Some Economic Considerations Relating to Climate Change

There exists no modern society today that manages its activities and economy with the strict objective of minimising climate or environmental impact.  In fact, most economies are managed to generate economic growth with little regard to the depleting stock of non-renewable resources and the output of greenhouse gases.

While periods of cooling and warming on Earth have been a natural occurrence over geological time periods, the fundamental question is whether human activity is itself leading to a significant change in climate? The answer, according to more than 95% of scientists and scientific reports, is an emphatic “yes”.

Aside from environmental considerations, climate change affects standards of living and resources devoted to combatting the effects of climate change could be used for other social and economic objectives.  Climate change increases global inequality by altering habitability across world regions and the distribution of natural entitlements. One result of this is human migration patterns across the world with the resultant political tensions we are currently witnessing across countries.

Various global initiatives (such as UNFCCC, Paris Agreement, COP) have drawn attention to this reality and introduced policy measures to internalise climate needs in corporate and consumer decision-making. The key policy tools have been the introduction of pricing schemes that seek to nudge overall consumption towards activities and products with a lower impact on climate change (“CC”) and the adoption of globally coordinated initiatives.

The other very important policy tool is to adopt globally coordinated initiatives, a complicated and politically charged objective at the best of times and now likely to be much harder to implement over the next few years, as foretold by the weak attendance and outcome of COP29.

Understanding the economics underlying human-induced climate change is useful in many other contexts.  For instance, indirect taxation, quotas, global coordination and game theory are concepts central to climate change and that also create a framework to assess the current impending trade and tariff wars or to understand some of the economic costs of Brexit.

Human-induced climate change and the steps taken to battle it, are creating innovative businesses and technologies and a burgeoning set of investment opportunities. In this article I return to first principles and explain why government intervention is a pre-condition to pave the way for the creation and implementation of CC solutions.

Incorporating climate change into a single measurable number

To simplify our understanding of the impact of CC, well-meaning influencers, politicians and solution-seekers have chosen to integrate the entirety of CC into a single measurable number.  This number a year’s average global temperature above an historic average, the assumption being that much of this excess over the historic average is being driven by human activity.

The policy objective of most global organisations involved in battling CC is to keep this excess temperature at or under 1.5 C.

There is no doubt that the complexity of the underlying climatic processes and the breadth of the human impact is lost through the simplification into one number, but it is nevertheless extremely useful as a tool to encapsulate marketing and advocacy messages to win the public support necessary to create useful government policies.  This possibly outweighs all other considerations.

A summary of the rationale for government intervention

A common saying is that there is no such thing as a free lunch.  Nothing is for free and human activity will always result in the use of resources.  And resources are limited in quantity.  Everything we produce and consume, whether directly or indirectly, affects the environment, but some goods and services are more damaging than others and we refer to these as “DGS” (i.e., climate damaging goods and services) to differentiate these from those goods and services that are more climate friendly (“FGS”).

Here below is a sequential set of reasons resulting in the need for government intervention to attract private capital.

The human condition

Human DNA and biology are such that human behaviour is engineered to react to external stimuli in order to meet the absolutely basic survival requirements for oneself and one’s closest family members.  These requirements include food, warmth, shelter, protection of one’s own body.  As societies and civilisations developed, the basic survival requirements became extended to include many other considerations such as future generations, a broader society, a faith or religion and so forth but as far as we know, none of these evolutions are embedded in the DNA of humans.  They were nurtured by a broader group of humans than would have happened within a nuclear unit of woman, man, children.

With this as a premise, it is observable that in today’s modern society humans will not freely act to minimise climate impact.  We do not freely alter our behaviours to make a significant impact.  We might recycle waste because our municipality has dictated so and provided us with three different sorting bags, but more generally most of us will act and consume based on our existing lifestyles, our budgets and the prices we face.

Climate change is an economic externality

CC is a by-product of human economic activities and if DGS are inexpensive relative to alternatives, they will tend to be consumed in excess.  The market mechanism does not have an auto-correction function and hence, there exists a justification for governments to intervene and fine-tune the functioning of the market mechanism.

The traditional market mechanism alone fails to generate a return on investments in climate friendly products, services and activities.  Energy is a fundamental building block of our societies and fossil fuels have been powering economic growth for millennia.  Market prices, particularly spot prices, of fossil fuels are driven by supply and demand and anticipations of changes to these. The market mechanism on its own has been unable to incorporate in the price of fossil fuels neither the environmental impact of their consumption nor the declining stock of non-renewable fossil fuels.  And as if this were not enough, people’s behaviours and consumption preferences are sticky and difficult to alter.

