The economics of climate change mitigation is the part of the economics of climate change related to climate change mitigation, that is actions that are designed to limit the amount of long-term climate change. Mitigation may be achieved through the reduction of greenhouse gas (GHG) emissions and the enhancement of sinks that absorb GHGs, for example forests.
Public good issues
The atmosphere is an international public good and GHG emissions are an international externality. A change in the quality of the atmosphere does not affect the welfare of all individuals and countries equally. In other words, some individuals and countries may benefit from climate change, but others may lose out.
Heterogeneity
GHG emissions are unevenly distributed around the world, as are the potential impacts of climate change. Nations with higher than average emissions that face potentially small negative/positive climate change impacts have little incentive to reduce their emissions. Nations with relatively low levels of emissions that face potentially large negative climate change impacts have a large incentive to reduce emissions. Nations that avoid mitigation can benefit from free-riding on the actions of others, and may even enjoy gains in trade and/or investment. The unequal distribution of benefits from mitigation, and the potential advantages of free-riding, made it difficult to secure the Paris Agreement, which aims to reduce emissions.
Intergenerational transfers
Mitigation of climate change can be considered a transfer of wealth from the present generation to future generations. The amount of mitigation determines the composition of resources (e.g., environmental or material) that future generations receive. Across generations, the costs and benefits of mitigation are not equally shared: future generations potentially benefit from mitigation, while the present generation bear the costs of mitigation but do not directly benefit (ignoring possible co-benefits, such as reduced air pollution). If the current generation also benefitted from mitigation, it might lead them to be more willing to bear the costs of mitigation.
Policies to reduce emissions
Stop subsidizing fossil fuels
Large fossil fuel subsidies are present in many countries. As of 2019 governments subsidize fossil fuels by about $500 billion per year: however using an unconventional definition of subsidy which includes failing to price greenhouse gas emissions, the International Monetary Fund estimated that fossil fuel subsidies were $5.2 trillion in 2017, which was 6.4% of global GDP. Economic theory indicates that the optimal policy would be to remove coal mining and burning subsidies and replace them with optimal taxes. Global studies indicate that even without introducing taxes, subsidy and trade barrier removal at a sectoral level would improve efficiency and reduce environmental damage (Barker et al., 2001:568). Removal of these subsidies would substantially reduce GHG emissions and create jobs in renewable energy.
The actual effects of removing fossil fuel subsidies would depend heavily on the type of subsidy removed and the availability and economics of other energy sources. There is also the issue of carbon leakage, where removal of a subsidy to an energy-intensive industry could lead to a shift in production to another country with less regulation, and thus to a net increase in global emissions.
In developed countries, energy costs are low and heavily subsidized, whereas in developing countries, the poor pay high costs for low-quality services. Bashmakov et al. (2001:410) commented on the difficulty of measuring energy subsidies, but found some evidence that coal production subsidies had declined in several developing and OECD countries.
Jacobson and Delucchi (2009) have advanced a plan to power 100% of the world's energy with wind, hydroelectric, and solar power by the year 2030, recommending transfer of energy subsidies from fossil fuel to renewable, and a price on carbon reflecting its cost for flood, cyclone, hurricane, drought, and related extreme weather expenses.
Some fossil fuel companies lobby governments. According to BloombergNEF excluding subsidies the levelized cost of electricity from new large-scale solar power in India and China has been below existing coal-fired power stations since 2021.
Stop subsidizing meat and dairy
The UK is reducing meat and dairy subsidies.
Price signals
Carbon pricing
A carbon price is a system of applying a price to carbon emissions, as a method of emissions mitigation. Potential methods of pricing include carbon emission trading, results-based climate finance, crediting mechanisms and more. Carbon pricing can also lend itself to the creation of carbon taxes, which would allow for governments to tax GHG emissions, as a method to benefit the government with a large increase in funding.
Carbon tax
Carbon taxes are considered especially useful because, once a number has been created, it will benefit the government either with currency or with a lowering in GHG emissions or even both, and therefore benefit the environment. It is almost a worldwide consensus that carbon taxing is the most cost-effective method of having a substantial and rapid response to climate change and carbon emissions. However, backlash to the tax includes that it could be considered regressive, as the impact from the tax would be damaging disproportionately to the poor who spend much of their income on energy for their homes. Still, even with the near universal approval, there are many questions that are unanswered regarding both the collection and redistribution of the taxes. One of the central questions being how the newly collected taxes will be redistributed.
