Developing a Framework for Short- and Long-Run Decisions on Climate Change Policies

October 1995

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by W. David Montgomery, Vice President, Charles River Associates. This report is based on a paper prepared for a September 13, 1995 policy conference sponsored by the American Council for Capital Formation Center for Policy Research, and appears in the Center's recently published monograph, An Economic Perspective on Climate Change Policies.

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Recent economic studies of the costs and benefits of reducing greenhouse gas emissions call into question the approach to climate policy outlined in the Berlin Mandate. These studies suggest strongly that imposing near-term goals for emission reductions represents a costly and potentially unnecessary approach to climate policy. Montgomery advocates an economically rational approach to climate change policies that addresses three related questions: (1) What actions can be supported on the basis of current understanding of climate science and economics; (2) How to make the best use of the new information that current scientific research and technology development will provide; and (3) When should emission reductions begin? Montgomery argues that the Berlin Mandate prejudges all these issues by concentrating on near-term targets for emissions from industrial countries. He also argues that "Specific policies and measures must be evaluated, not general goals. No goal can be assessed without specifying the policies likely to be used to achieve it."

Development of Economically Rational Responses to the Berlin Mandate

The findings of recent economic studies raise some serious questions about the ground rules that the Berlin Mandate establishes for the upcoming international negotiations, including: (1) the significant costs of near-term emission reductions; (2) the uncertainties about costs and emission reductions to be achieved from specific policies; (3) the likely benefits of a gradual approach to emission reductions combined with investment in climate science and development of new energy technologies; and (4) the impact of nonparticipating countries on the effectiveness of an international agreement.

These questions can be addressed through six steps that promote development of economically rational policy responses to the Berlin Mandate. First, all current proposals must be reviewed. Next, alternative response options should be inventoried and their economic merits analyzed. Third, specific policies and instruments that may be required to meet goals must be considered. Fourth, the net costs and benefits of the international sharing of the burden should be addressed. Fifth, the importance of timing and its impact on the costs of emission reduction should be evaluated. And last, the ultimate net costs and benefits to individual countries of specific agreements must be assessed. Return to Beginning

Economic Costs of Reducing Emissions

The economics literature has examined two very different approaches to analyzing the costs of reducing greenhouse gas emissions. These have come to be known as "top-down" and "bottom-up" models, though a distinction between market-based and technology-based approaches might be more appropriate.

The top-down approach uses standard economic models, extended to deal with energy supply and demand with sufficient detail to estimate carbon dioxide emissions. These models consistently conclude that measures to reduce carbon emissions below forecasted levels will have net economic costs. One study covering 10 top-down models, for example, estimated that reducing emissions to 80 percent of 1990 levels by 2010 would cost 0.9 to 1.7 percent of GDP. Another study estimated that a $200 per tonne carbon tax causing a 4.3 percent GDP loss would be insufficient to attain the 80 percent goal.

The bottom-up or technology-based models have little or no representation of the general economy, but considerable detail on the stock of energy-using equipment and on the technologies of energy use. These models conclude that the adoption of advanced technologies can reduce carbon emissions and reduce the life-cycle cost of energy use.

The difference between these two approaches has been called the "conservation paradox." Apparently rational consumers operating in free markets make choices (in top-down models) that imply that they are neglecting opportunities to save money and save energy (in bottom-up models). The differences between these models do not arise from differences in assumptions about the promise of new technology, but in how market behavior is characterized. The theoretical issues behind this apparent paradox are reasonably well understood, but not enough empirical work on either hidden costs or on market imperfections has been done to decide which view of the conservation paradox is more correct.

Benefits Estimates

Estimates of the benefits of avoided climate change are not nearly as well developed as cost estimates. Calculating a true estimate of benefits of climate change policies requires a number of steps that are literally beyond the current capability of climate modeling. For example, regional impacts are needed but current climate models can distinguish only very gross regional patterns and there is wide disparity across models. Moreover, the benefits of actions taken today to reduce emissions may not show up for 50 years or more. Thus, the discount rate used to compare future benefits and current costs is crucial. However, economists disagree about what discount rate accurately reflects real costs and benefits.

Integrated Economic Assessments for Climate Change Policy

Integrated assessment, in its simplest form, means putting together estimates of costs and benefits to choose actions whose benefits exceed their costs. One integrated assessment approach seeks to find an economically optimal policy-one that minimizes the sum of damages from climate change and the costs of avoiding climate change. This approach is illustrated in Figure 1, whose curves represent marginal costs and damages. Marginal damages are assumed to be positive at current levels and to fall as emissions are reduced. Marginal costs are assumed to be zero at current emissions and to increase as emissions are reduced.

