The Monetary Policy Approach to Climate Policy Design Warwick J. McKibbin CAMA, Australian National University & The Brookings Institution, Washington.

The Monetary Policy Approach to Climate Policy Design

Warwick J. McKibbin

CAMA, Australian National University

& The Brookings Institution, Washington DC

Prepared for Singapore Economic Review Conference 07 August 2009

Overview

• Climate Science and Policy• How to build a global framework

– Lessons from Kyoto– Lessons from the financial crisis

• Key issues in the design of a global system

• The McKibbin Wilcoxen Hybrid• Conclusion

Bathtubs

• What matters for the climate are the concentrations of greenhouse gases in the atmosphere

• Concentrations are the accumulation of greenhouse gas emissions from all sources over time less sinks

• The exact flow of greenhouse gas in any year is irrelevant relative to stabilizing concentrations

Climate Science

• “Science” does not tell us exactly what the global concentration target should be - but it guides us

Climate Science

• Even if we knew the concentration target “Science” does not tell us which of the many paths for global emissions should be followed for a given concentration target

Climate Science

• Even if we knew the optimal path for global emissions “Science” has nothing to say about what target an individual country should follow

Economics of Climate Change Policy

• Find the lowest cost distribution of emission reductions globally to achieve a global concentration target– this will not be an equal proportional

reduction for each country

• But how to do this is practice?

What is Needed

• A change in the behaviour of energy users and other greenhouse gas emitters

• Technologies to – reduce greenhouse gas emissions– reduce energy demand – increase energy efficiency

• Need to get the prices right

The Role of a Price on carbon

• The long term carbon price drives technology and is an opportunity– Demand side management

– The emergence of alternative technologies

– The adoption and diffusion of alternative technologies

• The short term carbon price is an input cost and is an economic loss

How to build a global system?

Alternative Philosophies(top down vs bottom up)

• Negotiate a global system in a common framework from the top down– The Kyoto approach

• Created a global system by coordinating national policies to build a global system– Nordhaus coordinated carbon tax– The McKibbin-Wilcoxen Hybrid

Alternative Philosophies(quantity vs price targets)

• IDEA - Pick an emissions target based on the expected costs and expected benefits – Targets and timetables (politically popular)– Stern and Garnaut

• POLICY – “Cap and Trade” - Require firms have a permit each year (based on a target) for each unit of emissions with emissions capped– Trade permits in the market– Revenue goes to permit owner– Emissions certain (targets and timetables) but cost is uncertain

• Global REGIME – join emission trading systems together to generate a global price

• IDEA - Pick a carbon price based on how much society is willing to pay for insurance against climate change and adjust the price over time as more information is revealed

• National POLICY – “carbon tax” where firms are charged a preannounced tax for each unit of carbon emissions– Revenue goes to the government– Emissions uncertain but cost (i.e. the tax) is certain

• Global REGIME – set the same price everywhere

Alternative Philosophies(quantity vs price targets)

• IDEA - Create a flexible system with long term concentration targets to tie down credibility but control the short term carbon price with flexibility as we learn about costs and benefits

• National POLICY - Create a Hybrid system of long term permit trading and short term carbon taxes similar to the monetary policy framework with long term carbon prices determined by a long term concentration target but short term carbon prices controlled by a central bank of carbon.

• Global REGIME – set the same price everywhere

Alternative Philosophies(quantity vs price targets)

Lessons from Kyoto Experience

• A system of rigid targets and timetables is difficult to negotiate because it is a zero sum game

• It is problematic for countries to commit to a rigid target for emissions under uncertainty about costs

• Even the most dedicated countries may be unable to meet their targets due to unforeseen events out of their control

Figure 1: Comparison of Projections of Energy Consumption, China

(Quadrillion(1015) Btu)

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40

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120

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200

1990 1995 2000 2005 2010 2015 2020 2025 2030

History Projection

Reference Case(EIA 2002)

High EconomicGrowth Case (EIA 2002)

Low EconomicGrowth Case (EIA 2002)

Reference Case (EIA 2007)

High EconomicGrowth Case (EIA 2007)

Low EconomicGrowth Case (EIA 2007)

Note: The base years for projections reported in EIA 2002 and 2007 are 1999 and 2004, respectively.Source: Energy Information Administration / International Energy Outlook 2002 and 2007

Why there will not be a global carbon trading market

• There will never be a global market for permits because permits are like money – they are the promise of a government to hit an emission target

• Governments have widely different degrees of credibility and national institutions are vastly different across countries

Lessons from the Financial Crisis

• Expected costs and benefits of a policy should not rely on our ability to forecast

• Critical to get global and national governance and regulatory systems right

• Shocks will occur and some firewalls between national climate policy systems is critical to minimize volatility of the global system

Principles of Climate Change Policy Design

• Need to enable households and firms in each country to manage the risks associated with climate change

• Should be credible, flexible and able to withstand future shocks

How to achieve credibility and flexibility

• Need long term property rights over carbon in the hands of private agents

• Need an independent national central bank of carbon to administer the policy with clear goals

• Need clear short term price control mechanism that enable costs to be smoothed

• Need to avoid reliance on foreign markets to smooth domestic prices – can also increase volatility

• Need fire walls around national systems

How do you actually build a monetary style national climate policy?

