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Discounting the Benefits of Climate Change Mitigation: How Much Do Uncertain Rates Increase Valuations?
Discounting the Benefits of Climate Change Mitigation: How Much Do Uncertain Rates Increase Valuations?
Prepared for the Pew Center on Global Climate Change
Richard Newell and William Pizer, Resources for the Future
Eileen Claussen, President, Pew Center on Global Climate Change
How do we compare the costs of greenhouse gas mitigation measures taken today with the benefits produced by these actions in the future? How do we calculate the value of an investment when benefits will continue to accrue over centuries? These are important questions, because the way we value the benefits of mitigation measures will guide us in developing cost-effective solutions to the threat of climate change. This report highlights one important variable in this determination that is often left unexamined in current climate change models-uncertainty in future interest rates.
Underlying existing climate change models is a specific set of assumptions regarding emissions levels, economic growth and flexibility, technological innovation, climate change policies, and the magnitude of climate change damages. Though this set of assumptions varies from model to model, each includes a discount rate, which is used to compare costs and benefits over time. The discount rate tells us how high future benefits need to be to justify spending a dollar today. While there is considerable debate regarding the appropriate discount rate to apply to any cost-benefit analysis conducted across generations, most climate models choose one rate (2-7 percent is a common range) and hold it constant over the time horizon of the model.
This study questions that conventional approach. Rather than assuming that interest rates remain fixed over hundreds of years, authors William Pizer and Richard Newell argue that future rates are uncertain. Using an integrated assessment model of climate change, they demonstrate that acknowledging uncertainty about future rates will lead to a higher valuation of future benefits-regardless of the initial rate one chooses. This is a significant finding, because it reveals that including the effect of interest rate uncertainty could raise valuations by as much as 95 percent relative to conventional discounting at a constant rate. In other words, changing the approach to discounting in this manner results in significantly higher projected benefits of addressing climate change.
This report is the first to be published as a technical report in the Pew Center's economics series. The results of this and other ongoing Pew Center analyses will be incorporated into a dynamic general equilibrium model in order to produce a set of model estimates that better capture the full complexity of the climate change issue.
The Pew Center and authors would like to thank William Cline, Ev Ehrlich, and Randy Lyon for commenting on previous drafts of this report. The authors would also like to recognize Michael Batz for research assistance and Andrew Metrick and participants in seminars at the 2000 NBER Summer Institute and 2000 American Economic Association meetings for helpful comments on previous versions of this paper. Greater technical detail on the approach and results described in this paper are given in Newell and Pizer (2000).
Most environmental policies involve a trade-off between short-term costs and longer-term benefits. Investments in cleaner technologies and abatement equipment, for example, require up front expenditures that produce environmental improvements over time. In cases where a pollutant decays within a few years, the time horizon for analyzing costs and benefits depends on the lifespan of the investment-perhaps as long as 50 or 100 years. By contrast, the benefits of climate change mitigation measures are linked not only to the lifespan of physical capital but also to the lifespan of greenhouse gases (GHGs), which may remain in the atmosphere for centuries. For this reason, climate change presents specific challenges for determining the proper balance between future benefits and present-day costs.
This paper explores some of the analytic difficulties of applying conventional discounting techniques to long-term problems such as global climate change. In particular, the paper focuses on the influence of uncertainty in the discount rate on the valuation of future climate damages, finding that this uncertainty has a large effect on valuations at horizons of 100 years or more in the future. Relative to the standard approach that ignores this uncertainty, the paper finds that the valuation today of benefits 300 years or more in the future rises by a factor of many thousand solely due to this uncertainty in discount rates. The paper also finds that the debate over which is the "right" rate to use is rendered less important once uncertainty in that rate is taken into account.
How do we compare costs and benefits that are separated by many decades or even centuries, thereby involving intergenerational comparisons? Individual experience typically involves trade-offs of at most 20-30 years, as one invests in a new house or saves for retirement. Businesses face decisions with similar horizons as they choose to invest in research and new equipment. In each of these cases, the market interest rate plays a central role: it allows us to convert costs and benefits at different points in time into comparable costs and benefits at a single point in time. This procedure is known as discounting.
Discounting is used as a tool for modeling optimal solutions for many long-term problems, including climate change. For example, an integrated assessment model of climate change can be used to estimate the time-profile of benefits associated with the reduction of one ton of carbon emissions in the year 2000. In order to use this information to conduct a policy analysis, the standard approach would be to choose a single interest rate, convert this path of values into equivalent discounted values in 2000 based on the chosen interest rate, and add them up.
Several practical issues complicate the application of this straightforward concept. Current tax policy creates a distinction between the rate of return to corporate investments (10 percent) and the rate of return that is available to individual investors after corporate taxes (7 percent). Focusing on the rate available to individuals, there is also a difference between the rate of return to equity (7 percent), the return to bonds (4 percent), and the return to each of these remaining after personal income taxes. While no consensus exists on the appropriate rate to use for discounting, there is a tendency to focus on the return to bonds (4 percent) for evaluating longer-term policies.
There is concern, however, among economists and non-economists about using conventional discounting techniques to value public benefits over hundreds of years, where trade-offs are evaluated across multiple generations. On the basis of equity, some argue that lower discount rates should be used to compare the value of costs and benefits between generations. Such an argument is common regarding the use of discount rates in the context of climate change modeling, which involves complex projections centuries into the future.
Here we focus on uncertainty in market interest rates, and evaluate the potential consequences for long-term discounting. Few markets exist for assets with maturities exceeding 30 years, making the interest rate beyond that horizon even more uncertain than the ambiguity among pre- and post-tax returns to bonds and equity. By focusing on the impact of this uncertainty, this study shows, perhaps surprisingly, that uncertainty about future changes in interest rates can have important consequences for the valuation of benefits over distant horizons.
To best understand how future interest rates are likely to change, we examine the behavior of long-term government bond rates in the United States. These rates reveal persistent changes, including a secular decline from near 6 percent in 1800 to 3 percent at the end of the 20th century along with five noticeable shifts of at least 1 percent lasting ten years or more. This leads us to believe that it should not be surprising if persistent changes in interest rates occur in the future, i.e., future rates are uncertain.
We use these data on long-term government bond rates to estimate the uncertainty surrounding interest rates in the past, to simulate uncertain rates in the future, and to compute the appropriate discount factors for various time horizons and alternative base rates. Starting with the assumption that the initial rate should equal the average rate of return to government bonds (4 percent), but that future rates follow an uncertain random trajectory (estimated based on historical data), we find that the discount factor after 400 years is over 40,000 times higher than if we instead assume that the rate remains fixed at 4 percent forever.
When we construct similar measures of the uncertainty effect for alternative initial rates of 2 percent and 7 percent, we find that the effect of uncertainty is larger for higher interest rates-this makes sense because higher rates have a larger opportunity to decline with uncertainty and thereby raise valuations. Comparing the discount factors directly, we find that the valuation of benefits occurring in the future is less sensitive to the choice of the initial discount rate when the effect of uncertainty is taken into account. That is, not only do valuations rise when one considers uncertainty, but they become less sensitive to whether the analysis is based on the after-tax return on bonds or the pre-tax return on equities.
Applied to one estimate of the consequences of climate change, the effect of uncertainty is large. Using the government bond rate of 4 percent, the expected present value of consequences from current carbon dioxide (CO2) emissions increases by over 80 percent when we incorporate the effect of future interest rate uncertainty. An initial rate of 7 percent yields a 95 percent increase in the value of carbon mitigation, while an initial rate of 2 percent yields an increase of about 55 percent.
The results of this study show that the conventional application of constant discount rates undervalues the benefits of GHG abatement measures. Moreover, they suggest that the concern expressed by those who argue for low discount rates is at least partially addressed-without abandoning conventional economic theory-by viewing future interest rates as uncertain. While this will not yield the same dramatic effects as the decision to arbitrarily apply a lower discount rate, uncertainty does have a large effect on valuations at horizons of 100 years or more in the future.
About the Authors
Richard Newell is a fellow in the Energy and Natural Resources division at Resources for the Future (RFF). His current research focuses on the economic analysis of policy design and performance, with a particular interest in incentive-based policy and technological change. His research applications encompass a range of environmental and natural resource issues, including discounting, energy-efficiency, climate change, air pollution, and fisheries management. His methodological approaches include econometric analysis, modeling, simulation, and cost-benefit analysis.
On the research staff since 1997, Newell received his Ph.D. in public policy from Harvard University, where he specialized in environmental and natural resource economics. He also holds a master's degree in public policy and urban planning from Princeton's Woodrow Wilson School of Public and International Affairs, and undergraduate degrees in engineering and philosophy.
Newell is a member of the American Economic Association (AEA) and the Association of Environmental and Resource Economists (AERE). He has served as a consultant to state and federal agencies, environmental groups, international organizations, business organizations, and private firms.
William (Billy) Pizer is a Fellow in the Quality of the Environment Division at Resources for the Future (RFF). His current research focuses on the design and efficiency of environmental regulation under different circumstances, including uncertainty, endogenous technical change, and firm and household heterogeneity. He is particularly interested in the design of policies to address the risk of climate change due to manmade emissions of greenhouse gases.
He has worked at RFF since receiving his Ph.D. in economics at Harvard University in 1996. Specializing in econometrics and public finance, his dissertation considered the importance of uncertainty in the design of efficient climate change mitigation policies. He also holds a master's degree in economics and an undergraduate degree in physics. He is currently on leave as a Senior Economist at the President's Council of Economic Advisers.
Worker Transition & Global Climate Change
Prepared for the Pew Center on Global Climate Change
Jim Barrett, Economic Policy Institute
Eileen Claussen, President, Pew Center on Global Climate Change
A Pew Center report series on the economics of climate change has identified ways in which economic modeling can more reliably project the costs of greenhouse gas reduction policies. These studies show that better model design — for instance, more realistically portraying technological progress and flexibility in the economy — can yield substantially lower projections for the costs of addressing climate change. They provide strong evidence that a rational climate policy that sets realistic short-, medium-, and long-term goals can achieve significant environmental gains while minimizing economic costs.
At the same time, it is important to recognize that the costs of addressing climate change are likely to fall disproportionately on certain industries, communities, and workers, and to explore ways to minimize these adverse impacts. This report draws from past worker transition efforts to recommend ways the government can best assist workers who may suffer economic dislocation as a result of climate change policies. A Pew Center report released simultaneously examines potential impacts on U.S. communities, and a future Pew Center report will evaluate competitiveness issues.
In the case of worker transition, the government has considerable experience assisting workers adversely affected by policy choices and market forces. Author Jim Barrett draws lessons from these government programs and outlines the building blocks of a worker transition program that could assist workers adversely affected by climate change policies. The report recommends that such a program include:
- Substantial retraining and/or education for laid-off workers;
- Substantial income support for program participants;
- A bridge to retirement for workers nearing retirement age that maintains their standards of living and retirement benefit levels;
- Maintenance of laid-off workers’ health and pension benefits until they find suitable employment;
- Rapid response programs to ensure prompt service provision, and avoidance of detailed eligibility requirements;
- Advance notice of layoffs when possible;
- Work with unions to inform workers about program availability and to administer services;
- Performance standards that avoid the unintended consequences of the overly simplistic standards used in the past; and
- Requirements and funding for assessments of the program’s effectiveness by comparing outcomes for participants and non-participants, and allowing for mid-course corrections.
