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FOIA Number: 2017-1095-F FOIA MARKER This is not a textual record. This is used as an administrative marker by the William J. Clinton Presidential Library Staff. Collection/Record Group: Clinton Presidential Records Subgroup/Office of Origin: Council of Economic Advisers Series/Staff Member: Joseph Stiglitz Subseries: OA/ID Number: 9569 FolderID: Folder Title: IPCC [Intergovernmental Panel on Climate Change] - Volume II [1] Stack: Row: Section: Shelf: Position: S 20 5 9 3 Chapter 4 Intertemporal Equity and Discounting Lead Authors: Kenneth J. Arrow, William R. Cline, Karl-Goran Maler, Mohan Munasinghe, and Joseph E. Stiglitz January, 1995 TABLE OF CONTENTS ii SUMMARY 1 4.1 Introduction 4.1.1 Importance of the Discount Rate 1 4.1.2 Toward an Emerging Consensus 2 3 4.2 Intergenerational Equity 4.3 Discounting and the Social Rate of Time Preference 5 4.3.1 Formulation of Prescriptive Approach 6 4.3.2 The Pure Rate of Time Preference Across Generations 7 4.3.3 Discounting Utility for Human Extinction 8 4.3.4 Discounting Utility for Acceptable Optimization Results 9 4.3.5 Discounting Utility for Empathic Distance 10 4.3.6 Discounting for Rising Levels of Consumption and Utility 11 4.3.7 Relationship between the Social Rate of Time Preference and Market Rates of Interest 12 4.3.8 Discount Rate Estimates -- Prescriptive Approach 13 4.4 Formulation of Descriptive Approach 14 4.4.1 Returns to Investment 14 4.5 Discounting for Risk 17 4.6 Producer or Consumer Interest Rates? 17 4.7 Discounting Environmental Impacts 19 4.8 Implications for Sustainable Development 20 Annex 4A 23 Endnotes 27 References 28 1 SUMMARY 2 3 The methodology for comparing effects at different points in time, and especially establishing 4 trade-offs across different generations is a matter of philosophy (and for some, religion and morals) 5 because it involves reaching judgements about what is fair or just. The issue is also a matter of 6 economics, because comparisons across time are appropriately judged in the light of changing 7 standards of living over time as well as opportunities for productive investment. 8 9 Intergenerational Equity 10 11 Climate policy raises particular questions of equity among generations, because future generations 12 are not able to influence directly the policies being chosen today that will affect their well-being and 13 because it might conceivably not be possible to compensate future generations for reductions in 14 well-being that might be caused by current policies. A proper formal treatment of fairness among 15 generations poses special challenges to economic science. 16 17 The report of the Commission on Environment and Development called for "sustainable 18 development," defined as economic activity that "meets the needs of the present without 19 compromising the ability of future generations to meet their own needs." Similarly, Brown-Weiss 20 (1989, 25) has argued from the standpoint of international law that "each generation is entitled to 21 inherit a planet and cultural resource base at least as good as that of previous generations." 22 23 Among economists the standard approach has been to summarize views about interpersonal equity 24 in the form of a social welfare function. Arguments then turn on the ability to derive a particular 25 social welfare function from sound theoretical principles, and about the resulting reasonableness of 26 its derived implications. 27 28 Discount Rate 29 30 The discount rate is the analytical tool economists use to compare economic effects that occur at 31 different points in time. Identifying the proper discount rate is probably the single most important 32 analytical step in economic analysis of climate change. It is also the most profound ethical question, 33 since it inherently confronts present pain of abatement cost against damages suffered by future 34 generations if no action is taken. 35 36 The literature on the appropriate discount rate for climate change analysis can be divided into two 37 approaches. The prescriptive approach asks whether a particular program would make society better 38 off, given a plausible social welfare function. The discounting rules specify how consumption at 39 different dates should be valued to provide the correct answer to that question. The descriptive 40 approach focuses on intertemporal efficiency and opportunity costs. 41 42 Prescriptive Approach 43 44 The prescriptive approach discounts consumption accruing to different generations using the "social 45 rate of time preference" (SRTP): 46 47 SRTP = P + Θg ii where p is the rate of "pure" time preference, Θ is the absolute value of the elasticity of marginal utility, and g is the growth rate of per capita consumption. 3 4 The first term (p), the rate of pure time preference, is the rate at which utility is discounted because 5 it occurs later rather than sooner. The second term (Θg) is the rate at which changes in consumption 6 levels are discounted to be translated into the resulting changes in utility or welfare levels. If per 7 capita consumption is growing a rate g, then an extra unit of consumption in the future should be 8 discounted by the term Θg to take account of the lower marginal to utility of consumption at higher 9 consumption levels. This approach takes into account opportunity costs in calculating changes in 10 consumption, but in valuing the changes in consumption, uses the SRTP. 11 12 With high rates of productivity increase (and high g), of the order of 1.5%, and high values of the 13 elasticity of marginal utility (Θ), the social discount rate is of the order of 3%; with low rates of 14 productivity increase, of the order of .5%, and low values of the elasticity of marginal utility, the 15 social discount rate is of the order of .5%. There is no reason why the discount rate should be 16 constant over time even if P and Θ are constant, since g need not be constant. Developing countries, 17 with high rates of per capita income growth (5 to 8% per year in some countries), and elasticities of 18 marginal utility of 2, could justify discount rates of the order of 10% to 16%. Countries with per 19 capita incomes close to subsistence levels could have high elasticities of marginal utility (rapid 20 dropoff of marginal utility from initially extremely high levels associated with privation), and so 21 justify high discount rates even if they were experiencing slow growth of per capita income. 22 23 Descriptive Approach 24 25 The descriptive approach to the discount rate looks at returns to investments in the real world, and 26 with this information seeks intertemporal efficiency. It asks: could consumption be increased at one 27 date without decreasing it at any other? 28 Market rates of return usually exceed the SRTP. Conceptually, funds could then be invested in 29 projects that provide a higher return with the proceeds being used to increase future consumption. In 30 the context of climate change, however, society is not likely to be able to set aside investments over 31 the next three centuries and earmark the proceeds the eventual compensation of those adversely 32 affected. 33 34 35 iii 1 Chapter 4 2 Intertemporal Equity and Discounting 3 4 5 4.1 Introduction 6 7 This chapter concerns the methodology for comparing effects at different points in time, 8 and especially establishing trade-offs across different generations. How we think of these 9 trade-offs involves issues of intertemporal equity. This issue is a matter of philosophy (and 10 for some, religion and morals) because it involves reaching judgements about what is fair or 11 just. The issue is also a matter of economics, because comparisons across time are 12 appropriately judged in the light of changing standards of living over time as well as 13 opportunities for productive investment. To reflect the balance of issues, an alternative 14 chapter title would be Intertemporal Equity, Discounting, and Economic Efficiency. 15 16 4.1.1 Importance of the Discount Rate 17 18 The discount rate is the analytical tool economists use to compare economic effects that 19 occur at different points in time. Identifying the proper discount rate is probably the single 20 most important analytical step in economic analysis of climate change. It is also the most 21 profound ethical question, since it inherently confronts present pain of abatement cost 22 against damages suffered by future generations if no action is taken. 23 24 The issue of choosing an appropriate discount rate has been discussed in the context of 25 general cost-benefit analysis (chapter 5) for many years (Dasgupta et al. 1972, Harberger 26 1976, Little and Mirrlees 1974, Sen 1967, Stiglitz 1982). The long term perspective 27 required for sustainable development suggests that the discount rate might play a critical 28 role in intertemporal decisions concerning the use of environmental resources. 29 30 The emission of carbon dioxide causes effects likely to persist on a time scale of centuries. 31 IPCC (1990a) estimates that the first half-life of CO2 is 50 years and the second half-life 32 another 250 years (with the decline to 1/e taking 120 years). In the absence of policy 33 intervention carbon dioxide concentrations could continue to rise for the next 300 years, 34 given current fossil fuel resources (Sundquist, 1990). Climate change thus poses unusual 35 problems for economic analysis, which more typically considers issues with time scales of 36 only a few decades at most. 37 38 The usual formulation for discounting over time involves exponential growth of the 39 discount (or value-shrinkage) factor. Thus, one unit of consumption that arrives t years from 40 today is equivalent to the fraction l/(1+i)' of one unit of consumption available today, 41 discounting at rate i. 42 43 Social scientists have debated the precise rate to use for global climate analysis (Broome, 44 1992; Cline, 1992; Nordhaus, 1993). There is general agreement that the choice of the 1 1 discount rate has extremely powerful effects on the economic evaluation of policy on 2 climate change because of the unusually long time horizons involved (e.g. Schmalensee, 3 1993). With benefits of greenhouse abatement accruing decades or even centuries into the 4 future, if a high discount rate is used, the benefits get heavily discounted relative to the 5 expenditures incurred today in trying to mitigate climate change. 6 7 For example, rates of 8% - 10% per annum are often used in project analysis. Such rates 8 cause the future to vanish rapidly. Thus, discounting at 8%, damage of $1 billion 50 years 9 from now is valued at only [$lx109]/[1.08⁵⁰] = $21.3 million; and the same damage 200 10 years from now, at only $200. This collapse of future values suggests the need to think 11 especially carefully about proper discounting for climate change analysis. 12 13 14 4.1.2 Toward an Emerging Consensus 15 16 The framework of an emerging consensus on discounting for climate change analysis would 17 include the following. 18 19 First, although economists have disagreed about (a) whether future generations at levels of 20 welfare or utility equal to those of today should nonetheless be discounted relative to the 21 present, and (b) how precisely to relate changes in the discount factor to changes in income, 22 there is widespread (but not universal) agreement about the following propositions: 23 24 (i) Rejection of environmentally specific egalitarianism: future generations can be 25 compensated for some environmental/natural resource effects by offsetting 26 accumulations of capital. 27 28 (ii) Acceptance of more generalized (but not, usually, absolute) egalitarianism: 29 differences in the overall standard of living should be reflected in the discount rate. 30 There is, in fact, remarkable consensus in the quantitative magnitudes by which 31 future discounting should be affected by rising per capita income. Given the best 32 available forecasts, expected increases in the standard of living should cause 33 discounting of changes in consumption of future generations on the order of 1/2 to 3 34 percent annually. 35 36 Second, trade-offs of consumption across generations, while affected by observed market 37 (producer) rates of interest, through the effect of market rates on the value of foregone 38 investment alternatives, are not in general equal to these market rates. 39 40 Third, trade-offs across generations in environmental goods (or public goods) need not 41 correspond to trade-offs across generations in private consumption goods. The standard 42 economist's procedure for dealing with this problem is to convert other goods into their 43 equivalent in private consumption goods, the apply the discount rate to the equivalents. 44 This procedure incorporates market rates of return, by including as a cost of a project the 2 1 foregone benefits of possible investments not undertaken. 2 3 Fourth, issues of discounting involve the relative values of goods at different dates, and 4 thus intertemporal pricing. Issues of pricing of risk need to be carefully separated out from 5 those involving intertemporal pricing. The standard procedure for conventional models, 6 involving impacts over a single individual's life, involves converting probabilistic 7 consumption patterns into their certainty equivalents, and then discounting at the social rate 8 of time preference -- not the incorporation of an incremental component into the discount 9 rate itself. This procedure does not, however, deal adequately with uncertainties about 10 future rates of growth of per capita income. Such uncertainties are much greater over 11 centuries-scale horizons. 12 13 Fifth, issues of equity can be treated in a way analogous to those of risk, through the use of 14 certainty equivalents (Atkinson 1970, Rothschild and Stiglitz 1974), though the likely effect 15 on the appropriate rate of discount have yet to be thoroughly studied. 16 17 4.2 Intergenerational Equity 18 19 Climate policy raises particular questions of equity among generations, because future 20 generations are not able to influence directly the policies being chosen today that will affect 21 their well-being (Mishan, 1975; Broome, 1992), and because it might conceivably not be 22 possible to compensate future generations for reductions in well-being that might be caused 23 by current policies. 24 25 The concern for fairness to future generations has long undergirded the environmental 26 movement. This concern spans a broad range of political, social, and ethical considerations 27 and viewpoints; a proper formal treatment poses special challenges to economic science. 28 Perhaps best known among recent formulations, the report of the Commission on 29 Environment and Development (United Nations, 1987), led by Norwegian Prime Minister 30 Gro Harlem Brundtland, called for "sustainable development," defined as economic activity 31 that "meets the needs of the present without compromising the ability of future generations 32 to meet their own needs" (United Nations, 1987; for a discussion of sustainable 33 development, see sections 1.6 above and 3.6 below). Similarly, Brown-Weiss (1989, 25) has 34 argued from the standpoint of international law that "each generation is entitled to inherit a 35 planet and cultural resource base at least as good as that of previous generations." 36 37 A consensus exists among economists that this does not imply that future generations 38 should inherit a world with at least as much of every resource; such a view would preclude 39 consuming any exhaustible natural resource. The common interpretation is that if the stock 40 of some natural resource be depleted, it be compensated by an increase in the stock of 41 capital (physical or human). Under most calculations, given the savings rates of all but the 42 lowest-saving countries in the world, most countries now pass this test of sustainability. 43 Discussions of intergenerational equity must thus go beyond a focus on sustainable 44 development. 3 1 Economists have long debated the equity of discounting distant future benefits (Ramsey, 2 1928; Mishan, 1975; Rawls, 1971; Sen, 1982). The standard approach to issues of equity 3 since Bergson (1938) has been to summarize views about interpersonal equity in the form 4 of a social welfare function, an algebraic formulation relating welfare to levels of 5 consumption of the society's members at a given point in time and across time. Arguments 6 about the choice among alternative social welfare functions then turn on the ability to 7 derive a particular function from sound theoretical principles (seemingly plausible axioms), 8 and about the resulting reasonableness of its derived implications. 9 10 While all social welfare functions have been criticized for assuming interpersonal 11 comparability of utility, there seems to be no way of addressing the ethical issues involved 12 in making decisions affecting different generations without making some assumptions 13 implicitly or explicitly about interpersonal comparability. Two polar views are represented 14 by the utilitarian approach, in which social welfare is the sum of utilities; and the Rawlsian 15 approach, in which social welfare reflects the welfare of the worst-off individuals. While 16 the utilitarian approach can be derived from what many view as a persuasive axiomatic 17 (theoretical) structure (Harsanyi, 1955), the Rawlsian approach is derived from a "max-min" 18 strategy (maximize the minimum outcome for any given party) popular in game theory, but 19 which itself does not rest on widely accepted axiomatic principles. 20 21 The Rawlsian max-min 22 principle is the strongest A Dissenting View on Discounting 23 in assuring (the least 24 fortunate groups of) One prominent economist, Thomas Schelling, has rejected the 25 future generations levels approach presented here, arguing that it is requires the assumption of utility maximization by a single representative 26 of consumption at least as individual who lives forever. Schelling emphasizes that the 27 great as that of (the least essence of climate change is that those likely to bear the cost of 28 fortunate groups of) the mitigation--the developed countries-differ from those likely to 29 current generation. It is enjoy the benefits-the currently developing countries. Thus he 30 consistent with the emphasizes the importance of distributional considerations. 31 Brown-Weiss (1989) Supporters of the approach set out in this chapter note that the 32 approach noted above. model of one immortal individual is used only for exposition, and 33 The max-min criterion that the results derived from the social welfare function approach 34 permits inequality in presented here remain true even with many individuals (or 35 consumption between countries) within each generation. 36 individuals (or in this 37 case, between 38 generations) only if it improves the position of the poorest. (For the remainder of this 39 chapter, we shall simplify by ignoring inequality within a generation.) In the absence of 40 technical change this would imply that consumption per head should be the same for all 41 generations. By contrast, the utilitarian criterion allows, in principle, future consumption to 42 fall below current consumption, provided the current generation is made sufficiently better 43 off as a result. Correspondingly, it also allows for decreases in present consumption, 44 provided the future generation is made sufficiently better off as a result. 4 1 The Rawls and utilitarian social welfare functions can be viewed as limiting cases of more 2 general social welfare functions embracing social values of equality (Atkinson, 1971; 3 Rothschild. and Stiglitz, 1973). In practice, so long as there is sufficient scope for 4 technological change, optimizing any egalitarian social welfare function over time yields 5 increases in consumption per capita. Moreover, with any of the approaches, earlier 6 generations are entitled to draw down the pool of exhaustible resources so long as they add 7 to the stock of reproducible capital. 8 9 The individualistic social welfare function, accepted by most economists as the basis of 10 ethical judgments, accepts individuals' own relative valuations of different goods. It does 11 not place separate valuations on unequal access to particular goods, other than through their 12 effects on the affected individuals. For example, Thurow (date) argued that income 13 distribution is a public good, but that its value could be captured in individuals' valuations. 14 Although this represents the consensus view, some economists have insisted that for 15 particular goods, individuals' valuations need not be the basis of societal valuations. For 16 instance, Tobin (1970), in what he called specific egalitarianism, argued that society might 17 argue for greater equality in distribution of health care than would be reflected in 18 individuals' own evaluations. Most economists, however, reject this view. 19 20 Sen (1982) similarly suggests a basis for not discounting when environmental effects are 21 in question. He argues that a fundamental right of the future generation may be violated 22 when the environment is degraded by the present generation, and that the resulting 23 "oppression" of the future generation is inappropriate even if that generation is richer than 24 the present and has a lower marginal utility of consumption. In this framework, 25 intertemporal equity for environmental questions requires "a rejection of 'welfarism,' which 26 judges social states exclusively by their personal welfare characteristics." 27 28 4.3 Discounting and the Social Rate of Time Preference 29 30 The approach described in this section is sometimes called the prescriptive approach. It 31 asks whether a particular program would make society better off, given a plausible social 32 welfare function. The discounting rules specify how consumption at different dates should 33 be valued to provide the correct answer to that question. The alternative view, described in 34 Section 4.4, focuses on intertemporal efficiency and opportunity costs. To distinguish it 35 from the prescriptive approach, it is sometimes referred to as the descriptive approach. 36 37 The question of the appropriate discount rate involves issues in normative as well as 38 positive economics. How ethically should we value impacts on future generations? And to 39 what extent, for instance, will investments made to reduce greenhouse gas emissions 40 displace investments elsewhere? The debate is often confused both because the ethical and 41 efficiency aspects are intermingled, and because there are, in fact, three separate issues that 42 have to be addressed: How do we discount the welfare or utility of future generations? 43 How do we discount future dollars? And how do we discount future pollution? The 44 following discussion summarizes some of the salient issues in the debate, reaching the 5 1 following conclusions: 2 3 1. Total impacts on consumption (or welfare) across generations: the social rate of time 4 preference, a reflection of societal views concerning trade-offs of consumption across 5 generations, should be employed. 6 7 2. Direct costs and benefits of a greenhouse mitigation project: Suppose that a mitigation 8 project would displace private investment, and that returns to both projects accrue to the 9 same generations. Then it is appropriate to use the opportunity cost of capital - the private 10 return - in discounting. 11 12 Investments in both physical capital (e.g. machines) and human capital (e.g. education) 13 yield on average a positive real return. That is, money invested today can be transformed 14 into more money later, even after adjusting for inflation. Discounting converts each future 15 dollar amount associated with the project into the equivalent present dollar amount that 16 must be invested today in the general economy in order to yield the same future amount. 17 18 Greenhouse gas emission control may be viewed as an investment: money is spent today on 19 emission controls today so that more money (or other benefits) may be received later in the 20 form of reduced economic costs of climate change. If the real rate of return on investment 21 in emission reduction exceeds the rate on investment in machines and education, then future 22 generations would be better off if less were invested today in machines and education and 23 more in controlling greenhouse gas emissions; the converse also holds. 24 25 3. Competing investments: The cost of a greenhouse mitigation project must include the 26 foregone benefits of other competing investments not undertaken. Only then will it be 27 appropriate to use the social rate of time preference. 28 29 4. Evaluating risk: uncertainty about the impacts (changes in consumption) can be 30 incorporated by analyzing their certainty equivalents (the certain result that would make an 31 individual indifferent between it and the uncertain outcome), and discounting the certainty 32 equivalents in the manner described above. 33 34 5. Evaluating environmental impacts: environmental impacts can be incorporated in an 35 analogous way--converting them to consumption equivalents, and discounting at the rate 36 described above. Under plausible assumptions, the relative price of environmental goods 37 will increase over time, which would have consequences equivalent to adopting a lower 38 discount rate for such goods at unchanged prices. 39 40 4.3.1 Formulation of Prescriptive Approach 41 42 The first issue in the analysis of the discount rate is the question of how we value 43 consumption accruing to different generations. Within the predominant utilitarian (as 44 opposed to Rawlsian) framework, with standard simplifications¹, the fundamental equation 6 1 for the discount rate of consumption, or the "social rate of time preference" (SRTP) is: 2 3 4.1) SRTP = p + Θg 4 5 where p is the rate of "pure" time preference, Θ is the absolute value of the elasticity of 6 marginal utility, and g is the growth rate of per capita consumption. 7 8 The first term (p) is the rate at which utility is discounted because it occurs later rather than 9 sooner. Sometimes this term, the rate of pure time preference, is referred to as discounting 10 for impatience or myopia. The second term (Θg) is the rate at which changes in 11 consumption levels are discounted to be translated into the resulting changes in utility or 12 welfare levels. The idea is that if per capita consumption is growing a rate g, then an extra 13 unit of consumption in the future should be discounted by the term Θg to take account of 14 the lower marginal to utility of consumption at higher consumption levels. 15 16 Annex 4A sets out the mathematics of discounting. Along an optimal path, with no 17 distortions, the marginal product of capital (equal to the market rate of interest) and the 18 discount rate on consumption both equal p + Θg. It is important to emphasize that in using 19 the SRTP approach, we value the total change in consumption at each date, not just the 20 direct outputs of the project. If the project displaces private investment that has a high 21 marginal productivity, then there will be a large loss in output and future consumption 22 resulting from the displacement. The prescriptive view takes into account opportunity costs 23 in calculating changes in consumption, but in valuing the changes in consumption, uses the 24 SRTP. In short, all effects are converted to their consumption equivalents (as discussed in 25 section 4.6), then discounted at the SRTP. 26 27 4.3.2 The Pure Rate of Time Preference Across Generations 28 29 Consider pure time preference first. In a society in which income levels are not expected to 30 rise, impatience may still cause a household (or the present generation) to discount the 31 future (generation), that is, to equate a smaller amount of consumption today with a larger 32 amount in the future. In his classic paper on optimal saving, Ramsey (1928, p. 543) judged 33 that any allowance for pure time preference (p> 0) "is ethically indefensible and arises 34 merely from the weakness of the imagination." Correspondingly, he argued that future 35 generations should have equal standing with the current generation; there was no moral 36 or ethical basis for weighing the welfare of future generations less than that of the current 37 generation. 38 39 For an individual, some non-zero value of pure time preference can make sense, because he 40 or she has a finite life and thus uncertainty about being alive to enjoy future consumption. 41 Nonetheless, for a life span of 70 years, pure time preference at even 1 percent per annum 42 implies that consumption at the end of life is worth only half that at the beginning. 43 Evidence also suggests that individuals' discount rates can change over time, with lower 44 discount rates being used for longer time horizons (Thaler and Lowenstein 1989). 7 1 Considerations for society as a whole are different. The approach described earlier asks: if 2 society values different generations in a particular way (the social welfare function), how 3 should changes in consumption in different generations be compared? How society values 4 different generations can be viewed then from two different perspectives: 1) How should 5 society value different generations (an ethical approach); or 2) How does the current 6 generation value the consumption of future generations. Ramsey's analysis focused on the 7 ethical presumption that consumption by all generations should have equal value. But this 8 does not exclude the possibility that as a matter of description the current generation gives 9 less value to consumption of future generations. 10 11 4.3.3 Discounting Utility for Human Extinction 12 13 One argument focuses on the fact that there is no absolute certainty that future generations 14 will exist since any number of catastrophic events could occur. This argument, which 15 might be called the "asteroid effect," might argue that it would make no sense to give up 16 consumption today for the generation 200 years from now because it may not come into 17 existence. Some economists believe it is appropriate for this reason to discount future 18 consumption to reflect the inherent uncertainty in future conditions. However, the 19 probability of human extinction would seem sufficiently small (especially within a time 20 frame of two to three centuries) that the quantitative magnitude of discounting for this 21 purpose is likely to be extremely small. 22 23 Thus, according to some estimates the probability that an individual will die because an 24 asteroid hits the earth during his or her lifespan is of the same order of magnitude as the 25 probability that he or she will die in an airplane crash (about one in ten thousand). The 26 chances of earth's collision with an asteroid large enough to cause species extinction (such 27 as the 10-km-diameter object believed by some to have caused the Cretaceous/Tertiary 28 dinosaur extinction) is far smaller (Wetherill and Shoemaker, 1982). However, to be 29 generous to the extinction argument and for purposes of illustration, consider the individual 30 risk at one in 10,000. The three-century horizon appropriate for climate change analysis is 31 about four life spans, so set the probability of asteroid impact over this period at 1/2,500, 32 for purposes of illustration. Then at the end of this period, a given economic effect should 33 be discounted enough to shrink its value by one- 2,500th. The discount rate required for 34 this shrinkage is vanishingly small (= 0.133x10⁴ percent per annum). 35 36 Perhaps one reason the optimal growth literature includes discounting for extinction is that 37 most of the literature emerged during the cold war, when nuclear annihilation was more 38 plausible than today. For public policy purposes, even under those conditions it is 39 arguably inappropriate to incorporate analytical assumptions that take as a premise the 40 failure of policy (breakdown into nuclear war). In any event this motive for 41 extinction-based discounting would seem even less appropriate for the future. 42 43 44 8 1 4.3.4 Discounting Utility for Acceptable Optimization Results 2 3 Another argument for non-zero pure time preference is that setting the rate at zero could 4 imply that the present generation should accept near-starvation consumption levels, and 5 correspondingly low utility, because with even very small returns on investment, an endless 6 stream of future generations could enjoy increased consumption and (to a lesser degree) 7 utility as a result. 8 9 To some extent, however, this concern is already addressed in the overall discount rate 10 equation (4.1). As noted, the first term in that equation discounts utility (pure time 11 preference), but the second term additionally discounts consumption to take account of 12 falling marginal utility. The present generation is protected against an optimizing program 13 setting its consumption near zero if the term for elasticity of marginal utility (Θ) is large 14 enough and marginal utility drops off fast enough to rule out impoverishment of the present 15 generation for gains to future generations. 16 17 More fundamentally, a basic concern about zero pure time preference has to do with the 18 mathematics of maximization over an infinite time horizon. If the utility function has no 19 upper limit, any savings-investment optimization problem is not well defined, because the 20 sum of utilities over time is infinite. There is some literature (Weizsacker 1965) proposing 21 criteria (the "overtaking criterion") to address this problem, but the implications of these 22 criteria for climate policy have not been examined. 23 24 Even when the optimization problem is made well-defined, for the purposes here, e.g., if 25 there is an upper bound to utility (as in the function in annex equation 4A.3), there is a 26 tendency toward knife-edge results, with one extreme outcome for zero pure time 27 preference and the opposite extreme for non-zero rates. Thus, whereas the concern of 28 Koopmans (1965), Mirlees (1974), and Chakravarty (1969) is that zero pure time 29 preference can suppress current consumption to unacceptably low levels, just the opposite 30 result can be reached in optimization models that take exhaustible resources into account. In 31 some specifications of such models (Dasgupta and Heal, 1974; Solow, 1974a), any pure 32 time preference rate in excess of zero generates the unacceptable result that optimal 33 consumption falls to zero over the very-long term (although Stiglitz, 1974, shows that this 34 awkward conclusion is not robust with respect to alternative assumptions about 35 technological change, production functions, and utility functions). 36 37 Knife-edge results can of course result from other properties of utility maximization models 38 as well (depending, for example, on whether the production function has non-unitary 39 elasticity of substitution between factors, or whether capital-augmenting technical change is 40 zero or positive). Focusing on the mathematical and knife-edge complications of 41 optimization approaches, they do not go far toward specifying the proper magnitude for the 42 rate of pure time preference, even though they might be seen as providing a set of 43 arguments that the rate is greater than zero. Thus, considering the infinite horizon in such 44 models, an infinitesimally small but non-zero rate of pure time preference could suffice to 9 1 avoid prejudicing the optimal consumption path against the present generation, depending 2 on other assumptions of the model. 3 4 A stronger attack on very low discount rates is provided by those models concluding that 5 low discount rates imply unreasonably high savings rates, particularly in poor economies. 6 Only by raising the discount rate to higher, "more reasonable" numbers can savings rates of 7 the kind actually observed be obtained (e.g. Mirlees, 1967; Chakravarty, 1969). This 8 illustrates a general problem with models founded on utilitarianism: they may imply very 9 large sacrifices from one generation or other group. This argument also assumes that the 10 model captures accurately the structure of the economy; typically, however, these models 11 imply much higher rates of return on capital than are in fact observed in LDCs. For 12 example, Chakravarty (1969) assumes constant return on capital at 33 percent. Instead, the 13 small differences between advanced and developing countries in observed rates of return in 14 spite of large differences in capital-labor ratios suggests either that the economies are not 15 on the same production function, or that the constant returns to scale production function 16 models employed are inappropriate. (See Stiglitz, 1988, Lucas, 1988). Manne (1994) uses 17 a standard growth model to examine the relation between discount rates and savings rates in 18 the context of developed economies. He finds that discount rates of one or two percent 19 imply an unrealistically rapid near-term increase in the rate of investment. Manne thus 20 concludes that a rate this low is grossly inconsistent with observed or plausibly anticipated 21 behavior. 22 23 Manne's analysis can, alternatively, be interpreted as showing that the intertemporal 24 equilibrium established by market economies differs markedly from that corresponding to 25 the solution of an intertemporal maximization problem based on a reasonable social welfare 26 function. Such results are consistent with standard life cycle models, without government 27 intervention. On the other hand, they are not consistent with dynastic models, in which 28 each generation incorporates into its own utility function the utility of future generations in 29 a manner exactly analogous to the way future generations are incorporated into the social 30 welfare function (Barro date). However, considerable evidence weighs against Barro's 31 hypothesis. 32 33 4.3.5 Discounting Utility for Empathic Distance 34 35 Rothenberg (1993) and Schelling (1993) have suggested that although non-zero pure time 36 preference might make sense for an initial two or three decades, beyond a certain future 37 point it makes no sense to apply further discounting of consumption for pure time 38 preference. Thus: "as the future recedes. single generations come to be perceived more 39 and more as homogeneous entities (Rothenberg). Similarly: "time may serve as a kind of 40 measure of distance Beyond certain distances there may be no further depreciation for 41 time, culture, geography, race, or kinship" (Schelling). A graph of the fraction of face 42 value accorded to each successive generation (for constant real consumption) would thus be 43 a series of declining, successively shallower steps that eventually reach a horizontal plateau. 44 A deep plateau signifies major discounting for empathic distance; a horizontal line 10 1 beginning and remaining at unity is the zero pure time preference rate across generations 2 recommended by Ramsey. Policy based on empathetic distance (a shelf lower than unity) 3 may be more defensible in a normative sense when the action is refraining from conferring 4 a windfall gain (as in penurious aid budgets) than when it involves the imposition of 5 windfall damage (as in climate change's effects on future generations). 6 7 4.3.6 Discounting for Rising Levels of Consumption and Utility 8 9 Even if future generations are given weight equal to that for current generations, so that 10 pure time preference (p) is zero, there could still be an important basis for discounting 11 future consumption: people are expected to be better off, so that an extra unit of 12 consumption would not be worth as much in the future as today. Thus, if technological 13 change continues to proceed at the rate at which it has over the last century, with 14 productivity and living standards doubling every thirty years or so, then marginal changes 15 in consumption of those future generations should be weighed much less. This 16 consideration is captured by the second right-hand term in equation 4.1. 17 18 There are two questions, corresponding to the two elements in the final term of the 19 equation. First, what are reasonable expectations concerning increases in per capita income 20 (growth rate g in the equation)? Second, how should intertemporal differences in expected 21 consumption per capita be translated into social weights, that is, marginal valuations of 22 dollars of future income. This second question refers to the parameter Θ, the elasticity of 23 marginal utility. This parameter essentially tells how rapidly the additional utility from an 24 extra unit of consumption drops off as consumption rises. 25 26 No consensus on the first question has emerged. The low levels of productivity increase 27 over the past two decades have raised the question: were the high rates of technological 28 change experienced in the decades following World War II an aberration? Or are the low 29 rates experienced from 1973 until 1993 an aberration? 30 31 While it is also the case that no consensus has emerged on the answer to the second 32 question, there is a generally accepted methodology for approaching the issue. The 33 evaluation of any individual's consumption can be summarized by a utility function of the 34 form U = U(c) where the parentheses indicate that U, utility, is a function of c, per capita 35 consumption. Marginal utility is positive (U'(c) > 0), but it declines as consumption rises 36 (U"(c) < 0). That is why if consumption of some future generation is higher, the marginal 37 valuation of its consumption will be lower. The question is, how much lower? Formally, 38 the answer is given by the elasticity of marginal utility (Θ) or: [dU'/U']/[dc/c]. 39 40 Individuals in their day-to-day decision making reveal information about their perceptions 41 concerning their own utility functions, in at least two different contexts: behavior towards 42 risk and intertemporal allocation of consumption. In both contexts, there seems to be a 43 consensus on elasticities of marginal utilities in the range of 1 to 2, even though the 44 empirical studies require strong assumptions about the specific form of the utility function 11 1 (symmetric and time-separable). 2 3 Thus, one of the most commonly used utility functions, logarithmic utility, implies Θ =1, 4 meaning that if income rises by 1% the marginal utility of consumption falls by 1%. 5 Attempts to estimate this elasticity by Fellner (1967) and Scott (1989) both place it 6 somewhat higher, at 1.5; whereas recent estimates reviewed by Pearce and Ulph (1994) 7 place it in the vicinity of 0.8. 8 9 Just as the choice of the rate of pure time preference (p) has important implications for 10 intergenerational equity, as discussed above, so does the choice of the elasticity of marginal 11 utility. The more weight the society gives to intergenerational equity, the higher the value 12 of Θ. Thus, a value of, say, 3, would mean that it would require a 30 percent rise in the 13 next generation's per capita consumption to warrant a 10 percent reduction in that of the 14 present generation; or, under a bleaker outlook, that if the future generation is expected to 15 be poorer than the present, the present would be prepared to accept a 30 percent reduction 16 in consumption to secure a 10 percent increase in that of the future generation (so long as 17 the two relative consumption levels did not reverse). Even a unitary value is equity 18 oriented, however. When Θ= 1, a 10 percent reduction in the richer generation's income 19 will be an acceptable trade-off for a 10 percent increase in that of the poorer generation, 20 even though the absolute reduction of the one exceeds the absolute increase of the other 21 (because the absolute consumption base of the one is larger than that of the other)². 22 23 4.3.7 Relationship between the Social Rate of Time Preference and Market Rates of Interest 24 25 Economists have long recognized that a competitive market equilibrium yields a (Pareto) 26 efficient outcome, under appropriate conditions (perfect competition, no externalities, etc.). 27 The distribution of income that it yields, however, has no special merit; that is, it does not, 28 in general, maximize any particular social welfare function. It is a well recognized 29 function of government to intervene in the distribution of income, e.g. by establishing 30 programs for the very poor. By the same token, the intertemporal distribution of welfare 31 that emerges from the market will not, in general, maximize any particular social welfare 32 function discussed in the preceding section. While it is a legitimate function of government 33 to intervene to change the intergenerational distribution of welfare, there is no presumption 34 that the government has in fact intervened so that the observed resource allocations are 35 those that maximize intertemporal social welfare. Moreover, in the case of climate change, 36 no one government exists to make these decisions. 37 38 In general, the market rate of interest--the relative price of consumption of one generation 39 in one year of its life to consumption in another year--will not equal the SRTP. In standard 40 life cycle models, even with no technological progress and an economy in steady state, 41 there would be no discounting for society's purposes -- each generation is identical, so the 42 marginal utility of consumption of each is the same. Nonetheless, the market rate of 43 interest will be positive in any efficient equilibrium under certain reasonable assumptions 44 about utility functions (such as individual impatience and zero bequest motive; Diamond, 12 1 1965). In such models the market rate of interest would thus always overestimate the SRTP. 2 Under some special conditions, with governments intervening with non-distortionary 3 taxation to optimally redistribute income across generations, then observed market rates of 4 interest will accord with the SRTP. But these are highly specialized conditions. (See 5 Stiglitz, 1985, Pestieau, 1972). The market rate of interest, of course, remains relevant, 6 because it reflects the opportunity cost of capital; the changes in consumption generated by 7 any change in policy will be strongly affected by the opportunity cost of capital, as the 8 discussion below will illustrate. 9 10 4.3.8 Discount Rate Estimates -- Prescriptive Approach 11 12 The approach described in the previous sections, under plausible assumptions, leads to low 13 discount rates for changes in consumption of future generations. With high rates of 14 productivity increase (and high g), of the order of 1.5%, and high values of the elasticity of 15 marginal utility (Θ), the social discount rate is of the order of 3%; with low rates of 16 productivity increase, of the order of .5%, and low values of the elasticity of marginal 17 utility, the social discount rate is of the order of .5%. 18 19 It must be emphasized that these discount rates apply to consumption only, and that they 20 can be applied only after the foregone benefits of other investments have been included in 21 the costs of the program. 22 23 In general, there is no reason why the discount rate should be constant over time even if p 24 and Θ are constant, since g need not be constant. In fact, if we assume a gloomy scenario 25 where future output and consumption decline, then g and thus the SRTP may be negative 26 (Munasinghe, 1993). 27 28 Developing countries, with higher rates of productivity increase, can justify higher rates of 29 discount, at least until the gap between their standards of living and those of the more 30 developed countries have been closed. With labor productivity increases and per capita 31 income growth of the order experienced by the Asian miracle countries of 5 to 8% per year, 32 and elasticities of marginal utility of 2, discount rates of the order of 10% to 16% could be 33 justified. Similarly, low-income countries close to subsistence levels could have high 34 elasticities of marginal utility (rapid dropoff of marginal utility from initially extremely high 35 levels associated with privation), so that their SRTPs could be high even if they were 36 experiencing slow growth over long periods. These distinctions have important 37 implications for climate change policy, because they would tend to mean that the calculus 38 of trading off present abatement costs against future benefits from avoidance of climate 39 change damage could be less attractive for developing countries than for industrial 40 countries. However, there are other elements in the calculus that could go the other way, 41 such as the likelihood of higher relative future damage from climate change for the 42 developing countries (see chapter 6). 43 44 Specific applications in the still new economic literature on climate change have adopted 13 1 important differences in estimation of the discount rate. To follow the approach suggested 2 by Cline (1992), with a zero rate of pure time preference (p), and using the consumption 3 growth rate of 1.6% per capita from the IPCC scenarios (IPCC 1992) multiplied by an 4 elasticity of marginal utility (Θ) of 1.5, gives an SRTP of 2.4%. If instead if is assumed that 5 per capita growth is only 1% (perhaps because of slower growth after 100 years), or if Θ = 6 1, then the SRTP becomes 1.5%. After taking account of the share of resources coming out 7 of capital (20% economy-wide, versus 80% out of consumption) and taking into account 8 the opportunity cost of displaced capital and depreciation, the effective discount rate 9 becomes 2% to 3%. 10 11 4.4 Formulation of Descriptive Approach 12 13 As noted above, on ethical grounds, it is difficult to support a rate of pure time preference 14 much above zero. On the same ethical grounds, however, it is equally difficult to support 15 development assistance budgets for the OECD countries that average as low as one quarter 16 of one percent of GDP, to cite one example. Yet this is what occurs in the real world. The 17 descriptive approach to the discount rate looks at returns to investments in the real world, 18 and with this information seeks intertemporal efficiency. It asks: could consumption be 19 increased at one date without decreasing it at any other? The descriptive approach says 20 that if a policy is not intertemporally efficient, it should not be adopted. 21 22 An important difference between the two approaches is that the descriptive approach 23 includes the opportunity cost of capital directly, while the prescriptive approach includes it 24 indirectly, as the box illustrates (and as discussed below with respect to shadow pricing 25 capital). Most climate change optimization models (e.g. Nordhaus, 1993a, b; Peck and 26 Teisberg, 1992; Manne et al., 1993) rely on the descriptive approach. In practice, both 27 approaches may lead to similar results, and similar policy recommendations. 28 29 4.4.1 Returns to Investment 30 31 Nordhaus (1994), Lind (1994), Birdsall and Steer (1993), and Manne (1994), among others, 32 have all stressed the importance of the opportunity cost of capital. Most investments return 33 far more than the 1% to 2% suggested above as the appropriate long-term discount rate for 34 consumption. A review of World Bank projects estimated a real rate of return of 16 percent 35 at project completion; one study found returns of 26% for primary education in developing 36 countries. Even in the OECD countries, equities have yielded over 5% for many decades, 37 after corporate and other taxes, comparable to a pretax rate of at least 7%. An investment 38 at even 5% returns 18 times more than one at 2% over 100 years. Thus, society would be 39 foolish to forgo a 5% investment for a 2% investment. 40 41 Further, selecting a discount rate of 2% implies far more investment than actually occurs in 42 any country now, and thus would require a big jump in savings rates to finance the 43 increased investment. But even if savings could be increased enough to drive the discount 44 rate to one or two percent, climate change investments would still have to compete with 14 Example: Project Evaluation using prescriptive and descriptive approaches Suppose a greenhouse mitigation project is under consideration. If undertaken now, it will cost $1 million. If not undertaken, a new sea wall might be required in year 50, costing $10 million. If it is necessary, building a sea wall would avoid damages of $ 1 million per year. capital cost: $ 1 million time until damages begin 50 years cost of sea wall, year 50 $10 m avoided damages, years 50,51,52,53 1 m/yr opportunity cost of capital: 5% The decision maker has 4 options: a. Do nothing (year 0), do nothing (year 50) b. Do nothing (0), build sea wall if necessary (50) -- C. Mitigation project (0), do nothing (50) d. Other investment (0), build sea wall if necessary (50) The stream of benefits is as follows: Option (year) 0 50 51 52 a. 0 0 0 0 b. 0 -10 1.0 1.0 C. -1 1.0 1.0 1.0 d. -1 11.5 1.0 1.0 -10 =1.5 At most plausible discount rates, option b dominates option a -- i.e. if the sea level rises, it is better to build the sea wall than do nothing. Option d dominates option C, as investing the $1 million in year 0 at 5% yields $11.5 million in year 50, enough to build the sea wall with $1.5 million left over. But option d may be institutionally infeasible, as there may be no way to put aside $1 million today and leave it untouched for 50 years in a sort of Fund for Future Greenhouse Victims. If d is infeasible, then the choice between b and C will depend on the value attached to the extra consumption along path b in years 0 to 49; this will depend on the consumption rate of discount. 1 many other public and private investments offering higher returns. Birdsall and Steer of the 2 World Bank (1993) explain the problem: 3 15 1 we feel that 2 meeting the needs Estimated returns on financial assets and direct investment 3 of future 4 generations will Asset Period Real return (%) 5 only be possible if High-income industrial 6 investable countries: 7 resources are equities 1960-84 5.4 8 channeled to bonds 1960-84 1.6 9 projects and nonresidential capital 1975-90 15.1 10 programs with the gvt. short-term bonds 1960-90 0.3 11 highest U.S. 12 environmental, equities 1925-92 6.5 13 social, and all private 14 economic rates of capital, pretax 1963-85 5.7 15 return. This is corporate capital, 16 much less likely to posttax 1963-85 5.7 17 real estate 1960-84 5.5 happen if the farmland 1947-84 5.5 18 discount rate is set Treasury bills 1926-86 0.3 19 significantly lower 20 than the cost of Developing countries: 21 capital. primary education various 26 22 higher education various 13 23 That opportunity costs Sources: Ibbotson and Brinson 1987; Stockfisch 1982, 1989; 24 (market rates of return) Brainard, Shapiro, and Shoven 1991; Psacharopoulos 1985; 25 usually exceed the SRTP Nordhaus 1994, Cline 1992. 26 suggests the existence of 27 better alternatives than 28 those barely satisfying, 29 say, a two percent rate of 30 return criterion. At this 31 point the question becomes: why has the SRTP not been brought into accord with observed 32 market rates of return? In the context of climate change, the central argument of the 33 prescriptionists is that other alternatives are not feasible. As suggested earlier, society is 34 not likely to be able to set aside investments over the next three centuries and earmark the 35 proceeds the eventual compensation of those adversely affected by climate change. Even if 36 such a commitment could somehow be made, there would be no guarantee that the rate of 37 return on capital would remain where it is today over this period. 38 39 Accordingly, if the long-term consumption rate of discount is 1% to 2%, say the 40 prescriptionists, then a climate change investment returning 2% is better than no investment 41 at all. To the argument that a discount rate of 2% is glaringly inconsistent with observed 42 behavior (e.g., government spending on education or research, development assistance by 43 donor countries), prescriptionists reply that just because the government fails to allocate 44 resources properly in one area is no reason to insist that decisions in other areas be 16 1 consistent with that initial decision. 2 3 4.5 Discounting for Risk 4 5 The standard treatment of risk in models involving impacts over a single individual's life is 6 not to raise the discount rate for riskier projects, but instead to convert probabilistic 7 consumption patterns into their certainty equivalents and then discount the results at the 8 standard rate. The same should be true for the pure time preference component of the 9 SRTP when discounting across generations. This component should remain unchanged 10 with respect to risk, and the influence of risk should be incorporated in the stream of 11 expected consumption effects instead. 12 13 There would seem to be an argument for varying the growth-based component of the SRTP 14 with respect to risk, however. If there is uncertainty about the rate of per capita income 15 growth, g, then consider the effect on the component Θg in the SRTP. Suppose there are 16 two scenarios each with 50 percent probability: per capita income growth of 1 percent and 17 per capita growth of 2 percent. There will be two resulting possible streams of marginal 18 utility over time. The stream of expected value of marginal utility will be the average of 19 these two streams. But if marginal utility is a convex function of consumption³, this 20 average will be greater than the stream of marginal utility generated by considering the 21 simple average growth rate over time, 1.5 percent. That is, with diminishing marginal 22 utility, at any point in time marginal utility along the path for 1.5 percent growth will be 23 closer to that of the 2 percent growth path than to that of the 1 percent growth path. 24 Correspondingly, the expected marginal utility path lying halfway between the two 25 scenarios will coincide with the marginal utility stream for a growth rate closer to 1 percent 26 than to 2 percent. Essentially, the expected value of marginal utility is greater than the 27 marginal utility of expected income. On this basis, there would be grounds for reducing the 28 growth-based component of the SRTP under circumstances of risk. 29 30 Because the risk in predicting per capita growth on centuries-scale horizons is high, this 31 consideration is particularly relevant for the problem of climate change. 32 33 4.6 Producer or Consumer Interest Rates? 34 35 A large literature has debated whether, for small changes in consumption levels, observed 36 rates of interest provide the appropriate basis of trading off government expenditures and 37 changes in consumption of individuals of different generations at different dates. In a 38 world in which there was no taxation, no market distortions, and a single individual living 39 forever (or else "dynastic" utility functions in which individuals take full account of their 40 descendants' welfare), society's intertemporal discount rate should presumably correspond 41 to that of the representative individual, and his trade-offs across time would be given by the 42 market rate of interest. 43 44 But these assumptions are not generally satisfied, as evidenced by the marked discrepancy 17 1 between the lower interest rates on savings typically facing consumers and the higher rates 2 earned on investments by producers. 3 4 Part of the source of the frequent confusion about appropriate discount rates is a confusion 5 about what is being discounted. In the social discount rate approach, what is being 6 discounted is changes in consumption at different dates. Typically, in the producer interest 7 rate approach, what is being discounted are the direct cash flows from the project. The two 8 need not be inconsistent; under certain conditions, using producer interest rates in 9 evaluating direct cash flows and using the social discount rate in evaluating changes in 10 consumption will give the same results -- but only under the specialized conditions 11 specified earlier. 12 13 Four schools of thought have emerged on the proper discount rate for public policy. One 14 suggests that it should be the producer interest rate, representing the private rate of 15 transformation between investment today and output in the future; one, the consumer 16 interest rate; one, that it should be some combination of the two; and one, that it should 17 have nothing to do with either. In the absence of any non-distortionary intertemporal social 18 welfare maximization by the government, we have already noted the general result that the 19 rate of discount should be neither. 20 21 In special cases, however, one of the other three schools of thought may be correct. 22 For instance, if the government were comparing two projects, both of which cost the same, 23 and both of which yielded their output in the same year, then a comparison of the rates of 24 return would provide an appropriate basis of choosing among projects. Cline (1992) 25 proposes a shadow price of capital set equal to the present discounted value of an annuity 26 paying equal annual installments over a lifetime of N years (set at 15 years for the lifetime 27 of typical capital equipment), with a return of r equal to the rate of return on capital, and 28 discounted at the social rate of time preference (SRTP). With plausible ranges for N, r, and 29 SRTP, the shadow price of capital tends to be in the range of 1-1/2 to 2 units of 30 consumption equivalent per unit of capital. 31 32 If a public project displaced a private project of equal cost, the same reasoning 33 would imply that the government should only undertake the public project if the rate of 34 return exceeded the rate of return in the private sector (Stiglitz, 1982). More generally, 35 when the government undertakes a project, complex general equilibrium effects can be 36 expected. The full consumption effects of these changes (or their consumption equivalents) 37 need to be calculated, and then discounted using the SRTP (Arrow and Kurz, 1970; 38 Feldstein, 1970; Bradford, 1975; Stiglitz, 1982). Implementation of this approach can 39 apply a shadow price of capital to convert all investment effects into their (magnified) 40 consumption equivalents, and then apply the social rate of time preference for consumption 41 to discount the resulting stream of consumption equivalents (Lind, 1982; Gramlich, 1990). 42 A shadow price of capital greater than unity reflects the fact that the rate of return on 43 capital exceeds the SRTP; care must be exercised in evaluating the shadow price and its 44 path over time (Cline, 1992). 18 1 Sometimes, as just discussed, one can look at the direct expenditures and apply an adjusted 2 discount factor, the public sector discount rate. There is a large literature emphasizing 3 different aspects of the adjustment methodology. One body of literature emphasizes the 4 effects on consumption versus investment, deriving a weighted average of the consumption 5 and investment rates of return, with weights depending on the respective importance of the 6 sources of finance (Sandmo and Dreze, 1971). Within the literature on optimal taxation and 7 production (where the discrepancy between producer and consumer rates of interest arises 8 from optimally determined tax rates), if the government is relatively unrestricted in the set 9 of commodity taxes that it can impose, the producer rate of interest should be used to 10 discount (Diamond and Mirrlees, 1971; Pestieau, 1974). However, in the more relevant 11 regime in which government faces constraints on the sets of taxes that are imposed, there is 12 no simple relationship between the appropriate public sector discount rate and the producer 13 interest rate (Stiglitz and Dasgupta, 1971, Stiglitz, 1985, 1988 ). 14 15 4.7 Discounting Environmental Impacts 16 17 The essence of social discounting is to convert all effects into their consumption equivalents 18 at the proper relative prices, and then to discount the resulting stream of consumption 19 equivalents at the social rate of time preference. Incorporating environmental effects thus 20 does not change the SRTP itself, but requires special attention to the proper relative pricing 21 of environmental goods over time. While there is a generally accepted approach to valuing 22 goods, there is less consensus concerning valuation of environmental impacts, other than 23 those valued solely for their impacts on the production of goods. The question is addressed 24 within the public finance literature in terms of the valuation of public goods. Assume 25 consumers have utility functions of the form U = U(c,G) where G is some public good 26 (e.g., quality of the environment). Then marginal rates of substitution between c at 27 different dates may bear no correspondence to marginal rates of substitution between G at 28 different dates. This implies that there is no justification for discounting environmental 29 degradation at market rates of interest The appropriate procedure entails converting the 30 environmental change into contemporaneous consumption benefits, and discounting those. 31 32 Technical progress and structural change over the past several decades have resulted in 33 improvements in several measures of environmental quality in the developed countries 34 (World Bank 1992). Moreover, recorded reserves of many "exhaustible resources" have 35 actually increased over the last century, accompanied by a fall in their real prices. This 36 provides evidence that continued growth in per capita incomes will result in improved 37 environmental quality in at least some dimensions. Some have supposed, however, that 38 environmental degradation will occur as society grows (Weitzman 1993). If this occurs or, 39 more likely, if the environment is an income elastic good on which people are willing to 40 spend relatively more as their income rises, then the marginal rate of substitution between 41 environmental quality and private goods will systematically change over time, toward a 42 higher relative marginal value of the environment. The result equivalent to using a low (or 43 even negative) discount rate for environmental amenities (see annex 4A), with prices 44 unchanged. However, it is important to reiterate that this process involves properly valuing 19 1 future environmental benefits in arriving at the future flow of consumption, and does not 2 change the appropriate discount rate itself at which the consumption stream should be 3 discounted. 4 5 Much of the environmental literature critical of cost-benefit analysis, in contrast, argues for 6 a zero discount rate without seeming to recognize the distinction between a zero rate of 7 pure time preference (p) and a zero social rate of time preference (SRTP; see, e.g., Daly 8 and Cobb, 1991; Norgaard and Howarth, 1991). But from equation 4.1, so long as 9 consumption growth is positive there will be a nonzero SRTP. Similarly, some modern 10 philosophers make the same mistake (e. g. Parfit, 1984; Cowen and Parfit, 1992). 11 12 Finally, there has been considerable discussion about the proper discounting method for 13 environmental projects of institutions such as the Global Environmental Facility of the 14 World Bank (see e.g. Munasinghe, 1993). The method that follows from the social 15 cost-benefit approach is to obtain consumption equivalents of the environmental effects over 16 time and then discount at the SRTP. The consumption equivalents of carbon emissions, for 17 example, can be evaluated by applying the carbon shadow price from models of climate 18 change damage and optimal abatement, so long as those models themselves are 19 implemented with discounting based on appropriate values for the rate of pure time 20 preference and the elasticity of marginal utility (Cline, 1993). Within a fixed institutional 21 investment budget, it may be that the collection of potential projects that successfully passes 22 a cost-benefit test on this basis more than exhausts available funds. If so, efficient 23 trade-offs within the menu of projects will appropriately involve cutoffs at a higher shadow 24 price in funds drawn from the institutional budget but always with benefits evaluation 25 based on the consumption equivalence principle just outlined. 26 27 28 4.8 Implications for Sustainable Development 29 30 Economics has long recognized the concept of sustainability. Hicks (1938) used the 31 idea in defining net national income. Neoclassical growth theory (Phelps date, Meade 32 date, Robinson date) advanced the idea of sustainability in its formulation of the "Golden 33 Rule": that configuration of the economy giving the highest level of consumption per head 34 that can be maintained indefinitely. A recent extension has proposed the "Green golden 35 rule" (Beltratti, Chichilnitsky, and Heal date). The recent economic debate on sustainable 36 development has focused on two issues: 1) intertemporal equity and 2) capital accumulation 37 and substitutability. 38 39 Intertemporal equity. Robert Solow's definition (Solow, 1992) focuses on 40 intertemporal equity: sustainable development requires that future generations be able to be 41 at least as well off as current generations. Sustainable development does not preclude the 42 use of exhaustible natural resources, but requires that any use be appropriately offset. 43 Likewise, any environmental degradation must be offset by an increase in productive capital 44 sufficient to enable future generations to obtain at least the same standard of living as those 20 1 alive today. 2 3 Capital accumulation and substitutability. Solow's definition, and much of 4 economic theory to date, implicitly assumes that substitutes exist or could be found for all 5 resources. If substitution possibilities are high, as most evidence from economic history 6 indicates, then no single resource is indispensable, and intertemporal equity stands as the 7 only crucial issue (Pearce 1988). If on the other hand, human and natural capital are 8 complements or only partial substitutes then different classes of assets must be treated 9 differently, and some assets are to be preserved at all costs. 10 11 Some have argued that the future damages from climate change are on the order of 1 to 2 12 percent of GDP or less, whereas aggressive abatement costs are larger (Nordhaus, 1993). If 13 this is the case, then taking costly actions now to mitigate global climate change later must 14 rest on one of two arguments: First, that prudence calls for avoiding a large-scale 15 experiment with the planet, and avoiding climate change lies beyond normal economic 16 calculus; or second, that the potential exists for large, sudden, irreversible non-linearities 17 with major effects on the economy, particularly the economy of certain countries or regions. 18 19 Others have argued that if a longer time horizon is considered than that of the conventional 20 benchmark of 2xCO₂, and if upper bound warming and damages are taken into account, and 21 considering the range of estimates for abatement costs, then even a standard economic 22 analysis using the social discounting approach outlined here can conclude that the benefits 23 of aggressive action outweigh the costs on economic grounds (Cline, 1992). This result 24 obtains even though technical progress permits future per capita incomes eventually to be 25 much higher than present, because given conventional estimates of the elasticity of marginal 26 utility, the intergenerational bargain of exchanging modest costs today for large avoided 27 damages in the future remains attractive. In this case, the two considerations just noted 28 simply reinforce this conclusion. 29 30 In many developing countries, Solow's definition would not be viewed as acceptable, since 31 it seems to place no weight on their aspirations for growth and development. Further, 32 formal models analyzing optimal development paths using a min-max (Rawlsian) criterion 33 would, of course, focus exclusively on the welfare of the less developed countries in the 34 first place (Note that in Rawls' formulation, Θ= ∞). But the prescription would be simple: 35 massive redistribution from the North to the South immediately, without introducing the 36 complication of long-term environmental problems. Even if there were limits on the 37 transfers, it would suggest that all of the costs of mitigation--including those occurring 38 within the South-- be borne by the North. 39 40 Of course, even the utilitarian approach (Θ< ∞) would tend to lead to higher general income 41 transfers to poor countries than presently observed. Adherents of the descriptive approach 42 would ask why the utilitarian construct is appropriate when considering intergenerational 43 equity (as in the identification of the SRTP suggested in equation 4.1) if it is not applied in 44 practice across (or, for that matter, within) countries at the present. In one sense, this 21 1 question is another application of the principle suggested above that in the absence of 2 optimal redistribution intervention by the government, observed market rates (in this case of 3 North-South transfers) will not necessarily or likely equal social rates. Alternatively, the 4 equity norm suggested here may not be widely shared by governments or voters. 5 6 Some might seek to explain the paucity of present-day North-South transfers on grounds of 7 incentive effects. Thus, the massive marginal tax rates on the North that would be 8 required to equalize income levels with the South could seriously reduce the amount of 9 output available for redistribution. Perhaps more relevant (in view of the modest but 10 unfulfilled international targets for grant aid), the problems of still unaddressed poverty 11 within the North and sharp inequality within many developing countries complicate 12 attempts to improve overall welfare through North-South transfers. The fundamental 13 explanation, however, is that each country tends to consider primarily the welfare of its 14 own citizens, and only secondarily that of others. 15 16 Despite the political constraints on present-day North-South transfers that would otherwise 17 be recommended by the utilitarian approach, the time-discounting concepts of that 18 approach, and the SRTP in particular, remain valid subject to these constraints. Thus, 19 consider a matrix with two rows North and South -- and two columns -- present and 20 future. The SRTP can appropriately be applied between the two columns along each row, 21 even if there is a barrier to its application between the two rows. Leaders and publics in 22 developing countries have cause for concern about their descendants just as do their 23 counterparts in developed countries. As noted above, however, the value of the SRTP is 24 likely to be higher for the South row than for the North row. 25 26 At the same time, both the Rawlsian and utilitarian approaches imply that the South should 27 actively engage in mitigation financed by transfers from the North, so that efficient 28 mitigation can be obtained. Any Pareto efficient development path (including any 29 reasonable definition of sustainable development) must have this property of efficient 30 mitigation. Thus, the level of mitigation should be set based on the eventual target of 31 greenhouse gas stabilization and implied levels of world emissions (without regard to where 32 those emissions originate). The magnitudes of actions required to attain those levels of 33 world emissions will, of course, depend on the rates of growth of the less developed 34 countries as well as the increased energy efficiency among both the developed and 35 developing countries. 22 1 Annex 4A 2 Methodological Notes on Discounting 3 4 4A.1 Intertemporal Maximization of Well-Being 5 6 In an influential series of articles, Koopmans (Koopmans, e.g., 1960) conducted a series of 7 thought-experiments on intertemporal choice so as to see the implications of alternative sets 8 of ethical assumptions in plausible worlds. He suggested that we can have no direct 9 intuition about the validity of discounting future well-beings, unless we know something 10 concrete about feasible development paths. Applying this approach, Mirrlees (1967) and 11 Chakravarty (1969) showed that in plausible economic models for developing countries, not 12 to discount future well-being could imply that the present generation be asked to save and 13 invest around 50 per cent of gross national product -- a stiff requirement when GNP is low. 14 Nonetheless, these models tended to assume high rates of return on capital (a constant 33 15 percent rate in Chakravarty, 1969) and to consider time periods of decades rather than 16 centuries. It is unclear that their findings hold for the centuries-scale problem 17 of climate change, in part because of the much lower likely average return to capital over 18 this horizon. 19 20 Koopmans (1960) considered the set of feasible consumption paths (from the present to the 21 indefinite future) and the corresponding et of welfare or "well-being" paths. These paths 22 could then be ordered to select the optimum path of well-being, according to the criterion: 23 24 4A.1) z=√ᵣ₀ W(c,) e⁻ptdt 25 26 where p > 0. 27 28 Correspondingly, the discount rate for the time path of consumption is: 29 30 4A.2) i,=i(c,) =p+0(c,) [dc,/dt]/c, 31 32 where Θ(c) is the elasticity of marginal well-being, or marginal utility, at time t (Arrow and 33 Kurz, 1970). (Note that whereas the main text treats this term as a constant, it is explicitly 34 considered to vary with the level of consumption in the treatment here.) Along a full 35 optimum path, the consumption rate of discount equals the productivity of capital (i.e. the 36 social rate of return on investment). This is the famous Ramsey Rule (Ramsey 1928). 37 38 A convenient form of W is that giving a constant elasticity of marginal utility, such as: 39 40 4A.3) W(c) = c-Θ 41 42 As discussed in the text, the larger is the rate of pure time preference (p) the lower is the 43 weight accorded to future generations' well-being relative to that of the present generation. 44 Mirrlee's (1967) computations essentially introduced this sort of bias (p > 0) as a way of 23 1 countering the advantages to be enjoyed by future generations, should the productivity of 2 capital and technological progress prove to be powerful engines of growth. 3 4 As noted in the text, a higher value of Θ means greater emphasis on intergenerational 5 equity. As Θ ∞, the well-being functional in 4A.1) resembles more and more the 6 Rawlsian max-min principle; in the limit, optimal growth is zero. 7 8 In 4A.3), W(c) is has no minimum value. If p = 0, this ensures that very low consumption 9 rates are penalized by the optimality criterion reflected in (4A.1). On the other hand, if 10 p were positive, low consumption rates by generations sufficiently far in the future would 11 not penalized by (4A.1). This means that unless the economy is sufficiently productive, 12 optimal consumption will tend to zero in the very long run. Dasgupta and Heal (1974) and 13 Solow (1974a) showed in a model economy with exhaustible resources that optimal 14 consumption declines to zero in the very long run if p > 0 and in the absence of technical 15 change, but that it increases to infinity if p=0. 16 17 It is in such examples that notions of sustainable development can offer some analytical 18 guidance. If by sustainable development we mean that the chosen consumption path should 19 never fall short of some stipulated, positive level, then it follows that the value of P would 20 need to be adjusted downward in a suitable manner to ensure that the optimal consumption 21 path meet the requirement. This was the substance of Solow's remark (see Solow, 1974b) 22 that, in the economies of exhaustible resources the choice of P can be a matter of 23 considerable moment. 24 25 So far an assumption underlying this discussion has been that well-being or utility has not 26 been bounded. If we restrict well-being to be bounded, other results obtain, because of the 27 mathematical properties of the space of bounded sequences. For such sequences present 28 value calculations are not rich enough to capture all of the subtleties of evaluation of a 29 utility stream. Instead, one has to add to the present value another term. Chichilnisky 30 (1994) has suggested that the present value term represents the requirement that the future 31 should not be a dictator over the present; and that the second term represents the 32 requirement that the present should not be a dictator over the future. This second term will 33 in general have the form of a long-term average. It could be approximated by minimum 34 requirements for the long run stocks of environmental resources. This formulation attempts 35 to account for both basic levels of human needs and limitations on total resources. 36 37 Resource Sourcing and the Consumption versus Investment Discount Rate 38 39 Sandmo and Dreze (1971) address the choice of the correct rate of discount to use in the 40 public sector when there are distortions in the economy, e.g. in the form of taxes, which 41 prevent the equalization of marginal rates of substitution and transformation in the private 42 sector. Under certain assumptions, the corporate tax drives a wedge between the marginal 43 rate of time preference of consumers and the marginal rate of transformation in private 44 firms. 24 1 They find that for a closed economy: 2 3 4A.4) 1+r<1+i< 1 r/l-t 4 5 where r is the consumer interest rate, t is the tax rate, and i is the public sector's discount 6 rate. This rate should thus be a weighted average of the rate facing consumers and the tax- 7 distorted rate used by firms. Since 1+r measures the marginal opportunity cost of 8 transferring a unit of resources from private consumption, and since 1+ r/(1-t) is the 9 measure for transfers from private investment, a unit of resources transferred from the 10 private to the public sector should be valued according to how much of it comes out of 11 consumption and how much out of investment⁴. 12 13 The general approach taken throughout this chapter is to calculate impacts on consumption, 14 and to find the appropriate discount factor for discounting those changes. We are, in effect, 15 taking consumption as our numeraire. This is convenient and natural, but there are other 16 ways of performing the calculations, using other numeraires. Using other numeraires, 17 relative prices over time (discount factors) will differ from those associated with the 18 consumption numeraire. The failure to recognize this is a great source of confusion in the 19 discounting literature. Thus, as suggested in section 4.7, if environmental goods had been 20 chosen as the numeraire, the discount rate could even have been negative. It is important to 21 remember, however, that nothing substantive depends on the choice of numeraire. 22 23 By the same token, if for example systematic relationships exist between the outputs and 24 inputs of a project and the total changes in consumption they induce, and if consumption 25 changes over time, then instead of discounting total consumption impacts as the SRTP, one 26 could calculate the direct impacts using another discount factor. The discussion above of 27 the Sandmo-Dreze formulation is a case in point. These alternatives do not provide 28 prescriptions, only alternative formulas for arriving at the same point. 29 30 The discrepancy between public evaluation of a marginal dollar to future generations, and 31 individuals' own intertemporal evaluations can arise even in the case of very simple social 32 welfare functions. Thus, assume that there is a utilitarian social welfare function, which 33 simply adds up the utility of successive generations, and for simplicity, assume each 34 generation lives for only two periods. The t generation's utility is represented by a utility 35 function of the form: 36 37 4A.5) U'(c',, c'₁+₁) 38 39 where the first argument refers to consumption the first period of the individual's life, the 40 second to consumption the second period. Then observed market rates of interest refer to 41 how individuals are willing to trade off consumption over their own life. These may or 42 may not bear a close correspondence to how society is willing to trade off consumption 43 across generations. The former corresponds to u'₂/u'₁, while the latter corresponds to 44 25 1 If the government has engaged n optimal intertemporal redistribution and does not face 2 constraints in imposing lump sum (i.e. nondistorting) taxes on each generation, then the two 3 will be the same, and equal to the marginal rate of transformation (in production, i.e. the 4 return to investment). But whenever either of these conditions is not satisfied, then market 5 rates of interest facing consumers (measuring their own marginal rates of substitution) need 6 bear no close relationship to society's marginal rate of substitution across generations. 7 Diamond and Mirrlees (1970, 1971) show that if the only reason for the discrepancy 8 between producer and consumer interest rates is optimally determined commodity taxes, 9 and there are no after-tax profits, possibly because there is a 100% pure profits tax, then the 10 government should use the producer rate of interest. Stiglitz and Dasgupta (1971) have 11 shown that this result does not hold if either of these assumptions is dropped. 12 13 Under certain circumstances (in particular the existence of optimal intergenerational lump 14 sum transfers), asymptotically the producer rate of interest will equal the pure rate of time 15 preference of society. More generally, when the government must resort to 16 distortionary taxes, not only is this not true, but the rates of discount employed may reflect 17 distributional considerations (see Stiglitz 1985). 26 1 Endnotes 2 3 & .This approach ignores diversity of individuals within any generation, and is thus subject to Schelling's 6 criticism. Other simplifying assumptions here include the use of a utilitarian social welfare function, the 7 assumption of the same utility function for each generation, and no recognition of changes in leisure (or, 8 alternatively, by the assumption that those impacts can be folded into a single consumption equivalent 9 variable). The standard models further assume that the elasticity of marginal utility with respect to changes in 10 consumption (Θ) is constant. Each of these assumptions could be lifted, complicating the analysis 11 substantially. The major effect would be to make the variables p and Θ depend on other, possibly 12 endogenous, variables, rather than taking the simple form postulated here. 13 2. With a non-utilitarian social welfare function, social welfare may be written in the form, e.g., 14 15 S = G(U(C)). 16 17 If G = U, then it is clear that the rate at which social marginal utility diminishes with increases in 18 consumption may differ from the rate at which private marginal utility diminishes, so that evidence about the 19 latter is only partially relevant for the former. 20 3. .There is a strong consensus within the economics profession that individual's marginal utility is convex. 21 The behavioral implications with respect to risk of the assumption that U" < 0 are consistently rejected by the 22 data (it would imply, in particular, that absolute risk aversion strongly increases with consumption). 23 4.For an open economy, the elasticity-adjusted rate on foreign loans also enters the calculus. However, for 24 analysis of a global issue, this extension is probably inappropriate, as globally the economy is closed. 27 1 References 2 3 Arrow, K.J. 1982. 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"On the Environmental Discount Rate," Journal of Environmental Economics and 38 Management, V. 26, no. 2, pp. 200-209. 39 40 Weizsacker, C.C. von, 1965. "Existence of Optimal Programs of Accumulation for an Infinite Time Horizon" 41 in Review of Economic Studies 32: 85-104. 42 43 Wetherill, G.W., and E.M. Shoemaker, 1982. "Collision of Astronomically Observable Bodies with the Earth" 44 in Leon Silver et al., Geological Implications of Impacts of Large Asteroids and Comets on the Earth, 45 Boulder, CO: Geological Society of America. 46 47 To be completed: 48 49 Phelps, E. Golden Rule article 50 51 Meade, J. Golden Rule article 32 1 Robinson, J. Golden Rule article 2 3 Beltratti, Chichilnitsky, and Heal, ... Green golden rule article 4 5 Thaler and Lowenstein 1989. 33 Chapter 1 Introduction: Scope of the Assessment Lead Authors: J. Goldemberg, R. Squitieri, J. Stiglitz, A. Amano, X. Shaoxiong, R. Saha January, 1995 1 INTRODUCTION: SCOPE OF THE ASSESSMENT 2 3 SUMMARY 1 4 1.1 INTRODUCTION 3 5 6 1.2 FEATURES OF CLIMATE CHANGE 4 7 8 1.3 CONTRIBUTION OF ECONOMICS 7 9 1.3.1 Risk 7 10 1.3.1.1 Portfolio Theory 8 11 1.3.1.2 Insurance 8 12 1.3.1.3 Precautionary investments 10 13 1.3.2 Sequential Decision Making 11 14 1.3.2.1 Value of information 11 15 1.3.2.2. Option value 11 16 1.3.3 Dynamics 12 17 1.3.3.1 Kaya Identity 12 18 1.3.3.2 Non-renewable resources, backstop technologies, and 19 emission reduction strategies 13 20 1.3.4 International Public Goods 14 21 1.3.4.1 Property rights 15 22 1.3.4.2 Paying For An International Public Good: Principles 23 and Approaches 15 24 1.3.4.4 Enforcement 17 25 1.3.4.5 Knowledge 18 26 1.3.5 Efficiency 18 27 1.3.5.1 Bankable permits 19 28 1.3.5.2 Exchange/risk efficiency. 19 29 1.3.5.3 Comprehensiveness 19 30 1.3.6 General Equilibrium 20 31 1.3.6.1 Intertemporal Substitution 20 32 33 1.4 EQUITY 21 34 1.4.1 General Issues 21 35 1.4.1 Intergenerational Equity 24 36 1.4.2 Within-country Equity 25 37 38 1.5 ECONOMICS OF POLICY ACTIONS 25 39 1.5.1 Zero-cost Options 26 40 1.5.2 Government Reform 26 41 1.5.2.1 Removing Energy Subsidies 26 42 1.5.2.2 Property Rights Reform 26 43 1.5.2.3 Administrative Reforms 27 44 1.5.2.4 Regulating Non-greenhouse Externalities 27 45 1.5.2.5 Special Problems of Economies in Transition 27 46 1.5.2.6 Examples of Efficiency-Increasing Policies 28 1 1.5.3 Market Failures and Government Responses 29 2 1.5.3.1 Revising national accounts 31 3 1.5.4 Innovation 32 4 1.5.5 Carbon Taxes and Tradable Permits. 33 5 1.5.5.1 A Double Dividend? 35 6 1.5.5.2 Energy Taxes 35 7 1.5.5.3 Tradeable Permit Markets. 36 8 1.5.5.4 Combining taxes with tradeable permits 36 9 1.5.5.5 Intertemporal patterns of taxation 36 10 1.5.6 Regulatory Approaches 37 11 12 1.6 SUSTAINABLE DEVELOPMENT 38 13 1.6.1 The Economic Concept of Sustainable Development 38 14 1.6.2 Implications of Sustainable Development for Developing 15 Countries 39 16 17 1.7 CONCLUSIONS 40 18 19 1.8 ENDNOTES 42 20 57 21 22 23 1.9 REFERENCES 58 24 25 26 1 SUMMARY 2 3 Climate change presents the analyst with a set of formidable complications: large 4 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, 5 long time lags between emissions and effects, an irreducibly global problem, wide regional 6 variation, and multiple greenhouse gases of concern. The risks of climate change are 7 highly asymmetrical, with a large probability of a small loss, and a small probability of a 8 large loss. Even in the presence of significant uncertainty, this asymmetry, plus the 9 principles of risk aversion and portfolio balancing provide the rationale for going beyond 10 no-regrets policies to those that incur net costs. 11 12 The atmosphere is an international public good, in that all countries benefit from each 13 country's reduction in greenhouse emissions; greenhouse gases are an international 14 externality, in that emissions by one country affect all other countries to the same extent. 15 16 Both public goods and externalities require a legal framework within which the 17 problems they pose can be addressed. No such legal framework now exists for global 18 climate change. Mechanisms for control of international public goods may include the 19 definition of property rights, the definition of limits to emissions and a consensus for 20 distributing the same in a fair and equitable manner. If, on the other hand, each agent acts 21 in its individual interest, the result will be too little of the public good and too much of the 22 externality. 23 24 Climate change demands a decision process that is sequential, can respond to new 25 information with mid-course corrections, and can include insurance, hedging, and the option 26 value of alternative courses of action. The challenge today is to identify short-term 27 strategies in the face of long-term uncertainty. The question is not, what is the best course 28 over the next 100 years, but rather, what is the best course for the next few years, knowing 29 that a prudent hedging strategy sill allow time to learn and change course. 30 31 Policy measures to reduce risks to future generations include 1) immediate reductions 32 in emissions; 2) R&D on new supply and conservation technologies; 3) continued research 33 on how much change is likely and what its effects will be; and 4) investments to assist in 34 adaptation if significant climate change occurs. A well-chosen portfolio of policies will 35 yield greater benefits for a given cost than any one option undertaken by itself. Striking the 36 appropriate balance requires taking into account costs, benefits, and risks. 37 38 In an interrelated global economic system, an attempt to reduce greenhouse gas 39 emissions in one region or one sector of the economy may be offset by increases in other 40 regions or sectors. This may occur through a) the loss of comparative advantage in the 41 carbon-intensive sectors of the regions that limit emissions; b) the relocation of industries; 42 or c) changes in world energy prices and the resulting shift in consumption. Any control 43 strategy must account for these global effects. 44 1 1 Issues of efficiency and equity can largely be separated. The Framework Convention on 2 Climate Change calls on all parties to implement cost-effective measures for abatement, 3 enhancement of sinks, and adaptation. The Framework Convention also explicitly requires 4 an equitable sharing of the burdens of response, recognizing the common but differentiated 5 responsibilities of the parties. Different countries will be affected differently by climate 6 change and by policy responses to it. The South is more likely to be adversely affected 7 than the North; moreover, developing countries often lack the financial and technical 8 resources to respond. The Framework Convention does not, however, include a formula for 9 sharing the costs of addressing climate change. 10 11 Efficiency requires that emission reductions occur where their cost is lowest, 12 irrespective of who bears the financial responsibility. Efficiency calls for removing energy 13 subsidies, reforming and clarifying property rights that affect energy use and carbon 14 storage, and reducing non-greenhouse externalities that have the side benefit of reducing 15 greenhouse emissions. Efficiency may also be promoted, and greenhouse emissions 16 reduced, by better information dissemination and by addressing capital market imperfections 17 that inhibit the adoption of energy-efficient technology. Dynamic analysis indicates large 18 potential gains from flexibility in timing of greenhouse reductions to allow for the 19 economical turnover of capital stock, and to allow time for the development of low-cost 20 substitutes. Policies that promote efficiency by requiring nations to face the full costs of 21 their actions will also address equity concerns. 22 23 Efficiency also calls for international mechanisms such as joint implementation and 24 coordinated economic instruments. Coordinated carbon taxes and tradable carbon emission 25 permits can correct the market failure associated with greenhouse emissions. 2 1 1.1 INTRODUCTION 2 3 In recent years, atmospheric emissions of greenhouse gases have risen significantly. 4 Concentrations are currently about 25 percent greater than at the beginning of the Industrial 5 Revolution. If current trends continue, concentrations will double from pre-industrial levels 6 before the end of the next century and, if unchecked, continue to rise thereafter (IPCC 7 1990). 8 9 The scientific community has noted the potentially serious effects of increased 10 concentrations. These climatic effects could, in turn, have further effects on the biosphere, 11 including an increase in mean global temperature, an increase in sea level, changes in 12 agricultural yields, forest cover and water resources, and a possible increase in storm 13 damage. 14 15 Increased concentrations of greenhouse gases are the result of fossil fuel burning, 16 livestock raising, and other human activities. Concerted action on the part of individuals 17 and governments will be required to slow the increase in concentrations. Changes in 18 greenhouse gases concentrations and the analysis of the climatic and other physical 19 consequences of those changes lie within the purview of the physical sciences. The role of 20 human activity in generating greenhouse gases, the consequences of those changes for 21 humans, and possible responses, lie within the purview of the social sciences. 22 23 Climate change impacts are likely to vary dramatically from country to country. A 24 warmer climate could benefit sectors of the economies of some mid- and high-latitude 25 countries. At the same time, a rising sea level and the possibility of increased storm surges 26 could threaten the survival of some small island states and coastal areas, and could increase 27 the risk of midcontinent drought and desertification for inland areas on the periphery of 28 deserts. 29 30 Within the past decade, a consensus has emerged on some key issues in the economics 31 of climate change. This report describes areas of consensus, as well as areas of 32 disagreement, the sources of disagreement, and further research that could narrow the range 33 of disagreement. This chapter frames the issue of climate change largely from the point of 34 view of economics but also from that of other social sciences, introducing the more detailed 35 discussions in the chapters to follow. 36 37 The commitment of resources to mitigate climate change may rest on one of two 38 arguments. The first arises from fundamental values, the second from decision analysis: 39 40 1. We have only one planet. Some changes are largely irreversible, and may occur 41 rapidly. Prudence calls for avoiding a large-scale experiment with the planet. Thus, 42 avoiding climate change lies beyond normal economic calculus. 43 44 2. The potential exists for sudden, largely irreversible non-linearities with major effects 3 1 on the economy, particularly the economy of certain countries or regions. 2 3 Even if the first view is adopted, economics has much to contribute to the discussion, for 4 the question of cost-effective emissions reductions must still be addressed. If the second 5 view is adopted, economics and cost-benefit analysis will clearly be relevant, both in 6 deciding how much mitigation to undertake, and in designing the measures. 7 8 This chapter, and others in this Assessment Report, draw on the findings of Working 9 Groups I and II, and follow the guidelines provided by the Framework Convention. That 10 Convention makes clear that important questions remain to be addressed by subsequent 11 negotiations, including the adequacy of national commitments. This chapter takes the 12 Framework convention as a political document, recognizing that particular terms of the 13 agreements reached by international negotiation may or may not accord with accepted 14 scientific research; that for instance, the agreements may or may not have provided the 15 basis of a cost-effective approach to mitigating climate change. It is hoped that the findings 16 of this chapter and the assessment report more broadly will enhance an understanding of the 17 costs and consequences of alternative actions, and will provide the scientific basis for 18 ongoing negotiations. 19 20 1.2 FEATURES OF CLIMATE CHANGE 21 22 Climate change could impose a variety of impacts on society. IPCC Working Group II 23 analyses these impacts in detail. They include effects on agriculture¹, forests², water 24 resources³, the costs of heating and cooling⁴, the impact of a rising sea level rise on small 25 island states and low-lying coastal areas⁵, and a possible increase in storm damage. 26 Although most attention to date has focused on negative impacts, some impacts will be 27 positive. Beyond these tangible impacts are a variety of intangible impacts⁶, including 28 damages to existing ecosystems and the threat of species losses⁷. 29 30 Climate change presents the analyst with a set of formidable complications: large 31 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, 32 long time lags between emissions and effects, an irreducibly global problem, wide regional 33 variations, and multiple greenhouse gases of concern. 34 35 Large uncertainties. While natural scientists agree that greenhouse gas emissions are 36 rising, they do not agree about the mechanism linking concentrations, and temperature. 37 Further, although natural scientists agree that some warming will occur, they do not agree 38 on the speed of change, or the ultimate amount of change (IPCC 1992, 1994). In addition, 39 social scientists do not agree on the size of the behavioral responses or economic effects 40 that would follow, or on the effect of these changes on well-being. 41 42 Nonlinearities and irreversibilities. Nonlinearities occur when changes in one variable 43 cause a more than proportionate impact on another variable. For example, some have 44 suggested that even a modest increase in atmospheric greenhouse gas concentrations could, 4 1 beyond a certain point, trigger a substantial increase in temperature. Alternatively, even a 2 modest increase in average temperature might significantly increase weather-related 3 agricultural losses because, for many crops, extra days of extreme heat severely limit yields. 4 In Figure 1, if the threshold temperature for crop damage is Tₒ, then even a small increase 5 in the mean temperature, from ml to m2, may greatly increase the number of days above 6 the threshold, represented by the area under the curves to the right of T₀⁸. Irreversibilities 7 are changes that once set in motion cannot be reversed, at least on human time scales. 8 "Runaway warming" that some have hypothesized is an example. Some oceanographers 9 have expressed concern that warming might disrupt the deep water formation and the North 10 Atlantic Ocean circulation, responsible for much of the oceans' carbon uptake. Once 11 disrupted, this current might not revert to its original position for centuries⁹. 12 13 Long planning horizon. Greenhouse gas concentration changes occur over a long 14 period of time, with the full consequences of actions taken over the coming decades being 15 felt in future centuries. The truly long term nature of the problem is one of the distinctive 16 aspects of greenhouse gas warming. Seldom has the world consciously faced a set of 17 decisions likely to affect our descendants one, two, or three centuries from now¹⁰. 18 Because the costs of taking action today are born by the current generation, while the 19 benefits accrue possibly hundreds of years in the future, the world community is now faced 20 with issues of intergenerational equity on an unprecedented scale. While society has 21 addressed similar problems concerning trade-offs over periods of fifty or even a hundred 22 years, the long planning horizon for climate change puts the analytic questions at issue in a 23 new light. The length of time involved has one further implication: changes in technology, 24 as well as population and consumption patterns, become of paramount importance. 