Chris Pinney
Few would disagree that capitalism is the most powerful economic system humanity has developed. Capitalist societies have experienced unprecedented economic and social progress, creating the highest standard of living the world has ever seen. It is the principles behind capitalism, such as individual rights, private property and free markets that generated the entrepreneurship, technological innovation and wealth that gave rise to the middle class in the seventeenth century. This in turn drove the political movements that overthrew monarchies and autocrats, leading to the development of the modern democratic state and the many freedoms its citizens now enjoy.
At the same time, it was the rise of nineteenth-century industrial capitalism and the impact on workers and income inequality that created a populist backlash against capitalism in the early twentieth century, giving rise to socialist movements and communism. As we enter the twenty-first century, it is a global capitalist economy that is once again seen as driving income inequality and disenfranchising workers in developed economies while exploiting those in emerging markets. As at the turn of the last century, we once again see a strong populist backlash against global capitalism and a growing political turmoil and uncertainty. In How Will Capitalism End? the economist Wolfgang Streeck notes that capitalism for the foreseeable future will hang in limbo, dead or about to die from an overdose of itself. Streeck envisages a ‘society devoid of reasonably coherent and minimally stable institutions and a period of uncertainty and insecurity’.[1]
Despite these sorts of gloomy predictions, there is good reason to believe that capitalism can be re-imagined to avoid a rerun of the early twentieth century. To do so will require a fundamental rethink of the failing social contract that successfully balanced the interests of markets with the broader interests of society for the last 60 years. We now need to re-examine the responsibilities of the private, public and civil society sectors in managing a global capitalist system. We should question what each must now do to ensure capitalism continues to play its vital role as an engine for economic and social progress. Finally, we must also examine the values and principles required to ensure that markets work effectively and fairly.
This chapter offers some thoughts on these themes from three perspectives. The first considers how the technological innovations driven by capitalism reshape society and its political and social institutions. The second considers the values, principles and assumptions that gave rise to capitalism and how they can inform the future. The third explores the unravelling social contract that has governed capitalism for the last 60 years and how it can be restructured to support twenty-first-century capitalism.
Over the last 500 years, capitalists in search of new ways to produce products more efficiently and profitably have been the driving force behind successive waves of technological innovations that transformed the economy from an agricultural to a mercantile one, from an industrial to a now globally integrated ‘post-industrial’ society. Each wave of innovation has dramatically lifted productivity, driving economic growth and increasing the returns to capital and to labour. While each advance has destroyed jobs in the previous economy, they have at the same time generated new jobs and income for workers as capitalists and their companies created new categories of products and services that raised the standard of living for all. For example, real per capita GDP in the USA grew nearly sevenfold during the twentieth century, and despite fluctuating levels of income inequality, standards of living improved for all economic groups, including the bottom 20 per cent of income earners. In 1900, fewer than one in five homes in the USA had running water, flush toilets, a vacuum cleaner or gas or electric heat. In 1950, fewer than 20 per cent of homes had air conditioning, a dishwasher or a microwave oven. Today, 80–100 per cent of American homes have these modern conveniences. As for standards of health:
Average life expectancy in the U.S. has grown by more than 50 per cent since 1900. Infant mortality declined from 1 in 10 back then to 1 in 150 today. Children under 15 are at least 10 times less likely to die, as one in four did during the 19th century, with their death rate reduced by 95 per cent.[2]
As we enter the twenty-first century, capitalism is driving the next wave of technological innovation, namely machine intelligence. This new wave of technology, coupled with the impact of the globalisation of the world economy, has profound implications for our economic model and society. On the one hand, this innovation has the potential to continue to improve quality of life and dramatically reduce the need for human labour in dangerous industrial jobs or boring and repetitive tasks in service industries. On the other hand, it raises fundamental questions about the future of work and the way income is distributed in society. This leads to far-reaching implications for our economic model and the political and social institutions that govern capitalism.
According to David Autor, an MIT economist who has studied the loss of middle-class jobs to technology, ‘it will be harder and harder to find things that people have a comparative advantage in versus machines’, a point reinforced in a blog called Welcome, Robot Overlords: Please Don’t Fire Us?[3] Indeed, half of the 7.5 million jobs lost during the ‘Great Recession’ were in industries that pay middle-class wages, which are defined as ranging from $38,000 to $68,000. Since the official end of the recession in June 2009, only about 70,000 – or 2 per cent – of the 3.5 million jobs gained have been in such mid-paying industries. At the same time, nearly 70 per cent of the restored jobs have been in low-paying industries. In the 17 European countries that use the euro as their currency, the numbers are even worse. Almost 4.3 million low-paying jobs have been gained since mid-2009, but the loss of mid-paying jobs has never stopped. Indeed, a total of 7.6 million such jobs are said to have disappeared between January 2008 and June 2013.
As more of the wealth generated by globalisation and machine intelligence goes to capital and large firms, so their influence on political systems increases. As the MIT economist Daron Acemoglu and James Robinson, a Harvard political scientist point out, although free markets tend to create widespread prosperity, they also have the potential to create concentrations of wealth and political power that are often used to suppress competition and entrench rent-seeking elites. This in turn further slows economic growth and income to labour. This skewed distribution of wealth has contributed to rising inequality, the decline of the middle class and the growth of a working poor ‘underclass’ whose inadequate education and low skills leave them with poor prospects for full participation in the economy as wage earners or consumers.
Some economists, including Thomas Piketty in his bestselling book Capital in the Twenty-First Century,[4] have argued that the period of high economic growth and moderate levels of income inequality in the developed economies during the last century are in fact an anomaly compared to historical norms. Piketty attributes the low levels of income inequality during this period to social upheavals, economic depressions and wars that shook up the social order, destroyed wealth and returns to capital and gave rise to pressures for higher taxation on both high-income earners and inherited wealth. But Piketty suggests that during the last 50 years, a period of relative stability and rising incomes in the developed economies, these pressures have moderated, contributing to a steady decline in tax rates on the wealthy. Therefore he postulates that we may now be returning to a norm in which the private return to capital exceeds the rate of national income and output. This condition, in the absence of high levels of taxation, is expected to accelerate the flow of income to those with capital and away from labour, leading to ever greater inequality and potential political unrest.
Piketty’s analysis is clearly reinforced by recent data. Until a decade ago, the share of total US national income going to workers was relatively stable at around 70 per cent. The share going to capital – mainly corporate profits and returns on financial investments – made up the other 30 per cent. Slowly but steadily, however, labour’s share of total national income in the USA and other OECD countries has been falling, while the share going to capital owners has gone up. During the period 2010–12, the top 1 per cent are said to have received 95 per cent of the growth in income and, according to a 2013 Credit Suisse report, now own 41 per cent of all global assets.
It is not surprising given these trends that capitalism finds itself in crisis. Once again, those who feel behind or maltreated by global capitalism are rallying behind populist and socialist movements seeking to challenge rising inequality and the power of capital over the economy and society. As in previous transitions, there is a heated debate about the values, principles and assumptions that underlie capitalism and the social contract that supports it.
Central to capitalism’s future success will be the need for a set of principles that can balance the self-interest of market participants with the broader interests of society. As we consider the road ahead, it will be useful to reflect on the values that have driven capitalism’s success in the past and how they can be drawn on to shape the path forward.
The foundations of capitalism were laid at a time when Catholicism still predominated and daily work itself was considered profane and mundane. It was the early Protestants Martin Luther (1483–1546) and John Calvin (1509–64) whose writings first established the perspective that daily work and self-improvement was a legitimate way to be in service of God’s will and therefore encouraged. It was Calvin’s writings around asceticism – frugality, rational planning and delayed gratification in service of God – that formed the backbone for the Protestant work ethic that in turn provided a strong underpinning for an emerging capitalist society.
Building from this foundation on the value of work, John Locke (1632–1704) championed free will and the right of individuals to own property, two principles that remain cornerstones of capitalist society today. His philosophy was founded on a belief in property rights, which are earned through work and can be transferred to other people only at the will of the owner. He believed that shareholders should receive profits because they have risked their property. Therefore it is the responsibility of the company’s workers to help the enterprise generate profits. Locke’s work on property rights and free enterprise is often seen as setting the groundwork and legal basis for the modern corporation.
Adam Smith (1723–90), following on Locke, was the champion of two additional principles that are still core to capitalism today. These are the principles that the best economic system for society is one that recognises individual self-interest, and that the means of production are best in private hands rather than the state’s. In his renowned Inquiry into the Nature and Causes of the Wealth of Nations (1776), Smith stated that society is best served when each person is allowed to pursue his own best interests and that the ‘invisible hand’, or the competition between individuals in the marketplace, would ensure benefit to all. Importantly, however, Smith viewed this competition played out within the confines of government regulation. He reasoned this would ensure that the self-interested behaviour of the individual would serve the common social good.
Also critical to both Locke and Smith’s reasoning was the assumption that the participants in the market were themselves moral beings who, acting in the spirit of the Protestant work ethic, adhered to the golden rule (see Tim Weinhold’s chapter below) and acted in the interests of themselves and their fellow man. This was further elaborated by Immanuel Kant (1724–1804). Under his ‘categorical imperative’, he held that people should act according to the maxims they would be willing to see become universal norms. People would adhere to the rules and keep promises, such as contracts, and follow the rules out of enlightened self-interest and therefore would never treat others simply as a means to an end.
Max Weber (1864–1920), in The Spirit of Capitalism, noted that the countries that adhered to the values espoused by Protestant theology had the highest rate of business and economic growth. Weber saw the emerging bureaucratic organisation of the industrial age with its high degree of specialisation of activities as the organisational form most capable of achieving commercial success and meeting the needs of a modern economy. He argued that this form of organisation was the most efficient and was technically superior to all other forms of administration. To him it was the most effective way of maximising efficiency and eliminating favouritism. The rise of the large, highly specialised and compartmentalised bureaucratic organisation, however, was to have a profound impact on society, and increasingly disconnected individuals from a view of work and capitalism being in the service of a higher purpose.
Weber later in his career became highly concerned about this. He noted that:
each man becomes a little cog in the machine and, aware of this, his one preoccupation is whether he can become a bigger cog. … The problem which besets us now is not how can this evolution be changed? That is impossible. The question is what will come of it.[5]
As capitalism developed in the twentieth century, Weber’s fears around the impact of the bureaucratic organisation were soon realised. While the power of large firms and the state grew in the industrial age, the influence of faith and the Protestant ethic diminished dramatically and was replaced by in an increasingly secular society focused on individualism, materialism and consumption. The values of respect for others and being of service to a higher social purpose that were an essential foundation for capitalism’s early success rapidly eroded. Business owners became narrowly focused on maximising profits in highly competitive markets. Workers became a commodity in fragmented specialised workplaces devoted to efficiency. The alienation and disregard for rights and needs of workers under this form of organisation gave rise to trade unions and in turn became the fodder for socialist movements that called for state control over the economy. This culminated in the communist revolution in Russia and the subsequent spread of communism through Eastern Europe and later China. In the Western developed capitalist economies that survived this tumultuous era, we saw the rise of the democratic welfare state with a popular mandate to ensure measures were in place to regulate the marketplace and that workers were fairly treated, including the right to form labour unions.
The rise of the social welfare state and the trade union movement brought balance back to the relationship between the interests of capital and society. It ensured that the benefits of a capitalist-driven economic growth were shared broadly with society. At the same time, this clear division of responsibility for social well-being between the public and private sectors allowed the private sector to continue focusing ever more narrowly on profits and wealth generation for their shareholders, leaving all responsibility for regulation of markets and care for society to government. This was most succinctly articulated in the late twentieth century by the economist Milton Friedman, who famously said:
there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.[6]
We now live in a global economy in which the ability of sovereign states to set the ‘rules of the game’ and sustain the social welfare of their citizens is in rapid decline. Built for the industrial age, the large bureaucratic institutions of most governments have little capacity to keep up with the pace of change and the needs of their citizens. As governments prove increasingly unable to serve the public interest, we see public confidence in them and their leaders falling to unprecedented lows. At the same time, companies and markets have flourished. Stock market valuations continually reach new highs. Large businesses now often have unprecedented power and influence on our political system and society. Indeed, if they were compared to the size of national economies, they would account for over half of the top 150 such entities.
It is not surprising in this environment that society is now demanding that capitalists and their companies take much greater direct responsibility for their impact and role in society. This lies not only in taking more responsibility for their environmental and social impacts but also in playing an active leadership role in helping address social challenges, from global warming to world poverty. As noted by Richard Edelman, the author behind the annual Edelman Trust Barometer, heads of large global firms must now understand that they are part of global governance and must see themselves as statesmen as well as business leaders.
This is a new paradigm for companies and their leaders. Corporate leaders must now consider the role and purpose of their firms in society in ways that go well beyond the Friedman doctrine. It requires them to think holistically about all the stakeholders their firm affects and manage their relationship with them. Operating legally is now simply one component of earning the licence to operate; the rest must be earned from the stakeholders they impact, including their workforce and customers.
At a personal level, this shift requires the leaders of large firms to rethink their role as leaders not simply of businesses but of organisations with a profound impact on society. Their challenge internally is to drive and align incentive systems around a purpose-driven culture that is about more than financial performance and the next bonus cheque.
There are signs that this reflection by business leaders on capitalism’s purpose and their role as leaders is beginning to happen. In the USA there are forums such as Conscious Capitalism that focus corporate members from mid- and small-sized firms around an agenda of higher purpose, stakeholder engagement and conscious leadership and culture. Catering to a similar audience, the B Corporation movement provides a framework for certification for businesses with explicit social-purpose statements in their mission.
At the large enterprise level there are global initiatives focused on business leadership on a wide variety of systemic issues. One example is the B Team, a not-for-profit initiative formed by a global group of leaders to catalyse a better way of doing business for the well-being of people and the planet. This organisation is led by executives from Global 500 firms including Richard Branson and Paul Polman. Similarly, the World Business Council on Sustainable Development (WBCSD) is a global, CEO-led organisation of over 200 businesses and partners working to accelerate the transition to a sustainable world. This council has played a major role in mobilising business behind COP21 and other initiatives to address climate change. In 2016 the World Economic Forum, with the support of business leaders, launched the Global Commission on Business and Sustainable Development to decode the newly launched UN Sustainable Development Goals (SDGs) and show why it makes sense for business to engage in sustainable development at a far more strategic level.
Turning to finance, the Focusing Capital on the Long Term initiative led by McKinsey and major financial and corporate leaders is committed to developing practical approaches that encourage long-term behaviours in business and investment decision-making. At the national and local level, we are also seeing growing engagement by business leaders. A good example is Business in the Community, a UK charity with more than 800 corporate members and 30 years’ experience tackling a wide range of issues that are essential to creating a fairer society and a more sustainable future. These are but a few examples of business-led initiatives working to help CEOs and their companies understand their changing role in society and expand their positive impact.
Another important driver pushing CEOs and their companies to consider the broader social impact and purpose of their firms is the competition for talent and the expectation of customers. There is a growing realisation by corporate leaders that having a clear sense of social purpose is increasingly important to attract and retain motivated employees from the millennial generation. A recent Babson College study found that companies with a strong sustainability commitment see increases in employees’ productivity by as much as 13 per cent, reductions in turnover by as much as 50 per cent, and workers willing to take a pay cut of up to 5 per cent to work there.[7] The corporate purpose conversation is complemented by the spirituality and mindfulness in the workplace movements. A study by a large multinational firm in 2013 showed that employees working in environments that support their right to be open about their religious beliefs feel safer, have better working relationships with colleagues and are more likely to be engaged in their work.[8]
Turning to consumer expectations, a 2015 Nielsen study showed that 66 per cent of global respondents said they were willing to pay more for sustainable goods, up from 55 per cent in 2014 (and 50 per cent in 2013). At the same time, there is a small but rapidly growing movement by investors in putting their money behind their beliefs. According to the US SIF Foundation’s 2016 report Sustainable and Responsible Investing Trends in the United States, as of year-end 2015, more than one out of every five dollars under professional management in the USA – $8.72 trillion or more – was invested in socially responsible and sustainable investment funds.
These kinds of marketplace drivers, coupled with broader societal expectation for business leadership in society, provide a useful platform for considering how to restore the values of enlightened self-interest and reciprocity with society that are essential to restoring faith in capitalism in the twenty-first century.
Central to the success of capitalism to date has been a social contract that relied on the ability of governments to ensure that the competitive and profit-driven ambitions of the marketplace played out within the confines of government regulation. This, as Adam Smith reasoned, would ensure that the self-interested behaviour of the individual would serve the common social good.
During most of the latter part of the twentieth century this arrangement worked well. Governments regulated markets, placed constraints on the movement of capital, set labour standards and the right of workers to organise unions, and imposed progressive taxation regimes to redistribute wealth. Labour unions operating within protected labour markets were in turn able to negotiate effectively for their share of income from the profits generated by capitalism. This ensured that the wealth generated by capitalism raised all boats and drove an increasingly consumer-based economy.
As we entered the twenty-first century, this social contract was fast unravelling in the developed nations due to an increasingly globally integrated economy driven by rapid advances in technology. Global economic integration began in the 1970s as new shipping and communications technologies gave the private sector unprecedented access to a global labour market and supply chain. Global labour market arbitrage enabled capital to escape the constraints of the high-cost developed-economy labour markets, reducing capital’s costs and increasing its profitability while diminishing the power of unions. For the first time in a century the developed economies saw financial gains from rising productivity no longer shared with their workforce. At the same time, the economic forces of globalisation created political pressure on governments to reduce tariffs and lower taxes on corporations and the wealthy to compete for capital investment and jobs in a global marketplace.
The net effect of globalisation and technological innovation over the last 50 years has been a dramatic change in the balance of power between capital, government and labour in favour of capital. While the power of government and labour has declined in relative terms, the power of civil society has increased dramatically. Today there are a host of activist NGOs, from Greenpeace to Human Rights Watch, that are now at the forefront of holding capitalism and the private sector accountable to the public interest. At the same time, it is organisations such as the Environmental Defense Fund and the Fair Factory Coalition that are working with companies to help them find practical ways to discharge their new responsibilities as corporate citizens.
Moving forward, we can expect a continuous decrease in the capability of governments to set viable rules for global capitalism and in providing services to citizens. Falling revenues, an ageing workforce and mounting entitlement spending will leave little room for governments to lead the innovations now needed. This will leave increasing responsibility for setting the rules to protect the public interest and for delivering public goods to the private sector and civil society. Successful twenty-first-century capitalism will require a much more collaborative and adaptive social contract where responsibility and accountability for setting the rules and ensuring provision of public goods and services are distributed across the public, private and civil society sectors. Central to this transition will be the need for governments to see their role not as the sole mandator of the ‘rules’ and primary deliverer of social services but rather as enabler and collaborator with the private and civil society sectors to ensure that rules are in place and services delivered.
The first decades of the twenty-first century have shown the beginnings of a move to this new social contract. Every major global firm is now issuing a corporate responsibility report of some kind and has dedicated staff working on corporate sustainability and social responsibility. Over the last 20 years, ‘rule setting’ for these firms has moved well beyond compliance with the law. It now includes embracing a wide variety of ‘soft law’ or voluntary codes and standards that have been actively negotiated with NGOs and other stakeholders, including governments. These range from standards on labour practices and human rights to consumer packaging to environmental practices. Governments have begun to appreciate that industry-level voluntary initiatives such as the Responsible Care programme of the American Chemistry Council, with some government oversight and monitoring, can make an important contribution to protecting the public interest. At the same time, governments are starting to understand that enabling adaptive problem-solving by the participants in a dispute can often be more effective than, or a useful supplement to, formal rules and regulations. The UN ‘Protect, Respect and Remedy’ Framework for Business and Human Rights, for example, sets out a set of principles for valuing human rights and a framework for dialogue designed to enable multisector solutions to human-rights challenges. The framework relies on voluntary corporate leadership recognising that respecting rights is not currently an obligation that international law generally imposes directly on companies. This kind of framework is a good example of adaptive problem-solving and multisector burden-sharing of the public interest that will be required as we go forward.
We will also need to see much more robust public–private partnerships to address systemic social and environmental challenges. A good example of emerging models for this can be seen in the active involvement of global firms in developing the COP21 framework to control global warming. The final COP21 agreement includes commitments from more than 5,000 companies that together represent over $38 trillion in revenue. Also in Paris, the Science Based Targets initiative announced that 114 companies – including Ikea, Coca-Cola, Walmart, Kellogg and Dell – voluntarily committed to set emissions reduction targets in line with what scientists say is necessary to keep global warming below the threshold of 2 °C.
From reducing poverty through the UN Sustainable Development Goals to improving education, there are now thousands of initiatives at the local and international levels in which business leaders are active participants trying to solve systemic social challenges with NGOs and governments. Scaling up these forms of collaborative governance and service delivery initiatives on a global scale is essential to build a twenty-first-century social contract. It is a contract in which the private sector must now take much greater direct responsibility for managing its impacts on society and partner with the public sector and government to address broader challenges. It is only through this kind of active sharing in responsibility for society by the private sector that we ensure capitalism can remain a key driver for economic and social progress.
The challenges facing capitalism today are many but there is good reason to believe that by drawing on the values that guided the founders of capitalism and by re-imagining the social contract, these challenges can be overcome. None of this will be easy or simple to achieve. It will require business leaders who understand that the business of business can no longer simply be maximising returns to shareholders. It will require government leaders who are willing to move beyond the twentieth-century command-and-control mindset of their industrial-age bureaucracies. It will require civil society leaders who are more than critics but are solutions-orientated.
As some of the most powerful actors in society, private-sector leadership will be particularly critical. It is also the private sector that has the most at stake in the current crisis in capitalism. It is only through their active participation and leadership that we can expect to achieve the kind of robust partnerships with government and civil society needed to address the complex challenges ahead. As we have seen, this kind of leadership is possible and the seeds of this transformation in the role of business in society are emerging. The challenge now is to make sure they develop fully into a new social contract that can ensure capitalism can continue to play its vital role in driving economic and social progress in the twenty-first century.
[1] Wolfgang Streeck, How Will Capitalism End? Essays on a Failing System, London: Verso, 2016.
[2] Stephen Moore and Julian Simon, It’s Getting Better All the Time: 100 Greatest Trends of the Last 100 Years, Washington, DC: Cato Institute, 2000.
[3] K. Drum, Welcome, Robot Overlords. Please Don’t Fire Us?, Mother Jones, 2013.
[4] Thomas Piketty, Capital in the Twenty-First Century, Cambridge, MA: Belknap Press of Harvard University, 2014.
[5] ‘Max Weber on Bureaucratization in 1909’, in J. P. Mayer, Max Weber Classic Monographs, Vol. 4: Max Weber and German Politics, London: Faber & Faber, 1944; repr. Routledge, 1998, pp. 126, 127.
[6] Milton Friedman, Capitalism and Freedom, 40th Anniversary Edition, Chicago, IL: University of Chicago Press, 2002, p. 133.
[7] S. Rochlin, R. Bliss, S. Jordan and C. Y. Kiser, Project ROI: Defining the Competitive and Financial Advantages of Corporate Responsibility and Sustainability, 2015, p. 3.
[8] Sirota Survey Intelligence report presented at the Society for Industrial and Organizational Psychology’s annual conference 2013.
Lord Griffiths of Fforestfach
I am a great admirer of Alasdair MacIntyre. He is one of the world’s greatest living philosophers, invariably provocative and controversial but never without interest or depth of thought. A few years ago he gave a lecture with the arresting title ‘The Irrelevance of Business Ethics’. He set out to argue that the financial crisis of 2008 was not the result of a lapse in ethics by bankers but that the very nature of dealing in financial markets was to offload risk on to a counterparty or client with no ethical consideration whatever, ‘the better the trader the more morally despicable’. The result is that trying to teach ethics to traders is like reading Aristotle to a dog.
From the evidence of opinion polls the very expression ‘business ethics’ is an oxymoron. Since the financial crisis, banks have been fined over $300 billion, Volkswagen has admitted cheating on emission tests on potentially 11 million cars, Mitsubishi has acknowledged that it intentionally misled regulators, shareholders of blue chip companies have revolted over executive pay and a House of Commons Select Committee has investigated the sale for £1 of BHS, subsequently put into administration with a huge pensions deficit. All these suggest that business ethics is for the general public a contradiction in terms.
Ethical behaviour by business is important for a number of reasons.
