designing climate mitigation policy

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Journal of Economic Literature 2010, 48:4, 903934http:www.aeaweb.org/articles.php?doi=10.1257/jel.48.4.903

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1. Introduction

Global warming is one of the most criti-cal, and also most daunting, challenges

facing policymakers in the twenty-rst cen-tury, (e.g., World Bank 2010). Assessing aglobally efcient time path for pricing orcontrolling greenhouse gas (GHG) emis-sions is difcult enough, with huge scienticuncertainties, disagreement over the ulti-mate goals of climate policy, and disagree-ment over which countries should bearmost responsibility for emissions reduc-tions. On top of this, domestic policy design

is inherently difcult because of multiple,and sometimes conicting, criteria for pol-icy evaluation. And at an international level,

there are multiple approaches to coordinat-ing emissions control agreements. Whatshould be a rational policy response forsuch an enormously complex problem?

This paper attempts to provide somebroad answers to this question, and to pin-point the main sources of controversy, bypulling together key ndings from diverseliteratures on mitigation costs, damage

valuation, policy instrument choice, tech-nological innovation, and international cli-mate policy. Given that our target audienceis the broader economics profession (ratherthan the climate specialist), our discussion is

highly succinct and avoids details.We begin with the broadest issue of how

much action to price or to control GHGs

Designing Climate Mitigation PolicyJE. A, AJ. K, RG. N,

IW. H. P, WA. P*

This paper provides (for the nonspecialist) a highly streamlined discussion of themain issues, and controversies, in the design of climate mitigation policy. Therstpart of the paper discusses how much action to reduce greenhouse gas emissions at

the global level is efcient under both the cost-effectiveness and welfare-maximizingparadigms. We then discuss various issues in the implementation of domestic emis-sions control policy, instrument choice, and incentives for technological innovation.Finally, we discuss alternative policy architectures at the international level. (JELQ54, Q58)

*Aldy: Special Assistant to the President on Energyand the Environment; his work on this paper was com-pleted while he was a full-time fellow at Resources forthe Future. Krupnick: Resources for the Future. Newell:Nicholas School of the Environment and Earth Sciences,Duke University. Parry: Resources for the Future. Pizer:

his work on this paper was completed while he was afull-time senior fellow at Resources for the Future. Theauthors are grateful to Carolyn Fischer, Roger Gordon,Charles Kolstad, Knut Rosendahl, Kenneth Small, andBrent Sohngen for helpful comments and to MichaelEber for research assistance.


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Journal of Economic Literature, Vol. XLVIII (December 2010)904

is warranted in the near and longer termat a global level. There are two distinctapproaches to this question. The cost-effec-tiveness approach acknowledges that policy-makers typically have some ultimate targetfor limiting the amount of projected climatechange or atmospheric GHG accumulations,and the question is what policy trajectorymight achieve alternative goals at minimumeconomic cost, accounting for practical con-straints, such as incomplete international coor-dination. The other approach is to weigh thebenets and costs of slowing climate change,which introduces highly contentious issues indamage valuation, dealing with extreme cli-

mate risks, and intergenerational discounting.The second part of the paper deals with

issues in the implementation of climate pol-icy. At a domestic (U.S.) level, these includea comparison of alternative emissions con-trol instruments and how they should bedesigned to simultaneously promote admin-istrative ease and minimize efciency costsin the presence of other policy distortions,abatement cost uncertainty, and possibledistributional constraints. We also discussthe extent to which additional policies are

warranted to promote the development anddeployment of emissions-saving technolo-gies. And we briey summarize emergingliterature on alternative international policyarchitectures. A nal section discusses keyareas for future research.

2. Policy Stringency

2.1. Emissions Pricing to Stabilize GlobalClimate

The cost-effectiveness approach to globalclimate policy uses models of the economicand climate system (known as integratedassessment models) to estimate the emis-sions price trajectory that minimizes thediscounted worldwide costs of emissionsabatement, subject to a climate stabilization

target and possibly other, practical con-straints like delayed developing countryparticipation. These models range from bot-tom-up engineeringeconomic models withconsiderable detail on adoption and use ofenergy technologies to computable generalequilibrium models with a more aggregatedand continuous structure that better repre-sents demand responses, capital dynamics,and factor substitution. Many models arehybrids containing substantial technologicaldetail in the energy sectors and more aggre-gate representation in others. Typically thesuite of existing and emerging technologiesis taken as given, although some models

capture induced innovation through learn-ing-by-doing and a few have incorporatedR&D-based technological change (e.g.,Lawrence H. Goulder and Koshy Mathai2000).

The choice of model structure is gener-ally less important than assumptions aboutfuture baseline data and technology options.Future mitigation costs are highly sensitiveto business-as-usual (BAU) emissions, whichdepend on future population and GDPgrowth, the energy-intensity of GDP, andthe fuel mix. They also depend on the futureavailability and cost of emissions-saving tech-nologies like nuclear and renewable power,carbon capture and storage, and alternativetransportation fuels. Considerable uncer-tainty surrounds all of these factors.

Given the difculty of judging which mod-els give the most reliable predictions, wediscuss a representative sample of results,

beginning with studies that assume emissionsreductions are efciently allocated acrosscountries and time, and use the least expen-sive technological options (this is known aswhere, when, and how exibility). Theresults, summarized in table 1, are fromthe U.S. Climate Change Science Program(CCSP, Product 2.1A), based on results fromthree widely regarded models (see Leon E.Clarke et al. 2007 for details), and from the


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905Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

Stanford Energy Modeling Forums EMF-21 study (reported in Francisco C. de laChesnaye and John P. Weyant 2006) basedon sixteen models.

2.1.1. Reference ScenariosGlobal CO2 emissions from fossil fuels

have grown from about 2 billion (metric)tons in 1900 to current levels of about 30 bil-lion tons and, in the absence of mitigationpolicy, are projected to roughly triple 2000levels by the end of the century (table 1). Thehuge bulk of the projected future emissionsgrowth is in non-Annex 1 (nonindustrial)countriesCO2emissions from these coun-

tries have just overtaken those from Annex1 (industrial) countries.1These rising emis-sions trends reect growing energy demandfrom population and real income growthoutweighing energy- and emissions-savingtechnological changetraditional fossil fuelsstill account for around three-quarters ofglobal primary energy consumption by 2100(Clarke et al. 2007, table TS1).2

About 55 percent of CO2 releases areimmediately absorbed by the upper oceansand terrestrial biosphere while the remain-der enters the atmosphere and is removedby the ocean and terrestrial sinks only verygradually (Intergovernmental Panel onClimate Change 2007). The longer term rateof removal of CO2 from the atmosphere isaround 1 percent a year (i.e., CO2 has anexpected atmospheric residence time of

1 The 1990 U.N. Framework Convention on ClimateChange grouped countries into either Annex 1 or non-Annex 1 according to their per capita income at that time.Only Annex 1 countries agreed to reduce emissions underthe 1997 Kyoto Protocol.

2 Land-use changes currently contribute about anadditional 5.5 billion tons of CO2 releases (primarilythrough deforestation in developing countries for agri-culture and timber) though these sources are projectedto grow at a much slower pace than fossil fuel emissions(Intergovernmental Panel on Climate Change 2007).Land-use CO2emissions are not priced in the models intable 1.

about a century), and even this very gradualdecay rate might decline as oceans becomemore saturated with CO2. Stabilizing atmo-spheric CO2 concentrations over the verylong term essentially requires elimination offossil fuel and other GHG emissions.

Atmospheric CO2concentrations increasedfrom preindustrial levels of about 280 partsper million (ppm) to 384 ppm in 2007, andare projected to rise to around 700900 ppmby 2100 (table 1). Accounting for non-CO2GHGs, such as methane and nitrous oxidesfrom agriculture, and expressing them ona lifetime warming equivalent basis, theCO2-equivalent concentration is about 430

ppm (Intergovernmental Panel on ClimateChange 2007). Total GHG concentrations inCO2-equivalents are projected to reach 550ppm (i.e., about double preindustrial levels)by around mid century.