Some or all of the proceeds of a carbon tax can be used to stop it disadvantaging the poor.
Structural market reforms
Market-orientated reforms, as undertaken by several countries in the 1990s, can have important effects on energy use, energy efficiency, and therefore GHG emissions. In a literature assessment, Bashmakov et al. (2001:409) gave the example of China, which has made structural reforms with the aim of increasing GDP. They found that since 1978, energy use in China had increased by an average of 4% per year, but at the same time, energy use had been reduced per unit of GDP.
Emissions trading
In addition to the implementation of command-and-control regulations (as with a carbon tax), governments can also use market-based approaches to mitigate emissions. One such method is emissions trading where governments set the total emissions of all polluters to a maximum and distribute permits, through auction or allocation, that allow entities to emit a portion, typically one ton of carbon dioxide equivalent (CO2e), of the mandated total emissions. In other words, the amount of pollution an entity can emit in an emissions trading system is limited by the number of permits they have. If a polluter wants to increase their emissions, they can only do so after buying permits from those who are willing to sell them. Many economists prefer this method of reducing emissions as it is market based and highly cost effective. That being said, emissions trading alone is not perfect since it fails to place a clear price on emissions. Without this price, emissions prices are volatile due to the supply of permits being fixed, meaning their price is entirely determined by shifts in demand. This uncertainty in price is especially disliked by businesses since it prevents them from investing in abatement technologies with confidence which hinders efforts for mitigating emissions. Regardless, while emissions trading alone has its problems and cannot reduce pollutants to the point of stabilizing the global climate, it remains an important tool for addressing climate change.
Liberalization of energy markets
Liberalization and restructuring of energy markets has occurred in several countries and regions, including Africa, the EU, Latin America, and the US. These policies have mainly been designed to increase competition in the market, but they can have a significant impact on emissions. Reform could allow the market to be more responsive to price signals placed on emissions. In 2020 it was estimated that by 2022 replacement of all existing coal-fired power stations by renewables and storage would be profitable in total but that "A key barrier to accelerating phaseout is that the vast majority (93 percent) of global coal plants are insulated from competition from renewables by long-term contracts and noncompetitive tariffs".
Climate and other environmental policies
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National
- Regulatory standards: These set technology or performance standards, and can be effective in addressing the market failure of informational barriers. If the costs of regulation are less than the benefits of addressing the market failure, standards can result in net benefits.
- Emission taxes and charges: an emissions tax requires domestic emitters to pay a fixed fee or tax for every tonne of CO2-eq GHG emissions released into the atmosphere. If every emitter were to face the same level of tax, the lowest cost way of achieving emission reductions in the economy would be undertaken first. In the real world, however, markets are not perfect, meaning that an emissions tax may deviate from this ideal. Distributional and equity considerations usually result in differential tax rates for different sources.
- Tradable permits: Emissions can be limited with a permit system. A number of permits are distributed equal to the emission limit, with each liable entity required to hold the number of permits equal to its actual emissions. A tradable permit system can be cost-effective so long as transaction costs are not excessive, and there are no significant imperfections in the permit market and markets relating to emitting activities.
- Voluntary agreements: These are agreements between government and industry. Agreements may relate to general issues, such as research and development, but in other cases, quantitative targets may be agreed upon. An advantage of voluntary agreements are their low transaction costs. There is, however, the risk that participants in the agreement will free ride, either by not complying with the agreement or by benefitting from the agreement while bearing no cost.
- Informational instruments: Poor information is recognized as a barrier to improved energy efficiency or reduced emissions. Examples of policies in this area include increasing public awareness of climate change, e.g., through advertising, and the funding of climate change research.
- Environmental subsidies: A subsidy for GHG emissions reductions pays entities a specific amount per tonne of CO2-eq for every tonne of GHG reduced or sequestered. Although subsidies are generally less efficient than taxes, distributional and competitiveness issues sometimes result in energy/emission taxes being coupled with subsidies or tax exceptions.
- Research and development policies: Government funding of research and development (R&D) on energy has historically favoured nuclear and coal technologies. Although research into renewable energy and energy-efficient technologies had increased, it was still a relatively small proportion of R&D budgets in the OECD in 2001.
- Green power: The policy ensures that part of the electricity supply comes from designated renewable sources. The cost of compliance is borne by all consumers.
- Demand-side management: This aims to reduce energy demand, e.g., through energy audits, labelling, and regulation.
The most effective and economically efficient approach of achieving lower emissions in the energy sector is to apply a combination of market-based instruments (taxes, permits), standards, and information policies.
