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Environmental Economics and Climate Change

First we introduce the concept of externality. An economic transaction takes place through markets. Buyers (consumers) and sellers (producers) get together in the market. When a transaction takes place in a market, the buyer pays, and the seller receives, the price owed for the product. When producers undertake production, their production activities can have “side effects” on third parties who are not part of the market transaction between the consumer and the producer. In economic parlance, such side effects are called “externalities.”

Consider the following example. A coal power plant generates electricity for a community. The community is the consumer and the plant is the producer. In the market for electricity, the community pays for the power it consumes. Coal power stations have rotating machines to convert the heat produced by burning coal into mechanical energy. The prime mover is a steam or gas turbine. There are byproducts released directly into the atmosphere or into river or lake water, or indirectly into the atmosphere using a cooling tower with river or lake water used as the cooling medium. The flue gas from the combustion of coal is discharged into the air. This gas contains carbon dioxide (CO2), water vapor, and more corrosive substances such as nitrogen oxides (NOx), sulfur oxides (SOx), mercury, and fly ash. While the price of electricity is paid for by the community, these other byproducts generate an externality that not only affects the neighboring community but also other communities with access to the river or to the air. These other communities bear the cost of the production of electricity indirectly, outside the market, without receiving any benefits. Therefore, from a societal point of view, the price paid for the electricity by the community typically does not take into account these emissions that cause harm through these toxic emissions.

This general principle is illustrated in Figure 6.1a. When consumers and producers are operating in the market alone, the producer considers only private marginal cost. In the context of the example of electricity production, this would mean that the producer does not take into account all the effluence such as NOx, SOx, mercury, and fly ash he produces in the atmosphere while producing electricity. We have assumed that the marginal cost of producing electricity goes up with higher volume of electricity production. It is well known that there are economies of scale in electricity production at low volumes of production. However, cost per unit eventually goes up.[1] This is represented by the upward slope of the marginal private cost line. The consumers in the aggregate are represented by the marginal (social and private) cost line—the demand curve. It is downward sloping as a higher price per unit would induce the consumers to use less electricity. The market equilibrium is reached at the

a Cost-benefit analysis when social and private costs differ

Figure 6.1a Cost-benefit analysis when social and private costs differ

“market price” when the equilibrium quantity of electricity produced with no government intervention in the market is Qp (quantity in the private market).

The additional cost of the effluence comes about through the impact of NOx, SOx, and other pollutants on the environment and human health. If, through government intervention, the social cost of the impact of the effluence is taken into account, the production would become more costly for the electric utility company. The “marginal social cost” line represents such an outcome: the cost of producing electricity at every level of output will go up. From a social point of view, taking the externality into account, the optimal output is Qs—socially optimal output. The price the consumers would pay in that case would be what is labeled as the “optimal price.”

Accounting for all externalities, valuing them, and calculating the marginal social cost line is not a trivial matter. But if the uncertainty regarding the social cost through different channels is small, this calculation can be performed. Note that Qs represents a level of output at which there will be less effluence than the private equilibrium at Qp—but not zero effluence. Therefore, Qs represents a compromise between society’s desire for electricity and society’s desire for a clean environment (in this case, clean water and clean air). From an economic point of view, a tradeoff exists between goods output and an unpolluted environment. It is rare to produce electricity with zero pollution. Even extremely clean production of electricity through photovoltaic cells generates pollution during the production of those cells themselves. Therefore we must decide how much pollution to tolerate if we wish to have the benefits of electricity production. In doing so, we must measure the social costs ofpollution and balance those costs against the social benefits of electricity production.

Such externalities lead to what economists call a market failure—the outcome generated by the market is not socially optimal. This example illustrates the case of a negative externality. There are examples of positive externalities as well. Economic theory offers solutions to such problems through internalization of externalities.

How would such internalization work? Suppose the government imposes a tax based on the output. The marginal social cost now becomes the private cost. The object of this tax is not just to penalize the electric utility company. It is to send an economic message: companies that create less pollution will pay less tax. Indirectly, it will create an incentive for the electric utility companies to generate electricity through cleaner technologies that produce less effluence.