One is that the public expect business to be ethical. They expect business to be conducted in an honest, fair and transparent manner, which serves the greater good of society and not just the interests of management and shareholders. They expect the senior managers of business firms and the entrepreneurs who set up private companies to have a moral compass that respects the dignity of those who work in the organisation and those they serve as customers. They expect that businesses will have standards that do not seek to mislead or misinform customers regarding the true price and the quality of the products and services they provide.
The fact that the public hold such views is important because through their elected representatives who pass legislation in parliaments, it is ultimately the public who grant business a licence to operate. Without such a licence, for example, limited liability companies would not exist. That licence can be changed at the will of Parliament. What has become increasingly clear is that the public will not put up with unethical business. Without ethical business, regulation will increase – just look at what’s happened in banking following the financial crisis. Regulation is at best a blunt instrument in that it cannot easily be tailored to meet the needs of individual companies. Not only that but regulation is a form of taxation, and like most taxes it has a deadweight cost to society.
A second reason why ethics in business matters is that it underpins the legitimacy and attractiveness of a market economy. From the latter half of the eighteenth century and Adam Smith’s great work on the causes of growth in The Wealth of Nations,[2] a market economy that fosters enterprise and freedom and allows markets to work is by far the best driver of prosperity that we know, and not only that but a market economy entails a degree of economic freedom, which is a key element of political freedom. Business without ethics and values therefore undermines the appeal of a market economy and a free society.
A third reason why ethics in business matters is a personal observation. Working in a company with ethical business principles and a culture built around strong values is far more fulfilling than working in a company that turns a blind eye to ethical standards and in which the culture is based principally on success and money. I have sat on the boards of 15 companies in the private sector since working for the first 25 years of my career in the public sector. These companies were varied. Some were main boards with shares traded on the NYSE, NASDAQ or LSE; others were wholly owned subsidiary boards; some were large, others medium, some small in terms of size; two were joint ventures. The products and services covered were extensive: banking, broking, rail freight, care homes, music, cable communications, television, cleaning, killing bugs.
For me and, I suspect, for most of those who worked for the companies, the most distinguishing factor in terms of a company being ‘a great place to work’ was the respect shown to fellow employees, the pride the firm took in its products and services, the sense of community that existed in the organisation, management’s commitment to help people develop to their full potential and the fact that it served a greater purpose than just focusing on maximising the bottom line. It is because of these qualities that such a company is trusted by its customers and the community in which it operates. It is also the reason it is able to build up a culture of trust within the organisation so that management can be trusted to make the right decisions.
If businesses are to act ethically there are three questions business leaders must ask themselves.
First, Who are we? Or to put it differently, What do we stand for? What is our purpose?
This, I believe, is the most fundamental and difficult question for any business leader to ask. To explore the purpose of a business is to go beyond profit. Without profit – which is the financial return to those who provide equity capital – a business will not survive. However, asking about purpose raises broader issues than the bottom line. Does the company take pride in the product or service it provides? Is being part of the firm a source of human flourishing? How does the company contribute to the common good by what it does?
The reason it is difficult to ask these questions is that they in turn ask each of us to look inwards and ask ourselves a far more searching set of questions, such as Who am I? What am I doing with my life? What is the purpose of my existence? Most of us most of the time want to park such questions and get on with the day-to-day challenges of running the business. Far better and more productive to log on and check what the markets have been doing overnight. Then respond to emails. After that, a look at today’s calendar with slots filled in from early morning to late at night.
I served for 21 years on the Board of a US company, Herman Miller, which designed and manufactured office furniture. It was in the twentieth century a world leader in its field both in terms of design (it attracted great designers such as Eames, Noguchi, Nelson, Gehry, Stumpf) and environmental stewardship well before that became an important item on corporate agendas. The Chairman who invited me to join the board was Max de Pree. It was only many years later that I came across an essay written by Nicholas Wolterstorff, a distinguished Yale professor of philosophy, that I became aware of the importance of the purpose of a business. This is what he said:
About ten years ago now I served – quite amazingly – as a philosophical consultant to the Herman Miller Furniture Company in New Zeeland, Michigan. Max de Pree, the executive officer of the company, had invited an architect, a physician, a journalist, a furniture designer, a theologian, and me to an all-day session with him and about five of the top officers in his company. At the beginning of the day he posed ten questions that he wanted us to discuss, in whatever order we wished. He asked us not to concern ourselves with trying to say things that we thought would be useful to the company; he wanted the discussion to take whatever shape it wanted to take. I remember three of the questions. ‘What is the purpose of business?’ he asked. Some of his younger executives were saying that the purpose of business was to make money. He himself didn’t believe that; but he wanted to talk about it. Second, he wondered whether there was ‘a moral imperative’, as he called it, for companies to produce products of good design. And third, he wanted to discuss whether it was possible to preserve what he called ‘intimacy’ in a large company.
It became clear, in the course of the discussion, what de Pree himself regarded as the purpose of business. The purpose, as he saw it, was twofold: to produce products that serve a genuine need and are aesthetically good, and to provide meaningful work in pleasant surroundings for those employed in the company. He added that these purposes had for a long time shaped his operation of the company.
Now it seems to me that these two purposes are, or can be, an expression of charity – that is, both consist to promote the welfare of the other. As a matter of fact, it became clear in the course of the discussion that it was de Pree’s religious commitment – specifically, his Christian commitment – that had led him to embrace these goals. He saw his operation of the company as an exercise of charity – though he didn’t use the word. His own case, at least as he presented it, was a case of ‘transcendental faith’ shaping economic activity.
Was he prevaricating? Or deluded?[3]
Second is the question What are our values? Have they been set out explicitly? Are they so general as to be vacuous? Who in the firm owns the values?
It is easy to write down a set of values for a business. Indeed, nearly all large companies have similar sets of values: respect for the individual, honesty and integrity, social responsibility to the community, environmental stewardship and so on. Far more difficult is to assess their effectiveness. How do the values shape the way I work and the decisions I make? How do I behave differently because these values are set down and I am a member of that firm? What responsibilities do I now have because of these values? Do I treat colleagues differently? Do I treat clients differently?
I have found that the key to effective values in business is that they must be lived by the leadership of the company. The leadership must walk the talk. Without that the values are empty and the leaders guilty of hypocrisy – preaching one thing but practising another. The leaders of a business cannot rely on regulation. Leadership cannot outsource the values of a business to regulators.
One test is what the leaders of a business think their values really are. Would that be shared by the average employee? Would it also be the perspective of clients and suppliers?
I was reminded of this recently in an article in Forbes magazine by James Heskett, professor emeritus at Harvard Business School, on the subject of servant leadership, which is a term used more in the USA than in Europe. The concept of servant leadership places great emphasis on the role of a business leader serving employees. Heskett recalls an incident at a ServiceMaster board meeting at which I was present and remember distinctly when the Chairman and CEO, William Pollard, spilled a cup of coffee prior to the board meeting.
Instead of summoning someone to clean it up, he asked a colleague to get him a cleaning compound and a cloth, things easily found in a company that provided cleaning services. Whereupon he proceeded to get down on his hands and knees to clean the spill up himself. The remarkable thing was that board member and employees alike hardly noticed as he did it. It was as if it was expected in a company with self-proclaimed servant leadership.[4]
The third question is What is going on in our business?
As a non-executive director of a company whose board meets four or six times a year, one of the most frustrating challenges is obtaining sufficient information to really find out what is happening in the business. I believe it is very important that non-executives meet not only senior but middle management and even junior staff. Only once have I ever found senior management reluctant to allow non-execs to talk directly to management. Frequently the binding constraint is the time non-execs are able to devote to meeting employees. However, it is only then that they find out what is really happening in the business.
In small companies, finding out what is really going on in the business is not really a problem. In large multinationals, however, the issue is a major challenge. In the money-laundering activities carried on by certain banks the sheer size, organisational structure and large number of countries in which the bank operated have proved a major obstacle to effective control.
A number of steps are necessary in making values effective in business.
First, it is important to set out explicitly the purpose of the business. For this a one-time mission statement is typically far too general and vague and begs the question of what the purpose of a business really is when spelt out in practical terms.
Second, it is important to set out in some detail the ethics, values and business principles of the firm. The temptation is to frame these in general terms. Management must accept that the actions of today will be judged by the standards of tomorrow, which means being ahead of the curve.
Third, on the basis of its purpose and values, the company must build a culture with implications for all employees, affecting every aspect of the business: reporting, firing, promotion, human resources, selling, buying, accounting, auditing and so on.
Fourth, senior leadership must show through ‘the tone from the top’ that they live the values and are committed to ensuring that the same values permeate the middle and lower echelons, the ‘permafrost’ of the firm.
Fifth, the leadership must be able to continually appraise the effectiveness of its values, code of ethics, business principles on conduct. They must trust, but verify. This will include keeping a close eye on disciplinary matters and terminations, with regular surveys of staff and clients. Such information is important in compensation discussions and promotion recommendations.
Sixth, in all of this, non-executive directors have a key role to play in that on behalf of the shareholders and stakeholders, they are the guardians of the purpose, values and ethics of the company.
The challenge of implementing values in a business can be made easier or more difficult by certain factors, namely size, ownership and the extent of competition in the markets in which the firm operates.
The size of a business matters. Implementing values in a small firm is easier than in a large firm. In a small firm it is much easier for senior management to know what is going on. A large firm needs systems of control and trust in those responsible for them. It may also be easier in a firm delivering a single product or service rather than in a conglomerate in which there are different kinds of businesses with different business cultures, something that becomes even more challenging when the company has operations in different countries.
Different forms of ownership will face different challenges. A private firm and especially a family business may find it easier to develop an effective culture than a publicly traded company. A partnership may have built in checks and balances to maintain high standards. It can be that in larger companies any concept of intimacy has disappeared.
The competitiveness of the markets in which a firm operates is a further factor to be taken into account. Competition is beneficial. It drives down costs and will lead to lower prices for consumers. It allows new firms to enter the business. It encourages innovation. However, in a highly competitive market when margins are under pressure, hiring staff is difficult and expensive; if competitors begin to use questionable methods (‘tolerated practice’), ethical standards will be under pressure. This raises an important issue for public policy. What is the optimal degree of competition? Reducing barriers to entry and opening markets to foreign companies is beneficial, but is there a point at which competition becomes excessive and undermines ethical behaviour? Will the market itself be self-correcting? Should it be left to regulation? And if the market is left unregulated, at what social cost?
I believe that the subject of maintaining ethical standards in business, of creating business cultures in firms that make them ‘great places to work’ and of punishing wrongdoers for illegal activity, is fundamental to a market economy and a free society.
[1] This chapter formed the basis of a lecture given by Lord Griffiths of Fforestfach at an event organised jointly by the Centre for Character and Values at the Legatum Institute and Clifford Chance LLP and chaired by Christina Odone, Chair of the Centre (9 May 2016).
[2] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, London, 1776.
[3] Extract from Nicholas Wolterstorff, ‘Should the Work of Our Hands Have Standing in the Christian College?’, in Ronald A. Wells (ed.), Keeping Faith: Embracing the Tensions in Christian Higher Education, Grand Rapids, MI: Eerdmans, 1996, pp. 133–51.
[4] Professor James Heskett, ‘Why isn’t Servant Leadership more Prevalent?’, Forbes, 5 January 2013.
If these observations are accurate, NEDs face such potentially severe liabilities, and the mismatch of expectations is so great, that there will be problems in recruitment and retention as well as more serious issues. A role may have been undermined that serves business and society with high standards of corporate governance. High-quality candidates will be lost.
What could be done about this?
The importance of the educational task was noted several times above; that is, educating society – tuning its expectations – about the proper role of NEDs, and NEDs about the expectations of society. This process might cover:
Professional bodies, trade groups, think tanks, individual companies and directors themselves have a shared responsibility for this task.
As a society, how do we get NEDs to do the job we want them to do? How do we implement good practice? Directors perform an essential role and must be held to the highest standards of governance, but proportion, balance and perspective are essential, along with recognising the complexities and the tensions.
Business and indeed business organisations have an educational responsibility, not only to their own constituents but also to society and policymakers, about the role of business, boards and directors. Society too has a responsibility to make known the benefits as well as the responsibilities of business. There needs to be more open dialogue about: principles rather than rules; an acceptance of learning from mistakes; and a need for greater realism. Fairness is a two-way street – the framework must be fair to individuals, business and wider society. NEDs need to be aware of their duties and the expectations put on them. We need to create a new system to encourage high-quality, thinking people to become NEDs – and they need to know that the legal standard is clear and the enforcement system fair. There must be clarity over what liability comes with honest decisions made in good faith.
Recommendations arising from this discussion are as follows:
Non-executive directors should be reminded of their duties and responsibilities and given clarity as to society’s expectations. The answer is not further liabilities. Knee-jerk reactions to scandal are unhelpful – not all failures involve scandal and some, in the normal course of business, afford opportunity to learn lessons. We should clarify and celebrate. The NED is a bridge between business and society – ensuring proper corporate governance while playing a wider role in societal leadership. We need people of character and experience to discharge this role. With this clarity, we can say that the non-executive director is indeed worth saving.
[1] Financial Reporting Council, ‘UK Corporate Governance Code’, London: FRC, January 2024; see https://media.frc.org.uk/documents/UK_Corporate_Governance_Code_2024_kRCm5ss.pdf.
The public narrative around NEDs illustrates a real tension between a proper desire to hold directors to account and a lack of understanding of the nature and complexity of the NED role. Complaints about ‘cosy clubs’, ‘asleep at the wheel’ or ‘overpaid’ NEDs will often feature on front pages at times of crisis.
We might ask, therefore: What is the real point of a non-executive director? Do we need such a role and, if so, what are the reasonable expectations and standards against which we might measure performance and accountability? Reputation matters for qualified individuals, and if we fail properly to establish expectations and boundaries, fewer quality candidates will accept the role, particularly if rather than being overpaid, as per the popular narrative, the risk/reward ratio becomes a disincentive to accepting office.
There is also a clear distinction to be drawn between SMEs and large public companies, often with multiple subsidiaries and geographical locations. How much grasp of detail should be expected of NEDs? How much can NEDs reasonably rely on assurances from management or professional advisors? Are NEDs expected to know of every activity, or even error or fraud, in every small subsidiary in a complex corporate structure? Society must be clear if that is what is expected – and then not be surprised if few wish to accept the responsibility.
There is a clear disconnect with the public, policymakers and regulators, which has led to the emphasis on criminal liability. There is a reason why we have NEDs as part of the functions of corporate structure at the level that we do, namely the proper exercise of governance. However, we do need greater clarity over their role and the expectations of society.
The nature of boards is a central feature of corporate governance reviews and discussions. The tradition in the UK, at least for listed and significant private companies, has been for a unitary board containing both executive and non-executive directors. This contrasts with some European approaches to corporate governance, which feature a supervisory board composed exclusively of NEDs sitting over a board of executives. There have sometimes been suggestions that the UK should adopt a similar model. In company law there is nothing to prevent UK companies adopting that approach (at least notionally, even if legally there remained one board), but in practice they have not. Nevertheless it is an important principle that nothing in law or practice requires a director to function as an executive; indeed, there is something both distinctive and important in the very idea of a non-executive director.
The contention here is that boards, executives and NEDs are all more effective in their strategic and accountability roles if they sit on the same single board, in the same room, have the same information before them (although, as discussed below, in practice the executives will have more company knowledge and information at their disposal), interact with one another and hold one another to account.
The attractions of the supervisory board – with its inherent separation of structure, people and function and yet within a system that views all directors as equal – are illusory. Indeed, the existence of such a model with Volkswagen did not prevent the 2015 emissions scandal and little suggests it assisted with the response. There is no evidence that a supervisory board model results in more effective corporate governance than a unitary system.
A single unitary board also brings both executives and non-executives into regular contact with advisers (auditors and lawyers), which can only enhance the governance process. Boards have traditionally, of course, been the slaves of the shareholders. Although these still appoint or remove the board, there is increasing recognition of the importance of other stakeholders. A variety of personnel on a single board not only prevents the passing of responsibility to others who are not in the room, but can also ensure a mix of voices are heard at the table.
However, that is not to say the existing structure works perfectly. There are several improvements that would enhance the role of all directors but which have particular relevance for NEDs.
One question relates to the number of executive directors on a board relative to non-executives. It is revealing that the regular flow of governance reports saw a steady increase in the recommended proportion of NEDs. This went from one-third (Turnbull Report, 1999), to a majority (Higgs Review, 2003), to the practice that seems most common today, especially in larger companies, of only two executive directors on the main boards (the Chief Executive Officer and the Chief Financial Officer, although others such as the General Counsel may be invited to attend).
This trend carries a number of implications. First, there is a potential concentration of power in the hands of one or two directors, in particular a chief executive, who might easily dominate one other senior executive on a board. Even if others attend, the effect is to diminish the range of comment and expertise. This may also weaken the wider insight available to NEDs and render them more dependent on the chief executive, in detriment to their strategic role. Second, and related, the existence of a wider group of executives on the board can act as a constraint on the chief executive – there are more voices that might challenge and/or offer alternatives. There is always the contrary danger, of course, that executives might not challenge a chief executive, but formal board membership rather than an invitation to attend makes the wider responsibilities much more explicit to all parties. Consequently, a board is likely to be better advised and able to make better decisions.
This does also raise the wider question of board composition and diversity in relation to NEDs, which Section 4.4 below will consider.
In conclusion, the role of non-executive director is best discharged within a unitary board, with a minimum of one-third executive directors (although NEDs should remain in the majority). This would enhance not only the diversity of skills on a board but also the shared mutual responsibilities it bears. It is a structure that gives the maximum weight to ensuring the appropriate balance of expertise and experience.
Clarity over the role and purpose of a non-executive director is core. There is a clear tension in the governance reports and the academic literature between the strategic and the monitoring roles of the NED. This goes to the heart of purpose. It is, perhaps, imbalance between these two roles that has led to unrealistic expectations among the public and policymakers, a confusion that might also lie behind the failure of some recent actions for disqualification, when the actual actions of directors are compared to legal duty and found wanting.
The NED is a long-term company steward if nothing else, and must therefore be both allowed and encouraged to focus on long-term strategy, alongside the expectations of monitoring, accountability and compliance. An effective NED will give weight to strategy, its development and assessment of progress towards achievement. This should lie at the heart of expectations.
As well as steward, Christopher Pass, noted earlier, sees the non-executive director as guardian. But steward or guardian of what? On a narrow basis we might argue that NEDs are stewards of the assets of the company, although that is not a responsibility specific to them but resides in the whole board. But the stewardship specific to a non-executive director goes much deeper. For Pass, the guardianship offered by the NED is of the corporate good of the company, although this still leaves the issue of definition. Some might argue that corporate good lies specifically in the maximisation of shareholder value, others that it should embrace a wider concern for stakeholders, for purpose and for society.
A few observations can be made. First, the NED role is long term. A recent report from PwC noted that the median length of service for a chief executive was five years. In addition, in the years reviewed (2000–18), although there were some longer-term CEOs there was also increased turnover. The report also noted a rise in ethical lapses and failures.[1] The NED can take the long view of a company, its history and wider purposes and what one might call the company’s well-being. Could we, then, see NEDs as long-term stewards of the company’s well-being and purpose?
Second, the NED role is, at least in part, strategic. We need to articulate, and have recognised in law, that a key role of a non-executive director is strategic oversight. Clearly, as the Higgs Review noted,[2] there is a balance to be struck between the strategic and monitoring roles, but an overemphasis on compliance may have the unintended consequence of directing NED attention away from strategy. Both are needed. Executives are focused on company performance, probably rightly; non-executives can place that in a broader context of strategic direction. This requires high levels of competence, independence of mind, vision and experience (see Section 4.4). The combination of the long-term and strategic aspects of the role of NEDs is essential to their very purpose, fundamental to the success of a company and foundational to the proper exercise of corporate governance in the social contract between business and society. It is for this reason that we need both greater clarity about the role but also more celebration of the NED.
Third, the NED is independent. This is more complex than it appears because some of the allegations laid at the door of NEDs concern actual or perceived threats to independence and the problem of loss of objectivity through long periods of service (that is, there is a degree of tension here with the long-term role of the NED). These are often issues of culture, and one function of an independent NED is to observe and, where necessary, challenge inappropriate cultures.
The NED represents an independent check on the executives, at one remove from the daily business of the company. He or she expresses the principle of independence in both approach and function. In terms of approach, their role is to bring an external view and an enquiring mind to the board. Their independence is born of both character and experience (again, more on this in Section 4.4). In terms of function, independence is in practice written into board structures through the particular roles and functions of NEDs, worked out in how they operate in respect of specific board committees. We see this in examples such as the nominations committee (appointing of board members), remuneration committee (setting remuneration, incentives and bonuses for senior executive) and audit committee (accounting and internal control oversight and liaison with external auditors). These are essential functions and activities of corporate governance, and the role of the NED is indispensable to their effective discharge. Society benefits from the external voice, the proper assessment of – and even constraint on – executive remuneration, the ensuring of good governance. These activities and responsibilities are key levers for the oversight of the company, its strategy, performance and key appointments, including advisers. In addition, NEDs play a central role in both the hiring – and firing – of the chief executive.
One of the complexities contributing to the confusion about role is the danger of overemphasis on monitoring, policing and compliance. Inevitably, the more weight put on this, the stricter will be the liabilities applied (‘Did the NED tick this box or that?’) and the less useful will be the role itself. There is an appropriate place for monitoring and accountability, but without the independent NED’s strategic, long-term stewardship of the company’s well-being and purpose, the corporate governance process will be the poorer and the flow of quality candidates reduced. Society will be less well served.
Time and information are central matters of concern in non-executive directors’ proper role and discharge of responsibilities. It has been shown that although the law recognises only one type of director, there are differences in the way directors’ duties apply, according to context. This was clear in discussion of Section 174 of the Companies Act and the various proceedings for potential disqualification under the Company Directors Disqualification Act. It was also noted that there is one general duty of care, skill and diligence, but that duty is limited by a general test of reasonableness and by the particular responsibilities and context.
Nowhere does this distinction come more into play than in the amount of time dedicated to a task by – and the nature of the information in the hands of – a non-executive director and an executive respectively. Any proper appreciation of the role of the NED requires evaluation of this difference.
The first issue is the time directors are able to dedicate to the business. The executive director is full time and their entire focus is on the company and their particular responsibilities. Hence the Chief Financial Officer, both in skill and role, will have considerably more expertise and capacity to acquire, process and indeed understand financial information. The same is true across the range of executive responsibilities. Contrast that with the typical NED, who might spend perhaps two days a month on company business. Not only is this a fraction of a full-time executive’s time, it may not be the NED’s only appointment. Consequently, the NED may feel they are always playing catch-up, needing to absorb and analyse information in a short timescale and possibly under pressure. Equally, the NED is always learning – no bad thing, but they have to contend with what is the daily beat of the executive with less time and potentially fewer direct skills.
This is not to excuse NEDs from their proper duties and responsibilities. Rather the intention is to expose the problem of the time gap between executives and non-executives.
It is largely for this reason that although the general duty still applies, it is unreasonable for the law to expect identical liabilities to accrue under such different circumstances. As was shown, the law does not so expect. A non-executive director cannot have full awareness of every issue or problem in a complex corporate structure. Perhaps corporate structures themselves have become too complex, impeding the flow of information (a topic in itself); in any event there needs to be greater understanding, clarity of expectation and proper responsibility in recognising the consequences of the time differential.
This issue is reinforced by the information challenge. Executives and non-executives are in possession of different information, at different levels of detail, for the very reason that their roles and time commitments are different. Hence it is more than possible for the volume of information to overload (a quantity problem) or even overwhelm (a comprehension problem) a non-executive director. This may result in poor decision-making if papers are not properly read, understood or weighed up, and if trends and material changes are not identified and assessed. Similarly, the outcome may affect the ability of the NED properly to discharge their legal duties and, indeed, their wider responsibilities to society.
As a result, what is important for the effective NED is not quantity of information but quality. They must have in their possession information that is summative, strategic and suited to the decisions in hand, as well as access to relevant company personnel and professional advisers. Information is also power, hence it is a further test of NED quality and independence that they be able to secure the most apposite information, presented to them in the most useful way for their purposes. Information must also be delivered to the directors – but especially the NEDs – in a timely fashion.
If the role of the NED is to make effective long-term strategic decisions in the best interests of the company, then the information received will inevitably be summative – covering key issues, backed by analysis, but avoiding excessive detail that might hamper effective decision-making. Nonetheless, the NED has a responsibility to press for the information they need to facilitate decision-making.
The question, then, is not whether the NED knows everything, or even made the correct decision, but whether they made a decision that a reasonable person could have made in the context.
