Stern Review on the economics of climate change

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This page is a summary of the important ideas and concepts in Part IV of the Stern Report - Policy Responses for Mitigation, which is part of the Knowledge Base. This is to help give context to the Economy section as it outlines the two mainstream economic solutions to the climate crisis - carbon taxes and emissions trading.

for the moment, these are raw notes which will be synthesized in the near future

Part IV

Introduction

Economic solutions to climate change tend to focus on putting the appropriate price on the price of greenhouse gases (through pricing carbon, taxes on carbon, and trading and regulation) so that those who produce greenhouse gases pay the "full social cost of their actions" (Stern, p308)

Essential elements of climate change policy (Stern, p308)

1st element: carbon pricing so that people switch away from high-carbon activities, but not sufficient alone
2nd element: technology policy needed to bring forward technologies needed to make deep reductions
3rd element: policies to remove the barriers to behavioural change (ie. Regulation, information, financing)
- also need to create a shared understanding of nature of climate change through evidence, education, persuasion, and discussion

Chapter 14: Harnessing Markets for Mitigation - the role of taxation and trading

Key Messages

“Agreeing a quantitative global stabilisation target range for the stock of greenhouse gases (GHGs) in the atmosphere is an important and useful foundation for overall policy. It is an efficient way to control the risk of catastrophic climate change in the long term. Short term policies to achieve emissions reductions will need to be consistent with this long-term stabilisation goal."
"In the short term, using price-driven instruments (through tax or trading) will allow flexibility in how, where and when emission reductions are made, providing opportunities and incentives to keep down the cost of mitigation. The price signal should reflect the marginal damage caused by emissions, and rise over time to reflect the increasing damages as the stock of GHGs grows. For efficiency, it should be common across sectors and countries."
"In theory, taxes or tradable quotas could establish this common price signal across countries and sectors. There can also be a role for regulation in setting an implicit price where market-based mechanisms alone prove ineffective. In practice, tradable quota systems – such as the EU’s emissions-trading scheme – may be the most straightforward way of establishing a common price signal across countries. To promote cost-effectiveness, they also need flexibility in the timing of emissions reductions."
"Both taxes and tradable quotas have the potential to raise public revenues. In the case of tradable quotas, this will occur only if some firms pay for allowances (through an auction or sale). Over time, there are good economic reasons for moving towards greater use of auctioning, though the transition must be carefully managed to ensure a robust revenue base."
"The global distributional impact of climate-change policy is also critical. Issues of equity are likely to be central to securing agreement on the way forward. Under the existing Kyoto protocol, participating developed countries have agreed binding commitments to reduce emissions. Within such a system, company-level trading schemes such as the EU ETS, which allow emission reductions to be made in the most cost-effective location – either within the EU, or elsewhere – can then drive financial flows between countries and promote, in an equitable way, accelerated mitigation in developing countries." (Stern, p309)

Overall, Stern concludes that a long-term quantity ceiling (stabilisation target) should be used to limit that total stock of GHGs in atmosphere. In shorter term, amount of abatement should be driven by a common price signal, that allows flexibility in how, where and when reductions (Stern, p310).

14.2 Designing policy to reduce the impact of greenhouse-gas externality

"In the standard theory of externalities, there are four ways in which negative externalities can be approached: (1) a tax can be introduced so that emitters face the full social cost of their emissions ie. a carbon price can be established that reflects the damage caused by emissions; (2) quantity restrictions can limit the volume of emissions, using a ‘command and control’ approach; (3) a full set of property rights can be allocated among those causing the externality and /or those are affected (in this case including future generations), which can underpin bargaining or trading; (4) a single organization can be created which brings those causing the externality together with all those affected.” Overall, Stern concludes that a long-term quantity ceiling (stabilisation target) should be used to limit that total stock of GHGs in atmosphere. In shorter term, amount of abatement should be driven by a common price signal, that allows flexibility in how, where and when reductions (Stern, p310).