International
Paris Agreement
The Paris Agreement (French: Accord de Paris), often referred to as the Paris Accords or the Paris Climate Accords, is an international treaty on climate change. Adopted in 2015, the agreement covers climate change mitigation, adaptation, and finance. The Paris Agreement was negotiated by 196 parties at the 2015 United Nations Climate Change Conference near Paris, France. As of September 2022, 194 members of the United Nations Framework Convention on Climate Change (UNFCCC) are parties to the agreement. Of the four UNFCCC member states which have not ratified the agreement, the only major emitter is Iran. The United States withdrew from the Agreement in 2020, but rejoined in 2021.
The Paris Agreement was opened for signature on 22 April 2016 (Earth Day) at a ceremony in New York. After the European Union ratified the agreement, sufficient countries had ratified the Agreement responsible for enough of the world's greenhouse gases for the Agreement to enter into force on 4 November 2016.
The Paris Agreement's long-term temperature goal is to keep the rise in mean global temperature to well below 2 °C (3.6 °F) above pre-industrial levels, and preferably limit the increase to 1.5 °C (2.7 °F), recognizing that this would substantially reduce the effects of climate change. Emissions should be reduced as soon as possible and reach net-zero by the middle of the 21st century. To stay below 1.5 °C of global warming, emissions need to be cut by roughly 50% by 2030. This is an aggregate of each country's nationally determined contributions.Other policies
- Regulatory instruments: This could involve the setting of regulatory standards for various products and processes for countries to adopt. The other option is to set national emission limits. The second option leads to inefficiency because the marginal costs of abatement differs between countries (Bashmakov et al., 2001:430).
Initiatives such as the EU "cap and trade" system have also been implemented.
- Carbon taxes: This would offer a potentially cost-effective means of reducing CO2 emissions. Compared with emissions trading, international or harmonized (where each country keeps the revenue it collects) taxes provide greater certainty about the likely costs of emission reductions. This is also true of a hybrid policy (see the article carbon tax) (Bashmakov et al., 2001:430).
Efficiency of international agreements
For the purposes of analysis, it is possible to separate efficiency from equity (Goldemberg et al., 1996, p. 30). It has been suggested that because of the low energy efficiency in many developing countries, efforts should first be made in those countries to reduce emissions. Goldemberg et al. (1996, p. 34) suggested a number of policies to improve efficiency, including:
- Property rights reform. For example, deforestation could be reduced through reform of property rights.
- Administrative reforms. For example, in many countries, electricity is priced at the cost of production. Economists, however, recommend that electricity, like any other good, should be priced at the competitive price.
- Regulating non-greenhouse externalities. There are externalities other than the emission of GHGs, for example, road congestion leading to air pollution. Addressing these externalities, e.g., through congestion pricing and energy taxes, could help to lower both air pollution and GHG emissions.
General equilibrium theory
One of the aspects of efficiency for an international agreement on reducing emissions is participation. In order to be efficient, mechanisms to reduce emissions still require all emitters to face the same costs of emission (Goldemberg et al., 1996, p. 30). Partial participation significantly reduces the effectiveness of policies to reduce emissions. This is because of how the global economy is connected through trade.
General equilibrium theory points to a number of difficulties with partial participation (p. 31). Examples are of "leakage" (carbon leakage) of emissions from countries with regulations on GHG emissions to countries with less regulation. For example, stringent regulation in developed countries could result in polluting industries such as aluminium production moving production to developing countries. Leakage is a type of "spillover" effect of mitigation policies.
Estimates of spillover effects are uncertain (Barker et al., 2007). If mitigation policies are only implemented in Kyoto Annex I countries, some researchers have concluded that spillover effects might render these policies ineffective, or possibly even cause global emissions to increase (Barker et al., 2007). Others have suggested that spillover might be beneficial and result in reduced emission intensities in developing countries.
Comprehensiveness
Efficiency also requires that the costs of emission reductions be minimized (Goldemberg et al., 1996, p. 31). This implies that all GHGs (CO2, methane, etc.) are considered as part of a policy to reduce emissions, and also that carbon sinks are included. Perhaps most controversially, the requirement for efficiency implies that all parts of the Kaya identity are included as part of a mitigation policy. The components of the Kaya identity are:
- CO2 emissions per unit of energy, (carbon intensity)
- energy per unit of output, (energy efficiency)
- economic output per capita,
- and human population.