There is also a gap between what information actors in media and public policy seem to assume NEDs have at their disposal and the reality – the nature of the information, its presentation and its digestibility. To define expectations of NEDs and appreciate their role, this gap needs to be closed – essentially, then, an education exercise (see Conclusions and recommendations below).
It is clear that the role of the NED carries significant responsibility but also serves wider business and society. While debating role, function, purpose, independence and so on, there is something more intangible at the heart of the effective NED, namely character. The combination of high moral character with the experience acquired over many years of executive responsibility delivers the highest-quality NED who, other things being equal, will deliver integrity and honesty in all dealings.
We should not shy away from a debate around moral character, by which is not meant particular religious convictions or commitments to various personal behaviours, but something deeper. What are the values that form and shape the life of the particular individual? Do they reflect the central importance of integrity, honesty, transparency, objectivity, selflessness, accountability and leadership – in other words, the ‘Nolan’ principles of public life?[3] These values represent moral character and we should expect them in all walks of public life, including business, boards and NEDs.
Hence character is an important starting point, not least because it is about the inner person, before that is overlaid by other aspects of life within or without business. The effective NED does not lay moral character over other skills and experiences, rather it forms their very basis.
How might this character be expressed in the potential or actual NED? We would expect some combination of service and leadership but also curiosity and an enquiring mind. These are the characteristics that lead to asking the right questions, probing effectively and providing an outlook of long-term stewardship and strategic direction and decision-making.
But while character is central it is not alone in the formation of the NED. The most effective NEDs bring to the board experience, wisdom and insight gained from careers elsewhere in business, most often as executive directors.
This does, of course, raise again the question of board appointment and diversity. It is hardly surprising that corporate governance reports and academic reflection lend weight to the question of appointment, ensuring proper processes – rather than informal networks – and enhancing boards’ diversity. There are good reasons to welcome this trajectory – it would be strange to argue that boards do not benefit from a diversity of backgrounds. However, elevating monitoring over strategy is likely to result in recruitment of lower-quality NEDs, with insufficient weight lent to business experience and leadership.
The effective NED will be a person of moral character and relevant experience. They will be naturally inquisitive and curious, deeply imbued with the values and principles reflected in Nolan. The law does provide protection for acting in good faith, and when the director has acted honestly and reasonably in their decision-making. Perhaps we need to make these expectations of character and experience more explicit. This would make clearer the qualities necessary for effective discharge of the role.
Company failures happen, alongside frauds and other misdemeanours. Most people consider it appropriate for society to hold individuals to proper account. In some cases there may be culpability, and the law can impose sanctions, from prosecution for criminal offences to civil proceedings for disqualification as a director. However, in other cases, instances of failure, insolvency or simply corporate difficulty are just part and parcel of the nature of the market economy.
In holding directors to account, the question arises whether society’s expectations of what boards and NEDs can achieve are out of kilter with reality, reflecting at the least misunderstanding. There is too the problem of the desire to apportion blame. The high bar (gross incompetency) in the case of official actions (for example, proceedings for disqualification) may be difficult to prove and not even accurate in law. Yet there is pressure to take action due to the mismatch of expectations. The burden of court proceedings can pressurise defendants to settle, which might not be entirely just. The government Insolvency Service has faced criticism from the courts for its handling of disqualification cases (see for example Farepak (2012) and in Re Keeping Kids Company (2021)). Liability must be about actual culpability based on fair evidence, not simply potentially arbitrary allocations of fault.
What is important is the nature of any potential liability. Recent cases have pursued what is generally known as a strict liability, and this may have significant consequences. It means holding a director liable for certain conduct or actions without regard to either their state of mind or the reasonableness of their actions. Thus in the case of Carillion, it was argued that the NEDs were strictly liable in the matter of executives’ misconduct in respect of alleged false accounting, regardless of their efforts to inform themselves. The consequence is that from the moment of appointment the director is strictly liable, assumed to be in possession of full information and knowledge of the company, its finances and all other aspects of its operation, without taking into account the reasonableness of their actions. Hence they may be subject to proceedings (for example for disqualification), irrespective of their actual role, knowledge or actions. This is not the law as it stands, nor should such a strict liability form part of the regulatory armoury – it would be damaging to the NED role, to business and to society.
The Insolvency Service, however, seems to have pursued exactly this policy in some recent cases. The aim here is not to debate the merits of recent failures and scandals or to apportion blame and culpability, rather to consider specific liabilities laid at the door of NEDs (leaving them exposed to disqualification proceedings), as well as implications for the role itself. Thus, in Re Keeping Kids Company (2021), Falk J made clear that the Official Receiver had failed to make out a single allegation against any of the directors. What is perhaps more surprising is that the mistake was repeated in the failed attempt to proceed against the NEDs of Carillion:
legal experts and defense counsel said the case was unclear, wrong in law and repeated mistakes made in the government’s failed attempt to disqualify the trustees of a charity in 2021, which was subject to criticisms over its handling of the case and for leaving defendants in the dark.[4]
The concept of a strict liability in respect of directors’ duties is and could not be the law in any reasonable assessment. This returns to the distinction between strategic and monitoring roles. The role of the NED is not essentially operational. It is to ask the right questions, probing, exercising skill and judgement and displaying curiosity, while not stifling management. The job is strategic oversight. As has also been shown, in terms of resources at their disposal, NEDs are disadvantaged relative to executives, auditors and other professional advisers.
In the wake of scandal, governments have to be seen to act. One temptation is to view everything through the eyes of criminal law, perhaps prompting draconian regulatory action. Hence a regulator views failure to prevent fraud – which may have multiple causes and not necessarily involve liability for directors – from an exclusively criminal or regulatory angle, which may not be to the general good: attempts to sanction directors, not least NEDs, for every failure or failing may have negative consequences for recruitment, retention and the role of NEDs. In a free and responsible society, not every action of a director that might be challenged, or for which a different decision could reasonably have been made, or that might be criticised or fall short of the ideal, should result in criminal or even regulatory action.
There is a rather fundamental mismatch of expectations. Directors cannot predict or know everything. The law recognises this, not however the political world, media and wider society. A narrative develops around what directors should have known, which then suggests that, as the chief architects of the company’s structure, organisation, policies and direction, directors may have been asleep at the wheel and hence should be held to account. The problem, though, is whether in law this constitutes a breach of duty and a liability, and whether in public policy it is a reasonable expectation of a non-executive director.
The danger is that we make British business an unattractive place to work, damaging aspiration and economic efficiency. This issue, again, is fundamentally one of education.
[1] PwC CEO Success Study, 2018, https://www.strategyand.pwc.com/gx/en/insights/ceo-success.html.
[2] The Higgs Review, paragraph 6.2.
[3] ‘The Seven Principles of Public Life’, https://www.gov.uk/government/publications/the-7-principles-of-public-life. For their latest iteration, see The Committee on Standards in Public Life, ‘Upholding Standards in Public Life: Final report of the Standards Matter 2 review’, November 2021, Appendix 1 (p. 92), https://assets.publishing.service.gov.uk/media/617c02fae90e07198334652d/Upholding_Standards_in_Public_Life_-_Web_Accessible.pdf.
[4] Joanne Faulkner, ‘Axing Carillion Case Puts Watchdog’s Approach in Spotlight’, 25 October 2023, LAW360, https://www.law360.com/articles/1736763.
What expectations are set out in law in respect of directors? The legal provisions are found in sections 170–177 of the Companies Act 2006.
Section 172 is intended to clarify the wider expectations and responsibilities relating to a director, who must act in ‘good faith’, and in acting for the benefit of the company’s members (shareholders) as a whole, must take into account several other factors, including the long-term consequences of decisions, a company’s various stakeholders (employees, customers, suppliers), sustainability, fairness and the ‘desirability of the company maintaining a reputation for high standards of business conduct’ (s 172(1)(e)). The Oxford Business Law Blog discusses the reasonableness of decision-making by directors in company law:
Under s 172 of the Companies Act 2006 (‘the Act’), courts will not interfere with the board’s decision concerning an alleged breach of the duty to promote the success of the company unless it is one that no reasonable director could have made, which is known as the Wednesbury standard. Section 172 has been interpreted to mean that courts are to abstain from reviewing on objective grounds whether the board’s decision was actually in the best interest of the company; it is for the directors, in their subjective view, to decide. Courts will only intervene if the decision is one that no reasonable director could have considered to be in the company’s best interest. In short, the standard of conduct required of directors under s 172 is subjective, and the standard of review adopted by courts is rationality or plausibility.[1]
The Wednesbury standard referred to derives from Associated Picture Houses Ltd v Wednesbury Corporation (1948): a decision is unreasonable or irrational only if it is so unreasonable that no reasonable person acting reasonably could have made it. In essence it puts in place a reasonableness test in the discharge of directors’ duties under Section 172.
Courts have generally been reluctant to find directors in breach of their Section 172 duties if they have acted reasonably. One recent example is in Re Marylebone Warwick Balfour Management Limited (2022), where the court found that the directors had discharged their duties under Section 172 by taking and relying on professional advice in respect of a tax avoidance scheme.[2] A further example is Atkinson & Mummery v Kingsley and Smith (2020), where a director was found not to be in breach of their Section 172 duty in failing to prevent access to the company bank account for one of the directors with whom relationships had deteriorated and who made a transfer from that account. While the facts are specific to the case, the point under Section 172 is that the initial test is subjective: based on the information available, did the director honestly believe they were acting in the best interests of the company and its shareholders? The court then applied an objective test: would an honest and intelligent person have taken the same actions to comply with their duties? This ensures that directors cannot simply ignore things and absolve themselves of responsibility, but there is also a reasonableness test in place. The recent case of ClientEarth v Shell Plc (2023) reinforced these points. It is for the directors themselves, acting in good faith, to determine how to act in the best interests of the company under Section 172. A breach requires proof of conduct other than in good faith. Indeed, under the general duty of reasonable skill, care and diligence imposed under Section 174 (discussed below), the law does not ‘superimpose on that duty more specific obligations as to what is and is not reasonable in every circumstance’.[3]
Section 172 is not without its controversies and detractors, and forms part of the wider debate around company purpose. Some criticism focuses on the expectation that the directors must act for the success of the company rather than any stated wider purpose.
A further important provision is Section 174 of the Companies Act 2006. This sets out that a director must exercise reasonable skill, care and diligence – a legal provision that applies to all directors, not just NEDs, in accordance with the principle that all directors have the same duty of care and diligence. This duty, however, is also qualified by both an objective reasonableness test and a subjective contextual test, set out in Section 174 (2) as follows:
2) This means the care, skill and diligence that would be exercised by a reasonably diligent person with –
a. the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and
b. the general knowledge, skill and experience that the director has.[4]
In respect of proceedings under the Company Directors Disqualification Act 1986, the test under its section 6 (1) (b) is that of unfitness. The courts have found that this test is also one that must be measured by context, by the actual responsibilities undertaken by the director. In Re Keeping Kids Company (2021), Falk J, at paragraph 144, cited Jonathan Parker J, in his judgment in Re Barings plc (No. 5) (1999), summarising the principles to be used in respect of disqualification and making clear that conduct must be evaluated in context, by reference (paragraph 144 (h)) to the actual role and responsibilities.
We might summarise the legal position around directors’ duties as a standard duty of care but tested by reasonableness and context. Thus, Gower’s Principles of Modern Company Law (11th edition) states:
What does this all mean for directors? First, although directors, executive and non-executive, are subject to a uniform and objective duty of care, what the discharge of that duty requires in particular cases will not be uniform. As the statutory formulation itself recognises, what is required of the director will depend on the functions carried out by the director, so that there will be variations, not only between executive and non-executive directors but also between different types of executive director (and equally of non-executives) and between different types and sizes of company.[5]
[1] Ernest Lim, ‘Judicial Intervention in Directors’ Decision-Making Process: Section 172 of the Companies Act 2006′, Oxford Business Law Blog, 22 February 2018, https://blogs.law.ox.ac.uk/business-law-blog/blog/2018/02/judicial-intervention-directors-decision-making-process-section-172.
[2] This case is under appeal.
[3] ClientEarth v Shell plc, [2023] EWHC 1897 (Ch), paragraph 31.
[4] Companies Act 2006, Part 10, Chapter 2, ‘General duties of directors’, Section 174, https://www.legislation.gov.uk/ukpga/2006/46/section/174.
[5] Gower: Principles of Modern Company Law, 11th edn, ed. Paul Davies, Sarah Worthington and Chris Hare, London: Sweet & Maxwell, 2021.
The current debates around the roles, responsibilities and liabilities of NEDs are not occurring in a vacuum: as recently as October 2023 the Insolvency Service’s disqualification action against the NEDs of Carillion (on behalf of the Secretary of State) was dropped a few days before the trial was due to commence. The aim here is not to analyse individual cases but to understand the background issues and the implications in respect of NED duties and expectations more broadly. Not only are there relevant contemporary cases and challenges but also a history of reviews and reports on corporate governance, as well as academic reflection. In the short space available it is at least possible to summarise how we have got to this point.
Corporate governance reports have been a feature of the British corporate and regulatory scene for many decades. They have been in more or less direct response to failure or scandal. As well as a regularly updated ‘UK Corporate Governance Code’[1] reflecting best practice there is also a history of reports that have specifically discussed the role of the NED. In addition, though beyond the main concern here, there have been proposals for a new governance regulator to replace the Financial Reporting Council (FRC).
This section will review the Corporate Governance Code and its guidance and also summarise the relevant provisions of previous corporate governance reports. Section 3 will return to legal and Section 4 to practical implications for this discussion.
The current Code, applicable to all UK companies with a premium listing on the London Stock Exchange and representing best practice for other companies, is the 2018 version published by the FRC. It has also published additional guidance, the most relevant being the ‘Guidance on Board Effectiveness’.
In 2024 the FRC published a revised Code that makes a number of amendments to that of 2018, particularly in relation to internal controls. The FRC also combined three elements of guidance, including ‘Guidance on Board Effectiveness’, into one document, the ‘2024 Code Guidance’, to which the online Code contains hyperlinks. The 2024 Code will apply mainly to financial years beginning on or after 1 January 2025.
The 2024 Code Guidance sets out the responsibilities of the various actors, including board chair, executive directors, the senior independent director and NEDs. Before turning to the specific roles and duties of the NED, it is worth noting what the Guidance says about directors more generally. Paragraph 69, dealing with the role of executive directors, states:
Executive directors have the same duties as other members of a unitary board. These duties extend to the whole of the business, and not just that part of it covered by their individual executive roles. Nor should executive directors see themselves only as members of the chief executive’s team when engaged in board business. Taking the wider view can help achieve the advantage of a unitary system, meaning greater knowledge, involvement and commitment at the point of decision. Executive directors are likely to be able to broaden their understanding of their board responsibilities if they take up a non-executive director position on another board.[2]
This paragraph recalls some of the basic principles of the roles and duties of a director and emphasises the importance of experience across the executive and non-executive roles. This is rather contrary to the perceived public narrative of ‘revolving doors’ – that is, of executives retiring from an executive role and immediately taking up a non-executive appointment – and a reminder of the educational theme at the heart of this publication.
The ‘Guidance on Board Effectiveness’ sets out several areas of guidance on board composition, roles, divisions of duties and other matters. The role of the NED is specifically commented on in paragraphs 75–78 and elsewhere. These points may be summarised as the importance of devoting sufficient time, demonstrating integrity, understanding the business and its culture and insisting on high-quality information. For example, the Guidance states in paragraph 76 that it ‘is vital that non-executive directors have sufficient time available to discharge their responsibilities effectively’.[3]
Paragraph 77 continues:
Non-executive directors need to insist on receiving high-quality information sufficiently in advance so that there can be thorough consideration of the issues prior to, and informed debate and challenge at, board meetings. They should seek clarification or amplification from management where they consider the information provided is inadequate or lacks clarity.[4]
The ‘UK Corporate Governance Code’ itself reflects a history of reports that have included the role of NEDs in wider reviews of corporate governance. The 1992 ‘Report of the Committee on the Financial Aspects of Corporate Governance’ (Cadbury Report) lays the foundation of the roles and responsibilities of NEDs in corporate governance. Paragraph 1.8 reinforces the position, now firmly established in both law and guidance, that ‘all directors are responsible for the stewardship of the company’s assets … [and] … whether or not they have executive responsibilities, have a monitoring role.’[5]
The Cadbury Report strongly advocated the unitary board system – that is, one single board (see Section 4.1) – and argued for the role of the NED in these terms: ‘the appointment of appropriate non-executive directors should make a positive contribution to the development of [the] businesses.’[6]
In paragraphs 4.1–4.6, Cadbury sets out its view that the roles of the NED are to:
A Remuneration Committee, consisting of NEDs, is an example of the last item in that the independent mind can reconcile the wider needs of the company with executive-director claims around pay, bonuses and other incentives, and ensure an alignment of interests between executives and members of the company.
Two other qualities the report brings out are independence and calibre. In respect of independence: ‘non-executive directors should bring an independent judgement to bear on issues of strategy, performance, resources, including key appointments, and standards of conduct.’
Naturally there are instances when such independence is threatened (for example, remaining on a board for too long or becoming too close to the executives), but sight should not be lost of the fact that Cadbury makes an articulated case and vision for the role and positive impact of NEDs in the conduct of business.[7]
Appearing in 1998, the Hampel Report[8] was another key building block in the development of the ‘UK Corporate Governance Code’. This reinforced Cadbury’s points on board balance, independence and the importance of the information supplied to NEDs – a recurring theme. Hampel also endorsed common duties for all directors but differed importantly from Cadbury in respect of the role of the NED.
Hampel argued that Cadbury overemphasised the monitoring role of the NED and insisted that NEDs ‘should have both a strategic and a monitoring function’.[9] This is an important corrective: in terms of public understanding of the NED’s roles, and indeed the media narrative, an overemphasis on monitoring at the expense of strategy has certainly been a feature of regulatory and legal actions against directors. Both Cadbury and Hampel argued for a substantial proportion of NEDs on boards.
A further piece of the framework came in 1999 with the Turnbull Report.[10] This focused principally on internal controls. The main points raised concerning NEDs are in respect of board balance. Turnbull argued that boards should be at least one-third NEDs and that no individual or group should exercise excessive power, and made other provisions, including in relation to audit committees and terms of office.
The Higgs Review of 2003, commissioned in the light of scandals and corporate failure, was specifically titled a ‘Review of the Role and Effectiveness of Non-Executive Directors’.[11] Higgs returns us to the strategy-versus-monitoring discussion and draws a distinction between US and UK developments, noting that: ‘the role of the non-executive director in this process contrasts with that of US regulators, who have tended to emphasise the monitoring role at the possible expense of the contribution the non-executive director can make to wealth creation.’[12] The report argued that lack of clarity around the role of the NED had been a recurrent theme in submissions to the committee.[13] Higgs reinforced the role of the NED around strategy, performance, risk and remuneration. The report also argued that at least 50 per cent of a board, excluding the chair, should be NEDs, hence a majority. One new feature was a recommendation that the NEDs should meet alone once a year.[14] Although some might argue that this introduces a division in the unitary view of a director, Higgs saw these as informal meetings that did not conflict with the wider partnership and trust across the board as a whole. The Review also picked up the question of diversity and the dangers of informality, and the use of personal contacts in the appointment process, which not only lacked rigour but tended simply to replicate the background of existing directors.
A final area of interest concerned the question of liability, which has become increasingly prominent. The overall position set out in Higgs has stood the test of time:
Although non-executive directors and executive directors have the same legal duties and objectives as board members, the time devoted to the company’s affairs is likely to be significantly less for a non-executive director than for an executive director and the detailed knowledge and experience of a company’s affairs that could reasonably be expected of a non-executive director will generally be less than for an executive director. These matters may be relevant in assessing the knowledge, skill and experience which may reasonably be expected of a non-executive director and therefore the care, skill and diligence that they may be expected to exercise.[15]
Consequently, there needs to be clarity around roles and expectations, appropriate induction and training and clear reasons given in case of resignation.
Higgs recommended a further review committee that would give prominence and guidance around the skills and experience needed to expand the pool of NEDs by identifying suitable candidates in the non-commercial sector. That came to fruition, also in 2003, as the Tyson Report,[16] which argued that: ‘Individuals with successful leadership careers in the non-commercial sector are likely to have attributes, skills and experience relevant to NED positions in the commercial sector.’[17] Examples included the chief executives or finance directors of large charities. Expanding the recruitment pool into the non-commercial sector was also likely to increase the representation of women. Tyson further recommended looking outside the domestic market.
Much of the discussion around non-executive directors in corporate governance codes draws on the academic literature, a review of which reveals three key aspects:
The evolution of corporate governance has been shaped by a confluence of global changes and academic developments, each playing a crucial role in transforming governance structures worldwide. In the 1970s and 1980s, a seismic shift occurred, marked by more widespread shareholding, increased shareholder activism, hostile takeovers and leveraged buyouts, particularly in the USA. This period prompted a re-evaluation of corporate governance structures, emphasising the need to align the interests of shareholders and managers. While managers are tasked with maximising shareholder value (or at least acting in shareholders’ best interests), without adequate governance mechanisms they may make decisions that benefit themselves at the expense of shareholders. Simultaneously, in academic circles the 1970s saw the emergence of agency theory (though the ideas existed prior to the term), a foundational framework that scrutinised the principal–agent relationships within organisations. It refers to the idea that a principal actor (for example, the shareholders) appoints an agent (the board) to act on their behalf. This theoretical underpinning provided crucial insights into the conflicts of interest between shareholders and executives, laying the foundation for subsequent academic research and discussions on corporate governance.
The practical reforms in corporate governance gained momentum after the 1980s, not least with the many UK reports into it, the most significant of which, as they relate to NEDs, were discussed above. Consequently, the role of the NED became more prominent and was placed under more scrutiny, as a governance mechanism aimed at introducing objectivity and reducing potential conflicts of interest. Hence the global evolution of corporate governance has been influenced by both practical proposals and academic insights, representing an interplay between theory, regulatory responses and the ever-changing landscape of business practice.
The focus on agency theory has been significant. Each successive wave of scandal or failure has exposed divergence of interests between executives and shareholders, but also between business and society more generally. Mahmoud Ezzamel and Robert Watson summarised the thinking around independent directors, examining ‘the managerial and governance functions of the board of directors and the changes in terms of their composition and governance roles brought about by recent reforms’, and focusing on ‘the governance roles now expected of the non-executive directors on the board’:
In the US and UK, these part-time NEDs are now expected to undertake two distinct and somewhat contradictory roles. One the one hand, they are expected to be full members of the top corporate management team with exactly the same responsibilities for the formulation and management of corporate strategy as their executive board colleagues. On the other hand, however, they are also required to be independent of these same colleagues. This is because NEDs are also now expected to be primarily responsible for ensuring the quality and reliability of corporate information disclosures, keeping executives focused on the generation of shareholder value, via the design and implementation of appropriate employment and remuneration schemes, and the disciplining of their executive director colleagues that appear to be underperforming.[18]
The role of the NED has generally been affirmed in the literature. For example, Svetlana Mira, Marc Goergen and Noel O’Sullivan argue, albeit with perhaps an overemphasis on the monitoring role of the NED, that:
In the UK, over the past 25 years the board of directors has been emphasized as one of the most important instruments of corporate governance. Central to this has been an emphasis on the monitoring potential of non-executive directors, with successive governance codes stressing the need for significant non-executive participation on boards. Consequently, a majority of board positions in large UK companies are now held by non-executive directors. The expectation is that non-executives are able to actively monitor the behaviour of management, ensuring that corporate decisions are made in the interests of shareholders.[19]
Anup Agrawal and Sahiba Chadha found that the presence of independent directors and, indeed, good governance more widely, had a positive influence when dealing with accounting scandals.[20] Mira et al. found that ‘the non-executive labour market is efficient and rewards non-executives for good acquisitions’, by which they meant that a non-executive director associated with good board decisions is likely to have other future non-executive opportunities. Nevertheless, it is also the case that deficiencies in the role of the NED may be seen as contributing to the global crisis of corporate governance,[21] and that NEDs may be failing to make the executives accountable. There are also significant debates around appointment, not least the reliance on informal networks.[22]
A 2010 article by Alessandro Zattoni and Francesca Cuomo reviewed the literature on NEDs and concluded that:
In a sense this academic discussion reflects both the strengths and weaknesses of the public narrative around NEDs, which will figure more below. Independence is key, but also the idea of NEDs as guardians or buffers – stewards of the corporate good and a barrier between the executive directors and shareholders. Christopher Pass represented a more empirical approach in the literature with his study of 51 large UK companies and their boards drawn from annual reports.[24]
A further example of this empirical methodology came from John Roberts, Terry McNulty and Philip Stiles, who argued that too much of the academic literature on NEDs, governance and board effectiveness was dominated by agency theory and its underlying assumptions. Their study examined the effectiveness of boards and NEDs based on 40 interviews with directors commissioned for the Higgs Review, and concluded that board effectiveness was determined by conduct and behaviour more than governance and structure, though clearly these are not mutually exclusive. They argued that it is perceptions of board effectiveness, rather than the actual experience of directors, that might shape approaches to corporate governance reform.[25]
This swift consideration of the academic literature serves as a reminder of the conceptual basis on which the various reviews of corporate governance were built, and the continued importance of both ideas and practicalities.