• Aim – Impose a long term carbon goal for the world and

distribute across economies– Generate a credible long term price for carbon in each

country to guide energy related investment decisions– Keep short term costs low– Provide a way for corporation and households to manage

climate risk– Each country adopts nationally and cooperate globally

McKibbin Wilcoxen Hybrid

Components of the Policy - 1

• Long-term permits (like a long term bond)– A bundle of annual permits with different dates for

each permit and which expire on that date

– Quantity of permits over time is the long run goal

– Supply is fixed (and diminishing) and allocated to households and industry

– Traded in a market with a flexible price

– NOT tradable across countries

Long Term Emission Permit

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CO

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Current Emissions = 100

2020

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2050

Why long term permits?

• Lock in long term goal

• Provide financing on the balance sheets of industry and households– Not provided by a tax or a permit auction (how do you

pay for the technologies for abatement and adaptation? Apply to a bureaucrat?)

• Act as a constraint on backsliding by governments by valuing the credibility of the policy where the assets are held by the voters

Components of the Policy - 2

• Annual permits– Must be acquitted against carbon emissions in the year of

issue– Expire in year of issue– Elastic supply from a central bank of carbon (CBC) or

limited international trade– Price fixed for five years and then reset given information

available– Act as a “safety valve” to cap the cost each year but

adjusted over time to hit the target

Short term Carbon price

• In any year companies will use a mix of an annual coupon from the long term permit and annual permits printed by the CBC for a fixed price to satisfy their emissions

• The price of permits in any year will be fixed at the price of the annual permits (effectively a carbon tax)

• The long term carbon price is determined in a market

Climate policy as monetary policy

• Monetary Policy– Target is inflation

over the cycle

– Short term target is the cash rate

– Key driver of economic activity is expected future interest rates (long term bond rates)

– Cooperate with other countries through international BIS/IMF

• Climate Policy– Target is

concentrations of greenhouse gases

– Short term target is the carbon price

– Key driver of emissions is expected future carbon prices (price of long term carbon asset)

– Cooperate with other countries through the UNFCCC processes

A Hypothetical Illustration

Fig 1: Long Term Permits in Annex B country

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Fig 2: Emissions and Long Term Permits

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long term permits actual emissions safety valve price reset

Figure 3 : Annual Permit Price

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2019

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2104

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Figure 4 : Stylized Value of Long Term Permits(Assuming r=5%)

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Coordination of National Markets

• Independent but coordinated via fixed annual carbon price (P)

Japan

US

EU

Australia

P

Key Issues Nationally

• Credible future price of carbon– Hybrid pre committed target driving 100 year

yield curve

• Short term price volatility (spikes)– Hybrid complete control for 5 year periods

Key Issues Nationally

• Financing change– Hybrid puts revenue in the hands of innovators

in industry and households with any annual permit sale revenue to finance R&D

• Balance Sheets– Hybrid preserves corporate and household

balance sheets but changes the structure of balance sheets

Stability

• Permits are like money – Credibility of government is critical

• Firewalls are important to shield domestic policy from foreign outcomes

• Domestic constituencies important– Who benefits from regime withdrawal?

Key Issues Globally

• Incentives to negotiate– The allocation of global targets is an allocation

of domestic revenue created by the carbon constraint WITHIN economies between the private sector and government. It is NOT a transfer of revenue across countries

How to Bring in Developing Countries ?

The MWH approach can be applied in countries at different levels of

development

Developing Countries

• Negotiate a long term permit allocation that is larger than current emissions

• Price of annual emission permits (or economic cost) is zero in the short run because more permits than needed

Figure 3 : Annual Permit Price

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China

Annex B

Figure 4 : Stylized Value of Long Term Permits(Assuming r=5%)

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2015

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2105

$US

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China

Annex B

Trading Across Borders

• Developing country permits can enter into the MWH national system but as annual permits on a bilateral basis

• Cap on the amount determined until all annual permits are used and CBC has no revenue

Key Issues Globally

• Transfers to Developing Countries– Partly through bilateral trade of annual permits– Need to create a technology transfer policy and

development policies outside the carbon markets so as to not complicate carbon pricing with other objectives

Conclusions

• For any policy to survive it is critical to get the balance between long run environmental benefits and short run economic costs right.

• Flexibility, credibility and sustainability of the policy framework are key

• Targets and timetables do not handle uncertainty as well as price based systems

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