Climate Change and the Free-Rider Problem

By Adelaide University Economics Club

There is near consensus among economists that a carbon tax is the most efficient method in reducing greenhouse emissions. It is therefore puzzling that political leaders around the globe remain stubborn in their opposition to such a tax. Take, for example, Prime Minister Scott Morrison’s recent comments during a speech at the National Press Club in which he announced that his Government ‘will not tax our way to net zero emissions’ and that ‘getting to net zero should be about technology not taxes.’ As sympathetic to the idea of progress through technology as one might be, an open letter signed by over 3000 economists stating that a carbon tax ‘offers the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary’ should hold more weight than a guy who brought a lump of coal into parliament. Unfortunately, it appears that the future of our planet is not significant enough to overcome what economists would refer to as a ‘free-rider’ problem, one that is typical in the provision of public goods.

Let’s define these concepts. The free-rider problem is a type of market failure in which an individual or group benefits from a public good without contributing to the costs. Think back to any group project you have suffered through in which one person contributed nothing to the end result but shared in the final grade — that person would be a free-rider. A public good is characterised by two key properties: (1) anyone is able access it; and (2) any one individual’s use does not prevent another from simultaneously accessing it. A lighthouse is the typical example given by economists. Consider the work of those group assignment students as a public good — everyone in the group receives the grade regardless of their contribution.

Recent work by William Nordhaus, winner of the 2018 Nobel Prize in Economics for his contributions to the economics of climate change, elucidates how these and other game theoretic concepts can be applied to the current problem of curbing greenhouse emissions. Nordhaus points to two different types of free-riding: one of an international nature in which countries rely on others to reduce their emissions without taking part in their own abatement; and a generational one in which the present generation benefits from goods produced by high carbon emitting production technologies, while future generations are forced to pay for this through more intensive emission reduction strategies or a deteriorated environment.

What makes the free-riding problem with respect to climate change so thorny is the global nature of the problem. Individual countries have an incentive to act in their own self-interest, collectively resulting in inaction. This problem can be related back to the most famous game theory concept — the Prisoner’s Dilemma. A Prisoner’s Dilemma is a strategic interaction in which agents are incentivised to act selfishly at the expense of others, resulting in an outcome where everyone is made worse off. When viewing the problem through this lens, it is easy to see why such little progress has been made.

In saying this, there certainly have been efforts towards international cooperation. The United Nations Framework Convention on Climate Change (UNFCCC) took the first tangible steps toward international cooperation in 1997 with the signing of the Kyoto Protocol, which came into effect in 2005. This agreement introduced an international cap-and-trade system for emissions in which countries were assigned limits, but were able to trade ‘rights’ to emissions to achieve efficient outcomes. Though ambitious in scope, the protocol was weak in implementation. Due to the voluntary nature of the agreement, advanced economies such as the US and Canada withdrew without any penalty. The Kyoto Protocol was superseded by the Paris Accord of 2015, though once again the prescriptions of the treaty fell short of their intended outcomes as participation was entirely voluntary (as was made abundantly clear when the Trump administration noisily withdrew in 2017).

To combat these free-rider problems, Nordhaus forcefully suggests restructuring the very nature of these agreements so that countries have stronger incentives to participate. To this end, he promotes the idea of a climate ‘club’, wherein a club is defined as ‘a voluntary group deriving mutual benefits from sharing the costs of producing a shared good or service.’ A successful club would have the following properties:

1. The gains to membership are large enough such that members are willing to pay their dues and adhere to club rules; and

2. Non-members and members that violate club rules are able to be penalised or excluded without cost to members; and

3. Membership is stable in that members do not choose to leave once they have joined.

Nordhaus views set a uniform price on carbon as the central rule for membership. He recommends an initial carbon price of $40 per tonne, which is to be increased in real terms by 3% per year. This is in stark contrast to the current price which the World Bank estimates at $2 per tonne, as of late 2019.

With regard to penalties, the most simple and effective solution is a uniform tariff on all imports from non-participating nations. It is about providing just enough incentive to participate so that the cost of not participating is greater than the carbon tax itself.

Tackling climate change will require a multifaceted strategy where both tax policy and advances in technology should play part. Given the time critical nature of the problem, however, it is imperative that the more effective policy levers are utilised immediately. Setting an international price on carbon through taxation will be central to this strategy, and such a tax will not be possible without the right alignment of incentives. Establishing a climate club, sooner rather than later, will go a long way to resolving these issues.