Dolan, Microeconomics 4e, Ch. 6 Survey of Economics Edwin G. Dolan and Kevin C. Klein Best Value Textbooks 4 th Edition Chapter 14 The Economics of Climate Change and Environmental Policy

Dolan and Klein, Survey of Economics 4e, Ch. 14 Marginal Cost of Abatement  This graph shows the marginal cost of abatement for carbon dioxide from a power plant.  With no pollution control, the plant would emit an amount of CO2 shown as “business as usual.”  Three methods of pollution control are shown, each more expensive than the one before:  Better generator design  Switch to natural gas  Carbon capture and storage  As the amount of pollution decreases, the marginal cost of abatement increases.

Dolan and Klein, Survey of Economics 4e, Ch. 14 Optimal Quantity of Pollution  The point where the marginal cost of abatement curve intersects the marginal external cost curve is the economically optimal quantity of pollution.  To the right of that point, the harm done by pollution exceeds the cost of eliminating it.  To the left of that point, the cost of abatement is greater than the harm done by pollution.

Dolan and Klein, Survey of Economics 4e, Ch. 14 Effects of a Carbon Tax Effect of a carbon tax of $20 per ton of CO2 equivalent (CO2E)  For levels of pollution above 50 gigatons per year, marginal abatement cost is less than the tax. It would be more profitable for pollution sources to reduce CO2 output than to pay the tax.  For pollution levels less than 50 gigatons per year, it would cost less to pay the tax than to make further reductions in emissions.  If the carbon tax is set at a level equal to the intersection of the marginal abatement cost and marginal external cost curves, the result will be an optimal level of emissions.

Dolan and Klein, Survey of Economics 4e, Ch. 14 Effects of Cap-and-Trade  The total amount of CO2 equivalent that may be discharged capped at 50 gigatons.  As permits are traded, equilibrium will be established when the marginal cost of abatement is equalized among all pollution sources.  The equilibrium price of a permit will be determined by the intersection of the marginal cost of abatement curve with the line representing the permit cap.  If the correct number of permits is issued, the optimum quantity of pollution will be achieved.

Dolan and Klein, Survey of Economics 4e, Ch. 14 Chapter Fourteen Appendix Evaluating Costs and Benefits over Time

Dolan and Klein, Survey of Economics 4e, Ch. 14 Discounting the Future  In many contexts, economics uses the principle of discounting, which values future costs and benefits less than present costs and benefits. Examples:  You win the lottery. Would you rather have $1,000,000 now or $100,000 per year for ten years?  You owe the government $1,000 in taxes. Would you rather pay it all at once, or pay $250 per quarter over the next year?

Dolan and Klein, Survey of Economics 4e, Ch. 14 Mathematics of discounting The present value equation Pv = Fv/(1+i) t Example  You will receive a payment of $100 two years from today. How much is this future payment worth now?  The present value, discounted at 5%, is 100/(1.05) 2 = 100/(1.1025) = $90.70  Another way of looking at it: $90.70 is the amount you would have to put in the bank today at 5% compound interest in order to have $100 two years from now.

Dolan and Klein, Survey of Economics 4e, Ch. 14 Application: How to Cut Carbon Emissions  You are CFO of your company.  In order to boost the company’s green image, your company wants to use low-carbon power source for a new store it plans to open.  Two methods are proposed.  Use a bio-diesel generator  Install a solar array  Which of these equally environment- friendly methods has the lowest cost? pdlipart.org

Dolan, Economics Combined Version 4e, Ch. 6 The Costs  The Solar array costs $25,000 to install, but its operating costs are very low.  The bio-diesel generator is cheaper, but its operating costs are higher.  Both types of equipment have a projected life of 10 years.  Ten-year total costs for solar are lower. Does that make it better?

Dolan, Economics Combined Version 4e, Ch. 6 The Cost of Money  Suppose you have to borrow at 6% to finance the project.  Postponing some expenses to later years will save borrowing costs.  When you compare the present values of expenses discounted at 6%, the bio- diesel unit turns out to be the least costly for your company.

Dolan, Economics Combined Version 4e, Ch. 6 Changing the Cost of Money  Suppose instead that your borrowing cost is just 4%.  Now there is less advantage to postponing expenses.  The total discounted cost is now lower for the solar unit!

Dolan and Klein, Survey of Economics 4e, Ch. 14 Generalizations from the Example  The method of discounting allows you to compare income or expenses that occur at different points in time.  A high discount rate places greater weight on costs or benefits that occur in the immediate future.  A low discount rate places greater weight on costs or benefits that occur in the more distant future.

Dolan and Klein, Survey of Economics 4e, Ch. 14 Discount Rates over Long Time Periods  There is one big problem in applying market-based discount rates to the long time horizon involved in climate change. A market-based discount rate of 2% to 4% implies that we don’t much care what happens in the distant future.  Many people reject this position on ethical grounds— we should care about the future!

Dolan and Klein, Survey of Economics 4e, Ch. 14 Effects of Discounting on Policy Choice  The strength of a policy can be stated in terms of the equivalent “carbon tax”—the incentive needed to reduce carbon emissions by a given amount.  Small differences in discount rates make big differences in policy.  Nordhaus/Boyer  discount rate of 4% falling to 2%  2008 optimal carbon tax of $10 to $30/ton  Stern  discount rate of 1.4%  2007 carbon tax of $311

Dolan and Klein, Survey of Economics 4e, Ch. 14 Chapter Six Supplemental Slides Some Basic Data on Global Warming Source: Intergovenmental Panel on Climate Change

Dolan and Klein, Survey of Economics 4e, Ch. 14  The Intergovernmental Panel on Climate Change summarizes many studies in its 2007 report.  The IPCC report suggests that global warming is accelerating.

Dolan, Economics Combined Version 4e, Ch. 6 CO2 Trends The warming trend has coincided with an increase in atmospheric CO2 concentrations (IPCC 2007).

Dolan, Economics Combined Version 4e, Ch. 6 Other Factors Also Contribute to Climate Change

Dolan and Klein, Survey of Economics 4e, Ch. 14 Causal Models of CO2-Warming Relationship  Black line = trend of observations  Blue band = natural forcing from 5 climate models  Red band = anthropogenic + natural forcing from 5 models Source: IPCC 2007

Dolan and Klein, Survey of Economics 4e, Ch. 14 Uncertainty  Climate change models agree on the direction of effects but show a wide range of uncertainty about their size.  Warming in 20 th century: 90% confidence interval is from.4 oC to.8 oC.  Future warming: See chart. Source: IPCC Climate Change 2001

Dolan, Economics Combined Version 4e, Ch. 6 Climate Change Momentum There are long lags in climate change; thus, even radical action to slow C02 emissions would not bring a quick end to global warming. Source: IPCC Climate Change 2001 Today100 yrs1000 yrs With firm action, CO2 emissions peak in this century and then decline