Economic policy issues for climate change

The design of appropriate policy interventions faces a number of difficulties - the characteristics of a global pollution externality, uncertainty about both the economic costs of climate change and the costs of mitigation, and the need to make intergenerational comparisons because of the very long time lags between cause and effect

By John Freebairn

This paper canvasses economic policy issues regarding the mitigation of the external costs of human activity that are likely to cause climate change. It begins with a background picture of some physical aspects of climate change. Policy questions and policy options in relation to climate change are discussed in terms of:

External costs and the rationale for government intervention;
Long time lags, intergenerational comparisons, and discount rates;
The international dimension and policy design challenges;
Imperfect knowledge; and
The pros and cons of different policy intervention options, including taxes, tradeable permits, R&D subsidies and regulations.

Background

The science base of climate change is a flow-stock process. The flow of greenhouse gases from all over the world, much of it associated with human activities such as the burning of fossil fuels for energy, transport and heating, and deforestation, adds to the stock of global greenhouse gases. A larger stock of greenhouse gases is thought to be a prime determinant of climate change, characterised by a rise in temperatures, and greater instances of extreme climatic events, such as droughts, floods and tornados. Likely climate change over the coming decades will have direct adverse economic effects, in particular on agriculture, infrastructure, the availability of water, biodiversity and sea levels. There is not unanimous scientific agreement, and there is uncertainty about the details. However, as documented by the International Panel on Climate Change, there is considerable support for both the likelihood of climate change and the belief that human activities are major contributors.

In terms of economic decisions by businesses, households and governments, the prospect of climate change raises two sets of decisions, namely:

Adapting choices to a different set of exogenous climate conditions; and
Developing appropriate policies to mitigate human decisions which contribute to climate change.

Both sets of decisions will involve changes in relative prices and the comparative advantages of different products and production processes. There will be a general equilibrium process of ‘creative destruction’ with some losses and some gains across different production and consumption activities. Particularly in the case of climate change mitigation, market failure and the potential for beneficial government intervention is important. Apart from government provision of information, there are less instances of market failure with climate change adaptation decisions. The design of appropriate policy interventions is challenged by the characteristics of a global pollution externality, uncertainty about both the economic costs of climate change and the costs of mitigation, and the need to make intergenerational comparisons because of the very long time lags between cause and effect.

Climate change as a market failure

Greenhouse gas emissions are a by-product of many human activities, and in most cases they are unrecognised emissions into a global atmosphere that nobody owns. For example, driving cars and burning of fossil fuels to produce electricity in every country, adds to the global stock of greenhouse gases, but the by-product is not included in the transaction costs or prices. In time, the build-up of the global stock of greenhouse gases leads to climate change and external costs in the form of changes in agricultural productivity, severe climatic events with adverse effects on infrastructure, loss of biodiversity and so forth. The production of greenhouse gases and associated climate change has sometimes been labelled ‘the mother of all externalities’. If left to market forces, ignoring the external costs of greenhouse gases will result in too much production and consumption of products intensive in the use of greenhouse gas, as well as in the choice of production methods that produce too much greenhouse gas.

Where external costs are involved, economics provides clear guidelines for making more efficient production and consumption decisions, and policy interventions. These methodologies are applicable to the climate change debate. Ideally, we would seek to find levels of production and consumption of products which generate external costs due to greenhouse gases where the marginal social costs, both private costs and external costs, equal marginal social benefits. Alternatively, this involves equating marginal external costs with marginal abatement costs (which in turn equal marginal private benefits less marginal private costs). This guideline has a number of important messages.

First, the socially efficient outcome almost certainly will not be a case of ‘business as usual’, that is, no government intervention or zero greenhouse gas emissions. In general, some level of pollution matches marginal social benefits and costs. Second, it would be an extraordinary coincidence if one of the current often touted technical measures is the economic optimum, such as the Kyoto target of 1990 emission levels, or the European stated targeted of 60 per cent below current emission levels by 2050. Current economic assessments of the marginal external costs and abatement costs of greenhouse gas emissions, with the Stern Review as an example, will provide a more informed basis for choosing an economically efficient level of global greenhouse gas emissions.

Third, and most important, the task of reducing greenhouse gas emissions below the ‘business as usual’ levels will involve changes in decisions on both demand and supply sides. Higher prices on the demand side to reflect the external costs of products with inputs producing greenhouse gas emissions are needed to shift consumer choices. Further, as illustrated by observed responses of demand to higher oil prices, these demand changes can be large. Falls in sales, together with a rise in the costs of greenhouse gas intensive production methods, provide incentives and rewards for producers to change production methods. New technology on both the demand and supply sides will be an important component of the adjustment processes.

The international dimension and policy challenges

Global cooperation is paramount to reduce greenhouse gas emissions, because of the global nature of the externality and because many greenhouse intensive industries are globally footloose. Yet, unlike local and national pollution externalities, such as acid rain and traffic congestion, there is no global governance structure with the powers of coercion of a national government.

From an individual country perspective, the mitigation of greenhouse gas emissions is a type of prisoners’ dilemma game. The lower climate change ‘product’ is a global public good with incentives to free-ride. This is true for large economies, including the US and China, and more so for small economies such as Australia. It is costly for a country to embark on a strategy of reducing greenhouse gas emissions, with many current estimates of the cost of stabilising emissions as high as one per cent of GDP. This would result in only a small fall in the global stock of greenhouse gas and, consequently, in a small reduction in adverse climate change effects for the country. Alternatively, to embark on a strategy of ‘business as usual’ involves no costs, but the country benefits from the decisions of other countries that have reduced their emissions. That is, the selfish country strategy is to free-ride and stay with ‘business as usual’. The result is a global outcome that is less satisfactory than a cooperative solution involving some reduction in emissions from all players.

