Discovery Guides Areas


Environmental Economics: Basic Concepts and Debates
(Released April 2007)

  by Ethan Goffman  


Key Citations



The Kyoto Treaty & Environmental Economics


The emission of greenhouse gases presents a paradigmatic tragedy of the commons. A country that emits a large proportion of the world's greenhouse gases may derive disproportionate economic benefits while bearing a relatively small share of the environmental damages caused by their emissions. As Sir Nicholas Stern explains it, "Greenhouse gases are, in economic terms, an externality: those who produce greenhouse-gas emissions are bringing about climate change, thereby imposing costs on the world and on future generations, but they do not face the full consequences of their actions themselves" (xviii).

The situation can be considered

a typical 'prisoner's dilemma.' The worst outcome would arise if no move were made by any global player. This situation would aggravate the greenhouse effect and make later adjustment more drastic and more costly. The best outcome would be obtained in the case of full cooperation between the players. (Bouzon 15)
To move toward the best outcome, by 1997 much of the world had signed the Kyoto Treaty, the primary international accord attempting to regulate global climate change. Although the United States and Australia never ratified the treaty, by 2005, when Russia finally signed, enough countries has ratified for it to come into force.

picture of sun's rays getting trapped in atmosphere
The basic science behind global warming
Integral to the Kyoto Treaty are mechanisms taken from environmental economics. The treaty is driven by the need to balance differences between countries in an economically efficient way:

Countries and regions differ in their degree of dependence on production activities that emit GHGs [greenhouse gases], the efficiency with which they produce goods and services per ton of GHGs emitted, and the ease with which they can change their current dependency and efficiency (for example, their relative ease of access to coal and natural gas resources or combined cycle combustion technology). Therefore, it is only natural that they would experience different marginal (incremental) abatement costs when they attempt to limit their emissions of GHGs. (Edmonds et al. 2)
The Kyoto Treaty therefore applies flexible economic instruments, notably Cap and Trade, to climate change emissions. Under Kyoto Cap and Trade, countries are granted emissions credits, which they may then buy and sell on a free market. This means that banks, brokers, and other market instruments are involved in the trading of such credits, which should eventually arrive at the best price for efficiently meeting conservation goals. Europe has led the way with a "cap-and-trade scheme intended to enable the EU to conform to its Kyoto targets in 2008-12" (Bouzon 3).

Kyoto appears to present a textbook case for Cap and Trade. A simpler scheme, such as taxing greenhouse emissions, may lead to problems: "The authorities set the amount levied arbitrarily and it can be either too high or two low" so that "the result in terms of emissions control is rather uncertain" (Bouzon 16). Particularly among a large number of countries, emissions trading by contrast will make it likely "that the production of emissions allowances and resulting allowances will be relocated in the zone presenting the lowest production costs" (15).

One of the issues in the Kyoto treaty is who should bear the cost of changes in production and consumption intended to reduce environmental damage. The distribution of climate change costs among nations and regions and between groups is only one among a number of distributional questions engaging economists. Kyoto divides countries into developed and developing. Because the wealthier, developed nations are responsible for a large majority of the greenhouse gases, only they are expected to satisfy emissions targets. Although not subject to these targets, developing countries may nevertheless participate in the process by selling credits to reduce their emissions. Besides the moral aspect of requiring those most responsible to take action first, the lack of enforceable reduction targets for developing countries also has an implicit basis in the Environmental Kuznets Curve, according to which developing countries are not yet ready to decrease greenhouse emissions. This assumption is a key factor in the United States' rejection of the treaty; America questions whether China and India, with their greatly increasing their greenhouse emissions, should be exempt.

Traditional economic approaches may also undercut Kyoto. Discounting, a common economics formula, may lead to the conclusion that the costs of Kyoto outweigh the benefits. Discounting means that some formula is applied to future events to lower their value based on distance in the future. This is because any money spent on environmental improvements could be invested elsewhere, and the potential interest on that investment must be considered lost. Theoretically, if we were to invest money spent on meeting Kyoto targets in economic growth, our stronger future economy would be more capable of paying to mitigate future effects of climate change. So the lost growth from following Kyoto would be a higher cost than the environmental damage the treaty alleviated.

portrait of Nicholas Stern
Sir Nicholas Stern, whose report calls for drastic action on climate change
Critics of this method argue that environmental impacts are not easily reducible to monetary amounts, that "for 'non-market goods' like human life (or the inherent value people place on the existence of other species), the assignment of a monetary value is much more controversial" than for market goods. (Farber & Hemmersbaugh 2). We also don't know the effects of certain climate thresholds, such as at what point the Greenland ice shelf is likely to collapse, or whether and when changes in ocean circulation will bring a new ice age to Europe. In a prominent report, Sir Nicholas Stern argues that "uncertainty is an argument for a more, not less, demanding goal, because of the size of the adverse climate-change impacts in the worst-case scenarios" (xvii). Stern sets an extremely low discount rate on the future; that is he values future problems nearly as much as current ones. The Stern report calls for immediate, drastic action, warning that to do otherwise "could create risks of major disruption to economic and social activity, later in this century and in the next, on a scale similar to those associated with the great wars and the economic depression of the first half of the 20th century" (ii).

