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Carbon, Tradable permits and Pigouvian Taxes.

The Stern Review of the Economics of Climate change has identified greenhouse gas emissions as the greatest market failure in history. Carbon dioxide (CO2) emissions are a leading cause of climate change and have been targeted by government and non-governmental organizations as an area of grave policy concern. Policy proposals to ameliorate CO2 emissions have centred around two broadly based methods: “ economic instruments” and “command and control regulations”. The adoption of economic instruments to regulate the problem of CO2 emissions can entail either the introduction of market mechanisms to price emissions and allocate the right to emit limited quantities of CO2, or price-based instruments such as tax regimes and subsidies. Command and control regulations are policies that involve direct government interventions into the forms of practices surrounding CO2 Emissions, from technological standards to performance targets. The mainstream economics literature on policy instruments has largely been couched in terms of economic efficiency according to marginalist principles. Ecological economics developed in opposition to the neoclassical approach and prioritizing the needs of the ecological system above short-run economic efficiencies. The environmental economics case for an emission trading system and carbon permits face two broad stumbling blocks. Firstly, from within neoclassical economics there is the case for command and control regulation or a hybrid policy that combines such regulation with economic instruments and secondly, theories developed outside of the neoclassical paradigm question its validity with regards to ecological sustainability.

In environmental economics, the problem of externalities and the issue of carbon emissions are often approached from two divergent perspectives influenced respectively by the work of Arthur Pigou and Roland Coase. Both advocated the use of economic instruments to reconcile social and private goods and overcome market failure. However, the tradition stemming from the work of Pigou heavily favoured price-based instruments (i.e. taxes) and the tradition that derives from the work of Coase favoured quantity-based instruments (i.e. tradeable permits). The relative merits of price and quantity based instruments have been a central nexus of environmental policy debates within neoclassical informed discourse. Prior to the work of Coase, Pigou’s position taken in The Economics of Welfare generally informed the discussion of environmental externalities.

Pigou’s approach to internalizing environmental externalities was by the imposition of a tax equal to the marginal social cost of the externality. The standard example of this, according to Coase, was of a factory emitting smoke that affected nearby residences. From the principle of polluter pay, central to Pigouvian taxes, the solution is to make the factory liable for the damages. However, from the perspective employed by Coase, this is not necessarily the most economically efficient solution to the problem of environmental externalities. The clear delineation between offender and victim that is exemplified in the polluter pay principle is therefore not unproblematic in Coase’s treatment of externalities. He argued that the problem was essentially reciprocal in nature. From Coase’s viewpoint, the above factory example is not merely a matter of the factories effect on the residences, but also the effect of the residences on the factory. Economic activity is often associated with positive and negative externalities; pollution from the Coasean perspective implies both utility and disutility. Therefore, with regards to externalities, the economic problem as conceived by neoclassical economics still applies: “how to maximise the value of production?” Coase’s proposed solution to the problem of externalities and imbalances between marginal costs and marginal benefits caused by such market failures is to introduce tradeable property rights to price and allocate resources efficiently. Emissions trading schemes are informed by the logic of Coase’s argument for tradable property rights and an economically efficient method to internalize environmental externalities.

The selection between quantity based and price based instruments to deal with environmental externalities is often defined by the nature of the externality. The cost associated with abetment and the social costs associated with the continued market failure at different levels of production have to be taken into account. Moreover, uncertainties with regards to the underlying scope of the externalities and information asymmetries within the market place and governmental bodies influence the policy instruments selected. Martin Weitzman’s work on the relative merit of price and quantity based instrument influenced the Stern Review on merit of adopting quantity based instrument such as emissions trading scheme to abate global climate change. Weitzman had concluded that price based instruments are beneficial when the price of mitigation is more pertinent than quantity of pollution. Conversely, when the cost of increased pollution levels outweigh the relative cost of abetment quantity based-instruments are preferable. The prospect of global climate change caused by the proliferation of greenhouse gasses and the resultant greenhouse effect renders the level of emissions crucial. Increased levels of CO2 emissions could lead to tipping points and feedback loops that could drastically increase global temperatures that would adversely impact numerous ecosystems. Consequently, given the cost of increasing emissions, quantity based instruments have been recommended to mitigate the market failure of CO2 emissions and other greenhouse gasses.

The economic arguments rendered by Coase and Weitzman in favour of quantity based instruments to that of Pigouian taxes are augmented by a theory of government failure. F.A. Hayek argued for the superiority of the market in conditions of imperfect information. When conditions of imperfect completion prevail, the determination of economic organization rests upon the ability to efficiently utilize information. From Hayek’s perspective, the implementation of Pigouvian taxes would require that governments have information of the individual production functions of firms. Whereas, by employing quantity based instruments, governments can set the level of desired outputs and allow the firms to find the most cost-efficient method of production. The economic rationale for the adoption of quantity based instrument, such as the tradable carbon emissions permit, is that they theoretically provide the most cost effective and least uncertain method of internalizing environmental externalities.

Tradable permit schemes have been successfully adopted to deal with negative environmental externalities in the past. In 1990, the United States’ legislature passed amendments to the clean air bill which established an emissions trading scheme for the emission of sulphur that had lead to widespread acid rain in the 1980s. The stated goal of the scheme was to reduce sulphur emission by 10 million tons annually through the gradual reduction of permit allowances. Before the introduction of the program, prices per allowance were predicted at $300 per permit, the actual average cost early in the program was $100 per allowance. This is evidence that the cost of emissions reduction was miscalculated by planner and that individual firms found a more cost efficient method to reduce emissions given the prospect of having to purchase permits. However, the problem of sulphur emissions and the issue of global climate change differ considerably in scope.

In mainstream environmental economics, the argument advanced either for quantity and price based instruments is crouched in the logic of the marginal principle and partial-equilibrium analysis. This is both a policy benefit and pitfall. Unlike local externalities, such as the smoke from a factory irritating local residences, carbon emissions and the prospect of global climate change affect the entire economy and ecological systems. Both Coase and Pigou’s analysis of the problem of social and private goods are subject to this weakness of scope. However, carbon permits could provide the intermediate means to signal the need to transform the economy to a low-carbon state. The economic case for carbon emission provides a rationale that preferences economic efficiency above that of ecological sustainability. Intuitively, there should be no divergence between these two goals, however, the problem of uncertainty remain whatever policy measures are adopted to address the issue of climate change and carbon emissions.

Written by Mathew Toll.


Coase, R.H. (1960), “The Problem of Social Cost”, The Journal of Law and Economics, Vol. 3, pp. 1-44.

Harris, Jonathan M. (2006), Environmental and Natural Resource Economics: A Contemporary Approach, Boston; Houghtoni Mifflin Co.

Helm, Dieter. (2005), “Economic Instruments and Environmental Policy”, The Economic and Social Review, Vol. 36, No. 3, pp. 205-228

Hepburn , Cameron. (2006), “Regulation by Prices, Quantities, or Both: A Review of Instrument Choice”, Oxford Review of Economics Policy, Vol 22, No. 2, p. 226-247.

Koldstad, Charles D. (1999), Environmental Economics, New York; Oxford University press.

Mckibbin, Warwick J. and Wilcoxen, Peter J., “The Role of Economics in Climate change Policy”, The Journal of Economic Perspectives, Vol. 16, No. 2, pp. 107-129.

Stern, Nicholas. (2006), Stern Review of the Economics of Climate change, Cambridge; Cambridge University press.


Mathew Toll said…
Nicholas Stern, author of the Stern Review referenced above, has rethought some of his predictions here:

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