25 26 Long life of capital stock. Every country has made large capital investments in its 27 cities, farms, ports, etc. Some of this investment cannot be changed without large costs: 28 low-lying port cities, for example, cannot easily be rebuilt. For other investments, the cost 29 of change will be small; for diversified agricultural economies, the cost of switching from 30 one annual crop to another will be small if the temperature increase is on the order of 31 0.2°C. to 0.3°C. per decade, as climate scientists now expect (IPCC 1994). For less 32 diversified economies, the costs may be larger. 33 34 Inertia in the climate system. Atmospheric concentrations, rather than emissions, 35 determine the amount of warming that occurs. Concentrations change much more slowly 36 than emissions, meaning that affected nations might not have enough time to prevent 37 warming damage or to mitigate economic impacts after the effects of climate change 38 become evident. In this respect, the risks of climate change are unlike those of earthquakes 39 or floods. The combination of time lags in the climate system and uncertainty about effects 40 requires taking action before unambiguous information emerges about the timing and 41 magnitude of climate effects. 42 43 Global scope. Climate change is a global challenge, which cannot be answered by a 44 single country acting by itself. Mitigation must be coordinated globally. In an interlinked 5 1 world economy, not only are the actions of a single country, or group of countries, not 2 likely to be sufficient to address the problem, they are likely to be largely offset by actions 3 of other countries. If, for instance, one group of countries reduces timber cutting to 4 increase carbon absorption, then the price of lumber will rise, which may induce other 5 countries to increase cutting in their forests. 6 7 Moreover, whereas economic analysis generally takes the point of view of a single 8 decision maker or government, the important decisions on climate change will of necessity 9 be made by many sovereign governments. Economic and decision sciences are not yet able 10 to predict the outcome of bargaining problems of this type¹¹. 11 12 Regional variation. Impacts are likely to vary greatly both within and among countries. 13 Some countries and regions will suffer from warming; others will benefit, at least in some 14 sectors. Some cold countries will benefit from a reduction in heating costs and an increase 15 in the length of growing seasons; some warm countries will see a drop in yields from 16 agriculture and forestry; low-lying states are likely to suffer from increased storm surges 17 and flooding. For the world as a whole, the net effect at any time will be the sum of local 18 effects at many points on the globe, some positive and some negative; analysts have no way 19 to estimate this sum without detailed local calculations (summarized in Chapter 6). 20 21 Aggregation. On a priori grounds, there is no reason to believe that greenhouse 22 warming should have in the aggregate, either positive or negative long-run effects (although 23 adjustment implies costs in the short run). Indeed, studies twenty years ago focused on the 24 dire consequences of global cooling. It seems unlikely that the earth is somehow endowed 25 at this moment with the optimal temperature; the Earth has nonetheless adjusted to its 26 current climate, and readjustments in either direction may be costly. 27 28 Multiple gases of interest. Increases in radiative forcing (heat trapping ability) depend 29 on the concentration of all greenhouse gases, not just CO2, even though most economic 30 modeling to date has limited itself to CO2. Because greenhouse gases differ in radiative 31 forcing and atmospheric lifetime, analysts have devised measures of global warming 32 potential (IPCC 1990), making the different gases commensurable¹². 33 34 Importance of net emissions. Because greenhouse gas concentrations depend on net 35 rather than gross emissions, changes in forests and other greenhouse gas sinks must be 36 taken into account¹. 37 38 Efficiency vs. Equity. How much to reduce emissions is a matter of efficiency. Who 39 pays is a matter of equity. Economics has much to say about the former, but much less 40 about the latter. Nonetheless, equity considerations will drive many of the policy decisions 41 to be made under the Framework Convention on Climate Change. 42 43 6 1 1.3 CONTRIBUTION OF ECONOMICS 2 3 Economics and the social sciences offer perspectives on climate change not provided by 4 the physical sciences. In the classic definition, economics is the study of the allocation of 5 scarce resources that have alternative uses. Economics emphasizes the importance of 6 tradeoffs between different uses of resources, and the foregone value of other uses of a 7 resource, called the opportunity cost. In the context of climate change, this means that 1) 8 costs and benefits matter; 2) resources are not free; and 3) resources used for one purpose 9 are no longer available for other purposes. 10 11 This chapter sets out the logic of cost-benefit analysis as applied to climate change. 12 Standard cost-benefit analysis requires 1) a valuing of costs and benefits over time, using 13 willingness to pay as a measure of value and 2) a criterion for accepting or rejecting 14 proposals¹⁴. The standard criterion is the compensation principle (Kaldor date, Hicks 15 date), which says that if the project yields positive net benefits, then those made better off 16 could compensate those made worse off with something extra left over. The result is an 17 unambiguous gain in welfare, without the necessity of weighing effects on different 18 individuals. 19 20 Climate change raises difficulties with both requirements. Valuation is difficult because 21 of the difficulty in valuing environmental amenities, which are generally not traded in the 22 market. And the compensation principle will not apply if mechanisms for affecting 23 transfers do not exist, either between countries or regions in one generation, or -- especially 24 -- between generations. If transfers are not feasible, then the analysis must assign weights 25 to different individuals (for example, the utilitarianism gives equal weight to each person). 26 Only then can conclusions be drawn about net benefits for society as a whole. This issue 27 will arise again in the discussion of equity in section 1.4 below. 28 29 Beyond these fundamental concepts are ideas, originally from other areas of economics, 30 that may be applied directly to the study of climate change; this includes work on risk, 31 dynamics, sequential decision making, public goods and externalities, taxation, and general 32 equilibrium. 33 34 1.3.1 Risk 35 36 The uncertainties associated with climate change are large. Moreover, results available 37 to date from integrated assessment models indicate that climate change risks are highly 38 asymmetrical, with a high probability of a small loss and a low probability of a large loss 39 (Manne and Richels 1992, Peck and Teisberg 1993, Nordhaus 1994). In the past thirty 40 years, much new economic research has focused on rational responses to risk¹⁵, including 41 three areas important to a systematic examination and rational response to climate change: 42 portfolio theory, insurance, and decision analysis. 43 44 7 1 1.3.1.1 Portfolio Theory 2 Risk and Uncertainty 3 A portfolio manager attempts to get the 4 best return for a given level of risk. One Uncertainty arises when a decision can lead 5 important approach is to buy several types to a range of outcomes. 6 of assets, whose returns are not correlated Expected return or expected value of a 7 or are negatively correlated (that is, whose decision is the mean of the distribution of 8 prices move either independently or in returns, the amount a person would on 9 opposite directions). In this respect, climate average receive as a consequence of the 10 change policy decisions can be compared decision. 11 to investment portfolio decisions. Risk aversion measures an individual's 12 unwillingness to take risks. 13 Several responses can reduce the impact 14 of climate change: insurance and Risk premium is the amount an individual 15 precautionary investments 16 Precautionary would pay to replace the uncertain 16 investments may take the form of distribution of outcomes with the expected 17 mitigation or in actions that enhance the value. 18 ability of future generations to adapt. Certainty equivalent is the amount that 19 Other choices include agreements for one makes an individual indifferent between it 20 country to fund emissions reductions in and a risky proposition; for a risk-averse 21 another country (joint implementation), person, the certainty equivalent is higher 22 technology transfer and other forms of than the expected return; the difference is 23 international cooperation; and phasing out the risk premium. 24 existing policies, such as subsidies to fossil 25 fuels, that reduce welfare and directly or 26 indirectly increase greenhouse gas emissions. 27 28 A well-chosen portfolio of climate change investments will yield greater benefit for 29 a given cost than any one option undertaken by itself. For an individual country, the 30 issue is how to choose the portfolio of policy measures best suited to its circumstances, and 31 to adjust the portfolio over time in response to new developments. Governments will be 32 making climate change decisions for several decades at least. This means that they will 33 have many opportunities to adjust the size (total resources) and mix (choice of measures) 34 of their portfolio of responses. 35 36 1.3.1.2 Insurance 37 38 Several concepts from insurance have important applications to climate change: risk 39 aversion, risk premium, and certainty equivalent. 40 41 That individuals and societies are risk averse means that average utility is increased by 42 pooling risks, or equivalently that people are willing to pay to reduce the risks they face. If 43 society as a whole is risk averse, then some investments with a negative expected return, 44 for example in climate change mitigation, should be undertaken if they reduce the 8 1 probability of a loss, or the costs of future adaptation. 2 3 The magnitude of those expenditures depends on (a) society's degree of risk aversion; 4 and (b) the magnitude of the risk. The risk premium--the extra amount that society is 5 willing to pay to reduce a risk--is small if the stakes (say, the maximum loss) are small, and 6 large if the stakes are large. An investment of a dollar is justified if it reduces the loss of 7 expected utility by more than a dollar, and not if it reduces the loss by less than a dollar. 8 Thus, results reported below focusing on the expected loss of GDP from climate change do 9 not directly address the risk premium. If a possible outcome is a loss of 10%, even though 10 the expected loss is only 3%, then the certainty equivalent loss will exceed 3%. A dollar 11 investment that reduces this certainty equivalent loss by more than a dollar should be 12 undertaken; such an investment could either reduce the average loss, e.g. by reducing the 13 probability of the loss occurring (through mitigation actions) or reduce the variance of the 14 loss. For example, some actions the reduce extreme losses will have more than 15 proportionate returns. 16 17 The insurance expenditures associated with mitigation actions and investments are, in a 18 sense, only the differences between the actual expenditures and the no-regrets benefits (the 19 benefits other than those associated with greenhouse gas emissions). Thus, investments in 20 fuel efficient cars may have a direct benefit in reducing the cost of running a car. The 21 mitigation investment is only the additional investment for climate purposes. 22 23 The economic principles of risk aversion and portfolio theory provide the rationale 24 for going beyond no-regrets policies. Naturally, actions that reduce greenhouse gas 25 emissions at zero or negative costs should be undertaken. But a prudent response to the risk 26 of greenhouse gas warming goes beyond no-regrets policies to some policies incurring net 27 costs. 28 29 Traditional insurance involves pooling a large number of diversifiable risks. Insurance 30 exist when people differ in their ability to bear a given risk, or would be affected 31 differently by the risk. Insurance markets transfer risks from those who are less able to bear 32 the risk to those who are more able to bear the risk, and by spreading the risk among a 33 large number of individuals, reduce the aggregate impact of the risk¹⁷. By transferring 34 risk, traditional insurance can address one aspect of the risk from climate change: the large 35 differences in expected regional impacts. This holds irrespective of who pays the cost, 36 because wealthier individuals and countries are better able to bear risk¹⁸, and because 37 many countries likely to be most adversely affected will be developing countries of the 38 South, while many of the countries least affected (or positively affected) will be the 39 industrialized countries of the North, who could provide insurance for effects of climate 40 change that might fall harder on the South¹⁹. 41 42 Traditional insurance will not, however, address all risks from climate change. 43 Shipowners can buy insurance against storm loss because shipping risks are diversified: one 44 storm is unlikely to sink all the ships covered by the insurer. But because climate change 9 1 is global by nature, and therefore undiversifiable, traditional (intragenerational) insurance 2 cannot fully insure against climate change risks. Rather, some form of intergenerational 3 insurance is likely to arise as a way to redistribute more of the risk. 4 5 Losses associated with climate change are likely to be both correlated and large, 6 compared to losses absorbed in a single year by the commercial insurance industry. The 7 long term nature of climate change insurance also raises the problem of contract 8 enforcement: will contracts signed today be enforceable tomorrow? Will the insurers be 9 around to pay claims 50 or 100 years from now? (Even in the industrialized countries, 10 private markets may be inadequate to insure against losses from a major national disaster 11 today.) These considerations suggest that private markets may not be able to provide 12 insurance against climate change, and argue for international action to establish insurance 13 markets, perhaps with government reinsurance. Should such an insurance market be 14 established, careful attention will have to be given to ensuring that the insured parties 15 engage in appropriate adaptation actions, mitigating the losses that might be associated with 16 any greenhouse gas warming.²⁰ 17 18 19 1.3.1.3 Precautionary investments 20 21 A business makes precautionary investments to reduce the total risk of its portfolio. 22 Numerous policy measures are available to reduce risks to future generations from climate 23 change. Four have dominated discussions in recent years: 1) immediate reductions in 24 emissions to slow climate change²¹; 2) R&D on new supply and conservation technology 25 to reduce future abatement costs; 3) continued research to reduce uncertainties about how 26 much change will occur and what effects it will have; and 4) investments in actions to 27 assist human and natural systems to adapt to climate change if it occurs. Other choices 28 include agreements for one country to fund emissions reductions in another country (joint 29 implementation), technology transfer and other forms of international cooperation; and 30 phasing out existing policies, such as subsidies to fossil fuels, that reduce welfare and 31 directly or indirectly increase greenhouse gas emissions. 32 33 Precautionary investments may also enhance the ability of future generations to react. 34 An important reason that people establish savings accounts is to reduce the impact of 35 unfavorable events in the future. Similarly, a society may elect to accumulate capital 36 against the possibility of a large loss from climate change. This is one thread of the debate 37 over discount rates in Chapter 3. Those who argue for a discount rate close to the 38 opportunity cost of capital point out that society may choose between immediate 39 greenhouse gas mitigation, at a cost, and delayed mitigation, with some of the money saved 40 put aside as a savings account for our grandchildren in the event of large climate-induced 41 damages. 42 43 44 10 1 1.3.2 Sequential Decision Making 2 3 As a policy question, global climate change is often posed as a choice between a) doing 4 nothing at all, or b) committing to all-out effort. Given the large current uncertainties about 5 costs and benefits of greenhouse mitigation, this is the wrong way to frame the issue, as it 6 obscures the choices that should be evaluated. Moreover, because option b) may be 7 perceived as too expensive to get political support, policy paralysis often results. 8 9 A more useful formulation is: "Given current knowledge and concerns, what actions 10 should we take over the next one or two decades to position ourselves to act on new 11 information that will become available?" (Lind 1993) For example, decisionmakers would 12 like to know if the possibility of irreversible damages²² justifies immediately undertaking 13 an aggressive abatement program²³. 14 15 Climate change demands a decision process that is sequential and can incorporate new 16 information. Timing will be a key element, and the date of resolution of uncertainty an 17 important element of the analysis. Figure 1 shows schematically the progression from a 18 simple decision to a sequence of linked decisions. The simple decision is sometimes 19 referred to as the "learn, then act" model, the second as "act, then learn"; or, in the case of 20 the decision depicted, "act, then learn, then act." 21 22 A sequential decision making strategy aims to identify short-term strategies in the face 23 of long-term uncertainty. The next several decades will offer opportunities for learning and 24 mid-course corrections. The relevant question is not: what is the best course for the next 25 100 years, but rather: what is the best course for the next few years, knowing that a prudent 26 hedging strategy will allow time to learn and change course. 27 28 For example, the choices might be 1) immediate investment in new plant and equipment 29 2) aggressive R&D on greenhouse abatement technology or 3) deferring large investment 30 for 10 years, until the nature and size of the threat is better understood, and when costs will 31 presumably have dropped and the job can be done more efficiently. 32 33 Because of the high cost of being wrong in either direction, the value of information 34 about climate change is likely to be great. In particular, the value of information about the 35 sensitivity of temperature to CO2 increases, the temperature damage function, the gdp 36 growth rate, and the rate of energy efficiency improvement is likely to be high (Chao 1991, 37 Peck and Teisberg 1991, Manne and Richels 1992, Nordhaus 1994)²⁴. 38 39 The presence of uncertainty along a dynamic path creates an option value, the value to 40 preserving choices for the future. In climate change, the term has been used in two 41 different ways. One stresses the irreversibilities of climate change; mitigation expenditures 42 now preserve the option of avoiding adaptation expenditure later. The other stresses 43 irreversibilities in investment, and the cost of premature turnover of capital. 44 11 1 1.3.3 Dynamics 2 3 The problem of greenhouse gas warming involves additions to concentrations resulting from 4 net emissions over extended periods of time. Thus the analysis must focus on dynamics. 5 Dynamic analysis involves three stages: the dynamic processes involved, the trade-offs, 6 and judgments concerning those trade-offs. 7 8 Dynamic analyses have lead to important insights. For example, atmospheric 9 concentrations and therefore temperatures depend on the total amount of greenhouse gases 10 emitted over a period of years. A given concentration target can be achieved by a variety 11 of emissions time paths. Time paths that provide for the economical turnover of existing 12 capital stock and time to develop low-cost substitutes are likely to be less costly. This 13 suggests large potential gains from flexibility in timing of emission reductions²⁵. 14 15 16 1.3.3.1 Kaya Identity 17 18 The driving forces in emissions of any greenhouse gas can be seen in the following identity 19 for carbon dioxide emissions (Kaya 1989): 20 21 CO2 = CO2/E E/Q Q/L L 22 carbon dioxide carbon dioxide energy output population 23 emissions emissions per per unit per 24 unit energy output capita 25 26 or, expressed in rates of change: 27 28 d In CO2/dt = d InCO2/E /dt + d InE/Q /dt + d InQ/L /dt + d InL /dt 29 30 that is, the percentage rate of change in carbon dioxide emissions is equal to the rate of 31 change in carbon dioxide emissions per unit energy plus the rate of change in energy 32 requirements per unit output plus the rate of change in output per capita plus the rate of 33 change in population²⁶. 34 35 This identity clarifies different approaches to reducing emissions. For a developed 36 country with a stable or slowly growing population, as long as increases in emissions/output 37 efficiency (emissions per unit energy times energy per unit GDP) keep pace with labor 38 productivity, CO2 emissions will not increase. Because of the substantial potential for 39 energy efficiency improvements, this seems feasible for most developed countries. Many 40 opportunities exist for increasing end-use efficiency, represented by the second term on the 41 right-hand side, for example from cars to public transportation, from less to more fuel- 42 efficient cars and homes²⁷. Fuel switching (for example, from coal-based electricity to oil, 43 gas, hydroelectric, wind, and geothermal), represented by the first term, also offers the 44 potential to limit CO2 emissions in many countries. 12 I For many developing countries, emissions will increase unless energy efficiency and 2 greenhouse gas emissions per unit of energy change to offset growth in per capita output 3 and population. For many developing countries with rapidly growing populations, pressures 4 for economic development will make it difficult to direct capital from investments with 5 higher greenhouse gas emissions to those with lower greenhouse gas emissions²⁸. 6 On two essential issues evidence is currently limited: (a) to what extent will 7 improvements in energy efficiency require net increases in investment beyond the resources 8 saved from reduced energy usage, i.e., how much does aggressive emission reduction 9 depress economic growth? Order-of-magnitude calculations suggest the presence of only 10 limited trade offs, at least for the near term; (b) do developing countries have the 11 institutional capacity to achieve the desired increases in emissions efficiency? 12 13 1.3.3.2 Non-renewable resources, backstop technologies, and emission reduction 14 strategies. 15 16 Though in principle the atmosphere is a renewable natural resource, the longevity of the 17 greenhouse gases and the relationships between stocks and flows mean that for practical 18 purposes, it may be better treated as an exhaustible natural resource, but one where welfare 19 depends not just on the flow out of the stock, but on the stock itself²⁹. 20 21 The central problem with natural resources, whether renewable or not, is timing. Many 22 renewable resources possess a maximum sustainable rate of exploitation. The harvest 23 cannot long exceed this maximum rate without depleting the stock, and ultimately reducing 24 the harvest. Corresponding to the sustainable flow rate is a steady-state stock. If, initially, 25 the actual stock exceeds the steady-state stock, then, for a while, the flow can exceed the 26 maximum sustainable flow. The question is how to distribute this excess over time. Even 27 when the stock is at the sustainable level, in times of emergency it may be desirable to 28 exceed the maximum sustainable flow. For a renewable resource, this can be done, though 29 only at the expense of decreased flows later³⁰. 30 31 Timing of reductions in greenhouse gas emissions should reflect differences in costs, 32 discounting (to evaluate those costs), and risk. If technological change will make future 33 emissions reductions much less costly, some reductions should be postponed³¹ 34 Conversely, research on "learning effects" shows that if actions taken today will lower costs 35 faced tomorrow, then these dynamic benefits should be included in the calculus (Arrow 36 1962, Atkinson and Stiglitz 1969). In the context of climate change, if emissions 37 constraints stimulate technical or other developments that help to lower the costs of 38 continuing or additional emission abatement, then reductions should be accelerated (Grubb 39 1993, 1995). If discount rates are high, the costs borne by future generations will carry less 40 weight than if discount rates are low. In the presence of risk, non-linearities, or 41 irreversibilities, the principle of risk aversion suggests a strategy of early mitigation. 42 43 The theory of non-renewable resources has a second set of lessons for climate change 44 policy. Among the four energy categories -- coal, gas and oil, biomass and non-carbon 13 1 sources --gas and oil are exhaustible; this limits total emissions from gas and oil. With 2 exhaustible natural resources, the question is not how much will be consumed, only 3 when³². 4 5 Figure 2 depicts fuel use in an economy, in three phases. In the first phase, the 6 economy relies on non-renewable resources; in the second, on coal; in the third, on 7 backstop technologies-- e.g., biomass combined with non-carbon sources. The switch 8 points depend on rising energy prices and improving technology, which lowers the costs of 9 the backstops. The figure shows alternative long run scenarios. In panel A, the price of 10 the backstop technology falls sufficiently slowly that for a time, the economy relies on coal. 11 In panel B, the price of the backstop technology falls fast enough to eliminate the 12 intervening stage of primary reliance on coal. 13 14 Since, to a first-order approximation, the total carbon load from oil and gas is fixed (and 15 limited), the total carbon load on the atmosphere is primarily related to coal usage. From 16 this perspective, an important uncertainty is the pace at which the cost of the backstop 17 decreases. If it decreases fast enough, the intermediate stage of coal dependence will be 18 short, and the total carbon load low, while if the price decreases slowly, the carbon load 19 can be much larger. 20 21 From this perspective, conservation of gas and oil is an important part of a risk strategy, 22 for it provides insurance against the possibility of delayed arrival of backstop energy 23 sources. 33 This, in turn, has important implications for the "leakage" debate, which asks 24 whether, in the event that the North imposes carbon taxes but the South does not, the 25 South's response will largely offset emission reductions made in the North. It is also 26 possible that lower prices for gas and oil will induce coal-rich countries to decrease their 27 reliance on coal, thus possibly producing negative leakages. But to the extent that occurs, 28 the insurance provided by greater conservation of oil and gas is eliminated, and it is this 29 insurance which should be an essential part of the dynamic strategy. If the backstop arrival 30 is delayed, then the earlier fuel switching by China and India will yield no long-run 31 benefits; while if the backstop arrival is early, the whole issue is largely moot. Leakage 32 needs to be looked at not from a static perspective, of what occurs in a single year, but 33 from a dynamic perspective, corresponding to the long run nature of the global climate 34 problem. 35 36 37 1.3.4 International Public Goods 38 39 The atmosphere is an international public good in that atmospheric concentrations are 40 the result of combined actions by all countries. A pure public good (Samuelson, 1954) has 41 two properties: the marginal cost of an additional individual using the good is zero 42 (non-rivalry), and the marginal cost of exclusion--of stopping an individual from enjoying 43 the good--is prohibitive (non-excludability.)* The atmosphere has both characteristics. 44 One country's greenhouse gas reductions affect all other countries as well. If this thwarts 14 1 climate change, all countries benefit³⁵. 2 Public Goods and Externalities 3 Different countries will be affected 4 differently, so that the benefits of avoiding Externality: An externality, or spillover, arises 5 greenhouse gas warming will differ from when the private costs or benefits of production differ from the social costs or 6 country to country. Further, some actions benefits. Because the social costs or benefits 7 will affect simultaneously local are external to the private costs that firms face, 8 atmospheric conditions (providing local private markets alone the economy will tend to 9 public goods) and greenhouse produce too little of a public good (like 10 concentrations. For example, actions that education) and too much of a public bad (like 11 reduce urban driving improve local air pollution). 12 quality and at the same time reduce Public good: A public good has two 13 greenhouse gas emissions³⁶. properties: the marginal cost of an additional 14 individual using the good is zero, and the 15 1.3.4.1 Property rights marginal cost of exclusion--of stopping an 16 individual from enjoying the good--is 17 An important strand of economic prohibitive. Lighthouses are public goods: thought associates externalities with a when lighthouse services are provided to one 18 person, others may enjoy the same services 19 failure to assign property rights (Coase without cost. 20 1990). Assigning property rights to the 21 atmosphere is particularly difficult, since Market Failure: Private markets may 22 this would require the agreement of many sometimes fail to provide a good at the most 23 sovereign states. Tradeable greenhouse desirable level: private markets alone will likely emission permits, discussed below, can be provide too few lighthouses and too much 24 pollution. 25 thought of as an attempt to resolve the 26 problem by explicitly assigning property 27 rights to greenhouse emissions. 28 29 1.3.4.2 Paying For An International Public Good 30 31 Who should pay for a global public good? every country faces this question internally 32 in determining who should pay for the public goods it provides. Who should, for instance, 33 pay for pollution control within a country? 34 35 Economists generally agree on several principles: 36 37 First, concerns about equity should be separated from concerns about efficiency, though 38 ultimately they are intertwined. An implication of this principle is that because pollution is 39 a social cost of production (and consumption), everyone should be made to pay the full 40 social costs of the pollution they generate. Thus, if there is a social cost to a unit of 41 emissions of greenhouse gases, that cost is the same no matter who produces the emissions. 42 All should pay the full social costs of their actions, whether rich or poor. In this 43 perspective, corrective (Pigouvian) taxes should be imposed uniformly. 44 15 I Second, it is inappropriate to redress all equity issues through climate change initiatives, 2 although climate change should not aggravate disparities between one region and another. 3 4 Economists agree less about the framework for deciding the burden of financing 5 mitigation and adaptation. At least four approaches have been proposed to determine how 6 the burdens of taxation should be shared. One approach looks at benefits: just as those who 7 benefit from private goods must pay for them, those who benefit from a public good should 8 be made to pay for them. The principle has some force when large differences in 9 preferences exist within any income class; providing a particular public good benefits some 10 of those individuals more than others, creating inequalities in the absence of benefit taxes. 11 A major problem frequently encountered, particularly for pure public goods, is that it may 12 be difficult to determine who benefits. It is in general possible to ascertain the economic 13 benefits of mitigation, and these are likely to be quite unequally distributed. But this 14 principle, by itself, does not fully determine who should bear the costs: appropriately 15 designed mitigation strategies will produce a surplus of benefits over costs, which must 16 somehow be divided. 17 18 A second approach looks at ability to pay. It is often held that richer countries (or 19 individuals) should pay more than poorer ones. This approach sometimes rests on the claim 20 that all people are entitled to a certain minimum consumption (Dasgupta 1982). But this 21 principle does not answer the question of how much extra the richer countries should pay. 22 23 A third approach is based on contribution to the problem. Because the North has 24 contributed more than two-thirds of the stock of greenhouse gases in the atmosphere today, 25 this approach seems to suggest a large responsibility for the North. On the other hand, by 26 the time greenhouse gas concentrations double from preindustrial levels, the developing 27 countries are projected to be contributing more than half of annual emissions, and roughly 28 half of the total stock in the atmosphere (IPCC, 1990; Cline 1992). Thus under this 29 criterion, the developing countries might eventually pay far more of the mitigation costs 30 than under the other principles described earlier. 31 32 Economists have turned to a fourth approach -- the social welfare function -- to answer 33 the question of how much extra different parties should pay, as well as the question of how 34 to distribute the surplus. The discussion of equity below differentiates between the 35 Rawlsian and utilitarian approaches. In this case, both approaches yield similar results: 36 In the absence of incentive problems, both imply that all of the surplus should be allocated 37 to the poorer countries, or that the burden of effort be borne by the richer countries³⁷. 38 39 Yet a different approach holds that social scientists as such have nothing to say about 40 these ethical issues. Coase [1960], for instance, approaches the problem of externalities by 41 emphasizing (a) the importance of assigning property rights, so that, in the absence of 42 bargaining costs, an efficient solution can be obtained³ and (b) that the outcome is 43 independent of how property rights are assigned³⁹ Coase also emphasizes the importance 44 of transactions costs, which will often influence the choice of policies. 16 1 A simple approach that yields efficiency but does not require redistribution (and is thus 2 consistent with the two principles enunciated above) requires coordinated tax rates so that 3 all countries face the same energy prices. This approach makes the cost of emitting an extra 4 ton of carbon equal across all countries, and each country retaining the revenues thus 5 generated⁴⁰. The net cost of such a tax (ignoring the benefits from reduced greenhouse 6 gas emissions) will, in general, be smaller for poorer countries, as a percentage of their 7 national output: the burden of the tax is progressive, even though the tax is levied at the 8 same rate in all countries⁴¹. 9 10 Accounting for past damages. The Framework Convention on Climate Change directs 11 the Annex I countries to take the lead in responding to the threat of climate change. Some 12 have argued in addition that because the North has been the major contributor to current 13 levels of greenhouse gases, it should bear most of the costs of mitigation. This view says 14 that costs should be borne not in proportion to benefits expected, but in proportion to 15 contribution to pollution. This argument, however, is not based on efficiency, which 16 requires that incentives be prospective (forward looking), not retrospective⁴. No incentive 17 effects attach to imposing charges based on past actions. Whether to charge nations that 18 contributed CO₂ to the atmosphere is an issue of ethics, not efficiency. Moreover, many 19 have challenged the ethical basis for assigning responsibility based on past damages⁴³. 20 21 The controversial issue of population growth, while central to the question of economic 22 development, bears on climate change largely through its effect on emissions. This chapter 23 will limit its treatment of population to this one effect⁴⁴. 24 25 1.3.4.3 Enforcement 26 27 Both externalities and public goods need a legal framework within which the problems 28 they pose can be addressed. Without compulsory taxation, there is an incentive for each 29 individual to be a free rider, though there is some empirical evidence that the free rider 30 effect may not be as significant as economists have previously assumed (Bohm [date]). In 31 the absence of compulsory taxation, externalities can only be addressed with well defined 32 property rights (Coase 1990)⁴⁵ and a legal system that enforces compensation for 33 externalities. 34 35 Though in many areas, great strides have been made in the development of an 36 international rule of law, problems are likely to face any system for enforcing climate 37 change agreements. For example, the incentive for free riding is great, whether through 38 delay, nonagreement, or noncompliance. Several alternatives have been proposed, each 39 raising political or economic concerns. No consensus now exists about the relative 40 desirability of these alternatives, though it is clear that some sort of international judicial 41 process will be required to determine and enforce compliance⁴⁶. 42 43 44 17 1 1.3.4.4 Knowledge 2 3 A key element in addressing the problem of climate change is an increase in 4 knowledge--knowledge about climate science as well as about the economic and social 5 aspects of impacts, mitigation, and adaptation. Much of this knowledge is in the nature of 6 an international public good. Developing ways of increasing energy efficiency will benefit 7 all countries. While in some cases, those engaged in the research will be able to 8 appropriate for themselves a significant fraction of the private benefits (mostly in reduced 9 energy costs), they will not be able to appropriate the broader social benefits, unless there is 10 a sufficiently high energy tax (or permit fee) that the price fully internalizes the emissions 11 externality. But even then, the social benefits of innovation tend to far exceed the private 12 benefits. 13 14 This suggests the need for an international agreement to fund basic research and 15 subsidize applied research, particularly in energy-related technologies for the developing 16 countries. There need not be a central funding agency, nor a central directorate 17 determining which research should be undertaken. But some mechanism, possibly 18 including joint implementation, must exist for sharing research plans results, and for 19 ensuring that the fruits of this research are made freely available. 20 21 1.3.5 Efficiency 22 23 With some exceptions noted below, issues of efficiency and equity can be separated⁴ 24 Analysts agree that any actions responding to climate change should be cost-effective: no 25 matter who bears the cost of emission reductions, reductions should occur where their cost 26 is lowest⁴ Because of the low energy efficiency in many developing countries, many 27 have proposed that the major effort at the emission reductions be concentrated there. 28 29 Mechanisms for reducing emissions equitably and efficiently, including joint 30 implementation, tradeable permits, and coordinated tax policies, are discussed below and in 31 chapter 11. All of these approaches, however, attempt to confront all individuals and 32 producers in all countries with the same cost of emissions. Emission control is an 33 international public good in that greenhouse emission reductions have the same effect, 34 wherever they occur. Just as efficiency in the production of steel or any other commodity 35 requires that all consumers and producers face the same price, so too with emissions. 36 Uniform prices can be achieved either through coordinated energy taxes or through 37 tradeable permit requirements; but unless the rules are applied in a systematic way to both 38 developed and developing countries, emission reductions will be inefficient. 39 40 Partial participation in an international emissions reduction program, however, will 41 significantly reduce its effectiveness. The growth of international trade has resulted in 42 important links between the developed and developing countries, and the total effects of any 43 policy undertaken in the North can only be evaluated in terms taking into account the 44 systemic responses, including responses from the South, as discussed under "General 18 1 Equilibrium," below⁴⁹. 2 3 1.3.5.1 Bankable permits 4 5 Efficiency imposes several requirements. One, just described, is that at any moment, the 6 costs of reducing emissions should be minimized. The second is intertemporal efficiency: 7 the marginal cost of reducing emissions at two points in time must be the same. If it will 8 cost less to reduce emissions at some future date, adjusting for time discounting, option 9 values (risk), and impacts on atmospheric concentrations, then the reduction schedule 10 should be adjusted accordingly. 11 12 Intertemporal efficiency would be promoted by allowing banking of permits (allowing a 13 source to use fewer permits in one year and more in another), and by the development of 14 futures and options markets. A bankable permit system would address some North-South 15 equity issues, including the concern in the South that delays in mitigation now by the North 16 would leave a greater burden for the future. 17 18 1.3.5.2 Exchange/risk efficiency. 19 20 When different parties to an agreement hold widely differing views about risk and the 21 probability of loss, significant efficiency gains can result from transferring risk among 22 parties. An earlier section discussed the importance of establishing an international 23 insurance market for those facing the threat of losses under climate change, and noted the 24 advantages of establishing a market within which countries who are less concerned about 25 the economic risks associated with climate change can assume more of the insurance 26 burden. Any efficient international system for addressing the problems of global climate 27 change must include both mitigation and insurance obligations. Governments that believe 28 they have a comparative advantage in assuming climate risks can assume a larger share of 29 those risks, trading off other obligations, and substantially reducing overall costs of 30 responding to climate change. 31 32 1.3.5.3 Comprehensiveness 33 34 Efficiency also requires that the cost of reducing all greenhouse emissions be minimized. 35 This principle implies that any mitigation program must include all greenhouse gases 36 (taking into consideration their heat-trapping potentials and atmospheric lifetimes⁵⁰), and 37 must include carbon sinks. 38 39 Finally, and perhaps most controversially, it implies that mitigation strategies focus on 40 all elements of the Kaya identity above, ensuring that the marginal cost of reductions be the 41 same for each of the possible strategies. Thus, population control may be an element in a 42 long term mitigation strategy no less than a shift in the composition of production or an 43 increase in the energy efficiency of the economy. 44 19 1 1.3.6 General Equilibrium 2 3 General equilibrium theory, a cornerstone of economic research over the past century, 4 demonstrates the advantage of looking beyond first-stage effects. It offers two important 5 insights for climate change analysis. First, the various parts of an economic system are 6 interrelated; perturbations to one part have ramifications for other parts, which may be quite 7 distant. Second, when all of the reverberations are taken into account, the net effect of an 8 action may be markedly different from the initial (and intended) effect. 9 10 One implication of general equilibrium theory has already been noted: taxes imposed on 11 one part of the global economy may have little if any effect on global emissions; they may 12 simply result in a relocation of economic activity. Increasingly, the world's economic 13 system must be viewed from a global perspective. Location of economic activities is 14 determined primarily by relative factor prices, taking into account certain specific locational 15 advantages and specialized competencies. If, for example, the OECD countries impose 16 carbon taxes on energy-intensive industries, those industries may relocate outside the 17 OECD. Further, if greenhouse mitigation puts an economic drag on the developed 18 countries, developing countries would be affected through trade. 19 20 If different countries have different obligations to reduce greenhouse emissions, different 21 implicit tax rates will result. This will interfere with world economic efficiency--decreasing 22 world real output--possibly with little effect on total greenhouse gas emissions. For 23 example, the most energy intensive activities--such as aluminum production--may well 24 relocate to developing countries⁵¹. 25 26 While many of the energy-economy-carbon models described in subsequent chapters 27 attempt to estimate the magnitude of carbon leaks, most are based on standard international 28 trade models, in which the location of production of various goods and machines is fixed 29 (Whalley and Wigle, 1992)⁵². Thus, estimates of carbon "leakages" are based only on 30 commodity substitution⁵³. But allowing for relocation of industries -- as would occur in 31 the very long run, the time span of interest for an analysis of climate change-- leakages 32 may well be higher. No consensus now exists on the magnitude of long-run leakages. 33 34 1.3.6.1 Intertemporal Substitution 35 36 General equilibrium issues also arise when production can be shifted from one period to 37 another. For example, in a partial equilibrium analysis, a tax on gas or oil raises the price 38 of the fuel taxed, thereby reducing its consumption, and thus associated emissions. But an 39 exhaustible natural resource like gas or oil has, over the long run, by definition an inelastic 40 supply (ignoring for the moment extraction costs, which, in the case of gas and oil, are 41 small relative to the price). The general theory of incidence argues that when a commodity 42 is in inelastic supply, a tax affects the price, but not the level of consumption. That is, 43 when all countries impose a tax on gas or oil, the price of oil falls, by an amount just equal 44 to the tax. The full incidence falls on producers; as a first approximation, the level of 20 1 consumption--and thus the level of emissions--remains unchanged. This provides a first 2 approximation. Obviously, if the tax is large enough, the price will fall below the cost of 3 extraction, and supply will be reduced. Moreover, in the case of exhaustible natural 4 resources, taxes may affect the timing of consumption of the oil and gas (Stiglitz, 1977, 5 1979, , 1993)⁵⁴. 6 7 8 1.4 EQUITY 9 10 Which nations will be allowed to increase their greenhouse emissions, and who pays for 11 greenhouse gas abatement and adaptation are among the most contentious issues in climate 12 change. This has immediate implications for policy as well, because the initial allocation of 13 emission rights and emission constraints will largely determine the distribution of costs. 14 The Framework Convention on Climate Change explicitly directs the parties to consider 15 equity: 16 17 The Parties should protect the climate system for the benefit of present and future 18 generations of humankind, on the basis of equity and in accordance with their common 19 but differentiated responsibilities and respective capabilities. Accordingly, the developed 20 country Parties should take the lead in combating climate change and the adverse effects 21 thereof 22 23 [Account must be taken of] the differences in their starting points and approaches, 24 economic structures and resource bases, the need to maintain strong and sustainable 25 economic growth, available technologies and other individual circumstances, as well as 26 the need for equitable and appropriate contributions by each of these Parties to the 27 global effort regarding [the Convention's] objective⁵⁵ 28 29 30 1.4.1 General Issues 31 32 Within the limits of cost-benefit analysis, equity arises because of the principle of 33 compensation, discussed in section 1.3, above. For example, suppose it could be shown 34 that a business-as-usual path produced higher total benefits than a path with lower 35 greenhouse emissions. We could not from this evidence conclude from this that the world 36 as a whole would be better off. Suppose that costs of warming fall predominantly on one 37 group or one generation, while benefits accrue to another. (For example, some have 38 speculated that the costs of damages from warming would fall largely on the South, without 39 a compensating increase in benefits (Parikh date).) Unless the gainers actually compensate 40 the losers for their losses, cost-benefit analysis cannot conclude that the change has been on 41 balance good for society. Compensation is particularly difficult if future generations would 42 bear most of the costs, because no "Fund for Future Greenhouse Victims" exists (Steer 43 1992). Thus, some have argued that in the absence of mechanisms to make these transfers, 44 we should not rely on possible future transfers from gainers to losers, but should instead 21 I insist that the gainers pay the costs up front. An alternative explanation addresses these 2 equity concerns by assigning different weights, perhaps based on economic status, to 3 changes in consumption of different individuals (Atkinson date). 4 5 No consensus exists among either economists or philosophers about the appropriate 6 ethical responses to the changes that would come with climate change. Should, for 7 instance, owners of resources be compensated for the losses that they incur as a result of 8 mitigation actions and the consequent change in prices or values? Economists have often 9 argued no, for several reasons. First, some wealth is not a reward for productive activity, 10 but merely an accident. It is not because country X did something that $200 billion worth 11 of minerals or oil was discovered to lie beneath its territory. Many would say that these 12 random allocations of wealth have actually contributed to world inequality, and that 13 eliminating a part of these windfall gains would, from the perspective of an egalitarian 14 social welfare function, be welfare-increasing. Another view denies that government 15 policies would be taking away value from assets that by right should be there; until now, 16 according to this view, these resources have simply been overpriced, not fully reflecting the 17 social costs imposed by their use. In this view, actions to discourage overuse would simply 18 rectify a previous mistake. 56 19 20 Whether investors or countries should be compensated for the adverse effects on their 21 market values remains controversial. There is, however, reasonable consensus on three 22 general principles: First, workers in adversely affected sectors may need assistance to 23 switch occupations (The market failure here is that workers cannot purchase insurance to 24 insure themselves against these kinds of adverse shocks.) Second, gradual transitions may 25 significantly lower the absolute cost of the transition. For instance, workers leave jobs 26 through natural attrition; if those leaving are not replaced, the industry will be scaled down, 27 with no transition cost to any individual worker. Third, the magnitudes of the 28 uncompensated redistributions associated with any change in policy are often correlated 29 with the magnitude of the political opposition. 30 31 Most policy changes produce winners as well as losers. If the relative price of natural 32 gas increases, owners of natural gas deposits may actually be better off. In economies with 33 progressive taxation, either of capital gains or consumption, then implicitly some part of 34 those gains are shared more broadly. 35 36 Virtually all policies discussed below also have different effects on different groups. 37 Residents of very hot and very cold climates consume more energy for heating and cooling, 38 and thus would be worse off, relative to those in more moderate climates. In some 39 countries, city dwellers can choose less energy-intensive modes of transport than those in 40 the countryside. 41 42 Many of these impacts will be reflected in capital costs. Thus, the value of land in 43 temperate climates is likely to rise, and the value in extreme climates to fall. (Similar 44 points can be raised, of course, about the costs imposed by climate change itself.) This 22 I capitalization effect has both favorable and unfavorable implications. In the long run, 2 residents of colder climates are likely to consume less heating fuel, but perhaps at a higher 3 price, which would leave them on balance about where they started. Energy prices are 4 likely to rise, and land rents to fall, in an almost offsetting way. On the other hand, current 5 owners of land would bear the full brunt of the present discounted value of all future 6 increases in taxes (or the tax-equivalent cost of regulations designed to reduce energy 7 utilization.) As a result, unless policy changes are introduced gradually, dramatic changes 8 in land values may occur, with possibly large effects on financial institutions and the 9 economy as a whole. Anticipation of these policies would partially offset these dramatic 10 changes in land values⁵⁷. 11 12 National Security. Climate change itself may affect the national security of many 13 countries. At the same time, policies to reduce greenhouse emissions may affect export 14 earnings and therefore national security of the energy exporting countries. 15 16 While countries may be willing (or forced) to accept changes in national wealth as a 17 result of changes in world prices induced by the response to the threat of climate change, 18 countries are less likely to be willing or able to accept what they may perceive as implied 19 threats to national security over which they have some control. Thus, a country with a 20 large endowment of coal becomes more vulnerable if it comes to rely on imported oil or 21 gas--supplies of which could be cut off in times of war. These countries may feel it 22 imprudent to switch, even if private economic gains were to be had; and they are 23 particularly unlikely to switch if the benefits take the form of an international public good. 24 25 Increasing world political stability would clearly address these concerns. But even were 26 that successful, it would not suffice. To increase national security, policies will need to 27 focus on increasing energy efficiency and reducing energy demand. This is an example of 28 the necessity in designing an international structure for greenhouse gas emissions for 29 allowing sufficient flexibility that the particular circumstances of each country can be 30 appropriately taken into account. 31 32 Benchmarks. The earlier discussion of equitable distribution of the burdens of 33 responding to greenhouse gases, employing generally accepted principles of public finance, 34 avoided the concept of benchmarks, which have played an important role in international 35 negotiations. Indeed, the "obligations" assumed under the Framework Convention obligates 36 the developed countries to return emissions to 1990 levels by the year 2000. One 37 justification for this form of obligation is that it gives some sense of equity. The difficulty 38 of the task for each country was gauged by its 1990 emissions; requiring each to keep 39 within that target appeared to impose a proportionate burden on each. It was a rough sense 40 of equity, because no attention was paid to the relative incomes of developed countries and 41 therefore no attention was paid to the implied tax rate. 42 43 But in a more fundamental sense this criterion can be criticized as inequitable. It pays 44 no attention to past efforts at achieving energy efficiency, nor to other circumstances that 23 1 might affect the implied tax rate. For instance, a country which, during the preceding ten 2 years, had made every effort to increase energy efficiency and switch consumption to less 3 energy-intensive commodities would face the burden of reducing its emissions still further. 4 Because the marginal cost curve for emissions reductions rises steeply beyond a certain 5 point, the implied tax rate would be considerably higher than for a country that had 6 previously encouraged overconsumption of energy, for example by energy subsidies. For 7 the second country, achieving the emission targets might require only eliminating the 8 energy subsidies, a policy with an implied negative tax rate. For a similar reason, countries 9 with large endowments of hydroelectric power may find it relatively difficult to meet an 10 emission target of this form. 11 12 Public finance theory has focused extensively on "second-best" policies, recognizing the 13 difficulty of achieving first-best objectives of either economic efficiency or distributive 14 justice. In this context, the central issue is whether there exist alternatives to 15 benchmarking, setting target emission reductions in relation to past emissions. When the 16 U.S. government recently issued tradeable emission permits for sulfur dioxide, it took 17 account of emission reductions already achieved. Benchmarking reflects information that 18 would not be reflected in a simple criteria, such as a particular emission level per unit 19 population or GDP. Thus, a strong case can be made for including benchmarking, if not in 20 the final allocation of permits (obligations), at least in the transition rules. 21 22 1.4.1 Intergenerational Equity 23 24 Efforts to control greenhouse emissions will provide benefits primarily for our 25 grandchildren and their descendants. We face a difficult task in estimating and judging 26 what aspects of climate and environment they will value and how best to preserve those 27 aspects for them. If we take aggressive action to limit climate change, they may regret that 28 we did not use the funds to push ahead development in Africa, to better protect the species 29 against the next retrovirus, or to dispose of nuclear materials safely. Chapter 3 addresses 30 directly the most important issue in intergenerational equity: choice of an appropriate 31 discount rate. 32 33 This argument also applies to actions with differential impacts on different regions. If 34 greenhouse warming turns out to be a major threat to countries of the South, and if the 35 North fails to reduce emissions aggressively now, countries of the South might suffer 36 additional damage later. Alternatively, if the North chooses to embark on an aggressive 37 control regime now, and if this cuts into Northern growth rates, the result would shrink 38 exports markets for the South, and thus reduce growth there; in addition, if the North views 39 its greenhouse efforts as, in effect, development aid for the South, it might cut back on 40 other programs (sanitation, water, education for women, etc.) with a greater impact on life 41 expectancy, health, and well-being. 42 43 44 24 1 1.4.2 Within-country Equity 2 3 While most discussions of equity and climate change have so far focused on North/South 4 issues or on issues between one country and another, issues of equity within a country are 5 also important, and indeed play a central role in the political debates about appropriate 6 responses to climate change. Most policy recommendations involve large within-country 7 losses for certain groups. For instance, any policy leading to less use of coal, and lower 8 producer prices for coal, will lead to large losses for coal mine owners and workers⁵. 9 10 The net efficiency gains (in reduced emissions) relative to the distributive effects may 11 differ markedly across resources. Thus, if elasticity of world oil supply is small, a tax on 12 oil will be reflected in the prices received by producers, and have little effect on cumulative 13 consumption of oil, though it may result in some short-run substitution against coal. 14 Policies aimed at increasing the date of arrival of substitutes for fossil fuels could lead to an 15 increase in current emissions, though long-run effects on atmospheric concentrations would 16 be positive. 17 18 19 1.5 ECONOMICS OF POLICY ACTIONS 20 21 Earlier sections set forth a basic framework for analyzing policies related to global 22 climate change, including a combination of mitigation, adaptation, and possibly climate 23 engineering. Striking the appropriate balance requires taking into account the costs, 24 benefits, and risks associated with each strategy. For instance, if risk were irrelevant, 25 governments should reduce emissions to the point at which a dollar of extra spending 26 would yield a dollar of expected savings in damages imposed by climate change, or save an 27 extra dollar of expected costs of adaptation. Adding risk and sequential decision making 28 complicates the analysis but leaves unchanged the basic principles. Because of the lasting 29 impact of climate change, and the magnitude of the resulting economic uncertainties, most 30 policy analysis has focused on a narrower set of questions: 31 32 1. What actions would improve economic efficiency (including the social costs of 33 implementing the policy) and reduce net greenhouse gas emissions? How much 34 emission reductions could be achieved by these means? 35 36 2. Beyond these zero-cost options, what are the least-cost methods of reducing 37 greenhouse gas emissions? What does the cost curve look like⁵⁹? What are the 38 alternative policy measures, and how do they compare? 39 40 3. What are the essential ingredients of an adaptation strategy, and to what extent will 41 market forces, on their own, provide the appropriate adaptive responses? 42 43 44 25 1 1.5.1 Zero-cost Options 2 3 A variety of inefficiencies in the energy sector--many of them government 4 induced--would, if eliminated, increase economic efficiency and reduce greenhouse gas 5 emissions at the same time. How large is the reservoir of conservation opportunities? 6 Proponents of the two major approaches to the question have debated this point for more 7 than a decade. Top-down models extrapolate observed behavior into the future. Bottom-up 8 models, combine engineering analyses to estimate costs with economic models of individual 9 choice. Top-down models generally show significant costs to reducing greenhouse 10 emissions in the future⁶⁰. Bottom-up, or technology-specified models, have been used to 11 show the existence of significant reductions in the cost of energy as new low emissions 12 technologies are adopted. Some proponents of bottom-up models argue that emission 13 reductions can be achieved at essentially no cost, seemingly repealing the long standing 14 economists' presumption that there is no free lunch⁶¹. 15 16 Much of the disagreement turns on empirical estimates. Economists have catalogued the 17 unintended consequences of government regulation. Many have also identified important 18 market failures that could give rise to inefficiencies within the private sector itself. The 19 next two sections will examine each of these effects. 20 21 1.5.2 Policy Reform 22 23 A variety of government reforms could enhance energy efficiency, including removing 24 energy subsidies, reforming or clarifying property rights, reducing non-greenhouse gas 25 externalities, and administrative reforms. 26 27 1.5.2.1 Removing Energy Subsidies 28 29 Energy subsidies induce inefficient energy use, reducing the total output of the economy 30 as well as increasing CO2 emissions. These subsidies are especially prevalent in 31 developing countries⁶. Shah and Larsen (1991) estimated world energy subsidies in 1990 32 to have been $230 billion, calculating that their elimination would reduce global carbon 33 emissions by 9 1/2% in addition to improving allocative efficiency thereby generating a 34 welfare gain in subsidizing countries. Burniaux et al. (1992) obtained similar results using 35 the GREEN model, concluding that the elimination of all existing distortions on energy 36 markets would yield an increase in world real income of 0.7% per year in addition to 37 cutting world emissions by 18% in 2050. (Dean 1994) Likewise, Unterwurzacher and Wirl 38 (1991) estimated that raising energy prices to world levels in Poland, Hungary, and 39 Czechoslovakia would reduce carbon emissions from those countries by 30%. Agricultural 40 subsidies also distort the outcome, especially affecting the size of forests. 41 42 1.5.2.2 Property Rights Reform 43 44 One responsibility of governments is to define property rights and enforce contracts. 26 1 Ill-defined property rights encourage overconsumption of resources. A clearer definition of 2 property rights could be particularly important in helping to decrease deforestation, for 3 example, while improving economic efficiency. Uncertainties about future property rights 4 may also contribute to economic inefficiency. Thus, for example, in developing countries 5 where large forests are owned by a few large landowners, excessive deforestation may 6 result from landowners' fear that their tenure will be limited. 7 8 1.5.2.3 Administrative Reforms 9 10 Defining property rights and eliminating energy subsidies are two important actions 11 governments can take to reduce greenhouse emissions. At the same time, many less 12 sweeping reforms can improve economic efficiency and simultaneously reduce greenhouse 13 gas emissions. For example: 14 15 Pricing of government produced electricity. Many governments price electricity not at the 16 market price but at the cost of production. Economists generally recommend that 17 electricity, like any good, be priced not at its cost of production, but at the competitive 18 price. In countries with a mix of plants, this means that electricity from all sources should 19 be priced the same--at the highest marginal cost of production⁶³ 20 21 Land use and other regulation. Changes in land use policy can also reduce energy 22 consumption (especially for transportation and space conditioning), and thus greenhouse gas 23 emissions⁶⁴ 24 25 1.5.2.4 Regulating Non-greenhouse Externalities 26 27 Many activities producing greenhouse emissions also generate pollution of other types. 28 For example, fossil fuel combustion releases conventional air pollutants; rush-hour auto use 29 contributes to road congestion. In the presence of these spillover effects or externalities, 30 market solutions will not properly reflect the externalities generated, leading to the 31 overconsumption of environmental resources. Energy taxes, congestion pricing, or tradable 32 permits can correct these market signals, resulting in lower emissions of both greenhouse 33 gases and other pollutants. Some reforms, such as congestion pricing, also reduce the need 34 for roads and other physical capacity. 35 36 1.5.2.5 Special Problems of Economies in Transition 37 38 The economies in transition provide special opportunities for mitigating greenhouse 39 emissions. In the old Soviet bloc, high energy subsidies and other price distortions affected 40 energy usage directly, as well as indirectly through the composition of output. Spotty 41 environmental regulation meant that Eastern Bloc nations lacked the environmental controls 42 common in the OECD. The capital shortage of the past decade has contributed to the 43 problem, through a general deterioration of physical capital stock. 44 27 1 While these problems are largely of governments' making, the remedy is likely to rely 2 on a combination of public and private actions: effective environmental regulation, 3 elimination of government-caused price distortions, and an economic environment in which 4 foreign and domestic investment can enhance the efficiency (including energy efficiency) of 5 the economy. For example, many analysts believe that cutting methane leakage from gas 6 pipelines will yield both high economic and cost-effective reductions in greenhouse 7 emissions. 8 9 1.5.2.6 Examples of Efficiency-Increasing Policies 10 11 Policies that cause individuals not to take into account the full social costs of their 12 actions often result in greater energy use and greenhouse emissions. The National Action 13 Plans of many countries have revealed examples of such policies, and have suggested 14 remedies, including: 15 16 Unit pricing of waste disposal to encourage recycling: The life-cycle social cost of 17 consuming a good includes its costs of production plus disposal. Most consumers, and 18 many businesses, pay a flat fee for trash disposal; with a flat fee, the marginal cost of 19 throwing away an extra pound of trash is zero. By moving from flat fees to unit pricing, 20 the actual price consumers pay to buy and dispose of a good will more closely match its 21 full life-cycle social cost. 22 23 Pay-at-the-pump automobile insurance: In most countries, drivers pay automobile 24 insurance yearly or monthly. Once the premium is paid, the marginal insurance cost of 25 driving an extra mile is zero, even though driving more does increase the chance of being 26 in an accident. As an alternative, drivers could be required to pay a portion of their 27 insurance bill at refueling. With pay-at-the-pump insurance, a tax would be levied on 28 gasoline and earmarked to pay for insurance premiums. This would raise the cost of 29 gasoline at the pump, but lower auto insurance premiums. 30 31 Subsidized parking. In some industrialized countries, many employers provide parking to 32 employees at no cost or lower-than-market cost, thus lowering the relative price of 33 commuting by car relative to public transportation. A distortion arises when governments 34 tax income spent on public transportation, but not income implicit in the parking subsidy. 35 36 Subsidized housing. In some industrialized countries, home mortgage interest is 37 tax-deductible. In all but a few countries, the implicit income on owner-occupied housing 38 is not taxed. These tax provisions encourage individuals to consume more housing than 39 they otherwise would. In cold or hot climates, where more housing space requires more 40 energy, this tax treatment increases CO2 emissions. 41 42 Subsidized trucking. Studies suggest that virtually all road damage is caused by heavy 43 trucks, which pay only a portion of the expense of building and maintaining the road 44 system. Many countries thus subsidize trucking compared with rail or barge transport, 28 1 probably increasing greenhouse emissions⁶. 2 3 1.5.3 Market Failures and Government Responses 4 5 Economists agree that governments can adopt policies to increase economic efficiency at 6 the same time that they reduce greenhouse emissions. For example, in some countries, fuel 7 prices do not reflect the full social cost of fuel burning; taxes can correct this market 8 failure. There is less agreement about whether, given market prices, firms fail to take 9 advantage of all of the energy efficiency opportunities available to them. This controversy 10 underlies the bottom-up versus top-down controversy treated at greater length in Chapter 8. 11 Engineers have identified a host of seemingly profitable actions that would also save 12 energy. Many economists, however, view this as evidence that the engineering analysis has 13 omitted characteristics important to consumers. 14 15 The substantial differences in practices both within and between countries suggests scope 16 for substantially increasing energy efficiency. Moreover, even best practices within a 17 country may not put it at the technological frontier. In deciding whether to adopt a new 18 production process, businessmen look only at the private costs and benefits. Many 19 technologists, however, conclude that even considering private costs only, firms should be 20 undertaking many energy-efficiency improvements. This section attempts to reconcile the 21 different schools of thought by reference to information-based market imperfections, as well 22 as by the criteria by which businesses make decisions. 23 24 Information dissemination. Acquiring information is costly; providing and disseminating 25 information has many features of a public good (Stiglitz 1988, Romer 19 , Arrow ). In 26 the absence of government intervention, there will be too little production and dissemination 27 of information. This is particularly true for information with widely dispersed impacts, as 28 opposed to information about, for example, the production of certain chemicals, which is 29 primarily of value to a few companies⁶. 30 Moreover, both theory and evidence support the view that markets, on their own, do not 31 provide an efficient level of disclosure of information⁶. Indeed, some evidence indicates 32 that markets may try to obfuscate relevant information.66 This provides the rationale for 33 government provision of information, or laws that in many countries require disclosure of 34 interest rates and other consumer-relevant information, including appliance energy 35 consumption. 36 37 Bureaucratic structure, limited scope of attention. In recent years, economic and 38 organizational theory⁶⁹ has emphasized that large organizations are not, in general, run by 39 owners; that the managers, even with the best designed incentives, do not in general 40 maximize the firm's market value; and that one of the principal scarce factors within an 41 organization is time and attention⁷⁰. How managers direct their attention has much to do 42 with what the firm does.⁷¹ The information disclosures noted in the previous subsection, 43 as well as a number of other government programs focusing on energy efficiency in 44 consumer products, electric lights, and motors, help focus management attention on energy 29 1 efficiency. The marginal managerial time required to make efficient energy decisions may 2 be small and focusing attention on this issue--when information is being freely provided 3 through government and other sources--may thus yield private returns well beyond these 4 slight marginal costs. 5 6 Returns to Scale and System Effects (network externalities): Some technologies might be 7 economically attractive at a large scale of production, but not on the much smaller scale on 8 which they might initially be adopted. Other technologies exhibit dynamic scale 9 economies: unit cost falls over time as a function of the cumulative output of firms or 10 industries. Technology "networks" may also affect diffusion rates. For example, cars and 11 trucks fueled with electricity, natural gas, methanol, etc., require a refueling infrastructure, 12 which itself competes for resources with the conventional fuel infrastructure already in 13 place⁷². 14 15 Building codes can be justified both in terms of these network externalities effects and in 16 terms of information failures. Consumers often have limited information concerning the 17 construction of their houses, and obtaining the information after the house is completed is 18 often difficult. Even were they to be provided with construction details, they would have 19 difficulty interpreting the implications. 20 21 Capital market imperfections. A major explanation of the difference between best-practice 22 and actual-practice technology is that bottom-up models often compute cost-effectiveness 23 using a discount rate substantially lower than the cost of capital calculated by firms.73 24 Studies of implicit discount rates consistently show that households and firms use discount 25 rates substantially above market rate for long-term government bonds. 26 27 Two explanations have been offered: 1) Risk: Interest rates facing firms and households 28 reflect the risk premium that lenders require to compensate them for the probability of 29 default. Firms often use discount rates that include a risk premium to reflect the riskiness 30 of projects; 2) Capital constraints: Individuals and firms often face rationing in capital 31 markets, both for credit and equity. Recent research has provided a rationale for this 32 rationing based on the fact that information is imperfect and costly.⁷⁴ 33 34 These capital market problems have one important implication: Models analyzing 35 best-practice cost-effective technologies using discount rates lower than those typically 36 employed by firms will overestimate the rate of dissemination of these technologies and 37 underestimate the perceived costs (to the firms and households adopting these technologies) 38 of mitigation strategies. 39 40 But these capital market problems raise three other questions: (1) Are firms rational in 41 using such high discount rates? (2) Does the use of such high discount rates imply a 42 market failure? (3) If so, will government intervention improve on the market outcome? 43 44 Economists emphasize that an analysis of the costs and benefits of a project must 30 1 separate four issues: timing, risk, capital constraints, and information. Discount rates are 2 only to be used for timing. Risk should be treated by converting costs and benefits into 3 certainty equivalents, then discounting costs and benefits for each year at the relevant 4 discount rate. Higher risks should not result in higher discount rates.⁷⁶ Similarly, 5 capital constraints should be reflected in the shadow price of capital, not in the discount 6 rate.⁷⁷ Because of limited information (and a version of the "winners' curse"78) firms 7 often require threshold rates of return significantly greater than the market rate of interest. 8 In doing so, they may confuse time and information risk: that is, the rules of thumb firms 9 use to evaluate investments may sometimes lead to market inefficiencies, including perhaps 10 in the area of energy-efficient technologies. 11 12 Even were firms to follow the economist's guidelines, in the presence of capital 13 constraints, market outcomes would not, in general, be socially efficient (i.e., they are not 14 constrained Pareto optimal.) There may be significant discrepancies between social and 15 private returns to investment (even apart from the externalities associated with greenhouse 16 gases or technological diffusion.) This provides part of the rationale for possible 17 government interventions in capital markets. Though these capital market imperfections 18 imply that there is no presumption that market allocations are efficient, there is no 19 consensus that they lead to significant underinvestment in energy-efficient technologies in 20 particular⁸⁰. 21 22 1.5.3.1 Revising national accounts 23 24 Some have suggested revising the conventional systems of national accounts to 25 incorporate full social pricing of resources. An early contribution suggested a new 26 measure of economic welfare based on consumption that increases quality of life (Tobin 27 and Nordhaus, 1972). These authors and others recognized that national income 28 accounting, widely adopted after World War II, measures aggregate income and expenditure 29 flows, but does not incorporate environmental costs and benefits. 30 31 Conventional national income accounting does not fully report three categories of 32 resource expenditures: a) defensive expenditures, either for pollution prevention before the 33 fact or for cleanup after the fact (although these expenditures are not separately reported, 34 they are counted in GDP); b) consumption of environmental goods (such as exhaustible 35 resources)81; and c) conflicting uses of environmental services (such as the atmosphere, 36 used by producers as an input into production, and by households as a consumption good). 37 38 One proposal would include in GDP the effect of changes in quality of the environment. 39 In Eastern Europe and the former Soviet Union, steady increases in reported post-war GDP 40 masked the effects of decades of environmental degradation; for part of that period, 41 environment-adjusted GDP almost certainly declined⁸². 42 43 However, important conceptual problems in defining levels and changes of 44 environmental assets, complicate the task of modifying national accounts. First, the stock 31 1 of natural resources has no obvious definition. While most geologists would agree on the 2 size of coal stocks - their location is known and their in situ value can be estimated this 3 cannot be said for oil or minerals⁸³. Second, environmental assets--such as air quality-- 4 present another set of problems, because no market prices exist to value the asset. 5 6 Four approaches are commonly used to calculate changes in the natural environment 7 (Peskin and Lutz, 1990): 8 9 a) The environmental expenditure approach, used recently in the United States, subtracts 10 pollution abatement expenditures from GDP; 11 b) The physical accounting approach, used in Norway and France, establishes satellite 12 accounts using physical units of measurement to account for flows and stocks of 13 resources; 14 c) The depreciation approach adjusts gross and net product by subtracting out the value of 15 natural resource depletion (Repetto 1989; El Serafy ***); and 16 d) The comprehensive approach uses both physical measures and value (Statistical Office of 17 the United Nations, 1992). 18 19 Another measure of broad-based welfare, although not including environmental amenities, is 20 the UN's human development index or HDI (UNDP, 1990). The HDI gives a composite 21 measure of human development by combining three key indicators: longevity (measured by 22 life expectancy at birth), education (measured by adult literacy and mean years of 23 schooling), and income (real GDP per capita adjusted for purchasing power). Although the 24 HDI is not directly related to global environmental issues, both climate change and 25 abatement policies may affect it⁸⁴. 26 27 1.5.4 Innovation 28 29 Standard competitive analysis argues that given all required information and technology 30 market economies produce efficient outcomes. But recent economic analyses have shown 31 that, in general, market economies need not result in the efficient allocation of resources to 32 information production and dissemination, and to innovation. The first of these issues was 33 discussed earlier. The second is more complex. 34 35 In the absence of intellectual property rights, firms would have less incentive to 36 innovate. With standard patent terms, firms are not able to appropriate all the returns to 37 their innovative activity. Setting the optimal patent life involves balancing off the 38 inefficiencies resulting from the exercise of monopoly power during the duration of the 39 patent (static inefficiencies) with the increased incentives for innovation85. Largely 40 because innovators seldom appropriate all of the returns to their innovation, there is a 41 general consensus that markets provide insufficient incentives for R & D; and the greater 42 the spill-overs, the greater the undersupply.86 Since the spill-overs are likely to be greater 43 the more basic the research, this suggests a role for government in subsidizing basic and 44 near-basic research. In the same way, the high cost of establishing intellectual property 32 1 rights impedes the transfer of technology to developing countries. 2 3 Still, there is a general consensus among economists that the patent system provides a 4 better basis of financing applied research than do government grants, largely because of 5 difficulties government has in picking those most likely to produce high returns. The 6 question is, is there any reason to believe that any market failures, in terms of insufficient 7 level of innovation, are worse in this area than in other areas, i.e. are there any special 8 grounds for arguing for government R & D subsidies, provided the government has 9 corrected energy prices to reflect the externalities generated? Obviously, in the absence of 10 such corrections, market incentives to provide energy saving innovations will be distorted, 11 just as market incentives to adopt energy saving technologies are reduced⁸⁷. (Tradeable 12 permits have similar effects to corrective taxes, since firms will value reductions in 13 emissions from new technologies, since such reductions will require them to purchase fewer 14 permits.) 15 16 Innovation is important, because it provides perhaps the best opportunity for low-cost 17 methods of reducing emissions. Several studies have confirmed the impact of accelerated 18 deployment of advanced energy technologies on the future rate and timing of anthropogenic 19 climate change⁸⁸ 20 21 1.5.5 Carbon Taxes and Tradable Permits. 22 23 Economic efficiency requires all agents in the economy to pay the full marginal social 24 costs of their actions. But firms and households are not charged for the additional warming 25 potential they add to the atmosphere, and so do not pay the full social costs they impose. 26 Two economic instruments can correct this market failure: carbon taxes and tradeable 27 permits. 28 29 A tradeable permit scheme involves a determination of the total level of permits and a 30 distribution of the initial allocation, with emission levels for any firm limited to the number 31 of permits held. The initial distribution may be made by an auction or allocation 32 according to benchmarks (e.g. per capita as of a given date), or by historical emission levels 33 ("grandfathering"); alternatively, emission rights could be grandfathered in at current levels, 34 and gradually shifted over to a per capita allocation as of a given date. 35 36 Once permits are distributed among the regulated entities, a market is set up allowing 37 companies to buy and sell permits according to their plants' planned emissions. The cost of 38 production then includes not only the costs of conventional inputs, but also the costs of 39 additional permits to offset additional emissions. Plants whose cost of mitigation is low 40 will find it relatively easier to abate pollution rather than to buy permits. Plants with higher 41 costs of mitigation will have a greater preference for buying permits than for abating 42 pollution. The price of the permits, which are artificially created scarce resources, is 43 determined by the market. With the use of tradable permits, companies have an incentive 44 to improve the efficiency of their production, thereby reducing their emissions level, as they 33 1 can sell excess permits on the market and generate revenue. 89 2 3 While permits thus create a marginal cost of production related to the marginal 4 emissions, carbon taxes impose a tax directly on the marginal emissions. Both systems thus 5 force producers and households to face the true social costs of their actions⁹⁰. Permits are 6 better for regulating large sources; carbon taxes are better for small sources. In principle, 7 both could be adjusted to achieve the desired level of emissions desired, although 8 adjustments of this sort are likely to be difficult in practice. 9 10 The initial allocation of permits will largely determine the distribution of costs of 11 abatement (Chapter 3 discusses these issues of equity at greater length), and at the same 12 time influence the growth path of participants' economies. For example, an allocation 13 based on population at a given date would provide an incentive for population control⁹¹. 14 15 Imposing carbon taxes can have large distributive consequences. While a system of 16 grants can largely offset these distributive consequences, such offsetting grants might well 17 not be made. Providing tradeable permits equal to existing levels of emissions seemingly 18 makes no firm or household a loser. But granting permits in that way represents effectively 19 a grant of money (such permits have monetary value) in a way which may not well accord 20 with standard ethical principles. For instance, by embarking on an ambitious program to 21 reduce emissions, a firm may qualify for fewer permits than it would otherwise. Not only 22 does this violate ordinary notions of fairness, but anticipation of granting permits in this 23 way would, accordingly, have strong adverse effects on emissions⁹². 24 25 That a tax has large distributive consequences, while presenting a political impediment to 26 its introduction, is not necessarily an argument against it. Some argue that those who failed 27 to pay the full social costs of their actions earlier are not therefore entitled to special 28 allotments now⁹³. 29 30 Once one recognizes that the distribution of permits across countries will, inevitably, be 31 decided by some principle other than current levels of emissions, then it becomes clear that 32 both taxes and tradeable permits will have distributive consequences. An agreement among 33 countries to impose uniform corrective taxes, with each country retaining its own revenue, 34 would have little redistributive consequences across countries and the burden of the tax 35 would, as noted earlier, likely be progressive. 36 37 Governments in the North might decide to use some of the revenues so generated to 38 encourage activities (such as R & D directed at technology appropriate for developing 39 countries) that benefit the South, or to provide other forms of assistance. Decisions about 40 this could be made bilaterally, or collectively. By contrast, decisions about how tradeable 41 permits would be allocated across countries would have to be made multilaterally. Arriving 42 at a formula for distributing these property rights may be far more difficult than arriving at 43 a tax rate and a procedure for its revision, as any such formula may entail substantial 44 redistribution. 34 1 1.5.5.1 A Double Dividend? 2 3 Revenues from carbon taxes may allow a reduction in distortionary taxes elsewhere in 4 the economy. If the (compensated) elasticity of demand of labor is relatively high, and the 5 revenues from the carbon tax are used to reduce taxes on labor income, then there would be 6 a double dividend from the carbon tax in the reduced dead-weight loss from the labor tax, 7 which would otherwise be significant. 8 9 At least three objections have been raised to this idea. First, conceptually: rationalizing 10 the tax system by reducing the most distortionary taxes is certainly a worthy goal, but 11 should not be confused with imposing a carbon tax; neither implies the other. Second, 12 empirically: if the (compensated) labor supply elasticity is relatively low, then the dead- 13 weight loss form the labor tax is low, and the commensurate welfare gain is reduced. 14 Third, politically: if carbon tax revenues are used to offset the existing deficit, rather than 15 to reduce taxes on labor and capital, then the carbon tax acts more like an ordinary tax 16 increase, increasing distortions from taxation to pay for budget items with a lower return 17 than the extra burden imposed. The gains to total welfare (reductions in dead-weight loss) 18 depend on the welfare losses associated with these other distortionary taxes, as well as the 19 cross-elasticities of demand between carbon and other taxed commodities⁹⁴. 20 21 Even though carbon taxes may have a positive effect on economic welfare, they can at 22 the same time have a negative effect on measured economic growth, since those measures 23 typically do not include the value of environmental degradation. Researchers differ on the 24 size of the loss. The wide spread in the numerical results, however, should not obscure 25 agreement among researchers on a number of important points. All models used in the 26 major comparison studies to date have projected: first, that intervention would be required 27 to achieve the emissions targets; second, that the size of the required tax increases with the 28 stringency of the carbon limit; and third, that the size of the appropriate carbon tax varies 29 over time, even for the same emissions or concentration target9⁵. 30 31 1.5.5.2 Energy Taxes 32 33 Energy taxes as a means of controlling greenhouse emissions must be viewed as "second 34 best" taxes in that they do not directly tax the externality, greenhouse emissions. While 35 carbon taxes directly penalize the externality-generating activity, less targeted alternatives, 36 such as energy taxes, may be politically more acceptable. Carbon taxes reduce emissions 37 first, directly, by moving up the demand curve; second, indirectly, by encouraging 38 consumers to switch to less carbon-intensive energy sources. On the other hand, energy 39 taxes work through the first path, by reducing total energy consumption. But to the extent 40 that certain kinds of energy, like hydroelectric, have, at least in the short run, a relatively 41 inelastic supply, a major impact will be on oil, gas, and coal; and to the extent that oil and 42 gas supplies are best described by a model of an exhaustible natural resource, with 43 relatively low extraction costs, most of the supply reduction will occur in coal. Thus, 44 indirectly, there will be a considerable amount of switching, through the indirect effects. 35 1 1.5.5.3 Tradeable Permit Markets. 2 3 In order for systems of emission permits to achieve reductions in emissions efficiently, 4 there needs to be a market for emissions across international boundaries. There is some 5 debate about the role of government or international organizations in establishing a market 6 for such emissions. While some believe that there are private incentives for the 7 establishment of markets, others contend that government can play a key market facilitation 8 role through establishing centralized clearinghouses for information or even provide for 9 permit banking (storage) or brokerage (trading) to facilitate trades between private parties. 10 These services would prove especially useful in the more complex international context. 11 12 1.5.5.4 Combining taxes with tradeable permits 13 14 While carbon taxes and tradeable permits are typically presented as alternatives, policy 15 makers may prefer to combine them. The major disadvantage is the additional 16 administrative cost. The advantage is more subtle: the market value of tradeable permits is 17 reduced as taxes increase. With an optimal carbon tax, and with a tradeable permit supply 18 set equal to the optimally chosen level of emissions, the price of a permit should be zero. 19 More generally, the greater the tax, the less the value of a permit (for a fixed supply of 20 permits); and thus, the less the distributive consequences of alternative rules for allocating 21 the initial endowments of permits. Another possible combination is permits for large 22 sources and a tax (set to equal the permit price) on small sources. 23 24 1.5.5.5 Intertemporal patterns of taxation 25 26 If the target is the long-run atmospheric concentrations of greenhouse gases, then climate 27 change damages will be approximately the same for emissions in any particular year, 28 although the optimal carbon tax must be adjusted for differences in costs, discounting, and 29 risk⁹⁶. The focus on concentrations also implies that early reductions are more valuable 30 than later reductions. 31 32 For exhaustible natural resources, such as oil, economic efficiency requires that those 33 deposits with the lowest cost of extraction be extracted first. Hotelling (1931) argued that 34 competitive equilibrium implies that rents (price minus costs of extraction) must rise at the 35 rate of interest. The price of the backstop technology (an energy source assumed to be 36 available in unlimited quantities at a certain price after a certain date, such as electricity 37 from solar photovoltaic cells) determines the set of resources to be ultimately exploited, i.e. 38 all resources for which the cost of extraction is less than the price implied by the backstop 39 technology's price. Thus, it is the tax on oil or gas at the date of switching to the backstop 40 technology which determines the ultimate amount of oil and gas that will be extracted, and 41 thus the total burden of CO2 placed on the atmosphere by oil and gas. If that were the 42 only matter of concern, one could imply announce a commitment to impose such a tax 43 sometime in the future, when relevant backstop technologies become available and 44 competitive. That announcement would, if believed, have an immediate effect on current 36 I prices. 2 3 Figure 3 shows the dynamics of exhaustible resources. S denotes the total available 4 stock of gas and oil. S. represents the amount of stock left in the ground, a function of the 5 "backstop" price. Imposing a uniform emission tax lowers the cut-off price, and flattens the 6 price curve. The effect on current price depends on how close the current stock is to 7 economic exhaustion (S₀). Given the currently high levels of rent, it is probable that the net 8 current effect on producers is to raise the producer price, not lower it. Thus, short-run 9 leakage effects will be the opposite of that predicted in many models. 10 11 1.5.6 Regulatory Approaches 12 13 Regulation of greenhouse emissions may take many forms, including fuel restrictions, 14 technology standards, and various economic incentives; Chapter 11 discusses these options 15 in detail. Economists have long argued for the use of economic incentives for 16 environmental management, although governments have so far relied on traditional 17 regulations almost exclusively, as traditional approaches have been more acceptable to the 18 public and industry. For example, Corporate Average Fuel Economy (CAFE) standards in 19 the U.S.A. require automobiles to meet certain mileage standards. 20 21 Proponents of the traditional approaches often claim that these approaches "force" 22 technology, with less redistribution than forcing technology through taxes. Thus, if 23 automobile makers are required to attain a certain mileage standard, they will meet the 24 standard; on the other hand, gasoline taxes might have to rise significantly to reduce fuel 25 consumption by the same amount. Evidence for the claim of technology forcing, however, 26 is equivocal. In several cases in which industry failed to meet the applicable standards, 27 regulators withdrew the standard in the face of unacceptably high economic costs. The 28 apparent advantage of technology forcing -- one large club instead of the subtle and 29 continuous incentives provided by market forces -- is often in fact a disadvantage. 30 31 Other disadvantages to the traditional approach are: First, traditional regulations do not 32 in general result in economic efficiency, since those in one sector face implicit or explicit 33 incentives at the margin that differ from those in other sectors. Second, traditional 34 regulations fail to account for offsetting private responses that may neutralize the 35 regulation's intended effects and even cause environmental harm. Third, traditional 36 regulations provide no incentives for exceeding the given target, even when doing so might 37 result in little additional cost⁹⁷. 38 39 Traditional regulations that focus on inputs and technology rather than outputs have the 40 further disadvantage of not directing research toward meeting performance objectives at 41 least cost. For instance, when stack gas scrubbers are required, research will be directed at 42 producing scrubbers at least cost, rather than reducing emissions at least cost. Hence, a 43 dynamic inefficiency is added to the obvious static inefficiencies. Finally, because of the 44 nature of the regulatory process, traditional regulatory designs are more likely to be 37 1 captured by special interest groups⁹⁸. 2 3 4 1.6 SUSTAINABLE DEVELOPMENT 5 6 The concept of sustainable development was formulated about 1980 as a response to the 7 apparent conflict between environmental concerns and the need for economic growth, 8 especially in developing countries. At the time, preserving biodiversity and maintenance of 9 environmental quality seemed incompatible with a 5- or 10-fold increase in world output, as 10 would be necessary if per capita incomes of the South were eventually to approach those of 11 the North now. The sustainable development debate rekindled interest in the question of 12 resource scarcity, originally addressed in the economics literature by Malthus (1798), and 13. revived in the policy arena with the publication of Limits to Growth (1972). A variety of 14 definitions of sustainable development have been proposed. The Bruntland Commission 15 offered this interpretation: 16 17 Sustainable development is development that meets the needs of the present without 18 compromising the ability of future generations to meet their own needs99. 19 20 Although the Commission clearly had in mind environmental considerations, its report did 21 not spell out exactly what sustainable development included. The Interamerican 22 Development Bank explicitly included environmental concerns in its formulation: 23 24 [Sustainable] development distributes the benefits of economic progress more equitably, 25 protects both local and global environments for future generations, and truly improves 26 the quality of life. 27 28 1.6.1 The Economic Concept of Sustainable Development 29 30 Although sustainable development began as an ethical principle, it is at the same time 31 an economic concept, focusing on two issues: 1) intertemporal equity and 2) capital 32 accumulation and substitutability. 33 34 Intertemporal equity. Robert Solow's definition (Solow 1992), which focuses on 35 intertemporal equity, has enjoyed wide currency among economists: sustainable 36 development requires that future generations be able to be at least as well off as current 37 generations. The central implication is that any environmental degradation should be offset 38 by increases in capital stock sufficient to ensure future generations at least the same 39 standard of living. Sustainable development does not preclude the use of exhaustible 40 natural resources, but requires that any use be appropriately offset. 41 42 In practice, sustainability as defined by Solow provides few constraints on growth paths 43 for the developed countries, so long as steady increases in productivity continue. Technical 44 change alone, without further capital accumulation, may well sustain future living standards 38 1 and offset any effects of environmental degradation. To see this with a numerical example, 2 note that even if estimates of adaptation costs are taken to be 1 to 3 percent of GDP should 3 significant warming occur, and if even moderate rates of technical progress of 1 to 1.5% 4 per annum continue to occur, then future generations 45 to 70 years from now will have 5 twice the income of the current generation. Even with no discounting, it would be hard on 6 this account alone to justify the sacrifice of further consumption by this generation in order 7 to enhance the standard of living of the future generation. 