Climate Change: The Move to Action(AOSS 480 // NRE 480)

Richard B. Rood734-647-3530

2525 Space Research Building (North Campus)rbrood@umich.edu

http://aoss.engin.umich.edu/people/rbrood

Winter 2010April 13, 2010

Class News

• Ctools site: AOSS 480 001 W10• On Line: 2008 Class

– Reference list from course

• Rood Blog Data Base

Projects

• Final presentation discussion;– April 22, 12:00 – 4:00, Place TBD.

• After class meetings– 4/13: Transportation– 4/15: Near-term solutions

Events

• Pollack and Rood, Author’s Forum– A World Without Ice: A Conversation with

Henry Pollack & Richard Rood • Wednesday, April 14, 2010• 5:30PM• Library Gallery, room 100, Harlan Hatcher

Graduate Library

– For more info visit www.lsa.umich.edu/humin

Readings

• Stavins, R.N. A U.S. cap-and trade system to address global climate change. The Hamilton Project, 2007. (http://www.brookings.edu/papers/2007/10climate_stavins.aspx)

• Metcalf, G.E. A proposal for a U.S. carbon tax swap: an equitable tax reform to address global climate change. The Hamilton Project, 2007. (http://ase.tufts.edu/econ/events/specialEventsDocs/metcalfCarbonTax.pdf)

Introduced the idea of a market

• There is some acceptable level of pollution.

• There will be an “allowance” of the amount of pollution that can be emitted without penalty. Leads to a “cap.”– Auction– Given away

• If you use less than your allowance, you can trade it to someone who uses more.

Basics of the Market

• The expense of exceeding the cap will motivate reduction of pollution.– How can reduction be achieved?

• Companies with efficient methods will develop something they can trade.– What is the cost of to compare with?

Cap and Trade Mechanism

Courtesy Justin Felt, Pointcarbon

Carbon Markets

• California Climate Change• Regional Greenhouse Gas Initiative

• EU ETS (Carbon Market)• Chicago Climate Exchange

• Pointcarbon• World Bank State of the Carbon Market

Market-based Solutions

• Based upon success of the sulfur market.– Provides flexibility in meeting the goal of

reduced sulfur emissions

• For large parts of the world, money and markets constitute the link between different elements of society, nations.– Infrastructure of developed society– Assumption that it is value based

Sulfur Market as a paradigm for CO2 Market

• How is the same how is it different?

• This is very important!

Cost-effective regulation

• Context: SO2 emissions (1980 baseline)– 14.92 million tons of SO2 – primarily from coal-fired electricity generation– acidification of lakes, rivers, and forests

• Acid Rain Program (1990)– 1990 amendments to Clean Air Act– SO2 allowance market

• The “Cap”– 8.95 million tons per year of SO2 …therefore,– 5.97 million tons per year of SO2 abatement

Cost-effective regulation (cont.)

• “cost effectiveness”: what is the least-cost way of achieving a specific goal?

• Goal – “The Cap” – SO2 emissions of 8.95 million tons per year

• Cost: SO2 abatement cost– Aggregate cost: abatement cost summed over all electricity

generators

• Policy tool – “Cap-and-trade” program – Theoretical finding: a market provides the incentive for companies to undertake least-cost abatement in the aggregate.

Cost-effective regulation (cont.)

Estimates for the SO2 market:

Abatement cost without trading = $1.82 billion/yr

Abatement cost with trading = $1.04 billion/yr (least-cost abatement)

Cost savings = $0.78 billion/yr

Cost-effective regulation (cont.)

• The “trade” in “cap and trade” is environmentally neutral– The cap remains fixed regardless of trading activity

• The cap is the intersection of science-based knowledge and the market

Company compliance decisions

• Context: SO2 “allowances”

– An allowance = 1 ton of SO2 emission

– Companies (electricity generators) are given a “quota” -- a fixed number of allowances each year

• Compliance options:– Without trading: Reduce SO2 emissions to comply with

their quota• Install new abatement technology (SO2 “scrubbers”)

• Use cleaner fuel sources (e.g., switch to low-sulfur coal)• Produce less electricity (typically not considered!)

Marginal cost (MC) of abatement (cont.)(without trading)

The area in red is the company’s

total cost of abating to E0.

MC

E

$/E

E0

MC @ E0

0

Example

• Monroe Power Plant (Monroe, MI)– Owned by Detroit Edison– 4th largest coal-fired power plant in country

• 2004 data– 95,364 allowances allocated– 99,735 tons of emissions– 4,371 tons in excess

• Purchased these on the market• Or, banked them from a prior year

Company compliance options(with trading as an option)

• Compliance options:– Without trading: Reduce SO2 emissions to

comply with their quota (scrubbers, low-sulfur coal)

– With trading: Same options as above plus• Purchase allowances at the market price (P)

Purchasing allowances as a compliance option

At price P, the company purchases (E0 – E*)

The area in red is the cost savings

from purchasing allowances

rather than undertaking abatement

MC

E

$/E

E0

P

MC @ E0

E*0

Cost-effective regulation (repeat)

Estimates for the SO2 market:

Abatement cost without trading = $1.82 billion/yr

Abatement cost with trading = $1.04 billion/yr

(least-cost abatement)

Cost savings = $0.78 billion/yr

43% reduction in abatement cost!!!

