The Market and The Environment

Personally, I am a firm believer in the efficiency of markets and view them as the best means of directing economic activity. However, there are circumstances in which the market cannot be expected to produce efficient outcomes and chief among these is the case of transactions involving externalities. An externality is a cost (called a negative externality)  or benefit (called a positive externality) from the transaction that is not realized by the parties involved in the transaction.  In this sense, the cost or benefit is external to the transaction and is not a factor in the transacting parties' decisions.

Because of this, some transactions that might produce a net loss to the society as a whole may occur because the transaction provides a private gain to the people involved in it. The cumulative effect of these transactions occurrence is to decrease the society's well being. At the same time, other transactions that might produce a net gain to the society may not occur because the transacting parties will not personally gain from it. The cumulative effect of these transactions not occurring is to prevent the society's well being from increasing as much as it could. In an efficient market, the first category of transactions would not occur, the second category of transactions would occur, and the net benefit to a society would be maximized. Therefore, it is necessary to address externalities in order to improve market efficiency and maximize social well being.

The IMF's Thomas Hebling provides a good explanation of positive and negative externalities that goes into more depth. Expressing the problem as one in which there is a difference between  social and private costs and returns, he writes:

When there are differences between private and social costs or private and social returns, the main problem is that market outcomes may not be efficient. To promote the well-being of all members of society, social returns should be maximized and social costs minimized. This implies that all costs and benefits need to be internalized by households and firms making buying and production decisions. Otherwise, market outcomes involve underproduction of goods or services that entail positive externalities or overproduction in the case of negative externalities. Overproduction or underproduction reflects less-than-optimal market outcomes in terms of a society’s overall condition (what economists call the “welfare perspective”).

The implication for environmental policy should be clear (indeed, pollution is the poster child for negative externalities). If a producer pollutes the environment, the costs of pollution are born by people whether or not they consume the product. More importantly, the costs of the pollution are not included in the price paid by consumers, which lowers the price and encourages consumers to purchase more of the product. This produces higher levels of production with correspondingly higher levels of pollution.

Consider a situation in which a utility company produces electricity at a private cost (i.e., the cost of capital, inputs such as fuel, and labor) of 10 cents per kilowatt hours(kWh) but emits pollution that imposes 5 cents/kWh on people around its plant. The social cost of the pollution is 15 cents/kWh, the sum of the private cost and the cost imposed by the pollution. If consumers had to pay the full social cost of the electricity (15 cents) then they would consume less electricity and there would be less pollution. Note that there would still be some pollution, but, through the market mechanism, consumers would implicitly (perhaps even unthinkingly) balance the cost and benefits of electricity when choosing to consume it. If the cost of pollution is not factored into their private cost of using electricity, some people might take its environmental costs into account, but they would be on their own to estimate those costs and could easily ignore them altogether.

However, overproduction/consumption is not the only thing at stake here. There is also the question of alternative means of producing products. In the case of the utility company, suppose the hypothetical costs given above were those associated with using coal to make electricity. Further suppose that the utility could alternatively produce electricity from natural gas at a private cost of 11 cents/kWh and a pollution cost of 3 cents/ kWh (yielding a social cost of 14 cents/kWh). Therefore, the private cost of producing electricity from natural gas is higher than the private cost of doing so from coal (11 vs 10 cents), but the social cost of using natural gas is lower than the social cost of coal (14 cents vs 15 cents). If the company makes the decision of how to produce electricity based on private costs, it will choose coal as the cheaper alternative. However, if the company had to pay the full social cost, it would choose natural gas as the cheaper alternative.

The point here is that markets won't 'get the prices right' on their own if there is a large gap between private and social costs. Therefore, somebody else has to impose the cost (or benefits) of externalities on market transactions in order for markets to be efficient and, generally, the only viable alternative is to have the government do it. As a result, this is one situation in which most economists favor government intervention in markets.

