The Economics of Climate Change: a Primer/Chapter 1

by the Congressional Budget Office

Summary and Introduction

Human activities—mainly deforestation and the burning of fossil fuels—are releasing large quantities of what are commonly known as greenhouse gases. The accumulation of those gases is changing the composition of the atmosphere and is probably contributing to a gradual warming of the Earth’s climate—the characteristic weather conditions that prevail in various regions of the world. Scientists generally agree that continued population growth and economic development over the next century will result in substantially more greenhouse gas emissions and further warming unless measures are taken to constrain those emissions.

Despite the general consensus that some amount of warming is highly likely, extensive scientific and economic uncertainty makes predicting and evaluating its effects extremely difficult. Because climate is generally a regional phenomenon, the effects of warming would vary by region. Moreover, some effects could be positive and some negative. Some could be relatively minor and some severe in their impact: warming could raise sea levels; expand the potential range of tropical diseases; disrupt agriculture, forestry, and natural ecosystems; and increase the variability and extremes of regional weather. There is also some possibility of unexpected, abrupt shifts in climate. Actual outcomes will probably be somewhere in the middle of the range of possibilities, but the longer that emissions grow unchecked, the larger the effects are likely to be.

A variety of technological options are available to restrain the growth of emissions, including improvements in the efficiency of people’s use of fossil energy, alternative energy technologies such as nuclear or renewable power, methods for removing greenhouse gases from smokestacks, and approaches to sequestering gases in forests, soils, and oceans. But those alternatives are likely to be costly, and they are unlikely to be widely implemented unless measures are taken to lower their price or to raise the price of greenhouse gas emissions.

This Congressional Budget Office (CBO) study presents an overview of the issue of climate change, focusing primarily on its economic aspects. The study draws from many published sources to summarize the current state of climate science. It also provides a conceptual framework for considering climate change as an economic problem, examines public policies and the trade-offs among them, and discusses the potential complications and benefits of international coordination.

Common Resources: Addressing a Market Failure

The Earth’s atmosphere is a global, open-access resource that no one owns, that everyone depends on, and that absorbs emissions from an enormous variety of natural and human activities. As such, it is vulnerable to overuse, and the climate is vulnerable to degradation—a problem known as the tragedy of the commons. The atmosphere’s global nature makes it very difficult for communities and nations to agree on and enforce individual rights to and responsibilities for its use.

With rights and responsibilities difficult to delineate and agreements a challenge to reach, markets may not develop to allocate atmospheric resources effectively. It may therefore fall to governments to develop alternative policies for addressing the risks from climate change. And because the causes and consequences of such change are global, effective policies will probably require extensive cooperation among countries with very different circumstances and interests.

However, governments may also fail to allocate resources effectively, and international cooperation will be extremely hard to achieve as well. Developed countries, which are responsible for the overwhelming bulk of emissions, will be reluctant to take on increasingly expensive unilateral commitments while there are inexpensive opportunities to constrain emissions in developing countries. But developing nations, which are expected to be the chief source of emissions growth in the future, will also be reluctant to adopt policies that constrain emissions and thereby limit their potential for economic growth—particularly when they have contributed so little to the historical rise in atmospheric greenhouse gas concentrations and may suffer disproportionately more of the negative effects if nothing is done.

Balancing Competing Uses

The atmosphere and climate are part of the stock of natural resources available to people to satisfy their needs and wants over time. From an economic point of view, climate policy involves measuring and comparing the values that people place on resources, across alternative uses and at different points in time, and applying the results to choose a course of action. An effective policy would balance the benefits and costs of using the atmosphere and distribute those benefits and costs among people in an acceptable way.

Uncertainty about the scientific aspects of climate change and about its potential effects complicates the challenge of developing policy by making it difficult to estimate or balance the costs of restricting greenhouse gas emissions and the benefits of averting climate change. (Some of the risks involved, moreover, may be effectively impossible to evaluate or balance in pecuniary terms.) Nevertheless, assessments of the potential costs and benefits of a warming climate typically conclude that the continued growth of emissions could ultimately cause extensive physical and economic damage. Many studies indicate significant benefits from undertaking research to better understand the processes and economic effects of climate change and to discover and develop new and better technologies to reduce or eliminate greenhouse gas emissions.

