Editor’s note: This is an excerpt from Adapt and Be Adept: Market Responses to Climate Change, edited by Terry L. Anderson, newly published by the Hoover Institution Press. Click here to buy a copy.

The globe is warming, ice caps are melting, and sea levels are creeping up. The most convincing evidence to an economist, however, is not measurement with thermometers or yardsticks but the fact that people are reacting to price changes, whether the result of government policies or the result of asset markets. Market forces are causing human beings to adapt to climate change, and that movement is the theme of a new book, Adapt and Be Adept.

Adaptation occurs in part because other policies aimed at slowing global warming show little prospect of being implemented or, if implemented, of having much effect.

First, the most common policy proposed for reducing global warming is regulation to reduce greenhouse gas (GHG) emissions. These regulations are the basis for most international agreements, such as the Paris Accord. Not surprising, not all countries sign on to such agreements, and not all that do abide by them, especially those wanting more development, such as China and India. Moreover, because so much carbon is already stored in the atmosphere, these agreements are unlikely to have much effect on global temperatures. In the case of the Paris Accord, even if all countries met the targets, projected temperatures by 2100 would be reduced by only 0.05 degrees Celsius, as Bjorn Lomborg showed in Global Policy in 2015.

Second, the alternative energy forms necessary to drive the global economy have inherent limits that, for the foreseeable future, will make a transition that eliminates hydrocarbons unlikely. Hydrocarbons are here to stay as a major share of the global energy supply, and therefore far more severe greenhouse gas regulations are unlikely to gain traction.

Third, and perhaps most important, politics, more than efficiency, drive climate policy. As Jeffrey Immelt said in answer to a question I posed at the 2008 ECO-nomics Conference sponsored by the Wall Street Journal, “If you’re not at the table, you’re on the menu.” Being at the table means having lobbyists who influence policy. This is why climate change policies promoted by economists as efficient are seldom adopted. Special interest groups seek subsidies, taxes, or regulations that make their products or services more profitable than they would be otherwise. Economists refer to this as rent seeking, meaning that political outcomes have little resemblance to theoretical efficiency depicted in economic models.

Most current policies proposed for reducing global warming or mitigating its effects require collective action. International agreements to reduce greenhouse emissions require global agreements that are difficult to enforce, even if agreed to. National and regional greenhouse gas reduction is easier to enforce but has little hope of reducing global warming because the GHG emissions immediately mix in the global atmosphere; any effect they have cannot be separated from other GHG emissions. Hence, local economies bear costs with few identifiable benefits locally or globally. Moreover, greenhouse gas limits placed on a local economy most often result in “leakage,” meaning emissions are shifted to economies without such regulations.

The policy that receives the most support from economists involves market-like mechanisms that give individuals and corporations incentives to reduce emissions. The two best known are carbon taxes and cap and trade. Even conservative economists, such as the late George Shultz, former secretary of treasury and state, and the late Gary Becker, a Nobel laureate, have called for carbon taxes on the grounds that they will promote an efficient solution to climate change. The argument is that energy producers and consumers create externalities, meaning they impose costs on others for which they are not liable. Shultz and Becker concluded that those who generate greenhouse gases “should bear the full costs of the use of the energy they provide,” including the costs “imposed on society by the pollution they emit.” Such a tax “would encourage producers and consumers to shift toward energy sources that emit less carbon.”

Indeed, price changes resulting from a carbon tax will influence producer and consumer behavior, but they are not the result of a market. It is easy to draw “blackboard” graphs making the case for carbon taxes but much harder to implement them as they are drawn.

Cap-and-trade policies are another example of the efficient blackboard economics favored by economists. Under cap and trade, the government places a cap on carbon emissions, allocates shares in the cap to carbon emitters, and allows the shares to be traded. This creates a market in the cap, the price of which is determined by willing buyers and willing sellers. As with a carbon tax, the price of the cap will affect producer and consumer behavior, but the quantity and its allocation are set through a political process, not through market forces.

Public investment in infrastructure is an effective way of mitigating, accommodating, or recovering from the effects of climate change. For example, seawalls can protect the coastline, flood control systems can reduce the effects of storm surge, and carbon capture or sequestration can lower atmospheric greenhouse gases. Unfortunately, these public expenditures face the ever-present collective action problem: costs are generally spread among the many and benefits accrue to the few.

This creates two problems. First, with benefits concentrated and costs diffuse, political rent seeking can promote investments that do not pass cost-benefit muster. Second, if the costs are not borne directly by asset owners who benefit, public investment in mitigation creates the potential for a moral hazard response, meaning people will take greater risks than they might otherwise because they are protected from the consequences. If seawalls reduce the risk of building in coastal areas and the increased risk is not priced—perhaps because of tax subsidies in construction of the seawalls or subsidized insurance—developers will have an incentive to build in places where climate change exacerbates risks.

Who Adapts, and How?

Because the typical policy proposals for addressing climate change are costly and have been slow to materialize, they have inherent collective action problems, and they often have adverse consequences. Adapt and Be Adept makes the case for more reliance on private action using asset, finance, and risk markets to give individuals and groups the incentive to adapt to the effects of climate change.

