The Economics of Climate Change Costs and Benefits

The Economics of Climate Change: Costs and Benefits of Reducing GHG Emissions Maureen Cropper University of Maryland Resources for the Future August 26 th 2010 1

Motivation • “Most of the observed increase in global average temperatures since the mid-20 th century is very likely due to the observed increase in anthropogenic greenhouse gas concentrations. ” (IPCC 2007) Policy Questions: • At what level should atmospheric CO 2 be stabilized? • What are the costs of reducing GHG emissions from Business as Usual? • What are the benefits of doing this? 2

Likelihood (in %) of exceeding a temperature increase at equilibrium Stabilisation level (in ppm CO 2 e) 2°C 3°C 4°C 5°C 6°C 7°C 450 78 18 3 1 0 0 500 96 44 11 3 1 0 550 99 69 24 7 2 1 650 100 94 58 24 9 4 750 100 99 82 47 22 9 Source: Hadley Centre: From Murphy et al. 2004 3

Objectives of the Talk • Costs of mitigation – – • Explain what factors drive estimates of the costs of mitigation and why estimates differ How costly is it to stabilize at 450 v. 550 ppm Benefits of mitigation – – • Overview of state of benefits estimation How benefits vary geographically Balancing costs v. benefits – How to deal with timing issues, uncertainty? What does this imply about the optimal stabilization level? 4

Sources of GHG Emissions, 2000 5

What Determines Fossil Fuel Emissions? • Emissions ≡ Population x (GDP per capita) x (Energy/GDP) x (CO 2/Energy) • Policies to reduce emissions must reduce: – Energy per unit of GDP (become more energy efficient) – Carbon intensity of energy (switch from coal to gas; fossil fuels to renewables and nuclear) • Carbon tax or explicit policies needed to promote move to a low carbon economy 6

How Economists Model Mitigation Costs • “Top-down” computable general equilibrium models – Divide the world into economically important regions – Model demand supply for commodities in all sectors of the economy • Estimate costs of mitigation by imposing a worldwide carbon tax • Tax causes substitution of low for high carbon fuel; cost of doing this represents cost of mitigation 7

What Determines the Cost of Reaching 550 ppm? • Ease of substituting energy for other inputs • Ease of substituting low-carbon for highcarbon fuels • Assumptions about rate of technical progress • Business-as-Usual Concentrations of GHGs 8

Costs of Meeting Various CO 2 Targets Pathways: default (black), delayed (red) and early action (green) ; Envelopes (set of grey 9 lines) Source: den Elzen et al. (2007)

What Are the Benefits of Reducing GHG Emissions? • Stabilizing at 550 ppm implies: – 24% chance of temperature change > 4° C – 7% chance of temperature change > 5° C • What does this mean in terms of impacts? • Following graph shows possible impacts by sector • Also danger of “tipping points” – positive feedbacks that would cause rapid temperature change 10

Projected impacts of climate change 0°C Food Water Global temperature change (relative to pre-industrial) 1°C 2°C 3°C 4°C 5°C Falling crop yields in many areas, particularly developing regions Falling yields in many Possible rising yields in developed regions some high latitude regions Small mountain glaciers disappear – water supplies threatened in several areas Significant decreases in water availability in many areas, including Mediterranean and Southern Africa Sea level rise threatens major cities Ecosystems Extensive Damage to Coral Reefs Rising number of species face extinction Extreme Rising intensity of storms, forest fires, droughts, flooding and heat waves Weather Events Risk of Abrupt and Increasing risk of dangerous feedbacks and Major Irreversible abrupt, large-scale shifts in the climate system Changes 11

Sectors for Which Impacts Have Been Studied • Agriculture • Forestry • Coastal infrastructure • Energy – Supply & Demand • Water – Supply & Demand • Health impacts – Malaria – Malnutrition – Heat Stroke, floods • Species loss • Ecosystem changes • Climate Disamenities 12

Projections of Surface Temperatures for Three IPCC Scenarios 13

Climate Change Damages • Best studied sectors are market sectors— agriculture, forestry, energy, water, coastal infrastructure • Damages in developing countries—especially low latitude developing countries—are often a larger percent of GDP than in high income countries • To compare with global costs of mitigation, need to aggregate benefits of mitigation across countries • How this is done has a big impact on results: – Aggregate by GDP or population? 14

The damages of climate change with increasing global temperatures 15

How to Balance Costs and Benefits? • Integrated Assessment Models (IAMs) • – Model (a) impact of emissions on temperature; (b)damages of temperature on GDP and (c) costs of mitigating emissions – Path of emissions chosen to maximize present discounted value of utility of per capita GDP Key Integrated Assessment Models – – – Nordhaus DICE/RICE models Tol FUND model Hope PAGE model 16

What Drives IAM Results? • Key factors affecting the optimal reduction in GHG emissions are: – Shape of the aggregate damage function • – Impact of emissions/atmospheric concentrations on temperature • – Steeper in Nordhaus (DICE) and Hope (PAGE) models than in Tol (FUND) model Measured by “Climate Sensitivity: - impact on mean global temperature of a doubling of CO 2 Discount rate used to express future damages and costs in present value terms 17

Importance of Uncertainty & Risk Aversion • Impact of atmospheric CO 2 on temperature uncertain – – Climate sensitivity = impact on temperature of a doubling of atmospheric CO 2 from pre-industrial levels 95% confidence interval = 2. 5°C – 5. 4°C • Nordhaus and Tol Integrated assessment models treat this parameter as certain; Hope does not • Allowing for risk aversion decreases optimal level at which to stabilize CO 2 18

Importance of Discounting • Future costs and damages associated with GHG emissions expressed in present value terms – – The present value of $1 received 50 years from now is the amount I must invest today to have $1 in 50 years At 4. 5%, this is 11 cents; at 1. 4% this is 50 cents • Cost of mitigation begin today, whereas major climate damages occur in the future • Lower discount rates imply more mitigation – Should discount rate reflect market opportunities or ethical concerns? 19

The Discounting Controversy • Nordhaus: Use market interest rates (approximately 4. 5%) • Stern/Hope: Use a discount rate that reflects how we weight the preferences of future generations v. ourselves – – • Allowing for the fact they will be better off Discount rate approximately 1. 4% Next slide shows results of Nordhaus model, which are conservative given – – Choice of discount rate Use of expected values 20

Mitigation Benefit and Cost Estimates Relative to No Mitigation – Nordhaus DICE Model Benefits (Reduced Damages) Abatement Benefits Costs Minus Costs $ Trillion (US 2005) Nordhaus/DICE Optimal $Trillion 5. 24 2. 16 3. 08 420 ppm 12. 60 27. 20 -14. 6 560 ppm 6. 57 3. 90 2. 67 700 ppm 5. 24 2. 16 3. 08 GHG Concentration Limits Note: Yale DICE model: Runs set to max. the value of net economic consumption, assuming complete implementation efficiency and universal participation. Source: Wheeler (2007) 21

What Can We Conclude About Costs and Benefits? • Conservative estimates suggest that costs of stabilizing CO 2 e at 550 ppm passes the benefit cost test • Allowing for uncertainty about climate sensitivity and risk aversion would increase the benefits of a 550 ppm target – • So would lowering the discount rate If this is the case, why are we doing so little? 22

Problems in Reaching an International Agreement • Reducing GHGs is a global public good – If one country reduces, all countries benefit – Individual countries have an incentive to “free ride” • Benefits of avoiding climate change occur in the future, and most benefits accrue to developing countries • Developing countries argue that they are not responsible for the majority of the stock of GHGs • And, their emissions are very low on a per capita basis 23