Climate Change Should We Mitigate? Tanveer Butt Bruce McCarl April, 2004 Texas A&M University

1. Climate Change Should We Mitigate?Tanveer ButtBruce McCarlApril, 2004Texas A&M University

2. Why Mitigate ? • Market impacts concerns. • Non-Market impacts concerns Ecology, • Distributional concerns. Climate change might adversely affect warmer regions, while benefiting colder regions. • Externality concerns. Countries likely to be adversely impacted are poor and have have minimal contribution to CC problem • Intergenerational equity concern. • Sustainability concerns • Uncertainty of impacts. Risk of learning there are large damages. • Irreversibility 400 years for ocean to recover

3. Why Mitigate ? Damages to CC Benefits from Climate Change stick

4. How do we decide? Society confronts two questions • Should we mitigate? • If so, at what rate? Second one is harder to answer, as it involves measurement of costs of abatement, damages of climate change, and a host of other factors

5. How do we decide? • Deciding the Rate of Mitigation. To address, one would need to determine a decision criterion • Net Present Value (NPV) based Cost Benefit Analysis (CBA) considers damages/benefits of mitigation and choses a rate of mitigation that maximizes NPV. • Social and Ecological Indicators (SEI) , for example tolerable sea level rise or increase in temperature, considers a rate of mitigation that would keep an SEI from crossing its threshold. • Appropriate risk exposure

6. CBA - Some Difficulties • Economic Assumptions - CSPS are based on certain premises • Scope of Assessment - Regions and sectors covered (US assessment considered 4 sectors) • Valuation of Non-Market Effects • Is efficient solution really efficient? - Institutional arrangement / Property rights regimes determine the position of cost/benefit curves when externalities are present. • Overlooked reality Modeling Complexities - biophysical sensitivities, extreme events and the probability of their occurrence • Equity Issue - The issue of weighing costs/benefits (Normative issues in welfare economics). • Lack of information - extrapolation of damage functions (Nordhaus and Mendelsohn use US damage response function and apply it to rest of the world wih certain modifications)

7. Optimal Rate of Mitigation - Empirical Investigations • The literature shows three camps on GHG abatement/mitigation issue. These are: • It is optimal to allow emissions of greenhouse gases to increase over the next century. Mitigation is an optimal strategy but only at a lower rate. • Substantial emissions reduction can be justified on economic grounds. Higher mitigation rates are optimal. • Uncertainties too large for CBA to provide any clear guide line on optimal rate of emission reduction.

8. Optimal Rate of Mitigation - Continue to Emit Nordhaus (DICE Model) • Stringent measures to control CO2 emissions would be costly even if benefits to emission reduction are considered (Nordhaus) • It is optimal to allow the emission rates to increase threefold over the next century. • The model finds a $5 per ton carbon tax to be an optimal strategy beginning 1995. • Existing costing studies are “extremely tentative” and “in their infancy” (Norhaus 1994). (this should be the underlying message from Nordhaus and not rate of emission reduction that came from his model… we tend to pay more attention to model experiments than the process of performing experiments)

9. Optimal Rate of Mitigation Analytical Framework in Nordhaus Study • Dynamic Integrated Climate-Economy (DICE) model based on optimal control theory that considers the interaction between the climate and the economy. • The model assumes a competitive global economy that produces a composite commodity. By maximizing an intertemporal objective function using labor, capital, and technology, the model determines the most efficient path for slowing climate change. • Major features • Objective function is based on a logarithmic utility function comprising consumption and population, which by default internalizes externalities from GHG emissions: • Income in-equalities handled by α - a measure of social valuation of different levels of consumption as shown by following equation • Dynamics of the economy and climate (time lag between climate’s impact on the economy) • Population growth is exogenous • 1.33% loss in global GDP as a result of doubling of CO2 : (low production low damage?) D(t) = 0.0133 [ T(t)/3]2 Q(t) • Does not have extreme events

10. Optimal Rate of Mitigation Results from Nordhaus Study - Gradual Reduction • Following four policy experiments performed • No Controls - indicative of the policy most nations followed (starting 1985 to 2105) • Optimal Policy - indicative of economically efficient or optimal policies to slow climate change by maximizing the present value of economic welfare where nations internalize GHG effect on utility • Ten-year delay in implementation. This policy examines the issue of the costs and benefits of delaying implementing policies until our knowledge about the GHG effect is better understood (Bush administration policy in during 1989-1992). • Stabilizing GHG concentration requiring a 20% emission reduction from 1990 level • Geo-engineering solution where technology would provide costless mitigation of climate change.

