July 09, 2008
Economics can smooth path towards global climate deal
Response to "Why obstacles to a deal on climate are mountainous" by Martin Wolf (Financial Times, 9 July 2008) in the Financial Time's Economists' Forum.
Martin Wolf is right to point to the difficulties inherent in any global deal on climate. Yet there are ways to smooth the path, and smart economics can play an important role.
First though, it is important to keep the distinction between efficiency and cost-effectiveness clear in our minds. Mr Wolf implicitly makes that distinction. Let me restate it more explicitly: efficiency is about weighing the costs and benefits of policies and setting a target; cost-effectiveness is about finding the best way to achieve that target. It is good to have economics on our side to address the former, but given the nature of the problem, economics has a lot more to say about the latter.
The first step is to set a global cap on emissions, which progressively tightens over time. As Martin Weitzman’s paper on the uncertainties around catastrophic climate change makes clear, traditional benefit-cost analysis is an inadequate tool to set the right target. Instead, this debate needs to center first and foremost around climate science. Again, it helps to have economic analysis support the agreement to limit emissions (current science centers around avoiding 2 degrees centigrade of warming, which translates roughly into progressively limiting pollution to arrive at around 20 gigatons of CO2 equivalent greenhouse gas emissions by 2050), but that agreement must be born from scientific necessity and political will.
Economics really enters the picture once that cap is set. For one, markets – in particular a cap-and-trade system – are an important tool to reaching the goal at minimum cost. Another aspect is when it comes to divvying up the room left under this global emission reduction pathway. How do we get countries to agree to individual limits that ensure the integrity of the cap?
One such economic tool could be so-called “premium emissions budgets.” Faced with the prospect of having to cap its emissions in the future, a country could gain significant financial advantage by adopting that exact same cap early. So instead of adopting a cap set at 2017 emissions levels, for example, a country could adopt that exact same cap in 2012 before it has reached the projected emissions levels. In the intervening five years, it could then sell off excess allowances to areas like the EU (and likely the US) with already binding caps, or it could ‘bank’ them itself for later use. The financial gain increases exponentially with every year that the cap is adopted earlier.
Of course, there would only be a limited number of these Premium Budgets to go around under a global cap, which would create an even larger incentive to act early. The first countries to sign on will have larger budgets available to them than the laggards. Early action pays. The sooner a country adopts a certain cap, the larger its financial advantage, and surely also goodwill in international negotiations.
Posted by Gernot Wagner on Wednesday, July 09, 2008. 
