Spring 2012

Using the Market to Address Climate Change: Insights from Theory & Experience

Authors
Joseph Aldy and Robert N. Stavins
Abstract

Emissions of greenhouse gases linked with global climate change are affected by diverse aspects of economic activity, including individual consumption, business investment, and government spending. An effective climate policy will have to modify the decision calculus for these activities in the direction of more efficient generation and use of energy, lower carbon-intensity of energy, and a more carbon-lean economy. The only technically feasible and cost-effective approach to achieving this goal on a meaningful scale is carbon pricing: that is, market-based climate policies that place a shadow-price on carbon dioxide emissions. We examine alternative designs of three such instruments: carbon taxes, cap and trade, and clean energy standards. We note that the U.S. political response to possible market-based approaches to climate policy has been, and will continue to be, largely a function of issues and structural factors that transcend the scope of environmental and climate policy.

JOSEPH E. ALDY is an Assistant Professor of Public Policy at the Harvard Kennedy School, a Nonresident Fellow of Resources for the Future, and a Faculty Research Fellow of the National Bureau of Economic Research. His research has been published in the Journal of Economic Literature, the Review of Economics and Statistics, and the Journal of Environmental Economics and Management, among others. He is the coeditor of Post-Kyoto International Climate Policy: Implementing Architectures for Agreement (with Robert Stavins, 2010) and Architectures for Agreement: Addressing Global Climate Change in the Post-Kyoto World (with Robert Stavins, 2007).

ROBERT N. STAVINS is the Albert Pratt Professor of Business and Government at the Harvard Kennedy School, a University Fellow of Resources for the Future, and a Research Associate of the National Bureau of Economic Research. His research has appeared in the American Economic Review, the Journal of Economic Perspectives, and the Quarterly Journal of Economics, among others. His edited books include Economics of the Environment: Selected Readings (6th ed., 2012), Post-Kyoto International Climate Policy: Implementing Architectures for Agreement (with Joseph Aldy, 2010), and Architectures for Agreement: Addressing Global Climate Change in the Post-Kyoto World (with Joseph Aldy, 2007).

Virtually all aspects of economic activity–individual consumption, business investment, and government spending–affect greenhouse gas emissions and, hence, the global climate. An effective climate change policy would change the decision calculus for these activities to promote more efficient generation and use of energy, lower carbon-intensity of energy, and a more carbon-lean economy. There are three ways to accomplish this goal: (1) mandate that businesses and individuals change their technology and emissions performance; (2) subsidize business and individual investment in and use of lower-emitting goods and services; or (3) price the greenhouse gas externality commensurate with the harm that such emissions impose on society.

Externality pricing can promote cost-effective abatement, deliver efficient innovation incentives, avoid picking technology winners, and ameliorate, not exacerbate, government fiscal conditions. When all businesses and households face a common price per unit of greenhouse gases embodied in fuels, goods, and services, no additional policies can lower the total cost of achieving a specified climate policy goal. By pricing carbon pollution, the government defers to private firms and individuals to find and exploit the lowest-cost ways to reduce emissions and to invest in the development of new technologies, processes, and ideas that could mitigate future emissions. A variety of policy approaches fall within the concept of externality pricing, including carbon taxes, cap and trade, and clean energy standards.

In contrast, the conventional approach to environmental policy employs uniform mandates to protect environmental quality. Although uniform technology and performance standards have been effective in achieving some established environmental goals and standards, they tend to lead to non-cost-effective outcomes in which some firms use unduly expensive means to control pollution. In addition, conventional technology or performance standards do not provide dynamic incentives for the development, adoption, and diffusion of environmentally and economically superior control technologies. Once a firm satisfies a performance standard, it has little incentive to develop or adopt cleaner technology. Indeed, regulated firms may fear that if they adopt a superior technology, the government may tighten the standard.

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