Clearly, the major policy challenge is to move towards a global cooperative solution in which all, or most, countries participate. Progress so far is not promising, with the Kyoto Protocol negotiated in 1997 as a prime example. Yet, many individual countries, and individual states in the US and Australia, unilaterally have introduced policy initiatives and targets to reduce greenhouse gas emissions. A top-down approach driven by the United Nations at this stage seems less likely to succeed than smaller groupings of nations such as the European Union, and the Asia Pacific ‘six’.

A particularly challenging equity issue relates to sharing the cost of reducing the stock of global greenhouse gas emissions between different countries, and particularly between the developed and developing countries. In the last 200 years, industrialisation has provided both much of the comparative wealth in developed countries and the increased stock of greenhouse gases. Understandably, developing countries who aspire to comparable living standards and industrialisation in the future - but so far have contributed relatively little to the stock of global greenhouse gases - reject a model of allocating greenhouse gas tradeable permits on a grandfathering arrangement (that is, based on current pollution levels). Developing countries would be more willing to sign up to a model that, for example, allocates tradeable permits on a per capita basis. A system based on a carbon tax, with the revenue going to the country, may have greater potential to win global support than the current policy-push for tradeable permits.

One avenue to support cooperation across countries involves the sharing of knowledge, and especially its transfer at low cost from the developed to the developing countries. Unfortunately, this strategy is not without some difficulties, particularly since much of the R&D to reduce the dependence on greenhouse gases is likely to be patentable. While this is important to provide the incentives and rewards for investment in such R&D in the developed countries, it raises the cost of the required information. Therefore, governments may have to subsidise the royalty fees for the use of patents in developing countries.

Long time lags, intergenerational equity and discount rates

Long time lags are important to the economic policy debate on climate change for at least two sets of reasons: intergenerational comparisons of well-being; and decisions on long-life and large lumpy investments.

The costs of reducing greenhouse gas emissions by the current generation will provide benefits several decades ahead for future generations in the form of less climate change and lower future adaptation costs. The appropriate benefit-cost assessment to find the appropriate level of mitigation (where marginal external costs and marginal abatement costs are roughly equal) involves making inter-temporal or intergenerational comparisons via a discount rate. Issues to consider include the time value of money as represented in inter-temporal consumption preferences and returns to investment, the relative utility of the current and future generations, and the expectation that future generations will be wealthier than the current generation. Further, the current generation faces a choice between a number of investment options, such as education and physical infrastructure as well as climate change, which affect the opportunities available to future generations. The Stern Review chose a low discount rate of 1.4 per cent based primarily on one generation having the same weight as another generation and that the marginal utility of wealth declines with wealth. Such a low discount rate favours early and significant emissions abatement. Critics argue for a higher rate, such as is used in choosing investments in education and infrastructure. Clearly, the discount rate is very important, and remains a subject of controversy.

Many investments affecting the levels of greenhouse gas emissions have long lives, are large and lumpy, and once committed become sunk costs. Examples include electricity generation plants of all energy sources, motor vehicles and aeroplanes, buildings, and R&D. To change these investment decisions, policy interventions to correct for the pollution externality need to have a long-term focus, be credible and be sustained over many decades. At the same time, longer adjustment periods lower the costs of responding to policy and climate change.

Uncertainty and more information

It is important to recognise that there is much uncertainty about the marginal external cost and marginal abatement cost functions, both from science and from economics.

Many see mitigation of greenhouse gas emissions as a risk-management exercise. More is known about the costs of mitigation over the next few decades than about the costs of climate change and adaptation in future decades. Indicative numbers provided in the Stern Review point to a strategy of taking some insurance by investing in the relatively low costs of mitigation now to avoid potentially much larger costs of climate change in the future. Further, current policy should note that as more information and more technology becomes available, it may be both desirable and necessary to modify the details of policy interventions in the future in response to the forthcoming information.

Policy instrument choice

Economists favour market-based instruments – taxes or tradeable permits – to deal with the external costs of greenhouse gas emissions. Regulations such as targets on renewable energy and fluorescent light bulbs, and subsidies for selected lower carbon production technologies such as solar power and carbon sequestration, provide signals for reducing emissions on only a fraction of the possible set of demand and supply change options.

There are important similarities and differences between taxes on carbon or on greenhouse gas emissions versus tradeable permits on carbon or emissions. Both place a cost wedge between the producer returns and consumer prices of products that involve the external costs of carbon or emissions. The share of this tax passed forward to the buyer or back to the seller depends on the relative elasticities of supply and demand. Since its seems that the long run elasticities of supply of most manufactured products that generate greenhouse gas emissions are highly elastic, consumers will bear most of the economic incidence of the tax or permit.

If the permits are auctioned, government revenue will be about the same with both the tax and tradeable permit options. However, many current proposals, including those in Australia, are to gift some to all of the tradeable permits to current polluters, a grandfathering system. This system effectively provides the recipient businesses with a windfall wealth transfer, with most of the cost then past forward to consumers.

Given the uncertainty about the marginal abatement cost function discussed above, the tax and tradeable permit options have different market realisation implications. The permit system provides certainty on the pollution reduction quantity, but the market price of the permit and the magnitude of business and household adjustment costs is uncertain. By contrast, the tax system provides certainty of the price, that is the tax rate, but it has an uncertain effect on the quantity of emissions reduced. In practice, both options are unlikely to hit the economic efficient production and consumption levels precisely.

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A simplified version of a paper given at the Melbourne Institute Forum on Climate Change on 17 April 2007. The full paper is available at http://melbourneinstitute.com/forums/pub_forums.html

Professor Freebairn is Professor of Economics in the Department of Economics, University of Melbourne.

Volume 2 OCT 2007