Climate Change Market Failure Essay Example

Posted on by Elizabeth Jones

Environmental market failure






  1. What is meant by market failure?















Climate of Doubt?





Now, despite the high credibility of climate modelers, there is still tremendous uncertainty in their long-term forecasts. But as we will see shortly, uncertainty makes the case for action stronger, not weaker. So climate change demands action. Is a cap-and-trade program along the lines of the model used to reduce sulfur dioxide the right way to go?

Serious opposition to cap and trade generally comes in two forms: an argument that more direct action — in particular, a ban on coal-fired power plants — would be more effective and an argument that an emissions tax would be better than emissions trading. (Let’s leave aside those who dismiss climate science altogether and oppose any limits on greenhouse-gas emissions, as well as those who oppose the use of any kind of market-based remedy.) There’s something to each of these positions, just not as much as their proponents think.

When it comes to direct action, you can make the case that economists love markets not wisely but too well, that they are too ready to assume that changing people’s financial incentives fixes every problem. In particular, you can’t put a price on something unless you can measure it accurately, and that can be both difficult and expensive. So sometimes it’s better simply to lay down some basic rules about what people can and cannot do.

Consider auto emissions, for example. Could we or should we charge each car owner a fee proportional to the emissions from his or her tailpipe? Surely not. You would have to install expensive monitoring equipment on every car, and you would also have to worry about fraud. It’s almost certainly better to do what we actually do, which is impose emissions standards on all cars.

Is there a comparable argument to be made for greenhouse-gas emissions? My initial reaction, which I suspect most economists would share, is that the very scale and complexity of the situation requires a market-based solution, whether cap and trade or an emissions tax. After all, greenhouse gases are a direct or indirect byproduct of almost everything produced in a modern economy, from the houses we live in to the cars we drive. Reducing emissions of those gases will require getting people to change their behavior in many different ways, some of them impossible to identify until we have a much better grasp of green technology. So can we really make meaningful progress by telling people specifically what will or will not be permitted? Econ 101 tells us — probably correctly — that the only way to get people to change their behavior appropriately is to put a price on emissions so this cost in turn gets incorporated into everything else in a way that reflects ultimate environmental impacts.

When shoppers go to the grocery store, for example, they will find that fruits and vegetables from farther away have higher prices than local produce, reflecting in part the cost of emission licenses or taxes paid to ship that produce. When businesses decide how much to spend on insulation, they will take into account the costs of heating and air-conditioning that include the price of emissions licenses or taxes for electricity generation. When electric utilities have to choose among energy sources, they will have to take into account the higher license fees or taxes associated with fossil-fuel consumption. And so on down the line. A market-based system would create decentralized incentives to do the right thing, and that’s the only way it can be done.

That said, some specific rules may be required. , the renowned climate scientist who deserves much of the for making global warming an issue in the first place, has argued forcefully that most of the climate-change problem comes down to just one thing, burning coal, and that whatever else we do, we have to shut down coal burning over the next couple decades. My economist’s reaction is that a stiff license fee would strongly discourage coal use anyway. But a market-based system might turn out to have loopholes — and their consequences could be dire. So I would advocate supplementing market-based disincentives with direct controls on coal burning.





The Cost of Action
Just as there is a rough consensus among climate modelers about the likely trajectory of temperatures if we do not act to cut the emissions of greenhouse gases, there is a rough consensus among economic modelers about the costs of action. That general opinion may be summed up as follows: Restricting emissions would slow economic growth — but not by much. The , relying on a survey of models, has concluded that Waxman-Markey “would reduce the projected average annual rate of growth of between 2010 and 2050 by 0.03 to 0.09 percentage points.” That is, it would trim average annual growth to 2.31 percent, at worst, from 2.4 percent. Over all, the Budget concludes, strong climate-change policy would leave the American economy between 1.1 percent and 3.4 percent smaller in 2050 than it would be otherwise.







Clearly, conservatives abandon all faith in the ability of markets to cope with climate-change policy because they don’t want government intervention. Their stated pessimism about the cost of climate policy is essentially a political ploy rather than a reasoned economic judgment. The giveaway is the strong tendency of conservative opponents of cap and trade to argue in bad faith. That Heritage Foundation broadside accuses the Congressional Budget Office of making elementary logical errors, but if you actually read the office’s report, it’s clear that the foundation is willfully misreading it. Conservative politicians have been even more shameless. The National Republican Congressional Committee, for example, issued multiple press releases specifically citing a study from as the basis for a claim that cap and trade would cost $3,100 per household, despite repeated attempts by the study’s authors to get out the word that the actual number was only about a quarter as much.


But that’s not the same as saying we should. Action will have costs, and these must be compared with the costs of not acting. Before I get to that, however, let me touch on an issue that will become central if we actually do get moving on climate policy: how to get the rest of the world to go along with us.