At the same time, such studies typically find relatively small net benefits from acting to reduce greenhouse gas emissions in the near term. In balancing alternative investments, they conclude that if modest restrictions on emissions were implemented today, they would yield net benefits in the future; however, more-extensive restrictions would crowd out other types of investment, reducing the rate of economic growth and affecting current and future generations’ material prosperity even more than the averted change would. As income and wealth grow and technology improves, the studies say, future generations are likely to find it easier to adapt to the effects of a changing climate and to gradually impose increasingly strict restraints on emissions to avoid further alteration.

Those conclusions greatly depend, among other things, on how one balances the welfare of current generations against that of future generations. In assessments of costs and benefits occurring at different points in time, that process of weighting is typically achieved by using an interest, or discount, rate to convert future values to present ones. But there is little agreement about how to discount costs and benefits over the long time horizons involved in analyzing climate change.

Whatever weighting scheme is chosen, consistency calls for applying it to all long-term investment alternatives. For example, applying a lower discount rate to give more weight to the welfare of future generations implies that society should reduce its current consumption and increase its overall rate of investment in productive physical and human capital of all kinds—not only those involved in ensuring a beneficial future climate.

Government policies that deal with use of the atmosphere inevitably affect the distribution of resources. Inaction benefits people who are alive today while potentially harming future generations. Reducing emissions now may benefit future generations while imposing costs on the current population and may benefit countries at relatively higher risk of adverse effects from warming while hurting those that stand to gain from it. Restraints on emissions would impose costs on nearly everyone in the global economy, but they would affect energy-producing and energy-intensive industries, regions, and countries much more than they would others. However, many studies of the costs and benefits of climate change fail to highlight the extent to which differences in geographic and economic circumstances complicate the balancing of interests.

Policy Options

Governments may respond to climate change by adopting a "wait-and-see" approach, by pursuing research programs to improve scientific knowledge and develop technological options, by regulating greenhouse gas emissions, or by engaging in a combination of research and regulation. The United States has invested in research and subsidized the development of carbon-removal and alternative energy technologies. Furthermore, some programs that were in tended to achieve other goals, such as pollution reduction, energy independence, and the limitation of soil erosion, also discourage emissions or encourage the removal of greenhouse gases from the atmosphere. However, other programs have opposing effects.

Should a government decide to control emissions, it may choose from a broad menu of regulatory approaches. One option is direct controls, which set emissions standards for equipment and processes, require households and businesses to use specific types of equipment, or prohibit them from using others. A government could also adopt more indirect, incentive-based approaches, either singly or in combination—for example, by restricting overall quantities of emissions through a system of permits or by raising the price of emissions through fees or taxes. Incentive based approaches are generally more cost-effective than direct controls as a means of regulating greenhouse gas emissions.

Uncertainty about the costs and benefits of regulation affects the relative advantages of different incentive-based approaches. Some research indicates that such uncertainty gives a system of emissions pricing economic advantages over a quota system that fixes the quantity of emissions. Those advantages stem from two facts: both the costs and benefits of reducing greenhouse gas emissions are uncertain; and the incremental costs—the additional costs of reducing an additional ton of emissions—can be expected to rise much faster than the incremental benefits fall. Under those circumstances, the cost of guessing wrong about the appropriate level of taxes—and, perhaps, of failing to reduce emissions enough in any given year—is likely to be fairly low. But the cost of miscalculating the appropriate level of emissions—and perhaps imposing an overly restrictive and hence expensive limit—could be quite high.

A system of emissions pricing has several other advantages over one of emissions quotas. Pricing could raise significant revenues that could be used to finance cuts in distortionary taxes—such as those on income—that discourage work and investment. Moreover, emissions pricing more effectively encourages the development of technologies that reduce or eliminate emissions than direct controls or strict limits on emissions do.

Restricting greenhouse gas emissions would tend to reduce emissions of some conventional pollutants as well, yielding a variety of ancillary benefits, such as improvements in health from better-quality air and water. Those additional benefits would partly offset the costs of greenhouse gas regulations, particularly in developing countries that have significant problems with local pollution.