Efficiency requires that the marginal costs of mitigation for each of these components is equal. In other words, from the perspective of improving the overall efficiency of a long-term mitigation strategy, population control has as much "validity" as efforts made to improve energy efficiency.
Equity in international agreements
Unlike efficiency, there is no consensus view of how to assess the fairness of a particular climate policy (Bashmakov et al., 2001:438–439; see also economics of global warming#Paying for an international public good). This does not prevent the study of how a particular policy impacts welfare. Edmonds et al. (1995) estimated that a policy of stabilizing national emissions without trading would, by 2020, shift more than 80% of the aggregate policy costs to non-OECD regions (Bashmakov et al., 2001:439). A common global carbon tax would result in an uneven burden of abatement costs across the world and would change with time. With a global tradable quota system, welfare impacts would vary according to quota allocation.
Finance
Article 4.2 of the United Nations Framework Convention on Climate Change commits industrialized countries to "[take] the lead" in reducing emissions. The Kyoto Protocol to the UNFCCC has provided only limited financial support to developing countries to assist them in climate change mitigation and adaptation. Additionally, private sector investment in mitigation and adaptation could be discouraged in the short and medium term because of the 2008 global financial crisis.
The International Energy Agency estimates that US$197 billion is required by states in the developing world above and beyond the underlying investments needed by various sectors regardless of climate considerations, this is twice the amount promised by the developed world at the UN Framework Convention on Climate Change (UNFCCC) CancĂșn Agreements. Thus, a new method is being developed to help ensure that funding is available for climate change mitigation. This involves financial leveraging, whereby public financing is used to encourage private investment.
The private sector is often unwilling to finance low carbon technologies in developing and emerging economies as the market incentives are often lacking. There are many perceived risks involved, in particular:
- General political risk associated politically instability, uncertain property rights and an unfamiliar legal framework.
- Currency risks are involved is financing is sought internationally and not provided in the nationally currency.
- Regulatory and policy risk – if the public incentives provided by a state may not be actually provided, or if provided, then not for the full length of the investment.
- Execution risk – reflecting concern that the local project developer/firm may lack the capacity and/or experience to execute the project efficiently.
- Technology risk as new technologies involved in low carbon technology may not work as well as expected.
- Unfamiliarity risks occur when investors have never undertaken such projects before.
Funds from the developed world can help mitigate these risks and thus leverage much larger private funds, the current aim to create $3 of private investment for every $1 of public funds. Public funds can be used to minimise the risks in the following way.
- Loan guarantees provided by international public financial institutions can be useful to reduce the risk to private lenders.
- Policy insurance can insurance the investor against changes or disruption to government policies designed to encourage low carbon technology, such as a feed-in tariff.
- Foreign exchange liquidity facilities can help reduce the risks associated with borrowing money in a different currency by creating a line of credit that can be drawn on when the project needs money as a result of local currency devaluation but then repaid when the project has a financial surplus.
- Pledge fund can help projects are too small for equity investors to consider or unable to access sufficient equity. In this model, public finance sponsors provide a small amount of equity to anchor and encourage much larger pledges from private investors, such as sovereign wealth funds, large private equity firms and pension funds. Private equity investors will tend to be risk-averse and focused primarily on long-term profitability, thus all projects would need to meet the fiduciary requirements of the investors.
- Subordinated equity fund – an alternative use of public finance is
through the provision of subordinated equity, meaning that the repayment
on the equity is of lower priority than the repayment of other equity
investors.
The subordinated equity would aim to leverage other equity investors by
ensuring that the latter have first claim on the distribution of
profit, thereby increasing their risk-adjusted returns. The fund would have claim on profits only after rewards to other equity investors were distributed.
- More firms (in Europe) plan to invest in low-carbon sectors, and to tackle climate change.
An investment survey conducted by the European Investment Bank in 2021 found that during the COVID-19 pandemic, climate change was addressed by 43% of EU enterprises. Despite the pandemic's effect on businesses, the percentage of firms planning climate-related investment rose to 47%. In 2020, the percentage of climate related investment was at 41%.
62% of Europeans believe that the green transition will reduce their buying power.
Eastern European and Central Asian businesses fall behind their Southern European counterparts in terms of the average quality of their green management practices, notably in terms of specified energy consumption and emissions objectives. External variables, such as consumer pressure and energy taxes, are more relevant than firm-level features, such as size and age, in influencing the quality of green management practices. Firms with less financial limitations and stronger green management practices are more likely to invest in a bigger variety of green initiatives. Energy efficiency investments are good to both the bottom line and the environment.