Clearly, some steps recommended in these reports will require funding. As policies to address climate change are developed, revenue streams from related fees (e.g., permit fees or auction revenues) could be used to assist with these programs. Addressing climate change through sound policy will make it possible to achieve our environmental objectives while shielding workers and communities from potential economic harm. Pew Center and the author wish to thank Susan Teegarden, Andrew Hoerner, Robert Ginsburg, Ev Ehrlich, Yolanda Kodryzycki, and Les Leopold, who offered helpful comments on previous drafts of this report. The author also would like to thank Brigit O’Brien and Terrel Hale for their research assistance.
With most scientists and politicians agreeing that human-induced climate change is a potentially serious problem, the question of how nations respond to it, if at all, now seems to hinge on the perceived costs of action and inaction. Several attempts have been made to estimate the cost to the U.S. economy of reducing carbon and other greenhouse gas emissions. While there remains substantial debate over the net costs (or benefits) of various policy alternatives, there is little debate over the fact that reducing emissions will have potentially negative impacts for certain sectors of the economy and their workers. Any major reduction in carbon emissions in the United States will almost certainly require a decline in demand for fossil fuels, and, therefore, will result in employment losses in the coal, petroleum, and electricity industries, and possibly other sectors as well.
The question often arises: What policy options are available to address the needs of impacted workers?
The United States has substantial experience with programs aimed at helping workers dislocated both by policy choices, such as trade agreements and environmental regulations, and by market forces, such as the ongoing shift away from manufacturing and toward a service-based economy. The Trade Adjustment Assistance (TAA) program established in the 1960s was designed to aid workers displaced by the effects of international trade, while the Job Training Partnership Act (JTPA) was aimed at workers displaced for any reason. The experiences of these programs can provide valuable guidance for the design of policies aimed at dealing with workers displaced by climate change policies. In 2000, both programs were subsumed by the Workforce Investment Act (WIA), which would serve workers dislocated by climate policies if they were to be laid off today.
Examinations of TAA and JTPA raised important questions about the effectiveness of their training components. Studies have found that the majority of participants who subsequently found jobs were employed in occupations unrelated to their training programs. A closer look at the evidence shows that there can be sizable gains from retraining displaced workers, with some studies finding significant benefits through higher wages at reemployment. The evidence also appears to indicate that the quality of training may be as important as the quantity.
In addition to training and education, another important aspect of worker displacement programs has been income support for participants. Both TAA and JTPA are meant to provide support for their participants, although many, including the vast majority of JTPA participants, received little or no support. Aside from the obvious hardships this can impose on workers and their families, it also had substantial impacts on the ability of the programs to move workers successfully into new jobs. A study of one JTPA program found that over the first year following layoff, program participants earned about 20 percent less than displaced workers who did not join a program. While participants’ earnings recovered substantially over time, the cost of participating in the program, in terms of lost earnings over the first year, represents a substantial barrier to participation.
While some workers likely opted out of programs due to lack of income support or other reasons, some may have been discouraged from participating. The use of performance-based contracts, which pay service providers based on reemployment and wage replacement rates, can give providers the incentive to filter out the workers who are more difficult to place and who might bring averages and compensation down. TAA had substantial problems in serving its intended population as well. One audit found that the eligibility determination process arrived at an incorrect conclusion in over 60 percent of cases.
There are a wide range of lessons that can be drawn from previous programs to help inform the design and administration of a successful program to assist workers affected by climate change policies. A critical, if broad, lesson is that numerous tradeoffs exist that can make designing an effective program difficult. At the same time, some tradeoffs that are assumed to exist may not. Continuing to assume that they do can be equally limiting.
Both TAA and JTPA have tried to strike a balance between providing compensation to workers and providing incentives to leave programs as quickly as possible. For JTPA, those incentives appear to have been too strong. A large majority of eligible workers (as many as 93 percent) never entered programs in the first place. Under JTPA and now WIA, the goal of compensation has been sacrificed in the name of efficiency. However, income compensation and training appear to be complementary, so that increasing compensation can enhance training outcomes and program success. With limited resources, unfortunately, training and compensation appear to be substitutes at least in the budgetary sense.
While providing for substantial retraining is an essential element of a successful transition program, it is no guarantee of success. Despite the relatively long training programs in TAA projects, reemployment outcomes have been disappointing, due largely to inadequate job search and placement services and to mismatches between training programs and labor market demand. Careful design of training programs and the provision of job search and placement services will be critical to the success of a climate change transition program, particularly given the long tenure and deteriorated labor market skills likely to characterize many of the program’s participants.
In addition to some of the larger issues like income support, there are numerous factors in the administration of transition programs that can help determine their success or failure. Some of these issues have already been addressed in WIA. The continuous operation of WIA offices and rapid response teams can help keep the lag time between layoff and program entry low. Addressing layoffs at the earliest possible stage can increase the legitimacy of the program and help workers face the reality of permanent separation from their jobs. This approach increases participation rates and reduces the lag time between layoff and program entry.
To ensure that these workers have access to training options, two conditions must exist. First, training programs must be offered that can serve their needs. Second, training providers must have a limited ability to exclude or discourage clients who are difficult to place. If these conditions are met, it may be possible to employ performance-based standards successfully. To ensure that programs suitable for the hard to place are available, a successful program needs to offer sufficient incentive to trainers to offer such programs. One approach is to offer higher payments for placements of the difficult to place. Rather than offer payment based on the number of people placed, a system could offer payment based on the expected intensity of training required. This approach would offer increased incentives for training providers to design programs for workers who need the most help.
A more fundamental issue is the appropriateness of a program explicitly designed to serve one type of worker and not another. To a laid-off worker, and possibly to society as a whole, it may seem arbitrary to deny or approve benefits based on whether it can be proven that climate change policies contributed to the layoff. Climate change policies may be only one of a combination of causes leading to a layoff, particularly for industries already in decline. Any eligibility restriction based on climate change policies will thus be difficult to implement.
The following elements appear critical to the success of a transition program aimed at helping workers dislocated by climate change policies or other causes:
- Substantial retraining and/or education should be available for laid-off workers.
- The program should provide substantial income support for program participants.
- For those workers nearing retirement age, the program should provide a bridge to retirement that maintains their standard of living as well as their retirement benefit levels.
- The program should maintain health and pension benefits of laid-off workers until they find suitable reemployment.
- To help ensure that services can be provided as quickly as possible, rapid response programs should continue to be employed, and detailed eligibility requirements should be avoided whenever possible.
- The program should encourage advance notice of layoffs when possible.
- The program should work with unions to inform workers about the availability of programs and to administer services.
- The program should establish performance standards that avoid the unintended consequences of the overly simplistic performance standards used in the past.
- The program should require, and provide funding for, assessments of the program’s effectiveness by comparing outcomes for participants and non-participants, and allow for mid-course corrections.
Press Release: Easing the Burden: Two New Reports Identify Steps for Reducing the Economic Impacts of Climate Action
For Immediate Release:
December 5, 2001
Contact: Katie Mandes
Easing the Burden: Two New Reports Identify Steps for Reducing the Economic Impacts of Climate Action on Affected Communities and Workers
Washington, DC - Policymakers can do a great deal to ease the economic burden of addressing climate change by taking specific steps to assist affected workers and communities. This according to two new reports released today by the Pew Center on Global Climate Change.
"Responding to climate change means reducing greenhouse gas emissions, and that means making a shift from the current carbon-intensive economy to an economy that relies less on fossil fuels," said Pew Center President Eileen Claussen. "This shift is in everybody's interest, but it will not affect everybody equally. As a result, we need to be thinking now about how to assist those workers and communities that will be affected by the policy choices we make. Rather than leave them behind in our quest for a new economy, we must give them the tools and the resources they need to play their rightful role in our future success."
Focusing on the workers and communities that are likely to be most affected by efforts to address climate change, the Pew Center reports recommend worker retraining programs, economic adjustment initiatives for affected communities, and other steps. According to Claussen, the cost of these and other initiatives would amount to a small fraction of the overall bill for dealing with climate change. She added that permit fees and other revenues related to the implementation of new climate policies could provide an important source of funding for the transition efforts.
Worker Transition & Global Climate Change
Any major reduction in greenhouse gas emissions in the United States will almost certainly cause a decline in demand for fossil fuels. The result could be employment losses in the coal, petroleum, and electricity industries, and possibly in other sectors as well.
Worker Transition & Global Climate Change is a Pew Center report written by Jim Barrett of the Economic Policy Institute. The report draws lessons from the government's experience assisting workers who were adversely affected by policy choices and market forces in the past. The author also outlines the building blocks of a worker transition program that could assist workers adversely affected by government efforts to address climate change.
This report recommends that a worker transition program include:
- Substantial retraining and/or education for laid-off workers, as well as income support for program participants;
- A bridge to retirement for workers nearing retirement age that maintains their standards of living and retirement benefit levels;
- Maintenance of laid-off workers' health and pension benefits until they find suitable employment; and
- Advance notice of layoffs whenever possible.
Community Adjustment to Climate Change Policy
Efforts to avert global climate change are also likely to place certain communities at risk of economic dislocation. Affected communities could include those with large numbers of jobs in energy production, such as coal mining communities in Wyoming or oil producing areas of Louisiana. Also affected could be communities with energy-intensive industries-for example, parts of Pennsylvania with steel manufacturing operations.
Community Adjustment to Climate Change Policy was authored by Judith M. Greenwald of the Pew Center on Global Climate Change, Brandon Roberts of Brandon Roberts & Associates, and Andrew D. Reamer of Andrew Reamer & Associates. Based on a survey of how policymakers in the United States and elsewhere have responded to similar challenges in the past, the report suggests that appropriately designed programs can lessen the pain of economic adjustment considerably.
The report recommends a new federal adjustment program for communities as part of global climate change policy, and calls on U.S. policymakers to take the following steps:
- Designate and fund the Economic Development Administration (EDA) of the U.S. Department of Commerce to design and implement an economic adjustment program for communities;
- Identify and assist communities that are particularly dependent on energy-producing and energy-intensive sectors before dislocations occur;
- Leverage and integrate additional resources by involving multiple federal agencies and state and local governments through regional task forces; and
- Support the development and implementation of locally determined, comprehensive adjustment strategies.
A future Pew Center report will address the issue of competitiveness for those industries affected by climate change policy.
The full text of both reports is accessible on the Internet:
The Pew Center was established in May 1998 by the Pew Charitable Trusts, one of the United States' largest philanthropies and an influential voice in efforts to improve the quality of the environment. The Pew Center is conducting studies, launching public education efforts and working with businesses to develop market-oriented solutions to reduce greenhouse gases. The Pew Center is led by Eileen Claussen, the former U.S. Assistant Secretary of State for Oceans and International Environmental and Scientific Affairs. The Pew Center includes the Business Environmental Leadership Council, which is composed of 36 major, largely Fortune 500 corporations all working with the Pew Center to address issues related to climate change. The companies do not contribute financially to the Pew Center - it is solely supported by contributions from charitable foundations.
