The Role of Economics in Climate Change Policy

M any policy problems have frustratingly long histories of inefficient regulation that can be difficult or impossible to reverse, even where large efficiency gains might be had from doing so. Climate change is an exception, however, because little real action has been undertaken to date. It presents an unusual opportunity for an efficient economic policy to be employed right from the beginning. However, the opportunity could easily be lost. Ongoing negotiations conducted under the auspices of the United Nations Framework Convention on Climate Change have so far produced the Kyoto Protocol, a deeply flawed agreement that manages to be both economically inefficient and politically impractical. In this article, we examine the key economic characteristics of climate change and argue that economic theory provides good guidance on the design of an efficient and politically realistic policy. Because climate change involves vast uncertainties and has potentially enormous distributional effects, neither of the standard market-based environmental policy instruments is a viable approach: a tradable permit system would be inefficient, and an emissions tax would be politically unrealistic. However, a hybrid policy, combining the best features of the two, would be an efficient and practical approach. We then compare our hybrid proposal to the Kyoto Protocol and argue that it overcomes the Protocol’s shortcomings.