1. 3.6.2008Economics of Climate Change1 Chapter 14 Harnessing Markets for Mitigation - the role of taxation and trading Sari Karvonen, Katri Oksanen

2. 3.6.20082Economics of Climate Change Overview The key features of greenhouse-gas externality The key features of greenhouse-gas externality Standart theory of externalities Standart theory of externalities Efficient carbon reduction Efficient carbon reduction Prices versus quantity in the short term and long term Prices versus quantity in the short term and long term Setting short term policy to meet long term goals Setting short term policy to meet long term goals The social cost of carbon and the carbon price The social cost of carbon and the carbon price Conclusion Conclusion

3. 3.6.20083Economics of Climate Change The key features of greenhouse-gas externality A global externality A global externality impacts are not immidiately tangible impacts are not immidiately tangible uncertainty around the scale and timing uncertainty around the scale and timing the effects are potentially on a massive scale the effects are potentially on a massive scale

4. 3.6.20084Economics of Climate Change Standard theory of externalities: 1) a tax can be introduced so that the emitters face the full social cost of their emissions 2) quantity restrictions can limit the volume of emissions 3) a full set of property rights can be allocated 4) a single organisation can be created which brings those causing the externality together with all those affected

5. 3.6.20085Economics of Climate Change The key aim of climate-change policy should be to ensure that those generating GHG’s face the marginal cost of emissions that reflects the damage they cause The key aim of climate-change policy should be to ensure that those generating GHG’s face the marginal cost of emissions that reflects the damage they cause -> encourages emitters to invest in alternative, low carbon technologies, and consumers of GHG- intensive goods and services to change their spending patterns in response to an increase in relative prices

6. 3.6.20086Economics of Climate Change Efficient carbon reduction: Two conditions must hold to reduce GHG emissions efficiently: Two conditions must hold to reduce GHG emissions efficiently: 1) Abatement should take place up to the point where the benefits of further emissions reductions are just balanced by the costs (social cost of carbon= marginal cost of abatement)‏ 2) To deliver reductions at the lowest cost, a common price signal is required across countries

7. 3.6.20087Economics of Climate Change Prices versus quantity in the short term and long term A) The efficiency of taxes and tradable allowances in climate-change mitigation in the short term A) The efficiency of taxes and tradable allowances in climate-change mitigation in the short term

8. 3.6.20088Economics of Climate Change Prices versus quantities in the short term and long term B) The efficiency of taxes and tradable allowance in climate-change mitigation in the long term B) The efficiency of taxes and tradable allowance in climate-change mitigation in the long term

9. 3.6.20089Economics of Climate Change Efficiency under uncertainty Weizman (1974) examined how the price and quota of quantity control instruments compare where there is uncertainty about the cost and benefits of action Applying the Weitzman analysis to pollution: Prices are preferable when the benefits of reducing pollution outweigh the costs, for example shown in the graph. This applies to quantity controls as well. Prices are preferable when the benefits of reducing pollution outweigh the costs, for example shown in the graph. This applies to quantity controls as well. However, at a given level of pollution, the costs could exceed the benefits However, at a given level of pollution, the costs could exceed the benefits

10. 3.6.200810Economics of Climate Change These characteristics of costs and damage benefits of abatement and damage from emission suggest three things: Policy instruments should distinguish between the short-term and long-term Policy instruments should distinguish between the short-term and long-term clear long-term goals clear long-term goals In the short term,the policy-maker will want to choose a flexible approach to achieving long term goals In the short term,the policy-maker will want to choose a flexible approach to achieving long term goals

11. 3.6.200811Economics of Climate Change Setting short term policy to meet long term goals Aspects: The price of carbon is likely to rise over time The price of carbon is likely to rise over time short-term tax or trading policies will then need to be consistent short-term tax or trading policies will then need to be consistent In tax-based regime, the tax should be set to reflect to marginal damage caused by emissions In tax-based regime, the tax should be set to reflect to marginal damage caused by emissions In tradable quota scheme, the parameters of the scheme should be set with a view to generating a market price that is consistent with the social cost of carbon In tradable quota scheme, the parameters of the scheme should be set with a view to generating a market price that is consistent with the social cost of carbon

12. 3.6.200812Economics of Climate Change The social cost of carbon and the carbon price

13. 3.6.200813Economics of Climate Change The stabilasation target is analogous to the inflation target. However, the analogy is not exact: 1) There is not yet agreement about the stabilisation level at which stability should achieved 2) The stabilitization objective is likely to be revised intermittently to reflect improved scientific and economic undestanding of climate-change problems 3) The locus of decision- making in monetary policy clearly lies with the monetary authority of the country for which the inflation rate is measured

