Bill Totten's Weblog

Friday, December 29, 2006

The Economics of Climate Change (second of three posts)

Stern Review: Executive Summary (Part 2 of 3)

<> Emissions have been, and continue to be, driven by economic growth; yet stabilisation of greenhouse-gas concentrations in the atmosphere is feasible and consistent with continued growth.

Carbon dioxide emissions per head have been strongly correlated with GDP per head. As a result, since 1850, North America and Europe have produced around seventy percent of all the CO2 emissions due to energy production, while developing countries have accounted for less than one quarter. Most future emissions growth will come from today's developing countries, because of their more rapid population and GDP growth and their increasing share of energy-intensive industries.

Yet despite the historical pattern and the business-as-usual projections, the world does not need to choose between averting climate change and promoting growth and development. Changes in energy technologies and the structure of economies have reduced the responsiveness of emissions to income growth, particularly in some of the richest countries. With strong, deliberate policy choices, it is possible to 'decarbonise' both developed and developing economies on the scale required for climate stabilisation, while maintaining economic growth in both.

Stabilisation - at whatever level - requires that annual emissions be brought down to the level that balances the Earth's natural capacity to remove greenhouse gases from the atmosphere. The longer emissions remain above this level, the higher the final stabilisation level. In the long term, annual global emissions will need to be reduced to below five billion tonnes of carbon dioxide equivalent (5 GtCO2e), the level that the earth can absorb without adding to the concentration of greenhouse gases in the atmosphere. This is more than eighty percent below the absolute level of current annual emissions.

This Review has focused on the feasibility and costs of stabilisation of greenhouse gas concentrations in the atmosphere in the range of 450 to 550 parts per million (ppm) carbon dioxide equivalents (CO2e).

Stabilising at or below 550 ppm CO2e would require global emissions to peak in the next ten to twenty years, and then fall at a rate of at least one to three percent per year. The range of paths is illustrated in Figure 3 (explanation and URL appear at end of this post). By 2050, global emissions would need to be around 25% below current levels. These cuts will have to be made in the context of a world economy in 2050 that may be three to four times larger than today - so emissions per unit of GDP would need to be just one quarter of current levels by 2050.

To stabilise at 450 ppm CO2e, without overshooting, global emissions would need to peak in the next ten years and then fall at more than five percent per year, reaching seventy percent below current levels by 2050.

Theoretically it might be possible to "overshoot" by allowing the atmospheric greenhouse gas concentration to peak above the stabilisation level and then fall, but this would be both practically very difficult and very unwise. Overshooting paths involve greater risks, as temperatures will also rise rapidly and peak at a higher level for many decades before falling back down. Also, overshooting requires that emissions subsequently be reduced to extremely low levels, below the level of natural carbon absorption, which may not be feasible. Furthermore, if the high temperatures were to weaken the capacity of the Earth to absorb carbon - as becomes more likely with overshooting - future emissions would need to be cut even more rapidly to hit any given stabilisation target for atmospheric concentration.

<> Achieving these deep cuts in emissions will have a cost. The Review estimates the annual costs of stabilisation at 500-550 ppm CO2e to be around one percent of GDP by 2050 - a level that is significant but manageable.

Reversing the historical trend in emissions growth, and achieving cuts of 25% or more against today's levels is a major challenge. Costs will be incurred as the world shifts from a high-carbon to a low-carbon trajectory. But there will also be business opportunities as the markets for low-carbon, high-efficiency goods and services expand.

Greenhouse-gas emissions can be cut in four ways. Costs will differ considerably depending on which combination of these methods is used, and in which sector:

* Reducing demand for emissions-intensive goods and services

* Increased efficiency, which can save both money and emissions

* Action on non-energy emissions, such as avoiding deforestation

* Switching to lower-carbon technologies for power, heat and transport

Estimating the costs of these changes can be done in two ways. One is to look at the resource costs of measures, including the introduction of low-carbon technologies and changes in land use, compared with the costs of the business-as-usual alternative. This provides an upper bound on costs, as it does not take account of opportunities to respond involving reductions in demand for high-carbon goods and services.

