Economics of climate change

Published September 30, 2019
In this file photo, students, children, and civil society members march to raise awareness for action against climate change on September 20. — Climate Action Now Pakistan's Twitter account
In this file photo, students, children, and civil society members march to raise awareness for action against climate change on September 20. — Climate Action Now Pakistan's Twitter account

People across Pakistan came out to demand immediate public action on climate change last week. The sizeable mobilisation of citizens could not have been possible without the efforts of our climate-change campaigners. Several opinion pieces in leading newspapers emphasised the urgency of countering the climate crisis and urged readers to band together and make their voices heard. Most, if not all, commentators squarely blamed the nature of market economies (read capitalism) for the crisis, arguing that market economies are by design extractive and polluting and that we’re all doomed as long as they continue to function.

Market economies are not the sole offenders when it comes to environmental degradation. The policies of the handful of centrally planned economies that history has witnessed led to large-scale environmental destruction. The Soviet Union’s Industrialisation and Collectivisation plans left in their wake a highly degraded environment while Mao’s Great Leap Forward obliterated China’s rich environmental landscape.

Broad-stroke criticisms of market economies vis-à-vis climate change not only betray a lack of comprehension of conventional economic theory but also disregard the decades of serious academic and policy work carried out by economists to address environmental challenges. In fact, the field of environmental economics emerged within the bastions of market economics in the 1960s as a response to understanding and addressing growing environmental problems.

Broad-stroke criticisms of market economies vis-à-vis climate change betray a lack of comprehension of conventional economic theory

Conventional economists acknowledge that emissions of greenhouse gases and pollutants are an inevitable by-product of growth — given the technologies at their disposal, firms will pollute as they increase their production of goods and services. In determining how much to produce, firms weigh their private benefits (revenue) against their private costs (costs of production). They ignore the social costs of their production — they do not factor in the cost of polluting the environment. As long as firms operate without internalising the costs of pollution, they will produce socially inefficient levels of goods and services.

This is an example of what economists call “market failure” — the inability of markets to provide the socially desirable levels of certain goods and services in an economy. The existence of market failures does not imply that market economies are inherently destructive; instead, it demonstrates the critical role of public intervention in forcing firms to internalise the social costs of their production outcomes. Professor Joseph Stiglitz succinctly states in his book People, Power, and Profits: “Capitalist economies have… always involved a blend of private market and government… the question is not markets or government, but how to combine the two to best advantage.”

Recognising the importance of the public sector in addressing market failures, conventional economists have created a number of policy tools to improve environmental outcomes. These fall under three broad categories: command-and-control strategies; price-based instruments; and information-based interventions.

Under a command-and-control strategy, the government legally mandates socially desirable behaviour and uses enforcement mechanisms such as courts, police and fines to ensure compliance. In the context of environmental policy, a command-and-control approach is a mandate on the minimum level of environmental performance (an environmental standard): for example, a provincial law that states that each paper-producing factory in Punjab cannot emit more than 200 units of a pollutant per day.

The existence of market failures does not imply that market economies are inherently destructive

Where command-and-control strategies depend on the strong arm of the government to alter firms’ behaviour, price-based instruments rely on tools such as emissions taxes and cap-and-trade markets to incentivise firms’ emissions reductions. An emissions tax — which stems from the oft-quoted “polluter pays principle” — incentivises firms to roll back their emissions to reduce their tax burden. This instrument further allows the government to distribute the revenue generated from such “green taxes” to support environmental programmes and institutions.

Professor William Nordhaus — who won the Nobel Prize last year for his seminal work on the economics of climate change — has shown that the prevention of a climate catastrophe requires a high tax on carbon emissions. Professor Martin Weitzman, known for some of the most outstanding contributions to the field and who tragically passed away a few weeks ago, argued for a uniform tax on global carbon emissions.

Under a cap-and-trade programme, the government allocates permits to emit a fixed amount of a pollutant for a given period of time. Firms can then exchange (buy or sell) their permits with each other in an “emissions market”. Permits flow from firms willing to sell them to those willing to buy them — a market failure corrected by a market instrument!

Information-based interventions are fairly new. By informing citizens of the environmental performance of firms in their locale, the government can harness the power of public pressure to force firms to reduce their emissions. Professor Michael Greenstone and his team conducted an experiment in India in which they rated firms on the basis of their environmental outcomes. They found evidence of better regulatory compliance when they made the ratings publicly available.

One would be naïve to assume that proponents of market economies do not envisage any significant role of the public sector — or collective action for that matter — in their appraisals of policy prescriptions. Conventional economists unanimously agree that public intervention is essential in fixing market failures, such as excessive pollution, unsustainable resource extraction and under-provision of education and health care services. The fundamental debate amongst economists centres on how much public intervention is appropriate without undermining well-functioning markets.

Blanket statements on the inability of market economies to mitigate environmental problems don’t offer a way forward — by the time the revolution comes, we will all probably be dead. In the meantime, let’s reflect on strengthening our public institutions and leveraging the policy tools economists have created to tackle the climate crisis.

The writer is an environmental economist. He teaches at Lums

Published in Dawn, The Business and Finance Weekly, September 30th, 2019

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