Climate Change: A Strategy for the Future
Speech by Eileen Claussen, President
Pew Center on Global Climate Change
Honors Colloquium on a Just and Sustainable Future
University of Rhode Island
September 25, 2001
I am very happy to have the opportunity to address this honors colloquium, and I want to pay tribute to the faculty, staff, and students here at the University of Rhode Island's Sustainable Communities Initiative for trying to come to terms with a very serious question-and that is, how do we create a just and sustainable future?
This, of course, is an extraordinary time, and a just and sustainable future may seem very far away as we ponder the horrific events of two weeks past. Usually, when I give a speech, I try to begin with some humor, and I do this because I think it is important that we not take ourselves, or our specific issues and interests, too seriously. But I think the events of September 11th have cast an enormous shadow over all of us-and, with it, a sadness and a seriousness of purpose that we cannot escape. And so I ask you, for the next short while at least, and for longer if you can, to be thoughtful about the issue of climate change, because it, too, requires us to be serious and reflective and determined about what we need to do to make the world a safer place.
In talking about climate change today, I want to touch first on the science - and, more specifically, on the ever-solidifying scientific consensus that this is a very serious problem that demands very serious action. I'd like to talk broadly about the challenge we face, and the ways in which many in the business community are rising to that challenge. I'll turn then to the essential role of government - both internationally and here in the United States. And, finally, I will suggest how we might forge a common path forward that is sustainable, just, and fair to all.
Our goal must be to facilitate the arrival of a second industrial revolution. And this means doing all we can to accelerate the development of new technologies that will move us closer to a low-carbon world economy.
The Science of Climate Change: A Few Observations
Let us focus first on the science of climate change. The Intergovernmental Panel on Climate Change (or IPCC) is a body created by the United Nations to reach scientific consensus about the magnitude and nature of the climate problem. In its "Third Assessment Report," approved in January of this year, the IPCC said it now expects the global average surface temperature to rise by between 2.5 and 10 degrees Fahrenheit over the course of the 21st century. This is a much greater increase than projected just five years ago. Even at the low end of the projection, the warming trend is expected to cause significant problems-more sea level rise, droughts and floods; increasingly violent storms; damage to our ecosystems; effects on the availability of water; and impacts on our forests and agriculture. And the higher-end projections of 10 degrees or more could prove catastrophic. Studies from the IPCC and others also confirm that greenhouse gases produced by human activities, mainly the burning of fossil fuels, are the principal cause of the continuing warming trend.
These findings were confirmed in June by a panel of the National Academy of Sciences, put together at the request of President Bush, and including some scientists who had previously expressed skepticism about the nature and pace of global climate change. The NAS report also affirms that temperatures at the Earth's surface already are rising and that the warming trend has intensified in the last 20 years.
What will be the impact of climate change here in Rhode Island? While it is hard to pinpoint impacts on a state-by-state basis, it is fair to say that Rhode Islanders-and, indeed, all New Englanders-will see temperatures rise, along with significant increases in precipitation. Fragile coastal ecosystems could be at risk as global sea levels rise, barrier reef islands are inundated, and we see an increase in the frequency and severity of storms-as scientists expect we will. Sea-level rise also could lead to flooding of low-lying property, loss of coastal wetlands, erosion of beaches, saltwater contamination of drinking water, and damage to low-lying roads, causeways, and bridges. Agricultural production will surely be affected both here and elsewhere because of warmer temperatures, less soil moisture, and other climate change-related problems. And the possibility of health problems, including increases in heat-related illnesses, cannot be discounted.
The bottom line is that if we need a reason to act on this issue, the latest science certainly provides one. The fact that there is uncertainty about exactly how much temperatures will rise or what the precise effects will be should be expected. Both the IPCC and the NAS have identified a number of critical research challenges that need to be addressed in the coming years. But, increasingly, the science tells us we would be irresponsible not to take the threat of climate change very seriously.
A Second Industrial Revolution
How, then, do we address this threat? How do we avert the many risks that the scientific community is warning us about? Quite obviously, we must reduce our emissions of the greenhouse gases that are contributing to climate change. And to do that, we must launch a new industrial revolution.
This will be a revolution characterized more than anything else by a growing reliance on low-carbon and even no-carbon energy sources to power the world's continuing economic development and growth. We must embrace the possibility of "decarbonizing" our economies. At the same time, we must also be realistic about what can be done and in what time frame. Before you start to think of me as a latter-day Pangloss, let me assure you that I am fully aware that all countries will continue to use petroleum and coal for many years to come. The challenge with respect to these traditional fuel sources will be to promote ever-increasing levels of efficiency in their transmission and use at the same time as we are working to develop and deploy cleaner energy sources for the future. Coal currently accounts for 24 percent of the United States' total primary energy supply-and a remarkable 57 percent of China's. Even if these numbers edge downward-as they are already doing with the introduction of increasing numbers of natural gas-fired power plants-the predominance of coal in the worldwide energy mix means we need to find and embrace cleaner-burning ways of using it. And we need to think seriously about sequestering coal-related carbon dioxide emissions.
But these types of steps clearly will not be enough. The bottom line is that we need new technologies to meet the energy and environmental challenges we face. To effectively address climate change, we need to lower carbon intensity (that is, the amount of carbon we emit per unit of GDP); we need to become more energy efficient, so that we use less energy to achieve the same results; we need to promote carbon sequestration, so that the carbon we do emit does not enter the atmosphere and affect the climate; and we must find ways to limit emissions of non-CO2 greenhouse gases. This will require fundamentally new technologies, as well as dramatic improvements in existing ones. New, less carbon-intensive ways of producing, distributing, and using energy will be essential. The redesign of industrial processes, consumer products, and agricultural technologies and practices will also be critical.
These changes need not take place overnight. They can be introduced over decades as we turn over our existing capital stocks and establish new infrastructure. But we must begin making the investments needed to usher in this new industrial revolution, and we must begin making those investments now.
Industry Takes the Lead
Many businesses, in fact, already are taking important steps to address climate change. About half of the 36 companies that are part of the Pew Center's Business Environmental Leadership Council have set specific, quantitative targets to reduce their greenhouse gas emissions, and others are working toward establishing these objectives. Consider DuPont, a corporation that is well on its way to achieving its goal of reducing greenhouse gas emissions by 65 percent before 2010, relative to 1990 levels. Or Baxter International, which is committed to improving its energy efficiency by 30 percent below 1996 levels by 2005. Or IBM, which has committed to having 90 to 100 percent of its new model computers meet Energy Star criteria for energy efficiency.
Other companies, too, are making process and efficiency improvements that are yielding real reductions in emissions. The energy company Enron, for example, reduced its greenhouse gas emissions by controlling leaks in its natural gas pipelines. And TransAlta Corporation improved its energy efficiency by about 4 percent when it upgraded old, less efficient turbines and other systems.
In addition to these types of steps, some companies are investing in dramatic changes to their production processes. Alcoa, for example, is developing a new technology for smelting aluminum that, if successful, will allow the company to reduce its greenhouse gas emissions to half their 1990 levels over the next nine years. Similarly, Shell aims to achieve its greenhouse gas reduction target by revamping its disposal of the waste gases resulting from oil and gas production, even as it puts increasing emphasis on renewable energy sources.
The States are Moving
We are also beginning to see real movement on this issue from a number of states. On August 28th of this year, the New England Governors and Eastern Canadian premiers approved a comprehensive Climate Change Action Plan at their annual meeting. This plan includes goals of returning the levels of greenhouse gas emissions to 1990 levels by 2010, reducing them to 10% below that level by 2020, and putting in place a process to review, adjust and add new goals.
The state of New Jersey is hoping to reduce its levels of greenhouse gases by 3.5% from 1990 levels by 2005. The state of Oregon has put in place carbon dioxide standards for new power plants. The state of Massachusetts is regulating its highest emitting power plants, and expects to see significant reductions in emissions by 2008. And many others are experimenting and beginning to implement different approaches to addressing the climate change issue.
The Role of Federal Government Action
All of these are important developments-and they show how increasing numbers of leading companies and states see a clear interest both in reducing their emissions and in helping to shape the energy economy of the future. But voluntary actions undertaken on a largely random basis by some members of the business community or by a small handful of states are not enough. In the United States, we have had voluntary efforts in place for much of the past decade, and still we have seen a dramatic rise in emissions - almost 12 percent over 1990 levels.
In the end, there is little incentive for any company or state to undertake real action unless, ultimately, all do-and unless all are in some manner held accountable. Markets, of course, will be instrumental in mobilizing the necessary resources and know-how. Market-based strategies such as emissions trading will also help deliver emissions reductions at the lowest possible cost. But markets can move us in the right direction only if they are given the right signals. It is our national government's job to send the right signals.
Government can and must play a critical role in establishing the ground rules for the energy economy of the future. Because this is a global problem that must eventually be solved globally, it means sending global signals and establishing mandatory global frameworks for action, because each country must be assured that others will act too. And it means, in turn, the adoption of mandatory programs on a country-by-country basis. What truly matters, of course, is what individual countries and individual businesses do to reduce their individual contributions to this problem. And there is no substitute for actually requiring countries and businesses to reduce emissions, because it is in the process of trying to meet clear objectives that innovation will flourish.
The Significance of the "Kyoto Compromise"
Is government rising to the challenge? Looking first to the international arena, we see that the world community-minus one very important player-has at long last agreed on a set of first steps to address climate change.
As all of you know, over the summer in Bonn, Germany, 178 nations reached a tentative compromise on the rules that will allow the Kyoto Protocol to enter into force. The Kyoto Protocol, of course is the agreement first negotiated in 1997 that requires developed countries to reduce or limit their emissions of greenhouse in relation to 1990 levels, with different countries agreeing to different targets.
In addition to establishing targets, the Kyoto Protocol outlines how countries can achieve them-for example, by making emission reductions at home, by trading emission credits with others, and by using "sinks" such as farms and forests to remove carbon from the atmosphere. Although many of the details on how these mechanisms will work still need to be decided, the compromise reached in Bonn will likely provide countries with a high degree of flexibility in how they use these various strategies. And this, I believe, is a very important and positive development, because it will permit countries and businesses to meet their objectives in the most cost-effective ways.
But the Kyoto Protocol is just a first step on what will be a long march to a less carbon-intensive world. Its initial targets for emission reductions take us only to the 2008-2012 period, and they represent just a very small down payment on the level of reductions that scientists say we must achieve in order to have a real effect on mitigating climate change.
It is also important to note that the ultimate impact of the Kyoto Protocol will be severely limited by the United States government's decision not to be a party to the agreement. The Bush Administration has said repeatedly that it believes Kyoto is fatally flawed and not acceptable to the United States. Granted, the Protocol does have its problems-it is, after all, an agreement of approximately 180 countries with differing aspirations, differing economies, and differing views of the environment. But I believe that the other nations of the world, in agreeing to a compromise solution in Bonn, decided to send a message to the United States that an imperfect agreement is better than none-and that we cannot wait any longer to begin working together to solve the most important environmental issue facing the world today.
