Climate is a multi-faceted problem. As Mark Carney has put it: “to solve the climate crisis, we must address three challenges, engineering, political, and financial.” And we need the available tools – science, policy and financial markets – working together in alignment.
This need for alignment is especially pressing between policy and markets. It’s easy to fall into the trap of seeing this as either/or: that you either have to believe in government action as the path to a climate solution or you have to believe in markets as that path.
I’m going to argue that the best hope really lies in a combined effort, and that the role of policy and the role of markets should be seen not as alternatives to one another, but rather as mutually supportive: different roles serving different purposes. I’ll get to carbon pricing in a moment, but let’s start with markets.
Capitalism is based on a belief in the power of markets. On a belief that people will make choices in favor of the things they value most, and that the freedom to pursue one’s own interest creates innovative solutions to emerging problems more quickly and more effectively than a central command structure ever can.
And markets do work. But a belief in markets should not be dogmatic like a belief in Santa Claus or the Easter Bunny; it should be based on a clear understanding of the necessary conditions that need to be in place for markets to serve the overall good, and a clear understanding of what can cause them to fail. They don’t work by magic.
This is where policy comes in. Policymakers can ensure that these necessary conditions are met, shaping the market’s incentives and pointing it in the right direction. Top of the list of the necessary conditions is the issue of externalities. I posted on that subject a few months ago, and in this post we’re looking at a specific example: greenhouse gas emissions.
The short version of the economics here is that if a tonne of carbon (technically: CO2e) emissions creates a cost for society in general of (say) $80, then the emitter should be required to pay that amount. Until that is done, then the entire fossil fuel industry – and all of their customers (i.e. everyone) – has a misdirected financial incentive, and markets don’t do their job of correctly allocating resources. In that situation, if I can generate $20 of economic benefit by burning a tonne of carbon, it’s in my financial interest to do so – even though that leaves everyone else worse off to the tune of $80.
There are all sorts of anti-market responses to this situation, various ways the government could step in to directly address the problem. But fighting the market is an uphill battle. The pro-market response is to internalize the externality: i.e., to require the emitter to pay the $80. In case you are not inclined to take my word that this is the “pure” economic answer, here is a video link of Milton Friedman making exactly that argument.
For the true believer in markets, this is the role of the policymaker; not simply to get out of the way, but rather to ensure that markets are set up to succeed.
But externalities are too often ignored. In a recent paper, Duncan Austin coined the brilliant expression “externality-denying capitalism”. And we need to be clear: capitalism that denies externalities is bad capitalism. It does not work. It eats itself.
Austin argues that “Western culture has not achieved sustained acceptance – distinct from mere theoretical admission – of the scale of market externalities”. And he has a strong point: Schroders, for example, have estimated that global corporate profits would fall by roughly 50% if externalities were taken into account.
As the world struggles to find a way to a reduce greenhouse gas emissions without wreaking economic havoc, we need the power of markets to be pointing in the right direction. Step one is a global carbon price.
Endnote #1: Yes, it’s more complicated than that
A few caveats are due. We don’t, of course, know the precise cost for society of a tonne of CO2e emissions. There are lots of reasons that it is difficult to place a financial value on natural and human capital. We do know the value is not zero, though.
And moving beyond a carbon price to the wider topic of externalities in general, there’s simply no way that these can all be internalized in the way that economic theory suggests they should. So we’ll never completely embed overall wellbeing into financial incentives or into law. The law must be supplemented by social norms. There will always be a role for values as well as financial motivation (but, once again, it’s not either/or.)
Endnote #2: A fourth challenge
I opened with a Mark Carney quote about three challenges. And today’s concerned teenagers would do well to channel their energy into becoming tomorrow’s scientists, policymakers and financiers helping to meet those challenges.
Let me add a fourth need: communication. To the public at large, a price on carbon would look a lot like a big old tax hit. They would see fuel costs go up and an increase in the cost of just about everything else as a result. They would see job losses. Their first thought would not be that this is a correction of a market distortion, and that it will lead to a stronger economy in the long term.
So it’s not just policymakers who need to be convinced. A carbon price needs to have the support of the wider public, too, if the policy is to succeed. The groundwork for that support needs to have been laid in advance.
Hence the communication challenge. There is no logical case to be made for externality-denying capitalism, and that is true whether you sit on the left or the right of the political spectrum. But capturing that idea in a way that resonates widely is no easy task. If anyone out there can take the message of this post and express it in a way that works for a less technical audience, or has the delivery channels to get that message out into the mass consciousness where it needs to be, bring it on!