7. Modelling economically efficient abatement of greenhouse gases

William R. Cline

1. Introduction

Cline (1992a) sets forth a comprehensive economic analysis of the greenhouse problem. That study develops estimates of the damage that may be expected from global warming; reviews other model estimates of the costs of abatement; and, after an in-depth examination of appropriate discounting methodology, presents cost-benefit calculations that find it is socially efficient to pursue an aggressive international policy of abatement of greenhouse gases (GHGs). The study suggests a two-phase policy approach, with more moderate action in the first decade pending further scientific confirmation.

Subsequent papers synthesize these findings and extend the analysis in various directions (North-South policy interaction, in Cline, 1992c; optimization using the Nordhaus, 1992a, DICE model in Cline, 1992b and 1992d; and a review of new benefits estimates, a survey of abatement cost models, and policy synthesis in Cline, 1993). To minimize duplication of these earlier studies, this paper presents only a summary statement of the cost-benefit analysis in Cline (1992a), and invites the reader to consult that study directly for further elaboration.

The emphasis here is on the evolving shape of the analytical debate. Recent scientific work tends to confirm the emphasis in Cline (1992a) on the much greater warming and damage that may be expected over a very long horizon (three centuries). New scientific results also underscore the risks of sudden and catastrophic effects. New damage estimates widen the menu of conceptual and regional effects even for the conventional doubling of CO₂. Ongoing comparisons of models provide a clearer emerging picture on the side of abatement costs as well.

For the overall cost-benefit comparison, it is becoming increasingly clear that the rate of time discounting is the single most important source of difference between analyses showing aggressive action to be socially efficient (Cline, 1992a) and conclusions in the opposite direction (Nordhaus, 1992b) Accordingly, this paper presents new estimates applying differing discount rates to the Nordhaus (1992a) optimization model, and incorporating backstop technology into that model as well. The analysis here also identifies the corresponding field of "carbon shadow prices," representing the socially efficient penalties for carbon emissions over time.

2. Damage from 2xCO₂ benchmark warming

The primary benefits of GHG abatement are the value of global warming damage thereby avoided. There are also secondary benefits, principally the reduction of urban pollution as a side-effect of reducing fossil fuel combustion. Most analyses examine these effects for the "equilibrium" warming associated with the doubling of carbon dioxide above pre-industrial levels ("2xCO₂").¹

For this conventional benchmark, and the corresponding equilibrium mean global warming of 2.5°C (the "best guess" estimate of the Intergovernmental Panel on Climate Change, IPCC, for the climate sensitivity parameter L), Cline (1992a) places damage to the US economy in a range of 1-2 per cent of GDP. The greatest damage occurs in agriculture (losses of 0.3 per cent of GDP), where careful attention to the appropriate allowance for "carbon fertilization" tends to leave greater net damage than is sometimes suggested.² Other major damage categories include the costs of increased energy for the excess of higher air-conditioning requirements over savings on heating (0.17 per cent of GDP); sealevel rise (0.12 per cent); losses in water supply (0.12 per cent); and increased losses of human life (0.1 per cent). On conservative valuations, forest loss, species loss, and increased air pollution from warmer temperatures (tropospheric ozone) add another 0.18 per cent of GDP to damage. More liberal allowances for species loss might place this damage alone on the order of 0.7 per cent of GDP. The secondary benefit of reduced air pollution could be of a comparable magnitude.

The 1 per cent of GDP damage estimate for 2xCO₂ in Cline (1992a: table 3.4) is thus best viewed as a moderate central value, with the figure easily reaching 2 per cent of GDP. Moreover, if upper-bound warming (L= 4.5°C) is applied, and with even modest non-linearity (damage exponent = 1.3), the corresponding range for damage reaches 2-4 per cent of GDP.

Important additional damage estimates have been made by Titus (1992) and Fankhauser (1992). For the United States, Titus suggests extremely large potential damage in forest loss (0.8 per cent of GDP) and in increased water pollution associated with decreased stream flow (0.6 per cent of GDP, for a damage category not even considered in Cline, 1992a). The larger figure for forest loss incorporates a broader concept of the consumer value of forest use, whereas the much smaller estimate in Cline (1992a) is based narrowly on the market value of lumber forgone.

For his part, Fankhauser (1992) extends the damage estimates to other countries, estimating them at 1.5 per cent of GDP for the European Communities, 0.7 per cent for the former Soviet Union, a remarkably high 6.1 per cent for China, and 2.8 per cent for non-OECD countries overall.³ His estimate for the United States is 1.3 per cent of GDP, which is comparable to the range in Cline (1992a). Fankhauser's estimate of an average of 1.4 per cent of GDP damage globally is comparable to that used by Nordhaus (1993b). It should be emphasized, however, that this is a GDP-weighted measure. Because of the relatively higher damage in developing countries, weighting by population would give a higher global estimate.

3. Very-long-term warming and damage

Cline (1992a) places heavy emphasis on the fact that, in the absence of policy intervention, global warming is likely to extend far beyond the amount associated with a doubling of pre-industrial atmospheric concentrations of carbon dioxide. A doubling of the carbon dioxide equivalent of all GHGs is expected to occur as early as 2025 (IPCC, 1990). In contrast, the proper time-horizon for analysis is at least three centuries. Thus, Sundquist (1990) estimates that the atmospheric concentration of carbon dioxide may be expected to rise until the end of the twenty-third century, after which time mixing into the deep ocean could cause a limited reversal.

As calculated in Cline (1992a), with reasonable baselines for population and economic activity and given abundant coal resources, global emissions would multiply approximately threefold by 2100 and ninefold by 2300. With the atmospheric retention ratio at its recent level of approximately 50 per cent of emissions, over this horizon atmospheric concentrations of carbon dioxide could multiply some eightfold. Taking other GHGs into account, and applying the radiative forcing relationships identified in IPCC (1990), the implication is a central warming projection of 10°C by 2300 for the IPCC's "best guess" climate sensitivity parameter of L = 2.5°C. This would take the earth back to the climate of the mid-Cretaceous period 100 million years ago, when mean temperatures were an estimated 6°C to 12°C higher than today (Hoffert and Covey, 1992). If instead the upper-bound climate sensitivity parameter is applied (L = 4.5°C), verylong-term warming could reach approximately 18°C.

Recent simulations of the GFDL (Geophysical Fluid Dynamics Laboratory) general circulation model (GCM) at Princeton University tend to confirm the central very-long-term baseline in Cline (1992a). Manabe and Stouffer (1993) examine the effects of a quadrupling of pre-industrial carbon dioxide equivalent by 140 years from now. They note that this level amounts to a 1 per cent annual increase in CO₂-equivalent concentration, and is consistent with the IPCC "business-as-usual" scenario. The equilibrium mean surface air temperature increase reaches 7°C.⁴ This estimate turns out to be slightly more severe than that in my study (a central estimate of 7°C warming commitment by the somewhat later date of 2150; Cline, 1992a 52).⁵

Manabe and Stouffer do not argue that atmospheric concentrations will in fact stop rising after 140 years. Instead, their interest is in examining the consequences of this specified century-scale scenario. They find that the sealevel rise from thermal expansion alone reaches 1.8 metres by the 500th year, and would presumably be much greater if the effect of melting of ice sheets were taken into account. In contrast, the IPCC's estimate for the sealevel rise by 2100 is only two-thirds of a metre (IPCC, 1990: fig. 9.6).

Damage is highly likely to be non-linear in warming. As just one example, water runoff is a residual between precipitation (which rises with global warming but primarily in the high latitudes) and evapotranspiration, which rises more than linearly with warming. Cline (1992a) uses a relatively modest degree of non-linearity for most effects: an exponent of 1.3. (In contrast, Nordhaus, 1993b, applies a quadratic damage function.) The Cline (1992a) estimate of very-long-term damage corresponding to 10°C warming is in the range of 612 per cent of GDP for central estimates. Even with moderate non-linearity, the damage reaches an average of 20 per cent of GDP for higher-damage cases (upper-bound warming; with base damage for 2xCO₂ at 1 or 2 per cent of GDP).

4. Catastrophic effects

One of the most disturbing findings of the new Manabe-Stouffer simulation for 4xCO₂ is that:

... the ocean settles into a new stable state in which the thermohaline circulation has ceased entirely and the thermocline deepens substantially. These changes prevent the ventilation of the deep ocean and could have a profound impact on the carbon cycle and biogeochemistry of the coupled system. (Manatee and Stouffer, 1993: 215)

In other words, the GFDL model simulated for just 4xCO₂ finds that in the base case one of the feared "catastrophes" occurs: the ocean conveyor belt shuts down, and along with it presumably the flow of the Gulf Stream that keeps Northern Europe from being as cold as its latitudinal peer, Canada's Hudson Bay region.⁶ Moreover, the same phenomenon would largely close off the potential large reservoir of the deep ocean as a sink for carbon dioxide, presumably raising the atmospheric retention ratio and accelerating atmospheric build-up as a consequence.

Other recent evidence on the risk of catastrophe comes from the climate records in Greenland ice cores, which suggest that warming can come in extremely compressed periods. Thus, there was an estimated 7°C (local) warming within the space of only 50 years in the Younger Dryas period some 12,000 years ago (Dansgaard et al., 1989); and a collapse and rebound of temperature by 14°C within a 70-year period near the end of the last (Eemian) interglacial period before the present (Holocene) interglacial, some 115,000 years ago (Anklin et al., 1993). The extreme speed of such warming would seem highly likely to increase the non-linearity of damage, perhaps to catastrophic levels.

In the benefit-cost analyses examined below, these and other catastrophic scenarios are simply absent. The possibility of catastrophic outcomes must be kept in mind as a consideration that could warrant more aggressive abatement than indicated by the central benefit-cost analysis.

5. The costs of greenhouse gas abatement

Cline (1992a: chap. 4) provides a survey of economic models of the cost of reducing carbon dioxide emissions. Conceptually this cost equals the output loss imposed by restricting the use of a productive input, energy, in the "production function" for economic output. The central range of results in these models indicates that, by 2050, it would cost some 2-3 per cent of gross world product (GWP) to reduce emissions by 50 per cent from their business-as-usual baseline. This range is consistent with the production function approach.⁷

The OECD has investigated standardized simulations of several of the carbon abatement models (Dean, 1993). In an aggressive intervention scenario in which carbon emissions are reduced by 2 per cent annually from their business-as-usual time-path, by 2050 emissions would stand 70 per cent below baseline; and by 2100, 88 per cent below baseline. This scenario is broadly consistent with the aggressive action plan examined in Cline (1992a), where emissions are cut by one-third from present levels and then held constant at 4 billion tons of carbon (4 GtC) annually.⁸

The results of this standardized exercise show that, for the United States, the costs of the aggressive reduction by 2050 are in a range of 1.3 per cent of GDP (OECD's "GREEN" model) to about 2.6 per cent of GDP (the Manne-Richels, MR, model; and the Rutherford model). The extremely deep cut by 2100 imposes costs of 3.1 per cent of GDP in the MR model and 2.6 per cent of GDP in the Rutherford model (Dean, 1993. 11).⁹

For global costs, the models show somewhat (but not dramatically) higher costs. The simple average for these three models is a cost of 2.9 per cent of GWP for the 70 per cent cut from baseline by 2050, and 4.2 per cent of GWP for the 88 per cent cut from baseline by 2100. For the former Soviet Union, China, and other developing countries, costs are in the range of 4.0-5.5 per cent of GDP for the deep cuts by 2100 (MR and Rutherford models). Importantly, the somewhat higher costs of abatement for developing countries parallel the relatively higher damage of greenhouse abatement suggested by Fankhauser (as noted above), implying that for developing countries the benefit-cost trade-off may be comparable to that in industrial countries but at higher levels on both sides of the ledger.

Although costs can be substantially non-linear with respect to the depth of emissions cut-back at a given technology, they need not be so if it is recognized that the deeper reductions tend to come later in the time-horizon when the array of technological alternatives is wider. In particular, the advent of a "backstop technology" providing unlimited non-carbon-emitting energy at a fixed price premium above fossil fuels makes a critical difference to the cost of deep carbon cutbacks late in the horizon. Manne and Richels (1992) estimate that such technologies (e.g. advanced nuclear, solar, or biomass) should be available by about 2030, at a premium of about US$200 per ton of carbon (in 1990 dollars) above the opportunity cost of energy from carbon-emitting backstop technologies (e.g. synthetic fuels from coal).

Cline (1992a: chap. 5) emphasizes that abatement costs can be held lower initially through two strategies: forestry measures; and a move to the efficiency frontier using existing technology (as stressed in the "bottom-up" models). Reduced deforestation can remove carbon emissions at a cost of less than US$10 per ton. Afforestation can sequester carbon at costs under US$20 per ton (Moulton and Richards, 1990). However, additional carbon is sequestered only during the forest's growing stage, suggesting that afforestation is primarily an option for the first three decades or so.

The National Academy of Sciences (NAS, 1991) has estimated that, by moving to the efficiency frontier of existing technology, it would be possible to reduce US carbon emissions by 10-40 per cent at zero or very low cost. Information costs, utility pricing distortions, and other market failures help explain the gap between actual practice and potential efficiency. It is important to emphasize, however, that closing this gap is a one-time proportionate gain. Once the economy has moved to an "efficient" baseline, the new path parallels the original business-as-usual baseline at a lower absolute level that none the less still rises over time. It is unrealistic to expect a constant succession of additional movements to ever-shifting efficiency frontiers at zero cost, because the market failures in the revised baseline have already been removed. This is particularly so if the business-as-usual baseline already incorporates a widening array of technological alternatives (as in the Manne-Richels 1992 model). Thus, adherents of the bottom-up school cannot reasonably expect cost-free carbon abatement over the whole time-horizon.

Finally, costs can be substantially reduced if revenues from a carbon tax are used to correct existing distortions in fiscal structure. Existing taxes (e.g. on income and capital gains) impose disincentives that result in an economic loss of about 30 cents for each dollar of revenue collected (estimates for the United States by Jorgenson and Yun, 1990). Similarly, McKibbin (1992: 41) estimates that whereas an OECD-wide tax of US$15 per ton of carbon reduces US GDP by about 0.4 percentage points from baseline over the next two decades, if the revenues are used to reduce the budget deficit (rather than returned in a "lump sum" to households) the adverse output effect would be reduced to a 0.3 per cent reduction from baseline. The reason is that a lower fiscal deficit would reduce interest rates and stimulate investment and growth.

6. Benefit-cost comparison

Figure 7.1 shows the benefit-cost trade-off over time that emerges for an aggressive action programme that cuts global carbon emissions by one-third (to 4 billion tons of carbon annually) and then holds them constant over time (Cline, 1992a: chap. 7). In lieu of specific estimates for other countries, the figure assumes that the US damage profile is representative globally.