[1] Financial Reporting Council, ‘UK Corporate Governance Code’, London: FRC, January 2024; see https://media.frc.org.uk/documents/UK_Corporate_Governance_Code_2024_kRCm5ss.pdf.
[2] Financial Reporting Council, ‘Guidance on Board Effectiveness’, July 2018, paragraph 69, https://media.frc.org.uk/documents/Guidance_on_Board_Effectiveness_MmfcOrz.pdf.
[3] ‘Guidance on Board Effectiveness’, paragraph 76.
[4] ‘Guidance on Board Effectiveness’, paragraph 78.
[5] ‘Report of the Committee on the Financial Aspects of Corporate Governance’, December 1992 (Cadbury Report), paragraph 1.8, https://www.icaew.com/-/media/corporate/files/library/subjects/corporate-governance/financial-aspects-of-corporate-governance.ashx?la=en.
[6] The Cadbury Report, paragraph 3.15.
[7] The Cadbury Report, paragraph 4.11.
[8] ‘Committee on Corporate Governance, Final Report January 1998’ (Hampel Report), https://www.icaew.com/technical/corporate-governance/codes-and-reports/hampel-report.
[9] Hampel Report, paragraph 3.8.
[10] Internal Control Working Party of The Institute of Chartered Accountants in England & Wales, ‘Internal Control: Guidance for Directors on the Combined Code’ (Turnbull Report), September 1999, https://www.ecgi.global/publications/codes/internal-control-guidance-for-directors-on-the-combined-code-turnbull-report.
[11] Derek Higgs, ‘Review of the Role and Effectiveness of Non-Executive Directors’, January 2003 (Higgs Review), https://webarchive.nationalarchives.gov.uk/ukgwa/20121212135622/http://www.bis.gov.uk/files/file23012.pdf.
[12] Higgs Review, paragraph 1.12.
[13] Higgs Review, paragraph 6.4.
[14] Higgs Review, paragraph 8.8.
[15] Higgs Review, Annex A, p. 92.
[16] ‘The Tyson Report on the Recruitment and Development of Non-Executive Directors’, June 2003, https://web.actuaries.ie/sites/default/files/erm-resources/250_tyson_report.pdf.
[17] Tyson Report, p. 13.
[18] Mahmoud Ezzamel and Robert Watson, ‘Boards of Directors and the Role of Non-Executive Directors in the Governance of Corporations’, in Corporate Governance: Accountability, Enterprise and International Comparisons, ed. Kevin Keasey, Steve Thompson and Mike Wright, Chichester: Wiley, 2005, pp. 118–36.
[19] Svetlana Mira, Marc Goergen and Noel O’Sullivan, ‘The Market for Non-Executive Directors: Does Acquisition Performance Influence Future Board Seats?’, British Journal of Management 30:2 (2019), pp. 415–36, https://doi.org/10.1111/1467-8551.12290.
[20] Anup Agrawal and Sahiba Chadha, ‘Corporate Governance and Accounting Scandals’, The Journal of Law & Economics 48:2 (2005), pp. 371–406, https://doi.org/10.1086/430808.
[21] Jill Solomon, Corporate Governance and Accountability, 3rd edn, Chichester: Wiley, 2010.
[22] Jay A. Conger and Edward Lawler, ‘Building a High-Performing Board: How to Choose the Right Members’, Business Strategy Review 12:3 (2001), pp. 11–19, https://doi.org/10.1111/1467-8616.00179.
[23] Alessandro Zattoni and Francesca Cuomo, ‘How Independent, Competent and Incentivized Should Non-executive Directors Be? An Empirical Investigation of Good Governance Codes’, British Journal of Management 21:1 (March 2010), pp. 63–79, https://doi.org/10.1111/j.1467-8551.2009.00669.x.
[24] Christopher Pass, ‘Corporate Governance and the Role of Non-executive Directors in Large UK Companies: An Empirical Study’, Corporate Governance 4:2 (June 2004), pp. 52–63; DOI: 10.1108/14720700410534976.
[25] John Roberts, Terry McNulty and Philip Stiles, ‘Beyond Agency Conceptions of the Work of the Non-Executive Director: Creating Accountability in the Boardroom’, British Journal of Management 16:s1, pp. S5–S26 (2005), https://doi.org/10.1111/j.1467-8551.2005.00444.x.
There is a view that the public square is ‘secular’ and that therefore religious believers should leave their baffling theology at home and learn to speak sensible, non-theological language in public. One well-known expression of this view came from the eminent German philosopher and public intellectual, Jürgen Habermas, who for a long time held that the onus is on religious people, when they speak in public, to translate what they have to say into common, non-religious terms.
There are a number of problems with this, I think. First, Western societies are not ‘secular’ in the sense of predominantly anti-religious or areligious. In fact, we comprise a plethora of different moral and metaphysical views, some atheist, others dogmatically religious, but most more or less agnostic, more or less religious. We are plural rather than ‘secular’ in the sense of being generally hostile or indifferent to religion.
A second objection I have to the Habermasian view is that theological expressions are by no means uniquely baffling. Bafflement is a common feature of human conversation; the political left and right frequently baffle each other. Nonetheless, we ordinarily find ways of exploring viewpoints that initially nonplus us, to reach a measure of understanding, perhaps even to discover points of common ground. Many people who think and speak in theological or religious terms are perfectly capable of that—or at least as capable as anyone else.
For those reasons, I prefer Augustine’s concept of the secular to Habermas’s. For Augustine, the saeculum is the age between the Resurrection of Christ and its fulfilment at the End of Time. The ‘secular’ age is one of ambiguity and mixture, and a ‘secular’ society is a religiously and philosophically plural one, not one that is predominantly or systematically hostile to religion.
In such a plural society, it seems to me, religious believers should be free to speak their minds in their own terms—just like anyone else. They should be free to refer in public to such things as God, Jesus, the Bible, and the afterlife. That said, if they want to be understood, they will often have a lot of explaining to do.
I find the thought of the leading English-speaking political philosopher, John Rawls, to be closer to the mark than Habermas’s. Rawls—who took a serious interest in theology as an undergraduate at Princeton—argues that ‘reasonable’ versions of humanism, Christianity, Judaism, and Islam can all sign up to ‘public reason’ on their own terms. By ‘public reason’ he means a set of presuppositions and rules for governing public discussion, not least ‘fairness’. This is something, Rawls argues, that certain kinds of Christian theology—alongside certain other worldviews or ‘comprehensive doctrines’—can own and endorse. In that sense, ‘public reason’ does not require ‘reasonable’ Christians to leave their theology at home when they venture out into public, for ‘public reason’ is itself an expression of that theology—albeit not only of that theology.
So far, I agree with Rawls. Nonetheless, I think he underestimates the scope for divergence and disagreement within ‘public reason’. He is inclined to think that ‘public reason’, once endorsed by ‘reasonable’ worldviews, floats free of them, a common creed whose content is entirely independent of each of its supporting worldviews. I think that is a mistake. I think that ‘public reason’ contains difference, both in the sense of limiting it and including it. That is why I refer to it, not simply as a consensus, but as a tense consensus.
So, for example, suppose a common presupposition of ‘public reason’ is the idea of the dignity of the individual. A post-modern Romantic humanist will understand that dignity as consisting in the individual’s expression of the self’s inimitable genius. A Christian, however, seeing the human individual as a sinful creature, will suppose that there’s a lot in human selves that is not worthy of expression at all. Instead, what makes for the individual’s dignity is his investment in objectively given goods such as truth, justice, and beauty. For sure, this investment will express itself in a particular self’s inimitable manner. But the main point is this: for a Christian, human dignity consists in the individual’s responding to and expressing a moral order that is God-given. It does not consist in the individual staring into his own murky depths and bringing out whatever he finds there, willy nilly.
Rawls is correct that non-religious humanists and Christians share a common idea and value: the dignity of the individual. And that is good, for it limits disagreement. However, within those limits, it also contains difference and controversy. Rawls underestimated that.
As affirmed above, my view is that religious believers should feel free to make explicit references to God, Christ, the Parables, the Bible—as I have heard Anglican bishops do in the House of Lords. Some peers may be irritated by that, others might be baffled, but irritation and bafflement can stimulate thinking and rethinking, which is often no bad thing. And besides, anyone who claims to support a liberal society has no business resenting the expression of viewpoints he does not agree with.
That said, how explicit or implicit theological expression should be depends on the circumstances. I am a Christian and a theologian trained to think in theological terms. I always intend to have my moral and political thinking derived from, or at least governed by, my Christian beliefs about God, Christ, the afterlife, etc. However, whether or how far I reveal the theological roots of my thinking depends on the nature and purpose of the gathering. In a church context, where I’ve been asked to talk about a Christian view of a certain topic, I will, of course, be explicit. But in a plural, public context where the topic is, say, the legalisation of assisted suicide, the surrender of the Chagos Island to Mauritius, or the banning of corporal punishment, I will make moral arguments that will not expose all or any of their theological roots. Why? Am I biting my theological tongue out of embarrassment? Not at all. I am merely reserving some of my thinking out of respect for my fellow citizens, who agreed to gather and discuss an ethical question, not to have a debate about the meaning and veracity of theological claims. I am merely respecting the purpose of our meeting. Should anyone tap me on the shoulder afterwards in the corridor or the bar and ask me to explain what my theology has to do with my ethical views, I would gladly tell them.
All the same, the fact that I usually do not talk theologically in the public square does not mean that what I say there is not theologically informed. So, for example, my opposition to the legalisation of assisted suicide is shaped by my Christian view of human beings as finite and fallible creatures. This makes me realistically sensitive to likely practical result of implementing assisted suicide in a healthcare system constantly under financial pressure and run by harassed and impatient—and, very occasionally, malevolently sinful—creatures. In contrast, it seems to me that the proponents of assisted suicide are recklessly idealistic, assuming that healthcare professionals and relatives are gods and saints, not creatures and sinners. In a sense, then, when I express my views on assisted suicide, I am speaking theologically—or at least I am speaking out of my theological worldview—even when the theology is not apparent.
In recent years, to my surprise, I have found myself fighting in public for the right to free speech. I do so as a Christian and because of my theological anthropology. One consequence of that is that, whereas some other free speech advocates explain what they are contending for in terms of the individual’s right to self-expression, my rationale is different. A signal advantage of believing in God is that you are less inclined to mistake yourself for one. Believing as I do in God, I regard humans as creatures and not gods, sinners and not angels. Our understanding of what’s true and good and beautiful is often incomplete or distorted. So, in order to reach a better understanding, we need to be free to challenge and test reigning orthodoxies, because if those orthodoxies are false and if they misshape our schools and workplaces, and the policies of our police and government, then we all suffer. Therefore, we need the freedom to challenge prevailing views and call them to public account. We need the freedom to prophesy. In this way, my Christian theology inclines me to be liberal in the classical, Millian sense.
In addition to fighting for the right to free speech, I have also found myself fighting the corner of reason. Since religious believers are typically accused of being irrational, I take a lot of smug pleasure in playing such a role. I have found myself doing it mainly in relation to the public controversy over Britain’s colonial history, our involvement in slavery, and whether or not we owe reparations. One thing I have observed of the ‘progressive’ advocates of ‘decolonisation’ and slavery reparations is that their claims typically run out way ahead of the facts, evidence, and reason. Evidently, personal and political passions so possess them that they are driven beyond reason. And these passions render them absolutely unfree to do justice to critics such as me. So instead, they resort to personal abuse, smearing, misrepresentation, and political manipulation. Rather than reason, they resort to unscrupulous power. They behave like little tyrannical gods, and they behave like that because they are driven, possessed, … demonic.
Observe: in order to explain the phenomenon of ‘progressive’ irrationality and illiberality, I have recourse to spiritual and theological terms: ‘gods’, ‘demonic’. And at the end of my books on colonialism and reparations, and in my next one on the culture wars, I am quite explicit about that. I turn explicitly theological because those terms illuminate something that other terms just do not.
But often, as I have said, the theology is, while still effective, nonetheless implicit. I think that one of the most important contributions that theologically-formed Christians can make to public controversy over colonial history—or racism or transgender identity or whatever—is to develop, exercise, and model virtues that are vital in keeping controversy civil and reasonable. These are virtues that make sense if you understand human beings to be creatures and sinners who find their fulfilment in aligning themselves with, and being answerable to, a moral order they did not create but is given to them.
These are virtues such as: courage in the face of ideas that are alien and threatening; strict justice in representing the views of others; charity in construing their ambiguities, preferring the strongest rather than the weakest possibility; docility in admitting the possibility that they might have something to teach; humility in admitting the possibility of correction by them; forbearance and temperance in the face of the unfairness and provocation that opponents may perpetrate; and above all, such a love for the truth that one keeps on saying it—prophesying it—in the face of hostility.
These virtues are not uniquely Christian. One can find many of them endorsed in Jewish, Muslim, and Confucian traditions. On the other hand, some are explicitly repudiated by the likes of Aristotle and Nietzsche, who did not recognise humility and compassion, respectively, as virtuous at all. So, my list of virtues is characteristically Christian and, as such, it is relatively distinctive. In general, my view is that authenticity is what is important, not distinctiveness. After all, how distinctive we are depends entirely on what issue is at stake and with whom we are being compared. As I have long said of myself, whether I am ‘right-wing’ or ‘left-wing’ depends entirely on what we are talking about and whom I am standing next to. Distinctiveness is relative.
Nevertheless, if the virtues I have mentioned are not uniquely Christian, they are rarely talked about in contemporary Western culture, where rights-talk so dominates as to push almost every other kind of moral vocabulary off the table. That is not to say that no one intuits virtue or exercises it. But it is to say that talk about it is so repressed that it is difficult to name, and being difficult to name, it is difficult to identify, communicate, and promote. The result is that vice flourishes unopposed.
Therefore, by developing, displaying, and naming intellectual and social virtues in the midst of no-holds-barred culture wars, theologically informed Christians have a very important role to play in giving voice to them and reminding their fellow citizens of their importance. In so doing, they will contribute to the vital task of defending and promoting a generously, responsibly, rationally liberal culture among us—and of preserving us from political bloodshed.
Nigel Biggar is Regius Professor Emeritus of Moral Theology at the University of Oxford.
Dr Richard Turnbull, who died on 26 November 2025 after a short battle with cancer, was a distinguished historian and Christian leader. He brought to business, church and the academy a deep faith, incisive mind and kind heart, all of which radiated a passionate love for God’s people.
Richard grew up in a non-Christian home and became a Christian while studying economics and accounting at Reading University. This gave him a lifelong interest in work with young people. He first qualified as a Chartered Accountant, serving the clients of Ernst and Young for eight years and being appointed as the youngest ever member of the Press Council.
Feeling a call to ordained ministry in the Church of England, he studied at Cranmer Hall in Durham, where he gained a first class honours degree and PhD in Theology. He ministered in Southampton and then as a much-loved leader of Christ Church Chineham. He served on the Church of England’s General Synod. He was a member of the Archbishops’ Council and chaired the Synod’s Business Committee and a number of working parties including a review of the remuneration of the clergy. He was appointed Principal of Wycliffe Hall in 2005, a major evangelical theological college, which he led for seven years with wisdom and courage at a time of rapid change. He was a member of the Faculty of Theology of the University of Oxford, a Fellow of the Royal Historical Society and served as Visiting Professor of St Mary’s University, Twickenham, and Chair of the Christian Institute.
After Wycliffe he founded The Centre for Enterprise, Markets and Ethics with Lord Griffiths of Fforestfach. He served with great distinction as our Founding Director for thirteen years until his retirement in 2025. His patient, faithful work established the Centre in its mission to equip business, church and policy leaders with faith-based perspectives on the economy.
His books include an outstanding biography of Anthony Ashley Cooper, the Seventh Earl of Shaftesbury (Shaftesbury: The Great Reformer), a history of the eighteenth century English revival (Reviving the Heart) and an influential account of evangelical spirituality (A Passionate Faith). For The Centre his work included theologies of work, the common good and capitalism, and scholarship on Quaker Capitalism, on which he was a globally renowned expert.
Richard’s exemplary service and distinctive witness inspired thousands of people around the world and his self-deprecating humour brought a smile to many faces. He cared deeply for those around him and for those in need. He is mourned by numerous friends, both across the UK from his native Yorkshire to the Isle of Wight where he spent holidays with his family, and in the United States which he visited frequently.
At the same time he was at heart a family man: a devoted husband, father and son. He is mourned especially by his wife, Caroline, his children and elderly father, who we hold in our prayers. Richard reached the end of his earthly life full of faith and hope and love. He said, ‘It is time to go to glory’. Amen.
Obituary (Church Times)
In the next decades increasing shares of personal and societal wealth willbe spent mitigating environmental harms. These harms are often blamed on the ramifications of the market system. To some extent this is true but the complaints too often ignore the human betterment deriving from the activity that results in environmental degradation. At its core the environmental problem facing humanity is how to govern individual actions with the understanding that this harm is a by-product of human desires. Any rational inquiry into ways of addressing the problems must account for the interests of individuals, including those in political office and regulatory agencies. Despite the centrality of economic analysis to the policy questions involved, much of the discussion about the economic constraints of environmental problems is shallow: the feasibility and desirability of green policy is too often taken as given and the reality of corrective actions ignored.
Economists are sometimes – and sometimes deservedly – accused of being Panglossian, but rather than simply offering support for a laissez-faire approach, market solutions to environmental problems encompass different policy solutions to wide-ranging environmental challenges. They can achieve a given level of reduction more efficiently and in some cases are more politically viable. Environmental problems vary in the institutional scale of the governance needed, while the physical nature of the problem partly shapes the difficulty of establishing property rights and creating markets.
The aim of this publication has been to take these issues from their fundamentals and build up the analysis to include contemporary policy questions. Throughout it has stressed fundamental insights of the Coasean approach: any consideration of governance must be comparative; and all solutions are bound to diverge from naïve ideals. The best answer is contingent and the result of weighing trade-offs.
If feasible, market solutions, including market-based regulations, allow the rational use ofscarce resources and preserve incentives to innovate in the longer run. The capacity for market solutions to outcompete alternative policies depends not only on the pure economic argument for them, but also on questions of political economy.
Economics has become less a series of doctrines than … an engine of analysis in which techniques, ranging from the theory of public goods and externalities, ideas about the role of property rights, negotiation, incentives, and mechanism design, are used together with ideas from other disciplines to work out possible solutions to very difficult problems.[1]
Roger Backhouse
Economics is the study of the allocation of scarce resources. This central focus, as much as anything else, makes it eminently suited to analyzing environmental problems. Let’s take a concrete example. The Columbia and the Snake Rivers drain much of the U.S. Pacific Northwest, providing water for drinking, irrigation, transportation, and electricity generation and supporting endangered salmon populations. All these activities – including salmon preservation – provide economic benefits to the extent that people value them.[2]
Nathaniel Keohane and Sheila Olmstead
While this publication is focused on considering the foundational economic issues connected with environmental protection, achieving a reasonable position requires some understanding of the pragmatic issues. For instance, the two related questions of into which issues the state should intervene to alter market outcomes and how it should do so depend in part on empirical questions about relevant alternatives. There are myriad existing regulatory mechanisms that attempt to improve outcomes. Do insights from economic analysis of their performance and the theories presented in the Chapters 1 and 2 present ideas about potential improvements?
Contemporary concerns are increasingly focused on climate change. This is because of the risks and costs associated with climate change and because of the success of environmental regulation, private actions and technological improvement in mitigating other environmental harms over the past decades. Despite the understandable focus on climate change, such comparatively mundane issues as air and water quality, habitat and species protection and fisheries management are still vital and register considerable interest.[3] In many cases climate change can be reduced with better management practices on these issues – a topic returned to in the short penultimate section on climate change.
Before getting into some specific environmental issues that show both the potential and limits of markets in assorted policy areas, it is necessary to provide some context for both the development of environmental policy and its economic analysis. The two quotes above are representative of the widely held view of economics as a policy science combining notions of efficiency, economic theory and rigorous empirical evaluation. While there is some question about the declining role of economists in policy discussions (such as climate policy in the Biden administration), economics manages to sit astride many topics and provide a framework for thinking about them.
Recent academic literature has attempted to reckon with the shift in policy in the last quarter of the twentieth century towards enabling markets and the rise of economic thinking over a broader period. Most of the work is on the United States and the United Kingdom; the focus in what follows will be on the former context. The term ‘neoliberalism’ is often but inconsistently used; the basic argument is that markets that were curtailed (or never existed) were freed (or created) by reforms beginning in the 1970s. To some degree these ideas were proposed by economists addressing the contemporary failures of their time, but they were also taken up by policy experts and political figures, on the left as well as the right. Nascent environmental policy is one example of a field where this was rampant, as Elizabeth Popp Berman details in her recent book, Thinking like an Economist.[4] This consensus broke down in the 2000s and the 2010s as the right shifted away from the more active policies involved in market-based regulation (while retaining a focus on deregulation), and the left became increasingly focused on distributional issues (what is called ‘environmental justice’) and green industrial strategy.[5]
Standard accounts rightly focus on the rise of the environmental movement in the middle decades of the twentieth century. It was then that major pieces of legislation were passed to regulate industrial polluters and clean up the environment. As Berman and others note, the language used in them – and the public debate around their passage – was markedly radical.
As one example, the Clean Water Act promised to end all water pollution. To show how far this was from the view of professional economists, Berman recounts:
Harvard economist Marc Roberts told the National Journal in 1972 that he was ‘a radical, a Democrat, and an ardent hater of Richard Nixon,’ yet continued, ‘There isn’t a single respectable economist in the country who would back the no-discharge goal adopted by the Senate [in the Clean Water Act]. It will waste billions of dollars for no useful social or environmental purpose.’[6]
These topics are popular both because of interest in the time period and a desire by interested parties to similarly reform policy. Many with environmental concerns hold that radical reform of state policy is needed to limit markets. This includes, at the extreme, those who think the consumption of resources and emissions of harmful substances generated by a wealthy society require degrowth. In her popular book Not the End of the World, Hannah Ritchie pushes back against the most pessimistic and doctrinaire claims of this kind with data on the progress made in the last decades.[7] Despite the pressing concerns of climate change, many of these ideas are not new, and earlier policy debates provide interesting context for contemporary ones, as does the performance of more idealistic regulation in the twentieth century.
Relevant for this chapter is how interventions for environmental purposes were conceptualised by both policymakers and economists. The through- line is that at least conceptually, reforms that enable markets to perform better (in efficiency terms) and in more dynamic ways, rather than direct command-and-control interventions, became more central to policy discussions over time (even if never that popular). Legislation passed at the time forbade some economic considerations but was rather based on concerns about health and a framework of creating rights to limit pollution irrespective of cost–benefit analysis. Initial proposals to introduce economic considerations were considered repulsive.
After a few decades the benefits of market reforms were more widely recognised, but for reasons connected to interest-group dynamics and politics generally, this conceptual victory has not led to the degree of reform many economists think desirable.[8] On the most important environmental issues, the last 15 years have witnessed a turn away from the standard economic advice of academic economists and towards a range of mandates, subsidies and other regulations. These are meant to enable an energy transition and combat climate change, while most economists support carbon pricing.
The 1960s was a decade of growing awareness of environmental issues, especially concerning air and water pollution and agrochemical toxicity. At the same time, the young field of environmental economics was developing as a specific focus among economists, separate from natural resources economics.[9]
Nathalie Berta
In 1960, a Gallup poll showed that just 1% of Americans saw ‘pollution/ecology’ as an important problem. By 1970, 25% did.[10]
Alec Stapp and Brian Potter
While earlier regulation attempted to address environmental harms (and legal judgements enshrined in common law created constraints on action), much of the existing legislation governing environmental harms dates only from the last five or six decades. Although environmental harms are frequently discussed in the language of standard economics, this was rarely the case at the time. Over the nineteenth and early-to-mid-twentieth centuries, environmental concerns were often couched in terms of either resource constraints or public health.
