How to Spend $50 Billion to Make the World a Better Place
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to ratify, for similar reasons.
The Protocol must be ratified by industrialized and tran-
sition countries, accounting for at least 55% of total emissions, to come into force. Without Russia’s ratification, this cannot be achieved. Although some signatories, particularly
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How to Spend $50 Billion to Make the World a Better Place 6
5
4
Benefits
3
Costs
2
1
0
2005
2035
2065
2095
2125
2155
2185
2215
2245
2275
2305
Figure 1.2. Benefits and costs of Kyoto Protocol abatement (% world product)
EU countries, have their own programs to limit emissions,
few are meeting their self-imposed targets.
The Kyoto Protocol is discussed further below as one
of the policy options. However, it is now doubtful that the Protocol is still relevant because of lack of support from key players. A more likely option is the re-opening of international negotiations to arrive at a new agreement to be
supported by the United States, Russia, and developing
countries.
Core analytical issues
For most projects, the economic analysis on which deci-
sions are based covers a period of, at most, a few decades.
However, global warming takes place on a much longer
timescale. IPCC projections cover at least the period up
to 2100. But arguably, the proper time horizon is in fact
300 years, because it would take that long for carbon dioxide
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to be mixed into the deep ocean and so start to reverse its build-up in the atmosphere.
Conventional discounting, even with low discount rates,
makes present day values of benefits to be received far in the future vanishingly small. The reason why we discount the
value of expected future benefits is that people tend to prefer consumption sooner rather than later. If asked to choose between getting $100 today or $100 in a year’s time, most
people would prefer $100 now. When people save money,
they forestall consumption today. Generally, they are only willing to do that because the savings can be invested to
yield an interest premium that ensures future consumption
will be larger. (Taking account of the large costs involved in the short term, a conventional economic analysis would
nearly always strongly suggest that no action be taken. And yet, potentially severe climate damage can only be limited by taking costly actions now. How can we establish an economic case for such actions?)
As an alternative to the conventional method, a system
of “utility-based discounting” is proposed. This approach
is used in the economics literature on social cost-benefit analysis. In this case, the discount rate for “pure time preference” (explicit preference for consumption today over con-
sumption tomorrow) is set at zero. However, future con-
sumption is still discounted on the basis that per capita
consumption will increase, so the marginal benefit of extra consumption will fall (for example, buying a car has an enormous benefit compared to not having one at all; buying a
second car for convenience has a smaller additional ben-
efit). In this case, the discount rate applied is called the
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How to Spend $50 Billion to Make the World a Better Place Social Rate of Time Preference (SRTP). Because the long-term per capita growth rate is about 1%, and because extra utility from extra consumption is estimated to decline by
1.5% when consumption per capita rises by 1%, the effective total discount rate is about 1.5%. This equals zero for the component of “pure” time preference (or “impatience”) and
1.5% for the component reflecting falling “marginal utility.”
Although there has been considerable work on the costs
of mitigating global warming, calculations of the bene-
fits (the climate-induced damage avoided) are far more
difficult to make. Based on figures available in the early 1990s, the potential damage calculated for a doubling of
atmospheric CO2 would amount to some 1% GDP annu-
ally, with one-quarter of this related to agriculture. Other authors have come to similar conclusions, with rates of
damage skewed toward developing countries because of
their reduced scope for adaptation.
Some economists have also tried to include an allowance
for potential catastrophic change in their assessments. A
number of possible catastrophes have been postulated,
including the widely publicized shut-down of the so-called thermohaline circulation in the Atlantic Ocean.
It has been suggested that the present “conveyor belt,”
in which cold water sinking in the Arctic induces upwelling of warm water in the southern Atlantic, could stop as melt-ing polar ice makes Arctic waters less salty. In Northwestern Europe, this circulation pattern manifests itself as the Gulf Stream, a phenomenon believed to have a significant moderating effect on the regional climate. It has been calculated that the economic loss for Europe of such a catastrophic
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shutdown could be over 40% of GDP. The probability of
such an occurrence rises steeply with the extent of global temperature rise, leading to the conclusion that, in the case of a 6◦C rise, the potential costs would warrant Europe sac-rificing 10% of GDP to avoid the catastrophe.
