Download Understanding The Economics of Global Climate Change

Global climate change:
Economics and public action
The experiment
Source: Stiglitz, 2006
The Big Picture
Agenda
• A (very) rapid look at the science of climate
change
• The economics of climate change
– Externalities and public goods
– Cost benefit analysis
– Policy choices
– The collective action problem
The science of global climate change
• The mechanism of global climate change
– Greenhouse gases affect temperature
– GHGs include carbon dioxide, methane, nitrous oxides, CFCs etc
– Some GHG’s (e.g. CO2, methane) are integral to the earth’s carbon cycle;
others (e.g. CFC) are human products
• The central views from scientists:
– Temperatures are rising; GHG levels have a causal influence
– Human influence is increasing GHG concentration
– If GHG concentrations double, global temperatures will rise of the order of 2-4
degrees
– There is still some controversy, but we’ll take the science as given for today
Note: CFCs are greenhouse gases, but the big issue around them was on
effects on the ozone layer and so on skin cancer (etc). More on the
(successful) Montreal Protocol below
Long-term increases in temperature
Climate models indicate these temperature increases
are related to human action…
...due to a variety of sources of GHGs affected by
human behavior
Predicted temperature effect of various levels of
stabilization of GHGs by 2100…
..and significant variation in predicted effects
even for same level of CO2 change…
…with a wide range of effects on water
availability…
...and possibilities of severe effects and tipping points
Changes in stocks require large cuts in emissions, given
long lives of GHGs
Rich countries account for most of the stock, but
developing countries for much of the projected
growth in emissions
So future developing country emissions are part
of the problem under these scenarios
The development and distribution issue
Carbon emissions given by:
C = C/E x E/Y x Y/P x P
C/E = carbon emissions per unit of energy
E/Y = energy use per unit of GDP
Y/P = GDP per capita
P = population growth
Illustrative number: US E/Y is 50% more than for Europe, 100%
more than Japan; many times than for developing countries
Different proposals focus on different variables: C; E/Y or C/Y;
C/P
The economics of climate change
• Emission creates a
negative externality
Net benefits to polluter
Costs to everyone else
Source: Nolan Miller lecture notes
Who is the emitter? Depends on level of aggregation:
(a) A firm, or
(b) A country, if externalities are internalized within the border
So abatement is a public good
• Non-rivalrous
• Non-excludable
…and will be under
produced
Benefits of abatement to the world
Benefits of abatement to country x
Costs of abatement to country x
Source: Nolan Miller lecture notes
Uncertainty prevails; over…
•
•
•
•
Size of temperature changes
Impacts on precipitation and sea-level effects
Probabilities of “large” adverse effects
Economic impacts on growth processes and so
benefits of action
• Costs of adaptation—but little work on socially
contingent responses e.g. migration and conflict
• Costs of mitigation/abatement
Irreversibilities matter..
• “Mega” irreversibilities may exist around
climatic conditions, creating option value of
preventing large climate change
• Economic irreversibilities matter, and these
cut both ways
– Changing the economic life of existing capital
stock
– Changing to greener capital stock (if prove
unnecessary)
Evaluation
How to evaluate the benefits and
costs of climate change?
Economic issues
(i)
Valuation of benefits and costs
(ii)
Inter-temporal equity and the
discount rate
(iii) Marginal utility of
consumption
•
•
(iv)
Will future generations be
richer?
Who is hurt by climate
change?
Uncertainty

