Economics of Global (and Economics of Global (and Domestic) Climate Change Domestic) Climate Change

Sabina ShaikhSabina ShaikhUniversity of ChicagoUniversity of Chicago

Climate Change: Biological and Social Climate Change: Biological and Social ImplicationsImplications

Summer Teachers InstituteSummer Teachers InstituteJune 24, 2008June 24, 2008

Introduction and OutlineIntroduction and Outline

1.1. Economics of Pollution ControlEconomics of Pollution Control

2.2. Economics of Global Climate PolicyEconomics of Global Climate Policy

3.3. Leveling the Playing Field: Pricing CarbonLeveling the Playing Field: Pricing Carbon Demand and Supply Responses Energy Efficiency as “low-hanging fruit”

4.4. Uncertainties and Some Uncertainties and Some RecommendationsRecommendations

FunFun Economic Concepts for Today!Economic Concepts for Today!Externalities, Moral Hazard, Prisoner’s Dilemma

Discount Rates, Principal Agent Problems

Economics of Pollution ControlEconomics of Pollution ControlMarkets and Government InterventionMarkets and Government InterventionExternalities as Market FailureExternalities as Market Failure

The The Private CostPrivate Cost of production or of production or consumption does not reflect the consumption does not reflect the Social or Social or True CostTrue Cost

The difference is the “external cost” or a The difference is the “external cost” or a negative externalitynegative externality..

Example:Example: Driving is “too cheap” Driving is “too cheap” Pollution, Congestion, AccidentsPollution, Congestion, Accidents

In this case, government intervention In this case, government intervention solves a market failure. What kind of solves a market failure. What kind of intervention is ‘efficient’?intervention is ‘efficient’?

Economics of Pollution ControlEconomics of Pollution Control Command and ControlCommand and Control Market-Based Instruments: Permits and TaxesMarket-Based Instruments: Permits and Taxes Marginal Costs Marginal Costs and and Marginal BenefitsMarginal Benefits

One more unit…One more unit… With Pollution Controls, the polluter’s choice With Pollution Controls, the polluter’s choice

compares the marginal cost of pollution abatement Vs. compares the marginal cost of pollution abatement Vs. the price of polluting.the price of polluting.

The price of pollution is the permit price or the tax.The price of pollution is the permit price or the tax. Each polluter is comparing their marginal cost of Each polluter is comparing their marginal cost of

abatement to this same price. They stop abating abatement to this same price. They stop abating where the marginal cost of abatement just equals the where the marginal cost of abatement just equals the price of pollution.price of pollution.

By equating the marginal costs of pollution By equating the marginal costs of pollution abatement, no one entity can reduce pollution cheaper abatement, no one entity can reduce pollution cheaper than another.than another.

Global Climate ChangeGlobal Climate ChangeThe Kyoto ProtocolThe Kyoto Protocol

Ratification: Nations representing 55% of Ratification: Nations representing 55% of world’s emissionsworld’s emissions

Average reduction 5% below 1990 levels Average reduction 5% below 1990 levels by 2012.by 2012.

U.S. not participating, Australia signed U.S. not participating, Australia signed 2007.2007.

The Role of Developing CountriesThe Role of Developing Countries

Kyoto Protocol and Flexibility Kyoto Protocol and Flexibility MechanismsMechanisms

1. Carbon Sinks and Sequestration2. Emissions Trading3. Joint Implementation4. Clean Development

Mechanism

Flexibility of Kyoto

Kyoto ProtocolKyoto Protocol

The “Inverted U”The “Inverted U”

Issues: Types of Pollutants, Globalization, Issues: Types of Pollutants, Globalization, Outsourced PollutionOutsourced Pollution

Kyoto ProtocolKyoto Protocol The Clean Development MechanismThe Clean Development Mechanism

Cuts costs of emissions reductions for developed Cuts costs of emissions reductions for developed countriescountries

Encourages pollution control in developing countriesEncourages pollution control in developing countries Generated $59B in total investment but value of new Generated $59B in total investment but value of new

projects halved next year, zero by 2010 (Economist 2008)projects halved next year, zero by 2010 (Economist 2008)

Concerns: Moral HazardConcerns: Moral Hazard ““Additionality”Additionality”

Projects must bring about Projects must bring about newnew emissions reductions emissions reductionsReduces incentives to voluntarily reduce emissions or Reduces incentives to voluntarily reduce emissions or

use new cleaner technology. use new cleaner technology. Why spend money when someone else will do it?Why spend money when someone else will do it?CDM rules modified to address this issue but questions CDM rules modified to address this issue but questions

remain for future.remain for future.

