Climate Change - Getting it Right: Chapter 1 Introduction



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Reducing the flow of greenhouse gas emissions will require substantial changes in human behaviour, both on the demand and production sides, says Professor John Freebairn. Effective policy toward climate change requires a global approach which places a price on carbon

By Professor John Freebairn

The prospect of climate change calls for devising and implementing risk management strategies. There are uncertainties about the science of climate change, the economic costs and benefits of different mitigation and adaptation options, domestic and global policy reactions, the future path of technological changes, and social atti-tudes to different policy options. However, imperfect knowledge is prevalent in most of the decisions facing governments, businesses and households, and there are well known strategies for making decisions under uncertainty. As regards climate change, interest lies in the choice of government policy interventions to reduce the flows of greenhouse gas emissions, and in risk management decision options for businesses, households and governments to adapt to changes in temperature, rainfall, storms, sea levels and other dimensions of climate change.

Science has made considerable progress in understanding climate as a result of extensive investments in measurement and modelling. Clearly, there are areas of disagreement and uncertainty, as is inevitable for this and for other areas of scientific inquiry. Even so, there is an extensive body of validated research pointing to the key role of human activity in causing the climate changes, and in providing probabilistic estimates of future changes in climate.

Data shows an increase in average temperatures since around 1950, and a near doubling in the stock of greenhouse gases over the last two centuries. The Intergovernmental Panel on Climate Change (IPCC) in its Fourth Assessment Report issued in early 2007, summarised in the chapters by Graeme Pearman and Ronald Prinn, concludes from extensive modelling studies that there is a 90 per cent probability that the increase in temperatures can be attributed to human activities, and particularly the burning of fossil fuels and agricultural practices.

The CO2-to-climate-change link involves a long-term global stock-flow process. CO2 emissions from any part of the globe, both natural and anthropogenic, accumulate as an increase in the global stock of CO2. In turn, climate models in their simplest structure assume that a larger stock of greenhouse gases allows a larger inflow of infrared energy from the sun and a lower outflow, with the effect of raising temperatures at the surface and lower atmosphere. The temperature increases vary across the continents. In turn, the temperature changes alter rainfall patterns, the frequency of extreme weather events, and other characteristics of the natural environment, but less is known about these other dimensions of climate change.

The available models have been used to prepare probabilistic estimates of the stock of greenhouse gases and of climate into the future decades and centuries, in different scenarios of greenhouse gas flows. For example, Prinn contends that if the world follows stringent policies to restrain the stock of greenhouse gases to about 550 parts per million of CO2 equivalent (about double the pre-industrial revolution level), average surface temperature will rise by a median of 2.4ºC from 1990 to 2100, but with a 95 per cent confidence interval of 1.0 to 4.9ºC, using an MIT model. Pearman reports similar probabilistic forecasts from the IPCC.More specific projections of climate change for Australia are examined by Pearman. Warmer temperatures, less rainfall for southern Australia, more intense storms and increases in sea levels are expected. These climate changes will directly alter the decision contexts for management of water, food and agriculture, ecosystems and tourism, industry, buildings and other infrastructure and settlements, with flow-on effects to almost all areas of the economy and society. More information on climate change projections at quite detailed geographic levels, and more information on potential climate change adaptation strategies, for example, in agriculture and water supply and demand, to lower the costs of adaptation, will be necessary and a valuable investment.

Reducing the flow of greenhouse gas emissions to stabilise the stock of greenhouse gases, especially in the context of a rapidly expanding global economy, will require substantial changes in human behaviour, both on the demand side and on the production side. Households can reduce their draw on fossil-fuel-intensive products by as much as 20 per cent in many ways, as has been illustrated by the responses to the sharp increases in oil prices in the mid-1970s, the early 1980s, and over the last few years. Adjustment options include smaller and more fuel-efficient vehicles, less energy-intensive household appliances, and better designed and managed homes.

Dramatic greenhouse gas reduction options on the supply side are implicit in many current proposals, particularly if the flow of emissions is to be reduced by 50 per cent or more. These include carbon sequestration and "clean coal", nuclear, renewable forms of stationary energy and biofuels for transport. In his chapter, Peter Cook, outlines developments in the area of carbon sequestration. He notes that large-scale systems are still untried and that the cost of electricity may double or more. Although nuclear energy is a proven supplier in other countries, notably France where it provides over 70 per cent of supply, concerns about the storage of waste materials and security make this option as much a political as an economic challenge for Australia. While there are good prospects for increasing the supply of electricity from solar, wind, geothermal and other renewable sources, under current technology their costs are high relative to coal and gas (e.g. see Prime Minister's Task Force, 2007) and few, including Prinn, see them contributing more than 10 to 20 per cent of total electricity needs. At current costs, biofuels are expensive relative to crude oil. Further, once we go beyond the use of waste products, expansion of the supply of biofuels quickly runs against the constraint of limited available arable land and its competing uses for food production and environmental conservation. All these areas have the potential for great technical advances over the coming decades.

