Economic Incentives to Reduce GHGs

In his recent inaugural address, President Obama cited climate change as one policy area he intended to pursue in his second term.  Many commentators welcomed this inclusion, but pointed out the difficulties of securing political agreement on the subject.  In the near term, therefore, prospects for policy change are uncertain.

In the meantime, the U.S. already has been cutting back on greenhouse gas emissions.  In part this is due to the recent recession and slow economic growth.  But in part it is due to economic incentives.  In this note, I explore some of those incentives and the behavior they have induced. 

Energy is a costly input

Energy generally combines with capital, labor and land to produce goods and services.  Though there are substitution possibilities amongst these various inputs, energy more often is complementary to the others, raising their productivity as more is utilized.  Thus, for example, more energy enables workers to raise output per labor hour, and it enables land to produce more product per acre. 

But energy also is costly, providing an incentive for managers to economize its use.  As relative prices of energy and other inputs change and as energy saving technology advances, new possibilities open up.  Over time, the trend is for people to find ways to use energy such that it becomes more productive per unit employed.

U.S. Energy Productivity

Over long periods, the trend in U.S. energy productivity is unmistakable.  The Energy Information Administration has documented energy use per dollar of real GDP over the past 40 years.  The table below shows these numbers starting in 1973 and every ten years since, ending in 2011, the last year for which data is available.  The numbers illustrate that over the period the U.S. has more than doubled the amount of output it secures from a given amount of energy.  

Savings in Energy Costs

The increase in energy productivity means that, averaged over the entire economy, managers can produce the same output as before with less than half the energy.  That’s a lot of savings!

But the dollar savings actually are bigger than this.  They would be the same as the increase in productivity had inflation-adjusted prices of energy stayed the same.  But they haven’t.  On balance, they’ve gone up, in some cases a lot.  The next table shows inflation-adjusted retail prices (expressed in 1982-1984 dollars) for common forms of energy in 1973 and again in 2011. 

The retail prices of oil, here represented by gasoline, and of natural gas have risen in real terms while that of electricity has declined slightly.  Since oil and gas make up almost 2/3 of U.S. energy use, it’s pretty clear that real prices of energy in the U.S. on average have risen.  This implies that the savings from less use of energy per unit of GDP actually are greater than the productivity gain alone.  In the cases of oil and gas in particular, economization has resulted in very substantial dollar savings. 

Implications for Climate Policy

Market based activity isn’t the same as policy measures to deal with climate change.  However, the record indicates that people likely will continue to look for ways to use energy more productively and to economize its use.  Applied to fossil fuels, this clearly will help reduce GHG emissions below what they otherwise would be.  That’s important to understand, encourage, and act on.  And it’s a reason why we wrote Climate Change: What You Can Do Now.  We hope the things we suggest in that book further the effort.