However, the question remains of how exactly to do this. In general, governments can either mandate outcomes (e.g., banning the use of coal, requiring the use of alternative energies, or requiring utilities to cut emissions to a certain level) or internalize the externalities into the market (e.g., tax emissions or set up a cap and trade system for emissions).  The IMF's  policy advice favors the latter course to address environmental concerns, as they state below:

Fiscal instruments (emissions taxes, trading systems with allowance auctions, fuel taxes, charges for scarce road space and water resources, etc.) can and should play a central role in promoting greener growth. These instruments are:

• effective at reducing environmental harm—so long as they are carefully targeted at the source of the problem (e.g., emissions);
• cost-effective (i.e., they impose the smallest burden on the economy for a given environmental improvement)—so long as the fiscal dividend from these policies is exploited (e.g., revenues are used to strengthen fiscal positions or reduce other taxes that discourage work effort and investment);
• strike the right balance between environmental benefits and economic costs—so long as they are set to reflect environmental damages.

Roberton Williams explains some of the advantages of this type of approach in  Three advantages of a carbon tax (a 2:38 minute video)

Jeffrey Frankel, noting that market based approaches, like the cap-and-trade system, seem to be falling out of favor with governments,  argues that the cap-and-trade system has been very effective:

The problem is not that cap-and-trade is a theoretical proposal from ivory-tower economists that cannot survive application in the real world. On the contrary, its performance in action surpassed expectations. The mechanism in the 1980s allowed lead to be phased out more rapidly than predicted and at an estimate savings of $250 million per year compared to the old-fashioned approach that did not permit trade (Stavins 2003). SO2 emissions were curbed at a much lower cost than even the proponents of cap-and-trade had predicted before 1995, let alone what the cost would have been under the old command-and-control approach. As expected, the electric power sector chose to close down those plants where it would have been most expensive to achieve pollution cuts. The flexibility of the cap-and-trade system also allowed the industry to take advantage of unexpected developments such as new scrubber technology and newly accessible low-sulphur coal, to a much greater extent than would have been possible without the market mechanism. (Among those explaining why costs came in so low are Ellerman et al. 2000).

The main problem with mandates is that they can be both more expensive and less effective. In terms of our utility company example, suppose the government banned the use of coal. This would require utilities to switch to other sources regardless of  either the cost of doing so, or the reduction in emissions involved. Such a move could send the cost of natural gas skyrocketing and encourage the use of other, perhaps even dirtier, fuel sources. The obviously high costs of doing this means that few such outright bans occur.

Alternatively, the government could mandate that a percentage of energy be produced by a clean source such as solar, wind, or hydrodynamics.  Such a mandate would implicitly subsidize whatever energies the government defined as 'clean' with unpredictable costs and benefits. Utilities covered by this mandate have an incentive to meet the quota not reduce emissions. Therefore, they would look for the cheapest 'clean' alternative (which will still be more expensive than non-'clean' alternatives) to meet the quota without regard for how much emissions are actually reduced. In producing the remainder of its non-quota electricity, the utility would have no incentive to reduce emissions at all. An interesting example of this is the EU's requirement that 20% of Europe's energy should come from 'renewable' resources which has encouraged massive exports of wood chips from the US to the UK with questionable environmental benefits. [The US mandate to blend ethanol with gasoline has also had unexpected costs and questionable net environmental benefits.]

In general, the problem with mandates is that they do not tie individual incentives directly to the overarching goal of improving net social benefit.  Instead, they create incentives for businesses to do more narrowly defined things, the value of which depends on the government having guessed correctly on what the results will be and what it will cost to achieve them. There is also generally less scope for innovation and adjustment to changing conditions under a mandate approach than under a market based approach.

Yet, as Frankel argues, market based approaches have seemed to fall out of favor in the US and Europe over the past five years. In the case of the US, he argues that Republicans, in an apparent anti-regulation frenzy, have abandoned market based approaches, such as cap-and-trade, that they traditionally favored. In Frankel's view, this has led to more costly and less effective command-and-control policies, such as the ethanol mandate, in the US.

The point I would make here is that, if you are an informed believer in markets, you have to admit that they fail when significant externalities are involved and that the best response is an intervention that allows them to get prices right. Therefore, doing nothing (i.e., laissez faire) is not a good option, and some type of market based approach (whether it be a carbon tax, a cap-ad-trade system, or something else along those lines) is probably the best one.