Most importantly, "whatever approach is taken, the key aim of climate-change policy should be to ensure that those generating GHGs, wherever they may be, face a marginal cost of emissions that reflects the damage they cause.” This encourages investment in climate-friendly technologies and incentive to consume less ghg-intensive goods (Stern, p311).

14.3 Delivering carbon reductions efficiently

Two overarching principles for reducing GHG emissions efficiently:

(1) “abatement should occur just up to the point where the costs of going any further would outweigh the extra benefits.” (Stern, p309-310)
(2) “a common price signal is needed across countries and sectors to ensure that emission reductions are delivered in the most cost-effective way” (Stern, p310)

14.4 Efficiency under uncertainty - the implications of climate change policy

Because of there is so much uncertainty regarding both the costs of abatement and the timing and scale of the impacts of climate change, prices and quantity controls are not equivalent, especially in terms of efficiency. (Stern, p312)

"prices are preferable where the benefits of making further reductions in pollution change less with the level of pollution than do the costs of delivering these reductions ie. when the marginal damage curve - or the marginal social cost of carbon - is relatively flat, compared with the marginal abatement cost curve, as pollutions rises"
"quantity controls are preferable where the benefits of further reductions increase more with the level of pollution than do the costs of delivering those reductions ie. there are potentially large and sharply rising costs associated with exceeding a given level of pollution" (Stern, p312)

Given the uncertainty and the market mechanisms that will be more efficient (taxes vs. emissions permits) will on the predictions what the marginal cost of abatement and the marginal benefits of abatement will be:

Therefore, "the most efficient instrument –over a particular time horizon – will depend on:" o “how the total costs of abatement change with the level of emissions; o how the total benefits of abatement change with the level of emissions; o the degree of uncertainty about both costs and benefits of abatement.” (Stern, p314)

In very simplified terms Marginal abatement cost is likely to be high in the short term, and less over the long-term as new technology is available. Marginal benefits of abatement are likely to be flat in the short-term, and very high in the long run. (Stern, p314-315)

Moreover, the "uncertainty of costs and benefits suggest three things":

“(1) Policy instruments should distinguish between the short term and long term, ensuring that short-term policy outcomes are consistent with achieving long-term goals;
(2) The policy-maker should have a clear long-term goal for stabilizing concentrations of greenhouse gases in the atmosphere. This reflects, first, the likelihood that marginal damages (relative to incomes) will accelerate as cumulative emissions rise and, second, that the marginal costs of abatement (relative to incomes) are likely to be relatively flat in the long term once new technologies are available.
(3) In the short term, the policy-maker will want to choose a flexible approach to achieving this long-term goal, reflecting the likelihood that marginal damages will be more or less constant, and there will be risks of sharply rising costs from forcing abatement too rapidly."(Stern, p315)

Therefore, "in practical terms, this means that a long-term stabilization target should be used to establish a quantity ceiling to limit the total stock of carbon over time. Short-term policies (based on tax, trading or in some circumstances regulation) will then need to be consistent with this long term stabilization goal. In the short term, the amount of abatement should be driven by a common price signal across countries and sectors, and should not be rigidly fixed” (Stern, p315)

Stern argues that, practically, a tradable quota scheme is more likely to deliver a common price signal across different sectors and countries because, politically, it will likely be difficult to get a harmonized carbon tax across different countries. However, an international tradable quota scheme requires agreement on the mechanics of the scheme. (Stern, p315)

14.5 Setting short term policies to meet the long term goal

Two important principles for short-term policies that will meet long-term goals:

(1) “Having established the long-term stabilization goal, the price of carbon is likely to rise over time, because the damage caused by further emissions at the margin-the social cost of carbon- is likely to increase as concentrations rise towards this agreed long term quantity constraint;
(2) short-term tax or trading policies will then need to be consistent with delivering this long-term quantitative goal.” (Stern, p315)

