A diesel lorry drives past a school. The owner paid for the lorry, the fuel and the driver. Nobody paid for the exhaust that the children breathe, or for the extra tonne of carbon dioxide that will stay in the air for centuries. Those costs are real, they are large, and they have landed on people who were not in the deal.
That gap between what a decision costs the decision-maker and what it costs everyone is the starting point of environmental economics. The second half of the subject is harder: once you see the gap, what do you do? Charge for the damage, let people negotiate, cap the total, ban the worst practice, or build a treaty? Reasonable people, and reasonable economists, pick differently. A graduate keeps both the tools and the arguments. This piece is about how the world works, not a recommendation for any country's policy.
- Who takes it
- Environmental science and environmental studies students, usually in the final year; economics students take it as an elective (MIT teaches it as 14.42, Environmental Policy and Economics). Programmes in public policy, development and energy teach versions of it too.
- What it is for
- Judging environmental policies by their costs and benefits, and understanding why pricing, trading, regulation and treaties each work in some places and fail in others.
- Comes after
- Microeconomics (34/42), where externalities first appear, and Public Economics (34/49), on taxes, public goods and government failure.
- Leads to
- It sits beside Climate Science (36/14), Energy Systems & Transitions (36/16) and Pollution & Environmental Health (36/17), and feeds How problems become policies, Public Policy (35/16).
- What this piece gives you
- You will not be able to design a carbon market. You will see why a tax and a cap are cousins, why the discount rate can matter more than the science, and why "who pays?" is a separate question from "what is efficient?". It goes further than the externality section of Microeconomics (34/42), which is the easier first read. Figures here are illustrative unless dated.
Externalities: the cost nobody was billed
Arthur Cecil Pigou, in The Economics of Welfare (1920), described the gap with a smoking factory chimney and the neighbours' laundry. His idea is still the core: if each extra tonne of pollution does damage that the polluter does not pay, charge them the damage and they will pollute to the point where cutting one more tonne costs more than the harm it prevents. Not zero pollution, which would be absurdly expensive, but the right amount.
The picture has two lines. Marginal damage rises with emissions: the first tonnes do little harm, later ones more. Marginal abatement cost falls as emissions rise: the cheap cuts come first and the last 5% costs the most. They cross at the efficient level of pollution, and the height of the crossing is the Pigouvian tax.
An invented economy that would emit 100 million tonnes a year if left alone. Damage per tonne = slope × emissions; cost of the next cut = slope × (100 − emissions). Money in arbitrary units.
Without JavaScript: with both slopes equal to 1 the efficient level is 50 million tonnes, the tax is 50 per tonne, and the policy is worth 2,500 units a year over doing nothing.
Steeper damage or cheaper cutting both lower the efficient quantity. And the efficient level is almost never zero, which many students find uncomfortable and critics attack. Defenders answer that the same arithmetic tells you to cut hard when damage is high.
Coase: when people can simply bargain
In 1960 Ronald Coase asked what happens if there is no tax and the two sides can talk. His example came from English law: in Sturges v Bridgman (1879) a confectioner's noisy machinery disturbed a doctor next door. Coase noticed that whoever the court sides with, if the parties can bargain cheaply, the outcome that is worth most gets chosen. If the confectioner's business is worth more than the doctor's quiet, the doctor sells the right to make noise; if not, the confectioner pays to stop. The law decides who pays, not which outcome happens.
The catch is the word "cheaply". Bargaining costs money and effort: finding the other party, agreeing the facts, enforcing the deal. With two neighbours that is small. With a river, a city's air or the atmosphere, the number of parties is huge and the cost of striking a deal swamps the gain. Pigou's tax and Coase's bargain answer the same gap in different settings.
Invented numbers. The best outcome is for the factory to run only if its gain beats the damage. A deal is struck only if its gain is bigger than the cost of making it.
Without JavaScript: with a gain of 60, damage of 80 and a deal cost of 5, the factory stops whichever side holds the right; the laundry pays if the factory holds it. If the deal cost is 30, the factory holding the right keeps polluting even though that is the worse outcome.
Price or quantity: carbon taxes versus cap-and-trade
For carbon, the two famous instruments are cousins. A carbon tax fixes the price and lets the quantity of emissions follow. A cap-and-trade system, or emissions trading system (ETS), fixes the quantity, issues that many permits, lets firms trade them and lets the price follow. In both, a firm with cheap cuts cuts more and a firm with dear cuts pays. That is the big gain over telling every firm to cut 10%: the same total reduction at lower total cost, because the cuts happen where they are cheapest.
Three invented firms whose cost of cutting the next unit rises at 1, 2 and 4 per unit already cut. Every number is computed from those slopes.