The second is to use macroeconomic models to explore the system-wide effects of the transition to a low-carbon energy economy. These can be useful in tracking the dynamic interactions of different factors over time, including the response of economies to changes in prices. But they can be complex, with their results affected by a whole range of assumptions.

On the basis of these two methods, central estimate is that stabilisation of greenhouse gases at levels of 500-550 ppm CO2e will cost, on average, around one percent of annual global GDP by 2050. This is significant, but is fully consistent with continued growth and development, in contrast with unabated climate change, which will eventually pose significant threats to growth.

<> Resource cost estimates suggest that an upper bound for the expected annual cost of emissions reductions consistent with a trajectory leading to stabilisation at 550 ppm CO2e is likely to be around one percent of GDP by 2050.

This Review has considered in detail the potential for, and costs of, technologies and measures to cut emissions across different sectors. As with the impacts of climate change, this is subject to important uncertainties. These include the difficulties of estimating the costs of technologies several decades into the future, as well as the way in which fossil-fuel prices evolve in the future. It is also hard to know how people will respond to price changes.

The precise evolution of the mitigation effort, and the composition across sectors of emissions reductions, will therefore depend on all these factors. But it is possible to make a central projection of costs across a portfolio of likely options, subject to a range.

The technical potential for efficiency improvements to reduce emissions and costs is substantial. Over the past century, efficiency in energy supply improved ten-fold or more in developed countries, and the possibilities for further gains are far from being exhausted. Studies by the International Energy Agency show that, by 2050, energy efficiency has the potential to be the biggest single source of emissions savings in the energy sector. This would have both environmental and economic benefits: energy-efficiency measures cut waste and often save money.

Non-energy emissions make up one-third of total greenhouse-gas emissions; action here will make an important contribution. A substantial body of evidence suggests that action to prevent further deforestation would be relatively cheap compared with other types of mitigation, if the right policies and institutional structures are put in place.

Large-scale uptake of a range of clean power, heat, and transport technologies is required for radical emission cuts in the medium to long term. The power sector around the world will have to be least sixty percent, and perhaps as much as 75%, decarbonised by 2050 to stabilise at or below 550 ppm CO2e. Deep cuts in the transport sector are likely to be more difficult in the shorter term, but will ultimately be needed. While many of the technologies to achieve this already exist, the priority is to bring down their costs so that they are competitive with fossil-fuel alternatives under a carbon-pricing policy regime.

A portfolio of technologies will be required to stabilise emissions. It is highly unlikely that any single technology will deliver all the necessary emission savings, because all technologies are subject to constraints of some kind, and because of the wide range of activities and sectors that generate greenhouse-gas emissions. It is also uncertain which technologies will turn out to be cheapest. Hence a portfolio will be required for low-cost abatement.

The shift to a low-carbon global economy will take place against the background of an abundant supply of fossil fuels. That is to say, the stocks of hydrocarbons that are profitable to extract (under current policies) are more than enough to take the world to levels of greenhouse-gas concentrations well beyond 750 ppm CO2e, with very dangerous consequences. Indeed, under business-as-usual, energy users are likely to switch towards more carbon-intensive coal and oil shales, increasing rates of emissions growth.

Even with very strong expansion of the use of renewable energy and other low-carbon energy sources, hydrocarbons may still make over half of global energy supply in 2050. Extensive carbon capture and storage would allow this continued use of fossil fuels without damage to the atmosphere, and also guard against the danger of strong climate-change policy being undermined at some stage by falls in fossil-fuel prices.

Estimates based on the likely costs of these methods of emissions reduction show that the annual costs of stabilising at around 550 ppm CO2e are likely to be around one percent of global GDP by 2050, with a range from -1% (net gains) to +3.5% of GDP.

<> Looking at broader macroeconomic models confirms these estimates.