11. Optimal Rate of Mitigation Results from Nordhaus Study - Gradual Reduction • Key Findings • Mitigation of GHG emissions is a superior policy compared to a no control at all, as it provides net benefits of $271 billion relative to no control policy. • The optimal rate of emission reduction is 10 percent in the early years that rises to 15 percent in the later years (till 2105).4The policy of reducing emissions 20% below 1990 levels is extremely costly, as it results in $10.9 trillion (1.5% of global GDP) of loss in present value terms. • The optimal path of GHG reduction under stabilizing policy shows that reduction rises steeply to 40 percent by 2000, it then increases gradually all the way upto 70 percent. • Existing studies are “extremely tentative” and “in their infancy”

12. Optimal Rate of Mitigation A Critical Review of Nordhaus Study • Damage function linearly weighted by output • Decision criterion based on present value of utility obtained from consumption (efficiency criterion as against equity criterion, e.g. inter-generational equity, which is one of the primary concern about climate change) • Nordhaus’s global economy approach hides the income distribution aspect of climate change impact • Damages from extreme events not considered • Damage function is based mainly on expert opinion who disagree widely on the temperature-damage relationship • Damage functions are based on US damages

13. Optimal Rate of Mitigation Extension/Critique of Nordhaus’s DICE model • Regional Integrated Climate-Economy (RICE) Model (1996) • Woodwards and Bishop (1997) • Roughgarden and Schneider (1998) • Mastrandrea and Schneider (2001) • Azar and Lindgren (2003) • Various other authors also questioned Nordhaus’s findings of low emission abatement mainly focusing following points: • Value-laden assumptions in CBA, e.g. discount rate, low probability of catastrophic events, valuation of non-market impacts, and income distributional issues • Tol (2003) questions the use of CBA as an appropriate tool to determine optimal emission abatement

14. Optimal Rate of Mitigation RICE Model by Nordhaus and Yang (1996) • The world is divided into 10 regions (US, Japan, China, EU, former USSR, Inida, Brazil and Indonesia, 11 large countries, 38 med-size countries, and 137 small countries). • A dynamic General Equilibrium model integrating economic activity with the sources, emissions, and consequences of GHGE and climate change. • The model considers how nations would choose the optimal (or Pareto-efficient) path for reductions of GHGs. • Discount rate used is 3%. • CO2 emissions are controlled by increasing prices of factors or outputs that are CO2 intensive (through paramaterically representing the co2 reduction cost schedule based on studies done in the US and Europe). • Damage functions are estimated from a number of studies, which the authors mentioned as the most uncertain part of the model. Other critical assumptions are long run economic growth rate and the discount rate. • Welfare weights set as inverse of marginal utility of consumption. • Scenarios considered: • Market policies: This strategy assumes that there is no correction for the climate-change externality and that there is therefore no abatement of CO2 emissions, which is consistent with the existing behavior of nations • Cooperative policies: All nations cooperatively address climate change and agree to reduce emissions through a globally efficient way (consistent with DICE model). • Noncooperative policies: Individual nations act in their own slef interest and ignore the spillovers of their actions on other nations. Each nation sets its CO2 emissions controls to maximimize its own economic welfare regardless of the behavior of other nations.

15. Optimal Rate of Mitigation RICE Model by Nordhaus and Yang (1996)

16. Optimal Rate of Mitigation RICE Model by Nordhaus and Yang (1996) Key Points • Substantially higher world output and emissions by the end of the 21st century are projected by RICE. High growth of emission is attributed to sharp economic growth in China and rest of the world. Nordhaus and Yang mention that economic growth that they used is larger that that in may projections prepared by international study groups. • RICE projects emissions to rise to 38 billion tons of carbon by the end of 21st centry, as against an estimate of 5-35 billion tons by IPCC. • Under cooperative strategy, US stands a loser, former USSR is a modest beneficiary, and rest of the world reaps major net benefits. This finding, no surprise in fact, points out to the difficulty in moving ahead with international agreements on GHGE control. • Efficient carbon tax suggested under rice is $6 per ton in 2000 that grows to $27 by the end of 21st century (Note that mitigation is an optimal policy, only that a slower rate is suggested by RICE). • Estimated losses from climate change are 1-2 percent of global income over the 21st century. A failure to cooperate on GHG mitigation agreements is unlikely to lead to economic disaster over the 21st century. However, there are major gains in case of cooperation. • The results are tentative and further work is needed to test their robustness against alternative assumptions (Nordhaus and Yang). • “Given many economic issues facing the humanity today, it would require an unusually dire risk and uncommonly statesmanlike behavior for nations to divert 1 or 2 percent of their national incomes today to reduce conjectural risks that wil not occur untill well into the next millennium.” This statement from Nordhaus ignore three fundamental issues - externality, income distribution, and sustainability.

