Welcome to the last video on the economics of nature. You will not be surprise to hear that it takes a neoclassical perspective. And yes, markets are central in this perspective. Also for the relationship between nature and economy. In fact, turning climate change prevention into a market is exactly what neoclassical economics advise us to do. And guess what? It's being implemented already. Let me take you through the neoclassical economic steps in this video. We start with a diagram, a curve similar to what you've seen before in videos on neoclassical economics. You will recognize increasing returns up to the maximum and decreasing returns after that point. The diagram shows the environmental Kuznets curve, with income on the horizontal axis and pollution on the vertical axis. So the curve indicates that when a country's income, measured as GDP, increases, pollution levels first go up. But after a certain level of GDP, pollution declines. This decline of pollution has been observed for developed countries and can be attributed to three factors. First, the introduction of regulation when countries grow out of poverty. They will have acquired the regulatory capacity to enforce environmental laws and rules limiting pollution. Second, the development and implementation of green technology. Only with sufficient economic development, firms and states will have the resources and long-run interest to invest in new technology for waste reduction. And the third factor that is driving the environmental Kuznets curve, is a general shift in economies worldwide from manufacturing to a service-oriented economy. A shift which generally implies a reduction of pollution. A new classical approach to pollution is to apply a cost-benefit analysis to reduction of pollution. The benefits are cleaner air and water and the cost are the resources to be spent in order to get these benefits. Hence, there must be a point where benefits no longer outweigh costs and hence, an economically acceptable level of pollution. But are such levels also morally acceptable? This is a good question because absolute levels of pollution are not the same between countries. And some forms of pollution do not limit themselves to national borders. Think about nuclear energy plant disasters and carbon emissions. Cost-benefit analysis works well when there is no redistribution of harm involved to human beings and nature. Theoretically, as a result of the cost-benefit analysis, it may be sensible to shift the most polluting and environmentally risky industries to the poorest countries of the world. Because there's not much industrial pollution yet, and people's life expectancy is very low anyway. So they will die of other causes well before industrial pollution can kill them with slowly developing diseases caused by toxic waste. Of course, this is a very cynical way of reasoning. And even when developing countries would get additional development aid to compensate for these costs, it still doesn't feel right, does it? The suggestion came from a famous economist. But it was meant as a joke. If we want to be fair, rich countries should not shift a problem to the other less developed countries, but solve it domestically. And cost-benefit analysis may help them to do this, with the highest environmental benefits, at the lowest cost. For example, to minimize the cost of waste reduction, the cost of waste reduction technology needs to be calculated for each method. For example, for burning waste, dumping it or recycling it. The next step is to calculate the cost of implementation. Any other costs such as for monitoring. Finally, the methods of waste reduction can be compared in the benefits and the cost of achieving this. This leads to a choice of method for waste reduction. The method that generates most waste reduction at the least cost. In other words, the most efficient method. The other neoclassical solution to environmental problems is the market. So, the negative externality created in industrial production such as air pollution, becomes a tradable good in itself in a newly created market for air pollution permits. This is currently done with carbon emissions by turning them into tradable emission permits. The first and biggest carbon trading market is in the European Union. It started in the year 2005 as an attempt to meet the target for CO2 reduction, as agreed in the Kyoto Protocol. It is called the EU emissions trading system, in short, ETS. One permit allows the emission of one ton of CO2. More than 10,000 firms are obliged to participate in this market. And it cover about half of all emissions in the EU. Of course, the trade will only reduce emissions when permits are relatively scarce, and hence, become more and more expensive to purchase for polluting firms. The more scarce, the more expensive to permit and the more likely it is that firms will use green technology to reduce the carbon emissions instead of buying expensive permits every year. This must be regulated by the EU by setting a cap on the total number of permits. If not, permits would not become scarce and the price would be zero. In that case, firms will not have a price incentive to invest in green technology reduce the carbon emissions. Now the lower the cap, the scarcer the permits and the more expensive they will be. This will induce firms to invest in new technology and to save on energy so that they will need to buy less permits. And the most efficient firms can make money by selling their surplus permits to firms that are less successful in reducing their emissions. But the more expensive the permits, the more efficient firms want to remain efficient, so that they can earn money by selling permits. And the more inefficient firms are likely to invest in green technology, in order to prevent to pay high prices for emission permits year after year. So ideally, CO2 emissions would go down as price reflects scarcity of permits. Does the market work? Did CO2 levels go down? Unfortunately, not. In the real world, it appears to be much more difficult to artificially create a market and make it efficient. It's much more difficult than it is the case for spontaneous markets. Here is what the experience of the European emission trading system has been over the past ten years. Due to the lobby of heavy industry, the cap was set too high, so that there were more permits than firms needed. And also, almost all permits were distributed freely at the beginning. If and when the EU reduced the number of permits in the second round, the price of a permit remained very low. It has been below 10 euro per permit for several years which was some days a price of only 1 euro. Moreover, some firms and a whole country had surplus permits. In particular, during and after the financial crisis when demand for the product went down. And hence, production levels decreased and pollution decreased with it. The permits that firms have bought but not used are put on their balance sheet as assets against a market value. Some firms even trade in them. Not for reasons of production, but for speculation. Indeed, making money out of the trade of these emission permits as new financial assets. This is possible because the EU has not limited the permits to being used in the same year. Inadvertently, they have created a new financial asset that is traded for its expected increase in value, rather than for the purpose of reducing CO2 emissions. The diagram shows the price development of emission permits in the emission trading system. As you will see, the price only rarely hits 30 euro per permit. But economic research has indicated that the market price for emissions permits, should be at least 30 euro and probably even more than 50 euro in order to be effective in reducing emissions in line with the Paris Climate Agreement. In order to get at such an increase in the price level, the EU needs to regulate the market in a very strict manner and resist the lobby of firms against this regulation. So the cap must be lower, and keeping permit for longer than say a year should be banned. And buying permits for speculation should be prohibited. Well, this raises the question whether the cost of arranging and monitoring this newly created market, are perhaps higher than the cost for regulation of levels of pollution per industry sector without setting up a market, but using fines for noncompliance. Perhaps you want to make a cost-benefits analysis comparing both methods, the markets, and regulation. This was the last video on nature and the economy. And I hope that you are impressed by the idea that it is possible to create a market, not as something that people want but as something that people want to get rid of. I find it pretty smart even though it does not work perfectly in the case of the trade in carbon emissions. The remaining videos of this week will be about poverty and well-being. Just like the topic of nature, it's an issue that concerns all of us. And therefore, receives lots of global policy attention. I really hope to see you back soon.