Europe
The European Investment Bank plans to support €1 trillion of climate investment by 2030 as part of the European Green Deal. In 2019 the EIB Board of Directors approved new targets for climate action and environmental sustainability to phase out fossil fuel financing. The bank will increase the share of its financing for to climate action and environmental sustainability to 50% by 2025 The European Investment Bank Group announced it will align all financing with the Paris Agreement by the end of 2020. The bank aims "to play a leading role in mobilising the finance needed to achieve the worldwide commitment to keep global warming well below 2˚C, aiming for 1.5˚C."
A survey in 2020 found that 45% of EU companies have invested in climate change mitigation or adaptation measures, compared to 32% in the US. Fewer companies plan future investment in the years following the COVID-19 pandemic. 40% of European companies want to invest in climate initiatives during the next three years. The proportion of investment in 2020 varies from 50% in Western and Northern Europe to 32% in Central and Eastern Europe. The majority of European companies, 75%, say regulatory and tax uncertainty is preventing them from investing in climate-related projects.
According to a 2020 Municipality Survey, 56% of European Union municipalities increased climate investment, while 66% believe their climate investment over the previous three years has been insufficient. In the three years preceding the pandemic, over two-thirds of EU towns boosted infrastructure investments, with a 56% focus on climate change mitigation.
Local municipalities contribute 45% of total government investment. Basic infrastructure, such as public transportation or water utilities, is included in their investment. They also update public facilities including schools, hospitals, and social housing. Prioritizing energy efficiency in these projects will assist Europe in meeting climate targets.
Cities & towns are also responsible for around 70% of total greenhouse gas emissions.
Municipal investment began to increase again about 2017. In the three years preceding the pandemic, over two-thirds of EU towns boosted infrastructure investments. This investment has tended to concentrate on certain types of infrastructure, such as digital infrastructure, at 70% and social services at 60%, as well as climate change mitigation at 56%.
Assessing costs and benefits
GDP
The costs of mitigation and adaptation policies can be measured as a change in GDP. A problem with this method of assessing costs is that GDP is an imperfect measure of welfare (Markandya et al., 2001:478):
- Not all welfare is included in GDP, e.g., housework and leisure activities.
- There are externalities in the economy which mean that some prices might not be truly reflective of their social costs.
Corrections can be made to GDP estimates to allow for these problems, but they are difficult to calculate. In response to this problem, some have suggested using other methods to assess policy. For example, the United Nations Commission for Sustainable Development has developed a system for "Green" GDP accounting and a list of sustainable development indicators.
Baselines
The emissions baseline is, by definition, the emissions that would occur in the absence of policy intervention. Definition of the baseline scenario is critical in the assessment of mitigation costs (Markandya et al., 2001:469–470). This because the baseline determines the potential for emissions reductions, and the costs of implementing emission reduction policies.
There are several concepts used in the literature over baselines, including the "efficient" and "business-as-usual" (BAU) baseline cases. In the efficient baseline, it is assumed that all resources are being employed efficiently. In the BAU case, it is assumed that future development trends follow those of the past, and no changes in policies will take place. The BAU baseline is often associated with high GHG emissions, and may reflect the continuation of current energy-subsidy policies, or other market failures.
Some high emission BAU baselines imply relatively low net mitigation costs per unit of emissions. If the BAU scenario projects a large growth in emissions, total mitigation costs can be relatively high. Conversely, in an efficient baseline, mitigation costs per unit of emissions can be relatively high, but total mitigation costs low.
Ancillary impacts
These are the secondary or side effects of mitigation policies, and including them in studies can result in higher or lower mitigation cost estimates (Markandya et al., 2001:455). Reduced mortality and morbidity costs are potentially a major ancillary benefit of mitigation. This benefit is associated with reduced use of fossil fuels, thereby resulting in less air pollution, which might even just by itself be a benefit greater than the cost. There may also be ancillary costs. In developing countries, for example, if policy changes resulted in a relative increase in electricity prices, this could result in more pollution (Markandya et al., 2001:462).
Flexibility
Flexibility is the ability to reduce emissions at the lowest cost. The greater the flexibility that governments allow in their regulatory framework to reduce emissions, the lower the potential costs are for achieving emissions reductions (Markandya et al., 2001:455).
- "Where" flexibility allows costs to be reduced by allowing emissions to be cut at locations where it is most efficient to do so. For example, the Flexibility Mechanisms of the Kyoto Protocol allow "where" flexibility (Toth et al., 2001:660).
