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Environmental economics and climate change

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Environmental economics is closed related to efficient allocation of natural resources and conservation of environment. The environment offers direct values and indirect inputs for economic activities, such as natural raw materials, water and air, and landscapes. Herman Daly in his book steady-state Economics argues that economic growth results in degradation in environment and inequalities in wealth distribution (Daly, 1991). The concept sustainable development is associated with this argument, which emphasize the quality rather than quantity of people’s life and the economy.

The aim of this study is to conduct a critical review on topics and theories related to environmental economics and climate changes. This essay mainly composes three part, including the market failure and the environment, environmental policies, and economics of climate change. First, the critical essay will build a link between environment issues and the economy by identifying several crucial concepts and notions. This section will also explain the mechanism to value environment issues. Then, it will go over the relation between market failure and the environment, and continues by giving a brief introduction of means of tackling environment problems. In the second part, the essay will investigate the two types of instruments, command and control and market-based instruments. In the last part, the essay will investigate the economics of climate change with specific focus on current resolutions and cooperation between countries.

Market Failure and The Environment

Environment and Economy

Environment and economy systems are interlinked with each other. Environment provides basic resources and services for the economy, including sources of energy and materials for production purpose, services as a waste sink, source of amenity, and provider of local and global support services such as climate regulation and substance cycling.

Environmental goods refer to inputs that individuals and firms prefer more to less such as landscape quality and good air conditions. When the good is increased, the amount of utility will increase correspondingly. Environmental bads are defined as items that individuals or firms prefer less to more, such as river water pollution. Greenhouse gas is an example of negative externality that contributes to climate change. It consists compound in the air that absorbs infrared radiation and lead to rise in temperature. In general, greenhouse gas comes from economically valuable activities such as deforestation and fossil fuels burning. However, the polluters do not pay for the negative impact of their actions. 22% of amazon rainforests has disappeared and 47% Cerrado Forest in British has been gone. More astonishingly, around 91% rainforest in Atlantic has disappeared. Market failures lead to over exploitation of these common properties. On the other hand, clean and fresh air is an example of public good. However, organizations and firms do not have incentive to preserve the fresh air and cut their emissions since they will not be rewarded for their good actions. For example, in China, few firms were taking actions to address the air pollution problems and the government has to shut down around 2,500 polluting firms to combat pollution issue (Kyung-Hoon, 2015).

When the bad is reduced, the amount of utility will increase correspondingly. Many of the environment good such as clean air and water might have none market price but have economic values and provide utility for people. As a result, there is divergence between market prices and economic value for environmental goods. In addition, due to preference heterogeneity, environmental good might have different value to different individuals or companies. In fact, according to Kuznets Curve, environmental improvement and increase in income are often closely related and in 2002 World Summit, the objectives regarding sustainable development include eliminating poverty, protect natural resources, and changing unsustainable productions.

Ecosystem services provide a conceptual way of linking the environment and the economy. Barbier (Barbier, 2009) argues that ecosystem can be viewed as a capital asset that can generate economic goods as valuable services. As a result, it can be regarded as a investment when it comes to environment preservation. In the United Kingdom, the National Ecosystem Assessment (NEA) demonstrates how economic values and state of ecosystems are interacted with each other (Hanley et al., 2013). Market or opportunity cost pricing is used for tangible products and replacement cost is the expenses to preserve the environment and damages. To measure the negative effects associated with goods and services, hedonic pricing will be used. In addition, contingent valuation is used to evaluate non use value as the individuals’ willingness to pay for a resources.

Market Failure

Externalities happen when an individual or an organization does not bear all the costs or receive all the benefits from their actions. When scarcity and pollution generation are included in production of a good and services, individuals and firms may fail to take these elements into consideration. As a result, such scarcity issue and pollution become a type of externalities, which means that the cost of the services and good does not reflect the full cost. Consequently, there is discrepancy between market equilibrium and market optimum level in terms of environmental problems. As a result, to make equilibrium and optimum in alignment with each other, economic policies are proposed as approaches to internalizing externalities and correcting the market mechanism (Endres and Fraser, 2011). If the market fails, there is need for government intervention. However, the government efforts might also fail to reach the desirable results or cause the situation worse, leading to government failures.

