Climate change policies

Session 9Macroeconomic Concepts and Issues

MSc Economic Policy StudiesAlan Matthews

Learning objectives

• Valuing the threat of global warming and the social cost of carbon

• Implications of the EU’s climate change targets for the Irish economy

• How can Ireland meet its GHG emission reduction targets at least cost?

VALUING THE SOCIAL COST OF CARBON

SECTION 1

The science of climate change

• What is the sustainable level of emissions?• Scientific consensus on global warming

– Climate is warming– The cause, with high probability, is GHGs– These emissions are in large part due to human

behaviour, including fossil fuel consumption– IIEA Occasional Paper on science of climate change– IPCC

Working Group 1 report summary for policymakers

Assessing the impact of climate change

• Projections of CO2 concentration in atmosphere• General circulation models (GCM) models

Expected temperature and precipitation effects for different regions

• CO2 concentrations now 380 ppmv compared to pre-industrial levels of 280 ppmv

• Projected to double by 2100 leading to temperature increases of between 1.8 to 4° (faster warming when all GHGs included)

• To have high probability of staying within the +2° target, mainstream view is to limit C02 concentration to 400 ppmv (50% probability at 450 ppmv)

Source: EEA SOER 2010

How likely are these trends?

• CGM models fit observed data from the past quite well

• But their weakness is that the physics of natural climate change is poorly understood and therefore there is uncertainty about model predictions

• Others argue that models take inadequate account of feedback effects and threshold mechanisms which could accelerate climate change

Integrated Assessment Models (IAMs)

• Seek to translate climate impacts into monetary damages

• Benefits of climate policy represent avoided climate impacts that would otherwise cause damages to society in the future.

• Used to calculate Social Cost of Carbon (SCC) (monetary estimates of the damage done to society in emitting one tonne of carbon today) for use in domestic CBA decisions

• Used to determine ‘optimal’ policy using form of global cost-benefit analysis.

Areas of uncertainty in IAMs, leading to different results for social cost of carbon

Impact of differences in climate sensitivity

• Models differ in their climate sensitivity, the long-term temperature increase associated with a sustained doubling of carbon dioxide concentrations in the atmosphere

• The higher the climate sensitivity, the greater the damages

• IPCC (2007) presented ‘likely range’ for climate sensitivity of 2-4.5°C, with best estimate of 3°C.

Differences in climate impacts

• Impacts of climate change are modeled using climate damage functions for each region

• Damage functions provide monetary estimates of climate impacts as a function of average temperature increase, often expressed as percentage loss of GDP

• Generally, damages assumed to rise non-linearly with temperature – different models assume different curvature and steepness of the rising damage function

• Damage estimates often based on single study which is then scaled up or down for application to other regions

Differences in adaptation assumptions

• The damages of global warming are a function of how easily societies can adapt to higher temperatures

• The lower the adaptation costs, the lower the benefits of avoiding climate change

Differences in discount rates

• Some method of aggregating gains and losses from different time period in required.

• In the ‘prescriptive’ approach presented by Ramsey (1928), the discount rate r can be expressed as:

r = ρ + ηgwhere ρ is the pure rate of time preference, η is the negative of the elasticity of the marginal utility of consumption (the rate at which additional consumption provides smaller increases in welfare) and g is growth rate of per capita consumption

• The ‘descriptive’ approach uses the market rate of interest

• Extensive debate about the appropriate values on economic and ethical grounds

Discount rates and equity weights

• Higher rate of pure time preference lowers calculations of benefits of climate change policy, because future climate change damages are discounted more heavily

• Value of the marginal utility of consumption can be varied to reflect equity weights (giving more weight to impacts in poor regions)

• Using purchasing power parity rates to aggregate damages across regions (Stern, 2007) gives greater weight to impacts in poorer regions where majority of impacts will occur, producing effect similar to equity weighting

Social cost of carbon estimates (Tol, 2009)

Note: SCC estimates can be converted into CO2e costs by dividing by 3.66

 

“Climate change is a moral problem. The main reason to reduce greenhouse gas emissions is a concern for faraway lands (Schelling 2000), distant futures (Nordhaus 1982), and remote probabilities (Weitzman 2009). The people who emit most are least affected by climate change, and the benefits of their abatement would be diffused. Carbon dioxide dwells in the atmosphere for decades and the effects on temperature and sea level play out over even longer periods. On central projections climate change and its impacts are a nuisance for rich countries and a problem for poor countries. But there is a chance that things will go horribly wrong. If you do not care about risk, the future, or other people, then you have little reason to care about climate change.”