- "When" flexibility potentially lowers costs by allowing reductions to be made at a time when it is most efficient to do so.
Including carbon sinks in a policy framework is another source of flexibility. Tree planting and forestry management actions can increase the capacity of sinks. Soils and other types of vegetation are also potential sinks. There is, however, uncertainty over how net emissions are affected by activities in this area.
No regrets options
No regret options are social and economic benefits developed under the assumption of taking action and establishing preventative measures in current times without fully knowing what climate change will look like in the future.
These are emission reduction options which can also make a lot of profit – such as adding solar and wind power.
Different studies make different assumptions about how far the economy is from the production frontier (defined as the maximum outputs attainable with the optimal use of available inputs – natural resources, labour, etc).
The benefits of coal phase out exceed the costs. Switching from cars by improving walking and cycling infrastructure is either free or beneficial to a country's economy as a whole.
Technology
Assumptions about technological development and efficiency in the baseline and mitigation scenarios have a major impact on mitigation costs, in particular in bottom-up studies. The magnitude of potential technological efficiency improvements depends on assumptions about future technological innovation and market penetration rates for these technologies.
Discount rates
Assessing climate change impacts and mitigation policies involves a comparison of economic flows that occur in different points in time. The discount rate is used by economists to compare economic effects occurring at different times. Discounting converts future economic impacts into their present-day value. The discount rate is generally positive because resources invested today can, on average, be transformed into more resources later. If climate change mitigation is viewed as an investment, then the return on investment can be used to decide how much should be spent on mitigation.
Integrated assessment models (IAM) are used for to estimate the social cost of carbon. The discount rate is one of the factors used in these models. The IAM frequently used is the Dynamic Integrated Climate-Economy (DICE) model developed by William Nordhaus. The DICE model uses discount rates, uncertainty, and risks to make benefit and cost estimations of climate policies and adapt to the current economic behavior.
The choice of discount rate has a large effect on the result of any climate change cost analysis (HalsnĂŠs et al., 2007:136). Using too high a discount rate will result in too little investment in mitigation, but using too low a rate will result in too much investment in mitigation. In other words, a high discount rate implies that the present-value of a dollar is worth more than the future-value of a dollar.
Discounting can either be prescriptive or descriptive. The descriptive approach is based on what discount rates are observed in the behaviour of people making every day decisions (the private discount rate) (IPCC, 2007c:813). In the prescriptive approach, a discount rate is chosen based on what is thought to be in the best interests of future generations (the social discount rate).
The descriptive approach can be interpreted as an effort to maximize the economic resources available to future generations, allowing them to decide how to use those resources (Arrow et al., 1996b:133–134). The prescriptive approach can be interpreted as an effort to do as much as is economically justified to reduce the risk of climate change.
The DICE model incorporates a descriptive approach, in which discounting reflects actual economic conditions. In a recent DICE model, DICE-2013R Model, the social cost of carbon is estimated based on the following alternative scenarios: (1) a baseline scenario, when climate change policies have not changed since 2010, (2) an optimal scenario, when climate change policies are optimal (fully implemented and followed), (3) when the optimal scenario does not exceed 2˚C limit after 1900 data, (4) when the 2˚C limit is an average and not the optimum, (5) when a near-zero (low) discount rate of 0.1% is used (as assumed in the Stern Review), (6) when a near-zero discount rate is also used but with calibrated interest rates, and (7) when a high discount rate of 3.5% is used.
According to Markandya et al. (2001:466), discount rates used in assessing mitigation programmes need to at least partly reflect the opportunity costs of capital. In developed countries, Markandya et al. (2001:466) thought that a discount rate of around 4–6% was probably justified, while in developing countries, a rate of 10–12% was cited. The discount rates used in assessing private projects were found to be higher – with potential rates of between 10% and 25%.
When deciding how to discount future climate change impacts, value judgements are necessary (Arrow et al., 1996b:130). IPCC (2001a:9) found that there was no consensus on the use of long-term discount rates in this area. The prescriptive approach to discounting leads to long-term discount rates of 2–3% in real terms, while the descriptive approach leads to rates of at least 4% after tax – sometimes much higher (HalsnĂŠs et al., 2007:136).
Even today, it is difficult to agree on an appropriate discount rate. The approach of discounting to be either prescriptive or descriptive stemmed from the views of Nordhaus and Stern. Nordhaus takes on a descriptive approach which "assumes that investments to slow climate change must compete with investments in other areas". While Stern takes on a prescriptive approach in which "leads to the conclusion that any positive pure rate of time preference is unethical".