Solutions to address environmental issues

Basically, there are three approaches to addressing environmental externalities. From welfare perspective, government interventions can be justified by environmental externalities (Hussen, 2004). Commonly used methods include taxation such as Pigovian taxes named after economist Pigou. From market economy point of view, it is more appropriate to use market incentives to eliminate environmental externalities because incentives bring about more flexibility in tackling with this issue. In addition, from free market economy perspective, environmental protection can reach its optimal level if obstacles preventing the environmental market are removed and the market can operate freely. Julian Simon, for example, believes that free market combined with property rights leads to healthy and sustainable environment (Myers and Simon, 1994).

Some will also categorize approaches that focus on legal systems into liabilities laws, emission standards, and Coasian methods. Liability laws make polluters liable for environmental damage by statutory enactment. As a result, polluters are required to make financial compensation for the third party who are negatively impacted by the pollutions. However, the enforcement action is slow and expensive since it follows legal remedies. In addition, the resolution might lack fairness if the victims do not have resources to sue. Moreover, since a case of pollution generally involves a lot of parties, a lawsuit might face difficulties to solve the problems and work for all the people involved (Tietenberg and Lewis, 2016).

Coase Theorem states that pollution problems can be solved by assignment of property rights arbitrarily, reducing the need for public regulators to assign the ownership rights. Therefore, through voluntary negotiation between private participants in the private market, the optima level of pollution can be attained.

However, there are some drawbacks of this approach. First, it assumes that sources of pollution can be easily identified, whereas in real world, it is a rare case. The diffused impact and multifaceted sources of pollution will complicate the problems. Additionally, various parties will be involved in a single environmental dispute and thus the cost of transactions cannot be neglected (Callan and Thomas, 2013). The high transaction cost will have large impact on the outcomes of environmental dispute. In addition, the theorem does not consider the fact that mere attainment of optimal result might not necessarily indicates the means of assigning property rights is the only contributor. It does not take initial assignment of property rights into consideration, which have impact on the income distribution, since generally, the property rights will positively impact the income position of the assigned parties.

The third approach of emission standard will set the maximum rate of emission that is permitted. It is mandatory and violators will be published by legal prosecutions, by momentary fine or even get imprisoned. Despite the simplicity and political feasibility, standards might have some adverse implications. Since standards are set by government, the high intervention reduces efficiency in the free market. In addition, transaction costs will be high since it requires establishment of large bureaucracy for administration purpose. Moreover, the standards are more likely to applied uniformly to all parties without considering the specific situation of each entity.

Environmental Policy

When constructing environmental policies, one underlying principle is the least-cost theorem of pollution control. The marginal cost of abatement should be equalized over all abates in order to reach the abatement at lease cost. Under the least-cost regime, marginal cost of abatement is equalized over all individuals or firms that undertake the pollution control actions but generally does not necessary mean all participants and polluters are making equal efforts in abatement. Based on cost efficiency, low-cost abaters will make the majority of efforts. There are two types of instruments, command and control and market-based instruments.

Command and Control

In the last 1960 and early 1970 when the United States had its environmental laws, there are various laws, besides setting certain emission limitations, that imposed penalties if entities exceeded the limited pollution or if they failed to install required equipment to reduce pollutions. It follows a command and control regime which helps the country keep clean environment. Meanwhile, the Environmental Protection Agency was established to oversee the laws and the Clean Air Act and Clean Water Act were past later on (Percival et al., 2013).