Figure 6.1b illustrates how such an effluence tax would work. The socially optimal output is now reached through the market itself. Qs is the new market equilibrium with the tax. It is usually possible to find ways to produce electricity that produces less effluence. Electricity that can be produced with less effluence will be taxed less. In that case, the social optimum will be achieved not through any reduction of production, but by shifting to a different production technology. The tax would still achieve the purpose of creating an economic incentive to achieve a socially beneficial economic shift. Arthur Pigou proposed this solution to “internalize” the total costs of an activity into the market. In honor of Pigou, it is often called a Pigovian tax.

It is challenging to design a tax that will achieve a socially optimal output that the society desires. We cannot be sure that the tax will hit the optimal quantity target we are trying to achieve.

The goal is to arrive at the socially optimal level of effluence production (Qs, in our example). Determining the correct level of Pigovian tax to reduce the effluence to the socially optimal level can be very difficult. For example, if a rising level of affluence causes ecological problems in addition to economic problems (such as the disappearance of an endangered species), it could be difficult to put a price on the ecological impact. But, suppose, after all such economic and ecological considerations, we come up with an optimal level of production such that all the considerations are taken into account with our optimal level. So, in our example, we have

b How a tax works to internalize an externality determined that Qs is the level that would not wipe out the endangered species that we are concerned about

Figure 6.1b How a tax works to internalize an externality determined that Qs is the level that would not wipe out the endangered species that we are concerned about. It is possible to design a market that will solve the optimal output problem as long as it is possible to monitor effluence production.

Suppose the government has determined that to achieve a socially optimal output of electricity Qs, the necessary effluence reduction is Es. The government then issues permits that allow all the firms together to produce a quantity of effluence of Es. The permits may be distributed to existing firms. They can be sold by auction to firms that are producing electricity for the community. This system will reach the same level of effluence as a command and control regulatory system. However, in a command and control regulatory system, every company has to comply with environmental regulation regardless of cost. Under the auctioning system, a company could choose to increase its level of effluence if it is able to buy credits from another firm. If a producer has a superior technology which produces very little effluence, it does not need as many permits to produce effluence. It can therefore sell the additional permits to companies that produce more effluence. The buyers of these permits can postpone costly controls until they can switch to a new technology that produces less effluence. In this system, the price of an effluence permit is determined by the effluence market through supply and demand. The government needs to monitor the activities of the companies in order to ensure compliance. It would be possible to tighten effluence standards over time by reducing the number of available permits according to revised goals each year. In this system, the role of the government is reduced to the necessary monitoring and sanctioning, but the role of the government is not eliminated. With command and control regulation, the government has to resort to micro management, which requires more government resources than a system based on permit trading.

The price of the permits will depend on two critical elements. All other things being equal, if fewer permits are available, the price of the permits will rise. On the other hand, if technological progress makes cutting effluence cheaper, then the price of the permits will fall.

In the case of a negative externality, the main problem that arises is often called the “tragedy of the commons.” The main problem was illustrated by Garrett Hardin:

The tragedy of the commons develops in this way. Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy. As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me of adding one more animal to my herd?” This utility has one negative and one positive component. 1) The positive component is a function of the increment of one animal. Since the herdsman receives all the proceeds from the sale of the additional animal, the positive utility is nearly +1.2) The negative component is a function of the additional overgrazing created by one more animal. Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any particular decision-making herdsman is only a fraction of -1. Adding together the component partial utilities, the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another. . . . But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit—in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons.[2]

In summary, it is easy to see the relevance of negative externality and the tragedy of the commons to the context of climate change. The emissions of greenhouse gases (principally CO2, N2O, SO2, and CH4) caused by human activities contribute substantially to the rising temperature in the long run around the globe. This process, in turn, contributes to climate change. Climate change does not necessarily mean simply a rise in the temperature. It also means a rise in the variability of the temperature. These effects produce more frequent extreme weather-related events, such as drought, floods, hurricanes, and tornados, and contribute to rising sea levels. All of these weather-related events have an impact on the existing ecological systems across the globe. These effects, in turn, will give rise to extreme poverty, migration, and other disruptive forces. If there were no short-term gains from these effects for any country, then it would be easy to get all countries around the table to find a solution. Unfortunately, the tragedy of the commons works with a vengeance in the short run. If a country can get away with adding to the greenhouse gases, which would give them business or economic growth advantage in the short run, they have every incentive to pursue that path. Like the herdsmen in the story above, countries would be willing to add to greenhouse gases for short-term gains, in spite of their long-term effects.

