The Evolution of Economic Thought On Climate Policy

Richard T. CarsonDepartment of Economics

University of California, San Diego

Trevor Swan LectureAustralian National University

21 August 2008

Few economists are aware of a wonderful problem.

While climatologists claimed it first, the twists and turns make the problem appear almost as if were devised to show off the tools and controversies of microeconomics. Even more astounding is the fact that such an abstract, long-term problem excites the interest of the general public and media and even politicians who desire more resources to be spent on research.

The issue is that human activities, such as burning fossil fuels and clearing forests, are adding vast quantities of carbon dioxide to the atmosphere …

Lester Lave in “Mitigation Strategies for Carbon Dioxide Problems,” American Economic Review (1982)

In the beginning …

• Possibility that burning fossil fuels would increase level of carbon dioxide identified

• Mechanism by which this leads to an increase in global temperature postulated

• Debate over whether this is good or bad begins• Key contributions:

– Fourier (1827), Tyndall (1861), Arrhenius (1896), Chamberlain (1897), Tolman (1899), Lotka (1924) Callendar (1938), Flohn (1941), Plass (1956)

Modern Times• Revelle and Suess (Tellus, 1957)• Keeling starts to measure CO2 concentrations at

Mauna Loa during the 1957-1958 International Geophysical Year

The 1960’s• Substantial improvements in understanding the science

behind climate change:– Manabe and Weatherall (1967): develop GCM model defining the key

parameter as the climate sensitivity of doubling CO2 – Culminates in “consensus” reports organized by Carroll Wilson (MIT)

• Study of Critical Environmental Problems (1970)• Study of Man’s Impact on Climate (1971)

• Conservation Foundation (1963) issues report:– “Implications of Rising Carbon Dioxide Content on the Atmosphere”

• President’s Science Advisory Committee– Restoring the Quality of Our Environment (1965) report calls attention

to CO2 problem. President Johnson notes in speech to Congress.

The Economic Story Begins

• Allen Kneese at Resources for the Future, often regarded as the father of environmental economics and winner of the first Volvo Environmental Prize, was the first prominent economist to look at climate issues

• Kneese starts using carbon dioxide as the example of a global externality in mid to late1960’s (Kneese, 1966; Ayres and Kneese, American Economic Review, 1969)

• Kneese: “Should we need to control such things as the production of energy and CO2 in the world, we will face an economic and political resource allocation problem of unprecedented difficulty and complexity” (Swedish J. of Economics, 1971)

Limits to GrowthNeo-Malthusian Perspective

• Boulding, “Economics of Spaceship Earth” (1966)

• Ehrlich, Population Bomb (1969/1971)– A rapid rate of change – A limit of some sort – Delays in perceiving the limit

• Limits to Growth (1972/1974) Meadows et al.

• Neo-Mathusian perspective attacked by prominent economists: Kneese/Ridker, Nordhaus, Solow

• Predictions of Limits to Growth critique fail to materialize

1972 UN Conference on the Human Environment (Stockholm)

• Seen as a large step in internationalizing scientific and political aspects of the environmental movement

• Led to the creation of the UN Environment Program• Influenced direction of EU environmental policy• Helped foster international scientific/monitoring programs• Failed:

– To sell no/slow growth agenda or to put population growth the heart of the environmental problems

– To get developing countries to see environmental quality as part of economic development rather than something to be sacrificed along the development path

Arab Oil Embargo 1973-1974

• Along with Limits to Growth critique spurs large interest by economists in theoretical properties of exhaustible resources– Culminated in the classic book by Dasgupta and Heal (1979)

• Substantial empirical work begins on modeling energy supply and demand as well as technological change– Conflict (continuing to present) between realists (econometricians

and modelers) versus optimists’ belief there are cheap easy solutions

• Nordhaus (Yale) builds an energy supply model of long term future with emphasis on switching to alternative technologies– Later as a member of President’s Council of Economic Advisors

worked on SST, synfuels, energy demand, limiting CO2 emissions

Science Developments of the 70’s

• Climate variability– Major droughts, fisheries collapses, desertification in West Africa

in focused attention on importance of short run fluctuations

• Interest moves beyond the carbon cycle– Molino & Rowland (Science, 1974) show CFC’s can destroy ozone– Ramanathan (Science, 1975) shows CFC’s are very potent GHG

• Role of Aerosols– Aerosols cause cooling – Can mask GHG trend but eventually the GHG trend dominates

Mid 1970’s• Supersonic transport plane becomes a key policy issue with

possible adverse climate impact a major consideration– U.S. Department of Transportation (DOT) launches Climate Impact