The Kyoto compromise very clearly does not amount to a solution to the problem of climate change. Rather, it is a first, strong statement of purpose and will to deal with this problem. And, therefore, it is an essential and historic step.
Launching Domestic Efforts in the U.S.
And what of the United States? Interestingly, in the same way that the Bush Administration's rejection of Kyoto seems to have galvanized international support for the Protocol, it appears to have generated new momentum on Capitol Hill to finally begin tackling the challenge of climate change. It is too early to know how the tragic events of September 11 will affect this and so many other vital issues in the months ahead. But prior to those events, there were strong indications that Congress was more prepared than ever to begin building the programs needed to reduce greenhouse gas emissions here in the United States.
It is important to note that this new support comes from both sides of the aisle. Perhaps the biggest sign of a "changing climate" in Congress is legislation introduced by Senator Robert Byrd of coal-producing West Virginia and Senator Ted Stevens of oil-producing Alaska. In addition to providing money for technology research, the Senators' bill would require the President to develop a climate change strategy aimed at stabilizing greenhouse gas concentrations in the atmosphere. Senators John McCain and Joseph Lieberman - another bipartisan team - are going even further. They have announced that they plan to introduce major legislation to require greenhouse gas reductions throughout the economy under an emissions trading system - a proven way to cut emissions cost-effectively, and one that we strongly support.
What are some of the other key elements of a serious domestic program? We need, first and foremost, an energy policy that is climate-friendly. We need policies to deal with energy-using products, such as automobiles and appliances, so that they use fuel more efficiently and are compatible with different, non-fossil fuels. And we need a technology policy that will speed our development and diffusion of new technologies.
None of this will happen overnight. But there is good reason to believe that as we approach the mid-term congressional elections next year, and the presidential election in 2004, the prospects will grow only stronger. And as the United States begins to demonstrate real effort to curb its own emissions, it can credibly reenter the international dialogue and work more closely with other nations to chart a common path forward.
Which leads me to the "strategy for the future" that is mentioned in the title of my remarks. The strategy, in my view, is to insure that the Kyoto Protocol stays on the road to ratification and entry into force, while the United States begins to pursue good-faith domestic efforts to reduce its greenhouse gas emissions. To the extent that U.S. efforts are compatible with the Kyoto framework-and I hope they will be compatible-then the world can still hold out hope that the two roads will eventually merge, yielding a truly global plan of action.
Resolving the Equity Issue
Achieving that global strategy, however, will mean coming to terms with an issue that has loomed over the climate debate from the start, but has yet to be faced head-on - and that is the issue of fairness. For as the title of your colloquium, "A Just and Sustainable Future," rightly suggests, this is not about sustainability alone, but justice as well. Indeed, it is hard to imagine a future that is truly sustainable unless it is also fair and just.
From Rio in 1992 through Kyoto in 1997 and up to the most recent round of negotiations in Bonn, the international climate talks have proceeded on the basis of a common understanding: developed countries must act first. This bargain of sorts - which obligates one group of countries to act with the understanding that the other group will follow - acknowledges the fundamental inequities presented by climate change. It is an undeniable fact that developed countries account for the vast majority of the greenhouse gases put in the atmosphere over the past century, and that their per capita emissions are many times those of developing countries. (The United States, for example, contributed nearly a third of worldwide emissions last century and continues to produce roughly a quarter of global emissions with only 4 percent of the world's population.)
But historic responsibility for climate change is just one piece of the equity equation. It is also undeniable that those least responsible, the developing countries, face a disproportionate share of the impacts of global warming - from flooding to disease to famine - while having fewer resources with which to cope.
So while many in the United States, including President Bush, fault Kyoto for letting developing countries off the hook, I believe it is only fair that the developed countries act first. But I also believe that, in time, the developing countries must act too. Indeed, the emission reduction efforts finally getting underway in the industrial world will be pointless unless developing countries agree in some way to restrain the rapid rise in their own emissions.
It is important to recognize the steps already being taken by developing countries. Measures such as market reforms and energy efficiency improvements, while more often motivated by concerns other than climate change, are, in fact, resulting in significant emissions savings. China, for example, cut carbon dioxide emissions by more than 10 percent over the last five years. But far more effort is needed. In a series of reports looking at electric power in developing countries, the Pew Center found that emissions from that sector alone will triple by 2020 under a business-as-usual scenario. However, we also found that efficiency improvements and the introduction of low-emission technologies could cut this increase in half while maintaining economic growth. Once again, technology is absolutely critical.
Arriving at a truly global strategy, then, will require a fundamental rethinking of the approach taken so far. The straightforward targets set by Kyoto - cutting each country's emissions by an agreed percentage - will hopefully succeed in starting industrialized countries on the right path. But a framework that encompasses both developed and developing countries, and fairly apportions responsibility among them, will have to be more sophisticated. It will have to accommodate the legitimate desire of developing countries to raise their living standards. It will have to recognize that different countries face very different challenges - for developed countries, the challenge is converting from the existing energy infrastructure to a clean one, while for developing countries, it is much more a matter of building the infrastructure right in the first place. An effective global strategy also will have to mobilize the flow of technology, know-how and resources from wealthier nations so that poorer countries are in a position to keep up their end of the bargain. In that sense, our challenge is to ensure not only that the new industrial revolution is launched, but also that its fruits are shared quickly and fairly.
These are my thoughts on where we stand in our effort to spare future generations the grave risks of an overheated planet. Enormous challenges lie ahead. But there are promising signs, both internationally and here in the United States, that we are at last mustering the will to begin confronting them. We must seize on that momentum, and keep moving forward. Thank you.
Oil & Gas Markets and
Climate Change Policy
August 9-10, 2001 - Snowmass, Colorado
On August 9 and 10, 2001, The Pew Center hosted a workshop in conjunction with the Energy Modeling Forum of Stanford University to bring together experts from around the world to discuss the manner in which economic models portray fuel use. Determining future supply and demand of natural gas (NG) is important in determining climate policies since natural gas is a relatively cleaner fuel – in terms of carbon emissions – than are coal and oil. A climate policy based on reducing the carbon content in fuels would presumably favor gas, along with other less carbon-intensive energy sources, thus accelerating its demand.
But economic models that examine the climate change issue show mixed results on this score: many models show the demand for gas increasing relative to more carbon-intensive fuels while others show its demand decreasing at a rate faster than oil (which is explained by gas demand being more responsive to a tax). Without clear information on the true path of natural gas, policy-makers will not be fully informed on how to address the climate change problem. The modelers took first steps towards investigating this problem by determining common definitions for various oil and gas categories and expect to be able to compare results of their various models regarding oil and gas consumption early next year.
Other topics discussed in this workshop included the anticipated supply of various fuels, primarily oil and gas, and the factors that determine the ultimate level of global reserves, the potential for developing a world market in natural gas through liquefaction, and advances in technology which influence the cost of production of oil and gas.
Addressing Climate Change and Growing the Global Economy: Can We Do It?
Lake Louise Energy Conference
January 26, 2001
Thank you very much. It is a great pleasure to be here with such an interesting and distinguished group of business and investment leaders. And how appropriate to be discussing the implications of global climate change against the backdrop of the beautiful Victoria Glacier and glacier-fed Lake Louise. In assessing the future of this remarkable area under a global warming scenario, I can't help but borrow from the investment lingo and say this: the glacier may not have much of a future, but there are real growth opportunities for the lake.
Seriously, I truly appreciate this opportunity to provide you with some perspective on: 1) what is happening on the issue of climate change today; 2) how this might affect your business and investment decisions in the years ahead; and 3) more fundamentally, whether we can address climate change and still maintain a growing global economy.
In preparing for my speech, I found it helpful to think of it as a visit to the ski slopes. I will take you up the lift with a brief overview of where things stand today, and then we will be free to explore the trails ahead. Rest assured that I fully intend to avoid any extreme plunges or expert runs. I am reminded of the old definition of a skier as someone who pays an arm and a leg for an opportunity to break them.
One of the messages I want to convey to you today is that climate change is real. The earth is warming, and the human hand in this warming is becoming clearer and clearer. A report due this spring (and already leaked) from the United Nations' Intergovernmental Panel on Climate Change suggests that the upper range of global warming over the next 100 years could be far higher than previously thought, with temperatures rising by 11 degrees Fahrenheit since 1990. By comparison, average temperatures today are 9 degrees Fahrenheit higher than they were at the end of the last ice age.
Even at the low end of the projected warming range, we can expect to see significant changes in weather patterns and sea-level rise. Such changes will be accompanied by effects on areas as diverse as human health, managed ecosystems (such as agriculture and water supply systems), and natural ecosystems. You may have heard that these changes could bring with them potential benefits as well as risks for certain regions - particularly parts of North America, where temperature increases could lead to longer growing seasons. But it is important to note that any positive impacts from global warming are unlikely to be sustained as the globe continues to warm. At higher temperatures, even high-latitude areas will eventually face decreased crop yields and negative impacts.
In the same way that we must accept that climate change is real, we must also accept that the time will have to come when we become significantly less dependent on the sources of energy that have fueled the world economy since the dawn of the Industrial Revolution. Environmental necessity, combined with the relentless drive to improve efficiencies and reduce costs, will spur a movement away from fossil fuels and toward a new energy future. And while it will be neither cheap nor easy, rewards will surely come to the early adopters and first movers. The task at hand is to allow these first movers the ability to experiment and innovate, while at the same time establishing the framework that sends clear signals to the market about what must be done in the long term.
Where Things Stand Today
So where do we stand today on responses to climate change? As we board the ski lift, I caution you to heed the advice of an actual sign on a lift in Taos, New Mexico. The sign reads: "No jumping from lift. Survivors will be prosecuted." That reminds me of another actual sign I heard about that read-and I quote-"Door Alarmed." Nearby, someone had posted a hand-made sign reading, "Window Frightened."
Well, in November, a great many people became both frightened and alarmed-or at the very least, somewhat concerned-about the current status of the international negotiations on climate change. As all of you know, that was when negotiators from 180 countries gathered in The Hague for the latest round of global climate talks. The goal of the meeting-officially known as the Sixth Session of the Conference of the Parties to the Framework Convention on Climate Change, or COP 6-was to put the finishing touches on the rules needed to implement the Kyoto Protocol. The Kyoto Protocol is the international agreement negotiated in 1997 that commits industrialized countries, including Canada and the U.S., to binding reductions below 1990 levels in their emissions of greenhouse gases.
The talks in The Hague, however, failed to reach their intended outcome. One of the key sticking points was how to account for the role of forestry and land-use practices in keeping carbon dioxide out of the atmosphere. There also was no agreement on whether there should be limits on how much of a country's emission reductions could be achieved by actions taken abroad, either through emissions trading, the Clean Development Mechanism or joint implementation.
