Economics of climate change mitigation

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The economics of climate change mitigation is a contentious part of climate change mitigation – action aimed to limit the dangerous socio-economic and environmental consequences of climate change.^[4]

Climate change mitigation centres on two main strategies: the reduction of greenhouse gas (GHG) emissions and the preservation and expansion of sinks which absorb greenhouse gases, including the sea and forests.

The economics of climate change mitigation are a central point of contention whose considerations significantly affect the level of climate action at every level from local to global.

For example, higher interest rates are slowing solar panel installation in developing countries.^[5]

A carbon price is a system of applying a price to carbon emissions, as a method of emissions mitigation.^[6] Potential methods of pricing include carbon emission trading, results-based climate finance, crediting mechanisms and more.^[7] Carbon pricing can lend itself to the creation of carbon taxes, which allows governments to tax emissions.^[6]

Carbon taxes are considered useful because, once a number^{[clarification needed]} has been created, it will benefit the government either with currency or with a lowering in emissions or both, and therefore benefit the environment.^[8] It is almost a consensus that carbon taxing is the most cost-effective method of having a substantial and rapid response to climate change and carbon emissions.^[9] However, backlash to the tax includes that it can be considered regressive, as the impact can be damaging disproportionately to the poor who spend much of their income on energy for their homes.^[10] Still, even with near universal approval, there are issues regarding both the collection and redistribution of the taxes. One of the central questions being how the newly collected taxes will be redistributed.^[11]

Some or all of the proceeds of a carbon tax can be used to stop it disadvantaging the poor.^[12]

In addition to the implementation of command-and-control regulations (as with a carbon tax), governments can also use market-based approaches to mitigate emissions. One such method is emissions trading where governments set the total emissions of all polluters to a maximum and distribute permits, through auction or allocation, that allow entities to emit a portion, typically one ton of carbon dioxide equivalent (CO₂e), of the mandated total emissions.^[13] In other words, the amount of pollution an entity can emit in an emissions trading system is limited by the number of permits they have. If a polluter wants to increase their emissions, they can only do so after buying permits from those who are willing to sell them.^[14] Many economists prefer this method of reducing emissions as it is market based and highly cost effective.^[13] That being said, emissions trading alone is not perfect since it fails to place a clear price on emissions. Without this price, emissions prices are volatile due to the supply of permits being fixed, meaning their price is entirely determined by shifts in demand.^[15] This uncertainty in price is especially disliked by businesses since it prevents them from investing in abatement technologies with confidence which hinders efforts for mitigating emissions.^[15] Regardless, while emissions trading alone has its problems and cannot reduce pollutants to the point of stabilizing the global climate, it remains an important tool for addressing climate change.

There is a debate about a potentially critical need for new ways of economic accounting, including directly monitoring and quantifying positive real-world environmental effects such as air quality improvements and related unprofitable work like forest protection, alongside far-reaching structural changes of lifestyles^[16][17] as well as acknowledging and moving beyond the limits of current economics such as GDP.^[18] Some argue that for effective climate change mitigation degrowth has to occur, while some argue that eco-economic decoupling could limit climate change enough while continuing high rates of traditional GDP growth.^[19][20] There is also research and debate about requirements of how economic systems could be transformed for sustainability – such as how their jobs could transition harmonously into green jobs – a just transition – and how relevant sectors of the economy – like the renewable energy industry and the bioeconomy – could be adequately supported.^[21][22]

While degrowth is often believed to be associated with decreased living standards and austerity measures, many of its proponents seek to expand universal public goods^[23][24] (such as public transport), increase health^[25][26][27] (fitness, wellbeing^[28] and freedom from diseases) and increase various forms of, often unconventional commons-oriented,^[29] labor. To this end, the application of both advanced technologies and reductions in various demands, including via overall reduced labor time^[30] or sufficiency-oriented strategies,^[31] are considered to be important by some.^[32][33]

This section is an excerpt from Climate finance.[edit]

