Monday, October 03, 2005

Is there a Conflict between Economic Viability and Sustainable Resource Utilization?

I recently attended a presentation titled "Is there a Conflict between Economic Viability and Sustainable Resource Utilization?". It was a trial lecture for one of the PhD students in our department and left a lot of questions (including the title) unanswered.

Michael Higgins' wonderful blog Chocolate and Gold Coins has quite a few posts on an economist's view of resource utilization (two of them are here and here). Half Sigma is another blog with an economist's view of resource utilization. His views on recycling (here and here) and energy are opposed to mine.

In this post, I will try to answer the question "Is there a Conflict between Economic Viability and Sustainable Resource Utilization?", while trying to show that applying economic theory coupled with science, the economists might have to change their views. For more on how to reason economically go here (Link via Michael Higgins' post Teaching Economics to Everyone).

Economics analyzes the costs and the benefits of improving patterns of resource use. Economic theory has failed as it does not have a connection to the physical world - where the resources originate. It has followed a price system where the environment (atmosphere, hydrosphere and lithosphere) are free; thus markets prices will not reflect the true costs associated with producing/consuming a product. I agree with economists in that markets work, but one must make sure that the basis is correct.

Thermodynamics is a formal system or procedure to evaluate and understand the interaction of people, machines etc with the environment. In other words, it is a set of rules governing the behaviour of the natural world. Thus, thermodynamics would be the ideal basis for setting the value of materials.

Exergy, a thermodynamic quantity derived from the Second Law, is defined as energy quality or the ability to do work. It is important to remember that there is continuous exergy loss in society as a whole. Exergy of any material can be calculated by defining a constant reference environment (it composition, temperature and pressure). Exergy is thus a measure of the physical value of the material. This can be used as a basis for the economic value of a material.

VAT (Value Added Tax) can be modified to include an exergy cost (sum of exergy consumption from the environment and waste exergy released to the environment). Thus VAT can move from the purview of bureaucrats to that of scientists, where the tax is a measure of the physical value. This would automatically increase the costs of products that have harmful waste products and renewables would get a boost.

When the two pillars of economic theory, incentives matter and markets work, are allowed to function with the material value based on exergy - recycling and renewable energy sources would be viable. And, of course, gasoline prices would probably reach double digits!!!

Thus, there is no conflict in Economic Viability and Sustainable Resource Utilization, as long as economic value is linked to the physical value of a material.

Update:

1. It is worthwhile to note that with this tax Nuclear power would be one of the most expensive sources of energy.

2. The tax proposed here is not my idea . It was mentioned by Prof Jan Szargut during a panel discussion on the furture of exergy analysis at the ECOS 05 conference. Goran Wall also proposed this idea a couple of years ago.

3. Sunil, in his post on the economics of conservation, adds a different dimension to the debate. He presents a case for the conservation of natural habitats and the economic costs incurred when they are ignored.

4. Browsing though my mail from when I was on vacation, I noticed that the Scientific American September edition is a Special Issue - Crossroads for Planet Earth. I haven't read it yet.

16 comments:

Michael Higgins said...

Hi Rahul
Interesting post and thanks for linking to my blog.
I will make the following analogy: suppose you inherit a house filled with 5 years supply of canned goods and frozen dinners (and a really big freezer). You don't know how to cook but you know you could learn. In the meantime, maybe you're happy to draw down your finite reasource of stored good. In the long term, this isn't sustainable and you know that. When do you need to worry about the transition from eating stored food to buying fresh food in the market and preparing it yourself?

Now, this analogy is perfect: maybe no sane person would want to eat stored food for 5 years. But when I was in college, I really didn't want to spend time cooking, so it seems to me that it might be rational to postpone the decision to learn to cook and develop "sustainable food resource". Maybe it is rational to wait until you are pretty low in the stored food to transition.

I think energy is like that. There are undesirable aspects to burning fossil fuels just as there are undesirable aspects of eating canned food instead of fresh. But it is a resource that has no value unless we use it for fuel (you could use it for plastics and some other uses also, but there is really no need for petroleum than cannot be met by other products). The point is that market will force us to transition from fossil fuel to sustainable energy when the need arises, and no government policy is really needed to dictate that transistion.