The China Syndrome
The United States is still the world’s largest economy, which makes the country one of the world’s largest sources of greenhouse gases. But it’s not the largest. China, which burns much more coal per dollar of gross domestic product than the United States does, overtook us by that measure around three years ago. Over all, the advanced countries — the rich man’s club comprising , and — account for only about half of greenhouse emissions, and that’s a fraction that will fall over time. In short, there can’t be a solution to climate change unless the rest of the world, emerging economies in particular, participates in a major way.

Inevitably those who resist tackling climate change point to the global nature of emissions as a reason not to act. Emissions limits in America won’t accomplish much, they argue, if China and others don’t match our effort. And they highlight China’s obduracy in the negotiations as evidence that other countries will not cooperate. Indeed, emerging economies feel that they have a right to emit freely without worrying about the consequences — that’s what today’s rich countries got to do for two centuries. It’s just not possible to get global cooperation on climate change, goes the argument, and that means there is no point in taking any action at all.

For those who think that taking action is essential, the right question is how to persuade China and other emerging nations to participate in emissions limits. Carrots, or positive inducements, are one answer. Imagine setting up cap-and-trade systems in China and the United States — but allow international trading in permits, so Chinese and American companies can trade emission rights. By setting overall caps at levels designed to ensure that China sells us a substantial number of permits, we would in effect be paying China to cut its emissions. Since the evidence suggests that the cost of cutting emissions would be lower in China than in the United States, this could be a good deal for everyone.

But what if the Chinese (or the Indians or the Brazilians, etc.) do not want to participate in such a system? Then you need sticks as well as carrots. In particular, you need carbon tariffs.


To the objection that such a policy would be , a violation of the principles of free trade, one reply is, So? Keeping world markets open is important, but avoiding planetary catastrophe is a lot more important. In any case, however, you can argue that carbon tariffs are well within the rules of normal trade relations. As long as the tariff imposed on the carbon content of imports is comparable to the cost of domestic carbon licenses, the effect is to charge your own consumers a price that reflects the carbon emitted in what they buy, no matter where it is produced. That should be legal under international-trading rules. In fact, even the , which is charged with policing trade policies, has published a study suggesting that carbon tariffs would pass muster.


The Costs of Inaction
In public discussion, the climate-change skeptics have clearly been gaining ground over the past couple of years, even though the odds have been looking good lately that 2010 could be the warmest year on record. But climate modelers themselves have grown increasingly pessimistic. What were previously worst-case scenarios have become base-line projections, with a number of organizations doubling their predictions for temperature rise over the course of the 21st century. Underlying this new pessimism is increased concern about feedback effects — for example, the release of methane, a significant greenhouse gas, from seabeds and tundra as the planet warms.





So how can we put a price tag on the effects of global warming? The most widely quoted estimates, like those in the Dynamic Integrated Model of Climate and the Economy, known as DICE, used by Yale’s William Nordhaus and colleagues, depend upon educated guesswork to place a value on the negative effects of global warming in a number of crucial areas, especially agriculture and coastal protection, then try to make some allowance for other possible repercussions. Nordhaus has argued that a global temperature rise of 4.5 degrees Fahrenheit — which used to be the consensus projection for 2100 — would reduce gross world product by a bit less than 2 percent. But what would happen if, as a growing number of models suggest, the actual temperature rise is twice as great? Nobody really knows how to make that extrapolation. For what it’s worth, Nordhaus’s model puts losses from a rise of 9 degrees at about 5 percent of gross world product. Many critics have argued, however, that the cost might be much higher.

Despite the uncertainty, it’s tempting to make a direct comparison between the estimated losses and the estimates of what the mitigation policies will cost: climate change will lower gross world product by 5 percent, stopping it will cost 2 percent, so let’s go ahead. Unfortunately the reckoning is not that simple for at least four reasons.

First, substantial global warming is already “baked in,” as a result of past emissions and because even with a strong climate-change policy the amount of carbon dioxide in the atmosphere is most likely to continue rising for many years. So even if the nations of the world do manage to take on climate change, we will still have to pay for earlier inaction. As a result, Nordhaus’s loss estimates may overstate the gains from action.

Second, the economic costs from emissions limits would start as soon as the policy went into effect and under most proposals would become substantial within around 20 years. If we don’t act, meanwhile, the big costs would probably come late this century (although some things, like the transformation of the American into a dust bowl, might come much sooner). So how you compare those costs depends on how much you value costs in the distant future relative to costs that materialize much sooner.

Third, and cutting in the opposite direction, if we don’t take action, global warming won’t stop in 2100: temperatures, and losses, will continue to rise. So if you place a significant weight on the really, really distant future, the case for action is stronger than even the 2100 estimates suggest.


