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)