The distributional effects of emissions regulations would depend on the type and stringency of the regulations and could be very large relative to how much the policy improved people’s well-being. Those potential effects might spur the affected parties to engage in rent-seeking—vying for regulatory provisions that would provide them with tax exemptions, access to permits, and so on. An emissions pricing system (based either on taxes or on auctioned permits) would benefit different groups in different ways, depending on how the government returned the receipts to the economy. Certain ways of using the revenues could offset some—but probably not all—of the costs of regulation. (For example, if the government issued permits free of charge, even permit recipients who were heavily regulated could benefit from the regulation.)

International Coordination

Because the causes and consequences of climate change are global in nature, effective policies to deal with it will probably require extensive international coordination among countries with very different circumstances and interests. Coordination may involve formal treaties or nonbinding agreements and could range from modest commitments to engage in research to more-extensive programs to restrict emissions, monitor compliance, and enforce penalties.

Effective international agreements typically involve straightforward commitments and distribute costs in a way that is acceptable to participating countries. Binding commitments with explicit penalties may be more likely than nonbinding ones to ensure compliance, but nonbinding agreements may also significantly affect a nation’s actions. Many factors will influence the effectiveness of international cooperation, particularly the size and distribution of the costs and benefits of mitigating climate change and the strength of conflicting interests. Successful cooperation would entail frequent interaction among national representatives and link discussion of climate issues with that of related problems.

An international system of emissions controls could draw on the same set of options that domestic regulation employs—direct controls, emissions taxes or permits, or a hybrid system—or it could allow each country to choose its own independent system. Much of the international debate in recent years has focused on strictly limiting emissions through national quotas, with or without the international trading of emissions rights. However, quantitative limits are likely to prove more costly than approaches that affect emissions indirectly by raising their price. And because there are low-cost opportunities to reduce emissions throughout the world and because fossil fuels can be transported relatively easily, a system that raised the price of emissions everywhere would probably be more cost-effective than one that applied only to a limited set of countries.

International cooperation on the issue of climate change has been developing since the Intergovernmental Panel on Climate Change was created in 1988. And nearly all nations, including the United States, are signatories to the United Nations Framework Convention on Climate Change, which commits them to undertake research and prevent dangerous changes in the Earth’s climate. In 1997, negotiators signed the Kyoto Protocol (a draft treaty) to the convention, under which developed countries agreed to limit emissions while developing countries remained exempt from restrictions. However, subsequent negotiations collapsed in 2000 over details of implementation, and the United States withdrew from the talks in 2001. Ironically, that withdrawal made some of the positions that the United States had advocated much more attractive to the remaining parties and helped them reach agreement on nearly all outstanding implementation issues. The European Union and Japan ratified the protocol in mid-2002; it will go into force if Russia follows suit.

The protocol’s implementation would establish a complex set of emissions rights for a limited set of developed countries for the period 2008 through 2012. It would also put into place institutions to oversee international financial transfers amounting to several billion dollars per year for the purchase of emissions allowances, mainly among the developed countries. However, the protocol would limit participating countries’ overall emissions by only a small amount and would have essentially no effect on the growth of emissions in the United States and in developing countries.

Analysts have proposed a variety of alternatives to the provisions of the Kyoto Protocol to try to improve the potential effectiveness of international cooperation and broaden its appeal. Each alternative simultaneously addresses the problems of limiting emissions and distributing the burden of regulation, which remain the crucial sources of disagreement. Each option reflects a distinct interpretation of the available evidence about the net benefits of averting climate change in different regions and for different generations, as well as practical concerns about how climate policy would affect the global economy.

Some analysts argue for a laissez-faire approach because they believe that the amount of warming is likely to be small and its effects largely benign, or that near-term action is unwarranted in the light of scientific uncertainty. Other researchers have proposed systems of emissions taxes or tradable emissions permits that would be auctioned at fixed prices. In general, the permits would apply to developed countries and exempt developing nations on the grounds of equity. Still other analysts have proposed complex systems that are intended to impose roughly uniform emissions prices throughout the world yet ensure that developed countries bear most of the cost.