8 9 Capital accumulation and substitutability. To what extent can technology, skills, and 10 capital equipment substitute for a decline in exhaustible resource stocks or a decline in per 11 capita environmental amenities? Solow's definition, and much of economic theory to date, 12 implicitly assumes that substitutes exist or could be found for all resources. As formulated 13 by Pearce (1988), if substitution possibilities are high, as most evidence from economic 14 history indicates, then no single resource is indispensable, and intertemporal equity stands 15 as the only crucial issue. If on the other hand, human and natural capital are complements 16 or only partial substitutes (e.g., if because of the irreversibility of extinction¹⁰⁰, capital 17 accumulation is only a partial substitute for biodiversity) then different classes of assets 18 must be treated differently, and some assets are to be preserved at all costs. 19 20 Pearce (1992) distinguished between strong and weak sustainability. Weak 21 sustainability requires that any depletion of natural capital be offset by increases in human- 22 produced capital -- the Solow criterion -- or by the substitution of other forms of natural 23 capital, such as renewable assets in place of nonrenewable assets. Strong sustainability 24 requires that some natural capital, being irreplaceable, must be preserved It has been 25 argued that there are no close substitutes for the atmosphere and the climate it produces, 26 implying no substitution possibilities and hence the need to preserve the atmosphere. 27 28 1.6.2 Implications of Sustainable Development for Developing Countries 29 30 In many developing countries, Solow's definition would not be viewed as 31 acceptable, since it seems to place no weight on their aspirations for growth and 32 development. Developing countries have also implicitly criticized the debate over 33 substitutability for the same reason: if some natural assets must be preserved at any cost, 34 then there may be no trade off with development. A leading spokesman for the G-77 has 35 emphasized the importance of economic growth in achieving sustainable development: 36 37 None of these linked [development] issues can be resolved unless and until there is 38 broad-based development in the South. Only such broad-based development can 39 provide the foundation of international security. The Northern approach is to attack the 40 symptoms, with a residual emphasis on poverty eradication. But the international 41 community must insist on addressing the underlying causes for concern. Development, 42 environmental protection, peace, and security are indivisible¹⁰². 43 44 Similarly, the G-77 and China emphasized the need for economic growth in the 39 1 following statement on sustainable development and the environment introduced during the 2 INC negotiations in 1991: 3 4 Protection of the global climate against human-induced change should proceed in an 5 integrated manner with economic development in light of the specific conditions of each 6 country, without prejudice to the socio-economic development of developing countries. 7 Measures to guard against climate change should be integrated into national 8 development programmes taking into account that environmental standards valid for 9 developed countries may have inappropriate and unwarranted social and economic costs 10 in developing countries 103 11 12 13 1.7 CONCLUSIONS 14 15 Climate change presents the analyst with a set of formidable complications: large 16 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, 17 long time lags between emissions and effects, an irreducibly global problem, wide regional 18 variation, and multiple greenhouse gases of concern. The risks of climate change are 19 highly asymmetrical, with a large probability of a small loss, and a small probability of a 20 large loss. Even in the presence of significant uncertainty, this asymmetry, plus the 21 principles of risk aversion and portfolio balancing provide the rationale for going beyond 22 no-regrets policies to those that incur net costs. 23 24 The atmosphere is an international public good, in that all countries benefit from each 25 country's reduction in greenhouse emissions; greenhouse gases are an international 26 externality, in that emissions by one country affect all other countries to the same extent. 27 28 Both public goods and externalities require a legal framework within which the 29 problems they pose can be addressed. No such legal framework now exists for global 30 climate change. Mechanisms for control of international public goods may include the 31 definition of property rights, the definition of limits to emissions and a consensus for 32 distributing the same in a fair and equitable manner. If, on the other hand, each agent acts 33 in its individual interest, the result will be too little of the public good and too much of the 34 externality. 35 36 Climate change demands a decision process that is sequential, can respond to new 37 information with mid-course corrections, and can include insurance, hedging, and the option 38 value of alternative courses of action. The challenge today is to identify short-term 39 strategies in the face of long-term uncertainty. The question is not, what is the best course 40 over the next 100 years, but rather, what is the best course for the next few years, knowing 41 that a prudent hedging strategy sill allow time to learn and change course. 42 43 Policy measures to reduce risks to future generations include 1) immediate reductions 44 in emissions; 2) R&D on new supply and conservation technologies; 3) continued research 40 1 on how much change is likely and what its effects will be; and 4) investments to assist in 2 adaptation if significant climate change occurs. A well-chosen portfolio of policies will 3 yield greater benefits for a given cost than any one option undertaken by itself. Striking the 4 appropriate balance requires taking into account costs, benefits, and risks. 5 6 In an interrelated global economic system, an attempt to reduce greenhouse gas 7 emissions in one region or one sector of the economy may be offset by increases in other 8 regions or sectors. This may occur through a) the loss of comparative advantage in the 9 carbon-intensive sectors of the regions that limit emissions; b) the relocation of industries; 10 or c) changes in world energy prices and the resulting shift in consumption. Any control 11 strategy must account for these global effects. 12 13 Issues of efficiency and equity can largely be separated. The Framework Convention on 14 Climate Change calls on all parties to implement cost-effective measures for abatement, 15 enhancement of sinks, and adaptation. The Framework Convention also explicitly requires 16 an equitable sharing of the burdens of response, recognizing the common but differentiated 17 responsibilities of the parties. Different countries will be affected differently by climate 18 change and by policy responses to it. The South is more likely to be adversely affected 19 than the North; moreover, developing countries often lack the financial and technical 20 resources to respond. The Framework Convention does not, however, include a formula for 21 sharing the costs of addressing climate change. 22 23 Efficiency requires that emission reductions occur where their cost is lowest, 24 irrespective of who bears the financial responsibility. Efficiency calls for removing energy 25 subsidies, reforming and clarifying property rights that affect energy use and carbon 26 storage, and reducing non-greenhouse externalities that have the side benefit of reducing 27 greenhouse emissions. Efficiency may also be promoted, and greenhouse emissions 28 reduced, by better information dissemination and by addressing capital market imperfections 29 that inhibit the adoption of energy-efficient technology. Dynamic analysis indicates large 30 potential gains from flexibility in timing of greenhouse reductions to allow for the 31 economical turnover of capital stock, and to allow time for the development of low-cost 32 substitutes. Policies that promote efficiency by requiring nations to face the full costs of 33 their actions will also address equity concerns. 34 35 Efficiency also calls for international mechanisms such as joint implementation and 36 coordinated economic instruments. Coordinated carbon taxes and tradable carbon emission 37 permits can correct the market failure associated with greenhouse emissions. 41 1 2 1.8 ENDNOTES 3 4 1.A warmer climate would directly affect the temperature-sensitive sectors of the economy: agriculture, forests, 6 and fisheries; and construction. Because of the risk of drought, arid and semi-arid regions are likely to be most 7 vulnerable to warming. A warmer climate may also encourage insect populations; this, in turn, is likely to 8 decrease agricultural yields in some regions. On the other hand, increased CO2 concentrations increase 9 photosynthesis and the effect of water consumption in controlled settings, and may also do so in farmers' fields, 10 increasing crop yields. 11 12 A warmer climate would hurt agriculture in some regions and help in others. Recent global studies find that 13 Northern temperate regions could benefit, particularly for small increases in temperature, but low latitude areas 14 could lose. The global studies show significant losses from climate change alone that are significantly offset by 15 the direct beneficial effects of higher ambient levels of carbon dioxide on plant growth. Reilly, et al. (1993) 16 calculate that global agricultural production will increase for global mean warming of up to 2°C. 17 Most analysts expect that agriculture can adapt without significant added costs for the world as a whole (although 18 some regions will suffer greater-than-average losses), in part because of crop shifting and other adaptation by 19 farmers. Trade in international commodity markets (Ausubel, 1990; Rosenzweig and Parry, 1994; Reilly, 20 Hohmann, and Kane, forthcoming; Kane, Reilly, and Tobey, 1992) can ensure that agricultural prices change only 21 moderately, though particular regions may gain or lose significantly. 22 2.A warmer climate implies both a poleward movement of forests and changes in forest composition. The result 23 would be to increase boreal forests and, by a smaller percentage, to decrease tropical forests. On balance, doubling 24 CO2 concentrations would modestly reduce both standing biomass and forest area (Sedjo and Solomon, 1989). 25 Some analysts also calculate an additional temporary decline in forest cover during the transition to a warmer 26 climate (EPA, 1989); this decline could last for several hundred years, as more forest death occurs on southern 27 edges than additional growth occurs on northern edges. Higher CO2 concentrations might also increase tree 28 growth, partially offsetting direct losses from warming. 29 .Some analysts conclude that a warmer climate would significantly reduce water supply (Gleick, 1987). Most 30 climate models now predict hotter and drier weather for the mid continents (IPCC, 1990a). If this occurs, the 31 downward pressures on water supply will be intensified by upward pressures on water demand. 32 33 Because of the key role of local conditions, further generalizations are difficult. River basin runoff is the 34 difference between precipitation and evaporation plus absorption (IPCC, 1990a). Hence small variations in these 35 three terms--each of which depends on the accuracy of regional climate forecasts--can make a large difference 36 in the runoff. 37 38 4. A warmer climate implies reduced heating costs and greater cooling costs. At least for countries in 39 temperate and cool climates, this would move the population-weighted average temperature closer to the ideal 40 indoor temperature. Nordhaus (1991) finds that warming of approximately 3.0°C in a 1981-sized U.S. 41 economy will increase electricity costs by $1.65 billion and decrease heating costs by $1.16 billion (1981 42 dollars), resulting in net costs of $0.49 billion. Rosenthal, Gruenspecht, and Moran (1994) find that global 43 warming lowers the cost of heating and cooling in the U.S.. Cline (1992) finds net costs of $9.9 billion. 44 45 5.Global mean sea level appears to have risen 10-20 cm over the past century (Warrick, Oerlemans et al., 1990). 46 The IPCC has projected a warming-induced rise in mean sea level of 21 to 71 cm by 2070 (IPCC, 1990a), sharply 47 reduced from estimates of 3 to 8 m. made in the early to mid-1980s (Schneider and Chen, 1980; Hoffman et al., 48 1983; Hoffman et al., 1986), which assumed a disintegration of the West Antarctic Ice Sheet. The current "best 42 I estimate" for mean global sea level rise by 2030 under "business as usual" is 18 cm (Warrick, Oerlmans et al. 2 1990; Raper et al., 1990). 3 4 A rising sea level could inundate some small island nations, flood some low-lying coastal cities (e.g. in 5 Bangladesh), damage coastal farmland, and contaminate water supplies (IPCC, 1990a). More severe storms 6 would accelerate coastal erosion and affect aquifers, intensifying problems existing today. Warmer oceans might 7 damage coral reefs, a natural defence for some coastal areas. To account for the costs of protective measures, 8 the costs of defending the world's developed coastlines against a 1 m rise over the next 100 years have been 9 estimated to range from 0.01% for the former USSR to 0.74% for Indian Ocean small islands, with a world 10 average of 0.028% of GNP per annum (IPCC, 1992). 11 6. Some analysts believe that the justification for costly and more restrictive actions rests on intangible costs 12 (Nordhaus, 1993). Intangible refers to the difficultly to measuring, and include migration, comfort, health, 13 leisure activities, urban infrastructure, and air pollution (Fankhauser 1992; Cline 1992). A warmer climate 14 would improve human comfort in cold areas, and in the winter generally, while decreasing comfort in warm 15 areas. Mearns et al. (1984) calculate a threefold increase in heat waves for a 1.7 degree C. rise in U.S. mean 16 temperature. It is not yet clear whether net comfort will rise or fall for a given rise in temperature. Chapter 17 6 covers these issues in more detail. 18 7.Both the natural rate and human contribution to the process of species loss are difficult to estimate (EPA, 1989). 19 Predicting the effect of climate change on species distribution is more difficult still. The magnitude and even the 20 sign of these intangibles remains in dispute, for uncertainty about the duration and type of environmental changes 21 that would be caused by climate changes make the long-term projection of species change highly complex. 22 Moreover, while some species may have difficulty adapting to climatic changes, opportunities for other species 23 that otherwise may have become extinct may open up. Population pressures have added to pressure on 24 ecosystems, particularly in the third world. Climate change may exacerbate these damages, particularly in Africa, 25 where environmental degradation has been particularly pronounced during the last 15 years (UN, 1989). 26 8. A warmer climate might also increase climate variability, though climatologists cannot say with assurance 27 whether climate will become more or less variable daily and seasonally. The normal variability of existing 28 climate also makes it difficult to detect any warming that might be occurring. The "signal to noise" problem 29 makes it possible for observers to mistakenly consider a normal extreme event as evidence of a trend, or to 30 fail to see a trend in a noisy data series. Because of the signal-to-noise problem, the scientific community is 31 unable to indicate confidently whether extremely warm years of the 1980's are evidence of climate change or 32 not (IPCC 1992, A. Solow 1992). 33 9.Recent ice core data from Greenland points to earlier temperature rises of several degrees occurring within a 34 few decades (IPCC 1994); reasons for these sudden changes are still not understood, but might have come from 35 changes in deep ocean currents. The other side of this debate holds that on the whole the biosphere is 36 homeostatic or self-correcting; this "Gaia hypothesis" compares the biosphere to a living being: once moved away 37 from equilibrium, self-correcting forces naturally move it back to equilibrium (Lovelock, 1979). The two 38 hypotheses are not necessarily inconsistent. Within a range of variation, homeostatic properties could dominate, 39 even if stability was not guaranteed outside that range. 40 Countries make century-long choices implicitly, as when they choose population policies, policies affecting 41 long-term capital formation and productivity growth, or protection of environmental assets. 42 11. Although bargaining theory has contributed some basic principles, such as the importance of threat points. 43 1 12. Scientists have proposed several methods to measure the warming potential of different greenhouse gases 2 (IPCC Special Report 1994). Although global warming potential (GWP), endorsed by the IPCC, is a useful 3 concept in formulating comprehensive approaches to greenhouse mitigation policies (Stewart and Wiener, 4 1990), some analysts have recently criticized the concept on the grounds that GWP implicitly sets the 5 opportunity costs of an increment in radiative forcing equal for all periods in the future (Schmalensee, 1993). 6 If all greenhouse gases had the same rate of decay, then this problem would not arise. 7 13. Although forests cannot be expanded indefinitely, and thus increased carbon sequestration is not a permanent 8 solution to increasing greenhouse gas emissions. 9 10 4.Advances is cost-benefit analysis have allowed the introduction of risk and equity issues in a systematic way. 11 15. Frank Knight's often-quoted distinction separates risk, for which the probabilities of different outcomes are 12 known, from uncertainty, in which either they are unknown, or some potential outcomes are not specified. Ref. 13 Knight, Frank, 1922, Risk, Uncertaintv, and Profit. 14 16. This division of responses is from Nordhaus (1994). 15 17. While most insurance markets do not reduce overall risk, there are a few exceptions: fire insurance companies, 16 by requiring commercial buildings to install sprinklers, do reduce the overall level of losses. 17 18. This assumes decreasing absolute risk aversion (about which there is a general consensus). Even if northern 18 countries were adversely affected, so long as the adverse effects were proportionately smaller, then, assuming 19 decreasing relative risk aversion (about which there is less consensus), the north would be in a position to insure 20 the south. 21 22 Insurance contracts may also be created because of differences in judgments concerning the probability of the 23 insured event occurring. This suggests the potential of an important principle to be invoked in future international 24 negotiations/agreements: countries that believe that the risks of climate change are low, and are therefore 25 seemingly unwilling to take strong actions to mitigate these risks, ought to be willing to provide insurance against 26 climate change at low cost (since it has, from their perspective, an actuarially low value). (See below for a 27 discussion of problems of enforce.) (Heal and Chichilnisky **date, reference**; earlier, Stiglitz ** date ** on 28 social risk bearing.) 29 30 Insurance markets, if appropriately designed, would have one further advantage: some of the losses associated 31 with climate change are easily avoidable, e.g. construction of durable ocean-front houses. Insurance firms work 32 hard to mitigate the losses that are incurred. Either the insurance should be based on exogenous events (e.g. not 33 on the dollar losses incurred, but on the rise in the sea water), or the insurance companies should be given broad 34 discretion to require the insured to undertake actions to mitigate losses. 35 Chapter 6 provides estimates of expected regional damage. 36 20.In the absence of such recuirements, moral hazard problems arise. It may be desirable to focus government 37 intervention not on the primary insurance market but on the reinsurance market. See recent U.S. government 38 analysis of the market failures and the design of appropriate responses to those market failures in insurance 39 markets for natural disasters. 40 21. Computer modelers participating in the Energy Modeling Forum examined an "accelerated R&D" 41 scenario in which the cost of nonelectric backstop falls from $100 to 50$ per barrel of oil equivalent, and the 42 cost of the electric backstop falls from 75 to 50 mills per Kwh. The four models used were remarkably 43 consistent in their estimates of economy-wide costs, reporting GDP losses falling by 65 per cent for the 20 44 1 percent emissions reduction scenario (EMF 1993). 2 22. For example, low-lying states may suffer permanent damage. 3 23. Weitzman et al. (1981), cited in Lind (1993), make these points in formulating a sequential decision strategy 4 for developing synthetic fuels. 5 24.Manne and Richels, Nordhaus, and Peck and Teisberg all report a high value of information on *** and *** 6 in their computer simulations. In addition, *** also reports a high value to information on *** 7 5.Richels and Edmonds (1993) provide a demonstration of this proposition; they calculate relatively low costs 8 for stabilizing CO2 concentrations if flexibility in timing is allowed, compared to capping and stabilizing 9 emissions to achieve the same atmospheric concentration. 10 26. Alternatively, the Kaya identity may be written 11 12 Growth rate = growth rate - decline in energy - emissions 13 of CO2 emissions of output per unit output per unit energy use 14 15 That is, CO2 emissions will not rise as long as output grows no faster than the combined decline in energy 16 intensity per unit of production and CO2 emissions per unit of energy use. This formulation applies most usefully 17 to the developed countries. 18 27. Chapter 8, "Evaluating the Costs of Mitigation," treats the important issue of inertia and technology. 19 28.Note that energy efficient development paths for developing countries have been proposed (Goldemberg and 20 Reddy 1988). 21 22 29. That is, for conventional exhaustible resources, there is a stock, S. Welfare depends on flows out of the stock 23 each year: 24 U(S, - So, S₂- S₁+₁ - S₁,......), where S, is the stock at the end of period t. 25 26 Here, welfare depends directly only on the stocks, though indirectly, through the effects on consumption, on 27 emissions, which affect the change in stock: 28 29 U(S,,C,(S, - S₀),S₁,C₂(S₂- S₁),........S₁, C,(S,+₁ - S₁),......). 30 30. Even when the flow exceeds the long-run sustainable level, it will not be optimal to reduce the flow 31 instantaneously, unless or even when - there are zero costs of adjustment. 32 33 For the atmosphere, a sustainable stock of greenhouse gases means stable concentrations. Current emissions are 34 estimated to be about twice emissions consistent with stable concentrations. 35 31. Postponing action may lead to some irreversible damages, for example the flooding of low-lying states. 36 32. This is not quite correct, since price affects incentives for exploration, and some marginal wells would not 37 be drilled if oil prices fall too low. 38 33. For analyses of market and optimal responses to uncertainty about the arrival of backstop technologies, see 39 Dasgupta, Gilbert, and Stiglitz [ ] and Dasgupta and Stiglitz [ ]1. 45 1 34.Although for counter examples to the received wisdom see Coase (1990). 2 35.Formally, if A measures the quality of the atmosphere, then each individual's or country's welfare, U, is a 3 function of its own consumption, C, and the shared public good, A: U' (C', A). This does not mean that all 4 individual's (country's) value changes in A the same; that is may differ in magnitude, and 5 even in sign. 6 36.Although there may also be trade-offs: reducing those gases that contribute most to local pollution may 7 sometimes be at the expense of increased emissions of greenhouse gases. 8 37.This kind of optimization problem was first studied by Edgeworth, Mathematical Psychics ( ). The 9 importance of incentive effects for the analysis of distributional issues was first emphasized by Mirrlees (1971) 10 and Fair (1970). There are, obviously, important incentive effects: if the LDCs were able to classify any 11 expenditure that had some effect on mitigation as a mitigation expenditure, with the cost borne by the developed 12 countries, they would have an incentive to undertake excess expenditures of this type. The GEF (Global 13 Environmental Facility) directly addresses this issue, by only providing funds for incremental costs, that is those 14 costs that go beyond what would have been the efficient level of expenditures ignoring the public good benefits 15 of greenhouse gas mitigation. 16 38. The importance of the assumptions of the absence of transactions costs, including the presence of perfect 17 information, has only gradually come to be recognized. See Farrell [ ], or Stiglitz [1988] for an elementary 18 textbook treatment. 19 39. That is, for instance, it makes no difference whether smokers or non-smokers are given the property rights to 20 air. Whether smokers value smoking more or less than non-smokers value clean air will determine whether 21 smoking occurs. How property rights are assigned does make an important difference for the distribution of 22 welfare. Coase's result that outcomes are unrelated to the initial assignment of property rights obviously ignore 23 potentially important income effects. 24 25 A slight extension of this perspective says that social scientists should simply describe the outcome of the 26 bargaining process by which property rights are assigned. Beginning with the important work of Nash [ ], a 27 variety of bargaining theories have been developed, most of which emphasize the importance of "threat 28 points"--the outcomes which arise in the absence of a bargaining agreement-- to the determination of the eventual 29 outcome. In this case, the fact that the net losses of many developed countries may be limited relative to those 30 of many of the less developed countries suggests a bargaining solution in which much more of the costs of 31 mitigation are borne by the less developed countries than under the "social welfare function" allocations described 32 earlier. 33 40.For small taxes, these are "compensated" taxes, and have no welfare effect, though they have a substitution 34 effect, and therefore do reduce pollution. 35 41. The loss in welfare (ignoring the benefits from reduced greenhouse gas warming) are the Harberger triangles, 36 and can thus be shown to be proportional to the product of the elasticity of demand for energy and the share of 37 energy in national output. Since poorer countries are likely to have less access to alternatives which increase the 38 elasticity of demand, and since the share of energy is larger in richer countries, the burden of the tax is 39 progressive. 40 42. The polluter pays principle endorsed by the OECD is exclusively prospective. 46 1 43.Using either an egalitarian social welfare function approach, or a Rawlsian analysis "behind the veil of 2 ignorance" (Rawls 1971) leads to the rejection of the "polluter pays principle." Since at the time the relevant 3 actions are taken, the polluter is not cognizant of the effects, such fees have no incentive effects, but rather appear 4 as random taxes, lowering each person's expected utility, and in particular the expected utility of the worst-off 5 individual. 6 7 There is a further ethical issue: ascertaining who the true beneficiary of escaping paying for the pollution is 8 generally difficult. It need not be the individual, firm, or country actually engaging in the externality generating 9 activity; in competitive markets, when firms are not charged the full social costs of production, product prices 10 will fall, giving consumers a substantial fraction of the benefits. 11 44. Manne and Richels (1992) show that, under the IPCC emissions scenarios, even the most drastic controls on 12 emissions from developed countries would be insufficient to stabilize greenhouse concentrations without some 13 means of controlling emissions from developing countries. 14 45.Public goods exist when property rights are not or cannot be clearly assigned. The atmosphere is an 15 international public good because assigning property rights to the atmosphere is difficult for one nation acting 16 alone, and particularly difficult when many sovereign states must agree among themselves. Tradable greenhouse 17 emission permits, discussed below, attempt to resolve the problem by explicitly assigning property rights to 18 greenhouse emissions. 19 20 46.See Abreu [ ]. 21 47. In some cases, equity considerations may prevent Coase (1960), in his discussion of externalities, emphasized 22 the separability between efficiency and equity issues. Though there have been several important qualifications 23 to Coase's conjecture, emphasizing the importance of public goods, imperfect information, and transaction costs 24 (see Farrell , Stiglitz [1988]), still, the basic insight remains applicable here. 25 48. Chapter 7 discusses this issue at greater length. 26 49. These concerns are not just theoretical possibilities, as the following two examples illustrate. Assume that 27 the North imposes high energy taxes, but the South fails to do so. Energy intensive industries, such as aluminum, 28 migrate from North to South. But energy efficiency in the south is much less than in the north, so that the total 29 energy used to produce a ton of aluminum could increase substantially. While economic efficiency would call 30 for locating energy intensive industries where energy efficiency is greatest, a system of partial controls would 31 results in energy intensive industries being located where energy efficiency is lowest. Similarly, the reduced 32 energy consumption by the North will result in lower producer prices of oil and gas, leading to increased 33 consumption of energy in the South, partially offsetting any energy conservation induced in the North. 34 50. The precise manner in which this should be done is a technical matter, treated in the literature on Global 35 Warming Potential (see, e.g., IPCC 1990). To the extent that there are large differences in atmospheric lifetimes, 36 then the relative weighting of different greenhouse gases should change over time, since the "shadow price" 37 associated with effects on relative concentrations at different dates will differ. 38 51. Similarly, if the developed countries restrict forest cutting, the price of lumber may rise, inducing the 39 developing countries to cut down more of their own trees. While total carbon sequestration may not increase, 40 environmental and economic efficiency will decrease if, as some researchers have concluded, hardwood forests 41 in the less developed countries may be the least desirable ones to cut down from an ecological or economic 42 perspective (Edmonds and Reilly, 1983). 47 1 52. Only a few models take into account international capital flows. Thus, most models do not address issues 2 of industry relocation (McKibben and Wilcoxen, 1992). Chapter 11 provides a more complete discussion on 3 leakages. 4 53. In the case of production of highly substitutable commodities, carbon leakage will, of course, be much greater. 5 6 54. Whether taxes in fact have this effect depends in part on the shape of the demand curves. With intertemporal 7 separability in demand curves and constant elasticity, with no backstop technology, a constant ad valorem tax has 8 no effect on the pattern of consumption. 9 10 Coal presents markedly different issues, not so much because of its greater emissions per unit energy, but because 11 of it higher cost of extraction to price ratio. Lowering producer prices may result in less coal being consumed, 12 provided alternative energy sources become available. Thus, taxes on coal are likely to have significant general 13 equilibrium as well as partial equilibrium effects; the increase in the price of coal will lead to a substitution of 14 gas and oil. If alternative energy sources are not available, such policies will only affect the intertemporal timing 15 of coal consumption (given the much more limited resources of gas and oil). But even that might be of some 16 value in reducing long run greenhouse gas emissions, as the ability to extract energy from coal may increase 17 significantly over time. Analyzing the optimal intertemporal structure of taxes, to minimize long run ambient 18 levels of greenhouse gases, taking into account both intertemporal substitution and substitution across energy 19 sources, is a complicated technical issue, that to date has not been adequately analyzed. 20 55. United Nations Conference on Environment and Development, Framework Convention on Climate Change, 21 May 9, 1992. 22 56. The most difficult problem is posed by those investors who invested in these resources, on the basis of one 23 regime (where these resources were not taxed). Do they have any special claim to compensation for a "change 24 in regime." Changes in demands and supplies occur for virtually all resources, and are an inevitable part of the 25 risks in investing. While most economists would argue that arbitrary and capricious changes in policies contribute 26 to business uncertainty, and therefore have an adverse effect on economic growth, reasoned changes in policies 27 in response to changes in information are an inevitable part of the business risk. 28 57. For example, some U.S.A. electric utilities are already making decisions in anticipation of some future policies 29 to limit greenhouse emissions. 30 58. These issues also arise among countries: countries with large coal deposits will find the value of their natural 31 wealth eroded, and quite naturally will be less enthusiastic about international agreements having that 32 consequence. 33 59. The studies show a marked variation in GDP losses across models. For example, stabilizing emissions at their 34 1990 levels is estimated to reduce U.S. GDP by .2% to .8% in the year 2010 - roughly a $20 billion to $80 billion 35 loss for that year. Estimate of the costs of reducing emissions by 20% below 1990 levels in the year 2010 range 36 from .9% to 1.7% of GDP. Aggregated models (top-down) have generally reported higher costs, while 37 disaggregated models (bottom-up) have shown lower costs. Chapter 9 contains a more complete discussion. 38 39 These GDP losses occur when the carbon taxes lead to investments that are more expensive than those that would 40 take place in the absence of the taxes. The higher the carbon taxes, the greater the investment in price-induced 41 conservation and the more fuel switching toward the less carbon-intensive substitutes. 42 43 The overall impact of a carbon tax will depend not only on the size of the tax but also on the uses to which the 44 revenues are put. In the standard EMF scenarios, it was assumed that tax revenues will be redistributed in a 45 neutral manner (i.e., without affecting the marginal tax rates). There are, of course, numerous ways in which tax 48 1 revenues can be used. These include: reducing budget deficits; reducing marginal rates of income, payroll, 2 corporate or other taxes; granting tax incentives to preferred activities; or increasing the level of government 3 expenditures. The costs of the tax will vary widely depending on how the revenues are recycled. 4 .Top-down models estimate that for developing countries there exist low-cost options to reduce emissions in 5 the near term, but eventually costs would exceed 1 to 2% of GDP (EMF 1993). For economies in transition, 6 because of historical inefficiencies and energy subsidies, there exist large opportunities to reduce emissions at 7 little or no cost. For developing countries, problems of informal economies make hard estimates difficult, but 8 the cost of stabilizing emissions would likely be large enough to cut into economic growth. 9 Recent comparisons indicate that the most important differences between top-down and bottom-up models arise 10 from differences in input parameters, rather than from differences in model structure. 11 Government institutions and regulations often hinder the efficient use of energy. The developing countries 12 are least able to absorb the costs of these inefficiencies. Thus, while some developing countries argue that they 13 cannot afford to reduce greenhouse emissions , the same countries have the most to gain from reforming 14 government-caused inefficiencies. At least in the short run, international agreements committing countries to 15 eliminate at least the most egregious of these practices might go a long way to addressing the problem of 16 emission reductions, 17 18 This may also be a problem with electricity generated by the private sector, as regulation has historically set 19 price equal to average cost, rather than allowing it to match the competitive price. In many countries, the increase 20 of competitive pressures has moved electricity prices closer to the marginal cost of production. 21 64.Full utilization of non-fossil fuel energy sources, taking account of other environmental impacts.) For example, 22 when hydroelectric power generation, which does not increase greenhouse emissions, can be cost-effectively 23 expanded without other environmental effects, it should be done. 24 25 Eliminating Regulations Impeding Efficient Energy Utilization. Many, perhaps most, countries have a host of 26 regulations which increase energy use as they impede economic efficiency. For instance, the United States has 27 had a policy of restricting oil exports to Alaska. Whatever the merits of that policy, it has forced Japan to import 28 oil from Indonesia and Saudi Arabia. World oil transportation costs have thus been greatly increased, at the 29 expense of the American economy. Another example of government reform, included in the US' Action Plan 30 (1993), encourages efforts to expand and improve natural gas markets through continued regulatory reform. These 31 reform efforts include guidelines to allow greater natural gas use in the summer in coal- and oil- fired power 32 plants. 33 34 Other regulation. Unintended effects of many tax, expenditure and other policies have contributing further to 35 inefficiencies in land use. Among the unfortunate effects of the U.S. Superfund program for the management of 36 hazardous wastes has been the creation of large unoccupied holes in the center of major cities. 37 .Consider the following thought experiment: compare an optimally designed road system which only carried 38 cars; and contrast that with an optimally design road system which also carries trucks. The incremental cost of 39 carrying trucks is, in most countries, much larger than the proportionate share of the cost they bear in gasoline 40 taxes and other fees. 41 66.For example, in many countries, governments have taken an active role in the dissemination of information 42 to the agriculture sector. These programs are in some measure responsible for the large increase in agricultural 43 productivity in countries with agricultural extension services. 44 49 1 67.This issue has been addressed in several papers. See, in particular, Stiglitz [1975, 1984] and Grossman [1981]. 2 This is both because those who would, under "true" disclosure, be at a competitive disadvantage have an 3 incentive to add "noise" and because there are strong market forces for product differentiation; in markets with 4 homogeneous commodities, profits, even with a limited number of suppliers, will be driven to zero (in Bertrand 5 competition.) For a discussion of these and related issues, see Salop [1977], Salop and Stiglitz [1977, 1982], 6 Stiglitz [1977, 1988]. 7 69. The standard reference in the organizational literature is March and Simon Economic theories emphasizing 8 the non-value maximizing behavior of managers include the works of Baumol [ ], Marris [ ], and Leibenstein 9 [ ]. The principal agent literature [Ross, 1973, Stiglitz, 1974] provided the informational micro-foundations for 10 understanding the divergences of interests. See Stiglitz [1988]. A more recent overview is provided by Stiglitz 11 [ ] and the symposium in the Journal of Economic Perspectives. 12 70.This key point, while noted in March and Simon's [1958] original work, was elaborated upon by Radner [ 13 ] and Hannaway [ ]. 14 71. The facts that time is a scarce commodity and that decision making in large organizations is decentralization 15 do not in themselves constitute a market failure; they do not prove that resources are not efficiently allocated 16 given the real constraints facing society, which include time. However, Greenwald and Stiglitz [1986, 1988] have 17 established a very general theorem showing that when information is imperfect and costly, market equilibrium 18 is, in general, not (constrained) Pareto efficient. Thus, there is no presumption concerning the efficiency of the 19 market economy, even in the absence of the kinds of externality and public goods problems that are associated 20 with greenhouse gases. For a more extended discussion, see Stiglitz [1994]. 21 22 One of the main insights of recent advances in the economics of information is to provide a sound 23 micro-foundations for these theories of the firm. And indeed, the importance of the limitations on the availability 24 of information, and the consequent importance of attention directing efforts applies to individuals as well as to 25 organizations. Some studies have suggested that the limited success of the special tax provisions in the United 26 States designed to encourage savings (IRA accounts) was primarily due to the competitive efforts of banks to 27 recruit these accounts, and the attention which savings got as a result. 28 29 2.Network externalities are manifested in other ways: builders fail to install energy efficient light bulbs, because 30 customers dislike them, because stores do not carry replacements; and stores do not carry them because the 31 demand for them is too low. 32 33 When there are important network externalities, market equilibria are frequently inefficient. The economy 34 might, for instance, get "stuck" in the wrong equilibrium. Government action can, in these instances, "force" the 35 economy to move from one equilibrium to another. 36 37 73.This is not the only explanation of differences between bottom-up and top-down models. There are several 38 other features of market behavior that bottom-up models often ignore. 39 40 (a) Hidden Costs: Consumers value a range of attributes difficult to include in an engineering model. For 41 example, auto buyers value not only initial costs and fuel economy (which computer models can easily calculate), 42 but also performance, safety, and durability, which they typically do not. 43 44 (b) Divergence between laboratory and in-use performance: Especially for new technologies, actual energy use 45 often differs significantly from energy use calculated in the laboratory. It is the latter upon which purchasers 50 1 focus. 2 3 (c) Variation across individual consumers: Engineering models generally assume an average consumer; actual 4 consumers may display a wide range of characteristics and usage patterns. Except when demand functions are 5 linear in the relevant variables, the consumption of the "average" individual is not equal to the average 6 consumption; and what is optimal for the average person may not be optimal for a significant fraction for the 7 population. 8 74.For a survey, see Jaffee and Stiglitz [ ]. The basic theory of credit rationing was developed in Stiglitz and 9 Weiss [1981] and the theory of credit rationing is developed in Greenwald, Stiglitz, and Weiss [1984] and Myers 10 and Maljuf [1984]. 11 75. This generally accepted methodology is, for instance, reflected in the guidelines issued by the Office of 12 Management and Budget in the United States for the evaluation of projects and regulations. The applied literature 13 does not address the question of whether this procedure is appropriate in the presence of certain types of time and 14 risk non-separabilities. 15 76. Though if the variance of the net benefits is increasing over time in a particular manner, the differences in the 16 two methodologies may not be large. 17 77.Again, under certain restrictive conditions, where the shadow value of a capital constraint is changing 18 systematically over time, the differences in the two methodologies may not be great. 19 78.See Wilson Though the original discussion of winners curse focused around bidding in auctions, it has 20 subsequently come to be applied to a range of other market phenomena. See, e.g. Stiglitz [ ]. 21 79.For a discussion of the role of the state in capital markets, see Stiglitz [1994]. 22 80.In some industrialized countries, energy efficient home mortgage lending may help correct the problem. 23 Lenders generally set criteria for the maximum loan amount based on the borrowers' ability to repay, which in 24 turn depends on income and wealth. The fact that a particular expenditure which would enhance efficiency and 25 reduce utility bills is not given special attention. Energy efficient mortgages provide funds to households to 26 make energy efficiency enhancing investments intended to pay for themselves, i.e. result in reduced utility bills 27 equal to or greater than the interest payments. With capital constraints, builders may have an incentive to trade 28 off initial capital costs for higher maintenance costs (lower energy efficiency). Building codes specifying minimal 29 levels of energy efficiency and full disclosure of expected life cycle energy costs may help address these market 30 distortions. 31 32 33 81. A country that rapidly depletes its natural resources may show a high rate of growth under conventional 34 income accounting, but a lower rate of growth when resource depletion is taken into account. Repetto (1991, 35 1992) calculated resource-adjusted GDP for several countries rapidly harvesting their stocks of hardwoods and 36 other resources, arguing that conventional measures sharply overstated GDP. 37 82.Cobb and Daley (1989) have even claimed that U.S. per capita GDP, when adjusted for environmental damage, 38 was stagnant between 1950 and 1986. This assertion is hard to reconcile with the steady improvement in most 39 measures of environmental quality since 1970, when measurements standards were established. 51 1 83. Analysts now use two methods to estimate stocks. The first assumes a fixed stock of a natural resources such 2 as oil. Consumption of oil then depletes the stock by the amount of consumption. The second begins by treating 3 discovered reserves as the asset. Thus, additions to reserves increase the asset, while consumption reduces it. 4 If in any given year, new discoveries match resource utilization, then according to this method no net depletion 5 has occurred. 6 84. Many researchers have noted deficiencies in standard national income accounts. First, national income 7 accounts do not, in general, provide an adequate measure of welfare; second, they do not provide the correct 8 information relevant for making policies relevant to sustainable development. Sustainable development is 9 concerned with society's resources; an economy is growing when its resource base (capital stock combined with 10 natural resources) is growing. GDP does not, and is not intended to be, a measure of resource availability. Firms 11 have two sets of accounts--cash flow (income) statements and balance sheet statements. GDP is a statement of 12 the former type. 13 14 Standard accounting procedures require that firms, in an attempt to present an accurate account of "true income," 15 take account of depreciation. GDP measures gross output; it does not take into account depreciation, either of 16 natural or physical capital stocks. The reason is simply that it is hard to get accurate measures of depreciation. 17 18 Net national product does take into account depreciation, the change in capital stock. And it is this account which 19 should be most subject to criticism, since it accounts for changes in the physical capital stock, but not in other 20 capital assets, in particular, environmental assets and natural resources. 21 22 A number of difficult conceptual problems face the analyst defining levels and changes in levels of these assets. 23 24 25 First, how should the "stock" of natural resources be defined? Coal poses perhaps the easiest situation. The 26 location of coal reserves is known. Costs of extraction are high, so the rents (the value of coal in situ) is low. 27 The depletion can be measured not by the coal used times the market price, but the coal used times the in situ 28 value. But for oil and other minerals, information about where reserves are located is vital. Two models have 29 been proposed. One sees the world as having a fixed stock of natural resources (say oil). When one uses oil, 30 one is depleting this stock. Thus, to calculate the value of depletion, one does not need to know the entire stock; 31 the flow (the amount of oil consumed) provides an accurate measure of the change in stock. 32 33 The alternative model looks at the size of discovered reserves. Reserves are treated as the asset. Additions to 34 reserves thus are viewed as increasing the resource base. If in any given year, new discoveries match resource 35 utilization, then there is no net depletion. This is the approach being taken by the U.S. Department of Commerce. 36 This accounting framework would be correct if there were an infinite supply of the resource (reflected in zero 37 rents); the essential "capital" good is information about where the resource is located. 38 39 Environmental assets--such as air quality--present another set of problems, because there are not market prices 40 to value the asset. Dynamic optimization problems of the kind described earlier can be used to calculate shadow 41 prices. How sensitive these shadow prices are to specific assumptions remains to be investigated. 42 43 Accounting systems do not, however, have to aggregate all information together. Just as information about 44 longevity and other indicators of well being (see below) serve to complement information from national income 45 accounts concerning standards of living, so too can information about physical environmental measures be used 46 to complement information from the extended national income accounts. 47 85. There is some concern that excessively broad and long patents may actually impede innovation. When 48 technological progress occurs by building on previous innovations, later innovator require permission of earlier 49 innovators to realize the returns on their innovation. While advocates of broad patent coverage argue that the 52 I parties always arrive at efficient bargaining solutions, critics point out that the outcomes of bargaining models 2 with incomplete information often entail large inefficiencies. 3 86. Matters are more complicated, since the patent does not reward the innovator with his marginal contribution-- 4 the increase in the present discounted value of benefits as a result of the innovation occurring earlier than it 5 otherwise would have occurred. For a fuller discussion, see Stiglitz [1994], Dasgupta and Stiglitz [1980a, 1980b], 6 Barzel [ ]. 7 87. If less developed countries fail to implement fully a set of corrective taxes or tradeable permits, or if less 8 developed countries fail to adopt and enforce effectively intellectual property rights, there will be insufficient 9 incentives to produce energy and emission savings innovations, particularly those appropriate for the level of 10 technological knowledge, human capital, and factor prices in those countries. If less developed 11 countries do take these actions, there is concern that they will result in higher prices of innovations, and thus the 12 pace of adoption will be retarded. An effective form of aid, targeted to reducing greenhouse gas emissions, may 13 be subsidies directed at producing appropriate energy saving and emission reducing technologies for LDCs. 14 15 88. Edmonds et al. (1994) has studied the importance of available advanced energy technologies such as those 16 proposed by Johannsen (1993). Edmonds et al. use the Edmonds-Reilly-Barnes model for energy related 17 greenhouse gas emissions; the MAGICC model for atmospheric composition, climate response, and sea level rise; 18 the IPCC scenario IS92a (IPCC, 1992) as the reference base case and five alternate energy scenarios that are far 19 more advanced over today's energy supply and transformation technologies. The five energy scenarios are: 20 21 a. advanced fossil fuel technologies 22 b. advanced liquified hydrogen fuel cells 23 C. advanced hydrogen fuel cells without liquified hydrogen 24 d. low cost biomass 25 e. accelerated rate of exogenous end-use energy intensity improvement 26 27 Combined, the energy technologies reduce annual emissions from fossil fuel use to levels that stabilize 28 atmospheric concentrations below 550 ppmv (i.e. double the concentration prior to the Industrial Revolution). 29 The tax rate, assumed to apply globally, used was the marginal cost of stabilizing fossil fuel carbon emissions 30 in the reference case. With values reflected for only carbon dioxide emission reductions, the cost of global 31. emission reductions grow from approximately $35 (US) Billion in 2005 to $230 (US) billion per year in the year 32 2095. With advanced fossil fuels, low cost solar electric power, low cost fuel cell vehicles, the present discounted 33 value of adding low cost biomass fuel to the energy technology bundle is almost half a trillion dollars (US). The 34 present discounted value of the advanced energy technologies taken together is $1.8 trillion (US). 35 36 The introduction of advanced biomass energy production technology was found to play a key role in reducing 37 emissions. Biomass energy at $2.00/GJ growing to become the core energy supply technology by 2050 could 38 significantly reduce emissions highlighting the potential role of technology development and deployment relative 39 to that of fiscal and regulatory intervention. 40 41 These results should be viewed as illustrative rather than predictive. In this analysis, the gains from introduction 42 and deployment of advanced energy technologies is dependent on the order of technologies evaluated in the study. 43 44 45 89. The literature has identified three types of permit systems. The ambient permit system (APS) works on the 46 basis of permits defined according to exposure at the receptor points. Each polluter, then, may face quite 47 complex markets - different permit markets according to different receptor points, and hence different prices. The 53 1 simpler emissions permit system (EPS) issues permits on the basis of source emissions and ignores what effects 2 those emissions have on the receptor points. Within a given region or zone, the polluter would have only one 3 market to deal with and one price. Finally, there is the pollution offset (PO) system wherein the permits are 4 defined in terms of emissions, trade takes place within a defined zone. However, the standard has to be met at 5 all receptor points. The exchange value of the permits is then determined by the effects of the pollutants at the 6 receptor points. The PO system thus combines characteristics of the EPS and the APS. (Pearce and Turner 7 1990) These distinctions are of limited relevance for greenhouse gases, where what is of concern is global 8 emission levels. The specific location of the emissions is of no concern. 9 10 90. The choice between taxes and tradeable permits depends on the objectives of the policy maker and nature of 11 the uncertainty about the marginal cost and marginal benefit curves for carbon emission reductions (Weitzman, 12 1974). Theory tells us that if the nature of the curves is known with very little certainty, but the marginal cost 13 curve is known to be relatively steeper (i.e. a change in the level of pollution allowed brings about a greater 14 change in the marginal costs of mitigation compared to the marginal benefits) then taxes should be the policy of 15 choice. This is because, in this case, an erroneous estimation of the optimal tax rate will lead to a relatively small 16 deviation from the optimal pollution level. On the other hand, an erroneous estimation of the optimal level of 17 total emissions in a permit scheme will lead to a relatively large deviation from the optimal cost of the permits. 18 19 If the marginal benefit curve is known to be relatively steeper than the marginal cost curve, however, tradable 20 permits are the better option. Here, an erroneous estimation of the optimal tax rate will lead to a relatively large 21 deviation from the optimal level of emissions while an erroneous estimation of the optimal level of emissions in 22 a permit strategy will lead to a relatively small deviation from the optimal cost of the permits. 23 24 In the case of greenhouse gas emissions, the time horizon for adjustment is sufficiently long that many of these 25 uncertainties become less important. If the tax rate initially chosen yields too high a level of emissions in one 26 year, it can be increased, and the net impact of the erroneous initial estimate on global warming (or the total cost 27 of achieving a given level of atmospheric concentration) will be negligible. In any case, as the earlier discussion 28 on sequential decision making has emphasized, there is likely to have to be continued revisions in either tax rates 29 or permit levels. 30 31 32 Still, there is some argument that the required adjustments under a permit scheme may be less burdensome. 33 (Tietenberg 1992) For instance, if the authority feels that the old standard needs some tightening they may enter 34 the market themselves and buy some of the permits, holding them out of the market. 35 36 There must be effective, competitive markets in tradeable permits, if such schemes are to achieve efficient 37 outcomes. There are transactions costs of running such schemes, just as there are transactions costs associated 38 with collecting tax revenues. Whether transactions costs gives one system a decided advantage over the other 39 is not clear. There seems to be no compelling reason to believe that good markets in tradeable permits would 40 not develop. 41 42 43 91. It is possible to design allocations of trading permits which (i) on average, impose no net burden on developing 44 countries (thus conforming to the ability to pay principle); (ii) provide those economies which are growing faster 45 per capita with commensurately greater permits, thus imposing no net drag on economic growth, provided the 46 economy exhibits an increase in fuel efficiency at least equal to the average of fast growing LDCs; and (iii) 47 rewards those economies which are able to reduce greenhouse gas emissions faster than benchmark, either through 48 greater control of population growth, through larger increases in energy efficiency, or through switching from 49 higher to lower carbon fuels. 50 54 1 The extent to which individual circumstances of countries should be taken into account in setting benchmarks 2 remains a question for international negotiations; to the extent that high emissions is due to natural endowments 3 (e.g. the availability of coal rather than natural gas as a source of energy), a persuasive case can be made for 4 benchmarks to reflect initial emission levels. To the extent that high emissions are due to inappropriate energy 5 pricing policies, the case that benchmarks should reflect initial emission levels is far more tenuous. 6 92. Similarly, some developing countries have asked, should the North be given higher levels of permits, simply 7 because it has, in the past, been the chief source of greenhouse gases? 8 93. For a discussion of the polluter pays principle, see above. 9 94. Standard tradeable permit schemes essentially take the revenue from a carbon tax, and distributes it to current 10 user emitters, rather than using the revenue to reduce other taxes. An alternative to these standard schemes is 11 for the government to auction off the tradeable permits. 12 13 If taxing carbon leads to reduced labor supply or reduced savings, then government revenues from wage or capital 14 taxes may be reduced, more than offsetting the direct revenue gain from the carbon tax. Cross elasticities of this 15 magnitude are unlikely, though any such cross elasticity will reduce the net gain from the carbon tax. The 16 magnitude of the double dividend has been the subject of some dispute, with Goulder ] and taking opposite 17 views. 18 19 95. Two main studies provide insights into the root of the variance in estimates of the economic effects of carbon 20 taxes: The Energy Modeling Forum Study (12) and the OECD comparison project. In each case, sophisticated 21 sensitivity analyses are run by standardizing key economic assumptions along with use of common reference case 22 scenarios of reductions. The magnitude of the effect on economic growth will depend both on assumptions 23 concerning the effect of carbon taxes on savings and labor supply, and the induced investment to offset the higher 24 energy prices. If higher energy prices do not lead to much capital substitution and if the cross elasticity with 25 savings and labor are low then the likely effect on economic growth will be small. 26 27 28 OECD Project on Economy-Wide Cost Estimates of Carbon Taxes: 29 An OECD model comparisons project was conducted to compare economy wide estimates of the effects of carbon 30 taxes. Time horizons as well as the key economic assumptions on growth, population and resource prices, and 31 the reduction scenarios for six global models were standardized. The global models compared were the GREEN 32 model, the IEA model and four North American models [Edmonds-Reilly Model (ERM), Global 2100 of Alan 33 Manne and Rich Richels (MR), the Carbon Rights Trade Model (CRTM) of Tom Rutherford, and the Whalley- 34 Wigle model] (Dean 1994). 35 36 There is significant variation in tax rates and costs for the same amount of emissions reduction among models 37 due to differing assumptions regarding several key considerations. Several factors explain the differences between 38 model results. The most important factors are: 39 40 a. The degree of substitution between fuels the ease with which producers and consumers can switch from 41 high-carbon content fuels to low-carbon content fuels; 42 b. Expectations about future energy prices and taxes; 43 C. The speed of emissions reduction; 44 d. The way in which revenue is recycled; 45 e. The treatment of the removal of energy subsidies; and 46 f. Assumptions regarding backstop technology and a host of other technical and economic factors. 47 48 Because of the varying approach to these questions, the range of estimated tax rates and costs are quite wide. 55 I For a 45% reduction in baseline emissions by 2020, the required tax would be in the range of $150-$325 per ton 2 of carbon and the cost might be in the range of 1.5%-2.9% of world GDP. A 70% reduction in baseline 3 emissions by 2050 could require a tax between $230 and $880 and a loss in world GDP of 2.4%-3.8% (Dean 4 1994). 5 6 The required carbon taxes and associated costs vary significantly across regions in all of the models. This 7 indicates that the same proportional reductions in emissions across all regions would give rise to very different 8 costs in different regions and would thus be globally inefficient - with great potential for savings in the global 9 cost of reducing emissions through the use of emission trading between countries or regions (see section 1.5.2.1) 10 or a global carbon tax. 11 12 Three insights emerging from the OECD study are (Dean, 1994): 13 a. Small amounts of emissions reduction can probably be achieved with low taxes; 14 b. Large reductions can only be achieved at high tax rates (i.e. marginal reduction costs rise with emissions 15 reductions). 16 C. Carbon-free backstop technologies are likely to slow the rise of the carbon tax, or halt it altogether, if they 17 are available at constant marginal cost. 18 19 Energy Modeling Forum Project 12 (Impact of Carbon Emission Control Strategies) 20 A recent study at Stanford, the Energy Modelling Forum Project - 12, examines the cost of reducing CO2 21 emissions (Energy Modeling Forum, 1993). A diverse group of economic models, employing common 22 assumptions for selected numerical inputs, were used to analyze a standardized set of emission reduction 23 scenarios. In all, 14 top-down models participated in the study. 24 25 The EMF model comparison provides the most comprehensive application of top-down methodologies to date. 26 The study addresses a wide range of policy questions. How large are emissions likely to grow in the absence 27 of controls? How much market intervention will be required to meet alternative targets? What will be the price 28 tag? In exploring economic costs, the modelers were asked to examine the impacts of timing, research and 29 development, and revenue recycling. 30 31 The EMF exercise provides a wealth of useful information for policy making. Although the focus was primarily 32 on the U.S., many of the insights are applicable to developed countries in general. 33 34 In selecting parameters for standardization, the EMF study focused on what were felt to be the most influential 35 determinants of mitigation costs. These included: GDP, population, the fossil-fuel resource base, and the cost 36 and availability of long-term supply options. in addition, although the EMF models differed considerably in their 37 technology representation, the study attempted to impose uniformity with regard to world oil prices, the oil and 38 gas resource base, and the cost of backstop technologies. For its reference case, EMF adopted the average of the 39 IPCC high and low economic growth cases (IPCC, 1990c). Also for consistency with the IPCC, the study 40 adopted the population growth projections based on Zachariah and Vu. 41 42 The modelers generally used taxes based on the carbon content of the fossil fuels in order to achieve a prescribed 43 emissions reduction. The magnitude of the tax provides a rough estimate of the degree of market intervention 44 that would be required to achieve the carbon emissions target. Estimates range from $20 to $140 per ton for the 45 carbon taxes required to hold emissions at 1990 levels in 2010. Estimates of the carbon taxes required to reduce 46 emissions by 20% below 1990 levels in 2010 range from $50 to $330 per ton. 47 48 Two parameters are particularly important in explaining the differences in tax projections: the price elasticity of 49 energy demand and the speed with which the capital stock adjusts to higher energy prices. Neither were 50 controlled in the EMF experiments. Those models using lower price elasticities required higher taxes to achieve 51 the same emissions goal. Those models which assumed greater malleability of capital required lower taxes. 56 1 2 96. Rapid capital stock retirement may add to the cost of immediate CO2 reductions. Also, reductions may be 3 cheaper later because of technical changes in the intervening years. 4 97. Indeed, the "ratchet effect," a commonly observed phenomena in the command and control economies 5 (Stiglitz, 1975, Weitzman, 19 ) leads firms to just satisfy the target. 6 98. Two examples from the United States Clean Air Act: 1) the requirement that coal-burning power plants 7 install stack-gas scrubbers even if they burn low-sulfur Western coal; 2) the mandates for ethanol in reformulated 8 gasoline. 9 99. World Commission on Environment and Development, Our Common Future, Oxford: Oxford University Press, 10 1987. 11 100.It has been argued that new species and varieties produced by genetic engineering may be able to more than 12 offset the loss in genetic variability from climate impacts, particularly because of the increasing capacity to direct 13 those mutations toward socially desirable objectives. 14 101. Other views represented in the debate on sustainable development but not generally accepted in the 15 economics profession include those of Daly (1977, 1980) and Daly and Cobb (1991), and those of the new field 16 of ecological economics (Costanza 1991). 17 102. Tariq Osman Hyder, "Climate Negotiations: the North/South Perspective," in Mintzer, ed. Hyder has headed 18 the Pakistani delegation at meetings of the INC, and GEF (Global Environment Facility). 19 103. "Principles of the G-77 and China on the Climate Convention," cited in Tariq Osman Hyder, "Climate 20 Negotiations, the North/South Perspective," in 1. Mintzer, ed., Confronting Climate Change: Risks, Implications, 21 and Responses, Cambridge: Cambridge University Press, 1992. 57 1 1.9 REFERENCES 2 3 Abreu (**date**) 4 5 Arrow (**date) 6 7 Ausubel, J.H. 1990, Conventional Wisdom About Impacts of Global Change. Rockefeller 8 University, New York. ?pp. 9 10 Baumol (**date**) 11 12 Barzel (**date**) 13 14 Bongaarts, J. 1994. "Population Policy Options in the Developing World," Science (263), 15 11 February 1994, pp. 771-776. 16 17 World Commission on Environment and Development 1987. Our Common Future. 18 London: Oxford University Press. 19 20 Burniaux, J.M., Martin, J.P. and Oliviera Martins, J. 1992. 'The effects of existing 21 distortions in energy markets on the costs of policies to reduce CO2 emissions: evidence 22 from GREEN.' OECD Economic Studies No. 19 23 24 Chao, Hung-po, 1992. "Managing the Risk of Global Climate Catastrophe," Electric Power 25 Research Insitute. 26 27 Cline, W.R. 1992. The Economics of Global Warming. Institute for International 28 Economics, Washington, D.C. 29 30 Coase (1990) 31 32 Coase (1960) 33 34 Dasgupta, Gilbert, andStiglitz (**date**) 35 36 Dasgupta, and Stiglitz (1980a, 1980b) 37 38 Dasgupta, P. and K.G. Maler 1990. The Environment and Emerging Developing Issues," 39 Proceedings of the World Bank Annual Conference on Development Economics, pp. 40 101-131. 41 42 Dean, A. 1994. 'The Effectiveness of Carbon Taxes at the International Level.' In: 43 Climate Change: Policy Instruments and their Implications: Proceedings of the Tsukuba 44 Workshop of IPCC Working Group III, 17-20 January, 1994. pp.46-59. 58 1 Dixon et al. (1994) 2 3 Edgeworth, Mathematical Physics, 4 5 Edmonds, J., Wise, M. and MacCracken, C. 1994. 'Advanced Energy Technologies and 6 Climate Change: An Analysis Using the Global Change Assessment Model (GCAM).' 7 Global Environmental Change Program, Pacific Northwest Laboratory. Wahington D.C. 8 Draft. 9 10 Energy Modeling Forum 1993. EMF 12 Global Climate Change: Impacts of Greenhouse 11 Gas Control Strategies. Palo Alto, Ca. 12 13 Environmental Protection Agency (EPA) 1989. 'Sea level rise.' In Report to Congress 14 on the Potential Effects of Global Climate Change on the United States. 15 16 Fair (1970) 17 18 Fankhauser (**date**) 19 20 Farrell (**date**) 21 22 Gleick, P.H. 1987, 'Regional Hydrologic Consequences of Increases in Atmospheric CO2 23 and Other Trace Gases'. Climatic Change 10, pp. 137-61. 24 25 Goulder (**date**) 26 27 Greenwald and Stiglitz (1986, 1988) 28 29 Greenwald, Stiglitz, and Weiss (1984) 30 31 Grossman (1981) 32 33 Grubb, M. et al. 1993. 'The Costs of Limiting Fossil-Fuel CO2 Emissions: A Survey and 34 Analysis.' Annual Review of Energy and the Environment 18. pp.397-478. 35 36 Grubb, M., Minh Ha Duong and Thierry Chapuis 1993. "Optimising Climate Change 37 Abatement Responses: on inertia and induced technology development," IIASA Workshop 38 on Integrative Assessment of Mitigation, Impacts, and Adaptation to Climate Change, 39 IIASA, October 1993. 40 41 Grubb, M., Thierry Chapuis and Minh Ha Duong 1995. "The Economics of Climate 42 Change: Implications of adaptability and inertia for optimal climate policy," forthcoming. 43 44 Hall et al. (1993) 59 2 DECISION MAKING FRAMEWORK TO ADDRESS CLIMATE CHANGE K.J. ARROW, J. PARIKH, G. PILLET Contributors: P.G.Babu, A.Beltratti, G.Chichilnisky, S.Fankhauser, S.Faucheux, G.Froger, F.Gassmann, E.F.Haites, W.Hediger, J.-Ch.Hourcade, S.Kavikumar, M.G.Morgan, K.Parikh, D.Pearce, S.Peck, R.Richels, R.Schubert, C.Suarez, U.Wellenmann I Decision Making Framework / Draft 05 / December 1994 2 CHAPTER 2 3 Draft 05 / December 1994 I 2 2.5 Economic Formulation of Individual and Collective Decision Making 27 3 2.5.1 Accommodating the supplementary uncertainty caused by climate change 28 4 DECISION MAKING FRAMEWORK TO ADDRESS 4 2.5.1.1 Strong uncertainty 29 5 2.5.1.2 Abrupt change adds unpredictability to uncertainty and risk 30 5 CLIMATE CHANGE 6 2.5.2 "Rationalities" 32 6 7 2.5.2.1 Utility-based decision criteria 33 8 2.5.2.2 7 Bounded rationality 35 9 2.5.2.3 Procedural rationality 35 8 IPCC Working Group III 10 2.5.3 Responses to uncertainty and risk 36 9 Writing Team II 11 2.5.3.1 Uncertainty and risk decision rules 37 12 2.5.3.2 Decision analysis techniques 38 10 13 2.5.3.3 Addressing strong uncertainty 39 14 2.5.4 Collective decision making 41 11 15 2.5.4.1 Steps in negotiating international environmental treaties and agreements 42 16 2.5.4.2 Collective decision criteria 43 12 TABLE OF CONTENTS 17 2.5.4.3 Decision procedure 44 18 13 19 20 2.6 A Sequential Decision Making Framework to Hedge Against Impacts of 14 2.1 Introduction 21 Uncertainty and Change 46 / 22 2.6.1 15 Decision making paths: Which strategy would be best? 46 2.1.1 Questions and issues / 23 2.6.1.1 Scenario analysis 46 16 17 2.1.2 Climate change uncertainties and their relationships 24 2.6.1.2 Sequential decision analysis 47 2 18 25 2.6.1.3 Clearing up the uncertainties? The value of improved information 50 2.1.3 SCOPE OF THE CHAPTER: 6 26 2.6.2 Exploring mutual insurance decisions and markets for risks 52 19 20 2.2 NATURE AND GENESIS OF THE CLIMATE CHANGE PROBLEM LEADING TO THE FCCC 7 27 2.6.2.1 Use of financial markets 53 21 28 2.6.2.2 Insurability of risks associated to climate change 54 2.2.1 CONCENTRATIONS NOT EMISSIONS: 7 22 29 2.6.2.3 A market framework to respond to collective risks 55 2.2.2 ABSORPTION CAPACITY: 8 23 2.2.3 NATURE OF RISK: 30 2.6.3 Portfolio analysis analogy 58 8 24 31 2.6.3.1 2.2.4 COMMON BUT DIFFERENTIATED RESPONSIBILITIES: Selecting a portfolio 59 9 25 32 2.6.3.2 No operational model is available 60 2.2.5 FCCC AS A KEY ELEMENT FOR DECISION MAKING 10 26 33 2.6.3.3 Three main forms of policy options 61 2.3 COLLECTIVE DECISION MAKING 27 II 34 28 2.3.1 How AND WHY COLLECTIVE DECISION MAKING: 11 35 2.3.2 FACTORS FOR COLLECTIVE DECISION MAKING: 36 2.7 REFERENCES 66 29 12 30 2.3.2.1 Vulnerability of food production systems: 12 31 2.3.2.2 Anthropocentric Vs Ecocentric approaches: 13 32 2.3.2.3 Poverty and Climate Change: 14 33 2.3.2.4 Intergenerational equity and discounting: 15 34 2.3.3 IMPLICATIONS OF COLLECTIVE DECISION MAKING: 16 35 2.3.3.1 Cost of delay and slippages (Free riding through delay): 16 36 2.3.3.2 Valuing Common Property (and Paying for It): 17 37 2.3.3.3 Accepting Adaptation 18 38 2.3.3.4 North-South transfers: 19 39 2.4 PROCESS OF COLLECTIVE DECISION MAKING 20 40 2.4.1 A SUMMARY OF THE STEPS IN ITERATIVE DECISION MAKING: 41 21 2.4.2 CRITERIA FOR INTERREGIONAL ALLOCATIONS: 42 22 2.4.3 NORTH-SOUTH COOPERATION 43 24 44 45 46 1 Chapter 2 2 DECISION MAKING FRAMEWORK TO ADDRESS 3 CLIMATE CHANGE 4 5 6 Summary for 2.5 & 2.6 7 8 9 Decision makers face strong uncertainties that are characterised by insufficient knowledge and lack of 10 information. There also is the possibility of large damages (low probability) whether climate change 11 is abrupt or not. In addition, models in the North do not usually build in the perspective of the South. 12 The presence of strong uncertainty, however, does not mean inaction. It means filtering paths of 13 action and choosing which strategy with which outcome would be best. 14 Decision theory leads to the assessment of alternative strategies and the valuation of likely outcomes. 15 As a consequence of insufficient knowledge and data, predictions of the rate and extent and timing of 16 climate change and their effects have been made in terms of scenarios rather than in usual probabilis- 17 tic terms. This situation reflects the gap between the information that is available on climatic pro- 18 cesses and economic effects and the one that would be relevant to Bayesian inference. Bayesian 19 scheme has two limitations with respect to climate change: first the existence of strong uncertainties 20 and, second, the existence of low probabilities attached to large potential damages. Alternatives, 21 however, are available: risk assessment (Chapter 7), fuzzy logic, or evidence theory. 22 Economic criteria for choice explicitly or implicitly are utility-based criteria. Ultimate choices are 23 made by individuals. Yet, because climate change engages considerations that are new in their glob- 24 ality and relate to unusual time-spans, choices also concern collective decision making. Under collec- 25 tive decision making, the valuation of outcomes is matter of negotiation. 26 The decision making framework to address climate change is made of stratgies at three different lev- 27 els. Sequential decision making. Sequential decision making paths are elected to hedge against uncer- 28 tainty and change. "Act-then learn" (then act) decision strategy would be best. Hypothesis: there is an 29 agreement that uncertainties cannot be resolved before a decision is taken. Exploring insurance 30 analysis. The word 'insurance' is sometimes abused in climate debate. Yet, the insurance industry 31 (individual, fixed, short-term contracts) cannot afford climate change related risk sharing. New 32 institutions should be envisaged, e.g., a market framework with new financial institutions, mutual 33 contracts and securities to deal with collective risks. Constructing a portfolio of policy measures. 34 Numerous policy measures are available to limit the impacts of climate changes. The decision 35 maker's problem is much more complex than the choice of a single policy measure to the exclusion of 36 all others. In practice, it is a question of constructing a portfolio of policy measures. 37 Jan. 18. 1995 Chapter 2/v05/Summary for 25 & 2.6 - page 1/1 responsibilities for current concentrations and development needs? In other words, who should bear the burden of emissions abatement at different phases? 2.1. INTRODUCTION 4. What kind of policies will achieve the desired reductions of concentrations of GHG gases The and in turn, the emissions? Framework convention of climate change (FCCC) signed by many heads of state at Earth summit at Rio in 1992 has been ratified by more than 50 countries by March 1994 and 5. Considering that uncertainties will always remain, shall we wait for more precise is now legally binding. To carry out the deliberations of this convention, a decision making information that reduces uncertainties? If we want to collect more information, and since framework is needed that encompasses global and national concerns. While short-term collection of information is expensive, on what aspects of uncertainties should we concentrate? decisions are governed by FCCC, there are some long-term considerations, say for several In this connection, we note that according to the earlier IPCC report, even decades, which also need to be looked into in the decision making framework by interpreting A present information is adequate to go for the goal of reducing global emissions by 60% for their consequences until 2050 and beyond. In the present chapter we construct such a stabilisation. framework. To answer these questions, a framework is needed which will be characterized by 2.1.1 Questions and Issues: uncertainties at all levels. We say that a decision situation is governed by uncertainty if the consequences of decisions and the state of nature are not known apriori. The agent(s) who Climate change due to accumulation of greenhouse gases (GHG) in the atmosphere makes the decisions is known as the decision maker(s) (DM in short). poses many economic, political and scientific challenges which have to be dealt with in a collective decision making framework by national and international decision making bodies. 2.1.2 Climate change uncertainties and their relationships: Policy decisions to address climate change have to be taken in a complex setting characterized It is fair to say that most decisions are made under some uncertainty or other. Consider by uncertainty. Apart from uncertainties, these decisions often involve use of conflicting for example, the uncertainties in decision to invest in an energy supply system. During the criteria such as equity, efficiency, sovereignity and ecological concerns. lifetime of the project there could be changes in demand, interest rates, availability of Decisions are usually based on one's beliefs about the likely occurrence or not of alternative technologies and environmental and other regulations that may change from time uncertain events which are relevant to the decisions at hand. The decision regarding climate to time. However, the uncertainities of climate change decision making are different from other change have to be made not only in the near future, but have to be reviewed on a continuous decisions because: basis, or at least periodically. The major decisions concenrning climate change that need to Climate change decisions have to be taken collectively and not by a single entity; be faced by all countries and their citizens are: The consequences of these decisions affect everyone differently and for a very long term 1. What should be the level of concentration of GHG gases that can be tolerated at different (Distributional/regional effects). times? Any decision made now with wrong outcome can only be identified after a long lag, by 2. By how much should GHG emissions be reduced to achieve these chosen levels of tolerable which time it might be too late. concentrations? It is subject to non-linearity and can Icad to large damages, irreversibility and even 3. How should these abatement levels be distributed among countries taking into account the catastrophic surprises. I That there is a rise in the accumulation of GHG is agreed upon by everyone. What is 2 uncertain is the extent of climatic impacts such as rise in temperature, rise in sea level or technologies and their impacts on reducing emissions. As shown by Hafele et al. (1981), it occurrence of extreme events and thereby changes in ecological balances in biosphere. Some Refecter takes nearly forty to fifty years for a new energy carier to capture 50% of the market from the expect that in the long term, efforts to contain these impacts and offsetting them would have significant economic costs. However, there are others who say that there are additional JAP time it captures 1% of the market. Judging by this thumb rule, there are not many technologies to look forward to in the very near future. Though many technologies look promising, they benefits in undertaking "hedging strategies" (see box) such as savings of fuel, local pollution, have yet to enter in global energy balances. Even if there are many successful demonstrations traffic congestion and so on. The uncertainties concerned with the climate change debate here of carbon free technologies, the ultimate test is to enter the global energy balances, which at can be classified into the following categories: present still consist of coal, oil, gas, hydro and nuclear energy¹. In fact, it is possible that 1. nuclear energy which is a part of the global and national energy balances today, might make Scientific uncertainties regarding the effects of emissions of GHG on climate change an exit without reaching its full potential. Thus, lead times required for transition in energy characterized by several important variables among many others, viz., mean temperature rise, system are very large. The lead times required for abatement technologies to be effective and 1 sea level rise, precipitation changes and changes in frequency of extreme events such as floods, extent of abatement possible by each, thus, become important factors in decision making. cyclones and draughts. One could also call these uncertainties relating to geographical and 2.1.2.1 Relating scientific uncertainties with impact uncertainties: atmospheric changes. The interrelationships among these variables for a given level of How are these uncertainties related? If one could structure the relationships among concentration are also uncertain. These are dealt with by working group I of IPCC. them, decision making can be guided with better understanding rather than getting 2. overwhelmed by uncertainties, and some action paths can become obvious. Scientific Impact uncertainties corresponding to each of the above scientific uncertainties where it is not uncertainties concerning the changes in climate variables for a given concentration level, can clear how much impacts different levels of climatological variables will have on, say, biomass be linked with impact uncertainties as follows. Considering only the temperature variable, productivity, eg., that of agriculture and forests, species loss - terrestrial and marine, and other figure 2.1 illustrates that for low levels of climate change one could be in the zone of discomfort and damage. These are dealt with by working group II of IPCC. adaptation. Further emissions could lead to higher concentrations, that could increase 3. (femperature and increase damages. Say, at Dt=2°C, there could be "discomfort" zone; but, Economic uncertainties (corresponding to impact uncertainties) concern the effects of Climate with some positive probability, this zone could mean disaster for some. We refer to disaster Change on national and therefore individual incomes due to physical impacts such as coastal as "an event occurring suddenly and causing great damanage or hardship". For example, a erosion or cost of increased airconditioning. Cline (1992) has elaborated these and calls them small percentage in sea level rise might cause serious damages only to Bangladesh and as benefits of avoiding climate change. Both the costs and benefits of abatement are uncertain. Maldives but, might not have as much effect on the rest of the globe. On the other hand, we Costs of abatement could be different for each region and could have different impacts on GDP define catastrophe as "a sudden and widespread disaster." This can occur with a very small growth of different nations. However, the uncertainties regarding the costs of abatement probability for say a temperature rise of 4°C but with a higher probability with a temperature measures are less than those associated with the benefits these measures bring. Here again, the change of 6°C. This has to be avoided because apparent and hidden costs of global and local same level of geophysical impacts could lead to different economic impacts to countries at irreversible damages and extensive adaptation are high. Figure 2.1 shows that as the GHG different levels of economic development. Several chapters in the present report deal with accummulation increase, the severity of damages could increase. economic and technological uncertainties, viz., chapters 7 and 8. 4. Technological uncertainties concern the timely availability (lead times) and cost of reliable I Biomass consumed in developing countries in the form of fuel-wood. crop residues and animal dung are not recorded ? satisfactorily. They provide 10% to 90% of household energy for cooking in many developing countries. 3 4 2.1.2.2 Relating impact uncertainties with economic uncertainties: 1 Now we shift from "damage" to "damage costs" and what they could mean in terms of ) economic impacts to a country. Damages have different impacts on different countries for three . reasons. Probability I. Impacts themselves may be higher in geophysical terms. For example, for a given rise in global mean temperature, sea level rise in Indian subcontinent could be higher than in, say, 7 North America. ДТ = 2°C II. Even the same change say, 1°C temperature rise, could have more impact at 25°C average temperature than at location with 15°C average temperature. AT . 4°C AT = 0.2°C AT = 6'C 10 III. Even for identical climate change, adapation to climate change imposes greater burden " on poor countries than rich countries, i.e., the same amount of adaptation costs says $1 12 billion, could have differnt economic impacts due to differences in population, Adaptation zone Discount and Disaster zone Catastrophic 13 economic resources and technological capability. impacts can Damage zone zone have marginal Frequency of 14 When damage costs for adaptation are considered, as figure 2.2 shows, the zone for costs mostly Substantial costs extreme events Irreversible avoidable through of discomfort and increase with damages to " acceptable costs for a pcor country compared to a rich country may be much smaller and the adaptation. damage disastrous global consequences for ecosystem. 16. some. disaster zone may be much wider beginning at a modest level of climate change. No Increasing Impact of Climate Change Impact Figure 2.1: Schematic linkage between scientific uncertainties and impacts Area under each probability distribution curve is 1 At At = 2°C. the probability that there is no or little impact is much larger than at at - 6°C. Reverse is the case for catastrophic zone. Different curves are meant to represent qualitative differences between "small" climate change and "large" climate change. and the range of temperatures corresponding to each curve remains a subject of discussion. Similar relationship may be there for different levels of sea level rise. 5 Hence, in this chapter we undertake a detailed analysis of the consequences of various issues and attitudes, such as, equity, poverty, ecocentric approach and discounting, information 3 uncertainty and distributional effects for climate change decision making problem marked by uncertainty. , 2.1.3 Scope of the chapter: Welfare Impacts This chapter raises the basic questions involved in climate change decision problem; it emphasizes the collective nature of the decisions to be taken at the international level; it focusses on the various issues related to climate change decision such as vulnerability of Catastrophe food production systems, poverty, cost of delay, free riding, valuing common property, 10 inequalities in responsibilities, North-South transfers, and ecocentric views; and it provides " the linkages between various components of the sequential climate change decision DIFFERENT WELFARE IMPACTS FOR THE SAME CLIMATIC DAMAGE : AN ILLUSTRATION Disaster 1 8 A rich country has more resources to deal with climate change, it can avoid even discomfort and be within adaptation zone 2 $ The same level of climate damage can bring economic disaster We have assumed that adaptation to climate change imposes greater hardship on poor countries than rich countries for identical climate impacts. 12 problem. It also discusses various decision tools such as the utility based criteria, the nature " of uncertainty, risk and non-linearity, the role of time, insurance and portfolio approaches to 14 climate change. 13 Discomfort Figure 2.2 To address the climate change decision problem, one should know what are the 16 questions. Section 2.1 raises all the relevant questions related to climate change decision 2 17 making and the various uncertainties related to climate change and their interrelationships II are also discussed. Section 2.2 gives an overview of the nature and genesis of the climate 19 change decision problem; this section includes topics such as concentrations, absorption Adaptation to a poor country 10 capacity, nature of risk and inequalities in responsibilities. Section 2.3 presents factors that " affect collective decision making. In section 2.3.1, how and why of collective decision 22 making are analyzed. Various considerations that go into collective decision making such as 23 vulnerabilities, ecocentric views, poverty, and intergenerational equity are covered in section 24 2.3.2. The implications arising out of collective decision making such as cost of delay, Probability of welfare 25 valuing common property, accepting adaptations and North-South transfers are dealt in impacts 26 section 2.3.3. In section 2.4, under the heading of process of collective decision making, " we look at the steps involved in iterative decision making, criteria for inter-regional 28 allocation, and North-South co-operation through global policy instruments. The economic 20 notions of uncertainty, risk, bounded rationality, as well as various decision tools are 30 discussed in section 2.5. Finally, in section 2.6, we provide a sequential decision making " framework to hedge against impacts of uncertainty and change. This framework is made of 32 three components, namely, decision making paths, mutual insurance decisions, and 6 2.2 NATURE AND GENESIS OF THE CLIMATE CHANGE PROBLEM LEADING TO THE FCCC 2.2.1 Concentrations not emissions: The climate change problem is one of increasing concentrations (i.e. accumulation of , gases over decades) and not just emissions in a given year (stock and not flows) of GHGs. Of course, to contain the increase in concentrations, one has to worry about the rate of emissions , as well. At present targets are being discussed in terms of emission levels, say reaching 1990 2050 level by 2000. However, consequences of each path to 1990 levels have to be worked out in terms of concentrations (Fig.2.3a). While there is a discussion on reporting emissions every 10 year at the Intergovenmental Negotiating Committee (INC), the concentration levels as shown " 12 " Cumm. Emission Targets Cum. Concen. for Fig.2.3b A B 1990 Fig.2.3c Risk is more by A than B in Fig.2.3b, are yet to be discussed. Both shape and area under emission curve are important, in Fig. 2.3b since risks are measured in CO2 -years. Hence, climate change decision problem need to be addressed in terms of concentrations where earlier reductions should be rewarded to account 14 for their more beneficial consequences and to encourage early actions. If we decide to wait for " EMISSIONS, CONCENTRATIONS AND CLIMATE CHANGE RISK 2020 more information without acting, the stock of concentration of the order of 750 billion tons 16 since pre-industrial times gets larger, passing a larger burden to future generations. A B 1990 2000 Fig. 2.3b Area under A & B are the same over some decades, but not risks 2000 1 Fig. 2.3a Same emission level for the target year in each curve, but not concentrations In Fig.2.3a, the emission levels in the target year are the same for all paths, but each path has obviously different implications in terms of cummulated emissions. Fig.2.3b shows that the cummulative emission targets are the same for paths A and B i.e., area under each path is the same. However, as shown in Fig.2.3c, the climate change risk is more under path A than path B due to higher "C02-years" in the atmosphere. Therefore, earlier reduction should be rewarded. Figure 2.3 Emission Targets 2 3 1990 7 2.2.2 Absorption capacity: adjustions Therefore, small but regular reductions may be desirable than hoping to reduce suddenly and 3 The difference between cummulated emissions and atmospheric concentrations is a lot later, which can be traumatic, if not impossible. It is better to initiate efforts to be on the due to absorption capacity of the atmoshpere. Due to lack of understanding this is often learning curve which is gradual. If new information suggests that scaling up is not required, . represented as a factor by which one reduces cummulated emissions. one could relax. However, in the meantime due to learning experience, understanding of how to deal with it develops. One could compare this with developing and testing fire fighting , Greenhouse gas emissions are absorbed by forests, oceans, agriculture and so on. systems before the fire breaks, not after. This capability is to be developed as early as possible. Thus, not all emissions end up as concentrations in the atmosphere. While some hold a As pointed out by Chichilnisky (1994), climate risk is endogenous, collective and correlated. view that absorption capacity, also known as sinks, may increase slightly with increased Delay ia response is associated with two risks: (a) need to adapt to the changes and (b) concentrations, others consider that this is eroding fast due to denuded forests and polluted irreversible damages. Can irreversible damages, say, by extreme events, be compensated by oceans. Assuming that about 4 billion tons of carbon dioxide is annually absorbed by the 10 insurance? The bigger issues such as increased costs and damages due to temperature rise, sea 10 sinks, one implication could be that if humanity lived a lifestyle corresponding to about level rise, loss in biodiversity and other unforeseen damages are unlikely to be covered by the II 0.66 tonne of carbon equivalent emissions per person, per year, there would be no rise in 12 insurance industry. Therefore, COP may need to exogenously decide on a risk minimization 12 atmospheric concentration of greenhouse gases from current levels. This figure is applicable 13 strategy in terms of concentrations of GHG, which the North could lead. For more deatils, refer 13 for the present population levels. According to this principle, those who emit less than this 14 chapter on equity. 14 amount may not be considered responsible for climate change effects. In other words, 15 responsibility of marginal damage begins after going above this limit. However, is this the " 2.2.4 Common but differentiated responsibilities: 16 right way to allocate absorption capacity? This is an important issue. While absorption 16 Climate change problem is beset with most difficult problem of inequalities in 17 capacity of forests and agriculture could belong to the state in which they are, capacity of 17 responsibilities. Annex I continues to emit 70% of CO₂ emissions and has been responsible for 18 oceans is a common global property. There is a need to understand how absorption takes 18 85% of the cumulated emissions from the pre-industrial period and 77% from 1950 onwards. 19 place and how the sink capacity can be distributed. 19 Decisions to reduce would have been easier, if there was equality among nations. Many non- 20 2.2.3 Nature of risk: 20 annex I countries have inadequate living standards with insufficient nutrition, provision for safe 21 Climate change risk is a trend risk and not a sudden risk, or a random event say as in 21 drinking water and access to sanitation. Nearly, 20% of them do not have even light bulbs. 22 nuclear accidents, earth quakes or floods. That is, if there is a risk at time t, then, there will 22 It is not correct to say that everyone emits. In the next 5 decades despite expected rise in 23 be similar risk at time t+1.² However, correspondingly there would be a stream of benefits of 23 South's emissions, concentrations contributed by North would be larger than the concentrations 14 abatement, i.e., if there is benefit at time t, there will be benefit at t+1 also, and they are 24 contributed by South, even if North goes back to the 1990 levels and reduces further. 25 additive. This has two implications: once climate change impacts get in motion, it would be 25 Therefore, there would have to be simultaneous trends of the rich (viz., North) reducing and difficult to halt them. Corollary of that is, that the problem has to be addressed in a systematic 26 the poor (viz., South) increasing their emissions, to give south the time needed to develop and 27 fashion by reducing the trends of growth, i.e., more like gradually decelerating a car, rather 27 fulfill basic needs. Here, the North has a stake in South's development. That is, to see that than swerving to avoid an accident. Second, higher abatement costs are justified in case of 28 South pursues on pathSthat requires least greenhouse gas emissions for given development trend risk, as it has stream of benefits for all years starting after a given year, in distant future. goals. If, North's contribution to past and future concentrations are put to zero, South can go That is, abatement avoids adaptation costs not in say, 2025 but for many years subsequently. on with its development for another century without worrying about the climate problem.)This 1 That is, presently, there is 750 giga (billion) tons of carbon equivalent greenhouse gases in the atmosphere accummulated I 1 The non-Annex I countries are not homogenously poor; hut. on average their living standards are much below that of 2 due to human activities. If there is risk at time t, then the risk at time [+] will be similar. 2 Annex I countries. We also note that there are poor in North and rich in South. 8 9 I point is analyzed in detail in the section on North-South transfers. 2.3 COLLECTIVE DECISION MAKING 2 2 2.2.5 FCCC As A Key Element For Decision Making 2.3.1 How and Why collective decision making: 3 Some of the features described above are directly or indirectly incorporated in the The Conference of Parties (COP) will be the apex forum which makes the collective FCCC. Some may yet guide future negotiations. The following features of Framework global environmental decisions for global welfare within the constraints set by equity and , Convention on Climate Change (FCCC) are relevant for the decision making framework. efficiency. A conservative choice gives South the space it needs to grow and develop and future generations more options to chose from. However, it can not be too conservative so as 1. Objectives: The ultimate objective is to achieve stabilization of GHG concentrations in the to deprive the present generation. There is a hierarchy of decisions involved here. , atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system. Climate change means different things to different people. To Annex I countries, it is the cost of abatement, to non-Annex I countries it is the burden of adaptation, and concern for 2. Principles: The parties should protect the climate system in accordance with their common vulnerability, irreversible damages and rise of frequency of extreme events and most of all 10 but differentiated responsibilities. The developed countries should take the lead in 11 costlier development. To island states, it is their existence and to oil exporters, it is their 11 controlling climate change. The specific needs and special circumstances of developing 12 revenue loss, if fossil-fuel demand drops. Again, it concerns differently economists and 12 countries should be given full consideration. " environmentalists. All these concerns need to be voiced in a comprehensive manner. 13 3. Commitment: Developed country parties should take lead to adopt national policies and 14 First stage as pointed out in section 2.1, involves decisions at global level, such as 14 measures by limiting their anthropogenic emissions of GHGs so as to modify longer term 14 choosing concentration level stabilization and emission growth paths and their interregional 14 trends. In order to promote progress to this end, each of these parties shall communicate 16 allocations. These decisions have to be taken collectively (by the COP). Utility based criteria 16 detailed information on measures taken with the aim of returning individually or jointly to 17 (see box 2.3, section 2.5.1) would be quite inadequate for this purpose. Global climate change " their 1990 levels of these anthropogenic emissions. 