But the standoff in The Hague should not have come as a complete surprise. There is no escaping the fact that expectations for the talks were too high. I can only compare it to the expectation that Washington, D.C. will become a partisanship-free zone in the wake of the 2000 presidential election. If you believe that one, then I have a bridge to the 22nd century that you might be interested in purchasing.
As we consider why the November meeting failed, as well as what needs to happen now, it is important to remember how we arrived at this point. The Kyoto Protocol was negotiated in recognition of the fact that the emission reduction provisions outlined in 1992's U.N. Framework Convention on Climate Change were not effectively limiting atmospheric concentrations of greenhouse gases. It had become eminently clear that the voluntary measures spelled out in the Convention were inadequate. Few developed countries were on track to reducing their emissions to 1990 levels by 2000, as they voluntarily agreed to do.
Under the Kyoto Protocol, industrialized countries agreed to binding emissions reductions during the period from 2008 to 2012, with countries' targets averaging about 5 percent below 1990 levels. The Protocol also began to outline how countries could achieve their targets-for example, by trading emission credits or by using "sinks" such as forests to remove carbon from the atmosphere. However, further elaboration of the rules that would allow the Kyoto Protocol to enter into force was still needed.
The breadth of the agenda for the meeting in The Hague--approximately 275 pages of text covering the full spectrum of tough political and technical issues-was enough to give new meaning to the term "full plate."
But the fact that the agenda was dominated by many complicated political and technical issues was not the only reason the talks failed. The U.S.-EU split on the issue of carbon sinks was emblematic of a deep divide between Europe on one side and the United States on the other over how best to respond to climate change. The EU takes as its starting point the need to effect widespread-and immediate-behavioral changes to address this problem: using public transportation, for example, and keeping our houses colder in the winter and warmer in the summer.
In contrast, the United States, Canada, Australia and Japan come down on the side of short-term, cost-effective actions, coupled with an effort to develop and deliver the technologies that will be needed for the long-term.
The negotiating positions inherent in these distinct philosophical approaches proved too far apart to bridge in The Hague. And there were other difficulties as well. These included the inability of the European Union to reach internal agreement on how to proceed; the position of the United States and others that credit should be given for "business as usual" activities and practices; and the virtual neglect of the developing world, which had important contributions to make to the discussion, and which would have to be a part of any consensus that emerged from the meeting.
The result of all these difficulties was a failed meeting, and although most countries are anxious to pick up the scattered ideas and pieces of negotiated language and meld them back together again, it is clear that this can only happen if there is a willingness to compromise. And, in this instance, compromise will mean the acceptance of different approaches under a common Kyoto umbrella. Hope is not a strategy, but I am hopeful that over time, we will develop a framework that will allow for these differences of view.
The Response from Business
So now we have taken the lift to the top of the mountain with an overview of where things stand today. I hope you are all still with me, and trust that no one has jumped off into the snow. (If you did, I understand that the Canadians have a wonderful health care system, and you will be back on your feet in no time.)
As I promised at the start of my speech, I will use the time I have left to explore the trails ahead. And I can think of no better place to start than by exploring the role of business in national and global efforts to reduce the risk of climate change.
Over the past several years, we have witnessed a remarkable shift in business activity and thinking on the issue of climate change. Many corporate leaders in North America and throughout the world no longer view climate protection efforts as a threat. Rather, they acknowledge the strength of the scientific case for action. And they accept that businesses must play a leading role in the global effort to reduce emissions.
I found it particularly interesting, in fact, that it was not just government officials and environmentalists who were disappointed in the unhappy ending to the talks in The Hague last November. Business leaders, as I mentioned before, also were notably glum. As a representative of the International Chamber of Commerce put it in an interview with the Los Angeles Times:
"We came here expecting a decision which would have clarified the rules and guidelines of the Kyoto Protocol. We now walk away as empty-handed as everyone else and leave as confused as when we arrived about the role we might play in contributing to solutions."
Or, as another business representative said, "There was industry, all dressed up with nowhere to go."
But all hope is not lost. Disappointing as the meeting in the Hague was for the progressive business community, most companies will forge ahead with existing programs to reduce their emissions, encourage greater energy efficiency, begin a switch to less carbon intensive fuels, and continue to develop alternative energy technologies. What they may not do is to undertake activities that are dependent on the Kyoto rules. For example, some industries are eager to pursue emissions-reducing power projects in other countries. But they are unlikely to move ahead vigorously until they know what kinds of projects will be eligible for credits under the Protocol. Similarly, there are many companies in a variety of industries that would like to begin participating in global emissions trading. And while they may begin these activities, they will hold off on major transactions until the climate negotiations paint a clearer picture of exactly how the market in emissions might work.
This turnaround in business behavior has been most evident in statements and actions from the companies associated with the Pew Center's Business Environmental Leadership Council. This Council now comprises 28 major corporations, including ABB, Alcoa, American Electric Power, Baxter, Boeing, BP, Dupont, Enron, Georgia-Pacific, IBM, Intel, Shell, Toyota, United Technologies, Weyerhaeuser, and Whirlpool. And just for comparison purposes, it is interesting to note that the combined annual revenues of these companies is in excess of $770 billion per year, greater than the GDP of most countries. In fact, it would rank number 11 in the world, ahead of Mexico, Canada, Russia and 180 other countries.
The fact remains, however, that industry efforts to meet the challenge of climate change will not be applied as broadly or as seriously as they need to be in the absence of a viable framework for national and international action on this issue. So to those who argue for an even greater commitment to protecting the climate on the part of the private sector, I say it will come. But only if we see a similar commitment on the part of national governments throughout the world to develop an environmentally effective, private-sector friendly framework for action. Companies will not sit on their hands and wait for governments to catch up, but governments will have to provide clear direction.
Speeding Technology Development
The way I see it, the business response to the issue of climate change in the years ahead will go through three phases. The first, short-term phase is the one I have already described, where companies are investing in energy efficiency and exploring and participating in emissions trading and carbon sequestration. The second, medium-term phase (and these are not sequential - there will clearly be overlap) will see a shift to fuels that are less carbon-intensive, particularly natural gas, but also to other fuels, including hydrogen, in those cases where the existing fossil fuel infrastructure can still be used.
The longer-term outlook is dramatically different. As individual countries and the international community finally come to grips with the need for serious, long-term action to reduce greenhouse gas emissions, we are destined to see a flood of new attention and new investment going to those technologies that are essentially carbon free. The development and delivery of these new technologies will be absolutely crucial to the success of national and international efforts to reduce worldwide concentrations of greenhouse gases. In fact, there is no other possibility. Behavioral changes, no matter how drastic (and drastic ones are politically impossible as we have seen over last summer and this winter in both North America and Europe), will not be sufficient to address the problem. What we need is a second industrial revolution, but one that allows us to move to a brave new world in an orderly and systematic way, a way that meets both our environmental and economic objectives.
In fact, I believe we are beginning to see attention being paid to this kind of phased approach. Industry leaders are now beginning to make serious commitments to everything from solar energy, biomass and other renewables to fuel cell technologies. Of course, many of you know more about this than I do, but let me offer a couple of examples from the companies that are part of the Pew Center's Business Environmental Leadership Council:
BP-which, as we all know, now stands for "Beyond Petroleum"-announced in June of last year that it was planning to invest $500 million in renewable energy projects. BP Solar, the world's largest solar electric company, now provides photovoltaic energy technology in 150 countries around the world, with major, multi-million dollar contracts for rural electrification in Indonesia and the Philippines. BP Solar's revenue projections for 2007? Over $1 billion.
Also making a significant investment in solar power and other alternative energy technologies is Shell. Shell Hydrogen was formed in 1999 to develop business opportunities related to hydrogen and fuel cells on a global basis. Among other activities, Shell is now cooperating with both Daimler Benz and Zevco (which stands for the Zero Emissions Vehicle Company) in the development of hydrogen fuel cells and the necessary infrastructure to support the supply and distribution of hydrogen fuels. The company also is investing $500 million in Shell International Renewables, with projects on forestry, photovoltaics, and biomass.
Toyota, for its part, also is working to develop fuel cell vehicles. The year 2000 marked the introduction of the Toyota Prius, the first mass-produced hybrid gas-electric car. The car's fuel efficiency rating is a remarkable 52 miles per gallon in city driving. This is a dramatic improvement, of course, over where we now stand on fuel efficiency for vehicles. And greater improvements, and more innovative technologies that will take us beyond hybrid vehicles, are now under development.
And finally, let us look at United Technologies, which through its International Fuel Cells (or IFC) subsidiary, produces the world's only commercial fuel cell power plants. More than 200 units have been installed in 15 countries on four continents to date. Since 1996, all U.S. manned (and womanned) space flights, including the Space Shuttle, have been powered with fuel cells supplied by IFC. And in 1999, IFC delivered its first hydrogen-fuel power unit to BMW.
As these examples show, there is a remarkable transition going on in how industry views environmental issues such as climate change. These issues are no longer considered mere opportunities for public relations gambits. Rather, they are serious problems that demand serious solutions. And, equally important, they represent serious opportunities for continued growth, innovation and improved performance.
The key in the years ahead, I believe, will be for governments in the U.S., Canada and elsewhere to work with industry to craft long-term policies that will enable a smooth transition. These policies can include incentives and support for research and development as well as conservation and energy efficiency, and, most importantly, clear goals and strategies for reducing greenhouse gas emissions both domestically and throughout the world.
The Future of the Kyoto Protocol
To return to the skiing metaphor for a moment, allow me to make the observation that the trails ahead for government and business may not be one and the same, but they certainly cross at important points. And the goal for the future should be to make a serious effort to coordinate and manage these crossings so there are as few collisions as possible. Speaking of collisions on the slopes, how could I forget the words of the minister at the funeral for a fallen skier: "We are gathered together on this slalom occasion." (You will be glad to know that is my final ski joke for the day.)
So where do the trails ahead for business and government cross? The answer is in the use of market-based strategies to achieve environmental progress. This has become a bedrock principle of national and global efforts on issues from climate change to reducing acid rain. The Kyoto Protocol reflects this principle by including a number of market-based strategies among the avenues that countries can pursue in order to meet their targets for reducing emissions.
Emissions trading, the Clean Development Mechanism, the use of carbon sinks, and other elements of the accord all rely to varying degrees on markets and business initiative to work effectively. It is my belief that all of these elements, which will keep costs down as they promise environmental improvement, will have to be part of a final agreement. I also believe that governments and industry will need to be granted a high degree of flexibility in how the market mechanisms are applied.
Right now, the EU nations and many countries in the developing world do not fully appreciate how market mechanisms can be put to work for the betterment of the environment. This must change, and I believe it will change
Of course, the alternative to reaching consensus on international action is to put the negotiations on hold and to proceed with domestic actions on a piecemeal basis. But everyone knows this is not a real solution. Global climate change is a global problem. And it can only be solved if the nations of the world work together to create an effective yet flexible regime for reducing atmospheric concentrations of greenhouse gases.