This is an example of the classic economic problem known as “externality” which occurs when an economic activity creates another (unintended) product that affects a third party not involved in the original economic activity. In the case of CC, this “third party” is the entire world.

The consumption of fossil fuels results in at least two broad externalities. The first is the emission of pollutants affecting the health of humans and other life. The second is the emission of greenhouse gases (GHGs) that result in global warming and are an externality affecting all life.

Production v consumption behaviour – drivers of economic activity

Both production and consumption drive economic activity and by influencing the price of goods and services, a government can nudge economic activity towards FGS.

There are structural considerations that act as obstacles and barriers to change.  The large investments required to build renewable energy plants are obvious enough.  Less obvious and equally powerful a barrier are institutional biases and behaviours.  For example, many institutions to truly act with an understanding of “sunk costs”.  institutions act without an understanding of “sunk costs”. A large DGS investment made many years ago that should be de-commissioned to favour FGS is instead kept alive because a lot of money (the “sunk cost”) has been spent.  Good money is thrown after bad. This is an example of an institutional behavioural bias that can limit or delay the introduction of CC solutions.

More than at the institutional level, the field of behavioural economics has focussed on the decision-making behaviour of the individual consumer.  Displacing current consumption practices requires a change in consumer behaviour and behavioural economics has emphasised the preference individuals place on the status quo.  “Anchoring” and “heuristic bias” tend to make consumption patterns “sticky” and hence public policy can effect important change to consumption patterns through subsidies to promote the use of energy efficient white goods and appliances.

All such policy efforts are important but the central reason for an excessive consumption of DGS is their price. Despite possible short and medium term “stickiness” in consumption patterns, the higher the price of DGS, the less eventually would be their consumption.

Trade-offs, supply, demand and prices

Economists look at an economy in terms of trade-offs. Without trade-offs, there would be no scarcity in goods and services and hence no real underlying price.

This concept is neatly summarised by the “production possibility frontier” (PPF). This describes the trade-off that exists in an economy between the production of different goods and services – since production processes require energy and other resources, in an optimally functioning economy, more of one good cannot be produced with producing less of another.

Let’s illustrate the concept using two relevant goods, electric vehicles and traditional petrol vehicles as depicted in the figure below. Their relative prices and the relative costs of running these vehicles are key determinants of which vehicle to buy. If the price of gasoline is low relative to electricity, consumers will favour petrol over electric vehicles. The government can introduce policies that can increase the price of gasoline used by traditional vehicles relative to the price of electricity used to charge EV’s. Such policies typically involve a sales tax on gasoline. In addition, the government can also introduce subsidies (outright subsidies or waivers of road taxes, for example) to reduce the relative cost of buying EV’s.

How can government intervention help reduce climate change?

Quotas and indirect taxation

The price of fossil fuels is the key determinant of their medium- and long-term consumption. The higher their price, the easier it is to justify the development of alternative fuels or energy sources that have a lesser impact on climate. In simple terms, the higher the price of fossil fuels, the higher the savings made by NOT using them and alternative solutions become more viable.

All economies will need time to move significantly away from fossil fuels.  The most immediate thing that can be done by governments is to improve and/or correct the market mechanism so that the price of fossil fuels better reflects these externalities. Governments have been addressing this by artificially creating quotas on the amount of GHGs that certain industries can emit. These quotas are then transferable and can be bought and sold to allow different business consumers of fossil fuels to expand their businesses as needed. This has the effect of increasing the total cost of using fossil fuels which over time should result in a reduction in their relative usage.

Another option is to simply add an indirect tax, such as a sales tax, on the price of fossil fuels to push their price to levels that would begin to move consumers away from fossil fuels to other energy sources. All these steps need to be taken and applied carefully to manage other objectives such as inflation and economic growth.

The big advantage of indirect taxation or the sale of quotas is that they generate revenues for governments that can be used to fund the development of alternatives. This said, the amount of money needed to move away from fossil fuels at a measured pace but fast enough to avert climate catastrophe is substantial.

An indirect taxation policy will need to consider that it does not per se guarantee a high price of fossil fuels as the actual market price (spot and futures) of fossil fuels can vary due to market conditions. What matters most is that indirect taxation shifts (increases) the price of fossil fuels relative to alternative fuels.

