Millennium Post

New Institutional Economics : Climate change conundrum

NIE+ framework is being used to address the increasingly pertinent yet stagnant issue of climate change

To continue with the theme of my last two articles on the need to supply global public goods, I will take up the issue of climate change in this article. I had written two years ago in these columns of the urgent need for an accord on emissions and other related issues, but a multilateral agreement has remained elusive. In the meantime, the world has been overtaken by other pressing issues such as the COVID-19 pandemic and trade wars. However, these events should not take away the urgent and continuing need for a climate change accord. Let us discuss this from the New Institutional Economics (+) perspective that I have outlined earlier in these columns. Let us see where we stand, what has gone wrong and what are the next steps.

Where we stand

We know that the main objective of the climate change negotiations is to limit the global rise in temperature to less than 2ºC. To do so, there is a need to cap the emission of greenhouse gases and this is where countries are facing collective action problems in deciding who will cap how much. There are a number of multilateral, plurilateral and bilateral agreements/frameworks on climate change, of which the UN Framework Convention on Climate Change (UNFCCC) and the Kyoto Protocol (KP) are perhaps the most well-known and crucial. The objective of the UNFCCC, which came into force in March 1994, is to ultimately achieve reductions in global emissions of greenhouse gases. There are other intergovernmental organisations that contribute to adaptation and mitigation measures related to climate change. Some of these are the World Trade Organisation (WTO), which frames rules for tariffs and non-tariff barriers to trade, including the issue of carbon trading; International Maritime Organisation (IMO), which frames rules for emissions of seafaring vessels; the UNEP, which is responsible for overall policy on the global environment and UN Convention on the Law of the Seas (UNCLOS), which governs the traffic in international waters. In addition, there are the well-known development and financial institutions such as the World Bank and IMF.

Unfortunately, the Copenhagen meeting in December 2009, billed as Kyoto II, fell short of expectations. The more recent COP-21 meeting in Paris in December 2015 was certainly successful in that members agreed to keep a global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius. While the Paris accord came into effect in November 2016, the agreement was not binding since members had to set self-determined goals called NDCs (or Nationally Determined Contributions) on emissions cut. It was thus a 'best effort' target, with no penalties for missing targets. Even the US withdrew from the Accord in July 2017, which made the accord less effective in its impact and reach. The COP-25 in Madrid in November 2019 discussed ways to implement the Paris accord and reporting mechanisms but little on the shortfalls in the outcomes and how to plug such shortfalls. In short, we are faced with a global institutional inertia in respect of climate change negotiations: a prisoners' dilemma situation where we are stuck in a situation where the efforts to maximise individual benefits has pushed collective benefits to the side.

What has gone wrong

We saw above that most meetings on climate change have fallen short of expectations. The primary reason for the prisoners' dilemma situation is of course the lack of trust in the mechanism to make commitments. Further, the big emitters/polluters have not shown any urgency to make serious commitments. These are also the reasons that members agreed for only 'best endeavour' commitments in the

Paris accord of 2015-16. Overcoming the institutional inertias therefore requires efforts on different levels and in various sectors.

Apart from the trust issues or the lack of social and relational capital (a factor that we saw in the lack of progress in the G20 countries in respect of global financial stability and in the WTO in respect of ensuring free and fair international trade), the overburdening of the UNFCCC system is another reason for the policy inaction or lack of progress. As mentioned above, climate change is a multi-dimensional and multi-sectoral issue that would require all international agencies and their members to come together. Hence, climate change linkages in other intergovernmental bodies need to be recognised and acted on. For example, there is a clear climate change linkage in the WTO mandate. The WTO also recognises the principle of special and differential treatment in seeking to protect and preserve the environment. The Preamble of the Marrakesh Agreement of the WTO calls for

'.....expanding the production of and trade in goods and services, while allowing for the optimal use of the world's resources in accordance with the objective of sustainable development, seeking both to protect and preserve the environment and to enhance the means for doing so in a manner consistent with their respective needs and concerns at different levels of economic development'

Climate change is not only about emission cuts per se, but also the concomitant changes in the way we travel, grow our food, generate our electricity, rear our cattle and undertake our industrialisation. In other words, emissions targets will bring about fundamental changes in production processes and in the most important sectors of the economy such as power generation, transportation, agricultural and animal husbandry practices, land-use and international trade. Further, these changes will impact developed and developing countries differently. And here lies another issue of discord: the proportionality of commitments. While it is generally accepted and recognised that a regime of common but differentiated responsibility is a must to overcome the collective action problems, there is no agreement on how to go about this or even what it entails.

The next steps

Interestingly, we may recall that Ronald Coase had developed the idea of transaction costs in the context of an environmental issue. As we know, transaction costs are one of the fundamental building blocks of NIE. We may recall that in his paper of 1960, 'The Problem of Social Cost', Coase had basically challenged Pigou's treatment of externalities. While Pigou basically suggested the 'polluter pays' principle, Coase proposed that the market would find an efficient solution to the problem of 'nuisances'. We know that Pigou in 1920, had applied neoclassical economics to find a solution to the problem of externalities. We also know that in the neoclassical world, efficient allocation of resources is not possible in the presence of externalities. Pigou's suggestion was to impose a tax on the generators of negative externalities and to subsidise the generators of positive externalities in order to reach the efficient allocation of resources. Pigou, of course, did not take the interdependent nature of the externality, a fact that Coase clearly recognised.

