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Is There An Environmental Free Lunch?

Last week, my friend Ted Gayer of the Brookings Institution caused a brief uproar when he dismissed a McKinsey study about the cost of reducing carbon emissions. McKinsey found that many firms could actually reduce their greenhouse gas emissions at negative cost – that is, they would save money in the form of lower energy costs. Ted treated this finding as a reason to doubt the study:

Krugman oversells the affordability claim by linking to a widely cited report by McKinsey & Company. The main point of the McKinsey study is provided in their Exhibit B, which illustrates a rather peculiar finding that there are a significant number of pollution abatement options that can be achieved at "negative cost." This finding violates the basic principles of economics. If firms (or consumers) could reduce emissions at negative cost, then they would do so. To say otherwise is to say that they are willingly or ignorantly passing up profits.

Many liberal critics interpreted this observation as a pure statement of free market dogma. Ezra Klein:

The authors argue that there literally can't be firms that could reduce pollution while enhancing profits because theory predicts those firms would already have done so. This is a bit like coming to a road that's not on your map and deciding the road is in the wrong.

Actually, that’s not quite what Ted was saying. He argued that we should be skeptical about any claim that firms are ignoring money-saving opportunities to save money. His main point, as he noted in a follow-up, was that if companies really do ignore already-available ways to save money by reducing energy costs, then why should we be confident that they’ll respond to new price incentives introduced by cap and trade? From his column:

One of the many problems with discarding the premise that firms maximize profits is that it then weakens the argument for cap-and-trade. As Krugman notes, cap-and-trade works because under this type of program, firms will "be able to increase their profits if they can burn less carbon--and there's every reason to believe that they'll be clever and creative about finding ways to do just that." If, as suggested by the McKinsey report, firms are not even "clever and creative" enough to engage in abatement activities that are negative cost, then we cannot rely on them to find innovative ways to reduce emissions under a cap-and-trade system.

This is a more subtle and interesting point than the bald markets-always-work assertion that some of his critics have portrayed it as. Alas, I find it unpersuasive as well. First, to note that firms ignore some negative cost energy reductions doesn’t mean they’ll ignore all such reductions. Cap and trade would make the savings larger and harder to ignore. Maybe busy CEOs are walking past twenty dollar bills on the sidewalk, but they’ll stop to pick up one hundred dollar bills.

Second, creating a major national energy market would serve an important signaling function. Companies currently ignore energy costs because their executives are focused on other, bigger issues. Enacting cap and trade legislation would help create a cultural change that would draw more corporate attention to the issue of reducing energy costs, causing executives to pay more attention to an issue they have ignored.