17. Extensions of Nordhaus’s DICE modelWoodwards and Bishop (1997) • Consider problems when expert opinions differ widely • Include possibility of extreme event (EE) • As contrast to Nordhaus’s 1.33% damage to world gross product (GWP), WB assume 24.1% damage to GWP in response to a 30 C rise in temperature. • WB consider optimal mitigation policy in the face of uncertainty where either 1.33% or 24.1% damage might happen due due to a 30 C. • WB find • irreversible damages occur under Nordhaus’s optimal mitigation rate if the catastrophic event happens • higher mitigation rates have merit when catastrophic events are considered • Advise use of safe minimum standard (SMS) crieterion when decision making confronts unresolved uncertainty

18. Extensions of Nordhaus’s DICE modelRoughgarden and Schneider (1998) • Mainly criticize Norhaus’s ‘best guess’ and ascribe it to low level of abatement suggested by Nordhaus (1994) • Alternate published estimates and opinions of possible damages from climate change are incorporated into DICE model • Include non-market impacts of climate change in the revised damage functions • Using Monte Carlo simulation, based on published climate damage distribution, provide a statistical distribution of optimal policy responses

19. Extensions of Nordhaus’s DICE modelRoughgarden and Schneider (1998) Alternate damages estimates for the US Researcher Warming (oC) Damage(% of GDP) ---------------- ----------------- ------------------------- Cline 2.5 1.1 Frankhauser 2.5 1.3 Nordhaus 3.0 1.0 Titus 4.0 2.5 Tol 2.5 1.5 ------------------------------------------------------------------- • Using the Nordhaus’s assumptions for adjustment of US damage function for global application, Roughgarden and Schneider derive alternative damage functions for use in DICE model

20. Extensions of Nordhaus’s DICE modelRoughgarden and Schneider (1998) Alternate damages functions use in DICE model dn(t) = 0.0133 [ΔT(t)/2.5]2 dc(t) = 0.0146 [ΔT(t)/2.5]2 8 percent higher df(t) = 0.0173 [ΔT(t)/2.5]2 30 percent higher dTi(t) = 0.03325 [ΔT(t)/2.5]2 2.5 times higher dc(t) = 0.0200 [ΔT(t)/2.5]2 50 percent higher

21. Extensions of Nordhaus’s DICE modelRoughgarden and Schneider (1998) Comparison of Monte Carlo Simulation Results with the Standard DICE Model -------------------------------------------------------- Source Optimal Carbon Tax($/ton C) -------------------------------------- 1995 2055 2105 -------------------------------------------------------- DICE 5.24 15.04 21.73 Median 22.85 51.72 66.98 Mean 40.42 84.10 109.73 “Surprise” 193.29 383.39 517.09 --------------------------------------------------------

22. Extensions of Nordhaus’s DICE modelRoughgarden and Schneider (1998) Conclusions: • DICE with Nordhaus’s original damage function is far more optimistic in suggesting lower abatement • Nordhaus’s recommendation of a slower abatement mainly stems from optimistic damage estimates, and from ignoring the uncertainty of the magnitudeof impacts from climate change • In particular, strategic hedging policies to deal with the 95th percentile, high damage outdome may well be chosen by policy makers, just as individuals or firms purchase insurance against low probability catasstrophic outcomes • Regardless of the risk proneness or risk aversion of the decision maker, the hcaracterization and range of uncertainties of the information provided by decision analysis tools must be made explicit and transparent to policy-makers.

23. Extensions of Nordhaus’s DICE modelMastrandrea and Schneider (2001) • Argue that abrupt climate change would give less time to adapt, consequently resulting in high damages • North Atlantic Thermohaline Circulation (THC) • Question all previous work that neglect the possibility of THC loss • Use Nordhaus’s DICE model and modify its damage function to reflect the possibility of THC loss.

