Free Exchange rightly criticizes Ted Gayer at Brookings for his argument is that if households and firms are forgoing a profit opportunity (the supposedly profitable decision to weatherize buildings), then cap-and-trade will not work because these same households and firms will ignore all of the cost-saving profit opportunities that cap-and-trade is meant to induce. His reasons that:

“If cap-and-trade does not drive down costs, then EPA regulators might feel justified in imposing inflexible, command-and-control regulations to reduce greenhouse gas emissions. Why establish a flexible, market-based approach when consumers and firms (but apparently not analysts) lack the ability to identify and act upon the least costly means for reducing pollution?”

Gayer should think hard before espousing the logic that “if markets participants aren’t currently doing something that is profitable, then market based mechanisms won’t work, so you might as well go with command-and-control policies”. Paul Krugman and Robert Reich might jump at this statement in full agreement that we need a new Federal Weatherization Workforce; a fully unionized, public option for weatherizing homes, as well as a weatherization mandate. He should be careful what he wishes for.

In addition to being terribly misguided, Free Exchange is right to call his argument “too-clever-by-one-half”, because it is also incorrect;. Even if all homeowners and business are currently incorrectly underestimating the returns to weatherization, if cap-and-trade raises energy prices, people might still estimate that weatherization has, on the margin, become a profitable investment.

Say, for instance that all households have identical costs of weatherization of X and benefits of X + e, with X and e > 0. Also assume all households are underestimating the benefits by some amount k > e, such that they view the net benefit as X + e – X – k = e – k < 0, i.e. the net benefits are negative. Say cap-and-trade raises the benefit of weatherization by k, and everyone can clearly observe that. Then the benefits of weatherization are X + e – X – k + k = e   > 0, i.e. the benefits are net positive. Ta-da!

This is just an algebraic way of saying all that we need to happen is for cap-and-trade to raise the benefits of weatherization by as much as some households and firms are underestimating it by, then some households will respond to cap-and-trade by weatherizing.

Unless, of course, households and firms can’t estimate net present value when you’re in a liquidity trap. In this case, we may need the weatherization public option and mandate.