Globally averaged surface temperature isestimated to have risen by 0.74C between1906 and 2006, with most of this warmingdue to rising atmospheric GHG concentra-tions, as opposed to other factors like changesin solar radiation, volcanic activity, and urbanheat absorption (Intergovernmental Panelon Climate Change 2007). Figure 1, fromIntergovernmental Panel on Climate Change(2007), shows the projected long run warm-ing associated with different stabilizationlevels for atmospheric CO2-equivalent con-centrations (the climate system takes severaldecades to fully adjust to changing concen-tration levels, due to gradual heat diffusionprocesses in the oceans). If CO2-equivalent

concentrations were stabilized at 450, 550,and 650 ppm, mean projected warming overpre-industrial levels is 2.1, 2.9, and 3.6Crespectively. Figure 1 also indicates likelyranges of warming about the mean projec-tion, which refer to an approximate 66 per-cent condence interval, based on sensitivityanalysis from scientic modelsfor example,the likely warming range for 550 ppm CO2-equivalent stabilization is 1.94.4C. The


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TABLE 1L-CPSGC

2025 2050 2100

CCSPa MERGEMini-CAM IGSM MERGE

Mini-CAM IGSM MERGE

Mini-CAM IGSM

Global CO2emissions, relative to 2000

Reference 1.27 1.46 1.70 1.59 1.98 2.59 3.42 3.21 3.45 450 CO2stabilization 0.92 0.97 0.86 0.53 0.57 0.64 0.24 0.39 0.55 550 CO2stabilization 1.25 1.35 1.22 1.32 1.56 1.20 0.79 0.71 0.81

CO2concentration, ppmb

Reference 422 430 436 485 507 544 711 746 875 450 CO2stabilization 412 416 408 434 440 430 426 456 451 550 CO2stabilization 421 427 421 478 490 472 535 562 526

CO2price, $/tonc

450 CO2stabilization 41 36 88 157 127 230 166 173 1,651 550 CO2stabilization 3 6 26 10 19 67 127 115 475

% reduction in world GDP d

450 CO2 stabilization 0.8 0.5 2.6 1.8 1.6 5.4 1.4 1.4 16.1 550 CO2stabilization 0.0 0.0 0.7 0.2 0.2 1.8 0.7 1.0 6.8

U.S. CO2emissions,relative to 2000

Reference 1.25 1.10 1.40 1.27 1.20 2.00 1.63 1.34 2.93 450 CO2stabilization 0.79 0.83 0.88 0.42 0.43 0.54 0.02 0.27 0.40 550 CO2stabilization 1.24 1.05 1.04 1.02 0.98 1.13 0.29 0.37 0.59

EMF-21e lower end median upper end lower end median upper end lower end median upper endGlobal CO2emissions,

relative to 2000 Reference 1.33 1.48 1.64 1.64 1.88 2.23 2.11 2.93 3.52 550 CO2stabilization 1.17 1.25 1.41 1.13 1.25 1.41 0.66 0.90 1.25

CO2price, $/tonc

550 CO2stabilization 3 13 21 12 33 99 31 92 166

% reduction in world GDPd

550 CO2stabilization 0.1 0.1 0.8 0.2 0.6 3.1 0.3 5.1 8.2

U.S. CO2emissions,relative to 2000

Reference 1.19 1.26 1.38 1.31 1.65 1.97 0.95 1.85 2.29

550 CO2stabilization 1.05 1.14 1.22 0.76 1.02 1.26 0.36 0.53 1.05

Notes: aResults are from the Integrated Global Systems Model (IGSM), the Model for Evaluating Regional andGlobal Effects (MERGE), and MiniCAM Model. See Clarke et al. (2007) for details.

bThe models stabilize concentrations of all GHGs, rather than CO2alone (i.e., the CO2-equivalent concen-tration level is higher than the CO2concentration). Actual CO2concentrations may temporarily overshootthe long run targets.

cIn year 2000 dollars or thereabouts. dGDP losses are not broken out by region in the models. Losses include those from pricing CO2and other

GHGs on an equivalent basis. The gures do not account for the benets of reduced climate change. eModeling results from Stanfords Energy Modeling Forum, reported in de la Chesnaye and Weyant (2006).

The results are from 16 models for CO2prices and 12 models for GDP. Lower and upper ends correspondto lower and upper two-thirds of model results. Atmospheric CO2concentrations are not reported.


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year 2012) at approximately 5 percent a year,where this gure is the consumer discountrate plus the atmospheric CO2 decay rate(Stephan C. Peck and Y. Steve Wan 1996).However, one striking feature in table 1 isthe considerable price variation across mod-els within a stabilization scenario, reectingdifferent assumptions about future BAUemissions growth and future costs of carbon-saving technologies. The other striking fea-ture is the dramatic differences between the550 and 450 ppm CO2stabilization targets.In the 550 ppm case, CO2prices are $326and $1099 per ton in 2025 and 2050 respec-tively, with global emissions 1741 percent

and 1356 percent above2000 levels at thesedates, respectively. In the 450 ppm case, CO2prices are 316 times those in the 550 ppmcase to mid century, while emissions are314 percent and 3647 percentbelow2000levels in 2025 and 2050 respectively.4

Although GDP losses may be an unreliableproxy for efciency losses we discuss themhere as they are the least common denomi-nator reported by the modeling groups.Under the 550 ppm CO

2target, most mod-

els project global GDP losses (from reducingboth CO2and non-CO2GHGs) of less than1 percent out to 2050, though some modelssuggest GDP losses could reach 23 percentby this date. In present value terms, theselosses amount to about $0.412 trillion outto 2050 when applied to a world GDP that is$60 trillion and growing (Richard G. Newell2008, p. 12). Under the 450 ppm CO2target,GDP losses are about 1.02.5 percent and

1.55.5 percent in 2025 and 2050 respec-tively or about $843 trillion in present valuefrom 2010 to 2050.

Under both 450 and 550 ppm CO2 sta-bilization scenarios, the energy system istransformed over the next century (though

4 Some analysts express prices per ton of carbon ratherthan CO2. To convert to $ per ton of carbon, multiply bythe ratio of molecular weights, 44/12=3.67.

at very different rates), through energyconservation, improved energy efciency,and particularly reductions in the carbonintensity of energy. Most of the emissionsreductions in the rst two to three decadesoccur in the power sector, largely throughthe progressive replacement of traditionalcoal plants by coal with carbon capture andstorage, natural gas, nuclear, and renew-ables (wind, solar, and biomass). However,the projected fuel mix is highly sensitive tospeculative assumptions about the relativecosts and availability of future technologies.For example, there are considerable prac-tical obstacles to the expansion of nuclear

power (because of safety issues), renewables(because sites are typically located far frompopulation centers), and carbon capture andstorage (because of the difculty of assigningsub-surface property rights).5

As for U.S. CO2 emissions, in the BAUcase they increase by about 30100 percentabove 2000 levels (of approximately 6 billiontons) by mid century (table 1). Under the550 CO2ppm target, emissions initially rise,then fall to roughly 2000 levels by 2050, andfall rapidly thereafter. Under the 450 ppmtarget, U.S. emissions are rapidly reducedto roughly half 2000 levels by 2050.6 U.S.-specic GDP losses are not reported in thestudies in table 1,but allocating a quarter ofthe global cost to the United States (basedon its share in global GDP) implies a present

5 The transition away from coal reects not only therange of substitution possibilities in the power sector, but

also the disproportionately large impact of emissions pric-ing on coal prices. A $10 price per ton of CO2in the UnitedStates would increase 2007 coal prices to utilities by about60 percent, wellhead natural gas prices by 9 percent, retailelectricity and crude oil prices each by 7 percent, and gaso-line prices by 3 percent (from Clarke et al. 2007, table TS5,and www.eia.gov).

