Climate policy according to Adam Smith

Adam Smith died in 1790, 37 years before Jean-Baptiste Fourier hypothesized that the atmosphere might act like an insulator, and 106 years before Svante Arrhenius argued that an increase in the atmospheric concentration of carbon dioxide would raise the global temperature. Therefore, Adam Smith had no opinion about climate change or climate policy.

Adam Smith did have opinions, though, and these help us speculate about what he would have thought about climate change and particularly about climate policy.

The emission of greenhouse gases, such as carbon dioxide, is conceptualized by economists nowadays as an externality, the unintended and uncompensated effect of an economic activity on a third party. Adam Smith did not recognize externalities. There are some passages in Moral Sentiments that some have interpreted as a precursor to the current understanding of externalities. This is too much of a stretch for me. Smith is also an unlikely supporter of the textbook solution to externalities, a corrective Pigou-Bator tax on emissions.

Adam Smith was what we now to the west of the Atlantic would call a libertarian and to the east a liberal. State intervention should be minimal. At the same time, Smith argued that the government has a role to play in deterring people from hurting others. Although he was thinking about murder, rape, and theft, a negative externality does harm bystanders. Smith would have opposed that.

The emission of carbon dioxide is an externality. The reduction of emissions is a public good. My enjoyment of a better climate does not affect your enjoyment, and you cannot stop me from emitting less. Although Adam Smith lacked the technical definition of a public good – no rivalry and no excludability – he did write about how public goods should be provided. Wary of government intervention, Smith thought that public goods are best provided through charity.

Adam Smith would thus have recognized and welcomed the 2015 Paris Agreement. Its Intended Nationally Determined Contributions are voluntary contributions to the provision of a global public good. The pledge-and-review system of Paris is an appeal to the morality of governments around the world, an approach advocated by Smith. Smith would also have applauded people like Bill Gates, who spend a substantial amount of private money to find technological solutions to greenhouse gas emission reduction.

Adam Smith would have been less enamored by the way some of these governments go about reducing emissions. He probably would have liked systems of tradeable emission permits. At its core, an externality is a missing market. Tradeable permits fill this gap. The market is completed. Friends of well-functioning economies with minimal government interference should welcome this.

However, there is more to climate policy than permit markets. The European Environment Agency counts thousands of climate policies in the European Union, and the Organization of Economic Development and Cooperation adds thousands more in other rich countries. Most of these measures are direct regulation: bans, standards, mandates, and whatever other names have been given to government command and control. On top of that, there are numerous subsidies. Adam Smith would have disapproved. He would have been right. The emission of greenhouse gases is a simple externality. A single problem is best solved by a single intervention. The cheapest way to meet an emissions targets is by equating the costs of emission reduction at the margin. A carbon tax, a uniform carbon tax, and nothing but a carbon tax would be one solution, a comprehensive permit market another.

Although Adam Smith would have been skeptical of the way governments go about climate policy, he would not have been skeptical of climate change itself. He was a major figure in the Enlightenment, after all. He would also have had little patience with those who predict economic ruin if we cut our emissions. Adam Smith was borne in coal country into a coal family. When writing about the poverty of Ireland, he noted that the lack of coal and wood hampered the “progress of great manufactures”. But, he added, the want of “order, police, and the administration of justice” were “more essential to the progress of industry than both coal and wood put together”. Acemoglu is Smith redux.

Adam Smith would have similarly little patience with environmental alarmists. Environmentalism is one of the offsprings of Romanticism, the movement that opposed the Enlightenment. Smith’s labour theory of value was developed to counter the Physiocrats’ land theory of value. According to Quetelet and friends, nature is the only source of wealth and the sole yardstick of value. This theory reincarnated in the Ecological Footprint, which is frequently used to predict imminent economic doom and environmental catastrophe. Smith, on the other hand, believed that value derived from labour.

His views on long-term development were mixed. On the one hand, resource constraints would force the economy into a steady-state, not a collapse. While the economy as a whole would be stationary, population growth would lead to the immiseration of the people. On the other hand, Smith recognized that institutions modulate the constraints of soil and climate. He did not believe, like Julian Simon would centuries later, that human ingenuity could lift these constraints altogether, but Smith certainly was no environmental determinist.

Returning to climate policy, although Adam Smith was generally in favour of markets, he also warned against market power and the tendency of business people to conspire against the public. That prospect is real. Climate policy has seen a number of scandals, some better known than others. In the pilot phase of the EU ETS, two large utilities traded a small number of permits back and forth at a high price in an attempt to convince the government of Germany not to tighten emission reduction targets. Chinese companies built HFC factories just to sell the carbon credits gained by closing them down again. Carousel fraud with tradeable permits cost the taxpayer hundreds of millions, if not billions of euros. Carbon offsets are now widely recognized as mostly fake.

And climate policy has hardly begun. The targets set in the 2015 Paris Agreement require a rapid increase in the price of greenhouse gas emission permits – so that climate scams become more lucrative. Climate policy initially focused on large point sources of carbon dioxide but is now expanding to many more, smaller sources that are harder to monitor. Similarly, climate policy started in well-regulated countries and is now moving into places with weaker legal systems. Climate fraud will increase.

But the problem does not stop with private crime. The Intergovernmental Panel on Climate Change reckons that, in order to have an even chance of keeping the global mean surface air temperature below two degrees Celsius above pre-industrial levels, large amounts of carbon dioxide will have to be removed from the atmosphere. Models assessed in the latest report of the IPCC find that the subsidies needed to achieve this may well be as high as seven percent of total economic output – that is, tens of trillions of dollars. This is a tempting target for political patronage. Adam Smith would not be in favour of expanding the government in this fashion.

In sum, although Adam Smith has not written about climate change and climate policy, we can deduce what he would have said. Smith would have argued that climate change is a problem that needs to be solved, without giving ground to the extremist views on either side. He would also have been wary of government overreach, instead argue for market-based solutions to the climate problem – and appeal to our moral obligation not to harm others.