18 will affect each country differently. Their risks and welfare costs are different. At the same " 4. Technology transfer: It also supports technology transfer and training to developing 19 time, those who have to take major abatement actions and therefore bear the costs of abatement 19 countries by developed countries. 20 are in general different countries from those who are at largest risk from climate change. We 21 20 do not have a global welfare function that integrates the utilities of different stakeholders. Since 5. Incremental costs: Global Environmental Facility (GEF) would be set up to provide "full 22 21 agreed incremental costs" to developing countries, when needed. global climate change affects every country, each country is a stake holder. In fact, since 21 developing countries are more vulnerable and have contributed little to the pollution so far, 22 Keeping these FCCC guidelines in view, we discuss various issues related to climate 24 they could have unequal rights, and could have more say in this matter. In fact, even in 21 change decision making in this section. 29 levying income tax, certain limits on taxable income is recognized widely and also progressive 26 income tax. It is seldom that polluters decide what level of pollution could be tolerated " particularly when they are less vulnerable to the possible impacts of the pollution. Yet, their 2K difficulties in responding quickly has to be kept in view. In such a situation one can use risk 24 based criteria, discussed later in this chapter. We discuss below the factors to be kept in view while choosing the level of risk. 10 11 2.3.2 Factors for collective decision making: 2.3.2.2 Anthropocentric Vs Ecocentric approaches: 2 2.3.2.1 Vulnerability of food production systems: So far, we have viewed climate change decision making purely from the point of homo sapiens. At this juncture we want to emphasize the existence of an alternative viewpoint, viz., 1 FCCC suggests that " stabilization of greenhouse gas concentrations in the that of ecocentricism, which gives adequate, if not equal weightage, to all the living species 4 atmosphere at a level that would prevent dangerous athropogenic interference with the climate in the world. , system. Such a level should be achieved within a time-frame sufficient to allow ecosystem to adapt naturally to climate change, to ensure that food production is not threatened and to enable Climate change may affect flora and fauna and their habitats, such as corral reefs and , economic development to proceed in a sustainable manner --". Parry & Rosenzweig's study physical environments that are a part of life support system. The earlier IPCC impact (1994) provides an idea of what is in store for future due to climate change in terms of food assessment indicates substantial pressures on biosphere and biodiversity due to climate change. vulnerability. For example, bleaching of coral reefs is expected. Due to the movement of temperature zones, without the rest of the life support system, species loss on land and sea is indicated. As we 10 They provide global assessment of the potential effects of climate change on crop " mentioned earlier, such a loss of species or damage to biodiversity has been traditionally " yields, world food supply, and regions vulnerable to food deficits. The national yield changes 12 ignored in the decision making framework. Only recently researchers have started developing 12 for the climate change scenarios were used as inputs into a world food trade model, the Basic " tools such as Environmental Impact Assessment to study the value of biodiversity for the 13 Linked System (BLS), developed at IIASA by Parikh K. et al (1988) and Fisher et.al. (1990). humans. Such studies are mostly anthropocentric valuations, carried out to find impact of the 14 Simulation outputs from the BLS provided estimates. of changes in cereal production, food 15 biodiversity loss on human recreation, medicines, education, research, chemicals, bio- 15 prices and the number of people at risk of hunger. 16 engineering etc. 16 The study concludes that the world cereal production is estimated to decrease between " An ecocentric view, on the other hand, views homo sapiens as one of the species on 17 1 and 7%, depending on the climate change scenarios used, by 2050. The study also indicates the planet earth expected not just to live in harmony and balance with other species but also ID that the impacts would be more severe on developing countries, in comparison with developed 14 to share the biosphere (which includes oceans, rivers, atmosphere, etc.) which provide " countries. With farm level adaptations, reduction in global cereal production is expected to be sustenance to other species too. To put it sharply, humankind's abrogation of decision making between 0 and 5%. However, the largest negative changes would occur in developing countries. 21 powers regarding nature is questioned. The ecocentric view proposes to curtail such decision 21 While, in the North (including China) there would be an increase in cereal production to the 22 making power. This view extends the ethical stand to include other animals and plants; Equity 22 tune of 2 to 14% after taking into account the direct physiological effects of CO₂ and the farm " is not only among human beings but also between humans and other living species. 23 level adaptations, there would be a decrease in developing countries to the tune of 6 to 12% 24 24 even after taking the fertilization effects of carbon dioxide and the farm level adaptations. This Though ecocentric viewpoint may seem extreme, it raises one crucial point. The link 25 " loss of production in developing countries, together with rising agriculture prices, according between the existence of other species and that of the human beings should be kept in mind to the study, is likely to increase the number of people at risk of hunger, in the order of 5-50%, while making any decisions regarding the activities of humans which would adversely affect " depending on the GCM scenario. the environment and inter alia other species. Thus, CO₂ concentration levels of double the value of preindustrial values in 2060 may 29 not be acceptable to the South. If 550 ppm is reached in 2060 AD, it is likely that given the long lead times required, stabilization reached by say, 2100 AD, would be much higher and 31 the outcome may be severe. 12 13 2.3.2.3 Poverty and Climate Change: concern. Such a concern automatically raises the issue of equitable distribution which we 2 2 Another important issue while making climate change decisions is that of poverty and discuss later. the linkages between poverty and climate change impacts. Suppose there is increased 2.3.2.4 Intergenerational equity and discounting: occurrence of extreme events such as floods, cyclones, typhones, hurricanes and so on occur , due to climate change. Then, in such a situation, it is the poor who are always vulnerable Climate change problem will affect many future generations because of long life time compared to the well off. Take the case of the recent earthquake in India; in this natural of GHG. But, whenever cost benefit analysis is used to evaluate long term benefits and costs, disaster, more than 10,000 people died compared to only a few in the earthquake of similar as in the case of global climate change, the practice of discounting the future is severely 7 intensity in California.⁴ In essence, the threshold level to withstand these impacts would be questioned. One set of critics base their criticism on the belief that discount rates place a low less for developing countries when compared to the developed ones. In such a case, given that weight on future generations. Another group argues that because discount rates dominate the present accumulation of GHG in atmosphere is due to advanced countries, will they be decisions relating to the future, one should use low discount rates whenever one evaluates 10 II forthcoming to insure the poor against such calamities? projects with long term implications. This is the position taken in Cline (1992) when he uses II a low discount rate ranging from 0 to 2%. 12 Large scale out-migration from coastal zones is expected due to sea level rise. Intrusion 12 13 of sea water in the ground water and changes in temperature can reduce agricultural incomes Ethically, generational welfares are to be treated equally. But, future generations could 13 14 everywhere. This will create a large number of environmenal refugees. Will they get migration be better or worse off than the present generation depending on the GDP growth rates. In the 14 15 rights (to the North)? Share of GDP from agriculture in total GDP ranges from 16% to 64% former case, if the future benefits outweigh the present abatement costs, one would expect that 15 16 in low income developing countries and 12% to 37% in middle income developing countries the future generations should pay for the abatement cost. Such an argument is based on the 16 " compared to only 3% of USA (World development report, 1994). Also, the share of population assumption that in the intergenerational welfare function, atmospheric capital (environment 17 " depending on agriculture are of similar proportions in the south. In short, the impact of climate space) is substitutable by man-nade capital. This substitutability assumption is highly 18 19 change will differ from region to region and sector to sector. questionable. If there is no such substitutability between physical and atmospheric capital, one 19 cannot delay abatement actions in favour of setting aside some man-made capital for future While the rich can argue about whether to enjoy more now or pay later in the future 20 generations. Chapter 3 on "Intergenerational equity and discounting" suggests that discounting 21 and if so what discount rate to use, this is unlikely to be a major issue for the poor who are 21 considerations change if the present generation is richer or poorer compared to the future 22 on the margin of subsistence. If a poor country is forced to reduce their GHG emissions or 22 generation. Most global modelling scenarios (chapter 11 on Integrated Assessment) show that 23 pushed to adapt to climate change without aid or efficient technology, they would have no 23 on the average, future generation of South will still be poorer compared to present generation 24 option but to reduce their current consumption below subsistence level. Rising concentrations 24 of North even by 2050 or beyond. Thus, global average of all regions can be the reference 25 of GHG in atmosphere will bring more constraints on their future development. To conclude, 24 point for such considerations. Present generation of North could choose discount rate as though 26 since the poor, whereever they are, have a very high marginal utility of income, if required to 26 global average would be less in future compared to their generation at present, while South can 27 curtail their GHG emissions in a comparable way to the rich, the poor will bear a 27 choose discount rate as though the next generation would be richer. 20 disproportionate burden of global warming caused mainly by the lifestyles and consumption 7 2a patterns of the rich. Any reasonable decision making framework needs to address this primary On the other hand, suppose that the future generations are worse off than the present 7 generation. In such a case, what the future would pay for the present abatement will be much less than the cost of abatement. Some argue that intergenerational equity should be dealt with 4 Of course, two carthquakes are never quite comparable. The point, however, is in the Indian carthquake if only the houses " separately as a political decision with ethical dimensions. For a forceful argument of this point 2 were built with modern construction material, even low cost ones, the loss of life would not have been as much. The people , could not afford even such low cost modern housing. 14 15 I we refer the readers to Schelling (1994), and chapter 3 of thus document. after 1990 which would be retroactively adjusted against their future share, after negotiations 3 Not doing anything for the benefit of future generation could be acceptable. But, if the are completed. This would prevent free riding and precipitate some action even while matters , present generation is responsible for the losses of the future, as is the case in the climate are being negotiated. While issues such as past concentrations, population can be discussed change problem, then not doing anything is morally unacceptable. That is, not giving them later, accepting this principle of accountability after 1990 could lead to prudent behaviour and large inheritance is acceptable, but we should not pass on liabilities. Abatement is not to be act as some deterrent to all against wasteful consumption. looked at as an investment option giving returns in the future but as a liability reduction 2.3.3.2 Valuing Common Property (and Paying for It): exercise. Hence, the level of abatement of concentrations could be chosen to minimise climatic , The emissions emitted beyond earth's absorption capacity then test the biosphere's impacts on poor and then look for the cost effective ways of fulfilling those commitments. Low adaptation capacity. This capacity to adapt may be also limited i.e., it is an exhaustible levels of discounting could play a role in the later step, but, not in the former. resource. How is the atmospheric resource different from many other exhaustible resources we 10 We have described some of the considerations that go into collective decision making. 10 use every day that include metals, and fossil fuels? First of all, these resources have property " Having collectively decided the concentration levels and interregional responsibilities, II rights and they are paid for, each time they are used. "Paying for what you use" is a sound 12 individual countries could formulate their strategies to follow respective emission paths. While 12 economic principle that should be enforced whenever atmosphere is used to prevent misuse. 13 deciding who needs to do what, one has to take into account various factors such as D If one does not have to pay for common property, it encourages appropriation of atmospheric 14 responsibility interregional equity, North-South transfers and various policy tools to achieve 14 capacity. The user charge should be either paid to others when the property also belongs to 15 the required emission reductions. " them or put in a common pool for future use. Second way it is different from other exhaustible resources is that there are substitutes available or likely to be available for them. This is 16 2.3.3 Implications of collective decision making: " unlikely to be the case for atmosphere of planet earth. 17 2.3.3.1 Cost of delay and slippages (Free riding through delay): II How does one pay for using atmosphere and to whom? Collective decision is required " International negotiations are difficult and take long time. Even if the decisions are to decide this. How does one value absorption capacity and adaptive capacity? How does one 19 taken at international level, it cannot be guaranteed that they will be followed up by people at 20 allocate property rights for both? One can think of several ways. 20 various social strata. Therefore, slippages may occur. However, in the mean time concentrations 21 (a) Consider that those who wish to emit more than their share should pay rent. 21 mount, if no directions are given. A ortion of every tonne of GHG emitted occupies some 22 22 environmental space for about 200 years, which is not available to either future generations (b) Consider that this is a permanent loss and pay damage costs. 23 everywhere, or constrains the development needs of non-Annex I countries. For example, " (c) If and when property rights are allocated, trade or lease them. 24 during the nineties, after signing the FCCC, the Annex I countries would emit about 40 to 50 25 billion tonnes of CO2. This could have been sufficient for South to grow and develop for more 26 than 25 years. In addition, high emissions by one party push the other parties either to adapt " or to forego their development. 20 Therefore, if no decisions can be reached soon, at least it should be agreed that Annex I countries would be liable for whatever concentrations emitted after 1990. That is, whatever the outcome of negotiations, it would hold parties accountable for the cumulated emissions 16 17 I 2.3.3.3 Accepting Adaptation: I come. 1 There is ever increasing reference to need for adaptation. Adaptation ranges from 2 2.3.3.4 North-South transfers: 1 switching to different crops, incurring increased cooling costs to migrating or giving up land , 4 rights if they are in the coastal areas. Parry & Rosenzweig (1994) have indicated increased Several justifications for the North-South transfers are given below. These are not 4 , hunger in developing countries which is also one way they adapt. That is, due to delay in necessarily mutually exclusive. That is, transfers for one may overlap with other. However, , these are different ways of looking at North-South transfers¹. abatement, global risks are externalised for which there will be no compensation. In any case, , adaptation will be too all-pervasive and costs too difficult to isolate for compensation. Will the 1. Currently there are many countries whose use of environmental space far exceeds their North pay for dykes in Bangladesh or give migration rights and compensate for shifting and 7 justifiable share of that space. J.Parikh (1993) has indicated that these privilages are worth rehabilitation to people from Maldives? US $70 billion per year. Also, North's use of environmental space has a temporal 10 characteristic; that is, these emissions will occupy the environmental space for hundreds of U.S. estimates for costs to build walls along the vulnerable zones to sea level rise is 10 " $130 billion (refer chapter 4). That may be a small share of U.S. GDP, but such measures, years in the future (Smith, 1991). According to the "polluter pays" principle, those who II 12 even scaling for their coast lines, for say, India, could require very large share of their GDP. have occupied this environmental space should pay rent for it for their excess use of the 12 13 Who shall pay India for such a wall? Moreover, one still does not know what would be the global environment to those whose use is below their entitlements. In addition, when the 13 14 latter need that space, that should be made available to them. (Rent for environmental environmental impact assessment of such walls. They could also have adverse ecological and 14 19 economic impacts on coastal zones. space). 15 16 It is said that there may be rise of mean temperature of 0.25 degree per decade. This 2. The consumption patterns of the rich countries have put constraints on the development 16 17 is sometimes multiplied to get 2.5°C for a century but there could be non-linearity and alternatives of the poor countries. Due to the climate change possibility, the poor will be forced " 18 temperature rise could be more with more GHG accumulations. Moreover, 2.5 degree to spend more resources for adapting to the climate change problems; this will constrain the " 19 resources available for their immediate development priorities. (Compensation for adaptation centigrade mean temperature rise could mean 5.5 degree centigrade rise in the Northern 19 20 hemishpere due to extensive land areas compared to oceans. Indeed, if this happens, it would burden imposed). 21 be difficult to live in many parts of Indian subcontinent and other populated countries in the 20 3. Those who have emitted more than their share of the absorption capacity of the atmosphere 22 mid-east and South Asia and large scale migration may take place. Thus, adaptation costs 21 (in per capita basis) and benefitted, are liable to others for the possible damages arising from 23 passed on to others should be internalised in one'sactions. It is important to note that marginal 22 global climate change. (Liability payments for damages and excess past concentrations). 24 damage of one extra degree of temperature is far more serious in the South than in the North, " 4. The cost of delay in emission reduction (by the North) in terms of South's foregone 25 where they may even benefit from that extra degree. Thus, risk tolerance of say, South should 24 opportunities to development is substantial. This will impose many constraints on the way the 26 matter more than that of North. 25 South decides on policy options regarding issues such as how to generate power, how to use 27 Most models developed in the North do not effectively build in the perspectives of the 20 land, and what crops to grow and so on. Hence, North-South transfers of large amounts are 28 South in adapting to climate change. The resources to adapt often do not exist and the outcome " needed to compensate South for the development opportunities foregone. (Lost opportunities 20 is further human suffering, manifested in, for example, frequent occurrences of the homeless 28 due to concentrations after 1990). dying from heat stress. South does not have the capacity to adapt except through increased 29 As against all these, Global Environment Facility (GEF) gets replenishment of US $ 2 31 human suffering and is poor enough to have problems of their own. Homeless die of heat stress 12 even today. Finally, adaptation does not solve the problem; it only postpones what more is to I 'K. Smith (1991) has used a concept of natural debt to address these issues. 18 19 billion for three years to address four different global environmental concerns, viz., climate 2 change, biodiversity, international water, CFC reducing to serve Montreal protocal. One could 1 also think of North-South transfers through global policy instruments such as tradeable 4 emission permit regime, joint implementation and so on. We briefly discuss these issues in the , next section. The reader can also see the separate Chapter on policy instruments for more details. , Having discussed considerations for and implications of collective decision making, we discuss some theoretical considerations involved in making the national and international decision making in the following section. " 2.4 PROCESS OF COLLECTIVE DECISION MAKING 12 Climate Research and Policy Research Integrated Assessment NATIONAL DM (Utility based Criteria) Response Options Technological Options Life Style etc. Let us now turn to the process of climate change decision making. In this section, we will first " provide a summary of steps involved in iterative climate change decision making problem, 14 criteria for interregional allocation, global policy instruments and consider sequential decision 15 making procedures. 16 2.4.1 A summary of the steps in iterative decision making: 17 Necessary elements of collective decision making are linked and brought together with 18 national decision making either directly or preferably through global policy instruments as DECISION MAKING FRAMEWORK Figure 2.4 21 19 shown in figure 2.4. 20 The first step in long-term decision making process is to select concentration level 21 through collective decision making by considering equity of stakeholders, of those stakeholders 22 whose emissions so far have not contributed significantly to the current atmospheric COLLECTIVE DM CONCENTRATION LEVELS (Risk based Criteria) EMISSION PATHS INTERREGIONAL ALLOCATIONS GLOBAL POLICY INSTRUMENTS Equity & Efficiency (Utility based Criteria) for interregional transfers South) (North-South) 23 concentration levels. For stabilizing atmospheric concentration of the main greenhouse gas, Tradeable Permits -Joint Implementation 24 namely CO2, at any level between 350 to 750 ppmv calls for significant reductions in the Carbon Tax " emission trends in the near future. Some alternatives are indicated in figure 2.5. If a very low 20 level is chosen, considerable sacrifice is expected from the present generation. If high level of 27 concentration is chosen, there would be danger of irreversible damages and high adaptative 28 costs. Remember that, if 550 ppm is chosen, it is difficult to go back to 440 ppm, but vice 29 versa is possible. 20 I than north. Emissions per GDP are sometimes taken as indication of inefficiency. However, 2 high emissions per GDP can be attributed only partially to inefficiencies in South. High 3 emissions are mainly due to low level of development which requires filling the backlog for 4 infrastructures such as, schools, hospitals, power plants, due to unsatisfied development needs , such as health, nutrition, education, lighting, and so on where relatively high share of GDP 6 goes (World Devp. Rep., 1994). This is referred as purchasing power parity. This is , comparable to the fact that, growing children need more food per kg. of body weight than 2250 adults past fifty. Higher need for new infrastructure building explains high emission per GDP and also calls for higher growth in future. Apart from investment in infrastructure, pricing and $750 $650 5550 $450 S350 10 valuation of non-tradeables also matter in these calculations. This can be captured by 11 adustment factor for purchasing power parity. 2200 12 One could think of a time table in terms of limiting emission by Annex I and non- " Annex I countries through reduction of emission growth rates. 14 15 Illustration of Strategic Decisions to be taken in Sequence 16 Time Period Growth rate of emissions (dC/dt) Rate of change of growth rate (d²C/dt²) 17 Annex I Non-Annex I Annex I Non-Annex I countries countries countries countries 18 ≥ 0 > 0 <0 > 0 tigure 2. 5 ANEXURE Figure a Profil:s of Atmospheric CO, Concentration Reading to Stabilisation at 350, 450, 550, 650 and 750 ppny 2150 Upto 1990 2100 19 1990-2000 = 0 > 0 <0 > 0 20 2001-2025 <0 > 0 <0 = 0 20 2026-2050 <0 ≥ 0 <0 <0 12 Beyond 2050 < 0 <0 <0 <0 " C Carbon dioxide emissions 24 2050 25 This is only an illustration of the process where Annex I Countries take lead and are 16 followed by non-Annex I countries after some lag. It is a sobering thought that over such a 27 long period, distinction between Annex I and non-Annex 1 countries may get blurred and 28 countries have to be grouped in terms of per capita emissions below and above the world Prescribed CO, (pprmv) Double Pre-Industrial Pre-Industrial 29 average. 1990 2000 30 The discussions regarding future entitlements for GHG emission so far have excluded 800 700 600 500 400 300 200 31 the historical record of past emissions. Such an omission might be wrong for the following 32 reason. Increases in the concentration of carbon in the atmosphere have taken place over a 33 prolonged period of time. The contribution of North America and Western Europe to the I $ 2 & 34 concentration is much greater than their share of current emissions. On the other hand, the 22 historical emissions from developing countries have been low and hence their share of the 2 overall concentration is also low. The current generation of developed countries are the , beneficiaries of resource transfers from past generations. These resource transfers have been possible only due to the exploitation of global environmental resources by their past , anthropogen CO, erissions in 1990 generations. As a result, the current generation living in the developing countries have the right to claim a part of these resource transfers, or, transfer of emission free technologies, or, right 7 to pollute (for development needs), as environmental resources are common property. S750 S650 S550 S450 2050 2.4.3 North-South Cooperation through Global Policy Instruments: S350 Once interregional obligations are decided, one could discuss global policy instruments, 10 which make it possible to reduce the cost burden by either trading emissions or by meeting the 2040 " obligations jointly or by contributing to carbon tax, which can be used to reduce emissions in- 13 Comparison of IPCC Emissions Scentrins and Emissions Profites Consistent with Stabilization of Atmospheric Concentrations of 350 to 750 ppmv IS92c non-Annex I countries. Global Policy is also needed to discuss ways of North-South transfer, 13 either through the above mentioned or other means. These are referred as global policy 14 IS92a 2030 instruments. They can be selected based on utility (global or national) based criteria. 15 Figure: 2. 2.6 Institutional failures, such as lack of well defined property rights, and distortionary subsidies, 16 always lead to market failures such as gaps between private and social costs of production and 17 ANEXURE :Figate 2020 consumption activities. As a result of this, producers and consumers do not appreciate the true " scarcity value of the resources they use up, such as environmental resources. The emerging IS92e 10 pattern of ecnomic growth from such production and consumption plans is usually 20 unsustainable. Economic instruments which are aimed to correct such unsustainable resource Anthropogenic emissions (G:C/yr) 2010 21 use, bridge the gap between social costs and private costs by internalizing all the external costs 22 and risks. The use of economic instruments at the global level to deal with climate change 23 requires special considerations. We emphasize here these, as they relate to some suggested 2000 24 policy instruments. For a more detailed discussion on the policy instruments, refer chapter 10 25 of this document. 24 To elaborate, economic instruments such as property rights, pollution taxes, and 13 12 11 10 6 8 7 6 5 4 3 2 1 0 1990 " tradeable emission permits bring about a realignment of resource allocation with the social 28 objectives. Such economic instruments achieve the objective of sustainable growth through (1) % providing a corrective to the functioning of the market, (2) encouraging cost minimization, (3) 30 permitting flexibility of use, and (4) adjustability to changing environment. The key to the , " promise of economic instruments is their ability to harness the power of the market. Economic 32 instruments can be broadly classified into the following categories: (1) allocation of property 24 63c alean 2260-692-91r :# MAION THE 111 TREATMENT 8 Spiff NCW F6.-92-835 I rights (ownership rights, use rights and development rights), (2) creating markets (tradeable emissions. A global level of tolerable emissions is set for greenhouse gases and allocated 2 emission permits, tradeable offsets), (3) economic incentives (emission taxes, subsidies), (4) among the nations by some criteria. Tradeable permits scheme on the other hand, give some ) financial instruments (such as GEF, green fund, location incentives), and (5) liability developing countries the possibility to earn additional foreign exchange for their development instruments (liability standards, damage liability, liability insurance). till such time that they have surplus permits. Sooner this is done, earlier the benefits. It will also indirectly encourage them to reduce GHG emissions early, unlike JI, which induces them , Joint implementation (JI), Tradeable permits and carbon tax are some of the global to reduce directly but sporadically. However, on what basis emission permits should be policy instruments that lead to economic efficiency but require international negotations. distributed is a thorny issue about which much is written. Though the desirability of , Among these options, JI is already referred in the FCCC and is in the advanced stage of distributing permits (quotas) on per capita basis is recognised at least in the long run (Manne negotiations. Pilot phase of JI is approved by the INC. Л gives opportunity for co-operation and Richels, 1993), population growth in developing countries is an issue of concern. A between North and South where North can invest in South to reduce GHG emissions, if it is 10 compromise could be to have the quotas on the basis of the population fixed in the year in 10 cheaper to do so. South gains in terms of energy efficiency if better technologies are provided. " which the agreement is reached. This will encourage North to reach agreement sooner and at II Key question is whether international credit or "offsets" should be given for such efforts. That 12 the same time South does not profit from population growth. 12 is, should GHG emissions reduced through JI accrue to the investing country, giving them " opportunity to increase their emissions to that extent? If yes, then further negotiations are 11 In addition to these options, other forms of co-operation also exist. This could be 14 needed on how much emission reductions through JI can be credited, mode of monitoring and 14 regional approaches, technology transfer, technology fund or joint technology development. 15 verification. 15 Apart from the North-South co-operation, regional approaches can also be developed keeping 16 in view the common features shared by the regions which may include socio-economic, 16 There are concerns that perhaps JI will delay new technology development or 17 ecological or meteorological features, viz., temperature, precipitation, solar radiation and so on. 17 consumption patterns of North will not change. Accountability of global GHG emissions when IS South does not have limits on the emissions is another concern. Therefore, there is no IS Once the goals and policy instruments are agreed upon, national level DM begins. This 10 agreement on the credit issue so far. Even if this is undecided, credits or incentives for the JI 19 strategy will depend on utility based criteria or regulatory mechanisms. Their responses will in the form of carbon tax rebate can be given internally by North. If carbon tax is not imposed vary from fuel substitutes, life style changes, technological alternatives, or increasing sinks. 21 by that country government, then it could permit rebate under some other category such as that 21 22 of treating JI as a category of R&D expense or charity or other tax deductible expenses. Thus, 23 internal incentives can be given to private entrepreneurs by the Governments in the North. Why should the governments in North do so without international credit? JI can have an 25 immense value in terms of capacity building in South, so that when they will have to reduce emissions, they will be ready for it. They may choose to go for energy efficient mode of 27 development. J. Parikh (1994) shows that if South makes some effort to reduce emissions 28 now, it will reduce pressure on North in future as well. Thus, it could have long term benefits in terms of preparedness of South and reduced global emissions. JI will require monitoring of the projects by certified auditors to account for carbon reduction, especially if international " credits are given. " Tradeable emission quotas (or permits) is one way of creating a market for GHG 25 26 1 2.5 Economic Formulation of Individual and Collective Decision Making I fecting decision making: among them one can cite attitude, poverty and intertemporal equity. 2 "Prior judgements that decision makers bring to the problem, 3 and the decision rules they employ, could be far more important 2 2.5.1 Accommodating the supplementary uncertainty caused by climate change 4 in controlling the policy conclusions that they reach 5 than are the results of scientific discoveries." 3 Cognitive and computational limitations make sense with respect to climate change concerns. Deci- 6 Dowlatabadi and Morgan, 1992 7 This section concerns methodological insights and guidance for making choice between a limited 4 sion making is concerned with these limitations. 3 Indeed, ignoring climate change would simplify decision making. However, it would be irrational 8 range of actions that have attached consequences, and especially establishing a point of convergence 9 between individual and collective decision making. How we think of choice involves issues of ratio- 6 to return to our previous lower level of uncertainty awareness. We thus have to accommodate the 10 nality and related decision criteria and rules, and is influenced by various factors among which uncer- 7 supplementary uncertainty caused by possible changes in climate (Caselton and Luo, 1994) and their 11 tainty comes first.¹ Whereas a key element of the decision making framework to address climate 8 effects on individual and social welfare. 12 change is the ratified FCCC (which indicates the objective to achieve, namely, the stabilisation of 9 As a consequence of insufficient knowledge and data, predictions of the rate and extent and timing 13 GHGs concentration), providing a steady economic basis to decision making paths and actions to 10 of climate change and their effects have been made in terms of scenarios rather than in usual proba- 14 bring about probably constitutes the most important contribution to the negotiating process. 11 bilistic terms. In particular, this situation reflects a gap between the information that is available on 15 The long term perspective and the globality of climate changes designate uncertainty as a key fac- 12 climatic processes and the one that would be relevant to Bayesian inference (the common way to use 16 tor in decision making. Uncertainty is related both to the science and to the economics of climate 13 new information to update beliefs "rationally"), and that is in short supply at present time. 17 change. On the one hand, there is a genuine uncertainty of the climate system-which has bounds but 14 What is the issue? In decision theory, decisions are based on the assessment of alternative strate- 18 which is not quantifiable (Bolin, 1994). For economics, on the other hand, estimates of the costs and 15 gies and the valuation of likely outcomes. The decision process describes uncertainties by means of 19 benefits of global warming are much uncertain. In particular, the uncertainty of impacts on individual 16 the concept of "state of nature" (a description of possible "states of the world"-that may be uncer- 20 and social welfare seems predominant. 17 tain, as well2). Common decision making is served by the Bayesian approach which represents any 21 For example, models in science, in economics and in social sciences provide quantitative estimates 18 information or knowledge concerning states of nature by assigning them probabilities. In this respect, 22 of effects based on critically important assumptions that openly leave large band of uncertainty in ref- 19 the representation of information in the form of conventional, necessarily precise, probability distri- 23 erence to climate change. Lack of knowledge about fundamental mechanisms that equations cannot 20 butions has been systematically developed in the statistical and economic literature since the 1930s.³ 24 currently master represents limits to computer models in each domain. It is also true that most models 2 To formalise the conditions of uncertainty, it is convenient to refer to Arrow's concept of state of the world (SOW), a de- acription of the world so complete that, if true and known, the consequences of every action would be known. The mean- 25 in the North do not effectively build in the perspective of the South in slowing down or adapting to ing of certainty is that the agent knows the state of the world while that of uncertainty is that the agent does not know the state of the world. Uncertainty characterises all activities; "it affects all fundamental variables that determine behaviour, 26 climate change-both in terms of resources and outcomes. explain choices and bring about decisions" (Kessler, in Edckhoudt and Gollier, 1995). 3 In decision making under uncertainty and risk, the analyst is provided with precise, either objective or subjective proba- 27 A priori, however, the existence of uncertainty does not mean inaction. Making decision under un- bilities. When it is not possible to arrive at such a unique probability distribution for an event. one tries to construct it from more fundamental events. Such a procedure is known as the Bayes' rule. Suppose the hypothesis B is true and that an 28 certainty rather implies to filter paths of action and to choose which strategy with which outcome event A has occurred. Then, the probability of hypothesis B under the condition that event A has taken place is given by P(BIA) = p(AB)/p(A). (2(BIA) is known as the posterior probability and depends upon p(A) which is known as the a 29 would be best. This can be done at various analytical levels such as economic rationality, utility- priori probability. How do we obtain the prior probabilities? If there are past empirical evidences one can obtain the priors from them. But if there is no evidence available to us about, say, whether global warming or climate change of unaccept- 30 based choice criteria and rules, collective decision procedure (the one FCCC brings forth), short run - ablc level is going to occur or not, then, according to the "principle of insufficient reason", one has to assign equal prior probabilities 10 all the mutually exclusive events (or to forget about the Bayes' rule if climate change simply does not al- 31 long run trade-offs, risk analysis, value of improved information, as well as other particular factors af- low to make prior probability assessments-Heap et al., 1992). In the first case, if new scientific information is forthcom- ing, one can use that information to update the prior probabilities or beliefs using the Bayes' rule (or shifts and alternatives 1 Decision analysis also includes a range of techniques such as cost-benefit analysis or multi-attribute utility analysis. to the Bayesian scheme-see below) to get the posteriors. In summary, the Bayesian theory yields instructions on how to use new information to update beliefs "rationally" in certain circumstances. In essence, the Bayesian decision theory is Each tool has a methodological foundation in decision theory but is suitable for different purposes. See 2.4.3.2, below. subjective expected utility theory. Chapter 2/page 27 Chapter 2/page 28 I In view of the climate change concerns, and lack of knowledge and data, we undoubtedly have to 1 probability can always be formulated "as a bet on a certain event". Under these circumstances, the 2 address decision situations that go beyond conventional levels of uncertainty. How to treat informa- 2 condition for making strong uncertainty computable is that agents at least believe that they know, 3 tion sources (these are diverse with respect to climate change, each of which providing only a small 3 even approximately, the relative frequencies of the states of the world. 4 component of the total information-IPCC reports provide the most comprehensive assessment in 5 this field), and how to allow probability assignments to which subsets becomes significant. 4 2.5.1.2 Abrupt climate change adds unpredictability to uncertainty and risk 5 Nevertheless, some controversy exists with respect to probabilities and possible climate changes. 6 2.5.1.1 Strong uncertainty 6 On the one hand, the climate change context makes associated risks endogenous (they are affected by 7 This means that decision making to address climate change appears as a category of decision making 7 our actions) and collective (they are not statistically independent risks) (Chichilnisky and Heal, 8 which must envisage shifts to the conventional Bayesian scheme (Caselton and Luo, 1994) when 8 1993). For example, circumstances have changed for the insurance industry "in ways that mean 9 confronting the "strong" uncertainties created by climate change. 9 traditional practice and the old statistical methodologies are no longer adequate"-"past experience is 10 "Strong" uncertainty refers to situations where chance is included (which by turn designates 10 no longer a safe guide to the far future" (Ayres and Weaver, 1994). On the other hand, strong 11 common uncertainty and risk). but knowledge is insufficient-in other words, situations for which 11 uncertainty persists with regard to the characteristics of the evolution (rate, abruptness, etc.) of 12 probabilities cannot conventionally be defined. 12 possible climate changes. In sum, climate changes seem to imply a certain degree of irreducible 13 In short, climate change gives rise to a type of uncertainty that might not be straightforwardly re- 13 unpredictability beyond the common categories of risk and uncertainty. 14 duced to traditional risk. Phrased in economic terms, technological and economic "common" uncer- 14 On the theoretical side, for example, the important processes influencing the global climate are 15 tainties (or, "variability"), while including chance, include the prospect of being pleasantly surprised, 15 identified and can be understood at least in principle. Particularly, gases influencing the greenhouse 16 whereas climatic and biological uncertainties, while including chance, lie beyond our current cogni- 16 effect are analysed in detail (absorption bands, infrared emissions, diffusion) and so, its anthro- 17 tive and computational capabilities-and (in as far as they are seen as catastrophes) normally imply a 17 pogenic modification can be rather exactly calculated. However, the basic assumptions made in such 18 downward trend of expected revenue (Price, 1993).4 18 calculations are that the structure of the climate system remains unchanged. Especially, atmospheric 19 A more sensible distinction would be between situations in which there is some experimental or 19 and oceanic circulation patterns and cloud formation, in many models, are assumed to remain quali- 20 observational knowledge on the whole system or parts of the system (i.e., conceivable outcomes 20 tatively the same, at most being quantitatively slightly affected and so contributing to a positive or 21 would be known, but their probability of occurrence would not), and when there is no such knowl- 21 negative feedback, amplifying or damping anthropogenic climate effects respectively. Easy to under- 22 edge. In the first case, strong uncertainty can generally be dealt with by assessing "subjective" proba- 22 stand, that the prognosticated anthropogenic warming is gradual without discontinuities (+0.3 K per 23 bilities to the possible states of the world. In the second case, the situation leads to ignorance.⁵ From a 23 decade). 24 probabilistic standpoint, one can however argue that the distinction between common uncertainty and 24 In contrast to this, the picture drawn by the newest ice core results (Anklin et al., 1993) empha- 25 strong uncertainty (and so between risk and uncertainty as well) is a gradual one, as "objective" 25 sises variability and instability in a surprisingly unexpected way. Not only does the last ice age show 26 probability assessment or statistical inference does not exist.6 From such a standpoint, a subjective 26 a large number of sharp transitions between a glacial and an interstadial climatic regime (what has 4 However, this is not the rule for climate change in as far as it might also represent an opportunity, e.g., for innovation, 27 been known before) but also reveals the last interglacial age ("Eem", 125'000 years ago) as being institutional and technological progress; i.e., it can be used positively whether true or not. 5 Ignorance basically designates a situation where there is absolutely no information about the unknown state of nature. In the Bayesian theory, ignorance is meant as an informationless prior. Ignorance, and similarly near ignorance, can also known/knowable (risk) or not (uncertainty). In this respect, a risk-like uncertainty (knowable probabilities) is sometimes be viewed from the perspectives of belief and plausibility. referred to as "weak" uncertainty. There exist more schemes of distinction between risk and uncertainty though 6 differences can rest on science-philosophical grounds (see Vercelli, 1991, Faucheux and Froger, 1994). An alternative is The distinction IS frequently made between risk and uncertainty on the basis of whether the probabilities are fuzzy logic. The one application of such logic to climate issues is contained in a paper by Leimbach (1993). Chapter 2/page 29 Chapter 2/page 30 1 composed of a series of sharp climatic transitions. The largest uninterrupted interval of Eem climate 1 next for what change. We would thus face a "globally weak but regionally strong uncertainty". 2 optimum (roughly 2K warmer than our Holocene level) encompasses only ca. 2500 years and around 2 These perspectives add to the complexity of making decision under uncertainty with respect to 3 20 important abrupt transitions between different climate levels can be observed. The most catas- 3 climate change. Climate change may be a sudden event. Yet, this does not preclude quantification. 4 trophical fluctuation yet analysed happened towards the end of the Eem, where the climate changed 4 In sum, one can argue that although there is some consensus on the ability to deal with uncertainty 5 into a glacial regime within about 15 years, to make the same abrupt change back to the original 5 and risk through subjective probabilities, some uncertainties and risks associated to climate changes 6 warm climate only 70 years later (Anklin et al., 1993)! 6 may stay outside the reach of traditional practice. Although this is not the right place to expand 7 The discrepancies between the paleoclimatic observations of abrupt changes and the smooth grad- 7 "classical" and "abrupt change" scenarios, and although probability distributions should not be at- 8 ual warming prognosticated by today's models could not be more pronounced. They are the result of 8 tached to such alternative scenarios, subjective probabilities reflecting low probability but great 9 the fact that the models simulate climate changes as marginal variations around a stable basic climate 9 severity are needed (see 2.5.3.3, below). Alternatively, one must be also aware of low probability 10 mode. That the dynamics of this basic mode could dramatically change, being replaced by a different 10 outcomes (e.g., in the case GHG emissions would in future be captured). This means that shifts to the 11 one, is only beginning to be modelled (eg., Manabe and Stouffer, 1993). 11 Bayesian decision theory must be taken into account. To conclude, Baysian decision theory has two 12 In the framework of the basic properties of non-linear systems with circular causality, small 12 limitations with respect to climate change: first the existence of strong uncertainties and, second, the 13 stochastic fluctuations can become important factors influencing the time evolution of a system. As 13 existence of low probabilities attached to large potential damages. Indeed, the search for variations as 14 soon as the system approaches a critical value of a control parameter, an unpredictable fluctuation 14 well as alternatives to the Bayesian scheme for reasoning under strong uncertainty has intensified 15 might be the cause triggering an abrupt phase transition into one of several possible nearby states. 15 over the past decades to make reliable inference available from unreliable information, vague, partial 16 Even if all the critical values would be exactly known, neither the transition time nor the follow-up 16 and contradictory data (see 2.5.3.2 and 2.5.3.3, below). This stresses that, essentially, uncertainties 17 state could be predicted due to the "strong" uncertainty coming from stochastic fluctuations and weak 17 lead to judgement, and that it is the task of political processes to make judgements. 18 causality. Indeed, the main characteristics of the global climate system is its structure consisting of 19 many interlinked feedback-loops, some of which being highly non-linear. Under these circumstances, 18 2.5.2 "Rationalities" 20 the most natural behaviour to be expected is not a gradual warming but rather an abrupt phase change, 19 What is choice? On which criteria do individuals make choices in an economic context? 21 a transition to another climate regime. 20 Alternatively, do choices with respect to environmental problems convincingly differ from choices in 22 It turns out that in addition to the "classical" scenario characterised by gradual warming. two 21 economic situations-which constitute the reference framework in which economic choices apply? 23 "abrupt change" scenarios can be considered for illustration purposes: 22 The general picture of the theory of choice (equivalently, decision making theory) is as follows. 24 The "abrupt global change" scenario, with a sudden important temperature increase within a 23 The individual can take a limited range of actions that have attached consequences. He or she "has in 25 short period (within a decade), which seems to be a natural candidate based on theoretical reasons as 24 mind an ordering of all possible consequences of actions". Among the actions actually at hand, "that 26 well as new scientific results. The time point where the abrupt change will take place as well as the 25 action is chosen whose consequences are preferred to those of any other available action" (Arrow, 27 26 amplitude of the step and the regional responses will be unknown, so implying "strong uncertainty". 1951). Such situations constitute the reference framework in which economic choices apply. 27 28 The "abrupt regional change" scenario with sudden important climate changes in certain re- Central conditions are, for example, a theory of market interactions and clearing as well as any co- 29 28 gions is a possible combination of the above and "classical" scenarios. While the global average tem- herent theory of reactions to the economic stimuli (prices, in essence). Discounting, scarcity of the re- 30 29 perature increase would be rather continuous and reliable, it would be unknown which region will be sources, and opportunity costs matter. Assumptions also compose the common economic framework. Chapter 2/page 31 Chapter 2/page 32 1 For instance, a decision-maker's beliefs can always be represented by a unique probability measure; 1 in terms of relative desirability" (Arrow, 1951, Blaug, 1992). It designates a "maximization of the ex- 2 economic agents are said to be perfectly competent to deal with the difficulty of the processes in- 2 pected value of a given utility function (Savage, 1954; Arrow, 1987). 3 volved in the decisional situation. Basically, economic situations (and theory) are based on the 3 Subjective arguments are compatible components of the assumption of a consistent utility-max- 4 consistency of human choice. 4 imising behaviour. Expected utility (together with the notion of expected value, the return) is the 5 Economic criteria of choice primarily rest upon representations and orderings of consequences of 5 prime economic criterion for choice. It can take account for risk through various utility-based criteria. 6 actions by means of the assumption of a utility function. Such a utility function renders intelligible 6 Utility-based criteria mean addressing the maximisation of expected utility (or value-cf. Box 7 with regard to observable situations the ability of the consumers to rank their preferences in a 7 2.5-1). They entail decisions that are based on the valuation of outcomes-wealth levels, time streams 8 consistent order (in like manner, entrepreneurs will prefer more profit to less if each is equally risky). 8 of consumption, etc.-(Morgan and Henrion, 1990). 9 9 The assumption of a utility function, therefore, postulates a consistency of human choice-in short, Box 2.5-1: Examples of some utility-based decision criteria 10 rationality. This postulate tells the decision-maker that the focus is on the decision to reach, not on Source: After Morgan and Henrion, 1990: 26 11 the process per se. Verily, inasmuch as individuals are assumed to be perfectly knowledgeable and Benefit-cost: Estimate the benefits and costs of the alternatives in economic terms and choose the one with the highest net benefit. 12 rational, the most valuable option-in terms of utility, or human wishes-is always chosen (Price, Maximise multi-attribute utility: This is the most general form of utility-based criterion. Rather than use monetary value as the evaluation measure, MAU in- 13 1993).7 volves specifying a utility function that evaluates outcomes in terms of all their Important attributes (Including uncertainties 14 Rationality and attached utility-based criteria of choice can still play the same pivotal role in and risks). The alternative with maximum utility is selected. 15 climate change-oriented decision making processes as in economic situations. Cost effectiveness: Select a desired performance level, perhaps on non economic grounds. Then choose the option that achieves the desired 16 However, decision-makers must initially be aware of the following differences. First, with respect level at the lowest cost. 17 to the climate change perspective, choices are of collective and of longer-term view nature-they are Minimise chance of worst possible outcome Political and behavioural considerations frequently dictate the Maximise chance of best possible outcome: use of such criteria. 18 no longer individual and fixed choices (for instance, a country individually cannot take abatement Set the maximum budget to devote to risk management Maximum budget (bounded cost criterion): 19 measures in so far as emissions in the rest of the world will affect the country in question and the activity. 20 gains from abatement by this country will accrue to the rest of the world). It turns out that a collective Minimise maximum regrets: Choose measures of "regret" and minimise the maximum regret. 21 decision procedure, based on a "procedural" kind of rationality, must be set up (see 2.5.4, below). Minimax Loss (Minimax critenon for catastrophic For each decision alternative find the loss associated with the risk): extreme event. From among these losses find one with the 22 Second, choices are not made with respect to a fixed set of alternatives, either. Third, choices are not maximum loss and try to minimise it. This is a conservative cri- terion. 23 confined to market related decision situations, but are also concerned with non-market related Maximin Gain: Find the gains associated with each action and try to maximise 24 decision situations (including issues of poverty or fragility of natural ecosystems and species). the minimum of these gains. 25 2.5.2.1 Utility-based decision criteria 10 For example, if the climate damage is sufficiently great, or the uncertainty of such effect suffi- 26 Economists do not assert that human agents are "rational" by definition. Rationality is a law-like 11 ciently strong, it will even pay a poor country to adapt or contribute to slowing down climate change, 27 refutable statement which "simply means behaviour in accordance with some ordering of alternatives 12 even at a low level of income. Poor countries have invested heavily in industrial and irrigation pro- 7 Simply. it is assumed that in evaluating uncertainty and risk situations, the decision-maker replaces the monetary value 13 jects, thereby sacrificing present consumption to seek higher incomes in the future. In some countries, of final outcome by the utility (a function) of that one. Therefore, utility can be interpreted as a method "of passing from a more objective level to a more subjective level: that of the amount of satisfaction achieved" (Eeckhoudt and Gollier, 14 such as Singapore, people have voluntarily engaged in high savings (45% of income approximately) 1995). Chapter 2/page 33 Chapter 2/page 34 1 I even at low present consumption levels to achieve a better life in the future. climate change. In addition, lack of knowledge about fundamental mechanisms that equations cannot 2 2 The implicit argument is a redistributionist argument based on the higher marginal utility of currently master represents limits to computer models in both domains. These difficulties typically 3 3 income at lower levels. occur with respect to decisions that are taken on a national or international scale when governments 4 negotiate some form of agreement and countries differ in their economic wealth, reliance on fossil 4 2.5.2.2 Bounded rationality 5 fuels, endowmens of alternative resources and technical capabilities. 5 Rational behaviour is a "first approximation" to actual behaviour. Indeed, as soon as one faces either 6 Specifically, "procedural" rationality designates the rationality of a decision in terms of the man- 6 imperfect forms of competition or non-market resources allocation decisions, knowledge require- 7 ner in which it is made while economic rationality names the rationality of a decision considered in- 7 ments radically shift and exceed those usually required for a pure market framework. In addition, 8 dependently of the manner in which it is made (in the case for economic-equivalently, substantive- 8 there might be as many rationalities as there are cultures. 9 rationality, rationality evaluation refers exclusively to the results of the choice, not to the decision- 9 It is anyhow widely accepted that (economic) rationality hypotheses be supplemented by assump- 10 making process in itself-Faucheux and Froger, 1994). 10 tions of a different character (e.g., information-gathering ability and limitation of both knowledge and 11 Which kind of theory can better support and explain the decisions at issue under FCCC? Shall we 11 computational capacity). It is accepted that rationality, obviously, is bounded (Simon, 1957, Arrow, 12 place interest in the decisions to be reached only, or shall we focus attention on the (international) 12 1987). In principle, these cognitive difficulties are connected to decisions that lie beyond individual- 13 decision procedure as such? Answering to these questions and the like would command the choice 13 related, common economic situations; they relate to decisions that must be reached through interna- 14 between economic and procedural rationality frameworks (Simon, 1987). From an economic stand- 14 tional conventions, or to decisions that, independently of the valuation of the outcomes, are destined 15 point, unfortunately, the fact that the manner in which the decision is made-and not the result of the 15 to eliminate risks. 16 choice-is at issue in the decision evaluation makes the procedural kind of rationality mostly unde- 16 As a concept, "bounded rationality" has been coined to name rational choice that takes into ac- 17 termined. This tells decision-makers that procedural rationality should be bounded to the processes of 17 count the "cognitive limitations of the decision-maker" (Simon, 1987). Basically, this tells the deci- 18 collective decision making, i.e., the steps in negotiating treaties and agreements. We will return to this 18 sion-makers that rationality can be also concerned with the ways in which the actual decision-making 19 in subsection 2.5.4., below. 19 process influences the decisions that are reached and not only with reaching decisions assuming the 20 2.5.3 20 maximisation of expected utility, as we are used to consider from a common economic viewpoint. Responses to uncertainty and risk 21 21 This concept thus designates a different type of rationality, namely procedural rationality. Getting back to the distinction between uncertainty and risk made on the basis of whether the proba- 22 22 Incidentally, a decision which optimises co-operation will possibly be in opposition with a decision bilities are not (uncertainty) or are known/knowable (risk), let's consider how (intuitively) to proceed. 23 23 which optimises the expected value of utility because the latter places the focus on the decision to The classical ingredients of a decision problem under uncertainty are a set of feasible acts (A), a 24 24 reach while the former places the emphasis on the decision process in itself. set of consequences (C), and a set of states of nature (S). The decision-maker does not know for sure 25 which consequence will result from a chosen act (probabilities for the events are not known in ad- 25 2523 Procedural rationality 26 vance). The role of the states of nature is to indicate the matching of feasible acts to consequences, 26 The former cognitive limitations may break usual limits on specific information. In the words of 27 thus resolving the uncertainty which relates acts to consequences. This makes states of nature exoge- 27 Simon, they are almost always limits on the adequacy of the scientific theories that can be used to 28 nous (uncertainty becomes in like manner exogenous, too) so that probabilities can be computed. As a 28 predict the relevant phenomena (Simon, 1987). Meteorology and atmospheric chemistry, on the one 29 result, the decision-makers basically have to assign utilities to the consequences (utility U assigned 29 hand, as well as economics, on the other hand, openly leave large bands of uncertainty in reference to Chapter 2/page 36 Chapter 2/page 35 I to each consequence c in C) and probabilities to the states (probability P assigned to each state 9 I Minimax (Savage, 1951) We should select measures of "regret" (i.e., the difference between an 2 actual pay-off and what the pay-off would have been if the correct strat- 2 in S) (Schmeidler and Wakker, 1987).8 In choosing between acts, the decision-makers will elect that 3 egy had been chosen). This is a cautious principle and ensures that, if the 3 one with the highest "expected utility" (or, expected value)-that is, the one with the highest sum of 4 worst happens, we make "the best of a bad job". 5 4 the products of probability and utility. Emphasises the cost of making the wrong decision (Price, 1993). 6 We should seek to minimise the maximum regrets. 5 A decision making under risk introduces a special formulation of the decision problem to the ex- 7 We should seek to minimise maximum loss (Dowlatabadi and Mor- 6 tent that probabilities for the events are known in advance. In other words, the decision problem in- 8 gan, 1992). 7 cludes the probability distribution of an act over the consequences. Accordingly, decision-makers 9 Second, basic individual/collective preferences towards risk can be outlined as follows: 10 a only have to determine utilities of consequences before choosing between acts. 11 Risk aversion: Higher expected return is needed as compensation for an increase in risk. A 9 Yet, this presentation reflects individual election and addresses common economic or technologi- 12 risk averter can be a diversifier and spread his portfolio over different assets- 10 13 cal variability; it is not straightforwardly designed to address unpredictability and judge risks like or a "plunger" and invest wholly in bonds and money. 11 those climatic and biological possible catastrophes might imply (see 2.5.3.3, below). As a first rough 14 Diversifier: Risk is likely to be the cause of portfolio diversification: if risks increase then 12 15 approximation with respect to climate change, the expected utility criterion says that it is possible to the diversifiers will move back to holding wealth in the form of money. 13 retain the notion of expected value (the return) while, with reference to uncertainty decision rules (see 16 Risk lover: A risk lover accepts a higher level of risk for a given expected return. 14 below) and efficient risk sharing (see 2.5.2), also taking risk into account. 17 Risk neutral: A risk neutral individual would be indifferent whether or not he or she ac- 18 cepted "fair" insurance. Under risk neutrality, the risk premium is zero. 15 2.5.3.1 Uncertainty and risk decision rules 16 19 Cautiousness: One can move from the pure decision criteria that appear in Box 2.5-1 to more simple decision rules; Defined as decreasing risk aversion (Pratt, 1995). The cautious person has no 20 dislike for uncertainty as such, but feels that he or she "can expect to do better 17 i.e., rules which do not need to elucidate all possible outcomes and their respective probabilities. 21 in the long run by playing it safe for the present and thus increasing probabil- 18 First, approved individual/collective decision rules with respect to uncertainty can be outlined as 22 ity that he/she will have the funds available to take advantage of more favor- 19 follows (MIT, 1986): 23 able deals which may arise in the future (Schlaifer, 1961; after Pratt, 1995). 24 Cautiousness is thus derived from risk aversion. 20 Maximax The decision maker should opt for that course of action which yields the 21 highest pay-off (net benefits, or whatever) regardless of any view taken 25 2.5.3.2 Decision analysis techniques 22 about which state of nature will occur. It's the optimistic rule. 26 Application of utility-based criteria and rules involve a full range of techniques, each of them being 23 Maximin (Wald, 1950) We should first observe all the minimum pay-offs and then select the 24 highest of these. 27 suitable for different purposes. Some are designed to serve as an aid to collective decision making. 25 Amounts to expecting the worst (Price, 1993)-presumably in our case, 28 One is a balancing of benefits and costs in a Benefit-cost analysis framework. Game theory is one 26 the failure of technology or substitution to relieve climate change con- 29 another. Techniques developed by management scientists over the last 10-20 years (which are some- 27 straints. 28 Decision-makers who employ this criterion are extreme pessimists. 30 times collectively referred to as "Soft System Analysis" and include Strategic choice analysis, Rob- 31 ustness analysis, Hypergame theory and a number or others) are other ones (cf. Ríos, 1994). One 8 A specific way allowing to cover the case for uncertainty-originally about the availability of resources and about consumption and production possibilities-is the idea of contingent commodity introduced by Arrow (1953) and 32 another grouping of methods for reasoning under uncertainty is Evidence Theory, or defeasible developed by Debreu (1953). This device is added to the current specifications of the commodity such as its physical characteristics and location to make the availability of the commodity contingent on the occurrence of some (uncertain) 33 reasoning and uncertainty management techniques (Kohlas et al., 1994). This group concerns the environmental event such as weather conditions. Chapter 2/page 37 Chapter 2/page 38 I study of symbolic and numerical methods for the representation and management of incomplete I tainty, which in this matter might not be exactly an exceptional situation but maybe the rule. In this 2 information. Basic research activities cover domains like nonmonotonic logics, fuzzy logic and 2 context, one may choose two different ways. 3 possibility theory, "surprise" (Shackle, 1967), "imprecise" probability (Walley, 1991), Bayesian net- 3 First, as regards strong uncertainty, the approach based on the exploration of the future on the ba- 4 works, Dempster-Shafer theory of evidence (Dempster, 1967, Shafer, 1976; Caselton and Luo, 1994) 4 sis of the use of scenarios appears as one of the few relatively-useful instruments. This can address 5 and "Non-expected utility models" (Yaari, 1987). It attacks, notably, problems related to uncertain, 5 mitigation and adaptation to climate changes, the phasing out existing policies, as well as climate and 6 unreliable, vague, partial and contradictory data.9 6 technology research. 7 A different conception is the Multi-attribute utility analysis which is suitable for situations where 7 Second, in so far as climate change risks can be delineated, the risk assessment of potential cli- 8 options involve "collections of attributes that are incommensurate" (Keeney and Raiffa, 1976, 8 mate change can deliver probability distributions of the different estimates to policy makers (see 9 Morgan and Henrion, 1990). The resulting decision model can avoid the dilemma of converting each 9 Chapter 7, below). On the other hand, in so far as we accept to bet on future events according to a set 10 attribute to an equivalent monetary value. 10 of possible descriptions of collective risk, it could be natural to allow agents to trade securities 11 Variations to utility-based decision criteria are available. A Cost effectiveness criterion can be 11 insurance contracts (see 2.5.2, below). 12 used where the value of benefits cannot be estimated-but a choice must be made between alterna- 12 In sum, an open question is: are policy makers better served by best guess scenarios than by prob- 13 tives (Morgan and Henrion, 1990). A Maximum budget can be set to devote to risk management ac- 13 ability distributions of these estimates (Shlyakhter et al., 1995)? 14 tivity (bounded cost criterion). Last, measures of "regret" can be chosen and the maximum regrets 14 These options can be reconciled by drawing distinctions between scenarios that are probable (risk 15 minimised. 15 situations) and those that are possible (strong uncertainty situations). According to Shlyakhter et al. 16 Other methods or tools are thought to help diagnose the negotiation process itself, for example, 16 (1995), those risks that fall below a particular threshold of probability-and thereby are ignored by a 17 Cognitive mapping, Simulation modelling, Rule-based systems, an Information management (HASA, 17 particular group or society-are called "de minimis" risks. "How societies and governments decide 18 1993). Techniques belonging to decision analysis can be reoriented to serve as negotiations supports 18 what constitutes de minimis risk in particular situations or contexts is largely a matter of political 19 as well. One can cite Cross-impact analysis that facilitates the modelling of complex situations or 19 judgement" (Shlyakhter et al., 1995). Although there is no clear definition of a de minimis risk, it can 20 stakeholder analysis which uses information on the position, interest, priorities, and preferences of 20 generally be seen to be closely akin to a related concept, namely, the probability of "surprise". 21 various stakeholders on a particular issue to facilitate analysis of the range of differences among 21 The next question is: "At what probability of a serious effect should society take action?" How to 22 stakeholders and the potential for coalition formation (IIASA, 1993). Multi-attribute utility analysis 22 compute a de minimis risk-equivalently, a probability of surprise? Although many conceptions and 23 techniques have been applied by researchers at IIASA to evaluate coalition building and preference 23 definitions are possible, the use by Shiyakhter et al. (1995) of the word surprise is meant to denote 24 adjustment in the UN Conference on Environment and Development. 24 those situations where the true values of a particular uncertain parameter, e.g., climate sensitivity to 25 CO₂ doubling, appear at least 2.6 standard deviations away from its current "best guess" value. For a 25 2.5.3.3 Addressing strong uncertainty 26 random variable that is assumed to be normally distributed, the probability that the "true" value is 26 Under climate changes situations, decision-makers need to pay attention to situations of strong uncer- 27 more than 2.6 standard deviations from the current "best guess" is just 1 percent. As Shlyakhter et al. 9 An essential aspect of a decision analysis is the ability to combine information from various independent sources. For 28 (1995) continue, it is interesting to note that public opinion polls suggest that many people are uncon- instance, in the Dempster-Shafer context, if two basic probability assignments (BPA) on the same unknown state of nature are obtained from two different independent sources of information, they can be combined to yield a new resultant BPA. 29 cerned about a 5 percent chance of a climate-related catastrophe within their lifetime, although they This kind of scheme also allows at specifying probabilities on intervals of the state of nature, leading to a possibilistic specification of probability. 30 are concerned about a 1 percent chance of a nuclear accident. They also note that an airliner with a Chapter 2/page 39 Chapter 2/page 40 1 calculated chance of failure around 5 percent in its 70 year life would not be allowed to fly in com- 1 decision making should read intergovernmental "negotiated" decision making. 10 2 mercial service. 2 2.5.4.1 Steps in negotiating international environmental treaties and agreements 3 Last, qualitative and probabilistic changes relate to the expected value of a single experience. As 3 Environmental accords tend to be partial and incremental. On the one hand, they tend to be inte- 4 such, they have "close affinities with the meaning of discounting" (Price, 1993; also cf. Chapter 3). 4 grated, complex packages of multiple linked issues that are difficult to negotiate internationally. On 5 2.5.4 Collective decision making 5 the other hand, they are made of several steps such as pre-negotiation, negotiation and post-nego- 6 To discuss the choices of a group rather than of an individual, one can use an index of social welfare 6 tiation processes. This is due largely to scientific uncertainty concerning the problems and possible 7 as a "utility" function. This fits into the framework of maximising the expected value of a function. 7 solutions, and the (a priori) need for continued learning about effects and consequences. Partial 8 The group then makes collective risky investment decisions and insurance decisions by using this 8 agreements are also customary because of the political uncertainty in devising fair and equitable ap- 9 function. Though collective decision making is central in economic analysis, many applications are 9 proaches at a global level (IIASA, 1993). 10 analysed in this way; that is, using microeconomic analogies and inferences. 10 Sustained negotiation or post-agreement negotiation are also an attribute of current international 11 Specifically, however, a group has possibilities of risk retention that are much greater than that of 11 environmental negotiations. This is the case, namely, for the UN FCCC, its former Intergovernmental 12 an individual. "This is partly due to the opportunities of diversification within the group and partly 12 Negotiating Committee (INC) and its new Conference of the Parties (CoP). Post-agreement negotiation 13 due to the transfer of risk towards the least risk-adverse members (or the richest members if absolute 13 can be defined as the dynamic and co-operative systems, procedures, and structures which are institu- 14 risk aversion is decreasing)" (Eeckhoudt and Gollier, 1995). This is why organisations have always 14 tionalised to sustain dialogue on issues that cannot, by their nature, be resolved by a single agreement. 15 been best suited to undertake risky activities-adapting to or slowing down climate changes is a risky 15 A framework convention or a protocol mechanism often have no clear end-point. A broad framework 16 activity by itself due to the existence of strong uncertainties. "Without this diminution of risk 16 of principles is agreed to first, followed by additional talks to specify details (IIASA, 1993). 17 aversion in an economy, thanks to the creation of risk pools, many risky projects would not have been 17 Procedural issues need to be addressed further. It results from a study by IIASA (Sjöstedt, 1993) 18 undertaken and we would undoubtedly not have known the economic expansion that we have 18 that the following ones need to be dealt with by practitioners and researchers alike: 19 observed over the last two centuries" (lbid.). In practice and with respect to climate change, 19 Many new groups and individuals beyond traditional governmental officials are now important 20 applications of collective decision making regard two out of three key rationales this chapter will 20 participants in the negotiation process. 21 21 select: insurance decisions (2.5.2) and a policy measures portfolio (2.5.3) (the first rationale is time- The complexity of international environmental negotiations is increasing. Policy makers have 22 linked environmental issues with other important policy concerns, such as development and 22 oriented, i.e., sequential decision making paths-see 2.5.1). 23 trade. The implications of these linkages are often not well understood. Ways must be found to 23 Specifically again, 'collective' decision making means the choice of weights for the members of the 24 develop a common understanding of these linkages. 25 24 group. For this reason, the valuation of outcomes will become matter of negociation under a collec- Bridging the differences between industrialised and developing countries will be a continuing 26 problem, given their different interpretations of what constitutes fair and equitable solutions. 25 tive decision making framework. Yet, negociation proceeds along a particular procedural scheme, to 27 New approaches to innovative problem solving need to be found and implemented, perhaps 26 which we turn now. 28 using the assistance of third parties or creative reasoning heuristics. 29 27 As a procedure, collective decision making concerns the processes of co-ordinated decision- New strategies to implement negotiated environmental agreements are needed to reduce 30 national ratification delays and increase the likelihood of compliance (DASA, 1993). 28 making, i.e., the steps in negotiating international treaties and agreements, the appropriate weights, 10 The choice of the country as decision unit has formal justification in international law. However, this does not solve 29 decision criteria and/or rules if any, and the particular decision procedure. In this context, 'collective' real world decision making in as far as major energy producers and users are directly involved in it. Therefore the paramount importance of utility-based decision making criteria and rules. Chapter 2/page 41 Chapter 2/page 42 I Unlike the processes of pre-negotiation and negotiation, post-agreement negotiation has received 1 of assuming technological progress which might fail to materialise. = 2 little attention from researchers in terms of their procedural rationality. Options can be: 2 Convention-related principles are still one another possibility. Indeed, the need for an equitable 3 Involving domestic stakeholders in negotiations from the beginning. 3 distribution of tasks both at the national and international levels is the cornerstone of the Framework 4 Modifying the structure of the accords themselves: Clusters of simple, single-issue agreements 4 5 may be more practical. Convention on Climate Change (FCCC). For example, while all the Parties are required to contribute 6 Initiating a new learning process in the post-agreement negotiation process in as far as 5 to the collective effort by elaborating a national programme, the application of the principle of 7 international problems can be more abstract than local environmental issues. 6 "common but differentiated responsibilities" implies that the industrialised nations should take 8 Post-agreement negotiations present policy makers with the challenge of progressively reframing 7 strong measures-first by adopting specific national measures to stabilise greenhouse gas emissions, 9 problems, adjusting strategies and perceptions, and refining solutions (HASA, 1993). 8 second by promoting the transfer of financial resources, know-how and/or technologies to developing 10 2.5.4.2 9 Collective decision criteria countries, in particular the least developed countries (FCCC, 1992, BUWAL, 1994). 10 11 At the world level, decisions cannot be easily based on individual-like utility functions (index of The precautionary principle also belong to the FCCC-related principles. Basically, it is a rights- 11 12 social welfare). In addition, once it is accepted that we have no world sovereignty and no global based criterion. According to FCCC, however, it has been thought to encourage nations and individu- 12 13 social welfare function, the outcome is a matter of negotiation. This is the way to address the choice als to take early actions to prevent environmental damage even when these actions are not 14 of weights for the members of the group. 13 "economically attractive". In this sense, it might look like some legal or ethical principle, and 15 14 How much each country has to say is, however, more a matter of what is than a matter of ethics. consequently be in contradiction with cost-effectiveness demands (that also are requested by the 15 16 The literature on negotiation analysis (Fisher and Ury, 1981; Raiffa, 1982; and others) stresses that framework convention on climate change!). 17 each party to an agreement must find himself better off with the agreement, than without. Otherwise 16 2.5.4.3 Decision procedure 18 he has no reason to agree. 17 The Convention establishes flexible procedures, based on the submission by governments of national 19 The Conference of the Parties (CoP) will be the apex forum which makes the collective global en- 18 communications, in order to ensure that States implement their commitments. These procedures are 20 vironmental decisions for global welfare within the constraints set by environmental risk and eco- 21 nomic efficiency. 11 Here are examples of some collective, rights-based criteria (Morgan and Henrion, 1990): Zero risk: 22 One possibility is to use collective decision criteria (or, rights-based criteria). Independent of the benefits and costs, and of how big the risks are, eliminate the risks, or do not allow their introduction. 23 One another possibility is-in as far as every country has its predispositions in the debate, and Bounded or constrained risk: Independent of the costs and benefits, constrain the level of risk so that it does not exceed a specific level or, more generally, so that it meets a set of specified criteria. 24 there can be no certainty about which position will be vindicated in the passing of time (Price, Approval/compensation: Allow risks to be imposed only on people who have voluntarily given consent, perhaps after compensation. 25 1993)-to adopt traditional criteria for decision making under uncertainty. Approved process: Not strictly a decision criterion for analysis, but widely applied in risk management 26 The maximin criterion (Wald, 1950; see also 2.5.3.1, above) amounts to expecting the worst- decision making. If all relevant parties observe a specified set of procedures (e.g., under some international convention). then any decision reached will by definition be 27 presumably the failure of energy and technology substitution to relieve climate change constraints- acceptable. Liability insurance: Parties which impose risk might be eligible for liability insurance (added example). 28 and adopting a policy based on that expectation (Price, 1993). Rights-based criteria have been thought to deal with processes and constrained actions or activities (Morgan and Henrion, 29 The minimax regret criterion (Savage, 1951; also see 2.5.3.1) emphasises the cost of making the 1990). For instance, the approved process criterion insists "that all the relevant parties observe a specified set of procedures" such as some internationally signed convention defining a due process (this leads us back to procedural 30 wrong decision-presumably, in the climate change context, the very high cost of damages as a result rationality). Some of these criteria are inconsistent to deal with exogenous. naturally occurring risks as for instance the zero risk criterion which simply does not allow the introduction of the risk. Hybrids of utility- and rights-based criteria are sometimes used. Chapter 2/page 43 Chapter 2/page 44 1 entitled to an overproportional share of tax recycling. In this respect, however, liability would be 1 also designed to allow if necessary to amend the Convention in the light of new knowledge, for ex- 2 impossible for emissions prior to the discovery of the possibility of anthropogenic warming (ca. 2 ample through protocols dealing with specific areas (BUWAL, 1994). 3 1988). Instead, it should be recognised that more GHG efficient technologies are available to 3 In line with the provisions of the FCCC (Art. 4.2e), industrialised countries must also co-ordinate 4 developing countries than it was the case when developed countries were in development phase, and 4 economic and administrative instruments. International co-ordination also helps at avoiding undesir- 5 that the only path to development is not the one that has been travelled by developed countries 5 able side-effects such as trade distortions and unwanted impacts on the environment of third coun- 6 (otherwise, it must be acknowledged that developing countries will be the source of most pollution in 6 tries. 7 All countries should participate collectively in efforts aimed at solving global environmental future years). 7 8 In this respect, joint implementation (JI) can be a valuable instrument though controversies-that 8 problems, based on an equitable sharing of responsibilities. In this respect, increased solidarity be- tween the planet's rich and poor regions is essential. 12 Attention should also be paid to providing fi- 9 mainly are political and not economic-still surround the concept. Used in very flexible manner, it 9 nancial support to the Central and eastern European nations, in order to encourage their full participa- 10 would induce additional transfers to the South. Developing countries would not invest in "climate 10 11 change abatement" but might change their development strategy in ways that are compativle with 11 tion in the work undertaken within the FCCC. 12 lower GHG emissions. Left without efficient devices then the South is unlikely to invest in abatement 12 Under FCCC, indeed, the developing countries have no obligation to control emissions and there- 13 13 of climate change. This will have to come from the North. Second is cost-effectiveness. Any Northern fore do not need to pay "global carbon taxes". However, if a CO₂ tax is imposed, efficiency requires 14 investment in abatement would be most cost-effective through joint implementation (Chapter 4; Pillet 14 that it be imposed on everyone. Energy efficiency is just as important in poor countries as in rich 15 countries. The issue is exceptionally sagacious: (a) Equity may demand that the proceeds of the tax be 15 et al., 1993). Last, it now clearly appears to many developing countries that solving the climate 16 remitted to the developing countries; (b) however, there seems to be no objections raised against 16 change issue is closely linked to future development paths (Villanuova, 1994). So it is in the global 17 tradable permits; (c) as a rule, transferable permits amount to a tax on emissions by all countries. 17 interest that North South trade reliable, cost-effective mitigation. 18 For example, if India or any other developing country seeks to increase its own combustion, it re- 18 2.6 A Sequential Decision Making Framework to Hedge Against Impacts 19 duces its sale of permits to the developed countries and therefore loses that revenue; this is equivalent 19 of Uncertainty and Change 20 to a tax. 13 20 This section concerns the decision making framework for hedging against possible climate changes 21 It turns out that all countries have to reduce their emissions, at least compared with what they oth- 21 and related impacts, and especially establishing decision making paths relative to uncertainty and 22 erwise would do. The growth of non-Annex I countries depends both on emission reductions in 22 risk, exploring the use of financial markets. and pooling different kinds of policy options. 23 Annex I countries and on increased efficiency in their own energy usage. Developing countries 23 2.6.1 Decision making paths: Which strategy would be best? 24 should not be exempted from the tax-as this would lead to inefficiencies. 14 Instead, they could be 24 2.6.1.1 Scenario analysis 12 This argument does not imply that poor countries cannot afford to take any thought for the future. They do, and have to do, though day-to-day adversity can become pervasive, as it is the case in large parts of Africa. This does not means that 25 The decision making framework to address climate change is served by scenario analysis. Scenario there is nothing for Northern parties to gain from an agreement, either: a growing prosperous South contributes to the North through international trade and reduces the possibility of environmental refugees and northward migration pressure 26 analysis is one of the few relatively-useful instruments at hand to look at the here-and-now in general; Northern countries do have moral and humanitarian interests in reducing poverty of some countries; though smaller than likely Southern adverse impacts, there are adverse impacts that the North will suffer too; last, we all have 27 significance of alternative futures. Uncertainty is indirectly treated; that is, the very existence of interest in avoiding an irreversible catastrophe. 13 This example also concerns the problem of decision making at the firm or at the household level (Chapter 8 deals with 28 uncertainty makes alternative scenarios different. but uncertainty is not incorporated within scenarios. the process of innovation and technology adaptation by firms and households-see 8.3.1.3). 14 In addition, one of the major thrusts of environmental economics is that society must internalise the costs of "free" natural resources (the atmosphere). This obligation applies to developing and developed countries alike. The carbon tax is one means of doing this. Chapter 2/page 45 Chapter 2/page 46 1 1 Within scenarios, therefore, the analysis proceeds as if we definitely had the opportunity to learn the 2 2 state of the world before taking action-in other words, it proceeds as if all uncertainties are resolved Energy Decisions Sector 3 3 prior to the date at which decisions are taken. Each scenario develops within a certainty-like context. Damage Potential 4 LOW 4 A decision-making framework is made of a combination of paths that lead to a decision making 5 5 strategy. Scenarios are no decision-making paths. Acting is a path. Learning is one another path. The Moderate 6 6 best combination of such paths would give the best strategy. 7 7 The size of the strategy will depend on the probabilities assigned to alternative outcomes attached 8 a) Learn. Then and Beyond Adt Decisions Sector 8 to possible states of the world (which can be served by alternative scenarios). The value of improved Damage Potential 9 Decisions Sector Low 9 information (expected value of perfect information) will play a central role. 10 Moderate 10 2.6.1.2 Sequential decision making 11 High 11 Alternative combinations of decision-making paths give alternative characterisations of the decision and Beyond 12 12 problem. 13 2000. 2010 13 One strategy is to proceed as if we definitely had the opportunity to learn the state of the world b) Act Then Leam 14 14 before taking action; in other words, as if all uncertainties were resolved prior to the date at which 15 Figure 2.6-1: Alternative decision making strategies 15 decisions will be taken. This decision making strategy can be called a "learn-then act" strategy. 16 A circle denotes a chance node-a poins at which an uncertainty is resolved. 17 A square denotes a decision node-a point at which actions are required. 18 16 Learning comes first. Then, once all uncertainties are more or less resolved, action can be taken. Manne and Richels (1992). 19 17 One another strategy is to hedge against the probability of surprise such as those risks that fall 20 18 below a particular threshold of probability. Such a strategy can be sequential, proceeding under an Box 2.6-I: Emissions level under "learn-then act" procedure (hypothetical) Damage potential Carbon emissions (2010 target) 19 "act-then learn" characterisation of the decision problem: decisions are taken (acting) for the years to Low Unlimited (hypothetical) 20 come without knowing which of the possible states of the world will occur in a sequence of decisions Moderate 20% below 1990 level (hypothetical) 21 allowing new information (learning) to be incorporated into a complex decision process. 15 High 50% below 1990 level (hypothetical) 21 Source Manne and Richels, 1993 22 See Figure 2.6-1(a) on which a circle denotes a chance, and a square a decision node. 23 To illustrate, Box 2.6-1 shows hypothetical emissions constraints ascribed to each of the three 22 If the damage potential proves low, then carbon emissions would remain unconstrained. With a 24 states of the world under the "learn-then act" procedure (Fig. 2.6-1a). 23 moderate damage potential, the 2010 target would be 20 percent below 1990 levels, and with a high 25 Figure 2.6-1 shows the decision trees: 24 damage potential, the 2010 target would become a 50 percent reduction (incidentally, this might not 26 (a) for a "leam-then act" decision strategy (learning about damage potential, then acting) and 25 be possible to be implemented at that time). 27 (b) for an "act-then learn" decision strategy (hedging against damage potential by acting first, then 26 Under a "act-then learn" hedging policy, decisions would be taken at discrete points of time 28 learning about the damage potential, and then acting again). 27 separated by intervals of one decade. It would be assumed that prior to 2020, the energy sector's 28 supply and demand decisions should be made under uncertainty about reaching a consensus on 15 Hedging is not equal to "act-then learn" as learning does not necessarily take place. Chapter 2/page 47 Chapter 2/page 48 1 carbon limits. From 2020 onward, it would be supposed that decisions would be made after the 2 resolution of uncertainty. Under the "act-then learn" strategy, we would make decisions for 2000 and Strenghtened 3 2010 without knowing which of the states of the world (low, moderate, and high damage potential) Continued 4 would occur and should select an optimal hedging policy for the emissions levels¹⁶. Aggressive 5 A sequential hedging strategy consists of adopting an emissions level that lies between the extreme Relaxed 6 cases shown by different emissions scenarios, and the size of the hedging strategy will depend on the Strenghtened 7 probabilities assigned to alternative outcomes. To illustrate a case in which the expected value of Moderate 8 perfect information (EVPI) would be high, and in which the probability of low damage would be 60 Continued 9 percent and that the probability of a 20 percent reduction 1.5 times that of a 50 percent reduction, Relaxed 10 then, Manne and Richels (1992) conclude, if controls are required, they are more likely to be I 11 moderate than high. 2 Figure 2.6-2: Decision tree for sequential policy choice. 3 At the beginning of the first period, (1992) either the moderate reduction or aggressive reduction near- 12 One another example of a sequential decision making is reported by Hammitt el al. (1992). 4 term abatement policy is selected. Ar the beginning of the second period (2002). uncertainties about 5 climate sensitivity and the damages of climate change are substantially resolved and the chosen policy is 13 According to well publicised works (see also Singer et al., 1991; Manne and Richels, 1991, 1992; 6 amended to limit climate change to the "optimal" level. Hammitt et al., (1992). 7 14 IUCC, 1993; Richels, 1994; Peck, 1994), first decisions might be to take those actions where the cost 8 Hammitt et al. consider two near-term policies, aggressive and moderate reduction (Fig. 2.6-2). 15 is not high while considering more aggressive-reduction policies (Fig. 2.6-2). 9 Under the aggressive-reduction policy, conservation and fuel-switching are adopted together 16 First, energy conservation represents a set of low-cost, quickly implemented policies. To illustrate, 10 starting in 1992. 17 if adopted at Lo, energy intensity falls 30% over 20 years (Hammitt et al., 1992). This corresponds to 11 Under the moderate-reduction policy, only the conservation policy is adopted and implemented in 18 some minimal agreement made of two complementary actions: conserve energy by discouraging 12 1992. At the beginning of the second period (2002), uncertainties about climate sensitivity and the 19 wasteful use globally, and improve efficiency in energy use (Singer et al., 1991). 13 damages of climate change are thought to be substantially resolved and the chosen policy is amended 20 Second, fuel switching represents a more aggressive-reduction policy. It is a set of high-cost, 14 to limit climate change to some "optimal" level (though this could appear as an irreversible process). 21 slowly implemented emission-reduction technologies. They are produced by long-lived capital 22 15 2.6.1.3 Clearing up the uncertainties? The value of improved information equipment using either emitting or non-emitting technologies (fossil fuel vs. nuclear, solar, biomass). 23 16 Under a "learn-then act" sequential decision making, the value of new information depends on Both have construction periods of about 10 years, and an operating period of roughly 30 years 24 (Hammitt et al., 1992). The motto is: use non-fossil fuel energy sources wherever this makes eco- 17 changes in the probabilities assigned to the (alternative) scenarios before and after the study. "If the 25 18 nomic sense (Singer et al., 1991). "The policy decisions are whether to begin substituting non-emit- probabilities of (alternative) scenarios remain equal, then the value of the study is zero; if, on the 26 19 other hand, only one scenario can be selected, a study might be worth as much as 100 billion dollars" ting or emitting equipment, and if so, the rate at which to substitute, specified as the transition half- 27 20 life, or the time until half the capital stock then operating is non-emitting" (Hammitt et al., 1992). (Shlyakhter et al., 1995).¹⁷ 28 17 Values of situations before and after imperfect or perfect information is received can be computed. When there is risk neutrality, these values also represent expected utility. Suppose that expected results are as follows: (a) without information: +150; (b) imperfect information: +325; (c) perfect information: + 500. This hypothetical example "illustrates a perfectly general result: the value of perfect information (500 150) clearly exceeds the value of imperfect information consumption (Global 2100 by Manne and Richels, 1992). 16 The period-to-period allocation of carbon emissions is determined so as to maximise the expected discounted utility of (325 150)"; it also indicates that some information-albeit imperfect-is better than no information at all (Eeckhoudt and Gollier, 1995). Hourcarde and Chapuis (1994) have shown that, accounting for climate change related surprises under Chapter 2/page 49 Chapter 2/page 50 1 Under an "act-then learn" sequential decision making, there is an agreement that uncertainty 1 moderate, or high (conditional probabilities; cf. Manne and Richels, 1992). 2 cannot be resolved before a decision is taken. This does not mean that uncertainty is an obstacle for 2 This representation allows the use of standard probabilistic techniques to incorporate the outcomes 3 decision making. This means that first, its resolution is at a too high a cost and, second, that maybe it 3 of the research program in the decision model (Global 2100, in this case). 4 will not facilitate a decision-clearing up the uncertainties could make the greenhouse warming issue 4 Maximum accuracy, or perfect information, would eliminate the need to hedge against surprise. 5 more difficult to resolve (Waterstone, 1993). Accordingly, it is for instance assumed that the damage 5 Accuracy of the forecast, however, will not be maximum. We therefore have to accommodate with 6 potential will remain unknown until 2010-2020. As a consequence, the appropriate emissions level 6 hedging under imperfect information. In this case, the research outcome will lead to a revision of our 7 would be known only well into the second decade of the twenty-first century. The actual level of 7 beliefs. It will help at modifying near-term decisions. 