Into the weeds a bit on economics & ethics

© 2009 Joshua Stark

I've received a few questions on my post about carbon sequestration and reforestation, mostly regarding the idea of "internalizing externalities". I wrote about externalities here, if anybody is interested, but here is a quick definition of "externalities":

Externalities are effects upon a third party from an economic transaction of two other parties.
flx1247rg
Economists are trying hard to figure out ways to alleviate negative externalities, because they are an inherent market inefficiency (the econ term for failure). So, starting from the beginning (the ethics), most economists believe that individuals in a transaction should be responsible for all the effects of that transaction. If somebody's purchase hurts somebody who wasn't even involved, then the purchaser and seller should have to pay for the damage.

Many economists are trying to figure out market-like ways to most efficiently alleviate the problem of negative externalities. One idea has been to create a market-like mechanism for the thing that causes the externality. In the case of carbon, this is putting a price on carbon emissions because they cause global warming (externality), and then requiring the participants to play in the market-like mechanism. This idea is called "internalizing the externality", because it forces a price into the transaction as a way to both reduce the amount of, and possibly provide revenue to, help mitigate the problems of the externality.

In the past two weeks, however, I've identified a few potential problems with this. First, I've always been leery of made-up markets like carbon, where you really aren't selling a good or service, you are selling the privilege to pollute. However, the polluters (both buyers and sellers) have had this privilege for free for years and years, so getting them to accept a new payment is very difficult. This is a problem when pricing in any externality.

Second, picking and choosing which externalities get priced is tough, too. In my earlier post on reforestation in Europe, I pointed out that if you don't/can't price in every externality, then you create incentives that worsen the remaining, un-priced externalities.

A third problem became apparent in my head after reading this from David Zetland's blog:

"Even if there was a market, we would only know the value "on the margin," which does not capture the (inframarginal) benefits that accrue to users."

Mr. Zetland was speaking about (the lack of) water markets, but the same concept can be applied to carbon, too.

Let me step back and explain: If we were to give carbon a price, what would that price be? Would it be the cost of its effects on the environment? Or, would it be based on the demand and supply for carbon? (Hint: it's the second one.)

This I see as a serious flaw when pricing externalities with a market-like mechanism like cap & trade. Markets work on supply and demand of the good being offered, but the problem we are trying to solve is the effect of an externality. Companies will only pay for carbon up until they would find it cheaper to just stop polluting (there's a great lesson on this at a fun & interesting site here). That price is determined by the company, not by the cost of damage from carbon to the atmosphere.

This price does not make enforcement any cheaper, either, but, sadly, it does help eliminate the stigma associated with being a polluter, while hiding a regulation over a pollutant in a pretend market.

To alleviate this, the cap & trade mechanism has the "cap" part that tightens over time. As this cap tightens, and fewer and fewer credits are allowed into the system, the price for carbon will increase. Can you see some downstream effects? Like, serious lobbying to loosen that cap, or postpone it just a little bit longer (see here for a great contemporary example)?

Ultimately, what this shows is that we are bending over backwards trying to make the transition to a low-carbon infrastructure as efficient and kind on businesses as possible. Unfortunately, what we might have done by this is:

A) create a decision-making process that favors problems where a market-looking solution is feasible, thus creating new distortions;
B) create a climate where we can call something a market if it appears to be a market, even when it is, in reality, a regulation; and
C) eliminate the stigma attached to paying a fine for polluting by hiding it in a pretend market, or in the case of giving away carbon credits, making taxpayers pay the fine for the companies in addition to helping pay the additional carbon costs whenever we buy anything.

And I'm in favor of a strong Cap & Trade! Weird, huh?