Economics climate

Markets must be used to help fight climate change. Here is why.

©David Rooney

Harsh financial reality often rides roughshod over good intentions when it comes to corporate and national balance sheets. Climate change is no exception, for though it may rouse worldwide concern, it also makes people uneasy because of how much it might cost and who should pay.

The trouble is, climate change is itself a harsh reality. And with the world economy set to double over the next 25 years, it is clear that a business-as-usual approach is no longer an option. New policies are needed and it is high time economic tools were made to play a fuller role in the antidote.

The latest OECD Environmental Outlook to 2030, issued in March, has been the focus of wide media and policy attention, including at the 2008 OECD environment ministers’ meeting in April. Its central message is a positive one: we can afford to tackle climate change, but new (and cost-effective) policies are needed sooner rather than later.

The report suggests some possible policy packages, and market-based instruments are the lynchpin in the strategy, including taxes and carbon trading. According to the OECD Environmental Outlook, early intervention could keep costs in 2050 down to about 2.5% of world GDP, or slowing annual growth by less than 0.1 percentage point on average between now and then. Mitigation would not be cheap, but it would be affordable, particularly in light of the expected costs of inaction and a projected three-fold increase of world GDP by 2050.

The OECD’s aim is to make globalisation and growth an ally of the environment, and this depends on keeping the cost of action manageable. Given the complex nature of the challenge of climate change, however, a mix of policies will be needed which, while varying in detail by country, may include economic instruments such as taxes and carbon trading, as well as regulations, voluntary and sectoral approaches, and information-based tools.

But to keep the costs of action low, the policy mix should put a strong emphasis on price-based instruments. A market-price on greenhouse gas emissions (GHGs) gives an economic incentive to reduce emissions across all sources, increase efficiency and also spur innovation. They provide polluters the flexibility to reduce emissions wherever they cost the least.

Putting a tax on GHGs may seem a straightforward way of curbing emissions. Taxes can work (and be made politically more attractive) if their revenues are used to reduce other taxes, on labour for instance. They send a clear price signal, and most OECD countries levy some kind of fuel and energy taxes, and a few even specific carbon taxes.

The problem is many of these taxes are weakened by a plethora of exemptions or reduced rates, in particular for energy-intensive industries; at last count, there were 845 exemptions for fossil fuel taxes and 524 for motor vehicles taxes in OECD countries. To fight climate change effectively, policymakers should focus on reducing such exemptions. Subsidies are tricky too. Energy producers in OECD countries currently receive US$20-30 billion in subsidies, the majority going to fossil fuels. The most harmful of these subsidies should be reduced or cut altogether.

Public support for basic R&D, to stimulate new technologies and innovation, is needed, however, but otherwise subsidies have to be handled carefully because they tend to lock-in specific production methods and interest groups, and are hard to reform later on.

Carbon markets
Emissions trading is one market instrument that is spreading rapidly across OECD countries. More players have become involved, as more people now see a chance of making the market work profitably. The World Bank estimates that emissions trading tripled in a year, up from $10 billion in 2005 to $30 billion in 2006. Of all trading schemes, the largest and most familiar is the EU Emissions Trading Scheme, which covers some 10,000 facilities belonging to sectors responsible for 52% of carbon emissions in Europe. But it has had its teething problems: Phase I (2005-2007) has come to term, and Phase II (2008-2012) is being revisited in light of criticism over the generous free allocation of emissions permits, which diluted the market and let the price fall too low. Carbon markets work best when they not only fix the amount of carbon to be reduced, but also provide clear long-term signals for the price of carbon.

Emissions trading schemes now cover at least 20% of the GHG emissions produced by the countries that ratified the Kyoto Protocol.

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A truly global carbon market must bring more countries into the marketplace. Something of this sort already exists in the CDM (Clean Development Mechanism), which allows firms to invest in emission reductions in developing countries and earn “credits” from these to put against their own emissions allowances. Governments have set aside over $10 billion for CDM projects, a sum expected to skim 2 billion tonnes off expected GHGs by 2012. However, there have been some questions regarding the effectiveness of CDM projects in reducing emissions below business-as-usual.

