A Coasean Rationale for a Carbon Tax

Executive summary:

This policy analysis develops a rationale for a carbon tax based on two key insights from the work of Ronald Coase.

The first insight is that problems of pollution should not be viewed simply as situations in which A harms B, so that A should be restrained with a tax, a suit for damages, an injunction, or a regulatory prohibition. Instead, they should be seen as coordination problems in which the plans of two parties conflict. Reaching optimal coordination typically requires action by both parties. Those will usually include both action by polluters to cut emissions (abatement) and action by pollution victims to reduce harm (adaptation). Putting too much of the burden of coordination on either party is inefficient.

The second insight is that a complete analysis must take into account the direct costs of abatement and adaptation, but also the transactions costs of achieving coordination. Transactions costs include the costs of identifying victims and sources of pollution, assessing damages, reaching agreements on actions to be taken, and enforcing those agreements once they are in place. In some cases, superficially attractive policy solutions turn out to be unsuitable because of their high transaction costs.

The analysis uses the example of coastal flooding caused by climate change as a case study in coordination. The polluters are fossil fuel burning power plants and the victims are coastal property owners. The former have a number of abatement options, including fuel switching and carbon capture, while the latter have abatement strategies that include building sea walls, improving construction, and retreating to higher ground. Following Coase, a full range of policy options are examined for their impact on the behavior of both polluters and pollution victims. When all aspects of the coordination problem are considered, including transaction costs, carbon taxes emerge as an attractive mechanism for dealing with climate change.

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