While such regulations help to reduce pollution, they have three major shortcomings. First, those regulations provide no incentives for firms or individuals to go beyond the pre-determined limits. As a result, firms normally will not beat standards. In addition, those regulations lack flexibility. Most of the standards set for all polluters regardless the real and specific situation of each entity (Aalders and Wilthagen, 1997). Government is hardly to know the cost structure of each firms and thus might set a one-size-fits-all standards without considering the flexibility for firms to addressing the externality issues. Firms that can reduce pollutions easily and inexpensively will not reduce emissions further and firms that find reducing pollution costly and difficult will simply pay the fine without reconsidering their production process and techniques that might reduce the pollution at lower expenses, leading to less economic efficiency. Furthermore, this paradigm leads to high administration costs. Governments have to create agencies to hold responsible for overseeing the rules and regulations, and if necessary, subsequent amendment and adjustments need to be published in time. As a result, the command and control cannot realize economic efficiency or least cost abatement.

However, there are also some advantages of the Command and Control paradigm (Bergquist et al., 2013). If the pollutant is highly toxic that the impact outweighs the concerns for overall economic efficiency, government should intervene with timely regulations to alleviate the problems immediately. In addition, if the marginal benefit of reducing the amount of pollutant gradually become less beneficial, which means the marginal benefit is inelastic, Command and Control might be a good alternative (Job et al., 2007).

Market Instrument

Instead of applying a command and control approach, incentive-based market instruments are more efficient and effective alternatives. The basic underlying principle is to change the pay-off structure faced by agents, thus incentivizing organizations or individuals to be voluntary in change their actions and behaviors (Lockie, 2013). To change the pay-off structure, the prices should be changed and there are two main approaches. The first one is to impose taxes on pollutions and harmful emissions or paying subsidies for emission abatement. The second approach is to employ tradable emission permit (Carraro et al., 2013).

Pollution taxes or subsidy to change market prices

One of the approaches to address environmental challenges is to impose environmental taxes. When tax scheme is properly designed, this instrument can be effective. There are mainly three types of pollution taxes, including taxes on energy, taxes on transport, and taxes on pollutions and resources. Environmental taxes can provide better predictability for firms and organizations and the pre-determined schedule helps firms to make their budget and conduct estimations. In some European countries such as Italy, Sweden, Denmark, and Belgium, the governments have introduced taxes on batteries. Some countries such as Ireland and Finland have imposed taxes on tyres and plastics.

Due to financial crisis, for example, passenger car sales dropped dramatically and in countries with higher transport taxes, the downturn in economy led to larger changes in car sales and the revenues from transport taxes. To alleviate the impact of financial crisis, governments then reduced such taxes. These two factors combined led to a decreased transport tax after financial crisis.

Instead of imposing taxes on environmental issues and pollutions, government may also consider provide subsidies for environmentally beneficial goods. For example, government might subsidize tax deductions or exemptions for energy-saving equipment or renewable energies. However, there are several concerns. First, subsidies are costly and may result in free riders. Other taxpayers have to pay for the subsidies and receive a deduction in their disposable incomes. In addition, some people will undertake the environmentally friendly activities even without the incentives, thus becoming free riders to receive the subsidies (Panayotou, 2013). Second, tax subsidies may reach undesirable results and indirectly lead to higher pollution levels. For example, if the government provides tax subsidies for people who drive hybrid electric cars, they might be encouraged to drive more instead of using public transit or riding a bike. Moreover, taxes alone cannot reach the optimal results and thus should be combined with other market instruments to obtain the most effective environmental solutions.

Market-based incentives: Tradable Permits

The tradable permits system is established by the principle that increase in pollution and emissions must be offset by corresponding decrease somewhere else. Instead of reducing pollution emissions as required by the given standards in the command and control regime, firms are able to trade their permits in the tradable permit system. Unlike the tax approach which is based on price, the tradable permits system is based on the quantity.