Without JavaScript: to cut 30 units, a uniform rule (10 each) costs 350 while a price or permit market costs about 257, around 27% less. If cutting turns out 50% dearer, a cap keeps the cut at 30 and the permit price rises by half; a tax stays put and the cut falls to 20.
The second half of the demo is Martin Weitzman's 1974 point (Prices vs. Quantities): when you are unsure of costs, a tax gives price certainty and quantity uncertainty, a cap the reverse. Which matters more depends on the shape of the damage. If damage rises sharply past a threshold, certainty about quantity is worth a lot, which favours a cap. If damage is spread evenly over decades, as it is for carbon accumulating in the air, an error in any one year's quantity matters little and price certainty has the edge.
| Instrument | Type | What is known (dated) |
|---|---|---|
| EU ETS | Cap-and-trade, since 2005 | About €82 per tonne on 5 October 2026 (S&P Global). Fell from about €30 in April 2006 to €0.10 in September 2007 when too many permits were issued; under €3 in 2013; above €100 in 2023. |
| Sweden | Carbon tax, since 1991 | Among the longest-running and highest carbon taxes in the world. |
| British Columbia | Carbon tax, since 2008 | Returned revenue through tax cuts and credits; studies found modest emission cuts. |
| Canada (federal) | Consumer fuel charge | Ended in spring 2025 by the new government; the carbon price on large industry continues. |
| China | National ETS, since 2021 | Began with the power sector, set against output rather than a fixed total cap, and has been widened to more industries. |
| World | All instruments | World Bank (May 2026): 87 carbon pricing instruments, just over 29% of global emissions covered, more than $107 billion raised in 2025, average price near $21 per tonne. |
The sides, in their own terms. Tax advocates (many economists; in 2019 thousands of US economists signed a statement backing a carbon tax with dividends) say it is simple, hard to game, gives firms a predictable price and raises revenue that can cut other taxes or be returned. Cap advocates say the point of climate policy is a quantity, the carbon budget, so fix it; trading systems have also proved easier to pass politically because permits can be handed out. Regulation and subsidy advocates point out that some barriers are not about price (landlords who do not pay the heating bill, grids that take a decade to build, research that benefits rivals), so standards and public investment do work a price alone cannot. Sceptics of pricing note that it can be reversed overnight (France's fuel-tax rise in 2018 set off the gilets jaunes protests and was dropped) and that markets can leave pollution hotspots. The evidence shows each working somewhere; the field has not declared one the winner.
The social cost of carbon: a price in search of a number
To set a Pigouvian tax, or to decide whether a new rule is worth its cost, you need the damage from one more tonne of CO₂: the social cost of carbon (SCC). It is built in steps. Emit a tonne; estimate the extra warming; estimate the damage to farms, health, coasts and labour that warming causes in every future year; convert those damages to money; add them up, with later years counted for less. Integrated assessment models such as Nordhaus's DICE do this arithmetic.
The answer swings hugely with the choices. The US government's interim estimate in 2021 was $51 per tonne (2020 dollars, 3% discount rate). In 2023 the Environmental Protection Agency published an update of $190 per tonne (2020 dollars, 2% discount rate, for emissions in 2020), reflecting newer science and a lower discount rate. In January 2025 an executive order disbanded the interagency group that produced the figures, and later that year the agency moved to overhaul the method. Other governments and researchers use their own numbers. Notice the range: a factor of four within a few years of one country's own work.
Critics come from two directions. Robert Pindyck argued in 2013 that the models' key inputs, such as climate sensitivity, the damage function and the chance of catastrophe, are so poorly known that the output gives a false sense of precision. Others, including Martin Weitzman, argued that the tail risks (low-probability, very bad outcomes) mean standard calculations understate the case for action. Defenders reply that policy needs some number, and a transparent range beats a default of zero.
Discounting: the Stern–Nordhaus argument
Carbon's damage arrives over a century or more, and that makes the discount rate the most powerful dial in the model. At 5% a year, $1,000 of damage in 100 years is worth about $8 today. At 1.4%, it is worth about $250. A thirty-fold difference from one assumption that is about ethics as much as finance.
The standard framework is the Ramsey rule: the rate is the pure rate of time preference ρ (do we value a future person's welfare less just because they are later?), plus the elasticity of marginal utility η (how much less an extra dollar matters to someone richer) times the growth rate g of consumption (the future will be richer). In symbols r = ρ + η·g.
In 2006 Nicholas Stern's review, written for the UK government, took ρ = 0.1% (only to allow for the small chance humanity does not exist) and η = 1, giving an average discount rate near 1.4% and an estimate that unchecked warming would cost at least 5% of global GDP every year, perhaps 20% or more. William Nordhaus (Nobel 2018) replied that these choices contradict how people actually save and invest: policy should use rates close to what markets pay, and doing so supports a gentler, slower rise in the carbon price. Stern's side answers that choosing a discount rate is an ethical decision, and that treating future people as worth less is hard to defend. Weitzman called Stern's conclusion "right for the wrong reasons", arguing the real case rests on tail risks. A survey of about 200 experts by Drupp, Freeman, Groom and Nesje (2018) found a median recommended rate of 2%, and most thought rates from 1% to 3% acceptable.