6 As of 2009, proposed climate policies in the UnitedStates embody emission reduction targets approximatelyequivalent to about of 80 percent below 2000 levels by2050. However, actual reductions in U.S. CO2 emissionswould be about 60 percent if provisions to use domesticand international emission offsets were fully exploited.


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value cost to the United States through midcentury of about $0.13 trillion (01 percentof the present value of GDP) for the 550ppm target and $211 trillion (13 percent ofpresent value GDP) for the 450 ppm target.7

2.1.3. Deviations from Least-Cost Pricing

Aside from the uncertainty surroundingmodeling assumptions, a key qualicationto the studies in table 1is that they assumeglobally efcient abatement policies. Morelikely, particularly given the common butdifferentiated responsibilities recognizedin the Kyoto Protocol, participation in globalmitigation efforts among major developing

country emitters will be delayed, causingmarginal abatement costs to differ acrossregions. For a given climate stabilizationscenario, to what extent does this affect

worldwide abatement costs and appropriatepolicies in developed countries?

James A. Edmonds et al. (2008) explorethese issues assuming Annex 1 countriesagree to impose a harmonized emissionsprice starting in 2012, China joins the agree-ment at a later date, and other countries join

whenever their per capita income reachesthat of China at the time of Chinas accession.In one scenario, they assume new entrantsimmediately face the prevailing Annex 1emissions price, while in another the emis-sions price for late entrants converges gradu-ally over time to the Annex 1 price. Theanalysis accounts for emissions leakage, thatis, the increase in emissions in nonparticipat-ing countries due to the global relocation of

energy-intensive rms, and increased use of

7 U.S.-specic models project emissions price rangesthat are broadly consistent with those in table 1. Forexample, analyses by Sergey Paltsev et al. (2007), U.S.Environmental Protection Agency (2008), U.S. Departmentof Energy, Energy Information Administration (2008a),and CRA International (2008) project emissions prices ofaround $4090 per ton of CO2in 2025 for climate legisla-tion that would reduce U.S. CO2 emissions by about 20percent below 2000 levels by that date.

fuels elsewhere as decreased demand in par-ticipating countries lowers world fuel prices.

Under the 550 ppm CO2 target, even ifChina joins between 2020 and 2035, theimplications for Annex 1 policies can be sig-nicant but are not that striking. Compared

with the globally efcient policy, near-termAnnex 1 emissions prices rise from betweena few percent to 100 percent under the dif-ferent scenarios, and discounted globalabatement costs are higher by 1070 per-cent. However, under the 450 ppm CO2target, essentially all of the foregone earlierreductions in non-Annex 1 countries must beoffset by additional early reduction in Annex

1 countries (rather than more global abate-ment later in the century). This can implydramatically higher near-term Annex 1 emis-sions prices, especially with longer delay andlower initial prices for late entrants. Underthese scenarios, discounted global abate-ment costs are about 30400 percent higherthan under globally efcient pricing, andnear and medium term emissions prices canbe an order of magnitude larger with Chinasaccession delayed till 2035.

A further key point from Edmonds et al.(2008) is the potentially large shift in theglobal incidence of abatement costs, under-lying the disincentives for early developingcountry participation. In the globally ef-cient policy, without any international trans-fer payments, developing countries bearabout 70 percent of discounted abatementcosts out to 2100, while they bear only1734 percent of global abatement costs

when Chinas accession occurs in 2035 andnew entrants face lower starting prices.

Finally, insofar as possible pricing non-CO2GHGs is also important. According to mod-eling results in de la Chesnaye and Weyant(2006), GDP costs are 2050 percent larger

when only CO2, as opposed to all, GHGs arepriced, for the same overall limit on atmo-spheric CO2-equivalent concentrations.This reects opportunities for large-scale,


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low-cost options for non-CO2abatement inthe rst half of this century, though practi-cal difculties in pricing other GHGs are notfactored into the models.

2.1.4. SummaryThere is a large difference in the appro-

priate starting prices for GHG emissions,depending on whether the ultimate objec-tive is to limit atmospheric CO2concentra-tions to 450 or 550 ppmtargets that areapproximately consistent with keeping theeventual, mean projected warming abovepreindustrial levels to 2.7 and 3.7oC respec-tively (assuming non-CO2 GHGs are also

priced). The 450 ppm target implies emis-sions prices should reach around $4090 perton of CO2by 2025, while the 550 ppm targetimplies prices should rise to $325 by thatdate. Securing early and widespread partici-pation in an international emissions controlregime can also be critical for containingcosts under the 450 ppm target, while underthe 550 ppm target there is greater scopefor offsetting the effect of delayed participa-tion through greater emissions reductions inthe latter half of the century. Given the con-siderable difference in GDP losses at stakebetween the two targets ($843 trillion inpresent value under cost-effective pricingout to 2050 compared with $0.412 trillion),it is important to carefully assess what start-ing prices might be justied by avoiding cli-mate change damages.

2.2. Welfare-Maximizing Emissions Pricing

2.2.1. Marginal Damage Estimates

Estimates of the marginal damages fromcurrent emissions begin with a point estimateof total contemporaneous damages from

warming, usually occurring around 2100.Total damage estimates from a number ofstudies are roughly in the same ballpark for agiven amount of warming. According to rep-resentative estimates ingure 2,damages are

in the range of about 12 percent of worldGDP for a warming of 2.5oC above preindus-trial levels, though some estimates are closeto zero or even negative (the prospects fornegative costs diminishes with greater warm-ing). For warming of about 4.0oC, damageestimates are typically in the order of 24percent of world GDP. However, similaritiesin aggregate impacts mask huge inconsisten-cies across these studies, which reach strik-ingly different conclusions about the size ofmarket and nonmarket damage categoriesand expected catastrophic risks.

Very few studies attempt to value the dam-ages from more extreme warming scenarios,

given so little is known about the physicalimpacts of large temperature changes. Twoexceptions are William D. Nordhaus andJoseph Boyer (2000) and Nicholas Stern(2007) who put expected total damages at10.2 and 11.3 percent of world GDP, for

warming of 6.0oC and 7.4oC respectively,though these gures are necessarily basedon extrapolations and subjective judgment.Again, there is little consistency across theestimates. In Nordhaus and Boyer (2000),catastrophic risks and market damagesaccount for about 60 and 40 percent oftotal damages respectively, with nonmarketimpacts roughly washing out (for example,the gains from leisure activities offset lossesfrom the disruption of ecosystems and set-tlements). In contrast, nonmarket impactsaccount for about half of Sterns overall dam-age estimate.

Marginal damage estimates are based on

assumptions about emissions/concentra-tion relationships, climate adjustment andsensitivity, damages from climate change(inferred from a point estimate of total dam-ages using functional form assumptions),and discount rates. Richard S. J. Tol (2009)conducts several meta-analyses of marginaldamage estimates, reporting median esti-mates of $4.120.2 per ton of CO2(individ-ual studies are not independent however, as


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consistent with cost-effective prices to sta-bilize CO2 concentrations at 450 ppm, orlower.

2.2.2 Controversies in Marginal Damage

AssessmentDifferences in marginal damage estimates

are largely explained by fundamentally dif-ferent approaches to discounting ratherthan differences in total damages from agiven amount of warming (Nordhaus 2007).However, the valuation of catastrophic andnoncatastrophic damages is also highlycontentious.

Discounting. The descriptive approach

to discounting argues that we can do nobetter than using observed market rates,typically assumed to be about 5 percent.9According to this approach, market ratesreveal individuals preferences, as best weunderstand them, about trade-offs betweenearly and later consumption within theirlifecycle, as well as their ethical or intergen-erational preferences. And they reect thereturn earned by a broad range of privateand public investmentsthe opportunitycost against which other, even intergenera-tional, investments ought to be measured.Proponents of the descriptive approach viewdiscounting at market rates as essential formeaningful, consistent policy analysis and toavoid highly perverse implications in otherpolicy contexts.

