1 William D. Nordhaus Yale University September 11, 2008 World Bank Seminar Slides are available at . Full study is William.

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William D. NordhausYale University

September 11, 2008

World Bank Seminar

Slides are available at http://nordhaus.econ.yale.edu/. Full study is William Nordhaus, A Question of Balance: Weighing the Options on Climate Change, Yale University Press, 2008, available in full at author’s web page.

The Challenge of Global Warming

for the Global Economy

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Outline of lecture

1. The science of global warming2. What is the underlying economic problem?3. What are the insights of economic integrated

assessment (IA) models?4. Major Issues for the Next Round of the

International Accords (post-Kyoto Protocol)- Impacts- Participation- Taxes v. caps

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CO2 concentrations at Mauna Loa

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320

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60 65 70 75 80 85 90 95 00 05

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Instrumental record: global mean temperature index(°C)

-0.4

-0.2

0.0

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0.4

0.6

0.8

1.0

1.2

1860 1880 1900 1920 1940 1960 1980 2000

GISSHadley

Global Mean Temperature Anomaly (Relative to 1900)

Deg

rees

C

IPCC AR4 Model Results: History and Projections

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DICE-2007model

What is the economist’s bottom on global warming?

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The fundamental problem is the climate-change externality – a “global public good”

Economic participants (millions of firms, billions of people, trillions of decisions) need to face realistic carbon prices if their decisions about consumption, investment, and innovation are to be correct.

1. To be effective, we need a market price of carbon emissions that reflects the social costs.

2. Moreover, to be efficient, the price must be universal and harmonized in every sector and country.

But a major economic question remains: what is the appropriate price of carbon? This question is addressed by integrated assessment models.

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Integrated Assessment (IA) Models

What are IA models?- These are models that include the full range of cause and effect in climate change (“end to end” modeling).

Major goals of IA models:Project trendsAssess costs and benefits of climate policies Assess uncertainties and research prioritiesEstimate the carbon price and efficient emissions

reductions for different goals

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Fossil fuel usegenerates CO2

emissions

Carbon cycle: redistributes around

atmosphere, oceans, etc.

Climate system: change in radiative warming, precip,

ocean currents, sea level rise,…

Impacts on ecosystems,agriculture, diseases,

skiing, golfing, …

Measures to controlemissions (limits, taxes,

subsidies, …)

The emissions-climate-impacts-policy nexus:

The DICE-2007 model

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1. Baseline. No emissions controls.2. Optimal policy. Emissions and carbon prices to

maximize discounted economic welfare.3. Limit to 2 °C. Climatic constraints with global

temperature increase limited to 2 °C above 1900

4. Strengthened Kyoto Protocol. Modeled on US proposal with rich countries at same time and developing countries join after 1 -3 decades.

5. “Ambitious”: Gore/Stern early emissions reductions

Policy Scenarios for Analysis

Temperature profiles: DICE 2008

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0.0

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6.0Te

mpe

ratu

re in

crea

se fr

om 19

00 (d

eg C

)

Base 2007Strong KyotoOptimum2 degree C limitBase 2008

Concentrations profiles: DICE 2008

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300

400

500

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800

900

1000

1100

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1300

Car

bon c

once

ntr

atio

ns

(ppm

)

Optimal

Baseline

< 2 deg C

Strong Kyoto

Double ofPre-industriallevel

Carbon prices for major scenarios

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0

100

200

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2005 2015 2025 2035 2045 2055 2065 2075 2085 2095 2105

Car

bon

pric

e (2

005

US$

per

ton

C)

Optimal

Baseline

< 2 degrees C

Strong Kyoto

What do carbon prices mean in practice?

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Carbon tax, 2010 Increase, price of energy, US

[$/tC] GasolineAll energy

expenditures

Kyoto: global average $2 0.2% 0.3%

"Optimal" 35 3.3% 5.4%

Climate constrained 50 4.8% 7.7%

Gore/Stern 200 19.0% 30.7%

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• Version discussed today is global aggregate (however, regional model has been developed and is being updated).

• Major uncertainties about many modules (particularly future technological change and impacts)

• Many modules are “reduced form” rather than structural

• Enduring controversy and confusion about “discounting”

Limitations of DICE Model

Major issues for a revised international regime

1. What are the likely impacts of climate change?

2. The economics of participation3. Cap and trade v. carbon taxes?

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1. The Question of Climate Impacts

Estimating the impact of climate change on society is the most treacherous of all areas.

First approximation of climate damages:- Relatively minor impacts on market economies of “North” for a century (+ 1 percent of output)

- Likely to have very large impacts on unmanaged ecosystems a century out and more

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The Economics of Hurricanes

Source: NOAA, Hurricane Katrina shortly before landfall

18P. J. Webster, G. J. Holland, J. A. Curry, H.-R. Chang, “Changes in Tropical Cyclone

Number, Duration, and Intensity in a Warming Environment,” Science, Sept. 2005

Global intensity

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Normalized costs of hurricanes, 1950-2008:08

Source: author’s estimates.

