Greening economics, greening economies

7 April 2014

Sir Nicholas Stern, in his landmark report on the economics of climate change published in 2007, famously described climate change as the "greatest market failure" in the history of humanity. The expression "market failure" is a technical term  economists use to describe a situation when the actions and decisions that seem privately desirable to the individuals and organisations that take them are not consistent with the welfare of society, or societies, as a whole. In the case of environmental matters, the concern is that market prices do not reflect the social costs associated with the depletion of environmental resources that occurs in the production and consumption of goods, and hence that neither producers nor consumers take sufficient account of the damage caused by their actions. As Stern put it in relation to climate change, "Those who damage others by emitting greenhouse gases generally do not pay."

While Stern's work on climate change brought the concept of market failures to the attention of the public at large, it is important to understand that the concept is one that mainstream economics has grappled with for well over a century. Indeed, it is central to understanding the way economists think about all environmental questions. To understand how market failure fits into the relationship between economics and the environment, consider the schematic below.

The fundamental aim of economics is to promote the welfare of society by allocating social resources, which are limited and have alternative uses, to the ends that are most valued by society. Drawing on a utilitarian ethical framework, the concept of what is valued has been defined in terms of the satisfaction of preferences. Because such satisfaction is hard to measure objectively, economists have further defined - some would say reduced - the concept of value in terms of consumption, since this is objectively measurable.

People consume both private and public goods. Private goods and services are usually transacted through markets, and their value at market prices is what ends up recorded as GDP. Public goods involve things like clean air, the value of biodiversity, the enjoyment derived from natural assets, and these are typically not provided through markets, or at least not without very specific forms of policy intervention. All goods, and ultimately economic welfare, depend in part on environmental resources, illustrating the adage coined by GA Nelson - the US politician who founded Earth Day - that the economy is a wholly owned subsidiary of the environment.

As the diagram points out, environmental resources are apportioned to some combination of private and public goods. The difficulty is that historically, the scarcity value of environmental resources used in the production of private goods has not been reflected in transactions, and neither has the value of public goods that are intrinsically tied into the preservation of environmental assets. This had led to an over-allocation of resources to activities in the left hand side of the diagram, and an under-allocation to those on the right. This is simply a broader illustration of the problem of market failure discussed above.

The diagram also helps to illustrate why the often cited metric of GDP is recognised by economists and environmentalists alike as an insufficient indicator of social wellbeing. For a start, it only captures a subset of the activities that contribute to wellbeing, namely those that can be priced in markets. Secondly, it does not reflect non-market goods and services that are foregone because of the choice to allocate environmental resources to marketed goods and services. Moreover, it does not capture the fact that the use of environmental resources is usually irreversible - once ecosystems have been consumed to make shopping malls or car parks, these cannot then be converted back into ecosystems.

Alternative measurement

The fact that environmental resources are chronically undervalued in economic decision-making and in popular metrics such as GDP, has prompted a search for alternative ways promote greener economies by ensuring that the scarcity of environmental resources is captured and that consumers, producers, and governments can act accordingly.

One approach is to try and guide consumers as to the broader environmental consequences of their choices. The idea is that if these consequences are not reflected in the price of a good or service, then conveying information through some other means may help consumers switch from purchases that have high environmental impacts to ones that do not. The expectation is that this will in turn create incentives for suppliers to select greener modes of production. Labelling initiatives - for example, as to whether fish products are derived from activities that avoid damaging impacts on other forms of marine life or energy efficiency ratings - are examples of these.

Recently, attempts have been made to develop more sophisticated metrics that attempt to capture the use of a scarce environmental resource in the production of a good or service. The concept of food miles, for example, has been advanced as a way of measuring the environmental impact of various food products by drawing attention to greenhouse gas emissions associated with bringing these to market. But the measure is fundamentally flawed as a mechanism to address underlying concerns about greenhouse gas emissions. For a start, these measures focus only on the energy used in transport, and ignore the possibility that producers in other regions may have more energy efficient practices involved in the production of the particular commodity.

In fact, the food miles concept appears at odds with a wider consideration of resource costs. Several recent studies have shown that local production can be more energy-intensive than production of the same good further away, even factoring in the energy use involved in transportation. This should come as no surprise when we learn that the transport task is a minor cost component of total production, measured in either dollar or energy terms. As a result it is not possible to draw reliable conclusions from food miles about the total energy used in producing and supplying a product to the consumer's plate. In addition, the linear measure of food miles cannot capture information about multifaceted issues such as the agronomic practices used in production - for example, how the landscape was managed, whether biodiversity was threatened, how much fertiliser or pesticide was required, whether soil was eroded, whether water quality was threatened or whether salinity was increased.

