Market Failure

8 October 2018 was a jarring day for climate news. The leading story that day was the IPCC’s release of its eagerly awaited “Special Report on Global Warming of 1.5ºC”. A headline in The Guardian captured the gravity of the report’s findings: “We have 12 years to limit climate change catastrophe, warns UN”. 

The positive news, according to the report’s authors, was that the 1.5ºC goal was still just within reach, but getting there would require a complete transformation of all aspects of our economy, and fast. In the words of the report, it would “require rapid and far-reaching transitions in energy, land, urban and infrastructure (including transport and buildings), and industrial systems.”

The IPCC report overshadowed another significant piece of climate news that day: William D. Nordhaus, an economics professor at Yale University, was announced as the joint winner of the 2018 Nobel Prize in Economics for his influential work on the economics of climate change. 

On face value, the timing appeared fortuitous: the very same day the IPCC was making the case for wholesale and rapid economic transformation, the economics establishment had finally awarded its highest honour to an economist whose career had focused on climate change. In reality, however, the Nordhaus Nobel revealed far more about the failures of economics and policymakers to grapple with the scale of the climate challenge articulated so forcefully by the IPCC. 

An inconvenient truth?

Nordhaus is by now synonymous with the dominant economic thinking that has for decades held a tight grip over the climate policy imagination. Where the IPCC’s report highlights the multi-dimensional and interconnected nature of the drivers, effects and responses to climate change, Nordhaus offers a seemingly simple — and singular — solution: carbon pricing. As Nordhaus outlined in his acceptance speech for the Prize, “economics points to one inconvenient truth about climate-change policy: For any policy to be effective, it must raise the market price of CO₂”. 

According to Nordhaus, the very premise of the IPCC’s report on limiting warming to 1.5°C was misplaced. “However attractive a temperature target may be as an aspirational goal”, said Nordhaus in his speech, “the target approach is questionable because it ignores the costs of attaining the goals.” In other words, the IPCC report was flawed because its reference point was the climate rather than cost. 

Nordhaus acknowledged in his Nobel speech that his own cost-benefit model controversially places the economically “optimal” level of global warming at 3°C. A target of 1.5°C, by contrast, was “essentially infeasible” — not due to technological constraints, but to inefficiently high economic costs that supposedly outweighed the economic benefits. In short, rather than the rapid and far-reaching transition envisaged by the IPCC for 1.5°C, Nordhaus’ optimal transition pathway amounts to a defence of business-as-usual. 

How did we reach a point where the world’s preeminent climate economist is so at odds with scientific consensus? And does it matter? A deeper look at the assumptions and record of the market-based climate paradigm exemplified by Nordhaus provides some answers. What emerges is the story of a dominant economics framework that, beneath the veneer of economic precision, places dangerous limits on the possibilities of transformative responses to climate change. 

At the heart of the dominant economic thinking about climate change is the concept of “market failure”. In his landmark 2007 report to the UK government, former World Bank Chief Economist Nicholas Stern famously described climate change as “the greatest and widest-ranging market failure ever seen”, the result of a collective failure to price greenhouse gas emissions. 

These unpriced emissions are understood to create “externalities”: social costs arising from climate consequences such as drought, sea level rise or vector-borne diseases, which are not paid for by polluters. Climate change, as market failure, is thus understood as a malfunctioning of the role of markets and prices in allocating resources efficiently, with the solution being to “price in” these externalities and, in doing so, encourage the market to account for them. 

Economists call the unpriced costs of climate change the “social cost of carbon” (SCC). Calculations of the SCC are powerful because they can be — and routinely are — used to judge exactly how much climate action, and climate damage, is acceptable from a cost-benefit perspective. 