The benefits of abatement are set at only 80 per cent of the damage from baseline warming, on the grounds that even with aggressive action warming cannot be avoided completely. Similarly, abatement costs are expanded by 20 per cent above those for carbon alone, to take account of other GHGs. The cost curve is low at first, because of a 20 per cent "free" reduction assumed for the move to the efficiency frontier, as well as the availability of forestry measures. The abatement cost time-path then peaks at about 3.5 per cent of GWP, and thereafter declines to a plateau of about 2.5 per cent, because the cost function in Cline (1992a) allows for lower cost at later dates as the consequence of widening technological alternatives.¹⁰

Over the horizon, the benefits of abatement as a percentage of GWP substantially exceed costs in the high-damage case but are moderately below costs on average in the moderate central case. Moreover, the costs of abatement tend to be concentrated early in the horizon, whereas the greenhouse damage and thus benefits of abatement occur later. As a result, two factors drive the cost-benefit comparison: risk weighting, and the time discount rate for comparison across different points in time. Cline (1992a) places heavier weight (0.375) on the high-damage case than on the low-damage case (0.125) in aggregating with the central case (weight of 0.5) to capture risk aversion. Perhaps the single most important methodological issue, however, is the proper rate for time discounting.

Fig. 7.1 The costs and benefits of aggressive abatement of greenhouse warning

The discount rate

When consumption is available at alternative time-periods, the proper discounting procedure applies a "social rate of time preference" equal to:

where g is the rate of growth of per capita income, a is the elasticity of marginal utility of consumption, and r is the rate of pure time preference (Cline, 1992a: chap. 6; Nordhaus, 1992b: 1319). That is, the term or (< 0) tells how rapidly marginal utility drops off as per capita income rises; and the term r tells how much society prefers consumption today rather than tomorrow even for an unchanged level of per capita income.

Cline (1992a) adopts the classic view of Ramsey (1928) and others that the rate of pure time preference (r) should be set to zero for the purposes of social welfare analysis. Especially for intergenerational comparisons, from the point of view of society it makes no sense to value a dollar of consumption for the future at less than a dollar of consumption today when per capita consumption is held constant between the two periods. In contrast, utility-based discounting for income and consumption growth is appropriate, and is incorporated in the second term (

).

Many econometric studies use a logarithmic utility function, which sets the elasticity of marginal utility (a) equal to -1.0 (Blanchard and Fischer, 1989). Two specific investigations of the elasticity of marginal utility independently place it at -1.5 (Fellner, 1967; Scott, 1989), indicating a somewhat more rapid drop-off in marginal utility than in the usual logarithmic utility function.

Cline (1992a) sets per capita income growth over the three-century horizon at about 1 per cent annually. With r = 0,

= 1.5, and g = 1, the result is a social rate of time preference of 1.5 per cent per annum. Even at this rate, which some economists would consider low, US$1 of consumption today equates with US$20 (in real terms) 200 years in the future.

Following modern discount theory, Cline (1992a) further incorporates the influence of the portion of resources diverted from capital investment (on which the rate of return is higher) by applying a shadow price on capital and converting these resources to consumption equivalents. The overall effect is a discount rate of about 2 per cent.

Returning to figure 7.1, when this discounting procedure is applied, and when greater weight is applied to the high-damage case than to the low-damage case (not shown), the result is that the risk-weighted benefit/cost ratio for aggressive policy action comfortably exceeds unity (at 1.3). Thus, the economic benefits of the aggressive abatement of greenhouse gases would appear to warrant the corresponding economic costs, adding an economic basis for action to any case that might be made on ecological or scientific grounds alone.

Optimal emissions paths and the DICE model

In sharp contrast, Nordhaus (1992b) finds that even freezing emissions at their current level would have net social costs equivalent to 0.7 per cent of discounted future consumption. His optimal path would cut emissions by only 10 per cent from baseline, rising to 15 per cent in the next century. Because baseline emissions multiply more than threefold by 2100, his result indicates that it is economically efficient to allow the great bulk of emission increases to proceed unhindered.

To reach these conclusions, Nordhaus uses his Dynamic Integrated Climate-Economy (DICE) model (Nordhaus, 1992a). The DICE model is a potentially important advance in economic analysis of greenhouse policy. The model directly integrates emissions and global warming with savings, investment, and growth over time. The model appropriately takes a very-long-term view of the problem, as its simulations span 400 years (although Nordhaus, 1992b, reports results only through 2105). In principle the model provides the basis for identifying an optimal path of emissions over time, although in practice this path is extremely sensitive to assumptions.

Cline (1992b) implements the DICE model and examines its sensitivity to key parameters. As might be expected for an analysis over such a long horizon, the time discount rate turns out to be the principal reason for the sharp divergence between the Nordhaus results and those of the cost-benefit analysis in Cline (1992a).

In the DICE model, utility-based discounting (equivalent to the term

discussed above) takes place through the combined effect of the logarithmic utility function (in which a 1 per cent rise in per capita income causes a 1 per cent decline in the marginal utility of consumption), on the one hand, and the model's optimal allocation of resources between present consumption and capital formation through saving (which drives the per capita growth rate, g), on the other. The model then explicitly further discounts by incorporating the rate of pure time preference, r. Its objective function is thus:

where P is population, c is per capita consumption, t is the year, and T is the final year in the horizon (400 in DICE).

Alternative simulations with DICE

The impact of alternative discount rates

Figure 7.2 reports the results of simulating DICE with alternative values for the rate of pure time preference, r. The figure shows the proportionate cut of carbon emissions from baseline (business as usual). For comparison, the path of proportionate cuts implied by the ceiling of 4 GtC annually is also shown, identified as "Cline."

The lowest path of cut-backs in the figure represents results setting the rate of pure time preference at 3 per cent, the value assumed by Nordhaus. As indicated, the implementation here successfully replicates the Nordhaus result of optimal cut-backs limited to only 10-15 per cent over the first 100 years when r = 3 per cent. However, the figure also shows that, if lower values are assigned to r, the DICE model itself generates much more aggressive optimal abatement paths. Indeed, if the rate of pure time preference is set equal to zero on the grounds argued above, the optimal abatement path in DICE becomes approximately equivalent to the 4 GtC ceiling of the aggressive abatement programme found to have a favourable risk-weighted benefit-cost ratio in Cline (1992a).

For comparability with the results in Cline (1992a), the appropriate value for the rate of pure time preference in figure 7.2 is in the range of 0.5 per cent per annum. The reason is that the DICE model applies a lower elasticity of marginal utility (a= -1 instead of -1.5). This difference can be approximately compensated for by raising the rate of pure time preference (r) from the conceptually appropriate level of zero to 0.5 per cent.¹¹

Fig. 7.2 The optimal rate of emissions reduction

As may be seen in figure 7.2, if the rate of pure time preference is set at 0.5 per cent per annum, the optimal cut-back from baseline reaches about 50 per cent by 2100. Although this reduction is far greater than the optimal cut-back of 14 per cent identified by Nordhaus (1993b) for that period, the reduction remains considerably smaller than that implied by the aggressive international programme of limiting emissions to 4 GtC. However, adjustment of other elements of the DICE model could easily close this gap, including incorporation of the risk of higher-damage cases and imposition of a backstop-technology ceiling on abatement costs (as discussed below).

It should come as no surprise that the most profound policy decision that must be made on greenhouse policy turns on the rate of pure time preference, or how much weight we place on our own consumption in preference to that of our descendants. Global warming is inherently a problem involving small sacrifice in the present for large damage avoided for future generations. The 3 per cent value for r assumed by Nordhaus would seem to give far too little weight to future generations. This rate means that, under conditions of equal per capita income today and 200 years in the future, we can justifiably ask our descendants to give up US$370 in consumption to permit us to enjoy just US$1 of extra consumption today (in constant price dollars).

In this debate, Nordhaus (1993a) has replied that a zero rate of pure time preference is "lower than would be consistent with observed real interest rates." Even if this were true it would not be the proper basis for policy determination. Society would be irresponsible to impose a US$370/US$1 trade-off against our descendants even if the markets today stated that this rate is what currently obtains in financial transactions. Policy should seek to correct market distortions where they exist, and a rate of 3 per cent for pure time preference would strongly imply a severe distortion in the inter-temporal consumption and assets markets. Indeed, it would be inconsistent to rule out the application of second-best pricing to compensate for market failure on the key analytical parameter the discount rate - in addressing a policy issue that takes as its point of departure the need for second-best correction of market failure on another central price - that of carbon (for which the market price does not incorporate the external diseconomy of greenhouse damage).

Moreover, it is by no means clear that observed market behaviour places a rate as high as 3 per cent on pure time preference. The closest asset to this concept is the real rate of return on Treasury bills, which involve no risk. This rate has averaged only 0.3 per cent over the past 60 years (Cline, 1992a: 258).¹²

Nordhaus himself has examined the sensitivity of the DICE results to the discount rate (Nordhaus, 1993b). However, his sensitivity test is a weak one, because he maintains the sum of the pure rate of time preference (r) and the "growth discounting" (

) constant at 6 per cent. In his base case, r = 3 per cent, and growth rate, g, under "today's conditions" equals 3 per cent; so that, with a =-1 (logarithmic utility), the left-hand side of equation (1) above equals 6 per cent, which he judges is the market rate for the present "real interest rate on goods." When he reduces the rate of pure time preference from 3 per cent to zero for purposes of sensitivity analysis, he compensates by increasing the elasticity of marginal utility from -1 to -2, so that the left-hand side of (1) remains 6 per cent with today's growth rate at g = 3 per cent. The result is that setting the rate of pure time preference to zero only increases optimal abatement from a 12.5 per cent cut-back from baseline in 2050 to a 25 per cent reduction; and from a 14.3 per cent cut-back by 2100 to a 28 per cent reduction (Nordhaus, 1993b: table 6-4). Moreover, even this increase in optimal abatement stems solely from the fact that growth is decelerating in Nordhaus's baseline. If growth were constant, there would be no change in optimal emissions, because the reduction of pure time preference would be wholly offset by the increase assumed for the elasticity of marginal utility.

As discussed above, insistence that equation (1) above must equal a "market" rate of 6 per cent would appear misguided. As noted, it is highly doubtful that the proper concept, the consumption rate of time preference, is anywhere near this high. Moreover, a "second-best" approach would consider the social rate of time preference rather than an observed market rate, as argued above.

Other model assumptions

There are other assumptions in DICE that may warrant change as well. The model's near-cubic cost curve for carbon reduction causes an extremely high marginal cost for deep cut-backs. This pattern stems in part from the fact that the cost curve has no time variable: the sacrifice for a 70 per cent cut-back of carbon from baseline is identical whether the cut-back occurs today or in the latter part of the next century.¹³

The high cost of deep carbon reductions in DICE is revealed by considering the "shadow price" on carbon (the marginal cost of reducing carbon by 1 ton) under alternative simulations. Figure 7.3 reports these prices. It is evident that, with the much steeper optimal carbon reductions identified with lower rates of pure time preference, it is optimal to pay even very high marginal costs for carbon reduction (and thus very high carbon taxes). At r = 0, the optimal carbon tax reaches about US$220 per ton by 2025, and US$590 per ton by 2105.

These marginal costs would appear to overstate the expense of reducing carbon emissions. In particular, the marginal costs in the DICE model can rise far above the level of about US$200 per ton of carbon identified by Manne and Richels (1992) as an appropriate range for the ceiling associated with backstop technology.

Cline and Hsieh (1993) show that the imposition of a backstop-technology ceiling on the marginal cost of avoiding carbon emissions causes the optimal abatement path to jump to nearly complete elimination of carbon at the period when the shadow price of carbon (and thus the marginal benefit of its removal) begins to exceed the backstop price. Thus, with a ceiling of US$200 per ton of carbon removed, and with a rate of pure time preference of 1 per cent, the optimal cutback from baseline jumps from 33 per cent in 2125 to 45 per cent in 2145 and nearly 100 per cent in 2155, compared with an optimal cutback of only 43 per cent at the latter date in the absence of the backstop ceiling.

Another crucial source of understatement of optimal abatement in the Nordhaus (1992b) DICE results is that they do not incorporate the risk of upper-bound warming and upper-bound damage in the damage function. The analysis is strictly central-case, yet the essence of the greenhouse problem is dealing appropriately with risk. 14 Indeed, without risk weighting, the Cline (1992a) analysis shows a benefit/cost ratio for aggressive action of only 0.7. Moreover, both analyses omit the potential of catastrophic impact. Thus, neither Nordhaus (1992b) nor Cline (1992a) quantifies the economic damage that would result from a shutting down of the "ocean conveyor belt" that generates the Gulf Stream. Similarly, the damage functions are at most quadratic, and assume gradual warming.

The Nordhaus formulation of DICE would also appear to understate baseline carbon emissions, and thus prospective warming. The model sets business-as-usual emissions at 25 GtC by 2100 and only 31 GtC by 2275. In contrast, Cline (1992a) places emissions at 21 GtC by the first date and 56 GtC by the second. For their part, Manne and Richels (1992) set baseline emissions at 39 GtC already by 2100. The principal reason for the low emissions late in the horizon in the Nordhaus baseline is his assumption of low economic growth, driven by decelerating technological change (as discussed in Cline, 1992b).

Fig. 7.3 The shadow price of carbon with alternative discount rates

Moreover, the climate module in DICE would appear to understate the prospective extent of even central-case warming. The global mean temperature rise never exceeds 5.5°C over four centuries in the model as specified; yet the IPCC (1990: chap. 6) places the commitment to global warming at 5.7°C already by 2100 under business as usual. One reason for the low very-long-term warming is the low emissions baseline, as noted. Another reason for the apparent understatement is that DICE specifies a low contribution of greenhouse gases other than carbon dioxide, which at their maximum add only 1.24 watts/m² (wm^-2) in radiative forcing as opposed to the level of 3.06 wm^-2 already by 2100 estimated for these gases by the IPCC (1990: table 2.7).15 Still another reason would appear to be that the DICE specification involves a declining atmospheric retention ratio for carbon dioxide emissions, which falls to only 37 per cent by 2100, 29 per cent by 2200, and 26 per cent by 2270 (Cline, 1992b). Yet Wigley has indicated that, under business as usual, a relatively constant atmospheric retention ratio of about 45 per cent can be expected to persist.¹⁶

Shadow prices and carbon taxes

Returning to figure 7.3, the alternative simulations with DICE provide a basis for identifying appropriate penalties to assign for carbon emissions. For a given point in time and a specified rate of pure time preference, the "shadow price" tells the marginal benefit of reducing emissions by an additional 1 ton of carbon and thereby reducing global warming; or, equivalently, the marginal economic cost of doing so. Accordingly, the shadow price also tells the optimal marginal carbon tax, because only a tax of this amount will send the proper price signal to economize on carbon emissions.

As indicated in figure 7.3, for a rate of pure time preference of 0.5 per cent, the shadow price of carbon (optimal carbon tax) rises from US$45 per ton initially to US$84 per ton by 2025, US$133 by 2055, and US$243 by 2105. As suggested above, this range for r corresponds roughly to the assumptions in Cline (1992a), albeit still with understatement of abatement from the standpoint of not incorporating the risk of upper-bound warming or cost limits from backstop technology.

In comparison, Fankhauser and Pearce (1993) identify a lower and flatter trajectory for the shadow price of carbon, rising from US$20 per ton in 1991-2000 to US$28 per ton by 2021-2030. An important source of the difference is that Fankhauser and Pearce use a probabilistic approach to the range of discount rates, thereby including considerable weight on rates substantially higher than suggested here. Conceptually their method differs as well, because it seeks to identify the shadow price on a basis of discounted greenhouse damage under probability-weighted scenarios of public action and inaction, rather than by identifying an optimal emissions path that takes account of the costs of abatement.

