What went wrong?

Part 2 of New Paradigm Knowledge Base: Greening Prosperity


Read Part 1: Greening Prosperity: The Challenge

In 1920, the famous economist Arthur Pigou described a fundamental economic challenge that is now more relevant than ever with regards to our current emission levels. Pigou noted that “when enormous quantities of coal are employed in high-speed vessels in order to shorten in a small degree the time of a journey that is already short, [we] cut an hour off the time of our passage to New York at the cost of preventing, perhaps, one of our descendants from making the passage at all.” Even though Pigou was referring to the stock of actual coal in the ground, the similarity to today’s problem of high carbon dioxide emissions is striking. There is only a certain amount of carbon dioxide that we can emit into the atmosphere without risking a climate crisis. In both cases the interests of individual market actors fail to align with those of wider society. Almost 100 years ago, these market failures became known as ‘externalities’.

Externalities, such as climate change, clearly justified some sort of government intervention. But during the heyday of orthodox economic thinking during the past few decades, economists argued that the most ‘efficient’ policy would be to generate a carbon price through the allocation and trading of emission permits. The idea that the government should create a market in which there was no carbon price was based on the contribution by Nobel Prize laureate and Chicago School economist Ronald Coase (1960). It was Coase’s “contention that [taxes or direct government interventions] are inappropriate, in that they lead to results which are not necessarily, or even usually, desirable.” Instead, creating a market that would enable trading in externalities would provide the most efficient outcome.

These ideas were put into practice in 2005, when the EU launched the first Emissions Trading Scheme (ETS). Nine years later, Germany’s Council of Economic Advisors (Sachverständigenrat) still came to the judgement, as it had done in previous years, that while there should be a global scheme, the EU-ETS “is the preferred and most expedient tool [to tackle climate change] … [and that] separate funding of renewable energies increases the costs of climate protection and is thereby inefficient (Sachverständigenrat, [p. 23] 2014)”.

However, more critical voices have emerged in recent years which question the belief in the effectiveness of emissions trading. These voices became louder as the price for emitting carbon dioxide fell below the levels anticipated at the market’s inception rather than increasing on a continuous basis in the way needed to change behavior. Under the EU-ETS, which is still the largest market for carbon dioxide  emissions, the price of carbon remained at €5 per ton between 2013 and 2018, and hence  far too low to stimulate investment in low carbon technologies. Only recently has the price increased and is currently around €25 per ton. However, leading climate experts, such as Ottmar Edenhofer, have determined that this is still too low, and that the price needs to be set between €35 and €50 and to rise up towards €130 by 2030 (Reuters, 2019).

The fact that carbon prices have been far too low despite the increasing likelihood of a climate crisis, suggests that market participants do not have the perfect foresight assumed by orthodox economists. Indeed, as Edenhofer argued in a study for the Forum New Economy, there are two main distortions that for a long time prevented prices from rising (Knopf et al., 2018). The first concerns market actors’ neglect of future price increases. When emission allowances are plentiful – as they were at the start of an ETS – the short-sightedness of market participants will yield relatively low prices (Kollenberg and Taschini, 2015). The second factor concerns uncertainty about governmental regulations that may distort the price of carbon. According to field studies with traders, their trading decisions and hence carbon price are very much influenced by the their expectations of future policy decisions regarding the supply of emission permits rather than by the current balance between the supply and demand for allowances. This causes the price to be heavily influenced by political speculation; if traders calculate that policy-makers will issue too many permits in the future, prices will remain too low (Salant, 2016).

These two factors are likely to be self-reinforcing. As Ottmar Edenhofer has argued, investors might question the political feasibility of sharp price increases in the future and will speculate on a relaxation of the emissions cap to alleviate the competitive burden on particular sectors. This may result in a self-fulfilling prophecy because excessively low prices at the present will lead to a lock-in of carbon-intensive industries, which in turn will raise the cost of adjustment in the future. Recent empirical evidence seems to support the idea that regulatory factors  play a far more significant role than the old market-driven paradigm would suggest, and that the short-sightedness of market participants prevails in the ETS market (Koch et al, 2016).

This means that, even if current ETSs prices are rising, it is reasonable to doubt the effectiveness of such trading systems. The risk is that market perceptions can quickly turn, resulting in a very volatile market with phases of strong price growth being followed by periods of sharp price declines. This is the opposite of what is needed in order to create a viable basis for planning and calculations of investment strategies, thereby threatening the long-term transition towards a system with low carbon emissions.

In addition, many climate and non-climate economists today argue that setting a carbon price alone is insufficient to achieve the transition towards a low-emissions system. One reason for this is that raising prices, for example of petrol and diesel for cars, is slow to change people’s behavior, especially the behavior of better-off people. Also, raising petrol and diesel pieces may not raise demand for, say,  electrical vehicles as long as the network of charging stations is poorly developed. The latter will not be addressed without massive public investment. Today, even the very orthodox German Council of Economic Advisers seems to agree that carbon pricing should be accompanied by additional measures such as public infrastructure investment (Sachverständigenrat, [p. 7] 2019).

Doubts about the effectiveness of rising carbon dioxide prices are also driven by the difficulty of designing socially acceptable ways of carrying this out. Rapidly rising prices may be effective but provoke social resistance, whereas low and only slowly rising carbon prices will take a very long time to produce a meaningful reduction in emissions.

Because of the heterogeneity of countries within the EU with regards to their willingness to pay for climate change, a higher price for allowances may still be difficult to achieve on a Europe-wide scale, let alone on a global scale. So far, the EU has tried to address this problem through transfers to regions whose energy infrastructure is outdated and which are unwilling or unable to bear the economic burden of reducing emissions faster. New research, however, suggests that these transfers may nevertheless be insufficient (Edenhofer et al, 2017).



Read Part 3: Greening Prosperity: New Economy in Progress


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