W 
t
u
(
c
)
e
t

0
Where W is social welfare, c is
consumption and δ is the social
rate of time preference
The debate on discount rates
    g
The discount rate (ρ) is a function of the social rate of time
preference (δ) the rate of growth of consumption (g) and
the elasticity of the marginal utility of consumption (η) [in
a simplified account]
Stern review argues for a δ close to zero, and a low value of
η (around 1), giving an overall discount rate close to 1.4%
Most economists argue for a higher discount rate, either
with a higher δ or a higher η.
This has a huge impact on the benefit cost ratio and the
implications for optimal action
Costs and benefits of action: large uncertainties
and still significant debate
Nordhaus circa 2000: optimal policy is for modest tax; stabilization
has negative benefit cost ratio
Now central estimates are shifting to a more favorable benefit cost ratio
for action: Nordhaus circa 2006 has increased estimate of global output
cost of 2.5 degrees from 2 to 3% of GDP. This still implies a ramping up
scenario
Stern Report argues for very favorable benefit cost ratio for strong early action
Some of this comes from estimates of higher estimates of costs, and lower
estimates of benefits; most revolves around the choice of the discount rate
Policy issues
Policy responses
Largely
national
Adaptation
Distribution of
adaptation costs
A side
payment
Finance/support
for poor country
adaptation
Mitigation
Choice of
instruments
Effort distribution
across countries
The collective
action problem
Intrinsically
international
Instruments for mitigation
Type of instrument
Advantage
Property rights/Coase
Disadvantage
Infeasible in international
context
Carbon tax
Optimal to guide efficient
decisions
Uncertain effects
Hard to get crosscountry consistency
Cap and trade
Politicians and citizens
understand caps
Trading can lead to
efficient choices
Hard to get agreement
on distribution of caps
Thin market; uncertain
price
Regulation
Clear and
understandable
Can be highly inefficient
Subsidies to
technological research
Good economics for a
public good
Finance
Private sector will be
central to research
Rich country bias on
adaptation
Policy: taxation (i) taxing emission
Polluter now producers
until marginal net benefit
equals the tax rate
Source: Nolan Miller lecture notes
Technical problems: (i) finding the Pigovian tax rate, (ii) finding a tax base strongly
correlated with carbon emissions; in principle past estimates, trial and error can
be used
Also large political and coordination problems
Policy: taxation (ii) subsidizing carbon sinks
• Deforestation is a source of increased emisions, so either
reforestation or slowing deforestation has a positive
externality, warranting a subsidy
• Concept underlying the Rainforest Initiative
Policy: cap and trade
• A cap is a quota, negotiated at country and
then industry level
• But can lead to highly inefficient results, since
marginal costs of meeting the quota highly
unlikely to be equalized
• Creating a market for firms to buy and sell
emission rights allows this marginal cost to be
equalized (amongst participants)
Policy: regulation
Example: the Governator
• Ambitious targets plus
regulation for California
• California can be a
standards-setter
• Is it credible?
The collective action problem: underlying structure of
the game is PD; polluting is a dominant strategy
Player Y
Player
X
Many countries: Payoffs to any country of playing abate
(Пa) and pollute (Пb)
Abate
Pollute
Пp
Пa
Abate
2, 2
-1, 3
0
Number of other countries playing abate
Pollute 3,-1
0, 0
The collective action problem
Why the Montreal Protocol worked
• Benefit cost ratios in
rich countries were
highly favorable to
action and
supported unilateral
action by US
• So US could lead,
including in
technological
change
Payoffs to
US (1985
$bln)
No
controls
Montreal
protocol
Unilateral
action of
Montreal
Benefits
0
3575
1373
Costs
0
21
21
Net
benefits
0
3554
1352
So the US problem is transformed to this…
Payoffs to US of playing abate (Пa) and pollute (Пb)
Пa
Пp
0
Number of other countries playing abate
• Its dominant strategy is
abate
• With incentives for US
business to innovate,
creating strategic
complementarities with
CFC-substitutes (via
standards and reduced
cost of abatement)
Solving cooperation with Europe was relatively
easy
• High benefits, low costs
• Internal coordination (partially) solved in
Europe; citizen attitudes underpinned an
“abate” domestic political equilibrium
• Two-thirds ratification for treaty to come in
force (a 90% threshold would have increased
leverage of Japan and USSR)
Trade sanctions were effective in changing the
equilibrium on signing for resisting countries
Payoffs to other countries of playing signatory (Пs) and non-signatory
(Пn) with trade sanctions
Пp
Пa
0
Number of other signatories
Restrictions on trade in
CFCs between
signatories and nonsignatories was part of
the agreement.
There is a tipping point
and the interaction
becomes a coordination
game
And why climate change is a lot harder
• Benefit cost ratios are less favorable
• Given higher costs concerns over competitiveness matter
– E.g. European carbon tax made conditional in 1992 on US
and Japan adopting the same. They didn’t
– US concerns over developing country competition
Kyoto Protocol
• Cap and trade
• Only sought to solve collective action across
rich countries, with negotiated “equitable”
caps only for rich countries
• Incentives for mitigation investments in
developing countries via inclusion in trading of
carbon allowances
Cap and trade
• Business preferred cap and trade to carbon tax
• Business persuaded governments that carbon
allowances be given, not auctioned
• Trading with developing countries is taking off,
especially for green investments (abatement)
in China—a form of side payment
The position of business
• Big concerns over cost effects and competitiveness. Latter is a
function of the extent to which collective action problem is
resolved
• Different views but most firms have “green” departments e.g.
Dupont again
• Pressures from investors
Takeaways and outstanding issues
• The Stern Review has done a huge service in bringing the economics of
global climate change to the center of the debate. Core public economics
principles pervade the report. But there is still controversy over choices
• Evaluating the economic case for action
– What discount rate(s) make sense?
– How to value the (catastrophic) tail?
– How to value net benefits to poorer groups?
• The domestic political equilibrium
– How do citizens value inter-generational equity?
– What is the dynamic between business and government policy?
– What drives overall political payoffs to government?
• The global strategic interaction
– Is there a self-enforcing equilibrium with US, Europe-Japan and China-India at
the core?
– Are trade sanctions credible? Against the US? Against “the rest”?
– Will rich countries want to use trading to subsidize Chinese industries?
– Do aid givers have a contingent liability to hard-hit poor countries?
• How to analyze strategic interactions and feasible, as opposed socially
optimal, outcomes is at the center of microeconomics II