Coase argued that it is necessary to define initial endowments when "an externality" exists and this could be done by assigning private property rights to one of the parties or by other ways such as introducing regulations governing pollution. Coase then demonstrated that under Pigou's own assumption of costless transactions, the establishment of private property rights is all that is needed. Coase argued that if transaction costs are low or zero, two parties to a dispute or a 'nuisance' would bargain with one another to produce the most efficient distribution of resources. Coase used the example of a case named Sturges v Bridgman, where two neighbours, a noisy sweetmaker and a quiet doctor were fighting that the other should move out and accordingly asked the court to intervene. According to Coase, regardless of whether the judge ruled that the sweetmaker had to stop using his machinery, or that the doctor had to put up with it, they could arrive at a mutually beneficial outcome that reaches the same outcome of productive activity. Coase's point was that since transaction costs were rarely low, many welfare-maximising solutions are ignored and hence the market should be allowed to find a solution, as long as the initial rights are assigned.

More pertinently, Coase's basis of the argument was rooted in environmental issues. A lot of research on the management of natural resources under common property institutions (see Baland and Platteau, 1996; Bromley et al., 1992; Dahlman, 1980; Ostrom, 1990; Ostrom, Gardner and Walker, 1994) is also inspired by NIE+. The central concepts of the NIE+ framework, namely transaction costs, formal and informal institutions and social capital are thus relevant to the current climate change negotiations and provide a possible way to come to an agreement, which would be equitable, fair and acceptable to all members. The reason is that the NIE+ framework emphasises the interdependence between members and the importance of social capital among members to overcome the collective action dilemmas of climate change governance. This interdependence was, of course, ignored in the neoclassical analysis, which Pigou put forth and has been discussed above.

If we apply the NIE+ framework to climate change governance, the members can be taken to be interdependent parties who would get affected adversely if there is no accord. On the other hand, getting into an accord would mean giving up environmental and economic sovereignty in areas such as emissions. In Coase's world, the accord will come about if the transaction costs of negotiating are low and the initial endowments are defined. Here, initial endowments could be various rights such as global regulations, transfer of technology from developed countries to developing countries, financing of various activities in the post-accord era (say, HCFC refrigeration in place of CFC refrigeration, increase in non-polluting fuels in industry etc.) and so on. Hence, some kind of 'ex-ante' understanding of the 'starting points' needs to be thrashed out. And this is possible only if there is a high level of social and relational capital among members. Once this is done, NIE+ tells us that a more ambitious climate change accord than the Paris Accord could be within reach.

Continuing with the NIE+ framework, we need to come up with policy innovations that address all environmental resources (renewable and non-renewable) and also the environmental issues that have become critical in the past decade or so, particularly in developing countries. Some of these issues include forests, water (surface and groundwater), minerals, biodiversity, clean air, population pressure on these resources and so on. If issues of concern to all are included and given equal importance, and interdependencies are recognised, all members will have a stake in the negotiations and will therefore be more willing to give and take. In other words, this will raise the social capital among members and reduce the transaction costs of negotiations. For sure, there will be differences on account of either local political compulsions or because the 'ex-ante' starting points are not perfectly delineated. For such differences to be settled, a sound, impartial and fair dispute settlement mechanism (on the lines of the one in WTO), must be designed, which again contributes to lowering transaction costs 'ex-post'.


The NIE+ framework gives us pointers to some policies that would enhance social capital and lower transaction costs of negotiations ' ex-ante' and implementation and enforcement costs 'ex-post'. We have seen above that if 'starting points' are agreed, interdependencies are recognised, and all environmental issues, including those of importance to developing countries are on the table, then there is a greater likelihood of a binding and serious multilateral accord on climate change. We have also noted that investment decisions taken by countries today involve choices about energy-efficient production methods, modes of transportation (electric cars), type of power generation systems (shift to wind and solar energy), agricultural and animal husbandry practices, etc. Such choices would determine the levels of greenhouse gas emissions of the future. In particular, there is pressure to move towards cleaner technologies. These challenges are obviously greater for developing countries, which lack resources and have equally pressing development challenges such as poverty eradication and universalisation of primary education and health care. For example, a move towards cleaner technologies would require greater investments in renewable energy sources such as wind and solar energy. Shifting to renewable energy sources is a costly affair and would obviously entail higher costs, as we know from the experience of developed countries such as Germany and the Scandinavian countries, where power tariffs rose as the proportion of renewable energy in their energy-mix rose. It is obvious that emission targets would have to recognise that the needs of development and the environment have to be balanced and the principle of 'common but differentiated responsibility' is accepted. The NIE+ framework has the potential to do so as we saw above and has given us something to work with.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal

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