Global climate change: Economics and public action

The experiment Source: Stiglitz, 2006

The Big Picture The Big Picture

Agenda A (very) rapid look at the science of climate change The economics of climate change Externalities and public goods Cost benefit analysis Policy choices The collective action problem

The science of global climate change The mechanism of global climate change Greenhouse gases affect temperature GHGs include carbon dioxide, methane, nitrous oxides, CFCs etc Some GHG’s (e.g. CO2, methane) are integral to the earth’s carbon cycle; others (e.g. CFC) are human products The central views from scientists: Temperatures are rising; GHG levels have a causal influence Human influence is increasing GHG concentration If GHG concentrations double, global temperatures will rise of the order of 2-4 degrees There is still some controversy, but we’ll take the science as given for today Note: CFCs are greenhouse gases, but the big issue around them was on effects on the ozone layer and so on skin cancer (etc). More on the (successful) Montreal Protocol below

Long-term increases in temperature

Climate models indicate these temperature increases are related to human action…

...due to a variety of sources of GHGs affected by human behavior

Predicted temperature effect of various levels of stabilization of GHGs by 2100…

..a range of projections on further temperature increases on “business as usual” effects of carbon emissions…

..and significant variation in predicted effects even for same level of CO2 change…

…with a wide range of effects on water availability…

...and possibilities of severe effects and tipping points

Changes in stocks require large cuts in emissions, given long lives of GHGs

Rich countries account for most of the stock, but developing countries for much of the projected growth in emissions

So future developing country emissions are part of the problem under these scenarios

The development and distribution issue Carbon emissions given by: C = C/E x E/Y x Y/P x P C/E = carbon emissions per unit of energy E/Y = energy use per unit of GDP Y/P = GDP per capita P = population growth Illustrative number: US E/Y is 50% more than for Europe, 100% more than Japan; many times than for developing countries Different proposals focus on different variables: C; E/Y or C/Y; C/P

The economics of climate change Emission creates a negative externality Net benefits to polluter Costs to everyone else Source: Nolan Miller lecture notes Who is the emitter? Depends on level of aggregation: A firm, or A country, if externalities are internalized within the border

So abatement is a public good Non-rivalrous Non-excludable …and will be under produced Benefits of abatement to the world Benefits of abatement to country x Source: Nolan Miller lecture notes Costs of abatement to country x

Uncertainty prevails; over… Size of temperature changes Impacts on precipitation and sea-level effects Probabilities of “large” adverse effects Economic impacts on growth processes and so benefits of action Costs of adaptation—but little work on socially contingent responses e.g. migration and conflict Costs of mitigation/abatement

Irreversibilities matter.. “Mega” irreversibilities may exist around climatic conditions, creating option value of preventing large climate change Economic irreversibilities matter, and these cut both ways Changing the economic life of existing capital stock Changing to greener capital stock (if prove unnecessary)

Evaluation How to evaluate the benefits and costs of climate change? Economic issues Valuation of benefits and costs Inter-temporal equity and the discount rate Marginal utility of consumption Will future generations be richer? Who is hurt by climate change? Uncertainty Where W is social welfare, c is consumption and δ is the social rate of time preference

The debate on discount rates The discount rate (ρ) is a function of the social rate of time preference (δ) the rate of growth of consumption (g) and the elasticity of the marginal utility of consumption (η) [in a simplified account] Stern review argues for a δ close to zero, and a low value of η (around 1), giving an overall discount rate close to 1.4% Most economists argue for a higher discount rate, either with a higher δ or a higher η. This has a huge impact on the benefit cost ratio and the implications for optimal action

Costs and benefits of action: large uncertainties and still significant debate Nordhaus circa 2000: optimal policy is for modest tax; stabilization has negative benefit cost ratio Now central estimates are shifting to a more favorable benefit cost ratio for action: Nordhaus circa 2006 has increased estimate of global output cost of 2.5 degrees from 2 to 3% of GDP. This still implies a ramping up scenario Stern Report argues for very favorable benefit cost ratio for strong early action Some of this comes from estimates of higher estimates of costs, and lower estimates of benefits; most revolves around the choice of the discount rate

Policy issues Policy responses Mitigation Adaptation Choice of Largely national Adaptation Choice of instruments Distribution of adaptation costs Intrinsically international Effort distribution across countries A side payment Finance/support for poor country adaptation The collective action problem

