1 William D. Nordhaus Yale University September 11, 2008 World Bank Seminar Slides are available at Full study is William Nordhaus, A Question of Balance: Weighing the Options on Climate Change, Yale University Press, 2008, available in full at author’s web page. The Challenge of Global Warming for the Global Economy

2 Outline of lecture 1.The science of global warming 2.What is the underlying economic problem? 3.What are the insights of economic integrated assessment (IA) models? 4.Major Issues for the Next Round of the International Accords (post-Kyoto Protocol) -Impacts -Participation -Taxes v. caps

3 CO 2 concentrations at Mauna Loa

4 Instrumental record: global mean temperature index(°C)

IPCC AR4 Model Results: History and Projections 5 DICE-2007 model

What is the economist’s bottom on global warming? 6 The fundamental problem is the climate-change externality – a “global public good” Economic participants (millions of firms, billions of people, trillions of decisions) need to face realistic carbon prices if their decisions about consumption, investment, and innovation are to be correct. 1.To be effective, we need a market price of carbon emissions that reflects the social costs. 2.Moreover, to be efficient, the price must be universal and harmonized in every sector and country. But a major economic question remains: what is the appropriate price of carbon? This question is addressed by integrated assessment models.

7 Integrated Assessment (IA) Models What are IA models? - These are models that include the full range of cause and effect in climate change (“end to end” modeling). Major goals of IA models: Project trends Assess costs and benefits of climate policies Assess uncertainties and research priorities Estimate the carbon price and efficient emissions reductions for different goals

8 Fossil fuel use generates CO2 emissions Carbon cycle: redistributes around atmosphere, oceans, etc. Climate system: change in radiative warming, precip, ocean currents, sea level rise,… Impacts on ecosystems, agriculture, diseases, skiing, golfing, … Measures to control emissions (limits, taxes, subsidies, …) The emissions- climate-impacts- policy nexus: The DICE-2007 model

9 1. Baseline. No emissions controls. 2. Optimal policy. Emissions and carbon prices to maximize discounted economic welfare. 3. Limit to 2 °C. Climatic constraints with global temperature increase limited to 2 °C above Strengthened Kyoto Protocol. Modeled on US proposal with rich countries at same time and developing countries join after 1 -3 decades. 5. “Ambitious”: Gore/Stern early emissions reductions Policy Scenarios for Analysis

Temperature profiles: DICE

Concentrations profiles: DICE Double of Pre-industrial level

Carbon prices for major scenarios 12

What do carbon prices mean in practice? 13 Carbon tax, 2010 Increase, price of energy, US [$/tC]Gasoline All energy expenditures Kyoto: global average$20.2%0.3% "Optimal"353.3%5.4% Climate constrained504.8%7.7% Gore/Stern %30.7%

14 Version discussed today is global aggregate (however, regional model has been developed and is being updated). Major uncertainties about many modules (particularly future technological change and impacts) Many modules are “reduced form” rather than structural Enduring controversy and confusion about “discounting” Limitations of DICE Model

Major issues for a revised international regime 1.What are the likely impacts of climate change? 2.The economics of participation 3.Cap and trade v. carbon taxes? 15

1. The Question of Climate Impacts Estimating the impact of climate change on society is the most treacherous of all areas. First approximation of climate damages: - Relatively minor impacts on market economies of “North” for a century (+ 1 percent of output) - Likely to have very large impacts on unmanaged ecosystems a century out and more 16

17 The Economics of Hurricanes Source: NOAA, Hurricane Katrina shortly before landfall

18 P. J. Webster, G. J. Holland, J. A. Curry, H.-R. Chang, “Changes in Tropical Cyclone Number, Duration, and Intensity in a Warming Environment,” Science, Sept Global intensity

19 Normalized costs of hurricanes, :08 Source: author’s estimates.

20 Damage and power for individual hurricanes,

21 Econometrics of hurricane damages (updated to 2008) “[The] amount of damage increases roughly as the cube of the maximum wind speed in storms…” (Kerry Emanuel, Nature, 2005) “While this may appear to be a relatively insignificant increase, nonlinear effects can make even a small increase important in causing damage, because damage is proportional to the cube of the wind speed.” (Anthes et al, BATIS, 2006) MAJOR SURPRISE: Super-high elasticity.

22 Estimated mean damages from global warming, central case and alternative estimates

2. The economics of participation One of the important issues in a climate policy regime is the extent of participation : -“Free riding” reduces the effectiveness of a policy -Free riding makes other countries angry and gives them an excuse not to participate. The excess costs of participation can be estimated as: (2) E(  ) ≈  1-  where  is the participation rate and  the convexity of the cost function. 23

Source: IPCC, Fourth Assessment Report, Summary of Mitigation Cost Models.

25 Attrition of Kyoto Protocol: share of global emissions

Source: Question of Balance 26

3. Major Policy Approaches for Global Warming Internationally harmonized carbon tax – economist’s ideal. Universal cap and trade – close second if well designed, but Kyoto Protocol is not doing well. ____________________________________________ Regulatory substitutes (CAFE standards, ban on light bulbs, …) – very inefficient approaches Voluntary measures (carbon offsets) are difficult to calculate and verify and probably a useless diversion. 27

28 Harmonized Carbon Taxes What are “harmonized carbon taxes”? Raise fossil fuel prices proportional to carbon content All countries would target a comparable tax Level of tax set to meet environmental target Use consumption basis for tax Many advantages over cap and trade (see slide below)

Cap and trade v. carbon taxes 1.The fundamental defect of most quantity regimes is the LACK OF CONNECTION between targets (emissions) and objective (climate or damages). 2. QUANTITY LIMITS TROUBLESOME in a world of differential economic growth and uncertain technological change. 3.Because of structure of uncertainty for stock pollutant, emissions taxes are MORE EFFICIENT than quantitative standards or auctionable quotas. (Weitzman) 4. Quantity-type regulations show EXTREMELY VOLATILE PRICES for the trading prices of carbon emissions (see slide). 29

Price volatility of emissions permits 30

Cap and trade v. carbon taxes 5. Tax-type mechanisms or auctions have advantage because they raise revenues and have potential for REDUCING DEAD-WEIGHT LOSS OF TAXATION. 6. Quantity-type systems with international trading are much more SUSCEPTIBLE TO CORRUPTION than price-type regimes. 7. The international cap and trade is a RADICAL AND UNPROVEN APPROACH, whereas taxes have been used in every country of the world. All these emphasize the difficulty of reaching an effective and efficient mechanism for global public goods. 31

32 Final thoughts “Mankind in spite of itself is conducting a great geophysical experiment, unprecedented in human history.” Roger Ravelle (1957)