Incentives for Environmentally Responsible Markets

When it comes to environmental issues, no single actor is completely to blame, and that means no single actor can make the necessary changes to prevent catastrophic climate change. This means we can’t put all the weight on governments to take actions to change the course of our climate future, and we can’t blame individual actors either. We have to think about economies, polities, and incentive structures.


In their book Nudge, economists Cass Sunstein and Richard Thaler look at what this means for markets and regulation as we try to find sustainable paths. They write, “markets are a big part of this system, and for all their virtues, they face two problems that contribute to environmental problems. First, incentives are not properly aligned. If you engage in environmentally costly behavior next year, through consumption choices, you will probably pay nothing for the environmental harms that you inflict. This is what is often called a tragedy of the commons.”


One reason markets bear some of the blame and responsibility for the climate change crisis is because market incentives can produce externalities that are hard to correct. Climate change mitigation strategies, such as research and development of more fuel efficient vehicles and technologies, are expensive, and the costs of climate change are far off. Market actors, both consumers and producers, don’t have proper incentives to make the costly changes today that would reduce the future costs of continued climate change.


A heavy handed approach to our climate change crisis would be for governments to step in with dramatic regulation – eliminating fossil fuel vehicles, setting almost unattainably high energy efficiency standards for furnaces and dishwashers, and limiting air travel. Such an approach, however, might anger the population and ruin any support for climate mitigation measures, making the crisis even more dire. I don’t think many credible people really support heavy handed government action, even if they do favor regulation which comes close to being as extreme as the examples I mentioned. Sunstein and Thaler’s suggestion of improved incentives to address failures in markets and change behaviors has advantages over heavy handed regulation. The authors write, “incentive-based approaches are more efficient and more effective, and they also increase freedom of choice.”


To some extent, regulation looks at a problem and asks what the most effective way to stop the problem is if everyone is acting rational. An incentives-based approach asks what behaviors need to be changed, and what existing forces encourage the negative behaviors and discourage changes toward better behaviors. Taxes, independent certifications, and public shaming can be useful incentives to get individuals, groups, and companies to make changes. I predict that in 10-15 years people who are not yet driving electric cars will start to be shamed for continuing to drive inefficient gas guzzlers (unfortunately this probably means people with low incomes will be shamed for not being able to afford a new car). In the US, we have tried to introduce taxes on carbon output, but have not been successful. Taxing energy consumption in terms of carbon output changes the incentives companies have with regard to negative environmental externalities form energy and resource consumption. And independent certification boards, like the one behind the EnergyStar label, can continue to play an important role in encouraging technological development of more efficient appliances. The incentives approach might seem less direct, slower, and less certain to work, but in many areas, not just climate change, we need broad public support to make changes, especially when the costs are high up front. This requires that we understand incentives and think about ways to change incentive structures. Nudges such as the ones I mentioned may work better than full government intervention if people are not acting fully rational, which is usually the case for most of us. Nudges can get us to change behaviors while believing that we are making choices for ourselves, rather than having choices forced on us by an outside authority.

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