For issues like air or water pollution, their categorisation as either an environmental or a public health problem was unclear. In many cases pollution was the result of situations in which noxious output was paired with weather conditions that caused acute crises, such as London’s Great Smog of 1952. While earlier reforms attempted to clean the air, it was this acute crisis that led to the Clean Air Act of 1956, which represented a real political effort to limit pollution. The Great Stink a century earlier had resulted in direct government action to deal with sewage polluting the Thames. In both situations the science of the general health effects was initially contested but the acute public health crisis spurred lasting environmental benefits.
The scale of these issues was new because of the total numbers of people involved and the new forms of polluting technology. The smoke from isolated chimneys may cause little harm but in much of the developing world or in historic centres such as London, wood smoke alone (not to mention new pollutants) can create widespread health issues. Economic growth, population growth and the technological innovations that empowered both may have led to new harms, but the wealth generated by cities also enabled the capacity to pay for improvements.
In their textbook on environmental economics, Nathaniel Keohane and Sheila Olmstead emphasise the standard contemporary approach to considering policy: cost–benefit analysis. As they write: ‘The basic approach is simple enough: Measure the costs and benefits of each possible policy, including a policy of doing nothing at all, and then choose the policy that generates the maximum net benefit to society as a whole (that is, benefits minus costs).’[11] At a minimum, a policy must ‘pass’ cost–benefit analysis; that is, generate net benefits. Similar statements occur in a number of textbooks. While much of the popular discussion and political efforts are still driven by broader concerns, formal policy analysis focuses on cost–benefit analysis.This is relatively new: when the crises above emerged, there was little role for economic analysis in broader policymaking.
In the United States, legal cases and local ordinances provided some protections even before wider legislation. There was logic in the processes by which these rules were made and adjudicated but prior to the formalisation of cost–benefit analysis, much public debate took place without quantified estimates of the benefits of pollution abatement.
In the nineteenth century the growing ability of the state to raise revenue – and assumption that it should step in – led to increased state action, but again, much of this took place before the widespread emergence of public policy practices attempting to deliver net value. While some major projects, such as turnpikes, canals and railways, were largely private in the United Kingdom (though carried out via private acts of parliament), the rise of public infrastructure projects led to the formalisation of cost–benefit analysis of some kind.
The great nineteenth-century engineers and social reformers such as Jules Depuit in France and Edwin Chadwick in England were forerunners of thinking about economic incentives and processes and a form of cost- benefit analysis even began in eighteenth-century France.[12] Over the nineteenth and twentieth centuries, increasingly formal efforts sought to understand the nature of harms.[13]
As currently practised, however, formal analysis can be traced to the American federal infrastructure projects to control flooding as part of the Flood Control Act of 1936.[14] Over the twentieth century, analysis of this sort became formalised in government decision-making, beginning with flood control efforts and water projects in the American West. From there it developed both within government and think tanks such as RAND and Resources for the Future, and within federal agencies. As one historian writes: ‘It is not a story of academic research, but of political pressure and administrative conflict.’[15] By the late twentieth century, executive orders issued by presidents of both parties compelled regulatory agencies to do a form of cost–benefit analysis – regulatory impact analysis – on any rule changes.[16]
Yet within this approach there are key questions about how benefits can be measured – and therefore whether they count – and how to consider future benefits properly. Spencer Banzhaf’s recent history of the field shows how the broader accounting for benefits such as recreation and health transformed resource economics into environmental economics.
[E]conomists began to measure abstract indices like Gross Domestic Product and inflation as well as the benefits and costs of public investments. When they similarly turned to quantifying natural resources and the environment, economists realized that if they limited themselves to those resources traded in markets, which come with a readily observed market price, they would omit much of what society holds dear.[17]
Spencer Banzhaf
Prior to the rise of the contemporary environmental movement in the 1960s, much of what would now be considered environmental economics was focused on questions of natural resource economics. The questions emphasised were those of how to ensure resources weren’t wasted and new resources were developed.[18] Over the course of the twentieth century, new methods allowed quantification of some of ‘what society holds dear’ and so allowed policy analysis that included relevant benefits of environmental protection.
In his book Pricing the Priceless, Banzhaf draws on the standard contrast used to sort environmentalists: conservationists who emphasise the use of resources prudently and preservationists who emphasise the purer protection of nature as a thing set apart from human uses. The earlier twentieth-century economists didn’t think about the environment beyond the conservationist approach. This approach also fits historically into a Cold War continuation of the mobilisation of resources for armed conflict and post-war economic growth. The 1952 Paley Commission published a report entitled ‘Resources for Freedom’, which detailed the potential material risks of the next decades and emphasised ways to ensure material plenty.[19] The goal was to enable economic growth and war-making ability. Out of the commission the influential think tank Resources for the Future was founded. Over the course of the 1960s, attention shifted from the lack of natural resources towards questions of how to respond to the degradation of the environment.
Up to this point the mechanics of economic analysis were geared towards a particular conservationist approach almost by design. In the formalisation of cost–benefit analysis during the mid-twentieth century, projects and policies were evaluated by their productive economic impact, with little room in the analysis for the value consumers might place on environmental preservation. What economists call the ‘amenity value’ of things that individuals enjoy and might even be willing to pay for – but generally don’t directly – can be difficult to estimate in situations far removed from standard markets. Banzhaf argues that part of the revolution in the evaluation of these benefits – like using water to support endangered salmon in the Snake River in the quote at the start of this chapter – is tied to the reorientation of economics away from crude output and towards applied welfare. As economic analysis gets further away from working markets, welfare analysis becomes more difficult. Contemporary environmental economics seeks to find robust ways of estimating the value of environmental benefits. By doing so it can inform policymaking that relies on cost–benefit analysis.
Cost–benefit analysis of environmental harms seeks to reduce their varied and complicated forms to a financial figure. Distilling harms to a figure may be subject to dispute but allows comparisons across areas. It might be clear that it isn’t worth devoting resources – whether actively expending money or restricting potential uses – to garner benefits if the net benefits are small, but this can also be true if alternatives have much higher net benefits. While mostly focused on future policy, cost-benefit analysis also allows a look back at some of the regulation passed in the 1960s and 1970s. Pairing economic theory and applied economic thinking about environmental harms, it is possible to see some of the potential for market-based regulatory reforms. The history of cost-benefit analysis reveals the intellectual difficulties of rigorous applied economic thinking apart from the standard notion that politics is the constraint on good policy.
To make this difficulty more apparent, consider the management of a section of national forest in the American West. If the forestry officials are tasked with deciding between allowing the forest to be used by logging companies or continue being used for recreation, it is easy to assess a value for the flow of timber that can be harvested but more difficult – though far from impossible – to impute a value for the walks and picnics that people use the forest for. In part, because of this difference between the legibility of use value, government policy can discourage uses that contemporary environmentalists seek. While amenity values or use values can be estimated with contemporary methods, so-called ‘existence values’ or ‘passive use values’ are more difficult to estimate. These are the values that one places on, for example, glaciers in Switzerland or polar bears in the Arctic whether or not one observes (or directly uses) them.
For these, economists have developed ‘contingent valuation’ methods that allow some estimates for goods such as the preservation of Half Dome in the Yosemite National Park, biodiversity and the damages caused by widespread harms like the Exxon Valdez oil spill. Despite this, they continue to disagree about the estimates and whether they are valuable.[20] The standard view of economists is that survey methods to estimate preferences or willingness to pay are far inferior to market situations where individuals must confront trade-offs directly. The use of surveys to estimate value fails to yield robust results because revealed preferences in markets (i.e. people’s preferences as manifested by their behaviour) often vary considerably from self-reported preferences. The methods can be useful in the same way that market analysis is useful to companies prior to launch of a new product – something with notable failures for the same reason.[21]
Apart from the more controversial aspects of economic analysis of environmental degradation, it is worth stressing the related development in estimating the health benefits of reductions in pollution. Many of the public health benefits of improvement in, say, air and water pollution rely on the notion of the value of a ‘statistical life’ to quantify the value of the lives saved by the marginal reduction in, for instance, particulate matter smaller than 2.5 micrometres in diameter (μm 2.5). These tiny pollutants were not directly targeted by conventional attempts to reduce air pollution (including twentieth-century attempts to reduce things like sulphur dioxide). Contemporary estimates of the cost-benefit ratio of air pollution policies find that many of the benefits come from the health benefits associated with the fall in μm 2.5 pollution. These estimates required measurement of this pollution and the notion of the value of a statistical life to account for the benefits. Like contingent valuation, the value of statistical life is a construct with a long history and the subject of much debate, from both an ethical and applied economic perspective.[22]
Despite these difficulties, contemporary empirical research attempts to create precise estimates of the benefits of removing types of pollution via different mechanisms. This includes research on a wide range of matters, such as how much individuals are willing to pay to escape polluted neighbourhoods and how much air pollution harms health outcomes, to name but two. One standard finding is that the marginal abatement cost of pollution rises; that is, it becomes more costly to lower pollution by additional units.
By the late 1950s, both economists and policymakers had formed quite well developed and deeply entrenched visions of how pollution-control policy should be constructed. Unfortunately, these two visions were worlds apart.[23]
Tom Tietenberg
The US government sets abatements standards, enforces them, and sometimes even prescribes the technology to be used, without attempting to equate marginal costs across pollution sources or provide incentives for technical progress … The blame for this lies, in our judgement, partly with the Congress and executive agencies for ignoring economists, and partly with economists for recommending impractical policies and for not offering compromises.[24]
Anthony Fisher and Frederick Peterson
Despite the growth of environmental economics in the 1960s, little of this approach filtered into the contemporary American regulatory framework. This section outlines some of this framework’s key features and explains why economists have advanced policy proposals that seek to rationalise the existing environmental protections. These proposals include methods of regulation that seek to reduce pollution in line with the costs and benefits of abatement. Economists argue that better regulation can provide a given level of environmental protection at a lower cost. As Nathalie Berta shows, in making these claims about efficiency, the argument for expert policy slipped from ivory tower notions of an optimal amount of pollution to reducing pollution in a least-cost way.[25] Despite successful intellectual arguments, gaining activist support and some legislative successes, there are still large gains to be made from adopting more market-based mechanisms for environmental protection. The failure of more of these policies to be adopted (and in some cases existing wins were rolled back) is discussed later in this chapter.
One example of an area of environmental policy with the most substantial reforms inspired by economics is the regulation of air pollution in the United States, much of which is via provisions originally passed in the 1970 amendment of the Clean Air Act (CAA). As part of these provisions, the Environmental Protection Agency (EPA) sets emitter National Ambient Air Quality Standards, which are emissions limits for the six targeted pollutants. These standards are set without consideration of abatement costs – though regulatory attempts to achieve these standards do consider costs. The
CAA also requires a State Implementation Plan for how states will reach those limits. Areas out of compliance generate additional regulations on existing and new polluters. Additionally, the act sets out that new industrial polluters are to be regulated according to technological standards via New Source Performance Standards issued by the EPA. These vary based on a number of factors, often but not always including cost. The 1970 amendment substantially altered the original 1963 legislation, and two major amendments took place in 1977 and 1990 (discussed below). The legislation also allows the discretion of the executive branch; since the 1980s executive orders have been subject to cost-benefit/regulatory impact analysis.
In the years since the passage of the 1970 CAA, the major pollutants have fallen in response, though causal estimates are difficult to generate. There is a consensus in the literature that the CAA reduced pollution relative to the baseline and passes retrospective cost–benefit analysis.[26] Much of the benefit derives from the health impacts of the reduction of the major pollutants. Despite the scale of the legislation and the active work of researchers, many of the aspects one would need in order to set optimal policy remain unknown. There is no reason to think the reductions were achieved at least cost, and there are clear examples of unintended consequences.
One example is from the 1977 amendment to the CAA that prescribed the technical requirements of new coal-based power plants to reduce emissions of noxious sulphur dioxide (SO2). This technical standard was in the interest of coal producers in the Eastern United States because they sold higher-sulphur coal, something not lost on them or their political allies.[27] Once industrial users met the standard by implementing the technology, they were free to pollute and therefore they were also free to minimise costs by using the cheaper, easier-to-transport eastern coal rather than the cleaner coal from the Western United States. The technical standard had no mechanism to govern the amount of SO2 generated. The absurdity of the rule is that even were a power plant able to achieve a reduction in the pollutant without the costly technology by using coal with less sulphur, the regulatory standard would rule them out of compliance because they didn’t install the technology. Furthermore, the height of the smokestacks increased in response to efforts that sought to improve local air quality. By increasing the height, industrial polluters were able to pollute in a way that generated acid rain miles away – including over international borders – as the pollutants fell back to earth. This is an example of public choice problems– dirty coal producers concentrated in politically important districts – combining with imprecise rules to result not just in a failure to solve existing environmental problems but also the generation of a new one in the form of acid rain. These failures of the conventional regulatory approach and the constrained fiscal space provided the political interest for an experiment in market-based reforms in 1990, explored under ‘Creating Markets in Practice’ below, preceded by the following discussion of the theoretical framework.
By the middle of the 1960s the waning focus on the importance of material resource constraints was being replaced by concern for the ill effects associated with material prosperity.[28] Economists at Resources for the Future and other organisations spearheaded efforts to address environmental degradation via more efficient approaches. Despite the association with Arthur Pigou, contemporary ideas about taxing pollution stem from Allen Kneese. Together with economists thinking about trading mechanisms, it was Kneese who sought least-cost ways to address environmental concerns. Achieving a given target at least cost was both more attainable than the idealised approach of taxing pollution at its marginal social cost and more efficient than heavy-handed regulation.
Kneese’s foundational work focused on the governance of water resources.[29] Here, a number of related questions arise about alternative uses and the impact of one use on another. In response to the complicated, interrelated system, Kneese argued – in line with Pigou – that a theoretically optimal solution would be ‘a system of spatially differentiated effluent fees, ideally set at the marginal damages of emissions’.[30] However, because this was untenable (at least for the time being), Kneese proposed a system whereby emitters were charged when water quality dropped below a regulatory standard (or emissions went above a certain level). Regulators could adapt prices in response to the observed reduction. But the logic of the tax would mean that emissions were reduced by those who could do so at a cost cheaper than the tax, while those for whom the tax was cheaper would continue polluting. As Banzhaf mentions in his treatment, ‘[Kneese] stressed the fact that with effluent charges, the market – not a planner – would find the way to reduced pollution.’[31]
Considering the difficulty – and cost – of estimating the benefits of abatement, Kneese showed that taxes could be applied over a politically determined level of emissions, with the benefit that the market would choose how to achieve it.[32] This represented the beginning of contemporary attempts to achieve environmental goals at least cost, rather than seeking an impractical optimal policy that achieves the economically ideal amount of reduction at least cost. While the level selected by the political process may be too high or too low (as compared to the textbook ideal), the process for achieving the level ensures that it does so in a way that doesn’t suffer from the waste of command-and-control regulations. This standard-and-tax approach was further developed by William Baumol and Wallace Oates.[33]
Such an aspect of the appeal of market-based regulations brings up a fundamental question about the nature and role of markets. While recent decades have seen an expanded understanding of what constitutes a marketplace, including domains previously considered outside market frameworks, this broader perspective has introduced important tensions in how we approach environmental challenges. Most advocates of market mechanisms take a moderate position, acknowledging that pure laissez-faire approaches may be insufficient for addressing contemporary environmental problems, particularly the most pressing issues of the twenty-first century. This moderation reflects a nuanced understanding that while conventional markets may emerge naturally, environmental issues often require some form of intervention to address market failures.
The key insight is that environmental policies, though preferable to no regulation at all, frequently achieve their pollution reduction goals at unnecessarily high costs. This has led to the development of market- based regulations that attempt to mimic the efficiency benefits of market mechanisms while addressing the inherent challenges of environmental management. More committed free-market environmentalists, while potentially sceptical of extensive regulation, often acknowledge that such market-based reforms represent an improvement over traditional command-and-control approaches.
Apart from the standard-and-tax approach, regulators can also generate trading by explicitly creating property rights to emit via a cap-and-trade programme.[34] Here a regulator puts an upper limit (‘cap’) on something like units of pollution and allows those affected by the cap to buy and sell (‘trade’) their rights or permits among themselves. Many ascribe the direction of travel in economic thinking about environmental regulation involving tradeable rights to Ronald Coase and set market-based regulations against both idealised Pigouvian taxes and command-and-control approaches. As a historical claim this argument runs into difficulties, but there is much similarity between Coase’s thinking and cap-and-trade approaches.
Coase’s foundational ideas about market mechanisms for managing spillover effects emerged not from his famous 1960 paper discussed in Chapter 1 but from his earlier work on radio spectrum allocation,[35] which bears closer resemblance to pollution trading markets. In examining the Federal Communications Commission’s (FCC) approach to managing broadcast frequencies, Coase challenged the conventional wisdom that government regulation through licensing was the only solution to managing signal interference between broadcasters. The existing system in the United States had evolved into a complex regulatory regime whereby the FCC awarded narrow frequency bands with wide buffer zones, allocating these valuable licences through arbitrary ‘beauty contests’ that consumed substantial resources from potential broadcasters.
Coase argued that the radio spectrum was not fundamentally different from other resources that markets successfully managed. He proposed replacing the discretionary licensing system with an auction mechanism in which the government would define clear usage rights and sell them to the highest bidders, allowing subsequent free trading of these rights. This proposal faced fierce resistance from both politicians and FCC regulators,but when spectrum auctions were implemented in the 1990s they not only generated significant revenue for the federal government but facilitated the rapid development of mobile phone technology, validating Coase’s insight that market mechanisms could efficiently allocate even complex resources with spillover effects (the interference). Taken together, estimates of these efficiency improvements are around $17 billion dollars.[36]
Shortly after Kneese’s first developments of his effluence fee scheme (and nearly ten years after Coase’s FCC paper), two economists – Thomas Crocker and John Dales – are generally credited with proposed emissions permits schemes whereby regulators would set a cap of total emissions and divide this cap into permits to pollute.[37] Thus, instead of setting (and re-setting) a tax in order to achieve an emissions target (as companies could choose to pay the tax instead of reducing emissions to the level desired), emissions would be reduced by way of a cap-and-trade system. As in Coase’s article on tradeable spectrum rights, Dales considers the foundational issues before arguing for a property rights scheme:
Economists tend to assume implicitly that it is impossible to own water and therefore seek to devise artificial price systems that are identical to what prices ‘would be’ if ownership were possible. The alternative strategy is to devise an ownership system and then let a price system develop. The purpose of this article is to suggest that there are very considerable advantages to attacking our water problems by means of a system of property rights.[38]
Cap-and-trade combines some of the benefits of the purer taxation approach with the political – if not necessarily welfare-enhancing – benefits of the command-and-control approach. Without examining any issue in detail, it is possible to think about some benefits that – an economist would point out – flow from this system as opposed to more standard command- and-control approaches. For one thing, the system is beneficial when the abatement costs that firms face vary. As shown in Chapter 1, this is one of the benefits of the tax approach as well. In the case of cap-and-trade, firms that engage in production that results in less pollution on the margin will be encouraged to continue producing – and perhaps even expand production – while those that engage in production that results in more pollution on the margin will be encouraged to produce less. It also maintains the incentives for firms to invest in known means of reducing pollution, as well as in research and development into new methods.
For policymakers, a benefit of the cap-and-trade mechanism is that it ensures a certain level of emissions can be achieved. In practice, when for scientific or political reasons achieving the target is of utmost importance, this is a drawback of the tax strategy because policymakers may choose to set the tax at a certain level hoping to achieve a certain result, yet find that the tax is too low to achieve it. This benefit of the cap-and-trade system is even more evident over time, as the permits market adapts to changing circumstances without explicitly changing the rate of tax. In theory, politicians could vary tax rates in pursuit of efficiency, but this runs into obvious political difficulties. The system also spurs innovation as companies look for new ways to reduce emissions when permits become valuable.
While conceptually clear, there are of course specific questions about implementation. The level of geography (whether local, regional, or national) and timespan for permits matter, both in theory and in practice. Additionally, theory suggests that assigning permits via auction is the most efficient outcome, while the political constraints of the situation generally result in their being allocated to existing polluters. Caps can also be designed to become progressively tighter as permits are retired. As the cap tightens over time, permit prices tend to rise, creating stronger incentives for developing – and adopting – cleaner technologies.
In the most important contemporary issue, the distinction between tradeable property rights and taxation is perhaps the least emphasised, instead falling under the combined concept of ‘carbon pricing’. This can occur via a cap on emissions and a resulting price being generated via market trading, or via a tax. As discussed below, the benefits of each are still debated,[39] but first, it is worth looking at how this theoretical development was adopted by regulators.
The first generation of American environmental regulations did not take advantage of the benefits of market-based mechanisms. Some later reforms have introduced them, in part because of the theoretical argument being won but also as a result of increased political interest in market-based mechanisms. Some of this interest was due to the increasingly fractious politics surrounding tightening environmental reforms in the slower-growth 1970s and the general political environment, but also to the success of incremental reforms at meeting targets that would otherwise not have been politically achievable. This section considers examples from the development of regulations emanating from the CAA,[40] most notably the SO2 trading scheme.
A consensus around the type of least-cost mechanisms discussed above formed in academic economics, but in some cases the market-based mechanisms were, surprisingly, proposed by political and regulatory figures in the early 1970s. For instance, the Nixon administration had sought to regulate SO2 with them from the outset. In other cases, as with an early attempt to allow emissions trading in California via state regulators, political pressure shot it down, or the ethical arguments over the right to pollute and the proper role of cost-benefit analysis in environmental/health regulation stymied early efforts. But Charles Halvorsen showed how regulators themselves increasingly turned towards market-based mechanisms.[41] Some of the successful programmes included so-called ‘bubbles’, which allowed polluters to aggregate their emissions between the plants that they owned, and offsets, which allowed new plants – which would have otherwise been banned – to gain approval by reducing existing emissions at a ratio of more than 1:1. Despite this opening-up to market mechanisms, regulators required approval for each scheme and otherwise limited the extent of adoption.
The development of market-based regulatory environmental mechanisms by the EPA and policymakers in the late twentieth and early twenty-first centuries represented shifts in regulatory strategy. After a few smaller-scale experiments (including removing lead from gasoline), the most notable example is the SO2 emissions market enabled by the 1990 amendments to the CAA.[42] A key milestone was Project 88, sponsored by Democratic Senator Timothy Wirth and Republican Senator John Heinz, and directed by the economist Robert Stavins, which proposed using market principles to address environmental challenges.[43] The project report covered a number of environmental issues, including ones that hadn’t been directly targeted by regulation. In line with the move from determination of optimality to achieving goals by efficient mechanisms, the report states:
This study is not about setting environmental goals by the use of economic criteria. It does not recommend the use of benefit-cost analysis, or setting dollar values on environmental amenities or human health. Indeed, for the most part, the report eschews judgement on goals and standards. It does not suggest how much air pollution is acceptable, how many acres of wilderness are needed, or how to balance the need for controlling emissions of toxic chemicals with the costs of such controls. These are important – even crucial – questions. But there is a need to set aside ongoing debates over specific environmental standards, in order to carry out a separate examination of effective mechanisms for environmental protection.[44]
One of its case studies set out a proposal that eventually became the SO2 emissions trading programme in the 1990 CAA amendments, creating a cap-and-trade system for reducing the emissions that were causing acid rain. Its adoption was influenced by the Environmental Defense Fund (EDF) and renewed interest in environmental outcomes among Republicans after a mainly deregulatory focus at the EPA under President Reagan. This approach, championed by EDF and economists-cum-policy entrepreneurs like Stavins, allowed companies to buy and sell pollution credits, providing financial incentives for more efficient emissions reduction. The programme has been studied by many scholars, and in line with theory, research has found that it achieved reductions at costs between 15% and 90% lower than command-and-control regulations. Furthermore, the incentive to achieve reductions at a lower cost spurred innovation in burning processes and technology.[45] Subsequent market-based mechanisms for carbon dioxide and other pollutants have built on this framework, California’s carbon cap- and-trade programme serving as a prominent example in the mid-2000s.
While market-based regulations, such as those creating trading programmes, offer efficiency gains over standard command-and-control, it should be remembered that political forces impact the nature, timing and existence of market-based regulations, which is relevant both for questions of assessment and for the viability of future schemes. For instance, one point of contention in the SO2 trading scheme was that EPA administrators – and environmental activists – insisted on classifying the tradeable rights as allowances and not a form of property subject to protections against later changes.[46] This type of insistence and the resulting uncertainty about the permanence of trading schemes has scuppered other markets.
