Can Market Forces Really Be Employed To Address Climate Change?

by Robert Stavins, via An Economic View of the Environment

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….

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.

… 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.

— Robert N. Stavins is the Albert Pratt Professor of Business and Government, Director of the Harvard Environmental Economics Program, and Chairman of the Environment and Natural Resources Faculty Group. This is an extended excerpt of a piece originally published at An Economic View of the Environment blog and was reprinted with permission.

9 Responses to Can Market Forces Really Be Employed To Address Climate Change?

  1. Davos says:

    I can’t help but see many of these suggestions, (“pricing externalities”, shifting “subsidies”, regulatory “incentives”, etc.) are not so much “market forces” but “forcing markets”.

    Kind of like a “if you build regulate, subsidize, incentivize it… They will come” with the market forcing on the opposite side of the driving equation.

    I liked your anecdote about the demand for fuel-efficient vehicles (definitely market/consumer driven), but your other examples do not seem to be analogous.

    Is it possible that true ‘market forces’ for this type of desired consumer change will/can only exist when the worst threats of climate change are already upon us?

  2. Mike Roddy says:

    There is a straightforward way to do this: attach carbon prices to imports, based on carbon intensity and pollution in general. Walmart would practically empty out.

    This won’t happen soon, because free trade is considered untouchable, for no particular reason. We also give do not account for bunker fuel on container ships or wood from industrial logging from countries like Canada and Indonesia.

    Retailers would holler like hell, but it would be good for domestic industry. As one example, Chinese steel is far more polluting and carbon intensive than US steel, but they have a competitive advantage. If we account for that, a lot of good things will happen, in steel and many other industries.

  3. Lou Grinzo says:

    I think a fundamental change in our attitudes towards the “free market” is required to enable us to make the needed changes to avoid very severe climate change impacts.

    First and foremost, we have to recognize that the free market is extremely good at one thing: Short-term resource allocation based on price signals. But that does not imply that if we simply let the market do its thing with almost no regulation or government intervention that we will get the results we want, including most notably dramatically lowered GHG emissions. The market is a tool, not a god.

    Second, the layperson notion of the “free market” is really what economists call “perfect competition”, which has, among other things, the characteristics of perfect information (everyone know everything of interest about prices, transactions, and goods and services) and immunity to control by individual actors. The overwhelming majority, some would argue all, of the various markets that make up a national economy obviously fail to meet those criteria. We try to force our imperfect markets to be closer to the ideal through things like laws against monopolistic practices, lying in advertising, etc., but it’s an uphill climb.

    The point is that in order to make the market serve our needs and deliver the desired results we have to continue to shove it in the right direction, because it certainly won’t do it on its own. As climate change becomes an ever more urgent issue, that means putting a price on carbon emissions and otherwise restricting known-bad activities are absolutely required.

  4. Mimikatz says:

    The first step in applying market forces would be removing the subsidies for fossil fuels, no? That would level the playing field more than subsidies for clean energy technologies. Certainly it is a necessary first step.

  5. Leif says:

    Of course Market forces can work for Humanity. It works great against humanity and for the controllers. Stop rewarding pollution for starters, all else will follow.

  6. danp says:

    Of course market forces can be employed to address climate changes. Externalities that can be priced should be!

    But the author dismisses regulatory approaches with the usual glibness of an economist who is apparently unaware of how environmental regulations have worked. The Clean Air & Water acts have been astonishingly effective and consistently cheaper to implement than both industry and the EPA itself has estimated. Industries vary from cautious to dumb about replacing crappy equipment and regulation provides a straightforward, predictable path to do so rather than playing chicken with other companies over worries of technology leapfrogging.

    Frankly it’s shameful for someone with these paper credentials to so blithely dismiss the astonishingly effective results of mileage standards, appliance standards, and clean air and water compliance, at so little cost and such great societal gain. I’m sure he can make some economic argument that manufacturers would have created and consumers would have bought more efficient refrigerators if only energy were more expensive. But even the most superficial reading of the industrial history around those regulations would remind us that economists consistently paper over market inefficiencies that are not always addressable with pure pricing solutions.

