Economics of Global (and Domestic) Climate Change Sabina Shaikh University of Chicago Climate Change: Biological and Social Implications Summer Teachers Institute June 24, 2008

Introduction and Outline 1. Economics of Pollution Control 2. Economics of Global Climate Policy 3. Leveling the Playing Field: Pricing Carbon   Demand and Supply Responses   Energy Efficiency as “low-hanging fruit” 4. Uncertainties and Some Recommendations Fun Economic Concepts for Today! Externalities, Moral Hazard, Prisoner’s Dilemma Discount Rates, Principal Agent Problems

Economics of Pollution Control Markets and Government Intervention Markets and Government Intervention Externalities as Market Failure Externalities as Market Failure The Private Cost of production or consumption does not reflect the Social or True Cost The Private Cost of production or consumption does not reflect the Social or True Cost The difference is the “external cost” or a negative externality. The difference is the “external cost” or a negative externality. Example: Driving is “too cheap” Example: Driving is “too cheap” Pollution, Congestion, Accidents Pollution, Congestion, Accidents In this case, government intervention solves a market failure. What kind of intervention is ‘efficient’? In this case, government intervention solves a market failure. What kind of intervention is ‘efficient’?

Economics of Pollution Control Command and Control Command and Control Market-Based Instruments: Permits and Taxes Market-Based Instruments: Permits and Taxes Marginal Costs and Marginal Benefits Marginal Costs and Marginal Benefits  One more unit… With Pollution Controls, the polluter’s choice compares the marginal cost of pollution abatement Vs. the price of polluting. With Pollution Controls, the polluter’s choice compares the marginal cost of pollution abatement Vs. the price of polluting. The price of pollution is the permit price or the tax. The price of pollution is the permit price or the tax. Each polluter is comparing their marginal cost of abatement to this same price. They stop abating where the marginal cost of abatement just equals the price of pollution. Each polluter is comparing their marginal cost of abatement to this same price. They stop abating where the marginal cost of abatement just equals the price of pollution. By equating the marginal costs of pollution abatement, no one entity can reduce pollution cheaper than another. By equating the marginal costs of pollution abatement, no one entity can reduce pollution cheaper than another.

Global Climate Change The Kyoto Protocol The Kyoto Protocol Ratification: Nations representing 55% of world’s emissions Ratification: Nations representing 55% of world’s emissions Average reduction 5% below 1990 levels by Average reduction 5% below 1990 levels by U.S. not participating, Australia signed U.S. not participating, Australia signed The Role of Developing Countries The Role of Developing Countries

Kyoto Protocol and Flexibility Mechanisms 1.Carbon Sinks and Sequestration 2.Emissions Trading 3.Joint Implementation 4.Clean Development Mechanism Flexibility of Kyoto

Kyoto Protocol The “Inverted U” The “Inverted U” Issues: Types of Pollutants, Globalization, Outsourced Pollution Issues: Types of Pollutants, Globalization, Outsourced Pollution

Kyoto Protocol The Clean Development Mechanism The Clean Development Mechanism Cuts costs of emissions reductions for developed countries Cuts costs of emissions reductions for developed countries Encourages pollution control in developing countries Encourages pollution control in developing countries Generated $59B in total investment but value of new projects halved next year, zero by 2010 (Economist 2008) Generated $59B in total investment but value of new projects halved next year, zero by 2010 (Economist 2008) Concerns: Moral Hazard Concerns: Moral Hazard “Additionality” “Additionality” Projects must bring about new emissions reductions Projects must bring about new emissions reductions Reduces incentives to voluntarily reduce emissions or use new cleaner technology. Reduces incentives to voluntarily reduce emissions or use new cleaner technology. Why spend money when someone else will do it? Why spend money when someone else will do it? CDM rules modified to address this issue but questions remain for future. CDM rules modified to address this issue but questions remain for future.

