We show, with the help of an excursion into game theory, why it is so difficult to reach a cooperative solution among all nations regarding “climate change and environmental protection”. We venture a prognosis on whether and how climate change could work.

 

Climate change imposes significant costs on all of humanity

The lion’s share of these costs is not borne by the polluters, the costs are not externalised and the injured parties are not financially compensated.

The Western world is desperately trying to fight global warming and slow down climate change. The destroyed environment and higher temperatures impose significant costs on all people (lower life expectancy, lower quality of life, higher food prices due to crop failure, loss of settlement areas, etc.)

Most of these costs cannot be offset because there are not properly defined and enforceable property rights. For example, the polluters of bad air (e.g., agricultural tractors without catalytic converters) do not have to pay compensation to the owners of the air (all of us). The legislator grants them the right to pollute the air for free (due to distributional goals and maximisation of votes). This is not the issue here, but if the legislator wants to reduce air pollutants in an economically efficient way, tightening exhaust emission regulations for cars at a given cost will bring less than the minimal tightening of exhaust emission regulations for agricultural vehicles (and marine diesel).

A greener economy translates into higher private production costs and higher consumer prices

This struggle is not free, quite the opposite. A greener economy (e.g. green electricity) increases production costs and thus inflation.
The pay-off matrix of investments in environmental protection, which has the structure of the so-called Prisoner’sDilemma, is problematic.

 

Free rider or freerider problem

The benefits of slowing climate change accrue to all nations, all people. However, the costs are borne only by those who make their economies more environmentally friendly, produce green electricity, etc. This structure corresponds to the freerider problem. If the industrialised nations invest in environmental protection but the emerging countries do not, the emerging countries can reap the benefits (lower temperature rise, etc.) without paying anything in return. For the fans of political correctness, the following sentence should be added: If the emerging countries invest in environmental protection and the industrialised countries do not, the industrialised countries can obtain the benefit (lower temperature rise, etc.) without a quid pro quo. The lower temperature rise is a so-called common good. This is characterised by non-excludability.

 

Excursus: Climate protection is a common good, your car a private good

Your car is private property. You decide who drives it and who doesn’t. A lower temperature rise is a common good. You cannot determine who should not benefit from it. If someone spends a lot of money to slow down the temperature rise, this “someone” cannot determine that those who do not spend money on climate protection do not also benefit from it.

We assume the following stylised costs of “economic greening” per year for a representative emerging market and a representative industrialised nation: 600 billion USD. To achieve the same environmentally improving effect, industrialised nations have higher costs. On the other hand, emerging economies located in climatically unfavourable zones or flood-prone lowlands should tend to benefit more. We simplify in the following and assume that costs and returns are symmetrical.

We also assume that the monetary returns to emerging and developed countries are equal and amount to a stylised USD 800 billion per year per country if all emerging and developed countries were to invest equally in environmental protection. If neither industrialised nor emerging countries invested in environmental protection, the economy would be damaged by additional, inherently avoidable environmental disasters amounting to USD 100 billion per year.

 

Sad fact: Energy-intensive, polluting manufacturing is increasingly shifting to emerging economies

The chart linked here shows that a large part of the manufacturing industry has been relocated to emerging markets (not least due to cost advantages). The increase cannot be explained by higher growth in emerging markets alone.

 

If the industrialised nations/emerging economies “green” their economies, everyone benefits and the investor “only marginally more”

We assume that the monetary benefits if only the developed or the developing countries invest in environmental protection are only half as high as if both groups invest: 400 billion USD. This is the profit of the free riders who benefit from the expensive investments of the others and save all costs themselves.

Pay-off matrix climate protection

Clearly, the best solution would be for industrialised nations and emerging economies to invest equally in environmental protection. The industrialised nations and the emerging countries would “win” 200 billion USD annually, in contrast to today.

What are the emerging markets thinking?

  1. Let’s assume that the industrialised countries invest in environmental protection and we do too:
    Then our profit is 200. But if we do not invest (and benefit from the investments of the industrialised nations, our profit is higher, namely 400. So it is best for us not to invest and instead benefit from the environmental protection investments of the emerging countries.
  2. Suppose the industrialised nations do not invest in environmental protection and we invest:
    Then our loss is 200. If we save the costs and do not invest either, our loss is lower at 100.

Conclusion: No matter what the industrialised countries do, it is always more profitable for the emerging countries not to invest in environmental protection.

 

What are the industrialised countries thinking?