7. Policy implications

The analysis in Cline (1992a) recommends an aggressive programme of international abatement of greenhouse gases. However, it suggests a two-phase strategy. In the first decade, more moderate measures would be applied. Thereafter, pending further scientific confirmation, policy measures would be intensified to limit emissions to a path similar to that of a 4 GtC ceiling.

In the event, industrial countries essentially committed at the Earth Summit in Rio de Janeiro in 1992 to return greenhouse gas emissions to 1990 levels by the year 2000. In view of the rising business-as-usual path, this commitment is equivalent to a cut-back somewhere on the order of 10-15 per cent.

There is a surprising convergence of the various analyses on action approximately consistent with this degree of restraint in the first decade. The Cline (1992a) aggressive action programme is a reduction of one-third; but, with a milder first phase, cut-back from baseline by some 10-15 per cent in the first decade is consistent with the overall strategy. The Nordhaus (1992b) optimal cut-back of 9 per cent by 1995 is not far from the same outcome. Similarly, the hedging strategy of Manne and Richels (1992) also leads to a cut-back from baseline of about 12 per cent by the year 2000.

Similarly, the carbon tax tends to converge for this initial period. Thus, the range suggested here of US$45 per ton in the 1990s (fig. 7.3 at r = 0.5 per cent) suggests that something like US$20-25 per ton might be appropriate in the initial decade of more moderate action pending further scientific confirmation. This range is consistent with the Fankhauser-Pearce initial shadow price (optimal carbon tax) of about US$20 per ton of carbon. This tax is even within reach of the Nordhaus Monte-Carlo results. Those sensitivity results place Nordhaus's optimal carbon tax at an expected value of about US$12 per ton of carbon in 1995, and as high as US$45 per ton at the 95th percentile of the distribution. Considering the suggestion of Yohe (1992) that incorporation of risk recommends "focusing on a scenario which describes something around the 75th percentile of potential economic damage," an intermediate point between the two Nordhaus Monte-Carlo estimates would also tend to converge in the US$20-25 per ton range for 1995. The policy prescriptions would begin to diverge more sharply only beyond the first decade, assuming scientific confirmation of the seriousness of the problem.

During this first decade, in addition to the moderate cut-backs and carbon taxes suggested here for the first phase, there should be intensive scientific research. One important area is in the narrowing of discrepancies among general circulation models on cloud feedback, the principal source of divergence generating the IPCC range of L from 1.5°C to 4.5°C. However, another key area for further research is on the very-long-term prospects for warming and damage. It would appear that, until recently, the scientific community may have been discouraged from looking at horizons beyond a century by the presumed tyranny of the economists' discount rate. That is, more distant results may have been thought to matter little because of time discounting in the policy process. However, as suggested here (and in Cline, 1992a), proper discounting methodology can leave room for serious damage even after a century to play a significant role in the analytical outcome. Economists should encourage the scientists to extend their analyses to these longer horizons (as in Manabe and Stouffer, 1993), rather than discourage such analysis.

In addition, there is a need in the coming decade for much more extensive analysis of the benefits and costs of GHG abatement for developing countries. Most of the economic analyses to date have been for the United States and other industrial countries. However, the fragmentary evidence for developing countries suggests that the stakes for limiting global warming may be even higher in these regions. Confirmation of this diagnosis, and its broader dissemination, could help the international community move toward a more global response in a second phase of policy action. It may be appropriate that abatement efforts in the first phase be concentrated in the industrial countries (including "joint" measures they might undertake with developing countries). In the longer run, however, ceilings on emissions in China and other developing countries will be necessary as well, if the problem of global warming is to be seriously addressed (Cline, 1992a: 336-342; Manne and Richels, 1992: 91).

Notes

1. Because of ocean thermal lag, equilibrium warming occurs perhaps some three decades after the corresponding radiative forcing from the increase in atmospheric concentrations of GHGs above pre-industrial levels. "Transient" or actual warming is thus less than the commitment" to equilibrium warming at a point in lime, unless atmospheric concentrations have been at a stable plateau for several decades.

2. Because of other trace gases, there is much less than twice the amount of carbon dioxide in the atmosphere when 2xCO₂-equivalent radiative forcing is attained.

3. The high estimate for China is driven by damage amounting to about 2 per cent of GDP each in two categories: agriculture and human mortality. The former reflects the large share of the agricultural sector in GDP. The latter is the consequence of applying a statistical value of life for China at US$150,000 only about one-tenth the typical range for industrial countries but relatively high compared with per capita income.

4. The actual transient warming by the 140th year is 5°C.

5. Note that the GFDL GCM has A = 3.5°C; Cline (1992a) uses A = 2.5°C.

6. The argument is that, with greater high-latitude precipitation and glacier melting, the waters near Greenland would become less saline and therefore less dense. In addition, warming (which would be much greater at this latitude than the global mean) would reduce the gradient of the thermocline. Together, the changes could mean that the cold surface waters there might no longer sink into the deep ocean as they currently do, shutting down the ocean conveyor belt.

7. Energy claims some 68 per cent of GDP. Economic theory states that this 'factor share" is also the "elasticity" of output with respect to the factor. The models tend to show that a 50 per cent cut-hack in carbon requires only a 25 per cent cut-back in energy. The resulting output loss would be 25% x 0.07 = 1.75 per cent of GDP, based on the factor elasticity approach.

8. Thus, the average baseline in the OECD survey is about 15 GtC by 2050 and 27 GtC by 2100 (Dean, 1993: 8).

9. The study also reports much higher cost estimates from simulations by Barns, Edmonds, and Reilly. However, those estimates apply an unreliable "GDP feedback parameter" in the Edmonds Reilly model. Unfortunately, the OECD survey did not use the methodologically preferable variant in the model, which instead estimates costs by integrating the area under the marginal carbon tax curve a method that gives much lower costs. See the discussion in Cline (1992a: 160-161).

10. Indeed, a floor is set on costs to prevent this influence from reducing them to extremely low levels late in the horizon.

11. Note also that the Nordhaus DICE technical change parameter generates an optimal growth path with considerably less per capita consumption growth than in Cline (1992a). Per capita consumption grows at 1.1 per cent in the first 50 years, 0.5 per cent in the second 50 years, and more slowly thereafter, with average growth of 0.4 per cent over three centuries (compared with 1 per cent in Cline, 1992a). Note further that there is an inherent compensation for this difference in the growth-discounting effect. Slower growth depresses late-period GDP and therefore the economic base to which the proportionate excess of damages over abatement costs present late in the horizon applies (fig. 7.1). In compensation, the growth-discounting component of the discount rate,

, is lower because of the lower growth rate, g. The lower discount rate enhances the importance of later periods. neutralizing their diminution from the standpoint of the size of the economic base. Finally, note that the use of pure time preference at r = 0.5 per cent to compensate for a lower elasticity of marginal utility probably introduces an upward bias in the discount rate for DICE compared with Cline (1992a). That is, with the low growth rate of 0.4 per cent in DICE, the appropriate discount rate would be: r = 0.4 x 1.5 + 0 = 0.6 per cent (equation 1). Instead, the approximation suggested as comparable in figure 7.2 here is r = 0.5, so that r = 0.4 x 1 + 0.5 = 0.9 per cent.

12. It is true that observed real rates of return on capital of as much as 8 per cent imply that there is a large wedge between the social rate of time preference to savers in equation (1) and the return on capital. Under perfect markets, we would have the rate of return on capital i equal to the social rate of time preference r, or:

. However, private capital return includes substantial project risk, and in addition includes a wedge representing marginal tax rates. As a result, i = r + w, where w is a wedge incorporating risk, tax distortions, and other market imperfections. Importantly, it is practically inconceivable that real return on capital could remain as high as 8 per cent over three centuries. Such a rate is strictly inconsistent with the size of GWP in both the Nordhaus and Cline projections. Thus, an investment of just 1 per cent of today's GWP, or US$200 billion, earning a steady 8 per cent real return would grow to 1.3 million times projected GWP at the end of the 300-year horizon. What these considerations do suggest is that there may he undersaving and underinvestment in a wide range of areas from society's viewpoint. However, the existence of such underinvestment is no justification for a social decision to underinvest in greenhouse abatement, where the consequences build up to proportionately much greater magnitudes because of the extremely long time-horizon.

13. The Nordhaus cost function is: c = 0.0686z2.887 where c is cost as a fraction of GDP and z is the proportionate cut-back of carbon emissions from baseline.

14. Although the subsequent version in Nordhaus (1993b) does conduct sensitivity analysis and address risk aversion through "Monte-Carlo" runs in which parameters are varied, that approach does not identify the optimal path under risk aversion with the key discount rate parameters set at r = 0 and a = -1.5. Even so, the sensitivity estimates indicate somewhat more forceful optimal action. Thus, in Nordhaus's base case, the optimal carbon tax is only US$5.32 per ton in 1995, rising to US$13.68 by 2045, and US$21.03 by 2095. The corresponding rates of reduction from baseline are 9 per cent, 12.5 per cent, and 14.3 per cent, respectively. In contrast, with 400 Monte-Carlo runs, the expected (probability-weighted) carbon tax is US$11.83 per ton by 1995; and the tax for the 95th percentile in the distribution is US$42 per ton in that year.

15. Adjustment for the more recent findings that radiative forcing from CFCs tends to be neutralized by reduced forcing from the stratospheric ozone stripped by CFCs would not alter this estimate by much.

16. T. M. L. Wigley, University of Colorado, personal communication, 16 July 1993, using the model described in Wigley (1993). Note that Wigley has warned that his model may not provide reliable estimates for atmospheric concentration and retention for concentration levels above 1,000 ppm. because of the possible effect of a large increase in the ocean sink from the influence of dissolution of oceanic carbonates and near shore sediments. However. Eric Sundquist of Woods Hole Oceanographic Institute has indicated that the three-century horizon investigated here is too short for this influence to have much effect on atmospheric concentration. Personal communication. 5 February 1993.

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8. Macroeconomic costs and other side-effects of reducing CO2 emissions

Akihiro Amano

1. Introduction

More than 150 nations signed the Framework Convention on Climate Change in June 1992 at Rio de Janeiro, revealing their determination to start coping with the global warming issue. Although the agreements were not as aggressive as had been expected in advance, the extensive guiding principles brought together in Agenda 21 represent a big step forward. One clear message is that more use is to be made of economic measures to combat global warming and other environmental problems. The question we now face is to decide the extent to which we should apply these measures with respect to the abatement of carbon dioxide and other greenhouse gas emissions. The nations that agreed to the Convention have not yet decided about it explicitly except for some environmentally advanced Northern European countries.

In this paper I shall first discuss, in section 2, the magnitudes of the macroeconomic costs of limiting carbon dioxide emissions. By comparing the results of the OECD global model comparison project and those of Japanese studies, I shall point up the importance of understanding the model structures behind these simulation experiments. Besides the macroeconomic costs, economic measures such as carbon taxes (and to a large extent other market-oriented measures as well) will have other side-effects both domestically and internationally. In section 3, some of these problems will also be addressed.

Assessment of mitigation costs alone cannot determine the optimum scale of measures against global warming. Recently, there have been interesting discussions concerning the size of optimal carbon taxes. In section 4, I shall attempt to discern the factors affecting the size of carbon taxes in the optimal abatement path, or the social costs of carbon emissions. Section 5 closes the paper with a summary and conclusions.

2. The macroeconomic costs of reducing CO₂ emissions

When the OECD convened an international workshop in 1991 to compare the simulation results of representative global models on cost estimates of limiting carbon dioxide emissions, one of the objectives was to investigate the reasons such diverse figures had been obtained. Intensive comparative studies of six global models of greenhouse gas emissions culminated in a number of OECD working papers and Economic Studies articles, and many important findings explaining the determinants of macroeconomic costs have been obtained. (See Dean, 1993, for a survey of the workshop.)

Table 8.1 is constructed from the simulation results of four dynamic, long-term models: the Manne-Richels model (MR), Rutherford's Carbon Rights Trade Model (CRTM), the Edmonds-Reilly model (ER), and the OECD GREEN model (GREEN). The figures in the table have been derived from the simulation results involving CO₂ abatement in terms of a 2 per cent reduction in annual rates of increase compared with the business-as-usual scenarios.

The left-hand panel of table 8.1 reports the ratio of percentage reductions in real GDP to those in CO₂ emissions (i.e. percentage GDP losses caused by a one percentage point reduction in CO₂ e missions relative to the baseline), and the right-hand panel reports the ratio of carbon tax rates (measured in dollars per ton carbon) to percentage reductions in CO₂ emissions (i.e. the amount of carbon taxes required to achieve a 1 per cent reduction in CO₂ emissions).

Because these simulation exercises were performed on the same set of exogenous assumptions and on the same method of perturbing the systems, the results turned out to be fairly similar, especially for developed countries. There are a couple of notable differences, however. The Edmonds Reilly model reports relatively larger impacts in the longer term, because backstop technologies do not play a large role compared with other models. The Rutherford model, on the other hand, reports smaller effects, because this model allows for opportunities to trade energy-intensive products and carbon emission rights. Noting these special cases, however, we may say that a 1 per cent reduction in carbon emissions generally requires a 0.02-0.05 per cent decrease in GDP in developed countries. The corresponding carbon tax rates are around US$2-10 per ton carbon (tC).

Table 8.1 The macroeconomic costs of CO₂ emission reduction

	Percentage reduction in GDPa					Carbon taxes (US$/tC)b
Year	United States	Other OECD	Former USSR	China	Other regions	United States	Other OECD	Former USSR	China	Other regions
MR
2000	0.05	0.03	0.10	0.11	0.18	7	7	11	12	12
2020	0.05	0.03	0.07	0.06	0.11	8	5	7	6	9
2100	0.04	0.02	0.06	0.06	0.06	2	2	9	2	2
CRTM
2000	0.01	0.00	0.04	0.04	0.13	10	9	9	9	12
2020	0.03	0.01	0.03	0.04	0.06	7	5	7	7	9
2100	0.03	0.02	0.05	0.04	0.05	2	2	9	1	2
ER
2000	0.03	0.03	0.03	0.05	0.05	4	6	3	3	6
2020	0.04	0.04	0.02	0.06	0.05	8	8	2	4	10
2100	0.10	0.05	0.04	0.07	0.06	31	14	8	8	23
GREEN
2000	0.02	0.02	0.02	0.02	0.06	7	9	1	1	5
2020	0.03	0.03	0.04	0.02	0.09	5	5	2	1	4
2050	0.02	0.02	0.05	0.02	0.06	5	4	3	1	5

Source: Dean and Hoeller (1992).

a. The percentage change in GDP relative to the business-as-usual scenario for a 1 per cent reduction in CO₂ emissions, also relative to the business-as-usual scenario.

b. Carbon faxes required for a 1 per cent reduction in CO₂ emissions relative to the business-as-usual scenario.

Table 8.2 Carbon tax simulations of Japanese models

Model	Final year	Percentage reduction in GNP	Carbon taxes ($/tC)
Goto	2030	0.02	3
Ban	2000	0.05	6
Mori	2020	0.22	17
Yamaji	2005	0.23	19
Ito	2010	0.29	17
Yamazaki	2010	0.41	19

Source: Amano (1992a,b).

For non-OECD countries the results are somewhat diverse, but I can make two observations. First, all models show relatively larger output effects in these countries, especially in the "rest of the world" region, which includes energy-exporting countries. Secondly, carbon taxes for the former USSR and China are fairly low in the GREEN and Edmonds Reilly models, because these models take into account the subsidized, low domestic energy prices in these countries.

