Global warming, externalities and government failure

Externalities are everywhere, and government policy to deal with them, at best, is mixed.

Just to remind readers, an ‘externality’ occurs when a market transaction affects people who are not involved in that transaction. For example, when I buy power from my electricity company, a generator somewhere in Victoria’s Latrobe valley works a little bit harder and makes some extra greenhouse gases. I pay for the electricity and that money compensates the electricity retailer, distributor, transmission company and the generator. But people who are adversely affected by the pollution receive no compensation. They suffer a ‘negative externality’.

With a negative externality, like pollution, the market tends to over produce the relevant commodity. Too much electricity is produced using coal because the buyers of that electricity do not face the full costs of their actions. If they did, they would buy less.

Externalities also can be positive. For example, basic research creates knowledge that can be used by many people even if they do not pay for using the knowledge. This ‘spillover’ from the research is a positive externality and the market will tend to produce too little research.

While externalities are everywhere, many are too trivial to worry about. If I forget to use deodorant then my colleagues may suffer an adverse impact, but that is not a reason for government intervention. Further, social rules and norms often develop to deal with these small externalities. If I forget deodorant every day then I may find that work colleagues and friends shun me.

But sometimes externalities have significant consequences. In these situations government intervention may improve the market. However, the government has a mixed record on dealing with externalities.

For example, antibiotics save millions of lives each year. They are also used in animal husbandry. But using antibiotics creates a negative externality. Each use raises the risk that resistant bacteria will develop. While using the antibiotic makes us well, we impose a small negative risk on the health system.

Governments are reluctant to restrict the human use of antibiotics. However, there is growing pressure on governments to restrict their use on farms and in fisheries. For example, earlier this month the Daily Mail reported calls by the British Science Minister to limit the use of antibiotics:

“Britain yesterday urged rich nations to clamp down on antibiotics amid fears their overuse will lead to the catastrophic spread of drug-resistant superbugs”.

The Science Minister stated that:

“Across the G8, we should regard the spread of antibiotic resistance as a global challenge that is up there with climate change, water stress and environmental damage, and there are genuine policy consequences that follow from that”.

Unfortunately, despite such calls and the recent history of superbugs, governments are reluctant to act. Indeed, concrete proposals to limit human use of antibiotics are not even discussed.

Similarly, vaccinations are a simple example of a health measure with a positive externality. Vaccinating your child against diseases such as measles or whooping cough reduces the risk of disease spreading. Government policy to deal with this type of positive externality is easier – subsidise it. Australian governments have subsidised childhood vaccinations for years.   However, governments have been reluctant to interfere when parents ignore the scientific evidence and put their children and society at risk by spurning vaccination. An exception is in New South Wales where parliament has just passed laws requiring childcare centres to ensure children in their centres are vaccinated.

“Childcare centres will face fines if they do not complete checks to ensure a child is vaccinated, or that they have exemption”.

The biggest government failure with an externality, however, is on greenhouse gases. Greenhouse gas pollution has the potential to cause major global climate change. Further, the pollution is not localised. The climate effects of carbon-based emissions are wide-spread and relatively slow.

To see why this matters, consider the problem of sulphur dioxide. This pollutant causes localised air pollution. Citizens living in polluted areas have a strong incentive to force the government to ‘do something’. Thus, in 1990, the United States government introduced a ‘cap and trade’ scheme to limit sulphur dioxide emissions. And the scheme worked. By putting a price on these pollutants, the scheme created significant incentives to reduce pollution.

Similarly, broad support and government action on greenhouse gases is most likely if there is a significant local problem. China is looking to limit its import of low quality coal. But this policy is driven by the problems of local air pollution. It may lower global greenhouse emissions but that is a side benefit of dealing with a local problem.

Global warming is a global negative externality and, in my opinion, it is highly unlikely that governments in different countries will agree to an effective scheme to deal with this negative externality. Even if developed nations could reach an agreement, developing nations would be reluctant to join in. After all, how do we tell the ‘bottom’ billion in Asia and Africa to limit their economic growth in order to avoid a problem which, from their perspective, seems ephemeral.

There are no easy answers to dealing with global warming. And, given the poor history of governments dealing with localised externalities, I am pessimistic that they will put policies in place to deal with a global issue. Sadly, effective policies to deal with global warming are only likely to gain political support when the problem becomes too big for it to be ignored at the local level.

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4 thoughts on “Global warming, externalities and government failure”

  1. Hi Stephen,

    Great article – never considered the importance of local/tangible impacts on the group sought to be influenced by economic measures aimed at addressing externalities.

    One thing that has always struck me in the debate however, is the extent to which the discussion of externalities always focusses on measures to cost in the negative – putting downward pressure on emissions.

    I recall reading recently that 80% of emissions growth to 2050 would be from emerging economies – predominantly due to emissions from increased fossil fuel powered electricity plant (pardon my lack of specificity).

    It seems to me that without commercialisation of a ‘step change technology’ capable of providing affordable base-load energy, the effect of emissions permits will be quite limited. After a while the options for energy efficiency improvement will be maxed out, as will small scale renewables.

    An affordable base load energy source capable of allowing the developed world to continue to grow without compromising their standard of living, whilst allowing the developed world to improve theirs, is a critical part of the solution.

    In that case, wouldn’t more be achieved by compensating developers of new technology for spill overs whilst regulating the worst emitters?

    That is, focussing policy much more around energy R&D and international cooperation on that front, rather than a cap and trade system to address the negative externalities?

  2. Also – pet topic of mine.

    I recently read an article by Jeffrey Sachs that indicated that “Several studies in the past year have shown that scientists can indeed detect long-term climate change in the rising frequency of extreme events.”

    Increasingly science will be able to link the nebulous phenomena of climate change to localised extreme weather catastrophes. Do you think this will change the equation?

  3. Hi Monika

    I think both points are important. To ‘sell’ climate change policy governments need to be able to tie it to local events. So if that ‘tie’ becomes more credible then that will help convince local groups of the need for action to correct the global externality.

    I also think that scientific developments and a ‘step change’ in technology are likely to be the only successful ways to overcome the climate change (until things get so bad that action is unavoidable). The benefits of carbon markets is that they change prices and create a monetary incentive to invest in the R&D necessary for technology advance. So rather than governments trying to pick technological winners, carbon markets and carbon pricing create incentives for business to invest in trying to find a solution – both existing business who need to reduce carbon emissions and ‘new’ business seeking to develop new technology that (given the carbon price) is cheaper by having lower emissions.

  4. Sadly, I would have to agree with the more pessimistic view that governments won’t be able to come together to agree on a policy on climate change (at least until something catastrophic happens).

    But who knows, maybe after it becomes completely evident that we must act will we finally do so (like the UN after WW2 for comparison).

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