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Global climate policy
Lennart Hjalmarsson
Distributional dimensions important
Who are going to pay?• We or our children? (Discount
rate)• Rich - or poor countries?• High-emitting or low-emitting
countries?• Vulnerable or less vulnerable
countries?
Important reports
UN:s Climate report 2007: IPCC• Scientific analysis• Almost unanimous
The Stern report 2006: The Economics of Climate Change
• Economic analysis• Very controversial
Key parameter: Discount rate
Max ∫U[C(t)]e-δtdtRamsey equation:r = δ + ηgDiscount rate = pure time preference rate +
value of increased consumption x increase in consumption
Very controversial issue. Big debate today.
Discount rate
δ and η capture preferences
g captures technology
δ discounts utility
r discounts consumption
r derived from all three parameters both taste and technology
η curvature of the utility function
Discount rate
η • elasticity of the marginal utility• relative risk aversion
measure of aversion to interpersonal inequality and
measure of personal risk aversion
Discount rate
The big issue: How much should we save (sacrifice) today for future generations?
T = 200 years
Close long-term link between r and s, discount rate and savings rate:
g = sr balanced optimal growth rate with constant savings rate and permanent income rW
s = (r-δ)/ηr
Discount rate
Standard assumptions:
δ + ηg = 2 + 2x2 = 6
s = (r-δ)/ηr = 4/12 = 1/3 = 0,33
Savings rate = 33%
Discount rate
Stern’s assumption:
δ = 0,1
η = 1
g = 1,2
r = 1,3
But then
s = (r-δ)/ηr = 1,2/1,3 = 0,92
92% savings rate!!
Important debate
Journal of Economic Literature 2008:• Weitzman• Nordhaus• DasGupta
Excellent discussion about discounting
Conclusions about discount rate
Weitzman:Uncertainty about g (thick tail) may
lead to a lower discount rate:r ≈ 3%
Nordhaus:Do not adjust the discount rate! Limit
climate change directly by taxes or caps (and trade)
Policies and measures
• Carbon taxes• Cap and trade (Kyoto)• (Green certificates)• Standards, regulations and energy
conservation• Technology agreements
Important aspects
• Economic efficiency:Same marginal abatement cost everywhere
• Distribution – burden sharing• Monitoring• Enforcement• Incentives for R&D : Endogeneous
technical progress
Carbon taxes
• Most efficient instrument when stock pollutant
• No distribution (but redistribution) of assets across countries
• Difficult to monitor real impact of taxes
• Requires strong international institutions
Carbon taxes, cont.
• Energy prices extremely high in most poor countries even at subsidised world market prices
• Energy taxes regressive
• Politically impossible in many countries
EU experience
• Extremely difficult to harmonise taxes: Sweden and UK totally against
• Very low minimum taxes: 0.05 Eurocents/kWh for coal and gas
• Exemptions even from these taxes (LTA)
Cap and trade
• Efficient solution to threshold problem • Difficult to negotiate worldwide
allocation• Very large asset values: EU
2 billion ton at 20 Euro/ton yields
an asset value of 40 billion Euro per year
• Easy to monitor permit trade in case of CO2 only
• Can rely on national legal systems in ”decent” countries
EU-Kyoto experience
• Grandfathering may be necessary although auctions preferable
• Grandfathering creates incentives for ”industrial policy”
• Regional solution – industry relocation to ”pollution havens”??
EU-Kyoto experience, cont
• Limited efforts: Kyoto 5% reduction, 20% of the world, ETS 8% ≈ BAU
• No incentives to comply – and some countries will not comply
• Success stories not due to Kyoto (UK, Germany)
• Difficult to predict CO2-prices
Standards
Might be good in some cases. Ex: Catalytic converters:• Economies of scale and learning –
low cost production• Product market international• Consumer network externalitiesBut:Strong incentives for pressure
groups
Energy conservation
Subsidies cost inefficient: Large variation in marginal abatement costs
Ambiguous impact on energy demand:
• Selection effect• Rebound effect• Vintage effect
23-04-21
Typical industrial structure
Average practice vs best practice over time
Technology agreements
R&D:• Extend the nose vs cutting off
the tail• Rich countries only• Difficult to coordinate even
within countries• Industrial policy – R&D races...• Picking winners difficult
Technology agreements, cont
Productivity in knowledge production
Experience from 1973/74- US synfuel program inefficient Swedish government-funded R&D
inefficient (De stora programmens tid.)
Only success story: Not governement-funded heat pumps
Cap and trade vs carbon taxes
In principle the same outcomeParadox:Why so difficult to agree on low-
level minimum taxes?Why so easy to agree on EU-ETS
with huge potential impact on electricity and fuel prices?
Smart or stupid politicians?