Climate finance is an umbrella term for financial resources such as loans, grants, or domestic budget allocations for climate change mitigation, adaptation or resiliency. Finance can come from private and public sources. It can be channeled by various intermediaries such as multilateral development banks or other development agencies. Those agencies are particularly important for the transfer of public resources from developed to developing countries in light of UN Climate Convention obligations that developed countries have.^[35]: 7

There are two main sub-categories of climate finance based on different aims. Mitigation finance is investment that aims to reduce global carbon emissions. Adaptation finance aims to respond to the consequences of climate change.^[36] Globally, there is a much greater focus on mitigation, accounting for over 90% of spending on climate.^{[37][38]: 2590} Renewable energy is an important growth area for mitigation investment and has growing policy support.^[39]: 5

Finance can come from private and public sources, and sometimes the two can intersect to create financial solutions. It is widely recognized that public budgets will be insufficient to meet the total needs for climate finance, and that private finance will be important to close the finance gap.^[40]: 16 Many different financial models or instruments have been used for financing climate actions. For example green bonds, carbon offsetting, and payment for ecosystem services are some promoted solutions. There is considerable innovation in this area. Transfer of solutions that were not developed specifically for climate finance is also taking place, such as public–private partnerships and blended finance.

There are many challenges with climate finance. Firstly, there are difficulties with measuring and tracking financial flows. Secondly, there are also questions around equitable financial support to developing countries for cutting emissions and adapting to impacts. It is also difficult to provide suitable incentives for investments from the private sector.

The costs of mitigation and adaptation policies can be measured as a percentage of GDP. A problem with this method of assessing costs is that GDP is an imperfect measure of welfare.^[41]: 478 There are externalities in the economy which mean that some prices might not be truly reflective of their social costs.

Corrections can be made to GDP estimates to allow for these problems, but they are difficult to calculate. In response to this problem, some have suggested using other methods to assess policy. For example, the United Nations Commission for Sustainable Development has developed a system for "Green" GDP accounting and a list of sustainable development indicators.

The emissions baseline is, by definition, the emissions that would occur in the absence of policy intervention. Definition of the baseline scenario is critical in the assessment of mitigation costs.^[41]: 469 This because the baseline determines the potential for emissions reductions, and the costs of implementing emission reduction policies.

There are several concepts used in the literature over baselines, including the "efficient" and "business-as-usual" (BAU) baseline cases. In the efficient baseline, it is assumed that all resources are being employed efficiently. In the BAU case, it is assumed that future development trends follow those of the past, and no changes in policies will take place. The BAU baseline is often associated with high GHG emissions, and may reflect the continuation of current energy-subsidy policies, or other market failures.

Some high emission BAU baselines imply relatively low net mitigation costs per unit of emissions. If the BAU scenario projects a large growth in emissions, total mitigation costs can be relatively high. Conversely, in an efficient baseline, mitigation costs per unit of emissions can be relatively high, but total mitigation costs low.^{[clarification needed]}

These are the secondary or side effects of mitigation policies, and including them in studies can result in higher or lower mitigation cost estimates.^[41]: 455 Reduced mortality and morbidity costs are potentially a major ancillary benefit of mitigation. This benefit is associated with reduced use of fossil fuels, thereby resulting in less air pollution, which might even just by itself be a benefit greater than the cost.^[42]: 48 There may also be ancillary costs.

Flexibility is the ability to reduce emissions at the lowest cost. The greater the flexibility that governments allow in their regulatory framework to reduce emissions, the lower the potential costs are for achieving emissions reductions (Markandya et al., 2001:455).^[41]

• "Where" flexibility allows costs to be reduced by allowing emissions to be cut at locations where it is most efficient to do so. For example, the Flexibility Mechanisms of the Kyoto Protocol allow "where" flexibility (Toth et al., 2001:660).^[43]
• "When" flexibility potentially lowers costs by allowing reductions to be made at a time when it is most efficient to do so.

