The Economics of Climate Change
(1) www.rainforestweb.org, (2) Dave Martin/AP Photo, (3) http://www.itk.ca, (4) http://cait.wri.org/
The problem in a nutshell
Temperature as function of GHG
Dieter et al. (2008)
• Conceptual model of the problem
• Major components of a climate policy
• Setting stringency:
– The Ramp vs. The Big Bang (Nordhaus vs. Stern)
– The role of deep structural uncertainty (Weitzman)
• Policy initiatives
– National: U.S.
– State: California AB-32
• Anthropogenic climate change can be
thought of as resulting from a market
– Nicholas Stern: “biggest market failure the
world has ever seen”
• What are the main externalities?
Climate change externalities
• (External) cost (damage) from a unit of
emissions associated with a given unit of
economic activity is not paid for by those
producing or consuming the good.
– Emissions inefficiently high
• Innovators of new technologies (of any
kind which addresses the GHG problem)
may not receive all of the benefits from
– Innovation is ineffeciently low
the bottom line
• “Virtually every activity directly or indirectly involves
combustion of fossil fuels, producing emissions of carbon
dioxide into the atmosphere.
• Single bottom line for policy: “correct this market failure by
– all people, everywhere, and for the indefinite future
are confronted with a market price for the use of
carbon that reflects the social costs of their activities.”
Nordhaus et al. (2008)
Major components: design decisions
• Setting the level of emissions cuts (abatement)
– Proposed emissions cuts X% below year Y0 levels by
the year Y1.
• E.g. X% below year Y0=1990 by Y1=2050:
– McCain: 60%
– Lieberman-Warner: 70%
– Clinton-Obama: 80%
• Setting the means by which the abatement goal
– Options: standards, tax, cap and trade
• Most likely U.S. instrument: cap and trade
– Allocation of permits
If the policy is cap and trade: How should
GHG emissions permits be allocated?
• Auction: government sells permits to the highest
bidders (generates revenue).
• Give away: government hands out permits for
free (who gets the handout and who doesn’t?)
• Reality: likely a combination of both, transitioning
to predominantly auction over time.
– E.g. Waxman-Markey (2009): 85% of permits given away to
industry, remainder auctioned (free permits phased out over
Why not just auction 100% of
• Political economy concerns
• "Some interest groups—particularly fossil-fuel suppliers
and industries that intensively use these fuels—can veto
a climate policy," (Larry Goulder, from the Stanford news bureau).
– Reach environmental goals
– Politically feasible
The Policy Ramp vs. The Big Bang
• Climate “policy ramp”
– Efficient GHG control policy: “modest rates of
emissions reductions in the near term, followed by
sharp reductions in the medium and long term.”
• If implemented via a tax: ~$30/ton of CO2 initially, rising
gradually to $200/ton towards 2100 (Krugman, 2010)
• The “Big Bang”** (**P. Krugman’s term/not generally used)
– Immediate and aggressive GHG control
– Stern Review (2006): high profile challenge to the
Policy Ramp vs. Big Bang
• The climate-policy ramp (gradualist approach)
– Based on output of “integrated assessment
• DICE: Dynamic Integrated Model of Climate and
the Economy (Nordhaus and colleagues)
• Mathematical model of economic growth
accounting for the effects of global warming.
– Dynamic economics: choices over consumption, working
(labor), production, investment
– Geophysical dynamics: emissionsgreenhouse gas
stock climate change
• Estimated reduction in gross world product:
– 4.5o F 2%. -- 9.0o F 5% (Krugman, 2010)
DICE model estimates
(summarized in Dyson (2008))
• PVENB change from business as usual over next
century ($23T damages, assumes disc. rate of 4%):
– Scenarios considered:
• (uncertain) backstop breakthrough technology: +$17T
• “optimal (tax) policy”: +$3T <Policy ramp-like policy>
• Kyoto-like with US: +$1T
• Kyoto-like without US: $0T <“business as usual”/baseline>
• “Stern”: -$15T <“Big Bang”-like policy>
• “Gore”: -$21T
• Some level of damage already in the pipeline
Economic logic of the ramp
• Given that “capital is productive and damages are far in
the future … the highest-return investments today are
primarily in tangible, technological, and human capital.”
