How to Move Forward on Climate Change: Greenhouse Gas Emissions as a Negative Externality

February 2, 2012 § Leave a comment

“Freedom in a commons brings ruin to all,” was the influential conclusion of Garrett Hardin’s 1968 essay, The Tragedy of the Commons. The essay demonstrates how innocent actors, working individually in a commons, often bring ruin to themselves and others even while maximizing profit for their own self-interest. Hardin’s principle asserts that the concentrated benefits and diffuse costs inherent in the private use of public resources create unsustainable economic systems, insofar as they are dependent on the abundance and integrity of natural resources and environments. It has shed substantial light on the limitations of the theory in the tradition of 18th-century economist Adam Smith’s “invisible hand,” which maintains that all self-interested economic action serves to benefit the system as a whole. Implied in liberal theory is the notion that self-interested action is necessarily self-regulatory, as a reasonable actor weighs personal costs and benefits in a manner that promotes sustained growth. The problem arises, however, when benefits are fully procured by the actor but costs are externalized to others — as is the case of private action in a commons. A major challenge to laissez-faire economics, then, is its failure to regulate what have been called “negative externalities” within systems. To avoid tragedies of the commons, adherents to free market capitalist systems must employ methods to make individuals accountable for the resource degradation that they cause and profit from.

There are many ways in which the internalization of costs can be achieved, and in deciding which one or combination of several is to be utilized, the natures of the particular type of commons degradation must be considered on a case-by-case basis. In the case presented in this post, we will conceptualize Earth’s atmosphere as a commons and will focus on the emission of fossil fuels as a negative externality. The consensus of climatological research affirms that anthropogenic greenhouse gas (GHG) emissions contribute to the greenhouse effect, which causes an overall warming trend in global temperatures and is predicted to have various other destabilizing effects on Earth’s climate. Because such effects will bring changes to the “planet . . . on which civilization developed and to which life on Earth is adapted,” the emission of GHGs results in the overall degradation of Earth’s economic capacity. In light of these considerations, this paper will explain the merits and particulars of one form of cost-internalization, Pigovian taxation, in comparison to four other methods: planned economy, cap-and-trade, abolition and tort restitution.

It is apparent that the negative externalities caused by GHG emissions, as a collective action problem, may appropriately be dealt with through public policy. The topic of contention involves the extent to which GHG-reduction policy should resemble a planned economy as opposed to a strictly free-market economy. From a moral standpoint, the latter course of action complies well with the principles of the philosopher and social theorist John Stuart Mill, who asserted in 1869 that “the only purpose for which power can be rightfully exercised over any member of a civilized community, against his will, is to prevent harm to others.” This line of thought stresses the removal of negative externalities as the sole rightful limiting factor of individual liberties. Indeed, from a purely practical and economic standpoint, Adam Smith’s invisible hand can be and often is a driving force of efficiency inasmuch as costs are internalized and emitters feel the full economic impact of their choices. Thus, many economists are focusing on finding ways of “harnessing markets for mitigation,” seeing that free markets themselves could help produce the answer to the shortcomings of the status quo. Consider that some of history’s most atrocious polluters have been planned-economy, Communist states. Whereas excessive planning in GHG-reduction policy may artificially pick a favorite means of reduction, markets parse out winners from losers in a practical, real-world setting. As Hardin said of evolutionary biology: “Natural selection commensurates the incommensurables.” In other words, those competitive advantages that cannot be predicted in models can be demonstrated in open competition. That competition encourages innovation is no less true in GHG-reduction than in anything else, especially when actors are properly incentivized to view the costs of emissions as internal costs. Overly intrusive policies, such as the subsidization of corn-based ethanol since 2005, should be avoided. The federal government picked a winner that, in many ways, was less efficient than competitors. By picking a winner, the government also picks losers: giving a competitive disadvantage to other budding technologies that may prove to be more effective. The ethanol controversy also provides an example of how complex, stipulation-ridden energy legislation opens the door to corporate influence, pork barrel spending, and payoffs to interested parties. Legislation for the reduction of GHG emissions should focus on fixing a glitch in the free market system (namely, the generation of negative externalities) and leave specific regional and corporate interests at bay. At the outset, the one certainty is that GHG emissions are an unfavorable form of economic activity. Favorability is then defined as any effective means of limiting GHG emissions, but, as in all market activities, no one can know what the most effective means might prove to be. These favorable practices will win out in free market competition, as successful companies save money on the costs that have now been internalized and do so with the least negative effects on the other aspects of their business models. Where possible, then, GHG-reduction policy ought to avoid guessing at what is favorable, but should let free markets with internalized costs demonstrate what is favorable.