The text book model
Efficiency ≠ equityAllocation of permits of no
importance.Hidden assumption:• Allocation (grandfathering) foreveror• AuctioningIn EU-ETS allocation for a short
period: updating problem
Asset allocation in EU
EU 2008-12: At least 90% grandfathering – in practice >95%.
• Old plants: Historical emissions• New plants: Benchmark emissions
Permit allocation = industrial policyNational allocation plans
EU-ETS: Heavy industry and energy
Industry: Very high price sensitivity, competes in the world market. (η≈8)
Energy: Very low price sensitivity (η≈0.1– 0.3) and substantial restrictions on technology choice esp. hydro and nuclear.
ETS Efficiency: Incumbent plants
No emissions – no permits
Industry: Annual free permit allocation eliminates the increase in marginal production cost for industry: No incentives to reduce production or close down
Energy: Small incentives to reduce production or close down
Putty-clay technology.
EU-ETS: What will happen?
Extremely low flexibility
Where will adjustment take place?
What will happen to CO2 prices?
CO2 -price explosion? Not yet but..?
Electricity-price explosion?
Electricity-price induced adjustment outside the trading sector.
Very difficult to predict!
ETS Efficiency: New plants
No emissions – no permits
Coal and gas plants: permits
Hydro, nuclear and wind: no permits
Investment subsidy to emitting plants
Weak investment incentives
• Volatile CO2 prices• Time horizon 2012• Annual free-permit allocation• Less CO2- emissions – less
free-permit allocation• Huge intra-industry profits in
electricity and very concentrated el. markets
ETS Equity
Political aspects:• Most capital owners in the trading
system more than compensated • No capital owners outside the trading
system compensated and esp. not in the electricity intensive industry
• High electricity prices• Huge intra-industry profits in
electricity
What will happen?
Decrease in profitability esp in electricity-intensive plants
Relocation Political pressure for:
• Exemptions of some industries (e.g. Steel)
• Regulation of the electricity market
Global impact of EU climate policy
Impact through global markets: price changes through decrease in demand for fossil fuels
What about supply of fossil fuels?
Oil and gas ≈ no impact
Coal: less supply
Electricity: The key sector
• 25 % of global CO2-emissions
• Interfuel substitution coal/gas
• Increased thermal efficiency
• CHP: Combined heat and power
• CO2-free technologies
CO2-free electricity technologies
• Hydro: • Controversial • To a large extent already exploited except for
Himalaya
• Wind: • Surface intensive• NIB large scale (millions) location problem• Expensive• Stochastic supply
CO2-free electricity technologies
• Geothermal• Location specific• Limited cheap • Abundant very expensive
• Solar and wave• Still very expensive• Location specific• Surface intensive
CO2-free electricity technologies
• Wood• CHP otherwise expensive• Limited resources – deforestation• Competition from forest industry• Competition from biomass fuels in the
future
CO2-free electricity technologies
• Nuclear• Cheapest large scale technology• Not surface intensive – few locations• Very compact waste – small deposit
problems• Requires strong regulators• Proliferation problem (Iran, North
Korea)• Some countries political comparative
advantages (France, Finland, UK, ....)
Comparative generating cost in EU - 10% discount rate
2005$c/kWh
Projected 2030with € 20-30/t CO2 cost
Gas CCGT 3.4-4.5 4.0-5.5
Coal - pulverised 3.0-4.0 4.5-6.0
Coal - fluidised bed
3.5-4.5 5.0-6.5
Coal IGCC 4.0-5.0 5.5-7.0
Nuclear 4.0-5.5 4.0-5.5
Wind onshore 3.5-11.0 2.8-8.0
Wind offshore 6.0-15.0 4.0-12.0European Commission, January 2007
Future solution
Most attractive GHG-free solution:
Nuclear and hydrogen: Electricity and fuel cells
Nuclear and hydrogen
Problems:• Nuclear regulation in weak
states• Fuel reprocessing• Nuclear proliferation• R&D:
• Fuel cells• Hydrogen storage
Nuclear and hydrogen
Attractive properties:
• No GHG emissions
• Large scale – global feasibility
• Low cost
• Not surface intensive
• Not location specific
Nuclear and hydrogen
Political aspects:
• Little reallocation of assets
• Little industrial restructuring
• Still cheap electricity
• Foreign technology
• Foreign control and ownership
• Capital intensive investments
Major political obstacle to climate policy
Nobody should get hurt: Very expensive policy (subsidies, regulations) with a lot of variation in marginal abatement costs.
Low productivity in climate policy
Low productivity example
Potential Swedish railroad investments:
5 Billion Euro – 1 Mton CO2
4% - 60 years – 0.064 in annuity:
320 MEuro per year i.e.
320 Euro/ton CO2 in abatement costs (10 times too expensive)