1. Global climate change: Economics and public action

2. The experiment
Source: Stiglitz, 2006

3. The Big Picture
The Big Picture

4. Agenda A (very) rapid look at the science of climate change
The economics of climate change
Externalities and public goods
Cost benefit analysis
Policy choices
The collective action problem

5. The science of global climate change
The mechanism of global climate change
Greenhouse gases affect temperature
GHGs include carbon dioxide, methane, nitrous oxides, CFCs etc
Some GHG’s (e.g. CO2, methane) are integral to the earth’s carbon cycle; others (e.g. CFC) are human products
The central views from scientists:
Temperatures are rising; GHG levels have a causal influence
Human influence is increasing GHG concentration
If GHG concentrations double, global temperatures will rise of the order of 2-4 degrees
There is still some controversy, but we’ll take the science as given for today
Note: CFCs are greenhouse gases, but the big issue around them was on effects on the ozone layer and so on skin cancer (etc). More on the (successful) Montreal Protocol below

6. Long-term increases in temperature

7. Climate models indicate these temperature increases are related to human action…

8. ...due to a variety of sources of GHGs affected by human behavior

9. Predicted temperature effect of various levels of stabilization of GHGs by 2100…

10. ..a range of projections on further temperature increases on “business as usual” effects of carbon emissions…

11. ..and significant variation in predicted effects even for same level of CO2 change…

12. …with a wide range of effects on water availability…

13. ...and possibilities of severe effects and tipping points

14. Changes in stocks require large cuts in emissions, given long lives of GHGs

15. Rich countries account for most of the stock, but developing countries for much of the projected growth in emissions

16. So future developing country emissions are part of the problem under these scenarios

17. The development and distribution issue
Carbon emissions given by:
C = C/E x E/Y x Y/P x P
C/E = carbon emissions per unit of energy
E/Y = energy use per unit of GDP
Y/P = GDP per capita
P = population growth
Illustrative number: US E/Y is 50% more than for Europe, 100% more than Japan; many times than for developing countries
Different proposals focus on different variables: C; E/Y or C/Y; C/P

18. The economics of climate change
Emission creates a negative externality
Net benefits to polluter
Costs to everyone else
Source: Nolan Miller lecture notes
Who is the emitter? Depends on level of aggregation:
A firm, or
A country, if externalities are internalized within the border

19. So abatement is a public good
Non-rivalrous
Non-excludable
…and will be under produced
Benefits of abatement to the world
Benefits of abatement to country x
Source: Nolan Miller lecture notes
Costs of abatement to country x

20. Uncertainty prevails; over…
Size of temperature changes
Impacts on precipitation and sea-level effects
Probabilities of “large” adverse effects
Economic impacts on growth processes and so benefits of action
Costs of adaptation—but little work on socially contingent responses e.g. migration and conflict
Costs of mitigation/abatement

21. Irreversibilities matter..
“Mega” irreversibilities may exist around climatic conditions, creating option value of preventing large climate change
Economic irreversibilities matter, and these cut both ways
Changing the economic life of existing capital stock
Changing to greener capital stock (if prove unnecessary)

22. Evaluation How to evaluate the benefits and costs of climate change?
Economic issues
Valuation of benefits and costs
Inter-temporal equity and the discount rate
Marginal utility of consumption
Will future generations be richer?
Who is hurt by climate change?
Uncertainty
Where W is social welfare, c is consumption and δ is the social rate of time preference

23. The debate on discount rates
The discount rate (ρ) is a function of the social rate of time preference (δ) the rate of growth of consumption (g) and the elasticity of the marginal utility of consumption (η) [in a simplified account]
Stern review argues for a δ close to zero, and a low value of η (around 1), giving an overall discount rate close to 1.4%
Most economists argue for a higher discount rate, either with a higher δ or a higher η.
This has a huge impact on the benefit cost ratio and the implications for optimal action

24. Costs and benefits of action: large uncertainties and still significant debate
Nordhaus circa 2000: optimal policy is for modest tax; stabilization
has negative benefit cost ratio
Now central estimates are shifting to a more favorable benefit cost ratio
for action: Nordhaus circa 2006 has increased estimate of global output
cost of 2.5 degrees from 2 to 3% of GDP. This still implies a ramping up
scenario
Stern Report argues for very favorable benefit cost ratio for strong early action
Some of this comes from estimates of higher estimates of costs, and lower
estimates of benefits; most revolves around the choice of the discount rate

25. Policy issues Policy responses Mitigation Adaptation Choice of
Largely
national
Adaptation
Choice of
instruments
Distribution of
adaptation costs
Intrinsically
international
Effort distribution
across countries
A side
payment
Finance/support
for poor country
adaptation
The collective
action problem