The second approach adopted by the Review was based comparisons of a broad range of macro-economic model estimates, such as that presented in Figure 4 (explanation and URL appear at end of this section). This comparison found that the costs for stabilisation at 500-550 ppm CO2e were centred on one percent of GDP by 2050, with a range of -2% to +5% of GDP. The range reflects a number of factors, including the pace of technological innovation and the efficiency with which policy is applied across the globe: the faster the innovation and the greater the efficiency, the lower the cost. These factors can be influenced by policy.

The average expected cost is likely to remain around one percent of GDP from mid-century, but the range of estimates around the one percent diverges strongly thereafter, with some falling and others rising sharply by 2100, reflecting the greater uncertainty about the costs of seeking out ever more innovative methods of mitigation.

Stabilisation at 450 ppm CO2e is already almost out of reach, given that we are likely to reach this level within ten years and that there are real difficulties of making the sharp reductions required with current and foreseeable technologies. Costs rise significantly as mitigation efforts become more ambitious or sudden. Efforts to reduce emissions rapidly are likely to be very costly.

An important corollary is that there is a high price to delay. Delay in taking action on climate change would make it necessary to accept both more climate change and, eventually, higher mitigation costs. Weak action in the next ten to twenty years would put stabilisation even at 550 ppm CO2e beyond reach - and this level is already associated with significant risks.

<> The transition to a low-carbon economy will bring challenges for competitiveness but also opportunities for growth.

Costs of mitigation of around one percent of GDP are small relative to the costs and risks of climate change that will be avoided. However, for some countries and some sectors, the costs will be higher. There may be some impacts on the competitiveness of a small number of internationally traded products and processes. These should not be overestimated, and can be reduced or eliminated if countries or sectors act together; nevertheless, there will be a transition to be managed. For the economy as a whole, there will be benefits from innovation that will offset some of these costs. All economies undergo continuous structural change; the most successful economies are those that have the flexibility and dynamism to embrace the change.

There are also significant new opportunities across a wide range of industries and services. Markets for low-carbon energy products are likely to be worth at least $500 billion per year by 2050, and perhaps much more. Individual companies and countries should position themselves to take advantage of these opportunities.

Climate-change policy can help to root out existing inefficiencies. At the company level, implementing climate policies may draw attention to money-saving opportunities. At the economy-wide level, climate-change policy may be a lever for reforming inefficient energy systems and removing distorting energy subsidies, on which governments around the world currently spend around $250 billion a year.

Policies on climate change can also help to achieve other objectives. These co-benefits can significantly reduce the overall cost to the economy of reducing greenhouse-gas emissions. If climate policy is designed well, it can, for example, contribute to reducing ill-health and mortality from air pollution, and to preserving forests that contain a significant proportion of the world's biodiversity.

National objectives for energy security can also be pursued alongside climate change objectives. Energy efficiency and diversification of energy sources and supplies support energy security, as do clear long-term policy frameworks for investors in power generation. Carbon capture and storage is essential to maintain the role of coal in providing secure and reliable energy for many economies.

<> Reducing the expected adverse impacts of climate change is therefore both highly desirable and feasible.

This conclusion follows from a comparison of the above estimates of the costs of mitigation with the high costs of inaction described from our first two methods (the aggregated and the disaggregated) of assessing the risks and costs of climate change impacts.

The third approach to analysing the costs and benefits of action on climate change adopted by this Review compares the marginal costs of abatement with the social cost of carbon. This approach compares estimates of the changes in the expected benefits and costs over time from a little extra reduction in emissions, and avoids large-scale formal economic models.

Preliminary calculations adopting the approach to valuation taken in this Review suggest that the social cost of carbon today, if we remain on a business-as-usual trajectory, is of the order of $85 per tonne of carbon dioxide - higher than typical numbers in the literature, largely because we treat risk explicitly and incorporate recent evidence on the risks, but nevertheless well within the range of published estimates. This number is well above marginal abatement costs in many sectors. Comparing the social costs of carbon on a business-as-usual trajectory and on a path towards stabilisation at 550 ppm CO2e, we estimate the excess of benefits over costs, in net present value terms, from implementing strong mitigation policies this year, shifting the world onto the better path: the net benefits would be of the order of $2.5 trillion. This figure will increase over time. This is not an estimate of net benefits occurring in this year, but a measure of the benefits that could flow from actions taken this year; many of the costs and benefits would be in the medium to long term.

