A new word entered the Australian climate change policy the other day. That word is “churn.” I hadn’t heard it before but here it was on the key press release:
The use of a baseline approach to the electricity generation sector greatly reduces the ‘churn’ involved in the ETS – less money is raised from industry and then redistributed to households to compensate them for higher electricity prices.
My understanding of what ‘churn’ described was the idea that we put in policy to change price signals (in particular raising one price) and then we use compensation to ensure that the income of the losers from that price increase is not diminished. That ensures that behaviour away from the thing whose price has increased (in this case, carbon) occurs but other broader macroeconomic impacts (say, by reducing consumption overall) are avoided. It is a basic part of introductory economics textbooks and a solid economic approach.
So why was it now given a label that suggested it was a bad thing and something that should be reduced? Since it figured so importantly in the media I took a look at the Frontier Economics report to see the analysis. In the 102 page report, “churn” or its variants is only 8 times and 5 of them are in the executive summary.
Here is a key paragraph (p.3):
The improvement in the economics of the CPRS reported below is mostly due to a reduction in the economic distortions arising from Government’s revenue churning, as described above. This churning occurs, for example, when the Government charges electricity consumers for the full cost of greenhouse gas emissions from electricity production and then returns the money it collects to various groups it believes are deserving of Government support to compensate for the financial hardship arising from the CPRS. If this reallocation of funds is made an in-built feature of the trading scheme, rather than a distinct exercise that relies on the Government to intercept and reallocate permit funds, this ensures lower electricity price increases, which is better for the economy.
But that is exactly the opposite of what we would surely want climate change policy to achieve. Before I saw this idea of shielding on price signals as an argument for gradualism — which may have some basis but I’m not sure the behavioural evidence points us that way. But the idea that we want to price then compensate is a sound one and certainly not something we want to remove from climate change policy as the Frontier Economics report suggests. Indeed, in my reading of that report, no argument is made that “churn” is actually a bad thing although it is asserted as such.
Anyhow, rather than go through the wonkish details myself, it turns out that this is a pressing issue for the climate change policy debate everywhere. In the US, Greg Mankiw provides the details — he talks of a carbon tax but the same logic applies for a cap and trade approach. It is a restatement of what is in our textbook (Chapter 22 from memory) and given its importance in the debate here this week, I am going to take the liberty of reproducing Mankiw’s whole post here:
We can think of the typical household as having to make two decisions. First, the household decides how much to work and consume. This is the standard consumption-leisure tradeoff. Second, the household decides how to allocate consumption between carbon-intensive products and less carbon-intensive products.
Mathematically, we might write utility as
U = u(C) + v(L)
where C is consumption and L is leisure. Consumption is a composite of carbon-intensive consumption C1 and less carbon-intensive consumption C2, which we can write as
There are two margins of adjustment: between C and L, and between C1 and C2.
We start in a situation in which each of these margins of adjustment is distorted. Because earnings are taxed via income and payroll taxes, people have too little incentive to work and consume. In addition, because there is a negative externality associated with carbon, people have too little incentive to move their consumption basket toward less carbon-intensive products. In other words, the relative price of consumption compared to leisure is too high, and the relative price of carbon consumption compared to noncarbon consumption is too low.
The trick is how to fix the second distortion without making the first one worse. A tax on carbon with the revenues used to cut income taxes does that. Everyone who thinks there are negative carbon externalities should agree that is the efficient policy.
A tax on carbon with the revenue squandered via lump-sum handouts to powerful special interests, however, fixes the second distortion but makes the first one worse. The good thing about this policy is that it raises the price of carbon-intensive consumption relative to less carbon-intensive consumption. The bad thing about it is that it also raises the price of consumption relative to leisure—in other words, it depresses the real wage. The basic problem is that a new tax on carbon-intensive products C1 is also an additional tax on consumption C, unless there is some other offsetting tax change.
This is where the Rorschach test comes in. A carbon tax without a compensating income tax cut makes one problem better and one worse. The question then is which problem is bigger. I don’t think there is a consensus among economists on this last question. That is why reasonable people can disagree about the bill being debated in Congress.
But there is a consensus, more or less, that we could fix one margin of adjustment without distorting the other margin more. But that requires a cut in income or payroll taxes to be a key part of the environmental policy.
Now I am more than happy for someone from Frontier Economics to point me to the refutation of this basic notion. I couldn’t find it in the report and are not aware of an industry-specific literature that might have this evidence.
And let us be clear: there is a criticism here of the Government’s approach as much as those of others. The CPRS gives compensation to generators but it also gives compensation to households in the form of tax cuts. I am not sure there is enough of the latter to satisfy us but I do think that to move away from the price then compensate approach to something that reduces “churn” is likely to be a step in the wrong direction.