supply (SRAS). This is illustrated in the following diagram, which shows a single shift in aggregate demand or short-run aggregate supply. For inflation to continue, rather than being a single rise in prices, the curves must continue to shift.

As you can see, the effects on real GDP (Y) are quite different. A rise in aggregate demand will tend to increase GDP (as long as capacity constraints allow). A rise in costs, and hence an upward shift in short-run aggregate supply, will lead to a fall in GDP as firms cut output in the face of rising costs and as consumers consume less as the cost of living rises.

The inflation experienced by the UK and other countries in recent months has been largely of the cost-push variety. Causes include: supply-chain bottlenecks as economies opened up after COVID-19; the war in Ukraine and its effects on oil and gas supplies and various grains; and avian flu and poor harvests from droughts and floods associated with global warming resulting in a fall in food supplies. These all led to a rise in prices. In the UK’s case, this was compounded by Brexit, which added to firms’ administrative costs and, according to the Bank of England, was estimated to cause a long-term fall in productivity of around 3 to 4 per cent.

The rise in costs had the effect of shifting short-run aggregate supply upwards to the left. As well as leading to a rise in prices and a cost-of-living squeeze, the rising costs dampened expenditure.

This was compounded by a tightening of fiscal policy as governments attempted to tackle public-sector deficits and debt, which had soared with the support measures during the pandemic. It was also compounded by rising interest rates as central banks attempted to bring inflation back to target.

Monetary policy response

Central banks are generally charged with keeping inflation in the medium term at a target rate set by the government or the central bank itself. For most developed countries, this is 2% (see table in the blog, Should central bank targets be changed?). So is raising interest rates the correct policy response to cost-push inflation?

One argument is that monetary policy is inappropriate in the face of supply shocks. The supply shocks themselves have the effect of dampening demand. Raising interest rates will compound this effect, resulting in lower growth or even a recession. If the supply shocks are temporary, such as supply-chain disruptions caused by lockdowns during the pandemic, then it might be better to ride out the problem and not raise interest rates or raise them by only a small amount. Already cost pressures are easing in some areas as supplies have risen.

If, however, the fall in aggregate supply is more persistent, such as from climate-related declines in harvests or the Ukraine war dragging on, or new disruptions to supply associated with the Israel–Gaza war, or, in the UK’s case, with Brexit, then real aggregate demand may need to be reduced in order to match the lower aggregate supply. Or, at the very least, the growth in aggregate demand may need to be slowed to match the slower growth in aggregate supply.

Huw Pill, the Chief Economist at the Bank of England, in a podcast from the Columbia Law School (see links below), argued that people should recognise that the rise in costs has made them poorer. If they respond to the rising costs by seeking higher wages, or in the case of businesses, by putting up prices, this will simply stoke inflation. In these circumstances, raising interest rates to cool aggregate demand may reduce people’s ability to gain higher wages or put up prices.

Another argument for raising interest rates in the face of cost-push inflation is when those cost increases are felt more than in other countries. The USA has suffered less from cost pressures than the UK. On the other hand, its growth rate is higher, suggesting that its inflation, albeit lower than in the UK, is more of the demand-pull variety. Despite its inflation rate being lower than in the UK, the problem of excess demand has led the Fed to adopt an aggressive interest rate policy. Its target rate is 5.25% to 5.50%, while the Bank of England’s is 5.25%. In order to prevent short-term capital outflows and a resulting depreciation in the pound, further stoking inflation, the Bank of England has been under pressure to mirror interest rate rises in the USA, the eurozone and elsewhere.

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Questions

  1. How may monetary policy affect inflationary expectations?
  2. If cost-push inflation makes people generally poorer, what role does the government have in making the distribution of a cut in real income a fair one?
  3. In the context of cost-push inflation, how might the authorities prevent a wage–price spiral?
  4. With reference to the second article above, explain the ‘monetary policy conundrum’ faced by the Bank of Japan.
  5. If central banks have a single policy instrument, namely changes in interest rates, how may conflicts arise when there is more than one macroeconomic objective?
  6. Is Russia’s rise in inflation the result of cost or demand pressures, or a mixture of the two (see articles above)?
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End of the line

HS2 has been cancelled north of Birmingham. The prime minister, Rishi Sunak, announced this at the Conservative Party conference on 4 October, some 13 years after the plan was adopted by the Labour government to build a new high-speed railway from London to Birmingham, which then would branch into two legs – one to Manchester and one to Leeds. The initial budget for this was £15.8bn to £17.4bn. When it came to power, the Conservative-Liberal coalition government ordered a review of the plan. In light of this, the government gave the green light in January 2012 for the full Y-shaped project to go ahead. The London–Birmingham leg was planned to open in 2026 and the two northern legs from 2033.