Even if we have sensible policies in place, the social cost of carbon will also rise steadily over time, making more and more technological options for mitigation costeffective. This does not mean that consumers will always face rising prices for the goods and services that they currently enjoy, as innovation driven by strong policy will ultimately reduce the carbon intensity of our economies, and consumers will then see reductions in the prices that they pay as low-carbon technologies mature.

The three approaches to the analysis of the costs of climate change used in the Review all point to the desirability of strong action, given estimates of the costs of action on mitigation. But how much action? The Review goes on to examine the economics of this question.

The current evidence suggests aiming for stabilisation somewhere within the range 450 to 550 ppm CO2e. Anything higher would substantially increase the risks of very harmful impacts while reducing the expected costs of mitigation by comparatively little. Aiming for the lower end of this range would mean that the costs of mitigation would be likely to rise rapidly. Anything lower would certainly impose very high adjustment costs in the near term for small gains and might not even be feasible, not least because of past delays in taking strong action.

Uncertainty is an argument for a more, not less, demanding goal, because of the size of the adverse climate-change impacts in the worst-case scenarios.

The ultimate concentration of greenhouse gases determines the trajectory for estimates of the social cost of carbon; these also reflect the particular ethical judgements and approach to the treatment of uncertainty embodied in the modelling. Preliminary work for this Review suggests that, if the target were between 450 and 550ppm CO2e, then the social cost of carbon would start in the region of $25 to $30 per tonne of CO2 - around one third of the level if the world stays with business-as-usual.

The social cost of carbon is likely to increase steadily over time because marginal damages increase with the stock of greenhouse gases in the atmosphere, and that stock rises over time. Policy should therefore ensure that abatement efforts at the margin also intensify over time. But it should also foster the development of technology that can drive down the average costs of abatement; although pricing carbon, by itself, will not be sufficient to bring forth all the necessary innovation, particularly in the early years.

The first half of the Review therefore demonstrates that strong action on climate change, including both mitigation and adaptation, is worthwhile, and suggests appropriate goals for climate-change policy.

The second half of the Review examines the appropriate form of such policy, and how it can be placed within a framework of international collective action.

<> Policy to reduce emissions should be based on three essential elements: carbon pricing, technology policy, and removal of barriers to behavioural change.

There are complex challenges in reducing greenhouse-gas emissions. Policy frameworks must deal with long time horizons and with interactions with a range of other market imperfections and dynamics.

A shared understanding of the long-term goals for stabilisation is a crucial guide to policy-making on climate change: it narrows down strongly the range of acceptable emissions paths. But from year to year, flexibility in what, where and when reductions are made will reduce the costs of meeting these stabilisation goals.

Policies should adapt to changing circumstances as the costs and benefits of responding to climate change become clearer over time. They should also build on diverse national conditions and approaches to policy-making. But the strong links between current actions and the long-term goal should be at the forefront of policy.

Three elements of policy for mitigation are essential: a carbon price, technology policy, and the removal of barriers to behavioural change. Leaving out any one of these elements will significantly increase the costs of action.

<> Establishing a carbon price, through tax, trading or regulation, is an essential foundation for climate-change policy.

The first element of policy is carbon pricing. Greenhouse gases are, in economic terms, an externality: those who produce greenhouse-gas emissions are bringing about climate change, thereby imposing costs on the world and on future generations, but they do not face the full consequences of their actions themselves.

Putting an appropriate price on carbon - explicitly through tax or trading, or implicitly through regulation - means that people are faced with the full social cost of their actions. This will lead individuals and businesses to switch away from high-carbon goods and services, and to invest in low-carbon alternatives. Economic efficiency points to the advantages of a common global carbon price: emissions reductions will then take place wherever they are cheapest.