Despite the importance of comparative institutional analysis in determining the relative performance of alternative regimes, Gary Libecap argues that: ‘In general, transaction costs are not examined in depth in the environmental economics literature. This is particularly the case for the costs of political bargaining and lobbying that arise from implementing and administering government regulation and tax policies, although these costs have received somewhat more attention with cap-and-trade regimes.’[47] Yet even here it is important to be clear that the caps are the result of a political process. Insofar as the cap is informed by economic analysis, it is often fairly casual. As Stavins writes of the SO2 cap:
When the policy was enacted, no credible estimates of economic benefits of alternative target levels were available … Instead, the target was selected based on what was believed to be the ‘elbow’ of the abatement cost curve – that is, a level of abatement that was possible at relatively low costs, and above which the marginal costs of reducing emissions would climb dramatically.[48]
While economics can inform and improve policy, both electoral and bureaucratic politics shape even market-based policy. Government policy and taxpayer money should be devoted to the environmental protection that is most needed. In some cases, privatisation can generate revenue and improve outcomes by empowering market mechanisms. In many of the most difficult cases, such as air pollution caused by disparate sources, the issues are likely to result in government policy improving outcomes when compared to a laissez-faire approach. Status quo (command-and-control) regulation can benefit from basic economic thinking about the issues, and as seen in the reforms presented in this section the stars can align and improve policy. While this section has focused on air pollution, the logic of other regulatory systems is discussed in the next.
While regulation cannot be analysed in detail here, it is worth offering a few examples of the status quo regulatory attempts to limit environmental harm across different policy areas, along with realistic market-based proposals to improve them. The examples are presented by topic area but underlying this they are broadly organised by order of increasing difficulty. Later proposals move towards increasingly involved regulations to create markets – as has been attempted in efforts to limit air pollution – rather than expecting them to emerge. Environmental problems represent a spectrum of issues that vary in their amenability to market solutions.
When thinking about how to address environmental issues, there are various factors to consider, from the origins of harms to their effects and reach, and how policies relate to each. For the most difficult issues, such as climate-change policy, there are myriad levers and policies that influence both the generation of the environmental harm and the scale of damage caused by it. For some pollutants the threshold for harm is clear – amounts below it cause little harm and marginal harm increases above it. In some cases, such as climate change, the emissions have the same impact on the issue at hand wherever they are released in the world. But even for regulatory schemes targeting climate emissions, the underlying behaviour generating greenhouse gases also generates local emissions. Policies can be adjusted to account for these concerns, including those of environmental justice activists and organisers.[49]
It is perhaps easiest to think about this variation in amenability to market mechanisms in terms of the transaction costs, which are to an extent determined by the nature of the resources involved in the environmental problem at hand. At one end are resources with clearly definable property rights and relatively localised impacts, such as timber production or riparian fishing, where private ownership can effectively align incentives for sustainable management. Moving along the spectrum there are resources with increasing complexity in terms of spillover effects and measurement challenges, such as watershed management and open-water fisheries, where hybrid approaches combining market mechanisms with regulatory oversight have merits. And at the extreme end lie greenhouse gases that threaten climate stability and atmospheric quality, where the global nature of impacts, scientific uncertainty and inability to exclude users make purer market solutions impractical and state involvement all but necessary.
This framework helps policymakers identify where market-based tools might be sufficient on their own, where they need to be supplemented with other approaches and where alternative policy instruments might be more appropriate. The basic point throughout the following examples is that state solutions to environmental problems are often suboptimal and can be improved with economic thinking.
[T]ransaction costs … tend to be at their lowest in the case of land-based issues… Other stationary resources, such as oyster beds and water-based assets such as rivers and inshore fisheries that are excludable with existing technology also exhibit relatively lower bargaining and enforcement costs. Although in many cases such assets are amenable to private ownership of one form or another, the political/ideological framework often prevents the development of environmental markets even where they have considerable potential to improve resource allocation.[50]
Mark Pennington
Over the past decades, private lands have increasingly been brought into conservation. In the United States these include lands purchased by such trusts as The Nature Conservancy and many smaller organisations. Apart from explicitly charitable organisations, land is being conserved by private owners such as Ted Turner, among others. More complex contracting mechanisms allow landowners and environmentalists to interact in mutually beneficial ways. Perhaps chief among these are conservation easements, which have grown to cover millions of acres.[51] These allow land to be held privately with restrictions that prevent certain environmentally harmful uses, such as, most obviously, building on them but also farming that generates nutrient pollution, or harvesting trees. Parties customise the easements depending on the nature of their goals, but it is difficult to remove easements once they are placed on the property. These efforts show the capacity of private individuals to conserve land with taxpayer support via tax credits introduced by governments.[52]
But for reasons discussed earlier, the public-interest argument for leasing public lands was to encourage their cultivation. There are binding rules either to use the land or forfeit the right to the lease. Conservation activities are not classified as uses of the land so in practice, this has led to a situation in which public lands can’t be leased by those wishing to use the land for conservation, while private lands can be. The rules thwart efforts to lease the land directly and to enter into agreements with those who have leased government land for myriad activities ranging from cattle ranching to logging. This is of importance in much of the American West, where a large share of land is held by different federal agencies.
In discussing the recent reforms to the Bureau of Land Management (BLM) rules to allow new leases to be issued for conservation, Shawn Regan writes of the general principle:
A better, market-based approach would allow competing groups to negotiate with or bid against each other to determine which use has more value to prospective leaseholders – mining, for instance, or restoration. This would streamline the lengthy and contentious battles that often pit extractive industries against conservation interests over certain tracts of land.[53]
The 2024 reforms still make it difficult for conservation groups to bargain with existing leaseholders in extractive industries, and while the BLM manages about a tenth of the land in the United States, the National Forest Service and other agencies still manage large swathes that are unaffected. Reforms and targeted incentives would allow markets to conserve land efficiently.
Some of these same features apply to waterway management, particularly in places like the Western United States where natural rainfall is low. Large populations rely on water collected in major reservoirs, transported long distances and taken from aquifers. This is also true of irrigation for agricultural users. There is a large degree of government involvement both within the legal system of water rights – where there is wide variation – and in public utilities.
Somewhere like the Colorado River basin involves millions of users over numerous jurisdictions. Water is used for recreation, direct consumption, agricultural production and the generation of power, among other things. Chief among these, of course, is the water left within the system for fish to live in, large mammals to drink and natural vegetation to grow. These so- called ‘instream’ uses have received increased attention in recent years as drought has caused levels to fall.
Two striking features of water governance are, first, how difficult it is to exchange property rights, and second, how little price mechanisms are used to ration water. In parts of the American West, water concerns prevent valuable residential development despite the marginal economic value of the water to the new residents being high enough to compensate existing users who value the marginal unit of water less. (The uses of water they would reduce first if the price were higher would likely include things like reducing the size of the front lawn). The nature of the system of allocation often means existing users have little interest in stewarding the water they use because they face lower – or in some systems zero – marginal cost; in the extreme, use-it-or-lose-it allocations encourage waste. More generally, without metering and charging a cost per unit, there is little reason to reduce use. This is true of many agricultural users but also residential users in water districts with earlier rights to water. For illustration, Sheila Olmstead cites research from 2008 showing that ‘farmers in Arizona’s Pima County pay $27 per acre-foot, and water customers in the nearby city of Tucson pay $479–$3267 per acre foot.’[54] For some farmers, their most valuable asset may be their water rights. While some trades do take place, the regulatory complexity in sales or leases adds unnecessary complexity, raising transaction costs.
More than just charging different rates to different users, when faced with drought, water authorities routinely engage in public appeals to conserve water and, for example, turn off fountains in parks and museums. In California, citizens are encouraged to report neighbours who let water run off their lawns. Yet as Olmstead cites, these types of rationing rules are costly.[55] Technology standards like low-flow toilets or mandating certain types of appliances are also less efficient than simply raising prices. They also suffer from a rebound effect whereby consumers use more as efficiency improves – which is also true of insulation and heating improvements.
Economists find this type of regulation – as opposed to charging higher marginal rates above a certain threshold of use or rebating some basic level of use for low-income users – rather bizarre. Regulation can be warranted in places where the market is expected to face difficulties, but in many cases the regulation is what limits the capacity of markets to do social good.
The differential treatment of agricultural users is not just a feature of the water prices they face. Increasingly stringent regulation on American waterways has meant there are few point sources of pollution left; that is, most pollution results not from drainage pipes from industrial users but from accumulated runoff from fields and roads that drains into watersheds.[56] The Clean Water Act leaves much of this pollution to the states, and while some have made efforts to reduce it, agricultural interests and the difficulty of regulating such disparate pollution have resulted in relatively little progress. Increasingly large sums of money are spent to further reduce some sources of water pollution while little is done to reduce pollution in cheaper ways because the two sources of water pollution are regulated differently. Recent judicial rulings in Europe have resulted in cost- prohibitive restrictions on the nutrient runoff from new polluters such as housing developments.[57] In the United Kingdom, potential exchanges were allowed but faced high transaction costs. Recently proposed reforms seek to allow new polluters to pay into a fund that the government uses to abate pollution in lower-cost ways.[58]
Instream uses of water rights have faced a similar challenge to the example above, of land used for conservation not falling into the standard of use set out by legal rules or regulations. Water-use rights in much of the American West depend on so-called ‘use-it-or-lose-it’ rules. Absent changes in the law, water rights purchased by conservation groups to leave water in rivers and streams for riparian habitats – rather than remove it for use on fields or human consumption – wouldn’t be classified as a use and would therefore risk being lost. This has occurred in some states including notably the Oregon Water Trust (later the Freshwater Trust) which has traded with local users to acquire water rights that allow them to improve and maintain salmon habitats among other things.[59]
Air pollution was discussed above, but a recent experiment in India – the first to apply industrial emissions trading to μm 2.5 particulate matter regulation – is worth mentioning here.[60] As additional research shows, the harms of this type of pollution, and many countries seek to improve air quality with the least economic harm, this experiment may prove influential. The researchers found that the cost of achieving the existing target for pollution via a cap-and-trade mechanism was 11% lower than the pre- existing plant-level controls. As it happened, the targets could be more aggressively set because polluters could achieve reductions at a lower cost. This made it politically viable to maintain lower targets. Compared to the control groups, the treatment group of plants regulated by the cap-and- trade system produced between 20% and 30% less pollution in practice because caps could be tightened. While theoretically targets could be set too low and reduce pollution below an optimal level, in this instance the cost–benefit analysis suggests that the benefits were around 25 times higher than the costs. One important feature of this experiment is that it also reduced the administrative cost of lowering pollution – something particularly valuable in contexts where past efforts to enforce regulation have failed.
Chapter 2 introduced the economic root of the environmental problem with fisheries: the high transaction costs involved in establishing property rights create an incentive to catch more fish than is sustainable. This is a classic collective action problem because any one person who seeks to limit overfishing has no means to stop others from acting in their own interests. Despite government policies to limit overfishing, poorly designed policies mean that resources are wasted as fishing enterprises invest in faster and bigger boats, for example, to maximise the catch during the short fishing seasons mandated by regulators. Ecologically determined seasons don’t solve the fundamental economic problem of fisheries management, with the result that seasons become ever shorter while fish stocks continue to be at risk.
While Elinor Ostrom showed that self-governance mechanisms can emerge in some settings, in higher transaction-cost settings, market-based regulations in fisheries have proved successful.[61] These typically operate through systems such as Individual Transferable Quotas, where fishers receive tradeable rights to harvest specific amounts of fish based on the sustainable yield (or the shareholders in a collectively owned fishery can themselves set the allowed catch).
This creates a property rights system that incentivises long-term sustainability, as quota holders have a vested interest in maintaining healthy fish populations to preserve the value of their quotas. The transferability allows more efficient operators to acquire additional quotas, potentially leading to better resource management while reducing overcapacity in fishing fleets. Competition occurs in the marketplace for the property rights rather than in open waters. Despite emerging in the literature in the 1970s, political challenges have slowed take-up of property rights systems in fisheries management, though there has been notable progress.[62]
Fish with widespread migration patterns, such as Atlantic tuna, provide a uniquely challenging fisheries management issue.[63] While domestic fisheries management similarly grapples with monitoring, enforcement and biological sustainability, international management must address these concerns across multiple jurisdictions, political systems and economic contexts. The added layers of international law, varying enforcement capabilities and cross-border transaction costs create a level of complexity that makes even successful domestic fishery management frameworks insufficient. In the late twentieth century the extension of Exclusive Economic Zones sought to reduce the number of international disputes, but for many migratory open- water fish species the issues remain severe.
These challenges foreshadowed many of the difficulties now faced in implementing global climate policies such as cap-and-trade systems. The larger the geographic range of the fish migration and the higher the number of governments involved in the negotiations, the more difficult have governance mechanisms been to negotiate. Like the efforts of climate-change agreements to address global emissions, these suffer from collective-action problems.
Most countries, including the United States, do not place an economy-wide tax on carbon, and instead have an array of greenhouse gas mitigation policies that provide subsidies or restrictions typically aimed at specific technologies or sectors … In the world of a Pigouvian tax, markets sort out the most cost-effective ways to reduce emissions, but in the world we live in, economists need to weigh in on the costs of specific technologies or narrow interventions.[64]
Kenneth Gillingham and James Stock
Climate change is the result of centuries of emissions generated by the very things that allow humans to achieve gains in their standard of living. Both the nature of climate change (multi-causal and wide-ranging) and the nature of the actors (diverse and under myriad legal systems with no worldwide decision-making body) make it not just the ‘greatest market failure ever known’ but perhaps the most difficult social problem to solve.
Many of the concepts presented throughout this publication apply to climate change. The atmosphere is the extreme example of a common-pool resource hard to protect with property rights that enable exclusion. Climate change stems from the global emissions produced by industrial users and individuals all around the world. While the results of the marginal increase in temperature may harm some regions more than others, whether they come from China or Norway, the pollutants have the same effects. Finally, even the results of the added pollutants today will not be felt for years. Other global environmental externalities, such as those of migratory fish stocks, are difficult to solve, but climate change is the most difficult. All humans benefit from solving the collective-action problem, but that only makes it more difficult because of the coordination needed.
Economists generally see the ideal solution as one of pricing the pollutants, ideally according to their social cost. For greenhouse gases they have created – and debated – the Social Cost of Carbon, which attempts to calculate the negative value of a unit of carbon dioxide (and equivalents).[65] It represents the value of the damage, so within this are the health and environmental costs of carbon, including in the future (which are discounted into a present value). Climate change generates changes in the future that must be accounted for in the present. Analogous to how firms discount their future streams of revenue and expected costs according to standard practices in corporate finance (because revenue in the future is worth less than revenue today), policy analysis uses assumptions about a social discount rate set by government to consider policy with implications in the future.[66]
Unsurprisingly, the Social Cost of Carbon is susceptible to many open debates about the values to be placed on parameters such as discount rates and a ‘statistical life’, not to mention the myriad scientific relationships relied on to estimate the relationship between emissions and events that cause damage. Given this, estimates vary, but a recent paper finds a value of $185 per ton.[67] This is notably higher than existing pricing schemes.[68]
Beyond the tricky question of what the price should be, of particular importance in relation to climate change is the epistemic function of markets. Pricing leads market participants to act in a new way based on information revealed by the price system. Pricing pollutants leads producers and consumers to mitigate the harm they occasion by more obviously incentivising the reduction of use but also, and perhaps more importantly, by adjusting behaviour on various margins – such as adopting new methods of production or spurring innovation. As many have noted, the considerations that consumers engage in with respect to the effect of their actions on the climate are particularly hard to work out. Are imported vegetables better or worse? Are the fewer resources needed to grow mature tomatoes in Morocco and Spain offset by the transportation miles? Beyond the core economic issues, well-meaning and well-informed consumers may attempt to act responsibly – even more so than some might predict – but the difficulty of knowing the right answer frustrates their efforts. A price on pollution, even if not the optimal price, performs a function that voluntary actions have difficulty achieving. Even if the price of carbon were too low as compared to the optimal price that reflected the social cost of the effects on the atmosphere for present and future generations, any price would lead to producers and consumers economising as relative prices changed. For instance, the price of the climate impact would filter into the decisions made along the tomato supply chain and the market would determine the trade- offs.
The political debates around both taxes and tradeable permits bring to the fore issues about take-up. While prices vary in typical markets, the inherently political nature of carbon markets means that businesses and green entrepreneurs are subject to political change. Governments want flexibility to change policy without legal constraints but market participants – especially in carbon credit schemes) – want the legal protections of real property rights.
Despite the growth of carbon pricing across the world, the United States has not followed suit. As Libecap writes:
Despite early optimism among some economists that cap and trade would become the template for US greenhouse gas (GHG) emission controls, that too has not been the case. The various federal and state regulatory efforts to address GHGs generally do not follow the national market-based approach in the SO2 phase-down, for example. Rather, the EPA, Congressional legislation, and Presidential executive orders outline a myriad of non-tradeable standards and restrictions on emissions from oil and gas use, coal and natural gas-fired power plants, industrial facilities, pipelines and other surface transport, along with subsidies and related tariffs for green energy development and electric vehicles.[69]
At least in terms of emissions reductions, climate-change prevention is a global public good: individuals cannot be excluded from the benefits of the reduction in emissions and the benefits that accrue are non-rival. This has led most to focus on binding legal actions between nations and regional groups. Despite this obvious logic, Ostrom has pointed out that many of the externalities are nested; that is, the control of pollution at the local level has benefits that accrue to the wider global populace.[70] This is of relevance for attempts to limit local air pollution.
In the absence of the ideal economic approach of taxing the pollutants themselves, these different features increase the difficulty of dealing with global warming in terms of reducing both the warming that occurs, and its impact, in some globally coordinated way. Much of the focus has understandably been on such agreements as those struck at Kyoto and Paris, but just as the warming outcome is the result of many varied decisions that take place without accounting for their negative effects, the limits to continued warming may result from decisions made at a less than global level (mainly national and subnational) and from technological developments achieved by entrepreneurs (both with and without the help of government policies).
Beyond the different responses to limit climate change, it is also worth considering that many of the mechanisms to limit the impact of natural disasters depend on subnational governance decisions and market actors more than national governments or international agreements. This is obvious at the time of the disaster and in the preparation for disasters but is also true of the broader framework of regulation that ensures reasonable decisions by individuals and firms. For instance, state policy should allow insurers to price according to risk, ensuring that both policyholders and insurers make the right investments,[71] yet in many cases insurance markets face politically motivated regulation. There is much room for improvement in management practices in resources where public bodies are in control, be that flood walls, firefighting equipment or controlled-burn policies in forests.[72] The cost of climate change will depend on the amount of warming but also on adaptation and preparation.
The last decade has seen large sums of money invested in the transition to green technology. Some of these investments are simply just market actors adopting new technology where profitable, and little different from the energy sector moving away from coal generation towards cleaner natural gas in the wake of the fracking revolution. Others are the result of state support, both explicitly as subsidy or implicitly as requirements on energy producers. Economists generally predict these acts of industrial strategy to prove poorly targeted and inefficient at reducing emissions; that is, achieving reductions at a greater cost than pricing the pollutants themselves via trading or tax. Research shows these inefficient ways of reducing greenhouse gases to be often more politically popular than relatively efficient alternatives.[73] Even in the United States the rollout of green energy generation has been hampered by environmental regulation in the form of the National Environmental Planning Act (1970) and state and local planning difficulties. If anything it has proved more difficult in the United Kingdom, despite the commitment to net zero.
In a period of increased fiscal strain across developed countries, market- based regulations can improve outcomes at greater efficiency by changing the incentives of regulated industries and disparate individuals. In much of the world, economic progress is still more important to many citizens than limiting environmental harm, especially when those reductions in harm accrue globally. The consequences of climate change are becoming clearer, and improvements must move from mere potential. The high-level approach to multinational agreements has much merit, but this section has emphasised some other elements of policy response that can help solve this difficult and complex problem.
The short answer is that command-and-control instruments have predominated because all of the main parties involved had reasons to favor them: affected firms, environmental advocacy groups, organized labor, legislators, and bureaucrats.[74]
Robert Stavins
Despite the theoretical advantages of a market-based approach to environmental problems that stresses property rights and market-based regulation, it often loses out in the political arena. For a time, these solutions seemed ascendant. A simplified version of this triumphant narrative is familiar to students of economics, but even with the rise of the economic framework for understanding and debating policy in the late twentieth century, much of the regulatory apparatus evolved prior to these developments. The continuing existence of much of the pre-existing regulatory framework is not the sole problem; in spite of new market-based regulation, much contemporary environmental policy suffers from the basic problems of command-and-control regulation.
This chapter has built on the work of historians of economics to show how those working in environmental economics in the past responded to theoretical and applied problems to craft market solutions to environmental issues inadequately addressed by regulatory measures. It has also pointed out some of the tendencies within the political sphere that have limited potential market solutions to environmental problems. While the topic is vast, two aspects of the stagnation can be identified.
One is at the intellectual level: despite the consensus for carbon pricing within economics, increased attention has been devoted to more radical transformations of the economy. At the level of more local pollution, political energy has shifted from technocratic reforms towards environmental justice, despite there being potential for many improvements to existing policy.
More generally, the incentives facing politicians and policymakers – shaped in part by the views of citizens and market participants – have limited the take-up of market-based reforms. Policies suggested by the framework are unpopular with politicians, regulators, and diverse interest groups, ranging from environmental activists and regulators to industry groups, as noted by Stavins in the mid-2000s. As with the FCC spectrum auctions mentioned above, market-based environmental policies often weaken policymakers’ control by reducing their discretionary authority and opportunities for visible regulatory intervention.
Environmental activists often prefer the perceived certainty of direct regulation, while regulators may resist mechanisms that diminish their bureaucratic role, and industry groups frequently favour targeted subsidies over market-wide pricing mechanisms. However, the continued effort towards limiting carbon emissions via a complex array of subsidies, mandates and bans risks the worst situation of all: spending enormous sums and constraining economic growth without achieving the emissions reductions that more efficient market-based approaches could deliver at lower economic cost.
[1] Roger E. Backhouse, The Penguin History of Economics (London: Penguin, 2023), p. 412.
[2] Nathaniel O. Keohane and Sheila M. Olmstead, Markets and the Environment, 2nd edn, Foundations of Contemporary Environmental Studies (Washington, DC: Island Press, 2016), p. 2.
[3] Gallup Inc., ‘Seven Key Gallup Findings about the Environment on Earth Day’, Gallup.com, April 2024, https://news.gallup.com/poll/643850/seven-key-gallup-findings-environment-earth-day.aspx.
[4] Elizabeth Popp Berman, Thinking like an Economist: How Efficiency replaced Equality in U.S. Public Policy (Princeton, NJ: Princeton University Press, 2022).
[5] Richard Schmalensee and Robert N. Stavins, ‘Policy Evolution under the Clean Air Act’, Journal of Economic Perspectives 33, no. 4 (November 2019), pp. 27–50, doi:10.1257/jep.33.4.27; Coral Davenport, ‘Claims of “Bleak” Environmental Justice Record Appear to Fell a Biden Favorite’, The New York Times, December 2020, https://www.nytimes.com/2020/12/14/climate/mary-nichols-epa.html
[6] Berman, Thinking like an Economist, p. 193.
[7] Hannah Ritchie, Not the End of the World: How we can be the First Generation to build a Sustainable Planet (London: Chatto & Windus, 2024).
[8] Gary D. Libecap, ‘Williamson and Coase: Transaction Costs or Rent-Seeking in the Formation of Institutions’, NBER Working Paper 32603 (Cambridge, MA: National Bureau of Economic Research, 2024), http://www.nber.org/papers/w32603
[9] Nathalie Berta, ‘Efficiency without Optimality: Environmental Policies and Pollution Pricing in the late 1960s’, Journal of the History of Economic Thought 42, no. 4 (December 2020), p. 539, doi:10.1017/S1053837219000579.
[10] Alex Stapp and Brian Potter, ‘Moving Past Environmental Proceduralism’, Institute for Progress, April 2024, https://ifp.org/moving-past-environmental-proceduralism/.
[11] Keohane and Olmstead, Markets and the Environment, p. 2
[12] Robert F. Hébert and Robert B. Ekelund, Secret Origins of Modern Microeconomics: Dupuit and the Engineers (Chicago: University of Chicago Press, 1999); Robert B. Ekelund, The Economics of Edwin Chadwick: Incentives Matter (Northampton, MA: Edward Elgar, 2012).