Globally concerned – global coordinated action

Even more than an economic externality, climate change is a classic “global commons” issue, meaning its causes and impacts transcend national borders. While climate-related harms (like extreme weather or rising sea levels) are felt globally, the actions required to mitigate them are largely taken within national boundaries.

This structure creates a paradox, namely that countries that act alone may incur significant costs, while benefits are spread worldwide, potentially discouraging unilateral action. This is particularly challenging as certain economies, often the largest emitters, must make the most substantial changes for meaningful progress.

Game theory has shed much light on the competitive and contradictory behaviors of different stakeholders making it difficult to ensure globally harmonized actions.  Economists argue that this “global commons externality” requires coordinated policies, such as carbon pricing and trade regulations that penalize carbon-intensive imports, to prevent “carbon leakage” (where emissions are effectively outsourced to countries with weaker climate policies). Without such coordination, individual national efforts risk being undermined, as production might simply shift to less regulated regions and global emissions would then continue unabated.

Therefore, policy measures are best taken in global coordination between different countries as this reduces the scope for any one actor to “cheat”.  Coordinated frameworks for climate action, such as the Paris Agreement, play an essential role in tackling climate change. These frameworks establish shared goals and timelines to reduce emissions.  As argued above, the effectiveness of these global initiatives hinges on national adherence and enforcement. Economic studies reveal that harmonizing climate policies – like emissions standards, green technology subsidies, and carbon border adjustments – reduces competitive disparities and incentivizes broader participation.

A globally harmonized approach also allows for scaling climate finance and technology-sharing mechanisms that can benefit lower-income countries disproportionately affected by climate change.  Such cooperative efforts are crucial in translating broad climate goals into achievable national targets.

Since climate change is an entire-earth problem compounded by the various environmental feedback loops, global coordination increases the effectiveness of any one policy and this, in turn, means that the extent of any single policy measure can be reduced in each country.  Thus, tax rises need not be as substantial if these are coordinated and taken by all countries.

Locally aware – national interests and sticky consumption

Behavioral and institutional obstacles to climate action are pervasive at both national and international levels. Consumers and policymakers often struggle to prioritize long-term climate goals over immediate economic interests.

Nations are hesitant to adopt stringent policies that could disadvantage their economies if competitors do not adopt similar standards. Economic research emphasizes “collective action” mechanisms (e.g. such as binding treaties) as essential to overcome these barriers. A greater focus on collaborative tools that tie economic incentives to climate goals, like the trade of emissions permits and green finance commitments, can align disparate national interests.

Behavioural economics suggests that the behaviours of actors must be influenced to nudge changes in consumption patterns, especially of more expensive items such as cars and white goods. Government policy will play a key role here through subsidies or by resetting the framework through which alternative products and services are assessed.

* The author is an economist and a managing partner of Antwort Capital, a specialised private equity business. He is also on the boards of various investment holding companies and private equity businesses such as GHO and Onepointfive Thematics. Vinayak has been in the fund management industry for over three decades and as an economist has researched and authored articles in behavioural economics and decision-making.

References

• “Why do Economists Describe Climate Change as a Market Failure?” Alex Bowen et al, The London School of Economics and Grantham Research Institute on Climate Change and the Environment, March 2014.
• “The Paris Agreement and Global Cooperation”, UNFCC Paris Agreement Overview, December 2015.
• “Global Climate Change Governance: The Search for Effectiveness and Universality”, Mari Luomi, IISD.org, December 2020.
• “The Economics of Climate Change: The Stern Review”, Nicholas Stern, https://digital.library.unt.edu/ark:/67531/metadc13733/m2/1/high_res_d/stern%20report.pdf, October 2006.
• “How do Economists Think about the Environment and Climate Change?” Christopher J. Neely, Federal Reserve Bank of St. Louis, 16 December 2022.
• “Thinking, Fast and Slow”, Daniel Kahneman, Penguin UK, April 2013.
• “Nudge: The Final Edition”, Richard H. Thaler and Cass R. Sunstein, Yale University Press, August 2021.
• “Energy Utilities, Conservation and Economic Efficiency” Bhattacharjee et al, Contemporary Policy Issues, January 1993.

More on topics covered in this article can be found on:

• The Global Commission on the Economy and Climate’s findings on cross-border climate impacts.
• Studies on climate policy harmonization by the Organization for Economic Cooperation and Development (OECD).
• Reports on carbon border adjustments and carbon leakage by the International Monetary Fund (IMF) and World Bank