Market Failure Failure

The orthodox economic framework for analysing climate policy in terms of correcting market failures contains important insights, but is too narrow to identify a complete set of policies. 

This post is a little more abstract than usual, with no data or charts.  It looks at the framework that often underlies analysis of policies for reducing greenhouse gas emissions, though only taking a brief look at a subject that warrants much more extensive treatment.

The orthodox policy framework around emissions mitigation, especially among economists and particularly in developed English-speaking economies, consists of identifying, assessing and fixing market failures.  At the risk of slightly caricaturing this approach, essentially it stipulates that the costs of damages from greenhouse gas emissions are not normally factored into economic decisions, a major market failure which needs to be addressed by pricing emissions.  Other market failures may also need to be addressed if emissions reduction is to be achieved efficiently.  For example, there is a divergence of incentives between tenants and landlords (a principal-agent failure), which needs to be addressed by other interventions such as building standards.  Once market failures have been identified and fixed, markets can be left to do their job of making efficient production and consumption decisions.

This framework contains some valuable insights.  Carbon pricing has the potential to help reduce emissions at lowest cost, because there will be many different opportunities to reduce emissions, and a market will help reveal where the low cost abatement can be achieved, and incentivise cost effective action.  And asking what might stop energy markets from operating efficiently can provide important – though not fully comprehensive – insights into where policy interventions might be needed.

However in practice the characteristics of the energy sector imply that the necessary range of policies and activities is much broader than the framework of market failures alone would suggest.  (In other sectors, especially land use, which accounts for a substantial proportion of global greenhouse gas emissions, the limitations of the market failure framework are if anything even greater, with a diverse set of policy approaches needed – but more on this will need to await a future post).  A narrative that focusses exclusively on fixing failures so that markets can do their job is likely to lead to important dimensions of policy being missed.  At best the framework  of market failures highlights where problems may exist, but in many cases says little about how they can best be addressed.

For example, the characteristics of electricity production and delivery mean that electricity markets must be designed, and the form they take can have a major effect on the extent to which they enable a transition to a system with lower emissions.  Electricity markets may, for instance, differ in the way they deal with a preponderance of generation with very low marginal costs, increased interaction between supply and demand (enabled by smart metering and related trends), and likely greatly increased use storage.  An understanding of economic principles will surely help achieve effective market design, but labelling the need to design a market as a market failure does little to help.

Related to this, electricity and gas flow through networks with strong natural monopoly or oligopoly characteristics.  Network development, operation and pricing are inevitably subject to regulation, which may be more or less effective in stimulating low carbon investment.  Again, characterising network monopoly as a market failure, while doubtless valid, does little to tell you how networks need to be designed to enable lower carbon energy systems.

Furthermore, people’s behaviour often does not conform to the simple rational profit maximisation that much mirco-economic theory assumes.  This is more of a failure of (traditional) economic theory than of markets themselves.  This has major effects in areas such as energy efficiency, and a range of policies is typically required to address behavioural characteristics.  Behavioural economics and psychology will offer more insight here.

And, crucially, decarbonisation requires a fundamentally new energy system, including new technologies, notably for electricity storage.  The role of technology policy is too large a subject to go into here, but it is worth noting that the state and various types of institutions other than private corporations, such as universities and research institutes, have played a major role in fundamental innovation in a range of sectors.  It is likely that many such institutions have a role to play in decarbonisation, and looking at their role within a framework of market failure is unduly constraining, and risks misinterpreting their appropriate role and likely behaviour.

More broadly market based instruments such as carbon pricing are just that: instruments for achieving a goal.  The goal cannot be defined by markets, not least because choices affect those still to be born and the type of world they will inherit may differ fundamentally, not just marginally, from the present, depending on the choices made today.

Furthermore, all markets are embedded in wider society, including political and legal institutions.  These institutions and their actions must continue to have legitimacy if the transformation to a lower carbon society is to be effectively achieved.  Enormous efforts are required to retain public support for actions to address the climate change problem, and for the institutions that must implement emissions reductions policies, including carbon pricing.  Maintaining and enhancing this social and political capital and infrastructure is a task that goes far beyond fixing market failures.

It is possible to force-fit some of these issues into a framework of market failures, but doing so risks limiting the range of policy options and associated actions that are considered.  A much broader and more active approach is needed, asking what needs to be done and what tools and approaches are best suited to reaching a goal.  Markets have a major role to play in an effective policy programme.  But talking exclusively within a framework of market failures is likely to miss important dimensions of good policy design and many aspects of the activities that need to be undertaken to achieve the scale of decarbonisation needed to reduce the risks of climate change to more acceptable levels.

Photo Credit: Failings of Market Failure/shutterstock