Fork in the Road

The production of fossil fuels causes negative externalities on society and the environment through water and air pollution, as well as global warming effects such as extreme weather. Climate scientist James Hansen believes we are at the ‘fork in the road’ where we either continue to produce fossil fuels without doing anything about its negative effects on climate, or we make a change. According to Hansen, “The cost of fossil fuels is artificially low because it does not include the price they incur on society.” He proposes a gradually rising fee on all fossil fuels at their mine or port of entry that would then be redistributed to the public.

As Hansen argues, the cost of fossil fuels is low because the externalities it produces are not taken into consideration when pricing carbon. Fossil fuels create a negative production externality where the private marginal cost curve meets the private marginal benefit curve at a point that leads to over-production of the good. In order to correct this market failure, Hansen proposes a pigovian tax on fossil fuels. The pigovian tax should be the size of the externality in order to shift the private marginal cost curve up by the amount of the tax. The private marginal cost curve then becomes the social marginal cost curve and the quantity of fossil fuel production decreases until reaching the point of allocated efficiency.

By imposing a pigovian tax, Hansen is trying to internalize the externality through the market channel as opposed to the political channel. If the tax increases were large enough, they may even cause fossil fuel producers to quit producing. They will only produce as long as the marginal benefits of producing are greater than the marginal costs which are now increasing due to the increases in taxes.