8 investment is also influenced by the conflict between the long term nature of the problem (and the 8 A sequential decision making strategy made of acting and learning decision making paths would 9 time that would be required for resolution of the uncertainties) - and the short term public and private 9 be the best strategy. 10 decision makers horizons (sometimes called NIMTOO phenomenon). Today decisions must thus 11 consider the partial disclosing of the uncertainties along with the long-term effects of short term 10 2.6.2 Exploring mutual insurance decisions and markets for risk 12 decisions. Sequential decision making can address this point. 11 Insurance is one another way to respond to risks and uncertainty which is worth to explore." 13 12 Transferring risk from one agent (country) to another or sharing risk collectively does not make 14 13 the risk disappear though restrictions can be attached to that kind of transfer. Yet, under what condi- 15 Research Research Outcome Energy Sector True Damage Energy Sector 14 tions, and why will an agent (country) demand insurance to cover possible climate change damages? Investment (damage forecast) Decisions Potential Decisions 16 Low Low 15 Can market evaluate the price of climate change risk? How would the allocation of risk be decided? 17 16 Exploring insurance decisions means addressing the problem of determining the economic value Moderate Moderate 18 17 of things. In particular, it goes much further than simple knowledge of costs and benefits of climate High High 19 18 change; that is, risks. Exploring insurance decisions and, consequently, markets for risks is addressing Today 2000. 2010 2020 20 and Beyond 19 the possibility of determining the final allocation of these risks. Who bears the economic risk of the 21 20 possibility of climate changes which is one of the large risks of our modern economies? 22 Figure 2.6-3: Decision tree for value of information analysis. 21 In particular, do transfers of risk improve welfare in an economy (or is it instead a 'zero sum 23 Source: Manne and Richels (1992) 24 22 game')? It appears from the literature that "the transfer of risk is a potential source of large improve- 25 A decision tree reflecting this type of sequential decision making can be adapted from the one in 23 ments in economic efficiency and social welfare" (Eeckhoudt and Gollier, 1995). 26 Figure 2.6-1b. Figure 2.6-3 shows this for the energy sector's near-term supply and conservation 24 Insurance markets leave uncovered collective or correlated risks such as the risk induced by 27 decisions that must be made with respect to the uncertainty regarding the ultimate damage potential. 18 The word 'insurance' is sometimes abused in climate debate. For instance, the insurance premium of, e.g., Manne and Richels (1992) is in fact a risk premium in the Arrow-Pratt sense (the Arrow-Pratt insurance premium describes situations 28 In this case, the degree of uncertainty is represented by a likelihood table indicating the probability where, because of risk aversion, people are willing to pay more than expected yearly damage), and the insurance scheme of AOSIS is in fact a liability scheme (see below). In addition, one can think that there is no analogue between the impact 29 that the damage forecast will be low, moderate, or high-given that the true damage potential is low, of climate change and the insurance market because climate change is not an isolated event, and that to control portfolios of insurances requires the risks to be fairly well known. Yet, the insurance industry is currently giving up because of increasing losses that are not indispensably linked to climate change-related natural catastrophes such as a new insurance orchestration must anyhow be envisaged. Simple evidence is given here to decision makers (the approach is purely a sequential decision model, a resolution of uncertainty had high value relative to no-regret potentials and technical normative due to the absence, to date, of any applied analysis of climate change insurance scheme). Note that the impacts innovation. Peck and Teisberg (1992) and Manne and Richels (1992) show similar results. of extreme events on property insurance market and adaptation to climate change by property insurers are the concern of IPCC WGB Chap. B9 on "Financial Services" and consequently are out of the scope of this section. Chapter 2/page 51 Chapter 2/page 52 1 ignorance of the true frequency distribution of harmful events. According to Chichilnisky and Heal I either laissez-faire or to let suboptimal policies being implemented-which for sure are biased 2 (1993), our ignorance of the frequency of the impacts of climate change constitutes a collective risk. 2 against the ecological-economic long run-, trading climate change risk positions that are contingent 3 This collective risk can be allocated through markets for securities that pay off contingent on that 3 on which model of the change is correct would interlace systems that basically are highly differenti- 4 frequency. For the individual risks that remain, it is more practical to use mutual insurance contracts: 4 ated ones. In addition, countries would have to express their estimates on global climatic risks 5 this is done by having a different individual insurance contract for each possible frequency of 5 through a market commitment and therefore will have to express their true views. If a country sells 6 impacts. 6 securities that pay off in the event that climate changes are not serious and buys those paying off if 7 7 2.6.2.1 they are serious on terms that do not correspond to its true beliefs, it will suffer a financial loss Use of financial markets 8 (Chichilnisky, 1994, Pillet, 1994). 8 According to Chichilnisky and Heal (1993) an interesting aspect of financial markets is that they can 9 provide a natural mechanism for reconciling differences in assessments of the likelihood of important 9 2.6.2.2 Insurability of risks associated to climate change 10 climate changes between countries, and for testing the conviction behind publicly-stated positions. 10 The insurance issue can also be accorded our attention in contrast with mitigation strategies. 11 International markets for risks of climate change would also provide an objective test of the 11 Basically, in view of uncertainties about consequences of carbon emissions, the question is: Is it 12 seriousness with which countries adhere to their publicly-professed positions on the risk of climate 12 worth taking costly and disruptive measures to reduce levels of emission far enough to stop the build- 13 change. 13 up of CO₂ (Chichilnisky, 1994)? Next, should you consistently decide to wait until more is known 14 The Arrow-Chichilnisky-Heal idea is then to settle a framework involving securities whose pay- 14 and better estimates of the consequences are available, would it not be cautious to insure against 15 offs depend on which description of the (collective) risk is correct. "Betting on which of several 15 harmful events even if the chance of their occurring is small and not immediate? Is a trading of risk 16 alternative descriptions of the way the world works is correct, is in effect what one does when 16 positions between regions of the world conceivable? 17 choosing one research strategy over another. (...) For example, a market for the securities of high- 17 Climate change associated risks are first difficult to quantify (in a classical statistical sense, the 18 technology firms pursuing different research strategies towards the same goal is a financial market in 18 probabilities describing them are unknowable). They are then endogenous (once steps have been 19 which these bets are made" (Chichilnisky, 1994). 19 taken toward reducing climate associated risks), correlated (which demands complex analysis to 20 The trading of climate risk positions from a global ecological-economic viewpoint is amply 20 assess probabilities), and collective (by which the uncertainty about the relative frequency of harmed 21 thinkable. In short, ecological models are energy oriented models whereas economic ones are based 21 agents is meant). In principle, however, once frequencies are at least approximately known, actuarial 22 on the behaviour of individual agents and groups. Under the case for climate change prospects, the 22 calculations can be set up, and the problem can be conceived as insurable. 23 behaviour of the agents contributes to make particular energy profiles to appear and develop, with 23 For instance, to the extent that carbon emissions lead to uncertainties about climate change and the 24 unknown feedbacks on future economic outcomes (Pillet, 1994). 24 corresponding damage that such changes cause, it can be said that the uncertainty is induced by the 25 Under this perspective, one better has to place the focus on the various matching and diverging 25 industrial countries (to date), and borne by the world as a whole. The available data also indicates that 26 points that dynamically occur; that is, on what will possibly emerge from such interconnections. This 26 developing countries are more vulnerable to climate change. Any insurance scheme must take this 27 amounts to allowing agents to identify the set of possible descriptions of the risks that humanity faces 27 distribution of causes and risks into account. 28 and to bet on which model of the climate change related risk is correct. 28 The floods of 1993 in the US, in Bangladesch, and in Europe (France, Switzerland) have reminded 29 Ecological systems (assets) cannot easily be allocated on the marketplace. Therefore, instead of 29 us of the profound vulnerability of human settlement to climate. There is considerable natural varia- Chapter 2/page 53 Chapter 2/page 54 1 tion in these phenomena, although climate scientists expect that variation induced by human activity I greenhouse gas emissions depend on their discount rates and degrees of risk aversion (even if there 2 will soon come to except the natural variation. 3 2 were complete agreement about all of the scientific aspects of the global change problem, there could Box 2.6-2: Natural events and attached Insured losses (after Weilenmann, 1994) 3 still be disagreement about policy responses). Differences in policy positions could then be attributed Event Date Insured Losses (in billion US$) 4 to differences in discount rates and degrees of risk aversion rather than, or in addition to, different Hurricane Gilbert September 1988 0.05 Hurricane Hugo September 1989 5.8 Winter storms Europe January/February 1990 10.0 5 interpretations of the current scientific evidence. Colorado storms July 1990 1.0 Hurricane Bob August 1991 0.62 6 Yet, different perceptions of the risk involved do not however preclude efficient solutions. Hurricane Andrew August 1992 15.5 Hurricane Inki September 1992 1.6 East coast storms US 7 Differences in attitudes toward risk could merely lead to the introduction of new markets in which March 1993 1.6 Midwest floods US Summer 1993 0.765 4 8 different risk positions are traded, with efficiency gains. Economics is about differences in prefer- 5 Correspondingly, one must bear in mind that before 1989, natural disasters caused by storm events 9 ences leading to trade (Chichilnisky, 1994). Betting on climate states could be envisaged, not only 6 with insured losses greater than one billion dollars were unknown (Weilenmann, 1994). For insurers, 10 because insurance can be provided within a market framework, but basically because there exists an 7 the most costly storm event to date has been 1992 hurricane "Andrew" with insured losses of 11 ecological-economic ground for the use of financial instruments in addressing climate change collec- 8 US$15.5 billion (see Box 5.2-II). This kind of losses has become more frequent and a potential rise is 12 tive risks induced by uncertainty about the overall/regional distribution of adverse effects (Pillet, 9 predicted on the standpoint of the insurance industry (Weilenmann, 1994). However, the causes for 13 1994). 14 10 that trend are not clear and are not conclusively linked to current "greenhouse activity". They seem to The institutional structure to be developed would use two types of financial instruments in order to 11 primarily depend upon the increasing concentration of people and insured economic values in areas of 15 deal with the two above-mentioned aspects of the problem. The aim is to obtain an efficient allocation 12 high risk although losses in climate related disasters have been increasing since the 60s at a rate 3: 16 in the face of those risks. One instrument is a mutual insurance contract which is tailored to deal with 13 times that in earthquakes (Yokohama document, 1994). 17 the risks faced on a regional basis by communities contingent on the distribution of harmful effects 18 world-wide. The other one is related to Arrow securities because we need such securities to deal with 14 2.6.2.3 A market framework to respond to collective risks 19 collective risks induced by strong uncertainty about the overall distribution of adverse effects. 15 Next, what a society believes it to be worth paying to reduce the risk of climate change depends inter 20 A mutual insurance contract is an agreement between parties subject to similar risks that those 16 alia on two key characteristics of that society: its degree of risk aversion and its discount rate. 21 who are harmed will be compensated by those who are not.20 In the climate change context, one can 17 The degree of risk aversion is a measure of how much an individual or group is willing to pay to 22 think of groups of communities subject to the possible impact of that change, with those unharmed 18 avoid a risk. 19 The discount rate is an equivalent measure of the value of the future relative to the 23 compensating the others. To illustrate, the Alliance Of Small Island States (AOSIS) has proposed that 19 present (see Chapter 4). 24 an "International Insurance Pool" be established to cover climate change impacts. The Pool would 20 It consequently turns out that different country's positions with respect to measures to restrict 25 take the financial burden suffered by affected developing countries and distribute it amongst the 26 industrialised countries. The members of the Pool would be divided into two groups. The first group 19 An indication of the degree of risk aversion can be obtained by the following exercise: offer a person the choice between either $0 if a tossed coin comes down heads and $100 if it comes down tails or $50 with certainty. Most people 27 would consist of low-lying coastal countries and small island states that would receive insurance will choose $50 with certainty, even though on average they will get the same by choosing to bet 00 the tossed coin and they stand some chance of doing better (and some change of doing worse). In fact most people will choose $45 with 28 coverage from the fund. The second group would include industrialised countries who would certainty to a bet on a tossed coin giving $0 for heads and $100 for tails. Suppose that $45 is the smallest amount for which this is true. Then the difference between $45, the reward in the risk less situation, and $50, the average reward in the risky situation, is a measure of the person's risk aversion. The more risk averse you are, the more you will insure 20 Examples are agricultural co-operatives of the type recorded in Europe at least since the fifteenth century, and the nine- (Chichilnisky, 1994). teenth century UK workers' associations and friendly societies. These involved agreements between a group of workers that if one were sick and unable to work, he or she would be compensated by the others. Chapter 2/page 55 Chapter 2/page 56 1 contribute funds (after IUCC, 1993). I safe guide to the far future" (Ayres and Weaver, 1994). The current trend in the insurance industry 2 Mutual insurance contracts would mean making transfers, the size of the latter depending on the 2 with respect to weather events is a clear attempt at modifying the underwriting guidelines by setting 3 overall level of prosperity, and the transfer per se being contingent on the overall incidence of 3 restrictions on coverage (exclusions), at setting total exposure limits for a specific high risk zone to 4 negative effects (in the sense of high or low overall incidence of negatives climate change-related 4 avoid the cumulation of risks (for instance the Eastern coast of US, Japan, Australia, low lying coastal 5 events in the population and in ecosystems). 5 areas), or at improving overall risk exposure by selective underwriting.² 6 The AOSIS proposal calls for Pool contributions to be collected in 2004, ten years after the Climate 6 To conclude, the markets just described can provide a natural mechanism for reconciling differ- 7 Change Convention enters into force-provided the rate of global mean sea-level rise has by then 7 ences in assessments of the likelihood of important climate changes between countries, and for testing 8 reached an agreed figure. This ten-year delay has been thought to give the funding countries sufficient 8 the conviction behind publicly-stated positions (Chichilnisky, 1994). Accordingly, this could be help- 9 time to make their initial investments. If sea-levels have not risen too much by the time the ten-year 9 ful in advancing negotiations between industrial countries with different perceptions of the risks, such 10 period expires, a review of conditions would be undertaken. 10 as the US and the EU (also see Pillet, 1994)23 as well as in correcting the North-South balance 11 The securities we would need to deal with collective risks induced by uncertainties about the 11 between the causes of climate risks (in the North), and the ecological-economic impacts of the risks 12 overall distribution of adverse effects would pay out if and only if there were a particular frequency 12 (which are believed to be more serious in developing countries). 13 of damage in the world as a whole. This would involve identifying the set of possible descriptions of 13 2.6.3 Portfolio Analysis Analogy 14 the risks that humanity as a whole face, which are called here collective risks. Climate-related events 14 Numerous policy measures are available to limit the impacts of climate change. Countries will typi- 15 such as floods, tropical storms or certain temperature patterns are examples. 15 cally implement several of these policy measures since no one measure is clearly superior. Indeed, the 16 Introducing, therefore, securities whose payoffs depend on which description of the risk is correct 16 decision-maker's problem is much more complex than the choice of a single action/policy measure to 17 would allow agents to bet on which model of the risk is correct. A similar financial instrument is 17 the exclusion of all others. In practice, it is a question of constructing a portfolio of actions/policy 18 already in use to hedge against environmental uncertainties and risks: CAT Futures (for Catastrophe 18 measures with the goal of best using the opportunities to diversify that are present in the economy.24 19 Futures). This instrument is a security which pays contingent on the frequency of the occurrence of a 19 Although governments will be making climate change decisions for most of the next century, this 20 major weather risk, such as tomadoes in the East Coast of the US, and floods in the Midwest. CAT 20 does not mean that they have unlimited opportunities to adjust the size and mix of their portfolio of 21 Futures are traded by insurance companies to hedge against their exposure to major climate risks as 21 climate change policies. The total resources devoted to measures to limit climate change (the size of 22 some sort of reinsurance scheme. 22 the portfolio) and the mix of measures implemented (the mix of the portfolio) cannot be changed as 23 Yet, would insurance companies be able to address global climate change risks? Currently not. A 23 often as governments deem appropriate because of lock-in effects as well as other time-, attitude-, and 24 new financial structure has to be set up. 24 scientific results-related factors. In many cases, instead of making decisions, options will be taken. 25 For the insurance industry, which is used to drive fixed, short-term contracts, climate change intro- 26 duces new circumstances "in ways that mean traditional practice and the old statistical methodologies 22 Swiss Insurance Industry, anonymous executive. Pers. com., 1994. 27 are no longer adequate". Climate change implies a certain degree of irreducible unpredictability be- 23 Suppose for example the US believes it most likely that there will be little climate change, and the European Union believes otherwise. Then through the market for securities whose payoffs depend on which description of climate change 28 is correct, the US will naturally sell insurance to the EU. The US would wish to be a seller of securities which pay if yond the category of risk-like uncertainties For insurance companies, "past experience is no longer a climate change is serious, because of its belief that this event will not occur, and a buyer of securities that pay if it is not, because of its belief that this will be the outcome. The EU would be on the opposite sides of these markets. (Chichilnisky, 21 Others would say: the island countries would have to contribute some funds to the Pool. Note that the AOSIS proposal 1994). was presented to the negotiators of the Climate Convention but was not included in the final treaty-and that it is closer to 24 This portfolio is not the same as a portfolio of an investor; however, decision makers should envisage the evaluation of a liability scheme than to an insurance contract. the expected return and the risk of that portfolio. Chapter 2/page 57 Chapter 2/page 58 I 2.6.3.1 Selecting a portfolio 1 political system must take for itself (countries do not use information; government departments may 2 In this respect, the key for selecting an optimal portfolio is to understand how the options interact 2 use information). 3 -e.g., better greenhouse information will influence technology development and emission reduction 3 2.6.3.2 No operational model is available 4 decisions (Manne and Richels, 1993). 4 5 An operational model to analyse the optimal portfolio of climate change policies for a country is not In principle, the policy measures/options available to countries to limit climate change and its im- 5 feasible given the state of our knowledge. But even the sparse information on the expected costs and 6 pacts include: 7 technology research aimed at improving the cost-effectiveness of greenhouse gas mitigation 6 benefits of some amongst the broad policy options can yield some useful insights. 8 technologies such as energy efficiency and non-fossil energy sources; 7 9 Peck and Teisberg (1993), and Manne and Richels (1993) have estimated the value of spending joint implementation, technology transfer and other forms of international co-operation to limit 8 on climate research. It is shown that the expected return is several times the current level of 10 climate change; 9 climate research spending. The same analysis could be performed for technology research. To 11 phasing out existing policies, such as subsidies to fossil fuels, that reduce welfare and directly 10 better encounter uncertainty, the main idea is to consider spending on climate research and cli- 12 of indirectly increase greenhouse gas emissions; 11 13 mate-related technology improvements as an risk premium, and not as subsidies to be randomly measures to reduce emissions, or increase sequestration, of greenhouse gases, 12 14 allocated. Indeed, the key for selecting an optimal portfolio is to understand how the options in- measures to adapt to the consequences of climate change; 13 15 teract, e.g., better greenhouse information will influence technology development as well as insurance orchestration to hedge against risks revealed by strong/unexpected uncertainties; 14 emission reduction decisions. 16 insurance for additional costs incurred due to adaptation. 15 Several researchers compare the costs of unilateral action and international co-operation to ad- 17 The specific policy measures available vary from country to country; research capabilities vary, 16 dress climate change. The analyses consistently show large returns to international co- 18 the inefficient existing policies vary, the costs and availability of measures to reduce greenhouse gas 17 operation. International co-operation should however contain an instrument by which welfare 18 can be redistributed among nations. If it is not the case, as shown by Pillet et al. (1993), small 19 emissions vary, the costs and availability of measures to increase sequestration of greenhouse gases 19 countries with a comparative advantage in the production of clean commodities and a high 20 vary, the damages due to climatic change and the measures for adapting to these damages vary. 20 emissions reduction marginal cost, might have arguments for doing nothing and thus adopting a 21 A portfolio manager attempts to get the best return given a level of risk (as derived from a given 21 free-rider behaviour until a complete international climate agreement is concluded. 22 22 An OECD analysis of the effects of phasing out existing inefficient policies suggested that level of uncertainty of a given type). The appropriate level of risk can be derived from the investor's 23 greenhouse gas emissions would be reduced by over 25% with a net economic benefit. In many 23 assets using assumptions about maximising expected value behaviour. The investor can also impose 24 cases eliminating existing subsidies is politically very difficult, nevertheless a large net benefit 24 constraints on the portfolio to reflect his or her preferences. Investing some or all of the funds in 25 is possible from this policy. 26 25 An emissions reduction supply curve or other analysis of the costs and potential emissions re- "environmentally friendly" assets or prohibiting investments in specified industries, regions, or assets 27 ductions that could be achieved through a wide range of specific measures has been conducted 26 for ethical reasons are examples of such restrictions. 28 for many countries. Virtually every study shows that some emissions reductions are possible at 27 Countries likewise will select a portfolio of climate change policies that reflect, at least implicitly, 29 very low, possibly negative, cost. Many of the measures also yield other environmental benefits 30 28 such as reductions in acid rain, ground-level ozone precursors, and toxic discharges. a variety of objectives and constraints. A country may look for the economically optimal portfolio of 31 Adaptation measures that reduce some of the damage due to climate change are available in 29 climate change policies. However, considerations of the impacts of the policy mix on different socio- 32 some countries; building dikes to protect low lying coastal areas from sea level rise for exam- 30 economic groups, international equity, and intergenerational equity are likely to come into play. 33 ple. Such measures can be implemented where they cost less than the damage that would oth- 34 erwise occur. 31 These objectives will have different weights and will vary from country to country. The "right" blend 35 Climate change insurance contracts and transfers, and trading of risk positions between regions 32 of options will include political costs and institutional capacities and is a decision which each 36 and countries can be referred to face unexpected uncertainties and collective risks. Chapter 2/page 59 Chapter 2/page 60 I 2.6.3.3 Three main forms of policy options I strictly economic considerations mentioned above. Expected damage to ecosystems, expected sea 2 It turns out that three mains forms of policy options dominate current discussions: continued intensive 2 level rise, potential socio-economic impacts, international equity concerns, intergenerational equity, 3 science research to reduce climate and impact uncertainties, development of new supply and 3 and economic development strategies based on development of mitigation and adaptation technolo- 4 conservation technologies to reduce abatement costs, and immediate emissions reductions in order to 4 gies are examples of other considerations that may influence a country's climate change limitation 5 slow down climate changes. The issue for the "option-taker" is not one of either-or but one of finding 5 spending. 6 the right blend of options. Policy makers must decide how to divide greenhouse spending among 6 Incorporating option values into the benefit-cost analyses of the policy measures indicates that 7 competing needs. What portion goes to resolving climate uncertainties? What portion goes to tech- 7 some action on climate change is economically justified by every country. No country can be confi- $ nology development? And what portion goes to immediate abatement of emissions? (Richels, 1994). 8 dent that it will not incur damage as a result of climate change. Thus, delaying action to limit climate 9 Using the portfolio analysis analogy, a country must use the available information to decide upon the 9 change is an option that has a cost, at least an insurance premium. Every country has available policy 10 size of its investment in climate change limitation and on the allocation of that investment across 10 measures that have negative or very low costs after accounting for any associated benefits. Thus ev- 11 policy measures. 11 ery country has some climate change mitigation measures that are economically justified. 12 The size of the investment will reflect the country's objectives and its obligations under interna- 12 Normally, the mix of assets in the portfolio is adjusted so that the risk-return ratio is equal at the 13 tional agreements (FCCC, 1992). Assume that the country has ratified an international agreement that 13 margin. As discussed above, only sketchy information is available on the expected costs and benefits 14 specifies national greenhouse gas emissions limits. Then the size of its climate change investment 14 of the main policy measures. The variability of the costs and benefits for these broad policy options is 15 reflects the most cost-effective means of achieving the country's agreed emissions limit plus 15 not known. Governments can make subjective assessments of the variability of costs and benefits of 16 expenditures on research and adaptation measures. In the absence of an international agreement a 16 different policy measures. The risks associated with phasing out existing inefficient programs or im- 17 country may have little alternative but to implement necessary adaptation measures. Since almost 17 plementing energy-efficiency measures are lower that those associated with reforestation to sequester 18 every country accounts for only a small fraction of global greenhouse gas emissions, unilateral 18 carbon or construction of sea walls. The latter offer only climate change benefits while the former 19 actions will have only a negligible effect on the pace and extent of climate change. No country, acting 19 also yield other benefits. 20 alone will be able to appreciably reduce the damage it suffers due to climate change except by 20 21 implementing adaptation measures. This suggests that all countries have an economic incentive to 22 reduce emissions of greenhouse gas emissions. 23 At a global level, benefit-cost analyses can help establish an appropriate level of climate change 24 investment. Climate change policy does not involve a one-time choice-or some go/not go type of 25 decision-between distinct, long-term options (do nothing or implement policy "X" for the next 26 century), the types of decisions to which benefit-cost analysis has historically been applied. Since 27 climate change policy can be modified frequently and incrementally, the "option values" of decisions 28 must also be considered (the option value of deferring action on climate change can be interpreted as 29 an insurance premium to cover the cost of damages that may result). 30 The level of their investment in climate change policy will be influenced by factors beyond the Chapter 2/page 61 Chapter 2/page 62 2.6 LINKAGES OF CLIMATE SYSTEM WITH DECISION MAKING 2 FRAMEWORK , 4 In this section, we briefly outline the linakges of decision making framework with , climate system illustrated in figure 2.8. Each square is fully discussed by various chapters in this report, so we restrain from elaboration. There are two other working groups on scientific , and impact assessments, summary of which have to be reflected also in the decision making. Thus, the framework encompasses outcomes of all the chapters in this report and highlights of the other working groups. 2 3 10 The figure shows that the chain of events start from cumulative emissions of " greenhouse gases (square 1 in the figure 2.8). These cumulated emissions may trigger off 12 various possible climate related changes such as change in the temperature, sea level rise, SCIENTIFIC EFFECTS Change in Temp. -Sea Level Rise -Moisture Loss -Precipitation Loss Extreme Events IMPACTS -Damage to Agricul. and Fishing -Heat Stress -Migration Species Loss -Irriy. & Hyd. Power IRREVERSIBILITIES Need for Adaptation " moisture loss, precipitation change and extreme events (square 2). These climate changes would LINKAGES WITHIN CLIMATE CHANGE DECISION Long term simulation through Climate Research Policy Research Integrative Assessment 16 in turn have impacts such as damage to agriculture and fishing, migration of population from 19 the coastal areas, species loss, and scarcity of water and so on, which in turn, will constrain 16 irrigation and hydro power generation (square 3). However, the decision making today has to MAKING FRAMEWORK UNDER UNCERTAINTY 5 9 17 consider climate changes and impacts that may occur 25, 50, 100 years and beyond and " respond to it_now by formulating, say, 10 or 20 year strategies that have to be periodically M revised. Since we do not know what may be in store, we have to rely on climate change CUMMULATIVE EMISSIONS ABSORPTION -Oceans Forests - . Other COLLECTIVE DM (Risk based Criteria) RISK Tolerance -Equity of Stakeholder Future Generation -Ecocentric Approach DECISION TOOLS (Utility based) Optimization -Cost-Benefit -Discounting Integrative Assessment Figure 2.8 64 20 research to say how the situation would look at different time periods. Economic costs of -Poverty 21 adaptation and irreversible damages for these impacts have to be compared with the abatement 6 22 8 costs using various decision tools. Thus research results are fed into collective decision making " process, which takes into account issues such as inter-regional and intergenerational equity, 24 ecological and poverty considerations apart from the various country specific factors such as EMISSIONS 25 risk tolerance and vulnerabilities (square 4). To assess the impacts and to facilitate the decision SOCIO-ECONOMIC SYSTEMS C C/B E/Y Y/N N C/E Carbon Intensity of energy E/Y : Energy Intensity of Y/N : Income levels per person Population .. RESPONSE OPTIONS L GDP 26 -Technological makers in designing the specific abatement policies, one can use various decision tools such -Life Style -North -North-South Transfers Increase Sinks POLICY INSTRUMENTS Market: -Tradeable Permits -Joint Implimentation Carbon Taxes Non-Market: -Quotas -Climate Research N 27 as decision theory, optimization, simulation, forecasting and more importantly integrative 20 assessment models (square 5). 7 63 I Thus, collective decision making is required to arrive at revised strategies to take into I 2.7 References 2 account the new information from climate research, and policy research. This helps to choose , the desired concentration levels and emission paths. Allocation of these emission levels among 2 Allais, M., 1953: "Le comportement de l'homme rationnel devant le risque, critique des postulats et 3 axiomes de l'école américaine". 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Temporal Dis- 33 counting in Judgemenis of Long-Term Risks. Mimeo. 34 Vercelli, A., 1991: Methodological Foundations of Macroeconomics: Keynes and Lucas. Cambridge: 35 Cambridge University Press. 36 Wald, A., 1950: Statistical Decision Functions. Wiley. 37 Walley, P., 1991: Statistical Reasoning with Imprecise Probabilities. London: Chapman and Hall. 38 Waterstone, 1993: Environmental Management 17(2): 141-152. A p. 8 There are several ways of responding to any risk: take actions which reduce the likelihood of the risk occurring or of its magnitude when it occurs; take actions which reduce the cost inflicted; or divesting the risk to others through insurance. There is an analogous portfolio of actions in response to the threat of global warming: Mitigation actions (reducing emissions) reduce the chances of significant global warming. Other actions facilitate the ability to adapt and reduce the magnitude of impacts. The include redesigning sea walls and the choice of location for new construction, both of which reduce the costs that might be incurred, say, from an increase in sea levels; the development of new seed strains, may reduce the impacts on agriculture of small changes in weather. The potential adequacy of insurance markets will be discussed below. Within each of the broad categories of mitigation and adaption there are again a wide range of actions which should be included in a portfolio approach designed to minimize risks. These include "policy" actions, such as phasing out subsidies to fossil fuels, that reduce welfare and directly or indirectly increase gas emissions; R & D, to develop technologies which lower the costs of reducing emissions as well as which may make it easier to adapt to any changes that do occur; and international actions, including joint implementation (agreements for one country to fund emissions reduction in another), technology transfer and other forms of international cooperation; policies aimed at enhancing IPCC, revisions, Chapter 1 February 16, 1995 1 sequestration as well as reducing gross emissions; and policies aimed at methane and other greenhouse gases, as well as those that focus on CO2. IPCC, revisions, Chapter 1 February 16, 1995 2 B, p. 8 1.3.1.2. Risk aversion There is a general consensus that individuals and societies are risk averse, that is, they are willing to pay something to reduce the risks which they face. The amount that they are willing to pay is called the risk premium (see box) . IPCC, revisions, Chapter 1 February 16, 1995 3 C. p. 9 Ascertaining the magnitude of the risks--or how they are affected by any particular action--is often difficult in a dynamic setting. As we note below, perhaps the most important aspect is how the particular action affects one's options, the set of actions, their costs and benefits, which are available in the future. We refer to risk reducing expenditures as precautionary investments. We can think of these expenditures in part as the purchase of "real" insurance. IPCC, revisions, Chapter 1 February 16, 1995 4 D. p. 9 Traditional insurance is based on two principles: the pooling of risks, and the transfer of risks from those that originally confront it to those who are more willing or better able to bear it.¹ Insurance markets face problems, though not insurmountable ones, on both accounts. Because the risks associated with climate change are correlated, pooling is less effective. Still, the variety of impacts (with some areas actually benefitting) noted earlier implies that the risks are far from perfectly correlated, so that some degree of risk pooling is possible. By the same token, risk transfer through an insurance mechanism is clearly feasible: ¹This "transfer" is facilitated by the dividing of the risk into small parts, so that any individual only faces a small risk. The magnitude of risk premium an individual needs to compensate him for bearing a small risk is very small. IPCC, revisions, Chapter 1 February 16, 1995 5 E There are, however, three problems facing insurance markets. First, ideally, one would like to have mechanisms by which the risk is transferred from those likely to bear the risks--future generations - to the current generation. The only way to effect such intergenerational risk transfers is through governmental actions. 2 Secondly, losses associated with climate change are likely to be both correlated and large, compared to losses absorbed in a single year by the commercial industry, which already has found itself hard pressed to handle natural disasters. Thirdly, ²This is often used as a basis for arguing that government should take "real" actions--such as undertaking mitigation investments; but there are financial mechanisms for effecting intergenerational risk redistributions. See Stiglitz 1984. However, without physical investments, there may be problems assuring that the government will actually undertake the financial redistributions promised. IPCC, revisions, Chapter 1 February 16, 1995 6 F (There are a myriad of other actions, including those listed above in section and those discussed below, in section ) Precautionary investments may not only be directed at reducing the magnitude of the risk of climate change (mitigation) but also at enhancing the ability of future generations to respond, in two different ways. The first can be understood by analogy to a "rainy day fund. " By setting money aside (which grows with the rate of interest) when things are going well, individuals are better able to cope with crisis when they occur. So too, countries by investing more today in productive assets will be better able to cope with climate change, should it occur. Precautionary investment policies entail investing more than one would otherwise have invested³ The second is the design of investment strategies (including investment in R & D) which reduce the magnitude of the economic impacts and which enhance the economy's adapt to those impacts, should significant climate change occur. ³On the basis of standard intertemporal trade-offs in the absence of the risk of climate change IPCC, revisions, Chapter 1 February 16, 1995 7 G, p. 11 The articulation of inappropriate interim goals and commitments can have a significant adverse impact on overall costs of mitigation strategies, inducing a significant departure from optimal sequential decision making strategies. For instance, commitments to particular levels of emissions in particular years ignores the important effect that temporary economic disturbances (such as prices of oil and the level of GDP) may have on emission levels, and therefore on the costs of attaining such a commitment. Similarly, focusing on such "flow" commitments ignores the critical role played by "stock" variables, and diverts attention away from policies aimed at these variables which are likely to play a more important role in the long run (including the development of technologies which reduce emissions and increase energy efficiency. IPCC, revisions, Chapter 1 February 16, 1995 8 H. p. 11 In a sense, any action today changes the options available in the future, or more precisely, it changes the consequences to any future action. Sequential decision making focuses on identifying how those consequences are affected if one action is taken today rather than another, or how those consequences are affected if an action is taken together rather than postpone by a short period of time. IPCC, revisions, Chapter 1 February 16, 1995 9 good does not serve as a perfect subsitute for domestic production.²⁷ In Malaysia, some claim that the local manufacturer of a car has had important spill-overs to the intermediate good firms producing parts, and that these firms, in turn, have had further benefits to the production of other final goods firms. 28 Returns to scale: a problematic explanation. Not all the arguments put forward by governments as a rational for industrial policies, however, are persuasive. One argument that particularly influenced the Japanese economy was that with returns to scale, without government intervention, firms will be too small scale. Government intervention is required to rationalize the industry. (Thus, the Japanese government not only condoned the increased concentration in the steel industry in the 1960s {check}, but, in one of its most famous "mistakes" tried to discourage Honda--at the time a successful manufacturer of motorcycles-- from entering the automobile market.) The reason that this often cited argument is unpersuasive is that if there truly were increasing returns to scale, then it would pay a single firm to increase its production; as it increased its production, its costs would be lowered, and it would then be able to undercut its rivals. Thus, natural economic forces lead to the rationalization of industries, in the absence of government intervention. Returns to scale combined with capital market imperfections. There is a slight variant of this argument which may have some validity. Increasing returns combined with capital market imperfections may lead to overly small firms. Firms cannot expand to take advantage of the increasing returns, either because they cannot get access to capital, or because the only form of capital to which they can get easy access is credit, and this imposes too high of a risk. Government intervention then can serve to lower costs of production and increase economic efficiency. ²⁷Note that in traditional planning/Marxian models, there was no rationale for why domestic production of say steel was required. 28Historically, these spill over effects have been extremely significant. The development of the machinery and related industries in the Ohio valley in the late nineteenth and early twentieth century, in conjunction with the development of the automobile industry, provided the intermediate goods which were necessary inputs in the development of the airplane. 23 Returns to scale and strategic trade policy. Still another variant of this argument relates increasing returns to strategic trade policy. Historically, the most common version of this argument focuses on industries with learning by doing. If today's production lowers future marginal costs, then there is a form of increasing returns much akin to the more familiar static increasing returns. A firm that expands its production will find that its future production costs are lower. It can undercut its rivals. Earlier versions of this argument led to the infant industry argument: protection is important so that the firm can gain the experience required to lower its production costs, so that it can be viable. More recent discussions discounted this argument, saying that if the firm really were to be profitable in the long run, it would pay for it to encounter losses today. But again, this counterargument runs into a fatal fallacy: it is based on the premise that capital markets are perfect. With imperfect capital markets, firms may not be able to sustain the losses that would enable it to produce at a level at which it would eventually become profitable. Moreover, if the firm is unable to appropriate all the returns to its learning, then social returns to production will exceed private returns. Beyond these arguments lies a third, fundamental argument: whenever there is learning by doing (or increasing returns more generally) markets will be imperfectly competitive²⁹; and with imperfect competition, social and private returns often differ. There may be imperfect competition rents earned by dominant firms in the developed countries. Government policies may be directed at trying to appropriate some of these rents. For instance, with even small sunk costs and fierce (Bertrand) competition, the first entrant into a market may have a distinct advantage: it can have sustained profits, without a threat of entry; since entrants know that, were they to enter, the profits will disappear. There is an effective entry barrier. (Stiglitz, 1987a). Protection allows the development of a domestic industry, removing this entry barrier. Protection generates profits-which form the basis of future investment and risk taking. This 2⁹See Dasgupta and Stiglitz [1987]. 24 provides a rationale for the (alleged) practice of the Japanese government in allowing or encouraging dumping.30 Japanese firms may be effectively protected, by a variety of formal or informal trade barriers, allowing them to charge high prices domestically. Prices can then be set in the international (unprotected) market at long run marginal cost, 31 which may be substantially less than current marginal cost, or average costs. The losses on international production are offset by profits in the protected market. Competition in the international market ensures that the firm be efficient. This policy ensures that the firm does not suffer from X inefficiency, at the same time that it ensures that the industry can benefit from returns to scale, and capture the rents associated with being the technological leader. Excessive competition. While imperfect competition thus provides one set of rationale for government industrial policies, excessive competition provides another set, one to which typically economists are not sympathetic. Since the theoretical ideal is only attained with perfect competition, there is no possibility, within the standard theory, for excessive competition. We have already discussed perhaps the two most important rationale for limiting competition. Increasing the opportunity to avail the economies of scale; and in the absence of strong equity/capital markets, the enhanced accumulation of equity capital. Government actions to stabilize the market (recession cartels) lead to some short run inefficiency. But if the elasticity of demand is relatively small, this inefficiency may be small. But the higher profits lead to greater investment (including in R & D) and willingness to bear risks, and this effect may well outweigh the short run efficiency effects. 32 30 Again, there is a market failur basis for this policy: with perfect capital markets, firms would have no trouble raising capital for worthwhile projects. With imperfect capital markets, in particular, imperfect equity markets, generating capital and divesting risk become important problems. For information theory explanations of these capital market imperfections, see, for instance, Stiglitz [1992]. ³¹It is possible to show, under certain simplifying assumptions (see Spence [1981]) that optimal production of the firm entails setting the marginal value of output equal to the long run marginal cost. ³²There is another reason of perhaps limited direct relevance to the East Asia economies. In the absence of perfect competition, competition may not have the positive force widely ascribed to it, of driving firms to produce better products at lower costs. Rather, it may take a destructive turn: firms 25 Thirdly, to a large extent, government policies were not directed at picking winners, in the narrow sense of the term. Several of the governments decided to support export oriented industries. This wining is picking a develbpment strategy. It does not necessarily entail micro-managing. Even when the X government picked an industry, for instance, the banks seem to have had discretion about picking which firms or projects within that industry to support. Creating Winners and Making Sure that Those Picked Remain Winners The discussion of "picking winners" focuses on one of the central problems facing any economic organization, the selection problem. But it is only one of the central problems, and the emphasis on it has perhaps detracted from the other major problems facing the developing economies, areas in which government policy may have been particularly efficacious. The first of these is "creating" (or finding) winners. The discussion of "picking winners" seems to envisage a fixed pool of applicants for government support, and the government passively culling among these for those with the highest long run social returns. At least within East Asia, governments have taken a far more active role. (See discuss below on government as entrepreneur.) The second of these is the monitoring problem, of ensuring that those to whom support is given Seprevin act "appropriately," e.g. due not siphon off funds for their private use. But again, this provides a too equy limited view of the role assumed by the East Asian countries, who not only undertook what might be marker viewed as the passive role of monitoring, but also undertook a more active role of trying to ensure the success of the favored industries and enterprises. GRWOTH WITH EQUALITY While industrial policies seek to direct the economies' resource allocations in ways which maximize growth, income distribution policies seek to promote greater equality. Historically, the development process has been characterized by marked increased in inequality (the Kuznets curve). Several theoretical arguments were put forward for this: the massive amounts of capital accumulation 28 equality, but also yielded reasonable economic returns. (viii) In Malaysia, policies which would in modern parlance be referred to as affirmative action policies not only were able to draw upon a reservoir of human talent that had not been well used before, but welded together a nation which had already demonstrated a potential for ethnic strife. A careful reader may have noticed seemingly contradictory statements concerning the effects of increased wages on growth. On the one hand, increased wages lead to increased efficiency (efficiency wage effects) and greater political stability, promoting growth; on the other hand, increased wages decrease profits, and thus capital accumulation in general and equity accumulation in particular. So long as wages are below the efficiency wage, there is no contradiction: increases in wages both increase profits and increase productivity. Whether these countries paid wages substantially higher than efficiency wages is not clear. There are, of course, positive feedback relations between growth and equality. The high rates of growth provided resources which could be used to promote equality; just as the high degree of equality helped sustain the high rates of growth. While all of this may seem to be little more than common sense, we need to recall that until the experience of East Asia, "common sense" suggested quite the contrary: growth produced inequality and inequality was necessary for growth. 31 I 1.1 INTRODUCTION I on the economy, particularly the economy of certain countries or regions. 2 2 3 In recent years, atmospheric emissions of greenhouse gases have risen significantly. 3 Even if the first view is adopted, economics has much to contribute to the discussion, for 4 Concentrations are currently about 25 percent greater than at the beginning of the Industrial 4 the question of cost-effective emissions reductions must still be addressed. If the second 5 Revolution. If current trends continue, concentrations will double from pre-industrial levels 5 view is adopted, economics and cost-benefit analysis will clearly be relevant, both in 6 before the end of the next century and, if unchecked, continue to rise thereafter (IPCC 6 deciding how much mitigation to undertake, and in designing the measures. 7 1990). 7 8 8 This chapter, and others in this Assessment Report, draw on the findings of Working 9 The scientific community has noted the potentially serious effects of increased 9 Groups I and II, and follow the guidelines provided by the Framework Convention. That 10 concentrations. These climatic effects could, in turn, have further effects on the biosphere, 10 Convention makes clear that important questions remain to be addressed by subsequent 11 including an increase in mean global temperature, an increase in sea level, changes in II negotiations, including the adequacy of national commitments. This chapter takes the 12 agricultural yields, forest cover and water resources, and a possible increase in storm 12 Framework convention as a political document, recognizing that particular terms of the 13 damage. 13 agreements reached by international negotiation may or may not accord with accepted 14 14 scientific research; that for instance, the agreements may or may not have provided the 15 Increased concentrations of greenhouse gases are the result of fossil fuel burning, 15 basis of a cost-effective approach to mitigating climate change. It is hoped that the findings 16 livestock raising, and other human activities. Concerted action on the part of individuals 16 of this chapter and the assessment report more broadly will enhance an understanding of the 17 and governments will be required to slow the increase in concentrations. Changes in 17 costs and consequences of alternative actions, and will provide the scientific basis for 18 greenhouse gases concentrations and the analysis of the climatic and other physical 18 ongoing negotiations. 19 consequences of those changes lie within the purview of the physical sciences. The role of 19 20 human activity in generating greenhouse gases, the consequences of those changes for 20 1.2 FEATURES OF CLIMATE CHANGE 21 humans, and possible responses, lie within the purview of the social sciences. 21 22 22 Climate change could impose a variety of impacts on society. IPCC Working Group II 23 Climate change impacts are likely to vary dramatically from country to country. A 23 analyses these impacts in detail. They include effects on agriculture¹, forests', water 24 warmer climate could benefit sectors of the economies of some mid- and high-latitude 24 resources', the costs of heating and cooling⁴, the impact of a rising sea level rise on small 25 countries. At the same time, a rising sea level and the possibility of increased storm surges 25 island states and low-lying coastal areas⁵, and a possible increase in storm damage. 26 could threaten the survival of some small island states and coastal areas, and could increase 26 Although most attention to date has focused on negative impacts, some impacts will be 27 the risk of midcontinent drought and desertification for inland areas on the periphery of 27 positive. Beyond these tangible impacts are a variety of intangible impacts including 28 deserts. 28 damages to existing ecosystems and the threat of species losses'. 29 29 30 Within the past decade, a consensus has emerged on some key issues in the economics 30 Climate change presents the analyst with a set of formidable complications: large 31 of climate change. This report describes areas of consensus, as well as areas of 31 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, 32 disagreement, the sources of disagreement, and further research that could narrow the range 32 long time lags between emissions and effects, an irreducibly global problem, wide regional 33 of disagreement. This chapter frames the issue of climate change largely from the point of 33 variations, and multiple greenhouse gases of concern. 34 view of economics but also from that of other social sciences, introducing the more detailed 34 35 discussions in the chapters to follow. 35 Large uncertainties. While natural scientists agree that greenhouse gas emissions are 36 36 rising, they do not agree about the mechanism linking concentrations, and temperature. 37 The commitment of resources to mitigate climate change may rest on one of two 37 Further, although natural scientists agree that some warming will occur, they do not agree 38 arguments. The first arises from fundamental values, the second from decision analysis: 38 on the speed of change, or the ultimate amount of change (IPCC 1992, 1994). In addition, 39 39 social scientists do not agree on the size of the behavioral responses or economic effects 40 1. We have only one planet. Some changes are largely irreversible, and may occur 40 that would follow, or on the effect of these changes on well-being. 41 rapidly. Prudence calls for avoiding a large-scale experiment with the planet. Thus, 41 42 avoiding climate change lies beyond normal economic calculus. 42 Nonlinearities and irreversibilities. Nonlinearities occur when changes in one variable 43 43 cause a more than proportionate impact on another variable. For example, some have 44 2. The potential exists for sudden, largely irreversible non-linearities with major effects 44 suggested that even a modest increase in atmospheric greenhouse gas concentrations could, 3 4 I SUMMARY I Issues of efficiency and equity can largely be separated. The Framework Convention on 2 2 Climate Change calls on all parties to implement cost-effective measures for abatement, 3 Climate change presents the analyst with a set of formidable complications: large 3 enhancement of sinks, and adaptation. The Framework Convention also explicitly requires 4 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, 4 an equitable sharing of the burdens of response, recognizing the common but differentiated 5 long time lags between emissions and effects, an irreducibly global problem, wide regional 5 responsibilities of the parties. Different countries will be affected differently by climate 6 variation, and multiple greenhouse gases of concern. The risks of climate change are 6 change and by policy responses to it. The South is more likely to be adversely affected 7 highly asymmetrical, with a large probability of a small loss, and a small probability of a 7 than the North; moreover, developing countries often lack the financial and technical 8 large loss. Even in the presence of significant uncertainty, this asymmetry, plus the 8 resources to respond. The Framework Convention does not, however, include a formula for 9 principles of risk aversion and portfolio balancing provide the rationale for going beyond 9 sharing the costs of addressing climate change. 10 no-regrets policies to those that incur net costs. 10 11 11 Efficiency requires that emission reductions occur where their cost is lowest, 12 The atmosphere is an international public good, in that all countries benefit from each 12 irrespective of who bears the financial responsibility. Efficiency calls for removing energy 13 country's reduction in greenhouse emissions; greenhouse gases are an international 13 subsidies, reforming and clarifying property rights that affect energy use and carbon 14 externality, in that emissions by one country affect all other countries to the same extent. 14 storage, and reducing non-greenhouse externalities that have the side benefit of reducing 15 15 greenhouse emissions. Efficiency may also be promoted, and greenhouse emissions 16 Both public goods and externalities require a legal framework within which the 16 reduced, by better information dissemination and by addressing capital market imperfections 17 problems they pose can be addressed. No such legal framework now exists for global 17 that inhibit the adoption of energy-efficient technology. Dynamic analysis indicates large 18 climate change. Mechanisms for control of international public goods may include the 18 potential gains from flexibility in timing of greenhouse reductions to allow for the 19 definition of property rights, the definition of limits to emissions and a consensus for 19 economical turnover of capital stock, and to allow time for the development of low-cost 20 distributing the same in a fair and equitable manner. If, on the other hand, each agent acts 20 substitutes. Policies that promote efficiency by requiring nations to face the full costs of 21 in its individual interest, the result will be too little of the public good and too much of the 21 their actions will also address equity concerns. 22 externality. 22 23 23 Efficiency also calls for international mechanisms such as joint implementation and 24 Climate change demands a decision process that is sequential, can respond to new 24 coordinated economic instruments. Coordinated carbon taxes and tradable carbon emission 25 information with mid-course corrections, and can include insurance, hedging, and the option 25 permits can correct the market failure associated with greenhouse emissions. 26 value of alternative courses of action. The challenge today is to identify short-term 27 strategies in the face of long-term uncertainty. The question is not, what is the best course 28 over the next 100 years, but rather, what is the best course for the next few years, knowing 29 that a prudent hedging strategy sill allow time to learn and change course. 30 31 Policy measures to reduce risks to future generations include 1) immediate reductions 32 in emissions; 2) R&D on new supply and conservation technologies; 3) continued research 33 on how much change is likely and what its effects will be; and 4) investments to assist in 34 adaptation if significant climate change occurs. A well-chosen portfolio of policies will 35 yield greater benefits for a given cost than any one option undertaken by itself. Striking the 36 appropriate balance requires taking into account costs, benefits, and risks. 37 38 In an interrelated global economic system, an attempt to reduce greenhouse gas 39 emissions in one region or one sector of the economy may be offset by increases in other 40 regions or sectors. This may occur through a) the loss of comparative advantage in the 41 carbon-intensive sectors of the regions that limit emissions; b) the relocation of industries; 42 or c) changes in world energy prices and the resulting shift in consumption. Any control 43 strategy must account for these global effects. 44 1 2 Chapter 1 Introduction: Scope of the Assessment Lead Authors: J. Goldemberg, R. Squitieri, J. Stiglitz, A. Amano, X. Shaoxiong, R. Saha January, 1995 I INTRODUCTION: SCOPE OF THE ASSESSMENT I 1.5.3 Market Failures and Government Responses 29 2 2 1.5.3.1 Revising national accounts 31 3 SUMMARY I 3 1.5.4 Innovation 32 4 1.1 INTRODUCTION 3 4 1.5.5 Carbon Taxes and Tradable Permits. 33 5 5 1.5.5.1 A Double Dividend? 35 6 1.2 FEATURES OF CLIMATE CHANGE 4 6 1.5.5.2 Energy Taxes 35 7 7 1.5.5.3 Tradeable Permit Markets. 36 8 1.3 CONTRIBUTION OF ECONOMICS 7 8 1.5.5.4 Combining taxes with tradeable permits 36 9 1.3.1 Risk 7 9 1.5.5.5 Intertemporal patterns of taxation 36 10 1.3.1.1 Portfolio Theory 8 10 1.5.6 Regulatory Approaches 37 11 1.3.1.2 Insurance 8 11 12 1.3.1.3 Precautionary investments 10 12 1.6 SUSTAINABLE DEVELOPMENT 38 13 1.3.2 Sequential Decision Making 11 13 1.6.1 The Economic Concept of Sustainable Development 38 14 1.3.2.1 Value of information 11 14 1.6.2 Implications of Sustainable Development for Developing 15 1.3.2.2. Option value 11 15 Countries 39 16 1.3.3 Dynamics 12 16 17 1.3.3.1 Kaya Identity 12 17 1.7 CONCLUSIONS 40 18 1.3.3.2 Non-renewable resources, backstop technologies, and 18 19 emission reduction strategies 13 19 1.8 ENDNOTES 42 20 1.3.4 International Public Goods 14 20 21 1.3.4.1 Property rights 15 21 57 22 1.3.4.2 Paying For An International Public Good: Principles 22 23 and Approaches 15 23 1.9 REFERENCES 58 24 1.3.4.4 Enforcement 17 24 25 1.3.4.5 Knowledge 18 25 26 1.3.5 Efficiency 18 26 27 1.3.5.1 Bankable permits 19 28 1.3.5.2 Exchange/risk efficiency. 19 29 1.3.5.3 Comprehensiveness 19 30 1.3.6 General Equilibrium 20 31 1.3.6.1 Intertemporal Substitution 20 32 33 1.4 EQUITY 21 34 1.4.1 General Issues 21 35 1.4.1 Intergenerational Equity 24 36 1.4.2 Within-country Equity 25 37 38 1.5 ECONOMICS OF POLICY ACTIONS 25 39 1.5.1 Zero-cost Options 26 40 1.5.2 Government Reform 26 41 1.5.2.1 Removing Energy Subsidies 26 42 1.5.2.2 Property Rights Reform 26 43 1.5.2.3 Administrative Reforms 27 44 1.5.2.4 Regulating Non-greenhouse Externalities 27 45 1.5.2.5 Special Problems of Economies in Transition 27 46 1.5.2.6 Examples of Efficiency-Increasing Policies 28 I parties always arrive at efficient bargaining solutions, critics point out that the outcomes of bargaining models I simpler emissions permit system (EPS) issues permits on the basis of source emissions and ignores what effects 2 with incomplete information often entail large inefficiencies. 2 those emissions have on the receptor points. Within a given region or zone, the polluter would have only one 3 market to deal with and one price. Finally, there is the pollution offset (PO) system wherein the permits are 3 86. Matters are more complicated, since the patent does not reward the innovator with his marginal contribution-- 4 defined in terms of emissions, trade takes place within a defined zone. However, the standard has to be met at 4 the increase in the present discounted value of benefits as a result of the innovation occurring earlier than it 5 all receptor points. The exchange value of the permits is then determined by the effects of the pollutants at the 5 otherwise would have occurred. For a fuller discussion, see Stiglitz [1994], Dasgupta and Stiglitz [1980a, 1980b], 6 receptor points. The PO system thus combines characteristics of the EPS and the APS. (Pearce and Turner 6 Barzel [ ]. 7 1990) These distinctions are of limited relevance for greenhouse gases, where what is of concern is global 8 emission levels. The specific location of the emissions is of no concern. 7 87. If less developed countries fail to implement fully a set of corrective taxes or tradeable permits, or if less 9 8 developed countries fail to adopt and enforce effectively intellectual property rights, there will be insufficient 9 incentives to produce energy and emission savings innovations, particularly those appropriate for the level of 10 90. The choice between taxes and tradeable permits depends on the objectives of the policy maker and nature of 10 technological knowledge, human capital, and factor prices in those countries. If less developed 11 the uncertainty about the marginal cost and marginal benefit curves for carbon emission reductions (Weitzman, II countries do take these actions, there is concern that they will result in higher prices of innovations, and thus the 12 1974). Theory tells us that if the nature of the curves is known with very little certainty, but the marginal cost 12 pace of adoption will be retarded. An effective form of aid, targeted to reducing greenhouse gas emissions, may 13 curve is known to be relatively steeper (i.e. a change in the level of pollution allowed brings about a greater 13 be subsidies directed at producing appropriate energy saving and emission reducing technologies for LDCs. 14 change in the marginal costs of mitigation compared to the marginal benefits) then taxes should be the policy of 14 15 choice. This is because, in this case, an erroneous estimation of the optimal tax rate will lead to a relatively small 16 deviation from the optimal pollution level. On the other hand, an erroneous estimation of the optimal level of 15 88. Edmonds et al. (1994) has studied the importance of available advanced energy technologies such as those 17 total emissions in a permit scheme will lead to a relatively large deviation from the optimal cost of the permits. 16 proposed by Johannsen (1993). Edmonds et al. use the Edmonds-Reilly-Barnes model for energy related 18 17 greenhouse gas emissions; the MAGICC model for atmospheric composition, climate response, and sea level rise; 19 If the marginal benefit curve is known to be relatively steeper than the marginal cost curve, however, tradable 18 the IPCC scenario IS92a (IPCC, 1992) as the reference base case and five alternate energy scenarios that are far 20 permits are the better option. Here, an erroneous estimation of the optimal tax rate will lead to a relatively large 19 more advanced over today's energy supply and transformation technologies. The five energy scenarios are: 21 deviation from the optimal level of emissions while an erroneous estimation of the optimal level of emissions in 20 22 a permit strategy will lead to a relatively small deviation from the optimal cost of the permits. 21 a. advanced fossil fuel technologies 23 22 b. advanced liquified hydrogen fuel cells 24 In the case of greenhouse gas emissions, the time horizon for adjustment is sufficiently long that many of these 23 C. advanced hydrogen fuel cells without liquified hydrogen 25 uncertainties become less important. If the tax rate initially chosen yields too high a level of emissions in one 24 d. low cost biomass 26 year, it can be increased, and the net impact of the erroneous initial estimate on global warming (or the total cost 25 e. accelerated rate of exogenous end-use energy intensity improvement 27 of achieving a given level of atmospheric concentration) will be negligible. In any case, as the earlier discussion 26 28 on sequential decision making has emphasized, there is likely to have to be continued revisions in either tax rates 27 Combined, the energy technologies reduce annual emissions from fossil fuel use to levels that stabilize 29 or permit levels. 28 atmospheric concentrations below 550 ppmv (i.e. double the concentration prior to the Industrial Revolution). 30 29 The tax rate, assumed to apply globally, used was the marginal cost of stabilizing fossil fuel carbon emissions 31 30 in the reference case. With values reflected for only carbon dioxide emission reductions, the cost of global 32 Still, there is some argument that the required adjustments under a permit scheme may be less burdensome. 31 emission reductions grow from approximately $35 (US) Billion in 2005 to $230 (US) billion per year in the year 33 (Tietenberg 1992) For instance, if the authority feels that the old standard needs some tightening they may enter 32 2095. With advanced fossil fuels, low cost solar electric power, low cost fuel cell vehicles, the present discounted 34 the market themselves and buy some of the permits, holding them out of the market. 33 value of adding low cost biomass fuel to the energy technology bundle is almost half a trillion dollars (US). The 35 34 present discounted value of the advanced energy technologies taken together is $1.8 trillion (US). 36 There must be effective, competitive markets in tradeable permits, if such schemes are to achieve efficient 35 37 outcomes. There are transactions costs of running such schemes, just as there are transactions costs associated 36 The introduction of advanced biomass energy production technology was found to play a key role in reducing 38 with collecting tax revenues. Whether transactions costs gives one system a decided advantage over the other 37 emissions. Biomass energy at $2.00/GJ growing to become the core energy supply technology by 2050 could 39 is not clear. There seems to be no compelling reason to believe that good markets in tradeable permits would 38 significantly reduce emissions highlighting the potential role of technology development and deployment relative 40 not develop. 39 to that of fiscal and regulatory intervention. 41 40 42 41 These results should be viewed as illustrative rather than predictive. In this analysis, the gains from introduction 42 and deployment of advanced energy technologies is dependent on the order of technologies evaluated in the study. 43 91 is possible to design allocations of trading permits which (i) on average, impose no net burden on developing 43 44 countries (thus conforming to the ability to pay principle); (ii) provide those economies which are growing faster 44 45 per capita with commensurately greater permits, thus imposing no net drag on economic growth, provided the 46 economy exhibits an increase in fuel efficiency at least equal to the average of fast growing LDCs; and (iii) 45 89. The literature has identified three types of permit systems. The ambient permit system (APS) works on the 47 rewards those economies which are able to reduce greenhouse gas emissions faster than benchmark, either through 46 basis of permits defined according to exposure at the receptor points. Each polluter, then, may face quite 48 greater control of population growth, through larger increases in energy efficiency, or through switching from 47 complex markets different permit markets according to different receptor points, and hence different prices. The 49 higher to lower carbon fuels. 50 53 54 I The extent to which individual circumstances of countries should be taken into account in setting benchmarks I For a 45% reduction in baseline emissions by 2020, the required tax would be in the range of $150-$325 per ton 2 remains a question for international negotiations; to the extent that high emissions is due to natural endowments 2 of carbon and the cost might be in the range of 1.5%-2.9% of world GDP. A 70% reduction in baseline 3 (e.g. the availability of coal rather than natural gas as a source of energy), a persuasive case can be made for 3 emissions by 2050 could require a tax between $230 and $880 and a loss in world GDP of 2.4%-3.8% (Dean 4 benchmarks to reflect initial emission levels. To the extent that high emissions are due to inappropriate energy 4 1994). 5 pricing policies, the case that benchmarks should reflect initial emission levels is far more tenuous. 5 6 The required carbon taxes and associated costs vary significantly across regions in all of the models. This 6 92. Similarly, some developing countries have asked, should the North be given higher levels of permits, simply 7 indicates that the same proportional reductions in emissions across all regions would give rise to very different 7 because it has, in the past, been the chief source of greenhouse gases? 8 costs in different regions and would thus be globally inefficient with great potential for savings in the global 9 cost of reducing emissions through the use of emission trading between countries or regions (see section 1.5.2.1) 8 93. For a discussion of the polluter pays principle, see above. 10 or a global carbon tax. 11 9 94. Standard tradeable permit schemes essentially take the revenue from a carbon tax, and distributes it to current 12 Three insights emerging from the OECD study are (Dean, 1994): 10 user emitters, rather than using the revenue to reduce other taxes. An alternative to these standard schemes is 13 a. Small amounts of emissions reduction can probably be achieved with low taxes; 11 for the government to auction off the tradeable permits. 14 b. Large reductions can only be achieved at high tax rates (i.e. marginal reduction costs rise with emissions 12 15 reductions). 13 If taxing carbon leads to reduced labor supply or reduced savings, then government revenues from wage or capital 16 C. Carbon-free backstop technologies are likely to slow the rise of the carbon tax, or halt it altogether, if they 14 taxes may be reduced, more than offsetting the direct revenue gain from the carbon tax. Cross elasticities of this 17 are available at constant marginal cost. 15 magnitude are unlikely, though any such cross elasticity will reduce the net gain from the carbon tax. The 18 16 magnitude of the double dividend has been the subject of some dispute, with Goulder [ ] and taking opposite 19 Energy Modeling Forum Project 12 (Impact of Carbon Emission Control Strategies) 17 views. 20 A recent study at Stanford, the Energy Modelling Forum Project 12, examines the cost of reducing CO2 18 21 emissions (Energy Modeling Forum, 1993). A diverse group of economic models, employing common 22 assumptions for selected numerical inputs, were used to analyze a standardized set of emission reduction 19 95. Two main studies provide insights into the root of the variance in estimates of the economic effects of carbon 23 scenarios. In all, 14 top-down models participated in the study. 20 taxes: The Energy Modeling Forum Study (12) and the OECD comparison project. In each case, sophisticated 24 21 sensitivity analyses are run by standardizing key economic assumptions along with use of common reference case 25 The EMF model comparison provides the most comprehensive application of top-down methodologies to date. 22 scenarios of reductions. The magnitude of the effect on economic growth will depend both on assumptions 26 The study addresses a wide range of policy questions. How large are emissions likely to grow in the absence 23 concerning the effect of carbon taxes on savings and labor supply, and the induced investment to offset the higher 27 of controls? How much market intervention will be required to meet alternative targets? What will be the price 24 energy prices. If higher energy prices do not lead to much capital substitution and if the cross elasticity with 28 tag? In exploring economic costs, the modelers were asked to examine the impacts of timing, research and 25 savings and labor are low then the likely effect on economic growth will be small. 29 development, and revenue recycling. 26 30 27 31 The EMF exercise provides a wealth of useful information for policy making. Although the focus was primarily 28 OECD Project on Economy-Wide Cost Estimates of Carbon Taxes: 32 on the U.S., many of the insights are applicable to developed countries in general. 29 An OECD model comparisons project was conducted to compare economy wide estimates of the effects of carbon 33 30 taxes. Time horizons as well as the key economic assumptions on growth, population and resource prices, and 34 In selecting parameters for standardization, the EMF study focused on what were felt to be the most influential 31 the reduction scenarios for six global models were standardized. The global models compared were the GREEN 35 determinants of mitigation costs. These included: GDP, population, the fossil-fuel resource base, and the cost 32 model, the IEA model and four North American models [Edmonds-Reilly Model (ERM), Global 2100 of Alan 36 and availability of long-term supply options. In addition, although the EMF models differed considerably in their 33 Manne and Rich Richels (MR), the Carbon Rights Trade Model (CRTM) of Tom Rutherford, and the Whalley- 37 technology representation, the study attempted to impose uniformity with regard to world oil prices, the oil and 34 Wigle model] (Dean 1994). 38 gas resource base, and the cost of backstop technologies. For its reference case, EMF adopted the average of the 35 39 IPCC high and low economic growth cases (IPCC, 1990c). Also for consistency with the IPCC, the study 36 There is significant variation in tax rates and costs for the same amount of emissions reduction among models 40 adopted the population growth projections based on Zachariah and Vu. 37 due to differing assumptions regarding several key considerations. Several factors explain the differences between 41 38 model results. The most important factors are: 42 The modelers generally used taxes based on the carbon content of the fossil fuels in order to achieve a prescribed 39 43 emissions reduction. The magnitude of the tax provides a rough estimate of the degree of market intervention 40 a. The degree of substitution between fuels the ease with which producers and consumers can switch from 44 that would be required to achieve the carbon emissions target. Estimates range from $20 to $140 per ton for the 41 high-carbon content fuels to low-carbon content fuels; 45 carbon taxes required to hold emissions at 1990 levels in 2010. 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Cambridge 30 University Press, Cambridge. 31 32 Weitzman, M.L. 1993. 'What to preserve? An application of diversity theory to crane 33 conservation.' Quarterly Journal of Economics 108, pp. 157-184. 34 35 Weitzman, M.L. 1991, 'On Diversity'. Discussion Paper 1553, Harvard University Institute 36 of Economic Research, Cambridge, MA. 54 pp. 37 38 Weitzman M.L., Newey, W., and Rabin, M. 1981. "Sequential R&D Strategy for 39 Synfuels," The Bell Journal of Economics 12(2), 574-590. 40 41 Weitzman (1974) 42 43 Wilson, E.O. 1988. The Current State of Biological Diversity,' in E.O. Wilson (ed.) 44 Biodiversity, National Academy Press, Washington, pp. 3-18. 65 66 I 83. Analysts now use two methods to estimate stocks. The first assumes a fixed stock of a natural resources such I focus. 2 as oil. Consumption of oil then depletes the stock by the amount of consumption. The second begins by treating 2 3 discovered reserves as the asset. Thus, additions to reserves increase the asset, while consumption reduces it. 3 (c) Variation across individual consumers: Engineering models generally assume an average consumer; actual 4 If in any given year, new discoveries match resource utilization, then according to this method no net depletion 4 consumers may display a wide range of characteristics and usage patterns. Except when demand functions are 5 has occurred. 5 linear in the relevant variables, the consumption of the "average" individual is not equal to the average 6 consumption; and what is optimal for the average person may not be optimal for a significant fraction for the 6 84. Many researchers have noted deficiencies in standard national income accounts. First, national income 7 population. 7 accounts do not, in general, provide an adequate measure of welfare; second, they do not provide the correct 8 information relevant for making policies relevant to sustainable development. Sustainable development is 8 74.For a survey, see Jaffee and Stiglitz [ ]. The basic theory of credit rationing was developed in Stiglitz and 9 concerned with society's resources; an economy is growing when its resource base (capital stock combined with 9 Weiss [1981] and the theory of credit rationing is developed in Greenwald, Stiglitz, and Weiss [1984] and Myers 10 natural resources) is growing. GDP does not, and is not intended to be, a measure of resource availability. Firms 10 and Maljuf [1984]. 11 have two sets of accounts-cash flow (income) statements and balance sheet statements. GDP is a statement of 12 11 75.This generally accepted methodology is, for instance, reflected in the guidelines issued by the Office of the former type. 13 12 Management and Budget in the United States for the evaluation of projects and regulations. The applied literature 14 Standard accounting procedures require that firms, in an attempt to present an accurate account of "true income," 13 does not address the question of whether this procedure is appropriate in the presence of certain types of time and 15 take account of depreciation. GDP measures gross output; it does not take into account depreciation, either of 14 risk non-separabilities. 16 natural or physical capital stocks. The reason is simply that it is hard to get accurate measures of depreciation. 17 15 76.Though if the variance of the net benefits is increasing over time in a particular manner, the differences in the 18 Net national product does take into account depreciation, the change in capital stock. And it is this account which 16 two methodologies may not be large. 19 should be most subject to criticism, since it accounts for changes in the physical capital stock, but not in other 20 17 77.Again, under certain restrictive conditions, where the shadow value of a capital constraint is changing capital assets, in particular, environmental assets and natural resources. 21 18 systematically over time, the differences in the two methodologies may not be great. 22 A number of difficult conceptual problems face the analyst defining levels and changes in levels of these assets. 23 19 78.See Wilson Though the original discussion of winners curse focused around bidding in auctions, it has 24 20 subsequently come to be applied to a range of other market phenomena. See, e.g. Stiglitz [ ]. 25 First, how should the "stock" of natural resources be defined? Coal poses perhaps the easiest situation. The 26 location of coal reserves is known. Costs of extraction are high, so the rents (the value of coal in situ) is low. 21 79.For a discussion of the role of the state in capital markets, see Stiglitz [1994]. 27 The depletion can be measured not by the coal used times the market price, but the coal used times the in situ 28 value. But for oil and other minerals, information about where reserves are located is vital. Two models have 22 80.In some industrialized countries, energy efficient home mortgage lending may help correct the problem. 29 23 Lenders generally set criteria for the maximum loan amount based on the borrowers' ability to repay, which in been proposed. One sees the world as having a fixed stock of natural resources (say oil). When one uses oil, 30 24 turn depends on income and wealth. The fact that a particular expenditure which would enhance efficiency and one is depleting this stock. Thus, to calculate the value of depletion, one does not need to know the entire stock; 31 25 reduce utility bills is not given special attention. Energy efficient mortgages provide funds to households to the flow (the amount of oil consumed) provides an accurate measure of the change in stock. 26 make energy efficiency enhancing investments intended to pay for themselves, i.e. result in reduced utility bills 32 27 33 The alternative model looks at the size of discovered reserves. Reserves are treated as the asset. Additions to equal to or greater than the interest payments. With capital constraints, builders may have an incentive to trade 28 off initial capital costs for higher maintenance costs (lower energy efficiency). Building codes specifying minimal 34 reserves thus are viewed as increasing the resource base. If in any given year, new discoveries match resource 29 levels of energy efficiency and full disclosure of expected life cycle energy costs may help address these market 35 utilization, then there is no net depletion. This is the approach being taken by the U.S. Department of Commerce. 30 distortions. 36 This accounting framework would be correct if there were an infinite supply of the resource (reflected in zero 37 31 rents): the essential "capital" good is information about where the resource is located. 38 32 39 Environmental assets-such as air quality-present another set of problems, because there are not market prices 33 81. A country that rapidly depletes its natural resources may show a high rate of growth under conventional 40 to value the asset. Dynamic aptimization problems of the kind described earlier can be used to calculate shadow 34 41 income accounting, but a lower rate of growth when resource depletion is taken into account. Repetto (1991, prices. How sensitive these shadow prices are to specific assumptions remains to be investigated. 35 1992) calculated resource-adjusted GDP for several countries rapidly harvesting their stocks of hardwoods and 42 36 other resources, arguing that conventional measures sharply overstated GDP. 43 Accounting systems do not, however, have to aggregate all information together. Just as information about 44 longevity and other indicators of well being (see below) serve to complement information from national income 37 82.Cobb and Daley (1989) have even claimed that U.S. per capita GDP, when adjusted for environmental damage, 45 accounts concerning standards of living, so too can information about physical environmental measures be used 38 was stagnant between 1950 and 1986. This assertion is hard to reconcile with the steady improvement in most 46 to complement information from the extended national income accounts. 39 measures of environmental quality since 1970, when measurements standards were established. 47 85. There is some concern that excessively broad and long patents may actually impede innovation. When 48 technological progress occurs by building on previous innovations, later innovator require permission of earlier 49 innovators to realize the returns on their innovation. While advocates of broad patent coverage argue that the 52 51 I revenues can be used. These include: reducing budget deficits; reducing marginal rates of income, payroll, I 67.This issue has been addressed in several papers. See, in particular, Stiglitz [1975, 1984] and Grossman [1981]. 2 corporate or other taxes; granting tax incentives to preferred activities; or increasing the level of government 3 expenditures. The costs of the tax will vary widely depending on how the revenues are recycled. 2 68.This is both because those who would, under "true" disclosure, be at 8 competitive disadvantage have an 3 incentive to add "noise" and because there are strong market forces for product differentiation; in markets with 4 60.Top-down models estimate that for developing countries there exist low-cost options to reduce emissions in 4 homogeneous commodities, profits, even with a limited number of suppliers, will be driven to zero (in Bertrand 5 the near term, but eventually costs would exceed I to 2% of GDP (EMF 1993). For economies in transition, 5 competition.) For a discussion of these and related issues, see Salop [1977], Salop and Stiglitz [1977, 1982], 6 because of historical inefficiencies and energy subsidies, there exist large opportunities to reduce emissions at 6 Stiglitz [1977, 1988]. 7 little or no cost. For developing countries, problems of informal economies make hard estimates difficult, but 8 the cost of stabilizing emissions would likely be large enough to cut into economic growth. 7 The standard reference in the organizational literature is March and Simon Economic theories emphasizing 8 the non-value maximizing behavior of managers include the works of Baumol 1 ]. Marris I ]. and Leibenstein 9 51.Recent comparisons indicate that the most important differences between top-down and bottom-up models arise 9 I ]. The principal agent literature [Ross, 1973, Stiglitz, 1974] provided the informational micro-foundations for 10 from differences in input parameters, rather than from differences in model structure. 10 understanding the divergence of interests. See Stiglitz [1988]. A more recent overview is provided by Stiglitz 11 I ] and the symposium in the Journal of Economic Perspectives. 11 62.Government institutions and regulations often hinder the efficient use of energy. The developing countries 12 are least able to absorb the costs of these inefficiencies. Thus, while some developing countries argue that they 12 70.This key point, while noted in March and Simon's [1958] original work, was elaborated upon by Radner [ 13 cannot afford to reduce greenhouse emissions the same countries have the most to gain from reforming 13 } and Hannaway I ]. 14 government-caused inefficiencies. At least in the short run, international agreements committing countries to 15 eliminate at least the most egregious of these practices might go a long way to addressing the problem of 14 71.The facts that time is a scarce commodity and that decision making in large organizations is decentralization 16 emission reductions, 15 do not in themselves constitute a market failure; they do not prove that resources are not efficiently allocated 17 16 given the real constraints facing society, which include time. However, Greenwald and Stiglitz [1986, 1988] have 17 established a very general theorem showing that when information is imperfect and costly, market equilibrium 18 63.This may also be a problem with electricity generated by the private sector, as regulation has historically set 18 is, in general, not (constrained) Pareto efficient. Thus, there is no presumption concerning the efficiency of the 19 price equal to average cost, rather than allowing it to match the competitive price. In many countries, the increase 19 market economy, even in the absence of the kinds of externality and public goods problems that are associated 20 of competitive pressures has moved electricity prices closer to the marginal cost of production. 20 with greenhouse gases. For a more extended discussion, see Stiglitz [1994]. 21 21 64.Full utilization of non-fossil fuel energy sources, taking account of other environmental impacts.) For example, 22 One of the main insights of recent advances in the economics of information is to provide a sound 22 when hydroelectric power generation, which does not increase greenhouse emissions, can be cost-effectively 23 micro-foundations for these theories of the firm. And indeed, the importance of the limitations on the availability 23 expanded without other environmental effects, it should be done. 24 of information, and the consequent importance of attention directing efforts applies to individuals as well as to 24 25 organizations. Some studies have suggested that the limited success of the special tax provisions in the United 25 Eliminating Regulations Impeding Efficient Energy Utilization Many, perhaps most, countries have a host of 26 States designed to encourage savings (IRA accounts) was primarily due to the competitive efforts of banks to 26 regulations which increase energy use as they impede economic efficiency. For instance, the United States has 27 recruit these accounts, and the attention which savings got as a result. 27 had a policy of restricting oil exports to Alaska. Whatever the merits of that policy, it has forced Japan to import 28 28 oil from Indonesia and Saudi Arabia. World oil transportation costs have thus been greatly increased, at the 29 expense of the American economy. Another example of government reform, included in the US' Action Plan 29 72.Network externalities are manifested in other ways: builders fail to install energy efficient light bulbs, because 30 (1993), encourages efforts to expand and improve natural gas markets through continued regulatory reform. These 30 customers dislike them, because stores do not carry replacements; and stores do not carry them because the 31 reform efforts include guidelines to allow greater natural gas use in the summer in coal- and oil- fired power 31 demand for them is too low. 32 plants. 32 33 33 When there are important network externalities, market equilibria are frequently inefficient. The economy 34 Other regulation Unintended effects of many tax, expenditure and other policies have contributing further to 34 might, for instance, get "stuck" in the wrong equilibrium. Government action can, in these instances, "force" the 35 inefficiencies in land use. Among the unfortunate effects of the U.S. Superfund program for the management of 35 economy to move from one equilibrium to another. 36 hazardous wastes has been the creation of large unoccupied holes in the center of major cities. 36 37 65.Consider the following thought experiment: compare an optimally designed road system which only carried 37 73.This is not the only explanation of differences between bottom-up and top-down models. There are several 38 cars; and contrast that with an optimally design road system which also carries trucks. The incremental cost of 38 other features of market behavior that bottom-up models often ignore. 39 carrying trucks is, in most countries, much larger than the proportionate share of the cost they bear in gasoline 39 40 taxes and other fees. 40 (a) Hidden Costs: Consumers value a range of attributes difficult to include in an engineering model. For 41 example, auto buyers value not only initial costs and fuel economy (which computer models can easily calculate), 41 66.For example, in many countries, governments have taken an active role in the dissemination of information 42 but also performance, safety, and durability, which they typically do not. 42 to the agriculture sector. These programs are in some measure responsible for the large increase in agricultural 43 43 productivity in countries with agricultural extension services. 44 (b) Divergence between laboratory and in-use performance: Especially for new technologies, actual energy use 44 45 often differs significantly from energy use calculated in the laboratory. It is the latter upon which purchasers 49 50 I 43.Using either an egalitarian social welfare function approach, or a Rawlsian analysis "behind the veil of I 52. Only a few models take into account international capital flows. Thus, most models do not address issues 2 ignorance" (Rawls 1971) leads to the rejection of the "polluter pays principle." Since at the time the relevant 2 of industry relocation (McKibben and Wilcoxen, 1992). Chapter 11 provides a more complete discussion on 3 actions are taken, the polluter is not cognizant of the effects, such fees have no incentive effects, but rather appear 3 leakages. 4 as random taxes, lowering each person's expected utility, and in particular the expected utility of the worst-off 5 individual. 4 53. In the case of production of highly substitutable commodities, carbon leakage will, of course, be much greater. 6 5 7 There is a further ethical issue: ascertaining who the true beneficiary of escaping paying for the pollution is $ generally difficult. It need not be the individual, firm, or country actually engaging in the externality generating 6 54. Whether taxes in fact have this effect depends in part on the shape of the demand curves. With intertemporal 9 activity; in competitive markets, when firms are not charged the full social costs of production, product prices 7 separability in demand curves and constant elasticity, with no backstop technology, a constant ad valorem tax has 10 will fall, giving consumers a substantial fraction of the benefits. 8 no effect on the pattern of consumption. 9 II 44. Manne and Richels (1992) show that, under the IPCC emissions scenarios, even the most drastic controls on 10 Coal presents markedly different issues, not so much because of its greater emissions per unit energy, but because 12 emissions from developed countries would be insufficient to stabilize greenhouse concentrations without some 11 of it higher cost of extraction to price ratio. Lowering producer prices may result in less coal being consumed, 13 means of controlling emissions from developing countries. 12 provided alternative energy sources become available. Thus, taxes on coal are likely to have significant general 13 equilibrium as well as partial equilibrium effects; the increase in the price of coal will lead to a substitution of 14 45.Public goods exist when property rights are not or cannot be clearly assigned. The atmosphere is an 14 gas and oil. If alternative energy sources are not available, such policies will only affect the intertemporal timing 15 international public good because assigning property rights to the atmosphere is difficult for one nation acting 15 of coal consumption (given the much more limited resources of gas and oil). But even that might be of some 16 alone, and particularly difficult when many sovereign states must agree among themselves. Tradable greenhouse 16 value in reducing long run greenhouse gas emissions, as the ability to extract energy from coal may increase 17 emission permits, discussed below, attempt to resolve the problem by explicitly assigning property rights to 17 significantly over time. Analyzing the optimal intertemporal structure of taxes, to minimize long run ambient 18 greenhouse emissions. 18 levels of greenhouse gases, taking into account both intertemporal substitution and substitution across energy 19 19 sources, is a complicated technical issue, that to date has not been adequately analyzed. 20 46.See Abreu I ]. 20 55. United Nations Conference on Environment and Development, Framework Convention on Climate Change, 21 May 9, 1992. 21 47. In some cases, equity considerations may prevent Coase (1960), in his discussion of externalities, emphasized 22 the separability between efficiency and equity issues. Though there have been several important qualifications 22 56. The most difficult problem is posed by those investors who invested in these resources, on the basis of one 23 to Coase's conjecture, emphasizing the importance of public goods, imperfect information, and transaction costs 23 regime (where these resources were not taxed). Do they have any special claim to compensation for a "change 24 (see Farrell Stiglitz [1988]). still, the basic insight remains applicable here. 24 in regime." Changes in demands and supplies occur for virtually all resources, and are an inevitable part of the 25 risks in investing. While most economists would argue that arbitrary and capricious changes in policies contribute 25 48. Chapter 7 discusses this issue at greater length. 