The project was divided into two phases: Phase 1 to Birmingham and Phase 2 to Manchester and Leeds. The Phase 1 parliamentary bill became law in February 2017 and soon after that, various construction contracts were signed. After some delays, preparation for construction work began in June 2019. There was growing doubt, however, about the viability of the northern legs.

On becoming prime minister in 2019, Boris Johnson ordered an independent review of the project after estimates that the costs of the full project would be some £88bn. The review, chaired by Douglas Oakervee, was published in December 2019 (for a link, see list of reports below). It found that costs (in 2015 prices) were likely to be between £62bn and £69bn. Nevertheless, it concluded that the project should proceed: that the original rationale for HS2 still held; that there were:

no shovel-ready alternative investments in the existing network that were available: if HS2 were to be cancelled, many years of planning work would be required to identify, design and develop new proposals; that the upgrading of existing lines would also come at a high passenger cost with significant disruption; that there would be serious consequences for the supply chain, the fragile UK construction industry and confidence in UK infrastructure planning if HS2 were to be cancelled at this late stage.

In February 2020, the prime minister announced that HS2 would go ahead, including the legs to Manchester and Leeds. The Department for Transport published a document (see source line to the following table) giving the full business case for Phase 1 and the outline case for Phase 2. The document itemised the costs and benefits as estimated at the time.

Source: Full Business Case: High Speed Two, Table 2.9, Department for Transport (April 2020)

Box 12.6 in Economics (eleventh edition) and Case study 8.16 on the Essentials of Economics (ninth edition) student website looks at these costs and benefits. The above table is taken from the box/case study. Net transport benefits (present value at 2015 prices) were estimated to be £74.2bn. These include benefits to passengers from shorter journey times, greater reliability, greater connectivity and less crowding, and reduced congestion on roads. They also include other benefits, such as a reduction in carbon emissions and a reduction in road accidents. Net benefits also include the wider benefits from greater connectivity between firms (resulting in increased specialism, trade and investment), greater competition and greater labour mobility. These wider benefits were estimated to be £20.5bn, giving total net benefits of £94.7bn.

Total costs to the government were estimated to be £108.9bn and revenues from fares to be £45.4bn, giving total net costs of £63.5bn. This gave a benefit/cost ratio of 1.5 (£94.7bn/£63.5bn). In the light of these findings, the government announced in September 2020 that the main work on the London to Birmingham leg would begin, despite the Public Accounts Committee’s finding that the project was badly off course and lacking in transparency.

Concern was expressed over whether the Leeds leg would go ahead, but in May 2021, the transport secretary, Grant Shapps, confirmed that it would be completed. However, with the publication of the Integrated Rail Plan in November 2021 (for a link, see list of reports below), the government decided that the eastern leg of HS2 would no longer reach Leeds but instead end in the East Midlands. Then in June 2022, the link between the HS2 line near Manchester and the West Coast Main Line was scrapped. This would have allowed HS2 trains to reach Scotland.

In early 2023, it was announced that the building of the terminus at Euston was being put on hold. Many interpreted this as meaning that it was being scrapped, with trains terminating at Old Oak Common, some six miles from Central London.

Finally, as we have seen, HS2 north of Birmingham has now been scrapped and the government is seeking private-sector funding to build the terminus at Euston and complete the line from Old Oak Common.

Arguments for scrapping the northern legs

The main argument given by the government was that projected costs have risen substantially above original estimates and that by cancelling the Manchester and east Midlands legs, the money saved could be better used elsewhere. The argument is one of opportunity cost. The cost of going ahead would mean not going ahead with better-value alternatives.