[.box][.box-header]Box 1: What is the social cost of carbon?[.box-header][.box-paragraph]The primary way of calculating SCC is through “integrated assessment models” (IAMs): climate economics models that calculate SCCs by “integrating” scientific models of climate change with economic models of growth to find the  “optimal” levels of both. The models are integrated via a “damage function” that calculates the total loss to the level of economic output because of climate change.[.box-paragraph][.box-paragraph]The most influential IAM is Nordhaus’ own Dynamic Integrated Climate-Economy (DICE). The most recent DICE calculations put the optimal social cost of carbon at $50 (in 2019). This figure is then meant to operate as a monetary benchmark for choosing between alternative climate pathways, pursuing cost effective mitigation while limiting climate action that is deemed too costly. According to the DICE model, if the cost of reducing greenhouse gas emissions is less than $50 per tonne, then it makes economic sense to do so. If, however, the cost of abatement is more than $50 per tonne, it makes economic sense to accept the additional climate damage.[.box-paragraph][.box]

For all the sophisticated methods of the models used to calculate the SCC, one input has an outsized influence in estimating the social cost of carbon: the discount rate. Discount rates are a financial economic solution to the problem of comparing values that occur at different points in time. However, the rate chosen has both drastic consequences for calculations of the social cost of carbon and profound ethical and political implications. 

Specifically, discounting works by reducing the value of future costs relative to today. There are two main justifications for discounting the future. The first is that economic productivity makes future societies richer, which places them in a relatively stronger position to deal with climate impacts than today. This assumption treats climate impacts as an external imposition on an otherwise normally functioning economy, downplaying the systemic economic consequences of climate change. 

The second justification, even more controversially, assumes that people discount the welfare of future generations compared to the present. The basis of this assumption is that people have a “pure time preference” to bring forward consumption, meaning they value consuming the same thing today more than in the future. 

Seemingly small differences in discount rates make large differences in how the costs and benefits of different climate pathways are calculated. Nordhaus adopts a relatively high discount rate: each year the value of future climate costs and benefits, measured in today’s dollars, are reduced by 4.25 per cent. Implicit in Nordhaus’ discount rate is that the welfare of people in 50 years is worth about one-eighth that of people today. Further, due to compounding effects, small changes in discount rates cause big changes in the social cost of carbon: adopting a three per cent rate in Nordhaus’ own DICE model yields a social cost of carbon of $87 per tonne; for a one per cent discount rate, it is $485 per tonne. 

Precision markets

Economists argue that applying these prices through carbon markets can guide economies towards the most economically efficient response to climate change, bypassing the need for fraught political decisions. In our recent book Climate Finance, we therefore describe carbon markets as “precision markets”, because they attempt to use market forces, rather than politics, to find the right price to incentivise private actors to respond to climate change in a way that avoids both too little and too much action. 

This precision logic, which reduces the response to climate change to a singular social cost of carbon, is challenged in a fundamental sense by the uncertainties of climate change. Climate uncertainties create a long tail of climate risk, due to potentially catastrophic climate damages that are less likely but not impossible. Such risks have near infinite costs that do not fit well with standard cost-benefit frameworks, because any cost today is justifiable to avoid infinite costs in the future. There is also no guarantee that the climate scenario that actually unfolds will not be an outlier from the “average” of possible scenarios: that is, a radically dangerous one. As geographer Geoff Mann puts it, “cost-benefit analyses hardly seem appropriate when we are considering the possibility of human extinction”. 

Over the last three decades, governments around the world have taken Nordhaus’ gamble and developed carbon pricing schemes that attempt to translate nominal SCCs into real economic costs for emissions. According to the World Bank, by 2023, 24 per cent of global greenhouse gas emissions were covered by 75 different carbon pricing instruments around the world. Of these, about half were emissions trading schemes or carbon offsetting schemes, with the other half being carbon taxes.  

