The Economics of Climate Change

1. The Economics of Climate Change

2. The basic mechanism

5. In the long run perspective

6. Do not mix up with Ozone layers • Both are environmental problems • Both are related to the atmosphere • But they different issues • The atomosphere is so complex that more than one process may go on there • The ozone layer stop ultra-violet rays • With a thin ozone layer, skin cancer more likely • But note: This is an example demonstrating that international agreement can be successful! • Global warming is an other problem

7. International agreement • The problems of reaching an agreement on CO2 is eminent. • In addition to the incentives discussed, we have distributional issues. • The cost likely to be born by developing countries • These countries have not caused the problems. • Equal emission cut in % will harm the poor • Equal emissions per capita will gain China and India hugely.

8. The Kyoto protocol • Agreement from December 1997 • Annex I: Countries listed to take cut in emission • Countries with emissions above 2 tC/cap 1990 • Reductions relative to 1990-level. • Not by populations or GDP • Avoid strategic emissions • Annex I countries may induce reduction in Non-Annex I countries through Clean Development mechanisms (CDM)

11. Emissions 2000 relative to target

15. Emission trading in Kyoto • Was controversial in negotiations • Concern about market power from large sellers (Russia) and buyers (US) • Resistance to emission trading in general. • Two main mechanism • Clean Development Mechanism (CDM) Countries with comittments can pay for development projects in countries without committment provided these would not be undertaken otherwise. • Joint implementation: Two or more countries with committment can jointly implement their committment (Trade quotas; EU has redistributed their quota and established a market)

16. Returning to optimal policyRecall from last week • Nordhaus find an optimal carbon price of 27$/tC • Stern find an optimal carbon price at 250$/tC • The main different is the discount rate • The Stern review implicitly uses 1.4% • Nordhaus uses 4% discount rate, but a 6% return on capital.

17. Return to investments • If we invest 1 million $ today, what will it be worth 100 years from now: • In Treasury Bills: at most 2,7 million $ (1%) • In stocks: 2,2 billion $ (historical return, 8%) • Why this huge difference? • Uncertainty explains some of the difference • But not all of it • Returns to stock may be lower if we estimate it today.

18. A Crash-course in Finance; CAPM • An investor is better of owning 50% of two firms than 100% of one. • If one firm get bankrupt he is still not broke. • The best hedged portfolio owns a share of all stocks. (The market portfolio) • Now consider selling 1000 $ of the portfolio and buy stock A: Will the portfolio be more or less risky? • Depends on the correlation with the market portfolio.

19. Example: To assets • Both A and B pays 1 million Kroner with probability 0.1%, otherwise nothing? • Are they equally risky? • Depends on how they correlate with your wealth: • A pay 1 million if your house burns. • B pay 1 million if the stock market is excep. good. • A makes you wealth less uncertain, B makes it more uncertain.

20. The Capital Asset Pricing Model(CAPM)

21. Does climate abatement add to future uncertainty? • Nordhaus: D’(A) is positively correlated with future GDP. • There is more at stake when future GDP is high • Implies a discount rate above the Treasury bill (1%) • Howarth estimate the CAPM model and finds a discount rate much closer to 1% than to 8%.

22. Temperature change and consumption

23. Subjective probabilities and tails • Difficult to estimate probabilities • Not like a dice we can roll hundreds of times and observe frequencies • The rare events that we almost never observe, may be the most important.

24. The equity premium puzzle • If stock pay 7% more than bonds, why don’t we put all our wealth into bonds? • Risk aversion must be implausibly high to explain it • The returns to stock may be overestimated? • Some other theories, resolution of uncertainty, behavioral economics, etc. • The implication for climate discounting not well studied.

25. The tick tail (Weitzman) • Consider the St. Petersburg paradox • Flip a coin until tail in n’th flip • Payment 2 to the n’th, 2,4,8,16,32… • Expected value • If we run 100 000 simulation, we will most likely not observe n above 30 • Estimated value will be rather small • With 100 000 observation we will miss the tail • And hence miss the real expected value • In climate chance the extreme event are important, events we do not observe and no model simulates

26. Assessing the tail of climate change (Weitzman) • There are hundreds of simulation of temperature change provided we stabilize at 560 ppm (2x 280 ppm, the pre-industrial level) • 1% of these give temperature change > 10 degree • The premise ignores feedback, methane will be released from the tundra, likely temperature increase is up to 20 degrees; the difference between summer and winter in Oslo. • No guarantee that mankind will survive • D’(A) and GDP negatively correlated • Weitzman conclude that the optimal carbon price is almost infinite. • Note: It is highly unlikely that the world will be able to stabilize CO2 at a level as low as 560 ppm