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Economics of Climate Change

EPA issued two findings in December 2009 that are necessary precursors to regulating greenhouse gas emissions under the Clean Air Act. The first finding is that six greenhouse gases — carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6) — endanger the public health and welfare of current and future generations. The second finding is that emissions of these six greenhouse gases from new motor vehicles cause or contribute to the greenhouse gas pollution that endangers public health and welfare.

EPA has been engaged in a wide range of research into approaches aimed at curbing the United States’ contribution to global warming. Areas of climate economics research include economic analyses of regulatory policy instruments such as emissions trading, estimation of greenhouse gas reduction benefits, the role of uncertainty, and modeling the economic impacts of ocean acidification.

Regulating Emissions: Prescriptive versus Market-Based Approaches

Since the 2007 Supreme Court ruling that concluded CO2 and other GHGs are pollutants, debate over policy approaches to addressing climate change has intensified in the United States.

A number of theoretical and empirical studies have shown important advantages of market-oriented policies over command-and-control approaches to controlling pollution. Specific market-oriented approaches that are often discussed by economists as a way to reduce greenhouse gas emissions are:

  • Tradable Permits: A tradable permits (a.k.a. cap-and-trade) program sets a specific target or cap on total emissions and allocates or auctions the necessary number of pollution permits or allowances to polluters to meet that goal. Polluters that are able to reduce their emissions more cost-effectively have an incentive to abate more to avoid purchasing allowances or to sell their excess emission allowances to polluters facing higher costs of compliance. Under this type of market-based approach, emission are set by the cap, but the overall compliance costs may be uncertain [see Section 6 of EPA Economic Incentives Report, 2001 (PDF, 44 pp., 632K, About PDF) and Chapter 4 of EPA’s Guidelines for Economic Analysis].
  • Emission Taxes: Like tradable permit systems, tax-based regulatory systems provide incentives for polluters to find cost-effective solutions to emissions control. Firms will either pay the tax or, if it is cheaper, they will reduce emissions to avoid the tax. In the case of emission taxes, the cost of compliance is known, but emission levels may be uncertain [see Section 4 of EPA Economic Incentives Report, 2001 (PDF, 24 pp., 491K, About PDF) and Chapter 4 of EPA’s Guidelines for Economic Analysis].

The primary regulatory advantage of a market-oriented approach is that it can achieve a particular emissions target at a lower social cost than a more prescriptive regulatory approach due to the greater flexibility that it offers sources in determining how to reduce emissions. In other words, market-oriented approaches leave the method for reducing pollution to the emitter. As such, emitters have an incentive to find the least cost way of achieving the regulatory requirement. More prescriptive regulatory policies typically restrict emitter choices with regard to how they reduce pollution; in part, it is this inflexibility that leads to a higher cost of controlling pollution. Furthermore, market-oriented approaches create a single price for emissions - either through the tax on emissions or the price of a tradable right to emit - that is common to all polluters. Given this common price for emissions, the total abatement required by the policy is distributed across all emitters in such a way that the cost of reducing emissions is minimized: polluters with the lowest control costs are those that abate the most.

By leaving the method of reducing pollution to the emitter, market-oriented approaches provide a greater incentive to develop new ways to reduce pollution than more prescriptive regulatory approaches. Polluters not only have an incentive to find the least cost way of adhering to a standard, they also have an incentive to continually reduce emissions beyond what is needed to comply with the standard: For every unit of emissions they reduce under a market-oriented policy, they either have a lower tax burden, must purchase fewer permits at auction, or can sell a permit.

Market-oriented approaches are well-suited to controlling greenhouse gas emissions because a unit of greenhouse gas emissions has the same effect on environmental quality regardless of where it occurs. Also, while policies can control the flow of emissions, what is of ultimate concern is the stock – the concentration of cumulative greenhouse gases in the atmosphere. In the short term, this means that damages per additional ton emitted into the atmosphere change little with the amount emitted. These two characteristics imply that it is less important to regulate the exact location and timing of emission reductions that are often the focus of a typical regulatory approach. Increased flexibility in how, what, and when sources reduce greenhouse gas emissions does not have much effect on the benefits from reducing them but can greatly influence the cost.