Assessment Program

• Economic part of evaluation of climate effects – Headed by Ralph d’Arge – Large number of economists work on various aspects of project:

• Hoch “Wages, Climate and the Quality of Life” (JEEM, 1974) shows workers willing to accept lower wages for warmer climate

• 10F increase in January temperature = $730 decrease in income

– Most effects other than health small and/or mixed in terms of sign

– d’Arge summarizes results of DOT study as suggesting a -2F change would cause substantial losses but a 0.9F increase small gains

• Work carried over to looking at CFC’s and CO2

• Two major economics conferences– 1978 Port Deposit Maryland on ozone (Cumberland/Hoch)– 1980 Ft. Lauderdale on climate change (V. Kerry Smith)

• A number of prominent economists involved:– Bailey, Bohm, Brookshire, d’Arge, Gladwin, Heal, Freeman, Kopp,

McFadden, McGuire, Mishan, Oates, Olson, Portney, Schulze,

• Most of the current issues being debated were raised: – discounting, – ethical issues: future generations v. current development– economic instruments for reducing emissions– valuation of climate impacts– adaptation and adjustment costs – atmosphere as an exhaustible resource/commons – risk, uncertainty, and irreversibilities – international implementation

Early Economic View of Climate Change

• CO2 emissions could alternatively be view as:– externality to be taxed to reduce to desired level– a global commons for which the lack of a charge for

use or regulation limiting use resulted in over use • Substantial uncertainty seen with respect to:

– magnitude of effects– timing of effects

• A long slow smooth process– allowed smooth adjustment of capital stock– discount rate would play a dominant role in analysis– formal definition of intergenerational equity necessary – developing countries not major contributor over

relevant horizon

• Benefits of control/damages avoided– inventory versus holistic approaches– insurance and valuation of non-marketed goods

• Problem had key aspects of irreversibility

Major U.S. Environmental Laws• National Environmental Policy Act (1970)• Clean Air Act (1970)• Clean Water Act (1972)• Coastal Zone Management Act (1972)• Marine Mammal Protection Act (1972)• Endangered Species Act (1973)• Safe Drinking Water Act (1974)• Federal Land Policy and Management Act (1976)• Fisheries Conservation and Management Act (1976)• Surface Mining Control and Reclamation Act (1976)• Resource Conservation and Recovery Act (1976)• Toxic Substances Control Act (1976)• Comprehensive Environmental Response, Compensation and

Liability Act [CERCLA/Superfund] (1980)

• Kneese and other economists testified repeatedly in favor of instituting pollution taxes

– Environmental groups fought these as “immoral” because they put a price on pollution

• Favored technology based standards because would force change

– Companies feared government would use pollution taxes to raise revenue

• Favored technology based standards because of their “certainty”

– End result: • Lower environmental quality at a higher cost • Grandfathering of old plants • Dramatically less technological innovation

Late 1970’sClimate Change Becomes a Political Issue

• 1977 U.S. National Academy Report: Energy and Climate

• 1977 Nordhaus produces “Economic Growth and Climate”

• U.S. Congress passes1978 Climate Program Act

• President’s Council on Environmental Quality– Carbon Dioxide Problem: Implications for Policy in the Management of

Energy and Other Resources (1979)

• 1979 World Meteorological Organization hosts world climate conference

• 1979 JASON Report for U.S. Department of Energy– Long Term Impacts of Atmospheric Carbon Dioxide on Climate

• 1979 U.S. National Academy issues Charney Report on CO2 & Climate – Climate sensitivity: best guess 3C with likely range 1.5C to 4.5C

1983 U.S. National Academy Nierenberg Climate Report

• Chaired by William Nierenberg (UCSD/SIO)• Plus the usual cast of science types and two

economists: – Nordhaus (Yale) and Schelling (Harvard)

• Energy Department officials tell National Academy they “do not approve of … speculative alarmist, wolf-crying scenarios.”

• Report effectively stopped movement toward regulating/reducing CO2 emissions

Calls For More Research Rather Than Action

• Underlying science sound but uncertainties needed resolved– Strong focus on the “WHEN” warming would occur question

• Little harm in waiting to see resolution of uncertainties

• Optimistic about possible future technological solutions

• Issues involved implementing a program not thought through • Adaptation might be better option than mitigation

• A large international component– Most benefits seen as going to developing countries, while developed

countries incur most costs

Opposing Views

• 1983 USEPA report: – CO2 should be regulating now

• 1984 ICSU– Scope 27 Climate Impact Assessment report

• WMO – starts series of international conferences that

lead up to 1985 Villach Austria consensus

• UNEP (Tolba) – promotes 1985 Vienna Convention on ozone

Response to Competing Interests

• Under what conditions would the U.S. play?

