Environmental Economics

Wim Carton

This is a chapter in the Routledge Companion to Environmental Studies, a learning resource for
students. It is published as:

Carton, W. (2018). Environmental Economics. In: Companion to Environmental Studies. Castree, N.,
Hulme, M. & Proctor, J. (eds.) Routledge, Oxon – New York, pp. 281-285.

ABSTRACT
This chapter gives a brief historical background to main trends in the field of environmental economics.
It outlines the development of market mechanisms as an influential focus in economic thinking about
environmental problems, and highlights the contributions of theorists such as Pigou, Coase and Dales.
The chapter then follows the concepts of environmental economists into the development of
instruments for the regulation of air pollution, and for climate and energy policy. The chapter ends on
a critical note, by highlighting the limitations of environmental economics and connecting to the
extensive literature that questions the current preoccupation with market instruments.

TEXT

Environmental economics is a sub-discipline of economics that aims to understand, and influence, the
economic causes of human impacts on the non-human world, such as atmospheric pollution. It seeks
to apply the main concepts and methods of economic thought to environmental goods (i.e. various
natural resources) and services (e.g. carbon sequestration) with the objective of managing those goods
and services more efficiently. Underlying this approach is the conviction that economic concepts are
useful tools for dealing with such problems as environmental degradation, resource depletion, and
global environmental change. Even though this assumption is heavily contested, environmental
economics has over the past decades proven highly influential in the design and implementation of
environmental policies. The sub-discipline takes the neo-classical perspective that has dominated the
economics discipline for about a century.

One of the foundations of environmental economics is the idea that environmental problems are a
form of market failure. This is the inability of the market to account for the full environmental costs of
economic production of goods and services. This concept goes back to the work of the English
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economist Arthur Pigou (1920) and essentially states that some (social and environmental) goods and
services tend to be undervalued in market exchange, resulting in resource allocation and a
supply/demand balance that is ‘suboptimal’. Pigou elaborated this idea by developing British economist
Alfred Marshall’s notion of the economic externality, or the unintended positive or negative effects of
economic activity on anyone who did not choose to experience these effects. From this perspective,
air pollution, for example, is a market failure because polluting industries do not bear the costs of the
unintended negative consequences that their activities have for wider society. Since air pollution is a
‘free’ factor in the production process, market mechanisms cannot give any incentives to limit its
occurrence. Similarly, some environmental economists see global climate change as “the greatest
example of market failure we have ever seen” (Stern, 2006, p. 1) because the social and environmental
costs of greenhouse gas emissions are not considered in standard economic accounting.

Traditionally, environmental policy took the form of so-called command and control-mechanisms, which
involve direct government intervention in the market, for example through laws and regulations that
set specific environmental standards or prohibit polluting practices. Conceptualizing environmental
problems as market failures, however, allowed the design of policies that aim to internalize
unaccounted-for environmental costs, by giving environmental externalities their ‘proper’ economic
value. This has spurred debates not only about what the economic value of ‘nature’ is (Costanza et al.,
1997), but also about how to account for this value through environmental policies. Over the years,
environmental economists have proposed different ways of doing this. Pigou (1920) himself argued that
market failures inevitably required government intervention in the form of subsidies or taxes.
Presumably he would have argued that a problem like climate change should be dealt with by
governments imposing a carbon tax on industries and energy producers, or conversely handing out
subsidies to producers of renewable energy. In this scenario, it is the government that decides on the
economic cost that externalities should have, and who then imposes that cost.

Over the years however, economists became more averse to the idea of environmental taxes and
subsidies. In an influential article from 1960, Ronald Coase argued that there was no economic reason
to suppose that government intervention in the market would be the preferred mechanism for
internalizing costs. In order to evaluate solutions on the basis of their economic efficiency, he argued,
one needed to account for the reciprocal character of the problem. Whereas Pigou’s solution primarily
recognized the rights of the victims of negative externalities, say, the right to clean air for people
affected by air pollution, Coase also insisted on the economic value of polluting activities, and therefore
the right to pollute. In other words, it was necessary also to take into account the economic benefits
connected to negative externalities, hence the potential costs of foregoing these. Following this logic,
the creation of scarce pollution rights should be at least as effective as taxes and subsidies, without the
alleged negative effects connected to government interventions (Coase, 1960).
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In the 1960s and 70s a number of economists further developed this argument. Most notable among
these is John H. Dales, whose treatise Pollution, Property & Prices (2002 [1968]) later became one of the
cornerstones for the design of market-based environmental policies. Inspired by Coase, Dales (2002
[1968]) reworked Pigou’s idea of market failure by defining environmental problems as a “failure to
devise property rights” (p. 792) for the use of environmental goods and services. The logical solution
to this then was the creation of a system of tradeable pollution rights. Using the example of water
pollution, Dales noted how a government could set a limit on the amount of pollution (e.g. wastewater)
it allows, and then sell the equivalent amount of pollution rights on the market. Anyone who wanted
to discharge wastewater into the environment would then need to possess a corresponding amount
of pollution rights or face a fine. Businesses that turn out to need less of these pollution rights than
they had originally purchased could sell their excess rights on the market. Since, according to Dales,
environmental objectives should ultimately be achieved in the least costly way, and because he expected
a tradeable pollution scheme to have clear cost-saving benefits, this mechanism would be preferable to
taxes and subsidies.