In contrast, the prescriptive approachargues that market rates cannot be used

when looking across cohorts (rather than

9 There are many market rates, from the long-term pre-tax real return to equities (about 7 percent) to the after-taxreturn to government bonds (about 2 percent). Convertingall values into their consumption equivalents, and dis-counting at the consumption rate of interest, narrows thepossible range of choice (e.g., Robert C. Lind 1982). Infact, Ellen R. McGrattan and Edward C. Prescott (2003)suggest that the divergence in effective rates of return isactually small, with an average real debt return duringpeacetime over the last century of almost 4 percent andthe average equity return somewhat under 5 percent.

within individuals lifetimes). Instead, thediscount rate (r) is decomposed as follows:r=+x, where is the pure rate of timepreference,xis the growth rate in consump-tion, and is the elasticity of marginal util-ity with respect to consumption. In Stern(2007), for example, = 0.1, x= 1.3, and=1, implying r=1.4. Choosing a valuefor, the rate at which the utility of futuregenerations is discounted just because theyare in the future, is viewed as a strictly ethi-cal judgment. And ethical neutrality, in thisapproach, essentially requires setting thepure rate of time preference equal to zero.Discriminating against people just because

they are in the future is viewed as beingakin to discriminating against people in thepresent generation just because they live indifferent countries (Geoffrey Heal 2009).There is also controversy over the appropri-ate value for , which is almost as importantas . For example, Partha Dasgupta (2007)argues for using a value of 2 to 4 on norma-tive grounds, while Anthony B. Atkinson andAndrea Brandolini (2010) suggest a valuebelow unity is plausible, based on observedgovernment behavior.10

Catastrophic Risks. Although Nordhausand Boyer (2000) and Stern (2007) includecatastrophic risks in their damage assess-ments, the numbers are best viewed ashighly speculative placeholders. Nordhausand Boyer (2000) put the annual willing-ness to pay to avoid catastrophic risks at 1.0and 6.9 percent of world GDP, for warminglevels of 2.5 and 6.0oC respectively, based

on subjective probabilities (from an expert

10 Besides ethical arguments, Thomas Sterner and U.Martin Persson (2008) argue for discounting the non-market impacts of climate change (e.g., ecosystem loss)at below market rates. This is because the value of non-market goods (which are essentially xed in supply) risesover time relative to the value of market goods (for whichsupply increases along with demand), assuming marketand nonmarket goods are imperfect substitutes for oneanother.


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elicitation survey) for these warming levelspermanently wiping out about a third of

world GDP. In his central case, Stern (2007)assumes the chance of catastrophic climatechange is zero up to a warming of about 5oC,beyond which the annualized risk of regionalGDP losses of 520 percent rises by about 10percent for each additional 1oC of warming.

Martin L. Weitzman (2009a) takes a radi-cally different perspective. He shows that, ifthe probability of increasingly catastrophicoutcomes falls more slowly than marginalutility in those outcomes rises (with dimin-ished consumption), then the certainty-equivalent marginal damage from current

emissions becomes innite. These condi-tions apply if the probability distribution forclimate sensitivity is a fat-tailedt-distribution(i.e., approaches zero at a less than exponen-tial rate) and utility is a power function ofconsumption. Although marginal utility isprobably not unbounded, Weitzman showsthat with probabilities of a 20oC temperaturechange inferred from IntergovernmentalPanel on Climate Change (2007), andassuming this temperature change wouldlower world consumption to 1 percent of itscurrent level, expected catastrophic damagescould easily dwarf noncatastrophic damages(even with these impacts delayed a centuryor more and discounted at market rates).11

There are several responses to theWeitzman critique. One is that, most likely,the probability distribution for climate sen-sitivity may have thin rather than fat tails.If the distribution is thin-tailed, Newbold

11 The Intergovernmental Panel on Climate Changereport provides probability distributions from twenty-two scientic studies. Combining these distributions,Weitzman (2009a) suggests that there is a 5 percent and 1percent probability that eventual warming from a doublingof CO2 equivalent concentrations will exceed 4.5C and7.0C respectively. However, making an (extremely crude)adjustment for the possibility of feedback effects he infersa distribution where the probability of eventual tempera-ture change exceeding 10C and 20C is 5 percent and 1percent respectively.

and Adam Daigneault (2009) and Robert S.Pindyck (2008) nd that damage risks fromextreme global warming are typically under3 percent of consumption (rather than in-nitely large).

Second, setting a modest emissions pricenow does not preclude the possibility of amid-course correction, involving a rapidphase-down in global emissions, shouldfuture learning reveal we are on a cata-strophic trajectory (e.g., Gary W. Yohe andTol 2009). This argument assumes policy-makers can avoid the catastropheit breaksdown if this would require reversingprevi-ous atmospheric accumulations because an

abrupt climate threshold has been crossed.Finally, a costly, rapid stabilization of

GHG concentrations is a highly inefcientway to address the very small probabil-ity of extreme outcomes, if a portfolio oflast-resort technologies could be success-fully developed and deployed, if needed,to head off the catastrophe. These includeair capture technologies for atmosphericGHG removal and geo-engineering tech-nologies for modifying global climate.12Moreover, these R&D efforts can be ledby one or several countries, avoiding thechallenges endemic in organizing a rapidemissions phasedown among a large num-ber of emitting countries with widely dif-fering interests. Nonetheless, public R&Dinto last-resort technologies (virtually non-existent at present) is highly contentious.One objection is that advancing last-resorttechnologies could undermine support for

emissions mitigation efforts. Another is thatgeo-engineering (though not air capture)

12 Besides rapid reforestation programs, air capturemight involve bringing air into contact with a sorbentmaterial that binds chemically with CO2and extraction ofthe CO2from the sorbent for underground, or other, dis-posal. Geo-engineering technologies include, for example,deection of incoming solar radiation through shootingparticles into the stratosphere or blowing oceanic watervapor to increase the cover of reective clouds.


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could have extreme downside risks (e.g.,from overcooling the planet or radicallyaltering precipitation patterns) that maybe difcult to evaluate prior to widespreaddeployment. Whether effective institutionscould be developed to prevent unilateraldeployment of climate modication tech-nologies prior to rigorous assessment oftheir risks is also unclear (e.g., Scott Barrett2008; David G. Victor 2008).

In short, the implications of extreme cata-strophic risks for emissions pricing are highlycontroversial. So long as there is some posi-tive likelihood, no matter how small, thatthe climate sensitivity function is fat-tailed

then catastrophic risks can still swamp non-catastrophic impacts. Mid-course policycorrections may come too late to prevent acatastrophe, given that it may take severaldecades for the full warming impacts of pre-

vious atmospheric accumulations to be real-ized. And the future viability of last-resorttechnologies is highly uncertain at present.All of these issuesthe nature and extent ofdamages from extreme warming, the feasibil-ity of future, mid-course policy corrections,and the efcient balance between mitigationand investment in last-resort technologiesare badly in need of economic analysis.

Noncatastrophic Impacts. Although ona different scale than catastrophic risks,controversies abound in the valuation ofnoncatastrophic damages. These includeagricultural impacts, costs of increased stormintensity and protecting against rising sealevels, health impacts from heatwaves and

the possible spread of vector-borne disease,loss of ecosystems, and so on. Box 1 pro-

vides a very brief summary of attempts tovalue these damage categories (see MichaelEber and Alan J. Krupnick 2009 for a moredetailed discussion). However, due to therapid outdating of prior research, dauntingmethodological challenges, and the smallnumber of economists working on aggregatedamage assessment, the valuation literature

remains highly inconsistent and poorlydeveloped, as a few examples illustrate (W.Michael Hanemann 2008).