[.box][.box-header]Box 2: Emissions trading and carbon offsets[.box-header][.box-paragraph]Emissions trading schemes are usually constructed as “cap-and-trade” markets, where governments set a total cap on emissions and then distribute a quantity of permits equal to the total cap. In effect, these permits represent rights to pollute that must be surrendered by polluters to cover their emissions levels. Crucially, these permits are tradeable. Trading is said to allow polluters to find “least cost” emissions reductions. The EU emissions trading system, which has been running since 2005, is the most established cap-and-trade market, but the largest in terms of pollution covered is now China’s national carbon market, which commenced in 2021.[.box-paragraph][.box-paragraph]Carbon offsetting schemes, sometimes called “baseline-and-credit”, are an increasingly prominent market-based option for carbon pricing. Here, emissions reduction projects — such as those promising to stop deforestation or to install renewable rather than fossil energy — are judged against a business-as-usual baseline. If project emissions are below this baseline, they are awarded credits that can be sold to governments, companies or individuals to offset their emissions. Further, these projects may claim to “remove” emissions, such as reforestation or carbon capture projects, or “avoid” emissions, as with energy efficiency projects.[.box-paragraph][.box]

Among these methods, carbon offsetting is both increasingly widely-used and controversial. The economic logic of carbon offsetting is that revenue from selling carbon credits incentivises “additional” emissions reduction relative to what would otherwise occur. Offsetting projects need not be zero-carbon, just lower carbon than they otherwise would be, and in a geographical flattening, offset credits are presented as environmentally equivalent to the buyer reducing their own emissions. 

Carbon offsetting occurs for both compliance and voluntary purposes. Compliance markets, such as the UN’s Clean Development Mechanism (CDM) that was established in the 1997 Kyoto Protocol, meet the compliance requirements of government-mandated climate policies – usually cap-and-trade schemes that allow the use of offset credits. The voluntary carbon offsetting market is driven largely by corporate net zero and carbon neutrality pledges. As net zero and carbon neutrality pledges have increased, so too has demand for voluntary carbon offsets — and concerns about their real impacts.

Carbon controversies

The history of carbon markets has been one of near-constant controversy. Both emissions trading and carbon offsetting schemes have been troubled by over-allocation and over-crediting, leading to chronically low and at times volatile prices. In April 2024, only one emissions trading scheme (the EU ETS) had a carbon price that was trading at Nordhaus’ estimate of the social cost of carbon in real terms. Carbon offset prices tend to be even lower. These vary according to project type and scheme, but in 2023 the average carbon price in voluntary carbon markets was just $6.53.

Further, carbon markets rarely approximate the ideal economic model. For example, due to political compromise, the EU ETS only covers certain sectors of the economy, rather than the universal carbon price economists tend to advocate. Sectors that are covered, largely energy and manufacturing, were initially allocated permits for free based on historical emissions, delivering windfall profits to some of the biggest polluters in Europe. This, combined with the impact of the 2008 Global Financial Crisis and widespread use of carbon offset credits, resulted in a chronic surplus of permits that saw prices crash and remain in the single digits throughout the 2010s. It took the EU 15 years to put in place reforms that lifted the carbon price, and even today manufacturing companies continue to receive free permits.   

Carbon offset markets more generally have suffered from a chronic combination of over-crediting and insufficient demand. Over-crediting occurs when carbon credits are issued for non-additional emissions reductions by way of using inflated baselines. The NGO Corporate Accountability found that 39 of the 50 biggest voluntary carbon offset projects globally were “likely junk” and that the credibility of none could be independently verified. These projects represent one-third of the voluntary offset market and their credits were surrendered by large companies including Delta, Volkswagen, ExxonMobil, Disney and Nestlé. 

Barely a day passes without a new carbon offsetting exposé being published. The forest-based Alto Mayo project in the Peruvian Amazon is just one example that has attracted recent attention. The Alto Mayo project promises to reduce carbon emissions from deforestation by partnering with a Peruvian government agency to stop land clearing by local farmers who have settled in the area. Disney has sourced carbon credits from the project to offset emissions from two of its Caribbean cruise ships, aptly named (at least for those who have emphasised the fantastical nature of offsets) Fantasy and Dream. An analysis of the project published in Science found that it had issued six-times more carbon credits than it could reasonably have claimed. Further, the project has intensified conflicts over land and livelihood, including reports of forced displacement.