This does not mean that Canada and the United States and other nations should sit idly by while we wait for the negotiations to produce a final agreement that we all can live with. Rather, at the same time that we are working on this issue internationally, our nations must begin to take serious action at home to reduce our contribution to climate change. The United States in particular has a clear responsibility to move forward on this issue. With only 4 percent of the world's population, we are responsible for 24 percent of global emissions of greenhouse gases. And we have yet to forge a coherent national policy for significantly reducing our emissions.
A priority for the United States, I believe, should be to design a straightforward system that will recognize and give credit to corporations that want to take early action to reduce greenhouse gas emissions. Put very simply, these companies need to know that reducing their emissions now will not put them at a competitive disadvantage down the line.
In addition to addressing the early action issue, governments must put in place the kinds of programs that will pave the way for dealing with this issue over the medium and long-term. We need to do more to improve the energy and carbon intensity of our economy, and we need to provide incentives for the development and diffusion of the best technologies that we are capable of producing. Governments can play an important role by setting targets that are ambitious, but not impossible to meet. And industry can do what it does best: experiment and innovate, until we have found the most effective and efficient ways of moving forward.
In short, we need to accept once and for all that this problem is real-and that real programs will be taking shape in the coming years that will require the world to shift away from fossil fuel combustion and implement changes in land use practices, such as deforestation, that are altering the global climate.
Now that we have concluded our little visit to the slopes-and our exploration of the trails ahead for climate change-I would like to leave you with two quotes to consider as you head out for a ski this afternoon. The first is from a great American outdoorsman who visited this area in 1915 and called the landscape here "as lovely as it is varied." President Theodore Roosevelt, in his inaugural address, told Americans, "There is no good reason why we should fear the future, but there is every reason why we should face it seriously."
The second is from a former Saudi Arabia Oil Minister, Sheik Ahmed Zaki Yamani, who, in speaking about the potential of alternative fuels, said, " The Stone Age came to an end not for a lack of stones, and the Oil Age will end, but not for a lack of oil."
Looking ahead, we would be wise to keep these words in mind as we consider how to address one of the critical challenges of our time.
Thank you very much.
"Getting It Right: Climate Change Problem Demands Thoughtful Solutions"
By Eileen Claussen, Executive Director for the Pew Center on Global Climate Change
Appeared in the Washington Post
November 14, 2000
Many of the government officials gathering this month for the climate change negotiations in The Hague are hoping to put the finishing touches on rules to implement the Kyoto Protocol. But getting those rules right is more important than getting them all completed.
Still unresolved on the eve of the meeting are a range of very complicated political and technical issues that will play a decisive role in determining whether we achieve our goal of stabilizing the earth's climate system. It is not a stretch to say that how we decide these issues will determine how we are judged by future generations.
Decision-makers in The Hague should remember that the Kyoto Protocol was designed as both a first step in reducing atmospheric concentrations of greenhouse gases and as a framework for long-term, cost-effective action. In other words, this is a treaty that will have to stand the test of time. Short-term political considerations-including the desire to resolve all remaining issues this year-should therefore take a backseat to the goal of creating a global system that is transparent, fair, environmentally effective, economically efficient, and as simple as possible.
The Remaining Issues
Four key sets of issues remain in play as the negotiators come together:
- The Kyoto Mechanisms. The Kyoto mechanisms were designed to allow countries to pursue the most cost-effective means of reducing their emissions-for example, by engaging in international emissions trading. But there are provisions being negotiated that would make the Kyoto mechanisms totally inoperable, and others that would seriously limit their use. If the negotiators are careless in defining the rules, or determined to constrain when and how the mechanisms can be used, this will simply increase the costs of complying with the Protocol. And the result might be a higher level of noncompliance, an outcome that no one should want.
- Carbon Sequestration. The question here is whether and how countries should receive credit toward their emissions reduction targets for using agricultural lands and forests to store carbon. A related question is whether credit should be given for investments in sequestration projects in developing countries. The important role of soil and forest sequestration in stabilizing the global climate system cannot be denied. However, we have not yet defined what types of sequestration activities ought to count-or even how to count them.
- Compliance. Yet another unanswered question is whether the Kyoto Protocol will include binding consequences for noncompliance. In other words, how will we penalize those countries that miss their targets? This is a crucial issue to the Protocol's success. Only by establishing and enforcing significant noncompliance penalties can we create a fair and efficient global system, and one that yields results.
- Assistance to Developing Countries. Developing countries properly argue that the industrialized world is not doing enough to implement provisions of the United Nations Framework Convention on Climate Change. In that precursor agreement to the Kyoto Protocol, the United States and other nations pledged to support developing countries in their efforts to reduce emissions through capacity building, technology transfer, and funding for "adaptation" initiatives. Decision makers in The Hague will have to respond seriously to these concerns at the same time as they are working on the more fractious issues of the Kyoto framework.
As if resolving these immediate questions were not enough of a challenge, everyone concerned with this issue must also give serious thought to the future. After all, the 2008-2012 deadline for achieving the first round of emissions reductions under the Kyoto Protocol is fast approaching. And, even if these initial targets are met (an unlikely prospect), they represent only a first step toward the sustained and significant reductions in emissions that will be necessary to reduce the threat of climate change throughout the 21st century.
A crucial issue for the future, then, is to think about what kind of targets we will have to establish in the years after 2012. At the same time, we need to think about how to involve developing countries in these future global efforts in a more active way. Developing countries are struggling to lift their people to a higher standard of living, and doing so will mean absolute increases in energy use and emissions.
We will accomplish very little, if anything, by requiring developing countries to achieve short-term emissions reductions. The better approach is to craft an equitable and effective framework for future targets for all countries, bearing in mind that we face a common challenge: maximizing the environmental benefits we are able to achieve while minimizing the costs of reducing and limiting our emissions.
Meeting the challenge of global climate change calls for no less than a second industrial revolution. We need to promote new technologies and new investments that will put the entire world on a path to clean economic development. And, in creating the global legal framework to make this happen, we need to make absolutely certain that we get it right.
For Immediate Release:
October 13, 2000
Contact: Katie Mandes, 703-516-4146
Dale Curtis, 202-777-3530
Report Suggests New Directions For Economic Analysis of Climate Change: Four Papers Explore Limitations of Current Models, and Future Possibilities
Washington, DC - The computer models used to analyze the potential effects of climate change policies do not capture key drivers of present and future economic prosperity or current climate science, according to a set of four papers issued by the Pew Center on Global Climate Change.
Computer models that integrate scientific and economic theories and reams of data have become essential tools in climate change policy discussions. These "integrated assessment" (IA) models can be useful for several reasons: they assess specific climate change policies, coordinate multiple issues in a systematic framework, and provide an analytical method for comparing climate policies to other, non-climate-related policies.
However, a great deal of IA analysis is based on questionable assumptions. For example, many models begin with the premise that consumers and firms always succeed in maximizing their "enlightened self-interest" and have complete information about current and future options. The papers released today offer critiques of the assumptions underlying most current IA, and suggest ways that new and improved models could provide greater insights into climate policies.
"All of our work on the economic analysis of climate change indicates that our current analytic tools are inadequate and need improvement," said Eileen Claussen, President of the Pew Center on Global Climate Change. "Despite the obvious need for economic modeling of climate change policies, the findings are often abused by some analysts claiming the 'holy grail' of modeling results. These four reports not only question this often-misplaced confidence, but also identify topics absent in nearly all economic models, such as climate 'surprises' and drivers of technological innovation. Consideration of these important factors could have major repercussions for any climate policy discussion."
The four papers, written by leading experts and issued together under the title "New Directions in the Economics and Integrated Assessment of Global Climate Change," examine four issues that have major implications for IA.
The first paper, by Alan Sanstad of Lawrence Berkeley National Laboratory, focuses on technological innovation and its treatment in IA models. Most models do not incorporate a realistic assessment of how market forces drive innovation. While innovation would clearly lower the costs of addressing climate change, many modelers focus on the opportunity cost of encouraging climate-friendly technology. The fear is that climate-related R&D will "crowd out" other kinds of R&D. Sanstad's paper shows that policies promoting climate-related R&D may simultaneously encourage, not discourage, R&D in other sectors.
The second paper, by Stephen DeCanio of the University of California, Santa Barbara, discusses how IA models tend to assume that firms focus only on, and are entirely successful in, maximizing profits. This often leads to misunderstandings about how firms innovate, and the kinds of trade-offs they must make between economic and environmental performance. DeCanio's work describes firms as "information networks" with multiple objectives, which leads to a more complete picture of how private-sector organizations innovate. Another finding with major significance for climate policy is that firms can make improvements in environmental performance without sacrificing overall profitability.
The third paper, by Richard Howarth of Dartmouth College, addresses how future generations are depicted in most IA models. Using the so-called "overlapping generations" approach - pioneered by Nobel Laureate Paul Samuelson and used widely in public finance modeling - Howarth compares the potential impacts of three policy regimes on the welfare of present and future generations. The analysis suggests that while rising greenhouse gas emissions are a factor in short-term economic welfare, climate stability can be viewed as an economic asset that would contribute strongly to the welfare of future generations. In other words, even if short-term environmental damages of climate change turn out to be moderate, Howarth finds that near-term emissions control is still consistent with maintaining long-term economic well-being.
In the fourth paper, Stephen Schneider of Stanford University and Starley Thompson of Complex Systems Research, Inc. provide a new model to explore the causes and consequences of one major type of "climate surprise" -- the possible collapse of the "conveyor belt" circulation of the North Atlantic Ocean. Climate "surprises" are the low-probability but high-consequence scenarios driving much of the international concern about climate change. Currently, most IA models assume the climate responds slowly and predictably. The authors conclude that IA models that ignore the possibility of climate surprises probably overestimate the capacity of human society to adapt and underestimate the optimal control rate for greenhouse gas emissions. The implication is that the full range of plausible climatic outcomes needs to become part of climate policy analysis.
The four papers released today are the latest in the Pew Center's series of reports on the economics of climate change. "But whereas until now we have focused on what has been done with economic analysis in the past, we are now beginning to focus on what needs to be done in the future," said Claussen. "We must explore new tools and methods to improve our forecasts."
"The aim", Claussen said, "is to suggest several new directions in which IA can and should develop to better enable citizens and policy-makers to grapple with the challenges posed by climate change." For example:
- IA models that more accurately portray innovation will help policy-makers answer such questions as whether the government should subsidize climate-friendly R&D, or how to phase in emission reductions to take maximal advantage of technological progress.
- IA models that more realistically portray businesses will make it clear that the challenge for policy-makers is to find ways to encourage businesses to innovate in multiple dimensions to meet multiple objectives.
- IA models that take into account the standpoint of future generations will enable policy-makers to explicitly consider the implications of policy for equity as well as efficiency. And,
- IA models that can explore the causes and consequences of "climate surprises" will help policy-makers to understand the implications of speeding up or slowing down the rate of greenhouse gas build-up, which may turn out to be as important as the size of the build-up.
A complete copy of these and other Pew Center reports can be accessed from the Pew Center's web site, www.c2es.org.