The government claims that £36bn will be saved and that this will be diverted to rail, road and other transport projects, primarily (although not exclusively) in the north of England. The money would be spent between 2029 and 2040. Projects include spending additional money on the planned upgrading of the rail link between Manchester and Liverpool, Sheffield, Leeds and Hull; building a new station at Bradford; developing a mass transit system for Leeds and its surroundings; a £2.5bn fund for improved transport for smaller cities, towns and the countryside in the north of England; extra funding for transport in the east and west Midlands, including funding a Midlands Rail Hub. Out of the £36bn, £6.5bn would be for projects elsewhere, including road improvement.

In order to judge whether the diversion of funds represents a better use of money, a full analysis of costs and benefits of the various projects would need to be conducted and compared with an updated cost–benefit analysis of continuing with the legs to Manchester and the east Midlands and possibly reinstating the Leeds leg too.

One possible benefit for the government is a political one. It hopes that promising more local projects rather than HS2 will appeal to the electorate in large parts of the north of England who are suffering from poor and unreliable transport links. However, most of these projects will be started well beyond the next election and this political gain may turn out to be small. Indeed, cancelling HS2 may breed cynicism, with people wondering whether any promised new projects will actually be delivered.

Arguments against scrapping the northern leg(s)

The benefits originally identified from HS2 will now be lost. It is not just that the northern legs of HS2 would have provided faster travel to Manchester and Leeds, but the new lines would have reduced congestion for slower trains and freight on existing lines. This has been the experience in countries such as Japan and Spain, which have invested heavily in new, separate high-speed lines.

When the line is completed to Birmingham, the HS2 trains will be able to continue north of Birmingham on existing lines. But these lines are heavily congested, which will limit the number of HS2 trains that can use them. Also they will be restricted to 110 mph on these lines as they have no tilting mechanism. Also they will have a maximum capacity of only 550 seats (a single train set) as the platforms at Manchester Piccadilly cannot accommodate double-set trains. The existing Pendalino trains on the West Coast mainline can travel at 125 mph as they do have the tilting mechanism and they have a higher capacity of 607 seats.

Then there are the signals that cancellation sends to industry about whether governments can be trusted to follow through on public-sector projects. Many business had expanded or relocated to places near the HS2 routes. Many others will wonder whether the promised new projects will go ahead. Indeed, shortly after giving a list of the projects (some of which had already been built or were being built), the list was removed from the government website. There is already a mood of scepticism amongst the electorate. Polling following the initial announcement showed that a majority believed that it was unlikely that the Conservatives would deliver the other projects if they won the next election.

The opportunity cost argument that the money would be better spent on alternative transport projects is predicated on various assumptions. One is that the money will actually be spent, which, as we have seen, people consider doubtful. Another is that the only choice is either spending a fixed pot of money on the northern leg(s) of HS2 or spending it on the alternative projects announced by the prime minister. It could be argued that the government should proceed with both the full HS2 and these other projects, and fund it by extra taxation. Investment as a percentage of GDP is low in the UK compared with other countries. Over the past 10 years, it has averaged 17.8% in the UK. This compares with 21.0% in the USA, 21.5% in Germany, 23.7% in France and 25.4% in Japan. Also, public-sector investment is low in the UK compared with that in other countries.

Assessing the arguments

Many of the costs and benefits of long-term projects, such as HS2, occur many years hence. There is, therefore, a great deal of uncertainty over their magnitude. This makes it extremely difficult to reach a clear conclusion over the desirability of cancelling HS2 north of Birmingham or continuing with it. Under such circumstances, politics tends to dominate decision making.

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Questions

  1. Why have the costs of HS2 (in real terms) risen substantially since the first estimates in 2012?
  2. Identify the types of environmental costs and benefits of the full Y-shaped HS2 project. Why might such costs and benefits be difficult to measure?
  3. Is the opportunity of cost of proceeding with the full Y-shaped HS2 a range of other transport projects? Explain.
  4. Find out the level of public-sector investment expenditure as a percentage of (a) total government expenditure and (b) GDP in some other developed countries and compare them with the UK. Comment on your findings.
  5. Should the decision whether or not to go ahead with the Manchester and east Midlands legs have been delayed until a new updated cost–benefit analysis had been conducted?
  6. If most of the benefits from the originally planned HS2 will be now be lost with the line ending at Birmingham, should this leg to Birmingham also be cancelled, even though many of the costs have already been incurred? Explain your reasoning.
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The growing gap between rich and poor

A recent report published by the High Pay Centre shows that the median annual CEO pay of the FTSE 100 companies rose by 15.7% in 2022, from £3.38 million in 2021 to £3.91 million – double the UK CPIH inflation rate of 7.9%. Average total pay across the whole economy grew by just 6.0%, representing a real pay cut of nearly 2%.

