An Economic View

of Environmental Protection

Robert N. StavinsAlbert Pratt Professor of Business and GovernmentJohn F. Kennedy School of Government, Harvard University

Conference on Sustainability in ManufacturingAssoreca and the Green Economy NetworkAssolombarda Auditorium, MilanoNovember 20, 2014

“What business are you in?”

“I’m an environmental economist.”1

“Environmental economics” is not oxymoronic.

1. The causes of environmental problems (in a market economy) are economic – unintended side-effects of market activity (“externalities”).

2. The consequences of environmental problems have important economic dimensions.

Therefore, an economic perspective is essential for

Understanding environmental problems

And therefore can be exceptionally helpful for the design of solutions that will be effective, economically sensible, and politically pragmatic.

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The Causes of Environmental Pollution are Economic

Pollution is an externality.

May (U.S.) firms go beyond full compliance with the law (sacrifice profits in the social interest)?

For publicly-owned firms:

Fiduciary responsibility to shareholders

But the business-judgment rule (long-term, public relations)

Can firms – public or private – go beyond full compliance on a sustainable basis?

Increase prices?

Commodities vs niche markets

Some firms can pass on price increase –monopolists

Where does the pollution go?

Commercial laundry next door

Does cost (to laundry) show up in annual report of steel producer?

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The Economic Consequences of Pollution

1. Producer Producer

(steel production & laundry services – $)

2. Producer Consumer

(paper production & recreational fishing)

3. Consumer Consumer

(secondary exposure to cigarette smoke)

4. Consumer Producer

(littering in a movie theatre – $)

Economic consequences ≥ financial consequences

Economics is not the same as accounting

The most important economic impacts are not the most obvious

Economic perspective is particularly important when thinking about global climate change …

Science Economics Geopolitics of Climate Change

Greenhouse gases mix in the atmosphere, so the location of emissions

has no effect on impacts – In economic terms, climate change is a

global commons problem

Any jurisdiction taking action – a country, province, or city – incurs the

costs of its actions

But direct benefits (averted climate change) are distributed globally

Therefore, for virtually any jurisdiction, the direct climate benefits it reaps

from its actions will be less than the direct costs it incurs ….

despite the fact that the global benefits may be greater – possibly

much greater – than the global costs

This presents a classic free-rider problem, ….

which is why international, if not global, cooperation will be essential,

And why the highest levels of effective governance need to be engaged,

that is, national governments …5

Most policy analysts favor national carbon-pricing.

Why?

No other feasible approach can provide meaningful emissions reductions

Least costly approach in short term (heterogeneous abatement costs)

Least costly approach in the long term (incentive for carbon-friendly

technological change)

Most policies have favored cap-and-trade over carbon taxes, partly because

of experience …

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Experience with Cap-and-Trade Policies

U.S. EPA Leaded Gasoline Phasedown (1982-1987)

U.S. SO2 Allowance Trading, CAAA of 1990 (1995-2010)

European Union Emissions Trading System (2008-2020)

U.S. Regional Greenhouse Gas Initiative, RGGI (2009-2019)

California’s AB-32 GHG Cap-and-Trade System (2013-2020)

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California’s Global Warming Solutions Act (2006, AB 32)

Broad, ambitious policy to cut GHG emissions to 1990 level by 2020

Energy efficiency standards for vehicles, buildings, & appliances

Renewable portfolio standard (increases from 20% to 33%)

Low carbon fuel standard

Cap-and-trade system …

Cap covers 85% of economy, declines from 2012 through 2020

Increasing use of auctions over time

Price collar creates essentially a hybrid of cap-and-trade and tax

Provides protection for trade-sensitive industries

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Lessons from California’s AB 32 Cap-and-Trade System

Carbon pricing is necessary, but not sufficient, due to other market failures

Examples include basic R&D and principal-agent problem (buildings)

So, specific non-pricing policies can be complementary

But some “complementary policies” conflict rather than complement!

California example – Low Carbon Fuel Standard, Renewable Electricity Standards

Consequences of policy for sources under the cap of a cap-and-trade system

Achieves no incremental CO2 emission reductions –relocates emissions

Drives up abatement costs (marginal costs not equated)

Suppresses allowance price (by reducing overall demand for allowances)

With carbon taxes, other policies can achieve additional reductions (but not c/e)

As long as cap-and-trade is employed, many so-called “complementary policies”

are nothing of the kind! (Also a major problem with European Union policies)9

More Lessons from California’s Cap-and-Trade System

Initial free allocation fostered political support

Economy-wide system feasible, and much more effective than sectoral system

Price collar effective (Europe resistant to this)

Free allocation per se does not affect leakage/competitiveness (inframarginal)

So, attempts at competitiveness protection under EU ETS are ineffective

But output-based updating system makes allocations marginal

So, in California system, this reduces competitiveness and leakage risks for

trade-sensitive sectors

But leakage risks remain for electricity sector, due to contract reshuffling

Ultimately, only way to eliminate leakage/competitiveness risk is through

broader (national & international) coalition of action …10

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International climate change policy is a marathon, not a sprint

Scientifically: stock, not flow environmental problem

Economically: cost-effective path is gradual global ramp-up in target severity (to avoid unnecessary capital-stock obsolescence)

Economically: technological change is key, hence long-term price signals

Administratively: creation of durable international institutions is essential

International climate negotiations will be an ongoing process – much like trade talks – not a single task with a clear end-point

So, sensible goal for climate negotiations is progress on sound foundation for meaningful long-term action, not necessarily an immediate “solution”

A View of the International Domain:

Placing Climate Negotiations in Perspective

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The Harvard Project on Climate Agreements

Mission: To help identify key design elements of a scientifically sound, economically rational, and politically pragmatic international policy architecture for global climate change

Drawing upon research & ideas from leading thinkers around the world from:

Academia (economics, political science, law, international relations)

Private industry NGOs Governments

50 research initiatives in Argentina, Australia, China,

Europe, India, Japan, and the United States

Searching for the Path Forward

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Four lessons have emerged

1. Market-based approaches are essential

2. Getting (carbon) prices right is necessary, but not sufficient

• Because of public-good nature of R&D, private sector will under-invest

• Possible need for government-funding of private-sector R&D, such as for CCS

3. “Developing county” participation is essential

• Impossible to address climate change without meaningful participation by China &

other key emerging economies (even if OECD emissions were zero)

• Central task in international negotiations is developing means of bringing key

emerging economies on board

4. Defacto interim (or post-2020) policy architecture may already be emerging

Direct and indirect linkage of regional, national, and sub-national cap-and-trade and

other policy instruments

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A Hybrid International Climate Policy Architecture

Bottom-up: National targets and actions that arise from – or are at least consistent with – national policies and goals.

Top-down: Centralized oversight, guidance, and coordination.

The Path Ahead to COP-21 in Paris, December 2015

Key Questions

Can such an agreement that is anchored in domestic political realities, …

… adequately address emissions with sufficient ambition?

Are there ways to enable and facilitate increased ambition over time?

Linkage of regional, national, and sub-national policies can be part of the answer.

Full answer forthcoming in Paris one year from now!

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“Environmental Economics” is not an oxymoron.

An economic perspective is essential for a

full understanding of environmental problems.

Economic analysis is key for design of solutions that are:

environmentally effective economically sensible politically pragmatic

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For More Information

Harvard Project on Climate Agreementswww.belfercenter.org/climate

Harvard Environmental Economics Programwww.hks.harvard.edu/m-rcbg/heep

Websitewww.stavins.com

Bloghttp://www.robertstavinsblog.org/

Twitter@robertstavins