Instruments for mitigation Type of instrument Advantage Disadvantage Property rights/Coase Infeasible in international context Carbon tax Optimal to guide efficient decisions Uncertain effects Hard to get cross-country consistency Cap and trade Politicians and citizens understand caps Trading can lead to efficient choices Hard to get agreement on distribution of caps Thin market; uncertain price Regulation Clear and understandable Can be highly inefficient Subsidies to technological research Good economics for a public good Finance Private sector will be central to research Rich country bias on adaptation

Policy: taxation (i) taxing emission Polluter now producers until marginal net benefit equals the tax rate Source: Nolan Miller lecture notes Technical problems: (i) finding the Pigovian tax rate, (ii) finding a tax base strongly correlated with carbon emissions; in principle past estimates, trial and error can be used Also large political and coordination problems

Policy: taxation (ii) subsidizing carbon sinks Deforestation is a source of increased emisions, so either reforestation or slowing deforestation has a positive externality, warranting a subsidy Concept underlying the Rainforest Initiative

Policy: cap and trade A cap is a quota, negotiated at country and then industry level But can lead to highly inefficient results, since marginal costs of meeting the quota highly unlikely to be equalized Creating a market for firms to buy and sell emission rights allows this marginal cost to be equalized (amongst participants)

Policy: regulation Example: the Governator Ambitious targets plus regulation for California California can be a standards-setter Is it credible?

The collective action problem: underlying structure of the game is PD; polluting is a dominant strategy Player Y Player X Abate Pollute 2, 2 -1, 3 3,-1 0, 0 Пa Пp Number of other countries playing abate Many countries: Payoffs to any country of playing abate (Пa) and pollute (Пb)

The collective action problem Why the Montreal Protocol worked Benefit cost ratios in rich countries were highly favorable to action and supported unilateral action by US So US could lead, including in technological change Payoffs to US (1985 $bln) No controls Montreal protocol Unilateral action of Montreal Benefits 3575 1373 Costs 21 Net benefits 3554 1352

So the US problem is transformed to this… Its dominant strategy is abate With incentives for US business to innovate, creating strategic complementarities with CFC-substitutes (via standards and reduced cost of abatement) Пa Пp Number of other countries playing abate Payoffs to US of playing abate (Пa) and pollute (Пb)

Solving cooperation with Europe was relatively easy High benefits, low costs Internal coordination (partially) solved in Europe; citizen attitudes underpinned an “abate” domestic political equilibrium Two-thirds ratification for treaty to come in force (a 90% threshold would have increased leverage of Japan and USSR)

Trade sanctions were effective in changing the equilibrium on signing for resisting countries Restrictions on trade in CFCs between signatories and non-signatories was part of the agreement. There is a tipping point and the interaction becomes a coordination game Пa Пp Payoffs to other countries of playing signatory (Пs) and non-signatory (Пn) with trade sanctions Number of other signatories

And why climate change is a lot harder Benefit cost ratios are less favorable Given higher costs concerns over competitiveness matter E.g. European carbon tax made conditional in 1992 on US and Japan adopting the same. They didn’t US concerns over developing country competition

Kyoto Protocol Cap and trade Only sought to solve collective action across rich countries, with negotiated “equitable” caps only for rich countries Incentives for mitigation investments in developing countries via inclusion in trading of carbon allowances

Cap and trade Business preferred cap and trade to carbon tax Business persuaded governments that carbon allowances be given, not auctioned Trading with developing countries is taking off, especially for green investments (abatement) in China—a form of side payment

A major distributional fight affecting the collective action problem Rich countries: responsible for stock Poor countries (including fast-growing China and India): increasingly responsible for margin, yet argue that they should be able to increase E/Y toward rich country levels Makes agreement on cap approach hard

The position of business Big concerns over cost effects and competitiveness. Latter is a function of the extent to which collective action problem is resolved Different views but most firms have “green” departments e.g. Dupont again Pressures from investors

Takeaways and outstanding issues The Stern Review has done a huge service in bringing the economics of global climate change to the center of the debate. Core public economics principles pervade the report. But there is still controversy over choices Evaluating the economic case for action What discount rate(s) make sense? How to value the (catastrophic) tail? How to value net benefits to poorer groups? The domestic political equilibrium How do citizens value inter-generational equity? What is the dynamic between business and government policy? What drives overall political payoffs to government? The global strategic interaction Is there a self-enforcing equilibrium with US, Europe-Japan and China-India at the core? Are trade sanctions credible? Against the US? Against “the rest”? Will rich countries want to use trading to subsidize Chinese industries? Do aid givers have a contingent liability to hard-hit poor countries? How to analyze strategic interactions and feasible, as opposed socially optimal, outcomes is at the center of microeconomics II