• Human capital: stock of skills and abilities of the
• Technological capital: the tangible means of
production (machines, tools, facilities, equipment,
• At each moment in time we can choose whether to
“invest” any given dollar in
– capital (human, technological, etc) or in
– costly actions to reduce GHG emissions.
The Big Bang & the Stern Review
• 2006: UK government releases a report: The Economics of Climate
Change: The Stern Review, lead by Sir Nicholas Stern (Nobel Laureate)
• SR estimates of costs of global warming are substantially higher than earlier
– Used similar data and methodology (IAM)
– Review summary:
• Unabated, climate change could result in an annual 5-20% decline
in global output by 2100.
– Comparison: US great depression – 1929-1930 real GDP fell by 9%
• Costs to mitigate are around 1% of GDP
• Policies for strong GHG reductions should be implemented
• Why did the SR come to such a starkly different conclusion than the ramp?
– Discounting (lower discount rate)
– Damages (higher damages)
• Weitzman (2007): “(t)he biggest
uncertainty of all in the economics of
climate change is the uncertainty about
which [rate] to use for discounting.”
• Discounting motivations:
– 1) social “rate of time preference” (reflects how
individuals make choices on payoffs over time)
– 2) “marginal productivity of investment”
(opportunity cost of investment or time value
Discounting – Ramsey equation
• Ramsey optimal growth model: central framework for thinking about
dynamic investment decisions.
• r = ρ + ƞg --equation holds in the welfare optimum--
– r: real return on capital
– ρ: social rate of time preference, rate at which utility from
consumption is discounted
– g: growth rate of consumption
– ƞ: %-decrease in marginal utility from a %-change in consumption
“elasticity of marginal utility of consumption”
• How quickly MU falls as consumption rises.
• Also indicates: aversion to consumption inequality among
– Lower ƞ (Stern) MU changes relatively little over
consumption pays less attention to whether future is
richer/poorer cares less about intergen. inequality
– Higher ƞ (Nordhaus) MU changes more rapidly more
attention to income (consumption) changes cares more
about intergen. inequality.
• SR approach—prescriptive/normative
– r = ρ + ƞg = 0.1% + 1*1.3% = 1.4%.
• ρ: favors a “low” social rate of time preference = 0.1%
– Argument: the only ethical reason to discount future
generations is that they might not be there at all (e.g.
– Prob. of extinction: 0.1%/year
• g: growth rate of consumption ~ 1.3%;
• ƞ: elasticity of marginal utility of consumption = 1
– (intergenerational) inequality aversion: lower
• Nordhaus approach--descriptive/positive
• ρ = 1.5% (assumed, Nordhaus 2008, p. 51)
• ƞ = 2 (calibrated, given r, ρ and g)
– (intergenerational) inequality aversion: higher
Nordhaus on Stern’s discounting approach
(2008, p. 174)
Comparison of the social rate of
Discount weight under various assumptions
1 Stern, =0.1%
0.6 The level at any given time t
represents the weight given to
net benefits arriving at the end
of year t.
0 50 100 150 200
SR used a
level of GHG
the high end
Nordhaus • The ratio of aggregate damages to the size of
(2008, p. 51) the economy ($D/$GDP) 100 years from now
• commonly assumed: 1-4%. (Weitzman, 2007)
• SR: >= 5%
• Weitzman (2007): `On the political side … my
most-charitable interpretation of (the Stern
Review’s) urgent tone is that the report is …
– an essay in persuasion…
– that is more about gut instincts regarding the horrors
of uncertain rare disasters whose probabilities we do
– than it is about (conventional) economic analysis.
• SR might be right (“act now”) for the wrong
reasons (due to bad model parameters instead
of a careful analysis of uncertainty).’
The role of uncertainty in climate
change policy—Weitzman (2009)
• What happens to expected utility-based
BCA for fat-tailed disasters?
– Can “turn thin-tail-based climate-change
policy on it’s head” (p. 2).