Source: Anthoff and Tol, 2010.

Critique of SCC calculations

• “Conventional economic analysis is rapidly replacing the arguments of the climate skeptics as the principal justification for inaction on climate change” (Ackerman, 2008)

• Interests of future generations should be more highly valued (ethics)

• Prevention of worst-case risks should be prioritised more than average outcomes (insurance)

• Some benefits cannot be given monetary values• Some ‘costs are better than others

Costing the externality due to carbon emissions

• Social cost of carbon– Measures the full global cost today of an incremental

unit of carbon emitted today, summing the cost of the damage it imposes over its lifetime in the atmosphere

• Market price of carbon– The value of traded emission rights in a market given

policy constraints on rights supply• Marginal cost of abatement

– Reflects the cost of reducing emissions rather than the damage imposed by creating emissions

• Under restrictive assumptions the three measures will be broadly equal, at the margin.

Policy approaches

• Command-and-control– Use of regulation

• Market-based approaches– Carbon tax– Cap and trade

• Advantages and disadvantages

The economic perspective

• Once target level of emissions set, what is the least cost abatement strategy?

• Government policies often industry and technology-specific

• Economists favour uniform price signals, on the basis that the same value is attached to each unit of emission reduction, whatever the source

• Optimal policy is a carbon tax (or equivalent cap-and-trade) at a low initial rate, increasing subsequently in real terms

Regulation vs tax to reduce pollution

MSC

MP

Profits, costs of pollution,

€/unit

Output of paper millQ* Q

Tax

Rationale for market-based interventions

• To correct for negative market externality• Huge differences in abatement costs across different

options• Use of market-based policy instrument can achieve GHG

emission reductions at lower cost than command-and-control approach

• Desirability of a uniform tax on all emitters as the marginal value of abatement is equal

• Channels of market-based approaches– Firms adapt by switching from higher to lower carbon fuels and

invest in energy saving technologies– Consumers adapt by purchasing less energy-intensive goods

and change behaviour in ways that conserve energy– GHG pricing policies also provide incentives to develop new

technologies

Comparison of GHG tax versus Cap and trade

• Both are market or incentive-based systems• Under perfect information, both approaches

would produce the same overall level of emissions at the same level of aggregate costs

• But uncertainty over future cost of reducing emissions can lead to different outcomes

• Compare approaches wrt environmental effectiveness, cost effectiveness and distributional equity

Environmental effectiveness

• Cap and trade provides emissions certainty, whereas total emissions abatement effect of a tax is uncertain when tax is set.– Certainty may be important in climate change if there

are systemic thresholds

• Cap and trade provides certainty on emission outcomes, but cost of meeting targets is uncertain at firm level

• Competitiveness effects and leakages?

Cost effectiveness

• A tax is more flexible and allows firms to minimise their compliance costs over time, although Cap and trade can be designed to mimic this (e.g. shifting emissions through time)

• Volatility of permit prices under Cap and trade schemes• Tax raises revenue, although can be mimicked in Cap

and trade if permits are auctioned• Carbon tax could have positive effects on GDP,

depending on how revenues are used • Grandfathering permits can gain political acceptability,

but at cost of positive growth and distributional effects from recycling revenue (inframarginal exemptions do the same for carbon tax).

Distributional consequences

• Not obvious the poor are worst hit by carbon taxes (motoring vs home heating)

• But proportionately poor will be hit more

• Distributional issues can be addressed by compensation (easier to finance under carbon tax)

THE INTERNATIONAL RESPONSE

SECTION 2

UNFCCC RIO 1992

• UNFCCC came into force 1994– Overall objective of “stabilisation of GHG

concentrations in atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system”

– Establishes principle of “common but differentiated responsibility”

– Commits to establishing inventories and reporting standards for GHG measurement

– Commits to launching national strategies to mitigate GHG emissions

– And to cooperate in preparing for adaptation to climate change

– Convention governed by Conference of Parties (COP)

