Thursday, December 1, 2016

Climate Change from an Economics Perspective: Part II

In an earlier post, we talked about climate change (see here), about the many aspects of climate change that are still surrounded by a great deal of uncertainty, and about mitigation strategies and challenges. This time, we will focus on adaptation to climate change, especially as it relates to small countries in terms of their greenhouse gas emissions.
Mitigation and adaptation are the two main prongs of the overarching strategy for dealing with climate change. The term “mitigation” refers to measures that help to reduce greenhouse gas emissions or to heighten the capacity of carbon sinks – measures that will lower the probability of negative climate change shocks in the future. The term “adaptation” refers to measures that will help to forestall and/or offset the effects of climate change. It is reasonable to suppose that the types of measures that each country decides to adopt will depend on the costs and benefits that they represent for that country’s economy. A decline in atmospheric CO2 emissions would appear to be a fairly ineffective strategy for Latin America and the Caribbean but a comparatively more effective one in, for example, the United States. Thus, the optimal strategies may differ from one country to another, with countries that produce higher levels of emissions choosing different policies from those selected by ones with lower levels of emissions (in the absence of a global binding agreement).
In an effort to plot the optimal expenditure paths for spending on mitigation and adaptation in different scenarios, Chisari, Galiani and Miller (2016) developed an analytic model and then calibrated it for what they describe as environmentally large, medium-sized and small economies (in terms of the emissions that they generate). That paper looked at the different kinds of measures that different economies would be willing to undertake if they were to optimize their expenditure on adaptation and mitigation in the absence of a global policy or, in other words, if there were no constraints on the environmental policies that they could pursue.
The results led to the following findings. First, small economies will tend to focus their environmental efforts, if they undertake them at all, on adaptation. Not only are large countries likely to spend more on mitigation and adaptation in absolute terms, but the mitigation/adaptation ratio will also tend to be higher in those economies. Second, small economies that cannot spend enough on adaptation measures will probably spend even less on mitigation measures, ceteris paribus, as future adverse climate effects impoverish them. Third, higher mitigation expenditures may arise not only as a result of greater optimal adaptation expenditures, but also because richer countries may provide more attractive external mitigation incentives.
International incentives (in the form of potential rewards and penalties) are still skewed toward mitigation. The potential rewards include access to financial assistance and technology transfer, while potential sanctions could include carbon taxes on exports and their transport. It is unlikely, however, that incentive schemes will incorporate broad sanctions in the form of trade restrictions any time soon.
Much less progress has been made in terms of adaptation at the international level. Considerably less funding has been made available, and the cost-effectiveness of the possible alternative measures has not yet been assessed. Adaptation entails a number of different dimensions, such as access to water, protection against human and crop diseases, assistance for the poor, and urban and infrastructure development.
In addition, the methods for arriving at estimates of the cost-effectiveness of mitigation and adaptation measures necessarily differ. The effectiveness of a given mitigation policy is measured on the basis of the reduction in the amount of greenhouse gas emissions that will be achieved by means of its implementation. Whether and how this translates into the avoidance of some degree of global warming remains to be seen, but this metric has allowed researchers and politicians to rank mitigation policies in terms of their cost-effectiveness. No such estimates are yet available for adaptation, mostly because policies for each sector translate into different kinds of damage avoidance that must then be monetized in order to gauge the results in monetary terms; only once that has been done can they be prioritized on the basis of their cost-effectiveness.
Some types of adaptation measures can be put in place right away at a low cost, such as early warning systems and new building and infrastructure regulations. Others will be costlier and may have to be deferred until more information is available. R&D focusing on the needs of each region can serve as a cost-effective learning process. There are as yet no well-developed, economically sound guidelines for the assessment of various adaptation measures in this field. Guidelines of this sort would be helpful in classifying different projects or measures under conditions of resource scarcity, especially in view of the fact that climate change is not the only challenge facing developing countries. The current priority for Latin America is thus to develop its working agenda for dealing with climate change.
In the medium term, a key factor in adaptation efforts will be the mobility of factors of production, particularly labor, which is limited at present. This will be a major challenge for the international community and one that should be addressed well in advance.

By: Sebastian Galiani

Chisari, O. and S. Galiani, 2010. Climate Change: A Research Agenda for Latin America and the Caribbean. IDB Technical Notes No. 164.
Chisari, O, S. Galiani and S. Miller, 2016. “Optimal Climate Change Adaptation and Mitigation to Climate Change in Small Environmental Economies”. Economia, Journal of the Latin American and Caribbean Economic Association.
Feld, B. and S. Galiani, 2015. Climate change in Latin America and the Caribbean: Policy options and research priorities. Latin American Economic Review, Volume 24, 2015, pages 150-188. 