• Concretely: a fat-tailed distribution over a
climate sensitivity parameter (S) which
maps CO2 changes into temperature
• Can drive applications of EU theory more
than discounting (p. 5).
UNFCCC: UN Framework
Convention on Climate Change
– 1992: treaty signed at Rio de Janeiro Earth
• Stabilize GHG concentrations to prevent
dangerous “interference with the climate system”
– Non-binding goal:
• GHG emissions at 1990 levels by 2000
– “Common but differentiated responsibilities”:
• rich countries take first and bigger steps
Aldy and Stavins (2007)
to the UNFCC
• Written 1997, in force 2005
• Rich countries: cut to 5.2%
below 1990 levels by 2012
• Market based approach—cost • 4 of 5 largest emitters not
• Flexibility (international trading, – US has not ratified
clean dev. mech.) – Russia’s allocation won’t bind
• Focus on rich countries puts until 2012
burden on responsible parties, – China and India not bound
with greater ability to pay • Emissions leakage
• Established emissions • Poor incentives for compliance
inventorying & reporting (withdrawal provision)
• First step Aldy and Stavins (2007)
• House: Waxman-Markey bill, H.R.
2454 (passed June 2009).
– First GHG bill approved by either house
– C&T (and lots of other stuff)
– 2005 baseline: 17% cut by 2020; 42% by
2030, 83% by 2050.
• Senate: “Tri-partisan” bill (Sens.
Kerry, Lieberman, and Graham).
– C&T for some industries now (utilities)
expanding to others (2016: steel, glass,
cement manufacturers), carbon tax on
other industries (oil, gasoline).
– 2005 baseline: 17% cut by 2020; 80% by
“I'll take dead aim at the cap and trade bill cause it's bad for West Virginia.“
Arguments against pricing carbon
1. Other countries won’t follow suit and then we are doing something with almost zero effectiveness.
2. It may push dirty industries to less well regulated countries and make the overall problem somewhat
3. Europe has stiff carbon taxes, and is a large market, but they have not seen a major burst of
innovation, just a lot of conservation and some substitution, no game changers.
4. Especially for large segments of the transportation sector, there simply aren’t plausible substitutes
for carbon on the horizon.
5. A tax on energy is a sectoral tax on the relatively productive sector of the economy — making stuff
— and it will shift more talent into finance and other less productive sectors.
6. Oil in particular will become so expensive in any case that a politically plausible tax won’t add much
value (careful readers will note that this argument is in tension with some of those listed above).
7. A carbon tax won’t work its magic until significant parts of the energy and alternative energy sector
are deregulated. No more NIMBY! But in the meantime perhaps we can’t proceed with the tax and
expect to get anywhere. Had we had today’s level of regulation and litigation from the get-go, we
never could have built today’s energy infrastructure.
8. A somewhat non-economic argument is to point out the regressive nature of a carbon tax.
9. Oil price shocks (may) have nastier economic consequences than many people realize (connection
9b. A more prosperous economy may, for political and budgetary reasons, lead to more subsidies for
alternative energy, and those subsidies may do more good than would the tax. Maybe we won’t adopt
green energy until it’s really quite cheap, in which case let’s just focus on the subsidies.
10. The actual application of such a tax will involve lots of rent-seeking, privileges, exemptions,
inefficiencies, and regulatory arbitrage.
Tyler Cowen (2011)
California – AB 32
• California Global Warming Solutions Act
– Efforts by other states: less ambitious (e.g.
RGGI: electricity gen.) or not legally binding
– Goal/state-wide cap:
• GHGs cut to 1990 levels by 2020 (25-30%
reduction) beginning 2012
– The means of implementation:
• Set criteria for implementation but detail left to
executive branch agency (CARB).
» E.g. maximize TB, avoid disproportionately impacting
low income communities, minimize leakage.
