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Nicholas Stern: Ideal Role of Government to combat market failures

DATE: 2021-05-27

Nicholas Stern: Economic efficiency not guaranteed in fully-competitive market

The Ideal Role of Government

David Daokui Li: Given your arguments above, what is the ideal role the government should play in order to correct market failures?

Nicholas Stern: Understanding what government should do requires two things. First, it requires a broad understanding of the strategy that we're trying to implement. In this case, that's fairly clear: it's very rapid change in the economy so that we go to zero carbon. So the role of government must be to get a broad understanding of that strategy, because it influences how people will behave and invest, and that's fundamental to understanding what government should do. Government should give this broad sense of direction and shape the expectations as to where we're going so that investment and innovation can take place with more confidence. That's the big part of the story: being clear on the strategy. 

The second part is looking at the details of market failures and what we need to do in order to implement that strategy. I've described six market failures, so from that, you get an agenda for government.

1. Carbon pricing to address the greenhouse gas emission market failure.

2. Research and development and innovation. Government should be working with the private sector to get more resources into changing technologies and discovering new ways of doing things. For example, we do know quite a bit about how to make steel without using fossil fuels, such as through the use of hydrogen. But this still requires a lot of research, particularly around how to make it cheaper. When it comes to the digital management of systems, there is tremendous potential there, but that's going to involve quite a lot of R&D as well.

3. Capital markets. There are different ways of managing risks, and development banks are one way. For example, they can take on early-stage risks and provide equity into infrastructure projects, where those infrastructure projects involve a lot of early-stage risks. They can help with many other aspects of the financial side as well. But that's about reducing, managing, and sharing risk, and there's a lot governments can do to promote that.

4. Networks. I can't go through them all because there are so many that are relevant: public transport, broadband, reusing, recycling, the circular economy, and so on. Here, let's take electricity grids as an example.

In many countries in the world, the functioning of the electricity grid is a major disincentive. In the UK, actually, we are quite advanced with offshore wind, and we're quite advanced with grid functioning. However, managing the politics and economics of those kinds of grids can be quite complicated and difficult, as they involve bringing the electricity to the shore, putting stations at the shore to manage that electricity, and transmitting that electricity across the country—often with high-voltage direct-current cables.

In China, we know that the grid structure has been historically tilted towards fossil fuels and against renewables. China has gotten extremely good at renewables and is now a world leader in the industry, but the Chinese grid structure is still an obstacle.

In Europe, Électricité de France is a very powerful monopoly in France. There's a lot of sunshine in southern Europe, particularly in Spain, where land has little value. That would be a tremendous place, really, to expand solar power, but then you'd want to export that northwards through Europe. You'd start to run into the way the grids and the systems function in France when you're trying to export from Spain into France.

Those are three examples—in the UK, China, and France/Spain—where the functioning of the grid structure is very important.

5. Information. I think governments can act strongly on the labeling and information involved in goods. Many consumers now want to understand where their goods come from, including the carbon content, and the government can insist on that. Government can help with information on technologies.

6. Finally, the market failure I pointed to, particularly around pollution, is extremely important for the government to act on. That would be done partially through regulation, and partially through pricing. Regulating against air pollution, such as by regulating against emissions from vehicles and so on, can be very powerful and very important.

All those are examples of tackling market failures through government policy. We need all of them—all six of the market failures I described are not small. They're all relevant. I put the greenhouse gas market failure first and correctly so, but those others are extremely important as well. All of this is within the vision and expectations generated by the government as to where it's going so that overall investment decisions can be pointed in a good direction. That's partly associated with the absence of key markets. So all of those areas are ways in which governments can act clearly and strongly to promote the pace of transformation and emission reduction.

Areas for Reform

David Daokui Li: Given that this is a very ambitious and comprehensive list, what are the reforms that governments should make within themselves to achieve these goals?

Nicholas Stern: I think the structure of government around the issues of going to net-zero is extremely important. It's important that these issues are addressed in all parts of the government. To put the delivery in just one place would be worrying, because the delivery has to be everywhere.

So for example, a few years ago, China assigned the challenge of climate to the Ministry of Ecology and Environment. That worries me, because then you have all the other ministries doing their individual jobs, and then the Ministry of Ecology and Environment comes along and is perceived very negatively for saying 'no, you can't do this, you can't do that.' What we want is a really entrepreneurial set of ideas and activities everywhere, because this has to be everywhere. Net-zero is net-zero. There aren't going to be so many negatives, so we've got to be net-zero practically everywhere.

That's why, for example, having an overall responsibility for working toward carbon neutrality in something like the NDRC makes sense. That's because the NDRC in China is looking across the whole economy and the whole investment story.

Now that's just the China example, which of course is very important, but in a more general sense, embedding this in every ministry—making each ministry responsible to the prime minister or the president for what they're doing in this area, I think, is extremely important. So, it's a whole-of-government approach that we need here.

Having said that, I think the monitoring story can be located in a particular place. In the UK, which is one interesting example I think, we have the Climate Change Committee that sets targets for 15 years ahead, which they think will be necessary to achieve in order to follow the path to net-zero effectively and efficiently. I also think that bodies like the Climate Change Committee could do more of what they're starting to do, which is to closely monitor what's happening in different parts of the economy so it can issue early alerts to problems and challenges.

So I do think that the monitoring side could be put in a particular agency, but the delivery side must be all across government and we need mechanisms within government to make sure that it is everywhere and embedded in the decisions. I do think the Ministry of Finance and the NDRC will be important, and I do think that the central bank has an important role to play as well. China and the UK and many other countries now are involved in the network on greening the financial system.

