Environmental economics and the economics of global

warmingThe Macro-Economics of European Economies

MSc in Economic Policy StudiesJohn FitzGerald, March 2015

Course Outline

1. How does an economy work? JF 16-1-2015

2. The genesis of macroeconomics AM 23-1-2015

3. Modern macroeconomics AM 30-1-2015

4. Banks and financial markets AM 6-2-2015

5. The recent crisis AM 13-2-2015

6. The labour market JF 20-2-2015

7. Fiscal Policy JF 6-3-2015

8. Trade JF 13-3-2015

9. Environmental economics & the economics of global warming JF 20-3-2015

10. The future of the Irish economy AM and JF 27-3-2015

Outline of Lecture

• Theory – Economic Tools for Analysis• Science of climate change• Economic tools for analysis in environmental economics

• Presentation:• The origins and resolution of the current crisis in Estonia, Bulgaria, Greece and Spain

• Break• Presentation:

• The origins and resolution of the current crisis in Latvia, Portugal, Spain and Italy

• Applied – examples of environmental policy design• EU emissions trading scheme• Carbon taxes• Other Policies

The science of climate change - 1

• What is the sustainable level of emissions?• Scientific consensus

• Climate is warming• Due to human behaviour – greenhouse gases• IIEA Occasional paper 3 http://www.iiea.com/news/climate-change-report

• Greenhouse gases accumulate in atmosphere• Safe stopping distance very long

• Concentrations of greenhouse gases to double by 2100• Likely increase in temperature of between 2° and 4°• To keep it to 2° need to greatly reduce world emissions

• Considerable uncertainty• Better safe than sorry?

The science of climate change - 2

• The higher the temperature rise the greater the damage• Non-linear effects – the bigger the increase in temperature the bigger the damage

• Modelling of climate change impact by region important• Damages not evenly distributed

• Provide monetary estimates of damage• However, not everything is quantifiable e.g. biodiversity

• Adaptation costs – and ability to pay them• Discounting future costs – damages v adaptation costs

• Problem – far in the future• Equity weights – because damage may be greater in poor countries

The science of climate change - 3

• “Climate change is a moral problem. The main reason to reduce greenhouse gas emissions is a concern for far away lands, distant futures and remote probabilities.”• The people who emit most are least affected.• “If you do not care about risk, the future, or other people, then you

have little reason to care about climate change” (Anthoff and Tol, 2010)

Economic Tools for Analysis

• Externalities - market failures• Valuing the environment• Cost-Benefit analysis• Trade and the environment• Instruments for policy

Environmental externalities

• Market failure – the environment is “free”• Nobody owns it – “tragedy of the commons”

• Examples of market failures:• Emission of greenhouse gases• Emissions of gases causing acid rain• Pollution of a river• Solid waste and litter

• Solutions – create a market?• Can it be solved by an appropriate price?• Apply quotas• Confer ownership?• Regulation?

Valuing the environment

• Stated Preference• Ask people what value they would put on…..

• Revealed preference• Infer it from behaviour

• Value over time• Discount rate?

• Examples• Dump for nuclear waste• Electricity transmission lines• Investment in public transport• Global warming - keeping temperature rise under 2 degrees

Environmental costs and benefits

• Can you measure marginal abatement cost?• Depends on the industry

• Can you measure marginal benefit from reducing pollution?• Marginal abatement cost• Example: A Farm and a fishery

• Marginal private benefit of farm from pollution• Marginal environmental cost from pollution• A deal is possible – depends on ownership and measurement

Cost-Benefit Analysis

• Framework for analysis• Honohan, 1998

• Cost of public funds• Honohan and Irvine, 1987

• Shadow price of labour• Green jobs?

• Shadow price of capital?

Trade and the environment

• Making environmental costs real (e.g. tax) affects competitiveness• If done unilaterally (e.g. EU) some activity relocates

• e.g. steel production shifting from Germany to China• e.g. milk production shifting from Ireland to Brazil

• What are the environmental effects?• Depends on whether world consumption changes• Depends on production efficiency (including emissions) in different countries• Moving milk production to Brazil would increase emissions.• Question for later – how to deal with this?• The carbon content of Irish (and EU) imports is much higher than of exports• China is doing the dirty work of Europe and the US

• Food miles?• Look at actual carbon content of production and the cost of carbon• e.g. Growing French beans in Ethiopia and flying them to Ireland may result in less emissions than growing them in

heated greenhouses in Ireland• If there was a universal carbon tax then buying the cheapest would be the correct environmental answer

13

Low carbon in what sense?

