Phenomenon: Gap between desire and reality
What do people think is the most pressing challenge? Unsurprisingly it is climate change. Sixty-seven per cent say so, according to the ‘world in 2030 Survey’ report by UNESCO.
Given this fact, how are we doing in fighting climate change? Again the answer is hardly surprising: We are doing pretty bad.
Today, all the world’s states collectively emit 40 per cent more greenhouse gas emissions than in 1990 (see chart above).
With far-reaching implications: damage to infrastructure through rising sea levels, thawing permafrost, and extreme weather events. Especially for the world’s poorest people: they pose a threat to their lives, as their risk of hunger and food insecurity increases.
Why are we allowing this to happen? Most people vote for lower greenhouse gas emissions – but they still continue to increase. What is the reason for this contradiction?
Explanation: Externality and free-riding cause man-made climate change
A primary reason for the climate change problem, like other environmental problems, are negative externalities.
A negative externality exists when the production or consumption of a product results in a cost to a third party. This is the case with emissions. The emission of greenhouse gases damages others at no cost to the agent responsible for the emissions.
Why should factory owners cut emissions when emitting is for free? Why should car drivers drive less when they are not charged for their negative externalities?
Some people try to quantify these externalities. According to the International Monetary Fund (IMF), the hidden global costs of fossil fuels amount to about 5 trillion US-Dollar a year. That is equivalent to 6.5 per cent of global gross domestic product (GDP).
Interim conclusion one: Externality leads to too high greenhouse gas emissions because without regulations polluters don’t bear the pollution costs.
There is a second reason why greenhouse gas emissions are still increasing. It is because of the free-rider problem.
The free-rider problem is a type of market failure. It occurs when those who benefit from resources, public goods (such as public roads or hospitals), or services of communal nature do not pay for them or under-pay.
By fighting climate change, the free-rider problem occurs. Because the climate is a global commons, the benefits of reducing emissions that are undertaken in one country will mostly accrue outside its borders. As a result, countries acting in their rational self-interest are incentivised to minimise their mitigation efforts and free-ride on those of others.
In the end, global efforts to reduce climate change are insufficient.
Interim conclusion two: Free-riding occurs when a party receives the benefits of a public good without contributing to the costs. In the case of the international climate change policy, every country has an incentive to rely on the emissions reductions of others without taking proportionate domestic abatement.
Solution: Put a price on carbon emission and found a club
There is extensive economic literature about addressing market failure triggered by externalities. Very briefly, the standard theory of externalities knows three ways to rectify a market failure:
- taxation of the emitter equivalent to marginal social cost; the so-called Pigovian taxes, named after English economist Arthur Cecil Pigou (1877-1959);
- the allocation of property rights with trading; the so-called Coase theorem attributed to Nobel Prize winner Ronald Coase (1910-2013) describes the economic efficiency of an economic allocation or outcome in the presence of externalities; and
- direct regulation.
Most economists agree that the best way to reduce greenhouse gas emissions is to put an explicit monetary price on carbon emissions.
There are two ways of doing so: a ‘cap and trade‘ system or a carbon tax:
- In a ‘cap and trade’ system, a maximum level of pollution (a ‘cap’) is defined, and manufacturers need licenses to emit carbon. As a result, the carbon price changes over time. The costs of these licenses are determined by a trading system. The price of a license increases as emissions approach the cap.
- A carbon tax is simply a levy that is applied to all goods and services, which lead to carbon emissions in their production.
“In both systems, the price of any product increases with the amount of carbon emitted in the production of it. The result is that products with a low carbon footprint (like taking the train or solar energy) do not get more expensive, while goods that do create a lot of emissions (like a flight or coal energy) do get more expensive. This helps us reduce emissions and pollution in two ways: it makes carbon-intensive goods much more expensive, meaning consumers will opt for cheaper low-carbon alternatives when they are available; and in markets where they’re not available yet producers will be incentivised to develop low-carbon alternatives.”
The differences between the ‘cap and trade’ system or a carbon tax approach:
- By setting an emissions cap that declines over time, a ‘cap and trade’- policy can increase the certainty that emissions will fall below the predetermined emissions targets.
- A carbon tax instead offers stable carbon prices, so energy producers and entrepreneurs can make investment decisions without fear of fluctuating regulatory costs.
So, there are workable solutions to internalise negative externalities. And in many places around the world, they have been implemented in many variations and with different strengths.
The greater challenge is the free-rider problem.
The crucial question is how to counter the tendency of countries to free-ride. The simple answer is: Incentives are needed not to free-ride.
The solution is a four-letter word: club.
William Nordhaus (born 1941), the winner of the Nobel Memorial Prize in Economic Sciences in 2018, is known for this idea.
That is how he explains the club idea:
“So what is a club? Although most of us belong to clubs, we seldom consider their structure. A club is a voluntary group deriving mutual benefits from sharing the costs of producing a shared good or service. The gains from a successful club are sufficiently large that members will pay dues and adhere to club rules to gain the benefits of membership.”
Again William Nordhaus: “The penalty suggested here is uniform percentage tariffs on the imports of non-participants into the club region. Calculations suggest that a relatively low penalty tariff rate will induce widespread participation among countries as long as the target carbon price is less than 50 Dollar per ton.”
For instance, country A, B and C found the FCC club (Fight Climate Change). They commit to reducing carbon emissions by pricing the emissions. Country D is not joining. Subsequently, country D will benefit from two things: a cleaner environment and a domestic industry with relatively lower production costs. But there is also a disadvantage for country D: It has to pay penalty tariffs as it is exporting to A, B or C. If the tariffs exceed the benefits of the cleaner environment and the lower production costs country D would benefit from joining the FCC club.
- It is possible to fight climate change successfully.
- Therefore we have to put a monetary price on carbon emissions. Where that is already done, growth and decline of greenhouse gas emissions can be two sides of the same coin (see chart above).
- Furthermore, we have to adopt the club model rather than the current voluntary model. This is necessary to create a strategic situation in which countries acting in their self-interest will choose to enter the club and undertake high levels of emissions reductions because of the structure of the incentives.
In this win-win situation, people and countries won’t have to decide whether to fight climate change or behave in their self-interest. What is in one’s self-interest is then, at the same time, good for the environment.
Max Roser: The argument for a carbon price
Nicholas Stern: What is the Economics of Climate Change?
Wiliam Nordhaus: Climate Clubs to Overcome Free-Riding
CoreEcon: Economics of Environment
David Coad, Ian Parry, Louis Sears, Baoping Shanga: How Large Are Global Fossil Fuel Subsidies?