Table 8.2 presents the results of similar simulation studies conducted in Japan. I report this additional information because it clearly shows that the objectives of model-building and the methods of simulation experiments can both influence the results substantially. The figures in table 8.2 are constructed in the same way as those in table 8.1.

We can distinguish two groups in this table. The first group (the Goto and Ban models) obtained comparable results to those of table 8.1 with respect to both GDP/GNP reductions and carbon taxes. The results of the second group, however, are surprisingly similar to each other, but they are much larger than other estimates in either table 8.2 or table 8.1.

Three reasons can explain these differences. First, the models in the second group have been developed by combining econometric forecasting models of the demand-determined type with some form of energy model, and most of them have usually been used for projection and simulation exercises. The role expected of such models is to make precise short- to medium-term projections and not to draw a clear picture of the distant future. On the other hand, computable general equilibrium (CGE) models can generally treat the long-run responses more explicitly and adequately with smoother adjustments in various sectors. As the above results indicate, the long-run and short-run responses captured by these two sets of models can give rise to notable differences.

The second reason for the difference is that short-run models involve temporary deviations from full employment resulting from higher energy prices, which are absent in CGE models by assumption. Of course, this does not mean that short-run adjustment problems are unimportant. There are, however, regular anti-cyclical measures in the policy arsenal, and these measures should be and will be integrated in the policy package at the level of actual implementation.

The third point relates to the treatment of tax revenue. In general equilibrium models, carbon tax revenue is usually recycled to the public to make the carbon tax revenue neutral. However, this is not true for the second group of models in table 8.2; the results reported in the table were based on an assumption of no change in public sector behaviour. This assumption, combined with the demand-determined type of macroeconometric model, can lead to a large decline in output with the imposition of carbon taxes.

These considerations suggest that policy simulation results should be presented and interpreted with care. Analysts try to identify the effects of some factors by isolating the disturbance as far as possible. But the way of isolating an event depends a great deal on how that factor is modelled. Therefore, the results of such simulations must be presented and interpreted with a clear understanding of the model structure.

In fact, actual policies may not be implemented as suggested by the model simulations we have just seen. Assignment of the same percentage reduction in emissions to all countries is not an efficient way of formulating a global or an international policy. An efficient policy would require that the rate of carbon tax be the same for all countries. The way in which tax revenue is recycled may vary from one country to another, reflecting differing public deficits. To say the same thing from a different angle, real policy simulations should be based on combinations of policy measures with realistic policy responses to expected unfavourable side-effects. Ordinary "policy simulations" are often not carried out in this way.

3. Some side-effects of reducing CO₂ emissions

The kind of consideration mentioned at the end of the last section provokes discussion concerning the various side-effects of economic measures to mitigate global warming (such as carbon taxes), including the regressive distributional effects within a country and undesirable effects upon international competitiveness when other countries do not adopt similar measures. There is some empirical evidence to support the first point (see, e.g., Poterba, 1991, and Smith, 1993), but these authors also indicate that there are policy instruments that can offset the socially undesirable distributional consequences of carbon taxes.

The question of international competitiveness seems to involve at least three points. First, when the external costs associated with carbon emissions are internalized, changes in the relative cost structure may lead to alterations in the pattern of the international division of labour. If an international carbon tax scheme is adopted with a uniform tax rate, then an efficient international division of labour will not be distorted, although ordinary short-term adjustment problems will accompany any change in comparative cost structures. Rather, international resource allocation will be improved because the price structure now reflects social costs rather than mere private costs. However, if only a subset of countries participate in this scheme, or if the tax rates vary substantially among countries, then "trade-diversion effects" may result. The supply sources of carbon-intensive goods may shift from more efficient and more benign-to-the-environment countries to less efficient and less benign-to-the-environment countries. In such circumstances, exemption from carbon taxes may be justified. It should be noted, however, that this argument applies only to those industries that suffer from the trade diversion, not to all industries suffering from a loss of international competitiveness.

In this connection, Hoeller and Wallin (1991) show that there exist fairly large differences in implicit carbon tax rates among major OECD countries, and Burniaux et al. (1992) subjoin that the differences are even wider if we consider the world economy as a whole. World energy and carbon uses would be made much more efficient if these distortions could be eliminated.

Secondly, when carbon taxes are introduced in some countries to the extent that world energy prices are depressed, then energy consumption or carbon emissions in other countries not participating in the carbon tax scheme will increase, and this tends to lessen the initial reduction in carbon emissions. This effect, combined with the offsetting influence resulting from trade-diversion effects mentioned above, is called "carbon leakages." Rutherford (1992) reported that the leakage effects are fairly large, especially when carbon limitation becomes very stringent. According to his model simulation, when OECD countries alone attempt to reduce the annual rate of increase in carbon emissions by 3 per cent, the leakage rate, i.e. the proportion of unilateral abatement effects that are offset by the expansion of carbon emissions in non-participating countries, will approach 100 per cent (see Rutherford, 1992). If this conclusion is correct, then any international unilateral action that might affect international energy prices should involve some arrangements to minimize such carbon leakage effects.

On the other hand, simulation analyses performed by the OECD GREEN model suggest that the carbon emission stabilization scheme unilaterally adopted by the OECD countries will lead to carbon leakages of only 2.5 per cent (see Burniaux et al., 1992, and Nicoletti and Oliveira-Martins, 1992). On the average for the period 1990-2050 the greatest reduction in the production of energy-intensive sectors occurs in Japan (- 2.6 per cent) and the smallest reduction in the United States (-0.4 per cent). These results are in sharp contrast to those of Rutherford.

Manne (1993) also examined the extent of carbon leakages with a global model incorporating international trade in crude oil, natural gas, energy-intensive products, and tradable emission permits. According to his simulation results, carbon leakages through the channel of oil trade seem unimportant except perhaps in the initial period. However, international trade in energy-intensive products creates a broad conduit for carbon leakages. The leakage rate starts from around 20 per cent in 2000, increasing to a level slightly above 30 per cent in 2050. Trade in natural gas also raises the leakage ratio in the medium term, but it tends to moderate the leakage in the longer run as world natural gas prices are capped at the backstop level. The overall results seem to fall between Rutherford and the GREEN model results.

Even with these leakage effects, however Manne concludes that unilateral carbon limitations by the OECD nations would be effective in that they could reduce global emissions for some time. At the same time, he also stresses the finding that, beyond 2020 or so, emissions from non-OECD countries will become quite important. These two major conclusions seem to suggest that carbon leakages are at most a medium-term issue, if relevant at all. In the longer teen, many energy-intensive activities will move to the non-OECD region anyway, irrespective of the introduction of carbon taxes in OECD countries, and emission reductions in the non-OECD region will become a central issue. Effective arrangements to contain the vast increase in emissions expected from this region will become imperative under most plausible scenarios.

All three models mentioned above aggregate industries into energy-intensive and energy-non-intensive sectors, but a more disaggregated approach would be needed to verify the results. Quantitative studies of the impacts of carbon taxes upon more disaggregated sectors, such as Jorgenson et al. (1992) for the United States and Kuroda and Shimpo (1992) for Japan, have shown that output responses brought about by the imposition of carbon taxes will be concentrated in a rather small number of energy-related industries such as coal mining, crude oil, electric utilities, gas utilities, and refining. The effects on energy-intensive manufacturing sectors such as iron and steel and paper and pulp products, however, are not as marked as in the energy industries. Therefore, the distinction between energy-intensive and energy-non-intensive sectors does not really indicate the uneven distribution of sectoral impacts upon output. Of course, aggregation does not affect the size of the total impact upon carbon dioxide emissions, so that the implications of simulation results concerning carbon leakages will remain unaffected. However, the distinction masks the differential burden of adjustments among industries which should somehow be taken into account in formulating an appropriate policy package.

Another interesting study applies the GREEN model. Oliveira-Martins et al. (1992) examined the effects of tax exemption of energy-intensive industries, in order to see if such measures can protect these industries from a loss of international competitiveness. Their results show, quite interestingly, that the effects of tax exemption are almost negligible in terms both of leakage rates and of changes in sectoral output. It appears that it is not the loss of competitiveness due to the imposition of the tax but a contraction in the market in question that hits these particular industries.

The third question related to the international competitiveness issue concerns the effects of changes in the terms of trade caused by an international carbon tax scheme. As discussed in relation to the second problem, the international application of carbon taxes, be they unilateral or worldwide, would most probably lead to changes in the international terms of trade of carbon energies in favour of energy-importing countries and against energy-exporting countries, implying large-scale international income transfers. There are not many global models that examine this question, but the OECD GREEN model has shown that the terms of trade effects upon real incomes are of non-negligible magnitudes (see Burniaux et al., 1992). In international negotiations to apply economic measures to mitigate global warming, due consideration will have to be given to this issue.

4. The social costs of CO₂ emissions

One of the important questions remaining unresolved in the discussion of how to cope with the global warming issue is the extent of the desirable, or socially optimal, strategy to reduce greenhouse gases. On the one hand, the group of scientists associated with the Intergovernmental Panel on Climate Change (IPCC) confirmed their earlier recommendation that in order to stabilize climatic change it would be necessary to reduce the current level of emissions of CO₂ by 60 per cent (IPCC, 1992). On the other hand, William Nordhaus has been maintaining in a series of papers that climatic stabilization or even emission stabilization is far from optimal from the socioeconomic viewpoint, and that the socially optimal abatement path is much closer to the uncontrolled path (Nordhaus, 1990a,b, 1992a,b). According to his view, percentage rates of reduction of greenhouse gases along the optimal path will be as low as 10 per cent in around 2000 and 14 per cent in around 2100. The levels of carbon taxes will also be moderate along the optimal path, ranging from about US$6/tC in 2000 to a little above US$20/tC in 2100.

William Cline (1992), on the other hand, considers that a more aggressive policy of stabilizing current CO₂ emissions at an annual rate of 4 billion tons of carbon (GtC) would be justified if (a) future benefits are given higher weights by means of a lower social rate of time discount, and if (b) the risk-averse stances of policy makers are taken into account. Although Cline's conclusions are not based on an optimization model, they are derived from a detailed global cost benefit analysis. If we reconstruct his cost-benefit model, we can calculate the carbon taxes required for the aggressive policy to obtain US$50/tC in 2013, US$100/tC in 2020, US$200/tC in 2025, and US$250/tC in 2054 and after. These rates are much higher than those of Nordhaus.

At an OECD/IEA international conference, Fankhauser and Pearce (1993) reported that their estimates of the social costs of CO₂ emissions, measured as the discounted sum of future incremental damages, are US$20/tC in 1991 -2000, US$23/tC in 2001-2010, US$25/tC in 2011-2020, and US$28/tC in 2021-2030. These estimates fall between those of Nordhaus and Cline, although Fankhauser and Pearce did not present estimates beyond 2030.

In this section I shall examine the factors affecting the magnitude of the shadow prices or social costs of carbon dioxide emissions by means of a small economy-climate model of the Nordhaus type (see the appendix at the end of the chapter for a brief description of the model).

I first performed simulation experiments in order to substantiate the wide differences between Nordhaus's results and those assuming stabilization of CO₂ emissions or of temperature rise. The first five columns of tables 8.3-8.7 present cases where (a) a 3 per cent annual social discount rate is used, as in Nordhaus's analysis, except for Case O' as will be explained below, (b) the IPCC's central estimate of 3°C is used for the climate sensitivity parameter (i.e. the temperature increase at the benchmark condition of doubling carbon dioxide concentration in the atmosphere relative to the pre-industrial level), and (c) the damage function is such that the damage parameter (i.e. the percentage reduction in world GDP at the benchmark climate of 2 x CO₂) is 1 per cent and the function is quadratic.

In these simulations, world output is influenced by climate change through the damage function, which reflects both the macroeconomic costs of emission control and the damage arising from a temperature increase (or the benefits of preventing temperature increase through emission control). The "Uncontrolled" case, however, refers to a situation where these cost-benefit interactions between climate and the economy are completely neglected. In what follows I shall call this the "Business as Usual" (BaU) case.

As expected, the characteristics of Case O are very similar to those of Nordhaus. Optimal percentage reductions in carbon emissions start from 7 per cent in 2000 and remain below 20 per cent all the time. Carbon taxes are also low, starting from US$5/tC and rising to US$13/tC in 21)50 and to US$25/tC in 2100. Reflecting such low emission control. the pattern of temperature rise is very similar to that of the BaU scenario. In other words, a large-scale reduction in CO₂ emissions would not be optimal, and the optimal control path under these conditions almost implies the maintenance of the status quo as far as global warming is concerned.

Table 8.3 Percentage reductions in CO₂ emissions

	Case
Year	U	O	O'	E	T	LT	MT	HT	LL	HH
2000	-	7	23	20	29	19	23	32	14	48
2010	-	7	25	32	34	20	25	34	15	52
2020	-	8	25	45	40	20	25	35	15	54
2050	-	8	26	55	60	20	26	37	14	59
2100	-	12	33	76	92	22	33	46	16	79
2150	-	15	37	86	92	23	37	53	17	95
2200	-	18	36	92	94	21	36	52	17	100

U:	Uncontrolled
O:	Optimization (3% discount)
O:	Optimization (0.5% discount)
E:	Emission stabilization
T:	Temperature rise stabilization
LT:	Low temperature rise
MT:	Medium temperature rise
HT:	High temperature rise
LL:	Low damage, etc.
HH:	High damage, etc.

Table 8.4 Carbon taxes (US$/tC)

	Case
Year	U	O	O'	E	T	LT	MT	HT	LL	HH
2000	-	5	60	46	94	41	60	117	23	263
2010	-	7	76	130	146	50	76	149	27	344
2020	8	89	280	219	56	89	174	30	415
2050	-	13	129	571	697	72	129	254	36	672
2100	-	25	200	1,116	1,704	91	200	401	47	1,214
2150	-	42	255	1,474	1,712	96	255	526	55	1,830
2200	-	58	244	1,700	1,777	64	244	514	52	2,268

Table 8.5 Carbon emissions (GtC)

	Case
Year	U	O	O'	E	T	LT	MT	HT	LL	HH
2000	7.6	7.0	6.1	6.0	5.4	6.4	6.1	5.4	6.6	4.2
2010	8.9	8.2	7.3	6.0	5.8	7.7	7.3	6.3	7.7	4.2
2020	11.0	10.2	9.0	6.0	6.6	9.7	9.0	7.8	9.0	6.1
2050	16.6	12.5	11.1	6.0	5.2	12.1	11.1	9.4	9.4	7.9
2100	26.2	23.0	19.3	6.0	1.9	22.5	19.3	15.3	12.1	10.7
2150	47.2	39.4	32.3	6.0	3.3	39.9	32.3	23.8	16.0	5.5
2200	82.9	65.8	56.6	6.0	4.7	71.3	56.6	41.3	28.2	0.2

Table 8.6 Temperature rise (°C)

	Case
Year	U	O	O'	E	T	LT	MT	HT	LL	HH
2000	1.1	1.1	1.1	1.1	1.1	0.6	1.1	1.7	0.6	1.7
2050	1.5	1.4	1.4	1.3	1.3	0.7	1.4	2.0	0.7	1.9
2100	2.4	2.3	2.1	1.6	1.5	1.1	2.1	2.9	1.0	2.6
2150	3.8	3.6	3.3	1.9	1.5	1.8	3.3	4.3	1.4	3.5
2200	5.7	5.2	4.7	2.2	1.5	2.6	4.7	6.1	1.8	3.9

Table 8.7 Percentage change in world GDP relative to "business-as-usual" scenario

	Case
Year	U	O	O'	E	T	LT	MT	HT	LL	HH
2000	-	-0.2	-0.4	-0.4	-0.6	-0.4	-0.4	-0.9	-0.3	- 1.6
2050	-	-0.4	-0.9	-2.9	-3.3	-0.7	-0.9	- 1.7	-0.5	-3.3
2100	-	-0.8	-1.5	-5.8	-9.3	-1.2	-1.5	-2.9	-0.8	-6.2
2150	-	-2.0	2.6	-7.9	- 9.0	-1.9	-2.6	-4.7	1.3	-10.1
2200	-	-3.7	-4.2	-9.3	-7.5	-2.8	-4.2	-7.0	-1.7	-12.0

The contrasting assumptions often adopted in the mitigation scenarios are cases of stabilizing emissions or temperature increases. In Case E, the annual level of CO₂ emissions is stabilized at the 1990 level, and, in Case T. the temperature rise from the pre-industrial level is constrained below or equal to 1.5°C. The required emission reductions in these two cases are, of course, substantial. The carbon taxes required in Case E, for instance, are US$46/tC in 2000, US$130/tC in 2010, US$280/tC in 2020, and so on; and in Case T they are somewhat higher in the near term and register US$697/tC in 2050 and US$1,704/tC in 2100. The rate of reduction in world GDP in 2100 is a mere 0.8 per cent in Case O, but it is much higher in Cases E and T (5.8 per cent and 9.3 per cent, respectively).

