Climate change policies

1. Climate change policies Session 9 Macroeconomic Concepts and Issues MSc Economic Policy Studies Alan Matthews

2. Learning objectives • Valuing the threat of global warming and the social cost of carbon • Implications of the EU’s climate change targets for the Irish economy • How can Ireland meet its GHG emission reduction targets at least cost?

3. Section 1 Valuing the social cost of carbon

4. The science of climate change • What is the sustainable level of emissions? • Scientific consensus on global warming • Climate is warming • The cause, with high probability, is GHGs • These emissions are in large part due to human behaviour, including fossil fuel consumption • IIEA Occasional Paper on science of climate change • IPCC Working Group 1 report summary for policymakers

5. Assessing the impact of climate change • Projections of CO2 concentration in atmosphere • General circulation models (GCM) models • Expected temperature and precipitation effects for different regions • CO2 concentrations now 380 ppmv compared to pre-industrial levels of 280 ppmv • Projected to double by 2100 leading to temperature increases of between 1.8 to 4° (faster warming when all GHGs included) • To have high probability of staying within the +2° target, mainstream view is to limit C02 concentration to 400 ppmv (50% probability at 450 ppmv)

6. Source: EEA SOER 2010

7. How likely are these trends? • CGM models fit observed data from the past quite well • But their weakness is that the physics of natural climate change is poorly understood and therefore there is uncertainty about model predictions • Others argue that models take inadequate account of feedback effects and threshold mechanisms which could accelerate climate change

8. Integrated Assessment Models (IAMs) • Seek to translate climate impacts into monetary damages • Benefits of climate policy represent avoided climate impacts that would otherwise cause damages to society in the future. • Used to calculate Social Cost of Carbon (SCC) (monetary estimates of the damage done to society in emitting one tonne of carbon today) for use in domestic CBA decisions • Used to determine ‘optimal’ policy using form of global cost-benefit analysis.

10. Areas of uncertainty in IAMs, leading to different results for social cost of carbon

11. Impact of differences in climate sensitivity • Models differ in their climate sensitivity, the long-term temperature increase associated with a sustained doubling of carbon dioxide concentrations in the atmosphere • The higher the climate sensitivity, the greater the damages • IPCC (2007) presented ‘likely range’ for climate sensitivity of 2-4.5°C, with best estimate of 3°C.

12. Differences in climate impacts • Impacts of climate change are modeled using climate damage functions for each region • Damage functions provide monetary estimates of climate impacts as a function of average temperature increase, often expressed as percentage loss of GDP • Generally, damages assumed to rise non-linearly with temperature – different models assume different curvature and steepness of the rising damage function • Damage estimates often based on single study which is then scaled up or down for application to other regions

13. Differences in adaptation assumptions • The damages of global warming are a function of how easily societies can adapt to higher temperatures • The lower the adaptation costs, the lower the benefits of avoiding climate change

14. Differences in discount rates • Some method of aggregating gains and losses from different time period in required. • In the ‘prescriptive’ approach presented by Ramsey (1928), the discount rate r can be expressed as: r = ρ + ηg where ρ is the pure rate of time preference, ηis the negative of the elasticity of the marginal utility of consumption (the rate at which additional consumption provides smaller increases in welfare) and g is growth rate of per capita consumption • The ‘descriptive’ approach uses the market rate of interest • Extensive debate about the appropriate values on economic and ethical grounds

15. Discount rates and equity weights • Higher rate of pure time preference lowers calculations of benefits of climate change policy, because future climate change damages are discounted more heavily • Value of the marginal utility of consumption can be varied to reflect equity weights (giving more weight to impacts in poor regions) • Using purchasing power parity rates to aggregate damages across regions (Stern, 2007) gives greater weight to impacts in poorer regions where majority of impacts will occur, producing effect similar to equity weighting

16. Social cost of carbon estimates (Tol, 2009) Note: SCC estimates can be converted into CO2e costs by dividing by 3.66

17. “Climate change is a moral problem. The main reason to reduce greenhouse gas emissions is a concern for faraway lands (Schelling 2000), distant futures (Nordhaus 1982), and remote probabilities (Weitzman 2009). The people who emit most are least affected by climate change, and the benefits of their abatement would be diffused. Carbon dioxide dwells in the atmosphere for decades and the effects on temperature and sea level play out over even longer periods. On central projections climate change and its impacts are a nuisance for rich countries and a problem for poor countries. But there is a chance that things will go horribly wrong. If you do not care about risk, the future, or other people, then you have little reason to care about climate change.” Source: Anthoff and Tol, 2010.