Kyoto Protocol 1997

• Annex 1 (developed) countries agreed to reduction targets

• Groups (‘bubbles’) of countries can manage their efforts in unison

• Defined three flexible mechanisms– Joint Implementation, Clean Development Mechanism

and Emissions Trading

• US refused ratification• EU ratified in 2002 and Protocol came into force

in 2005 following accession of Russia

Copenhagen 2009

• Agreed the Copenhagen Accord– Set long term goal of limiting global warming to 2

degrees Celcius– Called for new multilateral climate fund and set goals

of mobilising $30 billion in public finance 2010-2012 and €100 billion in public and private finance in 2020

– Further defined how countries’ actions are to be reported and verified

– Called on countries to list mitigation pledges (economy-wide targets for developed countries, mitigation actions by developing countries)

THE EU RESPONSESECTION 3

Initial EU responses

• Committed to goal of limiting global mean temperature rise to +2°C

• Accepted -8% target under Kyoto for EU-15– Burden-sharing agreement – Penalties

• Introduced ETS in Jan 2005– First (pilot) phase 2005-2007– Second phase 2008-2012

• Countries’ targets and strategies set out in National Allocation Plans which must be approved by Commission

EU ETS experience

• Initial pilot phase 2005-07. ETS covers about 40-50% of EU emissions.

• Combination of generous allowances and abatement produced an initial price of €30 per tonne, but fell to zero in late 2007, some recovery since then.

• Market value of allowances was passed through in electricity prices, even though allowances distributed free, resulting in considerable windfall profits

• The Linking Directive allows firms to meet some of their obligations by purchasing certified emission reductions achieved in projects in developing countries and other developed countries

Source: www.eex.com/en

Price of ETS allowances

EU Climate change 20:20:20 package Dec 2008

• Overall EU target 20% reduction by 2020 (relative to 1990 levels)

• Increased to 30% if there is new international agreement• Reduction effort split between ETS and non-ETS sectors• ETS reduction (EU-wide) of 21% by 2020 (compared to 2005)• Average EU non-ETS reduction target of 10% in 2020

(compared to 2005)• Overall, averages out at 14% reduction (compared to 2005)

and 20% reduction (compared to 1990)

• Non-ETS effort is shared among EU countries according to a formula based on GDP per capita.

• 20% energy from renewables by 2020

• 20% increase in energy efficiency by 2020

Long-term targets

• Spring European Council 2007 meeting agreed indicative EU targets of 60-80% emission reductions by 2050

• Economic activity by then needs to be largely carbon-free

• Implications?

IRISH TARGETS FOR GHG EMISSION REDUCTIONS

SECTION 4

Irish policy commitments

• Second highest per capita emitter in EU• EU Kyoto target was to reduce emissions

by 8% by 2012 over 1990• Under EU’s burden-sharing agreement,

Ireland’s target was to limit to 13% increase

• Ireland’s emissions in 2006 25.5% above 1990, almost 13% above its Kyoto target

Source: EPA 2010

Current situation

• EPA is charged with producing emission projections annually

• NCCS targets distinguish between (a) baseline (b) baseline with existing measures and (c) baseline with additional measures (post 2006)

• Under With Additional Measures scenario, government purchasing requirement estimated to be 12.7mt CO2e over Kyoto period.

• NTMA has acquired 8.3mt credits. Gap of 4.4mt to be met from New Entrants Set-aside of around 5mt in ETS sector. Therefore EPA views it as unlikely that further credit purchases will be required.

• Impact of economic recession on next updates?

Source: EPA 2010

Source: EPA 2010

2020 targets

• For ETS sector Ireland is allocated 88% of its 2005 emissions which will be auctioned starting 2013

• The target for Ireland for non-ETS sectors is to reduce emissions by 20% in 2020 relative to 2005 levels; the limit has been provisionally calculated by the EPA as 37.1 Mtonnes of CO2e.

• In addition, Member States must annually limit non-ETS greenhouse gas emissions in a linear manner between 2013 and 2020, including by making use of the flexibilities provided for in the Effort Sharing Decision

ESRI projections for ETS sector, low growth scenario

Source: ESRI 2010

Source: EPA 2010

Climate change bill

• Set 2020 reduction target of 30% below 2005 emissions (12% below 1990 emissions)– Problematic as separation of ETS sector would oblige

Ireland to meet the gap between the EU target (-20%) and the Irish target (-30%) through emission reduction in the domestic non-ETS sector

• Very ambitious targets for 2030 (40% below 1990 levels) and 2050 (80% below 1990 levels)

• National Climate Change Expert Advisory Body• Uninformative Regulatory Impact Assessment

ESRI projections for non-ETS sector, low growth scenario

IRISH CLIMATE CHANGE POLICIES

SECTION 5

National Climate Change Strategy

• Sets out in detail how Ireland will meet its GHG commitments in period 2007-2012

• Carbon Fund established in 2007 managed by NTMA to buy Kyoto Units with funding of €290m

• NCCS does not deal with post-2012 situation• Programme for Government commitment to

reduce GHG emissions by 3% p.a. for period of government.

