Lecture 17 - Climate Change, Externalities and Policy Design
1. Lecture Overview
This lecture introduces climate change as a core macroeconomic issue, emphasising its nature as a global negative externality and exploring the role of policy in addressing it.
Key themes:
- The structural challenges of climate change
- Cost-benefit analysis of environmental abatement
- Policy instruments: carbon tax vs cap-and-trade
- Trade-offs between efficiency, equity, and uncertainty
2. The Economic Nature of Climate Change
Negative externality: A cost imposed on third parties not reflected in market prices.
Climate change arises because greenhouse gas emissions impose social costs not internalised by firms or consumers. This leads to overproduction of pollution-intensive goods relative to the social optimum.
Climate change represents a market failure where
3. The Challenges of Climate Change
Structural Features
- Stock problem: Climate depends on cumulative emissions, not just current flows
- Irreversibility: CO₂ accumulation has long-lasting effects across generations
- Uncertainty: Extreme outcomes are low probability but high impact
- Global coordination problem: Requires cooperation between major economies
- Intergenerational conflict: Trade-off between present consumption and future welfare
Climate change is fundamentally a dynamic optimisation problem: emit today to grow, but at the cost of future output and welfare.
Climate Risk and Catastrophic Outcomes
This slide highlights the concept of a carbon budget and the probabilistic nature of catastrophic outcomes. Even if emissions are limited to maintain a 2°C increase, there remains a non-zero probability of extreme warming.
- Remaining carbon budget: ~1–1.5 trillion tonnes of CO₂
- Even within this limit: ~1% chance of >6°C warming
- Exceeding it increases catastrophe probability to ~10%
This introduces fat-tailed risk distributions, where extreme outcomes dominate expected welfare losses. Standard cost-benefit analysis may underestimate these risks.
Climate policy justification often relies on risk aversion and precautionary principles, not just expected values.
4. Environmental Abatement and Cost-Benefit Analysis
Core Question:
What is the optimal level of pollution reduction?
- Full elimination is inefficient due to high economic costs
- Optimal policy balances:
- Marginal benefit of abatement (reduced damage)
- Marginal cost of abatement (reduced output/consumption)
Abatement: Actions taken to reduce environmental harm, such as lowering emissions.
Economic Trade-offs
- Efficiency trade-off: Consumption vs environmental quality
- Ethical trade-off: Present vs future generations
This is an intertemporal welfare maximisation problem, often modelled using discounted utility. The choice of discount rate critically affects policy outcomes.
Assuming zero emissions is optimal ignores opportunity costs and diminishing returns to abatement.
5. Externalities and the Social Optimum
This diagram shows the divergence between marginal private cost (MPC) and marginal social cost (MSC) due to pollution.
- Market equilibrium: where MPC = MPB → overproduction
- Social optimum: where MSC = MPB → lower output
- Deadweight loss arises from unpriced external costs
Economic Intuition
Firms ignore pollution costs, so they produce “too much”. Society would prefer less output at a higher price.
6. Policy Instruments for Climate Change
6.1 Carbon Tax
A carbon tax increases MPC to equal MSC, correcting the externality.
- Raises cost of emissions
- Reduces demand for polluting goods
- Achieves socially optimal output
Carbon tax: A tax per unit of emissions designed to internalise environmental externalities.
Pros and Cons of Carbon Tax
Advantages:
- Internalises external costs
- Generates government revenue
- Encourages innovation and substitution
Disadvantages:
- Measurement difficulties
- Administrative costs
- Risk of carbon leakage (firms relocating)
Carbon taxes provide price certainty but not quantity certainty, unlike cap-and-trade systems.
6.2 Cap-and-Trade
- Government sets emissions cap
- Firms trade permits
- Market determines price of emissions
Cap-and-trade ensures quantity control, but introduces price volatility.
Comparison
| Policy | Certainty Type | Mechanism |
|---|---|---|
| Carbon Tax | Price certainty | Fixed tax per unit |
| Cap-and-Trade | Quantity certainty | Tradable permits |
Compare instruments using uncertainty: taxes preferred under cost uncertainty, permits under benefit uncertainty.
7. Policy Design Under Uncertainty
Climate policy must account for:
- Unknown damage functions
- Irreversibility
- Extreme tail risks
When uncertainty is large and damages are irreversible, early action is often optimal.
8. Global Coordination Problem
Climate change requires:
- International cooperation
- Burden sharing across countries
- Enforcement mechanisms
This is a prisoner’s dilemma:
- Each country benefits from others reducing emissions
- But has an incentive to free ride
9. Key Takeaways
- Climate change is a global externality with intertemporal consequences
- Efficient policy requires equating
- Carbon taxes and cap-and-trade are primary instruments
- Uncertainty and irreversibility justify precautionary policy
- International coordination is essential but difficult
10. Bibliography (Harvard Style)
- Andersson, M., Morgan, J. and Baccianti, C. (2020) Climate change and the macro economy. ECB Occasional Paper.
- Batten, S. (2018) Climate change and the macro-economy: a critical review. Bank of England.
- Batten, S., Sowerbutts, R. and Tanaka, M. (2020) Climate change: macroeconomic impact and implications for monetary policy.
- Bowen, A., Campiglio, E. and Tavoni, M. (2014) A macroeconomic perspective on climate change mitigation. Climate Change Economics.
- Kahn, M.E. et al. (2021) Long-term macroeconomic effects of climate change. Energy Economics.
- McInerney, N. (2022) Macroeconomic implications of climate change for central banks.
- Thakoor, M.V.V. and Kara, E. (2022) Macroeconomic effects of climate change in an ageing world. IMF.
- CORE Econ (2023) The Economy: Units 20.