Climate Economics

  • The economics of climate changeis straightforward. When we burn fossil fuels, we inadvertently emit CO2 into the atmosphere, and this leads to many potentially harmful impacts.
  • Such a process is an ‘externality’, which occurs because those who produce the emissions do not pay for that privilege, and those who are harmed are not compensated. One major lesson from economics is that unregulated markets cannot efficiently deal with harmful externalities. Here, unregulated markets will produce too much CO2 because there is a zero price on the external damages of CO2 emissions.
  • Global warming is a particularly thorny externality because it is global and extends for many decades into the future. Economics points to one inconvenient truth about climatechange policy: for any policy to be effective, it must raise the market price of CO2 and other GHG emissions. Putting a price on emissions corrects for the underpricing of the externality in the marketplace. Prices can be raised by putting a regulatory tradable limit on amount of allowable emissions (‘cap and trade’) or by levying a tax on carbon emissions (a ‘carbon tax’).
  • Acentral lesson of economic history is the power of incentives. To slow climate change, the incentive must be for everyone to increasingly replace their fossil fuel-driven consumption with low-carbon activities. The most effective incentive is a high price for carbon.


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