Economist William Nordhaus, working from more conventional economic assumptions about discount rate, came up with very different conclusions:

The [Stern] Review proposes using a social discount rate that is essentially zero. Combined with other assumptions, this magnifies enormously impacts in the distant future and rationalizes deep cuts in emissions, and indeed in all consumption, today. If we were to substitute more conventional discount rates used in other global-warming analyses . . . the Review's dramatic results would disappear (Stern review 6).
Nordhaus argues that "efficient or 'optimal' economic policies to slow climate change involve modest rates of emissions reductions in the near term, followed by sharp reductions in the medium and long term" (Stern review 2,3). Certainly, a more gradual introduction of greenhouse gas reductions would be politically easier to introduce than the extreme change Stern calls for.

The question of how to discount our responsibility to future generations is inherently difficult. Some scholars who favor Kyoto argue that, as more countries submit to Kyoto standards, the comparative advantage of those who abstain lessens. Regarding emissions trading, "the extension of this scheme beyond the EU creates a level playing field in which international competitors are confronted with similar constraints and costs associated with greenhouse gases" (Bouzon 9). The problem of the commons is reduced when enough countries sign on to protecting global environmental resources. A further argument is that conforming to Kyoto will benefit employment in those countries that develop new technology.

The centrality of Cap and Trade in the Kyoto Treaty, and in recent U.S. congressional proposals by Senator John McCain, among others, illustrates how ideas advanced in Environmental Economics have become the norm. Yet Nordhaus disagrees with this newly conventional wisdom, arguing that a simpler mechanism, such as carbon taxes, would work better. Kyoto Cap and Trade mechanisms use a 1990 baseline relative to which developed countries must regulate their emissions. Yet, as countries circumstances change, picking a specific year rewards some countries and penalizes others: "Base year emissions have become increasingly obsolete as the economic and political fortunes of different countries have changed. The 1990 base year penalizes efficient countries (like Sweden) or rapidly growing countries (such as Korea and the United States)" (after). Of course another base year could be picked, but this would just lead to another set of countries penalized or rewarded, depending upon which already had state of the art emissions control by that year, among other factors. Cap and Trade, then, leads to difficult choices in creating a set of standards, while a simpler carbon tax system impedes attainment of definite targets. The best way to regulate climate change emissions remains unsettled, even as the world struggles to deal with a mounting crisis.

Urbanization in coastal areas presents an example of how climate change interacts with other issues to create a difficult series of challenges. Developing and developed countries have experienced population movement toward the sea in recent years. Some argue that coastal urban development exposes increasing numbers to weather hazards and creates conditions for even more severe flooding by damaging natural protections (ScienceDaily). Among the questions likely to engage economists are: who will pay for the mitigation of rising sea level and possible migration coastal residents? How should water rights be distributed among regions and internationally? How do alternatives such as Cap and Trade, non-price rationing, and carbon tax affect the distribution of income within nations and between nations?

Environmental Economics has made an important contribution to questions raised be environmental changes, finding ways to add free market incentives that increase environmental efficiency. These mechanisms must be implemented through a process of adaptive management that struggles to define best practices, and ultimately through the political process. In addition, the debate over discounting and global climate change may point to some weaknesses in the over-reliance on classical economic thinking to solve complex environmental-and related social-problems. Certain basic philosophical questions, many of them regarding underlying values, remain a subject of debate.

Special thanks to Sonia Conly for her support, thoughtful suggestions, and careful editing

© 2007, ProQuest CSA LLC. All rights reserved.

List of Visuals


  1. Bouzon, J. 2005. A tale of two cities: Kyoto in the light of Lisbon, an analysis of the EU emissions trading scheme before its entry into force. EPC Issue Paper No. 22. European Policy Centre.

  2. Conly, S. 2007. Personal e-mail. March 14.

  3. Costanza, R., d'Arge R., de Groot R., Farberk S., Grasso M., Hannon B., Limburg K., Naeem S., O'Neill R., Paruelo J., Raskin R., Sutton P. & van den Belt M. 1997. The value of the world's ecosystem services and natural capital. Nature. 387 (15 May) pp. 253-260. accessed March 21, 2007.

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  9. Farber D. & Hemmersbaugh P. 1993. The shadow of the future: Discount rates, later generations, and the environment. Vanderbilt Law Review 46: 267-304. Reproduced on the Center for International Earth Science Information Network.

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  12. Hardin, G. 1968. The tragedy of the commons.Science (13 December) 162: 3859, pp. 1243 - 1248 accessed March 7, 2007.

  13. National Bureau of Economics Research (NBER). 2007. Environmental Economics Working Group Website. accessed March 7, 2007.

  14. Nordhaus, W. 2006. The Stern Review on the economics of climate change. National Bureau of Economic Research (NBER). accessed March 7, 2007.

  15. Nordhaus, W. 2007. After Kyoto: Alternative mechanisms to control global warming. Foreign Policy in Focus. accessed March 7, 2007.

  16. Panayotou T. 2003. Economic growth and the environment. United Nations Economic Commission for Europe, Geneva. accessed March 7, 2007.

  17. ScienceDaily. 2007. Climate change: Study maps those at greatest risk from cyclones and rising seas. March 28. accessed April 5, 2007.

  18. Stern D. 2003.The rise and fall of the environmental kuznets curve. Rensselaer Working Papers in Economics. Troy, NY. accessed March 7, 2007.

  19. Stern Review.2006. The economics of climate change. Executive summary. accessed March 7, 2007.

  20. Van den Bergh, J. 2000. Ecological Economics: Themes, approaches, and differences with Environmental Economics. Tinbergen Institute Discussion Paper. Amster-dam. accessed February 23, 2007.