Future of Global Climate Future of Global Climate PolicyPolicy

Developing CountriesDeveloping Countries Growth Rate in CO2 emissionsGrowth Rate in CO2 emissions China is now the world’s leader in CO2 emissionsChina is now the world’s leader in CO2 emissions But, Cumulative Emissions and Per-Capita EmissionsBut, Cumulative Emissions and Per-Capita Emissions

So, what happens now?So, what happens now? Countries (Cities, Companies, etc.) do not want to act

alone. Free Riders: Individual Costs and Shared Benefits

Game Theory: Prisoner’s Dilemma?Game Theory: Prisoner’s Dilemma? Everyone waiting on someone else to act. Those who do not sign on will free ride. But, if most countries sign on, they can agree to

sanction those who do not (Liebrich 2008)

Domestic Climate PolicyDomestic Climate Policy

Examples of Domestic PolicyExamples of Domestic PolicyLieberman/Warner, Regional, States, Lieberman/Warner, Regional, States,

CitiesCitiesSetting Carbon PricesSetting Carbon Prices In theory, Cap and Trade and In theory, Cap and Trade and

Carbon Taxes are equivalentCarbon Taxes are equivalentUpstream on Carbon ContentUpstream on Carbon ContentDownstream on EmissionsDownstream on EmissionsUncertaintyUncertainty

Carbon Pricing: Cap and Trade Vs. Carbon Carbon Pricing: Cap and Trade Vs. Carbon TaxesTaxes

Advantages of Cap and TradeAdvantages of Cap and Trade Potential Concerns of Cap and Trade and Potential Concerns of Cap and Trade and

SolutionsSolutions ““The chief political virtue of cap-and-trade is it’s complexity.” The chief political virtue of cap-and-trade is it’s complexity.”

Washington PostWashington Post, June 08, June 08 ““..cap and trade systems are complicated and conveniently ..cap and trade systems are complicated and conveniently

opaque.” opaque.” The EconomistThe Economist, June 07, June 07 Moral Hazard: AdditionalityMoral Hazard: Additionality Allocating Allowances: Free or Auctioned?Allocating Allowances: Free or Auctioned? Price UncertaintyPrice Uncertainty

Economic ShocksEconomic Shocks Lack of InnovationLack of Innovation Safety ValveSafety Valve

Fixed EmissionsFixed Emissions Adjust for Business CyclesAdjust for Business Cycles BankingBanking

Carbon TaxesCarbon Taxes Direct Examples: B.C.Direct Examples: B.C. Advantages of Carbon TaxesAdvantages of Carbon Taxes

Upstream: Easier, more EfficientUpstream: Easier, more EfficientCBO, May 2008: Carbon Tax five times more effective

than an inflexible Cap and Trade program. Fewer Administrative CostsFewer Administrative Costs Price CertaintyPrice Certainty

Less Volatility allows for Long-Term Investment, R & DAllow Emissions to Vary with Economic Conditions

Revenue Neutrality: Tax Swap, Distribution of IncomeRevenue Neutrality: Tax Swap, Distribution of Income

Concerns about Carbon Taxes:Concerns about Carbon Taxes: Quantity Uncertainty: Cumulative CO2 and ThresholdQuantity Uncertainty: Cumulative CO2 and Threshold Support: Political PalatabilitySupport: Political Palatability Loss of CDM?Loss of CDM? Inefficient Use of RevenuesInefficient Use of Revenues

Relative Efficiency of PoliciesRelative Efficiency of Policies

CBO, February 2008

Carbon PricesCarbon Prices

Regardless of Policy, a carbon price Regardless of Policy, a carbon price levels the playing fieldlevels the playing field

Supply ResponseSupply ResponseElasticity: Increased Price of Fossil-Fuel Elasticity: Increased Price of Fossil-Fuel

Based Inputs leads to SubstitutionBased Inputs leads to SubstitutionDemand ResponseDemand Response

Elasticity: As Price of Energy/Fuel goes up, Elasticity: As Price of Energy/Fuel goes up, the Amount Consumed Goes Downthe Amount Consumed Goes Down

How to Reduce Carbon Emissions?How to Reduce Carbon Emissions?Choose cheapest option? Choose cheapest option?