• Different agendas at U.S. agencies– DOE: stall and require government experts– EPA: reduce GHG emissions– State Department: control inevitable bargaining process

• Outcome– Intergovernmental Panel on Climate Change (IPCC)

Climate Process Modeled After Ozone Copying Success or Ensuring Failure

• Ozone– 1985 Vienna Convention (20 countries)– 1987 Montreal Protocol– 1990 London Amendments

• Climate– 1988 IPCC process begins– 1992 Rio Earth Summit/Framework Convention– 1997 Kyoto

Montreal versus Kyoto Protocols

• Standard benefit-cost assessment– 170 Montreal versus 0.44 Kyoto (with U.S.)

• Dramatic confirmation of underlying science– Montreal: yes; Kyoto: no

• Relatively near term human health impacts– Montreal: yes; Kyoto: no

• Availability of relatively low cost substitutes– Montreal: yes; Kyoto: no

• Number of producers– Montreal: few; Kyoto: large

• Limits for all countries– Montreal: yes; Kyoto: no

• Trade sanctions– Montreal: yes; Kyoto: no

Basic Science—Policy Disconnect

• Linear model of science-policy interaction:Science facts → policy

• But this of course is not true: – Perfectly acceptable to believe in science predicting

global warming and believe nothing should be done – Essentially position take by Nierenberg and Schelling

Why Do Nothing About Climate Change?

• Better uses for public money– Preventing malaria

• People benefiting in distant future– Politicians/public prefer spending on current generation– Future generations will be richer

• Most adverse impacts in developing countries– Africa, Latin America, China, India, Bangladesh

• Actions by United States/OECD may be completely ineffective without developing country participation

Organized Effort to FightGovernment Action

• Research on public’s views showed doing nothing, if science reasonably certain, was highly unpopular

• Tobacco industry blueprint adopted (Oreskes)– Science uncertain– Concerns were exaggerated – Government intervention pointless – Solve problem later shown if shown to exist

• Major deception campaign funded by Exxon/energy industry, far right foundations– Aided by news media telling “both” sides of the story

Science Moves Forward

• Climate sensitivity– Central estimate 3C with range 1.5C to 4.5C– Same as it was in 1979

• Fingerprinting the signs of climate change

• Increased climate modeling capability– Feedback loops– Spatial resolution

Figure 1.2

Figure 1.4

Humans Get in the Way• Time path of climate response driven by emissions

• Forecasting underlying causes of emissions– Population growth– Evolution of energy capital stock– Utilization of energy using that capital stock– Use of concrete– Rates of deforestation– Changes in agricultural practices– Use of [H]CFC’s and HFC’s

• Forecast response of emissions to policy changes

General Structure OfAn Economic Model of Climate Change

• Define utility – Across people, countries– Across time periods → discounting– Over what?

• Consumption versus (consumption & environment)– Functional form (declining marginal utility)– Degree of risk aversion

• Model production of economic output– Investment– Technology– Substitution between forms of energy– Relationship between production & environment

• Defining emission function– Emissions as function of energy mix/output– Emission reduction as function of investment

• Physical climate model– Emissions → pattern of climate change

• Cost of controlling emissions– Output, technology, energy mix

• Damages from emissions– Environment, economic output

• This is just an empirical implementation of a Solow-Swan growth model with a dynamic environmental externality

• Simplest framework thought to adequately capture the key aspects is Nordhaus’ 1994 DICE model– Dynamic Integrated Model of Climate and the Economy– 13 equations– 2 control variables (Investment, Control Expenditures)

• The optimal solution sets – Marginal control cost equal to marginal benefits– Optimal carbon tax is

• Increasing in – damage multiplier, – output climate sensitivity

• Decreasing in discount rate

• More realistic models add– Regional/spatial variation– Detailed production sectors– Interaction between countries including trade– Nuanced differences between a carbon tax

and a system of marketable carbon permits– Options for revenue recycling– Possibility of induced technological change

Key Feature of Optimal PolicyCarbon Tax Ramp

Time

TaxRate

Carbon Tax

Where Are the Controversies

• Treatment of population• Model flavor

– discount rate, r– magnitude and nature of damages– nature of cost function for reducing emissions

• Treatment of tax revenue/marketable permits• Treatment of uncertainty including abrupt climate

change and extreme changes• Implications of spatially disaggregating model

– Who should cut back and how much– Emissions trading across countries/regions

Population

• 1991 U.S. National Academy report– Policy Implications of Greenhouse Warming– “Encouraging voluntary population control

programs is of considerable benefit for slowing the future emissions of greenhouse gases.”

