The World’s Worst Market Failure: Greenhouse Gas Emissions

Economic theory is beautiful: It’s simple, elegant, and provides answers to tough challenges.

Importantly, it tells us how to most efficiently price goods and services to produce a socially optimal outcome. In particular, theory tells us how to deal with externalities. When any transaction impacts a party not directly involved in that transaction, the effect is called an externality, and such effects can be positive or negative. For example, a homeowner planting a new garden in front of her house beautifies the street and increases (even if slightly) the value of her neighbors’ houses—a positive externality. On the flip side, a new car racing track produces unwanted noise and decreases the value of nearby houses—a negative externality.

There are examples abound, but in our society, the most detrimental negative externality is greenhouse gas (GHG) pollution from the combustion of fossil fuels. GHG emission causes the average warming of our earth’s temperature and alters the global climate system, wreaking havoc on natural systems, which includes humans. As a pinnacle of the social sciences, economic theory tells us to do something about harmful GHG emission—in other words, to correct the market for this negative externality.

Many economists call for the reduction of fossil fuel consumption demand through one of two mechanisms: a carbon tax, or a cap-and-trade system. A carbon tax simply increases the cost of burning fossil fuels by a certain amount, which will—in theory—reduce the demand. Cap-and-trade is a bit more creative and complex: A governing body first sets a cap on permitted emissions, creates permits for units of GHG emissions, and then gives or sells those permits to emitters, who can emit GHGs per permits owned, or sell those permits to other emitters. Both of these strategies set a price on GHGs, colloquially called a “carbon price.”

Some countries have implemented policies of this kind, many of which were prompted by the United Nations’ 1997 Kyoto Protocol. Countries that ratified the Kyoto Protocol pledged to reduce GHG emissions in an international effort to fight climate change. One strategy that the protocol suggests is an International Emissions Trading System, a form of cap-and-trade. While there is not yet a completely inclusive world trading scheme, some transnational regions, countries, and subnational regions have begun to introduce their own

Currently, thirty-five countries and twenty subnational jurisdictions oversee emissions trading systems. Europe’s Emissions Trading Scheme (ETS) is the largest, as it encompasses thirty-one countries (twenty-eight European Union members, Iceland, Liechtenstein, and Norway). It began in 2005 and currently covers roughly 45 percent of the zone’s total GHG emissions. Unfortunately for the ETS, though, its success has plummeted since its inception. When first allocating permits, the European Commission gave out too many, producing an excess supply. Coupled with a recession, the demand for GHG permits dropped, yielding a price-per-permit decrease from $30 (per ton of carbon dioxide) in 2011 to $8 in 2013, and it’s even lower today. The EU had the right idea, and its cap has worked, but the trade and price aspects of cap-and-trade have not.

In the United States, the northeast’s Regional Greenhouse Gas Initiative (RGGI) has been successful in all facets, though it’s relatively small in scale. Nine Atlantic coastal states make up the RGGI, a cap-and-trade system that covers fossil fuel-burning power plants, which accounted for 38 percent of the country’s total GHG emissions in 2014. From 2009–2011, RGGI auctioned off GHG emission permits and generated $922 million in revenue, three-fourths of which has been invested in “climate-related programs.” However, the carbon price in this trading scheme has been low, increasing to just $5.14 per ton of emissions in 2015.

California has also established its own emissions trading system. Started in 2012, the Cap-and-Trade Program covered “large industrial plants” and electricity power plants until this year, when it expanded to include fuel distributors as well. That increased the program’s reach from 35 percent of California’s GHG emissions to roughly 85 percent, becoming one of the most effective trading schemes in the world. In 2014, California partnered with Quebec, so emitters in both jurisdictions can trade with one another, making this the second largest partnership in the world, behind the EU’s ETS. In 2015, California’s trading scheme’s permits sold for $12.21 per ton of emissions.

Across the world, China is entering the emissions trading game. In 2010, it implemented a few pilot trading schemes that have comprised of seven regions across the country. They cover between 40 and 60 percent of any given region’s GHG emissions, and the price has ranged from $3–$20 per ton of emissions. These have been fairly successful, and China plans to implement a national emissions trading beginning in 2016.