Some firms are able to meet the requirement with cheap and easy means while other have to adopt costly and difficult approaches. Under the tradable permit approach, firms that can reduce pollution with less expenses can meet the goal and sell the permits to other organizations. Thus, the cost of achieving the goal becomes less. Moreover, it encourages firms to seek for innovative technologies to reduce pollution when the permits are tradable due to the financial incentives. The dynamic efficiency feature of tradable permits makes the regime a great practice. This approach has been successfully used as a practice to reduce ozone depleting substances in the Montreal Protocol and greenhouse gas programs in Europe (Boasson and Wettestad, 2016). One example of the Tradable Permits program is the U.S. Regional Greenhouse Gas Initiative, which covered ten states that set carbon emission cap from power plants and allowed them to trade the emission allowances to comply with the requirement. The cap of allowances lowered each year and stabilize emission for power plant 188 tons annual during 2008 to 2011.

However, there are also some drawbacks of this approaches. The future development of new technologies and changes in market are quite unpredictable. As indicted in the chart above, compared with a carbon taxes, the EU ETS, a form of tradable quota, is more fluctuate. If there are dramatic changes in such elements, the quotas and limits have to be changed correspondingly, making it difficult for a market of tradable permits to operate and traded. Therefore, it is challenging to set appropriate limits on pollution and make proper allocation given the dynamics in market, technology development, and scientific information.

The Economics of Climate Change

The increasing greenhouses gas lead to change in climate and accelerate the process of severe stores, heat waves, further rise in sea level, and acidification of oceans. In addition, with the global warming continuing, the ecosystem and a large number of species are threatened and endangered. Higher temperature and other consequences related to greenhouse gases might lead to unconvertible damage to the earth and environment. In addition, uncertainty regarding the irreversible leads to possible sharp catastrophes. As a result, when growing business, governments have put more emphasis on addressing environmental issues and methods to tackle climate change problems. It is estimated that a unit of increase in temperature will lead to economic damage in terms of the world GPD around one percent based on CEA calculations.

Several current empirical studies also come to similar conclusions. For example, Dell, Jones, and Olken (2013) argue that the climate changes inferred by weather patterns are closed related to social and economic outcomes such as productivity, health, and political instability. Their research also suggests that when temperate is above 100° Fahrenheit in the US, the supply for labor in outdoor production activities dropped by one hour per day compared with situation in 76°-80° Fahrenheit temperature.

Based on data from Eurostat, it is noticeable that while EU has adopted several methods to address the global warming issue, the structure of economic activities that remains unchanged during the last decade.

Policies to reduce emission

Basically, there are three approaches to deal with the greenhouse gas emission issue, including carbon pricing, technology regulation, and removing barriers in behavioral changes (Zenghelis, 2006).

Carbon pricing

One of the most important element in designing policies to tackle environmental issue is through carbon pricing. Based on discussion in previous chapter, greenhouse gases can be treated as a type of economic externality. Greenhouse gas producers such as manufacturing plants do not bear the consequences of their pollution actions while the future generate will suffer from the cost incurred by climate change. To impose taxes on carbon goods and services, government can implicitly implement the policy by regulation or explicitly by tax or trading.

Trading schemes are popular in European areas where the European Union set up a trading schedule to cut emissions named European Union Emissions Trading System (EU ETS). The design is in consistence with the greenhouse gas objectives proposed in the Kyoto Protocol. To operate the trading regime, the emissions Trading System established a market for tradable permits of carbon emissions for members in European Union. Each member country has to meet its emission reduction commitment and according to the commitment, ETS distribute emissions permits to each member accordingly. Once the allowance is assigned and allocated, the emission permits can be treated among all firms and organizations in the market created by the system (Rausch et al., 2011). In addition, firms are allowed to take advantages of credits for emission reduction from the Clean Development Mechanism if they act in compliance with the system. Theses credits have high level of market liquidity and are structured as a means to control the cost of the program.

Australia, in 2012, began a program to address greenhouse gas issue. Initially, it imposed tax on carbon dioxide at $ 23 per ton. Then, in 2015, it made a transition to permits trading. A floor prices is set to be $ 15 per ton to give investors more certainty and will be implemented by permit auctions. In addition, to constrain price volatility, a ceiling priced is also set (Jotzo, 2012). To ensure that emission-intensive sectors will be negatively impacted ion the global market, the government also proposed and provided several financial assistance and free permits. As for household, the benefits will favor middle to low income populations. As a result, the policy will result in redistribution of income among individuals.