• Cline (1994) birth prevented is worth about $3000 from perspective of reducing GHGs

• Currently a taboo topic

Two Basic Modeling Strands • Framework driven by optimal growth theory

coupled with an externality framework and market driven parameters– Nordhaus (1977-2007)

• Dynamic benefit-cost framework with low discount rate. Errors on side of caution with respect to damages and optimistic on control costs– d’Arge, Brookshire and Schulze (1982), Cline (1994),

Stern (2006), Garnaut (2008)

Discount Rate• With climate change most costs of reducing GHG are in near term future

while damages avoided in distant future

• Low discount rate (r) strongly favors action to prevent GHG build up. High discount rate makes future irrelevant

• Ramsey equation:r = δ + ηg

where δ is the pure rate of time preference, η is the marginal utility of consumption, and g is growth rate of per capita consumption

Controversies over all parameters and whether r declines over time

– Nordhaus (r starts at 4.5%, declines to 2.5%) while Stern (r=1.4%)

Inventory Approach to Damages

• Divide sectors into two categories– Climate sensitive

• Agriculture, forestry, fisheries• Outdoor recreation, hotels• Energy for heating/cooling• Water resources, coastal areas

– Climate relatively insensitive – Health

• Climate sensitive sectors about 5% of U.S. economy– So hard to generate large effect

A More Direct Comparison

• Nordhaus and other models are cast in terms of the loss in GDP from controlling GHG emissions

• Maybe more interesting to examine relationship between temperature and per capita GDP (Horowitz, 2008)– Controlling for various factors including energy

resources and colonial mortality a 2F increase in temperature decreases GDP by about 3.5%

– Still does not take into account many non-market values such ecosystem impacts

China

Ethiopia

Finland

India

Kazakhstan

Saudi Arabia

Tanzania

United States6

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3.6 3.8 4 4.2 4.4ln temperature

non - OECD OECD Example countries Fitted values

An Alternative Approach• Use a contingent valuation survey

– Bypasses the near impossible task of aggregating over all possible impacts

• Allows holistic valuation• Allows treatment of issue as purchasing insurance

– Overcomes the discounting dilemma• Aggregates over the public’s individual discount rates• Respects consumer sovereignty

– Allows examination of sensitivity of valuation estimates to various types of information

• Degree of uncertainty• Participation by China and other developing countries

– Oddly resisted• Seen early by d’Arge, Smith as perhaps best way to go• More recently proposed by Portney and Kopp

Social Cost of CarbonOptimal Carbon Tax $/ton C

Nordhaus $17 - $25

Stern $90 - $310

IPCC

(4th assessment)

$10 - $350

Taxes versus Permits• Equivalent without uncertainty• Taxes

– Provide certainty with respect to future cost– Don’t constrain economic growth beyond tax cost

• Permits– Can prevent exceeding a dangerous threshold– Can restrict economic growth if faster than anticipated– Can dramatically drop in value– Popular because “free” permits handed out

• Hybrid schemes • International implications

Cost of Reducing Emissions

• Are there negative cost ways to reduce emissions?– Yes, but need political will to end subsidies

• Are there low cost ways to reduce emissions?– Yes, but need high prices to drive adoption

• Are there new technologies that can reduce cost?– Yes, but higher carbon prices are best way to induce

investment in that technology

Major Failings Of Initial Economic Vision of the GHG Problem

• Consequences of viewing cost of initial delay as low– Failure of a technological solution to emerge– Under estimated importance of taking early steps

• Soviet Union seen as key impediment to agreement– Large emitter with huge coal reserves – Seen as potentially gaining from warming– Economic collapse/restructuring undermines CO2 trading

• Failure to forecast emissions from developing countries growing near as rapidly as they have– Stockholm/Rio/Kyoto division of responsibility/climate agreement

architecture now seen as irresponsible

Projected 2050 CO2 Emissions By Forcast Date

0

1

2

3

4

5

6

7

8

9

N. America W. Europe Japan &ANZAC

Russia & E.Europe

China Other Asia Middle East L. America Africa

Regions

Gig

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1983

1992

1997

2007

Some Concluding Thoughts

• Scientific consensus underlying physics of climate change log past point of moving forward from a policy perspective

• Most of practical problems in moving forward involve economic and implementation issues– Yet have received less than 1% of research funding

• Technological optimists, of two types, have played a key role in preventing painful steps necessary to make progress– Wait to cutback until there is better technology– Better technology is here if only it was used

• Key driver of technology adoption around the world is higher prices– Policy options that do not cause this must fail

• Failure to quickly bring the rapidly industrializing countries on board in terms of large reductions from their current trajectories will subject the world to levels of climate change that have long been thought inconceivable