In Nordhaus' view, his descriptive approach translates that the impact of climate change is slow, thus investments in climate change should be on the same level of competition with other investments. He defines the discount rate to be the rate of return on capital investments. The DICE model uses the estimated market return on capital as the discount rate, around an average of 4%. He argues that a higher discount rate will make future damages look small, thus have less effort to reduce emissions today. A lower discount rate will make future damages look larger, thus put more effort to reduce emissions today.
In Stern's view, the pure rate of time preference is defined as the discount rate in a scenario where present and future generations have equal resources and opportunities. A zero pure rate of time preference in this case would indicate that all generations are treated equally. The future generation do not have a "voice" on today's current policies, so the present generation are morally responsible to treat the future generation in the same manner. He suggests for a lower discount rate in which the present generation should invest in the future to reduce the risks of climate change.
Assumptions are made to support estimating high and low discount rates. These estimates depend on future emissions, climate sensitivity relative to increase in greenhouse gas concentrations, and the seriousness of impacts over time. Long-term climate policies will significantly impact future generations and this is called intergenerational discounting. Factors that make intergenerational discounting complicated include the great uncertainty of economic growth, future generations are affected by today's policies, and private discounting will be affected due to a longer "investment horizon".
Controversy
Discounting is a relatively controversial issue in both climate change mitigation and environmental economics due to the ethical implications of valuing future generations less than present ones. Non-economists often find it difficult to grapple with the idea that thousands of dollars of future costs and benefits can be valued at less than a cent in the present after discounting. This devaluation can lead to overconsumption and "strategic ignorance" where individuals choose to ignore information that would prevent the overconsumption of resources. Contrary to this, orthodox economists concerned with equality argue that it is important to distribute society's resources equitably across time, and since they generally, rightly or wrongly predict positive economic growth, despite global climate change, they argue that current generations should damage the environment in which future generations live so that the current ones can consume and produce more to equalize the (rightly or wrongly) assumed gains to the future from a supposed growing net GDP. That being said, not all economists share this opinion as notable economist Frank Ramsey once described discounting as "ethically indefensible."
One root of this controversy can be attributed to the discrepancies between the time scales environmentalists and corporations/governments view the world with. Environmental processes such as the carbonate-silicate cycle and Milankovitch cycles occur on timescales of thousands of years while economic processes, such as infrastructure investments, occur on time scales as short as thirty years. The difference between these two scales makes balancing both interests, sustainability and efficiency, incredibly difficult.
Implementation
Because discounting rates are determined and implemented by individual governments, discounting rates are not unanimous across the globe. They range from percentages as high as 15%, as in the Philippines, to as low as 3%, as in Germany.
United States
Discounting in the United States is a complicated area for policy analysis. The discounting rate is not the same for every government agency. As of 1992, the recommended discounting rate from the Environmental Protection Agency is 2–3% while the Office of Management and Budget recommends a discount rate of 7%. Further complicating things, these rates are fluid and change every year depending on the administration.
United Kingdom
The United Kingdom is one of very few governmental bodies that currently use what is known as a declining discount rate. Declining discount rates are gaining popularity due to the fact that they address the uncertainties in economic growth which allows for greater weight to be placed on future benefits, but the extent to this advantage remains to be proven.
Employment
Whilst total employment is not expected to change much, some sectors, regions or skillsets may lose many jobs and others gain a lot.
Decision analysis
This is a quantitative type of analysis that is used to assess different potential decisions. Examples are cost-benefit and cost-effectiveness analysis. In cost-benefit analysis, both costs and benefits are assessed economically. In cost-effectiveness analysis, the benefit-side of the analysis, e.g., a specified ceiling for the atmospheric concentration of GHGs, is not based on economic assessment.
One of the benefits of decision analysis is that the analysis is reproducible. Weaknesses, however, have been citied:
- The decision maker:
- In decision analysis, it is assumed that a single decision maker, with well-order preferences, is present throughout the analysis. In a cost-benefit analysis, the preferences of the decision maker are determined by applying the concepts of "willingness to pay" (WTP) and "willingness to accept" (WTA). These concepts are applied in an attempt to determine the aggregate value that society places on different resources.
- In reality, there is no single decision maker. Different decision makers have different sets of values and preferences, and for this reason, decision analysis cannot yield a universally preferred solution.