Another metric that is sometimes put forward is the concept of virtual water. Virtual water measures estimate the total amount of water used in producing a specified good or service - including water from surface and groundwater resources and from rainfall. Some virtual water calculations also attempt to estimate the water content of inputs used in production. The idea is that, guided by virtual water estimates, consumers may assist in alleviating water scarcity by selecting products with low virtual water content.

The estimates of virtual water use can be spectacular and thought-provoking, given the water volumes used in production of our food and clothes can be orders of magnitude higher that the volumes of water we directly use. The concept is intuitively plausible - in a situation of water scarcity, the ability to work out what is less, rather than more water intensive seems valuable. This is especially the case when there is no formal mechanism, such as tradeable water rights, to mediate between competing uses of water.  However, the simple metric of virtual water is not an accurate reflection of the true scarcity value of water. Recall from our schematic that what we are really concerned about is the opportunity cost of resources - that is the alternatives, specifically environmental goods dependent on water, which may be sacrificed by allocating the water instead to marketable commodities such as pasture to support beef production or irrigation to support rice. Further, water is one input into the production of goods and services. Even if there is substitution from more water intensive products to less water intensive products, there is no guarantee that environmental or societal outcomes will be superior. So although metrics such as virtual water can act as a useful illustrative device or rule of thumb, they are less reliable in providing a guide to decisions on how systematically to allocate resources across competing claims.

The main difficulties with approaches discussed above is that they focus on selected subsets of environmental issues, and, while they may provide general rules of thumb, do not accurately capture the true scarcity value of environmental issues and hence the social cost associated with their use. Moreover, they largely attempt to address problems by trying to persuade consumers to change their choices. What is instead needed is a more comprehensive approach that helps to estimate the economic costs associated with environmental damages, and creates the right incentives across the whole economy, especially including incentives on the production and investment side. The idea is to find ways of making environmentally-friendly decisions systematically more profitable, in order to better align private self-interest with the public good.

Systematic green economy indicators

One example of such an approach is the Green Economy Initiative launched by the United Nations Environment Programme (UNEP). An important component of this initiative lies in helping countries develop indicators that measure the incidence of specific environmental problems, the inter-relationships between these, their overall impact on welfare, and that also help to identify the policy responses required to address these problems. For example, where water scarcity is an issue, an appropriate policy response could be to define tradable rights. Such a system allows governments to manage the allocation of water between environmental and market uses, while also allowing users of waters, such as irrigators and pastoralists, to trade water allocation so that the environmental good is allocated to the uses that are valued the most.

Tradable rights - of which carbon emissions permits are another example - are part of a class of instruments that are known as market-creating instruments. That is, they attempt to solve the resource allocation problem discussed at the start of this paper by establishing markets that would not otherwise have existed. In so doing they establish prices for resources such as water or clean air that would otherwise be considered a free good and hence used without giving any consideration to their true scarcity. Pricing resources creates precisely the sorts of incentives that are required to encourage producers and consumers to substitute greener alternatives to less green alternatives. Other price-based mechanisms such as taxes and subsidies can have the same effects, and often need to be supplemented by more coercive measures such as specific regulation, for example limits on emissions or discharges into rivers.

Including a focus on production

Whereas approaches based directly on labelling products are intended to guide consumer choices and thus create incentives for producers, the more systematic approach described above seeks to identify the appropriate policy response, and for this to send incentives for appropriate resource management though the production side of the economy. Because producers will, to some extent at least, pass on to consumers higher costs associated with the pricing of scarce resources, there will be incentives for consumers to modify their choices. But this will happen as a result of factors affecting their wallets directly, rather than the persuasive force associated with labelling.

More generally the approach described above is consistent with two general rules of economic policy-making. The first is that sound policies require a sufficient number of instruments to meet the selected targets with precision. The indicators do that by identifying and quantifying the sources of market failure, and suggesting approaches to address these. While  metrics that yield general rules of thumb, such as virtual water concepts are a useful starting point, greater precision is needed to support good policy, and address the multiple trade-offs that inevitably attend policy implementation. The second principle is that the management of risks should be allocated to parties that are best able to control them and manage them. Encouraging consumers to make environmentally sound choices is laudable. However, the reality is that they are often too far removed from the source of market failures to efficiently manage these - all the more so in a world in which supply chains are geographically decentralised. What is likely to work better is to ensure that the prices producers and consumers face better reflect the true scarcity of environmental resources that may be damaged or depleted as a result of economic activity.

In sum, the framework for addressing environmental issues within mainstream economics is well established. Much attention has been given to measuring resource scarcity and to identifying ways of ensuring these are properly considered when production and consumption decisions are made. The most promising approaches are ones that account for the opportunity cost of scarce resources, and which suggest policy responses to tackle market failures at their source. As these techniques become more refined, the remaining challenges are likely to lie in mobilising the political will to implement the appropriate solutions.

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