– Difference from CAA (implementation specified)
California – AB 32
• Use of market mechanisms (emissions
– Democrats: “may include”
– Schwarzenegger: “shall include”
– Opposition to permit trade
• Concerns with RECLAIM (Regional Clean Air
• Hot spots (NOx,Hg)
California – AB 32
• Safety valve –
loophole you could drive a Hummer through:
– "In the event of extraordinary circumstances,
catastrophic events, or threat of significant economic
– “… the Governor may adjust the applicable deadlines
for individual regulations, or for the state in aggregate,
to the earliest feasible date.”
• “…The adjustment period may not exceed one year unless
the Governor makes an additional adjustment.“
California Health and Safety Code, Division 25.5, Section 38599 (a)(b).
CA as a policy lab
• 1961/1964: CA adopts vehicle smog control measures
(crankcase and tailpipe emissions reg.)
– 1965: Adopted nationally
• 1967: National Clean Air law for vehicle and fixed
– CA alone granted special waiver to set more aggressive controls
• “unique problems and pioneering efforts” (Congress, 1967)
• “a kind of laboratory for innovation” (DC Circuit Court, 1979)
• AB 1493: reduction of GHGs from vehicles
– 13 other states expressed intent to adopt the AB 1493 standards
• State action as impetus for federal action
• “Coop D'Etat: Farmers, Humane Society Partner
On Chicken-Cage Revolution” Dan Charles. 1/26/12. All Things
• 2008: California voters adopt Proposition 2
• Gene Gregory, president of United Egg Producers (represents 95%
of industry) concerned about dozens of different state requirements:
• "It was going to be a nightmare, trying to
produce eggs and have a free flow of
eggs across state lines. So we reached
out to the Humane Society.
• July: “two sides announced…an
agreement to jointly lobby Congress for
new federal rules that would phase out
all traditional chicken cages within 15
years.” Introduced late January 2012,
now in subcomittee(HR 3798)
Additional slides on GHG policy
(for your interest only, not
covered this quarter)
State action as impetus for federal action
• Example: National Appliance Energy
– 1986: Six states had adopted energy
efficiency standards for appliances
– Appliance industry: preemptive national
standard might be preferred
– 1987: NAECA passed
• 8/13/06: An Inconvenient Truth released
• 10/30/06: The Stern Review on the
Economics of Climate Change released
• 11/18/08:Obama announces goal: GHGs to 1990 levels by 2020
• 4/17/09: EPA endangerment finding, GHGs threat to health, enables
EPA to regulate GHGs
• 6/26/09: House passes Waxman-Markey Bill (American Clean
Energy and Security Act)
• 10/10/09: Sen. Graham (R) announces he will work with Kerry (D)
and Lieberman (I).
• 11/24/09: “Climate-gate”
• 12/19/09: UN Copenhagen Summit, no binding agreement
• How do we evaluate what the “appropriate” discount rate
– What does the SR discount rate imply?
• Weitzman: Savings rate using SR taste parameters implies a
savings rate of 33%. (2007)
• Nordhaus: “The global savings rate would rise by 10 percentage
points, by a factor of almost half, implying that global consumption
declines by about 13 percent.”
– “This would require a $4 trillion per year reduction in current
– “Where would the consumption cuts come from?” If from the US alone,
“would require a percentage reduction in consumption three times as
large as that in the Great Depression.”
• Nordhaus: Stern review assumptions on productivity growth imply
that per capita income will go from $7K in 2006 to $94k in 2200.
– What are the ethics of transferring wealth from an individual who makes
$7k to one who makes $94k?
Discounting – Growth – Global Warming
(one more complication)
• If our discount rate incorporates the opportunity
cost of project investment (i.e. reflects foregone
private sector investment returns),
– AND private sector returns depend on economic
– AND economic growth is effected by climate change
– THEN the appropriate discount rate will not be
constant and is endogenous to (will be effected by)
• E.g. -- What if the growth rate becomes negative
(i.e. the economy contracts) due to climate
Many businesses are treating the advent
of GHG policy essentially as a given
• “JPMorgan Chase, Citigroup, HSBC, and Bank of
America now require borrowers to complete a detailed
environmental assessment, which includes a carbon
impact measurement as part of their commercial lending
and underwriting criteria.”
Summary of Climate Change Bills
Introduced in the 110th Congress (Pizer, 2007)