The visible hand in economics

Why are we using market mechanisms to fight climate change?

Posted on: July 21, 2008

Over at No Right Turn, Idiot/Savant appears to view the idea of using markets to fight climate change as a touch silly. This view is captured in the following quote (here):

What’s important is that we reduce emissions now, not whether our chosen policy is perfect and cleaves to neo-liberal orthodoxy.

Now I think this skepticism of using a market mechanism stems from the way he views the issue of climate change policy, take for example this quote:

Some of these measures are almost certainly more effective than economic measures; if you want to ban deforestation, then the easiest way is to ban deforestation, not muck about with tradable certificates. Where they fall down is that they lack flexibility – its rare to want a total ban on something, and the hassle factor of thinking up all the exceptions can be significant.

I completely agree that there are times when “banning” will provide a superior outcome than trying to set a price. However, these times have to be carefully defined – they are times when the imposition of the social cost (including the fiscal cost of running the scheme!) associated with the activity would stop the market existing, and when the cost of enforcing a ban is cheaper than the cost of running a non-existent market.

Where we differ is in the goals we are trying to achieve. I am stating that the goal is to “maximise welfare” by making people pay for the whole social cost of what they are doing – the market mechanism allows us to do this. However, the goal I/S appears to allude to is “reducing emissions”. As the market mechanism will still allow emissions to be produced (in cases where people really highly value the products that are created) I/S seems to imply that such a mechanism would be sub-optimal.

However, if this is the case, shouldn’t I/S provide transparency and just say that a market mechanism is suboptimal because it maximises social welfare, which is decremental to his ultimate goal of lower carbon emissions.

Now there is another way that I/S may view the problem which would allow for welfare maximisation and state that banning is superior to a market mechanism. Fundamentally, if the government knows the quantity of something that should be produced the best way to do it would be to just set the quantity, rather than having a market doing it. In fact, this is sort of what they are doing with the emissions trading scheme, as they have a quantity target. I agree with I/S that the current method is far from perfect (or fair) – however, I believe that is because of too little in the way of fair market instruments, rather than too much.

Furthermore, the government does not know everything. By changing the price, but still allowing people choices, households will reveal how much they value certain things. If we can quantify the external impact of our carbon creation, then we can charge that to products – leading to the welfare maximising solution. Ultimately, the “revealed preferences” provided by this mechanism is the reason why I prefer a carbon tax (which is still a market mechanism btw) to an emissions trading scheme.

I/S writes well on a range of important environmental issues, but I think in this case his anti-market bias has gotten the best of him. We are using a market mechanism to fight climate change because it is the best way of doing it – not because of a preconceived policy bias.

8 Responses to "Why are we using market mechanisms to fight climate change?"

Why is government tax collection of global warming costs a market mechanism?

Government, which is 38% of the total economy (local and federal) will use that money to fund its operations, and where does government get its emission slips? They just create them, the result being very suboptimal.

The perfect market mechanism is when the person who is damaged by global warming sues and collects from the people who are emitting.

Who is the damaged person? The person who uses much less than the average emissions.

In your scheme, what do bicycle commuters get? Nothing, unless they can get their claims through a congress which is distributing global warming taxes to other government services.

In my scheme, bicycle commuters would have sued five years ago, the bicycle commuting industry would have expanded, and we would have optimum equilibrium.

Use government, not the legislature, but the tort system. Step one is to get the legislature to hand the problem over to tort asap. If the legislature tries to find a path to equilibrium, expect the problem to last another 40 years.

“Why is government tax collection of global warming costs a market mechanism?”

Because there is still a market instead of direct regulation. The impact of the tax is to change the price in the market – rather than trying to legislate a certain quantity.

“In your scheme”

Just to be clear, none of these scheme are “my scheme”. I was just trying to defend having a carbon market as compared to direct regulation.

From your post I can see that you want a Coasian solution to the environmental externality – but, I think the transaction costs are too high, and the information requirements are too severe, for this to be the efficient cause of action.

Actually, I think a market mechanism is great provided we actually get one. And I think one of the strengths of a market mechanism (in addition to the above-mentioned flexibility) is precisely that it makes polluters pay the full social cost of their activities. I also think that setting the quantity (through an ETS) is far preferable to setting the price (through a carbon tax), for precisely the sorts of reasons you outline. The current ETS is flawed in that it rewards polluters and doesn’t do enough to reduce emissions in CP1, but as I’ve made clear in several posts, I’m willing to tolerate an imperfect system if it actually happens, rather than holding out for a perfect one which never arrives.

It’s that latter point which is important: I’m interested in environmental policy which actually works. I don’t care what colour the cat is, provided it catches mice and doesn’t shit on the carpet. An ETS would work, that’s great. Regulations would work too, that’s great as well. One might not work quite as well as the other? Better an imperfect solution which is actually implemented than a perfect one which never happens. If optimisation is too hard, then satisficing will suffice.

Which brings me to regulation. Other people have noticed that there is a very real chance of the ETS failing, and of the big theme of NZ climate change policy – doing nothing while quibbling over the perfect market mechanism – repeating again, and asked about regulatory alternatives. My post was an effort to explain what a regulatory alternative might look like. The choice proposed is not between regulation and the ETS, but between regulation and nothing. And on that, I’ll take regulation which decreases emissions in a way which improves aggregate welfare over nothing any day. And if that is heresey (or “anti-market bias”) to economists, then so much the worse for them.

I agree with I/S that the current method is far from perfect (or fair) – however, I believe that is because of too little in the way of fair market instruments, rather than too much.

I should also note that I agree with you here. The problem with the ETS is that it shields polluters too much, and replaces permit auctions (which provide a fair method of allocation) with free handouts to entrenched interests who should be allowed to go to the wall if they are not profitable when paying the full costs of their activities.

I’m not so much “against market instruments” as simply not ideologically biased towards them. Other countries have used regulations, or mixed regulatory and market mechanisms, and they’ve worked in reducing emissions. The ideological bent of our policy culture is the primary explanation for why we have not done the same.

Hi I/S,

Thanks heaps for replying, it is much appreciated. I have written a response up as a post. It should magically turn up at 8am tomorrow šŸ™‚

[…] Climate change: the heresy of pragmatism 28 07 2008 Idiot/Savant disputed our claim that market mechanisms are the best way to fight climate change on pragmatic grounds – namely stating that a regulatory solution that works would be better than a […]

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