Wall Street Journal COMMENTARY

Capitalism Against Climate Change

By R. GLENN HUBBARD
May 31, 2007; Page A15

The case for action to combat global climate change has grown increasingly compelling in recent years. Sadly the same can not be said for specific proposals to address the problem. Ideas grounded in sound science and good economics have been lacking.

One recent change is a proposal to balance a need for policy action with a mechanism for prudent economic risk management. I refer to new recommendations by the National Commission on Energy Policy for an emissions trading program that safeguards the economy. This is the idea behind proposed legislation by Sens. Jeff Bingaman (D., N.M.) and Arlen Specter (R., Pa.)

We do not know how much long-term climate change will result from our ever-expanding economic activity -- primarily from the burning of fossil fuels -- or how much climate change is "safe." To understand this from an economic perspective, we need a flexible, measured approach, one that continues to research the consequences of climate change and how we can avoid damage in the future. This approach would establish a policy architecture that sends appropriate signals to businesses and consumers in order to spur climate-saving innovations, while engaging both rich and poor nations in similar, cost-effective activities to reduce the threat of climate change throughout the world.

Good environmental policy relies on sound science. Some of the science surrounding climate change is clear. We know that concentration of greenhouse gases, particularly carbon dioxide, has increased significantly since the Industrial Revolution due to human activity. We also know that the surface temperature of the earth is warming due at least partly to that increased concentration.

Other aspects of the science are more ambiguous: With a bit of global warming, there are natural responses that could either amplify or dampen the warming effect. This means that estimates of the likely temperature and climate changes over the next century span a fairly wide range. The potential effects on people and ecosystems are even more uncertain.

Despite this uncertainty, most serious students of climate change believe that the likelihood of adverse climate change is sufficiently great to warrant action. But what action? This is where economic analysis should guide environmental policy. Just as a household or business makes plans to reduce the potential damage from uncertain events, the United States and other countries need to address the damaging -- if uncertain -- consequences of global warming.

But near-term actions should not impose greater risks than the problem they seek to address. MIT economist Richard Schmalensee, a member of the NCEP, once put forward a helpful analogy: If you smell smoke at home, it would be silly to do nothing until you actually see flames, but you also should not hose down the house after one whiff of what might be smoke.

For the global warming debate, uncertainty justifies neither inaction nor over-reaction. As the smoke analogy suggests, the United States should pursue a moderate policy that can be justified as we learn more about the threat of climate change and the costs of alternative responses.

The NCEP proposal meets this test of taking serious action while not imposing economic risks greater than the threat of climate change itself. It comprehensively addresses all U.S. emission of CO2 and other climate change-related gases. It does this using one system: tradable permits. In such a system, the use of coal, oil and natural gas will require permits in proportion to their CO2 emissions, typically sold along with the fuel -- so individuals need not deal with the permit market.

Those businesses and individuals who can reduce their fuel use and emissions most inexpensively will do so. Those who cannot will end up purchasing more permits and supporting those who can. In this way, the program flexibly encourages the least-expensive efforts to reduce emissions without constraining any individual or business. And revenue from the auction of a portion of these permits could be used to reduce the corporate income tax, blunting adverse economic consequences.

All true, but at what price? Permit markets can be uncertain and volatile, especially when they are first introduced, making it hard to gauge the economic impact of the program. Meanwhile, the alternative of an equivalent tax on carbon dioxide offers certainty about the price faced by businesses. In this sense, it is important that the NCEP proposal includes a "safety valve" mechanism -- an upper boundary on the price of tradable permits that limits the cost of the program to the businesses and individuals. In particular, the proposed program would not raise the cost of gasoline more than 7%, electricity 10%, and natural gas 8% beyond the amount that would otherwise arise over the next 20 years.

Over time, we know that new investment and technology will reduce costs; we do not want to force overly expensive reductions now when cheaper opportunities are just around the corner. Furthermore, pushing too hard too quickly will simply encourage emissions and jobs to move to other countries who have not yet adopted similar policies.

This economic emphasis only highlights that it is vital to develop global institutions for promoting and measuring emission reductions, institutions that prevent emissions from shifting overseas and encourage the lowest-cost abatement opportunities wherever they are in the world. Developing these international institutions is a tall order but it need not happen right away.

Under the NCEP approach, the conversation among nations would become broader and deeper over time, much like the 50-year effort for the General Agreement on Tariffs and Trade and the World Trade Organization. What is important in the short run is that domestic policies have a forward-looking design that encourages both efficiency and global cooperation. The U.S. should lead and take action early, but it must encourage and regularly review actions by other key nations. Those actions need to be increasingly coordinated to address the seriousness of the problem, while at the same time protecting U.S. economic interests.

Among the features of comprehensiveness, economic flexibility, and international leadership in the NCEP proposal, it is the safety valve and the emphasis on cost certainty that has drawn the ire of many environmental advocates. Some of those advocates seem unconcerned about economic impacts, or argue that technologies exist now to achieve their goals inexpensively. Those approaches are irresponsible and economically risky.

A serious response to climate change must begin by turning our emissions downward without betting the bank. The NCEP proposal does both, and its commitment to measured policy responses adds a breath of economic fresh air.

Mr. Hubbard, dean and professor of finance and economics at Columbia Business School, was chairman of the Council of Economic Advisers under President Bush.