The costs of mitigating climate change from macroeconomic models

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The costs of mitigating climate change from
macroeconomic models
A day-long forum cosponsored by the International
Council for Capital Formation and FORATOM on Do
Current Climate Policy Models Measure the Real
Cost of Emission Reductions?, 26 November, 2003,
Brussels

• Terry Barker
• University of Cambridge and Cambridge
  Econometrics

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Outline

• Approach to costs what type of model is used,
  what policies are simulated and what policies are
  implemented?
• Outline
• What are the costs?
• Types of models used
• Factors affecting the cost estimates
• Conclusions

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What are the costs?

• Costs not observable from market prices because
• outcome of complex E3 interactions
• involve changes in environment that have no
  market valuations
• Macroeconomic costs are usually measured in terms
  of future loss of GDP, comparing one hypothetical
  state of the world with another
• Costs include loss of fossil fuels output and
  employment, and short-term costs, e.g. from any
  premature retiring of fossil fuel burning power
  plant
• Such costs may be offset by ancillary benefits
  and benefits from use of tax or emission permit
  revenues
• but
• taxes/auctioned permits may incur high
  political costs
• free allocation of emission permits (as in phase
  I EU emissions trading scheme (ETS)) yields no
  revenues to recycle

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Assessing the costs of mitigation

• Need to understand types of models used
• energy sector models with no impact on rest of
  economy
• general equilibrium models that provide
  century-long time horizons but with rigid and
  implausible economic structures
• macro econometric E3 models which track the
  economy-wide adjustment process to new policies
• And what types of cost impacts are estimated
• cost-reducing government policies (e.g. many EC
  studies, WRI study for US)
• costs to business (e.g. EMF-16 studies)
• both (e.g. EIA study for US Congress)

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Some cost of mitigation estimates

• Government estimates
• UK White Paper (2003) on low-carbon economy 2050
  0.5 to 2 GDP for a 60 cut in CO2 an example of
  energy-sector modelling
• US Administration Kyoto would cost 4 GDP an
  example of a macro econometric E3 model analysis

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A key element short-term costs of adjustment

• Rapid, unplanned and unexpected adjustment is
  likely to be more costly than slow, planned and
  expected change
• eg coal-fired power stations are closed before
  end of working lives
• EIA study assumes that the US economy has to
  reduce CO2 emisisons by over 30 over 4 years
• the -4.2 GDP effect for 2010 reduces to -0.8GDP
  by 2020, with more time to adjust and with the
  Kyoto target continued to 2020
• the EMF-16 studies assume adjustment usually from
  2000
• not much research on time for adjustment, but one
  study found a 25 reduction in carbon tax rate
  for US ratification in 2000 rather than 2005

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Ancillary benefits of GHG mitigation

• The literature acknowledges that they may exist
  and may be comparable to costs of mitigation
• EU studies find substantial benefits for the US,
  WRI finds that inclusion of the benefits is
  important (1.1pp of GDP) but EIA and EMF studies
  do not include these benefits. (EIA estimates a
  77 reduction in coal consumption by 2010 13
  in oil products for the 31 reduction in CO2
  emissions)
• A conservative estimate of the value of the
  implied reduction in damages
• for the EU is 0.1 GDP for a 2 reduction in CO2
  and
• for the US is 0.4 GDP for a 30 reduction in CO2
• However, most ancillary benefits are off-line
  calculations done outside the macroeconomic
  modelling framework.

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The effects of recycling revenues

• If a general equilibrium optimum is assumed
  initially, then a carbon tax (with lump-sum
  recycling) will move the economy from the
  optimum, and reduce welfare
• The revenue-raising GHG mitigation policy has a
  potential benefit as an opportunity for reform of
  the tax system many EU studies find that
  recycling leads to increases in GDP
• however, the EU emissions trading system is not
  economy-wide and is not a full auction system.
• In EIA US study using revenues to reduce
  employers social security contributions, the
  4.2 GDP cost by 2010 falls to 1.9
• the permit revenues give the option for improving
  the tax system, but this may not be taken and the
  revenues may be wasted.

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Conclusions for low-cost mitigation in the EU by
2008-12

• From 2008, new eastern EU members will further
  modernise their energy sectors via ETS
• Substantial use of coal that can be easily and
  efficiently replaced by gas
• Ancillary benefits available
• ETS with free allocation will have effects
  depending price of allowances and use of higher
  profits by the power sector
• if used for new power generation, GDP may be
  higher
• if distributed as dividends, GDP is likely to be
  lower

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Kyoto and the US economy(effects on GDP in for
-30CO2)

• effects by 2010 EIA EMF-16 WRI
• date of study (1998) (1999) (1997)
• models covered 1 7 16
• no Annex I permit trade -4.2
• non-CO2sinks 0.7
• revenue recycling 1.9
• ancillary benefits 0.4
• total of above (no trade) -1.2
• total with permit trade
  -0.7 0.8 0.3
• (total with permit trade for 2020) -0.1

note denotes that the estimate includes
additional information not in original
study. Source http//www.econ.cam.ac.uk/dae/peopl
e/barker/v3ej_k.pdf
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Conclusions on the costs of mitigation

• Overall conclusion the high-cost estimates in
  the literature of mitigation action through
  market-based instruments demonstrate
• the costs of making policy mistakes (too hasty
  action or ill-advised use of permit revenues)
• costs of not using the Kyoto flexibilities for
  sinks, non-CO2 gases and international permit
  trading
• how selection of worst-case assumptions can
  accumulate to lead to high costs
• Costs are likely to be insignificant, or even
  negative provided policies are expected,
  long-term and well-designed
• ie market-based with revenues recycled to reduce
  burdensome taxes