Even without dramatic supply-side greenhouse reduction strategies, businesses directly involved in the burning of fossil fuels and the wider business sector, using electricity and transport as inputs, have many opportunities to improve efficiency and reduce the carbon content per unit of product. These options include changes in the input mix, redesigned and new buildings, and a vast range of more energy-efficient production methods.

Technological change holds the key to both the mitigation costs of reducing greenhouse gas emissions and the adaptation costs of adjusting to climate change for households and businesses. Explicit and higher carbon prices will provide enhanced incentives and rewards for private investment in R&D. While we can expect with some confidence gains in technology in the future, the magnitude of the gains, their timing and their specific areas are very much guesswork.

Economic factors

Key economic issues in the climate change debate include global pollution, long time lags between the costs and benefits of mitigation, and the extent of uncertainty of greenhouse gas abatement and external cost functions. Each of these economic issues is integrally related to and dependent upon the science of climate change.

Greenhouse gas emissions are a classic example of an external cost that is a result of market failure. Producers and consumers of, for example, electricity and road transport using fossil fuels as an input consider the private or market costs of labour, equipment and materials in producing the electricity and transport and the private benefits of the electricity and transport consumed in deciding on how much to produce and consume. However, both the producers and the consumers ignore any costs caused by the greenhouse gas emissions as they add to the stock of greenhouse gases. Ignoring these external costs means too much electricity and transport is produced and consumed, and with too carbon-intensive methods, from the society assessment that takes into account the external pollution costs as well as the private costs.

An appropriate policy response to the external costs of greenhouse gas emissions and climate change would seek a lower level of emissions. Ideally, we seek levels where the marginal costs of emissions mitigation equals the marginal benefits of lower costs spent on adaptation to climate change. This level is not just a technical issue per se of a particular flow of greenhouse gas emissions, for example, 1990 rates as specified in the Kyoto Protocol, or a particular stock of greenhouse gases, for example, stabilising at 550 parts per million of CO2 equivalent.

Further, with changes in technology, population, economic development, and other factors about which we have imperfect knowledge, the socially optimum level of emissions and climate change will also change over time. In particular, as argued in Mendelsohn's chapter (and implicitly in McKibbin and Wilcoxen's paper), the socially optimum rate of emissions reduction would be an increasing function of the stock of greenhouse gases (because of higher climate change adaptation costs). This points to a policy strategy of starting with a relatively generous emission target (or lower carbon tax) and building it up over time, rather than a one-size for all time.

A key characteristic of the climate change policy mitigation problem is the differences between the timing of the costs and benefits. Costs today to reduce emissions and climate change are an investment to reduce future costs of climate change adaptation. To compare the costs on the current generation with the benefits for future generations a discount rate (or price of time) should be used to convert future period dollars to today's dollar values.

Robert Mendelsohn, in his chapter, addresses these issues via a critical assessment of the Stern Report to the UK Treasury in 2006. Stern argues that setting a target for the stock of greenhouses gases at around 550 parts per million of CO2 equivalent would save climate adaptation costs from about 2050 onwards equivalent to between 5 and 20 per cent of GDP at a loss to GDP from now onwards at about 1 per cent of GDP.

Mendelsohn argues that Stern both overestimates the costs of climate change and underestimates the costs of mitigation. He is particularly critical of the use by Stern of a low discount rate of 1.7 per cent, rather than the real interest rate of 4-6 per cent commonly used in deciding levels of other investments to benefit future generations in education and physical infrastructure. Mendelsohn argues for a much more moderate reduction of greenhouse gas emissions than Stern.

Even though there is much uncertainty and legitimate debate about the magnitudes of the marginal cost and benefit functions for greenhouse gas emissions and climate change, there is a growing consensus that some climate mitigation is a desirable risk management strategy. Imperfect knowledge occurs in most other private and public investment decisions. Establishing a price on greenhouse gas emissions would provide explicit incentives for R&D to reduce future mitigation and adaptation costs, and it would provide a guide for the household and business sectors with which to choose investments in appliances, equipment and buildings that save on carbon.

Global policy

Effective policy toward greenhouse gas emissions and climate change requires a global policy approach with the involvement of as many countries as possible. However, as Brian Fisher and Anna Matysek describe in their chapter, we live in a world of independent national governments and a weak international governance structure. In the absence of a cooperative agreement there is an incentive for individual countries - not just the small ones but also the United States and China - to free-ride on the climate mitigation policies of other countries. By free-riding a country avoids all the costs of greenhouse gas mitigation but still shares in some of the benefits of reduced climate change. To achieve a global social optimum it is necessary that various governments reach and sustain a cooperative policy strategy to restrict greenhouse gas emissions.

