William Nordhaus defends the markets and the cap-and-trade system against the Pope’s worries. Does he have a point?

Pope Francis’s encyclical on the environment and capitalism, Laudato Si’, is an eloquent description of the natural world and its relationship to human societies.

He devotes much attention to the following passage in the Laudato Si:

The strategy of buying and selling “carbon credits” can lead to a new form of speculation which would not help reduce the emission of polluting gases worldwide. This system seems to provide a quick and easy solution under the guise of a certain commitment to the environment, but in no way does it allow for the radical change which present circumstances require. Rather, it may simply become a ploy which permits maintaining the excessive consumption of some countries and sectors.

William Nordhaus, certainly one of the most prominent economists working on climate change and a researcher whose work I seriously appreciate, then takes the point of view of an economist:

My major point is that the encyclical overlooks the central part that markets, particularly market-based environmental policies such as carbon pricing, must play if countries are to make substantial progress in slowing global warming… Because market-based environmental policies are so central, it will be useful to describe how they work. As with other environmental externalities, appropriate pricing is a central mechanism for reducing carbon dioxide emissions and slowing climate change.

When I read the Laudato Si I had exactly the same thoughts on my mind as WIlliam Nordhaus. I think this comes instinctively to an economist who works on markets and who is taught to view that externalities are the main things to worry about. However, I also believe that we should try to understand the worries of others and learn from them and thus try to understand where our angle of looking at the world is too limited.

I believe the Pope tries to explain that for most regulations that have been put in place, markets, economies or multi-national companies try to find a way around these regulations. In other words, in our world of increasing demands and habits in consumption we simply want more and more and the market will find a way to meet these demands. Hence, the Pope suggests we need a radical change in how we deal with the environment, and that prices may not necessarily send the right, or sufficient, signal. And he does have a point that economists dismiss much too quickly.

Of course, in our perfect economic models a cap-and-trade system works. Changing prices will change habits and optimal behavior. But the question is how this optimal behavior will be `corrected’ or `distorted’. Many prominent scholars, especially Rick van der Ploeg and Cees Withagen, have recently devoted much attention to e.g. the Green Paradox, showing that a well-meant regulation that is supposed to reduce emissions may, in the short-run, actually increase emissions. These additional distortions that occur due to regulations have seen too little attention in economics. And it is understandable: Models get complicated very quickly, and in the moment we try to model many interlinking sectors we start to lose insight and intuition and end up with a black box.

Furthermore, changing the price of CO2 may induce countries to more quickly adapt technologies like Carbon Capture and Storage – technologies that help emission reductions but where it is unclear as to how safe they are. Thus, by using a different `fix’ to a problem that we created we actually may create more problems.

Additionally, geoengineering will, in the future, be very likely to be a cheaper solution than a cap-and-trade system. On purely economic grounds we should, thus, focus our attention on geoengineering. But if history has shown us one thing then it is that these quick-fixes to our problems generally lead to more problems than previously expected. As a very simple example, in order to get back to work quickly many take antibiotics against bacterial infections, which led to strands of bacteria becoming resistent to these antibiotica and now they impose even larger health problems than before.

So my reading of the Laudato Si goes in a slightly different direction than Willian Nordhaus: The Pope believes that it is highly unlikely that our current economic model that led to this drastic environmental degradation can be adequately fixed such that we can at least halt the destruction of our planet. His main hope rests on a cultural change, emphasizing traditional values.

So who is right? I believe that both are neither wrong nor right. I think noone should dismiss both views – that market distortions can be fixed to a certain extent, but that at the same time it is unreasonable to believe that this may be sufficient to preserve our environment. The optimal solution lies, as usual, most likely in some reasonable middle way.