26 to business uncertainty, and therefore have an adverse effect on economic growth, reasoned changes in policies 27 in response to changes in information are an inevitable part of the business risk. 26 49. These concerns are not just theoretical possibilities, as the following two examples illustrate. Assume that 27 the North imposes high energy taxes, but the South fails to do so. Energy intensive industries, such as aluminum, 28 57. For example, some U.S.A. electric utilities are already making decisions in anticipation of some future policies 28 migrate from North to South. But energy efficiency in the south is much less than in the north, so that the total 29 to limit greenhouse emissions. 29 energy used to produce a ton of aluminum could increase substantially. While economic efficiency would call 30 for locating energy intensive industries where energy efficiency is greatest, a system of partial controls would 30 58. These issues also arise among countries: countries with large coal deposits will find the value of their natural 31 results in energy intensive industries being located where energy efficiency is lowest. Similarly, the reduced 31 wealth eroded, and quite naturally will be less enthusiastic about international agreements having that 32 energy consumption by the North will result in lower producer prices of oil and gas, leading to increased 32 consequence. 33 consumption of energy in the South, partially offsetting any energy conservation induced in the North. 33 59. The studies show a marked variation in GDP losses across models. For example, stabilizing emissions at their 34 50.The precise manner in which this should be done is a technical matter, treated in the literature on Global 34 1990 levels is estimated to reduce U.S. GDP by 2% to 8% in the year 2010 roughly a $20 billion to $80 billion 35 Warming Potential (see, e.g., IPCC 1990). To the extent that there are large differences in atmospheric lifetimes, 35 loss for that year. Estimate of the costs of reducing emissions by 20% below 1990 levels in the year 2010 range 36 then the relative weighting of different greenhouse gases should change over time, since the "shadow price" 36 from .9% to 1.7% of GDP. Aggregated models (top-down) have generally reported higher costs, while 37 associated with effects on relative concentrations at different dates will differ. 37 disaggregated models (bottom-up) have shown lower costs. Chapter 9 contains a more complete discussion. 38 38 51. Similarly, if the developed countries restrict forest cutting, the price of lumber may rise, inducing the 39 These GDP losses occur when the carbon taxes lead to investments that are more expensive than those that would 39 developing countries to cut down more of their own trees. While total carbon sequestration may not increase, 40 take place in the absence of the taxes. The higher the carbon taxes, the greater the investment in price-induced 40 environmental and economic efficiency will decrease if, as some researchers have concluded, hardwood forests 41 conservation and the more fuel switching toward the less carbon-intensive substitutes. 41 in the less developed countries may be the least desirable ones to cut down from an ecological or economic 42 42 perspective (Edmonds and Reilly, 1983). 43 The overall impact of a carbon tax will depend not only on the size of the tax but also on the uses to which the 44 revenues are put. In the standard EMF scenarios, it was assumed that tax revenues will be redistributed in a 45 neutral manner (i.e., without affecting the marginal tax rates). There are, of course, numerous ways in which tax 47 48 I percent emissions reduction scenario (EMF 1993). I 34.Although for counter examples to the received wisdom see Coase (1990). 2 22. For example, low-lying states may suffer permanent damage. 2 35.Formally, if A measures the quality of the atmosphere, then each individual's or country's welfare, U, is a 3 function of its own consumption, C, and the shared public good, A: U' (C', A). This does not mean that all 3 23. Weitzman et al. (1981), cited in Lind (1993), make these points in formulating a sequential decision strategy 4 individual's (country's) value changes in A the same; that is may differ in magnitude, and 4 for developing synthetic fuels. 5 even in sign. 5 24.Manne and Richels, Nordhaus, and Peck and Teisberg all report a high value of information on and 6 36.Although there may also be trade-offs: reducing those gases that contribute most to local pollution may 6 in their computer simulations. In addition, *** also reports a high value to information on ***. 7 sometimes be at the expense of increased emissions of greenhouse gases. 7 25.Richels and Edmonds (1993) provide a demonstration of this proposition; they calculate relatively low costs 8 37.This kind of optimization problem was first studied by Edgeworth, Mathematical Psychics ( ). The 8 for stabilizing CO2 concentrations if flexibility in timing is allowed, compared to capping and stabilizing 9 importance of incentive effects for the analysis of distributional issues was first emphasized by Mirriees (1971) 9 emissions to achieve the same atmospheric concentration. 10 and Fair (1970). There are, obviously, important incentive effects: if the LDCs were able to classify any 11 expenditure that had some effect on mitigation as a mitigation expenditure, with the cost borne by the developed 10 26. Alternatively, the Kaya identity may be written 12 countries, they would have an incentive to undertake excess expenditures of this type. The GEF (Global 11 13 Environmental Facility) directly addresses this issue, by only providing funds for incremental costs, that is those 12 Growth rate = growth rate decline in energy emissions 14 costs that go beyond what would have been the efficient level of expenditures ignoring the public good benefits 13 of CO2 emissions of output per unit output per unit energy use 15 of greenhouse gas mitigation. 14 15 That is, CO2 emissions will not rise as long as output grows no faster than the combined decline in energy 16 38. The importance of the assumptions of the absence of transactions costs, including the presence of perfect 16 intensity per unit of production and CO2 emissions per unit of energy use. This formulation applies most usefully 17 information, has only gradually come to be recognized. See Farrell I ]. or Stiglitz [1988] for an elementary 17 to the developed countries. 18 textbook treatment. 18 27. Chapter 8, "Evaluating the Costs of Mitigation," treats the important issue of inertia and technology. 19 That is, for instance, it makes no difference whether smokers or non-smokers are given the property rights to 20 air. Whether smokers value smoking more or less than non-smokers value clean air will determine whether 19 Note that energy efficient development paths for developing countries have been proposed (Goldemberg and 21 smoking occurs. How property rights are assigned does make an important difference for the distribution of 20 Reddy 1988). 22 welfare. Coase's result that outcomes are unrelated to the initial assignment of property rights obviously ignore 21 23 potentially important income effects. 24 22 29. That is, for conventional exhaustible resources, there is a stock, S. Welfare depends on flows out of the stock 25 A slight extension of this perspective says that social scientists should simply describe the outcome of the 23 each year: 26 bargaining process by which property rights are assigned. Beginning with the important work of Nash [ ). a 24 U(S, So, S2- S₁,........S₁,₁ - S₁,.....), where S, is the stock at the end of period 1. 27 variety of bargaining theories have been developed, most of which emphasize the importance of "threat 25 28 points"--the outcomes which arise in the absence of a bargaining agreement-- to the determination of the eventual 26 Here, welfare depends directly only on the stocks, though indirectly, through the effects on consumption, on 29 outcome. In this case, the fact that the net losses of many developed countries may be limited relative to those 27 emissions, which affect the change in stock: 30 of many of the less developed countries suggests a bargaining solution in which much more of the costs of 28 31 mitigation are borne by the less developed countries than under the "social welfare function" allocations described 29 U(S,,C,(S, - S,),S₁,C₂(S₂- S₁),.......S,, C,(S,,, S,),.....). 32 earlier. 30 30. Even when the flow exceeds the long-run sustainable level, it will not be optimal to reduce the flow 33 40.For small taxes, these are "compensated" taxes, and have no welfare effect, though they have a substitution 31 instantaneously, unless -- or even when - there are zero costs of adjustment. 34 effect, and therefore do reduce pollution. 32 33 For the atmosphere, a sustainable stock of greenhouse gases means stable concentrations. Current emissions are 35 41. The loss in welfare (ignoring the benefits from reduced greenhouse gas warming) are the Harberger triangles, 34 estimated to be about twice emissions consistent with stable concentrations. 36 and can thus be shown to be proportional to the product of the elasticity of demand for energy and the share of 37 energy in national output. Since poorer countries are likely to have less access to alternatives which increase the 35 31. Postponing action may lead to some irreversible damages, for example the flooding of low-lying states. 38 elasticity of demand, and since the share of energy is larger in richer countries, the burden of the tax is 39 36 progressive. 32. This is not quite correct, since price affects incentives for exploration, and some marginal wells would not 37 be drilled if oil prices fall too low. 40 42. The polluter pays principle endorsed by the OECD is exclusively prospective. 38 33. For analyses of market and optimal responses to uncertainty about the arrival of backstop technologies, see 39 Dasgupta, Gilbert, and Stiglitz [ ] and Dasgupta and Stiglitz I ]l. 45 46 PALGRAVES atc for CITES Chapter 1 Introduction: Scope of the Assessment Lead Authors: J. Goldemberg. R. Squitieri, J. Stiglitz. A. Amano, X. Shaoxiong. R. Saha January, 1995 I INTRODUCTION: SCOPE OF THE ASSESSMENT 1 1.5.3 Market Failures and Government Responses 29 2 2 1.5.3.1 Revising national accounts 31 3 SUMMARY I ) 1.5.4 Innovation 32 4 1.1 INTRODUCTION 3 4 1.5.5 Carbon Taxes and Tradable Permits. 33 5 3 1.5.5.1 A Double Dividend? 35 6 1.2 FEATURES OF CLIMATE CHANGE 4 6 1.5.5.2 Energy Taxes 35 7 7 1.5.5.3 Tradeable Permit Markets. 36 $ 1.3 CONTRIBUTION OF ECONOMICS 7 8 1.5.5.4 Combining taxes with tradeable permits 36 9 1.3.1 Risk 7 9 1.5.5.5 Intertemporal patterns of taxation 36 37 10 1.3.1.1 Portfolio Theory 8 10 1.5.6 Regulatory Approaches " 1.3.1.2 Insurance 8 11 12 1.3.1.3 Precautionary Investments 10 12 1.6 SUSTAINABLE DEVELOPMENT 38 13 1.3.2 Sequential Decision Making 11 1.6.1 The Economic Concept of Sustainable Development 38 13 14 1.3.2.1 Value of information II 14 1.6.2 Implications of Sustainable Development for Developing 15 1.3.2.2. Option value 11 15 Countries 39 16 1.3.3 Dynamics 12 16 17 1.3.3.1 Kaye Identity 12 17 1.7 CONCLUSIONS 40 18 1.3.3.2 Non-renewable resources, backstop technologies, and 18 1.8 ENDNOTES 42 19 emission reduction strategies 13 19 20 1.3.4 International Public Goods 14 20 21 1.3.4.1 Property rights IS 57 21 22 1.3.4.2 Paying For An International Public Good: Principles 22 23 and Approaches 15 23 1.9 REFERENCES 58 24 1.3.4.4 Enforcement 17 24 25 1.3.4.5 Knowledge 18 25 26 1.3.5 Efficiency 18 26 27 1.3.5.1 Bankable permits 19 28 1.3.5.2 Exchange/risk efficiency. 19 29 1.3.5.3 Comprehensiveness 19 30 13.6 General Equilibrium 20 31 1.3.6.1 Intertemporal Substitution 20 32 33 1.4 EQUITY 21 34 1.4.1 General Issues 21 35 1.4.1 Intergenerational Equity 24 36 1.4.2 Within-country Equity 25 37 38 1.5 ECONOMICS OF POLICY ACTIONS 25 39 1.5.1 Zero-cost Options 26 40 1.5.2 Government Reform 26 41 1.5.2.1 Removing Energy Subsidies 26 42 1.5.2.2 Property Rights Reform 26 43 1.5.2.3 Administrative Reforms 27 44 1.5.2.4 Regulating Non-greenhouse Externalities 27 45 1.5.2.5 Special Problems of Economies in Transition 27 46 1.5.2.6 Examples of Efficiency-Increasing Policies 28 I Issues of efficiency and equity can largely be separated. The Framework Convention on I SUMMARY 2 Climate Change calls on all parties to implement cost-effective measures for abatement, 2 3 enhancement of sinks, and adaptation. The Framework Convention also explicitly requires 3 Climate change presents the analyst with a set of formidable complications: large 4 an equitable sharing of the burdens of response, recognizing the common but differentiated 4 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, s long time lags between emissions and effects, an irreducibly global problem, wide regional responsibilities of the parties. Different countries will be affected differently by climate 5 6 change and by policy responses to it. The South is more likely to be adversely affected 6 variation, and multiple greenhouse gases of concern. The risks of climate change are 7 than the North; moreover, developing countries often lack the financial and technical 7 highly asymmetrical, with a large probability of a small loss, and a small probability of a 8 resources to respond. The Framework Convention does not, however, include a formula for 8 large loss. Even in the presence of significant uncertainty, this asymmetry, plus the 9 sharing the costs of addressing climate change. 9 principles of risk aversion and portfolio balancing provide the rationale for going beyond 10 10 no-regrets policies to those that incur net costs. 11 Efficiency requires that emission reductions occur where their cost is lowest, 11 The atmosphere is an international public good, in that all countries benefit from each 12 irrespective of who bears the financial responsibility. Efficiency calls for removing energy 12 13 subsidies, reforming and clarifying property rights that affect energy use and carbon 13 country's reduction in greenhouse emissions; greenhouse gases are an international externality, in that emissions by one country affect all other countries to the same extent. 14 storage, and reducing non-greenhouse externalities that have the side benefit of reducing 14 15 greenhouse emissions. Efficiency may also be promoted, and greenhouse emissions 15 16 reduced, by better information dissemination and by addressing capital market imperfections 16 Both public goods and externalities require a legal framework within which the 17 that inhibit the adoption of energy-efficient technology. Dynamic analysis indicates large 17 problems they pose can be addressed. No such legal framework now exists for global 18 potential gains from flexibility in timing of greenhouse reductions to allow for the IS climate change. Mechanisms for control of international public goods may include the definition of property rights, the definition of limits to emissions and a consensus for 19 economical turnover of capital stock, and to allow time for the development of low-cost 19 distributing the same in a fair and equitable manner. If, on the other hand, each agent acts 20 substitutes. Policies that promote efficiency by requiring nations to face the full costs of 20 21 their actions will also address equity concerns. 21 in its individual interest, the result will be too little of the public good and too much of the 22 22 externality. 23 Efficiency also calls for international mechanisms such as joint implementation and 23 Climate change demands a decision process that is sequential, can respond to new 24 coordinated economic instruments. Coordinated carbon taxes and tradable carbon emission 24 25 information with mid-course corrections, and can include insurance, hedging. and the option 25 permits can correct the market failure associated with greenhouse emissions. 26 value of alternative courses of action. The challenge today is to identify short-term 27 strategies in the face of long-term uncertainty. The question is not, what is the best course 28 over the next 100 years, but rather, what is the best course for the next few years, knowing 29 that a prudent hedging strategy sill allow time to learn and change course. 30 31 Policy measures to reduce risks to future generations include 1) immediate reductions 32 in emissions; 2) R&D on new supply and conservation technologies; 3) continued research 33 on how much change is likely and what its effects will be: and 4) investments to assist in 34 adaptation if significant climate change occurs. A well-chosen portfolio of policies will 35 yield greater benefits for a given cost than any one option undertaken by itself. Striking the 36 appropriate balance requires taking into account costs, benefits, and risks. 37 38 In an interrelated global economic system, an attempt to reduce greenhouse gas 39 emissions in one region or one sector of the economy may be offset by increases in other 40 regions or sectors. This may occur through a) the loss of comparative advantage in the 41 carbon-intensive sectors of the regions that limit emissions; b) the relocation of industries; 42 or c) changes in world energy prices and the resulting shift in consumption. Any control 43 strategy must account for these global effects. 44 2 I 1.1 INTRODUCTION I on the economy, particularly the economy of certain countries or regions. 2 2 3 In recent years, atmospheric emissions of greenhouse gases have risen significantly 3 Even if the first view is adopted, economics has much to contribute to the discussion, for 4 Concentrations are currently about 25 percent greater than at the beginning of the Industrial 4 the question of cost-effective emissions reductions must still be addressed. If the second 5 Revolution. If current trends continue, concentrations will double from pre-industrial levels 5 view is adopted, economics and cost-benefit analysis will clearly be relevant, both in 6 before the end of the next century and, if unchecked, continue to rise thereafter (IPCC 6 deciding how much mitigation to undertake, and in designing the measures. 7 1990). 7 I 8 This chapter, and others in this Assessment Report, draw on the findings of Working 9 The scientific community has noted the potentially serious effects of increased 9 Groups I and II, and follow the guidelines provided by the Framework Convention. That 10 concentrations. These climatic effects could, in turn, have further effects on the biosphere, 10 Convention makes clear that important questions remain to be addressed by subsequent " including an increase in mean global temperature, an increase in sea level, changes in " negotiations, including the adequacy of national commitments. This chapter takes the 12 agricultural yields, forest cover and water resources, and a possible increase in storm 12 Framework convention as a political document, recognizing that particular terms of the 13 damage. 13 agreements reached by international negotiation may or may not accord with accepted 14 14 scientific research; that for instance, the agreements may or may not have provided the 15 Increased concentrations of greenhouse gases are the result of fossil fuel burning. 13 basis of a cost-effective approach to mitigating climate change. It is hoped that the findings 16 livestock raising. and other human activities. Concerted action on the part of individuals 16 of this chapter and the assessment report more broadly will enhance an understanding of the 17 and governments will be required to slow the increase in concentrations Changes in 17 costs and consequences of alternative actions, and will provide the scientific basis for 18 greenhouse gases concentrations and the analysis of the climatic and other physical IS ongoing negotiations. 19 consequences of those changes lie within the purview of the physical sciences. The role of 19 20 human activity in generating greenhouse gases, the consequences of those changes for 20 1.2 FEATURES OF CLIMATE CHANGE 21 humans, and possible responses, lie within the purview of the social sciences. 21 22 22 Climate change could impose a variety of impacts on society. IPCC Working Group II 23 Climate change impacts are likely to vary dramatically from country to country A 23 analyses these impacts in detail. They include effects on agriculture¹, forests², water 24 warmer climate could benefit sectors of the economies of some mid- and high-latitude 24 resources', the costs of heating and cooling⁴, the impact of a rising sea level rise on small 25 countries. At the same time, a rising sea level and the possibility of increased storm surges 25 island states and low-lying coastal areas', and a possible increase in storm damage. 26 could threaten the survival of some small island states and coastal areas, and could increase 26 Although most attention to date has focused on negative impacts, some impacts will be 27 the risk of midcontinent drought and desertification for inland areas on the periphery of 27 positive. Beyond these tangible impacts are a variety of intangible impacts, including 28 deserts. 28 damages to existing ecosystems and the threat of species losses'. 29 29 30 Within the past decade, a consensus has emerged on some key issues in the economics 30 Climate change presents the analyst with a set of formidable complications: large 31 of climate change. This report describes areas of consensus, as well as areas of 31 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, 32 disagreement, the sources of disagreement, and further research that could narrow the range 32 long time lags between emissions and effects, an irreducibly global problem, wide regional 33 of disagreement. This chapter frames the issue of climate change largely from the point of 33 variations, and multiple greenhouse gases of concern. 34 view of economics but also from that of other social sciences, introducing the more detailed 34 35 discussions in the chapters to follow. 35 Large uncertainties. While natural scientists agree that greenhouse gas emissions are 36 36 rising, they do not agree about the mechanism linking concentrations, and temperature. 37 The commitment of resources to mitigate climate change may rest on one of two 37 Further, although natural scientists agree that some warming will occur, they do not agree 38 arguments. The first arises from fundamental values, the second from decision analysis: 38 on the speed of change, or the ultimate amount of change (IPCC 1992, 1994). In addition, 39 39 social scientists do not agree on the size of the behavioral responses or economic effects 40 1. We have only one planet. Some changes are largely irreversible, and may occur 40 that would follow, or on the effect of these changes on well-being. :41 rapidly. Prudence calls for avoiding a large-scale experiment with the planet. Thus, 41 42 avoiding climate change lies beyond normal economic calculus. 42 Nonlinearities and irreversibilities. Nonlinearities occur when changes in one variable 43 43 cause a more than proportionate impact on another variable. For example, some have 44 2. The potential exists for sudden, largely irreversible non-linearities with major effects 44 suggested that even a modest increase in atmospheric greenhouse gas concentrations could, 3 4 I beyond a certain point, trigger a substantial increase in temperature. Alternatively, even a I world economy, not only are the actions of a single country, or group of countries, not 2 modest increase in average temperature might significantly increase weather-related 2 likely to be sufficient to address the problem, they are likely to be largely offset by actions 3 agricultural losses because, for many crops, extra days of extreme heat severely limit yields 3 of other countries. If, for instance, one group of countries reduces timber cutting to 4 In Figure 1. if the threshold temperature for crop damage is T. then even a small increase 4 increase carbon absorption, then the price of humber will rise, which may induce other 5 in the mean temperature, from ml to m2, may greatly increase the number of days above , countries to increase cutting in their forests. 6 the threshold, represented by the area under the curves to the right of T,'. Irreversibilities 6 7 are changes that once set in motion cannot be reversed, at least on human time scales. 7 Moreover, whereas economic analysis generally takes the point of view of a single 8 "Runaway warming" that some have hypothesized is an example. Some oceanographers $ decision maker or government, the important decisions on climate change will of necessity 9 have expressed concern that warming might disrupt the deep water formation and the North 9 be made by many sovereign governments. Economic and decision sciences are not yet able 10 Atlantic Ocean circulation, responsible for much of the oceans' carbon uptake. Once 10 to predict the outcome of bargaining problems of this type". = disrupted, this current might not revert to its original position for centuries II 12 12 Regional variation. Impacts are likely to vary greatly both within and among countries. 13 Long planning horizon. Greenhouse gas concentration changes occur over a long 13 Some countries and regions will suffer from warming: others will benefit, at least in some 14 period of time, with the full consequences of actions taken over the coming decades being 14 sectors. Some cold countries will benefit from a reduction in heating costs and an increase 15 felt in future centuries. The truly long term nature of the problem is one of the distinctive 15 in the length of growing seasons; some warm countries will see a drop in yields from 16 aspects of greenhouse gas warming. Seldom has the world consciously faced a set of 16 agriculture and forestry; low-lying states are likely to suffer from increased storm surges 17 decisions likely to affect our descendants one, two, or three centuries from now". 17 and flooding. For the world as a whole, the net effect at any time will be the sum of local 10 Because the costs of taking action today are born by the current generation, while the 18 effects at many points on the globe, some positive and some negative; analysts have no way 19 benefits accrue possibly hundreds of years in the future, the world community is now faced 19 to estimate this sum without detailed local calculations (summarized in Chapter 6). 20 with issues of intergenerational equity on an unprecedented scale. While society has 20 21 addressed similar problems concerning trade-offs over periods of fifty or even a hundred 21 Aggregation. On a priori grounds, there is no reason to believe that greenhouse 22 years, the long planning horizon for climate change puts the analytic questions at issue in a 22 warming should have in the aggregate, either positive or negative long-run effects (although 23 new light. The length of time involved has one further implication changes in technology. 23 adjustment implies costs in the short run). Indeed, studies twenty years ago focused on the 24 as well as population and consumption patterns, become of paramount importance. 24 dire consequences of global cooling. It seems unlikely that the earth is somehow endowed 25 25 at this moment with the optimal temperature; the Earth has nonetheless adjusted to its 26 Long life of capital stock. Every country has made large capital investments in its 26 current climate, and readjustments in either direction may be costly. 27 cities, farms, ports, etc. Some of this investment cannot be changed without large costs: 27 28 low-lying port cities, for example, cannot easily be rebuilt. For other investments, the cost 28 Multiple gases of interest. Increases in radiative forcing (heat trapping ability) depend 29 of change will be small; for diversified agricultural economies, the cost of switching from 29 on the concentration of all greenhouse gases, not just CO2, even though most economic 30 one annual crop to another will be small if the temperature increase is on the order of 30 modeling to date has limited itself to co, Because greenhouse gases differ in radiative 31 0.2°C. to 0.3°C. per decade, as climate scientists now expect (IPCC 1994). For less 31 forcing and atmospheric lifetime, analysts have devised measures of global warming 32 diversified economies, the costs may be larger. 32 potential (IPCC 1990), making the different gases commensurable". 33 33 34 Inertia in the climate system. Atmospheric concentrations, rather than emissions, 34 Importance of net emissions. Because greenhouse gas concentrations depend on net 35 determine the amount of warming that occurs. Concentrations change much more slowly 35 rather than gross emissions, changes in forests and other greenhouse gas sinks must be 36 than emissions, meaning that affected nations might not have enough time to prevent 36 taken into account". 37 warming damage or to mitigate economic impacts after the effects of climate change 37 38 become evident. In this respect, the risks of climate change are unlike those of earthquake's 38 Efficiency vs. Equity. How much to reduce emissions is a matter of efficiency. Who 39 or floods. The combination of time lags in the climate system and uncertainty about effects 39 pays is a matter of equity. Economics has much to say about the former, but much less 40 requires taking action before unambiguous information emerges about the timing and 40 about the latter. Nonetheless, equity considerations will drive many of the policy decisions 41 magnitude of climate effects. 41 to be made under the Framework Convention on Climate Change. 42 42 43 Global scope. Climate change is a global challenge, which cannot be answered by a 43 44 single country acting by itself. Mitigation must be coordinated globally. In an interlinked 5 6 I I 13 CONTRIBUTION OF ECONOMICS 1.3.1.1 Portfolio Theory 2 2 Risk and Uncertainty 3 3 Economics and the social sciences offer perspectives on climate change not provided by A portfolio manager attempts to get the 4 best return for a given level of risk. One Uncertainty arises when a decision can lead 4 the physical sciences. In the classic definition, economics is the study of the allocation of 5 scarce resources that have alternative uses. Economics emphasizes the importance of important approach is to buy several types to a range of outcomes. 5 6 6 tradeoffs between different uses of resources, and the foregone value of other uses of a of assets, whose returns are not correlated Expected return or expected value of a 7 7 resource, called the opportunity cost. In the context of climate change. this means that I) or are negatively correlated (that is, whose decision is the mean of the distribution of 8 costs and benefits matter; 2) resources are not free; and 3) resources used for one purpose prices move either independently or in 8 returns, the amount a person would on 9 , are no longer available for other purposes. opposite directions). In this respect, climate average receive as a consequence of the 10 10 change policy decisions can be compared decision. If II This chapter sets out the logic of cost-benefit analysis as applied to climate change. to investment portfolio decisions. Risk aversion measures an individual's 12 12 Standard cost-benefit analysis requires I) a valuing of costs and benefits over time, using unwillingness to take risks. 13 13 willingness to pay as a measure of value and 2) a criterion for accepting or rejecting Several responses can reduce the impact 14 proposals". The standard criterion is the compensation principle (Kaldor date, Hicks 14 of climate change: insurance and Risk premium is the amount an individual date). which says that if the project yields positive net benefits, then those made better off 15 15 precautionary investments". Precautionary would pay to replace the uncertain 16 16 investments may take the form of distribution of outcomes with the expected could compensate those made worse off with something extra left over. The result is an 17 unambiguous gain in welfare. without the necessity of weighing effects on different mitigation or in actions that enhance the value. 17 IS individuals. IS ability of future generations to adapt. Certainty equivalent is the amount that 19 Other choices include agreements for one 19 makes an individual indifferent between it Climate change raises difficulties with both requirements. Valuation is difficult because 20 20 country to fund emissions reductions in and a risky proposition; for a risk-averse another country (joint implementation), person, the certainty equivalent is higher 21 of the difficulty in valuing environmental amenities, which are generally not traded in the 21 22 technology transfer and other forms of than the expected return; the difference is 22 market. And the compensation principle will not apply if mechanisms for affecting 23 23 international cooperation; and phasing out the risk premium. transfers do not exist, either between countries or regions in one generation. or -- especially 24 24 -- between generations. If transfers are not feamble, then the analysis must assign weights existing policies, such as subsidies to fossil to different individuals (for example, the utilitarianium gives equal weight to each person) 29 fuels, that reduce welfare and directly or 25 26 26 Only then can conclusions be drawn about net benefits for society as a whole. This issue indirectly increase greenhouse gas emissions. 27 27 will arise again in the discussion of equity in section I 4 below. 28 28 A well-chosen portfolio of climate change investments will yield greater benefit for Beyond these fundamental concepts are ideas, originally from other areas of economics, 29 29 a given cost than any one option undertaken by itself. For an individual country, the 30 30 that may be applied directly to the study of climate change; this includes work on risk, issue is how to choose the portfolio of policy measures best suited to its circumstances, and 31 31 dynamics, sequential decision making, public goods and externalities, taxation, and general to adjust the portfolio over time in response to new developments. Governments will be equilibrium. 32 32 making climate change decisions for several decades at least. This means that they will 33 33 have many opportunities to adjust the size (total resources) and mix (choice of measures) 34 1.3.1 Risk 34 of their portfolio of responses. 35 35 The uncertainties associated with climate change are large. Moreover, results available 36 1.3.1.2 Insurance 36 37 to date from integrated assessment models indicate that climate change risks are highly 37 38 asymmetrical, with a high probability of a small loss and a low probability of a large loss 38 Several concepts from insurance have important applications to climate change: risk 39 (Manne and Richels 1992, Peck and Teisberg 1993, Nordhaus 1994). In the past thirty 39 aversion, risk premium, and certainty equivalent. 40 years, much new economic research has focused on rational responses to risk". including 40 41 That individuals and societies are risk averse means that average utility is increased by 41 three areas important to a systematic examination and rational response to climate change: 42 portfolio theory, insurance, and decision analysis. 42 pooling risks, or equivalently that people are willing to pay to reduce the risks they face. If 43 43 society as a whole is risk averse, then some investments with a negative expected return, 44 44 for example in climate change mitigation, should be undertaken if they reduce the 8 7 probability of a loss, or the costs of future adaptation. I I is global by nature, and therefore undiversifiable, traditional (intragenerational) insurance 2 cannot fully insure against climate change risks. Rather, some form of intergenerational 2 3 The magnitude of those expenditures depends on (a) society's degree of risk aversion; 3 insurance is likely to arise as a way to redistribute more of the risk. and (b) the magnitude of the risk. The risk premium-the extra amount that society is 4 4 $ willing to pay to reduce a risk--is small if the stakes (say, the maximum loss) are small, and , Losses associated with climate change are likely to be both correlated and large, 6 large if the stakes are large. An investment of a dollar is justified if it reduces the loss of 6 compared to losses absorbed in a single year by the commercial insurance industry. The , expected utility by more than a dollar, and not if it reduces the loss by less than a dollar. , long term nature of climate change insurance also raises the problem of contract 8 Thus, results reported below focusing on the expected loss of GDP from climate change do I enforcement: will contracts signed today be enforceable tomorrow? Will the insurers be , not directly address the risk premium. If a possible outcome is a loss of 10%, even though 9 around to pay claims 50 or 100 years from now? (Even in the industrialized countries, 10 the expected loss is only 3%, then the certainty equivalent loss will exceed 3%. A dollar 10 private markets may be inadequate to insure against losses from a major national disaster 11 investment that reduces this certainty equivalent loss by more than a dollar should be II today.) These considerations suggest that private markets may not be able to provide 12 undertaken; such an investment could either reduce the average loss, e.g. by reducing the 12 insurance against climate change, and argue for international action to establish insurance 13 probability of the loss occurring (through mitigation actions) or reduce the variance of the 13 markets, perhaps with government reinsurance. Should such an insurance market be 14 loss. For example, some actions the reduce extreme losses will have more than 14 established, careful attention will have to be given to ensuring that the insured parties 15 proportionate returns. 15 engage in appropriate adaptation actions, mitigating the losses that might be associated with 16 16 any greenhouse gas warming. 17 The insurance expenditures associated with mitigation actions and investments are. in a 17 IS sense, only the differences between the actual expenditures and the no-regreis benefits (the IS 19 benefits other than those associated with greenhouse gas emissions). Thus, investments in 19 1.3.1.3 Precautionary investments 20 fuel efficient cars may have a direct benefit in reducing the cost of running a car. The 20 21 mitigation investment is only the additional investment for climate purposes. 21 A business makes precautionary investments to reduce the total risk of its portfolio. 22 22 Numerous policy measures are available to reduce risks to future generations from climate 23 The economic principles of risk aversion and portfolio theory provide the rationale 23 change. Four have dominated discussions in recent years: I) immediate reductions in 24 for going beyond no-regrets policies. Naturally. actions that reduce greenhouse gas 24 emissions to slow climate change"; 2) R&D on new supply and conservation technology 25 emissions at zero or negative costs should be undertaken But a prudent response to the risk 23 to reduce future abatement costs; 3) continued research to reduce uncertainties about how 26 of greenhouse gas warming goes beyond no-regrets policies to some policies incurring net 26 much change will occur and what effects it will have; and 4) investments in actions to 27 costs. 27 assist human and natural systems to adapt to climate change if it occurs. Other choices 28 28 include agreements for one country to fund emissions reductions in another country (joint 29 Traditional insurance involves pooling a large number of diversifiable risks. Insurance 29 implementation), technology transfer and other forms of international cooperation; and 30 exist when people differ in their ability to bear a given risk, or would be affected 30 phasing out existing policies, such as subsidies to fossil fuels, that reduce welfare and 31 differently by the risk. Insurance markets transfer risks from those who are less able to bear 31 directly or indirectly increase greenhouse gas emissions. 32 the risk to those who are more able to bear the risk, and by spreading the risk among a 32 33 large number of individuals, reduce the aggregate impact of the risk". By transferring 33 Precautionary investments may also enhance the ability of future generations to react. 34 risk, traditional insurance can address one aspect of the risk from climate change: the large 34 An important reason that people establish savings accounts is to reduce the impact of 35 differences in expected regional impacts. This holds irrespective of who pays the cost. 35 unfavorable events in the future. Similarly, a society may elect to accumulate capital 36 because wealthier individuals and countries are better able to bear risk". and because 36 against the possibility of a large loss from climate change. This is one thread of the debate 37 many countries likely to be most adversely affected will be developing countries of the 37 over discount rates in Chapter 3. Those who argue for a discount rate close to the 38 South, while many of the countries least affected (or positively affected) will be the 38 opportunity cost of capital point out that society may choose between immediate 39 industrialized countries of the North, who could provide insurance for effects of climate 39 greenhouse gas mitigation, at a cost, and delayed mitigation, with some of the money saved 40 change that might fall harder on the South". 40 put aside as a savings account for our grandchildren in the event of large climate-induced 41 41 damages. 42 Traditional insurance will not, however, address all risks from climate change. 42 43 Shipowners can buy insurance against storm loss because shipping risks are diversified: one 43 44 storm is unlikely to sink all the ships covered by the insurer. But because climate change 44 9 10 I 1.3.2 Sequential Decision Making I 1.3.3 Dynamics 2 2 3 As a policy question. global climate change is often posed as a choice between a) doing 3 The problem of greenhouse gas warming involves additions to concentrations resulting from 4 nothing at all, or b) committing to all-out effort. Given the large current uncertainties about 4 net emissions over extended periods of time. Thus the analysis must focus on dynamics. $ costs and benefits of greenhouse mitigation, this is the wrong way to frame the issue. as it 5 Dynamic analysis involves three stages: the dynamic processes involved, the trade-offs, 6 obscures the choices that should be evaluated. Moreover, because option b) may be 6 and judgments concerning those trade-offs. 7 perceived as too expensive to get political support, policy paralysis often results. , 8 $ Dynamic analyses have lead to important insights. For example, atmospheric 9 A more useful formulation is: "Given current knowledge and concerns, what actions , concentrations and therefore temperatures depend on the total amount of greenhouse gases 10 should we take over the next one or two decades to position ourselves to act on new 10 emitted over a period of years. A given concentration target can be achieved by a variety " information that will become available?" (Lind 1993) For example, decisionmakers would 11 of emissions time paths. Time paths that provide for the economical turnover of existing 12 like to know if the possibility of irreversible damages" justifies immediately undertaking 12 capital stock and time to develop low-cost substitutes are likely to be less costly. This 13 an aggressive abatement program". 13 suggests large potential gains from flexibility in timing of emission reductions". 14 14 15 Climate change demands a decision process that is sequential and can incorporate new 15 16 information. Timing will be a key element, and the date of resolution of uncertainty an 16 1.3.3.1 Kaya Identity 17 important element of the analysis. Figure I shows schematically the progression from a 17 IS simple decision to a sequence of linked decisions The simple decision is sometimes 18 The driving forces in emissions of any greenhouse gas can be seen in the following identity 19 referred to as the "leam, then act" model, the second as "act, then learn"; or, in the case of 19 for carbon dioxide emissions, (Kaya 1989): 20 the decision depicted, "act. then learn. then act." 20 21 20 CO2 CO2/E E/Q Q/L L 22 A sequential decision making strategy aims to identify short-term strategies in the face 22 carbon dioxide carbon dioxide energy output population 23 of long-term uncertainty. The next several decades will offer opportunities for learning and 23 emissions emissions per per unit per 24 mid-course corrections. The relevant question is not what is the best course for the next 24 unit energy output capita 25 100 years, but rather: what is the best course for the next few years, knowing that a prudent 25 26 hedging strategy will allow time to learn and change course. 26 or, expressed in rates of change: 27 27 28 For example, the choices might be 1) immediate investment in new plant and equipment 28 d In CO2/dt - d InCO2/E /dt + d InE/Q /dt + d InQ/L /dt + d InL /dt 29 2) aggressive R&D on greenhouse abatement technology or 3) deferring large investment 29 30 for 10 years, until the nature and size of the threat is better understood, and when costs will 30 that is, the percentage rate of change in carbon dioxide emissions is equal to the rate of 31 presumably have dropped and the job can be done more efficiently. 31 change in carbon dioxide emissions per unit energy plus the rate of change in energy 32 32 requirements per unit output plus the rate of change in output per capita plus the rate of 33 Because of the high cost of being wrong in either direction, the value of information 33 change in population 34 about climate change is likely to be great. In particular, the value of information about the 34 35 sensitivity of temperature to CO2 increases, the temperature damage function. the gdp 35 This identity clarifies different approaches to reducing emissions. For a developed 36 growth rate, and the rate of energy efficiency improvement is likely to be high (Chao 199 36 country with a stable or slowly growing population, as long as increases in emissions/output 37 Peck and Teisberg 1991, Manne and Richels 1992, Nordhaus 1994) 37 efficiency (emissions per unit energy times energy per unit GDP) keep pace with labor 38 38 productivity, CO2 emissions will not increase. Because of the substantial potential for 39 The presence of uncertainty along a dynamic path creates an option value. the value to 39 energy efficiency improvements, this seems feasible for most developed countries. Many 40 preserving choices for the future. In climate change, the term has been used in two 40 opportunities exist for increasing end-use efficiency, represented by the second term on the 41 different ways. One stresses the irreversibilities of climate change; mitigation expenditures 41 right-hand side, for example from cars to public transportation, from less to more fuel- 42 now preserve the option of avoiding adaptation expenditure later. The other stresses 42 efficient cars and homes". Fuel switching (for example, from coal-based electricity to oil, 43 irreversibilities in investment, and the cost of premature turnover of capital. 43 gas, hydroelectric, wind, and geothermal), represented by the first term, also offers the 44 44 potential to limit CO2 emissions in many countries. 11 12 I For many developing countries, emissions will increase unless energy efficiency and I sources --gas and oil are exhaustible; this limits total emissions from gas and oil. With greenhouse gas emissions per unit of energy change to offset growth in per capita output 2 exhaustible natural resources, the question is not how much will be consumed, only 2 3 and population. For many developing countries with rapidly growing populations, pressures 3 when". for economic development will make it difficult to direct capital from investments with 4 4 higher greenhouse gas emissions to those with lower greenhouse gas emissions" $ Figure 2 depicts fuel use in an economy, in three phases. In the first phase, the 5 On two essential issues evidence is currently limited: (a) to what extent will 6 economy relies on non-renewable resources; in the second, on coal; in the third, on 6 improvements in energy efficiency require net increases in investment beyond the resources 7 backstop technologies-- e.g., biomass combined with non-carbon sources. The switch 7 $ saved from reduced energy usage, i.e., how much does aggressive emission reduction 8 points depend on rising energy prices and improving technology, which lowers the costs of 9 depress economic growth? Order-of-magnitude calculations suggest the presence of only 9 the backstops. The figure shows alternative long run scenarios. In panel A, the price of limited trade offs, at least for the near term; (b) do developing countries have the 10 the backstop technology falls sufficiently slowly that for a time, the economy relies on coal. 10 institutional capacity to achieve the desired increases in emissions efficiency? II In panel B, the price of the backstop technology falls fast enough to eliminate the II 12 intervening stage of primary reliance on coal. 12 13 1.3.3.2 Non-renewable resources, backstop technologies, and emission reduction 13 14 Since, to a first-order approximation, the total carbon load from oil and gas is fixed (and 14 strategies. 15 limited), the total carbon load on the atmosphere is primarily related to coal usage. From 15 16 Though in principle the atmosphere is a renewable natural resource, the longevity of the 16 this perspective, an important uncertainty is the pace at which the cost of the backstop greenhouse gases and the relationships between stocks and flows mean that for practical 17 decreases. If it decreases fast enough, the intermediate stage of coal dependence will be " IS purposes, it may be better treated as an exhaustible natural resource, but one where welfare 18 short, and the total carbon load low, while if the price decreases slowly, the carbon load 19 depends not just on the flow out of the stock. but 00 the stock itself". 19 can be much larger. 20 20 The central problem with natural resources, whether renewable or not, is timing. Many 21 From this perspective, conservation of gas and oil is an important part of a risk strategy. 21 renewable resources possess a maximum sustainable rate of exploitation. The harvest 22 for it provides insurance against the possibility of delayed arrival of backstop energy 22 cannot long exceed this maximum rate without depleting the stock, and ultimately reducing " sources." This, in turn, has important implications for the "leakage" debate, which asks 23 the harvest. Corresponding to the sustainable flow rate is a meady-state stock If, initially. 24 whether, in the event that the North imposes carbon taxes but the South does not, the 24 the actual stock exceeds the steady-state stock. then. for a while. the flow can exceed the 25 South's response will largely offset emission reductions made in the North. It is also 25 26 maximum sustainable flow. The question is how to distribute this excess over time. Even 26 possible that lower prices for gas and oil will induce coal-rich countries to decrease their 27 when the stock is at the sustainable level, in times of emergency it may be desirable to 27 reliance on coal, thus possibly producing negative leakages. But to the extent that occurs, exceed the maximum sustainable flow. For a renewable resource, this can be done, though 28 the insurance provided by greater conservation of oil and gas is eliminated, and it is this 28 29 only at the expense of decreased flows later". 29 insurance which should be an essential part of the dynamic strategy. If the backstop arrival 30 is delayed, then the earlier fuel switching by China and India will yield no long-run 30 31 Timing of reductions in greenhouse gas emissions should reflect differences in costs, 31 benefits; while if the backstop arrival is early, the whole issue is largely moot. Leakage discounting (to evaluate those costs). and risk. If technological change will make future 32 needs to be looked at not from a static perspective, of what occurs in a single year, but 32 emissions reductions much less costly. some reductions should be postponed". 33 from a dynamic perspective, corresponding to the long run nature of the global climate 33 Conversely, research on "learning effects" shows that if actions taken today will lower costs 34 34 problem. faced tomorrow. then these dynamic benefits should be included in the calculus (Anow 35 35 1962, Atkinson and Stiglitz 1969).) In the context of climate change. if emissions 36 36 constraints stimulate technical of other developments that help to lower the costs of 37 1.3.4 International Public Goods 37 38 continuing or additional emission abatement, then reductions should be accelerated (Grubb 38 b 1993, 1995). If discount rates are high, the costs borne by future generations will carry less 39 The atmosphere is an International public good in that atmospheric concentrations are 39 A weight than if discount rates are low. In the presence of risk, non-linearities, or 40 the result of combined actions by all countries. A pure public good Samuelson, 1954) has 40 41 irreversibilities, the principle of risk aversion suggests a strategy of early mitigation. 41 two properties: the marginal cost of an additional individual using the good is zero 42 (non-rivalry), and the marginal cost of exclusion--of stopping an individual from enjoying 42 The theory of non-renewable resources has a second set of lessons for climate change 43 the good--is prohibitive (non-excludability.)" The atmosphere has both characteristics. 43 policy. Among the four energy categories -- coal, gas and oil, biomass and non-carbon 44 One country's greenhouse gas reductions affect all other countries as well. If this thwarts 44 14 13 I climate change, all countries benefit". I Second, it is inappropriate to redress all equity issues through climate change initiatives, 2 Public Goods and Externalities 2 although climate change should not aggravate disparities between one region and another. 3 Different countries will be affected ) 4 differently, so that the benefits of avoiding Externality An externality, or spillover, anses 4 5 greenhouse gas warming will differ from when the private costs or benefits of Economists agree less about the framework for deciding the burden of financing production differ from the social costs or 5 mitigation and adaptation. At least four approaches have been proposed to determine how 6 country to country. Further, some actions benefits Because the social costs or benefits 6 the burdens of taxation should be shared. One approach looks at benefits: just as those who 7 will affect simultaneously local are external to the private costs that firms face, 7 benefit from private goods must pay for them, those who benefit from a public good should 8 atmospheric conditions (providing local private markets alone the economy will tend to I be made to pay for them. The principle has some force when large differences in 9 public goods) and greenhouse produce too little of a public good (ke 9 10 concentrations. For example, actions that education) and too much of 8 public bad (lake preferences exist within any income class; providing a particular public good benefits some 10 pollution). of those individuals more than others, creating inequalities in the absence of benefit taxes. II reduce urban driving improve local air II A major problem frequently encountered, particularly for pure public goods, is that it may 12 quality and at the same time reduce Public good: A public good has two 12 be difficult to determine who benefits. It is in general possible to ascertain the economic 13 greenhouse gas emissions". properties. the marginal cost of an additional 13 benefits of mitigation, and these are likely to be quite unequally distributed. But this 14 individual using the good is zero, and the 14 principle, by itself, does not fully determine who should bear the costs: appropriately 13 1.3.4.1 Property rights marginal cost of exclusion-of stopping an 15 designed mitigation strategies will produce a surplus of benefits over costs, which must 16 individual from enjoying the good-rs 16 somehow be divided. 17 An important strand of economic prohibitive Lighthouses are public goods thought associates externalities with a when lighthouse services are provided to one 17 IS person, others may enjoy the same services 18 A second approach looks at ability to pay. It is often held that richer countries (or 19 failure to assign property rights (Coase without cost 19 individuals) should pay more than poorer ones. This approach sometimes rests on the claim 20 1990). Assigning property rights to the 20 that all people are entitled to a certain minimum consumption (Dasgupta 1982) But this 21 atmosphere is particularly difficult, since Market Failure: Private markets may 21 22 sometimes tall to provide a good at the most principle does not answer the question of how much extra the richer countries should pay. this would require the agreement of many 22 23 sovereign states. Tradeable greenhouse desirable level private markets alone will likely 24 emission permits, discussed below. can be provide too kew lighthouses and too much 23 A third approach is based on contribution to the problem. Because the North has pollution 24 contributed more than two-thirds of the stock of greenhouse gases in the atmosphere today, 25 thought of as an attempt to resolve the 25 this approach seems to suggest a large responsibility for the North. On the other hand, by 26 problem by explicitly assigning property 26 the time greenhouse gas concentrations double from preindustrial levels, the developing 27 rights to greenhouse emissions. 27 countries are projected to be contributing more than half of annual emissions, and roughly 28 28 half of the total stock in the atmosphere (IPCC, 1990; Cline 1992). Thus under this 29 1.3.4.2 Paying For An International Public Good 29 criterion, the developing countries might eventually pay far more of the mitigation costs 30 30 than under the other principles described earlier. 31 Who should pay for a global public good? every country faces this question internally 31 32 in determining who should pay for the public goods it provides. Who should. for instance. 32 Economists have turned to a fourth approach the social welfare function to answer 33 pay for pollution control within a country? 33 the question of how much extra different parties should pay, as well as the question of how 34 34 to distribute the surplus. The discussion of equity below differentiates between the 35 Economists generally agree on several principles: 35 Rawlsian and utilitarian approaches. In this case, both approaches yield similar results: 36 36 In the absence of incentive problems, both imply that all of the surplus should be allocated 37 First, concerns about equity should be separated from concerns about efficiency. though 37 to the poorer countries, or that the burden of effort be borne by the richer countries". 38 ultimately they are intertwined. An implication of this principle is that because pollution is 38 39 a social cost of production (and consumption). everyone should be made to pay the full 39 Yet a different approach holds that social scientists as such have nothing to say about 40 social costs of the pollution they generate. Thus, if there is a social cost to a unit of 40 these ethical issues. Coase [1960], for instance, approaches the problem of externalities by 41 emissions of greenhouse gases, that cost is the same no matter who produces the emissions 41 emphasizing (a) the importance of assigning property rights, so that, in the absence of 42 All should pay the full social costs of their actions, whether rich or poor. In this 42 bargaining costs, an efficient solution can be obtained and (b) that the outcome is 43 perspective, corrective (Pigouvian) taxes should be imposed uniformly. 43 independent of how property rights are assigned". Coase also emphasizes the importance 44 44 of transactions costs, which will often influence the choice of policies. 15 16 I A simple approach that yields efficiency but does not require redistribution (and is thus I 1.3.4.4 Knowledge consistent with the two principles enunciated above) requires coordinated tax rates so that 2 2 all countries face the same energy prices. This approach makes the cost of emitting an extra 3 A key element in addressing the problem of climate change is an increase in 3 4 ton of carbon equal across all countries, and each country retaining the revenues thus 4 knowledge--knowledge about climate science as well as about the economic and social generated The net cost of such a tax (ignoring the benefits from reduced greenhouse , aspects of impacts, mitigation, and adaptation. Much of this knowledge is in the nature of 5 gas emissions) will, in general, be smaller for poorer countries, as a percentage of their 6 an international public good. Developing ways of increasing energy efficiency will benefit 6 national output: the burden of the tax is progressive, even though the tax is levied at the 7 all countries. While in some cases, those engaged in the research will be able to , 8 same rate in all countries". I appropriate for themselves a significant fraction of the private benefits (mostly in reduced 9 energy costs), they will not be able to appropriate the broader social benefits, unless there is 9 Accounting for past damages. The Framework Convention on Climate Change directs 10 a sufficiently high energy tax (or permit fee) that the price fully internalizes the emissions 10 the Annex I countries to take the lead in responding to the threat of climate change. Some II externality. But even then, the social benefits of innovation tend to far exceed the private II have argued in addition that because the North has been the major contributor to current 12 benefits. 12 levels of greenhouse gases, it should bear most of the costs of mitigation. This view says 13 13 that costs should be borne not in proportion to benefits expected, but in proportion to 14 This suggests the need for an international agreement to fund basic research and 14 15 contribution to pollution. This argument, however, is not based on efficiency, which 15 subsidize applied research, particularly in energy-related technologies for the developing requires that incentives be prospective (forward looking). not retrospective No incentive 16 countries. There need not be a central funding agency, nor a central directorate 16 effects attach to imposing charges based on past actions. Whether to charge nations that 17 determining which research should be undertaken. But some mechanism, possibly " contributed co, to the atmosphere is an issue of ethics, not efficiency. Moreover, many IS including joint implementation, must exist for sharing research plans results, and for 18 have challenged the ethical basis for assigning responsibility based on past damages". 19 ensuring that the fruits of this research are made freely available. 19 20 20 The controversial issue of population growth. while central to the question of economic 21 1.3.5 Efficiency 21 development, bears on climate change largely through its effect on emissions. This chapter 22 22 will limit its treatment of population to this one effect 23 With some exceptions noted below, issues of efficiency and equity can be separated 23 24 Analysts agree that any actions responding to climate change should be cost-effective: no 24 25 matter who bears the cost of emission reductions, reductions should occur where their cost 25 1.3.4.3 Enforcement 26 is lowest". Because of the low energy efficiency in many developing countries, many 26 Both externalities and public goods need a legal framework within which the problems 27 have proposed that the major effort at the emission reductions be concentrated there. 27 they pose can be addressed. Without compulsory taxation, there is an incentive for each 28 28 individual to be a free rider, though there is some empirical evidence that the free rider 29 Mechanisms for reducing emissions equitably and efficiently, including joint 29 effect may not be as significant as economists have previously assumed (Bohm [date]). In 30 implementation, tradeable permits, and coordinated tax policies, are discussed below and in 30 31 the absence of compulsory taxation, externalities can only be addressed with well defined 31 chapter 11. All of these approaches, however, attempt to confront all individuals and 32 property rights (Coase 1990)45 and a legal system that enforces compensation for 32 producers in all countries with the same cost of emissions. Emission control is an 33 international public good in that greenhouse emission reductions have the same effect, 33 externalities. 34 wherever they occur. Just as efficiency in the production of steel or any other commodity 34 Though in many areas, great strides have been made in the development of an 35 requires that all consumers and producers face the same price, so too with emissions. 35 international rule of law, problems are likely to face any system for enforcing climate 36 Uniform prices can be achieved either through coordinated energy taxes or through 36 change agreements. For example, the incentive for free riding is great, whether through 37 tradeable permit requirements; but unless the rules are applied in a systematic way to both 37 delay, nonagreement, or noncompliance. Several alternatives have been proposed, each 38 developed and developing countries, emission reductions will be inefficient. 38 raising political or economic concerns. No consensus now exists about the relative 39 39 desirability of these alternatives, though it is clear that some sert of international judicial 40 Partial participation in an international emissions reduction program, however, will 40 41 significantly reduce its effectiveness. The growth of international trade has resulted in 41 process will be required to determine and enforce compliance Abren. 42 important links between the developed and developing countries, and the total effects of any 42 43 policy undertaken in the North can only be evaluated in terms taking into account the 43 44 systemic responses, including responses from the South, as discussed under "General 44 18 17 I Equilibrium," below". I 1.3.6 General Equilibrium 2 2 3 1.3.5.1 Bankable permits ) General equilibrium theory, a cornerstone of economic research over the past century, 4 4 demonstrates the advantage of looking beyond first-stage effects. It offers two important 5 Efficiency imposes several requirements. One, just described, is that at any moment, the 3 insights for climate change analysis. First, the various parts of an economic system are 6 costs of reducing emissions should be minimized. The second is intertemporal efficiency. 6 interrelated; perturbations to one part have ramifications for other parts, which may be quite 7 the marginal cost of reducing emissions at two points in time must be the same. If it will , distant. Second, when all of the reverberations are taken into account, the net effect of an 8 cost less to reduce emissions at some future date, adjusting for time discounting. option 8 action may be markedly different from the initial (and intended) effect. 9 values (risk), and impacts on atmospheric concentrations, then the reduction schedule 9 10 should be adjusted accordingly. 10 One implication of general equilibrium theory has already been noted: taxes imposed on II II one part of the global economy may have little if any effect on global emissions; they may 12 Intertemporal efficiency would be promoted by allowing banking of permits (allowing a 12 simply result in a relocation of economic activity. Increasingly, the world's economic 13 source to use fewer permits in one year and more in another), and by the development of 13 system must be viewed from a global perspective. Location of economic activities is 14 futures and options markets. A bankable permit system would address some North-South 14 determined primarily by relative factor prices, taking into account certain specific locational 15 equity issues, including the concern in the South that delays in mitigation now by the North IS advantages and specialized competencies. If, for example, the OECD countries impose 16 would leave 8 greater burden for the future. 16 carbon taxes on energy-intensive industries, those industries may relocate outside the 17 17 OECD. Further, if greenhouse mitigation puts an economic drag on the developed IS 1.3.5.2 Exchange/rish efficiency. II countries, developing countries would be affected through trade. 19 19 20 When different parties to an agreement hold widely differing views about risk and the 20 If different countries have different obligations to reduce greenhouse emissions, different 21 probability of loss, significant efficiency gains can result from transferring risk among 21 implicit tax rates will result. This will interfere with world economic efficiency--decreasing 22 parties. An earlier section discussed the importance of establishing an international " world real output--possiNly with little effect on total greenhouse gas emissions. For 23 insurance market for those facing the threat of losses under climate change. and noted the " example, the most energy intensive activities-such as aluminum production--may well 24 advantages of establishing a market within which countries who are less concerned shout 24 relocate to developing countries". 25 the economic risks associated with climate change can assume more of the insurance 25 26 burden. Any efficient international system for addressing the problems of global climate 26 While many of the energy-economy-carbon models described in subsequent chapters 27 change must include both mitigation and insurance obligations. Governments that believe 27 attempt to estimate the magnitude of carbon leaks, most are based on standard international 28 they have a comparative advantage in assuming climate nsks can assume a larger share of 28 trade models. in which the location of production of various goods and machines is fixed 29 those risks, trading off other obligations, and substantially reducing overall costs of 29 (Whalley and Wigle, 1992) Thus, estimates of carbon "leakages" are based only on 30 responding to climate change. 30 commodity substitution". But allowing for relocation of industries -- as would occur in 31 31 the very long run, the time span of interest for an analysis of climate change-- leakages 32 1.3.5.3 Comprehensiveness 32 may well be higher. No consensus now exists on the magnitude of long-run leakages. 33 33 34 Efficiency also requires that the cost of reducing all greenhouse emissions be minimized. 34 1.3.6.1 Intertemporal Substitution 35 This principle implies that any mitigation program must include all greenhouse gases 35 36 (taking into consideration their heat-trapping potentials and atmospheric lifetimes"), and 36 General equilibrium issues also arise when production can be shifted from one period to 37 must include carbon sinks. 37 another. For example, in a partial equilibrium analysis, a tax on gas or oil raises the price 38 38 of the fuel taxed, thereby reducing its consumption, and thus associated emissions. But an 39 Finally, and perhaps most controversially, it implies that mitigation strategies focus on 39 exhaustible natural resource like gas or oil has, over the long run, by definition an inelastic 40 all elements of the Kaya identity above, ensuring that the marginal cost of reductions be the 40 supply (ignoring for the moment extraction costs, which, in the case of gas and oil, are 41 same for each of the possible strategies. Thus, population control may be an element in a 41 small relative to the price). The general theory of incidence argues that when a commodity 42 long term mitigation strategy no less than a shift in the composition of production or an 42 is in inclastic supply, a tax affects the price, but not the level of consumption. That is, 43 increase in the energy efficiency of the economy. 43 when all countries impose a tax on gas or oil, the price of oil falls. by an amount just equal 44 44 to the tax. The full incidence falls on producers; as a first approximation, the level of 19 20 I consumption--and thus the level of emissions--remains unchanged. This provides a first I insist that the gainers pay the costs up front. An alternative explanation addresses these 2 approximation. Obviously. if the tax is large enough, the price will fall below the cost of 2 equity concerns by assigning different weights, perhaps based on economic status, to 3 extraction, and supply will be reduced. Moreover, in the case of exhaustible natural ) changes in consumption of different individuals (Atkinson date) resources, taxes may affect the timing of consumption of the oil and gae (Stiglitz, 1977, MC 4 4 5 1979, 1993) , No consensus exists among either economists or philosophers about the appropriate 6 6 ethical responses to the changes that would come with climate change. Should, for 7 , instance, owners of resources be compensated for the losses that they incur as a result of 8 1.4 EQUITY 8 mitigation actions and the consequent change in prices or values? Economists have often 9 , argued no, for several reasons. First, some wealth is not a reward for productive activity, 10 Which nations will be allowed to increase their greenhouse emissions, and who pays for 10 but merely an accident. It is not because country X did something that $200 billion worth II greenhouse gas abatement and adaptation are among the most contentious issues in climate II of minerals or oil was discovered to lie beneath its territory. Many would say that these 12 change. This has immediate implications for policy as well, because the initial allocation of 12 random allocations of wealth have actually contributed to world inequality, and that 13 emission rights and emission constraints will largely determine the distribution of costs. 13 eliminating a part of these windfall gains would, from the perspective of an egalitarian 14 The Framework Convention on Climate Change explicitly directs the parties to consider 14 social welfare function, be welfare-increasing. Another view denies that government 15 equity: 15 policies would be taking away value from assets that by right should be there; until now, 16 16 according to this view, these resources have simply been overpriced, not fully reflecting the 17 The Parties should protect the climate system for the benefit of present and future 17 social costs imposed by their use. In this view, actions to discourage overuse would simply IS generations of humankind, on the basis of equity and in accordance with their common 18 rectify a previous mistake." 19 but differentiated responsibilities and respective capabilities. Accordingly, the developed 19 20 country Parties should take the lead in combating climate change and the adverse effects 20 Whether investors or countries should be compensated for the adverse effects on their 21 thereof 21 market values remains controversial. There is, however, reasonable consensus on three 22 22 general principles: First, workers in adversely affected sectors may need assistance to 23 [Account must be taken of the differences in their starting points and approaches, 23 switch occupations (The market failure here is that workers cannot purchase insurance to 24 economic structures and resource bases, the need to maintain strong and sustainable 24 insure themselves against these kinds of adverse shocks.) Second, gradual transitions may 25 economic growth, available technologies and other individual circumstances, as well as 25 significantly lower the absolute cost of the transition. For instance, workers leave jobs 26 the need for equitable and appropriate contributions by each of these Parties to the 26 through natural attrition; if those leaving are not replaced, the industry will be scaled down, 27 global effort regarding [the Convention's) objective" 27 with no transition cost to any individual worker. Third, the magnitudes of the 28 28 uncompensated redistributions associated with any change in policy are often correlated 29 29 with the magnitude of the political opposition. 30 1.4.1 General Issues 30 31 31 Most policy changes produce winners as well as losers. If the relative price of natural 32 Within the limits of cost-benefit analysis, equity arises because of the principle of 32 gas increases, owners of natural gas deposits may actually be better off. In economies with 33 compensation, discussed in section 1.3, above. For example, suppose it could be shown 33 progressive taxation, either of capital gains or consumption, then implicitly some part of 34 that a business-as-usual path produced higher total benefits than a path with lower 34 those gains are shared more broadly. 35 greenhouse emissions. We could not from this evidence conclude from this that the world 35 36 as a whole would be better off. Suppose that costs of warming fall predominantly on one 36 Virtually all policies discussed below also have different effects on different groups. 37 group or one generation, while benefits accrue to another. (For example, some have 37 Residents of very hot and very cold climates consume more energy for heating and cooling, 38 speculated that the costs of damages from warming would fall largely on the South, without 38 and thus would be worse off, relative to those in more moderate climates. In some 39 a compensating increase in benefits (Parikh date).) Unless the gainers actually compensate 39 countries, city dwellers can choose less energy-intensive modes of transport than those in 40 the losers for their losses, cost-benefit analysis cannot conclude that the change has been on 40 the countryside. 41 balance good for society. Compensation is particularly difficult if future generations would 41 42 bear most of the costs, because no "Fund for Future Greenhouse Victims" exists (Steer 42 Many of these impacts will be reflected in capital costs. Thus, the value of land in 43 1992). Thus, some have argued that in the absence of mechanisms to make these transfers, 43 temperate climates is likely to rise, and the value in extreme climates to fall. (Similar 44 we should not rely on possible future transfers from gainers to losers, but should instead 44 points can be raised, of course, about the costs imposed by climate change itself.) This 21 22 I capitalization effect has both favorable and unfavorable implications. In the long run. 2 residents of colder climates are likely to consume less heating fuel, but perhaps at a higher I might affect the implied tax rate. For instance, a country which, during the preceding ten 3 price, which would leave them on balance about where they started. Energy prices are 2 years, had made every effort to increase energy efficiency and switch consumption to less 4 likely to rise, and land rents to fall, in an almost offsetting way. On the other hand. current 3 energy-intensive commodities would face the burden of reducing its emissions still further. 5 owners of land would bear the full brunt of the present discounted value of all future 4 Because the marginal cost curve for emissions reductions rises steeply beyond a certain 6 increases in taxes (or the tax-equivalent cost of regulations designed to reduce energy 5 point, the implied tax rate would be considerably higher than for a country that had 7 utilization.) As a result, unless policy changes are introduced gradually, dramatic changes 6 previously encouraged overconsumption of energy, for example by energy subsidies. For 8 in land values may occur, with possibly large effects on financial institutions and the 7 the second country, achieving the emission targets might require only eliminating the 9 economy as a whole. Anticipation of these policies would partially offset these dramatic 8 energy subsidies, a policy with an implied negative tax rate. For a similar reason, countries 10 changes in land values". 9 with large endowments of hydroelectric power may find it relatively difficult to meet an 11 10 emission target of this form. 12 National Security. Climate change itself may affect the national security of many 11 13 countries. At the same time, policies to reduce greenhouse emissions may affect export 12 Public finance theory has focused extensively on "second-best" policies, recognizing the 14 earnings and therefore national security of the energy exporting countries. 13 difficulty of achieving first-best objectives of either economic efficiency or distributive 15 14 justice. In this context, the central issue is whether there exist alternatives to 16 While countries may be willing (or forced) to accept changes in national wealth as a 15 benchmarking, setting target emission reductions in relation to past emissions. When the " result of changes in world prices induced by the response to the threat of climate change, 16 U.S. government recently issued tradeable emission permits for sulfur dioxide, it took IS countries are less likely to be willing or able to accept what they may perceive as implied 17 account of emission reductions already achieved. Benchmarking reflects information that 19 threats to national security over which they have some control. Thus, a country with 8 IS would not be reflected in a simple criteria, such as a particular emission level per unit 20 large endowment of coal becomes more vulnerable if it comes to rely on imported oil or 19 population or GDP. Thus, a strong case can be made for including benchmarking. if not in 21 gas-supplies of which could be cut off in times of war. These countries may feel it 20 the final allocation of permits (obligations), at least in the transition rules. 22. imprudent to switch, even if private economic gains were to be had; and they are 21 23 particularly unlikely to switch if the benefits take the form of an international public good 22 1.4.1 Intergenerational Equity 24 23 25 Increasing world political stability would clearly address these concerns. But even were 24 Efforts to control greenhouse emissions will provide benefits primarily for our 26 that successful, it would not suffice. To increase national security, policies will need to 25 grandchildren and their descendants. We face a difficult task in estimating and judging 27 focus on increasing energy efficiency and reducing energy demand. This is an example of 26 what aspects of climate and environment they will value and how best to preserve those 28 the necessity in designing an international structure for greenhouse gas emissions for 27 aspects for them. If we take aggressive action to limit climate change, they may regret that 29 allowing sufficient flexibility that the particular circumstances of each country can be 28 we did not use the funds to push ahead development in Africa, to better protect the species 30 appropriately taken into account. 29 against the next retrovirus, or to dispose of nuclear materials safely. Chapter 3 addresses 31 30 directly the most important issue in intergenerational equity: choice of an appropriate 32 Benchmarks. The earlier discussion of equitable distribution of the burdens of 31 discount rate. 33 responding to greenhouse gases, employing generally accepted principles of public finance, 32 34 avoided the concept of benchmarks, which have played an important role in international 33 This argument also applies to actions with differential impacts on different regions. If 35 negotiations. Indeed, the "obligations" assumed under the Framework Convention obligates 34 greenhouse warming turns out to be a major threat to countries of the South, and if the 36 the developed countries to return emissions to 1990 levels by the year 2000. One 35 North fails to reduce emissions aggressively now, countries of the South might suffer 37 justification for this form of obligation is that it gives some sense of equity. The difficulty 36 additional damage later. Alternatively, if the North chooses to embark on an aggressive 38 of the task for each country was gauged by its 1990 emissions; requiring each to keep 37 control regime now, and if this cuts into Northern growth rates, the result would shrink 39 within that target appeared to impose a proportionate burden on each. It was a rough sense 38 exports markets for the South, and thus reduce growth there; in addition, if the North views 40 of equity, because no attention was paid to the relative incomes of developed countries and 39 its greenhouse efforts as, in effect, development aid for the South, it might cut back on 41 therefore no attention was paid to the implied tax rate. 40 other programs (sanitation, water, education for women, etc.) with a greater impact on life 42 41 expectancy, health, and well-being. 43 But in a more fundamental sense this criterion can be criticized as inequitable. It pays 42 44 no attention to past efforts at achieving energy efficiency, nor to other circumstances that 43 44 23 24 I 1.5.1 Zero-cost Options I 1.4.2 Within-country Equity 2 2 While most discussions of equity and climate change have so far focused on North/South 3 A variety of inefficiencies in the energy sector-many of them government 3 4 induced--would, if eliminated, increase economic efficiency and reduce greenhouse gas 4 issues or on issues between one country and another, issues of equity within a country are 5 also important, and indeed play a central role in the political debates about appropriate 5 emissions at the same time. How large is the reservoir of conservation opportunities? responses to climate change. Most policy recommendations involve large within-country 6 Proponents of the two major approaches to the question have debated this point for more 6 losses for certain groups. For instance, any policy leading to less use of coal, and lower 1 than a decade. Top-down models extrapolate observed behavior into the future. Bottom-up 7 producer prices for coal, will lead to large losses for coal mine owners and workers". $ models, combine engineering analyses to estimate costs with economic models of individual 8 9 choice. Top-down models generally show significant costs to reducing greenhouse 9 10 The net efficiency gains (in reduced emissions) relative to the distributive effects may 10 emissions in the future Bottom-up, or technology-specified models, have been used to differ markedly across resources. Thus, if elasticity of world oil supply is small, a tax on If show the existence of significant reductions in the cost of energy as new low emissions " oil will be reflected in the prices received by producers, and have little effect on cumulative 12 technologies are adopted. Some proponents of bottom-up models argue that emission 12 13 reductions can be achieved at essentially no cost, seemingly repealing the long standing 13 consumption of oil, though it may result in some short-run substitution against coal. 14 Policies aimed at increasing the date of arrival of substitutes for fossil fuels could lead to an 14 economists' presumption that there is no free lunch". increase in current emissions, though long-run effects on atmospheric concentrations would 15 IS 16 Much of the disagreement turns on empirical estimates. Economists have catalogued the 16 be positive. " unintended consequences of government regulation. Many have also identified important 17 18 market failures that could give rise to inefficiencies within the private sector itself. The IS 19 next two sections will examine each of these effects. 19 1.5 ECONOMICS OF POLICY ACTIONS 20 20 Earlier sections set forth a basic framework for analyzing policies related to global 21 1.5.2 Policy Reform 21 climate change, including a combination of mitigation, adaptation, and possibly climate 22 22 23 A variety of government reforms could enhance energy efficiency, including removing 23 engineering. Striking the appropriate balance requires taking into account the costs, 24 benefits, and risks associated with each strategy. For instance, if risk were irrelevant. 24 energy subsidies, reforming or clarifying property rights, reducing non-greenhouse gas governments should reduce emissions to the point at which a dollar of extra spending 25 externalities, and administrative reforms. 25 would yield a dollar of expected savings in damages imposed by climate change. or save an 26 26 27 extra dollar of expected costs of adaptation. Adding risk and sequential decision making 27 1.5.2.1 Removing Energy Subsidies complicates the analysis but leaves unchanged the basic principles. Because of the lasting 28 28 impact of climate change, and the magnitude of the resulting economic uncertainties, most 29 Energy subsidies induce inefficient energy use, reducing the total output of the economy 29 30 as well as increasing CO2 emissions. These subsidies are especially prevalent in 30 policy analysis has focused on a narrower set of questions: 31 developing countries". Shah and Larsen (1991) estimated world energy subsidies in 1990 31 32 1. What actions would improve economic efficiency (including the social costs of 32 to have been $230 billion, calculating that their elimination would reduce global carbon implementing the policy) and reduce net greenhouse gas emissions? How much 33 emissions by 9 1/2% in addition to improving allocative efficiency thereby generating a 33 emission reductions could be achieved by these means? 34 welfare gain in subsidizing countries. Burniaux et al. (1992) obtained similar results using 34 35 the GREEN model, concluding that the elimination of all existing distortions on energy 35 2. Beyond these zero-cost options, what are the least-cost methods of reducing 36 markets would yield an increase in world real income of 0.7% per year in addition to 36 greenhouse gas emissions? What does the cost curve look like"? What are the 37 cutting world emissions by 18% in 2050. (Dean 1994) Likewise Unterwurzecher and Wirl 37 38 alternative policy measures, and how do they compare? 38 (1991) estimated that raising energy prices to world levels in Poland, Hungary, and 39 Czechoslovakia would reduce carbon emissions from those countries by 30%. Agricultural 39 40 3. What are the essential ingredients of an adaptation strategy, and to what extent will 40 subsidies also distort the outcome, especially affecting the size of forests. market forces, on their own, provide the appropriate adaptive responses? 41 41 42 1.5.2.2 Property Rights Reform 42 43 43 44 One responsibility of governments is to define property rights and enforce contracts. 44 26 25 I III-defined property rights encourage overconsumption of resources. A clearer definition of I While these problems are largely of governments' making, the remedy is likely to rely 2 property rights could be particularly important in helping to decrease deforestation, for 2 on a combination of public and private actions: effective environmental regulation, 3 example, while improving economic efficiency. Uncertainties about future property rights 3 elimination of government-caused price distortions, and an economic environment in which 4 may also contribute to economic inefficiency. Thus, for example, in developing countries 4 foreign and domestic investment can enhance the efficiency (including energy efficiency) of 5 where large forests are owned by a few large landowners, excessive deforestation may 5 6 result from landowners' fear that their tenure will be limited. the economy. For example, many analysts believe that cutting methane leakage from gas 6 7 pipelines will yield both high economic and cost-effective reductions in greenhouse , emissions. $ 1.5.2.3 Administrative Reforms 8 9 10 9 1.5.2.6 Defining property rights and eliminating energy subsidies are two important actions Examples of Efficiency-Increasing Policies II 10 governments can take to reduce greenhouse emissions. At the same time, many less Policies that cause individuals not to take into account the full social costs of their 12 11 sweeping reforms can improve economic efficiency and simultaneously reduce greenhouse 13 12 actions often result in greater energy use and greenhouse emissions. The National Action gas emissions. For example: 14 13 Plans of many countries have revealed examples of such policies, and have suggested 15 Pricing of government produced electricity. Many governments price electricity not at the 14 remedies, including: 16 market price but at the cost of production. Economists generally recommend that IS 17 electricity, like any good, be priced not at its cost of production, but at the competitive 16 Unit pricing of waste disposal to encourage recycling: The life-cycle social cost of 18 price. In countries with a mix of plants, this means that electricity from all sources should 17 consuming a good includes its costs of production plus disposal. Most consumers, and 19 be priced the same--at the highest marginal cost of production". 18 many businesses, pay a flat fee for trasi, disposal; with a flat fee, the marginal cost of 20 19 throwing away an extra pound of trash is zero. By moving from flat fees to unit pricing, 21 Land use and other regulation Changes in land use policy can also reduce energy 20 the actual price consumers pay to buy and dispose of a good will more closely match its 22 consumption (especially for transportation and space conditioning). and thus greenhouse gas 21 full life-cycle social cost. 23 emissions". 22 24 23 Pay-at-the-pump automobile Insurance: In most countries, drivers pay automobile 25 1.5.2.4 Regulating Non-greenhouse Externalities 24 insurance yearly or monthly. Once the premium is paid, the marginal insurance cost of 26 25 driving an extra mile is zero, even though driving more does increase the chance of being 26 in an accident. As an alternative, drivers could be required to pay a portion of their 27 Many activities producing greenhouse emissions also generate pollution of other types 28 For example, fossil fuel combustion releases conventional air pollutants: rush-hour auto use 27 insurance bill at refueling. With pay-at-the-pump insurance, a tax would be levied on 29 contributes to road congestion. In the presence of these spillover effects or externalities, 28 gasoline and earmarked to pay for insurance premiums. This would raise the cost of 30 market solutions will not properly reflect the externalities generated, leading to the 29 gasoline at the pump, but lower auto insurance premiums. 31 overconsumption of environmental resources. Energy taxes, congestion pricing. or tradable 30 32 permits can correct these market signals, resulting in lower emissions of both greenhouse 31 Subsidized parking. In some industrialized countries, many employers provide parking to 33 gases and other pollutants. Some reforms, such as congestion pricing, also reduce the need 32 employees at no cost or lower-than-market cost, thus lowering the relative price of 34 for roads and other physical capacity. 33 commuting by car relative to public transportation. A distortion arises when governments 35 34 tax income spent on public transportation, but not income implicit in the parking subsidy. 36 1.5.2.5 Special Problems of Economies In Transition 35 37 36 Subsidized housing In some industrialized countries, home morigage interest is 38 The economies in transition provide special opportunities for mitigating greenhouse 37 tax-deductible. In all but a few countries, the implicit income on owner-occupied housing 39 emissions. In the old Soviet bloc, high energy subsidies and other price distortions affected 38 is not taxed. These tax provisions encourage individuals to consume more housing than 40 energy usage directly, as well as indirectly through the composition of output. Spotty 39 they otherwise would. In cold or hot climates, where more housing space requires more 41 environmental regulation meant that Eastern Bloc nations lacked the environmental controls 40 energy, this tax treatment increases CO2 emissions. 42 common in the OECD. The capital shortage of the past decade has contributed to the 41 43 problem, through a general deterioration of physical capital stock. 42 Subsidized trucking. Studies suggest that virtually all road damage is caused by heavy 44 43 trucks, which pay only a portion of the expense of building and maintaining the road 44 system. Many countries thus subsidize trucking compared with rail or barge transport, 27 28 1 probably increasing greenhouse emissions". I efficiency. The marginal managerial time required to make efficient energy decisions may 2 2 be small and focusing attention on this issue--when information is being freely provided , 1.5.3 Market Failures and Government Responses 3 through government and other sources-may thus yield private returns well beyond these 4 4 slight marginal costs. 5 Economists agree that governments can adopt policies to increase economic efficiency at $ 6 the same time that they reduce greenhouse emissions. For example, in some countries, fuel 6 Returns to Scale and System Effects (network externalities): Some technologies might be 1 prices do not reflect the full social cost of fuel burning: taxes can correct this market 7 economically attractive at a large scale of production, but not on the much smaller scale on 8 failure. There is less agreement about whether, given market prices, firms fail to take 8 which they might initially be adopted. Other technologies exhibit dynamic scale 9 advantage of all of the energy efficiency opportunities available to them. This controversy 9 economies: unit cost falls over time as a function of the cumulative output of firms or 10 underlies the bottom-up versus top-down controversy treated at greater length in Chapter 8. 10 industries. Technology "networks" may also affect diffusion rates. For example, cars and II Engineers have identified a host of seemingly profitable actions that would also save " trucks fueled with electricity, natural gas, methanol, etc., require a refueling infrastructure, 12 energy. Many economists, however, view this as evidence that the engineering analysis has 12 which itself competes for resources with the conventional fuel infrastructure already in 13 omitted characteristics important to consumers. 13 place". 14 14 IS The substantial differences in practices both within and between countries suggests scope 15 Building codes can be justified both in terms of these network externalities effects and in 16 for substantially increasing energy efficiency. Moreover, even best practices within a 16 terms of information failures. Consumers often have limited information concerning the 17 country may not put it at the technological frontier. In deciding whether to adopt a new 17 construction of their houses, and obtaining the information after the house is completed is IS production process, businessmen look only at the private costs and benefits. Many 18 often difficult. Even were they to be provided with construction details, they would have 19 technologists, however, conclude that even considering private costs only. firms should he 19 difficulty interpreting the implications. 20 undertaking many energy-efficiency improvements. This section attempts to reconcile the 20 21 different schools of thought by reference to information-based market imperfections, as well 21 Capital market imperfections. A major explanation of the difference between best-practice 22 as by the criteria by which businesses make decisions , 22 and actual-practice technology is that bottom-up models often compute cost-effectiveness 23 23 using a discount rate substantially lower than the cost of capital calculated by firms." 24 Information dissemination Acquiring information is costly. providing and disseminating information has many features of a public gond Stiglits 1988 Romer 19 190 Arrow In 24 Studies of implicit discount rates consistently show that households and firms use discount 25 25 rates substantially above market rate for long-term government bonds. 26 the absence of government intervention, there will be too little production and dissemination 26 27 of information. This is particularly true for information with widely dispersed impacts, as 27 Two explanations have been offered: I) Risk: Interest rates facing firms and households 28 opposed to information about, for example, the production of certain chemicals, which is 28 reflect the risk premium that lenders require to compensate them for the probability of 29 primarily of value to a few companies 29 default. Firms often use discount rates that include a risk premium to reflect the riskiness 30 Moreover, both theory and evidence support the view that markets. on their own, do not 30 of projects; 2) Capital constraints: Individuals and firms often face rationing in capital 31 provide an efficient level of disclosure of information". Indeed. some evidence indicates 31 markets, both for credit and equity. Recent research has provided a rationale for this 32 that markets may try to obfuscate relevant information." This provides the rationale for 32 rationing based on the fact that information is imperfect and costly. 33 government provision of information, or laws that in many countries require disclosure of 33 34 interest rates and other consumer-relevant information, including appliance energy 34 These capital market problems have one important implication: Models analyzing 35 consumption. 35 best-practice cost-effective technologies using discount rates lower than those typically 36 36 employed by firms will overestimate the rate of dissemination of these technologies and 37 Bureaucratic structure, limited scope of attention In recent years, economic and 37 underestimate the perceived costs (to the firms and households adopting these technologies) 38 organizational theory" has emphasized that large organizations are not, in general. run by 38 of mitigation strategies. 39 owners; that the managers, even with the best designed incentives, do not in general 39 40 maximize the firm's market value; and that one of the principal scarce factors within an 40 But these capital market problems raise three other questions: (1) Are firms rational in 41 organization is time and attention. How managers direct their attention has much to do 41 using such high discount rates? (2) Does the use of such high discount rates imply a 42 with what the firm does." The information disclosures noted in the previous subsection, 42 market failure? (3) If so, will government intervention improve on the market outcome? 43 as well as a number of other government programs focusing on energy efficiency in 43 44 consumer products, electric lights, and motors, help focus management attention on energy 44 Economists emphasize that an analysis of the costs and benefits of a project must Anaw KJ 1971 29 Essays in the They 1 Rish Bearing 30 N-H I separate four issues: timing, risk, capital constraints, and information. Discount rates are I of natural resources has no obvious definition. While most geologists would agree on the 2 only to be used for timing. Risk should be treated by converting costs and benefits into 2 size of coal stocks - their location is known and their in situ value can be estimated - this 3 certainty equivalents, then discounting costs and benefits for each year at the relevant ) cannot be said for oil or minerals". Second, environmental assets-such as air quality-- 4 discount rate." Higher risks should not result in higher discount rates." Similarly, 4 present another set of problems, because no market prices exist to value the asset. 