Environmental economics for dummies

It’s quite rare you’ll find me reviewing a book on economics! I’m trying to make sense of the rather technical discussions around climate finance in the run-up to the Climate Conference, or COP 21, which will start end of November in Paris, so this is my small contribution to a better understanding of the international negotiations which we all hope will end up in a strong signal in favour of the planet’s and humanity’s long-term preservation.

Environmental Economics: A Very Short Introduction, by Stephen Smith, was published in 2011, so it does not reflect the latest debates around climate finance. It does however a solid basis to understand the principles underpinning most of the climate policy proposals out there.

I’ve attempted to summarise his ideas in an infographic which is not meant to look cool (I wouldn’t be allow to achieve that anyway) but rather to be informative and as clear as possible – a challenge when it comes to economics. You can also download my 7-page summary of the book.

Balancing environmental and economic interests

Environmental economics is about balancing economic and environmental considerations in a policy context. In other words, it’s about taking the right decisions that maximise environmental protection for the lowest possible price. Serious environmental pollution usually triggers policy responses and choices. Well-known examples include the London smog in 1952 which led to the adoption of the Clean Air Act in the UK in 1954 or the furore surrounding the publication of Silent Spring in 1962 which resulted in the ban of DDT and the creation of the US Environmental Protection Agency in 1970.

Usually the market would deal with pollution and ut a price on it, but the problem with pollution and environmental damage is that it is often not the same people who cause pollution and who suffer from it. In economic term, this is called an externality. It can be positive or negative, and it is because of negative externalities and other market failures that some form of State intervention is required.

This State intervention can take three different forms:

  • regulation, often called by economists ‘command and control’ interventions (guess what, economists don’t like regulation);
  • market mechanisms, also called pricing instruments, the two most relevant in the case of pollution being eco-taxes and emissions trading; and
  • non-pricing instruments, such  as public information campaigns, or more accessible data on pollution or market conditions.

The economic theory of efficient pollution control

So how to determine which price we are ready to pay for pollution? Economists determine this price by analysis the costs and benefits of each action. There are two issues: ALL relevant costs and benefits need to be calculated (e.g. long-term negative costs due to health issues), and these need to be translated into monetary value.

To understand cost-benefit analysis, you need to know what MAC and MED stand for. MAC is the marginal cost of pollution abatement, or the extra cut of cutting one more unit of emissions. MED is the extra reduction in damage achieved by reducing emissions by one more unit. So, if look at the diagram below, the optimal price for pollution is when MAC meets MED.

But economics don’t take social justice into account and this diagram doesn’t reflect the fact that abatement costs and environmental benefits will often accrue to different individuals, and that poor people will suffer more from environmental damage than the rich. In fact, if one were to follow economic thought stricto sensu, we would end up in a situation where those suffering from pollution would have to pay those polluting for them to stop polluting.  As Smith sums it up,

“It is an uncomfortable fact of diplomatic life that in this situation no deal is likely unless the ‘victims’ of the pollution finance a significant part of the abatement costs incurred by the polluters.”

How information and value affect environmental economics

Cost-benefit analysis reflects an opportunity cost, the one of using resources for one purpose rather than another purpose. This can be calculated using market prices for labour, capital and other productive resources. The problem is that not everything can be measured to fit economic theory. How do you calculate the recreational value of a forest, or its sacred value for indigenous tribes?

While Smith recognises that valuing the environment is a tricky task, he warns that not attempting to translate them into a monetary value raises another risk, that of not being on the radar of policy-makers at all.

“The power of numbers is only too apparent in public discourse and public decision-making, and there is a danger that things that do not get measured and valued simply get ignored. If the environment is to count in public choices, then it needs to be counted and valued.”

Personally, I find it hard to do so, as I ascribe an intrinsic value to the environment. Without the environment, there is nothing, no economic growth, no money, no humanity. The environment is a precondition of economics, not a part of the equation. As such I’m in the fourth category of what Smith calls the environmental values:

  • use value = the productive and recreative value of some aspects of the environment
  • option value = the possibility of future use of the environment
  • non-use value = environmental preservation for altruistic reasons, such as future generations
  • existence value = just because it exists, it is valuable, also called intrinsic value.

The economics of climate change

The economic analysis of climate change needs to take account of the specificities around climate change: its effects are unevenly distributed geographically, and the same goes for the increase of emissions. It concerns current and future generations – what has been coined intergenerational equity. This requires to calculate discount rates to determine the cost of climate action. Discounts is how economists translate costs and benefits arising at different times.

Depending on how important future generations are to you as an economist, you will include in your equation a low rate of discount (e.g. Stern) or a high rate of discount (e.g. Nordhaus) and your policy responses will radically differ: in the former case, you will want to tae early action to curb emissions soon, reducing costs borne by future generations; in the latter case, you will ask for a ‘policy ramp’ on climate change with gradual emission cuts.

Smith looks at other determinants of the cost of climate change, from regulation to the social cost of carbon and other carbon pricing mechanisms. He warns against partial implementation of pricing and non-price instruments. Lower prices in the energy sector for example aren’t always accompanied by a reduction in emissions. Therefore he advocates for higher energy prices to accompany energy-efficiency improvements (through technology for e.g.), so that

“improving energy efficiency will reduce energy consumption AND carbon emissions.”

He also looks at the limitations of international climate change negotiations and points to the risks of free-riding and burden sharing, which complicate climate negotiations even further.

Thanks to this small but comprehensive book, I can now look at the working documents of the COP 21 without the fear of a migraine!

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