Damage assessments (like those in gure2)assume losses in consumer and producersurplus in agricultural markets are equiva-lent to anything from a net gain of about 0.1percent to a net loss of 0.2 of world GDP for

warming of about 2.5oC occurring in 2100.However more recent, country-specic evi-dence suggests that output losses could be alot larger than those assumed in the damageassessments to infer welfare costs to agricul-ture. For example, William R. Cline (2007)suggests total losses of agricultural output in

developing countries in the order of 30 per-cent, while Raymond Guiteras (2008) esti-mates agricultural losses of 3040 percent forIndia. Even for the United States, WolframSchlenker, Hanemann, and Anthony C.Fisher (2005) suggest that the output ofindividual crops could fall by up to 70 per-cent by 2100. Similarly, recent evidence onice melting suggests that sea level rises overthe next century may be more extreme thanthe 2560 cm assumed in most previousdamage assessments (box 1). And estimatedecosystem losses of about 0.10.2 percent of

world GDP seem inconsistent with AndreasFischlin et al.s (2007) projection that 2030percent of the worlds species (an enor-mous amount of natural capital) faces some(though possibly slight) extinction risk.

More generally, scientic models cannotreliably predict local changes in average tem-perature, temperature variability, and precip-

itation, all of which are critical to crop yields.The baseline for impact assessment decadesfrom now is highly sensitive to assumptionsabout regional development (including theability to adapt to climate change), futuretechnological change (e.g., into climate- andood-resistant crops), and other policies(e.g., attempts to eradicate malaria or inte-grate global food markets). Controversiessurround the valuing of nonmarket effects


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B1. VNCD(W2.5C TOA2100)

Agriculture. Estimates of consumer and producer surplus losses in agricultural markets from pre-dicted changes in regional temperature and precipitation use evidence on crop/climate sensitivityfrom laboratory experiments and on regressions of land values or farm performance on climatevariables (e.g., Adams et al. 1990; Reilly et al. 2001; Mendelsohn et al. 1994, 2001). Laboratorystudies can control for confounding factors like soil quality and the fertilizing effect of higher CO2concentrations, while regression analyses account for farm level adaptation (e.g., changes in cropvariety and planting/harvesting dates). Worldwide agricultural impacts have been built up usingextrapolations from U.S. studies, adjusting for differences in local agricultural composition andclimate, and, more recently, country-specic evidence that captures local factors like adaptive ca-pability. Studies show a pattern of gains in high latitude and temperate regions (like Russia), wherecurrent temperatures are below optimum levels for crop growth, counteracting damages in tropicalregions, where current temperatures are already higher than optimal.

Sea Level. The annualized costs of future global sea level rises, due to thermal expansion and melt-ing of sea ice, have been estimated using projections of which coastal regions will be protected,engineering data on the costs of dikes, sea walls, beach replenishment, etc., and estimated lossesfrom abandoned or degraded property in unprotected areas. Some studies assume efcient behav-ior by local policymakers in their choice of which areas to protect and at what time, while othersassume all currently developed areas will be protected (Yohe 2000). Nordhaus (2008) also includesan estimate of property losses from increased storm intensity due to greater wind speed and wavescoming off a higher water level. Whether storm frequency will increase with more humid air is un-certain (IPCC 2007). Worldwide sea level impacts have been extrapolated from U.S. evidence, ad-justing for the fraction of local land area in close proximity to the coast, though recently there havebeen some local studies that account for the slope and elevation of coastal land and prospectivepopulation growth (e.g., Ng and Mendelsohn 2005 on Singapore). Overall, estimates are relativelymodest, for example they amount to 0.32 of world GDP in Nordhaus (2008).

Some scientists project that sea levels could increase by several meters by 2100 (Hansen 2007)rather than the 2560 cm projected by IPCC (2007). This would have major impacts on New York,Boston, Miami, London, Tokyo, Bangladesh, the whole of the Netherlands, and so on, and wouldcompletely inundate several small island states. Based on extrapolations from sea level protectioncosts in Holland, the global costs of this more extreme sea level rise may be at least an order ofmagnitude or more greater than for a moderate sea level rise, especially if coastal protection can-not be constructed expeditiously (Nicholls et al. 2008; Olsthoorn et al. 2008). Another possibilityis that warming may cause changes in ocean circulation patterns. However, IPCC (2007) projectsthat warming from climate change will dominate any cooling effect on Europe from a weaker GulfStream.

Other market sectors. Studies suggest other market impacts are relatively minor. With most forestsalong the increasing part of the inverted-U relation between forest productivity and temperature,Sohngen et al. (2001) nd positive overall impacts from warming on global timber markets. Moststudies nd a net loss for the energy sector, as increased costs for space cooling dominate savingsin space heating (e.g., Mendelsohn and Neumann 1999). Impacts on water availability also tend tobe negative, as increased evaporation reduces freshwater supplies, and the value of these losses iscompounded with greater demand for irrigation (Mendelsohn and Williams 2007).

(continued)


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(e.g., the value of mortality in poor coun-tries, how much people in wealthy countries

value ecosystem preservation in poor coun-tries). There is scant evidence on additionalrisks, such as extreme local climate change(e.g., from shifting monsoons and deserts)and broader health effects (e.g., malnutri-

tion from food shortages, the net effects ofmilder winters and hotter summers, anddiarrhea if droughts reduce safe drinking

water supplies). Most of the impact assess-ment literature is based on extrapolationsfrom U.S. studiescountry-specic studiesthat account for local factors (e.g., ability toadapt farm practices to changing climate)have only recently begun to emerge. Finally,

worldwide results mask huge disparities in

regional burdens, and there is disagreementon how to aggregate impacts across regions

with very different per capita income.13

2.2.3 Further Issues Posed by Uncertainty

Finally, we touch on some additional com-plications for emissions pricing posed by

uncertain discount rates, risk aversion, andirreversibility.

In damage valuation, the time path offuture discount rates is usually taken as

13 Most studies aggregate regional impacts usingweights equal to the regions share in world GDP or worldpopulation. More generally, use of distributional weightscan increase total damage estimates up to about 300 per-cent (e.g., David Pearce 2005).

B1 VNCD(W2.5C TOA2100) (continued)

Health. There have been some attempts to quantify future health damages. For example, using sta-tistical evidence on climate and disease, Nordhaus and Boyer (2000) put health risks from the possi-ble spread of vector-borne diseases like malaria at 0.10 percent of world GDP. Broader health risksare even more speculative. According to McMichael et al. (2004), there were 166,000 excess deathsworldwide in 2000 from climate change to date. Of these, only 16 percent were from malaria,46 percent reected greater malnutrition due to food shortages, another 28 percent more diarrheacases as droughts reduce safe drinking water supplies and concentrate contaminants, while 7 per-cent were from temperature extremes (most in Southeast Asia). However, malnutrition projectionsare extremely sensitive to assumptions about whether, over the next century, currently vulnerableregions develop, become more integrated into global food markets, and are able to adopt hardiercrops. And increased incidence of water-borne illness might be counteracted by future develop-

ment and adoption of water puri

cation systems. Monetizing mortality effects is also contentious asthere are very few direct estimates of the value of a statistical life for poor countries.

Ecosystems. All aspects of future climate change are potential stressors to natural systems. Com-bining projections of ecosystems at risk from climate change with evidence on the medicinal valueof plants and willingness to pay for species and habitat preservation, Fankhauser (1995) and Tol(1995) put the value of ecosystem loss in 2100 at 0.21 and 0.13 percent of world GDP respectively.Nordhaus and Boyer (2000) put the combined risks to natural ecosystems and climate-sensitivehuman settlements at 0.17 percent of world GDP in 2100, assuming the capital value of vulnerablesystems is 525 percent of regional output, and an annual willingness to pay equal to 1 percent ofcapital value. These estimates are highly speculative, given that very little is known about ecologicalimpacts and how people value large scale (as opposed to marginal) ecosystem loss.


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given. However, the discountfactorappliedto damages is a convex function of thefuture discount rate, so discount rate uncer-tainty (for a given expected value) increasesthe certainty-equivalent discount factor(Weitzman 1998). Newell and William A.Pizer (2003) estimated that discount rateuncertainty (inferred from U.S. historicalevidence) almost doubles estimates of mar-ginal emissions damages.