18. Critique of SCC calculations • “Conventional economic analysis is rapidly replacing the arguments of the climate skeptics as the principal justification for inaction on climate change” (Ackerman, 2008) • Interests of future generations should be more highly valued (ethics) • Prevention of worst-case risks should be prioritised more than average outcomes (insurance) • Some benefits cannot be given monetary values • Some ‘costs are better than others

19. Costing the externality due to carbon emissions • Social cost of carbon • Measures the full global cost today of an incremental unit of carbon emitted today, summing the cost of the damage it imposes over its lifetime in the atmosphere • Market price of carbon • The value of traded emission rights in a market given policy constraints on rights supply • Marginal cost of abatement • Reflects the cost of reducing emissions rather than the damage imposed by creating emissions • Under restrictive assumptions the three measures will be broadly equal, at the margin.

20. Policy approaches • Command-and-control • Use of regulation • Market-based approaches • Carbon tax • Cap and trade • Advantages and disadvantages

21. The economic perspective • Once target level of emissions set, what is the least cost abatement strategy? • Government policies often industry and technology-specific • Economists favour uniform price signals, on the basis that the same value is attached to each unit of emission reduction, whatever the source • Optimal policy is a carbon tax (or equivalent cap-and-trade) at a low initial rate, increasing subsequently in real terms

22. Regulation vs tax to reduce pollution Profits, costs of pollution, €/unit MP MSC Tax Q* Q Output of paper mill

23. Rationale for market-based interventions • To correct for negative market externality • Huge differences in abatement costs across different options • Use of market-based policy instrument can achieve GHG emission reductions at lower cost than command-and-control approach • Desirability of a uniform tax on all emitters as the marginal value of abatement is equal • Channels of market-based approaches • Firms adapt by switching from higher to lower carbon fuels and invest in energy saving technologies • Consumers adapt by purchasing less energy-intensive goods and change behaviour in ways that conserve energy • GHG pricing policies also provide incentives to develop new technologies

24. Comparison of GHG tax versus Cap and trade • Both are market or incentive-based systems • Under perfect information, both approaches would produce the same overall level of emissions at the same level of aggregate costs • But uncertainty over future cost of reducing emissions can lead to different outcomes • Compare approaches wrt environmental effectiveness, cost effectiveness and distributional equity

25. Environmental effectiveness • Cap and trade provides emissions certainty, whereas total emissions abatement effect of a tax is uncertain when tax is set. • Certainty may be important in climate change if there are systemic thresholds • Cap and trade provides certainty on emission outcomes, but cost of meeting targets is uncertain at firm level • Competitiveness effects and leakages?

26. Cost effectiveness • A tax is more flexible and allows firms to minimise their compliance costs over time, although Cap and trade can be designed to mimic this (e.g. shifting emissions through time) • Volatility of permit prices under Cap and trade schemes • Tax raises revenue, although can be mimicked in Cap and trade if permits are auctioned • Carbon tax could have positive effects on GDP, depending on how revenues are used • Grandfathering permits can gain political acceptability, but at cost of positive growth and distributional effects from recycling revenue (inframarginal exemptions do the same for carbon tax).

27. Distributional consequences • Not obvious the poor are worst hit by carbon taxes (motoring vs home heating) • But proportionately poor will be hit more • Distributional issues can be addressed by compensation (easier to finance under carbon tax)

28. Section 2 The International response

30. UNFCCC RIO 1992 • UNFCCC came into force 1994 • Overall objective of “stabilisation of GHG concentrations in atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system” • Establishes principle of “common but differentiated responsibility” • Commits to establishing inventories and reporting standards for GHG measurement • Commits to launching national strategies to mitigate GHG emissions • And to cooperate in preparing for adaptation to climate change • Convention governed by Conference of Parties (COP)

31. Kyoto Protocol 1997 • Annex 1 (developed) countries agreed to reduction targets • Groups (‘bubbles’) of countries can manage their efforts in unison • Defined three flexible mechanisms • Joint Implementation, Clean Development Mechanism and Emissions Trading • US refused ratification • EU ratified in 2002 and Protocol came into force in 2005 following accession of Russia

