Policy ramp versus big bang: optimal global mitigation policy ESP 165: Climate Policy Michael Springborn Department of Environmental Science & Policy UC Davis Policy ramp versus big bang: optimal global mitigation policy

In 2006 the UK released an “Economics of Climate Change” report by Nicholas Stern that sparked debate by calling for much more aggressive action than others AKA: the Stern Review (SR) Sir Nicholas Stern (Nobel Laureate) Adviser to the UK government on the Economics of Climate Change and Development 2005-2007 Chair of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics (LSE) since 2008

The SR used estimates of damage from climate change that were much larger than previous studies Adapted from a portion of Figure 1 in Tol and Yohe (2006) "A Review of the Stern Review" World Economics 7(4): 233–50. Tol and Yohe (2006)

The SR used a much lower discount rate than other mainstream economists. The level at any given time t represents the weight given to benefits and costs (affecting consumption) arriving at year t. Discount factor (weight) under various assumptions Discount weight

William Nordhaus is a distinguished economist with significant leadership experience in academia and public policy Faculty member of Yale University since 1967 Image source (Nordhaus and book cover) : http://www.salon.com/2013/10/30/william_nordhaus_smoking_can_teach_us_about_climate_change/ Image credit (Nordhaus and book cover): Michael Marsland/Yale University Image source (logos): from each institution’s website Nordhaus’ website: http://www.econ.yale.edu/~nordhaus/homepage/ Brief Bio - born in Albuquerque, New Mexico, USA - distinguished professor of Economics at Yale University where he has taught since 1967, also teaches in Yale’s School of Forestry & Environmental Studies - a prolific writer on a wide range of economic topics including energy and climate issues: 22 books, 158 journal publications, and 99 other kinds of publications (testimony, reports, working papers, etc.) - member of the President’s Council of Economic Advisers under President Jimmy Carter (1977-1979) - Chair of the Federal Reserve Bank of Boston’s Board of Directors (2014-), member since 2008 - President of the American Economic Association (2014-15) - 2006 Award for “Publication of Enduring Quality,” Association of Environmental and Resource Economics for Managing the Global Commons (MIT Press, 1994) - “Author of the D(ynamic)ICE and R(egional)ICE models of the economics of climate change, which have been widely used in research on studies of climate-change economics and policies.” Nordhaus, W. (2007).  “Critical assumptions in the Stern Review on climate change.”  Science 317, 201–202. Nordhaus, W. (2010). Economic aspects of global warming in a post-Copenhagen environment. Proceedings of the National Academy of Sciences 107(26), 11721-11726.

Nordhaus expresses the stringency of his policy ramp recommendation vs Nordhaus expresses the stringency of his policy ramp recommendation vs. the “big bang” by estimating the carbon tax needed to get the targeted mitigation. “big bang”/Stern assumptions Nordhaus (2007) http://nordhaus.econ.yale.edu/nordhaus_stern_science.pdf Nordhaus policy ramp/DICE baseline Nordhaus (2007)

To set the discount rate Stern was prescriptive (normative), Nordhaus was descriptive (positive). Nordhaus (2008, p. 174):

Specifying a social discount rate for long-run climate policy analysis often employs the Ramsey framework Ramsey (1928) optimal growth model: Economy operates as if a “representative agent” selects consumption and savings to max PV of the stream of utility from consumption over time. One implication of the Ramsey model is the following equation: ρ = δ+ ƞg ρ: discount rate on consumption, c “long-run real return on capital” (in equilibrium) δ: discount rate on utility, u(c) “pure rate of time preference”, “utility rate of discount” ƞ: elasticity of marginal utility w.r.t. consumption (how curved is the utility function) also an indicator of intergenerational inequality aversion g: average growth rate of consumption (per capita) Ramsey, F. P. 1928. A mathematical theory of saving. Economics Journal. 38:543–559.