5 capital constraints should be reflected in the shadow price of capital, not in the discount 5 6 rate." Because of limited information (and a version of the "winners' curse"") firms 6 Four approaches are commonly used to calculate changes in the natural environment , often require threshold rates of return significantly greater than the market rate of interest. , (Peskin and Lutz, 1990): $ In doing so, they may confuse time and information risk: that is, the rules of thumb firms I 9 use to evaluate investments may sometimes lead to market inefficiencies, including perhaps 9 a) The environmental expenditure approach, used recently in the United States, subtracts 10 in the area of energy-efficient technologies. 10 pollution abatement expenditures from GDP; 11 11 b) The physical accounting approach, used in Norway and France, establishes satellite 12 Even were firms to follow the economist's guidelines, in the presence of capital 12 accounts using physical units of measurement to account for flows and stocks of 13 constraints, market outcomes would not, in general, be socially efficient (i.e., they are not 13 resources; see box 14 constrained Pareto optimal.) There may be significant discrepancies between social and 14 c) The depreciation approach adjusts gross and net product by-subtracting out the value of 15 private returns to investment (even apart from the externalities associated with greenhouse 15 natural resource depletion Repello 1949; Serafy and 16 gases or technological diffusion.) This provides part of the rationale for possible 16 d) The comprehensive approach Uses both physical measures and value (Statistical Office 17 government interventions in capital markets." Though these capital market imperfections 17 the United Nations, 1992). IS imply that there is no presumption that market allocations are efficient. there is no IS 19 consensus that they lead to significant underinvestment in energy-efficient technologies in 19 Another measure of broad-based welfare, although not including environmental amenities,is 20 particular". 20 the UN's human development index or HDI (UNDP, 1990). The HDI gives a composite 21 21 measure of human development by combining three key indicators: longevity (measured by 22 1.5.3.1 Revising national accounts 22 life expectancy at birth), education (measured by adult literacy and mean years of 23 23 schooling), and income (real GDP per capita adjusted for purchasing power). Although the 24 Some have suggested revising the conventional systems of national accounts to 24 HDI is not directly related to global environmental issues, both climate change and 25 incorporate full social pricing of resources. An early contribution suggested a new 25 abatement policies may affect it". 26 measure of economic welfare based on consumption that increases quality of life (Tohin 26 27 and Nordhaus, 1972). These authors and others recognized that national income 27 1.5.4 Innovation 28 accounting, widely adopted after World War II, measures aggregate income and expenditure 28 29 flows, but does not incorporate environmental costs and benefits. 29 Standard competitive analysis argues that given all required Information and technology 30 30 market economies produce efficient outcomes. But recent economic analyses have shown 31 Conventional national income accounting does not fully report three categories of 31 that, in general, market economies need not result in the efficient allocation of resources to 32 resource expenditures: a) defensive expenditures, either for pollution prevention before the 32 information production and dissemination, and to innovation. The first of these issues was 33 fact or for cleanup after the fact (although these expenditures are not separately reported. 33 discussed earlier. The second is more complex. 34 they are counted in GDP); b) consumption of environmental goods (such as exhaustible 34 35 resources)"; and c) conflicting uses of environmental services (such as the atmosphere, 35 In the absence of intellectual property rights, firms would have less incentive to 36 used by producers as an input into production, and by households as a consumption good). 36 innovate. With standard patent terms, firms are not able to appropriate all the returns to 37 37 their innovative activity. Setting the optimal patent life involves balancing off the 38 One proposal would include in GDP the effect of changes in quality of the environment. 38 inefficiencies resulting from the exercise of monopoly power during the duration of the 39 In Eastern Europe and the former Soviet Union, steady increases in reported post-war GDP 39 patent (static inefficiencies) with the increased incentives for innovation. Largely 40 masked the effects of decades of environmental degradation; for part of that period, 40 because innovators seldom appropriate all of the returns to their innovation, there is a 41 environment-adjusted GDP almost certainly declined". 41 general consensus that markets provide insufficient incentives for R & D; and the greater 42 42 the spill-overs, the greater the undersupply." Since the spill-overs are likely to be greater 43 However, important conceptual problems in defining levels and changes of 43 the more basic the research, this suggests a role for government in subsidizing basic and 44 environmental assets, complicate the task of modifying national accounts. First, the stock 44 near-basic research. In the same way, the high cost of establishing intellectual property 31 32 I rights impedes the transfer of technology to developing countries. I can sell excess permits on the market and generate revenue." 2 2 Still, there is a general consensus among economists that the patent system provides a 3 While permits thus create a marginal cost of production related to the marginal 3 better basis of financing applied research than do government grants, largely because of 4 emissions, carbon taxes impose a tax directly on the marginal emissions. Both systems thus 4 difficulties government has in picking those most likely to produce high returns. The , force producers and households to face the true social costs of their actions". Permits are 3 question is, is there any reason to believe that any market failures, in terms of insufficient 6 better for regulating large sources; carbon taxes are better for small sources. In principle, 6 7 level of innovation, are worse in this area than in other areas, i.e. are there any special 1 both could be adjusted to achieve the desired level of emissions desired, although 8 grounds for arguing for government R & D subsidies, provided the government has $ adjustments of this sort are likely to be difficult in practice. 9 corrected energy prices to reflect the externalities generated? Obviously, in the absence of 9 such corrections, market incentives to provide energy saving innovations will be distorted, 10 The initial allocation of permits will largely determine the distribution of costs of 10 just as market incentives to adopt energy saving technologies are reduced". (Tradeable II abstement (Chapter 3 discusses these issues of equity at greater length), and at the same II permits have similar effects to corrective taxes, since firms will value reductions in 12 time influence the growth path of participants' economies. For example, an allocation 12 13 emissions from new technologies, since such reductions will require them to purchase fewer 13 based on population at a given date would provide an incentive for population control". permits.) 14 14 IS Imposing carbon taxes can have large distributive consequences. While a system of IS 16 Innovation is important, because it provides perhaps the best opportunity for low-cost 16 grants can largely offset these distributive consequences, such offsetting grants might well methods of reducing emissions. Several studies have confirmed the impact of accelerated 17 not be made. Providing tradeable permits equal to existing levels of emissions seemingly 17 deployment of advanced energy technologies on the future rate and timing of anthropogenic IS makes no firm or household a loser. But granting permits in that way represents effectively 18 19 climate change". 19 a grant of money (such permits have monetary value) in a way which may not well accord 20 with standard ethical principles. For instance, by embarking on an ambitious program to 20 21 1.5.5 Carbon Taxes and Tradable Permits. 21 reduce emissions, a firm may qualify for fewer permits than it would otherwise. Not only 22 does this violate ordinary notions of fairness, but anticipation of granting permits in this 22 Economic efficiency requires all agents in the economy to pay the full marginal social 23 way would, accordingly, have strong adverse effects on emissions". 23 costs of their actions. But firms and households are not charged for the additional warming 24 24 25 potential they add to the atmosphere, and so do not pay the full social costs they impose. 25 That a tax has large distributive consequences, while presenting a political impediment to 26 Two economic instruments can correct this market failure: carbon taxes and tradeable 26 its introduction, is not necessarily an argument against it. Some argue that those who failed 27 to pay the full social costs of their actions earlier are not therefore entitled to special 27 permits. 28 allotments now". 28 29 A tradeable permit scheme involves a determination of the total level of permits and a 29 distribution of the initial allocation, with emission levels for any firm limited to the number 30 Once one recognizes that the distribution of permits across countries will, inevitably, be 30 31 of permits held. The initial distribution may be made by an auction or allocation 31 decided by some principle other than current levels of emissions, then it becomes clear that 32 according to benchmarks (e.g. per capita as of a given date). or by historical emission levels 32 both taxes and tradeable permits will have distributive consequences. An agreement among 33 ("grandfathering"); alternatively, emission rights could be grandfathered in at current levels. 33 countries to impose uniform corrective taxes, with each country retaining its own revenue, and gradually shifted over to a per capita allocation as of a given date. 34 would have little redistributive consequences across countries and the burden of the tax 34 35 would, as noted earlier, likely be progressive. 35 36 Once permits are distributed among the regulated entities, a market is set up allowing 36 37 companies to buy and sell permits according to their plants' planned emissions. The cost of 37 Governments in the North might decide to use some of the revenues so generated to production then includes not only the costs of conventional inputs. but also the costs of 38 encourage activities (such as R & D directed at technology appropriate for developing 38 39 additional permits to offset additional emissions. Plants whose cost of mitigation is low 39 countries) that benefit the South, or to provide other forms of assistance. Decisions about will find it relatively easier to abate pollution rather than to buy permits. Plants with higher 40 this could be made bilaterally, or collectively. By contrast, decisions about how tradeable 40 41 costs of mitigation will have a greater preference for buying permits than for abating 41 permits would be allocated across countries would have to be made multilaterally. Arriving pollution. The price of the permits, which are artificially created scarce resources, is 42 at a formula for distributing these property rights may be far more difficult than arriving at 42 43 determined by the market. With the use of tradable permits, companies have an incentive 43 a tax rate and a procedure for its revision, as any such formula may entail substantial 44 to improve the efficiency of their production, thereby reducing their emissions level, as they 44 redistribution. 33 34 I 1.5.5.1 A Double Dividend? I 1.5.5.3 Tradeable Permit Markets. 2 2 , Revenues from carbon taxes may allow a reduction in distortionary taxes elsewhere in 3 In order for systems of emission permits to achieve reductions in emissions efficiently, 4 the economy. If the (compensated) elasticity of demand of labor is relatively high, and the 4 there needs to be a market for emissions across International boundaries. There is some 5 revenues from the carbon tax are used to reduce taxes on labor income, then there would be 5 debate about the role of government or international organizations in establishing a market 6 a double dividend from the carbon tax in the reduced dead-weight loss from the labor tax. 6 for such emissions. While some believe that there are private incentives for the , which would otherwise be significant. 7 establishment of markets, others contend that government can play a key market facilitation 8 8 role through establishing centralized clearinghouses for information or even provide for 9 At least three objections have been raised to this idea. First, conceptually: rationalizing 9 permit banking (storage) or brokerage (trading) to facilitate trades between private parties. 10 the tax system by reducing the most distortionary taxes is certainly a worthy goal. but 10 These services would prove especially useful in the more complex international context. " should not be confused with imposing a carbon tax; neither implies the other. Second, II 12 empirically: if the (compensated) labor supply elasticity is relatively low. then the dead- 12 1.5.5.4 Combining taxes with tradeable permits 13 weight loss form the labor tax is low, and the commensurate welfare gain is reduced. 13 14 Third, politically: if carbon tax revenues are used to offset the existing deficit, rather than 14 While carbon taxes and tradeable permits are typically presented as alternatives, policy 13 to reduce taxes on labor and capital, then the carbon tax acts more like an ordinary tax 15 makers may prefer to combine them. The major disadvantage is the additional 16 increase, increasing distortions from taxation to pay for budget items with a lower return 16 administrative cost. The advantage is more subtle: the market value of tradeable permits is 17 than the extra burden imposed. The gains to total welfare (reductions in dead-weight loss) 17 reduced as taxes increase. With an optimal carbon tax, and with a tradeable permit supply IS depend on the welfare losses associated with these other distortionary taxes, as well as the 18 set equal to the optimally chosen level of emissions, the price of a permit should be zero. 19 cross-elasticities of demand between carbon and other taxed commodities". 19 More generally, the greater the tax, the less the value of a permit (for a fixed supply of 20 20 permits): and thus, the less the distributive consequences of alternative rules for allocating 21 Even though carbon taxes may have 8 positive effect on economic welfare, they can at 21 the initial endowments of permits. Another possible combination is permits for large 22 the same time have a negative effect on measured economic growth. since those measures 22 sources and a tax (set to equal the permit price) on small sources. 23 typically do not include the value of environmental degradation Researchers differ on the 23 24 size of the loss. The wide spread in the numerical results, however, should not obscure 24 1.5.5.5 Intertemporal patterns of taxation 25 agreement among researchers on a number of important points. All models used in the 25 26 major comparison studies to date have projected: first, that intervention would be required 26 If the target is the long-run atmospheric concentrations of greenhouse gases, then climate 27 to achieve the emissions largets; second, that the size of the required tax increases with the 27 change damages will be approximately the same for emissions in any particular year, 28 stringency of the carbon limit; and third, that the size of the appropriate carbon tax varies 28 although the optimal carbon tax must be adjusted for differences in costs, discounting. and 29 over time, even for the same emissions or concentration target". 29 risk". The focus on concentrations also implies that early reductions are more valuable 30 30 than later reductions. 31 1.5.5.2 Energy Taxes 31 32 32 For exhaustible natural resources, such as oil, economic efficiency requires that those 33 Energy taxes as a means of controlling greenhouse emissions must be viewed as "second 33 deposits with the lowest cost of extraction be extracted first. Hotelling (1931) argued that 34 best" taxes in that they do not directly tax the externality, greenhouse emissions. While 34 competitive equilibrium implies that rents (price minus costs of extraction) must rise at the 35 carbon taxes directly penalize the externality-generating activity, less targeted alternatives. 35 rate of interest. The price of the backstop technology (an energy source assumed to be 36 such as energy taxes, may be politically more acceptable. Carbon taxes reduce emissions 36 available in unlimited quantities at a certain price after a certain date, such as electricity 37 first, directly, by moving up the demand curve; second, indirectly. by encouraging 37 from solar photovoltaic cells) determines the set of resources to be ultimately exploited, i.e. 38 consumers to switch to less carbon-intensive energy sources. On the other hand. energy 38 all resources for which the cost of extraction is less than the price implied by the backstop 39 taxes work through the first path, by reducing total energy consumption. But to the extent 39 technology's price. Thus, it is the tax on oil or gas at the date of switching to the backstop 40 that certain kinds of energy, like hydroelectric, have, at least in the short run, a relatively 40 technology which determines the ultimate amount of oil and gas that will be extracted, and 41 inelastic supply, a major impact will be on oil, gas, and coal; and to the extent that oil and 41 thus the total burden of CO2 placed on the atmosphere by oil and gas. If that were the 42 gas supplies are best described by a model of an exhaustible natural resource, with 42 only matter of concern, one could imply announce a commitment to impose such a tax 43 relatively low extraction costs, most of the supply reduction will occur in coal. Thus, 43 sometime in the future, when relevant backstop technologies become available and 44 indirectly, there will be a considerable amount of switching, through the indirect effects. 44 competitive. That announcement would, if believed, have an immediate effect on current 35 36 I captured by special interest groups". I prices. 2 2 3 Figure 3 shows the dynamics of exhaustible resources. S denotes the total available 3 stock of gas and oil. S. represents the amount of stock left in the ground. a function of the 4 1.6 SUSTAINABLE DEVELOPMENT 4 , "backstop" price. Imposing a uniform emission tax lowers the cut-off price, and flattens the , price curve. The effect on current price depends on how close the current stock is to 6 The concept of sustainable development was formulated about 1980 as a response to the 6 , economic exhaustion (S,). Given the currently high levels of rent, it is probable that the net 7 apparent conflict between environmental concerns and the need for economic growth, 8 current effect on producers is to raise the producer price, not lower it. Thus, short-run 8 especially in developing countries. At the time, preserving biodiversity and maintenance of 9 9 leakage effects will be the opposite of that predicted in many models. environmental quality seemed incompatible with a 5- or 10-fold increase in world output, as 10 would be necessary if per capita incomes of the South were eventually to approach those of 10 " the North now. The sustainable development debate rekindled interest in the question of II 1.5.6 Regulatory Approaches 12 resource scarcity, originally addressed in the economics literature by Malthus (1798), and 12 13 Regulation of greenhouse emissions may take many forms, including fuel restrictions, 13 revived in the policy arena with the publication of Limits to Growth (1972). A variety of technology standards, and various economic incentives; Chapter II discusses these options 14 definitions of sustainable development have been proposed. The Bruntland Commission 14 in detail. Economists have long argued for the use of economic incentives for 15 offered this interpretation: 15 environmental management, although governments have so far relied on traditional 16 Malthos Principle Penulation Lorder McMollan 16 regulations almost exclusively. as traditional approaches have been more acceptable to the 17 Sustainable development is development that meets the needs of the present without 17 IS public and industry. For example, Corporate Average Fuel Economy (CAFE) standards in IS compromising the ability of future generations to meet their own needs". 19 19 the U.S.A. require automobiles to meet certain mileage standards. 20 Although the Commission clearly had in mind environmental considerations, its report did 20 Proponents of the traditional approaches often claim that these approaches "force" 21 not spell out exactly what sustainable development included. The Interamerican 21 technology. with less redistribution than forcing technology through taxes Thus, if 22 Development Bank explicitly included environmental concerns in its formulation: 22 23 23 automobile makers are required to attain a certain mileage standard. they will meet the 24 standard; on the other hand. gasoline taxes might have to rise significantly to reduce fuel 24 [Sustainable] development distributes the benefits of economic progress more equitably, consumption by the same amount. Evidence for the claim of technology forcing. however, 25 protects both local and global environments for future generations, and truly improves 25 26 is equivocal. In several cases in which industry failed to meet the applicable standards. 26 the quality of life. 27 regulators withdrew the standard in the face of unacceptably high economic costs The 27 apparent advantage of technology forcing one large club instead of the subtle and 28 1.6.1 The Economic Concept of Sustainable Development 28 continuous incentives provided by market forces - is often in fact a disadvantage. 29 29 30 Although sustainable development began as an ethical principle, it is at the same time 30 31 Other disadvantages to the traditional approach are: First, traditional regulations do not 31 an economic concept, focusing on two issues: 1) intertemporal equity and 2) capital in general result in economic efficiency, since those in one sector face implicit or explicit 32 accumulation and substitutability. 32 33 incentives at the margin that differ from those in other sectors. Second. traditional 33 regulations fail to account for offsetting private responses that may neutralize the 34 Intertemporal equity. Robert Solow's definition (Solow 1992), which focuses on 34 regulation's intended effects and even cause environmental harm. Third, traditional 35 intertemporal equity, has enjoyed wide currency among economists: sustainable 35 regulations provide no incentives for exceeding the given target, even when doing so might 36 development requires that future generations be able to be at least as well off as current 36 37 result in little additional cost". 37 generations. The central implication is that any environmental degradation should be offset 38 by increases in capital stock sufficient to ensure future generations at least the same 38 Traditional regulations that focus on inputs and technology rather than outputs have the 39 standard of living. Sustainable development does not preclude the use of exhaustible 39 40 further disadvantage of not directing research toward meeting performance objectives at 40 natural resources, but requires that any use be appropriately offset. least cost. For instance, when stack gas scrubbers are required, research will be directed at 41 41 42 producing scrubbers at least cost, rather than reducing emissions at least cost. Hence. a 42 In practice, sustainability as defined by Solow provides few constraints on growth paths dynamic inefficiency is added to the obvious static inefficiencies. Finally. because of the 43 for the developed countries, so long as steady increases in productivity continue. Technical 43 nature of the regulatory process, traditional regulatory designs are more likely to be 44 change alone, without further capital accumulation, may well sustain future living standards 44 38 37 I and offset any effects of environmental degradation. To see this with a numerical example, I following statement on sustainable development and the environment introduced during the 2 note that even if estimates of adaptation costs are taken to be I to 3 percent of GDP should 2 INC negotiations in 1991: 3 significant warming occur, and if even moderate rates of technical progress of I to I 5% 3 4 per annum continue to occur, then future generations 45 to 70 years from now will have 4 Protection of the global climate against human-induced change should proceed in an 5 twice the income of the current generation. Even with no discounting. it would be hard on 5 integrated manner with economic development in light of the specific conditions of each 6 this account alone to justify the sacrifice of further consumption by this generation in order 6 country, without prejudice to the socio-economic development of developing countries. 7 to enhance the standard of living of the future generation. , Measures to guard against climate change should be integrated into national 8 8 development programmes taking into account that environmental standards valid for 9 Capital accumulation and substitutability. To what extent can technology. skills, and 9 developed countries may have inappropriate and unwarranted social and economic costs 10 capital equipment substitute for a decline in exhaustible resource stocks or a decline in per 10 in developing 11 capita environmental amenities? Solow's definition, and much of economic theory to date, II 12 implicitly assumes that substitutes exist or could be found for all resources. As formulated 12 13 by Pearce (1988), if substitution possibilities are high, as most evidence from economic 13 1.7 CONCLUSIONS seep. book 14 history indicates, then no single resource is indispensable, and intertemporal equity stands 14 15 as the only crucial issue. If on the other hand, human and natural capital are complements 15 Climate change presents the analyst with a set of formidable complications: large 16 or only partial substitutes (e.g., if because of the irreversibility of extinction' capital 16 uncertainties, the potential for irreversible damages or costs, a very long planning horizon, 17 accumulation is only a partial substitute for biodiversity) then different classes of assets 17 long time lags between emissions and effects, an irreducibly global problem, wide regional 18 must be treated differently, and some assets are to be preserved at all costs. 18 variation, and multiple greenhouse gases of concern. The risks of climate change are " 19 highly asymmetrical, with a large probability of a small loss, and a small probability of a 20 Pearce (1992) distinguished between strong and weak sustainability. Weak 20 large loss. Even in the presence of significant uncertainty, this asymmetry, plus the 21 sustainability-requires that any depletion of natural capital be offset by increases in human- 21 principles of risk aversion and portfolio balancing provide the rationale for going beyond 22 produced capital the Solow criterion - or by the substitution of other forms of natural 22 no-regreis policies to those that incur net costs. 23 capital, such as renewable assets in place of nonrenewable assets. Strong sustainability 23 24 requires that some natural capital, being irreplaceable, must be preserved". It has been 24 The atmosphere is an international public good, in that all countries benefit from each 25 argued that there are no close substitutes for the atmosphere and the climate it produces, 25 country's reduction in greenhouse emissions; greenhouse gases are an international 26 implying no substitution possibilities and hence the need to preserve the atmosphere 26 externality, in that emissions by one country affect all other countries to the same extent. 27 27 28 1.6.2 Implications of Sustainable Development for Developing Countries 28 Both public goods and externalities require a legal framework within which the 29 29 problems they pose can be addressed. No such legal framework now exists for global 30 In many developing countries, Solow's definition would not be viewed as 30 climate change. Mechanisms for control of international public goods may include the 31 acceptable, since it seems to place no weight on their aspirations for growth and 31 definition of property rights, the definition of limits to emissions and a consensus for 32 development. Developing countries have also implicitly criticized the debate over 32 distributing the same in a fair and equitable manner. If, on the other hand, each agent acts 33 substitutability for the same reason: if some natural assets must be preserved at any cost, 33 in its individual interest, the result will be too little of the public good and too much of the 34 then there may be no trade off with development. A leading spokesman for the G-77 has 34 externality. 35 emphasized the importance of economic growth in achieving sustainable development: 35 36 36 Climate change demands a decision process that is sequential, can respond to new 37 None of these linked [development] issues can be resolved unless and until there is 37 information with mid-course corrections, and can include insurance, hedging, and the option 38 broad-based development in the South. Only such broad-based development can 38 value of alternative courses of action. The challenge today is to identify short-term 39 provide the foundation of international security. The Northern approach is to attack the 39 strategies in the face of long-term uncertainty. The question is not, what is the best course 40 symptoms, with a residual emphasis on poverty eradication. But the international 40 over the next 100 years, but rather, what is the best course for the next few years, knowing 41 community must insist on addressing the underlying causes for concern. Development, 41 that a prudent hedging strategy sill allow time to learn and change course. 42 environmental protection, peace, and security are indivisible 42 43 43 Policy measures to reduce risks to future generations include 1) immediate reductions 44 Similarly, the G-77 and China emphasized the need for economic growth in the 44 in emissions; 2) R&D on new supply and conservation technologies; 3) continued research 39 40 I on how much change is likely and what its effects will be: and 4) investments to assist in I 2 adaptation if significant climate change occurs. A well-chosen portfolio of policies will 2 1.8 ENDNOTES 3 yield greater benefits for a given cost than any one option undertaken by itself. Striking the 1 4 appropriate balance requires taking into account costs, benefits, and risks. I I.A warmer climate would directly affect the temperature-sensitive sectors of the economy: agriculture, forests, 6 and fisheries; and construction. Because of the risk of drought, arid and semi-arid regions are likely to be most 5 7 vulnerable to warming. A warmer climate may also encourage insect populations; this, in turn, is likely to 6 In an interrelated global economic system, an attempt to reduce greenhouse gas $ decrease agricultural yields in some regions. On the other hand, increased CO2 concentrations increase 7 emissions in one region or one sector of the economy may be offset by increases in other 9 photosynthesis and the effect of water consumption in controlled settings, and may also do so in farmers' fields, $ regions or sectors. This may occur through a) the loss of comparative advantage in the 10 increasing crop yields. 9 carbon-intensive sectors of the regions that limit emissions; b) the relocation of industries; 11 or c) changes in world energy prices and the resulting shift in consumption. Any control 12 A warmer climate would hurt agriculture in some regions and help in others. Recent global studies find that 10 13 Northern temperate regions could benefit, particularly for small increases in temperature, but low latitude areas II strategy must account for these global effects. 14 could lose. The global studies show significant losses from climate change alone that are significantly offset by 12 IS the direct beneficial effects of higher ambient levels of carbon dioxide on plant growth. Reilly, et (1993) 13 Issues of efficiency and equity can largely be separated. The Framework Convention on 16 calculate that global agricultural production will increase for global mean warming of up to 2°C. 14 Climate Change calls on all parties to implement cost-effective measures for abatement, 17 Most analysts expect that agriculture can adapt without significant added costs for the world as a whole (although enhancement of sinks, and adaptation. The Framework Convention also explicitly requires IS some regions will suffer greater-than-sverage losses), in part because of crop shifting and other adaptation by 15 an equitable sharing of the burdens of response, recognizing the common but differentiated 19 farmers. Trade in international commodity markets (Ausubel, 1990; Rosenzweig and Parry, 1994; Reilly, 16 20 Hohmann, and Kane, forthcoming: Kane, Reilly, and Tobey, 1992) can ensure that agricultural prices change only 17 responsibilities of the parties. Different countries will be affected differently by climate 21 moderately, though particular regions may gain or lose significantly. IS change and by policy responses to it. The South is more likely to be adversely affected 19 than the North: moreover, developing countries often lack the financial and technical 22 2.A warmer climate implies both a poleward movement of forests and changes in forest composition. The result 20 resources to respond. The Framework Convention does not, however, include a formula for 23 would be to increase boreal forests and, by a smaller percentage, to decrease tropical forests. On balance, doubling 24 CO2 concentrations would modestly reduce both standing biomass and forest area (Sedjo and Solomon, 1989). 21 sharing the costs of addressing climate change. 25 Some analysts also calculate an additional temporary decline in forest cover during the transition to a warmer 22 Efficiency requires that emission reductions occur where their cost is lowest, 26 climate EPA, 1989). this decline could last for several hundred years, as more forest death occurs on southern 23 27 edges than additional growth occurs on northern edges. Higher CO2 concentrations might also increase tree 24 irrespective of who bears the financial responsibility Efficiency calls for removing energy 1 28 growth, partially offsetting direct losses from warming. 25 subsidies, reforming and clarifying property rights that affect energy use and carbon 26 storage, and reducing non-greenhouse externalities that have the side benefit of reducing 29 3.Some analysts conclude that a warmer climate would significantly reduce water supply (Gleick, 1987). Most 27 greenhouse emissions. Efficiency may also be promoted, and greenhouse emissions 30 climate models now predict hotter and drier weather for the mid continents (IPCC, 1990a). If this occurs, the 28 reduced, by better information dissemination and by addressing capital market imperfections 31 downward pressures on water supply will be intensified by upward pressures on water demand. that inhibit the adoption of energy-efficient technology. Dynamic analysis indicates large 32 29 33 Because of the key role of local conditions, further generalizations are difficult. River basin runoff is the 30 potential gains from flexibility in timing of greenhouse reductions to allow for the 34 difference between precipitation and evaporation plus absorption (IPCC, 1990a). Hence small variations in these 31 economical turnover of capital stock, and to allow time for the development of low-cost 35 three terms-each of which depends on the accuracy of regional climate forecasts-can make a large difference 32 substitutes. Policies that promote efficiency by requiring nations to face the full costs of 36 in the runoff. 33 their actions will also address equity concerns. 37 34 Efficiency also calls for international mechanisms such as joint implementation and 38 4. A warmer climate implies reduced heating costs and greater cooling costs. AI least for countries in 35 36 coordinated economic instruments. Coordinated carbon taxes and tradable carbon emission 39 temperate and cool climates, this would move the population-weighted average temperature closer to the ideal 40 indoor temperature. Nordhaus (1991) finds that warming of approximately 3.0°C in a 1981-sized U.S. 37 permits can correct the market failure associated with greenhouse emissions. 41 economy will increase electricity costs by $1.65 billion and decrease heating costs by $1.16 billion (1981 42 dollars). resulting in net costs of $0.49 billion. Rosenthal, Gruenspecht, and Moran (1994) find that global 43 warming lowers the cost of heating and cooling in the U.S.. Cline (1992) finds net costs of $9.9 billion. 44 45 5.Global mean sea level appears to have risen 10-20 cm over the past century Warrick, Oerlemans of al., 1990) 46 The IPCC has projected a warming-induced rise in mean sea level of 21 to 71 cm by 2070 (IPCC, 1990a). sharply 47 reduced from estimates of 3 to 8 m. made in the early to (Schneider and Chen, 1980> Hoffman et al., 48 1983; Hoffman et al., 1986). which assumed a disintegration of the West Antarctic Ice Sheet. The current "best 41 42 All 8/15 draft I estimate" for mean global sea level rise by 2030 under "business as usual" is 18 cm (Warrick, Oerlmans at of I 12. Scientists have proposed several methods to measure the warming potential of different greenhouse gases 2 1990; Reper-er al., 1990) 2 (IPCC Special Report 1994). Although global warming potential (GWP), endorsed by the IPCC, is a useful 3. Wisky 3 concept in formulating comprehensive approaches to greenhouse mitigation policies (Stewart and Wiener, 4 A rising sea level could inundate some small island nations, flood some low-lying coastal cities (eg in 4 1990), some analysts have recently criticized the concept on the grounds that GWP implicitly sets the 5 Bangladesh), damage coastal farmland, and contaminate water supplies (IPCC, 1990a) More severe storms , opportunity costs of an increment in radiative forcing equal for all periods in the future (Schmalemse, 1993). 6 would accelerate coastal erosion and affect aquifers, intensifying problems existing today. Warmer oceans might 6 If all greenhouse gases had the same rate of decay, then this problem would not arise. 7 damage coral reefs, a natural defence for some coastal areas. To account for the costs of protective measures, 8 the costs of defending the world's developed constlines against 8 I - rise over the next 100 years have been 7 , 13. Although forests cannot be expanded Indefinitely, and thus increased carbon sequestration is not a permanent estimated to range from 0.01% for the former USSR to 0.74% for Indian Ocean small islands, with a world 8 solution to increasing greenhouse gas emissions. 10 average of 0.028% of GNP per annum (IPCC, 1992). 9 II 6. Some analysts believe that the justification for costly and more restrictive actions rests on Intangible costs 10 14.Advances is cost-benefit analysis have allowed the introduction of risk and equity issues in a systematic way. 12 (Nordhaus, 1993). Intangible refers to the difficultly to measuring, and include migration, comfort, health, 13 leisure activities, urban infrastructure, and air pollution (Fankhauser 1992; Cline 1992). A warmer climate II 15. Frank Knight's often-quoted distinction separates risk, for which the probabilities of different outcomes-are 14 would Improve human comfi " in cold areas, and in the winter generally, while decreasing comfort in warm 12 15 areas. Means of al (1984) calculate a threefold increase in best waves for a 1.7 degree C. rise in U.S mean 13 known, from uncertainty, in which either they be unknown, Boston: or some potentjal putcomes are not specified. Ref. Knight, Frask, 1924 Risk. Uncertainty. and Profit 16 temperature It is not yes clear whether net comfort will rise or fall for a given rise in temperature. Chapter 17 6 covers these issues in more detail. 14 16. This division of responses is from Nordhaus (1994) 18 7 Both the natural rate and human contribution to the process of species less are difficult to estimate (EPA, 1989) 13 17. While most insurance markets do not reduce overall risk, there are a few exceptions: fire insurance companies, 19 Predicting the effect of clamate change on species distribution - more difficult will The magnitude and even the 16 by requiring commercial buildings to install sprinklers, do reduce the overall level of losses. 20 sign of these intangibles remains - dispute, for uncertainty about the duration and type of environmental changes 21 that would be caused by climate changes make the long-term projection of species change highly complex 17 IS This assumes decreasing absolute risk aversion (about which there is a general consensus). Even if northern 22 Moreover, while some species may have difficulty adapting to chmetic changes, opportunities for other species 18 countries were adversely affected. so long as the adverse effects were proportionately smaller, then, assuming 23 that otherwise may have become extenct may open up Population pressures have added to pressure on 19 decreasing relative risk aversion (about which there is less consensus), the north would be in 8 position to insure 24 ecosystems, particularly in the third world Climate change may exacorbase these damages, particularly IN Africa 20 the south 25 where environmental degradation has been particularly pronounced during the last 11 years (UN. 1989) 21 22 Insurance contracts may also be created because of differences in judgments concerning the probability of the 26 8. A warmer climate might also increase climate variability. though clamatologists cannot say with assurance 23 insured event occurring. This suggests the potential of an important principle to be invoked in future international 27 whether climate will become more or less variable dealy and seconnally The normal variability of existing 24 negotiations/agreements: countries that believe that the risks of climate change are low, and are therefore 28 climate also makes it difficult to detect any warming that might be occurring The "signal to none" problem 25 seemingly unwilling to take strong actions to mitigate these risks, ought to be willing to provide insurance against 29 makes it possible for observers to mistakenly consider a normal extreme event as evidence of . trend, or to 26 climate change at low cost (since it has, from their perspective, an actuarially low value). (See below for a 30 fail to see B trend in a noisy date series. Because of the signal-to-more problem. the scientific community n 27 discussion of problems of enforce.) (Heal and Chichilnisky **date, reference**; carlier, Stiglitz date ** on 31 unable to indicate confidently whether extremely warm years of the 1980's are evidence of climate change or 28 social risk bearing.) 32 not (IPCC 1992, A. Solow 1992). 29 30 Insurance markets, if appropriately designed, would have one further advantage: some of the losses associated 33 9:Recent ice core data from Greenland points to earlier temperature rises of several degrees occurring within a 31 with climate change are easily avoidable, e.g. construction of durable ocean-front bouses. Insurance firms work 34 few decades (IPCC 1994): reasons for these sudden changes are still not understood, but might have come from 32 hard to mitigate the losses that are incurred. Either the insurance should be based on exogenous events (e.g. not 35 changes in deep ocean currents. The other side of this debate holds that on the whole the biosphere is 33 on the dollar losses incurred, but on the rise in the sea water), or the insurance companies should be given broad 36 homeostatic or self-correcting: this "Gais hypothesis" compares the biosphere to 0 living being once moved away 34 discretion to require the insured to undertake actions to mitigate losses. 37 from equilibrium, self-correcting forces naturally move in back to equilibrium (Lovelock, 1979). The two 38 hypotheses are not necessarily Inconsistent. Within a range of variation, homeostatic properties could dominate, 35 19.Chapter 6 provides estimates of expected regional damage. 39 even if stability was not guaranteed outside that range. 36 20.1n the absence of such rec-irements, moral hazard problems arise. It may be desirable to focus government 40 0.Countries make century-long choices implicitly. as when they choose population policies, policies affecting 37 intervention not on the primary insurance market but on the reinsurance market. See recent U.S. government 41 long-term capital formation and productivity growth, or protection of environmental assets 38 enalysis of the market failures and the design of appropriate responses to those market failures in insurance 39 markets for natural disasters. 42 11. Although bargaining theory has contributed some basic principles, such as the importance of threat points. 40 21. Computer modelers participating in the Energy Modeling Forum examined an "accelerated R&D" 41 scenario in which the cost of nonelectric backstop falls from $100 to 50$ per barrel of oil equivalent, and the 42 cost of the electric backstop falls from 75 to 50 mills per Kwh. The four models used were remarkably 43 consistent in their estimates of economy-wide costs, reporting GDP losses falling by 65 per cent for the 20 43 44 I percent emissions reduction scenario (EMF 1993) - 34.Although for counter examples to the received wisdom see Coase (1990). 2 22. For example, low-lying states may suffer permanent damage. 2 5.Formally. if A measures the quality of the atmosphere, then each individual's or country's welfare, U, is 8 3 function of its own consumption, C, and the shared public good, A: U (C, A). This does not mean that all 3 23. Weitzman et al. (1981). cited in Lind (1993). make these points in formulating . sequential decision strategy 4 individual's (country's) value changes in A the same; that is may differ in magnitude, and 4 for developing synthetic fuels. 5 even in sign. 5 24.Manne and Richels, Nordhaus, and Peck and Teisberg all report a high value of information on and 6 36.Although there may also be trade-offs: reducing those gases that contribute most to local pollution may 6 in their computer simulations. in addition, also reports a high value to information on , sometimes be at the expense of increased emissions of greenhouse gases. F.Y. 1881 Londonic Kegan Paul +6. 7 25.Richels and Edmonds (1993) provide a demonstration of this proposition; they calculate relatively low costs 8 37.This kind of optimization problem was first studied by Edgeworth Mathematical Psychics ( The 8 for stabilizing co, concentrations if flexibility in timing is allowed, compared to capping and stabilizing 9 importance of incentive effects for the analysis of distributional issues was first emphasized by Millices (1971) , emissions to achieve the same atmospheric concentration. 10 and Fair (1970). There are, obviously, important Incentive effects: if the LDCs were able to classify any 11 expenditure that had some effect on mitigation as a mitigation expenditure, with the cost bome by the developed 10 26. Alternatively, the Kaya identity may be written 12 countries, they would have an incentive to undertake excess expenditures of this type. The GEF (Global II 13 Environmental Facility) directly addresses this issue, by only providing funds for incremental costs, that is those 12 Growth rate growth rate decline in energy emissions 14 costs that go beyond what would have been the efficient level of expenditures ignoring the public good benefits 13 of CO2 emissions of output per unit output per und energy use 15 of greenhouse gas mitigation. 14 15 That is. CO2 emissions will not rise as long as output grows no faster than the combined decline in energy 16 38 The importance of the assumptions of the absence of transactions costs, including the presence of perfect 16 intensity per unit of production and CO2 emissions per und of energy use This formulation applies most usefully " information, has only gradually come to be recognized See Farrell I Stiglitz (1988) for an elementary 17 to the developed countries IS textbook treatment. 18 27. Chapter 8. "Evaluating the Costs of Mitigation," treats the important issue of inertia and technology 19 39 That is, for instance, it makes no difference whether smokers or non-smokers are given the property rights to 20 air. Whether smokers value smoking more or less than non-smokers value clean air will determine whether 19 28 Note that energy efficient development packs for developing countries have been proposed (Goldemberg and 21 smoking occurs. How property rights are assigned does make an important difference for the distribution of 20 Reddy 1988). 22 welfare. Coase's result that outcomes are unrelated to the initial assignment of property rights obviously ignore 21 2) potentially Important income effects. 24 22 29. That is, for conventional exhaustible resources, there is 0 stock. $ Welfare depends on flows out of the stock 25 A slight extension of this perspective says that social scientists should simply describe the outcome of the 23 each year: 26 bargaining process by which property rights are assigned. Beginning with the important work of Nash a 24 UKS, S. S,- S,......). where S, is the stock at the end of period I 27 variety of bargaining theories have been developed, most of which emphasize the Importance of threet 25 28 points"-the outcomes which arise in the absence of a bargaining agreement- to the determination of the eventual 26 Here, welfare depends directly only on the stocks, though indirectly, through the effects on consumption, on 29 outcome. In this case, the fact that the net losses of many developed countries may be limited relative to those 27 emissions, which affect the change in stock: 30 of many of the less developed countries suggests a bargaining solution in which much more of the costs of 28 31 mitigation are bome by the less developed countries than under the "social welfare function" allocations described 29 U(S_C,(S, - S.),S,,C,(S,- S,) S, C,(S,, 32 earlier. 30 30. Even when the flow exceeds the long-run sustainable level, it will not be optimal to reduce the flow 33 40.For small taxes, these are "compensated" taxes, and have no welfare effect, though they have a substitution 31 instantaneously, unless - or even when - there are zero costs of adjustment. 34 effect, and therefore do reduce pollution. 32 33 For the atmosphere, a sustainable stock of greenhouse gases means stable concentrations Current emissions are 35 41.The loss in welfare (ignoring the benefits from reduced greenhouse gas warming) are the Harberger triangles, 34 estimated to be about twice emissions consistent with stable concentrations. 36 and can thus be shown to be proportional to the product of the elasticity of demand for energy and the share of 37 energy in national output. Since poorer countries are likely to have less access to alternatives which increase the 35 31. Postponing action may lead to some irreversible damages, for example the flooding of low-lying states. 38 elasticity of demand, and since the share of energy is larger in richer countries, the burden of the tax is 39 progressive. 36 32. This is not quite correct, since price affects Incentives for exploration, and some marginal wells would not 37 be drilled if oil prices fall too low. 40 42. The polluter pays principle endorsed by the OECD is exclusively prospective. 38 33. For analyses of market and optimal responses to uncertainty about the arrival of backstop technologies, see 39 Dasgupta, Gilbert, and Stiglitz and Desgupts and Stiglitz Nash, J.F. The Bangaming Problem. "Exametrica 155-62. 18, 45 46 I 43.Using either an egalitarian social welfare function approach, or a Rawlsian analysis "behind the veil of I 2 ignorance" (Rawls 1971) leads to the rejection of the "polluter pays principle Since al the time the relevant 52. Only a few models take into account international capital flows. Thus, most models do not address issues 2 ) actions are taken, the polluter is not cognizant of the effects, such fees have no incentive effects, but rather appear of industry relocation (McKibben and Wilcoxen, 1992). Chapter II provides a more complete discussion on 3 4 as random taxes, lowering each person's expected utility, and in particular the expected utility of the worst-off leakages. 5 individual. 4 6 53. In the case of production of highly substitutable commodities, carbon leakage will, of course, be much greater. , 7 There is a further ethical issue: ascertaining who the true beneficiary of escaping paying for the pollution is 8 generally difficult. It need not be the individual, firm, or country actually engaging in the externality generating 6 9 activity; in competitive markets, when firms are not charged the full social costs of production, product prices 54. Whether taxes in fact have this effect depends in part on the shape of the demand curves. With intertemporal , 10 will fall, giving consumers 8 substantial fraction of the benefits separability in demand curves and constant elasticity, with no backstop technology, a constant ad valorem tax has I no effect on the pattern of consumption. 11 9 44. Manne and Richels (1992) show that, under the IPCC emissions scenarios, even the most drastic controls on 12 10 emissions from developed countries would be insufficient 10 stabilize greenhouse concentrations without some Coal presents markedly different issues, not so much because of its greater emissions per unit energy, but because 13 II means of controlling emissions from developing countries. of in higher cost of extraction to price ratio. Lowering producer prices may result in less coal being consumed, 12 provided alternative energy sources become available. Thus, taxes on coal are likely to have significant general 14 13 Public goods exist when property rights are not or cannot be clearly assigned. The atmosphere is an equilibrium as well as partial equilibrium effects; the increase in the price of coal will lead to a substitution of 15 14 international public good because assigning property rights to the atmosphere is difficult for one nation acting gas and oil. If alternative energy sources are not available, such policies will only affect the intertemporal timing 16 15 alone, and particularly difficult when many sovereign states must agree among themselves. Tradable greenhouse of coal consumption (given the much more limited resources of gas and oil). But even that might be of some 17 16 emission permits, discussed below, attempt to resolve the problem by explicaly assigning property rights to value in reducing long run greenhouse gas emissions, as the ability to extract energy from coal may increase 18 17 greenhouse emissions significantly over time. Analyzing the optimal intertemporal structure of taxes, to minimize long run ambient 19 IS levels of greenhouse gases, taking into account both intertemporal substitution and substitution across energy 19 sources, is a complicated technical issue, that to due has not been adequately analyzed. 20 46 See Abrew 20 55. United Nations Conference on Environment and Development, Framework Convention on Climate Change, 21 21 47. In some cases, equity considerations may prevent Couse (1960). in hrs discussion of externalities, emphasized May 9, 1992. 22 the separability between efficiency and equity issues Though there have been several important qualifications 23 22 to Coase's conjecture, emphasizing the importance of public goods, imperfect information, and transaction costs 56 The most difficult problem is posed by those investors who invested in these resources, on the basis of one 24 (see Farrell 23 Stiglitz (1988)). still, the basic ensight remains applicable here regime (where these resources were not taxed). Do they have any special claim to compensation for a "change 24 in regime." Changes in demands and supplies occur for virtually all resources, and are an inevitable part of the 25 48. Chapter 7 discusses this issue at greater length 25 risks in investing. While most economists would argue that arbitrary and capricious changes in policies contribute 26 to business uncertainty, and therefore have an adverse effect on economic growth, reasoned changes in policies 26 49. These concerns are not just theoretical possibilities, as the following two examples illustrate Assume that 27 in response to changes in information are an inevitable part of the business risk. 27 the North imposes high energy taxes, but the South fails to do so Energy intensive industries, such as aluminum, 28 migrate from North to South. But energy efficiency in the south is much less than in the north, so that the total 28 57. For example, some U.S.A. electric utilities are already making decisions in anticipation of some future policies 29 29 energy used to produce a ton of aluminum could increase substantially. While economic efficiency would call to limit greenhouse emissions. 30 for locating energy intensive industries where energy efficiency is greatest, a system of partial controls would 31 30 results in energy intensive industries being located where energy efficiency is lowest. Similarly, the reduced These issues also arise among countries: countries with large coal deposits will find the value of their natural 32 31 energy consumption by the North will result in lower producer prices of oil and gas. leading to increased wealth eroded, and quite naturally will be less enthusiastic about international agreements having that 33 consumption of energy in the South, partially offsetting any energy conservation induced in the North 32 consequence. 34 50.The precise manner in which this should be done is a technical matter, treated in the literature on Global 33 59. The studies show a marked variation in GDP losses across models. For example, stabilizing emissions at their 35 Warming Potential (see, e.g., IPCC 1990). To the extent that there are large differences in atmospheric lifetimes, 34 1990 levels is estimated to reduce U.S. GDP by 2% to 8% in the year 2010 roughly a $20 billion to $80 billion 36 then the relative weighting of different greenhouse gases should change over time, since the "shadow price" 35 loss for that year. Estimate of the costs of reducing emissions by 20% below levels in the year 2010 range 37 associated with effects on relative concentrations at different dates will differ. 36 from 9% to 1.7% of GDP. Aggregated models (top-down) have generally reported higher costs, while 37 disaggregated models (bottom-up) have shows lower costs. Chapter 9 contains a more complete discussion. 38 51. Similarly, if the developed countries restrict forest cutting, the price of lumber may rise, inducing the 38 39 developing countries to cut down more of their own trees. While total carbon sequestration may not increase, 39 These GDP losses occur when the carbon taxes lead to investments that are more expensive than those that would 40 environmental and economic efficiency will decrease if, as some researchers have concluded, hardwood forests 40 take place in the absence of the taxes. The higher the carbon taxes, the greater the investment in price-induced 41 in the less developed countries may be the least desirable ones to cut down from an ecological or economic 41 conservation and the more fuel switching toward the less carbon-intensive substitutes. 42 perspective (Edmonds and Reilly, 1987). 42 43 The overall impact of a carbon tax will depend not only on the size of the tax but also on the uses to which the 44 revenues are put. In the standard EMF scenarios, is was assumed that tax revenues will be redistributed in 8 45 neutral manner (i.e., without affecting the marginal tax rates). There are, of course, numerous ways in which tax CK ypons 47 48 I 67 This issue has been addressed in several papers. See, in particular, Stiglitz [1975, 1984] and Grossman [1981]. I revenues can be used. These include: reducing budget deficits; reducing marginal rates of income, payroll, 2 corporate or other taxes: granting tax Incentives to preferred activities, or increasing the level of government 2 68 This is both because those who would, under "true" disclosure, be of 0 competitive disadvantage have an 3 expenditures. The costs of the tax will vary widely depending on how the revenues are recycled ) incentive to add "noise" and because there are strong market forces for product differentiation; in markets with 4 homogeneous commodities profits, even with a limited number of suppliers, will be driven to zero (in Bertrand 4 60.Top-down models estimate that for developing countries there. exist low-cost options to reduce emissions in 5 competition.) For a discussion of these and related issues, see Salop [1977] Salop and Stiglitz [1977, 1982], 5 the near term. but eventually costs would exceed I to 2% of GDP (EMF 1993) For economies in transition, 6 Stiglitz [1977, 1988]. A58 6 because of historical inefficiencies and energy subsidies, there exist large opportunities to reduce emissions at 7 little or no cost. For developing countries, problems of informal economies make hard estimates difficult, but , The standard reference in the organizational literature is March and Simon Economic theories emphasizing I the cost of stabilizing emissions would likely be large enough to cut into economic growth 8 the non-value maximizing behavior of managers include the works Baumol Marris and Leibenstein 9 1. The principal agent literature [Ross, 1973, Stiglitz, 1974] provided the foundations for 9 61. Recent comparisons indicate that the most important differences between top-down and bottom-up models arise 10 understanding the divergence: of interests. See Stiglitz [1988]. A more recent overview is provided by Stiglitz 10 from differences in input parameters, rather than from differences in model structure. II and the symposium in the Journal of Economic Perspectives, 11 Government institutions and regulations often hinder the efficient use of energy. The developing countries This -MEJEP key point, while noted in March and Simon's (1958) original work, was elaborated upon by Rednet Main, 12 12 are least able to absorb the costs of these inefficiencies. Thus, while some developing countries argue that they 13 Hannaway cannot afford to reduce greenhouse emissions the same countries have the most to gain from reforming Capvalism. 13 14 government-caused inefficiencies. At least in the short nm, International agreements committing countries to eliminate at least the most egregious of these practices might go a long way to addressing the problem of 14 71. The facts that time is a scarce commodity and that decision making in large organizations decentralization 15 15 do not in themselves constitute a market failure; they do not prove that resources are not efficiently allocated 16 emission reductions, 16 given the real constraints facing society, which include time. However, Greenwald and Stiglitz [1986, 1988] have 17 17 established a very general theorem showing that when information is imperfect and costly, market equilibrium 18 is, in general, not (constrained) Pareto efficient. Thus, there is no presumption concerning the efficiency of the IS 63 This may also be a problem with electricity generated by the private sector, as regulation has historically any 19 market economy, even in the absence of the kinds of externality and public goods problems that are associated 19 price equal to average cost, rather then allowing in to meach the competitive price. In many countries, the increase 20 with greenhouse gases. For a more extended discussion, see Stiglitz (1994) not in publication list. 20 of competitive pressures has moved electricity prices closer to the merginal cost of production 21 22 One of the main insights of recent advances in the economics of Information is to provide a sound 21 64.Full unilization of non-fossil ford energy sources. taking account of other environmental impacts For example. when hydroelectric power generation, which does not greenhouse CURISSIONS, can be cost-effectively 23 micro-foundations for these theories of the firm. And indeed, the importance of the limitations on the availability 22 24 of information, and the consequent importance of attention directing efforts applies to individuals as well as to 23 expanded without other environmental effects, # should be done 25 organizations. Some studies have suggested that the limited success of the special tax provisions in the United 24 25 Eliminating Regulations Impeding Efficient Energy Unitization Many. perhaps most, countries have a host of 26 States designed to encourage savings (IRA accounts) was primarily due to the competitive efforts of banks to 27 recruit these accounts, and the attention which savings got as a result. 26 regulations which increase energy use as they impode aconomic efficiency For asstance, the United States has 28 27 had 8 policy of restricting oil exports to Alaska Whatever the merits of that policy. N has forced Japan to import 28 oil from Indonesia and Saudi Arabia. World oil transportation costs have thus been greatly increased. at the 29 72 Network externalities are manifested in other ways: builders fail to install energy efficient light bulbs, because 29 expense of the American economy. Another example of government reform, included IN the US' Action Plan (1993). encourages efforts to expand and improve natural gas markets through continued regulatory reform These 30 customers dislike them, because stores do not carry replacements; and stores do not carry them because the 30 31 demand for them is too low. 31 reform efforts include guidelines to allow greater natural gas use in the summer in coal- and oil. fired power 32 32 plants. 33 When there are important network externalities, market equilibria are frequently inefficient. The economy 33 34 might, for instance, get "stuck" in the wrong equilibrium. Government action can, in these instances, "force" the 34 Other regulation. Unintended effects of many tax. expenditure and other policies have contributing further to inefficiencies in land use. Among the unfortunate effects of the U.S. Superfund program for the management of 35 economy to move from one equilibrium to another. 35 36 36 hazardous wastes has been the creation of large unoccupied holes in the center of major cities. 37 73.This is not the only explanation of differences between bottom-up and top-down models. There are several 37 65.Consider the following thought experiment: compare an optimally designed road system which only carried cars; and contrast that with an optimally design road system which also carries trucks. The incremental cost of 38 other features of market behavior that bottom-up models often ignore. 38 carrying trucks is, in most countries, much larger than the proportionate share of the cost they bear in gasoline 39 39 40 (a) Hidden Costs: Consumers value a range of attributes difficult to include in an engineering model. For 40 taxes and other fees. 41 example, auto buyers value not only initial costs and fuel economy (which computer models can easily calculate). 66.For example, in many countries, governments have taken an active role in the dissemination of Information 42 but also performance, safety, and durability, which they typically do not. 41 to the agriculture sector. These programs are in some measure responsible for the large increase in agricultural 43 42 44 (b) Divergence between laboratory and in-use performance: Especially for new technologies, actual energy use 43 productivity in countries with agricultural extension services. 45 often differs significantly from energy use calculated in the laboratory. It is the latter upon which purchasers 44 50 " I I focus. 83. Analysts now use two methods to estimate stocks. The first assumes a fixed stock of a natural resources such 2 2 as oil. Consumption of oil then depletes the stock by the amount of consumption. The second begins by treating 3 3 (c) Variation across individual CORSUMERS Engineering models generally assume an average consumer, actual discovered reserves as the asset. Thus, additions to reserves increase the asset, while consumption reduces it. 4 4 consumers may display a wide range of characteristics and usage patterns. Except when demand functions are If in any given year, new discoveries match resource utilization, then according to this method no net depletion 5 has occurred. 5 linear in the relevant variables, the consumption of the "average" individual is not equal to the average 6 consumption; and what is optimal for the average person may not be optimal for a significant fraction for the 7 population. 0 For a survey, see JES 1981 Credit Ratiming Mkh of lufo Impartate 8 84. Many researchers have noted deficiencies in standard national income accounts. First, national Income accounts do not, in general, provide an adequate measure of welfare; second, they do not provide the correct Juffer and Stiglitz The basic theory of credit rationing was developed inSuglitz information relevant for making policies relevant to sustainable development. Sustainable development is Weigs [1981] and the theory of credit retioning is developed in Greenwald, Stightz and Weiss (1984) and Myers AER 71(3)10 9 9 concerned with society's resources; an economy is growing when its resource base (capital stock combined with 10 and Maliuf 11284 10 natural resources) is growing GDP does not, and is not intended to be, a measure of resource availability. Firms tere 395-1710. have two sets of accounts-cash flow (income) statements and balance sheet statements. GDP is . statement of " 75.This generally accepted methodology is, for instance, reflected in the guidelines issued by the Office of the former type. 12 Management and Budget in the United States for the evaluation of projects and regulations. The applied Interature 13 13 does not address the question of whether this procedure is appropriate in the presence of certain types of time and 14 Standard accounting procedures require that firms, in an attempt to present an accurate account of "true income," 14 risk non-separabilities. 15 take account of depreciation. GDP measures gross output; it does not take into account depreciation, either of 16 natural or physical capital stocks. The reason is simply that it is hard to get accurate measures of depreciation. 15 76. Though if the variance of the net benefits is increasing over time in a particular manner, the differences in the 17 16 18 two methodologies may not be large. Net national product does take into account depreciation, the change in capital stock. And it is this account which 19 should be most subject to criticism, since it accounts for changes in the physical capital stock, but not in other 17 77 Again, under certain restrictive conditions, where the shadow value of a capital constraint is changing 20 capital assets, in particular, environmental assets and natural resources. 18 systematically over time, the differences - the two methodologies may not be great. 21 22 A number of difficult conceptual problems face the analyst defining levels and changes in levels of these assets. 19 78 See Vilson Though the original discussion of winners curse focused around bidding in auctions, it has 23 20 subsequently come to be applied to a range of other market phenomena See. " Stightz I I 24 25 First, how should the "stock" of natural resources be defined? Coal poses perhaps the easiest situation. The 21 79.For a discussion of the role of the state in capital markets. are Stiging 119941 26 location of coal reserves is known. Costs of extraction are high, so the rents (the value of coal in site) is low. 27 The depletion can be measured not by the coal used times the market price, but the coal used times the in site 22 80.1n some industrialized countries, energy efficient home mortgage lending may help correct the problem 28 value. But for oil and other minerals, information about where reserves are located is vital. Two models have 23 Lenders generally set criteria for the maximum loan amount based on the borrowers' ability to repay, which in 29 been proposed. One sees the world as having a fixed stock of natural resources (say oil). When one uses oil, 24 turn depends on income and wealth. The fact that a particular expenditure which would enhance efficiency and 30 one is depleting this stock. Thus, to calculate the value of depletion, one does not need to know the entire stock; 25 reduce utility bills is not given special attention. Energy efficient mortgages provide funds to households to 31 the flow (the amount of oil consumed) provides an accurate measure of the change in stock. 26 make energy efficiency enhancing investments intended to pay for themselves, ie. result in reduced utility bills 32 27 equal to or greater than the interest payments. With capital construints, builders may have an incentive to trade 33 The alternative model looks at the size of discovered reserves. Reserves are treated as the asset. Additions to 28 off initial capital costs for higher maintenance costs (lower energy efficiency). Building codes specifying minimal 34 reserves thus are viewed as increasing the resource base. If in any given year, new discoveries match resource 29 levels of energy efficiency and full disclosure of expected life cycle energy costs may help address these market 35 utilization, then there is DO net depletion. This is the approach being taken by the U.S. Department of Commerce. 30 distortions. 36 This accounting framework would be correct if there were an infinite supply of the resource (reflected in zero 31 37 rents); the essential "capital" good is information about where the resource is located. 32 38 39 Environmental assets-such as air quality-present another set of problems, because there are not market prices 33 81. A country that rapidly depletes its natural resources may show a high rate of growth under conventional 40 to value the asset. Dynamic optimization problems of the kind described earlier can be used to calculate shadow 34 income accounting. but a lower rate of growth when resource depletion is taken into account. Repetto (1991, 41 prices. How sensitive these shadow prices are to specific assumptions remains to be investigated. 35 1992) calculated resource-adjusted GDP for several countries rapidly harvesting their stocks of hardwoods and 42 36 other resources, arguing that conventional measures sharply overstated GDP. 43 Accounting systems do not, however, have to aggregate all information together. Just is Information about 44 longevity and other Indicators of well being (see below) serve to complement information from national income 37 82.Cobb and Daley (1989) have even claimed that U.S. per capita GDP, when adjusted for environmental damage, 45 accounts concerning standards of living, so 100 can information about physical environmental measures be used 38 was stughent 1950 and 1986. This assertion is hard to reconcile with the steady improvement in most 46 to complement information from the extended national income accounts. 39 measures of environmental quality since 1970, when measurements standards were established. 47 85. There is some concern that excessively broad and long patents may actually impede innovation. When 48 technological progress occurs by building on previous innovations, later Innovator require permission of earlier 49 innovators to realize the returns on their innovation. While advocates of broad patent coverage argue that the 51 52 1 parties always arrive at efficient bargaining solutions, critics point out that the outcomes of bargaining models I simpler emissions permit system (EPS) issues permits on the basis of source emissions and ignores what effects with incomplete information often entail large inefficiencies 2 2 those emissions have on the receptor points. Within a given region or zone, the polluter would have only one 3 market to deal with and one price. Finally, there is the pollution offset (PO) system wherein the permits are 3 86. Matters are more complicated, since the patent does not reward the innovator with his marginal contribution- 4 defined in terms of emissions, trade takes place within a defined zone. However, the standard has to be met at 4 the increase in the present discounted value of benefits as a result of the innovation occurring earlier than it 5 all receptor points. The exchange value of the permits is then determined by the effects of the pollutants at the 5 otherwise would have occurred. For a fuller discussion, see Stigling as 1. Desgupts and Stightz 1980a. 1980bl. 6 receptor points. The PO system thus combines characteristics of the EPS and the APS. (Pearce and Turner 6 Barzel I 1 7 1990) These distinctions are of limited relevance for greenhouse gases, where what is of concern is global B emission levels. The specific location of the emissions is of no concern. , 87. If less developed countries fail to implement fully a set of corrective taxes or tradeable permits, or if less , 8 developed countries fail to adopt and enforce effectively intellectual property rights, there will be insufficient , incentives to produce energy and emission savings innovations, particularly those appropriate for the level of 10 90. The choice between taxes and tradeable permits depends on the objectives of the policy maker and nature of 10 technological knowledge, human capital, and factor prices in those countries. If less developed II the uncertainty about the marginal cost and marginal benefit curves for carbon emission reductions (Weitzman, " countries do take these actions, there is concern that they will result in higher prices of innovations, and thus the 12 1974). Theory tells us that if the nature of the curves is known with very little certainty, but the marginal cost 12 pace of adoption will be retarded. An effective form of aid, targeted to reducing greenhouse gas emissions. may 13 curve is known to be relatively steeper (i.e. a change in the level of pollution allowed brings about a greater 13 be subsidies directed at producing appropriate energy saving and emission reducing technologies for LDCs. 14 change in the marginal costs of mitigation compared to the marginal benefits) then taxes should be the policy of 14 15 choice. This is because, in this case, an erroneous estimation of the optimal tax rate will lead to a relatively small 16 deviation from the optimal pollution level. On the other hand, an erroneous estimation of the optimal level of 13 $8 Edmonds of al (1994) has studied the importance of available advanced energy technologies such as those 17 total emissions in a permit scheme will lead to a relatively large deviation from the optimal cost of the permits. 16 proposed by Johannson (1993) Edmonds " of use the Edmonds-Resily-Rarnes model for energy related II 17 greenhouse gas emissions. the MAGICC model for atmospheric composition, climate response. and see level me, 19 If the marginal benefit curve is known to be relatively steeper than the marginal cost curve, however, tradable IS the IPCC scenario 1592a (IPCC, 1992) as the reference base case and five alternate energy scenarios that are for 20 permits are the better option. Here, an erroneous estimation of the optimal tax rate will lead to a relatively large 19 more advanced over today's energy supply and transformation technologies The five energy scenarios are 21 deviation from the optimal level of emissions while an erroneous estimation of the optimal level of emissions in 20 22 a permit strategy will lead to 8 relatively small deviation from the optimal cost of the permits. 21 a advanced fossil fuel technologies 23 22 b. advanced liquified hydrogen fuel cells 24 la the case of greenhouse gas emissions, the time horizon for adjustment is sufficiently long that many of these 23 c. advanced hydrogen fuel cells without liquified hydrogen 25 uncertainties become less important. If the tax rate initially chosen yields too high I level of emissions in one 24 d. low cost biomass 26 year, it can be increased, and the net impact of the erroneous initial estimate on global warming (or the total cost 25 c. accelerated rate of exogenous end-use energy intensity improvement 27 of achieving 8 given level of atmospheric concentration) will be negligible. In any case, as the earlier discussion 26 28 on sequential decision making has emphasized, there is likely to have to be continued revisions in either tax rates 27 Combined, the energy technologies reduce annual conssions from fossil fuel use to levels that stabilize 29 or permit levels. 28 atmospheric concentrations below 550 ppmv (ie double the concentration prior to the Industrial Revolution) 30 29 The tax rate, assumed to apply globally, used was the marginal cost of stabilizing fossil fuel carbon emissions II 30 in the reference case. With values reflected for only carbon dioxide emission reductions, the cost of global 32 Still, there is some argument that the required adjustments under a permit scheme may be less burdensome. 31 emission reductions grow from approximately $35 (US) Billion in 2005 to $230 (US) billion per year in the year " (Tistenberg 1992) For instance, if the authority feels that the old standard needs some tightening they may enter 32 2095. With advanced fossil fuels, low cost solar electric power, low cost fuel cell vehicles, the present discounted 34 the market themselves and buy some of the permits, holding them out of the market. 33 value of adding low cost biomass fuel to the energy technology bundle is almost half a trillion dollars (US) The 35 34 present discounted value of the advanced energy technologies taken together 19 SI $ trillion (US) 36 There must be effective, competitive markets in tradeable permits, if such schemes are to achieve efficient 35 37 outcomes. There are transactions costs of running such schemes, just as there are transactions costs associated 36 The introduction of advanced biomass energy production technology was found to play a key role in reducing 38 with collecting tax revenues. Whether transactions costs gives one system a decided advantage over the other 37 emissions. Biomass energy at $2.00/GJ growing to become the core energy supply technology by 2050 could 39 is not clear. There seems to be no compelling reason to believe that good markets in tradeable permits would 38 significantly reduce emissions highlighting the potential role of technology development and deployment relative 40 not develop. 39 to that of fiscal and regulatory intervention. 41 40 42 41 These results should be viewed as illustrative rather than predictive. in this analysis, the gains from introduction 42 and deployment of advanced energy technologies is dependent on the order of technologies evaluated in the study. 43 91.11 is possible to design allocations of trading permits which (i) on average, impose no net burden on developing 43 44 countries (thus conforming to the ability to pay principle); (ii) provide those economies which are growing faster 44 45 per capita with commensurately greater permits, thus imposing no net drag on economic growth, provided the 46 economy exhibits an increase in fuel efficiency at least equal to the average of fast growing LDCs; and (iii) 45 89. The literature has identified three types of permit systems. The ambient permit system (APS) works on the 47 rewards those economies which are able to reduce greenhouse gas emissions faster than benchmark, either through 46 basis of permits defined according to exposure at the receptor points. Each polluter, then, may face quite 48 greater control of population growth, through larger increases in energy efficiency, or through switching from 47 complex markets different permit markets according to different receptor points, and hence different prices. The 49 higher to lower carbon fuels. 50 53 54 I The extent to which individual circumstances of countries should be taken into account in setting benchmarks I For a 45% reduction in baseline emissions by 2020, the required tax would be in the range of $150-$325 per ton 2 remains a question for international negotiations; to the extent that high emissions is due to natural endowments 2 of carbon and the cost might be in the range of 1.5%-2.9% of world GDP. A 70% reduction in baseline 3 (e.g. the availability of cosl rather than natural gas as a source of energy). 0 persuasive case can be made for 3 emissions by 2050 could require a tax between $230 and $880 and a loss in world GDP of 2.4%-3.8% (Dean 4 benchmarks to reflect initial emission levels To the extent that high emissions are due to inappropriate energy 4 1994). 5 pricing policies, the case that benchmarks should reflect initial emission levels is for more tenuous 5 6 The required carbon taxes and associated costs vary significantly across regions in all of the models. This 6 92. Similarly, some developing countries have asked, should the North be given higher levels of permits. simply 7 indicates that the same proportional reductions in emissions across all regions would give rise to very different 1 because is has, in the past, been the chief source of greenhouse gases? $ costs in different regions and would thus be globally inefficient with great potential for savings in the global 9 cost of reducing emissions through the use of emission trading between countries or regions (see section 1.5.2.1) 8 93. For a discussion of the polluter pays principle, see above. 10 or a global carbon tax. 11 , 94. Standard tradeable permit schemes essentially take the revenue from a carbon tax. and distributes it to current 12 Three insights emerging from the OECD study are (Dean, 1994): 10 user emitters, rather than using the revenue to reduce other taxes. An alternative to these standard schemes is 13 a. Small amounts of emissions reduction can probably be achieved with low taxes; 11 for the government to auction off the tradeable permits. 14 b. Large reductions can only be achieved at high tax rates (i.e. marginal reduction costs rise with emissions 12 15 reductions). 13 If taxing carbon leads to reduced labor supply or reduced savings, then government revenues from wage or capital 16 c. Carbon-free backstop technologies are likely to slow the rise of the carbon tax, or halt k altogether, if they 14 taxes may be reduced, more than offsetting the direct revenue gain from the carbon tax. Cross elasticities of this 17 are available at constant marginal cost. 15 magnitude are unlikely, though any such cross elasticity will reduce the net gain from the carbon tax. The IS 16 magnitude of the double dividend has been the subject of some dispute, with Goulder 11 and taking opposite 19 Energy Modeling Forum Project 12 (Impact of Carbon Emission Control Strategies) 17 views. 20 A recent study at Stanford, the Energy Modelling Forum Project 12, examines the cost of reducing CO2 18 21 emissions (Energy Modeling Forem, 1993). A diverse group of economic models, employing common 22 assumptions for selected numerical inputs, were used to analyze a standardized set of emission reduction 19 95. Two main studies provide insights into the root of the variance in estimates of the economic effects of carbon 23 acenarios. In all, 14 top-down models participated in the study. 20 taxes: The Energy Modeling Forum Study (12) and the OECD comparison project. in each case, sophisticated 24 21 sensitivity analyses are run by standardizing key economic assumptions along with use of common reference case 25 The EMF model comparison provides the most comprehensive application of top-down methodologies to date. 22 scenarios of reductions. The magnitude of the effect on economic growth will depend both on assumptions 26 The study addresses 8 wide range of policy questions. How large are emissions likely to grow in the absence 23 concerning the effect of carbon taxes on savings and labor supply. and the induced investment to offset the higher 27 of controls? How much market intervention will be required to meet alternative targets? What will be the price 24 energy prices. If higher energy prices do not lead to much capital substitution and of the cross elasticity with 28 lag? In exploring economic costs, the modelers were asked to examine the Impacts of timing, research and 25 savings and labor are low then the likely effect on economic growth will be small 29 development, and revenue recycling. 26 30 27 31 The EMF exercise provides a wealth of useful information for policy making. Although the focus was primarily 28 OECD Project on Economy-Wide Cost Estimates of Carbon Taxes 32 on the U.S., many of the insights are applicable to developed countries in general. 29 An OECD model comparisons project was conducted to compare economy wide estimates of the effects of carbon 33 30 taxes. Time horizons as well as the key economic assumptions on growth, population and resource prices, and 34 In selecting parameters for standardization, the EMF study focused on what were felt to be the most influential 31 the reduction scenarios for six global models were standardized. The global models compared were the GREEN 35 determinants of mitigation costs. These included: GDP, population, the fossil-fuel resource base, and the cost 32 model, the IEA model and four North American models [Edmonds-Reilly Model (ERM). Global 2100 of Alan 36 and availability of long-term supply options. la addition, although the EMF models differed considerably in their 33 Manne and Rich Richels (MR). the Carbon Rights Trade Model (CRTM) of Tom Rutherford. and the Whalley- 37 technology representation, the study attempted to impose uniformity with regard to world oil prices, the oil and 34 Wigle model] (Deas 1994). 38 gas resource base, and the cost of backstop technologies. For its reference case, EMF adopted the average of the 35 39 IPCC high and low economic growth cases (IPCC, 1990c). Also for consistency with the IPCC, the study 36 There is significant variation in tax rates and costs for the same amount of emissions reduction among models 40 adopted the population growth projections based on Zachariah and Va. 37 due to differing assumptions regarding several key considerations. Several factors explain the differences between 41 38 model results. The most important factors are: 42 The modelers generally used taxes based on the carbon content of the fossil fuels in order to achieve a prescribed 39 43 emissions reduction. The magnitude of the tax provides a rough estimate of the degree of market intervention 40 a. The degree of substitution between fucts the ease with which producers and consumers can switch from 44 that would be required to achieve the carbon emissions target. Estimates range from $20 to $140 per ton for the 41 high-carbon content fuels to luw-carbon content fuels; 45 carbon taxes required to hold emissions at 1990 levels in 2010. Estimates of the carbon taxes required to reduce 42 b. Expectations about future energy prices and taxes; 46 emissions by 20% below 1990 levels in 2010 range from $50 to $330 per ton. 43 c. The speed of emissions reduction; 47 44 d. The way in which revenue is recycled; 48 Two parameters are particularly important in explaining the differences in tax projections: the price elasticity of 45 c. The treatment of the removal of energy subsidies; and 49 energy demand and the speed with which the capital stock adjusts to higher energy prices. Neither were 46 f. Assumptions regarding backstop technology and a host of other technical and economic factors. 50 controlled in the EMF experiments. Those models using lower price elasticities required higher taxes to achieve 47 51 the same emissions goal. 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American Economic Review, (forthcoming). 43 44 44 Ramsey, F.P. 1928, 'A Mathematical Theory of Saving'. The Economic Journal Vol??, Economic 61 62 V.15ne.1 87-107 I wisky 543-559. T. Michael Holine and Smah Rapar 1413. AGICE Madel I Schueider and Chen (1980) 2 for the Assessment I GH induced cc, 2 , Raper H al. (1990) 1 4 , Rawis, John. 1971, Theory Uux, of Justice, Consactions Belknap Press for Afimer. Rich, Boulder lolo Sedjo, R.A. and Solomon, A.M. 1989, 'Climate and Forests' 0? 4 , 6 Sen, A.K. 1993, 'The Economics of Life and Death'. Scientific American Vol?, pp. 40-47 6 7 Reddy and Goldemberg J., "Energy for the Developing World," Scinetific American, , Sea, A.K. 1982, 'Approaches to the Choice of Discount Rates for Social Benefit Cost $ September 1990, pp. 111-118. 8 , Analysis'. In: Discounting for Time and Risk in Energy Policy, R. Lind et al.(eds). 7 , Reilly (1993) Resources for the Future, Washington, DC, pp. 325-53. 10 1993. 10 II " in 12 Reilly. J., Hohman, N. and Kane, S., Climate Change and Agricultural Trade: Who Shah, A. and Larsen, B. 1991. "Carbon Taxes, the greenhouse effect and developing 12 13 Benefits, Who Loses?' Global Environmental Change, forthcoming. countries.' World Bank, Washington. sathy 13 14 14 15 Richels, R, and J. Edmonds 1993. "The Economics of Stabilizing Solow, A.R., Polasky, S. and Broadus, J.M. 1993. 'On the measurement of biological 15 16 Atmospheric CO2 Contentrations," draft, 11/2/93 diversity.' Journal of Environmental Economics and Management 24, pp. 60-68. 16 17 17 18 Robey et al. (1993) Solow, A.R. 1993. 'The response of sea level to global warming.' In: The World at Risk: IS 19 Natural Hazards and Climate Change, R. Bras (ed). AIP Conference Proceedings 277, pp. 19 Romer (**date**) 38-42. American Institute of Physics, New York. 20 20 21 21 Rosentbal. DH., Gruenspecht, HK. and Moran, E.A 1994. 'Effects of Global Warming Solow, Andrew (1992) sdan, R. "An Almost.. 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"Differential Taxation, Public Goods, and Economic 44 Samuelsan, ?.4. 1964 the Pure Theory of Public Exenditme[?] ) Efficiency," The Review of Economic Studies 37, pp. 151-74. reprented in Collected Pager of PAS. 64 I Stiglitz and Weiss (1981) I World Bank 1992, World Development Report 1992: Development and the Environment. 2 2 Washington, D.C. 3 Tietenberg (1992) , 4 4 5 Tites, J.G. 1987. "Causes and effects of sea level rise.' In: Preparing for Climate 6 Change. Proceedings of the First North American Conference on Preparing for Climate 7 Change. Government Institutes, Inc., Rockville, MD. $ 9 Tobia, J., and W. Nordhaus 1972, "Is Growth Obsolete?" ... 10 II Hartwick 1990, 12 13 United Nations Environment and Development Branch, U.N. 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Discussion Paper 1533, Harvard University Institute 36 of Economic Research, Cambridge, MA. 54 pp. 37 38 Weitzman M.L., Newey, W., and Rabin, M. 1981. "Sequential R&D Strategy for 39 Synfuels," The Bell Journal of Economics 12(2), 574-590. 40 41 Weitzman (1974) 42 43 Wilson, E.O. 1988. 'The Current State of Biological Diversity,' in E.O. Wilson (ed.) 44 Biodiversity, National Academy Press, Washington, PP. 3-18. 65 66 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY 1 SUMMARY FOR POLICYMAKERS I The Convention thus incorporates, and the literature assessed in this report (Chapters SECOND ASSESSMENT REPORT, WORKING GROUP III 2 2 1. 2. 8 and 9) supports a strategy of "act - then learn then act" where the actions to 3 3 address climate change are periodically adjusted in light of new knowledge and 4 4 The Context developments. The ultimate objective of stabilizing atmospheric concentrations of 5 5 greenhouse gases, although not yet operationally defined, provides guidance for betw 450-750 This assessment of the socio-economic literature related to climate change has been 6 6 policymakers when considering initial actions to address climate change. modestreductions 7 undertaken in the context of sustainable development as reflected in the Framework 7 8 Convention on Climate Change. This Convention is now a key element in the 8 The Convention establishes a collective decision making process where actions, in near.term decision making framework on climate change (Chapter 2). 9 9 reflecting their common but differentiated responsibilities, are agreed upon by the 10 10 Parties. The report identifies a number of general principles and findings that are 11 The ultimate objective of the Convention is "stabilization of greenhouse gas 11 relevant regardless of the decisionmaking process, such as those concerning the concentrations in the atmosphere at a level that would prevent dangerous 12 12 design of cost-effective policies. should be recognized that a collective decision anthropogenic interference with the climate system. Such a level should be achieved 13 13 4 making process may not reach the same conclusions as analyses that adopt a global within a time-frame sufficient to allow ecosystems to adapt naturally to climate 14 14 optimization perspective. IS change, to ensure that food production is not threatened and to enable economic 15 16 development to proceed in a sustainable manner." 16 A Portfolio of Possible Actions to Limit Climate Change 17 17 The Convention specifies that to achieve this objective the "Parties should take 18 18 The precautionary principle (Article 3.3) and the estimated damages due to current precautionary measures to anticipate, prevent or minimize the causes of climate 19 19 emissions of greenhouse gases (Chapter 6) argue for action beyond "no regrets" 20 change and mitigate its adverse effects. Where there are threats of serious or 20 measures.4 The decisions to be taken in the near future will necessarily have to be bigarsmall 21 irreversible damage, lack of full scientific certainty should not be used as a reason 21 taken under great uncertainty. However, these decisions are not very sensitive to the 22 for postponing such measures, taking into account that policies and measures should 22 level at which atmospheric concentrations are ultimately stabilized and can be as 23 be cost-effective 23 adjusted based on experience, new knowledge and other developments. shartan 24 24 25 Each of the Annex I Parties is committed to "adopt national policies and take 25 Actions analysed in the literature which countries can take, individually or jointly, to ofr solin in 26 corresponding measures on the mitigation of climate change, by limiting its 26 limit climate change and its impacts include: 27 anthropogenic emissions of greenhouse gases and protecting and enhancing its 27 nobustbur 28 greenhouse gas sinks and reservoirs." 28 implementing low cost measures to reduce emissions of greenhouse 29 29 30 are these gases. There is broad agreement that in most countries there are some Whatnit? measures, such as energy efficiency, that can reduce emissions of 31 being I United Nations Framework Convention on Climate Change, Article 2. The 33 recommended greenhouse gases at negative to slightly positive costs (Chapter 9). 32 Achieving such reductions may require policy intervention; 30 31 Intergovernmental Negotiation Committee (INC) requested that the IPCC assess the 34 phasing out existing distortionary policies, such as some subsidies to 32 scientific evidence that might help policy makers interpret Article 2 of the 35 fossil fuels, that reduce welfare and, directly or indirectly, increase 33 Convention. This topic will be addressed in the IPCC's Second Assessment Report 34 to be published in 1995. 35 2 United Nations Framework Convention on Climate Change, Article 3.3. 36 4 No regrets measures are those whose benefits, such as reduced energy costs and 37 reduced emissions of conventional pollutants equal or exceed their cost, excluding 36 3 United Nations Framework Convention on Climate Change, Article 4.2(a). 38 the benefits of climate change mitigation. I 2 Cour some $ some & n Cut: "Don't have to do anything for duades careful JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I greenhouse gas emissions. Global emissions reductions of 5% to 20% where does this I An illustrative simulation of global options with marginal costs of up to $50 per $50 2 have been estimated for removal of energy subsidies worldwide (Chapter 2 tonne of carbon suggests about 50% of the total reduction/sequestration would be come 3 11); 3 forestry measures, 25% would be through energy conservation and efficiency Latercites tran $5- 4 4 improvements, and the remainder would come from a mix of renewable energy use, 5 implementing fuel switching measures, such as coal-fired generation to 5 fuel switching, CO2 removal and disposal, and nuclear energy. The mix of options 20? 6 natural gas, to reduce emissions of greenhouse gases (Chapters 9 and 11); 6 and the magnitude of the reduction/sequestration relative to current emissions varies 7 7 significantly by region (Chapter 7). 8 implementing measures to enhance sinks or reservoirs of greenhouse 8 9 gases;' 9 Opportunities for Action Vary by Country and Over Time 10 10 II instituting forms of international cooperation to limit greenhouse gas 11 Each country's approach to climate change can be represented as a portfolio of 12 emissions such as joint implementation and technology transfer; 12 actions that reflects its objectives, economic conditions and constraints. The actions 13 13 taken by a particular country may reflect considerations such as their cost, secondary 14 undertaking research aimed at better understanding the causes and 14 benefits, the impacts on different socio-economic groups, international equity, 15 impacts of, and adaptation to, climate change. Economic studies suggest 15 intergenerational equity, the expected damage due to climate change or sea level rise 16 that such research can yield high returns by reducing the uncertainty as 16 within the country, and economic strategies based on development of new 17 to the most cost-effective actions to address climate change (Chapter 2); 17 technologies. The size of the investment will reflect the country's obligations under 18 18 international agreements, adjusted for resources transferred to or received from other 19 conducting technological research aimed at enhancing energy efficiency, 19 countries, as well as domestic goals and priorities. A country's climate change 20 minimizing emissions of greenhouse gases from continued use of fossil 20 actions will also reflect other priorities aimed at sustainable development, including 21 fuels, and developing commercial non-fossil energy sources. The timing 21 eradication of poverty, increased levels of education, protection of environmental 22 and availability of cost-effective of non-fossil energy technologies is one 22 resources, and improved human health. 23 of the major determinants of addressing climate change in the long run 23 24 (Chapters 9 and 10); 24 Governments can and should adjust their portfolio of climate change actions in 25 25 response to new information and developments. Indeed, both the investment in 26 planning, and implementing as necessary, measures to adapt to the 26 climate change limitation and the mix of policies will probably change over time. 27 consequences of climate change; and 27 That does not imply complete flexibility. Many of the measures involve capital and 28 28 technology commitments with long life times. Reversing such commitments could be 29 developing institutional mechanisms, such as insurance, to share the risks 29 relatively costly, however that risk would be incorporated into the analysis of the 30 of damages due to climate change (Chapters I and 2). 