Climate Change from an Economics Perspective: Part I

The debate about climate change revolves around two incontrovertible facts. The first is that there are what we have come to call “greenhouse gases” (GHGs) in the atmosphere that absorb infrared radiation. The main GHGs are carbon dioxide, water vapor, methane, nitrous oxide and chlorofluorocarbons. Solar energy in the form of ultraviolet light passes right through these GHGs and is absorbed by objects on the Earth’s surface. As these objects heat up, they release energy in the form of infrared radiation. If there were no GHGs in the atmosphere, most of this energy would escape into space. The second fact is that the amount of GHGs in the atmosphere has been increasing over the past two centuries. There are theoretical grounds for believing that this increase in the volume of GHGs will lead to global warming (see, for example, Emmanuel, 2007). These gases will soon reach a concentration of 400 parts per million (ppm) of carbon dioxide equivalent (CO2e) (40% more than pre-Industrial-Revolution levels) and, based on a typical scenario (IPCC, 2007), are expected to reach a concentration of 750 ppm by the end of the century. The relationship between the concentration of GHGs and temperature increases is far from straightforward, however. A long list of factors about which scientists are uncertain make it difficult to determine, with any degree of accuracy, how much global warming will be caused by a given increase in the concentrations of these gases, when that warming will occur or exactly how our planet’s various regions and ecosystems will be affected.
In an effort to dispel this uncertainty, the United Nations and the World Meteorological Organization (WMO) set up an international agency that has been tasked with assessing the existing body of scientific knowledge about climate change. This agency – the Intergovernmental Panel on Climate Change (IPCC) – has said that the “warming of the climate system is unequivocal, as is now evident from observations of increases in global average air and ocean temperatures, widespread melting of snow and ice, and rising global average sea level" (IPPC, 2007). Nonetheless, it is very difficult to gauge the degree or extent of global warming. Normal variations in global temperatures are quite large, and it is therefore very hard to determine if the increases in temperatures that we are now seeing are actually outside the normal range or how much warming is occurring.
Projecting future emissions levels is an even more complex undertaking, since those levels will vary depending on the size of the world’s population, the rate of economic growth and changes in technologies that alter the degree of efficiency in energy consumption and the mix of energy sources that are in use. The way that the IPCC has approached this problem has been to construct an array of emissions scenarios, each of which provides a different picture of how global development could influence future trends in emissions levels. The wide range of different emissions projections generated by these scenarios reflect just how much uncertainty there is about the relevant factors. Projections for the twenty-first century cover a broad spectrum – from 1.1°C to 6.4°C (IPCC, 2001) – but nonetheless they all point to an increase in global temperature during this century.
Uncertainty about the climate system is compounded by uncertainty about the physical and socioeconomic implications of global warming. Human settlements, along with their ecosystems and their associated pests and diseases, have generally adapted to the climates and geophysical features that surround them. It is posited that, during the next century, climate change will not have much of a direct impact on those segments of the economy that are relatively isolated from the natural environment, but unregulated human and natural systems, such as non-irrigated farming, seasonal snow accumulation, river run-off and more natural ecosystems may be heavily impacted.
The impressive study by Nordhaus (2008) provides an approximation of the economic impact of climate change. His results indicate that the economic damage caused by climate change, in the absence of any human intervention, will be on the order of 2.5% of world output per year by the end of the twenty-first century, with most of the damage being concentrated in low-income areas. While some countries may even benefit from climate change, areas closely linked to climate-sensitive systems are likely to experience significant disruptions.
There is also uncertainty about how much it will cost to reduce GHG emissions. Thus, when it comes to the issue of climate change, there is uncertainty all along the spectrum – from its climatological aspects all the way to its economic implications.
In addition to the uncertainty surrounding so many of the related factors, countries find it difficult to reach agreement on joint action to curb the concentration of GHGs in the atmosphere. What economists call “negative externalities” are the crux of the problem. This concept has to do with the fact that the persons or agents that are emitting GHGs are not covering the full cost of their actions. Since only the private cost of emissions is being paid for, and since that cost is lower than the social cost of those same emissions, we are generating levels of emissions that are above the social optimum.
One obvious way of resolving this problem is to increase the cost of acting as a source of GHG emissions. Actually, such an increase would achieve three different objectives: consumers would lower their demand for goods and services whose production is associated with high emissions; producers would substitute “cleaner” inputs for the high-emissions inputs that they currently use; and the higher cost would spur R&D in new, lower-emissions products and processes. The cost of GHG emissions could be raised in either one of two ways: via prices (levying a tax) or via quantities (setting a quota). Either such move would be accompanied by provisions for the purchase and sale of “emissions rights”, such that sources whose emissions are below their quota could sell the remaining margin to others.
The 1997 Kyoto Protocol is an example of the latter approach and was conceived of as a first step toward the goal of reducing GHG emissions. The signatory countries made a commitment to reduce their emissions by an average of 5% relative to their emissions levels at the start of that decade. It was hoped that this would be the starting point for a series of treaties that would set increasingly higher benchmarks for reductions in GHG emissions. Owing to a number of different design flaws, however, the Kyoto Protocol has not been a great success.
