MN7406 ClimateChange

Economics of Climate Change
Introduction
Prof Matthias Dahm
MN7406 International Business
Feb 2022
1 / 17
Climate change . . .
. . . is one of the greatest challenges of our times
Climate change threatens the well-being of future generations

unless the international community acts decisively
And this is well known . . .
. . . just think of COP26 . . .
2 / 17
“The government has come under fire in recent months for failing
to set out plans for a green recovery that would put the UK on
track to meet its goal of reaching net zero carbon emissions by
2050. Apart from £3bn for insulating homes, there were no green
measures in the Covid-19 recovery plan.”
In this lecture . . .
. . . we will see that economics can

I contribute to our understanding of this challenge
I indicate solutions to this challenge
More specifically, questions we will ask include

I Why have international negotiations made scant progress?
I Do international agreements work?
I What can we do to limit global warming?
I What is a carbon emissions tax?
12 / 17
Our approach is . . .
. . . to think like an economist . . .
I the goal of economics
I individual behaviour
I theory & empirical evidence

https://www.youtube.com/watch?v=H7n_
I models & mathematics 73j1c5c
I chapter on climate change Jean Tirole

Nobel laureate 2014
(The library has an on-line version of this book)
13 / 17
Thinking like an economist
What is the goal of economics?
The goal of economics is not . . .

I to justify economies based entirely on markets or
I to promote private property or
I to aid deregulation. . .
The goal is to make the world a better place
14 / 17
The goal is to make the world a better place
The task is to identify institutions and policies that work

In some situations markets (an institution) work well, in others
I they do not and must be complemented by regulation
I these situations are called market failures
I the market economy is not an end in itself
I the market economy is an imperfect instrument
Economics aspires to recommend better public policy
15 / 17
Climate change policy is needed because . . .
“Climate change is a result of

the greatest market failure the
world has seen.”
The Stern Review (2007)
16 / 17
The road map for this lecture
I Introduction
I What is climate change, and what to do about it?
I Why is action against climate change so difficult?
I The economic approach: Demand-side policies
I The economic approach: Supply-side policies
I Conclusions
17 / 17
I Introduction
I Conclusions
2 / 17
Climate change: Earth is warming
Watch the video! https://www.youtube.com/watch?v=gIUN5ziSfNc&t=14s&utm_source=NASEM+

News+and+Publications&utm_campaign=a4b6272c6d-auto-Welcome-social&utm_medium=email&utm_term=0_
96101de015-a4b6272c6d-107529689&mc_cid=a4b6272c6d&mc_eid=7f32ae0073
3 / 17
Remark: What are my sources?
This is a controversial topic and some people have ‘alternative facts’
Intergovernmental Panel on Climate Change https://www.ipcc.ch/
I U.N. body for assessing the science related to climate change
I authors and experts and reviewers are scientists
I jointly awarded the Nobel Peace Prize (2007 with Al Gore)
www.nationalacademies.org
I nonprofit institutions that provide expert advice on some of the most pressing challenges facing the nation
and the world
Climate science contains some degree of uncertainty but

major inroads have been made in increasing our
understanding of climate change and its causes
4 / 17
Climate and climate change
Climate is often defined as ‘average weather’

Climate is usually described in terms of the mean and variability of
temperature, precipitation and wind over a period of time, ranging
from months to millions of years (the classical period is 30 years)
Climate change refers to changes in these statistics
5 / 17
Climate System depends on changes in

I the incoming solar radiation (e.g., changes in the Sun itself)
I the fraction of solar radiation that is reflected (called ‘albedo’;

e.g., changes in cloud cover, atmospheric particles or
vegetation)
I the longwave radiation from Earth back towards space (e.g.,
changes in greenhouse gas concentrations)
6 / 17
7 / 17
Greenhouse effect
I greenhouse gases (GHGs) act as a partial blanket for the
longwave radiation of energy coming from the surface
I the more greenhouse gases, the ‘thicker the blanket’, the more
energy is trapped and the warmer Earth’s surface
I the most important greenhouse gases are water vapour and
carbon dioxide, others include nitrous oxide and methane
I human activities intensify the blanketing effect through the
release of greenhouse gases
I human activities release greenhouse gases primarily through
combustion of fossil fuels and deforestation
8 / 17
Global warming
Global warming
I long-term rise in average temperature of the Earth’s climate
I is a major aspect of climate change
How do we know that global warming is taking place?

