Economics FAQs

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BENEFITS AND COSTS  

1. What are the benefits of climate change policies?
2. How are the benefits of reducing greenhouse gas emissions valued?
3. What are the challenges in estimating benefits?
4. What other considerations are there in estimating benefits?
5. What are the costs of climate change policies?
6. How are greenhouse gas emission reduction costs valued?
7. Why is uncertainty such a critical dimension?
8. Why is timing such a critical dimension?

ECONOMIC MODELING 

1. What are the main types of economic modeling used for climate change policies?
2. What type of modeling does the Pew Center undertake?
3. What are the strengths and weakness of top-down (CGE) models?
4. What are the key structural features and external assumptions that drive models and produce different results?

ECONOMIC MODELING RESULTS 

1. What is the range of model estimates of the benefits of global climate change policies?
2. What is the range of model estimates of the costs of global climate change policies?
3. Would particular sectors or industries be more affected?
4. How do costs per ton of carbon translate into costs of fuels?
5. What economic instruments can be used to control emissions?
6. Why is emission trading receiving so much attention for reducing greenhouse gas emissions?
7. What other public policy issues should be considered in conjunction with climate change?

  1. What are the benefits of climate change policies?

The benefits of reducing greenhouse gas emissions are the value of avoided impacts from climate change.  These include:

• Changes in resource productivity; for example, lower agricultural yields, scarcer water resources
• Damages to human-built environment; for example, coastal flooding due to sea-level rise
• Human-health impacts; for example, increased incidence of tropical diseases in temperate climates
• Damages to ecosystems; for example, loss of biodiversity, damage to aquatic ecosystems. Top

For impacts on commodities that are marketed goods, actual decisions by consumers are observed in real markets; for example, how in the past firms and consumers have reacted to higher prices of fossil fuels and raw materials. This method is reliable and unbiased, but has narrow applicability - in particular it is not useful for ecological impacts as these are non market impacts.

For impacts on non-marketed goods, direct observation is not possible.  Thus subjective methods are used which have wide applicability but lower reliability. Research tools are used to ask people one of two questions:

1. What are you willing to pay for greater environmental quality?, or
2. What are you willing to accept as compensation for lower environmental quality? Top

  3. What are the challenges in estimating benefits?

Great uncertainties surround physical impacts of climate change, making them hard to value.  This is compounded by: 

• Imprecise estimates of the economic consequences of physical impacts 
  
  
• Valuation of non-marketed goods/services is notoriously imprecise 
  
  
• Economic damage estimates should allow for adaptation
  
  
• Economic estimates come from industrialized countries, mainly the U.S., but less is known about potential economic damages in developing countries which are particularly vulnerable to global climate change. Top

Factors further complicating the valuation of impacts of climate change include:

• Beyond a doubling of greenhouse gas concentrations, there may well be thresholds where impacts either accelerate or reverse; for example, higher temperatures may boost agricultural productivity to some extent but as it gets warmer and warmer, this benefit is exhausted and agriculture productivity declines
  
  
• Low probability but high impact events, also know as climate surprises, may well impose considerable costs; for example, storm surges or droughts
  
  
• Regional impacts may be far more pronounced that international or even national average impacts
  
  
• Adaptation and coping mechanisms will act to lessen the costs of climate change
  
  
• Existing vulnerabilities will place communities at greater risk; for example, real estate developments on low lying coastal areas. Top

Economic costs of climate change policies are defined as opportunity costs - in this case what must be sacrificed or changed in order to reduce emissions.  The main categories of economic costs are: 

• discouraged investment
• slowed innovation
• refocused management
• disrupted production
• increased capital and operating expenditures
• monitoring and enforcement costs
• legal and other transaction costs

In addition there are "positive costs", or benefits, including productivity improvements from a cleaner environment and innovation-stimulating effects of regulation. Top

  6. How are greenhouse gas emission reduction costs valued?

Calculating the costs of reducing greenhouse gas emissions is far easier than estimating benefits, as cost impacts are essentially within markets.  A major challenge is estimating economy wide impacts as greenhouse gas emission originate and affect every component of an economy. Top

  7. Why is uncertainty such a critical dimension?

Uncertainty is a prominent feature of the benefits and costs of climate change:

• Need to compare risk of premature or unnecessary actions with risk of failing to take actions that subsequently prove to be warranted
  
  
• Economic analysis suggests sequential decision-making (as new information becomes available).
  
