The Role of Market-Based Instruments in Alleviating Climate Change

Abstract

This paper evaluates how climate change mitigation can be achieved through market-based instruments. Guided by environmental economic theory, a partial equilibrium model is formed that attempts to determine an optimal policy rate. This paper finds that the optimal policy rate can be achieved by equating the policy rate to the marginal environmental damage function. Extending the model to multiple countries indicates that an optimal policy will never be achieved if nations set policy independently. Only when they cooperate can an optimal policy rate be achieved. Reviewing some of the current market-based initiatives indicates such policy has observed varying degrees of success. The paper finds that the failure of market participants to internalize environmental externalities suggests there is a large scope for policy, and that governments together implementing market-based policies can play a significant role in efficiently achieving climate change mitigation.