11.3: The Policy Challenge

In what follows, I discuss some economics of climate change policy and conclude by suggesting a path forward for international climate policy. A more extensive version of this discussion appears in Auffhammer et al. (2016).

Economic considerations when designing and evaluating climate policies

All undergraduate economics students are taught that under certain conditions, markets maximize social well-being and therefore do not require any government intervention—or even worse, government intervention can make society worse off! You may have heard this line of reasoning from some serious-looking people on the news networks. This is true for so-called perfectly competitive markets. It turns out, though, that perfectly competitive markets are about as abundant as panda bears. Many real-world markets do not satisfy the idealistic assumptions required, because of what we call market failures. There are numerous and well-studied types of market failures, but in the context of global climate change, two types of market failures reign supreme: negative externalities and public goods.

Negative externalities arise when individual agents do not internalize the full cost of their activities. In the absence of climate policy, individual consumers and firms do not pay for the negative effects of their greenhouse gas emissions on the environment and economy. This results in a larger than optimal amount of greenhouse gas emissions.

The second major market failure, public goods, arises when a good in question is non-excludable and non-rival. Non-excludability means that no one can be technically excluded from the consumption of the good (for example, national defense). Non-rivalry means that one agent’s consumption does not diminish the amount of the good left over for everyone else (for example, radio waves). If a good is public, it is both non-excludable and non-rival, and markets underprovide the good—and in some cases do not provide this good at all.

The public goods problem arises in two important ways in the context of global climate change. The first good related to global climate change that has public characteristics is emissions abatement. If one country (or state) abates its emissions, all other countries (or states) also benefit from the reduction and cannot be excluded from these benefits. This results in an underprovision of emissions reductions by individual countries, which is consistent with the outcome of the United Nations climate change conferences that have for the past 30 years not been able to come together with a binding treaty including all nations committing to anywhere near the optimal reductions in greenhouse gas emissions.

The second good related to global climate change that has public characteristics is innovation. If one private firm obtains a technological breakthrough in a renewable energy technology, unless intellectual property rights are well defined and enforced, other firms can copy the technology and capture some or all of the innovating firm’s profits. This leads to an underinvestment in innovation.

Owing to market failures related to global climate change, well-designed government policy is important for addressing global climate change. In order to determine the optimal level of policy intervention when market failures exist, basic economic theory mandates that one compare the benefits from a proposed policy to its costs. Regulators in many places are mandated to calculate a ratio of the benefits to the costs (often referred to as the benefit-cost ratio) and only pass policies when this ratio is greater than one. In the case of climate change, calculating this ratio is especially complex, as damages occur globally and over a very long time horizon, while the costs of mitigation are incurred much earlier and in their majority by a small number of countries or regions. Hence localities often compare local benefits to local damages when deciding whether to pass climate policies. But fundamentally this is a global problem with a corresponding global benefit-cost ratio.

In addition, since the benefits and costs of climate change policy occur over a very long time horizon, the appropriate measure of benefits is not the current benefits but rather the present discounted value of the entire stream of benefits over many years. Similarly, the appropriate measure of costs is not the current costs, but rather the present discounted value of the entire stream of costs over many years. Calculating the present discounted value of benefits and costs requires using an appropriate discount rate (Box 11.2.1). Moreover, since both investments in abatement technology and the damage from climate change are irreversible, there is a value to the option of waiting that should be accounted for when comparing benefits and costs. Estimating these benefits of greenhouse gas reductions is a complex undertaking.

While the social cost of carbon measures the marginal damage of emitting a ton of CO₂ equivalent (or the marginal benefit of avoiding its emission), there are significant other benefits to greenhouse gas reductions, which stem from the fact that the combustion of fossil fuels results in the emissions of greenhouse gases as well as other local and regional pollutants. There is a large literature on quantifying these co-benefits at the sectoral level. For many policies these co-benefits are a significant or in some cases the main portion of the benefits from greenhouse gas regulation. Importantly, the type and value of co-benefits from greenhouse gas regulation vary drastically across countries. For example, reducing the combustion of biofuels and fossil fuels not only has significant local impacts in terms of improved health, but also has large-scale positive impacts on local climate as black carbon is a highly potent, yet not long-lasting greenhouse gas (Chapter 15). The quantification of these local co-benefits through their direct pollution impacts on health and agriculture as well as their indirect climatic effect through black carbon and aerosols are an active area of research.

The direct and indirect benefits of climate policies in terms of their impact on human health are especially important as climate change is now considered the biggest global health threat of the twenty-first century. Over 150,000 deaths annually are attributed to ongoing climatic changes, and this toll is expected to grow by 250,000 additional deaths per year between 2030 and 2050, according to the World Health Organization.

Another challenge is to quantify the costs of greenhouse gas regulation, which in the economic literature is called the estimation of abatement cost curves. In theory, each firm that reduces its emissions of greenhouse gases incurs a cost to do so. It can choose to reduce its emissions by producing less output, using new technology, or switching to lower-carbon-content inputs. A firm will compare the costs of the strategies. The least cost approach to reducing its emissions at each level of output is called the firm’s abatement cost curve. Since much of this information is private to the firm, regulators can have a difficult time determining what the true costs of abatement for a firm are. Anticipating a new policy, firms have no incentive to reveal the true abatement cost, yet they have every incentive to exaggerate the costs of abatement. Hence, as the regulator attempts to determine the benefit-cost ratio, there is significant uncertainty about the cost component, and regulators often have to rely on simplistic engineering calculations or educated guessing.

