Can Market Forces Really be Employed to Address Climate Change?

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Debate continues in the United States, Europe, and throughout the world about whether the forces of the marketplace can be harnessed in the interest of environmental protection, in particular, to address the threat of global climate change.  In an essay that appears in the Spring 2012 issue of Daedalus, the journal of the American Academy of Arts and Sciences, my colleague, Joseph Aldy, and I take on this question.  In the article – “Using the Market to Address Climate Change:  Insights from Theory & Experience” – we investigate the technical, economic, and political feasibility of market-based climate policies, and examine alternative designs of carbon taxes, cap-and-trade, and clean energy standards.

The Premise

Virtually all aspects of economic activity – individual consumption, business investment, and government spending – affect greenhouse gas emissions and, therefore, the global climate. In essence, an effective climate change policy must change the nature of decisions regarding these activities in order to promote more efficient generation and use of energy, lower carbon-intensity of energy, and a more carbon-lean economy.

Basically, there are three possible ways to accomplish this: (1) mandate that businesses and individuals change their behavior; (2) subsidize business and individual investment; or (3) price the greenhouse gas externality proportional to the harms that these emissions cause.

Harnessing Market Forces by Pricing Externalities

The pricing of externalities can promote cost-effective abatement, deliver efficient innovation incentives, avoid picking technology winners, and ameliorate, not exacerbate, government fiscal conditions.

By pricing carbon emissions (or, equivalently, the carbon content of the three fossil fuels – coal, petroleum, and natural gas), the government provides incentives for firms and individuals to identify and exploit the lowest-cost ways to reduce emissions and to invest in the development of new technologies, processes, and ideas that can mitigate future emissions. A fairly wide variety of policy approaches fall within the concept of externality pricing in the climate-policy context, including carbon taxes, cap-and-trade, and clean energy standards.

What About Conventional Regulatory Approaches?

In contrast, conventional approaches to environmental protection typically employ uniform mandates to protect environmental quality. Although uniform technology and performance standards have been effective in achieving some established environmental goals and standards, they tend to lead to non-cost-effective outcomes in which some firms use unduly expensive means to control pollution.

In addition, conventional technology or performance standards do not provide dynamic incentives for the development, adoption, and diffusion of environmentally and economically superior control technologies. Once a firm satisfies a performance standard, it has little incentive to develop or adopt cleaner technology. Indeed, regulated firms may fear that if they adopt a superior technology, the government will tighten the standard.

Given the ubiquitous nature of greenhouse gas emissions from diverse sources, it is virtually inconceivable that a standards-based approach could form the centerpiece of a truly meaningful climate policy. The substantially higher cost of a standards-based policy may undermine support for such an approach, and securing political support may require weakening standards and lowering environmental benefits.

How About Technology Subsidies?

Government support for lower-emitting technologies often takes the form of investment or performance subsidies. Providing subsidies for targeting climate-friendly technologies entails revenues raised by taxing other economic activities. Given the tight fiscal environment throughout the developed world, it is difficult to justify increasing (or even continuing) the subsidies that would be necessary to change significantly the emissions intensity of economic activity.

Furthermore, by lowering the cost of energy, climate-oriented technology subsidies can actually lead to excessive levels of energy supply and consumption. Thus, subsidies can undermine incentives for efficiency and conservation, and impose higher costs per ton abated than cost-effective policy alternatives.

In practice, subsidies are typically designed to be technology specific. By designating technology winners, such approaches yield special-interest constituencies focused on maintaining subsidies beyond what would be socially desirable. They also provide little incentive for the development of novel, game-changing technologies.

That said, there is still a role for direct technology policies in combination with externality pricing, as I have argued in a previous essay at this blog.  This is because in addition to the environmental market failure (appropriately addressed by externality pricing) there exists another market failure in the climate change context, namely, the public-good nature of information produced by research and development.  I addressed this in my essay, “Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy.”

Back to Markets, and Some Real-World Experience

Empirical analysis drawing on actual experience has demonstrated the power of markets to drive profound changes in the investment and use of emission-intensive technologies.

The run-up in gasoline prices in 2008 increased consumer demand for more fuel-efficient new cars and trucks, while also reducing vehicle miles traveled by the existing fleet. Likewise, electricity generators responded to the dramatic decline in natural gas prices in 2009 and 2010 by dispatching more electricity from gas plants, resulting in lower CO2 emissions.

Longer-term evaluations of the impacts of energy prices on markets have found that higher prices have induced more innovation – measured by frequency and importance of patents – and increased the commercial availability of more energy-efficient products, especially among energy-intensive goods such as air conditioners and water heaters.

Experience with Externality Pricing

Real-world experience with policies that price externalities has illustrated the effectiveness of market-based instruments. Congestion charges in London, Singapore, and Stockholm have reduced traffic congestion in busy urban centers, lowered air pollution, and delivered net social benefits.  Likewise, the British Columbia carbon tax has reduced carbon dioxide emissions since 2008.