The many barriers to global cooperation and the underlying reasons for the limited progress so far are canvassed by Fisher and Matysek. To take one example, developed countries and developing countries have quite different perspectives on what is a fair and acceptable cooperative global system for reducing greenhouse gas emissions. As exemplified by the Kyoto Protocol and discussed in the chapter by Shapiro, most of the developed countries are happy with a cap-and-trade system of tradable permits, and with an initial allocation of permits to current polluters (the grandfather system). Contrary to this position, the developing countries argue that the developed countries, through the Industrial Revolution, have both improved their living standards and contributed to most of the growth of the global stock of greenhouse gases; so why should they bear a large part of the mitigation costs? Instead, they propose that permits be allocated on a per capita formula, a policy option explored by Jyoti Parkih. At this stage of international negotiations both sets of countries are far from reaching an agreed position. Fisher and Matysek are doubtful that a cooperative global agreement will be reached within the next 20 years. Rather, they concede that individual countries, and in many cases groupings of like-minded countries, will embark on independent climate mitigation schemes.

Mitigation instruments

Given a decision by governments to intervene to reduce the levels of greenhouse gas emissions, what policy instruments should be used? The options include a carbon or emissions tax, a cap-and-trade or system of tradable permits (with options on how the permits are initially distributed), regulations and subsidies for R&D and for products and processes that involve less pollution.

There is general agreement that the market-based tax and tradable permit systems are more desirable, although governments seem reluctant to move away from regulations and subsidies. The comparative advantage of the market-based instruments is that they place an explicit cost or price on pollution-intensive products and production processes. In turn, the carbon price provides incentives and rewards to all households and businesses to explore all the possible options for finding low-cost ways to reduce greenhouse gas emissions.

There are important similarities and differences in the tax and tradable permit options. Both internalise to household and business decisions the external cost of consumption and production activities which generate greenhouse gas emissions. In a world of perfect knowledge the market price of tradable permits for a given cap on greenhouse gas emissions would correspond with the emissions tax rate. In practice, though, we have imperfect knowledge of the pollution marginal abatement cost function, and the function shifts with technology, the level of economic activity, seasonal conditions, and so forth. In this realistic world, as explained in the chapters by Shapiro and by McKibbin and Wilcoxen, there are subtle but very important differences between the two systems. A system of tradable permits provides for certainty to pollution reduction, but with variation of and uncertainty about the market permit price (as illustrated with the European market for CO2 permits and the US market for SO2 permits). By contrast, the tax option gives certainty on the cost of greenhouse gas pollution emissions, but with variable and uncertain outcomes for the quantity of emissions. In this context, McKibbin and Wilcoxen seek to gain the better properties of both options with a combination long-term tradable permit and short-term carbon tax system.

Shapiro makes the case for using a carbon tax system, such as those of Sweden and Denmark, rather than a tradable permits system. In addition to the stability of the cost surcharge for pollution, he argues that a tax system has greater ease and integrity of administration, particularly in developing countries, and it has a greater potential acceptance for reaching a desirable cooperative global agreement.

An important question not yet fully explored is, who ultimately bears most of the cost of an emissions tax or a tradable permit? In the first instance, business pays the tax cheque to the government and sees the opportunity cost value of a tradable permit. However, just as is the case with other taxes, the additional expenses to businesses change decisions which then change market prices and quantities. The final economic incidence of the additional expenses of greenhouse-gas-emitting activities is passed to the seller or buyer side of the market, which is less responsive (or price elastic) to market price. Given that most of the activities that generate greenhouse gas emissions are manufacturing industries, where constant per unit production cost is a common characteristic over a long-run perspective, almost all of the cost increase of greenhouse gas mitigation policy interventions will be passed forward to consumers as higher prices.

The fact that most of the costs of greenhouse gas emissions reduction will be passed forward to consumers as higher prices has several important policy implications. It cautions against the idea of giving tradable permits to existing businesses as a necessary bribe for their participation, as has happened in the European Union scheme. Rather, the final distributional outcome recommends a system of auctioning tradable permits, or a carbon tax, with government revenue being the initial beneficiary. Households faced with higher prices and cost of living will seek some compensation. Compensation can come from tax reductions and social security payment increases funded from the extra government revenue. The alternative of workers seeking a compensating wage increase has the potential to initiate an unintended round of inflation, which would be harmful to the economy.

Conclusion

Given the imperfect knowledge of both the science and economics of climate change, there is a growing consensus that sensible risk management calls for government policy intervention to mitigate the flow of greenhouse gas emissions and for businesses and households to prepare and invest in climate change adaptation strategies. There is agreement that the principal policy intervention should involve placing a price on carbon to support changes on both the consumption and production sides and to encourage necessary investment in R&D. Many argue the case for a gradual ramping-up of the carbon tax or aggregate emission target over time. Unresolved policy areas are the emission levels at which marginal benefits and costs of mitigation equate, and the choice between a carbon tax, cap-and-trade system, or a hybrid system. A critical unresolved issue is the development of mechanisms to secure the cooperative agreement of most countries to combat the global greenhouse pollution problem, with general agreement that the Kyoto Protocol format will not suffice.