Global climate policy

Lennart Hjalmarsson

Distributional dimensions important • • • •

Who are going to pay?

We or our children? (Discount rate) Rich - or poor countries?

High-emitting or low-emitting countries?

Vulnerable or less vulnerable countries?

Important reports • •

UN:s Climate report 2007: IPCC Scientific analysis Almost unanimous

• •

The Stern report 2006: The Economics of Climate Change Economic analysis Very controversial

Key parameter: Discount rate

Max ∫U[C(t)]e δt dt Ramsey equation: r = δ + ηg Discount rate = pure time preference rate + value of increased consumption x increase in consumption Very controversial issue. Big debate today.

Discount rate

δ and η capture preferences g captures technology δ discounts utility r discounts consumption r derived from all three parameters both taste and technology η curvature of the utility function

Discount rate • •

η elasticity of the marginal utility relative risk aversion measure of aversion to interpersonal inequality and measure of personal risk aversion

Discount rate

The big issue: How much should we save (sacrifice) today for future generations?

T = 200 years Close long-term link between r and s, discount rate and savings rate: g = sr balanced optimal growth rate with constant savings rate and permanent income rW s = (r δ)/ηr

Discount rate

Standard assumptions: δ + ηg = 2 + 2x2 = 6 s = (r δ)/ηr = 4/12 = 1/3 = 0,33 Savings rate = 33%

Discount rate

Stern’s assumption: δ = 0,1 η = 1 g = 1,2 r = 1,3 But then s = (r δ)/ηr = 1,2/1,3 = 0,92 92% savings rate!!

Important debate • • •

Journal of Economic Literature 2008: Weitzman Nordhaus DasGupta Excellent discussion about discounting

Conclusions about discount rate

Weitzman: Uncertainty about g (thick tail) may lead to a lower discount rate: r ≈ 3% Nordhaus: Do not adjust the discount rate! Limit climate change directly by taxes or caps (and trade)

Policies and measures • • • • •

Carbon taxes Cap and trade (Kyoto) (Green certificates) Standards, regulations and energy conservation Technology agreements

Important aspects • • • • •

Economic efficiency:Same marginal abatement cost everywhere Distribution – burden sharing Monitoring Enforcement Incentives for R&D : Endogeneous technical progress

Carbon taxes • • • •

Most efficient instrument when stock pollutant No distribution (but redistribution) of assets across countries Difficult to monitor real impact of taxes Requires strong international institutions

Carbon taxes, cont.

• • •

Energy prices extremely high in most poor countries even at subsidised world market prices Energy taxes regressive Politically impossible in many countries

EU experience • • •

Extremely difficult to harmonise taxes: Sweden and UK totally against Very low minimum taxes: 0.05 Eurocents/kWh for coal and gas Exemptions even from these taxes (LTA)

Cap and trade • • • • •

Efficient solution to threshold problem Difficult to negotiate worldwide allocation Very large asset values : EU 2 billion ton at 20 Euro/ton yields an asset value of 40 billion Euro per year Easy to monitor permit trade in case of CO2 only Can rely on national legal systems in ”decent” countries

EU-Kyoto experience • • •

Grandfathering may be necessary although auctions preferable Grandfathering creates incentives for ”industrial policy” Regional solution – industry relocation to ”pollution havens”??

EU-Kyoto experience, cont • • • •

Limited efforts: Kyoto 5% reduction, 20% of the world, ETS 8% ≈ BAU No incentives to comply – and some countries will not comply Success stories not due to Kyoto (UK, Germany) Difficult to predict CO2-prices

Standards

Might be good in some cases.

• • •

Ex: Catalytic converters: Economies of scale and learning – low cost production Product market international Consumer network externalities But: Strong incentives for pressure groups

Energy conservation

Subsidies cost inefficient: Large variation in marginal abatement costs

• • •

Ambiguous impact on energy demand: Selection effect Rebound effect Vintage effect

Typical industrial structure 2020-04-26

Average practice vs best practice over time

Technology agreements • • • • •

R&D: Extend the nose vs cutting off the tail Rich countries only Difficult to coordinate even within countries Industrial policy – R&D races...

Picking winners difficult

Technology agreements, cont

Productivity in knowledge production Experience from 1973/74-

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US synfuel program inefficient

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Swedish government-funded R&D inefficient (De stora programmens tid.)

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Only success story: Not governement-funded heat pumps

Cap and trade vs carbon taxes

In principle the same outcome

Paradox:

Why so difficult to agree on low level minimum taxes?

Why so easy to agree on EU-ETS with huge potential impact on electricity and fuel prices?

Smart or stupid politicians?

The text book model

Efficiency ≠ equity Allocation of permits of no importance.

