The Economics of Climate Change

The Economics of Climate Change Thomas C. Kinnaman, Ph. D. Department of Economics Bucknell University

The Economics Perspective “… it will do us little good to solve our common global economic problems if we do not do something about the most pressing common environmental problem: global warming.” • Joseph E. Stiglitz, 2001 Nobel Memorial Prize in Economics

The Economics Perspective “we are much better off to act to reduce CO2 emissions substantially than to suffer and risk the consequences of failing to meet this challenge.” • Kenneth J. Arrow, 1972 Nobel Memorial Prize in Economics

The Economics Perspective “The basics of global warming are not in scientific dispute …the theory is not in doubt. … We need, urgently, to better understand what alternatives to fossil fuels there will be.” • Thomas C. Schelling, 2005 Nobel Memorial Prize in Economics

The Economics Perspective “In light of the near-consensus on the need to slow global warming, the question is not whether the United States will join other industrial countries in working to contain greenhouse gas emissions, but how and when.” • The Milkin Institute (a nonpartisan economic policy think tank)

Benefits and Costs • The UK issued a major government report directed by economist Nicholas Stern • Costs and benefits of reducing CO2 are estimated • Stern Report criticized for lack of discount rates (a considerable tradition among British economists and many philosophers)

Benefits and Costs • Economic benefits of reducing CO2 suggest growth of rate of GDP between now and 2200 will be 1.3% rather than 1.2%. • By 2200 GNP will be 20% higher (3%-34% confidence interval) if CO2 is reduced

Benefits and Costs • Costs: Stern estimate economic costs of 3.4% to -3.9% of GNP (as energy savings reduces energy costs) • Using a conservative mid-point estimate of 1% of GNP forever, benefits of reducing CO2 exceed costs for all discount rates less than 8.5% (Arrow, 2007).

Specific Policy Options • Technology-Push Subsidies • Direct Regulations (Tech-Based Standards) • Cap and Trade Scheme • Carbon Tax on all Fossil Fuels More than one approach is likely necessary

1. Technology Pushing • Subsidize R&D in carbon-reducing energy sources • Justified by external benefits of such energy sources • Can work within other policy environments

2. Direct Regulation • Examples include Clean Air Act and Clean Water Act in the US • Government determines best methods to reduce CO2, requires use of those methods, and punishes non-compliers. • Very costly • Only policy option in situations where emissions or inputs cannot be measured

3. Cap and Trade Examples include • Phase out of leaded gasoline in 1980’s saved $250 million per year over traditional regulatory approach • Reduction SO2 emissions in 1990’s saved $1 billion, or 45-55% of cost of traditional regulations (Carlson et al., 2000, Ellerman, 2003)

3. Cap and Trade Scheme Role for Government • Determine the desired reduction in CO2 emissions (30%, 60%?) • Identify all major sources of CO2 (power plants, heavy industries, autos, etc.) • Issue each source a permit for each unit of allowed CO2 emissions • Monitor CO2 emissions from each identified source

3. Cap and Trade Scheme Role for CO2 Emitters • Generate allowable quantity of CO2 • Generate more CO2 than allowed – must purchase permits (to avoid fines) • Generate less CO2 than allowed – sell permits

3. Cap and Trade Expected Savings: • Reduce compliance costs by 50% across the economy if implemented only in industrialized countries • Reduce costs by 75% if also implemented in developing countries (Edmonds, et al.)

3. Cap and Trade Other Advantages • Unregulated low-cost CO2 abaters will voluntarily join program to sell permits • Unregulated high-cost abaters will not join – this is OK too. • Anyone can purchase permits

Prices for CO2 Allowances

4. Carbon Tax All fossil fuels would be taxed to reflect the carbon content of the fuel • Those sources that can abate substantial CO2 levels pay less taxes – encourages abatement • Easy to administer as the bulk of fossil fuels are sold on international commodities markets. • Same level of economic savings

Cap and Trade or Carbon Tax? Economists have not reached a consensus • Advantages to Cap and Trade • Quantities are determined by regulators • Less of a financial burden on sources (if permits are given away) • Disadvantages: • Initial distribution will be difficult • Prices of permits may fluctuate

Cap and Trade or Carbon Tax • Advantages of Carbon Tax • Revenues are earned • Used to reduce income taxes • Used to finance R&D in clean energy technologies

CO2 Emission Reduction Paths • Begin at business-as-usual level and depart gradually (targets will rise at first). • avoid rendering large parts of the capital stock, constructed in era of free carbon emissions, prematurely obsolete • Depart widely from business-as-usual path • Politically pragmatic • Will alters future investment decisions • Will spur technological change • Kyoto protocol would require USA to reduce 25-30% of emissions at once, Canada 35%.

Policy Dilemma • Issue a unique CO2 reduction path to each country and allow that country to choose how to follow its own path (Kyoto Protocol). • Create a global CO2 reduction path and follow the global path at lowest cost

Country Specific Path Examples: • Each country must reduce CO2 by X% • Each country must reduce CO2 to year X levels (Kyoto) Problems: • Cost of CO2 abatement vary across countries • Penalizes those countries with economies that are not CO2 intensive

Global Path • Much less costly • Requires extraordinary international organization and cooperation • Can be achieved by either a carbon cap and trade program or a carbon tax

Developing Countries • Many argue industrial countries should take first step to combat climate change • responsible for the bulk of the problem • But, • Developing countries currently provide the greatest opportunity for low-cost emission reductions. • Production of carbon-intensive goods could “leak” outside coalition of participating countries • Could promote carbon-intensive growth paths in developing countries

Developing Countries Future economic aid could be reconfigured to take the form of large scale financing of the purchases of cleaner technologies • Could be justified by facts such as rich countries have caused the problem and poor countries are most vulnerable to consequences of climate change

International Compliance Allowing open market CO2 emission levels can be considered government subsidy to carbon intensive industries • Existing trade laws discourage such subsidies, and most nations have successfully eliminated subsidies on all forms of production except agriculture • Otherwise, costly trade sanctions must be imposed

Political Successes The “Emergency Economic Stabilization Act of 2008” included fiscal stimulus for alternative energy • Tax advantages to wind, refined coal, biomass, marine renewables (wave and tide), solar fuel cell, and geothermal • Tax credits for carbon abatement projects of 65% or more • Tax rebate on plug-in electric cars ($2,500-$7,500) • Firms can provide tax-free fringe benefit of bicycle storage

Summary • Economists take the threat to the climate seriously • Initial benefit-cost analyses justify CO2 reductions paths • A policy framework can be developed

The Economics of Climate Change