Attribution of CO2 emissions by demand, plus imports

Source: ESRI/EPA ISus model; Hertwich & Peters, 2009 (43) Env Sci Tech.-20

-10

0

10

20

30

40

50

60

70

80

1990 1995 2000 2005

mln

tCO

2

ImportsInventoriesInvestmentGovernmentCharityHouseholdsExports

Distributional effects of climate change policy• Between countries• Allocation based on models to ensure “equal burden”• National targets may involve very large transfers if models wrong• Problem – don’t know winners or losers or size of transfers

• Between household and company sector• E.g. Germany: households lose, companies win

• Between producers and consumers• E.g. Possible effects of UK carbon floor

• Between rich and poor• E.g. Large Public Service Obligations (PSO) to pay for renewables etc.

Climate change policy

• Target level of emissions set by politicians based on scientific advice• Economic question: how can you achieve the target at minimum cost?• How can you ensure that the cost of abatement is equal for all?• What are the implications of unequal costs?

• Not just equity but also efficiency:• By swopping obligations the same target could be met at lower cost

Implementing Policy

• Ideally:• one objective – one policy instrument

• Complexity is costly• Costly for regulators• Costly for firms• Cost of running a good scheme can kill it

Rationale for market-based interventions• Damage from carbon emissions unpriced• Huge difference in abatement costs from different technical solutions• Market based instrument allows the economy to choose least cost• Carbon tax set equal to marginal cost of carbon• Economic actors choose technical solutions where marginal

abatement cost < cost of carbon• E.g. firms use lower (zero) carbon energy sources• E.g. consumers save energy• E.g. investment in R&D to produce technologies that reduce carbon at low cost

Instruments for environmental policy• Targets?

• A target is not a policy instrument

• Ownership?• Prices - taxes

• Market chooses least cost solution, uncertainty about hitting precise target• Potential “double dividend” – revenue used to reduce other taxes

• Subsidies• Cost of public funds

• Quantity controls• Uncertainty about the true future cost, more certainty about environmental effects

• Regulation• Information deficit• Regulator plays God but is not as wise - the market is closer to Solomon!

• Research

Presentations

1. The origins and resolution of the current crisis in Estonia, Bulgaria, Greece and Spain

2. The origins and resolution of the current crisis in Latvia, Portugal, Spain and Italy

Climate change policy in practise

• Policy Instruments• EU emissions trading scheme (ETS)• Carbon Tax

• Tackling acid rain• EU policy

Instruments for environmental policy• Targets?

• A target is not a policy instrument

• Ownership?• Prices - taxes

• Market chooses least cost solution, uncertainty about hitting precise target• Potential “double dividend” – revenue used to reduce other taxes

• Subsidies• Cost of public funds

• Quantity controls• Uncertainty about the true future cost but more certainty about environmental effects

• Regulation• Information deficit• Regulator plays God but is not as wise - the market is closer to Solomon!

• Research

Example – Acid Rain

• Different from climate change• Imposing National Obligations• Clear up your own mess

• How much pollution in Ireland?• How much damage does it do?• Biggest problem elsewhere• Pay Czech republic to clean up?• Where not appropriate • Where pollution is local

EU Policy

• Original EU proposal of a carbon/energy tax in 1992• Today, multiple policies for one objective• For sectors covered by Emissions Trading Scheme (ETS)

• Emissions Trading• Renewables• Energy efficiency

• For rest of economy – national choice?• Carbon tax• Renewables• Energy efficiency

• Clean Development Mechanism? Pay other countries to do it• R&D – correct incentives?

EU Emissions Trading Scheme - 1

• If allocate permits to firms without trading• For some the target / permit will be easy, for some very difficult• This will impose differential costs on firms in a pretty arbitrary manner

• If allocate permits to firms with trading• Firms will buy and sell permits so the cost for each firms is equal to the price• Because the firms can sell the permit – it is an input with a cost so firms will

include it in their price.• All other firms will be passing on the permit cost

• If permits are provided free firms will make a windfall gain• Transfer of resources from consumers to producers

EU Emissions Trading Scheme - 2

• “Grandparenting” a big problem• No revenue for government to offset economic costs• Transfer from consumers to shareholders

• Distortions• Value depends on power station location

• Multiple rounds of permits• Dirty plant must stay in business to collect the jackpot every few years• Price driven up & NO clean up

Taxation - a “Double Dividend”?