Challenges of Reaching Carbon Neutrality

David Daokui Li: From an economic perspective, what are the challenges to reaching a carbon-neutral economy?

Nicholas Stern: Let me divide the challenges into four. The first one is the very big challenge of understanding that in order to get to net zero, we will have to have a different understanding of development. This is the new growth model, where four types of capital—physical, human, natural, and social—are central. It's a growth model where we understand that there are many market failures that will have to be overcome if we are to change our system as rapidly as necessary in terms of reaching net-zero. This new growth model does involve fundamental change. It does involve seeing things differently. But also, it is enormously attractive. It's a new way of doing things, with cities where you can move and breathe, and ecosystems that are robust and fruitful.

So, the first thing is to adopt this new and different way of thinking about growth—recognizing that it's not a tradeoff between environment and material living standards, it's just a different way of doing things. But one that involves fundamental, rapid change, including investment across a whole set of the four capitals that I describe. So if you like, it's a change of paradigm—a change of mindset—that will drive everything else.

The second is a sense of urgency. We're going to go net-zero, as a world, in 30 or 40 years, but we have to act very fast now. We have to build these new ways of doing things into our investments immediately. This decade is decisive. The world's infrastructure will double in the next 15 or 20 years, and the decisions around that infrastructure will be made in the next few years. We have to avoid lock-in of environmentally dirty forms of physical capital. We have to act quickly to protect biodiversity and natural capital, which are an important part of this whole process.

The third thing is that we're going to have to look forward and consider the new technologies still under development. There are some technologies that are coming down the track, but are not yet precise and complete. We're going to have to do a lot of innovation and R&D. So just as we have to act very quickly now and have that sense of urgency, at the same time, we have to look out ahead to see what we will need and to invest in what we're going to need in the next two or three decades.

The final point is recognizing that because this is such a new way of doing things, there will be dislocation. Some people who, for example, are working in coal mines will very quickly have to begin working somewhere else because using all that coal is incompatible with going to net-zero. Some things will also become more expensive. For a while, air transport will be more expensive. Using fossil fuels in automobiles will also be more expensive. So there will be dislocations both on the production side and the consumption side, and we have to think about how to manage those dislocations well both in terms of equity, but also in terms of getting the job done. If there are major dislocations and people resist (understandably, if they're not protected) then the whole process will slow down.

So those are four areas, I think, which are all different kinds of challenges, but they all fit together with the big challenge of changing the system very fast.


Market Failures and Absent Markets

David Daokui Li: Sometimes, as economists, we believe that the market can solve everything, or at least most things. Why do you think that market forces alone will not be able to tackle these four challenges?

Nicholas Stern: First, we must recognize that market forces are very important. They shape the incentives within which people make decisions, including the incentives of the investments and the entrepreneurship and the discovery that we're going to need.

So we start off by recognizing that markets are going to be a very central part of this process, but they absolutely cannot do it alone. Good economics requires recognition of the power of markets, but also recognition of how markets can fail. And actually, more than that, a recognition that some important markets here are simply absent.

Furthermore, we know that the economy, even if it's perfectly competitive, is not efficient if it has absent markets. We have no reason to expect it to be efficient. So market failures and absent markets are the reasons that these challenges cannot be met by the market alone.

First, there's the market failure associated with greenhouse gas emissions. That's the most commonly recognized one, and we speak about carbon prices, carbon taxes, carbon markets, and so on to correct that externality.

The second market failure is in research and development. Ideas are public goods, and it's very important that they are public goods so that people can pick up on other people's ideas. However, this means that the market doesn't give the full incentive to the person coming up with the idea in terms of the full rewards from that idea. So this is a familiar part of market failure that is particularly important when we need to change quickly and make discoveries.

A third type of market failure is capital markets. We know that capital markets, in many cases, fail to manage risk in an effective way. Thus, many people end up facing risks that they're not very well-equipped to carry, and then they have disincentives to make investments that we need.

A fourth kind of market failure involves networks. A great deal of the work toward carbon neutrality will be done via networks, and we know that networks cannot function without public policy, because so many things for each individual will depend on what the other individuals are doing in that network. So much of what we do involves grids and networks—such as electricity, broadband, and public transport. Reusing and recycling are also very important networks, as is information. Consumers will want to know what's in what they buy. Producers will want to know if alternative ways of doing things are available and easy to use.

And the fifth market failure, which is hugely important, is around pollution, biodiversity, and other co-benefits. Probably 50-plus million people die each year in the world, and around 10 million or so of those deaths are associated very closely with air pollution, either inside or outside. That's one example of what comes with using burning fossil fuels. There are also other consequences in relation to biodiversity, soil pollution, water pollution, etc. which are also extremely important parts of the story. If we move away from fossil fuels, we benefit enormously, but without public action, the market doesn't give the right signals around these other co-benefits.

Those are the market failures, now onto absent markets.

We know that future technologies are going to be very important, but markets for those don't yet exist. Indeed, we're not quite sure what all of them will look like. Market prices for carbon 20 years in the future will be important for people who are thinking of making investments in long-term assets now, but those markets don't exist. So the problem isn't just market failure—important markets don't exist, and where markets are absent, expectations become very important.

And lastly, you can't expect markets to do everything, because so much of what we do depends on the functioning of systems—cities, land, energy, transport—and the functioning of systems depends a great deal on governance and how the systems of governance actually work. 

So markets are at center stage, but there are a lot of fundamental reasons why they're not going to do it by themselves. Unfortunately, so much of economics in this area has suggested that if we can just put the right price on carbon, everything will be fine, and the market forces will handle everything else. But that's just wrong—it's bad economics. It would also be bad economics to abandon carbon pricing—it must be at center stage, but it's bad economics to suggest that that's all we have to do.

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