Previous cost–benefit analyses
In earlier work by the present author, it was assumed that, in the absence of policy changes, emissions of greenhouse
gasses would continue to rise to a maximum of 50 GtC
(gigatonnes, or million million tons of carbon) in the latter part of the 23rd century, from a baseline of 6.9 GtC in 2000.
This was based on the assumption that the large known
reserves of coal would increasingly be exploited as oil and gas reserves are depleted.
A central value of 10◦C for temperature rise by 2300
was estimated, giving an annual cost of 16% of global GDP.
Abatement costs are also difficult to estimate, but making reasonable assumptions about the availability of alternative energy sources and the application of today’s best technology, it would cost around 2% of the global economic product to cut world emissions in half by 2050. Because of the development of further technological alternatives, this same cost could produce a net emission reduction of 80% by the end
of the 21st century.
An alternative model (DICE) has been used for the past
two decades by William Nordhaus to estimate optimal car-
bon abatement. His most recent studies have indicated an
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How to Spend $50 Billion to Make the World a Better Place (5% at present, 11% by 2100), mediated by a carbon tax of
$9 per tons by 2005, rising to $67 per tons by the end of
the century. The result would be a reduction in warming
of less than 0.1◦C.
It is not the abatement costs as such that lead to such
limited results: In fact, figures generated for 2045 suggest that it would cost only 0.03% of global GDP to reduce
emissions by 10% (double what the model identifies as
optimal) and less than 1% to halve them. The results are
driven by the calculated low present value of the benefit, in turn determined by conventional assumptions about time
discounting.
The proposals in this chapter are therefore based on an
adapted version of this model – considered a good one for
showing the effects of policies over time – but using the preferred Social Rate of Time Preference (SRTP) discounting
approach.
Adapting the DICE99 model
The main changes made to this model (called DICE99CL in
its modified form) are:
r Setting pure time preference (the conventional discount
rate) at zero.
r Discounting future consumption using the SRTP
approach. This implies a falling marginal value of con-
sumption with growth.
r Shadow-pricing capital. The social cost–benefit app-
roach converts capital into consumption equivalents,
taking account of the fact that a proportion of the
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abatement costs would come from investment rather
than consumption.
r Increasing baseline carbon emissions. In Nordhaus’
recent use of the DICE model, he assumes a signifi-
cant reduction in carbon intensity (tons of carbon per
unit of GDP) by the end of the century because of large
increases in extraction costs for fossil fuels. This is not consistent with other analysts’ views on future emission scenarios, so the adapted model reflects what the
present author considers to be the more realistic of the
IPCC scenarios.
The net effect of these and other changes is to raise the
warming baseline, although it is still somewhat more opti-
mistic than several of the IPCC scenarios. In the adapted
model, warming reaches 3.3◦C by 2100, 5.5◦C by 2200, and
7.3◦C by 2300.
Alternative policy strategies
The adapted model examined above is applied to the anal-
ysis of the following three policy options. Note that adaptation to climate change is not considered to be a credible separate option. Rather, it is assumed that for all three policies feasible adaptations are already undertaken as part of the baseline case.
Option 1: Optimal carbon tax
This policy is for an internationally agreed and coordinated tax to be levied by national governments. Each country
would use the proceeds for its own purposes.
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How to Spend $50 Billion to Make the World a Better Place Optimal emission cuts (based on 1990 emissions as the
baseline) would start at around the 40% mark, rise to nearly 50% by the end of the century, and peak at 63% in 2200
before declining to around 15% in 2300. Carbon taxes to
achieve this would be similarly aggressive: $170 per ton in 2005, $600 in 2100, peaking at $1,300 in 2200, and taper-ing off.
The net effect is a gradual widening of the gap between
projected warming from “business as usual” and the opti-
mized carbon tax approach: By 2300, the temperature rise
is limited to 5.4◦C compared to the 7.3◦C baseline. The discounted present value of the abatement costs is $128 tril-
lion, but the value of benefits from avoiding damage is
$271 trillion: a benefit-cost ratio of 2.1. Although this is what the model defines as optimal, there is still considerable scope to implement an even more aggressive tax policy and further reduce warming while still producing a benefit-cost ratio of more than one.