• The environment does not have a price so it is “over-used”/ “abused”• Putting a price on polluting – a carbon tax.• Produces a dividend – reduced pollution – a welfare gain• The tax revenue allows governments to cut other taxes• Taxes on carbon are less damaging than taxes on labour• Switch from a tax on labour to a tax on carbon: a second dividend• Higher employment and output• Conefrey et al. 2012

EU Climate Change Policy - current

• Reliance on national targets: Distributional Effects• Not transparent because of targets and the Emissions Trading System (ETS)• Using models to forecast outcomes 15+ years hence??• Nonetheless – substantial distributional effects

• Renewables Policy• Do we need one? Renewables only have special value if reduce carbon• Advantages: drives research – an infant industry argument• Disadvantages: very expensive – often more expensive than alternatives

• Energy efficiency targets• Where is the market failure?• Difficult to quantify and verify

Lessons from Quotas: ETS

• Volatile C price : discourages C-saving investment• Arbitrary baseline: allocation of permits hi-jacked• Administration, traders, verifiers add to the cost• Auctioning resisted : transfer of assets to industry.

• Industry adds the asset value to the output price, but government gets no revenue to offset costs

• Revenue from auctioning in the future?

• Taxes impose same cost on consumers• But government has revenue to compensate• More certain price – better for investment• Lower administrative cost• Less political buy-in from losers

EU Climate Change Policy - future

• Price the best answer, ETS a second best• With ETS it should:• Cover all emissions• Auction all permits

• Don’t transfer resources to companies from consumers• National limits result in international transfers

• If national limits – need a mechanism to ensure equity• Possibility of a price floor?• Ireland should seek safeguards for all players

Non-ETS Sector

• The EU ETS covers only part of carbon dioxide emissions• Non-ETS: Households, transport, services• Regulation was left to Member States• Post 2012:targets for non-ETS emissions

• By 2020• EU emissions to be 10% below 2005 levels• Ireland –20%

• Very demanding for Ireland

Irish policy for non-ETS

• Tax best instrument• Very little scope to change emissions by 2020 in non-ETS. More scope

in ETS. However, Ireland cannot trade off ETS for non-ETS reduction.• To reach the target • Would require huge tax • Other policies would be even more expensive

• Very inefficient if price on non-ETS market hugely greater than on ETS.• Therefore, need flexibility

Flexibility for non-ETS in EU

• Three proposals Irish, Polish, Swedish• Swedish adopted• Allow countries to trade non-ETS quotas• Equates non-ETS compliance cost across EU

• Competitiveness within EU• ETS price the same• Non-ETS price the same• A level playing field in the EU• However, potentially inefficient if prices differ

Implementation in Ireland

• Carbon Tax essential – in place• Least cost implementation• Should it be higher?

• The revenue allows• Lower distortionary taxes elsewhere• Has negative income distribution effect

• Supplementary measures• Energy efficiency / insulation – social housing etc.

• Buy permits from other governments• IGES, 2014 models effects

Effects of a Carbon Tax – double dividend

Revenue recycled through lower income tax than before

Net effect on economy is positive

GNP, % 0.5

Employment, % 0.5

Wage Rates, % -0.9

Importance of Price Signal

• Short-run emission reduction limited• In long run emissions reduction will be achieved by new technologies• A higher price promises a return on investment in R&D• Sends signal – better than governments “picking winners”• Best approach: “The polluter pays”

Subsidies – Carrots??