The pay of top US CEOs is higher still. The median annual pay of S&P 500 CEOs in 2022 was a massive $14.8 million (£11.7 million). However, UK top CEOs earn a little more than those in France and Germany. The median pay of France’s CAC40 CEOs was €4.9 million (£4.2 million). This compares with a median of £4.6 million for the CEOs of the top 40 UK companies. The mean pay of Germany’s DAX30 CEOs was €6.1 million (£5.2 million) – lower than a mean of £6.0 million for the CEOs of the top 30 UK companies.

The gap between top CEO pay and that of average full-time workers narrowed somewhat after 2019 as the pandemic hit company performance. However, it has now started widening again. The ratio of the median UK CEO pay to the median pay of a UK full-time worker stood at 123.1 in 2018. This fell to 79.1 in 2020, but then grew to 108.1 in 2021 and 118.1 in 2022.

The TUC has argued that workers should be given seats on company boards and remuneration committees that decide executive pay. Otherwise, the gap is likely to continue rising, especially as remuneration committees in specific companies seek to benchmark pay against other large companies, both at home and abroad. This creates a competitive upward push on remuneration. What is more, members of remuneration committees have the incentive to be generous as they themselves might benefit from the process in the future.

Although the incomes of top CEOs is huge and growing, even if they are excluded, there is still a large gap in incomes between high and low earners generally in the UK. In March 2023, the top 1 per cent of earners had an average gross annual income of just over £200 000; the bottom 10 per cent had an average gross annual income of a little over £8500 – just 4.24% of the top 1 per cent (down from 4.36% in March 2020).

What is more, in recent months, the share of profits in GDP has been rising. In 2022 Q3, gross profits accounted for 21.2% of GDP. By 2023 Q2, this had risen to 23.4%. As costs have risen, so firms have tended to pass a greater percentage increase on to consumers, blaming these price increases on the rise in their costs.

Life at the bottom

The poor spend a larger proportion of their income on food, electricity and gas than people on average income; these essential items have a low income elasticity of demand. But food and energy inflation has been above that of CPIH inflation.

In 2022, the price of bread rose by 20.5%, eggs by 28.9%, pasta by 29.1%, butter by 29.4%, cheese by 32.6% and milk by 38.5%; the overall rise in food and non-alcoholic beverages was 16.9% – the highest rise in any of the different components of consumer price inflation. In the past two years there has been a large increase in the number of people relying on food banks. In the six months to September 2022, there was a 40% increase in new food bank users when compared to 2021.

As far as energy prices are concerned, from April 2022 to April 2023, under Ofgem’s price cap, which is based on wholesale energy prices, gas and electricity prices would have risen by 157%, from £1277 to £3286 for the typical household. The government, however, through the Energy Price Guarantee restricted the rise to an average of £2500 (a 96% rise). Also, further help was given in the form of £400 per household, paid in six monthly instalments from October 2022 to March 2023, effectively reducing the rise to £2100 (64%). Nevertheless, for the poorest of households, such a rise meant a huge percentage increase in their outgoings. Many were forced to ‘eat less and heat less’.

Many people have got into rent arrears and have been evicted or are at risk of being so. As the ITV News article and videos linked below state: 242 000 households are experiencing homelessness including rough sleeping, sofa-surfing and B&B stays; 85% of English councils have reported an increase in the number of homeless families needing support; 97% of councils are struggling to find rental properties for homeless families.

Financial strains have serious effects on people’s wellbeing and can adversely affect their physical and mental health. In a policy research paper, ‘From Drained and Desperate to Affluent and Apathetic’ (see link below), the consumer organisation, Which?, looked at the impact of the cost-of-living crisis on different groups. It found that in January 2023, the crisis had made just over half of UK adults feel more anxious or stressed. It divided the population into six groups (with numbers of UK adults in each category in brackets): Drained and Desperate (9.2m), Anxious and At Risk (7.9m), Cut off by Cutbacks (8.8m), Fretting about the Future (7.7m), Looking out for Loved Ones (8.9m), Affluent and Apathetic (8.8m).