The presets are illustrations of each camp's kind of choice, not their exact parameters, which change from model to model. The per-tonne damages are an invented stream (50 cents in year 1, rising 4 cents a year for 200 years), not a real social cost of carbon.
Without JavaScript: at 1.4%, $1,000 of damage in 100 years is worth about $250 today; at 2%, about $138; at 4.5%, about $12. An invented damage stream (50 cents in year 1, rising 4 cents a year, for 200 years) sums to about $192 a tonne at 1.4% and about $32 at 4.5%.
Paris: a treaty with no police
Climate is the extreme case of Coase's problem: nearly 200 countries, no world government, and a benefit (a stable climate) that everyone shares whether or not they pay. Economists call that a free-rider problem: each country does better if others cut and it does not. The Montreal Protocol (1987) beat a similar problem for ozone-depleting gases, helped by cheap substitutes and trade penalties for non-members. Carbon has no equally cheap substitute for everything.
Each country's cut costs it 10 units. The benefit of its cut is shared equally among all countries. An invented, simplified game: the real payoffs differ by country and over time.
Without JavaScript: with 10 countries, a global benefit of 30 per cut, a private cost of 10 and no home benefit, each country gains only 3 from its own cut, so none cuts, though all cutting would give each 20. A home benefit above 7 makes cutting worthwhile alone.
The Paris Agreement was adopted on 12 December 2015 and entered into force on 4 November 2016; 194 parties as of January 2026. Its design takes the game seriously. Instead of the top-down targets of the 1997 Kyoto Protocol, which bound mainly rich countries, each country submits its own nationally determined contribution (NDC), updated every five years and expected to progress. The aim is to hold warming "well below 2 °C" and pursue 1.5 °C. Nothing forces a country to meet its pledge. The enforcement is transparency, a global stocktake (the first reported in 2023) and reputation, plus the hope that cheap clean energy turns the "home benefit" slider in your favour. Article 6 allows countries to trade emission reductions, with rules settled at the Glasgow conference in 2021 to prevent double counting.
Money is the live dispute. Under the 1992 framework convention, richer countries accept "common but differentiated responsibilities" because they emitted most of the carbon already in the air. At COP29 in Baku (2024), developed countries agreed to lead on at least $300 billion a year of climate finance by 2035; developing countries had asked for much more. The United States gave notice of withdrawal from Paris in January 2025, effective 27 January 2026, having left once before (2017 notice, effective 2020) and rejoined in 2021. The EU's carbon border adjustment (CBAM), which takes effect from 2026, is called a trade barrier by some exporters and a fairness measure by its backers.
Environmental justice: who pays and who breathes it
"Efficient" does not mean "fair", and environmental harms are rarely spread evenly. In 1982, residents of Warren County, North Carolina, a poor county with a large Black population, protested a landfill for soil contaminated with PCBs; more than 500 people were arrested in six weeks. A 1987 report by the United Church of Christ found that race was the strongest predictor of where hazardous-waste sites stood in the US. The 1991 People of Color Environmental Leadership Summit adopted 17 principles of environmental justice. The movement is worldwide: in Nigeria's Ogoniland, the writer Ken Saro-Wiwa campaigned against oil pollution and was executed in 1995.
Economists give two partly separate analyses. One is exposure: poorer people often live nearer to roads, plants and dumps because land is cheaper there, and Coase would say the poor sell their quiet at a low price because they have fewer alternatives; critics note that a bargain between unequal parties is not a free one. The second is the incidence of the policy itself. A carbon price falls hardest, as a share of income, on households that spend the most on fuel and heating, which is why revenue use matters. A cap-and-trade system has a local twist: a national cap does not stop emissions of harmful local pollutants rising at a particular plant. A 2018 study of California's programme (Cushing and colleagues) found that in 2013–15, more than half of regulated facilities reported higher in-state greenhouse gas emissions than before, and that increases were more common near neighbourhoods with more residents of colour and more poverty; the authors called the results preliminary.
Ten invented income groups with invented fuel and goods spending, built so the burden is a bigger share of income at the bottom. Real results vary by country, climate and how the money is spent. The bars show the net effect as a percentage of income.
Without JavaScript: at $50 per tonne with no rebate, the poorest tenth loses about 3.2% of income and the richest tenth about 1.0%. If all the revenue is returned equally, the poorest tenth gains about 4.0% net and the richest tenth loses about 0.5%.