First of all, it does not take the positive externalities of GHG mitigation into account: the benefits of reductions are enjoyed by all countries, regardless of how much or little effort they have put into the endeavor. Yet the costs of mitigation are linked to the extent of the effort made. This gives rise to a prisoner’s dilemma, since each country will be better off if the other countries reduce their emissions rather than if it does so itself. The upshot is that no country reduces emissions voluntarily.
Secondly, as noted earlier, the damage associated with climate change is likely to be distributed unevenly across the planet. Worse still, a moderate rise in temperature (approximately 1-2°C) would provide net gains to some countries (by, just as one example, converting what is now infertile land into viable farmland). Ironically, most of these types of benefits would be reaped by high income countries (Canada, Finland, Russia) where GHG emissions levels are already high.
Thirdly, the Protocol does not make allowance for the fact that countries are sovereign nations and can therefore not be forced to ratify a treaty or commit themselves to cutting their emissions. As a result, countries with high GHG emissions levels, such as the United States, Canada and Australia, did not ratify the treaty or have not met the benchmarks – and are none the worse off on that account.
Finally, countries’ ability to reduce GHG concentrations in the atmosphere differs, with developing nations being the ones that are the least able to influence GHG emissions. While China and India are exceptions on this score, even their per capita emissions levels are much lower than those of developed countries, and they feel that it is unfair for them to be unable to enjoy the “cheap” energy that allowed today’s developed countries to lift a large part of their populations out of poverty. Part of this problem stems from a flaw in the Protocol that has been pointed out by Helm (2009), inasmuch as it sets targets for reductions in the production of carbon rather than in its consumption. In today’s globalized world, this allows companies to move their production operations to countries where emissions are cheaper, and the net effect on the concentration of GHGs in the atmosphere therefore turns out to be nil.
A credible agreement to curb rising global temperatures should include as many countries as possible and absolutely must include those responsible for the lion’s share of GHG emissions. In addition, developing countries’ mitigation efforts need to be offset to some extent by resource transfers from developed countries.
Even with such an agreement, the problem of how to reduce emissions remains. In order to attain the IPCC’s objective of holding the planet’s rise in temperature to 2°C or less, carbon dioxide emissions will have to be cut by 4% per year for the next 40 years. Technological advances should contribute to the effort in two ways: first of all, technological improvements in production processes would boost efficiency and thus make it possible to produce the same amount of a given good with fewer resources; secondly, those advances would spur a transition toward the use of “clean” energy sources and a concomitant decline in reliance on fossil fuels.
Of these two dynamics, the changeover in energy sources will be the one that holds out the greatest potential for bringing about a significant reduction in the volume of GHGs because the energy sector is the largest source of those gases. First of all, the energy that can be produced from renewable sources, such as solar energy, wind power, geothermal energy and others, is still much more expensive than the energy produced from traditional sources. Emissions taxes will have to be very high in order to create economic incentives for the “clean” production of electric power, and this will mean that consumers in all countries will have to pay a very heavy price. Secondly, none of the clean technologies has been deployed on a large scale, and the conditions that would make this possible are not yet in place. In addition, the public has recently become extremely mistrustful of nuclear energy, which further restricts the range of possible options. Many years of technological research, political decisions, regulation and –most importantly– a build-up of public support will be needed before we can make a full transition to alternative sources of energy.
In addition to the negative externality generated by the low private cost of emissions relative to their social cost, the innovation sector is subject to another externality: the benefits that it generates can be appropriated by other companies or sectors, and the social benefit of an investment is greater than its private benefit. One way to deal with these problems is to skew relative prices by subsidizing R&D for clean technologies and taxing GHG emissions. This approach is backed up by an insightful study authored by Acemoglu, Aghion, Bursztyn and Hemous (2012). These authors present a model in which a final good is produced using two inputs, one of which is harmful to the environment. In this model, investment is optimally distributed between the two input-producing sectors. More research is devoted to the sector with the greater advantages in terms of market size and price, which, in the status quo scenario, is the “dirty” sector. The model devised by these authors indicates that taxes on GHG emissions and research subsidies are both needed in order to channel investment into the “clean” input-producing sector, but only until such time as the returns for that sector surpass those on investment in the traditional, or “dirty”, sector. The validity of this result increases as the degree of these inputs’ substitutability rises. However, simulations run for this study lead the authors to conclude that, even in cases where inputs are highly substitutable, the transition to a nearly exclusive use of the “clean” inputs will take roughly 70 years. Be that as it may, the study clearly shows that any delay in implementing environmentally sound policies will simply spur investment in the development of traditional sectors and thus drive up the cost of reversing that situation.

By Sebastian Galiani

Acemoglu, D., P. Aghion, L. Bursztyn and D. Hemous, 2012. “The Environment and Directed Technical Change”, American Economic Review.
Emanuel, K., 2007.  What We Know about Climate Change. Cambridge, United States: MIT Press.
Helm, D., 2009. “Climate-change policy: Why has so little been achieved?” in Helm, D. and C. Hepburn, The Economics and Politics of Climate Change. Oxford University Press.
Intergovernmental Panel on Climate Change (IPCC), 2001. Climate Change 2001: The Scientific Basis. Cambridge University Press.
Intergovernmental Panel on Climate Change (IPCC), 2007. Climate Change 2007: The Physical Science Basis. Geneva, Switzerland: IPCC.
Nordhaus, W., 2008. A Question of Balance: Weighing the Options on Global Warming Policies. Yale University Press.