Many of these points are also applicable to the consideration of our next solution, cap-and-trade, which has been the most politically promising form of cost-internalization for GHG emissions in this country. Cap-and-trade is a system of imposing tradable quotas on emitters, creating a market for “carbon credits” that can be exchanged among companies and investors. The system sets an overall fossil fuel emissions quota and then allocates rights to carbon credits to various companies responsible for burning them. The scheme seeks to award those who choose not to emit while putting a price on emissions by those who do. Several regional carbon emissions trading schemes among states and provinces have recently cropped up across the United States and Canada. Federal cap-and-trade legislation in the U.S. has been very effective in past decades in mitigating sulfur dioxide and nitrogen oxide emissions as a part of the Environmental Protection Agency’s (EPA) Acid Rain Program. The growing political support for applying a similar federal program to carbon emissions has resulted in the 2009 passage of the American Clean Energy and Security Act in the House of Representatives. The bill never made it through the Senate, however, and the historic electoral swing in 2010 hurt its chances of being passed anytime soon. Globally, the largest and most successful cap-and-trade system of GHGs in terms of participation has been the European Union Emission Trading Scheme (EUETS), which was implemented in 2005. This system has come under considerable fire, however, for thus far inducing high costs on European Union member countries while resulting in minimal cuts in carbon emissions. Tim Yeo, Chairman of the United Kingdom’s Energy and Climate Change Select Committee, has argued that much of the Scheme’s failure has been due to its commission caving into lobbyists from various industries. Yeo’s criticism, though he supports the idea of carbon trading on the whole, highlights a very fundamental concern about the cap-and-trade scheme: it must arbitrarily allocate credits to emitters through a complicated, highly politicized process. In addition to the inefficiencies inherent in subsidy-distribution mentioned of above, emissions credit allocation also involves the grandfathering of companies that are big emitters historically, granting them windfall profits and thus disadvantaging companies that have chosen environmental responsibility already. There is no way to selectively allocate emissions credits without opening the door wide to special interests and bureaucratic inefficiencies.

Within an otherwise unplanned economy, abolition or phasing out may be an effective solution to the problem of negative externalities. This is especially true when it is concluded that the ultimately most efficient amount of consumption within a system is zero. It would appear that such is the case for GHG emissions in our own global system. Many estimates place the sustainable atmospheric level of carbon dioxide, the GHG whose emissions are contributing most to the greenhouse effect, at 350 parts per million (ppm). The 2008 level was 385 ppm. What is more, the Stern Review of the Economics of Climate Change estimates that the current trend in emissions would result in the near future in anywhere from a 5% to 20% loss of global GDP “each year, now and forever.” Regarding CFCs and HCFCs, the United States government and other states opted for abolition as they signed the Montreal Protocol in 1987 and subsequent years. The global community agreed to a phasing out of the use of these chemicals, which were shown to deplete the ozone layer in the troposphere. The situation of GHGs, however, is more complicated. The economies of industrialized nations worldwide are extremely dependent on the emission of GHGs, especially from burning fossil fuels that contain carbon. Meanwhile, developing nations, representing billions of the world’s inhabitants, are poised to become industrialized as well. With such immediate economic drawbacks, it is no wonder that a global agreement is so much harder to come by than it was for CFCs and HCFCs. While conceding that such an agreement would be politically difficult, the urgency of the matter elicits the argument that the United States should commit to a phasing-out abolition of GHG emissions, even if unilaterally. But this solution comes with a set of problems. While overwhelming evidence indicates that the absolute absence of any GHG emissions would be most efficient for the global economy, it must be recognized that fossil fuels are necessary in some capacity to attain an emissions-less economic system. Our dependence on energy from fossil fuels is such that the whole of our future, including our alternative-energy future, relies on it. The biofuel researcher’s drive to work, the environmental engineer’s flight to a wind energy conference, and the computers on which academic papers are written are all powered by the burning of fossil fuels. GHG emissions today are, to a certain extent, a necessary investment for their effective mitigation in the future. It should be the job of the free market to discern when those investments must be made and in what way, all the while feeling the pressures of internalized costs and the incentives of prospective freedom from their liability. Abolition of GHG emissions, even if imposed through an arbitrary phase-out mechanism, does not offer the free market that chance.