[13] H. Spencer Banzhaf and Randall Walsh, ‘Smoke from Factory Chimneys: The Applied Economics of Air Pollution in the Progressive Era’, NBER Working Paper 32328 (Cambridge, MA: National Bureau of Economic Research, 2024).
[14] H. Spencer Banzhaf, ‘Objective or Multi-Objective? Two Historically Competing Visions for Benefit-Cost Analysis’, Land Economics 85, no. 1 (2009), p. 3, doi:10.3368/le.85.1.3
[15] Theodore Porter, Trust in Numbers: The Pursuit of Objectivity in Science and Public Life (Princeton, NJ: Princeton University Press, 1995), p. 149._
[16] Berman, Thinking like an Economist, p. 212.
[17] H. Spencer Banzhaf, Pricing the Priceless: A History of Environmental Economics (Cambridge: Cambridge University Press, 2024), p. 3.
[18] Banzhaf, Pricing the Priceless.
[19] Banzhaf, Pricing the Priceless, p. 26
[20] Jerry Hausman, ‘Contingent Valuation: From Dubious to Hopeless’, Journal of Economic Perspectives 26, no. 4 (November 2012), pp. 43–56, doi:10.1257/jep.26.4.43; Richard T. Carson, ‘Contingent Valuation: A Practical Alternative when Prices aren’t Available’, Journal of Economic Perspectives 26, no. 4 (November 2012), pp. 27–42, doi:10.1257/jep.26.4.27.
[21] Banzhaf, Pricing the Priceless, pp. 98–120; NOAA Panel on Contingent Valuation, ‘Report of the NOAA Panel on Contingent Valuation, January 11, 1993’, (1995), https://repository.library.noaa.gov/view/noaa/60900.
[22] Banzhaf, Pricing the Priceless, pp. 149–68.
[23] Tom Tietenberg, ‘Cap-and-Trade: The Evolution of an Economic Idea’, Agricultural and Resource Economics Review 39, no. 3 (October 2010), pp. 359–67, doi:10.1017/S106828050000736X.
[24] Anthony C. Fisher and Frederick M. Peterson, ‘The Environment in Economics: A Survey’, Journal of Economic Literature 14, no. 1 (1976), p. 26; Berta, ‘Efficiency without Optimality’, 544.
[25] Berta, ‘Efficiency without Optimality’.
[26] Janet Currie and Reed Walker, ‘What do Economists have to say about the Clean Air Act 50 Years after the Establishment of the Environmental Protection Agency?’, Journal of Economic Perspectives 33, no. 4 (November 2019), pp. 3–26, doi:10.1257/jep.33.4.3.
[27] Bruce A. Ackerman and William T. Hassler, Clean Coal/Dirty Air: Or How the Clean Air Act Became a Multibillion-Dollar Bail-out for High-Sulfur Coal Producers and What Should be Done about It (New Haven, CT: Yale University Press, 1981).
[28] Banzhaf, Pricing the Priceless, pp. 120–46.
[29] Allen V. Kneese, The Economics of Regional Water Quality Management (Baltimore, MD: Johns Hopkins University Press, 1964); Allen V. Kneese and Blair T. Bower, Managing Water Quality: Economics, Technology, Institutions (Baltimore: Resources for the Future/Johns Hopkins University Press, 1968).
[30] Banzhaf, Pricing the Priceless, pp. 125.
[31] Banzhaf, Pricing the Priceless, pp. 126.
[32] Berta, ‘Efficiency without Optimality’.
[33] William J. Baumol and Wallace E. Oates, ‘The Use of Standards and Prices for Protection of the Environment’, The Swedish Journal of Economics 73, no. 1 (1971), pp. 42–54, doi:10.2307/3439132.
[34] Thomas H. Tietenberg, Emissions Trading: Principles and Practice, 2nd edn (Washington, DC: Resources for the Future, 2006).
[35] R. H. Coase, ‘The Federal Communications Commission’, The Journal of Law & Economics 2 (1959), pp. 1–40.
[36] Thomas W. Hazlett, ‘Assigning Property Rights to Radio Spectrum Users: Why Did FCC License Auctions take 67 Years?’, The Journal of Law and Economics 41, no. S2 (October 1998), pp. 529–76, doi:10.1086/467402.
[37] Thomas D. Crocker, ‘Structuring of Atmospheric Pollution Control Systems’, in The Economics of Air Pollution, ed. Harold Wolozin (New York: W. W. Norton and Co., 1966), pp. 61–86; John H. Dales, Pollution, Property and Prices: An Essay in Policy-making and Economics (Toronto: University of Toronto Press, 1968).
[38] J. H. Dales, ‘Land, Water, and Ownership’, Canadian Journal of Economics 1, no. 4 (1968), p. 792; Berta, ‘Efficiency without Optimality’, p. 552.
[39] Robert N. Stavins, ‘The Relative Merits of Carbon Pricing Instruments: Taxes versus Trading’, Review of Environmental Economics and Policy 16, no. 1 (January 2022), pp. 62–82, doi:10.1086/717773
[40] Schmalensee and Stavins, ‘Policy Evolution under the Clean Air Act’.
[41] Charles Halvorson, Valuing Clean Air : The EPA and the Economics of Environmental Protection (New York: Oxford University Press, 2021).
[42] Richard G. Newell and Kristian Rogers, ‘The U.S. Experience with the Phasedown of Lead in Gasoline’, Discussion Paper (Washington, DC: Resources for the Future, 2003).
[43] Robert N. Stavins, ‘Project 88: Harnessing Market Forces to Protect our Environment: Initiatives for the New President’, December 1988, https://scholar.harvard.edu/sites/scholar.harvard.edu/files/stavins/files/project_88-1.pdf.
[44] Stavins, ‘Project 88’, p. 2
[45] Richard Schmalensee and Robert N. Stavins, ‘The SO2 Allowance Trading System: The Ironic History of a Grand Policy Experiment’, Journal of Economic Perspectives 27, no. 1 (February 2013), p. 107, doi:10.1257/jep.27.1.103
[46] Robert Stavins, ‘Market-Based Environmental Policies: What Can We Learn from U.S. Experience (and Related Research)?’, in Moving to Markets in Environmental Regulation:Lessons from Twenty Years of Experience, ed. Jody Freeman and Charles D. Kolstad (Oxford and New York: Oxford University Press, 2007), p. 31.
[47] Gary D. Libecap, ‘Coasean Bargaining to Address Environmental Externalities’, in The Elgar Companion to Ronald H. Coase, ed. Claude Ménard and Elodie Bertrand (Cheltenham and Northampton, MA: Edward Elgar, 2016), p. 97, https://www.elgaronline.com/edcollchap/edcoll/9781782547983/9781782547983.00017.xml.
[48] Schmalensee and Stavins, ‘The SO2 Allowance Trading System’, p. 105.
[49] Danae Hernandez-Cortes and Kyle C. Meng, ‘Do Environmental Markets cause Environmental Injustice? Evidence from California’s Carbon Market’, Journal of Public Economics 217 (January 2023), p. 104786, doi:10.1016/j.jpubeco.2022.104786
[50] Mark Pennington, ‘Coase on Property Rights and the Political Economy of Environmental Protection’, in Forever Contemporary: The Economics of Ronald Coase, ed. Cento Veljanovski (London: The Institute of Economic Affairs, 2015), pp. 100–101.
[51] Sarah A. Brown, Robin M. Rotman, Michael A. Powell and Sonja A. Wilhelm Stanis, ‘Conservation Easements: A Tool for Preserving Wildlife Habitat on Private Lands’, Wildlife Society Bulletin 47, no. 2 (2023), doi:10.1002/wsb.1415
[52] Dominic P. Parker and Walter N. Thurman, ‘Tax Incentives and the Price of Conservation’, Journal of the Association of Environmental and Resource Economists 5, no. 2 (April 2018), doi:10.1086/695615.
[53] Shawn Regan, ‘We Have Taken a Monumental Step to Protect America’s Public Lands’’, The New York Times, 12 September 2024, https://www.nytimes.com/2024/09/12/opinion/public-land-conservation.html.
[54] Sheila M. Olmstead, ‘The Economics of Managing Scarce Water Resources’, Review of Environmental Economics and Policy 4, no. 2 (July 2010), p. 187, doi:10.1093/reep/req004; Jedidiah Brewer, Robert Glennon, Alan Ker and Gary Libecap, ‘Water Markets in the West:Prices, Trading, and Contractual Forms’, Economic Inquiry 46, no. 2 (2008), pp. 91–112, doi:10.1111/j.1465-7295.2007.00072.x.
[55] Olmstead, ‘The Economics of Managing Scarce Water Resources’, p. 191.
[56] Karen Fisher-Vanden and Sheila Olmstead, ‘Moving Pollution Trading from Air to Water: Potential, Problems, and Prognosis’, Journal of Economic Perspectives 27, no. 1 (February 2013), pp. 147–72, doi:10.1257/jep.27.1.147.
[57] Felicia Rankl, ‘Nutrient Neutrality and Housing Development’, House of Commons Library (October 2023), https://commonslibrary.parliament.uk/research-briefings/cbp-9850/.
[58] ‘Planning Reform Working Paper: Development and Nature Recovery’, Ministry of Housing, Communities and Local Government and Department for Environment, Food & Rural Affairs (December 2024), https://www.gov.uk/government/publications/planning-reform-working-paper-development-and-nature-recovery.
[59] Gary D. Libecap and Terry L. Anderson, Environmental Markets: A Property Rights Approach, Cambridge Studies in Economics, Choice, and Society (New York: Cambridge University Press, 2014), pp. 69–70, 134–9.
[60] Michael Greenstone, Rohini Pande, Nicholas Ryan and Anant Sudarshan, ‘Can Pollution Markets Work in Developing Countries? Experimental Evidence from India’, The Quarterly Journal of Economics 140, no. 2 (May 2025), pp. 1003–60, doi:10.1093/qje/qjaf009
[61] Christopher Costello et al., ‘Global Fishery Prospects under Contrasting Management Regimes’, Proceedings of the National Academy of Sciences of the United States of America 113, no. 18 (May 2016), pp. 5125–9, doi:10.1073/pnas.1520420113; Ragnar Arnason, ‘Property Rights in Fisheries: How much can Individual Transferable Quotas accomplish?’, Review of Environmental Economics and Policy 6, no. 2 (July 2012), pp. 217–36, doi:10.1093/reep/res011
[62] Rögnvaldur Hannesson, The Privatization of the Oceans (Cambridge, MA and London: The MIT Press, 2004), doi:10.7551/mitpress/5578.001.0001.
[63] Gary D. Libecap, ‘Addressing Global Environmental Externalities: Transaction Costs Considerations’, Journal of Economic Literature 52, no. 2 (June 2014), pp. 424–79, doi:10.1257/jel.52.2.424; Pablo Paniagua and Veeshan Rayamajhee, ‘Governing the Global Fisheries Commons’, Marine Policy 165 (July 2024), p. 106182, doi:10.1016/j.marpol.2024.106182.
[64] Kenneth Gillingham and James H. Stock, ‘The Cost of Reducing Greenhouse Gas Emissions’, Journal of Economic Perspectives 32, no. 4 (November 2018), pp. 53–4, doi:10.1257/jep.32.4.53.
[65] Joseph E. Aldy, Matthew J. Kotchen, Robert N. Stavins and James H. Stock, ‘Keep Climate Policy Focused on the Social Cost of Carbon’, Science 373, no. 6557 (August 2021), 850–52, doi:10.1126/science.abi7813.
[66] In the United Kingdom this is 3.5% whereas in the United States it is higher at 7%. Discounting the future at a higher rate means that fewer projects to limit the cost of climate change pass the hurdle. The first Trump administration adopted a 7% discount rate and limited the benefits of abatement captured in the social cost of carbon to those that accrue domestically, thus demonstrating the political nature of the current process.
[67] Kevin Rennert et al., ‘Comprehensive Evidence Implies a Higher Social Cost of CO2’, Nature 610, no. 7933 (October 2022), pp. 687–92, doi:10.1038/s41586-022-05224-9.
[68] World Bank, State and Trends of Carbon Pricing 2024 (Washington, DC: World Bank, 2024), p. 49.
[69] Libecap, ‘Williamson and Coase’.
[70] Elinor Ostrom, ‘Nested Externalities and Polycentric Institutions: Must We Wait For Global Solutions to Climate Change Before Taking Actions at Other Scales?’, Economic Theory 49, no. 2 (February 2012), pp. 353–69, doi:10.1007/s00199-010-0558-6
[71] Kristian Fors, ‘Why California’s Homeowners’ Insurance Market Collapsed—and How to Fix It’ (Independent Institute, May 2025), https://www.independent.org/article/2025/05/12/why-californias-homeowners-insurance-market-collapsed-and-how-to-fix-it/
[72] Nick Cowen and Charles Delmotte, ‘Ostrom, Floods and Mismatched Property Rights’, International Journal of the Commons 14, no. 1 (October 2020), pp. 583–96, doi:10.5334/ijc.983.
[73] Gillingham and Stock, ‘The Cost of Reducing Greenhouse Gas Emissions’.
[74] Stavins, ‘Market-Based Environmental Policies’, p. 30.
What this theory [mid-century neoclassical welfare economics] demonstrated, in a nutshell, was that perfect markets work perfectly, imperfect markets work imperfectly, and perfect government can cause imperfect markets to also function perfectly.[1]
Steven Medema
The theme of Chapter 1 was how features of some goods and markets mean that the sort of positive tendencies that might be assumed in standard markets don’t apply in situations described by the related concepts of public goods, spillover effects and commons. In these situations – once thought ‘exceptional and unimportant’[2] – the state can intervene, such that the logic of the market is reasserted via policies. In this framework the state is acting to ensure the outcome that the market would did it not have features of public goods or externalities – which could in fact be conceptualised as ‘missing markets’.[3]
The building blocks of economic thinking presented in Chapter 1 are the core of a mid-twentieth-century consensus in mainstream economic thinking about markets, external effects and public goods.[4] This theoretical frame relates to the broader view of the need for state action to tame markets and improve outcomes in situations where the invisible hand is defective or at least inadequate (e.g. via tax or regulation).[5] As with Pigouvian taxation, these interventions often derived from abstractions and not a set of pragmatic policy prescriptions (a theme returned to later). A series of theoretical developments and empirical studies in the intervening decades have undermined the claims of this framework.
This chapter introduces these developments and, in some cases, their misinterpretations. More specifically, it folds in related research that undermines one or multiple parts of the older consensus. First, the work of Ronald Coase – though this is complicated because Coase, like Adam Smith or John Maynard Keynes, is read in different and conflicting ways. On the sixtieth anniversary of the publication of ‘The Problem of Social Cost’, the economist and historian of economic thought Steven Medema considered the many plausible understandings and misunderstandings of the so-called ‘Coase Theorem’.[6]
An interesting facet of the Coase paper is its focus on the foundational issues and its emphasis on the institutional context of markets (including law), which is both defined by individuals and channels their interests. While the paper is something of a fountainhead for all sorts of relevant fields (perhaps most importantly law and economics), it also builds an analytic framework with clear relevance for environmental issues ranging from climate change to nutrient runoff. While it deals most explicitly with bilateral trades, its framework applies to broader externalities.
After introducing the basics of Coase’s paper the following will consider the evidence for the constructions of the last chapter. The illustrative and quaint examples that show the failure of markets provide evidence of the institutional component of markets and their capacity for contracting and bundling to address problems with externalities and public goods. Finally, the chapter turns to analyse the plausibility of state corrective action. This is not done in a comprehensive way but the point is to underline the fact that the assumption that the state is able simply to correct externality issues can be misleading. The point is not that government cannot solve problems in markets (or that market participants will be capable of solving all problems themselves), but to make the case for the comparative approach that Coase sets out in his paper. Chapter 3 brings these together with the recent history of the environmental movement and practical efforts to improve environmental outcomes via policy, including reforms that not only seek to tinker with existing markets but to create new markets.
One of the themes of this chapter and publication is that the specifics of each environmental problem matter greatly for both the analysis of the problem and the assessment of policy for improving outcomes. Deeper insights flow from the pairing of basic economic theory with political and scientific understanding of the problem. Coase and later thinkers argue that much of the basic economic theory invoked to support action stands on weak foundations and misleads citizens and regulators alike.
Much of modern welfare economics is indeed concerned with the problem of market failure, and the analysis of market failure appears to imply the desirability of administrative intervention. Until recently everybody agreed that where there are externalities, market allocation is bound to be non-optimal; the only point of controversy concerned the frequency and the severity of the external effects and the urgency of administrative action.[7]
Stanislaw Wellisz
In 1960 Ronald Coase published ‘The Problem of Social Cost’ in the Journal of Law & Economics. It challenged what he depicted as the prevailing Pigouvian analytic paradigm outlined in Chapter 1 and familiar to all students of economics. Rather than analysing externalities as being caused by one side, Coase argued that they are caused by both parties; that is, their interaction. This concept of reciprocity fundamentally changed the mechanics of thinking about externalities and ideal policy responses through taxes and subsidies imposed by government, undermining the principle that with environmental issues, the polluter should pay.
Coase demonstrated that harms arise from incompatible resource uses where both parties contribute to the problem. This reciprocal nature means that preventing harm to one party necessarily imposes costs on another, making the central question not how to eliminate externalities but how to minimise total social costs across all parties. This insight shifts the analytical focus from abstract welfare maximisation towards comparative institutional analysis, where different legal rules and property rights arrangements are evaluated based on their ability to facilitate welfare-enhancing exchanges despite transaction costs. The reciprocity framework thus replaces the presumptive need for corrective taxation with a more nuanced assessment that considers whose rights should be protected, whether exchange can resolve conflicts and when regulatory intervention might improve social outcomes – all while recognising that policy itself entails costs and operates within institutional constraints that may prevent theoretically optimal solutions.
Turning to the specific examples that Coase used makes what might seem an arcane point clearer. First, in an example from English law, Sturges v Bridgman (1879), a confectioner operating pestles and mortars in the kitchen of a terraced house backing on to a neighbouring London garden was sued by a doctor whose adjoining consultation room was affected by the noise and vibration of the mortars. The mortars didn’t cause harm until the doctor built an extension to his house. This consultation room abutting the confectioner’s kitchen rendered the noise audible. Standard analysis would depict the confectioner as the one imposing cost, but Coase argued that the social cost of the action relies on the doctor as much as the confectioner.
In abstract terms Coase set out the implication of introducing reciprocity:
The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm.[8]
This distinction sounds pedantic but conceptualising the issue as one of a conflict of uses changes understanding of the problem – and relevant solutions. In this view, issues of ‘external costs’ become part of a broader topic of property rights and exchange like other topics in economics. As Mark Pennington writes: ‘Whether an actor or group of actors is the “victim” or “perpetrator” of an “externality” is fundamentally a question of who has the rights to engage in the activity concerned and if they wish to trade such rights for compensation.’[9] With the focus on reciprocity, Coase argued that the appropriate analytical framework to start analysis was not to assume that one party is a polluter who should automatically pay but one in which a lowest-cost solution is found to address a conflict between those who have competing claims.
To facilitate seeing the logic in the question as lying in whether A to B – or B to A – is the best way to limit social cost, Coase considered cattle and crops:
Another example is afforded by the problem of straying cattle which destroy crops on neighbouring land. If it is inevitable that some cattle will stray, an increase in the supply of meat can only be obtained at the expense of a decrease in the supply of crops. The nature of the choice is clear: meat or crops. What answer should be given is, of course, not clear unless we know the value of what is obtained as well as the value of what is sacrificed to obtain it.[10]
Beyond this is where much confusion about Coase begins.
(T)he ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost.[11]
Ronald Coase
Coase argued that in a world of zero transaction costs the parties affected would exchange rights such that the initial distribution of rights wouldn’t alter the outcome (or the efficiency). The notion of transaction costs was defined only implicitly by Coase in the quote above (and in his 1937 paper ‘The Nature of the Firm’ in which it originated), although the subject of much debate it can be understood as the cost of defining and enforcing a property right.
To continue with the example, if it is assumed that farmer has the right to be compensated should a rancher’s cattle stray (i.e. the property rights are clear), the rancher will consider the expected damage that cattle will cause and take the optimal amount of precautions (e.g. building fences). The rancher will also rear the optimal amount of cattle. While the property rights might lie with the farmer, the rancher could also bargain with the farmer either by contracting or exchanging. Compensation for lost product only occurs after the farmer has taken on the costs of production so were the rancher to buy from the farmer the land most at risk of being trampled (or pay the farmer not to plant there), both could gain by avoiding the damage that might otherwise occur.
Alternatively, Coase showed that if the property right instead rested with the cattle rancher, the farmer would find it in his interest to take steps to mitigate the damage. Similarly, this could be done by removing land from cultivation, building a fence or bargaining with the rancher to reduce harm by rearing fewer cattle. The optimal solution would also be determined by the profitability of both producers. In fact, Coase demonstrated via example that in both property rights regimes the producers would end up with the same result in a world without transaction costs: an efficient outcome that would simply rely on the costs not the institutional context.
To go back to the earlier example: if the confectioner has the right to make noise but the doctor values quiet more than the former values that right, they will engage in trade to achieve the efficient result in a world with zero transaction costs. The right lying with either the confectioner or the doctor only affects who is paying whom rather than the efficiency of the outcome.
For many, Coase’s insight was some version of the general statement about the efficiency and invariance of outcome: if property rights are well defined and transaction costs are zero, parties will be able to bargain privately to reach an efficient outcome regardless of the initial allocation of rights;[12] that is, the total welfare will not change though the distribution will. This statement – not to mention a formal theorem – doesn’t appear in Coase’s paper but the notion, further pared down, was dubbed the ‘Coase Theorem’ by George Stigler.[13] It has had an enormous impact (by some measures it’s the most cited work in law reviews and among the most cited in social science), but in many ways Stiger’s rendering confuses Coase’s insights.
While the examples seem contrived, the insights they give rise to are useful in addressing problems in the real world – Coase’s main interest – and serve as a prelude to a framework for understanding how social cost is dealt with. This has clear relevance for thinking about environmental issues. Furthermore, within economic theory the Pigouvian framework collapses on its own assumptions, which are the same in Coase and in Pigou rather than some isolated feature of either. As Medema writes, the pitfall for some is to think about the world of the theorem as Coase’s world rather than the standard assumption of orthodox economic theory, including the Pigouvian apparatus he was undermining.[14]
The recognition that environmental problems are a consequence of positive transaction costs is perhaps the central Coasian insight, yet strangely enough this very idea has often led to the dismissal of Coasian policy ideas.[15]
Mark Pennington
The first third of ‘The Problem of Social Cost’ focused on the basic theoretical argument against Pigouvian analysis and forms the basis of the Coase Theorem; the remainder is about application to the real world. It proceeds by tracing out the implications for analysis of the same types of issues in a world with transaction costs. Perhaps the first and most obvious is that if the parties impacting each other can’t exchange the property rights without frictions, who has the right – the rancher or the farmer, for example – matters for efficiency.
To this point Coase remarked on the fact that the reasoning for the legal decision between the confectioner and the doctor, and many others – including ones about polluting factories – that emerged through the common law, dealt with not just the reciprocity of cause but the efficiency of the situation.[16] This shows up, for example, in ideas about the ‘reasonableness’ of precautions. In the ruling on the confectioner, the location and features of the neighbourhood mattered.[17] If the confectioner could be stopped on grounds of nuisance in a residential square, could someone move to an industrial area and stop the operation of externality- generating producers such as tanneries? The judge answered, as Coase quoted: ‘whether anything is a nuisance or not is a question to be determined, not merely by an abstract consideration of the thing itself, but in reference to its circumstances; What would be a nuisance in Belgrave Square would not necessarily be so in Bermondsey.’[18]
More than just being an exercise in abstracted deviations from efficiency, Coase illustrated how the legal system’s assignment of property rights and liability rules shaped bargaining around such externalities as pollution. His analysis highlighted the importance of transaction costs in determining whether parties could successfully negotiate mutually beneficial arrangements if the rights were assigned to the party that valued them less than the other. Coase’s work thus also drew attention to how alternative legal rules and institutions could minimise transaction costs and facilitate bargaining towards more efficient outcomes.