Against the view that deems continuing global warming optimal, there can be a criticism that it discriminates against future generations. Indeed, Cline argues that the application of a 3 per cent discount rate is inappropriate. On the basis of the facts that the elasticity of marginal utility of consumption is around 1.5 and that the long-term rate of growth of per capita income is roughly 1 per cent per annum, he considers that the annual rate of social time discount should be around 1.5 per cent. He also points out that, if a logarithmic utility function is used, the elasticity of marginal utility with respect to consumption is unity so that consumption growth at an annual rate of 1 per cent implies built-in discounting of 1 per cent per annum.

Case O' in tables 8.3-8.7 reports the results where only the rate of time discount is changed, from 3 per cent per annum to 0.5 per cent per annum, all other conditions being kept unchanged as in Case O. It can be seen that both the rates of emission reduction and carbon taxes are higher now, although the rates of emission reduction hardly exceed 40 per cent even in the 22nd century. Moreover, the time profile of temperature rise does not change very much. When the rate of social discount is lowered, a larger weight is given to the utility from future consumption. Therefore, when optimization involves savings-investment decisions, as in the present model, this change tends to induce larger investments and hence larger future output and CO₂ emissions. On the other hand, the lower discount rate also attaches a larger weight to future damage, so that it raises rates of emission reduction in the nearer term. Because these two opposing forces cancel each other out, the two scenarios look very similar as far as physical conditions are concerned. This means that lowering the discount rate can explain only a part of the differences between the Nordhaus and Cline results.

Let us now turn to the remaining five cases of tables 8.3-8.7. In these cases, I set the rate of discount at 0.5 per cent per annum. The first three cases distinguish climate sensitivity and the extent of damage from global warming as follows:

LT - low climate sensitivity parameter (1.5°C) and low damage parameter (1 per cent with the degree of non-linearity 1.3);

MT - medium climate sensitivity parameter (3.0°C) and medium damage parameter (1 per cent with the degree of non-linearity 2.0);

HT - high climate sensitivity parameter (4.5°C) and high damage parameter (2 per cent with the degree of non-linearity 3.0).

The central case, MT, is identical to Case O'. Comparing the results for these three cases, we can observe that climate and damage parameters can change the nature of optimal time paths substantially. Emission reduction rates and carbon taxes are higher in Case HT than in Case MT, with smaller emissions but larger temperature increases and larger output reductions in Case HT. The reverse holds for Case LT. However, none of the three cases would satisfy those who prefer stabilizing emissions or temperature rise. The temperature increases in 2200 lie in the range of 2.6-6.1°C, which is much higher than in Cases E and T.

In the last two columns of tables 8.3-8.7, I take up two extreme cases: for Case LL I assigned the lowest parameter values for climate sensitivity and output damage as well as for the rates of population growth, and similarly for Case HH I assigned the highest set of parameter values. I can point out two interesting similarities. First, Case LL has many points in common with Case O. This means that the application of rather high time discount rates is tantamount to assuming the most favourable global climate conditions in many important aspects: low temperature increases, little damage, less severe non-linearity of damage, and low rates of population growth. Second, Case HH, in turn, has many similarities with Cases E and T. CO₂ emissions are severely controlled by high carbon taxes, resulting in fairly large output losses in the long run. However, there is one important difference: even with such severe emission controls global warming will not be mitigated in Case HH as sufficiently as in cases E and T.

One might think that if the expected damage caused by global warming were much more substantial, then further stringent emission controls would lessen global warming. Thus, I considered two higher-damage scenarios in table 8.8: one with a higher degree of non-linearity of the damage function (power 3.5) and the other with an even higher damage parameter (4 per cent of world output at 2 x CO₂). In both cases carbon tax rates in 2100 are in the range of US$1.200-$1,500/tC, and rates of emission reduction in 2200 become 100 per cent. Indeed, in the case where damage is 4 per cent, the extent of temperature rise becomes lower than that in Case HT or HH. However, it is still larger than those of Cases E and T. Thus we must conclude that, even enlarging the size of the damage parameter by twice the most pessimistic estimate and making other assumptions most amenable to substantial damage, we cannot obtain optimal abatement paths that would justify immediate emission stabilization at about current levels. It appears that we need some other sort of social valuation function that incorporates much broader non-market values, or that takes a more serious view of uncertain, catastrophic situations in the distant future.

Table 8.8 Two high-damage scenarios

	Emission reduction (%)		Carbon tax (US$/tC)		Emissions (GtC)		Temperature rise (°C)
Year	Power 3.5	Damage 4%	Power 3.5	Damage 4%	Power 3.5	Damage 4%	Power 3.5	Damage 4%
2000	47	56	257	357	4.2	3.5	1.7	1.7
2010	52	60	338	461	4.9	4.0	1.7	1.7
2020	54	62	409	551	6.2	5.0	1.7	1.7
2050	59	67	671	868	7.9	6.3	1.9	1.8
2100	79	86	1,235	1,467	10.3	6.9	2.6	2.3
2150	96	100	1,874	2,075	4.4	0.1	3.5	2.8
2200	100	100	2,365	2,572	0.2	0.2	3.8	2.7

As I mentioned at the beginning of this section, Fankhauser and Pearce arrived at the conclusion that the social costs of carbon emissions for the period 1990-2030 are in the range of US$20-30/tC. I shall conclude this section by summarizing my own estimates in table 8.9. It is clear that Case O. which attempts to reproduce the Nordhausian situation, does not seem to be normal when we apply the discount rate of 0.5 per cent per annum. My MT scenario gives slightly higher estimates than those of Fankhauser and Pearce, but it should be noted that these numbers are only for a relatively short period. My Case MT shows that the estimates would rise as we move further into the future, and will approach US$200/tC by 2100.

I add one more simulation in table 8.9 within brackets. This case is based on exactly the same assumptions as Case MT, but the terminal year is 2250 rather than 2300. Thus, shortening the time-horizon tends to reduce the social costs of carbon emissions. Since the problem of global warming arises from stock externality, higher discounting of the future will make the social costs smaller. By shortening the time-horizon, we simply discount the events beyond the time-horizon by an infinite discount rate. We must therefore take a fairly long view in evaluating the social costs of greenhouse gas emissions.

Table 8.9 The social costs of carbon emissions (US$/tC)

Scenario	2000	2010	2020	2030
Optimization à la Nordhaus	5	7	8	11
Emission stabilization	48	130	280	375
Stabilization of temperature rise	94	146	219	331
Low temperature rise	41	50	56	62
Medium temperature rise	60	76	89	103
(With shorter time horizon	54	69	80	92)
High temperature rise	117	149	174	201
Low population growth, etc.	23	27	30	32
High population growth, etc.	263	344	415	497
High damage: power 3.5	257	338	409	493
High damage: damage parameter 4%	357	461	551	655

5. Summary and conclusions

In this paper I first examined the magnitudes of the macroeconomic costs of carbon emission reductions based upon the OECD project of global model comparisons. I found that a 1 per cent reduction in carbon emissions generally requires a 0.02-0.05 per cent decline in GDP in developed countries, and that corresponding carbon tax rates are around US$2-10/tC.

I also showed that many Japanese research results had found much larger macroeconomic costs, because these models are fairly short term in scope involving demand-determined output responses. Also, the treatment of tax revenue is different. These findings suggest that interpretation of simulation results should be based upon clear understanding of the nature of the model.

Economic measures to limit carbon dioxide emissions, such as carbon taxes, usually have some side-effects as well. There is some empirical evidence that carbon taxes would have regressive distributional implications, but there seem to exist appropriate instruments to accommodate these undesirable domestic side-effects.

International side-effects need careful distinction. Any change in the structure of comparative advantage induced by an efficient, international scheme to internalize the external costs of carbon emissions should not be counteracted. Sectoral adjustment problems should be handled as in many other cases of changing environments. Carbon leakages resulting from trade diversion and from changes in international energy prices can theoretically be large enough to negate the initial effort of limiting carbon emissions, but the available evidence seems to suggest that unilateral action by OECD countries, for example, will still be largely effective. Finally, due consideration should be given to the possibility of an international scheme to limit carbon emissions causing large-scale international redistribution of income against fossil-fuel-exporting countries.

In contrast to the macroeconomic cost estimates based upon some sort of stabilization objectives for the emission or atmospheric concentration of greenhouse gases, the optimal response approach suggested by William Nordhaus has led to the conclusion that optimal abatement paths are much closer to the business-as-usual scenario path than to stabilization paths. The questions of the appropriate rate of time discount and of proper estimates of damage from global warming do not seem to resolve the wide gap between the optimization approach and the stabilization approach It appears that we need to investigate further if we are to broaden our scope of non-market values and take a more serious view of uncertain, catastrophic situations in the distant future.

Appendix: A simple Nordhaus-type model of climate and the world economy

This appendix gives a short summary of a simple Nordhaus-type model of climate and the world economy to evaluate optimal emission control paths under various alternative assumptions. The model consists of the following 12 equations:

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

Variable and parameter names and parameter values as well as initial conditions are as given below.

Variables

At:	production technology factor
ACt:	atmospheric stock of carbon dioxide
Ct:	consumption
Et:	carbon dioxide emissions
GDPt:	gross domestic product
gA	annual growth rate of A
ga	annual rate of change in a
at:	emission factor
mt	emission control variable
Ft	damage factor
It	investment
Kt	capital stock
Lt	population
Tt	temperature rise
	equilibrium temperature rise
U	discounted sum of consumption utility
dK	capital depreciation rate
dM	fraction of CO2 transferred to deep ocean

Parameters

a:	percentage loss of world GDP due to GHG abatement
b:	percentage loss of world GDP due to global warming damage
ACP	pre-industrial level of atmospheric stock of carbon dioxide
N	time horizon
	temperature rise at the benchmark
b	feedback parameter
q	power of the damage function
g1,g2	coefficients in the damage function
k	fraction of CO2 remaining in the atmosphere
l	adjustment coefficient
p	share of capital
r	social discount rate

Parameter values and initial conditions

a = 1%
AC_P = 580(GtC)
AC₀ = 750(GtC)

b = 1% or 2%
E₀ = 6.003 (GtC)
g_A = 0.85% p.a.
g_a = -1.0% p.a.
GDP₀ = 25.8 (tril. $)


a₀ = E₀/GDP₀
g₁ = a/100/0.5³


d_K = 0.05
d_M = 0.002
q = 1.3, 2.0, or 3.0
k = 0.5
l = 0.2
K₀ = 70.32 (tril. $)
L₀ = 5.292 (bil.)
N = 2300
p = 0.25
r = 0.005 or 0.03

Acknowledgements

The author thanks Kenji Yamaji of the University of Tokyo and Tsuneyuki Morita of the National Institute of Environmental Studies for helpful comments and valuable suggestions. Of course, the author is solely responsible for any remaining errors.

References

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Amano, A. (ed.). 1992b. "Economic costs of reducing CO₂ emissions: Modeling experience in Japan." Paper presented at the IIASA Workshop, September.

Burniaux, J.-M., J. P. Martin, G. Nicoletti, and J. Oliveira-Martins. 1992. The Costs of Reducing CO₂ Emissions: Evidence from GREEN." Paris: OECD, Economics Department Working Papers No. 115.

Cline, W. R. 1992. The Economics of Global Warning. Washington, DC.: Institute for International Economics.

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9. The effects of CO2 reduction policies on energy markets

John P. Ferriter

1. Introduction

Numerous studies have now been completed on the macroeconomic effects of policies (mostly carbon taxes) to reduce greenhouse gas emissions.! These analyses show a range of economic effects that might be expected in the long term. But most long-term analyses are unable to give detailed descriptions of the next 10 to 20 years. This is the period for which governments have set CO₂ reduction or stabilization targets. It is a difficult period for policy makers. The risks and costs associated with climate change may remain uncertain for at least 20 years to come, and these uncertain costs have to be balanced against the possible costs to the economy of early intervention to reduce CO₂ emissions. In this context, policy makers have been eager to find "no-regrets" strategies, which reduce CO₂ emissions but which would be fully justified by other policy objectives. Even a carbon tax, ostensibly aimed at reducing CO₂ emissions, might be justified as a "no-regrets" strategy if it showed other benefits. These could include reduced dependence on imported fuel, the stimulation of technical progress in industry, reduced local pollution, and reductions in other taxation. Nevertheless, recent discussions about the BTU tax in the United States and the carbon/energy tax in Europe give an indication of the uncertainties about the timing and manner in which any tax might be introduced.

This paper examines some of the issues that might arise in energy markets during the next 20 years, using results from modelling by the International Energy Agency (IEA) of world energy markets over the period 1990-2010. Fuel markets will be the main focus of policies to reduce emissions of CO:. Most policy measures will aim either to limit or reduce the amount of energy consumed, or to change the form of energy used to acquire a given energy service.

As has frequently been stressed (Hoeller and Coppel, 1992; IEA, 1993b), carbon-based fuels are not currently priced or taxed to reflect their relative carbon content. Governments already intervene in energy markets for reasons including energy security, the local environment, social welfare, employment, and industrial competitiveness. Any policy to reduce energy demand or encourage fuel switching will be applied on top of a host of other measures and may have only marginal effects in some sectors. Without coherent action to deal with all of the policy objectives associated with energy use, we therefore start from a less than optimum position. Thus suboptimal economic efficiency of policy impact is to be expected and counter-intuitive consequences should not surprise us.

Approximations and simplifications are inherent in almost all modelling efforts and the IEA model is no exception. One of the most difficult areas to treat effectively in such models is the process of technical change, especially during times of rapid transition. Although we can use econometrics to relate energy efficiency to income and energy price, such a relationship cannot take account of the potential for technical breakthroughs or switching to fuels and energy sources that have not been widely used in the past.