To understand how this form of adaptation works its way through markets—especially land, capital, and other fixed asset values—assume for a moment that climate changes are not caused by anthropogenic greenhouse gas emissions but rather are the result of some force of nature beyond the control of human beings. Hence, climate change is not a result of private costs being less than social costs, because it is not human action causing the changes. Under this assumption, assets whose values are affected by climate will adjust, and asset owners will adjust, or adapt, how those assets are used. Beachfront properties subject to rising sea levels would be less valuable, inducing people to build differently or move to other locations. Agricultural land with more precipitation would be more valuable, inducing producers to use different crops or move production to different locations.

Relaxing the assumption that almost none of climate change is due to natural causes and assuming instead that climate change is due to anthropogenic GHG emissions yields the same conclusion about asset values. This conclusion follows the reasoning of Ronald Coase in his seminal article, “The Problem of Social Cost.” He explained that competition for resources—the use of the atmosphere as a disposal medium for GHG or a medium for stabilizing climate—generates costs that are reciprocal: greenhouse gas emitters impose costs on people whose asset values are affected by climate change, or those asset owners impose costs on GHG emitters by regulating GHG emissions.

Who gets to impose costs on whom depends on who has the right to emit or the right to have stable property values. Coase explains that parties can bargain to account for the costs, provided the property rights are clear and the costs of bargaining are low. Of course, neither of these conditions holds for the global atmosphere because there are millions of GHG emitters and millions of asset owners spread across multiple political jurisdictions.

Who adapts and how they adapt depends on how atmospheric rents are allocated and how they change—that is, who captures the value of using the atmosphere as a GHG dump and who adapts in what ways to the consequences. Do owners of fossil fuel or generation facilities capture rents from using the atmosphere as a medium for the disposal of carbon, or do beachfront property owners capture the value of stable sea levels? It is not surprising that owners of beachfront property would rather continue receiving their rents from the beach, with waves lapping at their feet, and that coal-burning power plant owners would rather continue receiving rents from disposing of GHG in the atmosphere. To date, however, neither party has attained a political resolution to the question of who gets the rents. Without that resolution, the status quo seems to prevail, with the emitters capturing benefits of atmospheric carbon disposal and the owners of land and capital adversely affected by climate change suffering reductions in asset values.

By focusing on market prices of land and capital that reflect the status quo, we begin to see how these prices induce market adaptation to climate change. Human beings are continually responding to changing environmental conditions (for example, rising sea levels or storm surges) and resource prices that reflect those conditions (such as falling recreational property values in the face of wildfires). As a result, the prospects of catastrophic climate change are reduced by human adaptation through market processes, entrepreneurial activities, and institutional evolution.

The extent to which human beings react to climate change depends critically on the quantity and quality of information they have about the consequences. As Nobel laureate Friedrich Hayek noted in 1945, prices provide condensed information about the costs of production and the value of goods and services produced, appropriately discounted by uncertainty about technology and resource scarcity. How good that information is depends crucially on how complete markets are. If there are missing markets—meaning some inputs or outputs are not priced—the incentive to adapt is truncated. Tied to missing markets are the authority and the wherewithal (wealth) to take action.

Given the uncertainty of climate’s effect on property values—including possibly warmer temperatures, lower temperatures, more precipitation, less precipitation, more humidity, or less humidity—it is difficult to measure the climate effects with much precision. Even having measures of the averages is of little help without knowing the variance, and the latter requires longer time trends. And knowing the means and variance of climate variables is useful only if those data can be translated into consequences. Will crop yields be lower or higher? Will new plant varieties mitigate the consequences? Will building techniques reduce the effects of climate change?

Find the Missing Markets

Information on risks and consequences is crucial if missing markets are to be filled. More and better information on how climate change affects assets will provide a foundation for the development of many products and services to facilitate adaptation. However, raw information related to climate change, including data related to natural phenomena, including sea level, precipitation, and temperature, is often not enough by itself to drive adaptation. Understanding the effects of climate change requires an understanding of how these natural systems interact with engineered and economic systems. Simply presenting hydropower producers, for example, with data on reduced stream flows will not inform them about the revenue losses they will experience from reduced electricity sales (the economic system) or how to optimize production (the engineered system). Only by accounting for all three systems—natural, engineered, and economic—will the information be available to allow asset owners, financial institutions, and risk arbitrageurs to price resources, products, and services that will incentivize people to adapt.

In short, climate change is about dealing with new averages and greater variation in climate measures and about providing the information and improved institutions that will incentivize adaptive measures. Doing so, however, also requires an understanding of the complex and interacting systems that determine climate change effects, all of which are time and place specific.

When humans experience changes in their environment and are not prevented from adapting to the changes, they have shown a remarkable ability to do so. There are many ways climate change can and will be incorporated into market prices and individual decisions, and there is some evidence that people are already adapting. How soon and how far adaptation progresses will depend importantly on implementing policies that produce clear price signals regarding the effect of climate change on asset prices. Development of the missing markets will lead to more adaptation, unless the prices are distorted by political intervention.

overlay image