General results

• P < MC implies a buyer on the market– A buyer saves money by purchasing allowances to cover its emissions.

• P > MC implies a seller on the market– A seller makes money by undertaking extra abatement and selling its

excess allowances.

• These incentives give rise to least-cost abatement.– We achieve cost-effective regulation

• The existence of this tension or balance between marginal cost and price of abatement implies that there is a market. There are options.– There is the requirement that

• The purchased allowance is a real reduction of sulfur• That P (Price per share) comparable to Marginal Cost (of abatement).

Some Specifics of Acid rain program and evidence on the SO2 market

• Phase I: 1995-1999– 110 dirtiest electric power plants– 7-8.7 million allowances allocated per year

• Phase II: 2000-2010– All fossil-fueled electric power plants– 9.2-10 million allowances allocated per year

• After 2010: 8.95 million allowances/year• Banking of allowances permitted

The Acid Rain Program

Trends in Wet Sulfate Deposition in the Eastern United States

(1989-1991 vs. 1995-1998)

SO2 Spot Market Prices, Aug 1994 - Dec 2003

0

50

100

150

200

250

Aug-94

Feb-95

Aug-95

Feb-96

Aug-96

Feb-97

Aug-97

Feb-98

Aug-98

Feb-99

Aug-99

Feb-00

Aug-00

Feb-01

Aug-01

Feb-02

Aug-02

Feb-03

Aug-03

Time

$ / t

on

CA Electricity Crisis9/11/01

CO2 markets to implement climate policy

• Kyoto Protocol (1997)– Participating nations: ~ 7-8% below 1990 emissions– European Union’s CO2 market most advanced– Expansion to all participating nations

• Kyoto’s Flexibility Mechanisms– Emissions Trading System (ETS)

• Can comply by purchasing CO2 credits from the ETS market

– Joint Implementation (JI)• Can comply by purchasing CO2 credits from

an entity in an industrialized country– Clean Development Mechanism (CDM)

• Can comply by purchasing CO2 credits from an entity in a developing country

EU Market

EU Market

Miscellaneous issue: emission tax vs. cap-and-trade

• Regulated firms strongly prefer cap-and-trade– quota distributed for free – enormous $$ value!– compare to: tax per unit of emissions

• Monroe power plant example– 95,364 SO2 allowances allocated for free in 1994

– All allowances were used to cover emissions– What if taxed at $200/ton?

95,365 * 200 = $19,073,000

Emission tax vs. cap-and-trade (cont.)

• The regulator likes the certainty of the cap; tax has an uncertain effect on aggregate emissions– Environmentalists

probably like this certainty, too

• Example: volatile SO2 prices, yet certain cap.

SO2 Spot Market Prices, Aug 1994 - Dec 2003

0

50

100

150

200

250

Aug-94

Feb-95

Aug-95

Feb-96

Aug-96

Feb-97

Aug-97

Feb-98

Aug-98

Feb-99

Aug-99

Feb-00

Aug-00

Feb-01

Aug-01

Feb-02

Aug-02

Feb-03

Aug-03

Time

$ / t

on

Emission tax vs. cap-and-trade (cont.)

• What politician will support a tax program?– Clinton/Gore’s failed BTU tax, early in 1st term

• Cap-and-trade has been the “consensus” strategy– But is there any reason to expect it can reduce carbon

dioxide?– What is its political viability?– Business support

• US Climate Action Partnership

Cap and Trade Viability

• Jim Hansen talk … market and banking too open to gaming and corruption. No value added.– Already past the amount for dangerous

climate change.

• Rood and Thoumi that the carbon market and the science don’t line up.

• Financial Interests of Advocates.

Even newer news

• Senators Ditching Cap and Trade

• Senators Propose to Abandon Cap and Trade

Conclude: Political economy of cap-and-trade programs

• Environmentalist perspective – Set the cap as low as politically feasible

• Business perspective– Maintain flexibility in compliance options – Cap and trade is most flexible

• Regulator perspective – Buy-in from stakeholders

• Good for environment and cost effective

– Enforceable

Many environmental organizations are

now advocates for cap-and-trade programs

Further Reading

• Tom Tietenberg, Environmental and Natural Resource Economics, 7th Edition, 2006. – It includes several chapters on environmental

regulation—both principles and applications.

• Ellerman, Joskow, Schmalensee, Montero, and Bailey, Markets for Clean Air: The U.S. Acid Rain Program, 2000. – An exhaustive evaluation of the acid rain program

and SO2 market by a team of great economists.