His insight represents a fundamental reimagining of environmental problem-solving. Contrary to simplistic market-based or government-control narratives, he argued that neither markets nor regulatory approaches are universally applicable solutions. Instead he challenged the existing Pigouvian framework – and the twentieth-century regulatory framework – by demonstrating the complexity of addressing environmental issues:
A better approach would seem to be to start our analysis with a situation approximating that which actually exists, to examine the effects of a proposed policy change and to attempt to decide whether the new situation would be, in total, better or worse than the original one. In this way, conclusions for policy would have some relevance to the actual situation.[19]
The crux of Coase’s contribution lies in his recognition that transaction costs are both ubiquitous and central to understanding environmental problems – without them, externalities would simply be another production cost that markets could handle efficiently. But precisely because transaction costs are so pervasive and significant, the choice of policy instruments becomes crucial. This creates a delicate balance: transaction costs are what make environmental externalities a genuine policy problem, yet these same costs call for special care when designing solutions because poorly chosen interventions can make matters worse.
This highlighted the need to properly align institutions and laws to allow efficient private bargaining and resolution of externalities where possible (e.g. by defining tradeable property rights). A benefit of the property rights solution versus a regulatory solution is that the market process would allow the type of knowledge-generating – and innovation-stimulating – relations characteristic of markets to continue.[20] Some argue that over time, regulatory solutions are hard to displace even when new technologies weaken the claims of their superiority over the market.[21]
More generally, Coase suggested that there are four types of responses to social-cost issues.[22] First, property rights can be specified and exchange can take place. In the presence of transaction costs this may not result in the idealised result but must be compared to the relevant alternatives. Second, the decisions can be brought within a single firm: if the same owner owns both the cattle and the crops, the externality is internalised.[23] Third, the state can regulate a solution. This might result in a better outcome in circumstances where it is implausible to expect that either exchange or the firm solution will work well, but the reality of this option must be considered rather than the idealised comparison (more on this later). Finally, the best option may simply be to do nothing.
While Coase undermined the basic theoretical argument for the necessity of corrective regulations, developments in the economics of regulation and political action further frustrate the simple premise of market failure arguments; that is, that they require some underspecified government intervention. Following Coase, economists have studied historic and contemporary examples of contracting solutions to issues. While the nature of the issue varies in each case, which makes it more difficult for the clear-cut property rights seen in standard exchanges to emerge, a large literature both before and after Coase deals with the institutional ingenuity of market participants in coming up with rules that deal with the difficulty of exclusion and the spillover nature of some goods. While debates about the comparative efficiency of different regimes still rages, the point is that the line of inquiry should be comparative and institutional rather than simply potential market failure leading to government intervention. Both the successes and failures of market participants to improve their own outcomes offer insights for social scientists and policy makers.
Whether or not Keynes was correct in his claim that policy makers are ‘distilling their frenzy’ from economists, it appears evident that some economists have been distilling their policy implications from fables.[24]
Steven Cheung
I think we should try to develop generalisations which would give us guidance as to how various activities should best be organised and financed. But such generalisations are not likely to be helpful unless they are derived from studies of how such activities are actually carried out within different institutional frameworks … by showing us the richness of the social alternatives between which we can choose.[25]
Ronald Coase
In an example towards the end of ‘The Problem of Social Cost’, Coase argued that a famous case Pigou draws on to make the broader argument that government action is needed to deal with externalities is factually erroneous. This is an example of a strand of research that makes a methodological and theoretical point about the need for comparative institutional analysis via empirical study of the very examples that economists use to argue the need for corrective action.
In this instance, the example Pigou used is of sparks thrown off by the friction between train wheels and track, which can cause fires in, say, neighbouring woodland. In Pigou’s rendering this damage is an example of the market not functioning adequately for the same reason as any other negative externality, i.e. train companies didn’t take this damage into account when making decisions. However, Coase showed that the reason they didn’t is because Britain passed an act rendering them not liable for damage resulting from sparks. In this case, then, the externality wasn’t straightforwardly produced by a market setting that failed to address it; it was rooted in an institutional context.
Chapter 1 gave two stock examples – lighthouses and bees – of goods with characteristics that make them difficult for markets to provide adequately. In the case of lighthouses the service provided is both non-rival and non- excludable: passing boats can see the beams of light emitted from the Fresnel lens whether or not they pay for the services of the lighthouse keeper; use of the service by one boat doesn’t diminish use by another. In the case of the bees the stock example is that of the positive spillover effect from apple orchards providing the nectar bees consume. In reality, neither example is as clear-cut as these simple treatments suggest.
Steven Cheung found that beekeepers and orchard owners had in fact developed sophisticated contractual arrangements to internalise the pollination externality.[26] Apple orchards provide little nectar to bees, so Cheung found that not only can markets deal with the externalities involved but the actual payments go the other way as apiarists pay beekeepers for their pollination services. More generally, there is variation in the contracts for these types of arrangements due to variation in the type of crop grown by farmers and whether the bees provided pollination or whether the crops provide nectar (something that differs with the crop grown). This discovery demonstrated that private markets could often solve externality problems without government intervention, provided transaction costs were low and property rights well defined. Cheung’s work reinforced Coase’s insights and highlighted the importance of empirical investigation in understanding how markets function in practice.
Additionally, Coase argued that in England, lighthouses were actually successfully built and operated by private individuals or organisations,[27] highlighting the fact that the services of the lighthouse could be tied with the ports in which ships would dock. His analysis demonstrated that the private provision of lighthouses was feasible under certain conditions, suggesting that the boundaries between public and private goods might not be as clear-cut as previously thought.
Garrett Hardin’s (1968) portrayal of the users of a common-pool resource – a pasture open to all – being trapped in an inexorable tragedy of overuse and destruction has been widely accepted since it was consistent with the prediction of no cooperation in a Prisoner’s Dilemma or other social dilemma games.[28]
The classic models have been used to view those who are involved… as always trapped in the situation without capabilities to change the structure themselves… Whether or not the individuals who are in a situation have capacities to transform the external variables affecting their own situation varies dramatically from one situation to the next. It is an empirical condition that varies from situation to situation rather than a logical universality. Public investigators purposely keep prisoners separated so they cannot communicate. The users of a common-pool resource are not so limited.[29]
Elinor Ostrom
The primary influence of Hardin’s famous paper – at least in economics – has simply been the name of the phenomenon and the pastoral example.[30] Hardin presents the tragedy of the commons in a way that doesn’t consider how the issue has been solved historically. Rules of use have emerged in many cases and in different ways. He considers property rights solutions but dismisses them for reasons of practicality. Yet there are clever mechanisms for creating property rights solutions, despite the theoretical problems of collective action, public good provision and externalities. By limiting access indirectly, whether by a licensing system or tying things together with goods that are excludable (e.g. tying lighthouses to ports), market actors limit the race to the bottom. Furthermore, Elinor Ostrom showed how collective governance solutions can also emerge in a decentralised way. Despite this, the conventional wisdom surrounding the tragedy of the commons is familiar: either a) privatise the resource in question or b) regulate its use. I describe the pure property rights and command-and-control solutions before adding Ostrom’s critique of the private-public dichotomy through her work on self-governance and collective property rights.
Property rights economists argue that the emergence of rights depends in large part on the transaction costs associated with defining, enforcing and exchanging a resource. In the capitalist world at least, if something was held in common in the mid-twentieth century it was usually because establishing property rights was difficult – it was difficult or too costly to exclude others: ‘the reason why some activities are not the subject of contracts is exactly the same as the reason why some contracts are commonly unsatisfactory – it would cost too much to put the matter right.’[31]
While many may dispute just where the extension of property rights with state support is impractical and where necessity dictates more involved regulation, the success of property rights generally is known but always worth repeating. For resources like grazing fields or forests, having an owner who can control access and benefits from the long-term value of the resource often prevents overuse. In England and Wales, for example, riparian fishing rights in rural contexts limit users and lead to legal cases by property owners such as angling clubs against polluters.[32]
As is standard in environmental and resource economics textbooks, Nathaniel Keohane and Sheila Olmstead show how in cases such as timber, where property rights have been established, optimal resource extraction for the owner coincides with the socially optimal outcome of scarce resources being efficiently used. In the past, however, many of these resources would have been open access. This raises the question of how and why property rights emerged, which is relevant to their potential extension as a solution. A foundational paper by Harold Demsetz introduced a simple theory for when property rights emerge,[33] arguing that this occurs when the costs of defining them and enforcing them are lower than the benefit of doing so.
Demsetz offered the example of when animal furs became more valuable to indigenous people in North America. Before the fur trade, the small population of hunters relative to beavers meant there was little to be gained from establishing property rights. After the trade increased the value of beaver pelts, the costly process of establishing rights became worthwhile – an example of a natural resource around which rights emerged because of the cost–benefit relationship, though it is also true of many other examples of natural resources that are relatively excludable.
Gary Libecap argues that the plausibility of property rights being established depends on where along a continuum of transaction costs a particular resource lies.[34] Three main features determine this: the resource value, the physical attributes of the resource in relation to excludability and the attributes of the parties. These features also affect non-property rights methods of preventing the tragedy of the commons.
As the benefit of establishing property rights over environmental goods increases as the goods themselves diminish, or because individuals value them more highly as wealth increases, we should expect more rights to be established.
The cost of establishing property rights is also subject to change. New means of preventing overuse or access, such as surveillance cameras or barbed wire,[35] make it easier to establish rights by making the resource more excludable. While no panacea, the incentives of interested parties are such as to support innovations and take them up once created.
A popular response to open-access issues is to have the state set rules. As discussed in Chapter 1 in reference to negative externalities, a command-and-control regulatory approach seeks to address the tragedy of the commons by imposing strict rules and regulations on common- pool resource use. Important for any comparison is analysis of just how governments implement these strategies through laws, permits and enforcement mechanisms. An example is the establishment of fishing quotas to limit the number of fish that can be caught in a particular area, preventing overfishing and ensuring sustainable resource management. While effective in some cases, such command-and-control can be costly to implement and enforce. The specific rules are full of trade-offs. Monitoring the number of fish caught is more difficult than monitoring when fishermen are operating, so regulation sometimes governs the number of operational months or days. This can result in dramatic unintended costs, such as seafood rotting on docks before it can be processed and even the death
of workers in accidents caused by exhaustion.[36] Alternative regulatory approaches that more efficiently limited access to commons are discussed in Chapter 3; first it is worth considering empirical examples of emergent common property rights.
It is crucial to recognize that common property is shared private property … Common property regimes are a way of privatizing the rights to something without dividing it into pieces … Historically, common property regimes have evolved in places where the demand on a resource is too great to tolerate open access, so property rights in resources have to be created, but some other factor makes it impossible or undesirable to parcel the resource itself.[37]
Margaret McKean and Elinor Ostrom
Ostrom’s book Governing the Commons[38] offered a critique of earlier economic theories that advocated for either individual private property rights as a solution to common resource management or for centralised regulation. Her research demonstrated that communities often develop effective self-governing institutions to manage common-pool resources sustainably, without resorting to private rights or centralised control. It emphasised the importance of local knowledge, communication and context-specific rules in successful resource management.
However, there are difficulties with generalising from the outcomes she surveyed, connected with two main types of variation: the type of resource being managed and the scale and type of group governing the common- pool resource. In cases such as long-standing grazing practices in rural Switzerland, there are features of the resource itself that make it difficult to establish private property rights, and features of the parties that make coordination easier – including a common culture and small scale.
This publication’s analysis of regulatory policy has so far focused on whether state action is necessary for dealing with the inadequacies of markets as compared to idealised alternatives. Apart from a short discussion of the weaknesses of command-and-control regulation and the need for comparative institutional analysis instead of knee-jerk ‘polluter pays’ approaches, it hasn’t considered the political process behind state action or the incentives of political actors. The next section considers the motivations and information problems associated with government action.
Inquiring how far the free play of private self-interest makes for social advantage, we find that it frequently fails to do this, but that there are many different forms and many different degrees in its failure. Inquiring how far Government is fitted to take action against these failures, we find that its fitness to do this varies, not only in different places and different times, but also as between interventions directed against different kinds of failure.[39]
Arthur Pigou
The mid-century developments in thinking on formal market failure bore little relation to detailed policy analysis. Both the practical and political dimensions of policy development were ignored, and instead much on state alternatives was couched in idealised terms, especially where theorists were more distant from real-world policy questions. This is not true of the applied economists thinking about policy directly (as discussed in Chapter 3), but even there the conception of political economy assumed that regulators would act in the public interest.
Beginning in the 1960s, economists began formally to study political processes with the same methodological assumption as that held about individuals in other domains of economic research, namely self-interest. This politics without romance approach would later be termed ‘public choice’.[40] Public choice is useful for understanding the real incentives of interested parties in public decision-making processes, and is crucially important for environmental issues because public agencies – from conservation agencies to planning authorities – are intimately involved in many issues. The basic Coasean point is that alternatives must be understood and compared.
Despite Pigou’s reputation among many public choice economists as simply an avatar of a politically naïve Cambridge don, his work exhibited more realistic – if not formalised – thinking about the constraints of state action than much of what came later. While later thinkers were only interested in the formal models, Pigou makes it clear that the pure theoretical ‘blackboard economics’ he engaged in was a conceptual basis for pragmatic intervention by experts.[41]
An understanding of the bureaucratic and political processes is clearly relevant for thinking about regulatory outcomes. At a most basic level, a difference between the market process and the political process is that, as Pennington writes: ‘Absent the profit-and-loss signals to which individuals and firms have access in markets, decisions by the state to impose taxes, subsidies or regulations are not subject to any obvious feedback mechanism that can weed out erroneous interventions and lead over time to an improved set of decisions.’[42]
As in the example of the rotting fish caused by regulation of fishermen’s operational hours, some of the more perverse environmental outcomes occur in settings where state involvement is anything but shallow. Some argue in line with Pennington that: ‘In many cases it is the intellectual dominance of the belief that markets cannot work that has locked in institutions which prohibit the emergence of private, contractual solutions.’[43]
Even ignoring questions about the incentives of legislators and regulators, in the absence of markets and their attendant prices, rational decision-making becomes more complex. Formal cost–benefit analysis emerged in the early twentieth century and has become more central to policy analysis and policymaking since. Firms make decisions based on profit, but cost–benefit analysis seeks to inform rational policymaking and government provision. As the size and scope of state provision increased, new bureaucratic forms and procedures were invented by experts to assess policy alternatives (considered in Chapter 3).
While expert cost–benefit analysis is necessary for contemporary practitioners, the world is rife with examples of public projects that wouldn’t stand up to rigorous analysis – while others that would are not pursued. In some cases this has been due to the beliefs of the broader public, as filtered through democratic institutions, which has meant that a project was politically worthwhile regardless of its ability to pass a cost-benefit analysis, while in others it has resulted from special interests. Any discussion of how the government hopes to step in to alter outcomes must be informed by a deeper, more realistic understanding of how and why policies succeed and fail.
Government failure, a concept emphasising potential inefficiencies in public sector interventions,[44] receives comparatively less attention than market failure. While the latter is often thoroughly explored, study of the former – including bureaucratic inefficiencies, rent-seeking behaviour and unintended policy consequences – is much less prominent in economics education and policy discussions.[45]
[T]he problem is to devise practical arrangements which will correct defects in one part of the system without causing more serious harm in other parts.[46]
Ronald Coase
The contributions of Coase, Ostrom and public choice theorists provide a more nuanced framework that challenges simplistic assumptions about the necessity and effectiveness of state action. Coase’s emphasis on transaction costs and property rights demonstrates that the real question isn’t whether government should intervene but which institutional arrangement – market, government or community-based – best addresses specific circumstances. His insight demands comparative institutional analysis rather than theoretical absolutes. Ostrom’s groundbreaking research revealed that communities often develop sophisticated self-governance systems for managing common-pool resources, providing viable alternatives to both state control and privatisation. Meanwhile, public choice theory reminds us that government actors respond to incentives and may pursue self-interest rather than public welfare, making government failure a real possibility when addressing market failures. This chapter has critiqued abstract theory but also established a framework for comparative institutional analysis – necessary for evaluating alternatives in environmental governance and determining which approaches will truly serve the public interest.
Such applied work is beyond the scope of this publication but provides a fruitful way to have rational public policy debates. Chapter 3 outlines the existing system of American environmental policy alongside applied methods of economic analysis. The second half of the chapter combines the foundational work on the economic nature of environmental problems with applied work to show how environmental policy can be improved.
[1] Steven G. Medema, The Hesitant Hand: Taming Self-Interest in the History of Economic Ideas
(Princeton, NJ: Princeton University Press, 2009), p. 76.
[2] Tibor Scitovsky, ‘Two Concepts of External Economies’, Journal of Political Economy 62, no. 2 (1954), pp. 143–51; Steven G. Medema, ‘“Exceptional and Unimportant”? Externalities, Competitive Equilibrium, and the Myth of a Pigovian Tradition’, History of Political Economy 52, no. 1 (February 2020), pp. 135–70, doi:10.1215/00182702-8009583.
[3] Kenneth J. Arrow, ‘The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Nonmarket Allocation’, The Analysis and Evaluation of Public Expenditure: The PPB System 1 (1969), pp. 47–64; Nathalie Berta, ‘On the Definition of Externality as a Missing Market’, The European Journal of the History of Economic Thought 24, no. 2 (March 2017), pp. 287–318, doi:10.1080/09672567.2016.1169304.
[4] Francis M. Bator, ‘The Anatomy of Market Failure’, The Quarterly Journal of Economics 72, no. 3 (1958), pp. 351–79, doi:10.2307/1882231.
[5] Medema, The Hesitant Hand.
[6] Steven G. Medema, ‘The Coase Theorem at Sixty’, Journal of Economic Literature 58, no. 4 (December 2020), pp. 1045–1128, doi:10.1257/jel.20191060.
[7] Stanislaw Wellisz, ‘On External Diseconomies and the Government-Assisted Invisible Hand’, Economica 31, no. 124 (November 1964), p. 345, doi:10.2307/2550514. Cited with emphasis in Medema, The Hesitant Hand, p. 102.
[8] R. H. Coase, ‘The Problem of Social Cost’, The Journal of Law & Economics 3 (1960), p. 2.
[9] Mark Pennington, ‘Coase on Property Rights and the Political Economy of Environmental Protection’, in Forever Contemporary: The Economics of Ronald Coase, ed. Cento Veljanovski (London: The Institute of Economic Affairs, 2015), p. 95; L. Lynne Kiesling, The Essential Ronald Coase (Vancouver, BC: Fraser Institute, 2021), p. 31.
[10] Coase, ‘The Problem of Social Cost’, p. 2.
[11] Coase, ‘The Problem of Social Cost’, p. 8.
[12] Medema, ‘The Coase Theorem at Sixty’.
[13] George J. Stigler, The Theory of Price, 3rd edn (New York: Macmillan, 1966), p. 113.
[14] Medema, The Hesitant Hand, p. 107.
[15] Pennington, ‘Coase on Property Rights’, p. 97.
[16] Coase, ‘The Problem of Social Cost’, p. 19.
[17] Coase, ‘The Problem of Social Cost’, p. 21
[18] Coase, ‘The Problem of Social Cost’, p. 21
[19] Coase, ‘The Problem of Social Cost’, p. 43
[20] Gary D. Libecap and Terry L. Anderson, Environmental Markets: A Property Rights Approach, Cambridge Studies in Economics, Choice, and Society (New York: Cambridge University Press, 2014), p. 54.
[21] Fred E. Foldvary and Daniel B. Klein, eds, The Half-Life of Policy Rationales: How New Technology Affects Old Policy Issues (New York: NYU Press, 2003).
[22] Medema, The Hesitant Hand, pp. 115–17.
[23] R. H. Coase, ‘The Nature of the Firm’, Economica 4, no. 16 (1937), pp. 386–405, doi:10.2307/2626876.
[24] Steven N. S. Cheung, ‘The Fable of the Bees: An Economic Investigation’, The Journal of Law & Economics 16, no. 1 (1973), p. 32.
[25] R. H. Coase, ‘The Lighthouse in Economics’, The Journal of Law & Economics 17, no. 2 (1974),p. 375.
[26] Cheung, ‘The Fable of the Bees’.
[27] Coase, ‘The Lighthouse in Economics’.
[28] Elinor Ostrom, ‘Beyond Markets and States: Polycentric Governance of Complex Economic Systems’, The American Economic Review 100, no. 3 (2010), pp.641–72, at p.648.
[29] Ostrom, ‘Beyond Markets and States’, p. 417.
[30] Garrett Hardin, ‘The Tragedy of the Commons: The Population Problem Has No Technical Solution; It Requires a Fundamental Extension in Morality’, Science 162, no. 3859 (December 1968), pp. 1243–8, p. 1248, doi:10.1126/science.162.3859.1243. See Brett M. Frischmann, Alain Marciano and Giovanni Battista Ramello, ‘Retrospectives: Tragedy of the Commons after 50 Years’, Journal of Economic Perspectives 33, no. 4 (November 2019), pp. 211–28, doi:10.1257/jep.33.4.211. It is lost to most who come across the term that Hardin’s short 1968 piece was about overpopulation and the need for state control of reproduction: ‘The only way we can preserve and nurture other and more precious freedoms is by relinquishing the freedom to breed, and that very soon’ (p. 1244).
[31] Coase, ‘The Problem of Social Cost’, p. 39; Libecap and Anderson, Environmental Markets, p. 73.
[32] Roger Bate, Saving Our Streams: The Role of the Anglers’ Conservation Association in Protecting English and Welsh Rivers (London: The Institute of Economic Affairs, 2001), https://iea.org.uk/ publications/research/saving-our-streams/.
[33] Harold Demsetz, ‘Toward a Theory of Property Rights’, The American Economic Review 57, no. 2 (1967), pp. 347–59.
[34] Gary D. Libecap, ‘Coasean Bargaining to Address Environmental Externalities’, in The Elgar Companion to Ronald H. Coase, ed. Claude Ménard and Elodie Bertrand (Cheltenham and Northampton, MA: Edward Elgar, 2016), pp. 101–2, https://www.elgaronline.com/edcollchap/ edcoll/9781782547983/9781782547983.00017.xml.
[35] Terry L. Anderson and P. J. Hill, ‘The Evolution of Property Rights: A Study of the American West’, The Journal of Law & Economics 18, no. 1 (1975), pp. 163–79.
[36] Nathaniel O. Keohane and Sheila M. Olmstead, Markets and the Environment, 2nd edn,
Foundations of Contemporary Environmental Studies (Washington, DC: Island Press, 2016),
[37] Margaret McKean and Elinor Ostrom, ‘Common Property Regimes in the Forest: Just a Relic from the Past?’, Unasylva 46, no. 180 (1995), p. 6; Also cited by Mark Pennington, ‘Elinor Ostrom, Common-Pool Resources and the Classical Liberal Tradition’, in Elinor Ostrom with Mark Pennington, Christina Chang and Vlad Tarko, The Future of the Commons: Beyond Market Failure and Government Regulation (London: The Institute of Economic Affairs, 2012), p. 40.
[38] Elinor Ostrom, Governing the Commons: The Evolution of Institutions for Collective Action
[39] Arthur C. Pigou, ‘State Action and Laisser-Faire’, in Economics in Practice: Six Lectures on Current Issues (London: Macmillan and Co., 1935), 127. See: Medema, The Hesitant Hand, p. 71.
[40] Peter Boettke and John Kroencke, ‘The Real Purpose of the Program: A Case Study in James M. Buchanan’s Efforts at Academic Entrepreneurship to “Save the Books” in Economics’, Public Choice 183, no. 3 (June 2020), pp. 227–45, doi:10.1007/s11127-020-00798-2.
[41] Roger E. Backhouse and Steven G. Medema, ‘Economists and the Analysis of Government Failure: Fallacies in the Chicago and Virginia Interpretations of Cambridge Welfare Economics’, Cambridge Journal of Economics 36, no. 4 (July 2012), pp. 981–94, doi:10.1093/cje/ber047.
[42] Pennington, ‘Coase on Property Rights’, p. 99.
[43] Pennington, ‘Coase on Property Rights’, p. 100; emphases original.
[44] William R. Keech and Michael C. Munger, ‘The Anatomy of Government Failure’, Public Choice 164, nos 1–2 (July 2015), pp. 1–42, doi:10.1007/s11127-015-0262-y.
[45] Rosemarie Fike and James Gwartney, ‘Public Choice, Market Failure, and Government Failure in Principles Textbooks’, The Journal of Economic Education 46, no. 2 (April 2015), pp. 207–18, doi:10.1080/00220485.2014.1002962.
[46] Coase, ‘The Problem of Social Cost’, p. 34; Medema, The Hesitant Hand, p. 121.