Class action tort restitution has been advocated by many environmentally conscious libertarian economists, who suggest that the equity of the courts should pay the costs of externalities while discouraging companies from generating them. Several reasons make this solution inapplicable to climate change, however. For one thing, cause-and-effect relationships between GHG emissions and their harmful effects are virtually impossible to discern. No court could calculate the cause that one company has on warming, let alone the damage that the warming attributable to the company has on the plaintiffs. Second, the effects of warming are international and intergenerational; no class action could fairly represent the populations devastated by global warming. Lastly, the quantification of the economic costs of climate variation in general is practically impossible. This would appear to also be the conclusion of the United States Supreme Court, which in 2011 threw out a lawsuit brought by several states against four energy companies. The lawyer for the energy companies argued, in the words of one reporter of the case, that “judges and courts are not suited to handling global problems through a lawsuit.” The Obama administration agreed. It opposed the case being brought before the court, reporting that new regulations are in the process of adoption by the EPA. The consensus among the Court, the administration, and the companies seems to be that dealing with global warming as a negative externality is best left to legislatures and regulatory agencies. Even the plaintiffs in the case argue that court action is only a temporary solution while the country inches slowly toward embracing more comprehensive public policies on climate change. Therefore, the complexity of the global warming dilemma makes the libertarian ideal of settling negative externalities in court absolutely infeasible in this instance.

In light of these alternatives, our search for a solution will now turn to Pigovian taxation, meaning a tax directly targeting the activity that generates a negative externality. A Pigovian tax targeted specifically at GHG emissions in proportion to their contribution to the greenhouse effect may be the most efficient way to internalize their costs. In order to retain all of the efficiencies of the free market, it meddles only at the exact point that it is necessary. Unlike cap-and-trade, it flatly imposes itself on the market regardless of a given company’s past, its future plans on paper, or its lobbying constituency. It should be noted that the cap-and-trade scheme could remove many of its inefficiencies by utilizing an auction-based allocation method for carbon credits, which amounts to a sort of modified Pigovian tax because it charges purchasers for the right to emit carbon. This type of allocation does not disrupt the market by having to decide how many credits to give to whom, but instead has its credits auctioned openly and fairly. An auction-based scheme is a feature of the Obama Administration’s proposed 2010 Fiscal Year Budget and will be implemented in Phase III of the EUETS. According to Nicholas Stern, both methods — the straight Pigovian tax, which regulates price, and the Pigovian tax modified by emissions trading, which regulates quantity — can raise revenue and both appear to be equally effective in mitigating GHG emissions. For the purposes of the remainder of this post, I will refer to both of them as forms of a GHG tax. A GHG tax would also be a more effective means of phasing out GHG emissions than abolition itself would. It allows for investment in fossil fuels as actors weigh internalized costs against potential future emissions reductions. Furthermore, the tax can become prohibitory over time, escalating its rate as demand for GHG wanes. The need for tort restitution to fix negative externalities is superseded by a GHG tax, because it effectually obtains remissions for would-be plaintiffs in a way that their day in court never could. Finally, where subsidies, complex regulation laws and reliance on the judicial system all fail in comparison to a GHG tax is on the budget line. These alternatives would cost money while a tax would raise substantial revenue.

The concern is raised that knee-jerk opposition to environmental taxation within the politics of the United States makes implementation of a GHG tax implausible. However, calls for tax reform in this country is one piece of evidence suggesting that a larger segment of the population than expected would get behind a GHG tax. Those who advocate for the Fair Tax, for example, insist upon taxing sales rather than income, encouraging people to work more and save more, which are the roots (they say) of a strong, sustainable economy. In the same way, GHG taxes could discourage what is bad for the economy (negative externalities from emitting greenhouse gases) and not punish what is good for the economy (work and production). For example, the carbon tax in the British Columbia is completely revenue neutral. As per law, “government must show how all of the carbon tax revenue flows back to individuals and businesses as tax reductions.” The proposition of a carbon tax would need to be heralded as tax reform, not as a tax increase. Like in British Columbia, a GHG tax in the United States could also be revenue neutral. While it is true that such a tax would be much more regressive than our present tax system, the issue may be easily offset through use of rebates according to income. The issue of mitigating global warming is too timeless and transcendent to become caught up in petty budget politicking, which should be avoided as much as possible. Environmentalists and Fair Taxers may very well form a coalition to make positive change going forward.

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