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Why the Pope is Wrong on Markets

On a recent speaking engagement in Germany I ran into Prof. John Schellnhuber, who was pope francison his way to the Vatican to present Pope Francis’ major coming out document on climate change. After I got over feeling oh so cool for being one degree of Kevin Bacon removed from one of the most powerful figures in the world, I did my homework and read the Laudato Si, which carries the subtitle “On care for our common home”. This is a well researched position paper which touches on a variety of topics and makes it very clear that the pope cares much more about distributional issues than the average economist. This is not difficult as we are too often obsessed with efficiency (maximizing the size of the pie) rather than equity (who gets what size slice). Even though I am a Bavarian protestant married to a lovely South African Jewish lady, I have been a big fan of Pope Francis until I got to point 190 in the Laudato Si:

“it should always be kept in mind that “environmental protection cannot be assured solely on the basis of financial calculations of costs and benefits. The environment is one of those goods that cannot be adequately safeguarded or promoted by market forces”. […] Once more, we need to reject a magical conception of the market, which would suggest that problems can be solved simply by an increase in the profits of companies or individuals. Is it realistic to hope that those who are obsessed with maximizing profits will stop to reflect on the environmental damage which they will leave behind for future generations?”

I went and sat in front of a wall and meditated on this statement for a little while (yes, my mom tried to make a Zen monk out of me). I agree with some of this sentiment. It is clear that profit/utility maximization has led to much of the environmental conundrum we find ourselves in. In a perfect world, firms pay for the full costs of their activities (which we call social cost of production). Consumers then only buy the product if these costs are at most as large as their willingness to pay for the good. If firms don’t have to pay for the full cost of their production (e.g. they get to use the atmosphere as a free dumping ground for greenhouse gases) the cost of production is artificially low and consumers buy more than they should at artificially low prices. Does this happen? Well yes! Most places in the world do not charge firms for their carbon emissions. California, Europe, parts of Canada are some noteworthy exceptions, though even in these places the price is well below the environmental cost of the emissions. Most Chinese firms, for example do not currently pay for their use of the atmosphere. Neither do India’s, Japan’s, Australia’s…. This leads to an overproduction of greenhouse gases.

decadal-with-forcing-small

Is the optimal level of greenhouse gas emissions zero? The economist’s answer is a clear no. We derive great benefits from the combustion of fossil fuels. Light to read, heat to cook, gasoline combustion for transport. But is the price of fossil fuels too low? Nearly everywhere, the answer is yes.

The clear answer to fix this is to put a price on carbon, which makes producers (and in turn consumers) pay for the full cost of their use of the atmosphere. This ain’t rocket science. My undergrads get this. President Obama gets this. In fact, Michael Greenstone – one of the most prominent environmental economists in the world and frequent EI visitor – led a federal working group to determine what the social cost of carbon is. The answer he and his coauthors came up with is approximately $40. What this means is that we should be adding approximately $40 to each ton of CO2 produced. This would raise the price of gas by roughly 40 cents per gallon.

The two ways economists argue one does this is by either charging a carbon tax or putting in place a cap and trade system. The word tax is political suicide, so we are most optimistic about the prospects of cap and trade. What you do is you issue a permit for each ton of CO2 and let firms trade these permits. This has been shown to be quite effective at reaching a prescribed amount of pollution reduction. At least cost. The trick is to issue just enough permits, so the price in the market reflects the social cost of carbon. Most economists are on board with this. It’s a Nobel worthy idea.

Well, the Pope does not agree.

“The strategy of buying and selling “carbon credits” can lead to a new form of speculation which would not help reduce the emission of polluting gases worldwide. This system seems to provide a quick and easy solution under the guise of a certain commitment to the environment, but in no way does it allow for the radical change which present circumstances require. Rather, it may simply become a ploy which permits maintaining the excessive consumption of some countries and sectors.”

And I just don’t agree with Pope Francis. I think this hostility towards market-based instruments comes from three possible lines of thought:

  1. Imperfect markets are the source of the current dire state of the environment, hence why would we use markets as a fix?
  2. There was evidence of some fraud in the ETS, showing that these markets are subject to manipulation.
  3. There is no way a cap and trade market will get us to 80% emissions reductions by 2050. You just have to tell people what to do. Command and control is better at that.

My response to 1) is simple. The reason the environment is in such bad shape is that some markets fail. We teach this to undergraduates as they walk through the door. You can use cap and trade markets to fix market failures! This is what they are designed to do. Markets to fix markets! We sometimes use dynamite to extinguish bad fires! The response to 2) is simple. Yes. Markets can be manipulated. But we learn and design better more foolproof instruments over time. No regulation is perfect. My response to 3) is that standards are expensive, provide little incentive for technological innovation and are a pain to enforce. Don’t get me wrong. Emissions trading is not the only policy we should engage in. I am strongly in favor of significantly subsidizing R&D for example.