It is similarly impossible to account in an econometric model for the uncertainties associated with the politics of fuel supply and for some of the unexpected results that may occur because of the way policy measures are implemented. World market prices for fuels in the IEA model are exogenously determined and these issues have been considered in choosing the price trajectories. Sensitivity analysis gives some idea of the effect of the variability of world market prices.

A further area that has been modelled at a minimal level of detail is the effect of changing market structure. Energy demand and prices, as well as the price elasticities of demand, are likely to be changed by the moves towards open energy markets and private ownership.

In analysing the results from the IEA model, this paper does not pretend to be giving a "correct" view of the effects of government policy in energy markets. It does give a view of the sectors and regions where different types of policy are likely to be most effective, and it identifies areas where further investigation is needed to improve our understanding of the effectiveness of policies.

2. Background - Energy markets and policies

Energy markets are dynamic, complex, interdependent systems, built on massive capital investments and relying on fuel supply systems that are in part commodity markets and in part dedicated transportation and conversion systems. Energy suppliers meet a constantly evolving and very broad spectrum of demand for energy services.

Markets for different energy forms are interdependent in a variety of ways. For example, gas and coal prices are often linked to the oil price in contracts; substitutable energy forms such as gas and electricity will have their prices linked through market forces; in other cases where energy products are co-produced, cross-subsidies can occur, one product having a highly variable price while the other's price is constant. These effects can confound efforts by governments to intervene in the market. To the extent that human behaviour is unpredictable, surprising effects can come from decisions made by fuel producers, commodity speculators, and energy service consumers.

The fuel mix in a regional market will depend greatly on the resource endowment of a region and the cost of extraction. It will also depend on the mix of demands for specific energy services, such as transport or refrigeration, where particular forms of energy are preferred. Thus, heterogeneity of energy markets is the point of departure for any analysis of their response to policy interventions.

Our definition of CO₂ reduction policies covers a broad range of government interventions. Parts of the energy industry are regulated to a greater or lesser extent, involving significant government ownership and/or direction in some countries. However, the focus in analysis of CO₂ reduction policy has been on market measures such as carbon taxes or energy efficiency standards rather than on measures to alter institutional factors. Market measures are more easily modelled than institutional changes and we view carbon taxes, or other price signals, as the most efficient way to induce the optimum response. Yet a broad spectrum of policy measures must ultimately be considered. Those most often mentioned in the CO₂ reduction context are: fuel-use restrictions; taxes and other fiscal instruments (including changes in fuel and technology subsidies and in R&D spending); regulations such as energy efficiency standards; and voluntary agreements with industry. Companion policies, such as emissions trading or joint implementation, are often advocated to improve the economic efficiency with which national or regional emission targets are met. Other policies of an economic reform nature, such as opening up access to electricity or gas transmission, have been mentioned in the context of climate change as "no-regrets" strategies. OECD countries already have considerable experience with all of these approaches to energy policy.

Policies to reduce emissions from the energy sector can do so by causing: (i) a reduction in fuel used without altering the quality of energy service (increased efficiency); (ii) a reduction in fuel used through a reduction in the service or in its quality (conservation); and/or (iii) a switch to a fuel with less or no carbon content while delivering the same service. Using carbon-stripping technologies is another response, but one that is currently not commercially available. See the appendix at the end of the chapter for a summary of the main policy types discussed in relation to CO₂ emission reduction.

3. The World Energy Outlook: A reference scenario

The IEA has updated its World Energy Outlook (WEO) using its medium-term energy econometric model (IEA, 1993a). Simultaneously we decided to use the model to investigate the effects of certain CO₂ reduction policies on energy markets. To do this we used the WEO model itself as a reference case and then created three policy scenarios: two carbon tax cases and one efficiency-driven case. The reference case assumes no major policy changes. We describe this case in some detail below.

Our results are similar to those from other models for energy and emission trends. In the WEO model, world energy demand grows by 48 per cent from 1990 to 2010. Three regions are defined in the model: (1) the OECD member countries (OECD); (2) the newly independent states and the Central and Eastern Europe economies in transition (NIS/CEE); and (3) the rest of the world (ROW). Over the period modelled, both OECD and NIS/CEE shares of energy consumption fall vis-à-vis ROW: OECD drops from 53 per cent to 46 per cent, NIS/CEE drops from 21 per cent to 15 per cent, and ROW rises from 26 per cent to 39 per cent (see fig. 9.1).

The use of fossil fuels grows significantly over the period: coal consumption rises by 44 per cent, oil by 33 per cent, and gas by 66 per cent. Of the increase in total fuel use, coal represents 27 per cent in energy terms, oil 39 per cent, and gas 30 per cent. Fuel shares change less dramatically than they did over the period 1971-1990 (see fig. 9.2).

Fig. 9.1 World total primary energy demand, 1971-2010 (Source: TEA, 1993a)

Fig. 9.2 World primary energy shares, 1971-2010 (Source: IEA, 1993a)

World trends mask some opposing trends in the three regions. For example, ROW and OECD coal growth is somewhat offset by reductions in coal consumption in the NIS/CEE. About 85 per cent of the net growth in coal demand occurs in the ROW. Oil growth is 72 per cent ROW and 26 per cent OECD. Gas growth is 48 per cent ROW and 44 per cent OECD. World electricity production grows 73 per cent. Electricity's share of primary energy continues its growth (from 25 per cent in 1971 in both the OECD and the World to 42 per cent and 38 per cent respectively in 2010). The shares of fuel for electricity generation continue to change between 1990 and 2010, with oil down 5 percentage points, gas up 8 percentage points, and nuclear down 5 percentage points.

Growth in OECD energy demand is greater in 1990-2000, slowing down during 2000-2010. The highest growth rate is in the OECD Pacific region, followed by OECD Europe and then North America. Although growth in ROW energy demand shows a similar slow-down in 2000-2010, the absolute growth rates are over three times higher in ROW than in OECD. Energy intensity declines worldwide, more in OECD than elsewhere and less where economies are in transition. Increasing electrification leads to a decrease in total final consumption (TFC) in relation to GDP, e.g. electricity demand growth is faster in North America during 2000-2010 than in 1990-2000. Lack of infrastructure in ROW retards the penetration of gas, and limited financial resources in both the ROW and NIS/CEE limit the uptake of more efficient technologies. Continued growth in the transport sector accounts for almost all of the incremental oil demand in the OECD.

Under the reference case assumptions, annual world carbon emissions rise from 5,880 million tonnes in 1990 to 8,600 million tonnes in 2010, or 46 per cent (see fig. 9.3). OECD carbon emissions rise from 2,830 million tonnes to 3,600 million tonnes by 2010, or 28 per cent. Increases vary among the OECD regions, rising 25 per cent in OECD North America, 48 per cent in the OECD Pacific region, and 24 per cent in OECD Europe. The faster rise in the OECD Pacific is due to a higher expansion of energy demand, occurring through a higher rate of economic growth than in North America and Europe, and despite the significant further addition of nuclear power plants in Japan.

Carbon emissions from the NIS/CEE region follow the same path as energy consumption, first falling and then returning to the 1990 level of 1,300 million tonnes by 2010. Carbon emissions from the ROW countries increase from 1,750 million tonnes to 3,700 million tonnes of carbon in the same period, or a rise of 111 per cent. By the end of the projection period, therefore, more carbon originates in ROW countries than in the OECD region. The major reason for this is the much faster rate of growth in energy demand in ROW countries cited earlier. Moreover, the major energy input into power generation in two of the most important and fastest-growing non-OECD countries - India and China - is coal, the most carbon intensive of the fossil fuels. In the absence of the improvement in efficiency of power generation that has been assumed in the reference case for these countries, their growth in emissions could be even faster. These two countries also account for 45 per cent of the world's population additions by 2010.

Fig. 9.3 World carbon emissions, 1971-2010 (Source: IEA, 1993a)

The robustness of the carbon emissions in the reference case was tested against alternative economic growth assumptions and lower oil and gas prices. Even under rather pessimistic economic growth assumptions, world carbon emissions over the projection period grow by at least 38 per cent. Under a scenario of low oil and gas prices (based on flat US$20 per barrel to 2010), emissions from OECD exceed those of the reference case by only about 3.7 per cent. Emissions from the ROW countries rise by some 5 per cent above the reference case if lower prices prevail.

4. Two carbon tax cases

Two carbon tax sensitivity cases (US$100 and US$300 per tonne of carbon emitted) were simulated with the WEO model.² In both cases, nearly one-third of the tax is imposed in 1993 with the remainder added in annual increments of almost US$4 in the US$100 case and US$12 under the US$300 case. These taxes are in addition to any excise or other taxes currently in place (see fig. 9.4) and are applied to final energy prices in the model. It must be emphasized that we are using these two cases to investigate the effects of large carbon taxes, not to represent any existing government policies. In the real world, carbon taxes are not likely to be introduced so soon, or with such high starting levels.

Fig. 9.4 Implicit carbon taxes, 1988 (Note: Coal is taxed only in Sweden)

Fig. 9.5 OECD carbon emissions: Carbon tax cases relative to reference case, 1990-2010

Figure 9.5 illustrates the emissions growth for the two tax cases and the reference case described above.³ Emissions in 2010 under the US$100 tax reach 3,300 tonnes, compared with 3,620 tonnes in the reference case (a 9 per cent reduction). This is still well above the 1990 level of 2,830 million tonnes per year. Under the tax of US$300 per tonne of carbon, emissions reach 2,990 tonnes in 2010, somewhat above the 1990 level and 17 per cent below the reference case.

The use of all fossil fuels is reduced in both tax cases (except natural gas under the US$100 tax), as shown in table 9.1. The reduction in contribution to total primary energy supply (TPES) is greatest for coal, then oil, and finally gas. Reductions in final energy use are greatest for oil, then coal, then electricity, and then gas. Contributions to CO₂ emission abatement follow the same ranking, as shown in table 9.2. Tripling the level of carbon tax only doubles the emission reduction, reflecting the diminishing scope for substitution between fuels in the medium term and implying that the effectiveness of the carbon tax is reduced as the tax gets higher.

5. An efficiency-driven scenario

An "efficiency-driven" scenario (EDS) has also been constructed. Under this scenario, the efficiency of energy conversion and use improves faster than in the reference case. The improvement rates are exogenous to the model and are based on the introduction of commercially available technology over the period (IEA, 1991, 1992a). In the reference case, the rate of take-up of technology is based on historical trends. Waste heat in power generation is also assumed to be utilized to a much greater extent than at present in all OECD regions. Table 9.3 details the efficiency assumptions used to construct this case. It is not suggested that these improvements would arise exogenously or that they would follow naturally from market factors. Implicitly these accelerated efficiency gains are achieved through some form of regulation or behaviour changes, which we have not specified.

By 2010 energy use is reduced relative to the reference case by 25 per cent in the residential/commercial sector, 7 per cent in the industrial sector, and 10 per cent in the transport sector. By our own assumptions, the EDS's effects involve no fuel switching in the industry or residential/commercial sectors. We have assumed some switching from gasoline to diesel cars in the transport sector.

Under these assumptions, emissions in Europe and North America by 2010 return almost to 1990 levels while in OECD Pacific some growth in emissions still occurs. Emissions for the OECD grow on average by less than 0.4 per cent per annum, compared with 1.2 per cent per annum in the reference case (see fig. 9.6). Whereas emissions in the reference case grow almost in line with primary energy, under this scenario they increase at just over half the energy demand growth rate of 0.6 per cent per annum. This is due to the growing proportion of non-fossil fuels in electricity base-load: non-fossil capacity grows at 1.6 per cent per annum in all cases, so that reduced electricity demand results in a reduction in fossil fuel use only.

Table 9.1 The effects of tax cases on fuel use relative to reference case

	In TPES				In TFC
	US$100		US$300		US$100		US$300
Fuel	Mtoe change	% of reference case use	Mtoe change	% of reference case use	Mtoe change	% of reference case use	Mtoe change	% of reference case use
Coal	-230	-20	-306	-26	-57	-22	-100	-39
Oil	-96	-5	-250	-13	-96	-5	-233	-13
Natural gas	+6	0	-148	-12	-36	-5	-94	-13
Electricity	-	-	-	-	-41	-5	-96	-12

Table 9.2 The effects of tax cases on CO₂ emissions associated with fuel use (MtC change relative to reference case)

	Emission change
Fuel	US$100	US$300
Coal in TFC	-62	-109
Oil in TFC	-81	-196
Natural gas in TFC	+23	-60

Table 9.3 Efficiency assumptions for reference case and efficiency-driven scenario

	Reference case	Efficiency-driven scenario
Use of heat produced as co-product in power generation
North America	6%	12%
OECD Europe	6%	12%
Japan	1%	7%
Residential/commercial sector energy efficiency improvement
All regions		1.5% p.a. energy savings (extra 25% in 2010)
Industrial sector energy efficiency improvement
All regions		0.4% p.a. energy savings (extra 7% in 2010)
Transport sector energy efficiency improvement
Air transport
All regions	1% p.a.	2% p.a.
Freight transport
North America and OECD Europe	0.5% p.a.	1% p.a.
Japan	1% p.a.	1.5% p.a.
New ear improvement by 2010
North America	19%	43%
OECD Europe	15%	47%
Diesel share in passenger transport
OECD Europe	14%	28%
North America	1%	14%

Fig. 9.6 OECD carbon emissions: Efficiency case relative to reference case, 19902010

6. Regional and sectoral differences in the three policy cases

Regional differences

Primary coal and gas prices and the taxes on energy products are lower in North America than in other regions, so that a given level of carbon tax leads to larger percentage increases in end-use prices. Prices combine with other factors such as economic structure, current fuel use patterns, and growth rates in their effect on carbon emissions. Nevertheless, under the US$300 tax, emissions stay close to 1990 levels in North America, rise slightly in Europe, and are about 13 per cent higher in OECD Pacific, reflecting the assumed, sustained higher growth rates in that region.

In all three sensitivity cases using the IEA model, over 50 per cent of the OECD emissions reductions occur in North America, about one-third in Europe, and the rest in the Pacific region, mainly Japan (fig. 9.7). These are roughly the regional shares of primary energy use in 1990. The EDS is more effective in reducing energy use than the US$300 carbon tax, although the US$300 case is slightly more effective than the EDS in achieving emissions reductions (see figs. 9.8 and 9.9.)

In the carbon tax cases there is more regional variation in energy savings than in emissions reductions. The US$300 tax leads to 17 per cent final energy savings in North America, but only 6 per cent in Europe. The Japanese savings are slightly more than in Europe. The OECD's GREEN model and other modelling produce generally the same results. The reasons for these regional differences are examined below.

Fig. 9.7 Carbon emission reductions, OECD 2010: Three cases regional breakdown

Fig. 9.8 Carbon emission reductions, OECD 2010: Three cases sectoral breakdown

Figure 9.10 shows a comparison between the Commission of the European Communities' (CEC) model, looking at the effect of the CEC's proposed energy/carbon tax, and the IEA model output for Europe. The CEC tax has much less effect than any of the WEO cases because the tax is much lower (equivalent to roughly US$70 on oil per tonne of carbon), and is introduced gradually over the period to 2000. The tax is disproportionately higher on gas and nuclear, but lower on coal, than a pure carbon tax. In the CEC model, gas use decreases with the tax, with gas for power generation going down as well as in end use. With the US$100 tax, the WEO produces increases in gas use for electricity generation in all regions. It produces a decrease only in the higher tax case.

