ECN105 Contemporary Economic Issues

Lecture 9

Climate Change
Lecture plan

• The Challenges of Climate Change

• Cost and Benefit of Environmental Damage Abatement
• Abatement Policies
• Cap and Trade Policy
• Carbon Tax Policy
The challenges of climate change
 The challenges of climate change
• Features of climate change
• Stabilising yearly emissions is not sufficient: climate is affected by the total amount
of greenhouse gasses in the atmosphere
• Irreversibility of climate change: increases in the amount of CO2 in the atmosphere
are partially irreversible i.e. current actions have long-lasting effects on future
generations
• The worst case scenario: there is uncertainty about the scale, timing and global
pattern of the effects of global change. Hence, in designing policy it is important to
take into consideration even the most unlikely and disastrous of outcomes
• A global problem requiring international cooperation: climate change can be
solved only by a high level of cooperation between, in particular, the largest and
most powerful nations
• Conflict of interest: how to balance the competing interests of individuals in
different economic circumstances and the interests of current and future
generations?
 The challenges of climate change
• It is estimated that we can emit only a
further 1 to 1.5 trillion tonnes of CO₂ into the
atmosphere to give reasonable odds of
limiting the increase in temperature to 2°C
above pre-industrial levels
• Should we manage to achieve this limit on
emissions, there is still a probability of
around 1% that temperature increases
would be more than 6°C, causing a global
economic catastrophe
• If we exceed the limit and temperature rises
to 3.4°C above pre-industrial levels, the
probability of a climate-induced economic
catastrophe would rise to 10%.1
The Abatement of Environmental
Damages: Cost-Benefit analysis
 Abatement of environmental damages: cost – benefit analysis

• Like other environmental problems, climate change can be addressed by

environmental damage abatement policies such as:
• discovering and adopting technologies that are less polluting
• choosing to consume fewer or less environmentally damaging goods
• banning or limiting the use of environmentally harmful substances or
activities
• However, the economic costs of immediately eliminating all CO₂
emissions would surely exceed the environmental benefits. But what
level of environmental abatement should be adopted instead?
 Abatement of environmental damages: cost – benefit analysis

• What level of environmental abatement should be adopted instead?

• This is in part a question about the facts:
• What is the trade-off between the benefits of producing and
consuming more, and the enjoyment of a less-degraded environment?
• It is also an ethical question:
• how should we value environmental quality? How should we trade off
consumption now, with environmental quality enjoyed both by
current and future generations?
 The abatement cost curve
Abatement policies can address climate change. The degree of abatement chosen
depends on the relative costs and benefits.

The abatement cost curve shows the

per-unit cost of abating greenhouse
gas emissions using abatement
policies, ranked from the most cost-
effective to the least

Marginal cost curve: showing the cost

of an additional tonne of abatement at
any given level of abatement,
assuming that we adopt the most
efficient technologies first
The least-cost Gas plant CCS retrofit

abatement curve Solar PV Least-cost abatement

curve

Environmental quality, E (amount abated) gTCO2

• How total abatement
Coal CCS new build

(at least cost) depends

Degraded forest
on total abatement reforestation Solar CSP

expenditures
Low penetration wind

• The curve, gives all the 2nd generation

biofuels
combinations of
expenditures and Nuclear

resulting abatement
Feasible set
when the lowest-cost Building efficiency new build

changes are Geothermal

introduced first and Reduced pastureland conversion

the higher-cost ones
are introduced later
Cost of Abatement. Billions € = cost per tonne abated x gigatonnes abated
 Least-cost abatement curve
It shows all the combinations of environmental quality (E) and cost of
abatement, when the abatement technologies are adopted in ascending
order of cost.

Point A is dominated by points A’ and

A”, but may still be chosen if
abatement policies are inefficient
e.g. adopting more costly methods
first
Flipping this curve horizontally gives
the feasible set….
 Environment-consumption trade-offs: feasible consumption and environmental quality

• The vertical axis still 100

Quality of the environment, E

measures the quality of the
environment, while the
horizontal axis now 62
X
measures the goods
available for consumption Feasible set
after abatement costs
(from left to right). Feasible consumption frontier (g
abatement technology)
• Abatement expenditures E with zero
abatement
are now measured from Consumption of goods and services, €bn
450 500
right to left. Abatement costs =
€50bn
Maximum level of
consumption,
zero abatement
 Environment-consumption trade-offs: feasible consumption and environmental quality

