Economics of Global (and Domestic) Climate Change

1. Economics of Global (and Domestic) Climate Change Sabina Shaikh University of Chicago Climate Change: Biological and Social Implications Summer Teachers Institute June 24, 2008

2. Introduction and Outline • Economics of Pollution Control • Economics of Global Climate Policy • Leveling the Playing Field: Pricing Carbon • Demand and Supply Responses • Energy Efficiency as “low-hanging fruit” • Uncertainties and Some Recommendations FunEconomic Concepts for Today! Externalities, Moral Hazard, Prisoner’s Dilemma Discount Rates, Principal Agent Problems

3. Economics of Pollution Control • Markets and Government Intervention • Externalities as Market Failure • The Private Cost of production or consumption does not reflect the Social or True Cost • The difference is the “external cost” or a negative externality. • Example: Driving is “too cheap” • Pollution, Congestion, Accidents • In this case, government intervention solves a market failure. What kind of intervention is ‘efficient’?

4. Economics of Pollution Control • Command and Control • Market-Based Instruments: Permits and Taxes • Marginal Costs and Marginal Benefits • One more unit… • With Pollution Controls, the polluter’s choice compares the marginal cost of pollution abatement Vs. the price of polluting. • The price of pollution is the permit price or the tax. • Each polluter is comparing their marginal cost of abatement to this same price. They stop abating where the marginal cost of abatement just equals the price of pollution. • By equating the marginal costs of pollution abatement, no one entity can reduce pollution cheaper than another.

5. Global Climate Change • The Kyoto Protocol • Ratification: Nations representing 55% of world’s emissions • Average reduction 5% below 1990 levels by 2012. • U.S. not participating, Australia signed 2007. • The Role of Developing Countries

6. Kyoto Protocol and Flexibility Mechanisms • Carbon Sinks and Sequestration • Emissions Trading • Joint Implementation • Clean Development Mechanism Flexibility of Kyoto

7. Kyoto Protocol • The “Inverted U” • Issues: Types of Pollutants, Globalization, Outsourced Pollution

8. Kyoto Protocol • The Clean Development Mechanism • Cuts costs of emissions reductions for developed countries • Encourages pollution control in developing countries • Generated $59B in total investment but value of new projects halved next year, zero by 2010 (Economist 2008) • Concerns: Moral Hazard • “Additionality” • Projects must bring about new emissions reductions • Reduces incentives to voluntarily reduce emissions or use new cleaner technology. • Why spend money when someone else will do it? • CDM rules modified to address this issue but questions remain for future.

9. Future of Global Climate Policy • Developing Countries • Growth Rate in CO2 emissions • China is now the world’s leader in CO2 emissions • But, Cumulative Emissions and Per-Capita Emissions • 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? • 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)

10. Domestic Climate Policy • Examples of Domestic Policy • Lieberman/Warner, Regional, States, Cities • Setting Carbon Prices • In theory, Cap and Trade and Carbon Taxes are equivalent • Upstream on Carbon Content • Downstream on Emissions • Uncertainty

11. Carbon Pricing: Cap and Trade Vs. Carbon Taxes • Advantages of Cap and Trade • Potential Concerns of Cap and Trade and Solutions • “The chief political virtue of cap-and-trade is it’s complexity.” Washington Post, June 08 • “..cap and trade systems are complicated and conveniently opaque.” The Economist, June 07 • Moral Hazard: Additionality • Allocating Allowances: Free or Auctioned? • Price Uncertainty • Economic Shocks • Lack of Innovation • Safety Valve • Fixed Emissions • Adjust for Business Cycles • Banking

12. Carbon Taxes • Direct Examples: B.C. • Advantages of Carbon Taxes • Upstream: Easier, more Efficient • CBO, May 2008: Carbon Tax five times more effective than an inflexible Cap and Trade program. • Fewer Administrative Costs • Price Certainty • Less Volatility allows for Long-Term Investment, R & D • Allow Emissions to Vary with Economic Conditions • Revenue Neutrality: Tax Swap, Distribution of Income • Concerns about Carbon Taxes: • Quantity Uncertainty: Cumulative CO2 and Threshold • Support: Political Palatability • Loss of CDM? • Inefficient Use of Revenues

13. Relative Efficiency of Policies CBO, February 2008

14. Carbon Prices • Regardless of Policy, a carbon price levels the playing field • Supply Response • Elasticity: Increased Price of Fossil-Fuel Based Inputs leads to Substitution • Demand Response • Elasticity: As Price of Energy/Fuel goes up, the Amount Consumed Goes Down • How to Reduce Carbon Emissions? • Choose cheapest option?

15. Supply Response • Fixing Coal • Clean Coal, Carbon Capture, FutureGen? • Renewable Energy: Wind, Solar, Nuclear? • Renewables projected to double by 2030 (EIA) • Petroleum, coal and natural gas will decrease from 85% in 2006 to 83% in 2030. • Increasing Domestic Oil Supply • ANWR, Tar Sands, Strategic Reserve, Ethanol Carbon price of at least $30 makes wind and coal carbon capture viable

16. Demand Response: Energy Efficiency • Global energy demand is increasing. Increased supply is not enough. • Buildings account for about 40% of the U.S. GHG emissions, 70% in cities • Buildings represent half of U.S. energy consumption and 70% of electricity use • 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.

18. Market Barriers to Energy Efficiency • Do higher energy prices lead to energy efficiency investments? • Potential Barriers • High Discount Rates • Principal-Agent Problems • Hidden Costs of Substitutes • Information and Transactions Costs

19. 1. High Discount Rates • Upfront Costs – Future Returns • Rates of Return • High Rates of Return Required: 25-300%? • Uncertainty from Future Legislation • Individual, Business/Utility, Legislator Levels

20. 2. Principal Agent Problems • Employer—Employee Relationship • Incentives and End Users • Developers, Builders • Landlord, Tenant • Demand for Green? • Other Incentives: Utility Companies - Decoupling

21. 3. Hidden Costs of Substitutes • Perfect Substitutability? • Sacrificing Quality or Convenience • Lightbulbs: Incandescent, CFL • Bottled Vs Tap Water • Hybrid Cars

22. 4. Information and Transactions Costs • Too Little Information • Too Much Information • “Greenwashing”, “Green Noise” • Inertia

23. Uncertainties and Some Recommendations • Future of Global Agreements: Address Additionality, Free Riders • Cap Vs Tax? Address concerns of either. • Carbon Prices are a Significant Step but Technology Improvements 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 Efficiency • Financing • Reconciling & Decoupling • Availability of Viable Substitutes • Evaluation of Outcomes for Consistency of Information • Portfolio of Demand Response and Supply Side Options