Nordhaus Nobel Recognizes What We've Long Known: Carbon pricing works

Last week William Nordhaus—together with Paul Romer—won the Nobel Prize for Economics.

He joins with other economists who have been awarded the Nobel prize since 1969, including such names as Kuznets, Arrow, Leontief, Coase and Sen. Each made lasting contributions to our understanding of macroeconomic theory, private property, regulatory impacts, the shape and limits of GDP, and financial sector risk.

Last week’s announcement was also the first time the Nobel committee has recognized the economics of climate change.

Nordhaus has published in the field of climate change economics for more than three decades. His 1984 work Managing the Global Commons: The Economics of Climate Change concluded climate change is real, its impacts are global and comparable to economic depression, and it's likely to occur in sudden jolts—tipping points—as rising global temperatures affect weather patterns, polar ice, human health and other areas. Last week, the UN Intergovernmental Panel on Climate Change issued its starkest warning of the dire global consequences of climate change, starkly warning that the window to act is closing.

In the face of these risks, Nordhaus demonstrates that the economics of climate change are straightforward. The burning of fossil fuels and release of carbon dioxide and other greenhouse gas emissions create significant externalities. On their own, markets are not yet capable of correcting these externalities. Hence, government action is needed. Nordhaus argues the most sensible response to climate externalities is also straightforward: price carbon pollution.

In his recent Climate Casino book, Nordhaus argues the pricing of carbon achieves four objectives: it sends signals to consumers about which goods and services are more carbon-intensive; it sends signals to producers about which activities are most carbon-intensive (such as coal burning) and which are less carbon-intensive (like solar or wind); it sends signals to propel innovation to find new, affordable alternatives; and finally, pricing is the best means to convey these signals within well-functioning markets.

The early approaches of Nordhaus have been proven in both more intensive research and real-world experience.  Conservative bodies that consistently support well-functioning markets—such as the OECD, the International Monetary Fund and others—have shown carbon pricing is the most effective and least distortionary way to tackle carbon pollution.  The World Trade Organization, hardly a climate crusader, observed years ago that market-based instruments led by pricing have the least distortionary effects on markets, competitiveness and trade.

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Since the 2015 Paris climate agreement, more jurisdictions are using carbon pricing: according to an annual review done by the World Bank, some 50 jurisdictions use carbon pricing at the national, provincial and municipal levels, from Germany to the city of Rio de Janeiro. Sweden, which has the most stringent carbon price in the world, also recorded impressive economic growth again in 2017, at around 5 per cent. Last year, the OECD concluded ambitious climate action through pricing can be achieved while sustaining aggregate economic growth rates.

While Nordhaus and other serious economists have concluded that the economics of climate change are clear, the political economy of climate action remains deeply contested. While debates in Australia, Canada and elsewhere suggest a division along left–right political lines, there are signs this is changing. Last year, U.S. Republicans George Schultz and James Baker helped launch the Climate Leadership Council, arguing the best approach to tackle climate change begins with ambitious climate pricing, together with delivering the dividends to households, removing regulations and using border tax adjustment to shield imports from jurisdictions with less stringent climate action. These and other proposals surely will continue to be contested.

But the economics of climate action have long been settled, and last week's IPCC report sends a clear warning that debates must shift to urgent action.