  
• Important irreversibilities in climate impacts and long term investments. Top

8. Why is timing such a critical dimension?

Time is a critical dimension of climate change policy:

• Slow natural decay rates of greenhouse gases (up to centuries)
• Long-lived capital stock (decades to 100 yrs)
• Gradual technological change
• People are not indifferent between incurring costs today or 10 or 30 years from now
• This imbalance between upfront costs and future benefits is likely to involve intergenerational tradeoffs. Top

ECONOMIC MODELING

1. What are the main types of economic modeling used for climate change policies?

A useful distinction is between "top-down" and "bottom up" models

• Top down or CGE (computational general equilibrium) models solve iteratively for policy induced changes in all sectors of the economy. 
  
  
• A bottom up or technology rich model starts with detailed representation of changes in the energy sector and then calculates broader effects on the economy. Top

The Pew Center has a multi-year modeling effort with a premier CGE model called IGEM, to improves the state-of-the-art economic modeling of climate policies, and generate robust and insightful analyses of various proposals as they are debated. Top

3. What are the strengths and weakness of top-down (CGE) models?

A top-down computational general equilibrium (CGE) model is able to estimate the macro-economic impacts of higher fossil fuel prices, higher raw material costs, altered productivity, changing competitive advantages and methods of recycling of emission credit revenue throughout the entire economy.

• These models generally produce results in the upper range of abatement costs, and provide insights into structural, sectoral and tax opportunities to minimize program costs over the entire economy. 
  
  
• Despite continuing modeling efforts, CGE models still lose detail on new technologies, characteristics of individual sectors and opportunities for energy efficiency that are the focus of technology-rich or "bottom-up" models.
  
  
• As a result, they often miss available opportunities to minimize policy costs. Top

Structural Features

• Substitution by Firms and Consumers
  
  - The U.S. economy is particular is extremely flexible, with firms and consumers being adept at trading off inputs and consumption due to changes in  prices.  How an economy adapts to available substitutes and/or finds new methods of production under a GHG constraint will be critical in minimizing overall costs of reducing emissions.
  
  
  - An important component of the substitution process is the flexibility of capital investments. How capital investments can be adjusted or retrofitted to take into account changing prices of fuels or raw materials will impact how various sectors can respond to emission constraints in the shorter term.  This is often discussed in terms of "putty and clay" investments.
  
  
  - Business objectives. Most models assume that firms only optimize on strict conditions of product output and profit maximization.  However, a range of other drivers including market share, corporate responsibility and other long term strategies may impact the adjustment process under emission reduction policies.
  
  
  - Initial state of the economy. Models can assume that the starting point of GHG emissions (especially through energy consumption) is optimal, or due to a range of regulatory and institutional factors there is considerable scope for energy efficiency improvements.  This will impact the substitution opportunities and hence costs of an emission reduction policy, especially in the near term.  This factor continues to be a key disagreement between CGE and technology-rich models. Top
  
  
• Technological Change
  
  - Technological change is an important (but not well quantified) factor in assessing the costs of long-term mitigation of GHG emissions. 
  
  
  -  Invention is an irregular process, and even with a portfolio of research ventures and feedback from market signals, producing new technologies from R&D expenditures is very uncertain. 
  
  
  - The relationship between GHG price signals and innovation and diffusion of new technologies is complex and poorly reflected in models.
  
  
  - Models that assume standard rates of technological progress (external to the policy) will not portray the full range of innovation driven by a given policy. Top

External Assumptions

• Inclusion of Benefits of Climate Change Policies
  
  - The benefits of a climate policy are the avoided impacts of climate change, including resource productivity (especially in agriculture), damages to the human built environment, human health impacts, and damages to ecosystems.  While some market-based impacts can be quantified, non-market environmental impacts cannot be adequately captured, and often models do not attempt to quantify any benefits.
  o Models cannot account for surprises that could involve more serious and abrupt impacts of climate change. 
  
  - Discounting.  Market based discounting estimation methods, designed for short-term investments, perform poorly in correctly estimating the present value of very long term, uncertain and possibly irreversible impacts.  Uncertainty in future long-term impacts argues for use of a lower discount rate.
  
  
• Baseline Estimates of Population, GDP, Energy Use and Hence Emissions
  
  - The estimate of how the world's population, economy and resultant GHG emissions would develop without climate policies, determines how big a reduction is required, and also what the impacts of climate change without policy will be.
  