• The slope of the feasible

frontier is known as the
marginal rate of 100

Quality of the environment, E

transformation (MRT)
• It measures how much of
the quantity on the vertical
axis you would get by
giving up one unit of the
Feasible set
quantity on the horizontal
axis Feasible consumption frontier (g
abatement technology)
• In the consumption- E with zero
environment feasible abatement Consumption of goods
and services, €bn
frontier, this is the marginal 500

rate of transformation of   𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑒𝑛𝑣𝑖𝑟𝑜𝑛𝑚𝑒𝑛𝑡𝑎𝑙 𝑞𝑢𝑎𝑙𝑖𝑡𝑦

𝑀𝑅𝑇 =
foregone consumption into 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 Maximum level of
consumption,
zero abatement
environmental quality
 The policymaker’s environment-consumption indifference curve
• It shows how much consumption
citizens are willing to trade in exchange
for better environmental quality

Quality of the environment, E

• The slope of the indifference curve is
called the marginal rate of substitution
(MRS)

 𝑀𝑅𝑆= 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛

𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑛𝑣𝑖𝑟𝑜𝑛𝑚𝑒𝑛𝑡𝑎𝑙 𝑞𝑢𝑎𝑙𝑖𝑡𝑦
IC3
• The higher the indifference curve (IC) IC2
the higher the level of utility from IC1
consumption and environmental quality Consumption of goods and services, €bn
 The policymaker’s environment-consumption indifference curve

• A steeper indifference curve, i.e. a

larger MRS (slope) denotes

Quality of the environment, E

preferences where consumption
is valued highly by the citizens
(large marginal utility of
consumption) while low value is
placed on the abatement of
environmental damage (marginal IC3
utility of abatement is low) IC1 IC2

Consumption of goods and services, €bn

The indifference curves are straight lines because we are assuming for simplicity that
the marginal utility of consumption and the marginal utility of environmental quality
are both constant. That means they do not depend on the quantity of consumption
or on the amount of abatement.
 The policymaker’s environment-consumption indifference curve

• A flatter indifference curve, i.e. a

Quality of the environment, E

smaller MRS (slope) denotes
preferences where consumption IC3
is valued less highly by the
citizens (small marginal utility of IC2
consumption) relative to the
IC1
value that they place on the
abatement of environmental
damage (marginal utility of
abatement is high)
Consumption of goods and services, €bn
 Which point on the feasible set will the policymaker choose? 

The policymaker uses two principles to make a decision about the level
of abatement:
• She considers only abatement policies on the frontier of the feasible
set: this eliminates higher-cost abatement policies that are inside the
shaded area
• She chooses the combination of environmental quality and
consumption that puts her on the highest possible indifference curve
 Which point on the feasible set will the policymaker choose? 

Policymaker’s optimal abatement choice is where MRS = MRT

100
Point X is the level of environmental protection that
the policymaker would wish to implement, with

Quality of the environment, E

environmental quality at E*. The ideal policy maker’s
indifference curves
X Slope: MRS
E* 62
At B, the MRS is less than the MRT (the
slope of the feasible set at B), so the B

policymaker would be better off by Feasible set

switching more resources from Feasible frontier
consumption into improving environmental Slope: MRT

quality. Spending more on abatement shifts E with zero Consumption of goods and services, €bn
the policymaker onto higher indifference abatement
curves until point X is reached 450 500
Abatement costs =
€50bn
Abatement policies
 Types of abatement policies

• How can we achieve the desired level of abatement?

• Policymaker’s aim: Achieve the desired amount of effective abatement
(e.g. units of CO2) at minimum cost
• There are 2 types of abatement policies:
• Price-based policies use taxes and subsidies to affect prices
• Aim to internalise the external effects of individual choices
• Quantity-based policies use bans, caps, and regulations
 Cap and Trade
A policy called cap and trade is a policy that combines a legal limit on the amount of
emissions with an incentive-based approach to assigning the abatement required to meet
this legal limit among firms and other actors.
Here is the idea:
• The government sets the total level of abatement required: the ‘cap’
• The government creates permits
• The government allocates permits: They can be given to the firms operating in
industries emitting the pollutant, or they can be auctioned
• The permits are traded: For some firms, polluting is very profitable and abatement
costly. They will buy permits from other firms. Firms that produce little pollution or
have low costs of abatement may have excess permits, which they can sell. Trade
occurs until the gains from trade are eliminated
• The firms submit permits to government to cover their emissions
 Cap and Trade: Model
Firms trade until permit price = MC of abatement (Pareto-efficient).
Abatement costs, Firm A, $ Abatement costs, Firm B, $
50:50 initial Split after
Example: Firm A has a lower marginal split of permits trading
private cost of abatement (MPCA) than
Firm B.
MPCA , Firm B
• Both firms benefit from D
buying/selling permits until the Abatement by B
MPCA is equalized across firms. X
P* Abatement by A
• Objective of cap and trade =
C
abatement is done by the firms for
which this is least costly. MPCA , Firm A