Option 2: The Kyoto Protocol
This option would commit the industrialized and transi-
tion economies to cutting emissions by 5% below 1990 lev-
els and maintaining them at that level, with no constraints on developing economies. Such an approach would reduce
global emissions far less than the Option 1.
Although the effect on temperature rise is modest – a
reduction from 7.3◦ to 6.1◦ by 2300 – damage to the world
economy is reduced from 15.4% to 10.3%. Over the same
period, the benefits rise steadily after a lag period, becoming greater than costs around 2100, and reaching more than 5%
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of global GDP by 2300. The present value of the benefits is $166 trillion, against costs of $94 trillion, which yields a benefit-cost ratio of 1.77.
However, assuming the Kyoto Protocol option is the only
abatement strategy in place, the full costs are borne by the present industrialized and transition economies (‘Annex 1’
countries). For this, they receive benefits of only $55 trillion, making the Protocol an unattractive option for these countries in economic terms.
Option 3: A value-at-risk approach
Value-at-risk is a concept used to manage risk in the financial sector, which seeks to identify the maximum loss within specified confidence limits, usually 90% or more. With a
90% confidence limit, you can be 90% certain that you will not lose more than the calculated maximum loss. Amongst
climatologists, this approach has been used to define an
upper limit for the Climate Sensitivity parameter (CS), the equilibrium temperature rise following a doubling of atmospheric carbon dioxide level. Using all available data, it was calculated that there was a 95% probability of CS lying
between 1.0 and 9.3◦C. The value-at-risk approach then
requires the evaluation of the damage caused when CS is
at the upper end of the range (9.3◦C); over twice the upper bound benchmark of 4.5◦C used by the IPCC).
Using this higher figure in the climate model, instead
of the mean IPCC CS value of 2.9◦C, a new set of opti-
mal abatement results is obtained. The baseline warming
reaches 15◦C by 2300, but this can be reduced to 5.9◦C using optimal measures to reduce emissions. Reduction by 90%
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How to Spend $50 Billion to Make the World a Better Place is optimal (the model has this as an upper boundary) from
now u
ntil the late 23rd century. To achieve this, a carbon tax starting at $450 per ton in 2005 would rise to $1,900 per ton in 2205, then decline after 2285.
Baseline climate-related damage would be massive:
8.6% of global GDP by 2100 and as high as 68% by 2300.
Optimal reduction of emissions would reduce these figures
to 2.1% and 9.4% respectively. Abatement costs average
about 3.5% of global GDP through this century, plateauing
at about 5% thereafter. The present value of the abatement costs is $458 trillion, but this is set against a benefit (damage avoided) of $1,749 trillion, which yields a benefit-cost ratio of 3.8. Therefore, although the taxes appear punitive, this scenario would be highly beneficial in net terms.
All these policies have been evaluated on the basis of
zero pure time preference, as discussed earlier. If conventional time-based discounting is applied, even at low rates, the options would look rather different. For example, costs exceed benefits for Option 1 if the discount rate exceeds 1%, and for the third option, the policy ceases to be cost effective at a rate between 1 and 2%. Because the total discount rate is about 1.5% per year higher than the pure time preference rate, these breakeven points correspond to about 2.5% for
the first option and about 3% for the third.
Conclusion
Three alternative policy options have been evaluated, using an adapted climate model that makes allowance for the
long timescale over which benefits of emission abatement
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are received. The timescale for assessment is also extended through to the year 2300, a period over which the full impact of policies will be felt.
A fairly aggressive abatement policy – with carbon taxes
set internationally but collected and spent nationally – is the basis of the first option. Global warming would be reduced by 0.8◦C by 2100 and by 1.9◦C by 2300, and the benefit-cost ratio would be approximately two, using the optimal
solution.
The second option – following the Kyoto Protocol –
would have more limited effects, although the benefits
would still marginally outweigh the costs. However, all these costs would be borne by the present industrialized and transition economies.
The third option is based on an estimate of the maximum
value-at-risk. This is a very risk-averse approach and would require a carbon tax of $450 per ton, rising to $1,900 by
2205, to cut carbon emissions by 90%. Despite the high cost of this option, its benefit-cost ratio is still about four.