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Climate Change Policy and Neoclassical Economics: Part 1/2

Updated: Jan 17, 2021

Everybody talks about the weather, but nobody does anything about it.

- Mark Twain

This witty quote opens the 2019 winter issue of Finance & Development, the IMF’s quarterly publication, which looks at the economic and financial impact of climate change and climate policy choices. Gita Bhatt, editor-in-chief of Finance & Development, explains that in Twain’s day, it was absurd to suppose humans could do anything about the weather, but that today we understand that we can and we must (International Monetary Fund, 2019, p. 2). The economic, social, and ecological havoc that the changing climate threatens to wreak on our planet has been largely caused by human emissions of greenhouse gases (GHGs). The rising sea levels, temperature extremes, and displacement of communities will only continue if effective mitigation policies are not put in place.

The Brundtland Commission (1987) explained environmentally sustainable development in terms of the interconnectedness of economic, social, and ecological processes, however this essay will specifically explore the economic reasoning that underpins specific environmental policy responses to climate change. The vastness and complexity of environmental policy warrants a limit on the scope of this essay; it will specifically explore how neoliberal values created neoclassical economics, and then how this economic framing has influenced market-based policy responses to climate change, including carbon taxes, discounting, and carbon trading. These policy responses raise important questions about how to calculate the social cost of carbon (SCC), how to manage market failure, and the ethics surrounding intergenerational equity and the commodification of nature.

Economics is a social science that seeks to analyse and describe the production, distribution, and consumption of wealth (Blaug, 2020), and neoclassical economics is a specific economic perspective that argues that the free market is the best way of allocating resources so as to maximise the well-being of members of society (Johnson & Dawson, 2019, p. 110). This perspective came from the liberal tradition of political thought which frames the liberal state as having an essential but limited role in protecting individuals’ rights and property. In this worldview, the free market is an impartial arena with no central authority within which actors can settle competing claims to economic resources. Market failure is a situation in which the allocation of goods and services by a free market is inefficient; it does not maximise the well-being of members of society. The application of neoclassical economics to environmental problems is known as environmental economics, which is a fairly established subdiscipline of economics (Söderbaum, 1994, p. 47) and has influenced many policies that aim to mitigate climate change. The current scientific consensus is that anthropogenic sources of GHGs are a leading cause of climate change (Stern, 2007, as cited by Johnson & Dawson, 2019, pp. 105-108) and this is an example of a market failure – CO2e emissions constitute a negative externality that is not included in the market value of goods and services that produce those emissions. A neoclassical economic policy to correct this market failure might be to introduce a carbon tax to reduce the negative externality of pollution.

Theoretically, establishing an SCC in monetary terms will produce an optimum level of production; a level of production that maximises the well-being of members of society. This optimum level of production will balance the economic benefits of industrial production against the economic costs of CO2e emissions that are created by production (Johnson & Dawson, 2019, pp. 110-111). Imposing a cost on CO2e emissions will provide an economic incentive for producers to shift away from carbon-intensive methods of production, for example fossil fuels, and toward low carbon technology, like renewable energy sources, in order to maximise profits.

Britain is an example of successful carbon tax in action. In 2013, Parliament enacted a carbon price floor policy for certain sectors that essentially functions as a carbon tax of around $25 per ton of CO2. This carbon tax has encouraged a rapid transition by electric utilities from coal to natural gas, thus reducing Britain’s GHG emissions to their lowest level since 1890 (Plumer & Popovich, 2019). In this example, we see that electric utilities companies in Britain’s free market system have to balance their Marginal Net Private Benefit (profit) with the Marginal External Cost of doing business (carbon tax on emissions) in order to continue to maximise their profits, which is leading them to transition away from coal, which produces significant negative externalities and is thus heavily taxed, and towards natural gas, which is less of a polluter and thus less heavily taxed. This example demonstrates the neoclassical economic thinking behind Britain’s carbon tax policy.


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