I has been demonstrated by direct temperature measurements
I consistent picture with other indicators (indirect satellite

measurements, more frequent heat waves, milder and shorter
cold periods, decreasing ice cover, melting glaciers, animal
and plant migrations)
9 / 17
Global warming
I +1.4◦ F (or +0.7778◦ C) was in 2012
I today +1.0◦ C above pre-industrial levels
I with a likely range of 0.8◦ C to 1.2◦ C
10 / 17
Human activities are responsible for global warming
Overwhelming majority of climate scientists agree that

human activities are responsible for global warming
I specially the burning of fossil fuel
I such as coal and oil
I and other activities, like deforestation
I release carbon dioxide into the atmosphere
I and increase the greenhouse effect
11 / 17
CO2 emissions higher than at any point in the last 800,000 years
12 / 17
“Based on a rigorous assessment of available temperature

records, climate forcing estimates and sources of natural
climate variability, scientists have concluded that there is
more than a 90% chance that most of the observed global
warming trend over the past 50-60 years can be at-
tributed to emissions from the burning of fossil fuels
and other human activities.”
“ Human activities are estimated to have caused ap-

proximately 1.0◦ C of global warming above pre-industrial
levels, with a likely range of 0.8◦ C to 1.2◦ C.”
13 / 17
Outlook
Global warming is likely to reach 1.5◦ C between 2030 and 2052 if

it continues to increase at the current rate (high confidence)
14 / 17
Outlook on the consequences of climate change
“Climate-related risks to health, livelihoods, food security,

water supply, human security, and economic growth are
projected to increase with global warming of 1.5◦ C and
increase further with 2◦ C.”
Thus the consequences include

I economic and geopolitical costs
I migrations
I resentment on the part of the most affected
I who tend to be those with the least resources (for adaptation)
15 / 17
Consensus on goal to limit global warming
There is an agreement to limit average global temperature

increase to 1.5◦ C
U.N. Climate Action Summit September 2019:

“The best science, according to the Intergovernmental
Panel on Climate Change, tells us that any temperature
rise above 1.5 degrees will lead to major and irreversible
damage to the ecosystems that support us,”
United Nations Secretary-General António Guterres
Paris Agreement 2015: 195 countries agreed to hold warming to

well below 2◦ C, with 1.5◦ C tacked on as an aspirational target
16 / 17
The challenge of limiting global warming
Limiting average global temperature increase to 1.5◦ C is an

enormous challenge
Remember:
It requires deep transformations (e.g. in energy consumption,

houses, transport, production of goods and services, management
of agriculture and forests. . . )
17 / 17
I Introduction
I Conclusions
2 / 20
Why is action against climate change so difficult?
I Climate change is a thorny problem
I Cognitive biases and political polarisation
I The major emitters will probably change
I Climate change is a “tragedy of the commons”
I There are incentives to delay policies
I The problem of “carbon leakage”
5 / 20
Climate change is a thorny problem
Going from understanding of climate change and its causes to

predicting climatic future presents additional difficulties
There is uncertainty concerning
I how much temperatures will rise on our current path
I what the consequences of temperature rises will be (an

inconvenience or a catastrophe?)
It is not straightforward to do a cost-benefit analysis that asks:
Do future benefits from cutting emissions outweigh costs?
6 / 20
Climate change is a thorny problem
Do future benefits from cutting emissions outweigh costs?
Economic analysis can help to structure the discussion and isolate

the cause for the disagreement (interest rate)
7 / 20
Cognitive biases and political polarisation
Americans’ views on global warming: a yearly Gallup poll

8 / 20
We see from the Gallup poll that

I in a 2003, 68% of self-identified Democrats believed that
temperature changes over the past century could be
attributed to human activity,
I relative to 52% of Republicans
I by 2013, these percentages had diverged to 78% and 39%
9 / 20
Dan Kahan provided proof of the anthropogenic factor, that is, the
human impact on global warming
I Americans who voted Democrat became more convinced of
the necessity of action against climate change
I Americans who voted Republican became confirmed in their
scepticism
I effect did not depend on education or intelligence
Dan M. Kahan “Ideology, motivated reasoning, and cognitive reflection,” Judgment and Decision Making, Vol. 8,
No. 4, July 2013, pp. 407–424
10 / 20
It is likely that emerging countries will play a central role in future emissions
11 / 20
It is likely that emerging countries will play a central role in future emissions
I countries that are now

developed responsible for
large proportion of
anthropogenic emissions
I China greatest emitter
I China still has a long way

to go to reach living
standards of
developed-world
I India and others are likely
to follow China’s path
I The major emitters will
probably change over the
next few decades
12 / 20
Climate change is a “tragedy of the commons”
Most countries would benefit enormously from a reduction in global