Leaving aside extreme risks, should mar-ginal damage estimates include a risk pre-mium? This would be appropriate if themarginal utility of consumption, net of cli-mate damages, were larger in high-damage

outcomes, in which case a mean-preservingincrease in the spread of possible damagesoutcomes would increase expected disutil-ity. However, if gross consumption is greaterin high-damage scenarios (for example,because rapid productivity growth leads toboth high consumption and high emissionrates), then the marginal utility of consump-tion net of damages is lower, and possiblyeven lower than marginal utility in low-damage states. Simulations by Nordhaus(2008, chapter 7) suggest this might in factbe the case, implying the risk premium isactually negative, though empirically small.On the other hand, we do not know whatthe probability distribution over damageoutcomes is. If policymakers are averse tosuch ambiguity this may, under certain con-ditions, imply a higher near term price onemissions, though how much higher is dif-cult to quantify (Andreas Lange and Nicolas

Treich 2008).Returning to the issue of irreversibility

and future learning, is there an option value(which should be reected in the emis-sions price) gained from delaying atmo-spheric GHG accumulations until more isknown about how much damage they willcause? Option values arise if such delayincreases the potential future welfare gainsfrom responding to new information about

damage risk (Pindyck 2007). If damagesare linear in GHG concentrations, changesin the inherited concentration level do notaffect marginal damages from additional,future accumulations. In this case, the wel-fare effects of policy interventions at differ-ent time periods are decoupled (at least fromthe damage side), and there is no optionvalue. If instead, damages are convex inatmospheric GHG accumulations the pros-pect of future learning reduces the optimalnear-term abatement level, to the extent thatthe damages from near-term emissions canbe lowered through greater abatement infuture, high-damage scenarios. Moreover, to

the extent that current abatement involves(nonrecoverable) sunk investments in emis-sions-saving technologies, there is anothersource of option value, from delaying long-lived emissions-saving investments untilmore is known about the benets of emis-sions reductions (Charles D. Kolstad 1996a).For these reasons, theoretical analyses sug-gest that the prospect of future learning

justies less near-term abatement (Kolstad1996b; Fisher and Urvashi Narain 2003;Pindyck 2007). However, as already noted,the critical exception to this is when there isa possibility of crossing a catastrophic thresh-old in atmospheric concentrations prior tofuture learning, which is essentially nonre-

versible given the nonnegativity constrainton future emissions.

2.2.4 Summary

Most estimates of near-term marginal

damages are in the order of $5$25 per tonof CO2. This range is in the same ballparkas near-term emissions prices consistent withleast-cost stabilization of atmospheric CO2concentrations at 550 ppm. These pricesrepresent a lower bound on appropriatepolicy stringency. Much higher prices (thatare consistent with 450 ppm, or even morestringent, CO2 stabilization targets) can beimplied by low discount rates and, possibly,


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For a given total emissions reduction, theestimated economic costs of downstreamprograms out to 2030 are not dramati-cally larger than those for comprehensiveupstream systemsabout 20 percent largeraccording to Goulder (2009)even thoughdownstream programs cover only abouthalf of total U.S. and EU CO2 emissions.This is because the huge bulk of low-costabatement opportunities are (initially) inthe power sector. Moreover, the infeasibil-ity of monitoring emissions from vehicles,home heating fuels, and small-scale indus-trial boilers in a downstream system can belargely addressed through supplementary

midstream measures targeted at renedtransportation and heating fuels, which fur-ther narrows the cost discrepancy betweenupstream and downstream systems.

There are a couple of other notable dif-ferences between the two systems. One isthat upstream programs must be combined

with a crediting system to encourage devel-opment and adoption of carbon captureand storage technologies at coal plants andindustrial sources. (The tax credit shouldequal the amount of carbon sequestered, asmeasured by continuous emission monitor-ing systems, times the emissions price). Theother is that, at least for the United States

where many states retain cost-of-serviceregulation, the opportunity cost of freelyallocated emissions allowances to electricutilities in a downstream system may notbe passed forward into higher generationprices. As a result, incentives for electricity

conservation could be a lot weaker, result-ing in a signicant loss of cost-effectiveness,compared with upstream programs or down-stream programs with full allowance auction-ing (Dallas Burtraw et al. 2001).

3.1.2 Scope of Regulation

Domestic programs that fail to coverembodied carbon in products imported fromcountries with suboptimal or no emissions

controls may cause signicant emissions leak-age. The problem is most relevant for down-stream, energy-intensive rms competing inglobal markets (e.g., chemicals and plastics,primary metals, petroleum rening), wherereduced production at home may be largelyoffset by increased production in other coun-tries with higher emissions intensity than inthe United States. According to some mod-els, as much as 1525 percent of economy-

wide U.S. CO2 reductions could be offsetby extra emissions elsewhere, although themajority of the leakage stems from changesin global fuel prices rather than relocation offootloose capital (Sujata Gupta et al. 2007;

Mun S. Ho, Richard Morgenstern, and Jhih-Shyang Shih 2008; Carolyn Fischer and AlanK. Fox 2007, 2009). Possible policy responsesto the latter source of leakage include impos-ing taxes, or permit requirements, accord-ing to embodied carbon in product imports(and symmetrical rebates for exporters) or tosubsidize the output of leakage-prone indus-tries (e.g., through output-based allocationsof free emissions allowances). However, allthese approaches may run afoul of interna-tional trade obligations.

Certain non-CO2GHGs are easily moni-tored (e.g., vented methane from under-ground coalmines, uorinated gases used inrefrigerants and air conditioners) and couldbe directly integrated into a CO2mitigationprogram through taxes, or permit tradingratios, reecting their relative lifetime warm-ing potential. Other gases are far more dif-cult to monitor, and are better incorporated,

insofar as possible, through offset provisions,where the onus falls on the individual entityto demonstrate valid reductions relativeto a credible baseline. For example, meth-ane from landlls and livestock waste mightbe collected, using an impermeable cover,and ared or used in onsite power genera-tion, while nitrous oxide might be reducedthrough changes in tilling and fertilizer use(e.g., Shih et al. 2006; Hall 2007).


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Finally, CO2abatement through forest car-bon sequestration (e.g., from reducing defor-estation, reforesting abandoned croplandand harvested timberland, modifying harvestpractices to reduce soil disturbance) appearsto be relatively cost effective. According toStavins and Kenneth R. Richards (2005), asmuch as 30 percent of U.S. fossil fuel CO2emissions might be sequestered at a cost ofup to about $20 per ton of CO2. Coupling adomestic mitigation program with offset pro-

visions for forest carbon sequestration willrequire measuring regional forest inventoriesto establish baselines, monitoring changesin forest use (through remote sensing and

ground-level sampling) relative to the base-line, and inferring the emissions implicationsof these changes based on sampling of localtree species and age. However, even if thesemonitoring challenges can be overcome, fur-ther problems remain. One is that, withoutan international program covering major for-ested countries, domestic reductions can beoffset through emissions leakage via changesin world timber prices (Brian C. Murray,Bruce A. McCarl, and Heng-Chi Lee 2002estimate the international leakage rate couldbe anywhere from less than 10 percent toover 90 percent depending on the type ofactivity and location in the United States).Another is that sequestered carbon in treesis not necessarily permanent if trees are latercut down, decay or burn, requiring assign-ment of liability to either the offset buyer orseller for the lost carbon.

3.1.3 Allocation of Policy Rents

In their traditional form, emissions taxesraise revenues for the government, whilecap-and-trade systems create rents forrms receiving free allowance allocations.However, through allowance auctions, cap-and-trade systems can generate comparablerevenues to a tax, while rents can be providedunder a tax through inframarginal exemp-tions for emissions or carbon content. Under

either instrument, the fraction of policy rentsaccruing to the government rather than pri-

vate rms, and how revenues are used, areextremely important for efciency and dis-tributional incidence.

