Climate change: Markets are the problem and solution

The United States’ reliance on carbon-based energy is the result of a market failure—markets do not price carbon dioxide despite its harmful effects on our climate. Senators John Kerry and Joe Lieberman have introduced the American Power Act to reduce our use of carbon-based energy. The legislation will create a market for tradable carbon dioxide allowances under a cap-and-trade system, finally putting a price on carbon dioxide. A market price for carbon dioxide will create incentives for us to switch to less harmful forms of energy.

Our energy choices are the result of the markets we use to organize economic activity. Markets do a wonderful job of producing and allocating goods. They are the reason that supermarket shelves are stocked with thousands of products and the reason we continue to innovate and grow our economy. But, as we have seen recently, markets don’t always lead to sound, sustainable outcomes.

Markets organize economic activity by aggregating vast amounts of information on the costs and benefits of the goods we produce and consume in the form of prices. Consumers buy the products that give them the most benefit for the prices they pay. Producers manufacture products only if the prices they receive cover their costs and yield profit. This system works extremely well—markets direct scarce resources to the uses that people value most and reward innovators. Yet the market system has led us to energy sources which threaten our climate.

The problem is that the market prices that guide individual decision-making sometimes fail to capture all of the costs associated with producing the things we want. Take gasoline for example. The price of gasoline reflects the costs of drilling, producing, and refining, but not the cost of the greenhouse gases emitted by burning it. Because market prices do not reflect the hidden costs of greenhouse gas emissions, markets make it appear that gasoline is cheaper than it really is. As a result, consumers and producers have favored carbon-based energy without considering all of its costs relative to alternatives.

One way to solve this problem is for the government to impose command-and-control regulations over carbon-based energy. Experience shows, however, that such policies lead to inefficient and undesirable outcomes especially when applied to pollution. Having the government dictate how we generate energy is a bad idea.

Harnessing market forces, however, offers a way forward. That is, markets are part of the problem, but also part of the solution.

The Kerry-Lieberman cap-and-trade proposal offers a means by which market forces can take the cost of greenhouse gas emissions into account. Under a cap-and-trade regime, those involved in economic activity that generates greenhouse gases would be required to purchase allowances authorizing those emissions. The market will set the price for allowances based on the supply available and the demand for them. This price captures the cost of greenhouse gas emissions and, by requiring emitters to purchase allowances, they will recognize the cost of the greenhouse gases they create. Thus, cap-and-trade leads the market to incorporate the cost of greenhouses gases into the prices of the goods our economy produces. Carbon-based energy will become more expensive as its full costs are realized, leading us to conserve and switch to cleaner energy sources.

The proposal by Senators Kerry and Lieberman is not an effort to subvert the free market. Rather, it is an effort to improve the markets we have and lead them to recognize costs that they do not capture on their own.

About the authors

Steven Peterson is a senior vice president at FTI Consulting, Inc. and has an economics Ph.D. from Harvard University. Andrew Lemon is a senior economist at FTI Consulting, Inc. and has an economics Ph.D. from Yale University.