  7. john atcheson says:

    Note the assumption here — that there is a cost associated with cutting carbon. This is a typical assumption by economists, particularly neoclassical economists.

    And certainly to get the kind of cuts we need to stabilize at 2 C, there is a cost.

    But as Mckenzie group, ACEEE and many others have shown, there are substantial cost-effictive energy efficiency opportunities available — as much as a 30% reduction in carbon at no net cost.

    This matters because it changes the policy debate and the economic assumptions.

    For example, because of the use of discounting, expenditures today to avoid damage tomorrow are perceived as having a very high and negative economic impact.

    But if we can cut 30% now at little or no cost, using efficiency, then the calculous changes dramatically. First, we don’t carry that cost forward — and we therefore don’t have to make that trade-off of the future vs the present; second, when we do begin to incur costs, we will be competing with fossil fuels that are more scarce and more expensive.

    This means strategies such as performance standards don’t automatically carry the economic inefficiencies that economists presume they do.

    Finally, there are other ways to align incentives to reduce carbon that Stavins didn’t consider, but which are as powerful or more powerful than the 3 that were considered.

    For example, right in Dr. Stavins own back yard ISO New England employs Forward Capacity Markets as a means of putting efficiency and onsite generation on an even footing with centralized generation.

    One could envision a price adder for carbon imposed in the auction rather than through cap and trade or a carbon tax. The latter are rather blunt instruments, while the price adder would apply the price precisely where it would have the most effect. It would incentivize aggregators and others to go right to the carbon source.

    My own belief is that economists typically view the world through their own discipline — which is a narrow and often abstract look at things. This does more harm than good, as the imbroglio over the Sterns Report shows.

    Sterns and Sterner after him dared to go beyond orthodoxy, and come up with some interesting conclusions — we need more economist like them, or fewer setting the terms of the policy debate.


  8. Rob Bradley says:

    Perhaps a better title or critical essay could be titled: “Can Government Really Be Employed to Address Climate Change?”

    ‘Government failure’ might be as great as the alleged market failure in this case.

  9. David Lewis says:

    Stavins argues about climate policy as if we’re wondering what to do about the rise of Hitler and we still think levelling Germany is out of the question. He doesn’t tell us what he means by “truly meaningful climate policy” although he uses these words when assessing the approaches he discusses. He points to US SO2 cap and trade policy as a “success”.

    Naomi Oreskes and Erik Conway have a chapter on acid rain policy in “Merchants of Doubt” where they note that although they themselves believe the cap and trade policy employed to reduce SO2 emissions was a “success”, no one told the affected forests. “The cap and trade system simply did not do enough. Not only did it not eliminate acid rain, it did not even reduce it sufficiently to stabilize the situation. Forest decline has continued”. Oreskes and Conway say the cap could have been set lower, but they also note that there are arguments that although regulation can impose an expensive one size fits all standard it may be that technological innovation proceeds more quickly under such regimes than under a perceived to be less expensive cap and trade approach.

    In any case, it is difficult to buy into an argument that points to a “success”, i.e. the SO2 cap and trade operation, that is similar to an argument where a medical proceedure is determined to be a “success” even though the patient died.

    The minimum I expect a “truly meaningful” climate policy to achieve is a stable climate system.

    Given that it appears that it is a widespread view among climate scientists that allowing warming to proceed beyond 2 degrees C globally is very likely going to produce an unstable system that will prove to be dangerous to the existence of civilization, and that the rate of emission reduction necessary now to achieve a realistic possibility of keeping the planetary system from going beyond 2 degrees is historically unprecedented even in regions suffering economic collapse such as the disintegrating former Soviet Union, I say that “truly meaningful” discussion of what policy options remain to us now needs to spell out exactly what the author means by “truly meaningful” policy.

    Stavins and Aldy don’t do this.