Fiscal Linkages. The implications foremissions control policies of preexisting taxdistortions in factor markets have receivedconsiderable attention in the broader envi-ronmental economics literature (e.g., A.Lans Bovenberg and Goulder 2002), thoughthese distortions are typically not integratedinto energyclimate models. This raises twoissues: to what extent is there a cost savingfrom policies that raise revenues and use

them to offset distortionary taxes like incomeand payroll taxes, and to what extent do mod-els that ignore prior tax distortions produceinaccurate estimates of policy costs?

The efciency gain from recycling rev-enues in other tax reductions (relative toreturning them lump sum or leaving policyrents in the private sector) is simply theamount of revenue raised times the marginalexcess burden of taxation. Although thereis uncertainty over behavioral responsesin factor markets, a typical assumption isthat the marginal excess burden of incometaxes (with revenue returned lump sum) isaround $0.25 for the United States, or per-haps as high as $0.40 if distortions in thepattern of spending created by tax prefer-ences (e.g., for employer medical insuranceor homeownership) are taken into account.For modest carbon policies, the efciencygain from revenue recycling can be large

relative to the direct efciency cost of thepolicy, or Harberger triangle under the mar-ginal abatement cost schedule. For example,if a $30 tax on U.S. CO2emissions (currentlyabout 6 billion tons) reduces annual emis-sions by 10 percent, the Harberger triangleis $9 billion, while the revenue-recyclingbenet is roughly $4065 billion per year.

However, this does not necessarily meanthat revenue-neutral CO2taxes, or auctioned


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Diane Lim Rogers (2002) estimated that,for a 15 percent reduction in CO2 emis-sions, U.S. households in the lowest-incomequintile would be worse off on average byaround $500 per year, while householdsin the top-income quintile reap a net gainof around $1,000 (i.e., increased stock-holder wealth overcompensates this groupfor higher energy prices). This inequitableoutcome could be avoided under emis-sions taxes and auctioned allowance sys-tems if revenues were recycled in incometax reductions tilted toward the poor (e.g.,Gilbert E. Metcalf 2009).

As regards feasibility, compensation for

adversely affected industries may be partof the political deal-making needed to rstinitiate, and progressively tighten, emissionscontrols (e.g., A. Denny Ellerman 2005).Compensation, through free allowance allo-cation or tax relief, may be required for bothformally regulated sectors and downstreamsectors vulnerable to higher energy prices(e.g., energy-intensive rms competing inglobal markets). However, given the ten-sion between providing industry compensa-tion, and the scal and (household) equityreasons for raising revenue, it is importantto know how much compensation is neededto keep rms whole. At least for a moder-ately scaled CO2permit system, only about1520 percent of allowances are needed tocompensate energy intensive industries fortheir loss of producer surplus, so the hugebulk of the allowances could still be auc-tioned (Bovenberg and Goulder 2001, Anne

E. Smith, Martin T. Ross, and Montgomery2002). Although there are reasons for phas-ing out compensation over time, rms maystill be amenable to this if they receive excess

compensation in the early years of the pro-gram (e.g., Stavins 2007).18

3.1.4 Price Volatility

Another reason CO2

taxes and cap-and-trade systems may produce different out-comes stems from uncertainty over futureabatement costs reecting, for example,uncertainty over energy prices, technologi-cal advances, and substitutes for fossil fuels.

Price Versus Quantity Instruments in theirPure Form. If the goal is welfare maximiza-tion, abatement cost uncertainty stronglyfavors emissions taxes over cap-and-tradesystems in their pure form. This is most

easily seen in a static setting where themarginal benets from abatement are con-stant. In this case, a Pigouvian emissionstax automatically equates marginal benetsto marginal abatement costs, regardless ofthe position of the marginal abatement costschedule. In contrast, when emissions arecapped to equate marginal benets withexpected marginal abatement costs, ex postabatement will either be too high or too lowdepending on whether the marginal abate-ment cost schedule is higher or lower thanexpected (Weitzman 1974; Marc J. Robertsand Michael Spence 1976; Yohe 1978).

This basic result carries over to a dynamiccontext with a sequence of annual (Pigouvian)taxes or emissions caps, and where environ-mental damages depend on the accumulatedatmospheric stock of emissions. Here, wehave strong reasons to believe that the mar-ginal benets from global emissions reduc-

tions are essentially constant, as abatementin any one year has minimal impact on theatmospheric stock. In fact, with abatementcost uncertainty, simulation analyses suggest

18 One reason for phasing out allowance allocations isthat they must initially be based on a rms historical emis-sion rates (prior to program implementation), which may beviewed as increasingly unfair as rms grow or contract at dif-ferent rates, or change their fuel mix, over time. However,

any updating of baselines based on rm performance willlikely introduce distortions in rm behavior (Knut EinarRosendahl 2008). Free allowance allocation may also retardthe exit of inefcient rms from an industry if rms lose theirrights to future allocations when they go out of business.


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technology spillovers, the scope for monop-oly pricing under patents, and asymmetricinformation between governments and rmsabout the expected benets and costs ofresearch (e.g., Brian Davern Wright 1983).And just how much applied R&D in theenergy sector should be expanded is difcultto estimate, given uncertainty over the pro-ductivity of research and the risk of crowdingout socially valuable research elsewhere inthe economy (e.g., Nordhaus 2002; Goulderand Schneider 1999).

3.2.2 Basic Research

Appropriability problems are most severe

for more basic research, which is largelyconducted by universities, other nonprof-its, and federal labs, mostly through centralgovernment funding. While it is not practicalto assess the efcient allocation of fundingacross individual programs, Newell (2008, p.32) suggests that a doubling of U.S. federalclimate research spending (currently about$4 billion a year) is likely warranted, basedon plausible assumptions about the rate ofreturn on such spending. To avoid crowd-ing out, this should be phased in to allow aprogressive expansion in supply of collegegraduates in engineering and science.

3.2.3 Deployment Policy

In principle there are several possibilitiesfor market failures at the technology deploy-ment stage. For example, through learning-by-doing early adopters of a new technology(e.g., a cellulosic ethanol plant or solar pho-

tovoltaic installations) may lower produc-tion costs for later adopters (e.g., Arthur vanBenthem, Gillingham, and James Sweeney2008). But, since the potential for these spill-overs may vary greatly depending on industrystructure, the maturity of the technology, etc.,any case for early adoption subsidies needs tobe considered on a case-by-case basis.

Another possible market failure is con-sumer undervaluation of energy efciency,

which has been a key motivation for regu-lations governing auto fuel economy andhousehold appliances. However, althoughthere is an empirical literature suggest-ing that households discount savings fromenergy efciency improvements at muchhigher rates than market rates, whether thisis evidence of a market failure as opposedto hidden costs or borrowing constraintsremains an unsettled issue (e.g., Gillingham,Newell, and Karen Palmer 2009). Other mar-ket imperfections might include asymmetricinformation between project developers andlenders, network effects in large integratedsystems, and incomplete insurance markets

for liability associated with specic technolo-gies. However, because solid empirical evi-dence is lacking, little can be said about theseriousness of all these market failure pos-sibilities, and whether or not they might war-rant additional policy interventions.

3.3 International Policy Design

Proposed architectures for internationalemissions control regimes can be loosely clas-sied into those based on bottom-up versustop-down (i.e., internationally negotiated)approaches and cap-and-trade systems ver-sus systems of emissions taxes (e.g., JosephE. Aldy and Stavins 2007). There is disagree-ment over which type of architecture is mostdesirable, and most likely to emerge in prac-tice. In the bottom up approach, norms forparticipation might evolve from small groupsof countries launching regional programsthat progressively expand and integrate, or

by explicit linking of domestic cap-and-tradeprograms (e.g., Carraro 2007; Judson Jaffeand Stavins 2008; Victor 2007). Alternatively,countries might regularly pledge emissionsreductions with periodic reviews by a for-mal institution (e.g., Thomas Schelling 2007;Pizer 2007). Here we focus on top-downapproaches, given that advocates of rapid cli-mate stabilization tend to favor internation-ally binding commitments.


