Climate Change Policy and Game Theory Martin Sewell E3 Foundation & 4CMR Rapid Decarbonisation Project: Workshop 3 London 21 September 2011

Economics of CO 2 emissions 2 1.The burning of fossil fuels releases CO 2 into the atmosphere. 2.CO 2 is a greenhouse gas that contributes to global warming. 3.Therefore the burning of fossil fuels reduces global social utility. 4.We have a market failure, CO 2 emissions being a negative externality. 5.A hypothetical global government would seek to correct the market failure by taxing CO 2 emissions. Typically, the emissions from burning fossil fuels within a nation have only a minor negative impact on national social utility, but a nation suffers significantly from emissions due to the rest of the world also burning fossil fuels. So, individual nations have little incentive to tax CO 2 emissions, but the world as a whole would be better off if all nations taxed emissions.

3 Tragedy of the commons Human-induced climate change is a classic case of the tragedy of the commons (Hardin 1968)—the benefits of burning fossil fuels accrue to individuals, companies and nations, whilst the costs accrue to the planet as a whole.

Prisoner’s dilemma 4 The most famous game in game theory. In 1950, puzzles with a similar structure to the prisoner’s dilemma were developed by RAND Corporation scientists Merrill Flood and Melvin Dresher. Princeton mathematician Albert W. Tucker formalized the game with prison sentence payoffs. Formally, the prisoner’s dilemma is a non-zero-sum game in which the unique Nash equilibrium (both players defect) is not a Pareto-optimal solution (both players cooperate). The prisoner’s dilemma is ubiquitous in our lives: the key dilemma an individual faces is when to behave selfishly in the immediate term, and when to risk cooperating in the hope of engaging in reciprocal altruism. Good reference: Poundstone (1993)

5 Prisoner’s dilemma payoff matrix CooperateDefect Cooperate win win much lose much Defect lose much win much lose

6 Multi-player, single cell prisoner’s dilemma Multi-player generalization of the prisoner’s dilemma (there are many prisoners, not two). Communication is possible (prisoners all in the same cell, not separated). Cooperation may be either unilateral or multilateral.

Which strategy is best? 7 Disadvantages of unilateral cooperation Motivating a reduction of fossil fuel consumption on anything other than a global scale will not only be less effective, but may create perverse incentives: if those countries that burn fossil fuels the most efficiently cut back, more of the remaining fossil fuels will be used up by those countries that burn fossil fuels less efficiently, leading to greater overall emissions. Disadvantages of multilateral cooperation Trying to bring all countries into a binding international agreement to reduce emissions at this time makes little sense because such agreements are extremely difficult to achieve and impossible to enforce. Disadvantages of defection Humans are very efficient cheater detectors, and apt at identifying and punishing freeloaders.

8 What do economists think? Should the US government commit to greenhouse gas reductions? source: Holladay, Horne and Schwartz (2009)

Unilateral-with-a-view-to-motivating- multilateral 9 What actions can my country take that would induce other countries to make emissions reductions on a similar and/or significant scale? We wish to disincentivize free riding by other significant emitters. It appears that subsidies for renewable energy in the West lead to the development of renewables in China, India and other developing nations, which should drive the price of green technologies down. Examples 95% of China’s solar panels are exported (Watts 2009). India became the third largest exporter of wind turbines in 2008 (Prahalathan, Kumar and Mazumdar 2011). Developing countries’ share of world exports in green products increased from 24% in 2002 to 50% in 2009 (BusinessWorld 2011).

10 Fossil fuel subsidies Half of the world’s population enjoys fossil fuel subsidies (The Economist 2008). Fossil-fuel consumption subsidies worldwide amounted to $312 billion in 2009, the vast majority of them in non-OECD countries (IEA 2010). As explained above, the burning of fossil fuels creates a negative externality, so for global efficiency should be taxed, certainly not subsidised.

11 References BusinessWorld, ‘Green’ demand seen opening export opportunities. 26 June HARDIN, Garrett, The tragedy of the commons. Science, 162(3859), 1243– HOLLADAY, J. Scott, Jonathan HORNE, and Jason A. SCHWARTZ, Economists and Climate Change: Consensus and Open Questions. Volume 5 of Policy Brief. New York: Institute for Policy Integrity, New York University School of Law. International Energy Agency, Key World Energy Statistics Paris: OECD/IEA. POUNDSTONE, William, Prisoner’s Dilemma. New York: Anchor Books. PRAHALATHAN, S., Ashish KUMAR, and Rahul MAZUMDAR, New renewable energy in India: Harnessing the potential. Occasional Paper 143, Export-Import Bank of India, Mumbai. The Economist, Fuel subsidies: Crude measures. pp. 91– May WATTS, Jonathan, China puts its faith in solar power with huge renewable energy investment. The Guardian. 26 May 2009.