24. Extensions of Nordhaus’s DICE modelMastrandrea and Schneider (2001)

25. Extensions of Nordhaus’s DICE modelMastrandrea and Schneider (2001)

26. Extensions of Nordhaus’s DICE modelAzar and Lindgren (2003 in Climatic Change) • Show the impact of including catastrophic event in the CBA analysis on optimal emission abatement and difficulties encountered in doing so • Develop a stochastic version of Nordhaus’s DICE model that includes a small probability of a catastrophic event • Potentially, catastrophic events include the possibility of a rapid disintegration of the West Antarctic Ice Sheet or a slow or even shut down of the thermohaline circulation • Discuss the complexities of incorporating catastrophic event in the analysis: • subjective probability distribution • value of env. and social catastrophe • catastrophe if it hits rich countries? Using $100,000 dollar for loss of one life (Frankhauser, 1995), a loss of 1000,000 citizens in Ethiopia, caused by climate change induced drought, amounts to only 0.25% of global GDP.

27. Extensions of Nordhaus’s DICE modelAzar and Lindgren (2003 in Climatic Change)…. Cont. • DICE model assumed abatement rates can be adjusted without any additional cost. AL added a constraint on how fast abatement rate can be increased/decreased to account for the reality that a more rapid rate of reduction would be costly. • Ajusted the discount rate in the DICE model r = α g + ρ, where α is the negative of the elasticity of marginal utility of income g is the growth rate in per capita income ρ is the pure rate of time preference DICE AL α 1 2 ρ 3% 0

28. Extensions of Nordhaus’s DICE modelAzar and Lindgren (2003 in Climatic Change)…. Cont.

29. 2090 1990 2040 Extensions of Nordhaus’s DICE modelAzar and Lindgren (2003 in Climatic Change)…. Cont. Gton C/Yr The green-black-red path shows optimal mission under Nordhaus’ DICE model results The green path shows emission abatement when catastrophe event occurs in 2035 and results in high damages The green-red path shows emission abatement when catastrophe event occurs in 2035 and results in low damages

30. Extensions of Nordhaus’s DICE modelAzar and Lindgren (2003 in Climatic Change)…. Cont. • Conclude: • Optimal emission abatement differ substantially from those found by Nordhaus (1994) • CBA can provide useful information, but it is appropriate when it comes to seeting emission targets in the context of global warming • Uncertainty about the impacts is so large that basically any optimal outcome can be justified • Alternative approach to CBA is required, for example environmental indicators (temperature change or sea level rise), for setting emission reduction targets

31. Optimal Rate of Mitigation - CBA not a guide Richard S. J. Tol (2003, Climatic Change) • Determine carbon tax to slow down emissions, where the tax equals to the marginal emission damage • Show that the marginal emission damage becomes infinite in some cases, leaving no guide for abatement • Discount rate is endogenous ρ is the pure rate of time preference η is the negative of marginal elasticity of income g is the growth rate in consumption • Using integral calculations, Tol shows that if catastrophe hits and the discount rate stays negative for some time, net present value of the impact becomes infinite - CBA fails • If the world is divided in groups of countries and equity weights are used: a catastrophe event might reduce per capita income of some group to zero - CBA fails • Tol also discusses the effect of weight factor under summation and product form of the social welfare function

32. Optimal Rate of Mitigation - CBA not a guide Richard S. J. Tol (2003, Climatic Change) Cont.. • Climate Framework for Uncertainty, Negotiation, and Distribution (FUND) model primarily developed to analyse efficient emission reduction strategies for various groups of countries. • Nine major regions, namely OECD-America, OECD-Europe, OECD-Pacific, Central and Eastern Ejrope and the former Soviet Union, Middle East, Latin America, South and South-East Asia, Centrally Planned Asia, and Africa • FUND also incorporates uncertainty in the form of extreme events • Economic growth, population growth, urban population, autonomous energy efficiency improvements, decarbonisation of the energy use, nitrous oxide emissions, and methane emissions are all exogenous factors in the FUND model • Damage function includes estimate of 1o C warming that range from a gain of 3.7 percent of GDP for OECD-Europe to 4.1 percent decrease for Africa • Tol makes 1000 simulation runs of the FUND model • In run number 383, Tol finds that in Central and Eastern Europe and former Soviet Union region, the economy collapses due to water shortages and the per capita income falls to zero in 2180. The run leads to following problems for CBA analysis: • Weight-factor for the region goes to infinity • The discount rate becomes negative by 2080, leading to large climate change impact and finally to infinity • Tol concludes • CBA can be applied only if the probability of catastrophe event is extremely low • Other crieterioa, such as minimax regret, safe minimum standard and tolerable window, may be considered