• Sourced from taxation, causes lost jobs and output elsewhere• Rewards item subsidised, not reductions• Need to be large to entice recipients• Goes to many who would invest anyway (deadweight)• Requires monitoring – rarely assessed• Selection record is poor : inappropriate solar panels, bio-fuels.• Dangerous support of liquid bio-fuels

Capital Cost a Key Issue

• Highly capital intensive industry• Need new investment• Rest of EU has not needed to worry• They didn’t need new investment

• However, EU will need lots of investment for environmental reasons• Reducing uncertainty for investors• Crucial for competitiveness

• How to combine certainty with competition

EU Renewables Obligation

• Why have a renewables obligation?• If there is a carbon price why is that not enough• Are renewables “beautiful”• Strong lobby• Designed to drive research – infant industry argument• Could the same result be produced by research rather than

production?• German approach – very expensive• Allocation of obligations – distributional effects across countries

Drive for renewables - Ireland

• Delivering increase without a subsidy?• Predominantly driven by the market• Subsidy lower in Ireland than Northern Ireland• Certainty minimises capital cost• Simulating more renewables by 2020• If gas prices cheap then there is a significant cost• If gas prices expensive then may be good value• An insurance policy?

Other Renewables

• Wave and tidal• Experimental, high risk• Share R&D costs• Tidal unlikely to be economic• Wave??

• Biomass• Replace peat gradually• Peat should drop out because dirty

Role for Nuclear?

• Minimum size 1000 MW?• Reliable small units – not available

• Managing Risk• Reserve needs• Nuclear is “must run” as is wind

• Will not fit with the Irish system• Too much wind?• How much interconnection?

Energy Efficiency

• Where is the market failure? What is wrong with the price? • Possible lack of information, access to finance, economies of scale

• Important how you tell consumers• Price on its own may not be enough

• Don’t impose energy efficiency obligations on suppliers• Hides the cost. • Likely to cost more than a national scheme

• BER scheme for dwellings delivering benefits

Domestic Policy

• Not fully worked out• Targets – imposed from outside

• Emissions Trading• Made best of a bad hand

• Renewables• A means to an end• In long run ETS should be enough• But ETS is distorted

• Absence of carbon tax• No incentive to change• Burden uneven – raises cost• Carbon tax should be higher? Carbon leakage? Why subsidise peat?

Transport - Aviation

• Very high income elasticity (responsiveness)• Low price elasticity• The last use of fossil fuels• Raise price• Grandparented permits – billions for O’Leary• Alternative mechanisms – Biggles?

Policy on Transport

• Carbon Tax - small effect• Congestion key environmental issue• Urban public transport• Congestion charging• Emissions reduction a by-product

• EU level crucial• Standards for fuel efficiency• Learn from California• Huge market - producers can react• Long lead in time on R&D

Research

• Essential if the world is to reduce emissions• Top-down:• The wise civil servant or• Competitive model – basic research

• Market Driven:• Profitable opportunities• Builds on basic science

International agreements?

• No matter what the EU does it will not solve the problem• Carbon leakage a real issue

• Getting agreement on a fair burden sharing across the world• Almost impossible• Difficult to verify and enforce• CDMs not a solution

• In the end, when new carbon neutral technologies are the cheapest solution they will be adopted• First get the technologies!

Lecture 27th March

• Two topics related to previous lectures• Prepare a few points on each topic. • Lecture will be in the form of a debate• Antóin Murphy and myself will participate, but not lead the debate

1. EMU A. Was it a good idea?B. How can EMU be improved?

2. How would you have advised the government on the financial crisis? A. In September 2008 B. November 2010

Reading for this lecture

• Basic text:• “Introduction to Environmental Economics”, Hanley Shogren and White. Not very exciting, but

provides the basics• Chapters 2, 3, 4, 6

• “Climate-Change Policy” Dieter Helm, OUP. Library: 333.7 P59• A series of articles – much more comprehensive.

• Other reading.Examples:• ESRI, Irish Energy Policy: An Analysis of Current Issues, Research Series No. 37, relevant parts of chapter 3. http://

www.esri.ie/UserFiles/publications/RS37.pdf• Honohan, 1998, on cost-benefit analysis http://www.esri.ie/UserFiles/publications/GRS172.pdf• Anthoff and Tol, 2010, http://dx.doi.org/10.1016/j.jeem.2010.04.002• IIEA Occasional paper 3 http://www.iiea.com/news/climate-change-report on the science• On emissions embodied in trade: http://dx.doi.org/10.1080/09640568.2014.973936• Conefrey et al., 2012 on the double dividend http://dx.doi.org/10.1080/09640568.2012.709467• IGES, 2014, on using carbon taxes to finance buying permits http://

igees.gov.ie/wp-content/uploads/2014/07/2014-07-01-MTES-Structural-Reforms_Staff-Working-Paper_finalforpub2.pdf