Changing climate, changing markets

Written by Mark Briggs on . Posted in Current features, Features

Photo by Alan D. Wilson

A  polar bear inspects the carcass of a whale. Photo by Alan D. Wilson

Scientists, political leaders and some business leaders have named climate change as “the biggest challenge we face”.

Extreme weather and rising sea levels, potentially caused by climate change, pose threats to life and property. But any serious response to this phenomena is likely to change the economy. So why does an environmental problem require an economic solution?

Since the industrial revolution, increasingly cost efficient methods of harnessing natural resources have gone hand in hand with economic growth. But we are now looking to break that link.

As the US biologist E.O.Wilson put it: “destroying a rainforest for economic gain is like burning a Renaissance painting to cook a meal.”

Tragedy of the commons

We may put fences around our property and border guards at national boundaries but some of the planet’s resources, water and air are considered to be common property and that can make them vulnerable.

This theory of the ‘Tragedy of the Commons’ was first described by Garrett Hardin. After observing farmers grazing their cattle on public land, he suggested that individuals acting independently and rationally in their own self-interest behave in contradiction to the group’s long term interest resulting in the depletion of common resources.

In the case of climate change, the extensive use of fossil fuels damages the environment we live in, a common resource. “It is essentially a problem of the commons,” says Aleksandar Zaklan, a Jean Monnet Fellow associated with the Climate Policy Research Unit (CPRU) at the EUI. The CPRU works to gather reliable statistics and analysis regarding EU climate polices to assist and enable policy makers across the continent and Zaklan has specialised environmental economics, “You have a common resource that you can’t punish people for using.”

With no charge and no individual responsibility, there is no motivation to ensure its upkeep. When the effect on the atmosphere isn’t taken into account you are free to seek the most effective means of producing energy, for example, regardless of its impact on that resource.

There is evidence from behavioural experiments suggesting that under certain circumstances some people will act in the common good but especially in large groups such behaviour cannot be expected. According to Zaklan, “You have way too many players for this sort of behaviour.”

Regulation time

There is a cost to damaging the environment, but it doesn’t appear on the balance sheet, even though such activity is to the long term detriment, not only to the abuser, but to all who use the resource.

“There is a clear market failure,” explains Vanessa Valero, also a Jean Monnet Fellow associated with the CPRU. “We don’t take into consideration the negative externalities.”

“The free market is efficient only when there is no market failure. As soon as market failure is identified you have to regulate,” says Valero.

According to Valero there are two ways to regulate emissions. “You can either regulate on price or quantity.” Regulating on price requires the imposition of taxes, something the European Union is barred from doing. Therefore a cap and trade system to regulate quantity was introduced in 2005.

The European Union Emission Trading System places an upper limit on the amount of carbon that can be emitted in the EU. This amount is then divided up into allowances each representing an amount of carbon. Allowances were divvied up among member states and industries roughly in line with historic emissions levels.

Essentially permits to pollute, these can be traded between firms or saved for future use. Each year the number of allowances available decreases creating a scarcity. In 2013, for the first time, electricity companies had to buy their entire allowance rather than receive free permits as was the case when the scheme was first established.

The plan is to reduce the amount of carbon emissions by 20 percent by 2020. Accompanying policies seek to ensure 20 per cent of the EU’s electricity comes from renewable energy and there is also a 20 per cent improvement in energy efficiency, both by 2020.

The idea is spreading. US President Barack Obama recently announced plans to dramatically cut carbon pollution from power plants, and promote a cap and trade policy. The move has been hailed as the most significant step the US has taken towards tackling climate change.

However, costs of reducing CO2 emissions are a definite concern. Additionally, its opponents continue to doubt the scientific evidence.

The bottom line

“It is natural that those who are negatively impacted by climate policy are mobilising against it,” says Zaklan.

This is the natural consequence of regulation readjusting for market failure. Such policies are monetising the previously negative externalities, raising the question: Who is going to foot the bill?

When companies were free to pollute, society paid the cost in terms of damage to its resources. Now companies are internalising that cost. It is appearing on their balance sheets as a cost of production. The price of raw materials, labour and facilities now sits alongside how much they pay for the right to pollute. However, the cost of production may be passed on to the consumers.

“The big [energy] producers have less than perfect competition,” says Zaklan. “They may charge the consumer for the entire cost of regulation.”

But after years of running up bills for the abuse of common, someone has to account for the damage. Either we pay now, or we pass the cost onto the next generation.

“It is hard for those coming in 20, 50, 100 years to argue with us,” says Zaklan. “We make the decisions. If we decide to put the costs on them there is nothing they can do about it.”

“The question is to what extent are you trying to be fair to your grandchildren. Or to what extent are you saying I maybe don’t care so much and I just want to maximise my output, consumption, everything that I can possibly get and they can deal with it.”

If we do delay, those who follow us will have a steeper bill to pay says Valero:  “It might be much more expensive in the future. The safest reply is we have to do it as soon as possible.”

However little doubt remains in the scientific community, such certainty is not matched in the general public. A perception has developed that we are sacrificing definite reward now to potentially solve possible problems later.

“People are myopic,” states Valero. “You need a public authority that has a longer view. If the question is can the market self-regulate to take into consideration climate change; the answer is definitely no. Regulation is something that is needed.”

Zaklan agrees and suggests such an approach is not unusual. “Most markets are regulated. The idea that the economy is totally free is a bit of a myth.”

“Without regulation we will never be able to solve this problem.”



*Vanessa Valero and Aleksandar Zaklan are Jean Monnet Fellows at the Robert Schuman Centre for Advanced Studies where they are currently researching topics in environmental economics, including the EU’s Emissions Trading System.