In economic terms, climate change is an externality with the following characteristics.

First, it is global. This feature gives rise to the tragedy of the commons problem. One country or one region cannot reduce the greenhouse gas emissions of other regions or countries. There is no simple way to deal with that problem because it is not possible to ban greenhouse gases from traveling from one part of the globe to another. It may be possible to create incentives for other countries, for example with unilateral trade restrictions or foreign aid that is conditional upon emissions reductions. However, as we saw in Chapter 3, trade restrictions may violate WTO law. Moreover, trade barriers do not just impose costs on the exporting country. They also impose costs on the importing country, where importers are affected by the increased cost of inputs. In addition, few domestic markets are large enough for trade barriers to have an economic impact that would be sufficient to create an adequate incentive to reduce emissions.[3] In the case of foreign aid, as we will see in Chapter 8, foreign aid that is conditioned upon the use of inputs from the donor country also may violate WTO law. Moreover, foreign aid costs money for donor countries, too. Even if we resolve the problems of cost and WTO consistency of trade barriers and foreign aid, they remain partial solutions only because they will not achieve the desired level of emissions reductions.

Second, there is substantial uncertainty about the impact of greenhouse gas emissions. We do know that human activities are contributing to the global stock of greenhouse gases. We can estimate that. However, the link between rising greenhouse gases and rising temperature under natural conditions is uncertain. Knutti and Hegerl reviewed the nature of this uncertainty in great detail.[4] Their results are summarized in Figure 6.2.

Figure 6.2 shows the following. Consider the top part of the graph. Suppose the carbon dioxide equivalent (CO2e) level rises to 400 parts per million (ppm) in the atmosphere. The consequence will be a rise in the temperature (relative to the preindustrial level). However, the exact rise cannot be predicted with precision. What we can say is that the temperature will rise between 0.5°C and 5.0°C. However, the chance of an increase in that range of 0.5°C and 5.0°C is not uniform. The consequence of a 400 ppm rise in CO2e will have a 90 percent chance of a temperature rise between 1°C and 3°C. Similarly, suppose the CO2e level rises to 650 ppm in the atmosphere. Then the temperature will rise between 1.5°C and 6°C. The probability that it will rise between 2°C and 6°C will now be 90 percent. How likely are these increases in CO2e? Upton gives us some idea.[5] Suppose the

Distribution of rising temperature as a consequence of rising CO2 levels so-called “business as usual” policy continues, where no action is taken to reduce the emissions

Figure 6.2 Distribution of rising temperature as a consequence of rising CO2 levels so-called “business as usual” policy continues, where no action is taken to reduce the emissions. Then, by 2050, the atmosphere will have between 500 and 600 ppm of CO2e, and by 2060 the atmosphere will have between 600 and 700 ppm of CO2e. Thus, we can estimate the future concentrations of greenhouse gases and we can estimate the probability of a range of temperature increases, but we cannot say precisely what the temperature increase will be, how that temperature increase will vary from one part of the planet to another, and what the ecological and economic effects will be.

Third, the problems of climate change are long-term problems. John Maynard Keynes once said: “In the long run we are all dead.”[6] In particular, the effects of more CO2e in the atmosphere do not show up immediately. They take decades to appear. There may be feedback effects. Specifically, small changes in temperature can lead to bigger changes in temperature in the future through other mechanisms such as rise in the sea level. The dire consequences of rising greenhouse gases in the early parts of the twenty-first century may well happen in the early parts of the twenty-second century. Most humans alive now will be dead by then. It is therefore difficult to motivate today’s citizens and voters to take action that will be costly for them, when the benefits of averting possible disasters are far into the future.

