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The economic hurdles for beating global warming

The Paris agreement on climate change is an important step forward in the battle to reduce greenhouse gas emissions. As the deal's negotiators acknowledged, the agreement won't not stop climate change by itself, but it provides an important framework for moving forward toward that goal.

In the past, under the Kyoto protocol, for example, developed countries faced mandatory emissions reductions, but developing countries did not. Because developing countries contribute a large fraction of greenhouse gas emissions, this made it nearly impossible to bring about meaningful action to reduce those emissions.

This agreement changes that by including all countries in the plans to reduce greenhouse gases. While this is a key improvement, it's important to recognize that effective action against climate change will require overcoming several problems, what economists call market failures.

Three come to mind regarding efforts to combat global warming:

"Externalities." This is the most important market failure, and it's well known. Regarding climate change, the problem here is that activities that emit carbon create costs don't all have to be paid for. For example, a coal-fired power plant sends carbon into the atmosphere that causes negative effects on society, but those costs aren't included in the firm's cost and profit calculations.

In effect, the power plant receives a subsidy -- the actual costs it pays are lower than the true costs of production -- and that leads to overproduction of the product and the additional pollution that comes with it.

The remedy is to force firms to pay all of the costs of production, and that's the purpose of policies such as cap-and-trade and carbon taxes. If and when the polluting companies do pay these costs, they'll reduce their production levels to be more consistent with the socially desirable amounts.

Worldwide coordination. Solving the climate change problem requires overcoming another obstacle: coordinating action across countries. This eliminates the problem of a firm operating in a country where these costs are forced on it losing a competitive edge to firms in countries where they can escape those costs. The climate talks are, of course, devoted to this problem (though many believe the U.S. should act unilaterally in any case to provide world leadership through demonstrable action).

Network effects. The third important problem is the existence of network effects. Electric vehicles are a good example. Before enough EVs can hit the road, recharging stations must be convenient and abundant. But who'll build the stations if the cars don't exist in volume, and who'll build the cars without the recharging stations?

There's a critical threshold for both that makes the network workable. It's possible for the private sector to solve this problem (see Tesla and its budding network of charging stations nationwide), but not easily.

However, government involvement can help establish charging networks of sufficient size to speed the adoption of EVs. We're seeing happening with tax credits for new charging stations. In effect, there's a positive externality with network size because a bigger and better network benefits all participants, and the tax credit acts as a subsidy that internalizes this positive effect.

Even as different as these three market failures are, if they could fix themselves quickly and easily, we'd call them something else, temporary market aberrations perhaps. Sometimes that happens, for example, when new innovation reduces the monopoly power of an existing firm (Uber undercutting the taxi medallion system). But most of the time, government intervention of some sort is needed, usually in the form of regulation and taxes and subsidies.

Government involvement doesn't distort the private market when it intervenes to fix a market failure. Government isn't perfect and won't always get it right, but neither does the private sector -- government doesn't have a monopoly on imperfection.

But overall such government involvement is clearly beneficial: How much do you think you'd pay for water, electricity, etc. if private sector owners were allowed to fully exploit their monopoly power? Cable-TV prices are bad enough, but what if those companies weren't regulated at all? How many more people would be excluded because they could no longer afford the service?

Overall, the two biggest hurdles I see to meaningful action on climate change are getting cooperation across all countries and overcoming each country's internal politics that stand in the way, particularly in the U.S.

Regarding the global scope of the battle against global warning, as part of this agreement, 186 of the 195 countries participating in the talks submitted "Intended Nationally Determined Contributions," which specify reduction targets for each country. The agreement also establishes a framework to provide oversight, enforcement, coordination and transparency requirements for the INDCs (see Harvard's Robert Stavins for a more detailed discussion of these points).

As Stavins points out, we won't know how well the Paris agreement will work for some time because it will depend upon how well the deal is executed and enforced, and what happens at the subsequent five-year reviews of the INDCs (at which point the emissions targets are supposed to be made more stringent). Still, the Paris agreement represents progress on the international coordination problem, but internal political problems remain a large obstacle.

In America, Republicans oppose action on climate change based upon their knee-jerk reaction to government involvement in the private sector, particularly where businesses are concerned. But opposition to policies such as a carbon tax or cap-and-trade or to international agreements that propel the world into action is -- as seen in the market failures above -- essentially gives a subsidy to firms that encourages them to produce too much pollution.

Politicians who block action that would take this subsidy away aren't adhering to free-market principles that seek efficient, socially optimal levels of production. It's the opposite of that. And the sooner we all understand the hypocrisy of citing free-market principles to support what amounts to a government subsidy that lowers costs of production below its true value, the better.

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