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.