Climate Change: humanity’s biggest externality

Unprecedented in its nature and consequences, climate change is the global economy’s greatest threat. Excessive greenhouse gas emissions in addition to unsustainable economic growth have spiked household carbon dioxide pollution – climate change’s greatest culprit.[1] As climate change is global in scope, each nation needs to lead by example and initiate environmental reforms at home so that the collective global result is effective.

Climate change in a nutshell

The Earth’s atmosphere operates as an insulator that traps in rays from the sun and translates these rays into heat energy. Human induced gases amplify this greenhouse effect by reducing the rate at which heat is lost from the earth. At a severe enough point, such a phenomenon impacts global water resources, food production, and precipitates the erosion of economies that rely on agriculture.

In New South Wales, the largest causes of human emissions are stationary energy sources, transport, coal mines, and land use. These sectors account for 47%, 12%, 11%, and 7% of total green-house gas production respectively.[2] Household behaviour is largely influential towards each of these components, as it is the structure of consumption that determines current trends in pollution.

In order to mitigate the effects of greenhouse gases, both households and producers must be chased up with effective policy to dissuade current complacency. An important feature to note is that the consequences of global warming are very much long-run repercussions. This requires a response of great prudency in holding the future generation’s best interests at heart as it will come at a cost to the current populace yet provide extensive benefit to the forthcoming generations.

Climate change as an externality

An externality is where the consumption or production choice of a particular party affects the utility of a third party without their permission; this effect can be either positive or negative. Climate change is a clear case of a negative externality as the economic transactions that contribute to the enhanced greenhouse effect adversely impact the utility of future generations through a degraded environment.[3]

The distinctive essence of climate change as an externality is achieved through four characteristics.[4]

1.The issue is global in presence; hence, an individual government cannot do anything substantial by intervening

2.The causality and implications are uncertain and unquantifiable

3.The uncertainty surrounding climate change creates further uncertainty about the economic change it will generate and the potential benefits of policy intervention

4.The consequences of climate change are extremely long term and are difficult to foresee

Far broader in its impacts than other policy challenges climate change is like no other negative externality. As such, measures to remedy the crisis must be equally unique and innovative. International unity is essential for driving real progress on this front.

On the spectrum of anthropocentrism (humans are most important) and biocentrism (emphasis on environmental ethics), the global policy should account for both, but  place higher weight on the latter.[5] Generous funding by nations around the world is required (closer to biocentrism) but not in a way that severely compromises the functionality of their respective markets by imposing counterproductive funding mechanisms.[6]

A graphical analysis

Negative externalities cause an unpreferable and inefficient situation of market failure. In the context of climate change, scarce resources are overallocated to processes that greatly contribute to greenhouse gas emissions far above the optimal quantity for social wellbeing.

Figure 1: Market for Coal Production

If left to the free market, goods that create a negative externality are inevitably overproduced, per Figure 1. Here the private cost for organisations to engage in coal production at the quantity Qp is far less than the actual social cost incurred by future generations. The optimal allocation for society is to decrease quantity to Qs so that the actual social cost is matched with the private cost.

Figure 2: Pigouvian Taxation for Coal Production

The solution to this dilemma is illustrated in Figure 2. We may increase the marginal private cost PMC to equal the actual cost to society (PMC’) through a tax t. This reduces the equilibrium quantity exchanged to xO from xm which is the socially optimal situation. This may play out as a progressive carbon tax whereby the large producers of CO2 are incentivised to reduce emissions. The offending industries of mass pollution will be faced with ruthless unaffordability and a requirement to change their ways in order to remain competitive. In summary, this policy will put a price on the externality – the externality of climate change.[7]

Conversely, rewarding environmental externalities may be an equally viable approach, Additional policies should be implemented to incentivise sustainability in production. Opposed to the tax, a Pigouvian subsidy might reallocate funds generated from a carbon tax to stimulate renewable energy sources.[8]

Take for instance the promotion of solar panel use through a subsidy. This attempts to cure market failure from the alternate angle as socially beneficial goods are underproduced by the free market. A subsidy works by boosting the prevalence of renewable energy sources in the composition of our energy market. If this system can be actioned holistically through a combination of Pigouvian taxes and subsidies, climate change may yet be outmanoeuvred.

A global issue with a global solution

If it isn’t already blatant, the global economy has to be comprehensively regulated so that the environment is returned somewhat to parity.[9]

While the complexities of climate change are widespread, intelligent modifications in the way we allocate resources are key to a brighter environmental future.

Pigouvian taxation is a vital tool for achieving this, as it rewards environmental merit whilst penalizing degradation. Yet the success of these schemes relies on the entire world working toward a common goal. One nation alone cannot harness the power of Pigouvian taxation to drive real change, but international cooperation along these lines would vastly increase our chances of success. No economy can hide from the externalities of climate change, and our solutions must likewise be global in scope.

[1] Zhang, X., & Wang, Y. (2017). How to Reduce Household Carbon Emissions: A Review of Experience and Policy Design Considerations. Energy Policy, 102, 116–124. https://doi-

[2] NSW Government. (2018). Causes of climate change. Retrieved from change

[3] Greenstone, M. (2014). Paying the Cost of Climate Change. from

[4]  Hindriks, J., & Myles, G. (2006). Intermediate public economics (2nd ed.). Cambridge, Mass.: MIT Press.

[5] Rottman J. (2014). Breaking down biocentrism: two distinct forms of moral concern for nature. Frontiers in psychology, 5, 905. doi:10.3389/fpsyg.2014.00905

[6] Tsur, Y., & Zemel, A. (2008). Regulating Environmental Threats. Environmental and Resource Economics, 39(3), 297–310.

[7] Kreiser, L., Sirisom, J., Ashiabor, H., & Milne, J. E. . eds. (2011). Environmental Taxation and Climate Change: Achieving Environmental Sustainability through Fiscal Policy. Critical Issues in Environmental Taxation, vol. 10. Retrieved from n&AN=1319381&site=ehost-live&scope=site

[8] Some more thoughts on a carbon tax. (2018).

[9] Kolstad, C. (2011). Intermediate Environmental Economics. New York: Oxford University.

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