What I wish the pope would have said is that market failures are the source of environmental degradation and we need to do everything we can to fix this. Our own governor Jerry Brown, who left a catholic seminary after three years to study classics at Berkeley is a staunch supporter of cap and trade.

So I would humbly ask Pope Francis to leave it up to science not faith to help us figure out how to fix the biggest environmental market failure mankind has faced in its history.

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Maximilian Auffhammer View All

Maximilian Auffhammer is the George Pardee Professor of International Sustainable Development at the University of California Berkeley. His fields of expertise are environmental and energy economics, with a specific focus on the impacts and regulation of climate change and air pollution.

31 thoughts on “Why the Pope is Wrong on Markets Leave a comment

  1. Using CO2 as the ‘bad guy’ is part of the problem. There are many more types of emissions that are just as, perhaps even more, harmful.
    I propose that the ‘tax’ or ‘regulation’ of industry be on the USE, ie intake, of oxygen. Users buy oxygen intake permits; O2 is the resource being ‘used’ so should be paid for.

  2. Well, I think I am half way between The Pope and Professor Auffhammer. But as an Adjunct professor who teaches two interdisciplinary courses on sustainable energy at The George Washington University — I see some misunderstandings by both gentlemen. The Pope in Laudato Si was vividly pointing out that using markets to let some pollute more is not the appropriate response to the Lord’s creation. Prof Auffhammer responds , that markets are imperfect, and maybe we can use other market mechanisms to correct, or not. But Prof Auffhamer is correct, and I believe the Pope would agree, that placing a market “fee” on carbon for everyone (no exemption or exceptions) would then NOT allow anyone to escape paying to pollute more, and I bet the markets would respond quickly and efficiently to switch to lower or non-carbon alternatives. What the Pope did, was jettison the conversation from government gobbledygook which most experts agree would not be as fast or as much reductions of greenhouse gases needed, to what we ethically need to address as being transient residents of this planet. Markets can only be valuable if the right signals and the right enforcement mechanism are applied. I am a businessman as well and see the strength or markets, but the Pope is dubious, and I have to say, at the momemnt so am I. – Scott Sklar (solarsklar@aol.com)

  3. Dear Maximilian,
    I read with interest your entry here. I enjoy reading the newsletter from the Energy Institute at Haas.
    I am in the field and I disagree partly with your view, and tend to agree partly with the Pope’s, and here is why.

    The notion that internalisation of externalities effectively fixes the market relies on a particular assumption about the effectiveness of such economic signals to correctly incentivise choice by a myriad of agents, who actually, are very diverse and have different reasons to choose what they choose. There is no real way with which you can ensure to know what the effectiveness is of a carbon price at incentivising aggregate choice. The classical response requires assuming some optimal ‘rational’ response, along with identical agents (i.e. no income distribution), which really is something the classical economist uses that avoids looking into all the possible motives that agents, in his model, have that drive their decisions. (1) Agents are not identical and (2) the modeller doesn’t know all of these motives and constraints => a very heterogeneous response not without systematic bias.

    The result of this is that the effectiveness of a carbon price to incentivise choice always falls short of the classical result: i.e. the carbon price incentivises a lot less than you’d expect. You get a lot less emissions reductions than you should optimally get if agents were identical and ‘rational’. Sometimes, policies that are not market-based work better (e.g. technology standards, information, labelling, but also technology R&D strategy, see Grubb’s Planetary Economics book).

    I thus sort of agree with the Pope’s statement that “environmental protection cannot be assured solely on the basis of financial calculations of costs and benefits”, i.e. that market-based instruments will do something, but you cannot ensure what.

    For example: take the private transport sector, a typically consumer-based sector, difficult to decarbonise. You put a carbon price as a tax on fuels, and the effectiveness of that to incentivise consumer choice of vehicles at the time of purchase will depend on their valuation of future fuel costs (the literature has no consensus on discount rates: 4 to 20-40%), and because fuel is not the largest component of costs (if they value it at all at the time of purchase), it contributes a minimal amount of incentive. If instead you set up a registration tax based on the price of carbon (and expected lifetime emissions), then you get that wealthy people, who typically buy $100k cars, can readily afford it (the price of cars goes up exponentially with linearly increasing emissions) while the less wealthy who buy $20k cars suffer because they can’t afford either the tax or a 30-40k Prius (that’s an income distribution problem — see our 2015 paper in ERL on this). The incentive given by a unique price on carbon decreases with the price of the car: some people just won’t care. The equitable policy in this case would be a non-linear function of emissions that maintains the incentive at high prices, meaning not a unique carbon price. Or industry standards to drastically reduce emissions of all vehicles without relying on optimal choice by people (e.g. Japan’s top runner program).

    Another example: you give subsidies/rebates to green house appliances (e.g. fridges) and you find that people use it to upgrade size (http://www.nber.org/papers/w20541), thus not reducing energy consumption. How well do we understand consumer-based markets? We should look into marketing research (e.g. McShane, Bradlow & Berger 2012 for cars), where money is made out of knowing the differences between market segments and the details of ‘irrational’ consumer behaviour.