The Alto Mayo project draws attention to the fundamental problems with carbon markets as a result of the false equivalences underpinning them. Carbon markets operate through a series of abstractions that turn greenhouse gases emitted and reduced into tradable units of CO₂. But are these abstracted units really equivalent — politically, economically or socially? In the Alto Mayo-Disney case, livelihood emissions are ultimately being traded to sustain an expansion in the cruise ship industry. 

Ultimately, views about carbon markets hinge on competing visions of the climate transition as either an incremental reformist or transformative process. Economists are adamant that carbon pricing works. A major econometric study of 142 countries found that those with carbon prices reduced fossil fuel combustion-based emissions by two per cent per year more than those without carbon prices. These reductions were described by the study’s authors as “substantial”. By contrast, a similar study by political scientist Jessica Green also found that carbon pricing schemes delivered emissions reductions of zero to two per cent  per year, but described such impacts as “limited”.

From the perspective of economists, incrementalism is a virtue, as carbon pricing is supposed to deliver least cost climate action at the margin. However, with global temperatures in 2023-24 already hitting up against 1.5°C of warning, far more transformative change beyond carbon pricing is required. According to the IEA, there is “no slow route” to limiting warming to 1.5°C, which requires an 80 per cent decline in emissions by 2035 in advanced economies — more than ten per cent each year. 

The inherent and significant risk of carbon markets is therefore that more transformational changes are traded for more incremental ones. This is built into the “least cost" logic of carbon trading, which seeks to order the sequence of the transition by delaying the reduction of emissions (such as from cruise ships) that are most profitable for polluters, by finding the “cheapest” emissions reductions (such as from Amazonian communities) first. 

The return of the political

Even setting aside concerns over their effectiveness in cutting emissions, the elegant logic of carbon markets has never translated into smooth politics, despite the avoidance of political challenges being one of their most commonly invoked selling points. Critics come not only from climate justice movements and those in favour of radical climate action, but from across the political spectrum. Attempts to legislate a national cap-and-trade system in the United States floundered in Congress for decades due to Republican opposition, while Australia infamously repealed its national carbon price following a right-wing campaign to “axe the tax” that is now being replicated in Canada.

Despite this, the significant economic interests in incremental and market-controlled climate responses nonetheless continue to drive efforts to reform and expand carbon markets.^[1] Meanwhile, the economic logic behind carbon pricing is increasingly being deployed to rein in the scope of other kinds of government responses to climate change. Recognition of the political failures of carbon pricing has led governments around the world to look for alternative policy tools including green industrial policy that seek to actively shape the direction and outcomes of the climate transition. To contain this trend, the IMF has responded by arguing that policy interventions should be limited to cases of “market failure” to avoid any “inefficient allocation of resources”. 

The political genesis of carbon pricing was in corporate support for a market-based climate policy as a palatable alternative to direct government regulation. This market-based thinking persists in warnings against the perils of governments “picking winners” in emerging forms of green statecraft, such as the Inflation Reduction Act in the US or the Future Made in Australia program. Although these economy-wide programs maintain a market-based orientation through a reliance on derisking private capital, they have widened the scope of policy agendas beyond correcting market failures to pursue just transition goals such as improving workers’ rights, as well as more fraught geopolitical goals framed around economic security.

Pushing emerging forms of green economic statecraft in a more progressive and transformative direction requires a climate economics that recognises a different kind of market failure: the failure of incremental solutions to a cascading climate crisis. This incrementalism is common to all market-based frameworks that seek an orderly (i.e. market-controlled) transition, from carbon pricing to derisking. This search for economic precision, in which the market delivers optimal outcomes at least cost, instead needs to make way for policy frameworks that maximise our chances of avoiding climate catastrophe while delivering the largest possible benefits to workers, communities and the environment. Achieving this shift will ultimately depend on expanding public and democratic deliberations over the goals of climate policy, how we should get there, and who should pay — inescapably political questions that are sidelined by the precision market paradigm.

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The ideas in this essay are explored in greater depth in the authors' recent book, Climate Finance: Taking a Position on Climate Futures (Agenda, 2024).