More prominently, the U.S. sulfur dioxide (SO2) cap-and-trade program has cut SO2 emissions from U.S. power plants by more than 50 percent since 1990, resulting in compliance costs one-half of what they would have been under conventional regulatory mandates.

The success of the SO2 allowance trading program motivated the design and implementation of the European Union’s Emissions Trading Scheme (EU ETS), the world’s largest cap-and-trade program, focused on cutting CO2 emissions from power plants and large manufacturing facilities throughout Europe.

And the 1980s phasedown of lead in gasoline, which reduced the lead content per gallon of fuel, served as an early, effective example of a tradable performance standard.

These positive experiences have provided ample reason to consider market-based instruments – carbon taxes, cap-and-trade, and clean energy standards – as potential approaches to mitigating greenhouse gas emissions.

The Rubber Hits the Road

The U.S. political response to possible market-based approaches to climate policy has been and will continue to be largely a function of issues and structural factors that transcend the scope of environmental and climate policy. Because a truly meaningful climate policy – whether market-based or conventional in design – will have significant impacts on economic activity in a wide variety of sectors and in every region of the country, it is not surprising that proposals for such policies bring forth significant opposition, particularly during difficult economic times.

In addition, U.S. political polarization – which began some four decades ago and accelerated during the economic downturn – has decimated what had long been the key political constituency in Congress for environmental (and energy) action: namely, the middle, including both moderate Republicans and moderate Democrats. Whereas congressional debates about environmental and energy policy have long featured regional politics, they are now largely partisan. In this political maelstrom, the failure of cap-and-trade climate policy in the Senate in 2010 was collateral damage in a much larger political war.

Better economic times may reduce the pace – if not the direction – of political polarization. And the ongoing challenge of large federal budgetary deficits may at some point increase the political feasibility of new sources of revenue. When and if this happens, consumption taxes – as opposed to traditional taxes on income and investment – could receive heightened attention; primary among these might be energy taxes, which, depending on their design, can function as significant climate policy instruments.

Many environmental advocates would respond that a mobilizing event will surely precipitate U.S. climate policy action.  But the nature of the climate change problem itself helps explain much of the relative apathy among the U.S. public and suggests that any such mobilizing events may come “too late.”

Nearly all our major environmental laws have been passed in the wake of highly publicized environmental events or “disasters,” including the spontaneous combustion of the Cuyahoga River in Cleveland, Ohio, in 1969, and the discovery of toxic substances at Love Canal in Niagara Falls, New York, in the mid-1970s. But note that the day after the Cuyahoga River caught on fire, no article in The Cleveland Plain Dealer commented that the cause was uncertain, that rivers periodically catch on fire from natural causes. On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries. A direct consequence of the observed “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different. Unlike the environmental threats addressed successfully in past U.S. legislation, climate change is essentially unobservable to the general population. We observe the weather, not the climate. Until there is an obvious and sudden event – such as a loss of part of the Antarctic ice sheet leading to a dramatic sea-level rise – it is unlikely that public opinion in the United States will provide the bottom-up demand for action that inspired previous congressional action on the environment over the past forty years.

A Half-Full Glass of Water?

Despite this rather bleak assessment of the politics of climate change policy in the United States, it is really much too soon to speculate on what the future will hold for the use of market-based policy instruments, whether for climate change or other environmental problems.

On the one hand, it is conceivable that two decades (1988–2008) of high receptivity in U.S. politics to cap-and-trade and offset mechanisms will turn out to be no more than a relatively brief departure from a long-term trend of reliance on conventional means of regulation.

On the other hand, it is also possible that the recent tarnishing of cap-and-trade in national political dialogue will itself turn out to be a temporary departure from a long-term trend of increasing reliance on market-based environmental policy instruments. Perhaps the ongoing interest in these policy mechanisms in California (Assembly Bill 32), the Northeast (Regional Greenhouse Gas Initiative), Europe, and other countries will eventually provide a bridge to a changed political climate in Washington.

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20 Responses to Can Market Forces Really be Employed to Address Climate Change?

  1. There is no doubt that one can argue in favour of each of the options mentioned in the post. Yes the market forces, through a variety of means, can be harnessed to decrease the rate of emissions of carbon dioxide and even to decrease the rate of ecological deterioration in the environment. But what does that mean? Unfortunately that amounts to buying some time but cannot be seen as a significant contribution towards dealing with the problem at its root. It is simply a palliative.
    Unless we do recognize that each and every one of the environmental issues is related to economic growth and unless welcome to the understanding that there are major physical limits to the scale of economic activities then all the gains from efficiency and substitution will be for naught. For how long are we going to fight the obvious; indefinite growth is the problem and the only possible solution is one that based on the ideas of a Steady State. Nothing else would provide a lasting solution.