26. Instruments for mitigation
Type of instrument
Advantage
Disadvantage
Property rights/Coase
Infeasible in international context
Carbon tax
Optimal to guide efficient decisions
Uncertain effects
Hard to get cross-country consistency
Cap and trade
Politicians and citizens understand caps
Trading can lead to efficient choices
Hard to get agreement on distribution of caps
Thin market; uncertain price
Regulation
Clear and understandable
Can be highly inefficient
Subsidies to technological research
Good economics for a public good
Finance
Private sector will be central to research
Rich country bias on adaptation

27. Policy: taxation (i) taxing emission
Polluter now producers
until marginal net benefit
equals the tax rate
Source: Nolan Miller lecture notes
Technical problems: (i) finding the Pigovian tax rate, (ii) finding a tax base strongly
correlated with carbon emissions; in principle past estimates, trial and error can
be used
Also large political and coordination problems

28. Policy: taxation (ii) subsidizing carbon sinks
Deforestation is a source of increased emisions, so either reforestation or slowing deforestation has a positive externality, warranting a subsidy
Concept underlying the Rainforest Initiative

29. Policy: cap and trade
A cap is a quota, negotiated at country and then industry level
But can lead to highly inefficient results, since marginal costs of meeting the quota highly unlikely to be equalized
Creating a market for firms to buy and sell emission rights allows this marginal cost to be equalized (amongst participants)

30. Policy: regulation Example: the Governator
Ambitious targets plus regulation for California
California can be a standards-setter
Is it credible?

31. The collective action problem: underlying structure of the game is PD; polluting is a dominant strategy
Player Y
Player X
Abate
Pollute
2, 2
-1, 3
3,-1
0, 0 Пa Пp
Number of other countries playing abate
Many countries: Payoffs to any country of playing abate (Пa) and pollute (Пb)

32. The collective action problem Why the Montreal Protocol worked
Benefit cost ratios in rich countries were highly favorable to action and supported unilateral action by US
So US could lead, including in technological change
Payoffs to US (1985 $bln)
No controls
Montreal protocol
Unilateral action of Montreal
Benefits
3575
1373
Costs 21
Net benefits
3554
1352

33. So the US problem is transformed to this…
Its dominant strategy is abate
With incentives for US business to innovate, creating strategic complementarities with CFC-substitutes (via standards and reduced cost of abatement) Пa Пp
Number of other countries playing abate
Payoffs to US of playing abate (Пa) and pollute (Пb)

34. Solving cooperation with Europe was relatively easy
High benefits, low costs
Internal coordination (partially) solved in Europe; citizen attitudes underpinned an “abate” domestic political equilibrium
Two-thirds ratification for treaty to come in force (a 90% threshold would have increased leverage of Japan and USSR)

35. Trade sanctions were effective in changing the equilibrium on signing for resisting countries
Restrictions on trade in CFCs between signatories and non-signatories was part of the agreement.
There is a tipping point and the interaction becomes a coordination game Пa Пp
Payoffs to other countries of playing signatory (Пs) and non-signatory (Пn) with trade sanctions
Number of other signatories

36. And why climate change is a lot harder
Benefit cost ratios are less favorable
Given higher costs concerns over competitiveness matter
E.g. European carbon tax made conditional in 1992 on US and Japan adopting the same. They didn’t
US concerns over developing country competition

37. Kyoto Protocol Cap and trade
Only sought to solve collective action across rich countries, with negotiated “equitable” caps only for rich countries
Incentives for mitigation investments in developing countries via inclusion in trading of carbon allowances

38. Cap and trade Business preferred cap and trade to carbon tax
Business persuaded governments that carbon allowances be given, not auctioned
Trading with developing countries is taking off, especially for green investments (abatement) in China—a form of side payment

39. A major distributional fight affecting the collective action problem
Rich countries: responsible for stock
Poor countries (including fast-growing China and India): increasingly responsible for margin, yet argue that they should be able to increase E/Y toward rich country levels
Makes agreement on cap approach hard

40. The position of business
Big concerns over cost effects and competitiveness. Latter is a function of the extent to which collective action problem is resolved
Different views but most firms have “green” departments e.g. Dupont again
Pressures from investors

41. Takeaways and outstanding issues
The Stern Review has done a huge service in bringing the economics of global climate change to the center of the debate. Core public economics principles pervade the report. But there is still controversy over choices
Evaluating the economic case for action
What discount rate(s) make sense?
How to value the (catastrophic) tail?
How to value net benefits to poorer groups?
The domestic political equilibrium
How do citizens value inter-generational equity?
What is the dynamic between business and government policy?
What drives overall political payoffs to government?
The global strategic interaction
Is there a self-enforcing equilibrium with US, Europe-Japan and China-India at the core?
Are trade sanctions credible? Against the US? Against “the rest”?
Will rich countries want to use trading to subsidize Chinese industries?
Do aid givers have a contingent liability to hard-hit poor countries?
How to analyze strategic interactions and feasible, as opposed socially optimal, outcomes is at the center of microeconomics II