Externalities of climate change and how to tackle them
What are the characteristics of the GHG-emission externality?
In economics, negative externalities are side-effects of economic activities. They arise somewhere during the lifecycle of products or services, are not considered by the market actors but have an influence on society’s welfare. When the negative effects (social costs) that are not taken into account at the market exceed the private gain, the market outcome does not maximise society’s welfare and thus externalities are one case of market failure (Metcalf, 2009; Fullerton & Stavins, 1998).
Greenhouse gas (GHG) emissions, in particular, are produced during the production, transport and disposal/recycling of all kinds of goods and GHG emissions have most likely a huge negative impact on society’s welfare by fostering climate change that tremendously exceeds the individual gains of the market actors (Stern, 2006). Neither the producers nor the consumers of goods that are causing GHG emissions are directly and personally affected by these emissions. Moreover, the damage often falls on people in developing countries or even on future generations. To conclude, GHG-emission can be seen as a market externality, because those responsible for the emissions do not pay the costs and thus have no economic incentive to reduce the emissions. In strict economic view, the market fails by producing more greenhouse gases than the socially optimal level (Nemet, 2013; Metcalf, 2009).
What are examples for additional climate policy-related technology externalities?
Although green technology is not the panacea to mitigate climate change, it plays an important role in the key endeavour of decarbonizing the economy. Green technology aims at increasing the efficiency of economic activities, meaning that less GHG is emitted per good or per unit of GDP (Nemet, 2013). Therefore, technological improvements can have two positive effects: First, less GHG are emitted and second, the companies can reach environmental requirements at lower costs. However, new technologies do not come overnight. To reach the win-win situation, a new technology has to be first invented and developed and second diffused throughout the economy. Both steps are costly and therefore may not occur in a desirable speed (Nemet, 2013). Jaffe, Newell, & Stavins (2005) identify a failure of the market in finding the right level of investment in innovation and diffusion of new greener technologies because of externalities. While GHG emissions are negative externalities and are therefore over-produced by the market, new more environmentally friendly production technologies produce positive externalities and are therefore underprovided by competitive markets.
Following the authors, the positive externalities arise because of two phenomena: First, research done by one firm also benefits all other firms and the customers, while only the researching firm has to bear the costs. Although, there are institutions such as patents to protect innovations, in general, new knowledge is at least partly a public good that can be used by everyone. This eliminates the competitive advantage of the innovator and therefore diminishes the incentive to develop new technologies. Second, the value of some technologies may be dependent on the use of the technology by other actors. Network effects (increasing returns with an increasing number of users) and the value of first observing competitors adopting a new technology can lead to a first mover disadvantage. The adoption of a new technology creates a positive externality for other actors that do not pay off for the adopting company. In addition to that, uncertainty about the potential of a new technology and asymmetric information between the innovator and the other actors can lead to scepticism that will hinder external investment in the development of a new technology. The market failure because of incomplete information and the positive externalities of innovation and adoption can be an explanation for the paradox that, although green technology reduces both, environmental impacts and costs, it is not developed fester and used more broadly within the economy (Jaffe et al., 2005).
Is more than one policy instrument required to tackle these externalities? If yes, why? What would be suitable policy instruments?
Overcoming the described market failures is an important step towards mitigating climate change. Because of their nature as market failures, externalities need external intervention and can only be tackled by policy instruments. Many different instruments have been developed for environmental policy with different strengths, weaknesses and applications. There is clearly no one-fits-all solution because no instrument is generally superior and a mix of instruments seems to be always more effective to combine the strengths and features (Goulder & Parry, 2008). In this memo, two different kinds of externalities regarding GHG emissions were described, negative and positive externalities, and consequently at least two different approaches are needed to tackle the market failure. In general, relevant instruments can be distinguished between softer incentive-based instruments that focus on cost-effective target attainment and harder regulatory instruments (Goulder & Parry, 2008).
The most economical solution is to internalize the externalities to bring the economic incentives in line with social aims. In the case of the GHG emission externality, this means a policy is needed that internalizes the social costs of GHG emissions into the production costs. This can be easily achieved with emissions taxes on products according to their GHG emissions. Another possibility to establish a price (that is what is missing for an externality) for emissions are tradable emissions allowances. In contrast to a tax, a so-called cap-and-trade system allows the government to set a fix maximum quota of possible emissions for the economy but still allows an efficient reduction because the firms can sell and buy the allowances and thus emissions will be reduced where it costs the least (Goulder & Parry, 2008). Implementation of these economic instruments can replace an inefficient regulatory instrument such as simply setting a max level of emissions per firm.
The positive technology externalities can be economically tackled by stimulating innovation with public investments. Financial support such as financing scientific research and providing technological infrastructure can be the basis for much needed private investments in innovative technologies (Jaffe et al., 2005; Nemet, 2013). A strong system to protect intellectual property and something like a top-runner or best cases approach with a continually rising minimum level of production efficiency can be additional regulatory instruments to incentivise investments in more efficient technologies (Nemet, 2013; Jänicke, 2008). A suitable policy is a mix of incentive-based and regulatory instruments in order to first, secure the change and second, to do it as efficient as possible.
Fullerton, D., & Stavins, R. (1998). How economists see the environment. Nature, 395 (6701), 433-434.
Goulder, L. H., & Parry, I. W. (2008). Instrument choice in environmental policy. Review of environmental economics and policy, 2 (2), 152-174.
Jaffe, A. B., Newell, R. G., & Stavins, R. N. (2005). A tale of two market failures: Technology and environmental policy. Ecological economics, 54 (2), 164-174.
Jänicke, M. (2008). Ecological modernisation: new perspectives. Journal of cleaner production, 16 (5), 557-565.
Metcalf, G. E. (2009). Designing a carbon tax to reduce US greenhouse gas emissions. Review of Environmental Economics and Policy, 3 (1), 63-83.
Nemet G.F. (2013). Technological Change and Climate Change Policy. In J.F. Shogren (ed.), Encyclopedia of Energy, Natural Resource, and Environmental Economics, volume 1, (pp. 107-116). Amsterdam: Elsevier.
Stern, N. (2006). Stern review executive summary. New Economics Foundation, London.
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