About the Pew Center: The Pew Center was established in May 1998 by the Pew Charitable Trusts, one of the United States' largest philanthropies and an influential voice in efforts to improve the quality of the environment. The Pew Center is a nonprofit, non-partisan and independent organization dedicated to providing credible information, straight answers and innovative solutions in the effort to address global climate change. Eileen Claussen, the former U.S. Assistant Secretary of State for Oceans and International Environmental and Scientific Affairs, leads the Pew Center. The Pew Center includes the Business Environmental Leadership Council, a group of large, mostly Fortune 500 corporations all working with the Pew Center to address issues related to climate change. The companies do not contribute financially to the Pew Center; it is solely supported by contributions from charitable foundations.
New Directions in the Economics and Integrated Assessment of Global Climate Change
Prepared for the Pew Center on Global Climate Change
Stephen J. DeCanio, University of California, Santa Barbara
Richard B. Howarth, Dartmouth College
Alan H. Sanstad, Lawrence Berkeley National Laboratory
Stephen H. Schneider, Stanford University
Starley L. Thompson, Complex Systems Research, Inc.
Eileen Claussen, President, Pew Center on Global Climate Change
This report elaborates on four issues - technological innovation, the behavior of firms, intergenerational equity, and climate "surprises" - that have profound implications for the modelers and makers of climate policy. Computer models that integrate climate science, policy, and economic research have become essential to climate change policy discussions. These "integrated assessment" (IA) models are extremely useful for several reasons: they assess specific climate change policies, coordinate the multiple issues in a systematic framework, and provide an analytical method for comparing climate policies to other, non-climate related policies. However, most IA is based largely on economic theories whose simplifications are not always applicable to climate change policy. This paper examines four kinds of assumptions that underlie most IA models, and shows how different approaches more in line with the latest research might change our view of the economics of the climate problem.
The first paper, by Alan Sanstad, focuses on technological innovation and its treatment in IA models. Most models do not incorporate a realistic assessment of how market forces drive innovation. While innovation would clearly lower the costs of addressing climate change, many modelers focus on the opportunity cost of encouraging technological progress on climate-friendly technology. The fear is that climate-related R&D will "crowd out" other kinds of R&D. Sanstad's work examines this question, taking into account that the economy systematically underinvests in R&D, and shows that policies promoting climate-related R&D may simultaneously encourage, not discourage, R&D in other sectors.
The second paper by Stephen DeCanio discusses how IA models characterize the behavior of firms by assuming they do no more than maximize profits, and that they always succeed perfectly in doing so. This often leads to misunderstandings about: (1) how firms innovate, and (2) the trade-offs firms must make between environmental and economic performance. DeCanio's model describes firms as information networks with multiple objectives, which leads to a more complete picture of how firms innovate. The model also shows that both superior economic and environmental performance can be achieved through technological and organizational innovation.
The third paper by Richard Howarth addresses how future generations are depicted in most IA models. Models typically use a single, simple discount rate to make intertemporal comparisons for anywhere from 50 years to sometimes 300 years into the future. But over very long periods of time, these comparisons involve different generations of people. Howarth accounts for these differences using the so-called "overlapping generations" models - a model that incorporates the detail of IA models while providing a more realistic assessment of each generation's spending and savings behavior. This work indicates that policies inclined towards climate stabilization provide an "insurance" policy that protects future generations against potentially catastrophic costs. Even if damage costs turn out to be moderate, Howarth finds, emissions control is still consistent with maintaining long-term economic well-being.
Stephen Schneider and Starley Thompson, in the final paper, provide a new model to explore the causes and consequences of one major type of "climate surprise" - the collapse of the "conveyor belt" circulation of the North Atlantic Ocean. Climate "surprises" are the low-probability but high-consequence scenarios driving much of the international concern about climate change. Currently, most IA models assume the climate responds slowly and predictably. The authors find IA models that ignore the implications of rapid, non-linear climatic changes or surprises are likely to overestimate the capacity of humans to adapt to climatic change and underestimate the optimal control rate for GHG emissions. The conclusion is that it is critical that the full range of plausible climatic states become part of IA policy analysis.
This report is the latest in the Pew Center's economics series. As with the rest of the series, these reports will help to demystify the models and explain what type of questions they can (and cannot) answer. But whereas until now we have focused on what has been done in the past, we now begin to focus on what needs to be done in the future. This report includes four critiques of the assumptions underlying IA, and suggests ways in which new and improved models could provide greater insights into what policies would be most efficient and effective in reducing greenhouse gas emissions:
- IA models that more accurately portray innovation will help policy-makers answer questions such as the following: Should the government subsidize climate-friendly R&D? Will increasing carbon prices alone drive sufficient innovation to solve the GHG problem? How should we time and phase emission reductions to take maximal advantage of technological progress?
- IA models that more realistically portray businesses will make it clear that the challenge for policy-makers is to find ways to encourage businesses to innovate in multiple dimensions to meet multiple objectives.
- IA models that take into account the standpoint of future generations will enable policy-makers to explicitly consider the implications of policy for equity as well as efficiency.
- IA models that can explore the causes and consequences of "climate surprises" will help policy-makers to understand the implications of speeding up or slowing down the rate of greenhouse gas build-up, which may turn out to be as important as the size of the build-up.
Earlier versions of the papers in this report were first presented during the Pew Center's July 1999 economics workshop, which convened leading experts to discuss potential improvements to current IA modeling methods. The insights of participants in that workshop were invaluable.
This report benefited greatly from the comments and input from several individuals. The Pew Center and authors would like to thank Kenneth Arrow, Larry Goulder, Robert Lind, Klaus Hasselman, and Bruce Haddad. Special thanks are also due to Ev Ehrlich and Judi Greenwald for serving as consultants on this project.
Our knowledge of the global climate system, and of how human actions may be changing it, is the product of a large and expanding body of scientific research. Translation of this knowledge into policies for dealing with the possibility of global climate change, however, has been largely carried out using the concepts and methods of economics. Unique among the social sciences, modern economics provides a set of powerful analytical and computational tools that support quantitative modeling of economy- and society-wide policies over the long run. The formidable challenges posed by the complexity of climate policy have made economic modeling an especially attractive means of organizing and applying a range of scientific, economic, and social research to analyzing how we should respond to the threat of climate change.
In practice, such analysis is typically carried out through the construction and application of large-scale computer models that combine scientific and economic theories and data into unified quantitative frameworks. These "integrated assessment" models have emerged as decision-makers’ primary tool for quantitative climate policy analysis.
In keeping with their origins, integrated assessment models (IAMs) are commonly built on the principles of what is often referred to as "standard" or "conventional" economic theory. The papers in this volume deal with four of the key assumptions underlying this theory as it has typically been applied to climate economics and integrated assessment. The first assumption is that technological change -- increases in outputs of goods and services without increases in productive inputs -- originates outside of the economy itself; in other words, technological progress is "exogenous" with respect to the market economy. The second is rational behavior on the part of consumers and firms. Colloquially, this is usually thought to mean no more than "enlightened self interest." In the theory and its applications, however, "rationality" is a considerably stronger assumption. It means complete optimization by economic agents over all possibilities open to them in the choice of commodities and actions: nothing is ignored or misunderstood, and no mistakes are made. The third assumption is that economic rationality takes into account all future as well as present possibilities: agents have perfect foresight infinitely far into the future. In practice, this assumption is represented by an infinitely-lived decision-maker, a representative consumer, or a social planner, who optimizes over a completely foreseen infinite horizon.
The final assumption has to do with the representation of the "externalities" or deleterious effects that could arise from climate change. The common approach in integrated assessment is to represent climate-related externalities as a function of the total stock of greenhouse gases (GHGs) in the atmosphere. A key conclusion of this method is that the climate problem is fundamentally "slow-moving," and that even "large" anthropogenic emissions constitute only "small" additions to the global GHG stock at any given time, so the total stock changes slowly relative to the time-scales on which policies are usually formulated.
These assumptions -- exogenous technological change, rational behavior, the infinitely-lived agent, and the basic stock externality model of GHGs -- are fundamental design principles underlying standard climate economics and almost all integrated models. The papers here report on the results of research in which these fundamental elements are altered and the resulting implications for climate policy modeling are analyzed. The first paper, by Alan Sanstad, considers the consequences of recognizing that technological change is not typically "exogenous" but rather is strongly influenced by market incentives. In the second paper, Stephen DeCanio explores what happens when the basic rationality assumption as it applies to firms is replaced by a model in which firms are viewed as complex communication networks that do not engage in the fully-informed, optimal decision-making posited in the neoclassical model. In the third paper, by Richard Howarth, the infinitely-lived decision-maker is replaced by a series of distinct demographic generations. In the concluding paper, Stephen Schneider and Starley Thompson describe a model that can display abrupt, non-linear changes in the ocean-atmosphere system as a result of increased carbon dioxide (CO2) concentrations. These particular ideas constitute a sampling, in effect, of important recent developments in economics and climate science that warrant application to climate policy and integrated assessment modeling. The aim is to indicate several directions in which integrated assessment can and should develop in order to better enable policy-makers and citizens to grapple with the daunting risks and challenges posed by global climate change. The sections below provide a brief introduction to these topics.
A. Endogenous Technological Change
The standard models rule out the possibility of entrepreneurial responses to climate policy -- the new innovation aimed at carbon reductions that would arise in response to new incentives. This innovation would be a form of "endogenous" technological change, in that it would occur within the economy in response to market forces. This omission raises the possibility that the models as currently structured systematically overestimate the costs of carbon abatement because they do not account for the accelerated carbon- or energy-saving innovation that would result from price-based carbon reduction policies.
In the past two decades, economists have made considerable strides in modeling the underlying processes of technological change and economic growth, focusing on how technical innovation arises within a market economy in response to economic incentives. This work -- the "new growth theory" or theory of "endogenous technological change" -- has been recognized as potentially significant for climate policy, and in recent years several initial applications have appeared. Sanstad discusses the key ideas of this theory and several of its applications to climate policy in the first paper.
As Sanstad describes, economists acknowledge (and partially confirm) the cost-saving potential of endogenous technological change. However, they have also emphasized the losses that would arise from reallocating resources such as human expertise to new carbon- or energy-saving innovation and away from other applications. For example, as engineers turn their attention to energy efficiency and away from other activities, there could be a slow-down of technical innovation in other sectors. Alternatively, there would be costs associated with training new engineers. It has been suggested that such opportunity costs of stimulating new "climate-friendly" technical change would be sufficiently large to nearly or completely offset the benefits.
Sanstad notes, however, that the modeling of technological change as an endogenous phenomenon is closely linked with the finding that the market system may systematically under-invest in innovation. This effect results from the "public good" character of knowledge as an economic commodity: the use of an idea by one does not preclude its use by another. The new growth theory provides tools for the rigorous analysis of this phenomenon in the general equilibrium setting necessary for applications to integrated assessment. Sanstad shows that, when this finding is taken into account, the opportunity cost problem may be substantially mitigated. In fact, it may be the case that policies to speed up one form of innovation would actually also speed up competing forms. These results follow from the fact that the economy’s initial equilibrium may allocate too few resources to innovation overall, so that policies that encourage a specific form of innovation may improve overall economic efficiency. As he discusses, this conclusion rests on the empirical question of the degree to which the new growth theory’s prediction of under-investment in research and development (R&D) is borne out in practice. This question is thus a key priority for further research.
