EVENTS

Date:	Thursday, April 17, 1997
Time:	12:00 AM -- 12:00 AM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

How Economics Can Inform the Climate Change Debate

On April 17, 1997, three prominent economists spoke at an AEI conference about the contribution that economic knowledge and theory can bring to the understanding of climate change. The panelists were William Nordhaus of Yale University, Dale Jorgenson of Harvard University, and Thomas Schelling of the University of Maryland. What follows is an edited summary of their presentations.

William Nordhaus:

A good starting point is the recent petition on climate change signed by some two thousand economists, including Dale Jorgenson and me. The petition has three parts. The first acknowledges the seriousness of global warming as a problem and the indisputable scientific evidence of accumulation of greenhouse gases in the atmosphere. It accepts the need for action even though the timing, magnitude, and effect on human society of climate change are still not known.

The second part of the petition notes the "public goods" or "externality" aspect of the problem, in which individual people and even individual industries and nations have little incentive to make the huge investments to slow climate change. Also making the problem especially difficult are the long lags between actions today and benefits in the future, along with the magnitude of the global investments necessary to make a significant dent in the problem--probably hundreds of billions of dollars a year. But an important goal of economic research, here as in other applications, is to examine policies that will find a balance between the costs of action and the costs of inaction, or between the costs of action and its benefits.

The state-of-the-art method of climate change research is known as integrated assessment modeling, which combines elements of different disciplines, from the natural sciences and ecology to economics. The most striking finding of this kind of research is the importance of harmonizing policies across different countries so that the incremental costs of reducing greenhouse gas emissions are equalized across firms and industrial sectors and even across countries. This principle is often called where-flexibility--flexibility regarding where emissions should be reduced, as opposed to sector-specific rules that yield different incremental costs in different industries. Such flexibility can reduce the costs of attaining climate goals substantially, perhaps by a factor of ten.

Studies using integrated assessment modeling have also indicated two other conclusions worth noting: first, that the stringency of required emissions reductions should increase over time, but could be relatively modest; and second, that uncertainty about many aspects of climate change cannot justify inaction, because full understanding of the effects of greenhouse emissions--if it is ever attained--will probably be reached only after the effects have become irreversible.

The third element of the petition involves recommendations for dealing with climate change. In domestic policy, the petition advocates the use of market-based instruments, such as carbon taxes or emissions trading, rather than command-and-control regulatory instruments. On an international level, the petition insists that cooperation among nations is imperative if the problem of global warming is to be handled efficiently. Inconsistent, ad hoc policies of a few rich countries--a carbon tax here, a coal subsidy there--will not slow climate change much and are sure to do so in a wasteful manner. Efficiency will require new thinking and radically new approaches. One such approach might be an international regime of emissions trading, in which each nation would have an emissions budget or allowance that could be traded to other countries.

It is important to think about ways of distributing quotas that would give countries incentives to participate in such a trading system. It is also important to avoid the free-rider problem, in which a nation gets the benefit of actions by other nations to reduce greenhouse gases and slow global warming but makes no contribution itself. Any nationalistic country might conclude that, if it participates in the global effort, its own benefits would be small relative to its costs. This problem leads to the need for sanctions of some kind, such as trade sanctions, on nonparticipants.

Dale Jorgenson:

Because the global climate is a common property resource, or public good, it is not possible to devise a pure free-market solution to the problem of global warming. Therefore, some kind of government intervention is necessary, and the natural way to begin to tackle the problem is to ponder how to get nations to agree on an international framework.

But even if this crucial first step were achieved, just as important would be the issue of domestic implementation in each country, including the United States. Each nation would presumably have some kind of emissions quota that could be traded, and eventually each would arrive at a mandated time path of allowable emissions. In that circumstance, what kind of policy instrument should the president select to meet an internationally agreed upon quota of emissions for the United States?

To illustrate the principles involved, let's assume that the United States chose to use a carbon tax to achieve the desired reduction in emissions. How much would the reductions cost in that case? The answer crucially turns on the degree of emissions reduction desired. Costs do not rise in a linear fashion but rise at an increasing rate with greater degrees of required emissions reduction. For example, the cost of simply stabilizing emissions at the projected level of the year 2000 would be a mere 0.3 percent of GDP, whereas stabilizing at 80 percent of 1990 emissions would cost five times as much, or 1.6 percent of GDP.