The majority of the poorest households are in the first group. As the report describes this group: ‘Severely impacted by the crisis, this segment has faced significant physical and mental challenges. Having already made severe cutbacks, there are few options left for them.’ In this group, 75% do not turn the heating on when cold, 63% skip one or more meals and 94% state that ‘It feels like I’m existing instead of living’.

Many of those on slightly higher incomes fall into the second group (Anxious and At Risk). ‘Driven by a large family and mortgage pressure, this segment has not been particularly financially stable and experienced mental health impacts. They have relied more on borrowing to ease financial pressure.’

Although inflation is now coming down, prices are still rising, interest rates have probably not yet peaked and real incomes for many have fallen significantly. Life at the bottom has got a lot harder.

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Questions

  1. What are the arguments for and against giving huge pay awards to CEOs?
  2. What are the arguments for and against raising the top rate of income tax to provide extra revenue to distribute to the poor? Distinguish between income and substitution effects.
  3. What policies could be adopted to alleviate poverty? Why are such policies not adopted?
  4. Using the ONS publication, the Effects of taxes and benefits on UK household income, find out how the distribution of income between the various decile groups of household income has changed over time? Comment on your findings.
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Global boiling – why not take urgent action now?

The global average temperature for July 2023 was the highest ever recorded and July 3rd was the world’s hottest day on record. We’ve seen scenes of wildfires raging across much of southern Europe, people suffering searing temperatures in south-west USA, southern India and western China, flash floods in South Korea, Japan and eastern USA. These are all directly related to global warming, which is causing weather systems to become more extreme. And as the planet continues to warm, so these problems will intensify.

The Secretary General of the United Nations, Antonio Guterres, in a press conference on 27 July warned that:

Climate change is here. It is terrifying. And it is just the beginning. The era of global warming has ended; the era of global boiling has arrived. The air is unbreathable. The heat is unbearable. And the level of fossil-fuel profits and climate inaction is unacceptable. Leaders must lead. No more hesitancy. No more excuses. No more waiting for others to move first. There is simply no more time for that.

The environmental, human, social and economic impact of global warming is huge, but concentrated on just part of the world’s population. For many, a more variable climate is at worst an inconvenience – at least in the short term. But it is the short term that politicians are most concerned about when seeking to win the next election.

Tackling climate change requires action to reduce carbon emissions now, even though the effects take many years. But one person’s emissions make only a minuscule contribution to global warming. So why not be selfish and carry on driving, flying off on holiday, using a gas boiler and eating large amounts of red meat? This is what many people want to do and governments know it. Many people do not like green policies as they involve sacrifice. Examples include higher fuel prices and restrictions on what you can do. So, despite the visions of fires, floods and destruction, governments are wary about raising fuel taxes, airport duties and charges to use old high-emission cars in cities; wary about raising taxes generally to provide subsidies for sustainable power generation; wary about banning new oil and gas fields that would reduce reliance on imported fuel.

Because the external costs of carbon emissions are so high and global, government action is required to change behaviour. Education can help and scenes of devastation from around the world may change the hearts and minds or some people. Also, the prospect of profits from cleaner and more fuel-efficient technology can help to spur innovation and investment. But to meet net zero targets still requires policies that are unpopular with many people who might be inconvenienced or have to pay higher petrol, energy and food prices, especially at a time when budgets are being squeezed by inflation.

Part of the problem is a distributional one. The people most affected by the cost-of-living crisis and higher interest rates are those on lower incomes and with higher debts. Politicians know that it will be hard to win the votes of such people if they are faced with higher green taxes. As elections approach, politicians are likely to backtrack on many environmental commitments to appeal to such people.

This is beginning to happen in the UK, with the government declaring that it is on the side of the motorist. Indeed, Rishi Sunak has just announced that the government will authorise more than 100 new licenses for new oil and gas wells in the North Sea. This is despite the United Nations, various other international bodies, climate scientists and charities calling for a halt to all licensing and funding of new oil and gas development from new and existing fields. The government argues that increased North Sea production would reduce the reliance on imported oil.

