Hedging Strategies for Climate Change Policy Informing the Short-term Debate in a Long-term Context

1. Hedging Strategies for Climate Change PolicyInforming the Short-term Debate in a Long-term Context Frontiers of Environmental Change Research Climate Change Drivers, Impacts and Policy September 15, 2005 Gary Yohe Wesleyan University

2. Take-home Messages Hedging to minimize adjustment costs makes sense in the climate change context given enormous uncertainty in benefits. There are analogs in other policy arenas and personal decision contexts � sources of motivation and resonance. Long-term uncertainties challenge the definition of the policy adjustment processes. Public perceptions of risk and causality are critical: Accepting the �hedging� risk-management approach to the near-term policy debate. Being comfortable with the proposed adjustment processes.

3. Designing an Adaptive Risk-management Approach to Climate Policy The idea is to envision an �act � learn � act � learn ��.� approach. The �act� parts are derived in terms of �buying insurance� (i.e., hedging) to minimize the expected economic cost of adjustment. The �learn� parts are directed at keeping track of forcings, predicting the definition, likelihood and pace of �dangerous� climate change and creating efficient adjustment mechanisms.

4. Learning ????The Policy-relevant Research Frontied What are the potential damages across multiple metrics allowed (�What is dangerous?�). How can policy influence the likelihoods of avoiding intolerable thresholds? What should be monitored to track the evolution of those likelihoods? On the impacts side, can �early warnings� be triggered before the system is committed to crossing an unfortunate threshold?

5. Acting ????The Policy-relevant Research Frontier What are the costs of policy adjustment? How are costs determined by the design of adaptive adjustment processes � decision thresholds and anticipated timings? How costs they be minimized? What role do public perceptions of risk and causality play beginning with near-term mitigation and continuing by sustaining the adjustment process?

6. Using Mitigative Capacity to Organize an Approach to these Questions Determinants include: Available options Resources and their distribution Governance structure and allocation of authority Human capital Social capital Access to risk spreading mechanisms Ability of decision-makers to manage information Public perception

7. An Alternative View of the Weakest Links Determinants include: Available options Resources and their distribution Governance structure and allocation of authority Human capital Social capital Access to risk spreading mechanisms Ability of decision-makers to manage information Public perception

8. An Illustrative Example(Yohe, Andronova and Schlesinger, Science, 2004) Start with a new CDF of climate sensitivity. The question: What does the expanding uncertainty mean for near term mitigation? The method: Envision hedging experiments in an modified EMF-14 approach Begin policy in 2005 Uncertainty and ultimate temperature target revealed in 2035 Associated least cost adjustment

9. More Specifics The model � a revised DICE global model Limit on the rate of decarbonization Policy as a carbon tax (scarcity rent) that increases over time at the endogenously determined private rate of interest. A discrete representation of the CDF on climate sensitivity associated with parameter that reflects the inverse of the thermal capacity of the atmospheric layer and the upper ocean

10. A CDF of Climate Sensitivity

11. Unregulated Temperature Trajectories

12. The Experiment Hedging strategies are evaluated in terms of robustness � the range of futures that they can handle with �reasonable� adjustment costs Hedging is also evaluated in terms of �keeping doors open� � temperature targets that are still possible The critical comparison is between a favored hedging strategy and doing nothing between 2005 and 2035

13. More Specifics Set near-term policy assuming that both the temperature target and climate sensitivity will be revealed in 2035 An initial global tax of $10 per ton of carbon maximizes expected global GDP Targets of 2, 2.5, 3, and 3.5 degrees are assumed to be equally likely choices in 2035 Climate sensitivity according to the CDF

14. Compare this Strategy with �Doing Nothing� over the Near Term The alternative considers a zero tax through 2035 followed by an adjustment designed then to achieve temperature targets at least cost. The $10 initial tax will increase at the rate of interest until 2035, and then require a similar adjustment � will be too high in some cases and too low in others.