A second issue involves the use to be made of the revenues from the hypothetical carbon tax. If the revenues were rebated to consumers in the form of reduced taxes on wage and salary income, the cost in the worst case (above of 1.6 percent of GDP) would be reduced to 0.6 percent, or by factor of three. But if the taxes were rebated on capital income instead, the loss in GDP would turn into a gain. The different ways of using the revenue from an emissions tax could potentially have an enormous effect on GDP.

A third question involves the type of tax used. A tax on units of energy is a possible alternative to a carbon tax, and its economic effects turn out to be very similar. But an ad valorem tax would bring twice the loss of a carbon tax. Thus the issue of the design of the tax is also of great importance.

Thomas Schelling:

While Messrs. Nordhaus and Jorgenson and I are very close in our assessments of the nature of the problem and of the way people should think about it, I chose not to sign the economists' petition because I believe that an international emissions trading agreement, while aesthetically elegant, is economically unworkable. There is no likelihood that the nations of the world can sit down and allocate once and for all among themselves several trillion dollars' worth, in present value, of very long-term, unchangeable emissions quotas. I do not believe they could even agree on what the trajectory of emissions ought to be.

Probably the best that can be hoped for is that a few rich countries, in an ad hoc fashion, will find not-very-efficient ways of reducing greenhouse gas emissions, and gradually over the decades something more systematic might come about.

Concerning the important issue of the trajectory of emissions reduction, the first order of business is to decide what ultimate level of concentration of greenhouse gases in the atmosphere is permissible--what is the concentration above which the problem becomes grave for humanity. Then the trajectory should be discussed in terms of costs and finding the most efficient path to follow. Some work now being done suggests that it would be more economical to suppress emissions some twenty, thirty, forty, or fifty years from now than it is to suppress them now. Thus an option that appears to have economic merit would be to continue increasing emissions for another decade or two, then to level off for a decade or two, and then to have a very substantial decline.

As for the uncertainties involved in the understanding of climate change, it is important in measuring potential damage from global warming to be aware that the world will be very different when this becomes a problem fifty to a hundred years from now, from what it is today. If people in 1920 had been asked to identify the worst environmental problem, they might well have selected mud, a problem that has now disappeared. Those who try to project levels of human disease from global warming overlook all the progress in both disease control and economic well-being that will have been made by the time the warming occurs. The likely improvement in human health over the next seventy-five years will swamp whatever benefits various mosquitoes and flies will gain from climate warming.

From an economic perspective, even though the costs of dealing with emissions seem high, climate change is not a big problem but rather a little one. If the cost of reducing emissions is 1.6 percent of GDP, this only means that the standard of living we might have reached in 2060 will not be attained until midway through 2062. The problem is not unmanageable economically, it is unmanageable only politically, just as the current modest budget deficit has until now proved unmanageable politically. Inefficient ways of dealing with emissions, such as regulations, are politically easier than are efficient ways, such as taxes.

Finally, what is to be gained by slowing down climate change? My colleagues here would, I think, agree with me that if climate change were to continue unabated for seventy-five years, nobody in the United States would notice the difference in material welfare. Climate has very little to do with economic activity in the United States, except perhaps farming, which now contributes less than 5 percent to GDP in almost all developed countries.

The people who are vulnerable to climate change are those in the less-developed countries. The only argument for benefiting future generations by slowing down climate change is that some of those future generations will still be poor, and we may want to help them. It can be argued, however, that the resources devoted to slowing greenhouse gas emissions could be better spent in spurring economic development in the poor countries. Furthermore, the descendants of today's Chinese and Malaysians and Bangladeshi will be better off than the people in those countries today, so the question arises: if we want to help somebody, do we want to help poor people who are alive now, some of whom are desperately poor, or do we want to help their more well-to-do descendants by slowing climate change? The case has yet to be made that we get more for our money by reducing carbon emissions than by directly aiding development in those countries.

My final point is that there is no chance that over the next twenty, thirty, or forty years the developing countries will devote any resources to carbon abatement, and we cannot change this by any kind of coercion. For the first few decades at least, the climate change problem, if it is anybody's problem, is a rich country's problem.