With respect to this focus on property rights, it is worth briefly mentioning another influential text
published at that time, namely biologist Garrett Hardin’s (1968) Tragedy of the Commons. Not unlike
Dales, Hardin argued that environmental problems arise because individuals or companies strive to
maximize their utility in a situation where the negative outcomes of their activities are commonly
shared. Unlike Dales though, Hardin’s primary concern was with population growth, which led him to
the conclusion that the problem of the commons required coercive measures, not necessarily private
property relations. Despite this, the ‘Tragedy of the Commons’ concept has in popular discourse
become fused with Dales’ arguments and now frequently serves as legitimation for market-based
environmental regulation and the privatization of various environment assets (Harvey, 2010; Hawkshaw
et al., 2012).

Post-1960s, environmental economists increasingly embraced the ideas of Coase and Dales, fine-tuning
their arguments but leaving the main tenets untouched. Tradeable pollution rights (or ‘permits’)
thereby gradually became the most popular approach for internalizing environmental costs (Tietenberg,
2010). Policy makers, however, initially proved reluctant to adopt the idea, holding on to their tried-
and-tested combination of command and control, and taxation and subsidies. While the first local and
regional attempts at implementing tradeable permit schemes occurred during the 1970s and 1980s, it
was not until the beginning of the 1990s, propelled by a broader neoliberal trend in policy making, that
the first large-scale experiment with tradeable permits was put in place. This was the United States
SO2 allowance trading system, a scheme designed to decrease emissions of sulphur dioxide (SO2) and
nitrogen oxides (NOx) in the power sector. The scheme was seen as a success and quickly became a
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best-practice example justifying the adoption of similar mechanisms for other environmental problems
(Stavins & Whitehead, 1997).

Since then, tradeable permit schemes have found their most widespread application in climate and
energy policy. Under the guise of three ‘flexibility mechanisms’, they were a key component of the
Kyoto Protocol, the world’s first binding climate change mitigation treaty (UNFCCC, 1997). As with
the US SO2 scheme, these instruments aimed to internalize the environmental costs of climate change
by creating tradeable emission rights. Regional and national adaptations of this approach have since
proliferated, as with the EU Emission Trading Scheme (EU ETS), which was instituted in 2005 as one
of the pillars of the European Union’s climate policy (Carton, 2014, 2016). As such, recent trends in
environmental policymaking clearly bear the hallmark of environmental economics. Reasons for the
popularity of this approach are many, but can at least in part be attributed to the alleged (but contested)
superiority of permit schemes in terms of their economic efficiency, the opportunities for ‘flexibility’
they provide to targeted businesses, and the opposition of politically influential businesses to regulatory
instruments such as carbon taxes (Braun, 2009; Lane, 2012).

It is also in the design and implementation of these concrete market instruments that the ideas of
environmental economists have met their most vocal critics, and that they have arguably faced their
own limits and shortcomings. Instruments such as the EU ETS and the Kyoto mechanisms have
struggled with serious and continuous problems over the years, exposing the enormous challenges
involved in creating functional markets in pollution rights (Gilbertson & Reyes, 2009; Morris, 2012). A
wide range of critics meanwhile opposes the underlying ideas of environmental economics on the
grounds that fitting environmental goods and services into existing economic frameworks is both
infeasible, undesirable, and insufficient for dealing with current environmental problems. For these
critics, seeing environmental degradation as primarily a market failure is hardly self-evident, and
certainly not inconsequential when taking a broader range of social, cultural and ecological perspectives
into account (Hyams & Fawcett, 2013; Lohmann, 2009; Spash, 2010).

Learning Resources
For an introduction to the field of Environmental Economics, see
- Field, B. C., & Field, M. K. (2009). Environmental Economics; An introduction. New York:
McGraw-Hill.

For a critique of the assumptions of Environmental Economics, and an alternative take on the
relationship between economy and environment, see
- Costanza, R., Cumberland, J. H., Daly, H., Goodland, R., Norgaard, R. B., Kubiszewski, I., &
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 Franco, C. (2015). An Introduction to Ecological Economics. Broca Raton: CRC Press.

For an introduction to some of the problems that have arisen in the development of tradable permit
schemes for climate change mitigation, see:
- Gilbertson, T., & Reyes, O. (2009). Carbon trading: how it works and why it fails. Critical
Currents. Available at http://www.dhf.uu.se/pdffiler/cc7/cc7_web.pdf
- Lohmann, L. (2006). Carbon Trading: A critical conversation on climate change, privatisation
and power. Development Dialogue (Vol. 36). Uddevalle, Sweden. Available at
http://www.thecornerhouse.org.uk/sites/thecornerhouse.org.uk/files/carbonDDlow.pdf

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