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rate is increased over time. And instead ofnegotiating over rules relating quota alloca-tions to the evolution of per capita income (oremissions) over time, countries would needto agree on rules for explicit side paymentsrelated to a countrys per capita income (oremissions).

However, under either the cap-and-tradeor tax-based approach, there is an obvioustension between compensating developingnations and policy stringency. For example,Jacoby et al. (2008) estimate that, under aglobal policy that stabilizes CO2concentra-tions at (approximately) 450 ppm, compen-sation for developing countries would entail

(explicit or implicit) side payments by theUnited States of $200 billion in 2020 (or tentimes current U.S. development assistance),

which calls into question the credibility ofsuch compensation schemes. Even with lessthan full compensation, the internationaltransfers are of unprecedented scale. A criti-cal lesson here is to keep down compensationto the minimum amount needed to enticedeveloping country participation. In thisregard, granting these countries initial quotaallocations equal to their BAU emissions is

wasteful, as it provides roughly twice thecompensation needed to cover abatementcosts (in the absence of other distortions,excess compensation is the integral betweenthe emissions price and the marginal abate-ment cost curve).

As regards verication of policies, onepotential problem with an emissions taxis that countries may undermine its effect

through reductions in other energy taxes.In principle, countries might be pressuredto adjust their emissions tax rate to offsetchanges in other energy tax provisions, basedon periodic reviews of country tax systems,and progress on emissions reductions, by anindependent agency like the InternationalMonetary Fund. Measuring other energy taxprovisions in terms of their equivalent tax(or subsidy) on CO2 would be contentious

however, because of opaque systems of taxpreferences for energy investments, the pos-sible role of energy taxes in correcting otherexternalities like local pollution and roadcongestion, and the possibility of non-taxregulations that further penalize or subsidizeenergy (e.g., fuel economy standards, energyprice regulations). On the other hand, mostcountries have established tax ministries that

would be able to implement a new tax on(the carbon content of) fossil fuels. In con-trast, many developing countries may lackthe capacity to enforce permit requirementsand property rights due to weak environ-mental agencies and judicial institutions.

Finally, although not incorporated inmost energy/climate models, the forest sec-tor appears to offer some of the easiest andleast expensive opportunities for cutting CO2emissions. For example, under a 550 ppmCO2 stabilization target, Massimo Tavoni,Brent Sohngen, and Valentina Bosetti (2007)estimate that forest sinks can contribute one-third of total abatement by 2050 and therebydecrease the required price on CO2 emis-sions by around 40 percent. This is mainlyachieved through avoided deforestation intropical forests, though it could be sustainedin the second half of the century throughaforestation and enhanced forest manage-ment. Emission credits for slowed defores-tation were not permitted under the 1997Kyoto framework, but since then analystshave become somewhat more optimisticabout the feasibility of integrating defores-tation into an international emissions con-

trol regime, despite the practical challengesnoted above (e.g., Ruth DeFries et al. 2006).However, broad participation in any agree-ment among major tropical forest regions

would be critical to avoid the risk of seriousemissions leakage.

3.4 Summary

A revenue-neutral CO2 tax has multipledesirable properties from an efciency


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standpoint. Although allowances can beauctioned, and emissions price volatilitycontained, why implement a more elabo-rate cap-and-trade system if its purpose isto largely mimic the advantages of a tax? Alikely answer is that political factors appearto favor the latter instrument (e.g., Goulder2009). Emissions taxes, at least in the UnitedStates, appear to be highly unpopular, whilecap-and-trade systems are popular amongenvironmental advocates given their focuson binding emissions targets and they alsohave active supporters in the nancial sec-tor, who see them as opportunities to makemoney. But whichever instrument is chosen,

getting the design details right is critical forcost-effectivenessespecially broad cover-age of emissions, raising and efciently usingrevenues, and containing price variability.

While most analysts agree that mitigationpolicies should be supplemented with addi-tional policies to promote basic and appliedresearch into emissions-saving technologiesat government, university, and private insti-tutions, the level of support and the specicinstruments that should be employed are farless clear. And there is little consensus aboutthe case for further policy intervention at thetechnology deployment stagethis dependson the specics of the industries or processesinvolved and assumptions about consumerbehavior that are in need of further study.

At an international level, the choicebetween cap-and-trade and emissions taxes isalso nuanced. Either system can be globallycost-effective and accommodate transfers to

developing countries. And while cap-and-trade systems are immune to the possibilityof offsetting changes in the broader energytax system, they may face larger implemen-tation obstacles in developing countries. Thebiggest problem in transitioning away fromthe CDM toward an integrated global emis-sions trading system is the possibility of alarge gap between the compensation thatmight be demanded by developing countries

in exchange for their participation and theamount of compensation that developedcountries are willing to providea gap thatcould be especially large under rapid atmo-spheric stabilization targets. Finally, inte-gration of carbon forest sequestration intointernational emissions control agreementsis potentially important for containing theburden of mitigation costs.

4. Research Priorities

While a great deal has been learned aboutclimate policy design over the last couple ofdecades, much economic analysis remains to

be done.Energy/climate models provide some

rough bounds on near-term emissions pric-ing trajectories, and associated GDP losses,implied by climate stabilization scenarios,and the range of uncertainty may narrow asmore is learned about the costs of new tech-nologies and behavioral responses to emis-sions pricing. Nonetheless, there are manyresearch priorities in this area, such as tryingto narrow disagreement over BAU emissionsassumptions (e.g., through better popula-tion projections); improving the represen-tation of endogenous technological change,prior policy distortions, and possible marketpower in world oil and natural gas markets;quantifying the benets of major technologi-cal breakthroughs to guide R&D efforts; andfurther exploring the cost and distributionalimplications of deviations from globally ef-cient emissions pricing.

Some of the biggest challenges facing cli-mate economists are to develop, and apply,methodologies for valuing the wide array ofmarket and non-market impacts across dif-ferent regions, time periods, and scenariosfor climate change (ecological, health, andextreme sea level impacts in particular, arepoorly understood). However, in terms ofshedding more light on whether there isa solid economic basis for aggressive, as


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opposed to more moderate, near-term emis-sions pricing, the most critical issues in needof study appear to be the nature and magni-tude of damage risks from extreme warmingscenarios and the extent to which the possi-bility of future, mid-course corrections, anddeployment of last-resort technologies, inresponse to future learning, lowers the near-term emissions price. More research on dis-count rates might also be valuable, especiallyin trying to reconcile different approaches(e.g., Wilfred Beckerman and Hepburn2007).

On the design of domestic mitigationschemes, one topic badly in need of study,

given the potentially large revenues fromcarbon policies, is the efciency and distri-butional implications of the diverse array ofoptions for revenue use. Additional researchpriorities include the design of practical, andcost-effective, provisions to address inter-national emissions leakage and incorporateincentives for abatement of non-CO2GHGsand forest carbon sequestration.

As regards complementary technologypolicy, research is needed on both the appro-priate level, and the relative efciency, ofalternative instruments to encourage appliedR&D, as well as the amount and compositionof basic energy R&D. Empirical research isalso needed to ascertain whether or not thereare additional market failures that justify fur-ther policy intervention at the technologydeployment stage. Even if the empirical basisfor such market failures is weak, research isstill needed on the interactions, and possible

redundancies, between all kinds of increas-ingly prevalent climate and energy-relatedregulatory interventions. For example, inthe transportation sector this would includeinteractions between carbon policies, fueltaxes, fuel economy standards, low-carbonfuel standards, hybrid vehicle purchasesubsidies, and subsidies and mandates forrenewable fuels. In the power sector it

would include interactions with regulations

governing the efciency of buildings, appli-ances, and lighting and inducements forrenewable and other low-carbon fuels.

Finally, a critical issue at an internationallevel is the design of rules for accession andgraduated responsibilities for developingcountries that are widely perceived as beingfair. At the same time, agreements shouldminimize deviations from cost-effectiveemissions pricing as well as minimizing therisks of excessive transfers to developingcountries.

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