You might think that this uncertainty weakens the case for action, but it actually strengthens it. As ’s Martin Weitzman has argued in several influential papers, if there is a significant chance of utter catastrophe, that chance — rather than what is most likely to happen — should dominate cost-benefit calculations. And utter catastrophe does look like a realistic possibility, even if it is not the most likely outcome.


Still that leaves a big debate about the pace of action.

The Ramp Versus the Big Bang
Economists who analyze climate policies agree on some key issues. There is a broad consensus that we need to put a price on carbon emissions, that this price must eventually be very high but that the negative economic effects from this policy will be of manageable size. In other words, we can and should act to limit climate change. But there is a ferocious debate among knowledgeable analysts about timing, about how fast carbon prices should rise to significant levels.

On one side are economists who have been working for many years on so-called integrated-assessment models, which combine models of climate change with models of both the damage from global warming and the costs of cutting emissions. For the most part, the message from these economists is a sort of climate version of St. Augustine’s famous prayer, “Give me chastity and continence, but not just now.” Thus Nordhaus’s DICE model says that the price of carbon emissions should eventually rise to more than $200 a ton, effectively more than quadrupling the cost of coal, but that most of that increase should come late this century, with a much more modest initial fee of around $30 a ton. Nordhaus calls this recommendation for a policy that builds gradually over a long period the “climate-policy ramp.”


I find it easiest to make sense of the arguments by thinking of policies to reduce carbon emissions as a sort of public project: you pay a price now and derive benefits in the form of a less-damaged planet later. And by later, I mean much later; today’s emissions will affect the amount of carbon in the atmosphere decades, and possibly centuries, into the future. So if you want to assess whether a given investment in emissions reduction is worth making, you have to estimate the damage that an additional ton of carbon in the atmosphere will do, not just this year but for a century or more to come; and you also have to decide how much weight to place on harm that will take a very long time to materialize.

The policy-ramp advocates argue that the damage done by an additional ton of carbon in the atmosphere is fairly low at current concentrations; the cost will not get really large until there is a lot more carbon dioxide in the air, and that won’t happen until late this century. And they argue that costs that far in the future should not have a large influence on policy today. They point to market rates of return, which indicate that investors place only a small weight on the gains or losses they expect in the distant future, and argue that public policies, including climate policies, should do the same.

The big-bang advocates argue that government should take a much longer view than private investors. Stern, in particular, argues that policy makers should give the same weight to future generations’ welfare as we give to those now living. Moreover, the proponents of fast action hold that the damage from emissions may be much larger than the policy-ramp analyses suggest, either because global temperatures are more sensitive to greenhouse-gas emissions than previously thought or because the economic damage from a large rise in temperatures is much greater than the guesstimates in the climate-ramp models.

As a professional economist, I find this debate painful. There are smart, well-intentioned people on both sides — some of them, as it happens, old friends and mentors of mine — and each side has scored some major points. Unfortunately, we can’t just declare it an honorable draw, because there’s a decision to be made.



The Political Atmosphere
As I’ve mentioned, the House has already passed Waxman-Markey, a fairly strong bill aimed at reducing greenhouse-gas emissions. It’s not as strong as what the big-bang advocates propose, but it appears to move faster than the policy-ramp proposals. But the vote on Waxman-Markey, which was taken last June, revealed a starkly divided Congress. Only 8 Republicans voted in favor of it, while 44 Democrats voted against. And the odds are that it would not pass if it were brought up for a vote today.

Prospects in the Senate, where it takes 60 votes to get most legislation through, are even worse. A number of Democratic senators, representing energy-producing and agricultural states, have come out against cap and trade (modern American agriculture is strongly energy-intensive). In the past, some Republican senators have supported cap and trade. But with partisanship on the rise, most of them have been changing their tune. The most striking about-face has come from , who played a leading role in promoting cap and trade, introducing a bill broadly similar to Waxman-Markey in 2003. Today McCain lambastes the whole idea as “cap and tax,” to the dismay of former aides.

Oh, and a snowy winter on the East Coast of the U.S. has given climate skeptics a field day, even though globally this has been one of the warmest winters on record.

So the immediate prospects for climate action do not look promising, despite an ongoing effort by three senators — , and — to come up with a compromise proposal. (They plan to introduce legislation later this month.) Yet the issue isn’t going away. There’s a pretty good chance that the record temperatures the world outside Washington has seen so far this year will continue, depriving climate skeptics of one of their main talking points. And in a more general sense, given the twists and turns of American politics in recent years — since 2005 the conventional wisdom has gone from permanent Republican domination to permanent Democratic domination to God knows what — there has to be a real chance that political support for action on climate change will revive.


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