I will also point out that taxes on fuel do not spur the kind of innovation that will lead to better energy sources coming about. Any entrepreneur is going to realize that the government is fairly addicted to the revenue that comes from taxing gasoline. If a new energy source comes along that replaces gasoline, government will tax it also.

Iyer the Great said...

Michael - The issue here is not only the question of limited resources, but also the wastes rejected to the environment.

Taking your analogy - if eating canned goods and frozen dinner gave me medical problems; maybe not initially, but an overdoze of it; I would then add the cost my medical expenses and time lost to the actual cost of the food and realize that it is not worth it.

The problem with economic theory, as I stated in my blog, is that it considers the environment free to reject any waste. But it is not actually free. Rejecting waste to the environment, as consuming material from the environment, must be charged.

Roland Clift likes to say "Stone age did not end because of the lack of stones". The age of petroleum also will not end because of the lack of petroleum. It will not be possible for renewables to satisfy our entire energy needs. Thus petroleum, coal, natural gas etc. will always be part of the energy mix. Pertroleum, as you rightly pointed out, can be used for plastics, with energy as its by-product.

no government policy is really needed to dictate that transistion.

I will also point out that taxes on fuel do not spur the kind of innovation that will lead to better energy sources coming about. Any entrepreneur is going to realize that the government is fairly addicted to the revenue that comes from taxing gasoline. If a new energy source comes along that replaces gasoline, government will tax it also.


I am not referring to any governmental action in my post - either for fuel transition or for taxation. I am actually recommending (well, the idea isn't mine originally) removing taxation levied by governments as VAT and replace it with this Exergy Tax - a natural resource tax that is firmly based on first principles.

The basic idea here is to ensure the cost - of removing a material from its natural state from the environment and rejecting a material to the environment not in it snatural state - is included. A cost neglected by economics thus far.

Rahul

Sunil said...

This is an excellent post.

I do find that economists (often) tend to ignore indirect economic costs to the environment.

Rahul's statement: The basic idea here is to ensure the cost - of removing a material from its natural state from the environment and rejecting a material to the environment not in it snatural state - is included. A cost neglected by economics thus far,

is a fair and valid assessment. There does need to be an economic price on the environment.

Invariably, economists tend to look at medium term solutions of only the issue at hand, and try to ignore other issues (if they are environment related), even though they do end up having indirect (but sometimes large) economic consequences.

Including these costs will make economists think more about these effects, and should result in a more economically viable final outcome anyway..

gawker said...

Wonderful posts both Iyer and Sunil, who added to his argument. Articulated a number of thoughts I myself had, in terms of economics and science. We need more such expressive articles from environmentalists to show the free-marketeers that it certainly would be in the best interests of the economy to protect the environment because of their close interrelation. Kudos.

Iyer the Great said...

Thanx Gawker. We can only keep our fingers crossed.

Rahul

Michael Higgins said...

Hi Rahul
If you are talking about global warming and other externalities associated with the energy production, I agree that there needs to be some mechanism to allow the price to reflect the total cost, and some form of tax can help. I will point out, though, that it is extremely difficult to put a cost on such things as global climate change.

There are several reasons why this is difficult:
1. You need to be able project your current models years into the future. Anyone familiar with statistics will be familiar the the problem: out of sample estimation. The error bounds are very high.
2. Part of the problem of estimating costs is not just estimating the change in the environment but also how future people would be affected by it. The problem is that to a large extent, future generations will probably be very comfortable with whatever climate they inherit because they will have never known any other climate.
3. It is not enough to know what impact that an energy policy will have on future costs. We need to know how much those cost could be avoided by a more drastic change in policy in future years. It pays to put off a decision about things that are extremely uncertain and will become less uncertain over time.
4. Future generations will likely be much much more wealthy than us. Focusing on environmental problems that occur 100 years from now might be like the poor taking care of the rich.

I'm not saying that nothing should be done. Infact, priority number one should be to use the best information possible to understand the problem better a reduce the uncertainty in these projections. Also, if we want to limit C02 emissions, the "pollution rights" method might be more effecitive than a tax method. Energy firms would have to pay for a limited number of pollution rights to be able to produce pollution causing fuels like coal or gasoline.

The advantage of the polution right over the tax is that governments get addicted to these externality taxes and when they see people adjust behavior to avoid the tax (which is what you want them to do) goverments then change the tax to make up the revenue and destroy the economic benefits of the tax. The polution right would not have this effect.