In the short-term this means that:

“In a tax-based regime, the tax should be set to reflect the marginal damage caused by emissions. Abatement should then occur up to the point where the marginal cost of abatement is equal to this tax.”
“In a tradable-quota scheme, the parameters of the scheme – notably the total quota allocation – should be set with a view to generating a market price that is consistent with the social cost of carbon (SCC)” (Stern, p315)
- for example, policy could set a emissions trading quota for a 5-year term period, "with firms and household making their own decisions about emissions reductions subject to that carbon-price path and their expectations about policy-maker's commitment to the long-term stabilization goal" (Stern, p316)

Moreover, "as GHG concentrations move towards the stabilisation goal, the price of carbon should reflect the social cost of carbon. In any given year, abatement should then occur up to where the marginal cost is equal to the price" (Stern, p315)

14.6 The interaction between carbon pricing and fossil fuel markets

14.7 Public Finance Issues

both taxes and tradable quotas can raise public funds - taxes automatically, but permits "only if firms have to purchase the quotas from government through a sale or auction" (Stern, p318)

Taxes

revenue raised can be used to
- "enhance the revenue base
- limit the overall tax burden on the industry affected through revenue recyling
- reduce taxes elsewhere in the economy" (Stern, p318-319)

Suggests revenue recycling to the taxed industry, which will “encourage emitters to reduce GHG emissions, without increasing their overall tax burden relative to other parts of the economy” (Stern, p319)

Tradeable Quotas

while auctioning permits creates a revenue base, it is not a steady revenue stream like that delivered by taxation
auctioning the quotas makes more sense, since there is little justification for grandfathering them - all the benefits that accrue will go to the owners and shareholders of the firms given the quotas (Stern, p319)

14.8 Co-ordinating action across countries

Addressing the climate crisis requires global action and cooperation, thus, the implications for taxes vs. tradable quotas for the "relavtive ease with which they can drive financial flows between countries" (Stern, p320)
in theory, both taxes and a tradable quota system could drive financial flows
- with taxes, there would need to be a mechanism for the transfer of tax revenue between governments
- with tradable quotas, many different ways for transfer, including purchase of quotas allocated to developing countries, and company-level trading where companies can get credits for emissions reductions in developing countries (a la CDM)
however, "market-driven financial flows will only occur automatically under the latter route, and only at a sufficient scale if national quotas are set appropriate" (Stern, p320)

14.9 The performance of taxation and trading against principles of efficiency, equity, and public finance considerations

In terms of these principles, carbon taxes perform well because they:

can contribute to the establishment of consistent price signals across regions and sectors
raise public revenues
can be kept stable

but

they do not automatically generate financial flows to developing countries (Stern, p320-321)

In terms of these principles, a tradable quota scheme is beneficial because it would:

establish a common price signal and therefore drive down carbon emissions efficiently (to the extent that the scheme embraces diff. sectors and countries
ensure cost-effective carbon reductions and drive private-sector financial flows between regions (if inter-country trading is allowed)
generate public revenue (if allowances are sold or auctioned) (Stern, p320)

Overall

Performance of taxes and tradable schemes will depend on their credibility and good design. (Stern, p321)

14.10 Conclusion - building policies for the future

need a long-term stabilization and flexibility from year to year in when, where and how reductions are made

At international level, key objectives a policy regime should be to:

establish a long-term quantity goal to limit risk of catastrophic damage
use a price signal (tax or trading) to drive short-term emission reductions
establish a consistent price signal across countries and sectors to reduce GHG emissions which reflect the damage caused by carbon emissions (Stern, p321-322)

