Transition failure: neoclassical thinking falls short for good climate policy

Market failure. Government failure. Any student schooled in neoclassical economics knows these terms. Due to some form of market failure – for example irrational consumers, incomplete competition between producers, asymmetric information, external effects, or entry barriers – free market forces lead to sub-optimal welfare outcomes. This can be a legitimate reason for government intervention.

The policy economist as plumber: repair that market.

At the same time, a repairing government is always fallible. It does not possess complete market information, its officials have limited rationality, the costs of its intervention can be high and the electoral motives of politicians become decisive in policy decisions. These disadvantages of government intervention must outweigh the advantages. Market failure and government failure are useful neoclassical tools for considering good government policy.

However, if all production and consumption processes have to change radically to protect the earth and humanity, these two handles turn out to be not very useful. It takes more than repairs. Transformations are necessary. Old polluting markets must disappear and new clean markets emerge. Under what conditions does a successful transfer occur?

The new challenge for an economist is to prevent transition failures – the faltering, slowing down or stalling of the necessary radical changes in market processes. Then the government’s role changes to that of entrepreneur and director, officials from the Ministry of Economic Affairs and Climate Policy write. I think it helps to see an economy as a closed system and how system innovation comes about.

Firstly, most market parties only switch to a new system – the clean method of production and consumption – once the fundamental uncertainty has disappeared. Companies that are afraid of not reaping the benefits of innovative investments (themselves) will do little – or at least less than is possible.

A government can limit this uncertainty through co-financing and long-term public-private contracts. In this way, the direct financial risk is reduced in the short term and, in the long term, it is in line with the payback period of private investments in innovative machines and infrastructure. This requires a turnaround in government action, but fits in with modern discussions about green industrial politics.

Secondly, strong central management must be carried out in setting up an infrastructure that can absorb clean energy after generation and deliver it to the market. For a massive system switch, all innovative generators must be able to deliver carefree and all households and companies must be able to consume.

Transition failure will always occur if the new energy infrastructure has too little capacity, is of too low quality, or is too fragmented a network. This is happening now that the Dutch power grid is coming to a standstill. A lesson from the successful natural gas transition in the 1960s is that the central government must choose and invest heavily in infrastructure for years.

Thirdly, access to the old system must become increasingly difficult and, in the long run, simply closed. Ultimately, a transition is fully successful if all players play in the new system. It starts with a big commitment to reach a tipping point, then the government has to push the new equilibrium point as far forward as possible. An lock in of parties in polluting production and consumption processes can remain rational from their own point of view. By imposing legally clean standards for future production, lock ineffects appearance.

The fact that neoclassical economic theory fails to make the best climate policy was known and is becoming increasingly clear. Economists are working hard to supplement the handles market failure and government failure (and system failure) with transition failure. However, the assessment framework for exactly when and how transition failure occurs, and above all which instruments are effective and efficient to repair it, has not yet been fully developed.

The economist has a clean task ahead of him.

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