Iyer the Great said...

Sunil - I just noticed that my earlier reply to your comment is missing!! Must have missed it when I browsed over to your post. Sorry about that. Thanks for the comment and your post. Yes, the market looks at medium term solutions, rather than the long term.

Michael - This idea of exergy tax is does not stem from the debate on global warming, even though CO2 emmissions would be greatly reduced. Also, it is not a government specific tax. This would be a tax, common to all countries and admnistered by a world council. The tax would be a fee for using up any resource in the lithosphere, hydrosphere & atmosphere and wastes rejected to them.

Pollution rights are wrong in the sense it gives you a right to pollute. Also, it is an artificial way of dealing with the problem. On what basis will you decide how much you are allowed to pollute? Anything not rooted in basic principles does not make sense. When you are dealing with nature, let natural rules decide how much you pay.

The points you raise are more pertinent to the economic costs of maintaining our natural habitat as discussed in Sunil's post. But I'll try to answer them from my view point.

1. This is very true, as I point out in my comment on Sunil's post

2,3,4: Not with you mate. Isn't there uncertainity in your statements as well - probably more uncertainity here than costs associated with global warming. Why aren't we willing to take responsibility now rather than hoping our future generations adjust to the change in climate and are rich enough to pay their way out of it????

Perhaps Sunil could put it across better.

Rahul

Srikanth said...

Hi Rahul,
Came here via Sunil's blog. A very absorbing discussion. Wonderful post!

Michael Higgins said...

Hi Rahul
Let me put it this way. If you could communicate with the people who lived 100 years ago and could send them a message about taking care of the environment for future generations, what would it be? I don't think I would give any message; things worked out okay in the U.S. The environmental problems that people worried about 100 years ago largely didn't come to pass. The one thing they did do that really mattered is they grew the economy. It helped up have the wealth to clean up our environment. Over time, the amount of forested land has actually increased in the U.S. The air quality became worse but later improved.

Of course there were some things they did that really mattered to us today. They made some species extinct. That is a whole different category of problem. Once they are extinct, they won't come back.

The issues you raise about how to treat the environment for future generations are less economic and more ethical. You believe it is unethical to change the world's environment. I cannot argue against that except to say the future generation will probably feel that your ethical concern was misplaced. But maybe your ethic really isn't about them, it is about us and about how we feel about the future. That is something I cannot really argue about.

If it is worth a lot for people living today to keep the environment as we have it today, then maybe we should pay to keep it the way it is. But a lot of people don't have that preference.

Iyer the Great said...

Michael, please read my follow up post with quotes from Scientific American.

Sunil said...

f it is worth a lot for people living today to keep the environment as we have it today, then maybe we should pay to keep it the way it is. But a lot of people don't have that preference.

Michael....i think the key point that both Rahul and I have tried to make is that it IS economically better to keep or improve the environment (i had some more numbers in my earlier post).

Transmogrifier said...

Great posts Rahul and Sunil. I got to know about these posts through Gawker's comment on my blog. Thanks to Gawker for that. I got interested in relation between economics and the ennvironmental issues because of some readings on the fair trade movement. But few weeks ago I had read a post about The Natural step framework. I had looked into it a bit and then kept it as a issue for further reading. But from what I read the natural step framework basically comes from an idea similar to the one Rahul has proposed i.e the exergy destruction in production processes etc. It is based on the 1st and 2nd laws of Thermodynamics. I have NO detailed idea what the natural step framework is. But just thought I'd mention it and see what your thoughts were. Also it suggests to me that some means of quantifying the exergy destruction (i.e putting an economic cost on the destruction of environment) may already be available?

Iyer the Great said...

Thanks Transmogrifier. I visited the site of Natural Step Framework. Though they say that they use the first and second laws of thermodynamics, they are not clear how they use it for sustainable development. Most propbably with an idea similar to that described here.

Also it suggests to me that some means of quantifying the exergy destruction (i.e putting an economic cost on the destruction of environment) may already be available?

Yes, it does exist - but has not been discovered (by the masses).

Anonymous said...

Please, check my site on exergy (http://exergy.se) and in particular my draft on exergy and sustainable development (http://www.exergy.se/ftp/easd.pdf). Maybe this will help to see the importance of adopting the exergy concept into economics and resource management.
/Göran Wall

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