Including carbon sinks in a policy framework is another source of flexibility. Tree planting and forestry management actions can increase the capacity of sinks. Soils and other types of vegetation are also potential sinks. There is, however, uncertainty over how net emissions are affected by activities in this area.^{[41][clarification needed]}

No regret options are social and economic benefits developed under the assumption of taking action and establishing preventative measures in current times without fully knowing what climate change will look like in the future.^[44][45]

These are emission reduction options which can also make a lot of profit – such as adding solar and wind power.^{[46]: TS-108}

Different studies make different assumptions about how far the economy is from the production frontier (defined as the maximum outputs attainable with the optimal use of available inputs – natural resources, labour, etc.).^{[47][clarification needed]}

The benefits of coal phase out exceed the costs.^[48] Switching from cars by improving walking and cycling infrastructure is either free or beneficial to a country's economy as a whole.^[49]

Assumptions about technological development and efficiency in the baseline and mitigation scenarios have a major impact on mitigation costs, in particular in bottom-up studies.^[41] The magnitude of potential technological efficiency improvements depends on assumptions about future technological innovation and market penetration rates for these technologies.

Assessing climate change impacts and mitigation policies involves a comparison of economic flows that occur in different points in time. The discount rate is used by economists to compare economic effects occurring at different times. Discounting converts future economic impacts into their present-day value. The discount rate is generally positive because resources invested today can, on average, be transformed into more resources later. If climate change mitigation is viewed as an investment, then the return on investment can be used to decide how much should be spent on mitigation.

Integrated assessment models (IAM) are used to estimate the social cost of carbon. The discount rate is one of the factors used in these models. The IAM frequently used is the Dynamic Integrated Climate-Economy (DICE) model developed by William Nordhaus. The DICE model uses discount rates, uncertainty, and risks to make benefit and cost estimations of climate policies and adapt to the current economic behavior.^[50]

The choice of discount rate has a large effect on the result of any climate change cost analysis (Halsnæs et al., 2007:136).^[51] Using too high a discount rate will result in too little investment in mitigation, but using too low a rate will result in too much investment in mitigation. In other words, a high discount rate implies that the present-value of a dollar is worth more than the future-value of a dollar.

Discounting can either be prescriptive or descriptive. The descriptive approach is based on what discount rates are observed in the behaviour of people making every day decisions (the private discount rate) (IPCC, 2007c:813).^[47] In the prescriptive approach, a discount rate is chosen based on what is thought to be in the best interests of future generations (the social discount rate).

The descriptive approach can be interpreted^{[clarification needed]} as an effort to maximize the economic resources available to future generations, allowing them to decide how to use those resources (Arrow et al., 1996b:133–134).^[52] The prescriptive approach can be interpreted as an effort to do as much as is economically justified^{[clarification needed]} to reduce the risk of climate change.

The DICE model incorporates a descriptive approach, in which discounting reflects actual economic conditions. In a recent^[when?] DICE model, DICE-2013R Model, the social cost of carbon is estimated based on the following alternative scenarios: (1) a baseline scenario, when climate change policies have not changed since 2010, (2) an optimal scenario, when climate change policies are optimal (fully implemented and followed), (3) when the optimal scenario does not exceed 2˚C limit after 1900 data, (4) when the 2˚C limit is an average and not the optimum, (5) when a near-zero (low) discount rate of 0.1% is used (as assumed in the Stern Review), (6) when a near-zero discount rate is also used but with calibrated interest rates, and (7) when a high discount rate of 3.5% is used.^{[53][needs update]}

According to Markandya et al. (2001:466), discount rates used in assessing mitigation programmes need to at least partly reflect the opportunity costs of capital.^[41] In developed countries, Markandya et al. (2001:466) thought that a discount rate of around 4–6% was probably justified, while in developing countries, a rate of 10–12% was cited. The discount rates used in assessing private projects were found to be higher – with potential rates of between 10% and 25%.

