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William D. NordhausYale University

Lecture for the Yale Climate InstituteJanuary 15, 2010

Slides are available nordhaus.econ.yale.edu .

Economic Perspectives on Climate Change

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Outline of lecture

1. Some historical background 2. What are economic integrated assessment

models (IAM)?3. What are some insights from IAM?4. What are the issues in implementing international

climate agreements?

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CO2 concentrations at Mauna Loa

310

320

330

340

350

360

370

380

390

60 65 70 75 80 85 90 95 00 05

4

2,000

1,600

1,200

800

400

1930 1940 1950 1960 1970 1980 1990 2000 2010

CO2 emissions US (millions tC/yr)

5

.6

.5

.4

.3

.2

.11930 1940 1950 1960 1970 1980 1990 2000 2010

CO2-GDP ratioTrend (-1.7 percent per year)

Trend in CO2 emissions relative to GDP, US

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Instrumental record: global mean temperature index (°C)

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1850 1875 1900 1925 1950 1975 2000

GISSHadleyUS NCDC

Tem

per

ature

anom

aly

(189

5-19

05 =

0)

IPCC AR4 Model Results: History and Projections

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8

Projections and the paleoclimatic record

-12

-8

-4

0

4

8

-400,000 -300,000 -200,000 -100,000 0

Tem

per

ature

(20

00 =

0)

Years before present

Temperature record and projections to 2200, Vostok core, Antarctica

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The Contribution of Economics:Integrated Assessment (IA) Models

What are IA models?These are models that include the full range of cause and effect in climate change (“end to end” modeling).

Major goals of IA models:Project trends in consistent manner Assess costs and benefits of climate policies Estimate the carbon price and efficient emissions

reductions for different goals

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Fossil fuel usegenerates CO2

emissions

Carbon cycle: redistributes around

atmosphere, oceans, etc.

Climate system: change in radiative warming, precip,

ocean currents, sea level rise,…

Impacts on ecosystems,agriculture, diseases,

skiing, golfing, …

Measures to controlemissions (limits, taxes,

subsidies, …)

The emissions-climate-impacts-policy nexus:

The RICE-2009model

Fossil fuel usegenerates CO2

emissions

Now focus for a moment on the

details of:

Some detail on how output and emissions are generated

j j jt tt-1

j j jt tt-1

j j jt t t

Twelve regions (j = US, China, India, EU, Africa, ...)

1. Population exogenous: ΔL =L G

2. Total factor productivity exogenous: ΔA =A H

3. Production is Cobb-Douglas in A, L, K : Y =A K

jt

j j j jt t t t

2

α 1-αL

4. CO emissions are function of output, intensity, and carbon price (p)

λE =σ Y p

5. Carbon price is determined by Hotelling rents and carbon-pricing policy

6. National invest

jt

12

c j=1 t=1

j j jt t t

ment rate is endogenous and optimized per the Ramsey model,

over per capita consumption (c), and countries are combined using the "Negishi algorithm."

maxW = φ U(c ,L )R(t)

7. Curr

∞

ent version is solved on Excel -Solver, with approximately 155 lines per country.

The Impacts of Climate Change

The Copenhagen Accord, which recognized “the scientific view that the increase in global temperature should be below 2 degrees Celsius.”

Is this firmly based in “scientific” estimates of the impacts of climate change?

Facts on the ground:– Estimating impacts has been the most difficult part

of all climate science: house-to-house combat for analysts.

– Very scant empirical support for the 2 degree target

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What will be the impacts by sector?

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Impact ofIndusty

Climate policiesAdaptation

policiesClimate-change

impacts

Energy-intensive Large near termModerate

medium termModerate long

term

"Nature-intensive"

SmallModerate

medium termLarge long term

Other Small Small Small

Aggregate damage estimates from different studies

Source: Richard Tol, Jour. Econ. Persp., 200915

-3

-2

-1

0

1

2

3

4

5

6

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

Dam

ages

as

per

cent

of o

utp

ut

Global mean temperature increase (°C)

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1. Baseline. No emissions controls.2. Economic cost-benefit “optimum.” Emissions

and carbon prices to maximize discounted economic welfare.

3. Limit to 2 °C. Climatic constraints with global temperature increase limited to 2 °C above 1900

4. Copenhagen, all countries. Uses US emissions targets joined by other rich countries, with developing countries entering after 1 -3 decades.

5. Copenhagen, rich only. Uses US emissions reductions joined by other rich countries, with developing countries staying out.

Policy Scenarios for Analysis

Rate of growth of CO2-GDP ratio: history and Congressional proposals

-7

-6

-5

-4

-3

-2

-1

0

50 60 70 80 90 00 10 20 30 40 50

Congressionalproposals

Gro

wth

(pe

rcen

t p e

r ye

ar)

Baseline projections: IPCC Scenarios and RICE-2009

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RICE-2009Model with no policy measures

Temperature profiles: RICE -2009

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0.0

1.0

2.0

3.0

4.0

5.0

6.0

2005 2025 2045 2065 2085 2105 2125 2145 2165 2185 2205

Glo

bal m

ean

tem

pera

ture

(deg

rees

C)

Optimal

Baseline

Lim T<2

Copen trade

Copen rich

Temperature

Available at http://www.econ.yale.edu/~nordhaus/homepage/RICEModelDiscussionasofSeptember30.htm

What do carbon prices mean in practice?

