Download 4 The Economics of Climate Change

THE ECONOMICS OF CLIMATE CHANGE
4 The Economics of Climate Change
4.1
Climate Change – A Case for Action
In recent years, global climate change has been increasingly recognised as one of
the most critical and daunting challenges that policymakers face in this century. It is
an issue that the world will have to grapple with for many decades to come.
The Intergovernmental Panel on Climate Change (IPCC) has concluded that climate
change can be largely attributed to emissions of greenhouse gases (GHG) from
human activities, particularly carbon dioxide from the combustion of fossil fuels. An
increase in GHG concentrations could lead to profound and widespread global
impacts, such as a rise in sea levels, an increase in extreme weather events, stress
on water resources and food supplies, and increased risks of disease.
The Stern Review, a report released by a team of economists led by Sir Nicholas
Stern in 2006 for the British Government, argues that the benefits of strong, early
action on climate change will considerably outweigh the costs. The report estimates
that annual costs of achieving stabilization between 500-550ppm CO27 are around
1% of global GDP if action is taken now, but the costs will increase significantly with
delay.
While there is no agreement among economists and policymakers on the specific
conclusions of this report, there is growing consensus that rapid, sustained and
effective mitigation is required to avoid severe impacts of climate change. Mitigation
actions and policies range from development and deployment of renewable energy
technologies, improvements in energy efficiency in various sectors, carbon capture
and storage, to reforestation.
4.2
Dealing with Market Imperfections
Carbon emissions constitute a negative externality that is not factored into private
cost-benefit decisions8. There is a gap between private and social costs as the price
paid by the carbon emitter often does not fully compensate for the adverse effects to
society. Such a disparity results in an over production of emissions relative to the
benefits from consumption or production.
Climate change is particularly unique as an externality in a few respects. Firstly,
carbon dioxide, a major greenhouse gas, is still not regulated or viewed as a pollutant
in most countries. Secondly, the costs of undertaking carbon mitigation are
immediately felt and highly visible, while benefits of early mitigation are less clear and
accrue to future generations. Furthermore, scientists, economists and policymakers
are still grappling with uncertainties over direct and indirect impacts of climate
change. Lastly, and most critically, climate change crosses political borders. Hence, it
necessitates an internationally coordinated response, which has thus far proven to be
extremely difficult to achieve.
7
The concentration of 500-550 parts per million of CO2 (or equivalent) corresponds to mid-range of IPCC scenarios,
which is estimated to cause an increase in global average temperature of 3-40C.
8
An externality arises when the actions of the producers or consumers affect people other than themselves, i.e.
spillover impact. In such a case, the market will not lead to social efficiency as the price does not reflect the full
costs/benefits of production/consumption of a good.
BUDGET HIGHLIGHTS
Price-Based Mechanisms for Carbon Mitigation
The figure below shows that there is a gap between the marginal social cost of
carbon emissions (horizontal blue line) and the marginal private cost of carbon
emissions (horizontal red line), which is equal to zero in the absence of a carbon
pricing regime. Hence, firms produce Q0 of emissions, where the marginal benefit
(downward sloping line) and marginal private cost intersect. A price signal can shift
the marginal private cost of producing carbon upwards to bridge the externality, i.e.,
difference between private and social costs. This provides the right incentives for
polluters to cut back on emissions to the socially optimum level, Q’.
Price instruments for carbon abatement generally fall into two categories:
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
Emission Tax. Theoretically, an economy-wide Pigouvian 9 tax can fix the
price at the marginal social externality of emitting one unit of carbon. This
provides incentives for polluters to cut back on emissions to a point where
marginal cost of abatement is equal to level of tax. In this manner, market
forces help to efficiently allocate abatement across different sectors of the
economy.

Emissions Trading Scheme. An emissions trading scheme sets a limit on
total emissions by awarding or auctioning emissions permits to firms.
Participants can buy and sell permits in the event of excess/shortage. This
leads to a carbon price, which incentivises polluters with the lowest cost of
abatement to cut emissions in place of those that face high costs of
abatement. This is also known as a ‘cap-and-trade’ system and is the basis of
international emissions trading markets under the Kyoto Protocol10.
A Pigouvian tax in general refers to a tax levied on activities that generate negative externalities. It is named after
economist Arthur Pigou who also developed the concept of economic externalities.
10
The Kyoto Protocol is a protocol to the United Nations Framework Convention on Climate Change (UNFCCC), an
international environmental treaty aimed at combating global warming. The Kyoto Protocol was initially adopted on
Dec 1997 in Kyoto, Japan, and entered into force in Feb 2005. As of 2009, 187 states have signed and ratified the
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THE ECONOMICS OF CLIMATE CHANGE
The figure below shows the effects of tax and emissions trading scheme on carbon
abatement. In the absence of either a tax or emissions trading scheme, no carbon is
abated (Q0). A tax (horizontal blue line) can intersect the marginal cost curve
horizontally at the same point where an emissions cap (vertical red line) intersects
the curve. In theory, both mechanisms are able to achieve the same market
equilibrium and reduction in carbon emissions, Q’.
In practice, however, they perform differently under uncertain conditions. It is debated
among economists which is preferable and some have advocated hybrid
mechanisms that combine elements of both instruments.