Discounting – Ramsey equation Ramsey optimal growth model: central framework for thinking about dynamic investment decisions organizing principle for setting long-run discount rates The Ramsey equation holds in the welfare optimum r = ρ + ƞ * g ƞ: How quickly marginal utility falls as consumption rises (elasticity of marginal utility of consumption) Utility(c) low ƞ Notes on the Ramsey model: http://www.fidrmuc.net/ec5518/02.pdf. Note that eta is the coef. of relative risk aversion in the CRRA utility function over consumption. Nordhaus (2008): Stern sets the discount rate equal to the rate of growth of per capita consumption, plus 0.1%. Since economic growth averages 1.3% in his model, his discount rate averages 1.4%. Ramsey model assumptions: Annual pure rate of time pref: 0.1%; annual growth rate: 1.3%; elasticity of marginal utility of consumption: 1 (low inequality aversion) growth rate of consumption consumption disc. rate utility function shape param. utility discount rate high ƞ ct ct+1 c: consumption

Discounting – Ramsey equation ƞ: Also indicates: aversion to consumption inequality among generations. Lower ƞ (Stern) MU changes relatively little over consumption pays less attention to whether future is richer/poorer  cares less about intergenerational inequality Higher ƞ (Nordhaus)  MU changes more rapidly more attention to income (consumption) changes  cares more about intergen. inequality. Notes on the Ramsey model: http://www.fidrmuc.net/ec5518/02.pdf. Note that eta is the coef. of relative risk aversion in the CRRA utility function over consumption. Nordhaus (2008): Stern sets the discount rate equal to the rate of growth of per capita consumption, plus 0.1%. Since economic growth averages 1.3% in his model, his discount rate averages 1.4%. Ramsey model assumptions: Annual pure rate of time pref: 0.1%; annual growth rate: 1.3%; elasticity of marginal utility of consumption: 1 (low inequality aversion)

To set the discount rate Stern was prescriptive, Nordhaus descriptive SR approach—prescriptive/normative r = ρ + ƞg = 0.1% + 1*1.3% = 1.4%. ρ: favors a “low” social rate of time preference = 0.1% Argument: the only ethical reason to discount future generations is that they might not be there at all (e.g. cataclysmic comet) [consistent with Frank Ramsey] Prob. of extinction: 0.1%/year g: growth rate of consumption ~ 1.3%; ƞ: elasticity of marginal utility of consumption = 1 (intergenerational) inequality aversion: lower Nordhaus approach--descriptive/positive ρ = 1.5% (assumed, Nordhaus 2008, p. 51) ƞ = 2 (calibrated, given r, ρ and g) (intergenerational) inequality aversion: higher r = 6.5% in 2015, falls over time to 4.5% in 2095 as g falls (in DICE 2007, Arrow et al. 2012) (average over the next century (Nordhaus, 2008, 10)): r = 0.04 5.5% over first 50 years (61). Economic growth and population growth will slow, rate will fall over time. Nordhaus (2008): Stern sets the discount rate equal to the rate of growth of per capita consumption, plus 0.1%. Since economic growth averages 1.3% in his model, his discount rate averages 1.4%. Ramsey model assumptions: Annual pure rate of time pref: 0.1%; annual growth rate: 1.3%; elasticity of marginal utility of consumption: 1 (low inequality aversion)

The big bang approach is >10 times more stringent than Nordhaus’ policy ramp in the short term. “big bang”/Stern assumptions Nordhaus (2007) http://nordhaus.econ.yale.edu/nordhaus_stern_science.pdf Nordhaus policy ramp/DICE baseline Nordhaus (2007)

Stern’s analysis is substantially driven by damages from the distant future Nordhaus (2008): “…if the Stern Review’s methodology is used, more than half of the estimated damages “now and forever” occur after 2800.”

The economic logic of the policy ramp is that some investment in mitigation capital is good but only up to a point--forgoing investment in technological (and other kinds of) capital is costly t: time At+1 = At + a(Mt)Ft - R(At) At: GHG stock GHG emissions Mt+1 = Mt + mt mitigation capital +R(At) R(At): natural GHG cycling Since “capital is productive and damages are far in the future … the highest-return investments today are primarily in tangible, technological, and human capital.” (Nordhaus, 2007) Kt+1 = Kt + kt Kt: technological capital stock mt: invest in mitig. cap. U(Ct): utility (1-D(At))*FE(Kt): Production Consumption: Ct kt: Investment et: educ./invest in human. cap. Et+1 = Et + et

While CO2 intensity (tons/$GDP) has fallen, growth in population & GDP have led to rising emissions. (Nordhaus, 2012)