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Institutions for Climate Change

The deal is done. Contrary to the expectations of the skeptics, negotiators in Paris agreed on a final text to climate change accord. It is, I think, an historic agreement if for no other reason that it brings all members of the international community into the climate change tent.

Lest we become inebriated by the euphoria of the moment (and the celebratory champagne), however, we need to cast a sober eye to the challenges ahead.

The agreement commits governments to emission-reduction targets and subjects these targets to review and compliance monitoring. That is good progress. But if the climate change challenge is akin to the optimal provision of a public good, as suggested in a previous post,here, some enforcement mechanism is required. Countries will, inevitably, have an incentive to misreport progress and free ride on the efforts of others. The simple fact is that, if pressed, sovereign states that jealously guard their independence will choose the welfare of their own citizens here and now over the welfare of future generations of global citizens.

This somewhat pessimistic assumption reflects that meeting these targets will not be easy. If it were so, there wouldn’t be difficult decisions to make. Of course, we can hope that technological and scientific innovations will so greatly enhance the competitiveness of non-carbon energy sources that the economic problem becomes trivial — we can have both growth and lower CO2 emissions. (Think of technology pushing out the production possibility frontier of societal choices so that resources are better utilized to create wealth without accelerating climate change.)

Technology will undoubtedly help, of that I have absolutely no doubt. Yet, here’s the rub: that technological “fix” won’t materialize without investments in research and development. That investment will come from the public and/or private sectors. At the end of the day, both public and private investment will have to be mobilized: publicly-financed R&D to generate the basic research that can be distributed as a public good; private research (which is focused on increasing private returns for the firms undertaking it) to hone applications and spread the use of new technology. Regardless, we are back to the question posed in the previous post: who will pay?

If the investment comes from the public sector, taxes will have to be increased. And since the theoretical non-distortionary lump-sum taxes of Welfare Economics are not available in practice, those taxes will entail distortions — if levied on wages, labour supply decisions will be affected; if applied on capital, private investment decisions will change. Make no mistake: this is no reason not to impose taxes; if taxes are the price of civilization (as Ben Franklin observed), taxes imposed to prevent climate change may be the price of saving civilization. The issue is balancing the costs of the distortions against the benefits of the investment.

If the investments that could provide the technological “fix” are to be made by the private sector, however, firms must have an incentive to undertake them. That is the underlying point of the last (or previous) post.

So, is there a way to minimize the distortions induced by the funding of public investment while creating incentives for private investment? By happy coincidence there is.

Carbon taxes would both generate revenues for governments that implement them and increase the relative returns from green investments. An effective global strategy for climate change will be based on carbon taxes. Moreover, it should be possible to assemble a broad carbon tax coalition that spans both poles of the political spectrum. Here in the United States, Republican economists in the thinking wing of the party, who support carbon taxes as a tax on Pigovian “bads” (or negative externalities), can sit next to Democrats; the same can be said of the politics in other countries. The political sweetener is the fact that taxes on productive inputs (labour and capital) can be reduced (or increased less than would otherwise be required). This is a growth-enhancing strategy.

Carbon taxes should be a key element of a global response to climate change—that much is clear. This is, obviously, a big part of the “who will pay?” question. However, there is a separate, equally important issue to resolve: how do we ensure that countries have an incentive to introduce carbon taxes and don’t “defect” from the cooperative equilibrium?

A basic result of game theory is that cooperative equilibria dominate non-cooperative outcomes. The heuristic proof is the “folk” theorem — if a non-cooperative outcome is inferior to a potential cooperative result, the parties would voluntarily negotiate until there is equilibrium that dominates the non-cooperative outcome. The “catch” is that cooperative equilibria must be supported by some kind of enforcement mechanism; otherwise one of the players will have an incentive to defect from cooperative play to achieve a higher private return at the expense of the other players. This isn’t the case with respect to non-cooperative equilibria, which incorporate the potential for non-cooperative play with strategies that penalize defection. Institutions are either created de novo or ‘evolve’ endogenously, through practice, to support cooperative outcomes. They do this through monitoring of individual plays and enforcing penalties.

All to say, some institutional structure will likely be required. But what shape will this institution take?

Although trade policy purists will undoubtedly recoil in horror there is an existing institutional apparatus that could be mobilized. Rather than create some new monolithic supranational tax administration body, which in any event would be viewed as an entirely unacceptable infringement on national sovereignty and thus a nonstarter, why not use the existing WTO framework? As I will argue in a follow on post, the WTO has the economic and legal frameworks to enforce an internationally-binding agreement on carbon taxes and an established appellate procedure.

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