• Cabinet Committee on Climate Change and Energy Security

Climate strategy

By 2020, Ireland will have achieved•20% improvement in energy efficiency across all sectors•33% energy end-use efficiency savings target for the public sector•40% renewable electricity (RES-E) share•12% renewable heat (RES-H) share•10% renewable transport (RES-T) share (including 10% electric vehicles penetration target)

Carbon budgets

• First carbon budget presented in 2007• Objectives to integrate climate change into

budgetary policy, to assess progress towards targets and to help efforts to increase public understanding

• Measures introduced include– Carbon tax– Reform of motor tax regime– New building regulations for new homes– New national energy efficiency standard for lightbulbs– Residential home insulation scheme grants

Reading a marginal abatement cost curve

Source: McKinsey 2009 for SEAI

Issues: Need to avoid double counting with successive measures Considers technical but not behavioural changes (e.g. modal shift in transport)

Source: McKinsey 2009 for SEAI

Source: McKinsey 2009 for SEAI

Policy outlook - ETS

• Removal of ETS sector from national inventories changes the ground rules

• Irish tradable (ETS) sector covers around 34% of Irish emissions (41% across EU)

• Reduction requirement across EU is -21% or -1.74% p.a.• Price of CERs will reflect abatement cost to industry• Irish operators exposed to competitive pressures will

continue to receive free allocation of permits (to extent to be decided)

• The measures to increase renewables share in energy and improve efficiency of powergen sector do not count in national emission inventories

Policy outlook – non-ETS sectors

• 66% of overall Irish emissions, mainly transport and agriculture

• Reduction of 20% on 2005 levels by 2020• Use of flexible mechanisms limited to 3%• Huge challenge, even if less than PfG target and targets

set out in NCCS• Future position of carbon sinks still unclear• Important flexibility introduced in EU package to allow

(some) trading in non-ETS sectors which will cap marginal cost of abatement in Ireland

• Differences in marginal cost of abatement in the two sectors could create incentives to ‘migrate’ emissions (e.g. through electrification)

Renewable energy

• EU targets – 16% in total final energy use and 10% in transport use

• Controversies over use of first-generation biofuels

• Doubts over penetration of electric vehicles and their impact on emissions

• Growing concern in other EU MS about cost of meeting renewable targets

Designing a carbon taxTol et al 2008

• What level of tax?– Set equal to ETS permit price as then uniform tax applied to

all emission sources

• Who should be taxed?– All emission sources except those covered by the ETS

• What is expected revenue? – €500 – 1,400m

• What to do with the revenue?

• What are macro-economic implications?

• What are the effects on emissions?– Substitution vs growth effects

Designing a carbon taxTol et al 2008

• What will be distributional consequences?– Poor/rich Urban/rural– Possible to compensate relatively easily

• How to tax internationally traded goods and services?– ETS industries – cement and aluminium– Non-ETS sectors – agriculture

• What about fuel tourism?

Assessing the NCCS

• Preference for quantitative targets vs economic instruments

• Within economic instrument category, very high reliance on subsidies (50% of overall total emissions) – how to finance?

• Critique of individual measures – McCarthy and Scott (2008)

Assessing the NCCS

• One-third of emissions regulated by tradable permits mainly power– But double regulation (subsidies for

renewables, peat)

• One-third of emissions regulated through carbon tax and other instruments– But exemptions for coal and peat for home

heating, subsidies for renewable heating

• One-third of emissions not regulated

Adaptation issues

• Various recent reports– Forfás , Adaptation to Climate Change: Issues

for Business, 2010– Irish Academy of Engineers, Critical

Infrastructure: Adaptation to Climate Change, 2009

– EPA, A Summary of the State of Knowledge on Climate Change Impacts on Ireland, 2009

– Sweeney et al, Climate Change: Refining the Impacts for Ireland, 2008

Follow up and further information

• Institute for International and European Affairs, Climate Change Group

• EPA, Climate Change

• DOEHLG, Climate Change

• European Environment Agency, Data Viewer