Monday, December 28, 2009

Copenhagen and the Economics of Climate Change

This is a guest post by Greg Shinsky from Monash University, Australia . It is based on a paper Greg is working on right now. He talks about the role of public goods, coordination games, free riding and the sufficiency of the current international response under the United Nations Framework Convention on Climate Change. An earlier blog post from Greg can be found here.


Economists view climate change (CC) as a market failure, derived from under provision of the global public good represented by a stable atmosphere. This in turn is manifested as a negative externality which is neither time nor location specific.

At its source, this market failure stems from the inability of governments to coordinate policies that equalise the marginal private and social costs of greenhouse gas (GHG) usage. This is, however, no easy feat as the diffusive nature of GHGs means that the level of emissions from any one State will ultimately be borne by all other States. Therefore, the amount of the global public good per se that any one State receives is dependent on how many (and how much) GHGs the largest emitter or, in the context of CC, the weakest link emits.

Hence, the coordination game of CC approximates a weakest link type global public good. That is to say, the overall level of GHG concentration is only as good as the worst (or highest) level of emissions in any given State. Accordingly, provision of this global public good represents a sequential game where any attempt to free-ride in the long-run is inefficient and irrational due to the inevitable harm that results if agents receive a ‘payoff’ less than their subjective valuation. Therefore, at least according to economic theory, international policy cooperation will ultimately be invoked in order to avoid a Pareto-inferior outcome.

The recent summit at Copenhagen demonstrates that mere goodwill and benevolent intentions, without market based mechanisms, will not solve the CC problem. Resolution of CC issues demands market-based approaches because there is a profound insufficiency of knowledge on how to deal with a problem of such unprecedented complexity. Ultimate resolution of the CC coordination game thus requires a common price signal which in turn permits the efficient equalisation of the marginal social cost of GHG usage with the marginal abatement cost. Such a mechanism, however, must also satisfy the additional hurdle of actual State participation. Such participation is likely to be forthcoming when an excludable stream of private goods, which necessarily mitigates prospects of free-riding, is associated with involvement.

It is questionable whether the 1992 United Nations Framework Convention on Climate Change (UNFCCC), its associated protocol and accord, are the requisite geopolitical policy solution to avoid a Pareto-inferior outcome. Firstly, although the UNFCCC might demonstrate some incremental progress, both the Kyoto and Copenhagen summits have failed to reach a much needed comprehensive legally binding agreement. Furthermore, seventeen years of discussions have only yielded some unilateral commitments to reduce emissions to levels which current science suggest, even if adopted collectively, are manifestly insufficient. These points are given particular salience due to the possible dire consequences associated with further protracted policy responses.

Whether the weakest link theoretical prediction of a CC resolution holds is uncertain. This stems from the unique characteristic of possible ‘irreversible consequences’ associated with CC – which is not normally associated with the provision of other public goods. With time literally being ‘of the essence’, it is essential that any positive mitigation action is collectively supported by the international community. However, any such policies must continue to adhere to the long held international legal principle recognising the ‘common but differentiated responsibilities’ of developed and developing States.