The Greenhouse Gas Externality: Market failure, innovation opportunity

Climate change is no longer a distant threat; it's an existential crisis unfolding before our eyes. On our current trajectory, SwissRe estimates that the cascading effects of global warming could wipe out roughly 18% of the global economy by 2050, costing a projected $40 trillion annually in lost productivity, lost revenue, and damages. These losses will fall disproportionately on developing and impoverished nations, with SwissRe projecting that, under business-as-usual conditions, ASEAN will suffer a staggering 37.4% loss in GDP. Yet, despite the urgency to act, a significant barrier stands in our way – the greenhouse gas externality.

The irony of our current climate crisis is rooted in the very technologies that fueled the greatest prosperity boom in human history. Abundant, energy-dense fossil fuels served as the lifeblood of modern society. The fossil-fuel era revolutionized every aspect of life, from powering industry to improving living standards. However, 150 years of fossil fuel use has concentrated a trillion tons of greenhouse gases in our atmosphere, driving the climate crisis and creating a "debt of progress". While the initial adoption of heavy-emissions technologies was not malicious, we now have a moral, financial, and ethical imperative to address this debt. Unfortunately, the current misalignment of incentives renders this transition dauntingly quixotic.

At its core, the greenhouse gas externality is a market failure that distorts incentives and impedes climate action. It represents a dislocation where the true costs of emissions are not borne by those responsible for generating them. Instead, the economic burden – spanning health impacts, environmental degradation, and more – is distributed across society, creating a tragedy of the commons. Leading research and government entities estimate that the social cost of carbon is anywhere between $51 to $450 per ton of CO2e, highlighting the significant economic burden imposed on society. Since emitters are not held accountable for the true costs of their emissions, there are no inherent economic reasons to stop polluting or invest in solutions; individuals, businesses, and governments alike lack the motivation to prioritize sustainable practices. The complexity and vast scope of climate change further complicate efforts to foster collective accountability. This existential misalignment between economic incentives and environmental well-being is the core obstacle to tackling climate change.

Even still, studies from the IPCC and World Resources Institute indicate that existing technologies, scaled up and advanced through appropriate investments, are capable of reversing climate change. Yet, McKinsey, Bloomberg, the IMF, and WEF have all shown that the current investment rate of $.8-1 Trillion per year is insufficient to meet the Paris Accord goals, and additional investment in sustainable technologies of $4-8 Trillion per year is required to limit warming by the end of the century to 1.5°C. Bridging this gap requires not only increased investment but also accelerated innovation to drive down costs. The challenge lies in reconciling long-term climate risks with present-day financial considerations. By aligning incentives, we can unlock sustainable technologies' full potential to deliver on environmental and economic priorities.

For investors and business leaders, sustainability goals are often at odds with fiduciary responsibilities and shareholder interests. While some shareholders champion “green” initiatives, the vast majority prioritize maximizing short-term returns. Decarbonization efforts are effectively high-cost low-return initiatives, which means that choosing these efforts often contradicts shareholders' core operating objectives. Resolving this contradiction necessitates aligning incentives to make sustainable, low-carbon technologies financially viable, bridging the gap between environmental and economic objectives.

As the urgency to address climate change intensifies, a burgeoning climatetech industry has begun to emerge, offering innovative solutions to reduce emissions and mitigate the impacts of global warming. However, the full potential of this industry remains constrained by the market dislocation caused by the greenhouse gas externality. A bright spot, though, lies in the rise of sustainability-focused companies that prioritize energy efficiency, waste reduction, and operational improvements. These companies offer valuable products and services that allow them to competitively price their offerings under current market conditions while providing decarbonization as a compelling secondary benefit. As these businesses plot a path to scale, they lay the groundwork for a robust climatetech market, ready to expand rapidly as regulatory systems catch up. 

By internalizing the cost of emissions, whether through carbon pricing or other market-based mechanisms, we can realign incentives and make tremendous headway towards leveling the playing field for climatetech. There are notable success stories in this regard. For example, in both California, which has employed a cap-and-trade system, and British Columbia, revenue-neutral carbon tax, there has been a marked acceleration in the adoption of renewable energy, investment in climatetech, and prioritization of efficiency. While these systems effectively internalize, in part or in whole, the cost of emissions, other programs like Germany’s feed-in-tariff, work by selectively prioritizing and increasing the competitiveness of specific technologies, ie renewable energy systems, to incentivize the innovation, development, and deployment of next-generation technologies. These policies create an environment where sustainable practices not only become more viable but also more profitable.

Effective climate action requires a multi-pronged approach. While market mechanisms like carbon pricing are crucial for internalizing costs and creating a more equitable market, regulations, education, and knowledge sharing play important complementary roles. Well-designed regulations establish clear standards for emissions reductions, incentivize clean technologies, and foster innovation. Education and awareness are foundational to driving public and private actions towards decarbonization; campaigns and programs that increase understanding of climate issues can motivate communities and industries to adopt more sustainable practices. International cooperation and knowledge sharing enhance these efforts by facilitating the exchange of innovative technologies and effective policies, underpinned by global agreements like the Paris Accords, which orchestrate collective action against climate change.

Policymakers, acting as de facto market makers, play a crucial role in shaping incentives. Local Law 97 (LL97) in New York City is a prime example. Enacted in 2019, it targets buildings over 25,000 square feet with strict carbon caps to reduce emissions by 40% by 2030 and 80% by 2050 compared to a 2005 baseline. LL97, which is expected to create 140,000 jobs and reduce NYC's building emissions by 26% citywide by 2030, has been replicated in over 40 jurisdictions, including Washington, D.C., and Boston​. Similarly, on the federal level, the Inflation Reduction Act (IRA) has catalyzed a surge in private investments, channeling over $100 billion into clean energy, manufacturing, and efficiency efforts within a year of its enactment. The IRA also supports LL97 compliance, showing how federal initiatives can amplify local efforts. These examples highlight the importance of thoughtful policymaking that fosters collaboration between the public and private sectors to accelerate the transition to a low-carbon future.

Despite advancements in technology, falling costs, and a growing public movement, the climate challenge remains daunting. To bridge the gap, we need clear and durable market signals, like well-designed carbon pricing mechanisms, to internalize the true cost of emissions. But the fight extends beyond policy. Empowering individuals and businesses through education and awareness is critical for informed decision-making and driving sustainable practices. International cooperation and knowledge sharing are also paramount. By fostering global collaboration, we can accelerate innovation, share best practices, and ensure a unified approach to this existential threat. By tackling climate change on multiple fronts – economics, policy, education, and international cooperation – we can build a more sustainable and equitable future for all.