Supply ResponseSupply Response

Fixing CoalFixing CoalClean Coal, Carbon Clean Coal, Carbon

Capture, FutureGen?Capture, FutureGen? Renewable Energy: Renewable Energy:

Wind, Solar, Nuclear?Wind, Solar, Nuclear? Renewables projected to Renewables projected to

double by 2030 (EIA)double by 2030 (EIA) Petroleum, coal and Petroleum, coal and

natural gas will decrease natural gas will decrease from 85% in 2006 to 83% from 85% in 2006 to 83% in 2030. in 2030.

Increasing Domestic Oil Increasing Domestic Oil SupplySupply ANWR, Tar Sands, ANWR, Tar Sands,

Strategic Reserve, Strategic Reserve, EthanolEthanol

Carbon price of at least $30 makes wind and coal carbon capture viable

Demand Response: Energy Demand Response: Energy EfficiencyEfficiency

Global energy demand is increasing. Increased Global energy demand is increasing. Increased supply is not enough.supply is not enough.

Buildings account for about 40% of the U.S. Buildings account for about 40% of the U.S. GHG emissions, 70% in citiesGHG emissions, 70% in cities

Buildings represent half of U.S. energy Buildings represent half of U.S. energy consumption and 70% of electricity useconsumption and 70% of electricity use

McKinsey Report (2008)McKinsey Report (2008) Energy Efficiency in Buildings is the lowest cost (cost-

saving) way to abate GHG emissions. Low-Cost energy efficiency improvements in buildings

could offset 85% of projected increase in energy demand by 2030.

Energy efficiency investments with average rates of return of 17% could return $900 billion in annual energy cost savings by 2020.

Improving global energy productivity could provide half of abatement recommended by IPCC.

Market Barriers to Energy Market Barriers to Energy EfficiencyEfficiency

Do higher energy prices lead to Do higher energy prices lead to energy efficiency investments? energy efficiency investments?

Potential BarriersPotential Barriers1.1. High Discount RatesHigh Discount Rates

2.2. Principal-Agent ProblemsPrincipal-Agent Problems

3.3. Hidden Costs of SubstitutesHidden Costs of Substitutes

4.4. Information and Transactions CostsInformation and Transactions Costs

1. High Discount Rates1. High Discount Rates

Upfront Costs – Future ReturnsUpfront Costs – Future ReturnsRates of ReturnRates of Return

High Rates of Return Required: 25-High Rates of Return Required: 25-300%?300%?

Uncertainty from Future LegislationUncertainty from Future Legislation Individual, Business/Utility, Individual, Business/Utility,

Legislator LevelsLegislator Levels

2. Principal Agent Problems2. Principal Agent Problems

Employer—Employee RelationshipEmployer—Employee Relationship Incentives and End UsersIncentives and End Users

Developers, BuildersDevelopers, BuildersLandlord, TenantLandlord, TenantDemand for Green?Demand for Green?

Other Incentives: Utility Companies - Other Incentives: Utility Companies - DecouplingDecoupling

3. Hidden Costs of Substitutes3. Hidden Costs of Substitutes

Perfect Substitutability?Perfect Substitutability?Sacrificing Quality or ConvenienceSacrificing Quality or Convenience

Lightbulbs: Incandescent, CFLLightbulbs: Incandescent, CFLBottled Vs Tap WaterBottled Vs Tap WaterHybrid CarsHybrid Cars

4. Information and Transactions 4. Information and Transactions CostsCosts

Too Little InformationToo Little InformationToo Much InformationToo Much Information““Greenwashing”, “Green Noise”Greenwashing”, “Green Noise” InertiaInertia

Uncertainties and Some Uncertainties and Some RecommendationsRecommendations

Future of Global Agreements: Address Additionality, Future of Global Agreements: Address Additionality, Free RidersFree Riders

Cap Vs Tax? Address concerns of either.Cap Vs Tax? Address concerns of either. Carbon Prices are a Significant Step but Technology Carbon Prices are a Significant Step but Technology

Improvements NeededImprovements Needed“Europe’s carbon-trading system has not shown much

capacity to generate large-scale research nor to develop, demonstrate and deploy breakthrough technologies.” Sachs (2008)

Energy EfficiencyEnergy Efficiency FinancingFinancing Reconciling & DecouplingReconciling & Decoupling Availability of Viable SubstitutesAvailability of Viable Substitutes Evaluation of Outcomes for Consistency of Evaluation of Outcomes for Consistency of

InformationInformation Portfolio of Demand Response and Supply Side OptionsPortfolio of Demand Response and Supply Side Options