Climate Change, Market Failures, and the Need for Government Intervention.

This article is part of the series ‘Economic Policies for the Global Green Transition: Optimal policies under conditions of government and market failures’.

Climate change entails significant global risks that require immediate mitigation efforts (Hindriks and Myles 2013). This has been acknowledged by global leaders as climate change related global risks have risen to the top of the global policy agenda with the World Economic Forum (WEF), which has ranking climate change related risks as most likely and impactful in 2020 (WEF 2020). However, states struggle to formulate and coordinate effective climate policies on a global level due to political economy constraints, government failures (Hughes and Urpelainen 2015). This series sets out to address and formulate optimal economic policies to mitigate climate change under conditions of uncertainty, market and government failures. It will do so from a public economics and political economy perspective. This first piece outlines why effective climate policy requires government intervention. The second piece examines policy options. Finally, the third reviews policy options to advise feasible policies using a basic political economy of climate change framework.  

Climate change ‘is the mother of all externalities: larger, more complex, and more uncertain than any other environmental problem’ (Tol 2009, p. 1). Thus, it entails significant negative externalities, where the adverse global damages associated with climate change are not reflected in market price mechanisms. Because of this, climate mitigation can be characterised as a global public good as it globally effects everyone – the resulting benefits being non-excludable (i.e. no one can be excluded from benefiting) and non-rivalrous (i.e. consumption of benefits by one does not reduce availability to others) (Rosen and Gayer 2014, pp. 73-78; Tresch 2014, pp. 123-124). The first fundamental welfare theorem – which states that fully competitive pareto-optimal markets, where all welfare improving trade-offs without making someone else worse-off, have been made – does not apply if externalities are not fully internalised. Thus, markets overproduce negative and underproduce positive externalities, leading to market outcomes below socially efficient levels. If not for this, this is where the optimal distribution of resources would be if all externalities were internalised (Hindriks and Myles 2013, pp. 897-910).

There are three solutions to achieve socially efficient outcomes. The first is government intervention, by which externalities are introduced into markets. The second is the Coase theorem, which states that if property rights are established and transaction costs negligible, private bargaining internalises externalities. The third option is to merge the polluting and negatively affected parties to internalise externalities in their decision making (Rosen and Gayer 2014, pp. 78-84). So why do we need government intervention if there are other options available to internalise externalities? The Coase theorem and mergers are inappropriate, as climate change involves too many parties to be negotiated at sufficiently, with low costs and mergers at best solving locally concentrated pollution problems. Thus, government intervention, optimally on a global level, is the most effective way to internalise climate change related externalities (Rosen and Gayer 2014, pp. 78-93).

In fact, one can go well beyond the market failure argument. Climate mitigation investments are often highly uncertain, risky, and long-term with considerable public good characteristics – resulting in significant private market underinvestment well below socially efficient levels (Laplane and Mazzucato 2020). Given the scale, uncertainty and complexity of climate change active policy interventions can be of great importance by directing markets into new qualitatively different directions of development. Thus, mission-oriented fiscal, industrial and innovation policies aimed at co-creating new markets and technologies are a necessary step towards effectively mitigating climate change (Kattel and Mazzucato 2018, p. 9; Mazzucato and Penna 2015, p. 30; Pollin 2020, p. 1). If ‘government’ is understood in a consequentialist and individualist social contract perspective – whereby government’s primary objective is to enhance the welfare of its constituents – then pareto-improving government interventions that result in socially efficient outcomes are not just normatively legitimate but also desirable (Rosen and Gayer 2014, pp. 81-84). However, it is important to note that ideas matter. Other political/social philosophies may oppose government intervention or the notion of pareto-efficiency independent of the welfare-improving consequences. This can result in government and market failures and will be discussed further in a piece on the political economy of climate policy.

Featured image credit: “2DU Kenya 76” by CIAT International Center for Tropical Agriculture is licensed under CC BY-SA 2.0

Disclaimer: This Article is based on an essay and a policy paper written in November 2020.

Bibliography

Hindriks, J., and Myles, G.D. (2013) Intermediate Public Economics. MIT Press, Cambridge.

Hughes, L., and Urpelainen, J. (2015) “Interests, institutions, and climate policy: Explaining the choice of policy instruments for the energy sector”. Environmental Science & Policy, 54, pp. 52-63.

Kattel, R. and Mazzucato, M. (2018) Mission-oriented innovation policy and dynamic capabilities in the public sector. Industrial and Corporate Change, 27 (5), pp.787–801.

Laplane, A. and Mazzucato, M. (2020) Socializing the risks and rewards of public investments: Economic, policy, and legal issues. Research Policy, 2, 100008.

Mazzucato, M. and Penna, C.C.R. (2015) Beyond Market Failures: The Market Creating and Shaping Roles of State Investment Banks. Journal of Economic Policy Reform, 19 (4), pp.305-326.

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Rosen, H.S. and Gayer, T. (2014) Public finance. Maidenhead, United Kingdom: McGraw-Hill Education.

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Tresch, R.W. (2014) Public Finance: A Normative Theory. Elsevier Science & Technology, San Diego. 

World Economic Forum (WEF) (2020) The Global Risks Report 2020. World Economic Forum Insight Report, 15.