B. The Theory of the Firm
Within the economics community there has been a lively and long running debate on the nature of the firm and assumptions regarding the degree to which the typical firm’s behavior can be characterized as "rational." Beginning with the work of Herbert Simon in the 1940s and 1950s, there has been a steady expansion of theoretical and empirical efforts to open up the "black box" of the profit-seeking private sector firm to better understand how companies actually behave in a market economy. In the second paper, DeCanio summarizes several aspects of the modern critique of the neoclassical theory of the firm that have a bearing on integrated assessment issues. The questionable elements of neoclassical theory include: (1) the assumption that firms have a unitary objective -- profit maximization -- rather than the multiple objectives they are known to pursue; (2) the exclusive focus on the firm’s selection of how much of each aggregate "factor of production" (land, labor, capital, materials) to employ, when these choices actually occupy only a small portion of managers’ time and attention; (3) the assumption that technological change arises from "exogenous" factors, independent of the activity of the firm, instead of its being in large part a product of the procedures and decisions of the firm; and (4) the premise that firms always make optimal decisions, rather than, as in reality, searching for improvements in an environment too complex to allow full optimization.
DeCanio goes on to describe modern advances in the theory of the firm from fields such as the new institutional economics and management science, showing how these ideas could improve the treatment of firms in integrated assessment. He describes how these alternative frameworks call into question the conventionally assumed trade-off between environmental quality and the production of other goods. Instead, he argues for a perspective in which these two objectives are complementary.
DeCanio next presents results from the application of a mathematical "network" model of organizational structure and evolution that contrasts sharply with the neoclassical model. The premise of the network model is that patterns of communication and control within the firm are fundamental to understanding the dynamics of decision-making. Accordingly, the focus is on the behavior of the firm as an information processing system that is capable of "learning" over time in the sense of establishing new internal patterns of communication links. The model is explicitly economic in that it includes the costs associated with establishing and maintaining communications within the firm. This richer representation makes it possible to analyze rigorously phenomena that are essentially ignored in the neoclassical framework.
Among the most important of these phenomena is the manner in which the firm evolves in order to improve its performance on specific tasks -- such as adopting a profitable technological innovation (e.g., in energy efficiency). All else being equal, increasing the density of communication links yields an economic gain to the firm; at the same time, however, it carries a commensurate cost. Thus, the organizational structure arrived at by an evolutionary process will depend on the particular form and parameters of the cost and reward functions. As a result, there will in general be no single "optimal" internal organization for the firm that prevails under all circumstances: the result of evolutionary learning will depend on the changeable nature of the firm’s tasks and opportunities. In addition, the evolutionary course of a firm’s development is likely to depend on the path it takes, with multiple outcomes -- having roughly equal profitability but different organizational structures -- possible. One corollary of these findings with particular significance for environmental policy is that different organizations may be comparable in profitability but can exhibit very different environmental behaviors and impacts. This means that improvement in environmental performance is possible without sacrificing overall profitability. In essence, the trade-off between profitability and environmental protection dissolves.
C. Intergenerational Fairness and Efficiency
One of the most basic features of global climate change is that while the present generation is deciding what if anything to do about it, the impacts of climate change (and hence the consequences of today’s actions or inaction) are likely to be borne by future generations. Cost-benefit analysis that ignores the standpoint of future generations sidesteps some of the issues of fairness and equity associated with climate change, notably including the risks that today’s lifestyles and technologies may be imposing on posterity through GHG emissions.
In the third paper, Howarth conducts a quantitative analysis that emphasizes the differential impacts that climate change response strategies would have on the welfare of present and future generations. This analysis employs a so-called "overlapping generations" (OLG) model, which posits (as the name suggests) a succession of generations. OLG models were pioneered in the 1950s by Paul Samuelson, and have since become a mainstay in the field of public finance, where they are used to study the impacts of taxation and government debt on the distribution of income between generations. This framework, however, has not been widely used in climate policy modeling.
Howarth uses an OLG-based IAM to compare the impacts of three policy regimes on the welfare of present and future generations. In the first scenario -- the laissez faire base-case -- the economy is managed according to free-market political precepts, and no steps are taken to reduce GHG emissions. Over the long-term future, this scenario yields an increase in mean global temperature of 8.0 ºC relative to the pre-industrial norm, which imposes costs on future generations equivalent to 9 percent of economic output. In the second scenario -- cost-benefit analysis -- conventional economic criteria are used to balance the present costs and expected future benefits of climate change mitigation measures. In this scenario, future environmental benefits are discounted relative to the present, so that only modest steps are taken to reduce GHG emissions. Relative to the laissez faire baseline, the emissions control rate rises from 15 to 23 percent between the years 2000 and 2105. These reductions provide relatively small environmental benefits to future generations.
In the third policy scenario -- climate stabilization -- GHG emissions are reduced to the levels required to maintain mean global temperature at its current level, which requires a GHG emissions tax that rises from $560 per metric ton of carbon in the year 2000 to $1,081 in the long-term future. Although critics claim that such aggressive policies might "lock up" the resources required to sustain a productive economy to the detriment of both present and future society, Howarth’s analysis reaches a rather different conclusion. In comparison with the laissez faire and cost-benefit scenarios, climate stabilization reduces short-term consumption by 7 percent. In the long run, however, climate stabilization confers welfare gains of $6.4 trillion per year on members of future generations in comparison with the laissez faire baseline, or $2.4 trillion per year relative to the cost-benefit scenario.
This analysis suggests that although GHG emissions are an important contributor to short-term economic welfare, sustained climatic stability may be viewed as an economic asset that would contribute strongly to the welfare of future generations. The results highlight the importance of moral considerations in the identification of "optimal" policies, finding that conventional cost-benefit analysis tends to favor the interests of present producers and consumers at the expense of future society.
D. Climatic Nonlinearities
The standard assumption in most IAMs is that the climate responds slowly and predictably, gradually warming as atmospheric GHG concentrations increase. Recent research on the long run behavior of the climate, however, has focused attention on the possibility of quite different climate dynamics. It is possible that, in fact, the climate may be subject to very rapid changes or "nonlinearities." An important example of this kind of behavior has to do with the Atlantic thermohaline circulation, or "conveyor belt." This is the natural process by which warm water moving northward from the Gulf stream into the Atlantic Ocean transports heat from more southerly latitudes, thereby increasing the temperature of the North Atlantic region. It is now thought possible that this conveyor belt might collapse under certain scenarios of anthropogenic CO2 emissions, rapidly altering the global climate and profoundly changing the climate in western Europe.
Determining how climate policies should take into account this possibility is clearly a high priority for integrated assessment modeling. Full computer models of the global climate system are far too large and complex to be embedded in IAMs containing economic detail. Indeed, the trend in climate modeling is toward super-computer-run models with integrated atmosphere, land, and ocean sub-models. Thus, economic IAMs have generally incorporated highly simplified representations of the global climate. The immediate challenge is thus to capture these more complicated dynamics in a simplified form that is amenable to linkages with economic models. In the fourth paper, Schneider and Thompson describe the results of such an effort, a "Simple Climate Demonstrator" (SCD) model. Technically, SCD is a simplified model of the northern hemisphere atmosphere-land-ocean system. Overall, the model replicates the behavior of more elaborate climate models. Schneider and Thompson study the conditions under which a conveyor belt collapse would occur, and find that the probability of this event is increased by: (1) greater CO2 concentrations, (2) higher rates of increase in CO2 concentrations, (3) greater sensitivity of the climate to CO2 concentrations, and (4) assumption of a weaker initial circulation. These findings confirm that IAMs with simpler representations of the climate may not be appropriate for studying the policy implications of rapid climate shifts. It also provides an alternative means of representing such shifts that is sufficiently complex to capture the behavior of more complex climate models while being sufficiently simple for applications to integrated assessment. Preliminary analyses coupling the SCD model to the Nordhaus 1992 Dynamic Integrated Climate Economy (DICE) model demonstrate that the potential for severe climatic damages as a result of non-linear climatic behavior in the twenty-second century and beyond can have a substantial influence on present climate policy decisions if discount rates are below 2 percent (Mastrandrea and Schneider, submitted).
E. Summary Remarks
Integrated assessment modeling is still in its early stages. Because it is by nature an interdisciplinary endeavor, it is ultimately based on the ideas and methods of its constituent disciplines. To date, IAMs have drawn most heavily on neoclassical economics, which is well developed and lends itself to this kind of application. As integrated assessment matures, it will need to broaden its scope to incorporate key ideas at the frontiers of research in economics and in other fields. In this volume, several such ideas are presented. The hope is that these papers will serve to advance discussion and applications that will contribute to the evolution of the integrated assessment modeling of global climate change.
Technology and the Economics of Climate Change Policy
Prepared for the Pew Center on Global Climate Change
Jae Edmonds, Joseph M. Roop, and Michael J. Scott of Battelle, Washington, DC
Eileen Claussen, President, Pew Center on Global Climate Change
Climate change policy analysis is fraught with uncertainty and controversy, but at least one thing is perfectly clear: technological innovation is the key to addressing climate change. Moving the economy to a greenhouse - friendly future will necessitate a profound economic transition - a transition that simply cannot come to pass without technological progress.
In this report, an impressive team of economists led by Jae Edmonds and Joe Roop explains how economic models of climate change take technological innovation into account. The authors demystify a highly technical subject that is essential to sound policy formulation, raising five central insights:
- All future projections of technological change are a matter of assumption. Much is known about how technological change has occurred in the past and what will drive it in the future. However, all projections require assumptions about the future role of technological change in the way the economy grows, in the way energy is used, and in the options available as alternatives to fossil fuels.
- Technological progress reduces the cost of climate change mitigation. This result is robust across a broad range of model types and assumptions.
- Significant technological progress occurs over long time horizons. This fact should be taken into account in establishing lead times for climate policies.
- Policies and prices can "induce" technological change. Thus both policy-makers and businesses play a major role in fostering technological change.
- Modeling "induced" technological change (that is, change stimulated by climate policies or price changes) is important because it more closely reflects reality. However, modeling this phenomenon is in its infancy.
This report on technological change addresses one of the factors identified by the Pew Center as having the largest influence on economic modeling results. An earlier Center report, "An Introduction to the Economics of Climate Change Policy," by John Weyant describes the five factors, which include: how baseline greenhouse gas projections are measured, what climate policies are considered, how the substitution of goods and services by producers and consumers is represented, and whether and how GHG reduction benefits are addressed. Two other Pew Center reports explore in detail the role of climate policies, with an emphasis on international emissions trading, and the role of substitution in determining the outcome of economic modeling.
The Center and the authors appreciate the valuable insights of several reviewers of early drafts of this paper, including Nebojsa Nakicenovic, Ian Parry, and Alan Sanstad. Special thanks are due to Ev Ehrlich for serving as a consultant for the Center's economics series and to Judi Greenwald for her editorial assistance.