  2. replicnt6 says:

    You describe this as “a rather bleak assessment.” I have to say it strikes me as more as “irrational exuberance,” presupposing, as it does, that at some point there will be a political consensus in the US that a) climate change is real, b) greenhouse gas emissions are a significant factor, c) reducing greenhouse gas emissions will help, d) it is worth the cost and effort to reduce the likelihood of the most catastrophic climate change outcomes.

    In today’s politics, (a) is a left of center viewpoint, (b) is left wing viewpoint, (c) is extreme left and (d) is radical left.

    I’m not sure I see a path to (d), when the conversation in our politics will turn to how best to address greenhouse gas emissions.

  3. David Rahni says:

    This is an excerpt from what I wrote in the 2001 issue of the Chronicle of Higher Education:

    Recognizing the Earth’s finite natural resources and its limited carrying capacity, we should appreciate that we are merely the guardians of such resources having borrowed them from our future generations, and not the sole proprietors having inherited them from our past ancestors. Therefore, we should perpetually refine and optimize practices, lifestyles, science and technologies and Yes, novel green chemistries that are environmentally benign by design– that meet the needs of the present generation without compromising the abilities of the future generations to meet theirs. We humans are not the apex of the pyramid of life, but rather an integrated and interactive player of a horizontal web of life. This requires a multijurisdictional paradigm shift with a cross disciplinary approach that almost touches all the “E” curricula: Earth, Environment, Ecology, Education, Energy, Economics, E-Commerce, E-Communication, Ethics, Equity, aesthetics, and Empowerment….This is the epitome of sustainable development and inter generational equity as a guiding principle in my life…..

  4. Jan Freed says:

    Are you aware of the Stark bill? HR3242. It mandates a $15/ton fee on any carbon source, and returns these fees to the taxpayer to defray the resultant rise in energy costs. So, the money it returned to the taxpayer, yet market forces will shift choices to renewables with lower carbon content.

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  7. Mark Muro says:

    Trying to think strategically I wonder if you would assess the relative depths of bleakness ssociated with two of your possible ways forward. Specifically: Do you feel that carbon pricing or technology subsidization is the more viable approach right now?

    As a co-author of the report “Beyond Boom and Bust,” which reviews of the gravity of the coming federal policy pull-back given scheduled program expirations, I am acutely worried, as you are, about the prognosis for even well-established R+D programs, tax programs, and subsidies. I fear significant program expirations given the political atmosphere but also budget realities. Pricing carbon seems really hard as well, although some here in Washington hold out hopes for its introduction as a source of revenue during the coming brutal budget scrum.

    So which agenda seems more plausible to you: maintaining and even expanding direct technology investment or introducing a carbon assessment? Of course both are obviously needed in my view.

  8. Despite budgetary imperatives, which would surely argue for carbon pricing as a revenue-raising instruments, I am forced to acknowledge that technology subsidies are the far easier route politically in the United States, given the reality that elected officials much prefer to pass out benefits rather than costs.

    Rob Stavins

  9. Pingback: Can Market Forces Really Be Employed To Address Climate Change? | The Next 100 Years

  10. Ed Reid says:

    Another excellent article.

    I would suggest that much of the cause of the failure of “Cap & Trade” in the US Senate had little or nothing to do with the cap and trade mechanism, which has been successful previously, as you noted. Rather, the failure resulted from the exclusionary approach taken by both the House and Senate authors in the preparation of the bills: and, the tax, spend, redistribute, pick winners and punish losers components which caused the various bills to be massive and unwieldy. It was my impression that the authors and their co-sponsors were more interested in the revenue raising aspects of the various bills; and, the opportunities those revenues would have presented to “buy” votes.

    Also, when discussing “market-based mechanisms”, I believe it is important to distinguish between the “command and control” action (cap, tax, environmental externality price, etc.) which triggers the need for the market response and the “market mechanism” (trade, repowering, etc.) which provides the flexibility for the market to respond to the “command and control” action which perturbed the market and to readjust market function.

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  13. Changgui Dong says:

    When could the comparison between the two/three approaches turn to the practical and feasibility level? I mean, find out the political and economical barriers confronting them and try to either solve the problem or propose a middle approach?

  14. Magnus w says:

    But what catastrophe lead up to the cut in SO2 emissions from U.S. power plants?

    (my long term hope is that EU could find allies to form some kind of tax on import) however it seams like we will do to little to late. Still we better aim to limit the damages!

  15. Pingback: Links to Adler guest posts at The Atlantic, and a related Stavins post « Knowledge Problem

  16. gogole says:

    so-called market defenders in the GOP standing in the way of policies that would internalize externalities

    I’m all for internalizing externalities. The 0th question in any given situation is whether those externalities actually exist. When it comes to a topic like CO2-emission-driven climate change, economists as a group simply are not equipped to answer that question.

