Carbon market and economic progress – Accounting for Externalities

Experience and practice are two distinct areas of science, but they must work together. Observation provides the basis for theory, and theory is confirmed by experience. It also happens, when faced with robust theories, that the latter opens the door to experimental discoveries. Thus the theory allowed to detect the probable existence of the eighth planet Neptune, on the findings of theoretical irregularities, and then the observation by Le Verrier de Neptune in 1846. The scientific progress was thus made by an alternation of experimental and theoretical advances, the two legs of science which articulates its forward movement.

This link between experimentation and theory, in economics, is more tenuous and less obvious. We will indeed see that for the carbon tax, but if the initial objective is indeed to internalize a social cost (Coase’s theorem), the implementation and its experimentation turns out to be more complex.

Why is the conceptual, theoretical framework so complex to apply?

R. Coasse, with his eponymous theorem, proposes to establish a market to deal with the problem of externality:

if transaction costs are zero and property rights are well defined, individuals involved in an externality will negotiate in order to obtain an efficient allocation of resources,
the allocation of resources will be the same regardless of the distribution of property rights.

This implies two elements:

correctly defining the property rights,
include the parties involved in these externalities.

Within the framework of the carbon market, and in order to make it feasible, the authorities have defined the following:

a market, between polluters,
a base price, uncorrelated to any externality.

Why a market only between polluters?
Mainly to circumvent the problem with naive application of Pareto’s law: we solve 80% of the problem with 20% of the actors. This simplification nevertheless has an impact on the determination of the price. Indeed, Coase’s theorem specifies that there must be an effect between 2 actors for the externality to be internalisable through a market. However, there is no externality between two polluting firms. Nevertheless, these two companies may be interested in reducing their carbon emissions to be more competitive and efficient. In this case, the price driver, for the carbon ton, is not the value of the externality, but the cumulative investments and efforts to reduce the carbon footprint in a sector. Thus, if the entire automotive industry does not decide to make any investments, the price is likely to remain low. Otherwise, if one of the players invests in a clean vehicle, in order to benefit from the non-emission of greenhouse gases, it can impose a higher price per ton of carbon, create a competitive advantage, and thus encourage other players to invest.
Thus, this carbon market is not really an application of Coase’s theorem, but rather the implementation of a financial constraint to stimulate innovation.

Strict implementation of the Coasse theorem is impossible for the following reasons:

the notion of property is not clear and involves actors who may not have been born at the time of reading this article: strictly speaking, the “global warming” externality should include future generations who will most likely see their living standards decrease (pressure on food resources, economic decline, increased susceptibility to certain diseases, …).
monitoring and follow-up of costs is complex: indeed, we know how to evaluate externalities in the near future, over which we control the factors. For global warming, the complexity lies in the evaluation of interrelated impacts, over the long term, on which we cannot evaluate the possible feedbacks (a priori rather pessimistic). This succession of impacts, in chains, over long time horizons, prevents us from having a clear vision of the value of the climate externality.

So why include the climate externality in the balance of externalities and how can it be monitored over time?
Today, the only existing and credible value is that provided by the carbon market. This value has all the shortcomings of the world, but allows us to know the value of a ton of carbon in the current economic system (a system that is still very poorly adapted to this new constraint). It is to be hoped that this value of the carbon ton will increase over time, as investments are made to reduce the carbon footprint. In addition, other elements will influence its value: social pressure for a fairer value of the ton of carbon, discovery and improvement of climate models, …
By integrating the ton of carbon in the balance of externalities now, we anticipate that progress will be made. Taking into account current knowledge, we integrate the social cost of our emissions. Finally, we reserve the right to correct the impacts.

This method reveals two advantages.
The first is an application of the precautionary principle, not only to measures but also to future impacts.
The second is to prepare an experimental base, in order to invalidate or confirm the hypotheses and models of evolution that we may be led to make. The balance of externalities thus becomes one of the first long-term models to be applied to the economy. The balance of externalities can become one of the economic metrics for improving models and better understanding the notion of progress.

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