  1. Suppose the emerging countries invest in environmental protection and we do too:
    Then our profit is 200. But if we do not invest (and benefit from the investments of the emerging countries), our profit is higher, namely 400. So it is best for us not to invest and instead benefit from the environmental investments of the developing countries.
  2. Suppose developing countries do not invest in environmental protection and we invest:
    Then our loss is 200. If we save the costs and do not invest either, our loss is lower at 100.

Conclusion: No matter what the emerging countries do, it is always more profitable for the industrialised countries not to invest in environmental protection.


If everyone optimises on their own, both groups of countries will not invest and the sad result (environmental damage of 100 billion USD each, which corresponds to the Nash equilibrium here) is that too little is done for the environment, for climate protection, which probably corresponds to reality.

If both worked together, everyone would be better off. Cheating, that is, not investing and only pretending to invest, pays off for both groups of countries.

 

Majority of Western industrialised nations willing to pay for climate change and environmental protection

A large part of the Western industrialised nations have now decided to take up the fight against climate change, regardless of what the developing countries do. It is to be feared that many emerging countries will not join in (or will only pretend to fight climate change and pollution or are not even able to do so from a financial point of view). They will not let the “rich” tell them that they should invest more in environmental protection. They will argue that they have a lower standard of living. Only when their standard of living is just as high, when hunger and poverty are less bad than environmental damage, will emerging countries adopt the view of industrialised countries. “It is more important for my fellow villagers to have something to eat tomorrow than to afford excessive eco-luxury.»

 

Optimum Optimum can unfortunately not be achieved

It is thus likely that the stylised pay-off at the bottom left will become reality. The industrialised countries are thus threatened with production cost increases, from which the emerging countries are likely to benefit even more through further relocations of the particularly polluting industries.

 

In the long run, the emerging countries must join in, otherwise the efforts will probably be almost in vain in the long run

The cost of reducing pollution by one unit is lower in emerging economies because production costs (wages, salaries, raw materials) are generally lower. With USD 100 billion investments in environmental technologies, much more can be achieved in most emerging countries than in the majority of industrialised nations.

 

Compensation payments

One solution would therefore be for the rich industrialised nations to pay the emerging countries for part of the investment in environmental protection. There would very well be monitoring problems, but thanks to satellite technology, cheaters and polluters can be “monitored and motivated” more cheaply.

 

Pay-off matrix climate protection with compensation payments

How much do the industrialised nations have to offer to benefit economically compared to the selfish Nash equilibrium?

300 billion are available. In the above matrix “Pay-off with compensation payments” we assume payments of 250 billion USD to the developing countries, paid out ex-post when the target is reached. This still leaves the industrialised nations 50 billion USD better off (compared to the selfish solution, where everyone optimises for themselves without thinking of the others).

Given that the majority of voters in the industrialised countries would definitely like to fight climate change and pollution with much more money, it is now advantageous with the compensation payments also for the emerging countries if they behave purely egoistically, because if they join in, they will receive a part of the resulting profits of the industrialised nations in the form of support payments, a total of 450, which according to Adam Riese is higher than 400. With this solution, there would also be the “advantage” that production costs in the emerging countries would also increase due to stricter regulations and fewer goods would be senselessly shipped around on the world’s oceans. Competition over lower standards would be defused. Presumably, therefore, the net costs for the industrialised nation would be significantly lower than the payments actually made to the emerging countries (assuming strict coupling of payments to the achievement of environmental protection targets).

Critics may now object that China, for example, invests a lot in environmental protection and, at an estimated 17%, has a higher share of electronically operated vehicles (cars, trucks, trains) than most industrialised countries (USA: around 3%). Correct! But: No industrial nation produces electricity as polluting as China (57% is produced in coal-fired power plants) Source: here!

 

Conclusion

The Western industrialised nations have decided, regardless of whether it is net beneficial for them and regardless of whether the emerging economies join in, to invest considerable sums in environmental protection and to damage their own competitiveness through a higher cost base.

The example of the rejection of the CO2 law in Switzerland on 13 June 2021 shows that going it alone primarily harms one’s own economy (and one’s own wallet), does little good and the population has recognised this.

If we move forward unilaterally, it is likely that even more parts of the manufacturing industry will be relocated to countries with lower environmental standards. All efforts to stop climate change are very likely to fail if the emerging economies do not join in. Presumably, there is little willingness on the part of the industrialised nations to make compensation payments to the emerging countries. The problem of climate protection thus remains unsolved for the time being. However, as we all know, hope dies last. In this case, hope for cooperative, not self-maximising behaviour. The fact that many industrialised nations want to and will invest “vast sums” in environmental protection, regardless of what the others do, is an indication that in some cases behaviour that is not solely self-centred exists and that partial cooperation is possible.

 

Thomas Härter
Chief Investment Officer Aquila

 

 

 

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