Other countries have simply utilized the standard price adjustment tool, the tax, to correct for the disastrous negative externality of GHG emission. Northern Europe was first to price emissions, between Finland (tax imposed in 1990), Norway (1991), Sweden (1991), and Denmark (1992). These countries have some of the highest carbon taxes in the world, beginning with Sweden’s astronomical $168 per ton, covering 25 percent of the country’s emissions. Finland prices emissions at either $48 or $83 per ton, depending on the fuel type, covering just 15 percent of the country’s emissions; Denmark prices at $31 per ton, covering 45 percent of emissions; and Norway prices anywhere from $4-$69, covering 50 percent of emissions.

Elsewhere, other countries price carbon far cheaper. In Chile (beginning in 2017), Japan, and Mexico, the price is around $5 per ton or less, similar to RGGI or China’s pilot regions. But in the U.K., France, Iceland, and Ireland, the price is closer to $15 or $20 per ton.

Outside of northern Europe, Canada’s province British Columbia has an impressive carbon tax, amounting to $25 per ton of fossil fuel consumption (“purchase or use”) in the territory. It’s estimated that this covers 70 percent of GHG emissions in the province, which is equivalent to removing roughly 800,000 cars from the road each year. Since implementation, emissions have decreased 16 percent in British Columbia. However, British Columbia produces much of its energy from large hydroelectric sources, a luxury that many other government jurisdictions don’t have.

Up until now, we’ve only discussed the pricing mechanisms. Politically, emissions trading and pricing legislation can be tricky to pass and implement, as it purposefully increases costs for the fossil fuel industry, which is notoriously involved in politics, particularly in the United States. Additionally, GHG emitters can often pass the increased cost onto the consumer, raising pricing for everyone.

Very little about this sounds politically popular, but there are ways to persuade voters and representatives. Fiscally, British Columbia’s carbon tax is neutral, meaning all tax revenue generated from the policy is used to offset other provincial taxes. Over time, British Columbia has actually returned $500 million more to citizens than it has collected through a price increase.

In 2014, United States Representative Chris Van Hollen, a Democrat from Maryland, introduced the Healthy Climate and Family Security Act, which would establish a cap-and-trade system in the United States. The act specifies that all tax revenue generated from selling permits would be returned to American families, distributed to avoid the regressive nature of such a tax—as lower-income families are proportionally more dependent on fossil fuels—so that 80 percent of citizens would actually financially benefit from the trading system.

Unfortunately, Congress is too entrenched in special interests and free-market values to enact serious climate change policy anytime soon. After all, although the U.S. House passed the 2009 Waxman-Markey bill—which would have established a nationwide cap-and-trade system—the Senate did not approve the bill. However, the more market-based climate change mitigation policies are proven to work, the more they will catch on in other countries. California and Quebec’s trading scheme has the potential to eventually link with RGGI, which could pave the way for a global emission trading system.

Political will is certainly necessary for all this. A cap-and-trade system can be politically viable, as it gives emitters more freedom to allocate permits than a simple carbon tax. While trading schemes authoritatively control the GHG emission market more than a carbon tax, they allow clearer control of emissions per period, as the government sets the cap and can decrease it as it sees fit, which bodes better for mitigating climate change. However, cap-and-trade carbon pricing is more uncertain, as the supply and demand for permits is unknown, and applying a standard carbon tax much more clearly prices the negative externality as accurately as possible.

In 2013, the United States government determined the social cost of carbon dioxide to be $37 per ton, far higher than prices in most countries, and way higher than few emissions prices in the U.S. Even more startling, Stanford University published a 2015 report stating that the actual cost is $220 per ton, which tops existing prices everywhere in the world. The first issue is that estimates of GHG emissions’ social cost are far higher than most actual carbon prices, so according to current estimates, the market in most places is not adequately corrected for the externality. Secondly, there haven’t been consistent measures of the social cost, which will likely need recognized, legitimate valuation and some agreement among experts to have an impact on policy. Regardless of agreement, though, everyone knows the social cost is above zero, which is the current, unacceptable price in most countries.

Regardless of how you look at it, climate change-inducing GHG emissions are an incredibly detrimental externality, and as seen, there are existing policy options to correct for the externality. There are two remaining pieces of the equation: First, economists need to more effectively evaluate GHG emissions’ effect on the world—their social cost—and re-assess that value often. And second, politicians need to listen to those economists—they know a thing or two about markets.

The image featured in this article depicts a high-level ministerial roundtable under the Kyoto Protocol and can be found on the UN Climate Change Flickr page.