  - Models do not accurately predict important events (e.g., war or structural economic changes) that alter the base-lines and costs of any emissions reductions. 
  
  - Energy resource availability.  The available supply and price of fossil and alternative resources will play a huge role in estimating how much a GHG constraint will cost.  In the North American context, natural gas supply (and thus price) is particularly important, as it is expected to be a transition fuel to a lower carbon economy.
  
  
• Policy Regime Considered
  
  - International emissions trading. The opportunity to use low-cost emission reduction opportunities across sectors, and across other developed and developing countries is a major determinant of the costs of shorter term emissions reductions. Gains from trading may be limited by excessive banking by those holding cheap reduction opportunities (e.g. Russia), or by transaction costs.
  
  - Inclusion of non-CO₂ GHGs will reduce overall abatement costs.  Non-CO₂ GHGs will provide low cost reductions due to their potency in producing warming and because few price signals have existed to spur firms to investigate mitigation opportunities.
  o Sequestration.  Inclusion of carbon storage in biomass and geological reservoirs is another flexibility mechanism that can deliver low cost GHG emission offsets.  Geological sequestration offers the opportunity of continuing use of the very large U.S coal resource.
  
  - Revenue Recycling.  The recycling of revenues from a GHG reduction can be used to offset other taxes and further to replace inefficiencies in existing tax codes.  If the existing tax system is sufficiently inefficient, the revenue recycling process could provide savings that outweigh the costs of controlling GHG emissions.  This positive environmental and economic outcome is commonly termed a "double dividend." Top

ECONOMIC MODELING RESULTS

1. What is the range of model estimates of the benefits of global climate change policies?

• For a doubling of GHG concentrations, estimates of the benefits of mitigation of greenhouse gas emissions vary between $55 billion to $140 billion, or approximately 0.5 to 2% of U.S. GDP
  
  
• The impact would be much greater for developing countries, from 2 to 9% of GDP
  
  
• Several factors affect the potential magnitude of the benefits of greenhouse gas mitigation;
      1. The potential scale and timing of damages avoided
      2. Assumptions about adaptation
      3. Damage costs are uncertain and also involve a chance of catastrophe
      4. Irreversibility of greenhouse emissions
      5. Policies that reduce greenhouse gases can yield ancillary benefits in
          terms of local environmental quality improvement. Top 

Economic models give a range of cost estimates due to the number of key variables that drive results.  For the U.S. to meet an emission reduction goal similar to the Kyoto Protocol:

• CGE or top-down models generally give marginal costs of $25-200/ton of carbon. This translates to 0.2 to 1.5% of U.S. GDP.
  
  
• Technology-rich or bottom-up models generally give marginal costs of $0-50/ton carbon.  This translates to less than 0.5% of U.S. GDP. Top

• Sectors responsible for a predominant share of greenhouse gas emissions would bear a proportionate burden.  This includes coal mines, oil refineries, natural gas importers, electricity producers, cement works, chemical facilities, paper and pulp mills, steel and other metal companies and glass manufacturers.  However mechanisms exist to compensate these sectors; these include recycling of revenues from emission permits or taxes, and to offer transitionary assistance to affected communities and workers. Top

A carbon price of $50/tC is equivalent to:

• 12¢/gallon of gasoline: from a base price of $1.50/gallon this is an 8% rise
• 75¢/mcf of natural gas: from a base price of $3/mcf this is an 25% rise
• $25/ton of coal: from a base price of $30/ton this is an 83% rise. Top

• Incentives for research and development of new technologies, or for diffusion of new technologies to hasten their impact on emissions and allow cost reductions through learning by doing
  
  
• Command and control regulations such as technology or efficiency standards (which have significant economic impacts)
  
  
• Energy or greenhouse gas taxes to set up a price incentive to reduce emissions
  
  
• Emissions trading to set up a quantity based incentive to reduce emissions. Top

• Emission trading is the most economically efficient mechanism to reduce emissions as it allows sources with cheap abatement opportunities to sell these reduction to other sources facing much higher abatement costs.  Hence it is a win-win trade.  The gains from emissions trading are biggest when inclusion of reduction opportunities is as wide as feasible to allow a range of abatement costs, and when trading is transparent and simple to reduce transaction costs. Top

• The costs of any reduction of greenhouse gases may well have ancillary benefits in reducing local air pollution and reducing reliance on imported fuels, especially Middle East oil. Top