Regulation and information tools–such as energy efficiency labels on appliances–also have a role to play, and can complement market price signals by providing information and overcoming other market barriers (see interview with Finland’s transport minister, Anu Vehviläinen). For more efficiency, a number of improvements can be made at very low or no cost, such as phasing out incandescent light bulbs or setting an international “1-watt” standard for all standby power.

One way to encourage the use of renewable energy through the marketplace is to follow the example in some OECD countries of allocating “green” and “white” certificates to energy suppliers for each kilowatt of electricity they produce through renewables or through greater end-use efficiency.

What about regulations? Some people may distrust them as much as taxes, yet rules that set standards, such as building requirements, insulation, or energy supply have already started to unleash new markets for goods, services and skills. Indeed, stipulating the rules of the game, rather than say, specific technologies or suppliers, can empower markets.

So can basic R&D. Between 1992 and 2005, OECD countries increased budgets for renewable energies and energy efficiency by 51% and 38% respectively, but will need to be raised further–after all, public R&D budgets for fossil and nuclear energy are still about double those for renewables and energy-efficient technologies.

There is also adaptation to the changing climate. Some climate change is already locked-in due to past emissions, and from Europe’s ski resorts to farming in northern Canada, or coastal settlements in rich and poor countries, adapting will bring costs and opportunities.

The developing world will be hit hard though. Bangladesh, Egypt, Fiji, Tanzania, Uruguay and Nepal are among the countries expected to suffer major economic losses as a result of climate change. And around 150 million people could be exposed to a 1-in- 100 year coastal flood event by 2070, up from 40 million today.

Development aid must adapt too. The OECD has found that a large portion of official development assistance (ODA) is directed at activities that are exposed to climate risks, notably water supplies, sanitation and transport infrastructure. Such aid needs to be “climate-proofed”.

This raises the thorny question of how to tackle climate change most cost effectively, and who should lead? OECD countries are historically the largest emitters and many consider that they have a particular responsibility for ensuring further emissions reductions. The trouble is, they have invested heavily in reductions already, and more cuts will cost far more without necessarily stabilising climate change.

The most cost-effective mitigation potential is therefore likely to be in developing and emerging countries, which will churn out three-quarters of emissions by 2030, although financing and technology support may be needed to achieve some of these emission reductions.

Many developing countries will need aid, more lenient reduction targets than those for developed countries, deferred engagement, financial support, technological co-operation, and so on. Some question whether all of these countries are that poor though. Take China. Since 2000, it has emerged as one of the world’s largest economies and its largest emitters, overtaking the US. However, a closer look shows that its car ownership and GHG emission per capita in China are nowhere near OECD levels, reflecting a much lower level of development.

As ever, while carbon traders are eager to get going, sorting out a truly balanced, acceptable and effective global carbon market will demand political skill and compromise as much as market prices or business acumen.

No-one knows the precise costs of inaction, but can we afford to wait? What we do know is that we can move to a sustainable growth path, but to help that happen, markets need clear price signals. As philosopher Francis Bacon said, “a wise man will make more opportunities than he finds.” Climate change demands us to find those opportunities fast.  LT/RJC



  • Ellis, J. and Kamel S. (2007), “Overcoming Barriers to Clean Development Mechanism Projects”, OECD/IEA, available at; see also “Market power: Can Clean Development Mechanisms work?” in OECD Observer No 264, December 2007 at
  • OECD (2008), OECD Environmental Outlook to 2030, Paris.
  • OECD (2007), Climate Change in the European Alps: Adapting Winter Tourism and Natural Hazards Management, Paris.
  • OECD (2004), Bridge over Troubled Waters: Linking Climate change and Development, Paris.
  • Philibert, C. and Reinaud, D. (2007), Emission Trading: Trends and Prospects, OECD/IEA, available at

©OECD Observer No 267 May-June 2008 

Economic data

GDP growth: -9.8% Q2/Q1 2020 2020
Consumer price inflation: 1.3% Sep 2020 annual
Trade (G20): -17.7% exp, -16.7% imp, Q2/Q1 2020
Unemployment: 7.3% Sep 2020
Last update: 10 Nov 2020

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