Figure 1Benefits and Costs of Emissions Control

If the costs of reductions in emissions rise rapidly when emissions are reduced, and if damages from further increases in emissions rise slowly when emissions are increased, then the policy with maximum net benefits will entail relatively small emission reductions-optimal emissions would be at point B. If costs rise slowly when emissions are reduced, but damages rise rapidly when emissions are increased, the opposite is true. Optimal emissions would then be at point A, where large emission reductions are required to achieve maximum net economic benefits. Different conclusions about the likely magnitude of costs and avoided damages lead to different decisions about mitigation strategies. Improved information about the relative worth of large or small reductions in emissions helps avoid incorrect decisions about costs.

The Timing Issue

Climate scientists believe that concentrations of greenhouse gases in the atmosphere have a greater influence on global equilibrium temperatures than do emissions in any given year. Since integrated assessment models can deal explicitly with the connections between emissions, concentrations, and climate effects, a second use of integrated assessment is to analyze questions about when emission reduction policies have their greatest impact at the least cost.

Prominent researchers in integrated assessment models T. Wigley, R. Richels, and J. Edmonds report a remarkable result. For a wide variety of climate goals, it is less costly to allow emissions to rise for a decade or more-following the baseline-and then to make sufficiently large reductions in later years to achieve the climate objective, than it is to begin with emission limits (see Figure 2). Dramatic near-term emission reductions are not warranted.

Figure 2Least-Cost Emission Profiles

There are three major reasons why delay in reducing emissions reduces costs. First, funds devoted to capital investment with a positive return allows greater reduction in emissions in the future than devoting those funds to emission reductions today. Second, future costs will be lower than current costs because it is more costly to make efficiency or emissions changes on existing equipment than to make the same changes when equipment is being replaced at the end of its normal life. Third, it takes time to develop technologies that make possible use of carbon-free energy sources at reasonable cost.

Specific Policies Must be Evaluated

Specific policies and measures must be evaluated, not general goals. Command and control approaches to emission reductions can cost much more than the broadly based economic incentives generally assumed in cost studies. Targeted efforts to reduce market imperfections may produce economic benefits and some emission reductions, but their actual impacts on emissions are impossible to estimate with current data and economic models. With this wide range of possible costs, depending on what policies are chosen, no goal can be assessed without specifying the policies likely to be used to achieve it.

Moreover, other countries have not attained the emission reduction goals they announced several years ago. If the United States does act to carry out its commitments but other countries do not, it is unlikely that the United States will receive benefits commensurate with its costs. Commitments to implement specific policies can be monitored more easily and in a more timely fashion than promises to achieve future goals.

Carbon Contributions of Different Regions

Figure 3 illustrates the problem of omitting countries from the Berlin Mandate. Over the next century the share of responsibility for emissions will be very different from what it was in the past. The United States and other OECD countries will be responsible for only about 25 percent of cumulative emissions over the next century, and the United States alone for only about 10 percent. Unless the developing countries participate, it would be impossible to hold global emissions to current levels even if the OECD countries were removed from the picture entirely.

Figure 3Relative Contributions of Different Regions to Global Carbon Emissions

Source: A.S. Manne and R.G. Richels (1992), Buying Greenhouse Gas Insurance: The Economic Costs of CO2 Emission Limits, Cambridge, MA: MIT Press.

The International Free-rider Problem

Table 1 illustrates a hypothetical climate change policy in which all countries participate, at a cost of 2 percent of the country's GDP, and all countries receive benefits in the form of reduced climate change damage equivalent to 2 percent of GDP. Such a policy would be just acceptable, as an economic proposition, for the world as a whole. If only OECD countries (Annex I) participate, benefits would be reduced by 75 percent to 0.5 percent of GDP for each country. Nonparticipating countries get a free ride-they receive benefits but bear none of the costs. Under the assumptions of this example, if only the United States followed the policy, benefits to the United States would be only 0.2 percent of GDP. Thus, a policy that might be acceptable to the United States (or other group of countries accounting for 10 percent of emissions through 2100) if all countries participated on an equal basis turns out to have costs 10 times as large as the benefits if that policy is adopted unilaterally. This is the classic public goods problem, in which it is impossible to exclude countries from the benefits of the policy change.
Table 1 The Hypothetical International Free-rider Problem
Participating CountriesCosts to ParticipantsBenefits to Participants
Entire World2.0% of GDP2.0% of GDP
Annex I (25% of emissions to 2100)2.0% of GDP0.5% of GDP
United States (10% of emissions to 2100)2.0% of GDP0.2% of GDP


Economic studies suggest that only the most modest emission reductions undertaken now can be justified on a cost-benefit basis. The policies that appear to have economic benefits are fail-safe policies that can achieve emission reductions at no cost, and investing in science and in development of technologies that will reduce future costs. In assessing policy options, specific policies and measures must be evaluated, not general goals, since no goal can be assessed without specifying the policies likely to be used to achieve it.