30 options before the commitments are made. This is particularly important for 31 31 developing countries and countries with economies in transition where significant 32 infrastructure investments will be made over the next few decades. 33 32 34 Stabilization of Greenhouse Gas Concentrations $ Energy prices that do not reflect the externalities associated with energy use can be 33 considered a distortionary policy. Under some circumstances, kerosene subsidies to 35 34 reduce fuelwood use, can increase welfare or decrease emissions (Chapters 2 and 36 Climate change impacts are related to the stock of greenhouse gases (concentration) 35 11). 37 in the atmosphere, rather than the annual emissions, hence the ultimate objective of 36 6 Some actions to increase sinks may have indirect effects, such as a change in 37 albedo. In such cases the net effect of the measure should be considered. 3 4 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY 1 the Convention is to stabilize atmospheric concentrations of greenhouse gases.' I Stabilization of the atmospheric concentrations of other greenhouse gases at today's 2 Currently, the atmospheric concentration of CO2 is about 360 ppmv; the pre- 2 levels requires lesser reductions, but nevertheless reductions, of the emissions of 3 industrial concentration was about 280 ppmv." The danger of significant harmful 3 those gases." Thus, stabilization of atmospheric concentrations of greenhouse gases 4 effects from climate change increase as the concentration of greenhouse gases in the 4 will require very low population and economic growth rates (as assumed for IS92c), 5 atmosphere rises. The discussion below focuses on the effects associated with 5 a major "natural" change in energy technologies, or intervention to reduce emissions 6 stabilization of atmospheric concentrations of CO2 within the range of 350 to 750 6 and enhance sinks. The effect of the initial commitments of Annex I Parties, 7 ppmv "could be attained only with global anthropogenic emissions that eventually 7 assuming that they are achieved and continued to 2050, is shown in Figure 2. The 8 drop to substantially below 1990 levels." 8 current commitments are not sufficient to stabilize atmospheric concentrations of 9 9 CO2 except under scenario IS92c which has emissions below current commitments 10 The IPCC's six emissions scenarios assume virtually no new policies specifically (Chapter 12). 11 designed to reduce greenhouse gas emissions (Chapter 12). Three scenarios that Applicability of Cost-Benefit Analysis Annex 1" 12 span the full range (IS92a, IS92c and IS92e) are compared with the illustrative 13 profiles of anthropogenic emissions consistent with stabilization of atmospheric 14 concentrations at levels between 350 and 750 ppmv in Figure 1. These emissions Edmind But wanto 12 A stabilization objective could be based upon an absolute standard, an affordable Key is LDCs 15 profiles indicate that at some stage major reductions of CO2 emissions (of the order 16 of 50% of current emissions) will be required to eventually stabilize concentrations. Averynt 15 safe minimum standard, or a cost-benefit analysis, the approach favoured by most Weyans 16 economists. These approaches are illustrated in Figure 3. The absolute standard 17 The pattern and timing of reductions of emissions can have a major effect on the 17 approach would define a maximum atmospheric concentration of greenhouse gases 18 overall costs of mitigation. "Emissions for all stabilization levels studied are lower 18 that is considered to constitute "dangerous anthropogenic interference with the 19 than those for IS92a and e, even in the first few decades of the 21" century. 19 climate system" on the basis of predicted changes to the climate system or of the 20 Emissions for the IS92c Scenario lie between the emissions [profiles] which 20 predicted impacts of climate change regardless of the cost of achieving this 21 achieve stabilization at 450 and 550 ppmv."" 21 concentration. Environmental standards designed to safeguard human health are 22 22 often established using this approach. But fig. 1 decs not based m min C. 23 24 The safe minimum standard approach would specify a maximum atmospheric 25 concentration of greenhouse gases based on an assessment of the risks associated 23 , It is not clear from the Convention whether the ultimate objective is to stabilize the 26 with different atmospheric concentrations and the costs of achieving those 24 atmospheric concentration of each gas at a particular level or to stabilize greenhouse 27 concentrations. The standard would seek to reduce the risks of climate change to an 25 gas concentrations, expressed in terms of CO₂ equivalents, at a particular level. 28 acceptable level at an acceptable cost. Cost-benefit analysis attempts to value the 29 impacts of climate change and seeks the atmospheric concentration where the 26 . ppmv is parts per million by volume, a measure of concentration. 30 marginal value of the net impact is equal to the marginal cost of abatement. 31 27 , Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 28 Assessment Working Group of IPCC, Summary for Policy Makers, IPCC, 1994, p. 4. 32 Working Group III was specifically requested to assess whether cost-benefit analysis 29 Analyses of emissions profiles consistent with stabilization of atmospheric 33 is applicable to climate change. Cost-benefit analysis was broadly interpreted to 30 concentrations of CO2 at levels lower than 350 ppmv or higher than 750 ppmv are 34 include traditional project level cost-benefit analysis, cost-effectiveness analysis, 31 presently not available in the literature. 35 multi-criteria analysis and decision analysis. The traditional cost-benefit approach is 32 10 The 1994 Special Report of IPCC, Summary for Policy Makers, IPCC, 1994, p. ?. 33 " Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 36 12 Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 34 Assessment Working Group of IPCC, Summary for Policy Makers, IPCC, 1994, p. 37 Assessment Working Group of IPCC. Summary for Policy Makers, IPCC, 1994, p. 35 15. 38 18 and 20. 5 6 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY 1 depicted in Figure 3(c). Cost effectiveness analysis seeks to find the lowest cost I The literature contains a few aggregate (across all sectors and regions) estimates of option to achieve a specified objective; the marginal cost of abatement curves in 2 2 the damages associated with a climate characterized by a globally-averaged 2.5°C 3 Figures 3(b) and 3(c) represent cost-effective options. Multi-criteria analysis is 3 warming. The estimates suggest that if such warming occurred now it would impose designed to deal with problems where benefits and/or costs can not be valued; it 4 4 net damages equivalent to 1.5% to 2.5% of world GDP on the present world could be used for the approaches described in Figures 3(a) or 3(b), where non- 5 5 economy (Chapter 6). The regional variation in climate change damage would be 6 economic effects are brought into the analysis, but without a formal way of valuing 6 substantial. Damage in developing countries is estimated to be at least 2% with a 7 those effects relative to the economic impacts. Decision analysis focuses expressly 7 maximum central estimate of 9% of GDP for some regions. Small islands and low on making decisions under uncertainty and conceptually could be used in any of the 8 8 lying coastal areas are particularly vulnerable. Climate changes of this magnitude are 9 approaches described in Figure 3. 9 not expected to be realized for some decades and damages in the interim would be 10 10 smaller. 11 Cost-benefit analysis (broadly defined) could contribute to resolution of three 11 12 questions facing decisionmakers. These are: 12 Most estimates of the additional damage done by CO₂ emitted now range from $5 to 13 13 $25 (1990 $ U.S.) per tonne of carbon, although a few estimates range up to $125 14 By how much should emissions of greenhouse gases be reduced or sinks 14 per tonne of carbon." The models used to develop these estimates are simplistic and 15 of greenhouse gases be enhanced? 15 are poor representations of dynamic processes, but they reflect the current state of 16 16 the art. The wide range of estimates reflects variations in models, scenarios, discount 17 When should emissions be reduced or sinks be enhanced? 17 rates and other assumptions. 18 18 19 What methods should be employed to reduce emissions and enhance 19 Climate change benefits of emissions reduction measures can be very complex to 20 sinks? 20 estimate. Some energy efficiency and fuel switching measures simultaneously reduce 21 21 emissions of greenhouse gases and sulphate aerosols. The negative radiative forcing 22 Because of the large uncertainties surrounding estimates of damages due to climate 22 from sulphate aerosols is significant. "Tropospheric aerosols have a lifetime of only 23 change (Chapter 6) and the costs of mitigation (Chapter 9) make it difficult in 23 a few days So the atmospheric concentration of aerosols responds rapidly to 24 practice to rely solely on cost-benefit analysis for the selection of an appropriate 24 changes in emissions. Control of sulphate emissions would immediately reduce 25 stabilization objective at this time. Still, the information provided by cost-benefit 25 the amount of aerosols in the atmosphere." A recent model analysis finds that 26 analysis is critical in making judgements not only about that decision, but also about 26 replacement of fossil fuels with carbon-free energy sources leads to lower 27 the timing of emission reductions and the design of cost-effective strategies. 27 temperature increases in the long run, but higher temperatures in the interim due to 28 Integrated assessment models best suited to such analyses are quite new (Chapter 28 the reduced sulphur emissions (Chapter 10). 29 10). 29 30 30 Costs of Response Options 31 However, cost-effectiveness analysis can and should be used to evaluate adaptation 31 32 and mitigation options. 32 What matters from a policy perspective is the net cost (total cost adjusted for 33 33 secondary benefits and costs) of a mitigation or adaptation option apart from its 34 The Benefits of Limiting Greenhouse Gas Emissions and Enhancing Sinks 35 The benefits of limiting greenhouse gas emissions and enhancing sinks are the 34 36 13 A tonne is a metric ton or 1,000 kg. $5 per tonne of carbon corresponds to climate change damages avoided. Since some increase in atmospheric concentrations 35 approximately 0.35 per litre of motor gasoline. 37 38 from the current level is virtually inevitable, some impacts and damages due to 36 14 Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 39 climate change seem unavoidable. 37 Assessment Working Group of IPCC, Summary for Policy Makers, IPCC, 1994, p. 40 38 24. 7 8 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I climate change benefits (Chapter 8). A wide range of estimates of the costs of I same set of input assumptions, such as the cost and availability of different energy 2 response options is found in the literature. The wide range is due in large measure to 2 sources. 3 differences in assumptions. Alternative views of the costs of emissions reduction are 3 4 shown schematically in Figure 4. Curve A assumes that there are no reducible 4 Top-Down and Bottom-Up Models 5 market or government induced imperfections; thus there are no "no regrets" options. 5 6 Curves B, C and D all assume market failures or government induced imperfections 7 8 9 benefits yield net cost savings. Curves C and D incorporate secondary economic and perfect 1mg Pating Bor Pni BED In the jargon of modelers "top-down" models are aggregate models, often exist in one or more sectors that can be corrected by policies that reduce costs and also lower greenhouse gas emissions. Curve B includes only measures whose direct give 9 8 7 macroeconomic models, that analyse how changes in one sector of the economy affect other sectors and regions. Early top-down models tended to have little detail on energy consumption, especially at the technology-specific level, but explicit 10 environmental benefits into the calculation of the net cost of the option. 0 treatment of behaviour and economic interactions. In contrast, "bottom-up" models 11 II tended to describe energy consumption in detail, however consumer behaviour and 12 The potential for "no regrets" policies is represented by the line OD2. The area 12 interactions with other sectors of the economy tended to be down played. 13 OD,D₂ is the potential net benefit to society of implementing all "no regrets" 13 14 measures. Some analysts have argued that measures with a positive cost should be 14 This simple characterization of top-down and bottom-up models is increasingly 15 implemented to the point where the total net cost to society is zero, i.e. to a point 15 misleading as more recent versions of each approach have tended to provide greater 16 D₃D₂ such that the area under curve D between D₂ and D, is equal to that area 16 detail in the areas that were less developed in the past. This convergence means that 17 OD,D2. 17 differences in model results are increasingly driven by differences in input 18 18 assumptions rather than model structure. Most results available in the literature do 19 Despite significant differences in views, there is agreement that some energy 19 not reflect the effects of this convergence of model structure since the evolution in 20 efficiency improvements (perhaps to 10% to 30% of current consumption) can be 20 model structure is a relatively recent occurrence. 21 realized at negative to slightly positive costs in many countries, depending on the 21 22 baseline assumptions and the time frame (Chapter 9). Measures to reduce greenhouse 22 Nevertheless, differences in model structure remain important as different models are 23 gas emissions often yield additional economic benefits (such as reduced traffic 23 best suited to answer different types of questions. 24 congestion) and/or environmental benefits (such as reduced emissions of acid rain 24 25 and urban smog precursors). The magnitude of these secondary benefits depends on 25 Equity and Social Considerations 26 local circumstances. Studies for Norway, the U.K. and some other countries indicate 26 27 that secondary benefits could offset 30% to 100% of abatement costs (Chapter 6). 27 Equity considerations are an important aspect of climate change policy and feature 28 28 prominently in the Convention. Inaction is likely to impose costs on future 29 The long run costs of addressing climate change will ultimately be determined by 29 generations and on regions where damages occur, often regions with low greenhouse 30 the rate of capital replacement, the discount rate and the effect of research and 30 gas emissions. Action to address climate change is likely to impose some costs on 31 development. Implementation of "no regrets" measures will increase the time 31 the present generation. Since actions to address climate change are deliberate, 32 available to learn about climate change and to bring new technologies to the market. 32 explicit decisions can be made as to how to share these burdens. 33 Infrastructure decisions are crucial because they can enhance or restrict future 33 34 options and different choices can lead to very different cost outcomes. 34 The Convention recognizes the differentiated responsibilities of the Parties, but it 35 35 does not include an explicit formula for sharing the costs of addressing climate 36 Estimates of the costs of stabilizing CO2 emissions vary widely as a result of 36 change. It also lists factors to be considered in determining how the burden should 37 differences in the baseline scenario, the estimated long run costs of mitigation 37 be shared and provides for development of mechanisms for sharing the burdens. 38 measures, and the date for achieving the stabilization objective. Differences among 38 Issues of equity and efficiency can for the most part be separated. Cost-effective 39 models are less significant than differences in the underlying assumptions. Indeed 39 strategies can be developed embracing a variety of ways for sharing the burden. 40 widely differing methods can produce quite similar results when calibrated to the 40 9 10 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I Equity issues involved in addressing climate change may be divided into four I contributions to the problem, while emissions from others may well start to dominate 2 categories: 2 it. 3 3 4 distributing the costs of adaptation; 4 Countries (such as low lying coastal regions and islands or drylands) and special 5 5 groups within society (such as the poor, and sometimes women or children, or 6 distributing future emissions rights; 6 specific occupations or regions) that are especially vulnerable to climate change - 7 7 those on whom the costs of abatement and coping would be especially burdensome 8 distributing the costs of abatement; and 8 - merit special attention. 9 9 10 ensuring institutional and procedural fairness. 10 All Parties have equal status under the Convention. Procedural equity also requires 11 II that all Parties be able to participate effectively in international negotiations related 12 The Convention offers some guidance on all of these issues, but doesn't resolve any 12 to climate change. Assistance to enable developing country Parties to participate 13 of them. 13 effectively in negotiations would increase the prospects for achieving effective, 14 14 lasting and equitable agreements on how best to address the threat of climate 15 A variety of ethical principles, including the importance of meeting people's basic 15 change. 16 needs, are relevant to sharing the burden of addressing climate change. No single 16 17 rule will command universal agreement. Furthermore, any arrangement may need to 17 Intergenerational Equity 18 change over time to continue to be perceived as equitable and to take new 18 19 developments into account. Analysts can not prescribe how the burden of addressing 19 Climate policy raises particular questions of equity among generations, because 20 climate change should be shared, they can only clarify the implications of different 20 future generations are not able to influence directly the policies being chosen today 21 principles (Chapter 3). 21 that will affect their well-being and because it might conceivably not be possible to 22 22 compensate future generations for reductions in well-being that might be caused by 23 Countries differ in terms of current greenhouse gas emissions (see Figures 5 and 6), 23 current policies. 24 vulnerability to climate change (Chapter 6), wealth, resource endowments, and 24 25 institutional capacity to respond effectively. The Convention provides that these 25 Sustainable development and the concept of an environmental trust have been 26 circumstances be reflected in differentiated responsibilities. Developed countries 26 proposed to address intergenerational equity. Sustainable development would meet 27 have undertaken commitments through the Convention for technology transfer and 27 "the needs of the present without compromising the ability of future generations to 28 contributions to the financial mechanism. 28 meet their own needs." An environmental trust, as proposed by Brown-Weiss, would 29 29 require each generation to ensure that the next inherits "a planet and cultural 30 A rigid "north-south" delineation of equity issues is inappropriate and may be highly 30 resource base at least as good as that of previous generations." 31 damaging in the long run, although it permeates much of the debate at present. The 31 32 implications of climate change for developing countries are different than those for 32 Discount Rate 33 developed countries because the former are generally poorer, have contributed much 33 good. 34 less to past emissions and still emit much less per capita, have shorter policy time- 34 The discount rate is the analytical tool economists use to compare economic effects 35 horizons, often weaker institutions, other urgent priorities, and are generally more 35 that occur at different points in time. Identifying the proper discount rate is probably 36 vulnerable to climate change. However, there are substantial variations within the 36 the single most important analytical step in economic analysis of global warming. 37 "north" and within the "south" in terms of absolute and per capita emissions, the 37 The choice of discount rate is important in climate change analyses because the time 38 likely impacts of climate change, institutional strengths and preferences, and 38 horizon is extremely long and the abatement costs tend to come earlier than the 39 endowment of natural resources that may be affected by mitigation. Similarly, over 39 benefits of avoided damages. It is also the most profound ethical question, since it 40 the next century some developing countries will continue to make marginal 11 12 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I inherently confronts present pain of abatement cost against damages suffered by I climate change, however, society is not likely to be able to set aside investments future generations if no action is taken. 2 2 over the next three centuries and earmark the proceeds the eventual compensation of 3 3 those adversely affected. Determining the discount rate on the basis of descriptive or The literature on the appropriate discount rate for climate change analysis can be 4 4 market considerations yields a global rate in the range of 3% to 6% real, with rates divided into two approaches. The prescriptive approach asks whether a particular 5 5 declining within this range as income rises. action would make society better off, given a plausible social welfare function. The 6 6 7 discounting rules specify how consumption at different dates should be valued to 7 Increasing the discount rate because of risk is generally inappropriate. 8 provide the correct answer to that question. The descriptive approach focuses on 8 9 intertemporal efficiency and opportunity costs. 9 Policy Instruments 10 10 11 The prescriptive approach discounts consumption accruing to different generations II A clear distinction needs to be drawn between actions to reduce the impacts of 12 using the "social rate of time preference" (SRTP). The SRTP is composed of two 12 climate change and actions to reduce emissions. The former also involve 13 components, "pure time preference" and the incremental welfare derived from future 13 consideration of adaptation policies. 14 14 ------------------------- consumption: 15 15 Policy instruments designed to mitigate climate change need to be assessed at the 16 Pure time preference is a reflection of impatience. Although there is 16 international and domestic levels. Such instruments can help participating countries 17 debate in the literature, values tend to range from zero to 1% 17 comply with multilateral commitments on climate change abatement, including 18 18 international transfers of resources and technology. The international and domestic 19 The incremental welfare of future consumption accounts for rising per 19 policy instruments need not be the same, but international agreements may constrain 20 capita income over time and the resulting decline in the incremental 20 the choice of domestic policy instruments. 21 welfare (marginal utility) derived from the higher future consumption. 21 22 22 The policy instruments available internationally and for adoption by groups of 23 Depending upon the values assumed for the different parameters, values for the 23 countries include: non-tradeable quotas, tradeable quotas, joint implementation, 24 SRTP on a global basis tend to fall between 0.5% and 3.0% per year. Developing 24 harmonized domestic carbon taxes, international carbon taxes, various international 25 countries may have much higher (10% to 20%) rates of SRTP due to high rates of 25 standards and technology transfer. Domestic policy instruments include carbon taxes, 26 per capita income growth or high elasticities of marginal utility for small increases 26 tradeable permits, deposit-refund systems, technology standards, performance 27 in per capita income from subsistence levels. 27 standards, product bans, voluntary agreements, energy taxes, energy efficiency 28 28 subsidies, non-fossil fuel subsidies, and removing existing market distortions. 29 It is important remember that in making choices concerning alternative policies, that 29 30 while differences in consumption at different dates will be valued using the SRTP, 30 Among the criteria that governments can consider when selecting from among the 31 those differences in consumption will be affected by the opportunity cost of capital, 31 available policy instruments are: distributional (including intergenerational) equity, 32 which typically is in the range of 7% to 15% real. Thus, where mitigation projects 32 flexibility in the face of technological change and new information, efficiency or 33 displace other investments yielding higher returns, the mitigation projects typically 33 cost-effectiveness, compatibility with the institutional structure and existing policies, 34 will not be chosen unless they yield returns at least equal to those on the displaced 34 and understandability to the general public. A mix of instruments may be needed to 35 capital. 35 achieve the best results. Governments may apply different criteria with different 36 36 weights to the selection of international and domestic policy instruments. 37 The descriptive approach to the discount rate looks at returns to investments in the 37 38 real world. Market rates of return usually exceed the values estimated for the SRTP. 38 Cost-effectiveness should always be a criteria for selecting policy instruments, but it 39 Conceptually, funds could then be invested in projects that provide a higher return 39 becomes more important at both the international and domestic levels as the 40 with the proceeds being used to increase future consumption. In the context of 40 abatement effort becomes more stringent. The economic literature suggests that the 13 14 a 7 6 5 4 3 2 - 15 depend on their acceptability to the public and to governments. design and implementation of those policies. The effectiveness of policies will also change policy will be determined by the choice of policy instrument as well as the consistent with equitable international burden sharing. The consequences of climate Although there are implementation problems associated with each, both can be made more economically efficient instruments include carbon taxes and tradeable quotas. JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY opt path doesn't Figure 1 divence Illustrative Anthropogenic Emissions Profiles of CO, Leading to Stabilization at Concentrations of 350 to 750 ppmv Using a Mid-range Carbon Cycle Model and CO2 Emissions for the IS92a, c and e Scenarios Anthropogenic emissions (GtC/yr) 20 IS92e IS92a 15 S750 take winds Ryer E mb 10 S650 S550 IS92c Anthropogenic CO, emissions in 1990 5 S450 S350 0 2000 2100 2200 2300 Year 930005 - 1/95.20 Source: 1994 Special Report of the IPCC Figure 3 Global Warming, Cost-Benefit anthropogenic CO, emissions in 1990 Analysis and Sustainable Development Damage and Abstement 2050 Costs Minimum Risk Zone Zone of Uncertainly S750 S650 S550 S450 S350 Comparison of IPCC Emissions Scenarios Adjusted for Current Commitments and Emissions Profiles Consistent with Stabilization of Unscceptable Resk 0 2040 AT Atmospheric Concentrations of 350 to 750 ppmv Source: Based on Chapter 12/adjusted for current commitments by Annex I Parties extended to 2050 A Trax IS92c (a) Absolute Standard Approach IS92eC IS92aC 2030 Damage Marginel Cost and of Abstement Abstement Unscceptable Flisk Costs Figure 2 IS92a 2020 Legend: IS92aC (IS92eC) is scenario IS92a (IS92e) 4 Unacceptable Cost 0 A Tran AT Anthropogenic emissions (GtC/yr) IS92e 2010 (b) Safe Minimum Standard Approach 2000 Marginal Cost Marginal Damage of Abalement Damage and Abstement Costs 1990 13 12 11 10 6 8 7 9 5 4 3 2 1 0 0 s Topt AT wish 1 I (c) Cost-Benelit Approach Source: Chapter 6 938005 Age L/BS - Figure 4 Alternative Views on Costs of Emission Reduction un inch me 1 revenues Marginal Cost A B CA not harefits carlyon D (no Ace CAST Inackelton analysis 0 (Gorlder papa) D2 D₃ Emission Reduction also chap 8 D, A - No reducible market imperfections and/or distatcon. Nardhave (woh) B - - "Negative cost potential" achieved C - Curve B plus "economic double dividends" Tan recycling BUT D . Curve C plus "environmental double dividends" 71 pm recta + 938005 tige 1/95 ap that SOu aerosols could 80 other way Source: Chapter 8 sector spanders an piblic 7 Prb finance question? 7 Figure 5 Carbon Emissions per Capita and Population, 1993 8 tC/cap 6 4 2 0 Africa Former India China Japan Other Latin US USSR Asia America EU12 Other Australia Canada Europe Population, Billion Source: Derived by M. Grubb from BP Statistical Review of World Energy 1994 and World Population Prospects, UN 938005 - 1/95.ap Figure 6 Carbon Emissions/GNP and Total GNP, 1992 Carbon emissions/GNP (kg/USSm) 1.4 1.2 1 0.8 0.6 0.4 0.2 0 Africa Former India Japan Australia Latin US Canada USSR China America EU12 Other Other Europe Asia World total GNP, Sbn (market exchange rate) Source: Chapter 3 930000 - Visap Chapter 5: Applicability of Techniques of Cost-Benefit Analysis to Climate Change Overall: This chapter is very lengthy and repetitive with other chapters, especially chapter 1. Basic terminology should be used more carefully, especially couching benefits and costs in present value terms. The chapter needs careful editing. SECTION II: SUMMARY OF COMMENTS This chapter is long and reproduces information found in other chapters (particularly the characteristics of the climate change problems found in chapter 1). Benefit and cost estimates should be couched in present value terms. Treatment of the discount rate is brief and not entirely consistent with that found in chapter 4. The discussion of the developing countries' public statements condemning joint implementation is not appropriate for the assessment. Host countries have something to lose if emissions reductions they undertake affect the baseline against which further emissions reductions are measured. Table 5.2 detracts from the section's description of multicriteria analysis. Since 3-4 of the criteria are considered to be central elements of the approach, the table seems superfluous and could be deleted. Some of the figures require more detailed information to improve the readers' comprehension of the material. SECTION III: DETAILED COMMENTS p. iii 1. 16-17 The global scale of the greenhouse gas control analysis derives from the characteristics of the climate change problem and is not " a fundamental result of cost-benefit analysis". Replace last sentence in the paragraph with the following: "The global scale for the analysis of greenhouse gas emissions control comes from the characteristics of the problem; that is, the composition of the atmosphere is a global public good, whereby the services the atmosphere provides are commonly held globally and the primary underlying forces that influence the earth's climate are also global (see chapter 1)." p. 6 line 16 Section 3. Unique Features of climate change This section overlaps greatly with the discussion in chapter 1. The points should be summarized, referring the reader to the earlier chapter. p. 11 Figure 4.1 Terms in the figure are not defined in the text: CHP, CCGTs, PWRs p. 12 1. 4 What are "T&D losses"? p. 14 2nd line below table 4.1 Market impacts should be emphasized where possible in the summary of damage estimates. Insert ", particularly the market impacts," after "the economic impact of climate change". p. 18 1. 18 Replace "true" with "the actual budget curve". p. 18 1. 20 Replace "true" with "the actual budget curve". p. 22 1. 41-42 The second full paragraph seems to imply that the risk premiums for lotteries with expected return X will necessarily be equal -- which is not true. The wording should be changed. p. 22 1. 47 The two alternatives do not seem to have the same expected reduction of 100 tons. p. 23 1. 12-13 The sentence should be replaced with wording similar to the following: "Even if not enough is known about the probability distribution of a variable to express it as a single expected estimate, we should note qualitatively the information that is available; the information should not be left out of the analysis completely." p. 23 1. 23-24 Increased knowledge about climate change will not automatically narrow the range of uncertainties in the future. In some cases, additional knowledge results in an appreciation of additional influencing factors of which individually little may be known. p. 24 1. 30 Interaction between the assumptions is important as well. Add text such as: "Moreover, there is considerable uncertainty about the interactions of these assumptions. To some extent, economists have little idea about the sensitivity of general equilibrium results to assumed parameters; there is no good analogue to confidence intervals used in empirical analyses." p. 24 point 6, 1. 6 Information imperfections are a good example of market imperfections. Insert "(e.g. information imperfections") after "market imperfection". p. 25 1. 7-8 This point made in this sentence is supported by articles in the literature (Kahnman and Tversky -- among others) i This work suggests that individuals have a difficult time rationally dealing with low probability events. p. 25 1. 47-48 Since the total US budget on defense was between $200-$300 per year and no decline of more than $100 billion has taken place since the end of the cold war, it is highly unlikely that this statement is true. "hundreds of billions of dollars" should be changed to "many billions of dollars". p. 26 1. 4-5 Expected benefits and costs should be discussed in present value terms. Insert "present value of" before "expected" in line 4 and before "expected costs" in line 5. p. 28 footnote 59 The footnote is incomplete. p. 31 1. 44-47 The treatment of CVM needs additional clarification. As part of the rulemaking exercise in the US under the Oil Pollution Act, a blue-ribbon panel of economists was convened to judge the adequacy of CVM for use in damage assessments. The findings from the panel should be included in this box. p. 33 1. 16-18 How is the 5 percent increase calculated? is it an increase in the annual rate of growth in the "price" of the environment? p. 33 1. 22 Replace "correct" with "optimal"; replace "optimal social rate" with "social discount rate". p. 33 1. 23-25 Why is the saturation and decline in economic growth rates more likely than remaining constant or increasing? p. 34 1. 27 The discussion of the resistance of developing countries to joint implementation is too simplistic. Host countries have something to lose if emissions reductions affect the baseline against which further emission reductions are measured. Lines 26-35 should be deleted. The discussion of reasons developing countries publicly renounce joint implementation does not further the assessment of CBA. p. 40 1. 5 The estimate of typical planning horizons of 15-25 years was used in the chapter. Why has the estimate of 20 years used in the summary? p. 40 1. 14-15 The text should use costs and benefits in present value terms. Minor changes: p. iii 1. 6 Insert "area of" before "climate change." p. 5 footnote 9, third line Remove "," after basin and insert "s" after require p. 7 1. 10 Insert "for greenhouse gases" after "calculus of CBA" p. 8 1. 23 Insert "damages" before "are related to " p. 8 1. 48 "Special" is misspelled p. 16 1. 17 Depletion of natural resources is important but a lesser concern to that of the appropriate measure of welfare. "Equally" should be changed to "Also". p. 18 footnote 43 "Kroner" should follow each currency estimate, (i.e. 2.6 billion "Kroner", with a range of 1.0-3.8 billion "Kroner") p. 20 1. 23 Where are the results "above"? p. 23 1. 25 Delete the word "value" since it is used again beginning of line 26. p. 24 1. 5 Insert "of emissions reductions" after "estimating the costs" . p. 24 1. 12 Insert ")" after "is difficult." p. 26 1. 10 Replace "to buy (and sell) with "make future purchases (or sales)". p. 32 1. 34 Insert "affecting climate change" at the end of sentence. Chapter 5 p. iii, line 3. The criticism of narrow cost-benefit analysis attacks a strawman. p. iii, line 13. Cost-benefit analysis can help answer the first question, but it would be simplistic to rely upon it unless losers can be fully compensated by winners. For example, if people have a "right" to a clean environment, then polluters should not necessarily be allowed to discharge, just because the costs may be greater than the benefits. p. 32, line 35. In chapter 4 most of the discussion concerns the case where the discount rate reflects time preference, not opportunity cost. Opportunity cost can be reflected through the shadow price of capital. p. 33, line 1. The opportunity costs of different investments could vary, depending on the share of costs drawn from consumption and investment, for example. p. 33, line 22. As a whole, the discussion of the discount rate here is very brief and not particularly consistent with chapter 4. The treatment here is more straightforward, though, about the difficulty of knowing the precise discount rate with certainty. p. 34, line 25. The idea that receiving countries have nothing to lose is too simplistic, if emissions reductions they undertake affect the baseline against which further emissions reductions are measured. This issue is more properly treated on line 39. p. 35, table 5.2. The table presents what appear to be far too many overlapping criteria. Basically, a tough problem is made even worse by this type of presentation. Fortunately this is recognized in line 42; however, the reader is dragged through an unnecessarily difficult presentation in the process. 9 Chapter 12: An Evaluation of the IPCC IS92 Emission Scenarios Section II: SUMMARY OF COMMENTS This chapter is poorly written, has a defensive tone, and is in some cases internally inconsistent. The presentation of the material in mostly bullet form is not easy to follow. The summary for policy makers for emissions scenarios should be used as the chapter core. The "scenarios summary" has several figures, one of which is included in the overall "summary for policy makers". If the emissions chapter carries no figures, what is the source material for the figures currently carried in the overall "summary for policy makers"? If a figure is carried in the emissions scenarios chapter, it should reflect current literature suggesting that near-term optimal paths are very similar regardless of the desired concentration level. The discussion of "purposes" should be dropped completely because it is confusing. Too much effort is expended in describing the different stages of policy analysis that utilize emissions projections when the very scenarios under discussion can only be used for the first out of four stages. SECTION III: DETAILED COMMENTS This chapter (chapter 12) is quite literally the technical summary for the chapter on emissions scenarios found in the 1994 Special Report. The tone is defensive -- justifying unsuccessfully why true analysis of emissions projections developed in 1992 was not accomplished. The text excessively discusses to what ends emissions projections should be used, why only energy and land-use activities are covered, why only a few geographic regions were studied, and why only a subset of greenhouse gas emissions were included in the analysis. It is abundently clear that minimal effort was expended to actually compare models that generated the emissions paths, to examine the reasonableness of the assumptions, and to test the sensitivity of the results to the models and the underlying assumptions. The information in the chapter is not well presented. Much of the text is organized into bullets. The writing is imprecise and confusing, making it difficult to follow the arguments even if one is technically trained in economics. A set of "purposes" identified for the use of emissions scenarios adds little to the understanding of the IPCC 1992 scenarios but underscores their limited utility beyond that as input data for general circulation models. The easiest way to fix this chapter is to use the summary for policy makers found in the 1994 Special Report as its core. More detailed information can be added where appropriate. The writing of the summary for policy makers for emissions scenarios is much cleaner and technically correct than that of the technical summary of the chapter. The summary for policy makers has been through contentious government review and plenary debate. Its tone is matter-of-fact and presents information carefully. No figure is currently found in the chapter. The "policy makers summary" needs to reference material in the underlying chapters. If figures are used in the emissions scenario, they should be vetted extensively. Detailed information from the underlying chapter in the special report or the technical summary could be added to the emissions summary for policy makers to enhance its contribution to the readers' understanding of climate change. JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I SUMMARY FOR POLICYMAKERS 1 The Convention thus incorporates, and the literature assessed in this report (Chapters 2 SECOND ASSESSMENT REPORT, WORKING GROUP III 2 1, 2, 8 and 9) supports a strategy of "act - then learn - then act" where the actions to 3 3 address climate change are periodically adjusted in light of new knowledge and 4 The Context 4 developments. The ultimate objective of stabilizing atmospheric concentrations of 5 5 greenhouse gases, although not yet operationally defined, provides guidance for 6 This assessment of the socio-economic literature related to climate change has been 6 policymakers when considering initial actions to address climate change. 7 undertaken in the context of sustainable development as reflected in the Framework 7 8 Convention on Climate Change. This Convention is now a key element in the 8 The Convention establishes a collective decision making process where actions, 9 decision making framework on climate change (Chapter 2). 9 reflecting their common but differentiated responsibilities, are agreed upon by the 10 10 Parties. The report identifies a number of general principles and findings that are 11 The ultimate objective of the Convention is "stabilization of greenhouse gas 11 relevant regardless of the decisionmaking process, such as those concerning the 12 concentrations in the atmosphere at a level that would prevent dangerous 12 design of cost-effective policies. It should be recognized that a collective decision 13 anthropogenic interference with the climate system. Such a level should be achieved 13 making process may not reach the same conclusions as analyses that adopt a global 14 within a time-frame sufficient to allow ecosystems to adapt naturally to climate 14 optimization perspective. 15 change, to ensure that food production is not threatened and to enable economic 15 16 development to proceed in a sustainable manner." 16 A Portfolio of Possible Actions to Limit Climate Change 17 17 18 The Convention specifies that to achieve this objective the "Parties should take 18 The precautionary principle (Article 3.3) and the estimated damages due to current 19 precautionary measures to anticipate, prevent or minimize the causes of climate 19 emissions of greenhouse gases (Chapter 6) argue for action beyond "no regrets" 20 change and mitigate its adverse effects. Where there are threats of serious or 20 measures. The decisions to be taken in the near future will necessarily have to be 21 irreversible damage, lack of full scientific certainty should not be used as a reason 21 taken under great uncertainty. However, these decisions are not very sensitive to the 22 for postponing such measures, taking into account that policies and measures should 22 level at which atmospheric concentrations are ultimately stabilized and can be 23 be cost-effective #2 23 adjusted based on experience, new knowledge and other developments. 24 24 25 Each of the Annex I Parties is committed to "adopt national policies and take 25 Actions analysed in the literature which countries can take, individually or jointly, to 26 corresponding measures on the mitigation of climate change, by limiting its 26 limit climate change and its impacts include: 27 anthropogenic emissions of greenhouse gases and protecting and enhancing its 27 28 greenhouse gas sinks and reservoirs." 28 implementing low cost measures to reduce emissions of greenhouse 29 29 gases. There is broad agreement that in most countries there are some 30 measures, such as energy efficiency, that can reduce emissions of 31 greenhouse gases at negative to slightly positive costs (Chapter 9). 32 Achieving such reductions may require policy intervention; 30 I United Nations Framework Convention on Climate Change. Article 2. The 33 31 Intergovernmental Negotiation Committee (INC) requested that the IPCC assess the 34 phasing out existing distortionary policies, such as some subsidies to 32 scientific evidence that might help policy makers interpret Article 2 of the 35 fossil fuels, that reduce welfare and, directly or indirectly, increase 33 Convention. This topic will be addressed in the IPCC's Second Assessment Report 34 to be published in 1995. 35 2 United Nations Framework Convention on Climate Change, Article 3.3. 36 4 No regrets measures are those whose benefits, such as reduced energy costs and 37 reduced emissions of conventional pollutants equal or exceed their cost, excluding 36 3 United Nations Framework Convention on Climate Change, Article 4.2(a). 38 the benefits of climate change mitigation. 1 2 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I greenhouse gas emissions. Global emissions reductions of 5% to 20% I An illustrative simulation of global options with marginal costs of up to $50 per 2 have been estimated for removal of energy subsidies worldwide (Chapter 2 tonne of carbon suggests about 50% of the total reduction/sequestration would be 3 11); 3 forestry measures, 25% would be through energy conservation and efficiency 4 4 improvements, and the remainder would come from a mix of renewable energy use, 5 implementing fuel switching measures, such as coal-fired generation to 5 fuel switching, CO2 removal and disposal, and nuclear energy. The mix of options 6 natural gas, to reduce emissions of greenhouse gases (Chapters 9 and 11); 6 and the magnitude of the reduction/sequestration relative to current emissions varies 7 7 significantly by region (Chapter 7). 8 implementing measures to enhance sinks or reservoirs of greenhouse 8 9 gases;6 9 Opportunities for Action Vary by Country and Over Time 10 10 11 instituting forms of international cooperation to limit greenhouse gas 11 Each country's approach to climate change can be represented as a portfolio of 12 emissions such as joint implementation and technology transfer; 12 actions that reflects its objectives, economic conditions and constraints. The actions 13 13 taken by a particular country may reflect considerations such as their cost, secondary 14 undertaking research aimed at better understanding the causes and 14 benefits, the impacts on different socio-economic groups, international equity, 15 impacts of, and adaptation to, climate change. Economic studies suggest 15 intergenerational equity, the expected damage due to climate change or sea level rise 16 that such research can yield high returns by reducing the uncertainty as 16 within the country, and economic strategies based on development of new 17 to the most cost-effective actions to address climate change (Chapter 2); 17 technologies. The size of the investment will reflect the country's obligations under 18 18 international agreements, adjusted for resources transferred to or received from other 19 conducting technological research aimed at enhancing energy efficiency, 19 countries, as well as domestic goals and priorities. A country's climate change 20 minimizing emissions of greenhouse gases from continued use of fossil 20 actions will also reflect other priorities aimed at sustainable development, including 21 fuels, and developing commercial non-fossil energy sources. The timing 21 eradication of poverty, increased levels of education, protection of environmental 22 and availability of cost-effective of non-fossil energy technologies is one 22 resources, and improved human health. 23 of the major determinants of addressing climate change in the long run 23 24 (Chapters 9 and 10); 24 Governments can and should adjust their portfolio of climate change actions in 25 25 response to new information and developments. Indeed, both the investment in 26 planning, and implementing as necessary, measures to adapt to the 26 climate change limitation and the mix of policies will probably change over time. 27 consequences of climate change; and 27 That does not imply complete flexibility. Many of the measures involve capital and 28 28 technology commitments with long life times. Reversing such commitments could be 29 developing institutional mechanisms, such as insurance, to share the risks 29 relatively costly. however that risk would be incorporated into the analysis of the 30 of damages due to climate change (Chapters I and 2). 30 options before the commitments are made. This is particularly important for 31 31 developing countries and countries with economies in transition where significant 32 infrastructure investments will be made over the next few decades. 33 34 Stabilization of Greenhouse Gas Concentrations 32 5 Energy prices that do not reflect the externalities associated with energy use can be 35 33 considered a distortionary policy. Under some circumstances, kerosene subsidies to 36 Climate change impacts are related to the stock of greenhouse gases (concentration) 34 reduce fuelwood use, can increase welfare or decrease emissions (Chapters 2 and 37 in the atmosphere, rather than the annual emissions, hence the ultimate objective of 35 11). 36 6 Some actions to increase sinks may have indirect effects, such as a change in 37 albedo. In such cases the net effect of the measure should be considered. 3 4 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY 1 the Convention is to stabilize atmospheric concentrations of greenhouse gases.' I Stabilization of the atmospheric concentrations of other greenhouse gases at today's 2 Currently, the atmospheric concentration of CO₂ is about 360 ppmv; the pre- 2 levels requires lesser reductions, but nevertheless reductions, of the emissions of 3 industrial concentration was about 280 ppmv.' The danger of significant harmful 3 those gases.¹² Thus, stabilization of atmospheric concentrations of greenhouse gases 4 effects from climate change increase as the concentration of greenhouse gases in the 4 will require very low population and economic growth rates (as assumed for IS92c), 5 atmosphere rises. The discussion below focuses on the effects associated with 5 a major "natural" change in energy technologies, or intervention to reduce emissions 6 stabilization of atmospheric concentrations of CO₂ within the range of 350 to 750 6 and enhance sinks. The effect of the initial commitments of Annex I Parties, 7 ppmv "could be attained only with global anthropogenic emissions that eventually 7 assuming that they are achieved and continued to 2050, is shown in Figure 2. The 8 drop to substantially below 1990 levels." 8 current commitments are not sufficient to stabilize atmospheric concentrations of 9 9 CO2, except under scenario IS92c which has emissions below current commitments 10 The IPCC's six emissions scenarios assume virtually no new policies specifically 10 (Chapter 12). 11 designed to reduce greenhouse gas emissions (Chapter 12). 10 Three scenarios that 11 12 span the full range (IS92a, IS92c and IS92e) are compared with the illustrative 12 Applicability of Cost-Benefit Analysis 13 profiles of anthropogenic emissions consistent with stabilization of atmospheric 13 14 concentrations at levels between 350 and 750 ppmv in Figure 1. These emissions 14 A stabilization objective could be based upon an absolute standard, an affordable 15 profiles indicate that at some stage major reductions of CO2 emissions (of the order 15 safe minimum standard, or a cost-benefit analysis, the approach favoured by most 16 of 50% of current emissions) will be required to eventually stabilize concentrations. 16 economists. These approaches are illustrated in Figure 3. The absolute standard 17 The pattern and timing of reductions of emissions can have a major effect on the 17 approach would define a maximum atmospheric concentration of greenhouse gases 18 overall costs of mitigation. "Emissions for all stabilization levels studied are lower 18 that is considered to constitute "dangerous anthropogenic interference with the 19 than those for IS92a and e, even in the first few decades of the 21" century. 19 climate system" on the basis of predicted changes to-the climate system or of the 20 Emissions for the IS92c Scenario lie between the emissions [profiles] which 20 predicted impacts of climate change regardless of the cost of achieving this 21 achieve stabilization at 450 and 550 ppmv."" 21 concentration. Environmental standards designed to safeguard human health are 22 22 often established using this approach. 23 24 The safe minimum standard approach would specify a maximum atmospheric 25 concentration of greenhouse gases based on an assessment of the risks associated 23 7 It is not clear from the Convention whether the ultimate objective is to stabilize the 26 with different atmospheric concentrations and the costs of achieving those 24 atmospheric concentration of each gas at a particular level or to stabilize greenhouse 27 concentrations. The standard would seek to reduce the risks of climate change to an 25 gas concentrations, expressed in terms of CO₂ equivalents, at a particular level. 28 acceptable level at an acceptable cost. Cost-benefit analysis attempts to value the 29 impacts of climate change and seeks the atmospheric concentration where the 26 a ppmv is parts per million by volume, a measure of concentration. 30 marginal value of the net impact is equal to the marginal cost of abatement. 27 9 31 Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 28 Assessment Working Group of IPCC, Summary for Policy Makers, IPCC, 1994, p. 4. 32 Working Group III was specifically requested to assess whether cost-benefit analysis 29 Analyses of emissions profiles consistent with stabilization of atmospheric 33 is applicable to climate change. Cost-benefit analysis was broadly interpreted to 30 concentrations of CO2 at levels lower than 350 ppmv or higher than 750 ppmv are 34 include traditional project level cost-benefit analysis, cost-effectiveness analysis, 31 presently not available in the literature. 35 multi-criteria analysis and decision analysis. The traditional cost-benefit approach is 32 10 The 1994 Special Report of IPCC, Summary for Policy Makers, IPCC, 1994, p. ?. 33 11 Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 36 12 Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 34 Assessment Working Group of IPCC, Summary for Policy Makers, IPCC, 1994, p. 37 Assessment Working Group of IPCC, Summary for Policy Makers, IPCC, 1994, p. 35 15. 38 18 and 20. 5 6 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY 1 depicted in Figure 3(c). Cost effectiveness analysis seeks to find the lowest cost I The literature contains a few aggregate (across all sectors and regions) estimates of option to achieve a specified objective; the marginal cost of abatement curves in 2 2 the damages associated with a climate characterized by a globally-averaged 2.5°C 3 Figures 3(b) and 3(c) represent cost-effective options. Multi-criteria analysis is 3 warming. The estimates suggest that if such warming occurred now it would impose designed to deal with problems where benefits and/or costs can not be valued; it 4 4 net damages equivalent to 1.5% to 2.5% of world GDP on the present world could be used for the approaches described in Figures 3(a) or 3(b), where non- 5 5 economy (Chapter 6). The regional variation in climate change damage would be 6 economic effects are brought into the analysis, but without a formal way of valuing 6 substantial. Damage in developing countries is estimated to be at least 2% with a 7 those effects relative to the economic impacts. Decision analysis focuses expressly 7 maximum central estimate of 9% of GDP for some regions. Small islands and low on making decisions under uncertainty and conceptually could be used in any of the 8 8 lying coastal areas are particularly vulnerable. Climate changes of this magnitude are 9 approaches described in Figure 3. 9 not expected to be realized for some decades and damages in the interim would be 10 10 smaller. Cost-benefit analysis (broadly defined) could contribute to resolution of three II 11 questions facing decisionmakers. These are: 12 12 Most estimates of the additional damage done by CO2 emitted now range from $5 to 13 13 $25 (1990 $ U.S.) per tonne of carbon, although a few estimates range up to $125 By how much should emissions of greenhouse gases be reduced or sinks 14 14 per tonne of carbon.¹ The models used to develop these estimates are simplistic and 15 of greenhouse gases be enhanced? 15 are poor representations of dynamic processes, but they reflect the current state of 16 16 the art. The wide range of estimates reflects variations in models, scenarios, discount 17 When should emissions be reduced or sinks be enhanced? 17 rates and other assumptions. 18 18 19 What methods should be employed to reduce emissions and enhance 19 Climate change benefits of emissions reduction measures can be very complex to 20 sinks? 20 estimate. Some energy efficiency and fuel switching measures simultaneously reduce 21 21 emissions of greenhouse gases and sulphate aerosols. The negative radiative forcing 22 Because of the large uncertainties surrounding estimates of damages due to climate 22 from sulphate aerosols is significant. "Tropospheric aerosols have a lifetime of only 23 change (Chapter 6) and the costs of mitigation (Chapter 9) make it difficult in 23 a few days So the atmospheric concentration of aerosols responds rapidly to 24 practice to rely solely on cost-benefit analysis for the selection of an appropriate 24 changes in emissions. Control of sulphate emissions would immediately reduce 25 stabilization objective at this time. Still, the information provided by cost-benefit 25 the amount of aerosols in the atmosphere." A recent model analysis finds that 26 analysis is critical in making judgements not only about that decision, but also about 26 replacement of fossil fuels with carbon-free energy sources leads to lower 27 the timing of emission reductions and the design of cost-effective strategies. 27 temperature increases in the long run, but higher temperatures in the interim due to 28 Integrated assessment models best suited to such analyses are quite new (Chapter 28 the reduced sulphur emissions (Chapter 10). 29 10). 29 30 30 Costs of Response Options 31 However, cost-effectiveness analysis can and should be used to evaluate adaptation 31 32 and mitigation options. 32 What matters from a policy perspective is the net cost (total cost adjusted for 33 33 secondary benefits and costs) of a mitigation or adaptation option apart from its 34 The Benefits of Limiting Greenhouse Gas Emissions and Enhancing Sinks 35 The benefits of limiting greenhouse gas emissions and enhancing sinks are the 34 36 13 A tonne is a metric ton or 1,000 kg. $5 per tonne of carbon corresponds to climate change damages avoided. Since some increase in atmospheric concentrations 35 approximately 0.35c per litre of motor gasoline. 37 38 from the current level is virtually inevitable, some impacts and damages due to 36 14 Radiative Forcing of Climate Change: The 1994 Special Report of the Scientific 39 climate change seem unavoidable. 37 Assessment Working Group of IPCC, Summary for Policy Makers, IPCC, 1994, p. 40 38 24. 7 8 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I climate change benefits (Chapter 8). A wide range of estimates of the costs of I same set of input assumptions, such as the cost and availability of different energy 2 response options is found in the literature. The wide range is due in large measure to 2 sources. 3 differences in assumptions. Alternative views of the costs of emissions reduction are 3 4 shown schematically in Figure 4. Curve A assumes that there are no reducible 4 Top-Down and Bottom-Up Models 5 market or government induced imperfections; thus there are no "no regrets" options. 5 6 Curves B, C and D all assume market failures or government induced imperfections 6 In the jargon of modelers "top-down" models are aggregate models, often 7 exist in one or more sectors that can be corrected by policies that reduce costs and 7 macroeconomic models, that analyse how changes in one sector of the economy 8 also lower greenhouse gas emissions. Curve B includes only measures whose direct 8 affect other sectors and regions. Early top-down models tended to have little detail 9 benefits yield net cost savings. Curves C and D incorporate secondary economic and 9 on energy consumption, especially at the technology-specific level, but explicit 10 environmental benefits into the calculation of the net cost of the option. 10 treatment of behaviour and economic interactions. In contrast, "bottom-up" models 11 11 tended to describe energy consumption in detail, however consumer behaviour and 12 The potential for "no regrets" policies is represented by the line OD2. The area 12 interactions with other sectors of the economy tended to be down played. 13 OD,D, is the potential net benefit to society of implementing all "no regrets" 13 14 measures. Some analysts have argued that measures with a positive cost should be 14 This simple characterization of top-down and bottom-up models is increasingly 15 implemented to the point where the total net cost to society is zero, i.e. to a point 15 misleading as more recent versions of each approach have tended to provide greater 16 D,>D₂ such that the area under curve D between D₂ and D₃ is equal to that area 16 detail in the areas that were less developed in the past. This convergence means that 17 OD,D₂. 17 differences in model results are increasingly driven by differences in input 18 18 assumptions rather than model structure. Most results available in the literature do 19 Despite significant differences in views, there is agreement that some energy 19 not reflect the effects of this convergence of model structure since the evolution in 20 efficiency improvements (perhaps to 10% to 30% of current consumption) can be 20 model structure is a relatively recent occurrence. 21 realized at negative to slightly positive costs in many countries, depending on the 21 22 baseline assumptions and the time frame (Chapter 9). Measures to reduce greenhouse 22 Nevertheless, differences in model structure remain important as different models are 23 gas emissions often yield additional economic benefits (such as reduced traffic 23 best suited to answer different types of questions. 24 congestion) and/or environmental benefits (such as reduced emissions of acid rain 24 25 and urban smog precursors). The magnitude of these secondary benefits depends on 25 Equity and Social Considerations 26 local circumstances. Studies for Norway, the U.K. and some other countries indicate 26 27 that secondary benefits could offset 30% to 100% of abatement costs (Chapter 6). 27 Equity considerations are an important aspect of climate change policy and feature 28 28 prominently in the Convention. Inaction is likely to impose costs on future 29 The long run costs of addressing climate change will ultimately be determined by 29 generations and on regions where damages occur, often regions with low greenhouse 30 the rate of capital replacement. the discount rate and the effect of research and 30 gas emissions. Action to address climate change is likely to impose some costs on 31 development. Implementation of "no regrets" measures will increase the time 31 the present generation. Since actions to address clinfate change are deliberate, 32 available to learn about climate change and to bring new technologies to the market. 32 explicit decisions can be made as to how to share these burdens. 33 Infrastructure decisions are crucial because they can enhance or restrict future 33 34 options and different choices can lead to very different cost outcomes. 34 The Convention recognizes the differentiated responsibilities of the Parties, but it 35 35 does not include an explicit formula for sharing the costs of addressing climate 36 Estimates of the costs of stabilizing CO2 emissions vary widely as a result of 36 change. It also lists factors to be considered in determining how the burden should 37 differences in the baseline scenario, the estimated long run costs of mitigation 37 be shared and provides for development of mechanisms for sharing the burdens. 38 measures, and the date for achieving the stabilization objective. Differences among 38 Issues of equity and efficiency can for the most part be separated. Cost-effective 39 models are less significant than differences in the underlying assumptions. Indeed 39 strategies can be developed embracing a variety of ways for sharing the burden. 40 widely differing methods can produce quite similar results when calibrated to the 40 9 10 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I Equity issues involved in addressing climate change may be divided into four I contributions to the problem, while emissions from others may well start to dominate 2 categories: 2 it. 3 3 4 distributing the costs of adaptation; 4 Countries (such as low lying coastal regions and islands or drylands) and special 5 5 groups within society (such as the poor, and sometimes women or children, or 6 distributing future emissions rights; 6 specific occupations or regions) that are especially vulnerable to climate change - 7 7 those on whom the costs of abatement and coping would be especially burdensome 8 distributing the costs of abatement; and 8 - merit special attention. 9 9 10 ensuring institutional and procedural fairness. 10 All Parties have equal status under the Convention. Procedural equity also requires 11 11 that all Parties be able to participate effectively in international negotiations related 12 The Convention offers some guidance on all of these issues, but doesn't resolve any 12 to climate change. Assistance to enable developing country Parties to participate 13 of them. 13 effectively in negotiations would increase the prospects for achieving effective, 14 14 lasting and equitable agreements on how best to address the threat of climate 15 A variety of ethical principles, including the importance of meeting people's basic 15 change. 16 needs, are relevant to sharing the burden of addressing climate change. No single 16 17 rule will command universal agreement. Furthermore, any arrangement may need to 17 Intergenerational Equity 18 change over time to continue to be perceived as equitable and to take new 18 19 developments into account. Analysts can not prescribe how the burden of addressing 19 Climate policy raises particular questions of equity among generations, because 20 climate change should be shared, they can only clarify the implications of different 20 future generations are not able to influence directly the policies being chosen today 21 principles (Chapter 3). 21 that will affect their well-being and because it might conceivably not be possible to 22 22 compensate future generations for reductions in wêll-being that might be caused by 23 Countries differ in terms of current greenhouse gas emissions (see Figures 5 and 6), 23 current policies. 24 vulnerability to climate change (Chapter 6). wealth, resource endowments, and 24 25 institutional capacity to respond effectively. The Convention provides that these 25 Sustainable development and the concept of an environmental trust have been 26 circumstances be reflected in differentiated responsibilities. Developed countries 26 proposed to address intergenerational equity. Sustainable development would meet 27 have undertaken commitments through the Convention for technology transfer and 27 "the needs of the present without compromising the ability of future generations to 28 contributions to the financial mechanism. 28 meet their own needs." An environmental trust, as proposed by Brown-Weiss, would 29 29 require each generation to ensure that the next inherits "a planet and cultural 30 A rigid "north-south" delineation of equity issues is inappropriate and may be highly 30 resource base at least as good as that of previous generations." 31 damaging in the long run, although it permeates much of the debate at present. The 31 32 implications of climate change for developing countries are different than those for 32 Discount Rate 33 developed countries because the former are generally poorer, have contributed much 33 34 less to past emissions and still emit much less per capita, have shorter policy time- 34 The discount rate is the analytical tool economists use to compare economic effects 35 horizons, often weaker institutions, other urgent priorities, and are generally more 35 that occur at different points in time. Identifying the proper discount rate is probably 36 vulnerable to climate change. However, there are substantial variations within the 36 the single most important analytical step in economic analysis of global warming. 37 "north" and within the "south" in terms of absolute and per capita emissions, the 37 The choice of discount rate is important in climate change analyses because the time 38 likely impacts of climate change, institutional strengths and preferences, and 38 horizon is extremely long and the abatement costs tend to come earlier than the 39 endowment of natural resources that may be affected by mitigation. Similarly, over 39 benefits of avoided damages. It is also the most profound ethical question, since it 40 the next century some developing countries will continue to make marginal 11 12 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY I inherently confronts present pain of abatement cost against damages suffered by I climate change, however, society is not likely to be able to set aside investments 2 future generations if no action is taken. 2 over the next three centuries and earmark the proceeds the eventual compensation of 3 3 those adversely affected. Determining the discount rate on the basis of descriptive or 4 The literature on the appropriate discount rate for climate change analysis can be 4 market considerations yields a global rate in the range of 3% to 6% real, with rates 5 divided into two approaches. The prescriptive approach asks whether a particular 5 declining within this range as income rises. 6 action would make society better off, given a plausible social welfare function. The 6 7 discounting rules specify how consumption at different dates should be valued to 7 Increasing the discount rate because of risk is generally inappropriate. 8 provide the correct answer to that question. The descriptive approach focuses on 8 9 intertemporal efficiency and opportunity costs. 9 Policy Instruments 10 10 11 The prescriptive approach discounts consumption accruing to different generations II A clear distinction needs to be drawn between actions to reduce the impacts of 12 using the "social rate of time preference" (SRTP). The SRTP is composed of two 12 climate change and actions to reduce emissions. The former also involve 13 components, "pure time preference" and the incremental welfare derived from future 13 consideration of adaptation policies. 14 consumption: 14 15 15 Policy instruments designed to mitigate climate change need to be assessed at the 16 Pure time preference is a reflection of impatience. Although there is 16 international and domestic levels. Such instruments can help participating countries 17 debate in the literature, values tend to range from zero to 1% 17 comply with multilateral commitments on climate change abatement, including 18 18 international transfers of resources and technology. The international and domestic 19 The incremental welfare of future consumption accounts for rising per 19 policy instruments need not be the same, but international agreements may constrain 20 capita income over time and the resulting decline in the incremental 20 the choice of domestic policy instruments. 21 welfare (marginal utility) derived from the higher future consumption. 21 22 22 The policy instruments available internationally and for adoption by groups of 23 Depending upon the values assumed for the different parameters, values for the 23 countries include: non-tradeable quotas, tradeable quotas, joint implementation, 24 SRTP on a global basis tend to fall between 0.5% and 3.0% per year. Developing 24 harmonized domestic carbon taxes, international carbon taxes, various international 25 countries may have much higher (10% to 20%) rates of SRTP due to high rates of 25 standards and technology transfer. Domestic policy instruments include carbon taxes, 26 per capita income growth or high elasticities of marginal utility for small increases 26 tradeable permits, deposit-refund systems, technology standards, performance 27 in per capita income from subsistence levels. 27 standards, product bans, voluntary agreements, energy taxes, energy efficiency 28 28 subsidies, non-fossil fuel subsidies, and removing éxisting market distortions. 29 It is important remember that in making choices concerning alternative policies, that 29 30 while differences in consumption at different dates will be valued using the SRTP. 30 Among the criteria that governments can consider when selecting from among the 31 those differences in consumption will be affected by the opportunity cost of capital, 31 available policy instruments are: distributional (including intergenerational) equity, 32 which typically is in the range of 7% to 15% real. Thus, where mitigation projects 32 flexibility in the face of technological change and new information, efficiency or 33 displace other investments yielding higher returns, the mitigation projects typically 33 cost-effectiveness, compatibility with the institutional structure and existing policies, 34 will not be chosen unless they yield returns at least equal to those on the displaced 34 and understandability to the general public. A mix of instruments may be needed to 35 capital. 35 achieve the best results. Governments may apply different criteria with different 36 36 weights to the selection of international and domestic policy instruments. 37 The descriptive approach to the discount rate looks at returns to investments in the 37 38 real world. Market rates of return usually exceed the values estimated for the SRTP. 38 Cost-effectiveness should always be a criteria for selecting policy instruments, but it 39 Conceptually, funds could then be invested in projects that provide a higher return 39 becomes more important at both the international and domestic levels as the 40 with the proceeds being used to increase future consumption. In the context of 40 abatement effort becomes more stringent. The economic literature suggests that the 13 14 JANUARY 20 DRAFT. DO NOT QUOTE. FOR REVIEW ONLY 1 more economically efficient instruments include carbon taxes and tradeable quotas. 2 Although there are implementation problems associated with each, both can be made 3 consistent with equitable international burden sharing. The consequences of climate 4 change policy will be determined by the choice of policy instrument as well as the 5 design and implementation of those policies. The effectiveness of policies will also Anthropogenic CO, emissions in 1990 6 depend on their acceptability to the public and to governments. 7 2300 Figure 1 Illustrative Anthropogenic Emissions Profiles of CO, Leading to Stabilization at Concentrations of 350 to 750 ppmv Using a Mid-range Carbon Cycle Model and CO2 Emissions for the IS92a, c and e Scenarios Source: 1994 Special Report of the IPCC 2200 S750 S650 S550 S450 Year IS92a IS92c 2100 Anthropogenic emissions (GtC/yr) S350 IS92e 2000 20 15 10 5 0 194 130003 , I 15 Figure 3 Global Warming, Cost-Benefit anthropogenic CO2 emissions in 1990 Analysis and Sustainable Development Damage and Abstement 2050 Costs Minimum Risk Zone Zone of Uncertainty S750 S650 S550 S450 S350 Comparison of IPCC Emissions Scenarios Adjusted for Current Commitments and Emissions Profiles Consistent with Stabilization of Unacceptable Flisk 0 2040 AT Atmospheric Concentrations of 350 to 750 ppmv Source: Based on Chapter 12/adjusted for current commitments by Annex I Parties extended to 2050 ^ Tmax IS92c (a) Absolute Standard Approach IS92eC IS92aC 2030 Damage Marginal Cost and Abstement Abelement Unacceptable Risk Costs Figure 2 IS92a 2020 Legend: IS92aC (IS92eC) is scenario IS92a (IS92e) 4 Unacceptable Cost Acceptable Cost 0 A Tmax AT Anthropogenic emissions (GtC/yr) IS92e 2010 (b) Safe Minimum Standard Approach 2000 Marginel Cost Marginal Damage of Abstement Damage and Abstement Costs 1990 13 12 11 10 9 8 7 6 5 4 3 2 1 0 0 ^ Topi AT $ 038003 , . (c) Cost-Benefit Approach Source: Chapter 6 938005 figs 1/95 - Figure 4 Alternative Views on Costs of Emission Reduction Marginal Cost A B C D 0 D₂ Emission D₃ Reduction D, A No reducible market imperfections and/or distantion B - - "Negative cost potential" achieved C - Curve B plus "economic double dividends" D - Curve C plus "environmental double dividends" Source: Chapter 8 938005 Age 1A5 up Figure 5 Carbon Emissions per Capita and Population, 1993 8 tC/cap 6 4 2 0 Africa Former India China Japan Other Latin US USSR Asia America EU12 Other Australia Canada Europe Population, Billion Source: Derived by M. Grubb from BP Statistical Review of World Energy 1994 and World Population Prospects, UN 938005 fign 1/95 mg Figure 6 Carbon Emissions/GNP and Total GNP, 1992 Carbon emissions/GNP (kg/US$m) 1.4 1.2 1 0.8 0.6 0.4 0.2 0 Africa Former India Japan Australia Latin US Canada USSR China America EU12 Other Other Europe Asia World total GNP, $bn (market exchange rate) Source: Chapter 3 936005 - 1/95.mp Chapter 4 This chapter has improved over earlier versions, but still could use some work. One general suggestion would be to have the chapter consider efficiency on a level more comparable to the current emphasis on equity. For example, shouldn't efficiency be in the chapter title and receive more attention in the summary? Also, there could be some additional explicit discussion of what efficiency means in the intergenerational context; the standard view that efficiency is a less controversial criterion than equity has some merit for this application. p. ii, line 20. How accepted in Brown-Weiss's argument? My sense is that it is not supported by any treaty. Rather it is more an ethical norm. Does terming it an international legal principle give it more weight than other philosophical criteria (e.g., Rawls's difference principle or Nozick's theory of rights) ? p. 11, line 32. The chapter does not explicitly recommend sensitivity analysis, despite the wide range of rates that can be justified. Shouldn't sensitivity analysis be recommended? If so, what would the recommendation be -- perhaps use of social rates of time preference of 2 to 4 percent with commensurate shadow prices of capital? If so, the shadow price of capital (SPC) or a range for this measure should be suggested. Higher discount rates should be considered in the case where no adjustment is made for the SPC (e.g., 2 to 8 percent). p. 1, line 14. Why is the alternative chapter title posited? If efficiency is an important consideration in discounting -- and it surely is -- then it should be mentioned in the actual title and should get adequate treatment in the chapter. p. 2, line 11. The flip side of the collapse of future values due to discounting is that very small displaced investments can lead to very large future shortfalls in output. p. 2, line 38. The implication that markets do not effectively allocate goods over time (and particularly over generations) is controversial. It affects more than global warming policy, and raises significant questions about national savings policy and use of exhaustible resources. I do not think that there is, in fact, a consensus among economists that market interest rates are generally incorrect guides to behaviors in those settings. p. 2, line 43. "the apply" should be "and then to apply". p. 3, line 21. The compensation problem deserves some discussion; it is relevant for any discount rate. p. 3, line 33. See comment for p. ii, line 20. 5 p. 3, last line. Why "must" discussions of intergenerational equity go beyond sustainability? Brown-Weiss, for example, implies that sustainability is a "legal" (though perhaps more accurately, "a plausible ethical") obligation that generations face. What evidence is there of a consensus that governments should be allowed to make poorer generations suffer so long as richer generations gain sufficiently? Arguably this view is controversial, yet it is implicit in the utilitarian framework that drives the equity analysis in this chapter. While this framework is important ànd merits exploring, it should be made clear that this is not the only possible framework. It should also be explained to policymakers that despite the technical content of this discussion, the material covered is quite normative, and that while economists have expertise in analyzing these norms, they are not in a position to determine them for society. p. 4, box. The discussion of Schelling's view is too abstract to be useful to policymakers. Regarding the conclusion in the box, it is not obvious that the analysis presented in the chapter -- which, in effect, suggests consumption transfers across generations to help equate marginal utility -- is appropriate in a world where richer nations make only modest transfers to poorer ones. p. 5, line 12. The sentence on Thurow's paper should probably be moved later in the paragraph. p. 5, line 30. The discussion in the prior section is also prescriptive. p. 6, line 38. Should add the following sentence to this paragraph: "However, given appropriate estimates of relative prices, there is no reason to explicitly modify the discount rate." p. 7, line 3. The social welfare function and related relationships used to derive this equation should be stated explicitly. This is the most important equation in the chapter, but it is not clearly derived for readers. A reference to the annex and a full presentation there would be useful. p. 9, line 19. The finding that the optimization problem is not well defined should be explained somewhat more. p. 11, line 22. Insert "absolute value of" before "elasticity". p. 11, line 26. Are the low rates of productivity a U.S. phenomenon or a world phenomenon? p. 11, line 38. See comment for p. 11, line 22. 6 p. 12, line 11. What is meant by "The more weight the society gives to intergenerational equity"? There are all kinds of equity criteria, each with different values of Θ. One view of equity would be very protective of worse-off generations; another might be less SO. p. 12, line 27. While there are a number of equity reasons to intervene to help the very poor, the idea that government should generally fine-tune the income distribution is less clear. At some point government intervention can cause inefficiencies and can run into other equity problems, such as those associated with confiscation. p. 12, line 40. Should "even" be "particularly"? p. 14, line 13. Shouldn't one state that based on "certain" ethical grounds, it is tough to support the higher time preference rate? p. 14, lines 34-5. The World Bank review and other study should be properly cited. Were they comprehensive or selective reviews of completed projects? Were poor projects dropped by virtue of being uncompleted? p. 15, line 30. Replace "most plausible discount rates" with "discount rates below 10 percent". p. 16, line 9. The estimate of a 15.1 percent real return to nonresidential capital over the period 1975-90 seems very high. The estimates should be properly attributed to their respective authors. p. 16, line 33. Wouldn't general economic growth address a large share of the damages from warming? Moreover, compensation of future parties that lose from particular policy choices is difficult regardless of the discount rate chosen. p. 17, line 1. The existence of multiple market failures is a classic problem of the second best. It is not obvious whether piecemeal fixes would make things better or worse. p. 17, line 19. Footnote 3 is unclear. Risk aversion (declining marginal utility) is supported by data, for example. p. 18, line 17. If there is no intertemporal welfare maximization by the government, then how can one assert that market rates are necessarily wrong? Couldn't the lack of intervention be viewed as an endorsement of market rates? p. 18, line 29. The work presented by Lyon at the IPCC meetings shows that a shadow price of capital of 1.5 to 2 may be quite low, given the rates of time preference assumed by Cline and 7 others. For example, with no reinvestment of capital income (except for coverage of depreciation), a rate of time preference of 2 percent, and a return to capital of 8 percent, the SPC will be 4.0. If 10 percent of net returns to capital are reinvested, the SPC rises to 6; and if 20 percent of net returns are reinvested, the SPC rises to 16. Moreover, if the rate of time preference is 1.5 percent -- as is argued at times in chapter 4 - - then the SPC under the last set of assumptions would be infinite. (Note that the total weight on costs will be below these values, as only the portion of costs coming from investment gets weighted by the SPC.) p. 19, line 1. The relationship of the discussion in this paragraph to the shadow price of capital approach is unclear. p. 23, line 24. This derivation of the discount rate could be explained a bit more. Equation 4A.1 should be maximized, and the relationship of the interest rate to this equation should be explained. p. 24, line 4. Again, intergenerational equity can be far more complex than determination of Θ. See comment for p. 12, line 11. p. 25, line 20. Again, the discount rate would not be negative if prices are appropriately adjusted. See comment for p. 6, line 38. p. 25, line 23. The relationship of the Sandmo-Dreze approach to the SPC approach is unclear. p. 27, line 17. Should the statement refer to G=U or G not equal to U? 8 a) If new technologies will become available in the near to medium term, it may be much less expensive to wait to reduce emission levels beyond modest amounts. This is one of the basic findings of studies cited elsewhere in the IPCC report. If the authors of this chapter disagree with those studies, they should state the reason, not just assert an alternative conclusion. b) The argument given earlier suggests that the shadow price of abatement today may be considerably lower than in 100 years. c) Though the argument on p. 9 that there may be large costs for sudden reductions is correct, the analysis does not take into account the important role of fixed costs, which suggest that while new investments should take into account the desirability of abatement, levels of abatement will increase only gradually. p. 1 The questions posed on page 1 are not well formulated. Key terms are not well defined. For instance, what does the word "tolerated" mean? Question 3 confuses issues of efficiency (where abatement occurs) and finance (who should pay the costs of abatement). p. 2 "In this connection, we note that accordign to the earlier IPCC report, even present information is adequate to go for the goal of reducing gloabl emissions by 60% for stabilisation." The sentence is difficult to follow. "Go for": Does this mean, justified by a cost benefit analysis? The earlier IPCC report did not have a cost benefit analysis. "stabilisation": stabilisation at what level? p. 7." risks are measured in CO₂ years.' I think I know what the authors are trying to get at, but it appears to be based on the wrong model (or at least a questionable model.) The sentence which follows is even more questionable. (Assume we were fairly confident that concentration levels below some threshold substantially higher than current levels were safe. Then increases in concentration levels in intervening years would pose no risk. And if the half life was short enough, most of the CO₂ emitted today would be dissipated by the time threshhold levels were attained: current emissions would pose little (integrated) risk to global warming.) The final sentence, however, is correct qualitatively, that is, increased concentration levels today have adverse consequences for future generations, by making whatever task they have in limiting concentrations more difficult. p. 8 Discussion of absorption capacity confuses analytic and scientific issues with normative issues. Thus, the fact that absorption capacity may be endogenous and changing does not affect the conclusion that absorption reduces net emissions. The question of the extent to which absorption levels are affected by concentration levels is an important one, and deserves more than the passing reference given here. Allocating the per capita absorption capacity of the world uniformly is one "normative" basis, but not the only one, as the authors indicate with the question, "Is this the right way to allocate absorption?" No hint is given of the other factors that might be considered. For instance, should countries that have brought their population growth rates under control be given "credit" for doing so? Proposals which allocate pollution rights simply on a per capita basis have severe problems of intellectual coherency. p. 8 The risk analysis at the bottom of p. 8 is faulty, or at least based on special assumptions. The authors should first state the general optimization problem to be solved, and then state the asserted qualitative properties, related to certain empirical parameters. Among the objections to the conclusions stated are the following: 02/24/95 12:48 9 202 6221294 TREASURY E 002 SECTION I: BIOGRAPHICAL INFORMATION Name: Joseph E. Stiglitz Organization: Council of Economic Advisors, Washington Area of Expertise: Microeconomics Phone: 202-395-5036 Fax: 202-395-6958 E-mail: none The following comments are on Chapter 2: Decision Making Framework SECTION II: SUMMARY OF COMMENTS Chapter is not yet in a form that can be effectively reviewed by experts or governments. ^ Chapter presents normative conclusions unsupported by scientific argument. This is not appropriate to a scientific assessment Chapter fails to focus attention on its major conclusions; the conclusions it does highlight are often at variance with economists' theory and empirical results. Logical foundation for many claims is shaky. Chapter does not make a balanced presentation of the issues. Writing is not up to the standard of a major IPCC publication. SECTION III: DETAILED COMMENTS Notes: 1) The rough state of the present draft makes it difficult to give helpful comments yet; 2) These comments are only a small fraction of the many that could be offered. Addressing these comments alone without other major work would probably still not result in a chapter that would gain acceptance in the economics profession. p. <Summary, page unnumbered> 1. 23-24. Causal relationship not established. p 2, section 2.1.2. Uncertainties are summarized better in 02/24/95 12:48 9 202 6221294 TREASURY E 003 Chapter 1; this list should be improved or deleted. p. 3, 1. 2-5. "Some expect " This is what economists generally view. believe, and should be presented as the prevailing p. 3, point 3. Text leaves the impression that Cline damage estimates, which have not received wide acceptance among economists are the accepted values. Nordhaus, Tol and Fankhauser have also published comprehensive damage estimates. p. 4, section 2.1.2.1. This paragraph assumes the conclusion. NOXT to last rentence, Normative conclusion no epet denved p. 5, 1. 6-7. sea level rise in Indian subcontinent from could be higher than in, say, North America. If How would the Indian Ocean rise more than the Atlantic and Pacific Oceans? analysis p. 5, 1. 8. Insert words in bold: " could have more or less impact " p. 5, figure 2.1. Delete temperature estimates. It is not the accepted view that for 2°C warming, damage would be "substantial. Also, graph appears to present probability density functions (but then what is the curve that starts highest on the probability axis?) If that is the case, the areas under the curves should be the same, the tails of the curves should extend to the left of the origin (implying some probability of benefits from warming), and other logical problems should be corrected. R.5, figure 2.2. Brobability of welfare impacts is irrelevant to the discussion I suggest a graph of delta Temperature (x-axis) against delta Welfare (y-axis). p. 6, 1. 32. Text missing. p. 7, 1. 14-16. Assumes the conclusion, which may be wrong. 12 Need to explain 1A what some NICKIS measured -years p. 8, 1. 10 ff. " if humanity lived a lifestyle corresponding to about 0.66 tonne of carbon equivalent emissions per person, per year " With no warning, sentence suddenly appears to endorse one side of a delicate political issue; out of place in a scientific assessment. p. 8, section 2.2.3. trend risk and not a sudden risk. " What does this mean? L. 28: " higher abatement costs are justified in case of trend risk. " Why is this? Because CO2 in atmosphere has an infinite lifetime? p. 9, 1. 1. "Therefore, small but regular ... if not impossible.' This may be correct, but it is not self-evident and does not fit here. Coreept of "acceptable GT" not dofined has no generally accepted defin TM in economics) 02/24/95 12:49 9 202 6221294 TREASURY E 004 p. 9, section 2.2.4. Why insert this political argument here? Political arguments belong in the INC. p. 11, 1. 1. What is the "apex forum?" p. 11. 1. 11. Change sentence: "To a few low-lying island states, climate change may threaten their existence. To oil exporters, climate change mitigation measures threaten their revenues." p. 11, 1. 12. "Again, it concerns differently economists and environmentalists." What does this mean? p. 12, 1. 7. Parry and Rosenzweig (cited) do not find large vulnerability in food supplies, contrary to impression left by text. p. 13, section 2.3.2.2. Economists will not take seriously this presentation of "Ecocentrism, " e.g., "To put it sharply, humankind's abrogation [?] of decision making power's regarding nature is questioned. The ecocentric view proposes to curtail such decision making power Equity is not only among human beings but also between human beings and other living species." In economics, value is generally defined with reference to willingness to pay. Resources have value because of someone's to willingness to pay for their use (or even just for their existence). Section 2.3.2.2 appears rest its argument on the idea that a resource may have value to other species; do other species have a willingness to pay, apart from our willingness to pay to protect them or make them happy? p. 14, 1. 20. "While the rich can argue " This political argument does not belong in a scientific assessment. p. 15, 1. 6. " the practice of discounting the future is severely questioned, etc. Sentence should be deleted, as address Chapter 4 settles this issue. Also, Cline's estimate cited in first paragraph is not widely accepted by economists. This reference should carry a note to that effect, or should be deleted. "This substitutability assumption is highly questionable. This statement assumes the conclusion. The section should either make the case for its assertion, or be silent. p. 16, 1. 4. " then not doing anything is morally unacceptable." This is a moral judgement, not a statement of scientific agreement. p. 16, section 2.3.3.1. First paragraph should also note that cutting back on growth in the North -- for example as a result of climate change programs -- is likely to hurt residents of the South as well, through a drop in southern exports. 02/24/95 12:50 9 202 6221294 TREASURY E 005 p. 18, 1. 5. "That is, due to delay in abatement, global risks are externalized." Alternatively, spending a lot now on the wrong programs could easily impoverish our descendants. p. 18, 1. 25. "Thus risk tolerance of, say South should matter more than that of North." This conclusion is unsupported. " homeless dying from heat stress " At least in the U.S. many more homeless die during winter than during summer. p. 18, 1. 27. "Most models developed in the North do not effectively build in the perspectives of the South in adapting to climate change. Economic models, like physical models, should be value-free. Do we speak of Northern physics and Southern physics -- or just good physics and bad physics? An economic model may be flawed for several reasons: it may be poorly formulated, or based on flawed estimation results; it may be internally inconsistent, or may predict poorly. We may say that it fails to reflect available resources, or misstates likely behavioral responses, but not that it does or does not "build in perspectives of the South." p. 19, section 2.3.3.4. This section presents political conclusions as if they were scientific conclusions, e.g., "Currently there are many countries whose use of environmental space far exceeds their justifiable share of that space. J. Parikh has indicated that these privileges are worth US $70 billion per year.' The section also presents apparently scientific conclusions that are probably wrong, e.g., "The cost of delay in emission reduction (by the North) in terms of South's foregone opportunities to development is substantial." (see Richels and Edmonds 1993, Schlesinger and Zhang 1992, etc.) p. 20, section 2.4.1. This section -- and indeed the entire chapter -- inappropriately presses a certain political point of view. For example, 1. 28: "Remember that if 550 ppm is chosen, it is difficult to go back to 440 ppm, but vice versa is possible." p. 22, above table. "This is referred as purchasing power parity." Wrong use of the term. p. 27, section 2.5. Why begin with the quote from Dowlatabadi and Morgan? Placed at the top of the section "Economic Formulation of Individual and Collective Decision Making", it suggests that the most important consideration is the prejudices of the decision makers. These may indeed be important, but the contribution of scientific analysis lies elsewhere. p. 28, 1. 17-20. II Bayesian approach, which represents information in the form of conventional, necessarily precise, 02/24/95 12:51 9 202 6221294 TREASURY E 006 probability distributions " The writer appears to be unaware of the voluminous and widely disseminated work on decision analysis that has appeared since the late 1950s. p. 29, 1. 26 ff. "From such a standpoint, a subjective probability can always be formulated as a 'bet on a certain event'. " What does this mean? p. 29, 1. 12. "In sum, climate change seems to imply a certain degree of irreducible unpredictability beyond the common categories of risk and uncertainty." Climate change is a difficult analytical problem, but not for this reason. Decision analysis has been applied to many questions involving great uncertainty. p. 31, 1. 3. "The most catastrophical fluctuation yet analyzed " Why describe this event as catastrophic? I don't believe we have any evidence of any large die off of plants or animals, or of an unusual number of species extinctions. p. 31, 1. 7. "The discrepancies between the paleoclimatic observations of abrupt change and the smooth gradual warming prognosticated by today's models could not be more pronounced." This is false and irrelevant. GCMs can in general show rapid changes. p. 32, 1. 13. If low probabilities attached to large potential damages." This is not a fatal problem, as the text claims. p. 35, 1. 8. " there might be as many rationalities as there are cultures." This may or may not be true, but it adds nothing to an assessment of the state of scientific knowledge. p. 38, 1. 11 ff. The writer does not seem to be familiar with the terms that economists use in describing risk. E.g.: "A risk averter can be a diversifier and spread his portfolio over different assets--or a "plunger" and invest wholly in bonds and money. " "Cautiousness: Defined as decreasing risk aversion ... (Schaifer, 1961; after Pratt, 1995) " It would be useful to consult a basic text such as Raiffa (1964). p. 38, 1. 26 ff. This section strings together terms from decision theory like cranberries on a Christmas tree, with no explanation of their meaning, and no attempt to relate them. Throwing around jargon and padding it with scholarly references will not help most readers. p. 40, 1. 10. " trade securities insurance contracts." Of what relevance is this here? p. 40, 1. 15. "According to Shlyakhter et al. (1995), those risks that fall below a particular threshold of probability--and thereby are ignored by a particular group or society--are called 02/24/95 12:52 89 202 6221294 TREASURY E 007 "de minimis" risks. [emphasis in original]. This is not a research result but merely a definition. p. 40, 1. 29. " 5 percent chance of a climate-related catastrophe within their lifetime. It is difficult to imagine what climate-related catastrophe could occur by, say 2050. p. 44, 1. 6. implies that the industrialized nations should take strong measures " "[emphasis in original]. This is a political conclusion. Why is it included here? p. 54, 1. 14. " would it not be cautious to insure ?" This statement assumes the conclusion, and inappropriately makes a policy recommendation. p. 55, 1. 5 ff. Paragraph is highly speculative and does not belong here. p. 55, footnote 19. "The more risk averse you are, the more you will insure (Chichilnisky, 1994) "[emphasis in original] This is not a research result. p. 56, 1. 8. "Economics is about differences in preferences leading to trade (Chichilnisky, 1994) " This is not a research result. p. 56, 1. 9. "Betting on climate states " What is this sentence saying? p. 56, 1. 23. "To illustrate, the Alliance of Small Island States (AOSIS) has proposed that an "International Insurance Pool" be established " Here, and in many other places, a tangential discussion deflects the reader's attention from the major arguments. This should go in a footnote or be deleted. p. 60, 1. 4. "An operational model to analyze the optimal portfolio of climate change policies for a country is not feasible given the state of our knowledge." No economic model will produce an error-free, bullet-proof answer to anything; on the other hand, several models already exist to examine precisely the question stated. The writer may want to consult recent papers of the Energy Modeling Forum at Stanford (for projects EMF-12 and EMF-14) for more details. .p. 64, figure 2.8. What is the message of this figure?