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1950 1960 1970 1980 1990 2000 2010

Year

H

urr

ican

e co

st(%

of G

DP/ye

ar)

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Damage and power for individual hurricanes, 1950-2005

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-8

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0

4

3.6 4.0 4.4 4.8 5.2

ln (maximum wind)

ln (d

amag

e/G

DP)

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Econometrics of hurricane damages (updated to 2008)

“[The] amount of damage increases roughly as the cube of the maximum wind speed in storms…” (Kerry Emanuel, Nature, 2005)

“While this may appear to be a relatively insignificant increase, nonlinear effects can make even a small increase important in causing damage, because damage is proportional to the cube of the wind speed.” (Anthes et al, BATIS, 2006)

MAJOR SURPRISE: Super-high elasticity.

2R 0.503; N 154; standard errors of coefficients in parentheses

(1) ln(cost/GDP) 8.09 ln (maxwind) 0.023 year(0.66) (0.0071)

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Estimated mean damages from global warming, central case and alternative

estimates (1) (2) (3) (4)

Case

Elasticity of damages

w.r.t. windspeed

Semi-elasticity of maximum wind speed

w.r.t. T

Change in tropical sea-

surface temperature (SST , oC)

Estimated increase in

mean damages

(% increase)

Central case 8.0 0.035 2.5 96%

OLS elasticity 7.2 0.035 2.5 83%Emanuel semi-elasticity 8.5 0.055 2.5 199%Conventional damage impact 3.0 0.035 2.5 29%SST warming since 1950 8.0 0.035 0.4 12%Higher storm elasticities 8.5 0.125 2.5 2018%

2. The economics of participation

One of the important issues in a climate policy regime is the extent of participation :- “Free riding” reduces the effectiveness of a policy- Free riding makes other countries angry and gives

them an excuse not to participate.The excess costs of participation can be estimated as:

(2) E() ≈ 1-

where is the participation rate and the convexity of the cost function.

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0

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1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1

Cos

t (as

frac

tion

of 1

00%

par

tici

pat

ion)

Participation rate

Normalized cost as function of participation rate

Top down studies

Bottom up studies

Source: IPCC, Fourth Assessment Report, Summary of Mitigation Cost Models.

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Attrition of Kyoto Protocol: share of global emissions

Source: Question of Balance 26

0

1

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9

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Original design Current participation

Cos

t (as

fra

ctio

n o

f 10

0% p

artici

pat

ion)

Penalty of non-participation in Kyoto Protocol

3. Major Policy Approaches for Global Warming

• Internationally harmonized carbon tax – economist’s ideal.

• Universal cap and trade – close second if well designed, but Kyoto Protocol is not doing well.

____________________________________________

• Regulatory substitutes (CAFE standards, ban on light bulbs, …) – very inefficient approaches

• Voluntary measures (carbon offsets) are difficult to calculate and verify and probably a useless diversion.

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Harmonized Carbon Taxes

What are “harmonized carbon taxes”?• Raise fossil fuel prices proportional to carbon

content• All countries would target a comparable tax• Level of tax set to meet environmental target • Use consumption basis for tax

Many advantages over cap and trade (see slide below)

Cap and trade v. carbon taxes 1. The fundamental defect of most quantity regimes is the LACK

OF CONNECTION between targets (emissions) and objective (climate or damages).

2. QUANTITY LIMITS TROUBLESOME in a world of differential economic growth and uncertain technological change.

3. Because of structure of uncertainty for stock pollutant, emissions taxes are MORE EFFICIENT than quantitative standards or auctionable quotas. (Weitzman)

4. Quantity-type regulations show EXTREMELY VOLATILE PRICES for the trading prices of carbon emissions (see slide).

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Price volatility of emissions permits

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94 95 96 97 98 99 00 01 02 03 04 05

Price oilPrice SO2 allowancesS&P 500

Pric

e (M

ay 1

994=

1)

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Cap and trade v. carbon taxes 5. Tax-type mechanisms or auctions have advantage because

they raise revenues and have potential for REDUCING DEAD-WEIGHT LOSS OF TAXATION.

6. Quantity-type systems with international trading are much more SUSCEPTIBLE TO CORRUPTION than price-type regimes.

7. The international cap and trade is a RADICAL AND UNPROVEN APPROACH, whereas taxes have been used in every country of the world.

All these emphasize the difficulty of reaching an effective and efficient mechanism for global public goods.

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Final thoughts

“Mankind in spite of itself is conducting a great geophysical experiment, unprecedented in human history.” Roger Ravelle (1957)