Fig. 9.9 Energy use reductions, OECD 2010: Three cases breakdown by fuel

Fig. 9.10 Energy use reductions, OECD Europe 2010: The three cases and the CEC carbon tax case

Sectoral effects

In examining the responses of energy consumers to policy measures, there are important distinctions between individuals such as car drivers and home-owners making personal decisions, and industrial or corporate decision makers. For personal decisions, lifestyle and personal values can often have more influence on fuel-use decisions than price signals, whereas industry is generally expected to be more price responsive. Industrial consumers generally have better access to information about alternative technologies and to the capital needed to invest in them.

Fig. 9.11 Carbon emission reductions, OECD 2010: Three cases sectoral breakdown

Figure 9.11 presents breakdowns by sector of carbon emissions reductions for the three cases. The sectoral emissions reductions in the two tax cases are in more or less the same proportions. Changes in power generation provide roughly 50 per cent of emission reductions, final fuel use in industry roughly 25 per cent, and the transport and residential/commercial sectors the rest.

The EDS differs significantly in its sectoral effects from the carbon tax cases. Changes in electricity generation account for roughly 55 per cent of emissions reductions and there are significant differences in end-use sectors. Excluding electricity, the transport and domestic sectors each account for roughly 40 per cent of the reduction in emissions from final energy use, while industry provides the rest (20 per cent). The EDS is far more effective in the "problem" residential/commercial sector.

Figure 9.12 shows the breakdown of emissions reductions by sector for each region in the US$300 tax case. The differences in the sectoral contribution to each region's emission abatement are mostly explained by differences in the sectoral shares in emissions in the reference case. Even the percentage changes in transport energy use are similar in North America, Japan, and Europe, which may seem surprising given the higher reference case fuel price in Europe and Japan to which the tax is added. Different turnover rates and saturation of vehicle-miles travelled in North America account for the closeness of the reductions. Fuels are affected differently according to sector. Faced with carbon taxes, industry tends to reduce electricity use more than gas, whereas the residential/commercial sector reduces gas more than electricity.

Fig. 9.12 Carbon emission reductions, OECD 2010: Regional and sectoral breakdown, US$300 tax case

The relationship between primary energy prices and consumer energy prices

One reason for the apparent insensitivity of energy demand in the transport and residential/commercial sectors to high levels of carbon taxes is the relatively modest impact of the taxes on the prices that consumers actually pay. Whereas the imposition of a US$100 carbon tax is likely to increase gasoline prices by about 20 per cent in the United States, prices would increase by less than 8 per cent in Europe and Japan. Similarly, the impact on the price of residential gas is around 22 per cent in the United States, 12 per cent in Europe, and less than 6 per cent in Japan. Whereas a US$100 carbon tax is greater than the primary coal price by 2010, its impact on the price of electricity, by far the largest consumer of coal, would be less than 10 per cent in Europe and Japan. Thus, unless carbon taxes are set at a very high level, the reaction of energy consumers is expected to be moderate.

Fig. 9.13 Indices of real energy end-use prices: Total OECD (Note: 1985 = base year for "total energy" price; further moving averages of 4 quarters are used. Source: International Energy Agency, Paris)

7. The effects of CO₂ reduction policies on energy commodity markets

The nature of energy commodity markets

Crude oil is the largest single commodity traded on world markets in dollar terms. It represents 75 per cent of the world trade in fossil fuels partly because of its ease of transport, storage, and use. Markets for gas tend to be organized regionally; in the case of coal, sources are linked to particular users. Although the coal industry has made great strides in developing preparation and blending techniques to increase the number of potential buyers, improved coal products make up a very small percentage of coal in international trade. Because of its ubiquitousness and flexibility of use, oil tends to be the price leader, with coal and natural gas following (see fig. 9.13).

Energy commodity markets are not entirely distinct, but major regional markets are recognized in North America, Western Europe, Central and Eastern Europe and the newly independent states, and the Asia/Pacific region. Some national economies are virtually self-sufficient in energy, especially for gas and coal.

There is a high degree of government ownership in many regional markets, whether developed countries, economies in transition, or developing countries. Government control is especially prominent in the utility sector but it is also significant in natural gas and oil production and transformation. Government control generally inhibits the efficient functioning of the markets for these fuels, for example in limiting market access and competition among suppliers or by ensuring cross-subsidies to certain consumer sectors.

Concurrently it will be important to understand the strength of other changes that have been set into motion in energy commodity markets. Examples are the effects of a global trend (particularly in a number of large ROW and NIS/CEE greenhouse gas emitters) to eliminate energy subsidies and to open up markets to greater competition.

The effects of removing subsidies should not be overestimated. In competitive situations, producers may not be able to raise prices to cover the loss of former subsidies. In situations with other types of government control, the removal of subsidies alone might not "free" the producer from other regulations that constrain fuel choice.

Although the elimination of consumer subsidies is expected to lead to a reduction in demand for some fuels, greater competition in energy markets could reduce prices and raise demand. In some regions, including parts of OECD Europe, protection of indigenous coal production is being reduced, allowing cheaper imports into the market. Coal prices could be reduced relative to those of oil and gas, resulting in a shift towards a fuel mix with a higher carbon content. Conversely, open access to electricity grids for power producers, especially small suppliers, could lead to an increase in co-generation and renewable energy use. Furthermore, the move away from government ownership and control could result in higher discount rates being used for energy-related investment. In electricity systems this might result in a move away from nuclear and coal toward less capital-intensive capacity such as oil- or gas-fired plant.

In an energy commodity market such as the Japanese market, even without direct fuel-use requirements, a considerable amount of "administrative guidance" creates a "price wedge" that keeps the prices of fuels higher than the world price although the fuels are not actually taxed. Although either the European or the Japanese case has the effect of a tax on demand, it is not clear what would happen if other policies were superimposed in order to reduce greenhouse gas emissions. One could easily imagine the wedge reducing somewhat in the face of new taxes, with the net result being a lower price than one might calculate taking the actual price and simply adding the tax to it.

Coal market issues

In all three CO₂ reduction policy cases using the IEA model, coal in OECD primary energy supply falls relative to the reference case. The 2010 level is below the 1990 level in the US$300 tax case. Carbon taxes are likely to have more effect on coal than on other fuels because coal contains more carbon per unit of energy. However, coal is also at a disadvantage relative to oil and gas in that it is mainly used in non-premium applications. Although some oil products (mainly heavy fuel oil) are sold in these non-premium markets, oil companies may be able to pass on most of the carbon tax to consumers of premium fuels in the transport sector. Similarly gas producers may be able to raise residential gas prices more than commercial contract prices. Fuel suppliers are likely to cross-subsidize their customers in this way to some extent, regardless of whether taxes are imposed on primary fuels or on final energy products. Thus, not only is coal more affected than other fuels by a carbon tax, it is also likely to be disproportionately more affected in the markets where fuel switching is easiest.

OECD carbon taxes could affect the coal market in the rest of the world. Reduced OECD demand could lead to a fall in the pre-tax price. However, if the tax is applied only in the OECD, rising demand in other regions may stabilize the market. Meanwhile the movement in the OECD and former Comecon countries away from domestic coal subsidies will increase demand for imported coal.

Countries typically have energy systems (especially electricity generation) based largely on their indigenous resources even when these take the form of relatively highly polluting coal. Most of the world's very large CO₂ emitters are also very large energy producers. Included in the top 10 CO₂ emitters are the United States, Russia, China, India, Ukraine, and Canada, which are large energy producers although some of these are not exporters (IEA, 1992b). Some governments might be expected to continue to shield certain fuels from the effects of carbon taxes, offsetting some of the demand-dampening effect of the CO₂ reduction policy.

Oil markets

It is not possible to predict how major oil-exporting countries would react to an OECD-wide tax. To date they have criticized such proposals as being an incursion on the rent that should be theirs as owners of the oil resources. They correctly point to the existing taxes on fossil fuels and note that premium oil products in most OECD countries already bear high taxes. Producers may attempt to increase volume to offset the revenue losses stemming from a carbon-tax-driven lower demand, or they may prefer to reduce exports to the OECD, given that markets are growing elsewhere.

Natural gas markets

Gas is the only fuel for which consumption is increased overall under any of the CO₂ reduction policy cases and electricity generation is the only sector in which this occurs for the OECD as a whole. There are some regional variations, and increases in gas used for electricity generation in Japan and Europe are masked by larger decreases elsewhere.

The trend towards the use of natural gas, particularly in Europe and Japan, leads to questions about the speed and cost at which fuel substitution could be achieved. In the European and Japanese markets, significant incremental gas supplies would have to be imported and preceded by major investment in production and transportation systems. Policies intended to encourage switching away from high carbon fuels could be frustrated, or their effects delayed, by a lack of infrastructure for natural gas, the regional concentration of resources, and the expense and time-lags to build the infrastructure to connect them to distant new users.

The Pacific gas market, where rapid growth in energy demand exists, will remain dominated by liquefied natural gas (LNG) for the next two or three decades at least. LNG markets are only beginning to go into their "second era": the first of the early 1970s' contracts are being renegotiated and, unlike the first contracts, formal contract re-opener or price review clauses have been introduced. In future there is likely to be more competition between LNG suppliers than in the past 20 years. As more markets open for LNG, and given variations in demand in different countries, there are greater prospects of lower-priced spot cargoes. Against this, LNG depends on large investments in terminals and no new projects are assured at current prices.

One of the biggest uncertainties in the European energy commodity market is the stability of the supply of oil and gas from Russia and other newly independent states. These countries are strongly motivated to export gas and oil to obtain Western currency, but political instability and poor infrastructure lead to uncertainties about the availability of the fuels. Deep economic recessions in recent years have led to declines in fossil fuel use, potentially freeing up supplies for export. Many of these countries are in the process of raising domestic energy prices, which will continue to have some dampening effect on demand. The European Energy Charter, with its emphasis on opening and improving the technical aspects of energy commodity trade, is also an important step in stabilizing the European energy commodities markets.

Other factors mitigate against the availability of oil and gas from the former Comecon region. Carbon taxes are not likely to be introduced by these countries in the near future, but some may move away from existing coal and nuclear energy use for environmental and safety reasons. In this case, domestic demand for gas, which is already significant, could increase rapidly. Oil demand is also likely to increase rapidly as a result of increasing car use.

8. Areas for further study

There is clearly a need for more work on the analytical base from which we make conclusions about the costs and effects of CO₂ reduction policies. For example, further elaboration of the IEA model could take account of the technical possibilities, including the introduction of non-fossil fuels and the retrofitting of existing energy-using equipment, especially in electricity generation, to use low-carbon fuels.

More importantly, several different analytical approaches are needed to comprehend the full range of effects on the economy, including the energy sector. Econometric modelling is only one of these tools one that is particularly suited to examining the effects of policy measures in the short to medium term.

Linkages with other modelling efforts must continue. This will allow the analysis to incorporate the impacts of CO₂ reduction policies on economic activity and the important feedback effects of changes in economic activity on energy demand and prices, on fuel commodity markets, and on the rate of carbon leakage.

More questions have been raised than answered in this paper, but this was by design. More attention must be given to in-depth analysis of CO₂ reduction policies and energy markets. At the OECD/IEA Conference on the Economics of Climate Change in June 1993 in Paris, participants raised a number of questions for further analysis.

· How will the costs of carbon taxes be distributed between fuel producers, suppliers, and consumers? How is this affected by moving the point at which the tax is levied?

· How might OPEC react to carbon taxes or other CO₂ reduction policies?

· What does the historical relationship between crude oil prices and oil product prices tell us about the way carbon taxes would be passed on to consumers?

· How will changing government intervention in coal markets modify the effects of carbon taxes?

· What are the financial implications of the capital costs associated with switching to natural gas on a very large scale vis-à-vis interest rates and the financing of energy investments in general? On what time-scale?

· What are the options for moving natural gas to key markets, and what are the economic and political constraints on various source and/or transportation options?

· Will exporting countries (again) wish to retain significant natural gas supplies for domestic consumption, for both environmental and trade-competitive reasons?

· In choosing fuels for power generation, will utilities be able to select among fuels freely, taking into account not only price (including tax) but also supply security and other factors, or will price be the only determinant allowed by the regulators?

· How do emissions trading, power-wheeling, and other efforts to find least-cost approaches affect the cost-effectiveness of CO₂ reduction policies?

9. Conclusions

The IEA's energy modelling work has shown, within the assumptions applied, that a US$300 per ton carbon tax might be able to reduce OECD carbon emissions in 2010 nearly to 1990 levels. This level of tax is far beyond any that has been seriously discussed in international forums, yet governments already intervene to a greater extent, and in some instances at considerable cost to national budgets, in parts of the energy market. Institutional and transitional issues require careful consideration on a national and regional basis. Opening up energy markets and reducing subsidies could reduce the economic costs of applying CO₂ reduction policies. The degree and timing of the implementation of a policy could be fine tuned to divert future investment toward more environmentally friendly fuels and technologies without resulting in excessive disruption in the economy.

The reader is strongly cautioned against concluding that either a regulatory approach, or the use of fiscal or financial incentives, could achieve CO₂ stabilization at little or no cost. Considerable further work should be done to develop a better understanding of the possible economic impact of regulations, taxes, and other fiscal measures before such a judgement is made.

The analysis presented here does suggest that a mix of policies may be the most effective, although not the most cost-effective, approach to reducing emissions. In the foreseeable future, it appears unlikely that OECD governments will adopt substantial carbon taxes. Voluntary agreements with industry are receiving increasing attention. All measures attempting to bring emissions back to 1990 levels by reducing demand or improving efficiency have to be continually strengthened to hold emissions at 1990 levels. The effects of achieved improvements in efficiency could lead to increased energy use elsewhere in the economy. Decreased GDP might suppress gains in energy efficiency through reduced capital replacement.

A hedging strategy would contain a balance of measures to improve the efficiency with which we use energy (e.g. through voluntary agreements, performance standards, and incentives), with a much heavier emphasis on R&D to make renewable energy sources competitive earlier. Two major questions brought out in an OECD/IEA model comparisons project relate to the rate of autonomous energy efficiency change and the availability of backstop technology. These both depend on clear policy signals such as encouragement of R&D and the creation of necessary market conditions.

The results of the IEA World Energy Outlook model also point to the need for realistic and palatable policies not only for the OECD but also for relations between the OECD and the rest of the world. This may include examining the potential for investment in clean energy supply and industry, but also programmes to facilitate local initiatives for the efficient and clean use of energy. For the OECD, energy efficiency standards or voluntary agreements may be needed to address energy use in the residential/commercial sector and for transport. Where taxes are effective, such as in industry and in affecting the electricity fuel mix, these might be the preferred route. Meanwhile we should not forget that governments themselves are a major wild card in the design and implementation of CO₂ reduction policies. Subsidies and fuel-use restrictions are still widespread inside as well as outside of the OECD. Thus, much reform of local and regional energy policies is required within countries, which could go a long way to reducing the severity of any eventual national or international policy actions needed to reduce CO₂ emissions.