GHG emissions, but a given country has negligible incentives
I bears 100% of the cost (e.g. insulating homes or switching to
more expensive but cleaner energy sources)
I receives only a small part of the benefits of its policy
I (if its exposure to the risks of climate change is average)
I most of the benefits of its policy go to other countries
I and to future generations (who have no vote yet)
I there is an externality
I each country prefers other countries to choose green policies
Thus there is a free-rider problem, policies remain inadequate

and there is a market failure
13 / 20
Climate change is a “tragedy of the commons”
Consider a simple example with two countries
I switching to cleaner energy sources has (private) cost of 6
I if one country switches both get (social) benefit of 5
country B
don’t switch switch
country A don’t switch (0,0) (5,-1)
switch (-1,5) (4,4)
Every country acting in its own interest (on behalf of its

people) leads to a dilemma, as (0,0)<<(4,4)
14 / 20
There are incentives to delay policies
The fact that climate change is a “tragedy of the commons” shows

the need for a global solution but
I a global future agreement is expected to require compensation
I a country’s capacity to demand compensation will depend on

its bargaining position
I its bargaining position will be better the more the country’s
reliance on carbon-based fuels
I in other words
I the more the economy depends on fossil fuels, the less the
incentives to join agreement and the larger the compensation
required to make the country join the agreement voluntarily
15 / 20
Climate change is aggravated by the problem of “carbon leakage”
Suppose a country is “virtuous” and takes unilateral action

taxing carbon emissions
I this imposes additional costs on national industries
I results in disadvantage in international competition
I with firms from countries where polluting activity is cheaper
I companies have an incentives to relocate production facilities

I to countries where polluting activity is cheaper
The policy has no environmental benefit but leads to

redistribution of production and wealth
16 / 20

taxing the domestic price of gasoline or fuel oil
I this reduces the domestic demand of gasoline
I results in fall of the price on the world market
I encouraging free-riding in other countries
I leading to an increase in demand in other countries
I and to an increase in emissions in other countries
The net climatic effect of the policy is hence reduced
17 / 20
Consider a project to preserve a forest somewhere in the world

I fundamentals in the market for lumber have not changed
I and these fundamentals created the incentives for

deforestation in the first place
I the project avoids some deforestation but
I increases the price of lumber
I encouraging deforestation and free-riding elsewhere
Only a global solution can resolve the climate question
18 / 20
I the initial shift in supply is from x 0 to x̂

I the net reduction in equilibrium quantity is from x 0 to x 1
The global reduction in equilibrium deforestation is smaller

than initial reduction in deforestation
19 / 20
Climate change requires a global solution
A global solution needs to establish incentives to motivate

nations with strong and divers self-interests to move
voluntarily toward a collective goal of reduced carbon
emissions
A global solution is a challenge, as it requires

I to define an ambitious international treaty overcoming the
free-rider problem
I the agreement to be self-enforcing, since there is no global
authority to punish violators
20 / 20
I Introduction
I Conclusions
2 / 18
The economic approach: Demand-side policies
To restrict carbon emissions caused by fossil fuel combustion, one

might regulate fossil fuel demand or supply, or both
Supply-side policies regulate exploration and extraction
Demand-side policies regulate the combustion
We start with demand-side policies
3 / 18
Most economists recommend establishing a global price for carbon
4 / 18
Most economists recommend establishing a global carbon price
Global means
I for all countries
I for all economic sectors
I for all economic agents
There are two instruments to implement carbon pricing

I a carbon tax
I tradable emission permits (or emissions trading system ETS)
5 / 18
A carbon tax
Requires an agreement on a minimum price for GHG emissions

I say £50 per ton of CO2 emissions
I each country collects the corresponding revenues
I all countries have the same price for GHG emissions (or
higher)
I more sophisticated arrangements set average carbon price
emerging from mix of policies (carbon tax, tax credits and
penalties based on car emissions . . . )
Monitoring and verification that a country complies with the

international agreement is a challenge, because of free-riding
incentives and technical issues
6 / 18
Tradable emissions permits
The international agreement

I defines a total global emissions target
I emission rights are traded globally
I thereby ensuring a uniform carbon price
I since emissions are “capped” often called “cap and trade”
The initial allocation of the corresponding volume of permits