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Hidden assumption: Allocation (grandfathering) forever

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or Auctioning In EU-ETS allocation for a short period: updating problem

Asset allocation in EU • •

EU 2008-12: At least 90% grandfathering – in practice >95%.

Old plants: Historical emissions New plants: Benchmark emissions Permit allocation = industrial policy National allocation plans

EU-ETS: Heavy industry and energy

Industry: Very high price sensitivity, competes in the world market. ( η≈8) Energy: Very low price sensitivity ( η≈0.1– 0.3) and substantial restrictions on technology choice esp. hydro and nuclear.

ETS Efficiency: Incumbent plants

No emissions – no permits Industry: Annual free permit allocation eliminates the increase in marginal production cost for industry: No incentives to reduce production or close down Energy: Small incentives to reduce production or close down Putty-clay technology.

EU-ETS: What will happen?

Extremely low flexibility Where will adjustment take place?

What will happen to CO 2 prices?

CO 2 -price explosion? Not yet but..?

Electricity-price explosion?

Electricity-price induced adjustment outside the trading sector.

Very difficult to predict!

ETS Efficiency: New plants

No emissions – no permits Coal and gas plants: permits Hydro, nuclear and wind: no permits Investment subsidy to emitting plants

Weak investment incentives • • • • •

Volatile CO 2 prices Time horizon 2012 Annual free-permit allocation Less CO 2 - emissions – less free-permit allocation Huge intra-industry profits in electricity and very concentrated el. markets

ETS Equity • • • •

Political aspects: Most capital owners in the trading system more than compensated No capital owners outside the trading system compensated and esp. not in the electricity intensive industry High electricity prices Huge intra-industry profits in electricity

What will happen?

  

Decrease in profitability esp in electricity-intensive plants Relocation Political pressure for:

• •

Exemptions of some industries (e.g. Steel) Regulation of the electricity market

Global impact of EU climate policy

Impact through global markets: price changes through decrease in demand for fossil fuels What about supply of fossil fuels?

Oil and gas ≈ no impact Coal: less supply

Electricity: The key sector • • • •

25 % of global CO2-emissions Interfuel substitution coal/gas Increased thermal efficiency CHP: Combined heat and power

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CO2-free technologies

CO2-free electricity technologies • •

Hydro:

• •

Controversial To a large extent already exploited except for Himalaya Wind:

• • • •

Surface intensive NIB large scale (millions) location problem Expensive Stochastic supply

CO2-free electricity technologies •

Geothermal

• • •

Location specific Limited cheap Abundant very expensive

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Solar and wave

• • •

Still very expensive Location specific Surface intensive

CO2-free electricity technologies •

Wood

• • • •

CHP otherwise expensive Limited resources – deforestation Competition from forest industry Competition from biomass fuels in the future

CO2-free electricity technologies •

Nuclear

• • •

Cheapest large scale technology Not surface intensive – few locations Very compact waste – small deposit problems

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Requires strong regulators Proliferation problem (Iran, North Korea)

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Some countries political comparative advantages (France, Finland, UK, ....)

Comparative generating cost in EU - 10% discount rate

Gas CCGT Coal - pulverised

2005 $c/kWh Projected 2030 with € 20-30/t CO2 cost

3.4-4.5 4.0-5.5

3.0-4.0 4.5-6.0

Coal - fluidised bed 3.5-4.5 5.0-6.5

Coal IGCC

Nuclear

4.0-5.0 5.5-7.0

4.0-5.5 4.0-5.5

Wind onshore Wind offshore 3.5-11.0 2.8-8.0

6.0-15.0 4.0-12.0

European Commission, January 2007

Future solution

Most attractive GHG-free solution: Nuclear and hydrogen: Electricity and fuel cells

Nuclear and hydrogen • • • •

Problems: Nuclear regulation in weak states Fuel reprocessing Nuclear proliferation R&D:

• •

Fuel cells Hydrogen storage

Nuclear and hydrogen • • • • •

Attractive properties: No GHG emissions Large scale Low cost – global feasibility Not surface intensive Not location specific

Nuclear and hydrogen • • • • • •

Political aspects: Little reallocation of assets Little industrial restructuring Still cheap electricity Foreign technology Foreign control and ownership Capital intensive investments

Major political obstacle to climate policy

Nobody should get hurt: Very expensive policy (subsidies, regulations) with a lot of variation in marginal abatement costs.

Low productivity in climate policy

Low productivity example

Potential Swedish railroad investments: 5 Billion Euro – 1 Mton CO 2 4% - 60 years – 0.064 in annuity: 320 MEuro per year i.e. 320 Euro/ton CO 2 in abatement costs (10 times too expensive)