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Questions

  1. In what sense is the environment a ‘public good’? How is the concept of externalities relevant in analysing the private decisions made about the use of a public good?
  2. How may game theory be used to help understand the difficulties in reaching international agreement about climate change policies?
  3. What is meant by ‘net zero’? Is carbon capture and storage an acceptable alternative to cutting carbon emissions?
  4. In what ways could policies to tackle climate change be designed to reduce income inequality rather than increase it?
  5. What are the arguments for and against banning (a) petrol and diesel cars; (b) gas boilers; (c) fossil-fuel power stations? How much notice should be given if such bans are to be introduced?
  6. What is meant by ‘nudge theory’? In what ways could people be nudged into making greener decisions?
  7. What are the arguments for and against granting new licences for North Sea oil and gas drilling? Explain where you feel the balance of the arguments lies.
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Tackling climate change: ‘Everything, everywhere, all at once’

The United Nations International Panel on Climate Change (IPCC) has just published its most comprehensive report so far. It finds that ‘human activities, principally through emissions of greenhouse gases, have unequivocally caused global warming’. This has led to widespread and rapid changes in climate and biodiversity and to more extreme weather patterns, such as droughts, floods and hurricanes. What is more, the distribution of these effects is uneven, with communities who have contributed the least to current climate change being disproportionately affected.

At the 2015 COP21 climate change conference in Paris (see also), it was agreed to adopt policies to limit the increase in global temperatures to ‘well below’ 2°C above pre-industrial levels and to make an effort to limit it to 1.5°C. Global temperatures have already risen 1.1°C above 1850–1900 levels and are set to reach 1.5°C in the early 2030s. Every increment of global warming will intensify ‘multiple and concurrent hazards’.

Deep, rapid and sustained reductions in emissions would slow down the rise in global temperatures, but even with such reductions, temperatures will still exceed 1.5°C in the next few years and, even under the best-case scenario, would not fall below 1.5°C again until the end of the 21st century. Under more pessimistic scenarios, global temperatures could rise to 2.7°C above pre-industrial levels by the end of the century under an intermediate greenhouse gas emissions scenario and to 4.4°C under a very high emissions scenario. Anything above 2°C would be likely to have catastrophic effects. The longer countries wait to take action, the greater the rise in global temperatures and hence the greater the damage and the more costly it will be to rectify it.

‘For any given future warming level… projected long-term impacts are up to multiple times higher than currently observed (high confidence). Risks and projected adverse impacts and related losses and damages from climate change escalate with every increment of global warming (very high confidence). Climatic and non-climatic risks will increasingly interact, creating compound and cascading risks that are more complex and difficult to manage (high confidence).’ (Paragraph B2)

But the report is not all ‘doom and gloom’. It is possible to limit global warming to 1.5°C or only a little over by making rapid, deep and, in most cases, immediate greenhouse gas emissions reductions in all sectors and reaching net zero emissions in the early 2050s. Science and technology have the answers – answers that are now much cheaper and more available than back in 2015 when the 1.5°C target was agreed. But what it does require is doing ‘everything, everywhere, all at once’. And that requires political will and the right economic incentives.

The politics and economics of achieving net zero

In terms of the politics, there is general global agreement by governments about the likely effects of climate change. And most governments agree that action needs to be taken. However, there are three key political problems.

The first is that the costs of action will be borne now, while the benefits of action will accrue over a much longer period of time. This links to the second problem – the mismatch between the lives of governments and the long-term effects of climate change. If governments put off doing anything now and merely promise that something will be done in the future, they will not have to take unpopular actions, such as raising taxes on energy, private transport and certain goods or banning various activities. Future governments will have to sort things out, by when, although the problems will be greater, the existing politicians will no longer be in power.

The third problem concerns the distribution of the costs and benefits of action. The major emitters of carbon are the rich countries, while the major sufferers are poor people in countries subject to drought, flooding and rising sea levels. Not surprisingly, who should cut down on emissions and pay for the mitigation necessary in many of the poorer countries is a difficult political issue, which is why it’s much easier to say what needs to be achieved overall than precisely what measures should be taken by which countries.

These problems reflect the fact that many, if not most, of the environmental costs of production and consumption are external costs – costs borne, not by the direct producer or consumer, but by other people at other places and/or in the future.