Future of Global Climate Policy Developing Countries Developing Countries Growth Rate in CO2 emissions Growth Rate in CO2 emissions China is now the world’s leader in CO2 emissions China is now the world’s leader in CO2 emissions But, Cumulative Emissions and Per-Capita Emissions But, Cumulative Emissions and Per-Capita Emissions So, what happens now? So, what happens now? Countries (Cities, Companies, etc.) do not want to act alone. Free Riders: Individual Costs and Shared Benefits Game Theory: Prisoner’s Dilemma? Game Theory: Prisoner’s Dilemma? Everyone waiting on someone else to act. Those who do not sign on will free ride. But, if most countries sign on, they can agree to sanction those who do not (Liebrich 2008)

Domestic Climate Policy Examples of Domestic Policy Examples of Domestic Policy Lieberman/Warner, Regional, States, Cities Lieberman/Warner, Regional, States, Cities Setting Carbon Prices Setting Carbon Prices In theory, Cap and Trade and Carbon Taxes are equivalent In theory, Cap and Trade and Carbon Taxes are equivalent Upstream on Carbon Content Upstream on Carbon Content Downstream on Emissions Downstream on Emissions Uncertainty Uncertainty

Carbon Pricing: Cap and Trade Vs. Carbon Taxes Advantages of Cap and Trade Advantages of Cap and Trade Potential Concerns of Cap and Trade and Solutions Potential Concerns of Cap and Trade and Solutions “The chief political virtue of cap-and-trade is it’s complexity.” Washington Post, June 08 “The chief political virtue of cap-and-trade is it’s complexity.” Washington Post, June 08 “..cap and trade systems are complicated and conveniently opaque.” The Economist, June 07 “..cap and trade systems are complicated and conveniently opaque.” The Economist, June 07 Moral Hazard: Additionality Moral Hazard: Additionality Allocating Allowances: Free or Auctioned? Allocating Allowances: Free or Auctioned? Price Uncertainty Price Uncertainty Economic Shocks Economic Shocks Lack of Innovation Lack of Innovation Safety Valve Safety Valve Fixed Emissions Fixed Emissions Adjust for Business Cycles Adjust for Business Cycles Banking Banking

Carbon Taxes Direct Examples: B.C. Direct Examples: B.C. Advantages of Carbon Taxes Advantages of Carbon Taxes Upstream: Easier, more Efficient Upstream: Easier, more Efficient CBO, May 2008: Carbon Tax five times more effective than an inflexible Cap and Trade program. Fewer Administrative Costs Fewer Administrative Costs Price Certainty Price Certainty Less Volatility allows for Long-Term Investment, R & D Allow Emissions to Vary with Economic Conditions Revenue Neutrality: Tax Swap, Distribution of Income Revenue Neutrality: Tax Swap, Distribution of Income Concerns about Carbon Taxes: Concerns about Carbon Taxes: Quantity Uncertainty: Cumulative CO2 and Threshold Quantity Uncertainty: Cumulative CO2 and Threshold Support: Political Palatability Support: Political Palatability Loss of CDM? Loss of CDM? Inefficient Use of Revenues Inefficient Use of Revenues

Relative Efficiency of Policies CBO, February 2008

Carbon Prices Regardless of Policy, a carbon price levels the playing field Regardless of Policy, a carbon price levels the playing field Supply Response Supply Response Elasticity: Increased Price of Fossil-Fuel Based Inputs leads to Substitution Elasticity: Increased Price of Fossil-Fuel Based Inputs leads to Substitution Demand Response Demand Response Elasticity: As Price of Energy/Fuel goes up, the Amount Consumed Goes Down Elasticity: As Price of Energy/Fuel goes up, the Amount Consumed Goes Down How to Reduce Carbon Emissions? How to Reduce Carbon Emissions? Choose cheapest option? Choose cheapest option?