The choice of policy tool will depend on countries' national circumstances, on the characteristics of particular sectors, and on the interaction between climate-change policy and other policies. Policies also have important differences in their consequences for the distribution of costs across individuals, and their impact on the public finances. Taxation has the advantage of delivering a steady flow of revenue, while, in the case of trading, increasing the use of auctioning is likely to have strong benefits for efficiency, for distribution and for the public finances. Some administrations may choose to focus on trading initiatives, others on taxation or regulation, and others on a mix of policies. And their choices may vary across sectors.

Trading schemes can be an effective way to equalise carbon prices across countries and sectors, and the EU Emissions Trading Scheme is now the centrepiece of European efforts to cut emissions. To reap the benefits of emissions trading, schemes must provide incentives for a flexible and efficient response. Broadening the scope of trading schemes will tend to lower costs and reduce volatility. Clarity and predictability about the future rules and shape of schemes will help to build confidence in a future carbon price.

In order to influence behaviour and investment decisions, investors and consumers must believe that the carbon price will be maintained into the future. This is particularly important for investments in long-lived capital stock. Investments such as power stations, buildings, industrial plants and aircraft last for many decades. If there is a lack of confidence that climate change policies will persist, then businesses may not factor a carbon price into their decision-making. The result may be overinvestment in long-lived, high-carbon infrastructure - which will make emissions cuts later on much more expensive and difficult.

But establishing credibility takes time. The next ten to twenty years will be a period of transition, from a world where carbon-pricing schemes are in their infancy, to one where carbon pricing is universal and is automatically factored into decision making. In this transitional period, while the credibility of policy is still being established and the international framework is taking shape, it is critical that governments consider how to avoid the risks of locking into a high-carbon infrastructure, including considering whether any additional measures may be justified to reduce the risks.

<> Policies are required to support the development of a range of low-carbon and high-efficiency technologies on an urgent timescale.

The second element of climate-change policy is technology policy, covering the full spectrum from research and development, to demonstration and early stage deployment. The development and deployment of a wide range of low-carbon technologies is essential in achieving the deep cuts in emissions that are needed. The private sector plays the major role in R&D and technology diffusion, but closer collaboration between government and industry will further stimulate the development of a broad portfolio of low carbon technologies and reduce costs.

Many low-carbon technologies are currently more expensive than the fossil-fuel alternatives. But experience shows that the costs of technologies fall with scale and experience, as shown in Figure 5 (see URL at end of this post).

Carbon pricing gives an incentive to invest in new technologies to reduce carbon; indeed, without it, there is little reason to make such investments. But investing in new lower-carbon technologies carries risks. Companies may worry that they will not have a market for their new product if carbon-pricing policy is not maintained into the future. And the knowledge gained from research and development is a public good; companies may under-invest in projects with a big social payoff if they fear they will be unable to capture the full benefits. Thus there are good economic reasons to promote new technology directly.

Public spending on research, development and demonstration has fallen significantly in the last two decades and is now low relative to other industries. There are likely to be high returns to a doubling of investments in this area to around $20 billion per annum globally, to support the development of a diverse portfolio of technologies.

In some sectors - particularly electricity generation, where new technologies can struggle to gain a foothold - policies to support the market for early-stage technologies will be critical. The Review argues that the scale of existing deployment incentives worldwide should increase by two to five times, from the current level of around $34 billion per annum. Such measures will be a powerful motivation for innovation across the private sector to bring forward the range of technologies needed.

<> The removal of barriers to behavioural change is a third essential element, one that is particularly important in encouraging the take-up of opportunities for energy efficiency.

The third element is the removal of barriers to behavioural change. Even where measures to reduce emissions are cost-effective, there may be barriers preventing action. These include a lack of reliable information, transaction costs, and behavioural and organisational inertia. The impact of these barriers can be most clearly seen in the frequent failure to realise the potential for cost-effective energy efficiency measures.