If certain sources are exempt from the policy, then some relatively low cost emission reductions might not occur, raising the overall cost of the policy. If sources of pollution are compartmentalized into different sector-specific or pollutant-specific approaches, each class of polluter may face a different price for their contribution to the environmental harm, and therefore trading opportunities that reduce pollution control costs will be unrealized (Burtraw and Evans, 2008, "Tradable Rights to Emit Air Pollution"ExitAustralian Journal of Agricultural and Resource Economics 53: 59-84.). Pizer et. al (2006)Exit(PDF, 45 pp., 404K, About PDF) have demonstrated that taking a non-integrated approach to control greenhouse gas emissions will likely result in higher costs. For example, they find that limiting a market-oriented GHG policy to the electricity and transportation sectors doubles the cost of achieving a five percent reduction in carbon emissions compared to when the industrial sector is also included. For any given GHG emissions goal within the U.S., a market-oriented approach likely would result in less leakage of industrial production and GHG emissions abroad than a less flexible regulatory approach to regulation because of the ability to keep the costs of regulation lower.

Also relevant to decision-makers is how the costs of a market-oriented climate policy will be distributed across households with different consumption patterns and levels of wealth. Households are affected by both the stringency of the policy and how potential allowance value or emissions tax revenue is distributed. The way that allowances or tax revenue are distributed can also affect the overall cost of the policy. For example, allocating allowance value based on the amount of electricity a household consumes is generally progressive because low-income households spend a larger percentage of their incomes on electricity than higher-income households. However, this in effect subsidizes electricity consumption and in turn makes it more expensive overall for the economy to achieve the desired carbon emission reductions since it must look for those reductions elsewhere. EPA's National Center for Environmental Economics (NCEE) collaborates with other EPA offices to estimate the distributional effects of proposed legislative climate policies. (See, for example, EPA’s 2010 analysis of the American Power Act).

To date, tradable permit systems have been the most widely used method for regulating GHG emissions. The most comprehensive cap-and-trade scheme currently in operation is the European Union’s Emission Trading Scheme, which was initiated to help EU member states comply with their Kyoto Protocol targets. Several regional cap-and-trade systems are also in place or under development in the United States, including the Regional Greenhouse Gas Initiative in the Northeast and the California cap-and-trade program.

The EU Emission Trading Scheme allows the use of offsets. An offset is an emission reduction from a source outside of the cap in place of a reduction from a regulated source. For example, a coal-fired power plant might purchase offsets from a landowner who sequesters carbon by reforesting grazing land instead of installing technology to reduce smokestack emissions. Other examples could include improving livestock management to reduce methane emissions, investing in clean energy in developing countries, or reducing deforestation in the tropics. The Kyoto Protocol’s Clean Development Mechanism is the largest existing offsets program.

Extending the market-based incentives of cap-and-trade programs to unregulated sectors and countries through offsets offers advantages by increasing flexibility and decreasing costs to meet emissions targets. EPA’s 2010 analysis of the American Clean Energy and Security Act estimated that eliminating international offsets would raise carbon allowance prices 54-146 percent. Challenges to designing credible offsets programs include additionality (ensuring emission reductions exceed what would have happened without the program), leakage (displacing emissions outside the boundaries of the project), and permanence (preventing loss of sequestered carbon from forest fires or land clearing), as well as measuring and verifying emissions from small heterogeneous sources and sources abroad.

Challenges in Estimating Costs and Benefits of Greenhouse Gas Policies

The long time horizon over which benefits and costs of climate change policy would accrue and the global relationships they involve raise challenges for estimation. The exact benefits and costs of virtually every environmental regulation are at least somewhat uncertain, because estimating benefits and costs involves projections of future economic activity and the future effects and costs of reducing the environmental harm. In almost every case, some of the future effects and costs are not entirely known or able to be quantified or monetized.

In the case of climate change, the uncertainty inherent in economic analyses of environmental regulations is magnified by the long-term and global scale of the problem. There are uncertainties regarding the pace and form of future technological innovation, economic growth, and thresholds for climate impacts. These difficulties in predicting the future can be addressed to some extent by evaluating alternative scenarios. In uncertain situations, EPA typically recommends that analysis consider a range of benefit and cost estimates, and the potential implications of non-monetized and non-quantified benefits.

Weitzman (2008) has raised the importance of accounting for low probability but high impact outcomes in economic analyses of climate change. In standard integrated economic assessment models of climate change policies, central or “best-guess” estimates typically are used for all input parameters. For example, the current central estimate for doubling the atmospheric concentration of carbon dioxide emissions is a temperature increase of around 3oC. However, the actual value could turn out to be lower or much higher.

