This article is part of the series ‘Economic Policies for the Global Green Transition: Optimal policies under conditions of government and market failures’.
Climate change entails an array of market failures that require government intervention. Policymakers have multiple policy options available to them. However, policies often have negative side-effects and unintended consequences. Thus, a supplementary framework of consistently well-coordinated policies is best suited to reach socially efficient market outcomes (Hepburn 2006, p. 6). These policy options range from command-and-control policies, market-based policies to industrial and monetary policies. This piece will examine command-and-control polices and market-based policies, which are the first policy categories that usually come to mind when thinking about climate policy. The next piece will shed light on further policy options, which are then reviewed to construct an optimal policy framework using a political economy of climate change perspective.
Policy makers are interested in the most cost-effective policies – those that achieve targets at the minimum possible cost (Hindriks and Myles 2013, p. 931). Market-based policies are incentive-based regulations that use market mechanisms to increase the opportunity cost of externalities; thus incentivising the internalisation and reduction of externalities (e.g. pollution) (Rosen and Gayer 2014, p. 97). Market-based policies do this by using flexible market mechanisms to find the most cost-effective way of externality internalisation (e.g. pollution reduction). In contrast, command-and-control policies require a certain amount of pollution reduction and have no or limited flexibility in how to achieve this (Rosen and Gayer 2014, p. 98). Consequently, command-and-control policies tend to be more expensive and less efficient than marked-based policies (Hindriks and Myles 2013).
Command-and-control policies can be split into technology and performance standards. Technology standards require polluters to install specific technologies to cut pollution; performance standards set an emission goal with flexibility of how to meet that standard left to the polluters. Thus, performance standards are more cost-effective than technology standards (Rosen and Gayer 2014; Tresch 2014; Hindriks and Myles 2013).
However, as polluters are not required to pay for their polluting activities, they weigh the opportunity costs of shirking against the costs of regulations. Thus, governance capacities – the ability and willingness to issue, monitor and enforce regulations – are crucial for the effective implementation of command-and-control policies (Gayer and Rosen 2014, p. 100). In contrast, market-based policies require lower governance capacities as they rely on the competencies of tax collection agencies – capacities that even weak states usually enjoy (Rosen and Gayer 2014, p. 100; Tresch 2014, pp. 132-133). Having outlined command-and-control policies, what are the most cost-effective market-based policy options?
The most cost-effective, market-based policies are cap-and-trade and emission-fee policies (Tresch 2014 ,p. 126). Emission-fee policies entail a tax levied on each unit of emission, thus setting a price control which limits the price of emission reductions and changes the quantity of emissions supplied. In contrast, a cap-and-trade system is a quantity control system – whereby a desired level of pollution is set and pollution permits are granted in accordance, resulting in changes to the price of emission reductions. In theory, these two are symmetrical as there is always one quantity that achieves a certain price of pollution and vice versa (Rosen and Gayer 2014; Hindriks and Myles 2013).
However, the elasticity of marginal benefits determines which of these two is optimal in the real world. In fact, most research suggests that an emission-fee is preferable because climate change is a stock externality with marginal benefits that stay rather flat over time. In contrast, a cap-and-trade system would be preferable if there were no stock externalities and if short-term mitigation had greater marginal benefits than later mitigation (Hepburn 2006, pp. 6-7). Yet a cap-and-trade system can overcome this by using a ‘safety valve’. This entails the supply of additional permits at high pre-determined prices to add quantity flexibility and account for higher than expected costs of pollution reduction (Fell and Morgenstern 2010, p. 2; Rosen and Gayer 2014, p. 94). However, even if a ‘hybrid’ cap-and-trade system is used, an emission tax is preferable because of several important reasons:
- Cap-and-trade systems often have high price volatility, resulting in economic and political uncertainty. This can negatively affect long-term green investment confidence and economic performance.
- States are familiar with taxation and have the necessary capabilities to collect them.
- An emission tax pressures policymakers to collect tax revenue and companies to save taxes. In contrast, cap-and-trade systems can incentivise companies and policymakers to shirk and sell permits for income (Tresch 2014, pp. 132-133).
- An emission tax can be paid out as a lump-sum payment to the population – a ‘carbon-dividend’ – to incentivise sustainable consumption/production via relative price changes, while compensating socio-economic groups most adversely effected. An emission tax is preferable because it collects and redistributes the carbon dividend in a less volatile and uncertain way than cap-and-trade systems (Baltensperger and Bruegel 2019).
Yet, despite their lower cost-effectiveness, command-and-control policies can be used to supplement market-based policies due to the latter’s negative side effects. If emissions cannot be effectively monitored, the issuance of certificates and determination of appropriate emission fees is very difficult. Thus, technology standards can be more efficient, as they are comparatively easy to monitor and enforce (Rosen and Gayer 2014, pp. 97-99; Tresch 2014, p. 130). Market-based policies can also result in highly concentrated pollution known as ‘pollution hot spots’, which can result in higher environmental damages instead of more diffused pollution. In this case, performance standards can reduce hot spots by limiting emissions per polluter (Rosen and Gayer 2014, p. 99; Tresch 2014, p. 130).
With all of these factors considered, the sheer complexity of climate change related market failures – even when monitored with very cost-effective market-based policies – can have unintended negative side-effects. These can be mitigated using a supplementary policy framework of consistently well coordinated policies to reach socially efficient market outcomes (Hepburn 2006, p. 6). This framework will be constructed after having outlined further policy options in the next article of this series.
Featured image credit: “NYC Clean Heat Project – mapping local air pollution” by Carbon Visuals is licensed under CC BY 2.0
Disclaimer: This article is based on an essay written in November 2020.
Baltensperger and Bruegel (2019) “The Economists’ Statement on Carbon Dividends and the Green New Deal”. Bruegel Economics Think Tank. Bruegel Blog Post, Energy and Climate. Available: https://www.bruegel.org/2019/02/the-economists-statement-on-carbon-dividends-and-the-green-new-deal/ [Accessed: 7th November 2020].
Fell, H., and Morgenstern, R.D. (2010) “Alternative Approaches to Cost Containment in a Cap-and-Trade System”. Environmental Resource Economics, 47, pp.275–297.
Hepburn, C. (2006) “Regulation by Prices, Quantities, or both: A Review of Instrument Choice”. Oxford Review of Economic Policy, 22 (2), pp.226-247.
Hindriks, J., and Myles, G.D. (2013) Intermediate Public Economics. Cambridge: MIT Press.
Rosen, H.S. and Gayer, T. (2014) Public finance. McGraw-Hill Education: Maidenhead.
Tresch, R.W. (2014) Public Finance: A Normative Theory. San Diego: Elsevier Science & Technology.