I can be via auction or free of charge
I can ensure compensation (aims: participation and fairness)
7 / 18
Tradable emissions permits
The uniform carbon price on the global carbon market

I arises from demand and supply in this market
I through mutually advantageous exchanges
The opportunity cost of pollution for everyone is the market price

I agents who pollute more than their quota buy
I agents who pollute less than their quota sell
I this does not depend on the initial allocation mechanism
I consumers are also incentivised, as the carbon price affects the

price of goods and services
8 / 18
Tradable emissions permits–the example of acid rain
Sulfur dioxide (SO2 ) and nitrogen oxides (NOx ) emissions result in

Acid rain
U.S. created a market for tradable permits in 1990
I the law mandated a reduction in emissions by half of
emissions by 1995 and was successful
I each year permits with horizon of 30 years are issued
I at each point in time a price for emissions over next 30 years

is available
I if this price is high there are incentives to invest in alternatives
This shows a single carbon price can work
9 / 18
Equivalence of carbon tax and tradable emissions permits
The market for GHG-emitting products
Without climate policy the equilibrium is at point A

With climate policy the equilibrium is at point B 10 / 18
Equivalence of carbon tax and tradable emissions permits
The equivalence assumes that demand and supply are well known
But when there is some uncertainty

I with tradable emissions permits the environmental impact is
certain while the price is uncertain
I with carbon tax the environmental impact is uncertain while
the price is certain
11 / 18
Why not just “command and control” policies?
These regulations include

I emissions limits differentiated by the source of emissions
I mandated uniform reductions in pollution
I subsidies and taxes that do not depend on emissions
I ...
These regulations are well meaning, often described as ‘green’,

very visible, and very popular with voters
But often, for the same cost, emissions could be reduced
much more!
There are estimates that “command and control” is twice as
expensive as single carbon price
12 / 18
Why not just “command and control” policies?–An example
An example
I two companies, each of which emits two tons of carbon
I regulator wishes to cut total emissions in half
I company 1 has clean-up cost of £1,000 per ton
I company 2 has clean-up cost of £10 per ton
13 / 18
Consider a ‘fair’ policy

I requiring each company to cut its emissions by half
I total clean-up cost are £1,010
Efficiency requires
I company 2 should eliminate all emissions
I company 1 should not do anything
I total clean-up cost are £20
I saving society £990 compared to ‘fair’ policy
14 / 18
Consider the economic approach

I setting a price for carbon at, say £50 per ton of carbon
I company 1 chooses between
I paying £2,000 to avoid emissions
I paying the carbon price of £100
I company 2 chooses between

I paying £20 to avoid emissions
I paying the carbon price of £100
This is efficient!
The tax revenue of £100 can be used to offset the £120 loss
15 / 18
16 / 18
“Why is putting a price on carbon better than direct reg-
ulation of emissions? Every economist knows the argu-
ments: efforts to reduce emissions can take place along
many “margins,” and we should give people an incentive
to exploit all of those margins. Should consumers try to
use less energy themselves? Should they shift their con-
sumption toward products that use relatively less energy
to produce? Should we try to produce energy from low-
emission sources (e.g., natural gas) or nonemission sources
(e.g., wind)? Should we try to remove CO2 after the car-
bon is burned, e.g., by capture and sequestration at power
plants? The answer is, all of the above. And putting a
price on carbon does, in fact, give people an incentive to
do all of the above.”
Krugman (2013)
17 / 18
“By contrast, it would be very hard to set rules to accom-

plish all these goals; in fact, even figuring out the compar-
ative emissions from a simple choice, like whether to drive
or fly to a city a few hundred miles away, is by no means
a simple problem.”
“. . . studies attempting to analyze how we might most effi-

ciently reduce carbon emissions strongly suggest that just
one of these margins should account for the bulk of any
improvement—namely, we have to sharply reduce emis-
sions from coal-fired electricity generation.”
Krugman (2013)
18 / 18
I Introduction
I Conclusions
2/7
The economic approach: Supply-side policies
Recap:
To restrict carbon emissions caused by fossil fuel combustion, one
might regulate fossil fuel demand or supply, or both
Supply-side policies regulate exploration and extraction
Demand-side policies regulate the combustion
We consider now supply-side policies for example, one could

I limit fossil fuel supply through regulation
I purchase fossil-fuel deposits (coal, oil, or gas), or the right to

extract from a deposit and decide whether or not to exploit it
3/7
Recap: Why is action against climate change so difficult?