The basic rationale for excluding low-probability high-impact outcomes from assessments of climate change policies seems to be that the associated scientific uncertainty surrounding them is too large to provide a solid basis for policy decisions. However, a key point that follows from Weitzman’s research is that the “high-impact” component can potentially cancel out and even overwhelm the “low-probability” component. In general, it is the product of the probability and the impact that is important, rather than one or the other alone. A few recent studies have tried to account for uncertainty when evaluating climate change policy, but so far the results are mixed. (See Daigneault and Newbold (2008), Climate Response Uncertainty and the Unexpected Benefits of Greenhouse Gas Emissions.)

Even with these uncertainties, there is a rich literature that attempts to estimate the “social cost of carbon” (SCC); the monetized damages associated with an incremental increase in carbon dioxide emissions in a given year. The SCC reflects changes in agricultural productivity, human health, property damages from increased flood risk, the value of ecosystem services, and other impacts caused by a changing climate. Estimates of SCC range widely and are influenced by assumptions such as discount rates, the shape of the damage function, and projected future economic and emissions growth absent policy to constrain GHG emissions, among others. (See Newbold et al (2010), The 'Social Cost of Carbon' Made Simple.)

In 2010, an interagency working group produced original estimates of the SCC. NCEE was an active participant in that effort. The purpose of the SCC estimates is to make it possible for agencies to incorporate the social benefits from reducing CO2 emissions into cost-benefit analyses of regulatory actions that have a relatively small impact on cumulative global emissions. A report summarizing the technical details and a set of four estimates to be used by agencies in regulatory analyses was released. (See Social Cost of Carbon for Regulatory Impact Analysis Under Executive Order 12866 (PDF, 848K, About PDF)). In 2013, the interagency working group produced a technical update that leaves all interagency assumptions unchanged but updates to the latest version of each of the three integrated assessment models used to estimate the social cost of carbon. (See Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis under Executive Order 12866 (PDF, 664K, About PDF)).

The interagency working group has committed itself to updating these estimates as the science and economic understanding of climate change and its impacts on society improves over time. Two workshops hosted by EPA and DOE in 2010-2011 brought the best climate modelers from the scientific and economic communities together to discuss current modeling capabilities and key gaps that could be potentially addressed before the interagency group revisits the SCC estimation process. NCEE has also hosted a workshop on intergenerational discounting. Please see NCEE's Climate Research page for more information.

Ocean Acidification

In addition to the impacts of climate change, the increasing levels of carbon dioxide in the atmosphere are contributing to another potentially devastating process. The oceans are the largest carbon sinks on Earth, absorbing nearly one-third of anthropogenic carbon dioxide emissions. As the atmospheric concentration increases, the ocean absorbs more CO2, which lowers the pH of sea water, making it more acidic. The altered chemistry of the ocean will affect the ability of some marine organisms to form shells and skeletons, threatening already vulnerable coral reefs, shellfish, and the plankton that form the base of the ocean’s food web. (See Orr et al. (2005) "Anthropogenic ocean acidification over the twenty-first century and its impact on calcifying organisms" Nature 437:681–86).

Projections of impacts vary across marine species, region, and CO2 emissions forecasts. But in general, we can expect calcifying marine organisms to be adversely affected by ocean acidification in the next 50 to 100 years. The first noticeable impacts will probably be widespread loss of coral reefs. The last time atmospheric concentrations of CO2 reached projected levels (doubling of preindustrial levels or about 550 ppm) coral reefs disappeared from the fossil record for one million years.

Climate change and ocean acidification are closely linked and should be considered jointly when deciding how to regulate CO2 emissions. For example, the damages to coral reefs from ocean acidification are exacerbated by ‘coral bleaching’ which is being caused by warmer ocean waters. These same coral reefs act as buffers to tropical storms that are expected to increase in frequency and severity as a result of climate change. And because reducing the atmospheric concentration of CO2 is the only way to mitigate ocean acidification on a global scale, some strategies to combat climate change – for instance, those that focus on non-CO2 GHGs - could have negligible effects on the acidification of the ocean.

NCEE is conducting research to assess the economic impacts of ocean acidification so they can be included in estimates damages from greenhouse gas emissions. In addition, NCEE participates in cross-office and interagency efforts to guide research in this area and inform the national policy discussion.

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