Some Market Issues

• How do we make a carbon market?

• What is the role of allowances?– Savings relative to what baseline?

• Cost of allowance relative to other choices?

Elements of environmental pollutant market

ENERGY PRODUCTION

FUEL SOURCES

ABATEMENT

SHARES OF POLLUTANT CREDITS

F1c F2

c Fic

F1A F2

A FiA

A1 A2 Ai

GDP

.

POLLUTANT

efficiency

CO

ST

GA

P

Common Unit of Transference

Cost $

What about the carbon market

• Basics of a market

• This is once again a place where the idea that there is a system “in balance.” And that small changes from the balance are important. In the presence of small changes, perhaps the system is self regulating.

Elements of environmental pollutant market

ENERGY PRODUCTION

FUEL SOURCES

ABATEMENT

SHARES OF POLLUTANT CREDITS

F1c F2

c Fic

F1A F2

A FiA

A1 A2 Ai

GDP

.

POLLUTANT

efficiency

CO

ST

GA

P

22

][ 2COCO LP

t

CO

Let’s Think about the Market

• First, to be clear, this is another version of the continuity equation.

22

][ 2COCO LP

t

CO

PRODUCTION LOSS

PRODUCTION

• For our problem:– Production comes from burning fossil fuels.

– Here are the ways to reduce production• Use less energy• Consume less stuff• Shrink the economy• Find fuels that don’t emit carbon dioxide

– Don’t increase other greenhouse gases exponentially!

Production

• The real way to address the climate change problem in the short term is to reduce production of carbon dioxide, and

• the real way to do that is to consume less,– which will shrink the economy.

Production

• To maintain the growth of the economy and to address the climate change problem must de-correlate energy consumption from carbon dioxide emission.– This leads to alternative sources of energy.

Alternative energy

• According the Nathan Lewis, in the long-term there are three known sources of adequate energy for, say, more than a century or two.– Nuclear energy with breeder reactors– Solar energy, but requires new technology for efficiency and

storage– Coal with sequestration

• Other alternative energy, while important, do not scale with population and economic growth.

• Technology, exploration, and discovery and development of new energy sources

Current alternative energy

• With the presumption that cost of alternative energy needs to be comparable with fossil fuel sources there needs to be some way to bridge the cost gap.

• Personal analysis: fee or tax policy seems reasonable to bridge this gap.– Short term, and would help to develop a market.

CO

ST

GA

P

Production

• In the near term, by far the most effective way we have to reduce production of carbon dioxide is efficiency.– And this makes economic sense.

Efficiency

• But at this moment we have no way to really give valuation to efficiency.– Hence, historically, efficiency is often met with

increased consumption.

• How can this be changed?– Cost of energy is high enough that it demands

reduction– Efficiency is given valuation by market or policy (fee

and tax?)• Scale to help bridge the fuel cost gap?

– Other?

efficiency

United Nations Foundation: Realizing Potential of Energy Efficiency

McKinsey 2007: Large

Elements of environmental pollutant market

ENERGY PRODUCTION

FUEL SOURCES

ABATEMENT

SHARES OF POLLUTANT CREDITS

F1c F2

c Fic

F1A F2

A FiA

A1 A2 Ai

GDP

.

POLLUTANT

efficiency

CO

ST

GA

P

22

][ 2COCO LP

t

CO

Abatement

• What are the forms of abatement?

The abatement that we talk about

• Terrestrial sink?– This is fragile, limited, and there is growing

evidence that it does not “grow” to address the problem.

• That is “carbon fertilization” is less effective than posed.

• Oceanic sink?– Evidence of ocean “taking up less.”– Other environmental impacts

General form of balanced system

GOOD

BAD

Temperature(other environmental parameter)

Abatement

• What are the forms of abatement?

• Sequestration to keep carbon dioxide out of the atmosphere.

• Some engineered way to remove carbon dioxide from the atmosphere.– Think about the energy of this requires

something “biological” to use the Sun.?

Abatement

• We don’t really have enough abatement options to make a market.

Does a market do anything for CO2

• Evidence to date– EU: Some accounting of reduction– Motivate interest in mitigation– Is it the way to get us started– Billions of dollars tied up

Granularity

Energy-Economy-Climate Change

ENERGYECONOMY

CLIMATE CHANGE

THESE THREE ARE BIG

WHAT ARE THEIR ATTRIBUTES? ______________________________HOW ARE THEY RELATED? ______________________________

A moment with time scales

25 years 50 years 75 years 100 years0 years

ENERGY

ECONOMYCLIMATE CHANGE

We keep arriving at levels of granularity

TEMPORAL

NEAR-TERM LONG-TERM

SPATIAL

LOCAL

GLOBAL

WEALTH

Small scales inform large scales.Large scales inform small scales.