The discourse on climate change is dominated by the narrative that when it comes to mitigation, free-riding pays off for the individual actor. A new publication by the Global Climate Forum presents a different perspective on the transition from a brown to a green economy from a game-theoretic point of view.

When Donald Trump recently announced that the USA will abandon the Paris agreement, he claimed that this decision was necessary in order to protect the nation’s prosperity, i.e. to avoid a welfare reduction due to climate mitigation efforts. This kind of reasoning (which has been described by Hardin as the “tragedy of the commons”) relates, game-theoretically speaking, to the prisoner’s dilemma:
When it comes to climate protection, every actor has the option to mitigate or to keep on doing business as usual. If everyone mitigates, the payoffs for everyone are higher than if nobody does (because the future costs of dealing with the climatic change will then be very high). However, mitigation is linked to costs, and thus an actor receives the highest payoff if she keeps on without making any mitigation efforts while the other players take care of the issue.
This perspective is widespread, however, some of the advocates of climate mitigation tell another story when arguing why to make these efforts. They claim that an economic trajectory is possible, which is characterised by reducing CO2-emissions compared to a business-as-usual scenario while achieving (at least) the same level of welfare – not only in the distant future by also short term. This narrative is often referred to as the possibility of green growth. The paper suggests that this narrative can game-theoretically be seen as a stag hunt (see Appendix).
Let us assume that the proponents of green-growth are right: There is a green equilibrium out there at which the economy experiences at least the same level of welfare while emitting significantly less CO2 to the atmosphere. However, in order to obtain this equilibrium, large-scale investments into green infrastructures and technologies are needed. In the paper, a situation is assumed in which, if only a few investors take this effort, the transition is not achieved and their returns are very low; on the other hand, investing in the well-established brown infrastructures and technologies delivers a return on investment that does not depend that strongly on what other investors do. Under these assumptions, will the green equilibrium be obtained, which is payoff-dominant but requires the single investors to take the risk that returns rely on the behaviour of the others?

How does this relate to investment decisions?
As multiple experiments with stag-hunt-like games show, actors often fail to coordinate on a payoff-dominant equilibrium in such games due to uncertainty. In order to coordinate, players have to have enough trust in the others “chasing the stag”. The necessary coordination can be fostered by what is often called focal points, e.g. social norms, signals, or narratives. If the investors of the scenario assumed above (i.e. a world with a possible green growth trajectory) live in an environment in which the discourse about climate mitigation is dominated by the picture of the prisoner’s dilemma, nobody expects the others to invest in the green technologies, and thus it is very unlikely that they will coordinate on the payoff-dominant equilibrium. On the other hand, if the narrative of the possibility of a Pareto-superior equilibrium is widespread and supported by policies that show credible effort to make the sustainability transition, the coordination which is necessary for achieving the payoff-dominant state is much more likely.

What are policy implications?
First of all, if the possibility of win-win options (in the sense that green investment can also increase economic well-being) is excluded in the first place, nothing follows for policy making from the considerations sketched above. However, parts of the world, and in particular the Euro zone, are currently experiencing a situation of low growth and low investments (which also implies high unemployment in some parts, and high vulnerability to financial shocks). At the same time, for achieving the goal to keep global warming well below 2°C, a lot of capital – also stemming from private sources – has to be innvested in green infrastructures and technologies. If the possibility to increase economic growth through the sustainable investments is not rejected a priori, the assumption that we might be in a situation that can be described by the stag-hunt picture is not very far-fetched.
In this case, it is crucial to build and foster the expectations that are needed for the actors to coordinate on the Pareto-superior equilibrium. Policy is a factor in the formation of expectations, and political decisions can shift investment strategies. In the current political and historical circumstances, a coherent energy, climate and investment policy has the potential to coordinate actors towards a higher growth path. In order to coordinate expectations, policy signals and regulations have to be coherent and credible. Additionally, pilot projects can be very helpful as showcases which can also serve as focal points for coordination.

Further reading: J. Mielke and G. A. Steudle (2017), “Green investment and coordination failure: An investors’ perspective”. GCF Working Paper No. 1/2017.

Appendix: The “Stag Hunt” in Game Theory

In game theory, the story of the stag hunt is as follows: There are two hunters, who can either chase a stag or a hare. In order to bag the stag, two hunters are needed but a hare can be caught by one of them alone. The payoff of half a stag is higher than the payoff of one hare. That means that if both players hunt the stag they will both receive a higher payoff than in the case that both go for hares. However, if one player decides to chase the stag while the other goes hare hunting, the hare hunter will catch a hare and the stag hunter gets nothing at all. A possible payoff table looks like this:

The game has two Nash equilibria, both players hunting the stag, and both players hunting a hare. This brings up the problem of equilibrium selection: which of the two will be obtained? It probably depends on the expectations of
the players: If I assume the other player to hunt the stag for whatever reason (e.g. I know that he used to hunt stags, or I trust him to keep to some prior agreement to do so, or I live in a society in which there is a social norm saying that stag hunting is the “normal” behaviour, or we both have observed a lot of successful stag hunters in the past etc.), I will probably do so as well. On the other hand, if I am unsure what the other will do, I have an incentive to play the save option and go for a hare to avoid the risk of starving.