14. 3.6.200814Economics of Climate Change Public finance issues This transfer may be used to: enhance the revenue base enhance the revenue base limit the overall tax burden on the industry affected through revenue recycling limit the overall tax burden on the industry affected through revenue recycling reduce taxes elsewhere in the economy reduce taxes elsewhere in the economy

15. 3.6.200815Economics of Climate Change The strengths of the carbon taxes: can contribute to establishing a consistent price signal across regions and sectors can contribute to establishing a consistent price signal across regions and sectors raise public revenues raise public revenues can be kept stable and thus do not risk fluctuations in the marginal cost that could increase the total cost of mitigation policy can be kept stable and thus do not risk fluctuations in the marginal cost that could increase the total cost of mitigation policy However, they do not automatically generate financial flows to developing countries in search of the most effective carbon reductions

16. 3.6.200816Economics of Climate Change The strengths of tradable quotas: the extent that the scheme embraces different sectors and countries the extent that the scheme embraces different sectors and countries the extent that inter country trading is allowed the extent that inter country trading is allowed if allowances are sold or auctioned, then the scheme also has the potential to genarate public revenues if allowances are sold or auctioned, then the scheme also has the potential to genarate public revenues

17. 3.6.200817Economics of Climate Change Conclusion At the international level, this means that the key policy objectives for tackling climate change should include chosing a policy regime: in the long term will stabilise the GHG in the atmosphere in the long term will stabilise the GHG in the atmosphere in the short term use a price signal (tax or trading) to drive emission reduction in the short term use a price signal (tax or trading) to drive emission reduction Establishing a consistent price signal across countries and sectors to reduce GHG emissions Establishing a consistent price signal across countries and sectors to reduce GHG emissions

18. 3.6.2008Economics of Climate Change18 Chapter 18 Understanding the Economics of Adaptation Sari Karvonen, Katri Oksanen

19. 3.6.200819Economics of Climate Change Contents Role of adaptation Role of adaptation Adaptation perspectives Adaptation perspectives Barriers and limits to adaptation Barriers and limits to adaptation Conclusions Conclusions

20. 3.6.200820Economics of Climate Change Role of adaptation What is adaptation? What is adaptation? ”Any adjustment in natural or human systems in response to actual or expected climatic stimuli or their effects, which moderates harm or exploits beneficial opportunities.” Intergovernmental Panel on Climate Change IPCC (2001)

21. 3.6.200821Economics of Climate Change An essential part of a response to the challenge of climate change An essential part of a response to the challenge of climate change  crucial and only way to deal with the unavoidable effects of climate change  offers an opportunity to adjust economic activity in vulnerable sectors and support sustainable development

22. 3.6.200822Economics of Climate Change Objective: to reduce vulnerability to climatic change and variability Objective: to reduce vulnerability to climatic change and variability  reduces their negative impacts  enhances the capability to capture any benefits of climate change Thus adaptation together with mitigation is an important response strategy!

23. 3.6.200823Economics of Climate Change The role of adaptation in reducing climate change damages The Stern Review page 405 Figure 18.1

24. 3.6.200824Economics of Climate Change Adaptation perspectives Two adaptation perspectives: Two adaptation perspectives:  Autonomous: actions that are taken naturally by private actors without any active intervention of policy  Policy-driven: adaptation a result of a deliberate policy decision The need for policy-driven adaptation is defined by the extent to which society can rely on autonomous adaptation The need for policy-driven adaptation is defined by the extent to which society can rely on autonomous adaptation

25. 3.6.200825Economics of Climate Change Examples of adaptation in practice The Stern Review page 406 Table 18.1

26. 3.6.200826Economics of Climate Change Difference between short-run and long-run adaptation decisions Difference between short-run and long-run adaptation decisions Basic diagram: K x E The Stern Review page 408 Box 18.1

27. 3.6.200827Economics of Climate Change In the short run In the short run  responding only by changing variable inputs The Stern Review page 408 Box 18.1 Change in E due to climatic change and variability over a short period of time

28. 3.6.200828Economics of Climate Change In the long run In the long run  responding by changing both variable inputs and the capital stock The Stern Review page 408 Box 18.1 Change in E due to climatic change and variability over a long period of time

29. 3.6.200829Economics of Climate Change In practise adaptation occurs in response to particular climate events and in context of other socio-economic changes In practise adaptation occurs in response to particular climate events and in context of other socio-economic changes First step of adaptation First step of adaptation  responding to changed climate and weather Second step of adaptation Second step of adaptation  enhancing these responses to prepare for future impacts

30. 3.6.200830Economics of Climate Change Many decisions made autonomously Many decisions made autonomously  important consequences for the way economists understand and appraise adaptation policy 1) much adaptation will be triggered by the way climate change is experienced 2) many adaptation decisions involve a measure of habit and custom