- Utility valuation: Many of the outcomes of climate policy decisions are difficult to value.
Arrow et al. (1996a) concluded that while decision analysis had value, it could not identify a globally optimal policy for mitigation. In determining nationally optimal mitigation policies, the problems of decision analysis were viewed as being less important.
Cost-benefit analysis
In an economically efficient mitigation response, the marginal (or incremental) costs of mitigation would be balanced against the marginal benefits of emission reduction. "Marginal" means that the costs and benefits of preventing (abating) the emission of the last unit of CO2-eq are being compared. Units are measured in tonnes of CO2-eq. The marginal benefits are the avoided damages from an additional tonne of carbon (emitted as carbon dioxide) being abated in a given emissions pathway (the social cost of carbon).
A problem with this approach is that the marginal costs and benefits of mitigation are uncertain, particularly with regards to the benefits of mitigation (Munasinghe et al., 1996, p. 159). In the absence of risk aversion, and certainty over the costs and benefits, the optimum level of mitigation would be the point where marginal costs equal marginal benefits. As of 2022 the models are not good enough to be certain, but the IPCC said that "emerging evidence suggests that, even without accounting for co-benefits of mitigation on other sustainable development dimensions, the global benefits of pathways likely to limit warming to 2°C outweigh global mitigation costs over the 21st century" (see economics of global warming#Trade offs).
Damage function
In cost-benefit analysis, the optimal timing of mitigation depends more on the shape of the aggregate damage function than the overall damages of climate change (Fisher et al., 2007:235). If a damage function is used that shows smooth and regular damages, e.g., a cubic function, the results suggest that emission abatement should be postponed. This is because the benefits of early abatement are outweighed by the benefits of investing in other areas that accelerate economic growth. This result can change if the damage function is changed to include the possibility of catastrophic climate change impacts.
Cost estimates
Global costs
According to a literature assessment by Barker et al. (2007:622), mitigation cost estimates depend critically on the baseline (in this case, a reference scenario that the alternative scenario is compared with), the way costs are modelled, and assumptions about future government policy. Fisher et al. (2007) estimated macroeconomic costs in 2030 for multi-gas mitigation (reducing emissions of carbon dioxide and other GHGs, such as methane) as between a 3% decrease in global GDP to a small increase, relative to baseline. This was for an emissions pathway consistent with atmospheric stabilization of GHGs between 445 and 710 ppm CO2-eq. In 2050, the estimated costs for stabilization between 710 and 445 ppm CO2-eq ranged between a 1% gain to a 5.5% decrease in global GDP, relative to baseline. These cost estimates were supported by a moderate amount of evidence and much agreement in the literature (IPCC, 2007b:11,18).
Macroeconomic cost estimates made by Fisher et al. (2007:204) were mostly based on models that assumed transparent markets, no transaction costs, and perfect implementation of cost-effective policy measures across all regions throughout the 21st century. According to Fisher et al. (2007), relaxation of some or all these assumptions would lead to an appreciable increase in cost estimates. On the other hand, IPCC (2007b:8) noted that cost estimates could be reduced by allowing for accelerated technological learning, or the possible use of carbon tax/emission permit revenues to reform national tax systems.
In most of the assessed studies, costs rose for increasingly stringent stabilization targets. In scenarios that had high baseline emissions, mitigation costs were generally higher for comparable stabilization targets. In scenarios with low emissions baselines, mitigation costs were generally lower for comparable stabilization targets.
Phasing out coal has been estimated to have a net benefit of 78 trillion dollars.
Distributional effects
Regional costs
Gupta et al. (2007:776–777) assessed studies where estimates are given for regional mitigation costs. The conclusions of these studies are as follows:
- Regional abatement costs are largely dependent on the assumed stabilization level and baseline scenario. The allocation of emission allowances/permits is also an important factor, but for most countries, is less important than the stabilization level (Gupta et al., 2007, pp. 776–777).
- Other costs arise from changes in international trade. Fossil fuel-exporting regions are likely to be affected by losses in coal and oil exports compared to baseline, while some regions might experience increased bio-energy (energy derived from biomass) exports (Gupta et al., 2007, pp. 776–777).
- Allocation schemes based on current emissions (i.e., where the most allowances/permits are given to the largest current polluters, and the fewest allowances are given to smallest current polluters) lead to welfare losses for developing countries, while allocation schemes based on a per capita convergence of emissions (i.e., where per capita emissions are equalized) lead to welfare gains for developing countries.
