The consequences of a one-sided externality in a dynamic, two-agent framework

Ingmar Schumacher on his article “G. Müller-Fürstenberger, I. Schumacher, The consequences of a one-sided externality in a dynamic, two-agent framework, European Journal of Operational Research, Volume 257, Issue 1, 16 February 2017, Pages 310–322 “.

Climate change is intensifying, but at the same time it is not going to affect every country on the planet in the same way. For example, sub-Saharan Africa is expected to be impacted the strongest, while regions like Russia or even the US are believed to bear only minor impacts from climate change. This obviously gives rise to different incentives when it comes to preventing climate change. In the article “The consequences of a one-sided externality in a dynamic, two-agent framework,“ co-authored with Georg Müller-Fürstenberger and published in the European Journal of Operations Research, we model the incentives for reducing carbon emissions when regions are asymmetrically affected by climate change.

We find that one major problem in this case is that this setting corresponds to what one may call a unilateral externality – richer countries that are also polluting the most are less impacted by climate change while poor regions that add little to climate change are going to be hit the hardest. The costs to poor regions to offset the carbon emissions from the rich, either by reducing their own or by strategies such as carbon-capture-and-storage, may then be so high that this could drain their wealth. We identify the conditions under which this would be the case.

In general, strategies to avoid this scenario are carbon policies, such as taxes or emission trading schemes. However, these tend to require a level of international agreement that we have yet to see. In particular, during the past years the international community has moved away from top down international agreements towards the so-called Nationally Determined Contributions. These allow each country to set their own emission policy, which essentially shows that international negotiations have failed.

So what could be a solution to the above problem? One potential strategy that regions may have would be to integrate their capital markets. In this case, rich regions would have incentives to invest in poor regions and thus this would avoid the case where poor regions run down their wealth to save them from climate change. It is, obviously, necessary for the rich regions to have an incentive to integrate capital markets. We study the conditions under which both the rich and the poor countries have an incentive to combine their capital markets. As such, this could be an additional solution that has been neglected by research and policy makers alike and provides an additional argument against the Trumpian era of nationalism.