taxing the domestic price of gasoline or fuel oil
I this reduces the domestic demand of gasoline
I results in fall of the price on the world market
I encouraging free-riding in other countries
I leading to an increase in demand in other countries
I and to an increase in emissions in other countries
The net climatic effect of the policy is hence reduced
4/7
I Consider the global
market for fossil fuels
I Abstracting from
differences between
coal, oil and gas
I p is the price
I Q is the quantity
I Without climate policies

I S 0 long-term fossil
fuel supply
I D 0 long-term
fossil fuel demand
I equilibrium Q 0 , p 0
5/7
I Assume that climate

policies in some
countries reduce
demand by ∆D
I Demand curve shifts to
D1
I New equilibrium Q 1 , p 1
I Consumption is reduced
by less than ∆D
I So-called problem of
“carbon leakage”
6/7
I If fossil fuel supply is

also reduced by
∆S = ∆D
I Supply curve shifts to
S1
I New equilibrium Q 2 , p 0
I Consumption is further
reduced to ∆D
Supply-side policies can strengthen demand-side policies
7/7
I Introduction
I Conclusions
2/6
Conclusions
Is the world is likely to meet its climate goals?
3/6
Conclusions
For some the possibility of catastrophe is enough to argue in
favour of taking action as soon and as strongly as possible
Others disagree
To make the world a better place we need to

I decide how much to invest in climate action
(comparing the future benefits with the costs that mitigation incurs today)
I identify institutions and policies that are effective

(e.g. promote the adoption of electric vehicles?; effects of carbon tax on innovation? . . . )
Careful economic analysis can contribute to this aim!
Today’s obstacles to climate action are largely political!

4/6
Conclusions
What can YOU do?
5/6
Conclusions
What can YOU do?
https://www.youtube.com/watch?v=1ViK6BfLqTI
minutes: 59:25-1:00:46
6/6

MN7406 ClimateChange

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MN7406 ClimateChange

Uploaded by

Copyright:

Available Formats

Economics of Climate Change

Prof Matthias Dahm

MN7406 International Business

. . . is one of the greatest challenges of our times

Climate change threatens the well-being of future generations

And this is well known . . .

. . . just think of COP26 . . .

. . . we will see that economics can

I indicate solutions to this challenge

More specifically, questions we will ask include

I Do international agreements work?

I What can we do to limit global warming?

I What is a carbon emissions tax?

. . . to think like an economist . . .

I the goal of economics

I theory & empirical evidence

I chapter on climate change Jean Tirole

(The library has an on-line version of this book)

The goal of economics is not . . .

I to promote private property or

The goal is to make the world a better place

The goal is to make the world a better place

The task is to identify institutions and policies that work

I these situations are called market failures

I the market economy is not an end in itself

I the market economy is an imperfect instrument

Economics aspires to recommend better public policy

Climate change policy is needed because . . .

“Climate change is a result of

The Stern Review (2007)

I What is climate change, and what to do about it?

I Why is action against climate change so difficult?

I The economic approach: Demand-side policies

I The economic approach: Supply-side policies

I What is climate change, and what to do about it?

I Why is action against climate change so difficult?

I The economic approach: Demand-side policies

I The economic approach: Supply-side policies

Watch the video! https://www.youtube.com/watch?v=gIUN5ziSfNc&t=14s&utm_source=NASEM+

Intergovernmental Panel on Climate Change https://www.ipcc.ch/

I U.N. body for assessing the science related to climate change

I authors and experts and reviewers are scientists

I jointly awarded the Nobel Peace Prize (2007 with Al Gore)

Climate science contains some degree of uncertainty but

Climate is often defined as ‘average weather’

Climate change refers to changes in these statistics

Climate System depends on changes in

I the fraction of solar radiation that is reflected (called ‘albedo’;

I is a major aspect of climate change

How do we know that global warming is taking place?

I consistent picture with other indicators (indirect satellite

I +1.4◦ F (or +0.7778◦ C) was in 2012

I today +1.0◦ C above pre-industrial levels

I with a likely range of 0.8◦ C to 1.2◦ C

Overwhelming majority of climate scientists agree that

I such as coal and oil

I and other activities, like deforestation

I release carbon dioxide into the atmosphere

I and increase the greenhouse effect

“Based on a rigorous assessment of available temperature

“ Human activities are estimated to have caused ap-

Global warming is likely to reach 1.5◦ C between 2030 and 2052 if

“Climate-related risks to health, livelihoods, food security,