    For some reason, this does not prevent (some of) them from slandering those who disagree with their preferred method of internalizing the purported “externality” that they couldn’t in a million years prove exists in the first place if their life depended on it.

  17. Ed Reid says:

    Professor Stavins:

    Some broader observations from the “peanut gallery” regarding both this post and the previous post on EU-ETS and RGGI.

    It is interesting that, in the ~35 years since the focus of concern shifted from global cooling to global warming, there is no universally accepted global goal regarding climate change and no plan to achieve that goal. All the nations of the world have to show for the expenditure of multiple tens of billions of dollars are: masses of land and sea temperature records which are no longer data; a collection of climate models which don’t very well; 17 large parties; agreement to hold at least 8 more large parties; a very limited Accord; some number of local or regional CO2 emissions reduction programs; and, a “wish” that the increase in global average temperature not exceed 2 degrees Centigrade. That seems like a very limited return on investment.

    Your discussion of RGGI and the EU-ETS, as well as a separate but related post by David Hone of Shell (http://blogs.shell.com/climatechange/2012/05/debate/), suggest that the current concerns with the programs have relatively little to do with reducing CO2 emissions; and, far more to do with the decline in revenues produced by the programs, primarily as the result of the global recession. The EU is apparently considering reducing the number of allowances available in the market to increase their price, which would probably work as long as the EU market does not recover from the current recession. However, it could produce a disastrous increase in allowance prices if economic activity attempts to return to pre-recession levels and begin growing again.

    I am fascinated at how the economic geniuses in numerous state, national and regional governments, including our own, have converted the relatively simple concept of “Cap & Trade” into a complex morass. An emissions cap established at a date certain, declining at a predetermined rate over a predetermined period of time, could produce whatever level of emissions reduction was required to control / stabilize / reduce the atmospheric concentrations of CO2 and other GHGs. The ability to trade would provide flexibility for those entities for which emissions reductions required the application of technologies not yet commercialized, long construction lead times, high investment and operating costs, etc. That is neither brain science nor rocket surgery.

    Achieving a significant reduction in global GHG emissions would require massive capital investments. The IEA estimate for a 50% reduction in CO2 emissions by 2050 is on the order of $45 trillion. My estimate for the investment required to effectively eliminate anthropogenic GHG emissions globally is ~$150 trillion. Selling or auctioning emissions allowances merely adds to the total cost of compliance; and, to the consumer cost increases which would be the inevitable result, barring some major technological breakthroughs. I understand that selling or auctioning the emissions allowances is an attempt to hide the tax aspects of the programs from the broad consumer population, though I question how effective that attempt has been. However, it does tend to direct the uninformed consumer dissatisfaction with the rising costs to the business sector and away from the political class.

    There is no question that eliminating global GHG emissions would require concerted global action, rather than the largely symbolic actions of some subset of nations (EU)or even states (RGGI). Absent such concerted global action, it appears to me to make no sense for some players to surrender their negotiating positions.

    “When you find that you are digging yourself into a hole, the first imperative is to stop digging.” I find myself imagining a scene in which the developing nations of Asia are digging the hole with power shovels, while the EU and others attempt to refill the hole using teaspoons.

    All of the above, of course, is based on the belief that eliminating the ~4% of annual CO2 emissions and other GHGs which are of anthropogenic origin would stabilize the global climate, even though the available proxy data suggests has not ever been stable previously.

  18. Surjit says:

    Non Renewal Sources are primary reason for high temperature. Govt’s should promote renewable like hydro, wind energy to utilize in industry

  19. pwiz says:

    This paper covered more than just electricity transmission & distribution but its on the mark if you consider that Australian electricity big-grid generation has fallen the last two years. This is attributed to penetration of solar PV and thermal hot water along with efficiency and conservation. Perhaps in response to massive costs rises along big government subsidies and the approaching $23 carbon tax (July 1st).
    The problem is side-effects, visible economic ones driving living standards down for vulnerable families and business (incl FDI). There has to be a level playing field globally otherwise it’s just self mutilation.

  20. Stephenwv says:

    Climate change is real. It is undeniable. Climate change has produced many glacial periods over the past many million years (approximately one every 150,000 years) followed by a warming cycle (of approximately 25,000 years). We have not even reached the naturally occurring peak temperatures according to NOAA charts and data. Man has never played a roll in altering climate change. In fact as CO2 levels have increased, natural CO2 absorption rates by plants has increased by 25%. Projections of gloom and doom have all been based on Earth having a constant rate of absorption of CO2. The fact that past projections of problems have not been realized over the past 30 or 40 years, has caused official and authoritative statements to change from “man caused global warming” to “climate change.” Only unofficial unauthorized extremists speak of man as a major impact on climate change. “Climate change” is not a lie; “man caused global warming” is.

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