In order to design an optimal global climate policy, two market failures have to be addressed simultaneously. First, from a global perspective, since there is no global police person monitoring and enforcing a possibly agreed-to climate policy by all countries, individual countries will underprovide abatement or simply not agree to follow or join an international agreement of cutbacks. This will lead to an ineffective global agreement on emissions reductions, which will fall short on what is required to stay under a maximum of 2°C warming. One example of this approach is the largely ineffective Kyoto Protocol; the reasons for its failure are discussed in Chapter 10. The subsequent Paris Agreement, under which individual countries proposed individual cutback plans up front, aimed to respond to some of Kyoto’s failings. In order to work, a type of agreement such as Paris will need to rely on climate “clubs,” which are regimes with small trade penalties on nonparticipants, to coordinate emissions reductions that are enforced with border tariffs (Chapter 10).

The second market failure that needs to be addressed is the general externality problem once countries have agreed to an emissions target. To reduce emissions to address the externality, there are two types of approaches: (1) command and control and (2) incentive- or market-based approaches. Command-and-control approaches come in three flavors generally. The first type is an emissions standard, which simply prescribes how much each emitter can emit. The second is an input target, which prescribes which type of input to production an emitter has to use, for example, low-sulfur coal. Another example of an input target is a low carbon fuel standard. The third type is a technology standard, which prescribes a specific technology, for example, electric vehicles.

Incentive- and market-based approaches also come in three flavors. The first is an emissions fee/tax, which charges an emitter the marginal external cost and makes the emitter internalize this cost. Hence the emitter is paying for the full opportunity cost of its activity. The second is a cap-and-trade system, which caps the total amount of emissions and issues a right to pollute for each ton emitted, which can then be traded. This approach essentially places a price on carbon, as the permits have a price. The final incentive-based approach is subsidizing certain low-carbon technologies or fuels, which artificially lowers their price in the market and increases the incentive for adoption.

The advantages and disadvantages of command-and-control versus incentive- and market-based approaches are discussed in more detail in Chapter 12. In brief, however, in order to determine which policy should be used, two criteria are usually applied by economists for evaluating policy: cost-effectiveness and efficiency. For a given emission reduction, a policy is cost-effective if it achieves this reduction at least cost. A policy is efficient if it maximizes net benefits, or total benefits minus total costs. From an economy-wide perspective, cost-effectiveness and efficiency make sense, as one would not want to spend scarce resources on meeting policies in an unnecessarily costly manner. Policies that put a price on carbon—carbon taxes and cap and trade—have been shown to achieve this goal of efficiency time and time again. In contrast, command-and-control policies have been shown to be very costly ways of meeting a given emissions target.

One argument often raised in support of command-and-control standards is the fact that they are more fair or equitable than price-based policies. Under a standard, sources usually are subject to similar reduction targets, which is perceived to be fair. However, market-based policies can be made more equitable as they generate significant revenue, which can be redistributed to increase fairness, all while minimizing the cost of the emissions reductions. These revenues can also be used to address the innovation market failure, whereby tax revenue is used to enable research in promising future low-carbon technologies. One such example is research on carbon sequestration and storage, which carries a hefty price tag—in the billions of dollars for each experiment. Such large-scale projects are almost impossible to fund by the private sector and thus are likely to be a good place for the regulator to step in.

Where we are

Figure 11.3.1 How much warming will we get for different policy scenarios? Reproduced with permission from Climate Interactive.

Globally greenhouse gas emissions are the highest in human history. Atmospheric concentrations worldwide are the highest they have been in thousands of years. Human population and incomes continue to grow. There is a clear trade-off. Pulling humans out of poverty is an unambiguously good thing. But it comes at a tremendous cost to the global climate and ecosystem. I would like to close with Figure 11.3.1, which shows us how far we have to go.

Even though all but a single country have signed on to the Paris Agreement, even if every one meets its target, we fall significantly short of the 2°C target. There is a long way to go to solve this major problem. Smart implementation of cost-effective policies is the key to getting us even close to the 2°C goal. There are some small beacons of hope. The Kigali Amendment to the Montreal Protocol on Substances that Deplete the Ozone Layer (Chapter 15) has been an effective international agreement targeted at substances that deplete the ozone layer. The substances it covers suffer from the same externality and public goods problems as greenhouse gases do. Yet, it is effective. Some of that may have to do with the fact that the substances it controls (for example, hydrofluorocarbons) are very inexpensive and good alternatives exist. Carbon, in contrast, is everywhere and our economies have largely been built by injecting large quantities of it into the atmosphere.

The other beacon of hope is technology. Renewable energy sources such as wind and solar have come down in price in truly stunning ways and are now cheaper in many settings than natural gas and certainly coal. In order to truly decarbonize the electrical grid, we need to find cost-competitive electricity storage solutions (Chapter 13), as the production profile of renewables does not match the consumption profile. So the hope for the future is a combination of engineering genius, smart economics, and savvy policymakers. It’s time for you to get to work!