Total abatement required, E* (e.g. units of CO2 abated)

 Cap and Trade: Issues
CO2 European Emissions Allowances
30

• Policymakers need to set the correct total level

25
of abatement (the cap) – not easy to
determine 20

• Putting a price on pollution may send the 15

Euros
wrong signal to firms e.g. making production 10

profitable 5

0
08 08 08 09 09 10 10 10 11 11 12 12 13 13 13 14 14 15 15 15 16 16 17 17 18 18 18 19 19 20
n- n- v- r- p- b- l- c- y- t- r- g- n- n- v- r- p- b- l- c- y- t- r- g- n- n- v- r- p- b-
Ja Ju No Ap Se Fe Ju De Ma Oc Ma Au Ja Ju No Ap Se Fe Ju De Ma Oc Ma Au Ja Ju No Ap Se Fe

Example: EU Emissions Trading Scheme set too large a cap. The price fell
dramatically after the 2008 crisis, providing little incentive to abate.
• A price floor on permits can mitigate this issue (e.g. UK).
 Cap and Trade: Issues
• The estimated total external cost of a
tonne of carbon dioxide emissions differs
depending on how we value future
generations CO2 European Emissions Allowances
30
• A low-end estimate in 2017 dollars is
about $40 per tonne of CO₂ emissions, and 25

it is rising fast because the greater the 20

amount of CO₂ in the atmosphere, the

higher the marginal effect on climate of 15

Euros
adding more 10

• The recent price of a permit on the 5

European Union Emissions Trading Scheme

is about 60% of this cost, so the permit 0
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n- n- v- r- p- b- l- c- y- t- r- g- n- n- v- r- p- b- l- c- y- t- r- g- n- n- v- r- p- b-
Ja Ju No Ap Se Fe Ju De Ma Oc Ma Au Ja Ju No Ap Se Fe Ju De Ma Oc Ma Au Ja Ju No Ap Se Fe
plan is inducing decision-makers to
internalize only a small fraction of the
negative external effects.
The Carbon Tax
 The Carbon Tax
• Ideally, a tax on fossil fuels (carbon tax) could entirely offset the external effects from
production, with the added advantage that businesses and others would then face less
uncertainty about the cost of burning carbon
• A tax on carbon would raise the cost of emitting carbon in exactly the same way as
having to pay for an emissions permit would do
• In fact, the effect on costs would be identical if the market-determined cost of the
permit were to be the same as the tax rate per tonne of emissions set by the
government
• The effect of the increase in costs would be higher prices of emissions-intensive goods
and hence, ceteris paribus, demand for such goods would fall
• Both the cap and trade and a carbon tax are said to be a way to ‘put a price on’ the
external effects of carbon emissions.
 Pollution as externality
MSC = marginal social cost
Costs, Benefits

S = MPC
The supply curve denotes the
marginal private (to the firm)
cost of production. However,
PS the emission of pollution from
Deadweight loss of
firms’ production activity
social welfare
P causes a negative production
because MSC > MPC
externality such that the
“social” cost of production is
higher for each level of output
produced. The ‘social’
equilibrium is characterised by
D=MPB less production and a higher
market price

QS Q Quantity
 Pollution as externality
MPC + Carbon Tax
Costs, Benefits

S = MPC

The government can introduce

a tax per unit of pollution
PS produced that firms have to
pay. An accurate estimation of
P the tax can increase the
marginal private cost of
production to the actual
marginal social cost of
production so that the
optimum level of output is
D=MPB produced

QS Q Quantity
 Pros and Cons of a Carbon Tax
Pros Cons
Forces polluters to pay cost of carbon Higher tax can discourage investment and
emissions economic growth

Leads to greater social efficiency as social May encourage tax evasion – firms polluting
cost is fully paid in secret to avoid tax

Raises revenues to mitigate the It can be difficult to measure the social cost
environmental damage and, hence, the correct tax level

Encourages firms and consumers to look for Administration costs of measuring pollution
alternatives and collecting tax

Reduces environmental cost associated with Firms might shift production to countries
excess carbon pollution without a carbon tax
Next week:

 Climate change and the Discount Rate

 Cryptocurrencies
Readings

Econ CORE – Units 20.1-20.3; 20.5-20.6; 20.9-20.11