15. An Example � Hedging or Not to Meet a 3 Degree Target with a 6 Degree Sensitivity

16. Discounted Adjustment Cost with No Mitigation through 2135 (billions of dollars) Climate Ultimate Temperature Target Sensitivity 2 2.5 3 3.5 1.5 $32 $11 $3 $0 2 $38 $22 $16 $4 3 $180 $29 $18 $22 4 IL $60 $24 $24 5 IL $142 $25 $25 6 IN IL $27 $28 7 IN IL IL $34 8 IN IL IL $35 9 IN IL IL $38

17. Discounted Adjustment Cost with $10 Initial Tax (billions of dollars) Climate Ultimate Temperature Target Sensitivity 2 2.5 3 3.5 1.5 $0 $0 $0 $0 2 $2 $1 $0 $0 3 $4 $3 $1 $0 4 IL $6 $2 $0 5 IL $12 $3 $0 6 IN IL $4 $1 7 IN IL $6 $3 8 IN IL $9 $5 9 IN IL $12 $9

18. Remaining Issues Given than Hedging Against Adjustment Costs Makes Sense Numerical results are model specific � EMF-22. Temperature targets attached to what �unfortunate� impacts? What should we monitor to support adaptive adjustments? On the impacts side? On the �driving� side? What is the role of public perception? Are there analogs in a macro-policy setting?

19. A Macro-policy Analog �For example, policy A might be judged as best advancing the policymakers� objectives, conditional on a particular model of the economy, but might also be seen as having relatively severe adverse consequences if the true structure of the economy turns out to be other that the one assumed. On the other hand, policy B might be somewhat less effective under the assumed baseline model � but might be relatively benign in the event that the structure of the economy turns out to differ from the baseline. These considerations have inclined the Federal Reserve policymakers toward policies that limit the risk of deflation even though the baseline forecasts from most conventional models would not project such an event.� �Opening Remarks� Federal Reserve Bank of Kansas City, Jackson Hole, WY, August 28-30, 2003, pages 3-4

20. More Help � Focusing Attention on the Information Processing Determinant ��the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. � � This framework also entails, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goals�� (page 37) American Economic Review 94: 33-40, 2004.

21. An Aside � The Risk of Deflation The primary cost falls of millions of borrowers (small businesses and individuals) who have to pay back loans with dollars that are worth more. There are benefactors: lenders (big institutions) who get higher than expected returns on their loans. Not unlike mitigation where the benefits are widely distributed across the �little guys� and the costs are concentrated in large energy companies.

22. More on the Risk of Deflation In point of fact, none of the models that the FED reviews currently see any chance of deflation along baseline scenarios or across wide ranges of sensitivity analyses � but Greenspan still led the FED to hedge at the expense of slightly less robust economic activity (a shared cost). In the climate arena, there are models that generate abrupt and perhaps irreversible change along baseline scenarios

23. Additionally Monetary policy proceeds with adaptive management despite ongoing debate on What to monitor routinely? How to make adjustments routinely? How frequently to contemplate adjustments against what �triggers�? How to cope with stochastic shocks? The �hedging� against the chance of �unfortunate� deflation continues.

24. Targets for Climate Policy, Impacts, and Public Perception The public�s attention focuses on big and noticeable events and threats (in a risk-based sense � i.e., likelihood times consequence): Monitor the potential of abrupt climate change and the link between crossing thresholds, macro (global) state variables, and mitigation? Monitor the potential links between extreme events and macro (global) state variables and mitigation? The connection to mitigation requires acceptance that it will accomplish something.

25. So, What do We Know, Now, about Abrupt Climate Change, for example? Contemplate five possible abrupt changes: Weakening or collapse of the meridional overturning circulation (the MOC) Coral bleaching Changes in ENSO Greenland Ice Sheet Melting West Antarctic Ice Sheet Disintegration Beware of Type III errors!!

