Environmental Economics

The economic underlay: The Tragedy of the Commons, the Nash Equilibrium, etc

Carbon capture, offsetting and carbon trading are all born of economic theory that says damage caused to the environment by human activity is actually brought about by market failure. The factors most responsible for failure concern a lack of property rights - the inability to (a) define certain property rights, (b) buy and sell those rights freely; (c) prevent non-payers from using those rights; (d) limit the number of users. (You may not be into economics but if you saw the film ‘A Beautiful Mind’ you’ll have ‘met’ Nash, the author of some of the theory we're drawing on here here.)

Imagine owning a nice new car which any stranger is entitled to use whenever he feels like it.  The deal is you can use his or anyone else’s too - but theirs are all old bangers. That sort of system is an obvious non-starter.  (a) You’d never be able to rely on there being a car available when you needed one; (b) your nice new car will be in such demand by others that you’d never get to use it yourself; (c) you’d be put off from ever buying another new ‘communal’ car again; (d) the car manufacturers would find demand for their goods grinding to a halt - market failure!

The absence of property rights can apply to all sorts of situations - including property.  If you buy a home that looks out across a pretty valley you'll undoubtedly have to pay extra for the amazing view - but neither you nor anyone else can own the view itself (and people passing by can enjoy ‘your’ view for free). Next thing you know, the landowner in the valley gets planning permission for a sprawling ugly development that makes him a fortune by wrecking your view (but without compensating you for it).

All economic activity has ‘externalities’, i.e. actions that impose a cost somewhere else, a cost that will not be recognised or incorporated in the cost of production. The property developer did not have to pay for spoiling a beautiful view because the view has no legal owner - but if it had had a price tag then the developer's proposed project could well have proved non-viable.

Environmental economics seeks ways of quantifying and ‘internalising’ these sort of costs into their economic acts, the idea being to create the incentives that lead to optimum production/consumption.  For instance, a shoe factory that pollutes a river by using it as a free dump incurs first an environmental cost to the river and next a financial one to whoever ultimately cleans it up. But in the absence of property rights on the river, and no need to incude that cost in the selling price of the shoes, you'll get more people buying more artificially low-priced shoes, and the river beside the shoe factory takes even more abuse.

The problem outlined above is summarised in a now famous 1968 paper – The Tragedy of the Commons – by Garret Hardin. Hardin explains how, due to the collective acts of self-interested individuals under conditions where there are no property rights the usual positive outcomes of a free market are likely to be lost. His explanation takes for its example ‘the commons’ - public grazing land, open for the collective use of all herdsmen who (he observes) will ultimately (even when they know better) add cow after cow to their personal herd until the commons are overgrazed to extiinction.

‘The commons’ he refers to is public grazing land, open to all. If a herdsman were to contemplate, rationally, the consequences of his adding one cow to his personal herd, he would see two: (1) one cow’s worth of benefit to himself, and (2) the negative cost (met by all of the herdsmen collectively) of the loss of grazing caused by his extra cow’s consumption. What generally happens, though, is that even when all of the herdsmen collectively recognise the perils of owning more than 20 cows each, no-one will trust anyone else to restrict themselves to that number. Even if most honour the agreement there will still always be one who exceeds the quota; and because the land is non-excludable (no property rights) the 'honourable' herders will bear the vast majority of the marginal costs whilst the dishonourable one gets a free ride.

Environmental economics (e.g. 'game theory', Nash's 'equilibrium', the ‘free-rider’, etc.) says that this equation applies, unfortunately, to the whole of society. It's easy to see how it applies to our ‘global commons’ with its over-fished oceans and polluted atmosphere. There appear to be only two solutions: (a) regulation or (b) the correct charging of the externalities, i.e. making sure that an activity reflects its true cost.)

Whether we’re removing too much (e.g. in the form of overfishing, biodiversity loss, species extinction) or adding too much (e.g. greenhouse gases, nuclear waste, etc.) something finite is being used up.  In the case of the atmosphere, this finite resource is time - the time left until irreversible harm is done to the planet.

Economic solutions

The goal of internalising externalities and achieving a socially optimum level out output can be approached in two ways: (a) a ‘green tax‘; (b) ‘cap and trade‘ type mechanisms.

With the imposition of a ‘green’ tax on production the tax raised is supposed to be equal to the social costs of the given activity, fully internalising them. In theory you could claim a ‘double dividend’ here - based on the premise that socially optimum output has been achieved plus revenue raised for government to be spent on some environmental benefit. But experience shows that green taxes are never really set high enough to influence consumer behaviour (e.g. UK flight taxes - they don’t really stop us flying and the money doesn’t go to environmental projects anyway; it just disappears into government coffers). The other problem is the impossibility of making a tax assessment that is accurate.

The second option is to create a market in permits for harmful activitity such as the ‘cap and trade’ system utilised in the Kyoto Protocol for greenhouse gas emissions trading.  A limit is set on a given activity (e.g. carbon emissions) and the set number of permits is issued (like vouchers) giving the user the right to carry out the emission-causing activity. If the user manages to operate without using up all their permitted CO2 ‘vouchers’ they can trade them. This sort of scheme can only work when permits are scarce and have all the attributes of full property rights. The permits must be (a) well defined, (b) freely tradable, with no government interference, (c) bankable and (d) be able to produce profit for those trading in them. In this situation emissions become just another raw material of production that has to be paid for and included in the price.

The positive result of a good cap and trade scheme is that some businesses will decide that it’s cheaper to reduce their emissions by cleaning up their processes, and sell their permits.  For others already operating modern efficient factories it would be cheaper to buy those permits than attempt to reduce their emissions further. Over all though, the amount of the harmful activity (CO2 emissions) will be reduced.

The first place this was tried was in the US, with the so called Acid Rain (sulphur dioxide) permits. Experience showed that emissions reductions were successfully achieved ahead of time and at substantially lower cost than anticipated. The EU Emissions Trading Scheme is also such a scheme.

At Forest Carbon none of our clients is subject to any mandatory scheme - which offers hope for the future, defying as it does Hardin’s grim observation that we tend to act selfishly against what is rationally right. Our clients are voluntarily reducing their emissions and capturing the balance through carbon native woodland creation, thus imposing on themselves an informal, internal, ‘cap and trade’ scheme, bringing benefit to the their business, to the environment and to everyone else who likes a nice tree and a bit of fresh air.