Technology Policy and Removal of barriers

While carbon pricing is the major policy in place that reduces carbon emissions, it cannot fully address all the problems. Thus, some compensatory policies are demanded.

To support the research and development of low-carbon and energy-saving equipment and technologies, policy-makers also have to come up with technology policies. Currently, most low-carbon and energy-saving technologies are much more expensive than the traditional methods, thus companies should be rewarded for taking risks to create public good by investing low-carbon techniques (Foxon et al., 2005). According to learning curves, as the scale increase, the cost for low-carbon technologies will fall. However, the initial investment of high-efficient and green energy is costly. To realize the benefits of economies of scales for the new technologies, policies might be designed to support the research and development activities for the first few years to incentivize more innovations (Painuly, 2001).

Moreover, the uncertainty nature of environmental problems may discourage firms and individuals from change their behaviors and traditional operation process. As a result, policies should support the change by offering clarify and certainty (Helm et al., 2012). For example, information policies could be used to make those environmentally friendly companies stand out by labeling and rewarding them publicly. As consumers become aware of the companies’ ethical behaviors, these companies can gain advantages in the market and will then create a competitive market for low-carbon products and services.

Cooperation and Game Theories

Since climate change is a global environmental issues, countries are cooperating to seek solutions to reduce the emissions of greenhouse gases. Emission reductions are considered as public good on global scale, which gives rise potential free-rider behaviors. For example, a country can decide not to participate in an IEA and thus contribute less to improve the quality of global environment than members of IEA. In addition, a country that belongs to an IEA can also choose not to comply and follow requirements (Wood, 2011). In general, there are three ways to analyze the global cooperation for climate change under game theories, including non-cooperative game theory, cooperative game theory, and implementation theory.

In the simple one-step model, climate change reduction is a prisoner dilemma which has a Nash equilibrium. In this situation, players, namely, different countries, act in a non-cooperative manner and reach sub-optimal socially. However, as countries have continuous choice, at the the equilibrium, there would be more pollution than optimal level. In a multi-steps model, the sub game involves more players instead of only two (Milinski et al., 2008). As a result, the cooperation becomes partial. Using cooperative game theory, Chander and Tulkens in 1997 predicted the social optima level (Tavoni et al., 2011). Accordingly, countries are willing to reduce their emission and increase their commitment when other countries are willing to do the same thing and thus when binding conditional commitment and global mechanism exist, companies are more likely to cooperate to address the climate change issue.


Different policies to address environmental issues have their own drawbacks and advantages. As a result, when structuring a package of policies, policy-makers have to consider the pros and cons of each approach. Besides, a mix of policies might be more capable to achieve desirable results.

In general, environmental policies have impacts on people’s real income. In the case for addressing greenhouse gas, the policy of carbon pricing changes the relative price to carbon emissions. In addition, it has different impact on people and companies in different levels of income. However, a policy itself cannot work out the problem of climate and environmental issues perfectly, since it may bring about some other side effects that need to be addressed by other complementary policies. Again, in the example of carbon pricing, the effect is regressive and lower income groups will be advantaged and thus raises need for other policies to prevent adverse distributional effects. For example, carbon pricing can be associated with other policy instruments that have compensatory benefits. Moreover, the mere adoption of carbon pricing might lead to under investment in research and development for new technology, but technology policy alone might not be able to fully motivate firms to reduce emission. As a result, policies to address environmental issues should be carefully designed to maintain fairness and to avoid adverse effects.

In addition, due to the uncertainty of environmental issues, policies and solutions should be dynamic and adaptive. To achieve this goal, it is important for policy-makers to observe and communicate with the participants on a frequent basis. To make the policies acceptable, government should also communicate to the public and tell them about the rational and benefits of certain solutions.


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