Climate justice adds a global version: the countries that emitted least, many in Africa, suffer much of the damage, and a fund for "loss and damage" was agreed at the 2022 conference in Sharm el-Sheikh. What counts as fair is a question of values; economics supplies the costs and the tools. A tax on carbon can be made progressive; a ban on a polluting plant can protect a neighbourhood a price would not; neither is automatic.
What a graduate just sees
- An environmental problem is a cost landing on someone who was not in the decision.
- The efficient amount of pollution is where the next cut costs as much as the harm it prevents, almost never zero.
- A tax and a cap-and-trade system are cousins: one fixes the price, the other the quantity.
- Letting the cheap cuts happen first is where the savings come from.
- Bargaining fixes the problem only when the parties are few and the deal is cheap.
- The discount rate is an ethical choice that can swing the answer thirty-fold.
- A free-rider problem will not solve itself; treaties work through self-interest, transparency and, sometimes, trade penalties.
- "Who pays?" and "what is efficient?" are different questions; the answer to the first can be built into the policy.
Where it shows up next
- Climate Science (36/14) and Energy Systems & Transitions (36/16): the carbon budget and the cost curves that make a price work.
- Pollution & Environmental Health (36/17): the damage side of the graph, from air pollution deaths to lead in water.
- Public Policy (35/16): how a carbon price or a ban survives a legislature, and why some are dropped.
- In the world: the permit price in the news, a congestion charge, a plastic-bag fee, an offset on a flight, a company's internal carbon price, and every debate about who bears the cost of the energy transition.
If you want to go deeper
- 📘 Textbook. Tom Tietenberg and Lynne Lewis, Environmental and Natural Resource Economics (Routledge, many editions), or Charles Kolstad, Environmental Economics (Oxford University Press). Both are standard undergraduate texts; check for a recent edition.
- 📘 Gentler. William Nordhaus, The Climate Casino (Yale University Press, 2013), or Gernot Wagner and Martin Weitzman, Climate Shock (Princeton University Press, 2015); they disagree usefully on the risks.
- 🌐 Free reports. The World Bank's State and Trends of Carbon Pricing (yearly, free) and the Stern Review (2006, free online).
- 🌐 Free course. MIT OpenCourseWare 14.42 Environmental Policy and Economics (Spring 2011).
Environmental economics starts from a missing bill. Prices, caps, bargains, standards and treaties are different ways of putting the bill back, and each works in the setting it fits. The numbers that decide the most, the social cost of carbon and the discount rate, rest on ethical choices that no measurement can settle. Efficiency says what a policy costs and who gains; it does not say who deserves to pay.
Try this: pick one thing you did today that has an external cost (a drive, a flight, a plastic wrapper), and write down who bears that cost and what price, tax or rule would put it on your bill.
Sources. Pigou, The Economics of Welfare (1920); Coase, "The Problem of Social Cost," Journal of Law and Economics 1960, with Sturges v Bridgman (1879); Weitzman, "Prices vs. Quantities," Review of Economic Studies 1974. EU ETS history and the 2013 low: Wikipedia, "European Union Emissions Trading System" (read 2 November 2026); EU ETS price of about €82 on 5 October 2026: S&P Global Commodity Insights report of that date; the reading of "above €100 in 2023" is from the same Wikipedia page. World Bank, State and Trends of Carbon Pricing 2026 (press release of 19 May 2026). Canada: Wikipedia, "Carbon tax," on the March 2025 declaration ending the consumer charge. Social cost of carbon: Resources for the Future primer on the EPA's 2023 estimates ($190 per tonne, 2020 dollars, 2% discount rate); Executive Order 14154 (January 2025); Wikipedia, "Social cost of carbon"; Pindyck, "Climate Change Policy: What Do the Models Tell Us?" Journal of Economic Literature 2013; Weitzman, "Fat-Tailed Uncertainty in the Economics of Catastrophic Climate Change" (2011) and "Fat Tails and the Social Cost of Carbon" (2014). Stern Review (30 October 2006); Nordhaus, "A Review of the Stern Review" (2007); Drupp, Freeman, Groom and Nesje, American Economic Journal: Economic Policy 2018. Paris Agreement: UNFCCC text and Wikipedia, "Paris Agreement" (194 parties as of January 2026; US withdrawal effective 27 January 2026). COP29 finance goal and COP27 loss-and-damage fund: UNFCCC decisions. Environmental justice: Wikipedia, "Environmental justice"; United Church of Christ, Toxic Wastes and Race in the United States (1987); Cushing et al., PLOS Medicine 2018 (data 2011–2015).
- 📘 Tietenberg and Lewis, Environmental and Natural Resource Economics
- 🌐 MIT OpenCourseWare 14.42
- 🌐 World Bank Carbon Pricing Dashboard