26. MOC Weakening Threshold: very low � seems to be happening. Process: salinity change caused by �fresh water infusion� from Greenland, the Arctic Ocean, � Timely detection likely to be feasible. Consequences: precipitation and temperature change; fisheries effect; terrestrial ecosystems effect�

27. IPCC Categories of Confidence

28. MOC Weakening Threshold: very low � seems to be happening. Process: salinity change from fresh water infusion from Greenland, the Arctic Ocean, and elsewhere. Timely detection likely to be feasible. Consequences: precipitation and temperature change; fisheries effect�; terrestrial ecosystems effects�

29. Sources of Uncertainty in Understanding the Processes of MOC Weakening Salinity matters � multiple sources Are they all regulated by global mean temperature? Are there positive or negative feedbacks? Heat transport matters � may be driven more by wind than the MOC Are winds as vulnerable to climate change as the MOC? Can calibrate ocean models to paleo data (the last time the MOC collapsed), but not wind models.

30. MOC Collapse Threshold: 400 � 900 ppm concentrations. Process: Rapid and likely irreversible. Timely detection very difficult given the pace. Consequences: precipitation and temperature change; fisheries effect; terrestrial ecosystems effect�

31. Coral Bleaching Threshold: 1.5 degrees C. Process: threshold response per temperature and rate of change of temperature. Timely detection: difficult, since it may have been crossed. Consequences: ecosystems changes; food production; lost tourism.

32. ENSO Changes Threshold: Deeply uncertain Process: Possible hysteresis response. Timely detection difficult. Consequences: Precipitation and temperature changes; ecosystem changes and migration; food production vulnerability; drought or flooding?, etc�

33. Greenland Ice Sheet Melting Threshold: 0.7 � 2.7 degrees C. Process: Possible response on century timescale. Timely detection likely to be feasible. Consequences: 5 - 6 m. of global SLR; MOC weakening; economic damages dependent on the pace of melting.

34. WAIS Disintegration Threshold: 2 to 3 degrees C. Process: abrupt collapse sometime over a very long time scale. Timely detection is difficult given uncertain fingerprints. Consequences: 5 � 7 m. of global SLR; severe economic damage worldwide.

35. Extreme Events (like hurricanes) The Florida experience last year. Katrina�s intensity and size. THIS SUGGESTS HIGH CONSEQUENCE IN THE PUBLIC�S RISK CALCULATOR The link from warming to warmer waters to more intense storms is speculative, but IPCC-TAR reported high confidence of the link in the future. THIS SUGGESTS LOW LIKELIHOOD IN THE CURRENT RISK CALCULATOR AND A WEAK LINK BACK TO MITIGATION FOR THINKING ABOUT ADAPTIVE RISK MANAGEMENT

36. Current State of Debate: Brief Coverage Emanuel (Nature, 2005): Some attribution of destructiveness to warming Pielke, et al. (Bull. Amer. Meteor. Soc, 2005): Premature to claim connection given human behavior and natural variability. Pew Center on Global Climate Change (Sept. 2005): connects the dots from warming to warmer water to perhaps more intensity.

37. So, the Issue of Policy Design and Research Strategies Near-term mitigation � at what level? Periodic adjustment � at what interval and on what basis? Abrupt change extreme events prioritization � what is most dangerous? Avoid Type III errors as well as the more usual Type I�s and Type II�s.

38. So, the Issue of Policy Design and Research Strategies Monitoring and prediction � what variables? Climate sensitivity Emissions (of what) Concentrations Temperature Forcing Rates of change Specific Impact variables � monitoring Specific impact variables � links to policy levers

39. Take-home Messages Hedging to minimize adjustment costs makes sense in the climate change context given enormous uncertainty in benefits. There are analogs in other policy arenas and personal decision contexts � sources of motivation and resonance. Long-term uncertainties challenge the definition of the policy adjustment processes. Public perceptions of risk and causality are critical: Accepting the �hedging� risk-management approach to the near-term policy debate. Being comfortable with the proposed adjustment processes.

40. The Elephant in the Corner:Honest Portrayal of the Science Hypothesis 1: Showing uncertainty works if decision-makers and the public adopt a risk-management approach. Hedging becomes a reason to act, though perhaps cautiously. Hypothesis 2: Honest portrayal is imperative because the bill may come due. Policy connection must be able to demonstrably lower risk (likelihood or consequence or both)

41. So What? The real frontier imperative may be selling the risk-management approach on its merits with all of its warts so that the policy and its adjustments are not oversold.