Second-best climate policy

When political economy trumps economic efficiency

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Estimated reading time ~ 7 mins

“I have long believed that the most elegant way to drive innovation and to reduce carbon emissions is to put a price on it.” - President Obama, December 2015, at COP 21 in Paris

Welfare economic theory focuses on finding the optimal allocation of resources. According to Vilfredo Pareto - he of 80/20 fame - a legitimate welfare improvement can only happen if a change makes one person better off, without making any other person worse off. The Pareto optimal equilibrium occurs when this is no longer possible. Pareto’s theory relies on a series of optimal conditions being in place that allow market participants to efficiently converge on the point at which welfare is maximised.

By Njr00 - Own work, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=31254379

The theory is central to why carbon pricing is so attractive, at least to economists. In the absence of a reason for markets to self-correct, the most efficient solution is to price the externality - the carbon emissions. A carbon price sends a signal to consumers about which goods and services are carbon-intensive; it signals to producers of products and services which inputs and activities they should switch towards to reduce their carbon costs; and it signals to innovators and entrepreneurs that demand for low carbon alternatives are likely to rise. President Obama outlined the reasoning succinctly when at the 2015 Paris climate conference:

“This is a classic market failure. If you open up an Econ101 textbook, it will say the market is very good about determining prices and allocating capital towards its most productive use — except there are certain externalities, there are certain things that the market just doesn’t count, it doesn’t price, at least not on its own… If you put a price on it, then the entire market would respond. And the best investments and the smartest technologies would begin scrubbing effectively our entire economy.”

Simple in theory. Much tougher in reality. The most common obstacle is political support.