Chapter 15 Carbon Pricing and Emission Markets

Key Messages

tax and trading creates an explicit price for carbon; regulation, an implicit price
Credibility, flexibility, and predictability are all vital to effectiveness of climate change policy
Deep and liquid markets with well-designed rules are needed to reap benefits of emissions trading
Increasing use of auctioning will likely to have benefits for efficiencies, distribution and potentially public finances
Establishment of common incentives across different sectors is important for efficiency. However, the overall structure of incentives will reflect other market failures and complexities within the sectors concerned, as well as the climate change externality
The characteristics of different sectors will influence the design and choice of policy tool. Ie. transaction costs of a trading scheme tend to be higher in sectors where there are many emission sources. The existing framework of national policies in these sectors will be an important policy choice (Stern, p324)

15. 1 Introduction

“the choice and design of such policy instruments also depends on the specific sectoral context. Policies which work for one sector may be inappropriate for another, although a common price is still needed across sectors for efficiency in the costs of mitigation” (Stern, p324)

15. 2 Carbon pricing and investment decisions

credibility (support from a wide range of groups), flexibility and predictability are key
uncertainty about price of carbon will be reflected in investment decisions that do not properly take the price of carbon into account and are therefore inefficient and more carbon-intensive than they should be

policy uncertainty also creates an incentive to delay decision-making - “wait and see” attitude

“specific national circumstances, including constitutional structures, the stability of political institutions and the quality of legal infrastructures and enforcement, play a key role in determining what credibly policy is” (Stern, p326)

15.3 Experience in emissions trading

emission trading “can deliver least cost emission reductions by allowing reductions to occur wherever they are cheapest. A key corollary benefit to this is that it generates automatic transfers between countries, while delivering least-cost reductions” (Stern, p327)
it is easier to establish a common price through trading than through taxes; therefore, “trading schemes can be used to introduce carbon pricing, without risking carbon leakage and competitiveness implications between participating countries”  therefore “powerful” tool at international level (Stern, p327)
Review of the EU ETS experience demonstrates need for transparency in initial allocation plans - how are calculations made? (Stern, p329)
scarcity has been difficult to ensure in EU. In EU, overall allocation is not set centrally but by individual member states whose plans are subject to approval; therefore need for “stringent criteria on allocation levels for member states, and robust decisions by the European Commission on NAPs to ensure scarcity in the scheme” (Stern, p329)
experience shown that trading schemes need robust administrative systems - which expensive for firms
Countries to introduce emissions trading:
- Australia (baseline and credit scheme for electricity retailers)
- Norway (major energy plants and heavy industry),
- Japan and South Korea (pilot programs)
- Countries planning to introduce schemes
- US – Regional Greenhouse Gas Initiative (RGGI) – 2009
- California cap and trade scheme – 2008
- Switzerland
- Canada
Voluntary market is growing (Stern, p329)

15.4 Designing efficient and well-functioning emissions trading schemes

Need “deep and liquid markets and well-designed rules” (Stern, p329)
Emissions trading schemes will deliver carbon prices that vary over time, but price stability can be gained through “the emergence of a predictable average price within the emissions trading mechanism” which is important, especially for long-term investment decisions
Options to limit the price movements:
- “supplement the market instrument itself through price controls, such as formal price caps and price floors” (Stern, p330)
- Price caps would eliminate risk of price spikes and price floors would stop the carbon price from falling below a minimum level (Stern, p330)
Problems:
- Uncertainty of price cap and floor
- Price Cap might damage incentives for investing in low carbon technologies “as it sets an upper limit on the future expected price, lowering potential returns to low carbon technology” (Stern, p330)
- Efficiency: “different caps and floors in different schemes would compromise the efficiency of regional trading schemes – there are risks of carbon leakage and unintended transfers across jurisdictions with different carbon price ranges” (Stern, p330)
  - This is a significant practical drawback

Factors that can facilitate deep, liquid and efficient markets: ((Stern, p331)
- broadening the scope of the scheme, to include more gases, more counties, and international credits;
- ensuring appropriate scarcity in the system;
- lengthening the trading periods, to provide longer-term confidence;
- designing appropriate allocation schemes; and
- promoting transparency