Fourth, the damages caused by climate change are potentially large and irreversible. For example, small island countries such as Kiribati, Maldives, and Tuvalu are most at risk to be completely under water within a few decades. Other countries such as Barbados or Bangladesh will not be completely under water but they will have to resettle a large number of people within their own borders away from the densely populated coastal areas. Thus, while we cannot predict with absolute certainty how and when these damages will occur, the risks are great.

The 2013 Draft Climate Assessment Report encapsulates the nature of this uncertainty as follows:

A significant issue in studying and preparing for global climate change is the fact that changes in human, social, and physical systems do not always occur gradually. Same changes may occur in a relatively predictable way, while others involve unexpected break-points or thresholds beyond which there are irreversible changes or changes ofhigher magnitudes than expected based on previous experience. These “tipping points” are very hard to predict, as there are many uncertainties associated with understanding future conditions. These uncertainties come from a number of sources, including insufficient data associated with low probability/high consequence events, models that are not yet able to represent the interactions of multiple stresses, incomplete understanding of physical climate mechanisms related to tipping points, and a multitude of issues associated with human behavior, risk management, and decision-making.[7]

Many developing countries are especially vulnerable to climate change. They will face rising water in coastal regions and thus need to relocate people. For example, Bangladesh will need to move at least 20 million people if the sea level rises by just three feet. A large number of rural poor will suffer due to falling agricultural yields that will lead to falling incomes of the marginal farmers and rural agricultural workers. Rising disruptive rainfall will lead to more malnutrition and disease. Migration and conflict will rise as a consequence of climate change.[8]

Developed countries are not immune either. Regions that experience high levels of water shortages today will experience worse shortages in the decades to come. In particular, such problems will become more pronounced in Southern Europe and in the South Western United States (such as Arizona, California, Nevada, and Texas). Sea level rises could force the relocation of people from populous cities such as New York, Osaka, and Tokyo. Insurance against hurricanes, floods, and drought will become more expensive and, in some cases, nonexistent. We analyze insurance issues in Chapter 7.

The foregoing analysis points to the importance of internalizing the externalities associated with greenhouse gas emissions. However, these negative externalities are not being internalized in the price of goods and services. Indeed, as we will see in Chapter 8, the opposite is occurring. Countries around the world, both developed and developing, spend far more money subsidizing the production and consumption of fossil fuels than the amount of money developed countries have promised to mobilize by 2020 to combat climate change.

  • [1] Laurits R. Christensen and William H. Green, “Economies of Scale in U.S. Electric PowerGeneration” (1976) 84 Journal of Political Economy 655.
  • [2] Garrett Hardin, “The Tragedy of the Commons” (1968) 162 Science 1243.
  • [3] Bradly J. Condon, Environmental Sovereignty and the WTO: Trade Sanctions and InternationalLaw (Transnational Publishers, Ardsley NY 2006) 224-9.
  • [4] Reto Knutti and Gabriele C. Hegerl, “The Equilibrium Sensitivity of the Earth’s Temperature toRadiation Changes” (2008) 1 Nature Geoscience 735 (accessed March 15, 2013).
  • [5] Simon Upton, “Environmental Outlook to 2050” Online slide presentation (June 27,2012) slide 8 (accessed March 15, 2013).
  • [6] John M. Keynes, A Tract on Monetary Reform (MacMillan Publishers, London 1924) ch. 3, 92(accessed December 30, 2012). The context of the quote is somewhat different. Keynes was discussingcurrent affairs back in the 1920s: “The long run is a misleading guide to current affairs. In the long runwe are all dead. Economists set themselves too easy, too useless a task ifin tempestuous seasons they canonly tell us that when the storm is past the ocean is flat again.”
  • [7] National Climate Assessment Development Advisory Committee, Draft Climate Assessment Report(January 11, 2013) 13 (accessed January 12, 2013).
  • [8] Rafael Reuveny, “Climate Change-Induced Migration and Violent Conflict” (2007) 26 PoliticalGeography 656.
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