33. Should We Mitigate? - Summary of CBA Based Studies • Regardless ‘who we are’, it is optimal to mitigate. • The optimal rate of mitigation is relative to ‘who we are’ and our value-judgments regarding the choice of modeling assumptions. • Among the leading proponents of ‘slow mitigation’ is Nordhaus, who has cautioned on the tentative nature of his conclusion and also ignored low probability catastrophic events (true for both DICE and RICE models). Nordhaus (1994) also considered catastrophic events. • Various authors have used Nordhuas’s DICE model by incorporating alternative assumptions about key model parameters or/and including low probability catastrophic events. They found a merit in mitigation rates substantially higher than suggested by DICE/RICE. • The study by Mastrandrea and Schneider (2001) is unique in the sense it simulated the possibility of a thermohaline circulation (THC) collapse. They find optimal emission rate substantially higher than those suggested by earlier ‘low abatement studies’. by couplinga climate model capable of exhibiting abrupt non-linear dynamics with DICE model. • Benefits from climate change have not been included in the damage functions. • The cost of abatement is likely to be overstated. A 20% cut compatible with 450% rise in income. • Ancillary benefits of mitigation (clean air, SD, etc) have been ignored. • Studies that find minimal reductions are warranted have mostly neglected the most common arguments in favor of emission reductions (irreversibility, uncertainty, equity etc.; Azar, 1998). • When applied to large scale, interregional and intergenerational problems with deep uncertainty and multiple measures of what is to be optimized, there is a considerable risk that CBA might mislead those not aware of the limitations and implicit assumptions in its calculation (Schenieder and Azar, 2001 Pew Foundation)

34. Should We Mitigate? - Politics of Mitigation Schenieder and Azar (2001 Pew Foundation) • Developing countries favor for an early control of emissions. They hold developed countries responsible for the problem and its cure. They argue that an equal per capita access to international environmental resource is consistent with democratic norms (India). • Europeans argue in favor of an upper limit on the increase in temperature (2 oC above pre-industrial levels), mainly due to the possibility of large scale unforseen negative events. • In US policy arena, valuable findings of literature have been downplayed. Statements like “destroy the global economy” and ‘threatens the American way of life”have been used in policy briefs. • Should we defer abatement? • Deferred emission reductions would raise the possibility of future non-compliance (Daowlatabadi, 1996). • Stabilization of CO2 concentration to 550, 400, or 350 ppm? Defering abatement would erode the political feasibility of meeting higher conentration targets. • One argument in favor of deferred emission reductions could be the development of fossil fuel alternatives. However, progress on this front would slow down once the decision to defer abatement is made.

35. Summary Guidelines for Economists • Azar (1998, Climatic Change) suggested that for any cost-benefit study regarding GHG abatement following four issues ought to get some consideraton: • Low probability of catastroph. The related issues to be dealt with in this regard are probability of such events, the extent of associated damage, and assumptions about the inertia of the energy system. In case of a catastrophe event, it is difficult to quantify the extent of maximum damage that leaves CBA less useful for mitigation policy. Hence, one may consider SMS or maximin crieterion. • Method for Evaluating Costs. Extrapolating damage functions need to be done carefully and not across the board, as done in Nordhaus’s study that uses US damage functions representative of rest of the world. In general, the concern about climate change is driven by its non-market impacts (life and habitat of other species, not just human). Hence, the damage function should give due consideration to non-market impacts, with caution excercised in use of willingness to pay method for estimating costs especially in poorer countries. • The Choice of Discount Rate. The studies that justfiy emissions and those that justify abatement have, among other factors, used different discount rates. Though there is no easy prescription on the choice of discount rate, there are two different roads that can be taken; these are descriptive and prescriptive. Descriptive is more in line with market interest rate, while prescriptive is more in line with intergeneral equity considerations (the Ramsey discount rate); in case of climate change it is the later that should be given more considerations. See the Azar (1998, Climatic Change) for detail. • The Choice of Decision Crieterion. CBA is based on the so-called Kaldor criterion, which is based on the compensation principle. If loosers are not compensated, then the ethical basis for using the Kaldor criterion is questionable. For instance, a Kaldor improvement may lead to a reduction in social welfare if the “improvement” also involves sufficiently large wealth transfers from the poor to the rich. This is an income distribution issue and weighting factor is an important issue, as is the poorer countries that are likely to hurt by climate changes. • Today’s presentation warrants a caution on relying on CBA to determine optimal mitigation strategy. CBA is value-laden analytical framework, not as positive as usually thought. However, its use provides valuable insights on climate change mitigation issue. Park’s presentation will focus on what might be other reasons in favor of GHG mitigation.