Nevertheless, the relative costs of moving to greener production and consumption are falling. The costs of renewable energy, including solar power, onshore and offshore wind and hydroelectric power are falling relative to that generated from fossil fuels. At the same time, the take up of electric cars is likely to continue rising as battery technology improves. This does, of course, require an increase in charging infrastructure. Domestic heat pump technology is improving and home insulation methods are becoming more efficient.

Persuading consumers and firms to take account of environmental externalities could in part be achieved by education. It makes it much easier for politicians to take appropriate action now if their populations are on board. There has been increasing awareness over the years of the environmental impact of people’s actions. People have become more willing to take responsibility for the world that future generations will inherit. This is helped both by education in schools and colleges and by frequent items in the media.

But incentives also have a major part to play. To internalise environmental externalities, external costs could be taxed and external benefits subsidised.

The effect of a carbon tax on production

The use of taxes to reduce activities with negative environmental externalities is illustrated in the diagram (click here for a PowerPoint). It takes the case of carbon emissions from coal-fired electricity generation in a large country. To keep the analysis simple, it is assumed that all electricity in the country is generated from coal-fired power stations and that there are many such power stations, making the market perfectly competitive.

It is assumed that all the benefits from electricity production accrue solely to the consumers of electricity (i.e. there are no external benefits from consumption). Marginal private and marginal social benefits of the production of electricity are thus the same (MPB = MSB). The curve slopes downwards because, with a downward-sloping demand for electricity, higher output results in a lower marginal benefit (diminishing marginal utility).

Competitive market forces, with producers and consumers responding only to private costs and benefits, will result in a market equilibrium at point a in the diagram: i.e. where demand equals supply. The market equilibrium price is P0 while the market equilibrium quantity is Q0. However the presence of external costs in production means that MSC > MPC. In other words, MEC = b – a.

The socially optimal output would be Q* where P = MSB = MSC, achieved at the socially optimal price of P*. This is illustrated at point d and clearly shows how external costs of production in a perfectly competitive market result in overproduction: i.e. Q0 > Q*. From society’s point of view, too much electricity is being produced and consumed.

If a carbon tax of d – c is imposed on the electricity producers, it will now be in producers’ interests to produce at Q*, where their new private marginal costs (including tax) equals their marginal private benefit.

But this brings us back to the politics of measures to reduce emissions. People do not like paying higher taxes. In his latest Budget, the UK Chancellor, Jeremy Hunt, decided not to raise fuel duties by the 12p that had been previously planned, despite fuel prices having recently fallen. Meanwhile, charging prices for electric cars have risen.

Other economic measures

A simpler method for dealing with environmental externalities is ban certain activities that omit CO2. For example, in the UK there will be a ban on the sale of new petrol and diesel cars and vans from 2030 (with the exception of some low-emission hybrids until 2035). In the EU there will be a similar ban from 2035. Clearly, such measures are only suitable when there are non-emitting alternatives.

Another alternative is a cap-and-trade system, such as the European Emissions Trading Scheme. It involves setting quotas for emissions and allowing firms which manage to cut emissions to sell their surplus permits to less efficient firms. This puts a price pressure on firms to be more efficient. But the quotas (the ‘cap’) must be sufficiently tight if emissions are going to be cut to desired levels. Nevertheless, it is an efficient way of cutting emissions as it gives a competitive advantage to low-emission producers.

Conclusion

If the problem of global warming is to be limited to 1.5°C, or only very little above, multiple solutions will need to be found and there must be a combination of political will, economic incentives and the mobilisation of scientific and technical know-how. As the Secretary-General of the United Nations, António Guterres, stated in launching the new report:

This report is a clarion call to massively fast-track climate efforts by every country and every sector and on every timeframe. In short, our world needs climate action on all fronts – everything, everywhere, all at once.

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Questions

  1. Why might countries not do ‘everything, everywhere, all at once’ to avert climate change?
  2. What might an optimist conclude from the ICC report?
  3. To what extent is climate change an economic problem?
  4. On a diagram similar to the one above, show how a subsidy could be used to internalise positive externalities.
  5. How might countries reduce the consumption of fossil fuels in the most efficient way? Are they likely to want to do this? Explain.
  6. Is a ‘cap-and-trade’ (tradable permits) system (a) an effective means of reducing emissions; (b) an efficient system?