An emission tax is a price instrument because it fixes the price per unit of
carbon, while allowing the emissions level (quantity) to vary according to the
marginal cost of abatement for the economy. A common criticism of the tax
instrument is that the regulator bears the responsibility of setting the right
price levels at the marginal cost of emissions, which is difficult to do
accurately and can vary in a volatile market. Another drawback is that a tax
may not provide certainty on the amount of emission reductions.

In comparison, an emission trading system is a quantity instrument because it
fixes the overall emission level (quantity), while allowing the price of carbon to
vary through auctions. However, such a system would not provide any
certainty on the price of carbon.
For a small domestic market like Singapore, a carbon tax could be more practical to
implement than cap-and-trade. Firstly, the latter could lead to price uncertainty, and
may deter or delay carbon reduction investments. Furthermore, it requires a new
carbon trading infrastructure, and could pose substantial transaction and monitoring
costs on both the Government and firms. With a relatively small market that has only
Protocol. The major feature of the Kyoto Protocol is that it sets binding targets for industrialised countries and the
European community for reducing greenhouse gas (GHG) emissions.
BUDGET HIGHLIGHTS
a few large energy consumers, a tax can provide greater price certainty and stability
that will incentivise investments in energy efficiency and low carbon solutions.
Non-Price-Based Interventions to Address Market Failures
On top of price signals, there may be a need for non-market policy interventions and
regulation to address market failures in specific sectors. Market failures are
obstructions that prevent agents from reacting to price signals, and undertaking
welfare-increasing actions. Table 4.1 below displays some examples of market
failures that impede energy efficiency improvements, even when they are costeffective to undertake.
Table 4.1: Examples of Market Failures
Market Failure/Barrier
Examples
Split incentives or Transactions
where
principal-agent
economic benefits (of
problems
energy conservation)
do not accrue to the
party that makes the
investment
Landlords do not make capital
investments in energy-efficient
appliances because they do not
reap savings from utility bills, which
are borne by tenants
Imperfect
information
Lack of consumer awareness of
energy consumption of household
appliances, vehicles
Information
about
energy
efficiency
options
can
be
incomplete, unavailable
or expensive to obtain
Government intervention can help resolve market failures, and enable higher
responsiveness to price signals. This can be done through a mix of policy
instruments such as financing and loans, capability building and technology
development programmes, as well as regulation. As such interventions may cause
economic distortions, they should be carefully designed and tailored to the type of
market failure that is present.
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THE ECONOMICS OF CLIMATE CHANGE
Box 4.1: Singapore’s climate change mitigation strategy

Singapore has an important stake in a successful global deal. As a small and
low-lying island state, we are vulnerable to the effects of climate change. Hence,
we will do our part in a global agreement on climate change even though we
have no historical responsibility for climate change, and our absolute greenhouse
gas emissions are very low.

Singapore is constrained as an alternative energy disadvantaged country. There
are inherent limitations to what we can do to reduce emissions and we face
constraints in switching to alternative energies.

Despite these constraints, we have taken significant steps to ensure our
development is sustainable. Under the Sustainable Singapore Blueprint (SSB)
announced last year, $1b was committed over 5 years to improve the energy
efficiency of our economy in industry, transport, households and buildings.
Measures outlined under the SSB will help us reduce our carbon emissions by 711% from the business-as-usual (BAU) scenario by 2020. Thus far, more than
$400m has been committed to these measures.

The Government had earlier announced that we will undertake voluntary actions
to reduce our emissions growth by 16% below 2020 BAU, contingent on a global
agreement being reached. This represents a substantial commitment that will
require a major effort by all sectors of the economy.

To achieve this reduction in emissions, we will have to rely on a combination of
price signals, fiscal measures and other policy interventions. We are currently
studying all the options, and specific measures will be announced at a future date
after we have worked out the details, and when the outcome of climate change
negotiations is clearer.