When deciding how to discount future climate change impacts, value judgements are necessary (Arrow et al., 1996b:130). IPCC (2001a:9) found that there was no consensus on the use of long-term discount rates in this area.^[54] The prescriptive approach to discounting leads to long-term discount rates of 2–3% in real terms, while the descriptive approach leads to rates of at least 4% after tax – sometimes much higher (Halsnæs et al., 2007:136).

Even today, it is difficult to agree on an appropriate discount rate. The approach of discounting to be either prescriptive or descriptive stemmed from the views of Nordhaus and Stern. Nordhaus takes on a descriptive approach which "assumes that investments to slow climate change must compete with investments in other areas". While Stern takes on a prescriptive approach in which "leads to the conclusion that any positive pure rate of time preference is unethical".^[50]

In Nordhaus' view, his descriptive approach translates that the impact of climate change is slow, thus investments in climate change should be on the same level of competition with other investments. He defines the discount rate to be the rate of return on capital investments. The DICE model uses the estimated market return on capital as the discount rate, around an average of 4%. He argues that a higher discount rate will make future damages look small, thus have less effort to reduce emissions today. A lower discount rate will make future damages look larger, thus put more effort to reduce emissions today.^[55]

In Stern's view, the pure rate of time preference is defined as the discount rate in a scenario where present and future generations have equal resources and opportunities.^[56] A zero pure rate of time preference in this case would indicate that all generations are treated equally. The future generation do not have a "voice" on today's current policies, so the present generation are morally responsible to treat the future generation in the same manner. He suggests for a lower discount rate in which the present generation should invest in the future to reduce the risks of climate change.

Assumptions are made to support estimating high and low discount rates. These estimates depend on future emissions, climate sensitivity relative to increase in greenhouse gas concentrations, and the seriousness of impacts over time.^[57] Long-term climate policies will significantly impact future generations and this is called intergenerational discounting. Factors that make intergenerational discounting complicated include the great uncertainty of economic growth, future generations are affected by today's policies, and private discounting will be affected due to a longer "investment horizon".^[58]

Discounting is a relatively controversial issue in both climate change mitigation and environmental economics due to the ethical implications of valuing future generations less than present ones. Non-economists often find it difficult to grapple with the idea that thousands of dollars of future costs and benefits can be valued at less than a cent in the present after discounting.^[59]

Mitigation cost estimates depend critically on the baseline (in this case, a reference scenario that the alternative scenario is compared with), the way costs are modelled, and assumptions about future government policy.^[74]: 622 Macroeconomic costs in 2030 were estimated for multi-gas mitigation (reducing emissions of carbon dioxide and other GHGs, such as methane) as between a 3% decrease in global GDP to a small increase, relative to baseline.^[4] This was for an emissions pathway consistent with atmospheric stabilization of GHGs between 445 and 710 ppm CO₂-eq. In 2050, the estimated costs for stabilization between 710 and 445 ppm CO₂-eq ranged between a 1% gain to a 5.5% decrease in global GDP, relative to baseline. These cost estimates were supported by a moderate amount of evidence and much agreement in the literature.^{[75]: 11, 18}

Macroeconomic cost estimates were mostly based on models that assumed transparent markets, no transaction costs, and perfect implementation of cost-effective policy measures across all regions throughout the 21st century.^[4]: 204 Relaxation of some or all these assumptions would lead to an appreciable increase in cost estimates. On the other hand, cost estimates could be reduced by allowing for accelerated technological learning, or the possible use of carbon tax/emission permit revenues to reform national tax systems.^[75]: 8

In most of the assessed studies, costs rose for increasingly stringent stabilization targets. In scenarios that had high baseline emissions, mitigation costs were generally higher for comparable stabilization targets. In scenarios with low emissions baselines, mitigation costs were generally lower for comparable stabilization targets.