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Carbon tax, 2010 Increase, price of energy, US

[$/tC] GasolineAll energy

expenditures

Minimal $10 1.0% 1.5%

“Optimal” 35 3.3% 5.4%

Climate constrained (ΔT < 2 °C)

50 4.8% 7.7%

Carbon prices for major scenarios

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0

50

100

150

200

250

300

350

400

450

500

2005 2025 2045 2065 2085 2105

Car

bon

pric

e (2

005

$ pe

r ton

C)

Optimal

Lim T<2

Copen All Trade

Copen rich only

Global carbon price

Carbon prices for major scenarios

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0

10

20

30

40

50

60

70

80

90

100

2005 2015 2025 2035

Car

bon p

rice

(200

5 $

per

ton C

)

Optimal

Lim T<2

Copen all

Copen rich only Actual equivalent global carbon price = $4 / tC

Carbon prices for major scenarios

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0

10

20

30

40

50

60

70

80

90

100

2005 2015 2025 2035

Car

bon p

rice

(200

5 $

per

ton C

)

Optimal

Lim T<2

Copen all

Copen rich only

Actual equivalentglobal carbon price = $4/tC

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Net impacts by region to 2050 of Copenhagen proposal

-350

-300

-250

-200

-150

-100

-50

0

50

100

US

EU

Japa

n

Russ

ia

Eura

sia

Chin

a

Indi

a

Mid

dle

East

Afric

a

Latin

Am

eric

a

OH

I

Oth

er

Net

ben

efit t

hrou

gh 2

050

(bill

ions

)

Final Question: How Should Policies Be Implemented

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Major Policy Approaches for Global Warming

• Internationally harmonized carbon tax – economist’s ideal.

• Universal cap and trade – close second if well designed, but Kyoto Protocol is not doing well.

____________________________________________

• Regulatory substitutes (CAFE standards, ban on light bulbs, …) – very inefficient approaches

• Voluntary measures (carbon offsets) are difficult to calculate and verify and probably a useless diversion.

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Harmonized Carbon Taxes

What are “harmonized carbon taxes”?• Raise prices of GHGs proportional to carbon

content• All countries would levy a comparable tax• Countries would retain all revenues (this is not an

international transfer program)

Hybrid plans:• Auction permits• Floor and cap on auction prices

Cap and trade v. Carbon taxes

The problems with cap-and-trade systems for climate change, particularly in the international arena, are insufficiently appreciated. Some concerns:

Quantity limits are troublesome in a world of differential economic growth and uncertain technological change because of the difficulty of resetting country limits.

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Quantity-type regimes show extremely volatile prices

0.4

0.8

1.2

1.62.0

2.8

4.0

8.0

12.0

94 95 96 97 98 99 00 01 02 03 04 05

Price oilPrice SO2 allowancesS&P 500

Pric

e (M

ay 1

994=

1)

29Source: Nordhaus, Various.

30

0

4

8

12

16

20

80 81 82 00 01 02 03 04 05 06 07 08

Federal funds rateThree-month Treasury bill rate

Period ofquantitativemonetarypolicy

Period of price-typemonetary policy

Financial volatility under quantity-and price-type monetary regimes

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Volatility in EU CO2 trading system:

This volatility is inherent in such a system because of price-inelasticity of supply and demand

Source: Metcalf, Carbon Taxes, Hamilton Project.

It is important for governments to capture the revenues (either through 100% auctions or taxes): – raise revenues for distributional policies – reduce the efficiency losses from taxation.

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Cap and trade systems are not attractive regimes for countries to join.

Fraction of Global Emissions Covered by KP

0%

20%

40%

60%

80%

100%

1990 2002

With US

Without US

Enthusiasts

Corruption

Quantity-type systems with international trading are much more susceptible to corruption than price-type regimes.

International cap-and-trade plans are a three-sided game. There are strong incentives for a corrupt domestic government to collude with corrupt polluting firms to underestimate domestic emissions and hide from international monitors.

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The problem of offsets

Offsets have been part of all plans.Clean Development Mechanism (CDM) in the Kyoto

Protocol has been major source of “accounting emissions” and has very questionable additionality.

For example, in EU-ETS, there have been virtually no internal emissions reductions. The Clean Development Mechanism in EU has 280 million tons of offsets compared to 130 million tons of emissions reductions for current phase.

Another set of defective financial instruments like credit default swaps?

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The Perils of the Current Regime

• The international cap-and-trade program is a radical and unproven approach, whereas taxes are well understood and have been used in every country of the world.

• To bet the world’s climate system and global environment on this untested approach which such clear structural flaws would appear a reckless gamble.

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Final thoughts

“Mankind in spite of itself is conducting a great geophysical experiment, unprecedented in human history.” Roger Ravelle (1957)