31. 3.6.200831Economics of Climate Change Decisions about the timing and amount of adaptation require that costs and benefits are compared Decisions about the timing and amount of adaptation require that costs and benefits are compared  the chosen route should be the one with the highest net benefit while the risks and uncertainties of climate change have been taken into account

32. 3.6.200832Economics of Climate Change Adaptation costs and benefits T 0 : without climate changeA 0 : Without climate change T 1 : with climate changeA 1 : With climate change Climate change damage: W(T 1, A 0 ) – W(T 0, A 0 )‏ Climate change damage: W(T 1, A 0 ) – W(T 0, A 0 )‏ Net benefits of adaptation: W(T 1,A 1 ) – W(T 1, A 0 )‏ Net benefits of adaptation: W(T 1,A 1 ) – W(T 1, A 0 )‏ Climate change damage after adaptation: W(T 1, A 1 ) – W(T 0, A 0 )‏ Climate change damage after adaptation: W(T 1, A 1 ) – W(T 0, A 0 )‏ The Stern Review page 409 Box 18.2

33. 3.6.200833Economics of Climate Change The trade-offs of planning adaptation under uncertainty  When deciding which adaptation strategy to implement, the balance of risks and costs of planning for climate change that do not occur (and vice versa) should be take into account The Stern Review page 409 Box 18.2

34. 3.6.200834Economics of Climate Change Not a lot of studies where adaptation costs and benefits are reported separately Not a lot of studies where adaptation costs and benefits are reported separately However some studies have been made for sectors especially vulnerable to climate change However some studies have been made for sectors especially vulnerable to climate change  coastal protection  agriculture

35. 3.6.200835Economics of Climate Change The Stern Review page 411 Table 18.2

36. 3.6.200836Economics of Climate Change Barriers and limits to adaptation Autonomous adaptation unlikely to lead to efficient adaptation because Autonomous adaptation unlikely to lead to efficient adaptation because 1) uncertainty and imperfect information 2) missing and misaligned markets 3) financial constraints.  the barriers of adaptation

37. 3.6.200837Economics of Climate Change 1) Uncertainty and imperfect information - high-quality information on future climate change is important - determined understanding about the likely consequences of climate change  uncertainty acts as a significant disadvantage to adaptation

38. 3.6.200838Economics of Climate Change 2) Missing and misaligned markets - Autonomous adaptation is more likely in the short-run when the benefits pile up to those investing in adaptation - In the long-run effective adaptation may be challenging to private markets  uncertain future benefits vs. most certain current costs  also those who didn’t share the costs are going to benefit

39. 3.6.200839Economics of Climate Change 3) Financial constraints - the poorest in society have the least capacity to adapt  the impacts of climate change could exacerbate existing inequalities Limits of adaptation 1) residual uncertainty 2) natural limits 3) technical limits

40. 3.6.200840Economics of Climate Change Conclusions Many ways to adapt both autonomously and through policies Many ways to adapt both autonomously and through policies Governments have to support autonomous adaptation Governments have to support autonomous adaptation Adaptation can mute the impacts, but it can not solve the problem of climate change  limits Adaptation can mute the impacts, but it can not solve the problem of climate change  limits

41. 3.6.200841Economics of Climate Change Questions

42. 3.6.200842Economics of Climate Change 1) In the standard theory of externalities, there are four ways in which negative externalities can be approached. Which one is the best way? Can you imagine any other ways to reduce negative externalities?

43. 3.6.200843Economics of Climate Change 2) Is it fair, that if marginal cost of reduction is lower in country A than in country B, then abatement costs could be reduced by doing a little more reduction in country A and a little less in country B? How we can reduce emissions efficiently? Why is emission reducing so problematic?

44. 3.6.200844Economics of Climate Change 3) What kind of short-term policy should we use to achieve long-term stabilisation goals? What problems can arise?

45. 3.6.200845Economics of Climate Change 4) Revenue recycling to the industry can encourage emitters to reduce GHG emissions, without increasing their overall tax burden relative to other parts of the economy. What are the advantages and disadvantages of this approach?

46. 3.6.200846Economics of Climate Change 5) Why is adaptation so important? Couldn’t we just rely on mitigation?

47. 3.6.200847Economics of Climate Change 6) There are two adaptation perspectives, an autonomous and a policy-driven response to climate change. What are the characteristics of them and would the use of autonomous adaptation in itself be sufficient enough?

48. 3.6.200848Economics of Climate Change 7) In which areas is it indicated that efficient adaptation might reduce climate damages significantly and why is that?

49. 3.6.200849Economics of Climate Change 8) Why are both mitigation and adaptation important?