    My personal view is that we need much more elaborate policies than just pure market, i.e. internalising the externality, (see our Energy Policy 2014 paper, sorry to self-cite) and that we need to fully integrate behavioural economics as well as evolutionary economics to our analysis (see Grubb’s Planetary Economics book). On this, I think that the pope wants to bring forth a vision of a different future, that doesn’t rely uniquely on a carbon price (because that would be a lot of eggs in the classical economist’s basket).

    Many thanks for your entry. Happy to debate! All the best!
    J-F Mercure, U. Cambridge, jm801@cam.ac.uk

  4. Hi Max:

    Yes, people read what you write; even old colleagues.
    The problem is more than one of market failure; we simply have very few markets for all of the externalities including carbon and this lack of full cost benefit pricing is not going to be overcome by a carbon tax or cap and trade.
    Also if the Pope’s utility function is lexicographic and contains equity as a strong requirement, the carbon pricing schemes fail.
    Pollution, global warming or climate change, and inequality as well as globalization and the low economic benefit from far too much financial manipulation are all of a mix. Simple market failure cannot cure these, nor will a command and control economy of course.

    So the Pope calls for an attitude change, discourse, and perhaps moral reflection and considerations.
    In reality, I am not optimistic about any of this happening enough to make the difference we need.

    Best to you,

    Edward Kokkelenberg

  5. I’m going to humbly submit that I think you are missing the point. You wish the pope had said that market failures are the problem, not the concept of the market itself. I think the point is that while markets “in theory” could achieve some desired goal of environmental protection, “in practice” they don’t. That is, in theory, there is no difference between theory and practice, but in practice, there is.

    I’d also take you to task on the idea that the environment is in bad shape simply because “some markets fail.” Really? Hundreds to thousands of years of civilization’s emergence and slow disconnection from the intrinsic value of nature has nothing to do with it? Did market mechanisms fix slavery? Another example of our willingness to pervert our basic respect for living breathing, spiritual beings. You wouldn’t argue that market failures is the reason we had, actually still have, slavery? There’s clearly something deeper going on here.

    The point is that there is an intrinsic sacredness to the complexity of life that can’t be reduced to numbers and equations. The point is, that replacing God, the Great Spirit, Gaia, (or insert your favorite here) with the god of economic theory is a reasonably disastrous unfolding. It’s not an easily solved situation. To pretend that the answer is “simple” is really unfortunate, if not painful, to witness.

  6. Thanks for the thoughtful post. I do have a couple of comments:

    1. Another issue with command and control is not only the issue of innovation, but also of efficiency (of course the two are linked). It is unlikely that the regulator or policy maker has perfect information to identify the strategy that achieves environmental protection with the minimal use of resources and disruption to the economy. A market-based approach (economic instruments) is more likely to do so.

    2. I wouldn’t rule out a carbon tax entirely. A fair number of conservative pundits are warming to the idea.

    Mike King

  7. Assume for a moment that it is possible to convince the Pope that a well designed market can provide an efficient method of allocating resources. (A truly heroic and unrealistic assumption) It seems that the challenge here is, as you indicate, fully developing the cost function. Simple in concept, very difficult in application.

    Assume that insofar as climate change is concerned, this is done. Are there remaining market failures, again in reference to climate change? If so, they are worthy of discussion. If not, why the claim that markets alone won’t work? What else are you trying to accomplish?

    The reason I ask is as follows: There are some people who will never support the role of markets in environmental policy short of the markets being perfect. Thus, from an advocacy perspective unless we are willing to support markets as stand alone policy tools, we can’t ever hope to have a meaningful discussion with those who don’t support markets. They will always see a hole in the market, thus they will always see a role for direct measures. If there is a role for direct measures, there are too many people who will look first at direct measures and then once all direct measures are exhausted, toward markets.

    This is precisely what has happened in California. We can laud California for its market policy, but this is false praise. The cap and trade market in California is a distant residual policy tool, one that was only developed after the Air Resources Board exhausted all possible direct measures. Only if the direct measures are removed from California’s suite of climate policies can anyone honestly and with a straight face claim that California is promoting a market based solution for climate policy. And only if the direct measures are removed will California policy makers be able to honestly claim that the State has developed an efficient climate policy structure.

    Unfortunately also an unrealistic scenario.

  8. Also, command and control can “get it wrong”, either requiring too much or too little GHG reduction relative to the amounts that reflect full social cost. We live in a second-best (or third-best) world, and look for improvements, not perfection.

  9. Very nicely done Max. Loved 99% of the article and have a couple of tiny comments on the other 1% :

    1. I am curious about your statement “standards are expensive.” Having recently read the CPUC’s evaluation of EE programs in California, I believe codes and standards were the cheapest program in the portfolio. But perhaps EE is an exception.

    2. I am a strong believer in using science to help fix the world’s problems, but I think there’s also a place for faith – not in my life, but for those who don’t believe in science. Using both science and faith might get us further along, and at this point we need all the help we can get.

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