32. Copenhagen 2009 • Agreed the Copenhagen Accord • Set long term goal of limiting global warming to 2 degrees Celcius • Called for new multilateral climate fund and set goals of mobilising $30 billion in public finance 2010-2012 and €100 billion in public and private finance in 2020 • Further defined how countries’ actions are to be reported and verified • Called on countries to list mitigation pledges (economy-wide targets for developed countries, mitigation actions by developing countries)

33. Section 3 The eu response

34. Initial EU responses • Committed to goal of limiting global mean temperature rise to +2°C • Accepted -8% target under Kyoto for EU-15 • Burden-sharing agreement • Penalties • Introduced ETS in Jan 2005 • First (pilot) phase 2005-2007 • Second phase 2008-2012 • Countries’ targets and strategies set out in National Allocation Plans which must be approved by Commission

35. EU ETS experience • Initial pilot phase 2005-07. ETS covers about 40-50% of EU emissions. • Combination of generous allowances and abatement produced an initial price of €30 per tonne, but fell to zero in late 2007, some recovery since then. • Market value of allowances was passed through in electricity prices, even though allowances distributed free, resulting in considerable windfall profits • The Linking Directive allows firms to meet some of their obligations by purchasing certified emission reductions achieved in projects in developing countries and other developed countries

36. Price of ETS allowances Source: www.eex.com/en

37. EU Climate change 20:20:20 package Dec 2008 • Overall EU target 20% reduction by 2020 (relative to 1990 levels) • Increased to 30% if there is new international agreement • Reduction effort split between ETS and non-ETS sectors • ETS reduction (EU-wide) of 21% by 2020 (compared to 2005) • Average EU non-ETS reduction target of 10% in 2020 (compared to 2005) • Overall, averages out at 14% reduction (compared to 2005) and 20% reduction (compared to 1990) • Non-ETS effort is shared among EU countries according to a formula based on GDP per capita. • 20% energy from renewables by 2020 • 20% increase in energy efficiency by 2020

38. Long-term targets • Spring European Council 2007 meeting agreed indicative EU targets of 60-80% emission reductions by 2050 • Economic activity by then needs to be largely carbon-free • Implications?

39. Section 4 Irish targets for ghg emission reductions

40. Irish policy commitments • Second highest per capita emitter in EU • EU Kyoto target was to reduce emissions by 8% by 2012 over 1990 • Under EU’s burden-sharing agreement, Ireland’s target was to limit to 13% increase • Ireland’s emissions in 2006 25.5% above 1990, almost 13% above its Kyoto target

41. Source: EPA 2010

42. Current situation • EPA is charged with producing emission projections annually • NCCS targets distinguish between (a) baseline (b) baseline with existing measures and (c) baseline with additional measures (post 2006) • Under With Additional Measures scenario, government purchasing requirement estimated to be 12.7mt CO2e over Kyoto period. • NTMA has acquired 8.3mt credits. Gap of 4.4mt to be met from New Entrants Set-aside of around 5mt in ETS sector. Therefore EPA views it as unlikely that further credit purchases will be required. • Impact of economic recession on next updates?

43. Source: EPA 2010

44. Source: EPA 2010

45. 2020 targets • For ETS sector Ireland is allocated 88% of its 2005 emissions which will be auctioned starting 2013 • The target for Ireland for non-ETS sectors is to reduce emissions by 20% in 2020 relative to 2005 levels; the limit has been provisionally calculated by the EPA as 37.1 Mtonnes of CO2e. • In addition, Member States must annually limit non-ETS greenhouse gas emissions in a linear manner between 2013 and 2020, including by making use of the flexibilities provided for in the Effort Sharing Decision

46. ESRI projections for ETS sector, low growth scenario Source: ESRI 2010

47. Source: EPA 2010

48. Climate change bill • Set 2020 reduction target of 30% below 2005 emissions (12% below 1990 emissions) • Problematic as separation of ETS sector would oblige Ireland to meet the gap between the EU target (-20%) and the Irish target (-30%) through emission reduction in the domestic non-ETS sector • Very ambitious targets for 2030 (40% below 1990 levels) and 2050 (80% below 1990 levels) • National Climate Change Expert Advisory Body • Uninformative Regulatory Impact Assessment

49. ESRI projections for non-ETS sector, low growth scenario

50. Section 5 Irish Climate change policies