Regulatory measures can play a powerful role in cutting through these complexities, and providing clarity and certainty. Minimum standards for buildings and appliances have proved a cost-effective way to improve performance, where price signals alone may be too muted to have a significant impact.

Information policies, including labelling and the sharing of best practice, can help consumers and businesses make sound decisions, and stimulate competitive markets for low-carbon and high-efficiency goods and services. Financing measures can also help, through overcoming possible constraints to paying the upfront cost of efficiency improvements.

Fostering a shared understanding of the nature of climate change, and its consequences, is critical in shaping behaviour, as well as in underpinning national and international action. Governments can be a catalyst for dialogue through evidence, education, persuasion and discussion. Educating those currently at school about climate change will help to shape and sustain future policy-making, and a broad public and international debate will support today's policy-makers in taking strong action now.

Figures Referenced Above

Figure 3: Illustrative emissions paths to stabilise at 550 ppm CO2e.

This figure shows six illustrative paths to stabilisation at 550 ppm CO2e. The rates of emissions cuts given in the legend are the maximum ten-year average rate of decline of global emissions. The figure shows that delaying emissions cuts (shifting the peak to the right) means that emissions must be reduced more rapidly to achieve the same stabilisation goal. The rate of emissions cuts is also very sensitive to the height of the peak. For example, if emissions peak at 48 billion tonnes of carbon dioxide equivalent (48 GtCO2) rather than 52 GtCO2 in 2020, the rate of cuts is reduced from 2.5% per year to 1.5% per year.

Source: Reproduced by the Stern Review based on Meinshausen, M (2006): 'What does a two degrees Celsius target mean for greenhouse gas concentrations? A brief analysis based on multi-gas emission pathways and several climate sensitivity uncertainty estimates', Avoiding dangerous climate change, in H J Schellnhuber et al (eds), Cambridge: Cambridge University Press, pages 265-280.

Figure 4: Model cost projections scatter plot [showing] costs of CO2 reductions as a fraction of world GDP against level of reduction

A broad range of modelling studies, which include exercises undertaken by the IMCP, EMF and USCCSP as well at work commissioned by the IPCC, show that costs for 2050 consistent with an emissions trajectory leading to stabilisation at around 500 to 550 ppm CO2e are clustered in the range of minus two percent to plus five percent of GDP, with an average around one percent of GDP. The range reflects uncertainties over the scale of mitigation required, the pace of technological innovation and the degree of policy flexibility.

This figure uses Barker's combined three-model dataset to show the reduction in annual CO2 emissions from the baseline and the associated changes in world GDP. The wide range of model results reflects the design of the models and the choice of assumptions included within them, which itself reflects uncertainties and differing approaches inherent in projecting the future. This shows that the full range of estimates drawn from a variety of stabilisation paths and years extends from minus four percent of GDP (that is, net gains) to plus fifteen percent of GDP costs, but this mainly reflects outlying studies; most estimates are still centred around one percent of GDP. In particular, the models arriving at higher cost estimates make assumptions about technological progress that are very pessimistic by historical standards.

Source: Barker, T, M S Qureshi and J Kohler (2006): 'The costs of greenhouse-gas mitigation with induced technological change: A Meta-Analysis of estimates in the literature', 4CMR, Cambridge Centre for Climate Change Mitigation Research, Cambridge: University of Cambridge.

Figure 5: The costs of technologies are likely to fall over time

Historical experience of both fossil-fuel and low-carbon technologies shows that as scale increases, costs tend to fall. Economists have fitted "learning curves" to costs data to estimate the size of this effect.

An illustrative curve is shown for a new electricity-generation technology; the technology is initially much more expensive than the established alternative, but as its scale increases, the costs fall, and beyond Point A it becomes cheaper. Work by the International Energy Agency and others shows that such relationships hold for a range of different energy technologies.

A number of factors explain this, including the effects of learning and economies of scale. But the relationship is more complex than the figure suggests. Step-change improvements in a technology might accelerate progress, while constraints such as the availability of land or materials could result in increasing marginal costs.

Bill Totten


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