The emissions of the richest 1% of the global population account for more than twice the combined share of the poorest 50%. Compliance with the 1.5°C goal of the Paris Agreement would require the richest 1% to reduce their current emissions by at least a factor of 30, while per-person emissions of the poorest 50% could increase by a factor of about three.^[76]

This pie chart illustrates both total emissions for each income group, and emissions per person within each income group. For example, the 10% with the highest incomes are responsible for half of carbon emissions, and its members emit an average of more than five times as much per person as members of the lowest half of the income scale.^[77]

Several studies have estimated regional mitigation costs. The conclusions of these studies are as follows:^[78]: 776

• Regional abatement costs are largely dependent on the assumed stabilization level and baseline scenario. The allocation of emission allowances/permits is also an important factor, but for most countries, is less important than the stabilization level.
• Other costs arise from changes in international trade. Fossil fuel-exporting regions are likely to be affected by losses in coal and oil exports compared to baseline, while some regions might experience increased bio-energy (energy derived from biomass) exports.
• Allocation schemes based on current emissions (i.e., where the most allowances/permits are given to the largest current polluters, and the fewest allowances are given to smallest current polluters) lead to welfare losses for developing countries, while allocation schemes based on a per capita convergence of emissions (i.e., where per capita emissions are equalized) lead to welfare gains for developing countries.

There have been different proposals on how to allocate responsibility for cutting emissions:^[79]: 103

• Egalitarianism: this system interprets the problem as one where each person has equal rights to a global resource, i.e., polluting the atmosphere.
• Basic needs: this system would have emissions allocated according to basic needs, as defined according to a minimum level of consumption. Consumption above basic needs would require countries to buy more emission rights. From this viewpoint, developing countries would need to be at least as well off under an emissions control regime as they would be outside the regime.
• Proportionality and polluter-pays principle: Proportionality reflects the ancient Aristotelian principle that people should receive in proportion to what they put in, and pay in proportion to the damages they cause. This has a potential relationship with the "polluter-pays principle", which can be interpreted in a number of ways:
  • Historical responsibilities: this asserts that allocation of emission rights should be based on patterns of past emissions. Two-thirds of the stock of GHGs in the atmosphere at present is due to the past actions of developed countries.^[80]: 29
  • Comparable burdens and ability to pay: with this approach, countries would reduce emissions based on comparable burdens and their ability to take on the costs of reduction. Ways to assess burdens include monetary costs per head of population, as well as other, more complex measures, like the UNDP's Human Development Index.
  • Willingness to pay: with this approach, countries take on emission reductions based on their ability to pay along with how much they benefit^[81] from reducing their emissions.

• Equal per capita entitlements: this is the most widely cited method of distributing abatement costs, and is derived from egalitarianism.^[79]: 106 This approach can be divided into two categories. In the first category, emissions are allocated according to national population. In the second category, emissions are allocated in a way that attempts to account for historical (cumulative) emissions.
• Status quo: with this approach, historical emissions are ignored, and current emission levels are taken as a status quo right to emit.^[79]: 107 An analogy for this approach can be made with fisheries, which is a common, limited resource. The analogy would be with the atmosphere, which can be viewed as an exhaustible natural resource.^[80]: 27 In international law, one state recognized the long-established use of another state's use of the fisheries resource. It was also recognized by the state that part of the other state's economy was dependent on that resource.

Economic components like the stock market underestimate or cannot value social benefits of climate change mitigation.^[82] Climate change is largely an externality,^[83][84][85] despite a limited recent internalization of impacts that previously were fully 'external' to the economy.^[86]

Consumers can be and are affected by policies that relate to e.g. ethical consumer literacy,^[87] the available choices they have, transportation policy,^[88] product transparency policies,^{[89][90][91][92]} and larger-order economic policies that for example facilitate large-scale shifts of jobs.^[93][94] Such policies or measures are sometimes unpopular with the population. Therefore, they may be difficult for politicians to enact directly or help facilitate indirectly.

Climate policies-induced future lost financial profits from global stranded fossil-fuel assets would lead to major losses for freely managed wealth of investors in advanced economies in current economics.^[95]

• Ecological economics
• EU climate pact
• Green economy