Supply Response Fixing Coal Fixing Coal Clean Coal, Carbon Capture, FutureGen? Clean Coal, Carbon Capture, FutureGen? Renewable Energy: Wind, Solar, Nuclear? Renewable Energy: Wind, Solar, Nuclear? Renewables projected to double by 2030 (EIA) Renewables projected to double by 2030 (EIA) Petroleum, coal and natural gas will decrease from 85% in 2006 to 83% in Petroleum, coal and natural gas will decrease from 85% in 2006 to 83% in Increasing Domestic Oil Supply Increasing Domestic Oil Supply ANWR, Tar Sands, Strategic Reserve, Ethanol ANWR, Tar Sands, Strategic Reserve, Ethanol Carbon price of at least $30 makes wind and coal carbon capture viable

Demand Response: Energy Efficiency Global energy demand is increasing. Increased supply is not enough. Global energy demand is increasing. Increased supply is not enough. Buildings account for about 40% of the U.S. GHG emissions, 70% in cities Buildings account for about 40% of the U.S. GHG emissions, 70% in cities Buildings represent half of U.S. energy consumption and 70% of electricity use Buildings represent half of U.S. energy consumption and 70% of electricity use McKinsey Report (2008) McKinsey Report (2008) Energy Efficiency in Buildings is the lowest cost (cost-saving) way to abate GHG emissions. Low-Cost energy efficiency improvements in buildings could offset 85% of projected increase in energy demand by Energy efficiency investments with average rates of return of 17% could return $900 billion in annual energy cost savings by Improving global energy productivity could provide half of abatement recommended by IPCC.

Market Barriers to Energy Efficiency Do higher energy prices lead to energy efficiency investments? Do higher energy prices lead to energy efficiency investments? Potential Barriers Potential Barriers 1. High Discount Rates 2. Principal-Agent Problems 3. Hidden Costs of Substitutes 4. Information and Transactions Costs

1. High Discount Rates Upfront Costs – Future Returns Upfront Costs – Future Returns Rates of Return Rates of Return High Rates of Return Required: %? High Rates of Return Required: %? Uncertainty from Future Legislation Uncertainty from Future Legislation Individual, Business/Utility, Legislator Levels Individual, Business/Utility, Legislator Levels

2. Principal Agent Problems Employer—Employee Relationship Employer—Employee Relationship Incentives and End Users Incentives and End Users Developers, Builders Developers, Builders Landlord, Tenant Landlord, Tenant Demand for Green? Demand for Green? Other Incentives: Utility Companies - Decoupling Other Incentives: Utility Companies - Decoupling

3. Hidden Costs of Substitutes Perfect Substitutability? Perfect Substitutability? Sacrificing Quality or Convenience Sacrificing Quality or Convenience Lightbulbs: Incandescent, CFL Lightbulbs: Incandescent, CFL Bottled Vs Tap Water Bottled Vs Tap Water Hybrid Cars Hybrid Cars

4. Information and Transactions Costs Too Little Information Too Little Information Too Much Information Too Much Information “Greenwashing”, “Green Noise” “Greenwashing”, “Green Noise” Inertia Inertia

Uncertainties and Some Recommendations Future of Global Agreements: Address Additionality, Free Riders Future of Global Agreements: Address Additionality, Free Riders Cap Vs Tax? Address concerns of either. Cap Vs Tax? Address concerns of either. Carbon Prices are a Significant Step but Technology Improvements Needed Carbon Prices are a Significant Step but Technology Improvements Needed “Europe’s carbon-trading system has not shown much capacity to generate large-scale research nor to develop, demonstrate and deploy breakthrough technologies.” Sachs (2008) Energy Efficiency Energy Efficiency Financing Financing Reconciling & Decoupling Reconciling & Decoupling Availability of Viable Substitutes Availability of Viable Substitutes Evaluation of Outcomes for Consistency of Information Evaluation of Outcomes for Consistency of Information Portfolio of Demand Response and Supply Side Options Portfolio of Demand Response and Supply Side Options