Appendix: Commonly proposed CO₂ reduction policies

Instrument	General purpose	Specific GHG application
Economic or quasi-economic
Taxes (carbon, BTU, or combination)	Induce behaviour changes	Reduce CO2 emissions, or reduce energy use, or both
	Raise funds for programmes	R&D or grants for efficiency or renewables
Subsidies	Induce behaviour changes or provide funds for specific behaviour or R&D	Efficiency or renewable investments and development
Price supports	Increase use of "desirable" fuels	Increase use of non-fossil fuel
Other (regulatory and quasi-regulatory)
Fuel-use requirements and restrictions	Force users to move to more "desirable" fuel or prohibit use of "undesirable" fuel	Increase nuclear and renewables
Performance standards	Force greater efficiency or fuel switching	Decrease emissions
Voluntary programmes(for industry or individuals)	Induce beneficial actions, often by "carrot" (financial incentives) or "stick"(possibility of regulation or fines)	Allow end-user to choose means for emission reduction
Regulatory planning approaches	Require consideration of social good of fuels in supply planning	Shift fuel choices to less polluting fuels and give efficiency a better chance to compete
Joint implementation and offsets/credits	Reduce costs of compliance and accelerate beneficial actions	Induce action in non-OECD countries as well as within OECD countries

Notes

1. This paper is based on a study prepared by Mr. Robert Skinner, Director of the IEA Office of Long-Term Co-operation, with contributions from Ms. Connie Smyser, Head of the IEA Energy and Environment Division, and Mr. Laurie Michaelis, Administrator, Energy and Environment Division, and presented to the OCED/IEA Conference on the Economics of Climate Change, 14-16 June 1993 in Paris. It is further derived from research conducted by Mr. Robert Reinstein, consultant, and Ms. Christina Shåhle, IEA Energy and Environment Division. Much of the discussion of the World Energy Outlook and the policy cases is derived from IEA (1993a). For more details on the IEA's model, see Vonyoukas (1992).

2. The results obtained from the IEA econometric model differ from those derived from the OECD GREEN model and from other models. This is because of the very different structures of the different models, the different time-periods considered, and the degree to which existing capital stock and capital stock turnover rates are explicitly modelled. The IEA model was designed to analyse the world energy markets. It was not designed to assess macroeconomic questions and there is no feedback link for evaluating the impact of taxes such as those examined here on GDP.

The two carbon tax sensitivity cases differ from the reference case only in the taxes incrementally applied as described. GDP and fossil fuel supply costs were kept as in the reference case. The ability to resort to non-fossil alternatives such as hydro and nuclear was also constrained as in the reference case. The sensitivity analysis did not include effects on the NIS/CEE region or China.

3. The rise in emissions between 2001 and 2008 in the US$100 case is caused by a change in the merit order in the electricity generation submodel for Europe. This occurs as coal becomes cheaper with the opening up of European markets and increasing use of imported coal. Although in practice this effect might be smoothed, it draws attention to the possibility of unexpected changes in market conditions resulting in rises in emissions.

References

Hoeller, P. and J. Coppel. 1992. "Carbon taxes and current energy policies in OECD countries." The Economic Costs of Reducing CO₂ Emissions. Paris: OECD Economic Studies No. 19, Winter.

IEA (International Energy Agency). 1991. Energy Efficiency and the Environment. Paris: OECD.

IEA (International Energy Agency). 1992a. Cars and Climate Change. Paris: OECD.

IEA (International Energy Agency). 1992b. Climate Change Policy Initiatives. Paris: OECD.

IEA (International Energy Agency). 1993a. World Energy Outlook to 2070. Paris: OECD/IEA.

IEA (International Energy Agency). 1993b. Taxing Energy: Why and flow. Paris: OECD.

Vouyoukas, L. 1992. Carbon Taxes and CO₂ Emissions Targets: Results from the IEA Model. Paris: OECD Economics Department Working Paper No. 114.

1. Lawrence R. Klein

Uncertainty in environmental analysis

Statistical model building is a natural procedure to use in studying environmental impacts on social activity and also in examining the effects of alternative environmental policies. There are, however, uncertainties in this, as in any other, approach. It appears to me that some of the discussion at the conference was based on the assumption that model findings are correct, and accurate beyond their abilities.

I simply want to caution those among us who would speak as though certain estimates - say, of CO₂ pollution or many other environmental measures - are quite correct. The discussion has been based on "point" estimates with more digits or decimals than can be justified, on the basis either of observational accuracy or of our precision in estimating technical or behavioural reactions.

The models that are being used are based on meagre data samples, often with large measurement errors. If the errors were to be evaluated by appropriate statistical formulas, we would undoubtedly find that the estimated confidence intervals, based on standard errors of extrapolation, are quite large. These intervals (or regions in higher dimensions) are often so wide that a surprisingly large number of qualitatively different social consequences could plausibly occur, yet I notice people speaking of societal results that are deceptively implied to be quite precise. For example, there is great uncertainty about the amount of carbon reduction in the atmosphere that would be associated with a given carbon tax.

My guess is that the interval of uncertainty, for a given degree of probability (such as two-thirds), is as great as 1,000 million metric tons. Those who confidently expect that emission levels can be held to the global amounts that prevailed in 1990 as a result of the imposition of a moderate tax of less than US$75/ton may well be wrong. It may require a much steeper tax to hold emissions at 1990 levels, and this good, in itself, would not be a very satisfactory outcome for the world. In fact, the different models that are used for the projection of CO₂ emissions come to very different conclusions as to the effectiveness of taxation in reducing emissions. The spread among different model estimates is as large as a carefully evaluated confidence interval based on any one model.

Some of the main sources of error and uncertainty are the following:

- the estimation of the rate and volume of emissions from prevailing technologies;

- reactions of consumers and producers to price changes, either by market forces or by tax changes, in the use of energy;

- a flawed global database, such that some magnitudes are not available and the combustion effects, on a global basis, from the burning of fuel are not precisely known;

- the effects of climate and other natural conditions in which the model is assumed to operate not being fully (or even "well") known.

There are formidable obstacles to accurate projections of the economy and the physical environment, in tandem. These obstacles do not mean that we can say nothing about the problem or that we should remain silent in the face of the obstacles. They do imply, however, that we should describe our findings in general terms, with both point values and regions of uncertainty.

How can this be done? In the first place, well-known statistical methods for the estimation of standard errors of extrapolation or projection should be employed as far as possible. In some cases, sample data will be too sparse to permit careful evaluation of the underlying estimates of error variances.

A second step involves the calculation of stochastic simulations of the associated models. The investigation must assess all entry-points in the model design that admit error, and use drawings of numerical disturbance values (random in many cases) for the computation of alternative extrapolations. If this process is replicated, over and over again, an entire distribution of extrapolations can be assembled. Error variances or ranges can be determined from the replicated set of extrapolations. Of course, a minimal first or preliminary step should be to make a sensitivity analysis of the effect of assigning very different values, in a plausible range, to key parameters of the system. These different parameter estimates should not be purely one-at-a-time, because many of the key parameter estimates are interrelated with one another. This is an important point that is frequently overlooked in sensitivity analysis.

There is one saving aspect in this approach. If analysts concentrate on the examination of deviations from baseline cases they can take advantage of the phenomenon of "error cancellation." To the extent that some of the underlying uncertainties are the same, both in the baseline case and in the scenario case, there will tend to be high correlation between the same magnitude extrapolated from the two cases.

In the well-known statistical formula for the variance of a difference,

var(x^s - x^b) = varx^s - 2covx^sx^b + varx^b,

we find that large positive values for covx^sx^b can help offset the cumulative effects of var x^s plus var x^b. In this formula, x^s stands for a scenario value, x^b for a baseline value, var for variance and cov for covariance. If x^s and x^b are highly correlated, as one might suspect, then covx^sx^b will be large, relative to varx^s + varx^b.

This issue does not necessarily make the analysis accurate, in an absolute sense, but it does help to restrain the inherent degree of uncertainty.

It should also be noted that many environmental phenomena take a very long time to build up to serious magnitudes, i.e. serious for the quality of life. It is my conviction that the error of extrapolation grows with the length of the extrapolation horizon. Statements about the year 2020, or in some cases 2050, are extremely uncertain. We must try to look ahead, but we must be aware of the high degree of uncertainty associated with an attempt to extrapolate that far into the future.

2. Warwick J. McKibbin

The three papers in part 3 have a number of common themes. The central theme is the costs and benefits of implementing policies to reduce the expected increase in CO₂ emissions over the next 10-300 years. I found that all three papers offered useful insights on the issues that they address, but they also highlight the need for more detailed research and better modelling efforts in this area. I will raise comments on specific aspects of each paper and then present some results from a new report to the US Environmental Protection Agency that uses a model called G-Cubed that I have developed jointly with Peter Wilcoxen. This model has a time-horizon of 300 years but integrates the short-run macroeconomic adjustment process in a model with multiple sectors in production and trade. It also explicitly deals with the interaction of asset flows and goods flows in international trade which are ignored in all other models that examine carbon taxes. In addition, this model is participating in the next round of OECD model comparisons. Each of the authors refers to results from the last round of model comparisons and thus these new results from G-Cubed will supplement the discussion of these earlier studies.

The paper by William Cline presents further extensions to his important contributions over the past several years, related to the issue of the benefits of reducing greenhouse gas emissions. His main argument is that more aggressive action is needed to combat the emission of CO₂ than is likely to be implemented. His basic argument is that standard calculations of costs and benefits ignore the potential of a major disaster if nothing is done. In addition, economists have used discount rates that are high so that major problems that occur more than 100 years in the future are discounted away. Although I disagree with his arguments on this point, I agree with his policy prescription for the next decade. That is, to introduce a carbon tax of US$20-25 per ton and to increase investment in scientific research so as to improve our understanding of where we are and where we may be going. In addition, at the end of these comments I will provide some evidence that will support Cline's position that more can be done to reduce carbon emissions by illustrating that there need not be a trade-off between carbon emission reduction and lower economic growth. It is possible to reduce CO₂ emissions with only short-term loss of GDP if the revenue that is generated by the tax is invested appropriately.

I would also like to raise several issues that Cline touches upon in his paper. First, in my opinion, the cost-effectiveness of planting trees to absorb CO₂ is significantly overestimated. The sort of estimates for the United States from the studies that Cline cites are that around 20 per cent of the arable land in the United States should be planted to significantly reduce net projected increases in US carbon emissions. The general equilibrium effects of this are potentially large, given that it will raise the price of land, especially in agriculture. These general equilibrium effects have been ignored in the studies to date. The G-Cubed modelling work to which I have referred is attempting to focus more on this issue. We do not yet have a clear picture of the cost-effectiveness of the tree-planting strategy on a scale sufficiently large to lead to a reduction in baseline emissions.

Cline is right to point out the important role played by the discount rate in cost-benefit calculations. But also of great importance in any of these evaluations are: the extent of baseline emissions; the existence of backstop technologies; and how the revenue from the carbon tax is used.

Specifically on the question of discount rates, I tend to agree with the standard economists, approach of using a pure rate of time preference closer to 3 per cent. Cline points out when criticizing Nordhaus's assumption of 3 per cent: "This rate means that, under conditions of equal per capita income today and 200 years in the future, we can justifiably ask our descendants to give up US$370 in consumption to permit us to enjoy just US$1 of extra consumption today (in constant price dollars)." But it can easily be countered that, with a 3 per cent marginal product of capital, why should we be expected to give up US$1 of extra consumption today so that our descendants 200 years from now will have US$370 in extra consumption? In standard intertemporal consumer theory, where we have a representative consumer who dives forever, it can be shown that the marginal product of capital (or the real interest rate) is driven to the pure rate of time preference in steady state. If the discount rate is greater than the real interest rate then it pays to borrow and raise consumption today because the forgone consumption is less valuable in terms of future utility. If the discount rate is less than the real interest rate then it pays to forgo consumption today, invest the saving in physical capital, and get a future return that in terms of utility makes you better off. As consumption is forgone, the capital stock rises and the marginal product of capital falls until the interest rate equals the rate of time preference. In terms of valuing per capita consumption between any two periods, then the rate of time preference equal to the marginal product of capital is the logical assumption to use (at least in steady state).

I remain unconvinced by Cline's argument about discount rates, although I agree with Cline that more should be done, especially in the United States, to limit the emission of greenhouse gases. My view is based on the argument below that there need not be a linear relationship between reductions in CO₂ emissions and GDP loss.

Professor Amano also addresses the consequences of reducing CO₂ emissions through carbon taxes. He does this by comparing results from the models used in the OECD global model comparison project with results from Japanese studies. He makes a number of important points with which I agree. I will provide evidence in support of his contentions below.

Amano argues that many of the Japanese models have a larger loss of GDP per unit of carbon tax than the models in the OECD study because they place more weight on short-run changes in aggregate demand. Secondly, the Japanese models allow for unemployed resources in the short run, which computable general equilibrium (CGE) models typically do not. Thirdly, he points out that what is done with the revenue from the tax is very important. In addition, he raises questions about the extent of trade diversion leading to leakage of the effects of a unilateral tax levied by one country. Amano argues that to capture the overall effects requires a model with disaggregated sectoral detail because the carbon tax does not fall uniformly across the economy.

As already mentioned, I agree with many of Professor Amano's points. One aspect of the paper with which I disagree is the link between GDP growth and carbon emissions. Despite making the point that the impact of a carbon tax falls differentially on different sectors of the economy, Amano then summarizes the model results, as many commentators in this debate do, by inferring that a 1 per cent reduction in CO₂ emissions requires a carbon tax of US$2-10 per ton. This tax then implies a reduction in GDP of between 0.02 and 0.05 per cent. Below, I will show that in the G-Cubed model a 1 per cent reduction requires a carbon tax of around US$8 per ton but the outcome for GDP depends crucially on how the revenue is used. By 2010 it could lead to a fall in GDP of 0.3 per cent if revenue is rebated back to consumers or to a rise of 0.4 per cent if the revenue is recycled to fund an investment tax credit.

In the final paper John Ferriter presents a baseline scenario out to the year 2010 from the International Energy Agency model. He then presents results for a US$100 per ton carbon tax, US$300 per ton carbon tax, and an increase in energy efficiency. I have little to argue with in the baseline scenario, but I question the usefulness of the model results. From my reading of the paper, it is assumed that between 1993 and 2010 there is no feedback from the change in energy prices after tax to aggregate GDP and then back to energy demand. This result is counter to most other model studies, including those of the models he refers to in his paper. I also found the results that a carbon tax of US$300 per ton by 2010 is the stabilizing level for the United States to be at the high end of the evidence from other models. Part of the reason a large tax is required is that there is no aggregate reduction in GDP that drives down the demand for energy. I will now present some results for the impact of a US$15 per ton carbon tax in the G-Cubed model to add evidence to that presented by the three papers as well as to show the crucial importance of the assumption about how the revenue from the tax is used. In addition, the difference between short-run aggregate demand consequences and long-run production substitution that is pointed to by Professor Amano will be highlighted.

The G-Cubed model

The G-Cubed model is documented in McKibbin and Wilcoxen (1992). This model is a multi-sector dynamic general equilibrium growth model. The key features of G-Cubed can be summarized as follows:

· specification of the demand and supply sides of industrial economies;

· integration of the real and financial markets of these economies;

· intertemporal accounting of the stocks and flows of real resources and financial assets;

· imposition of intertemporal budget constraints so that agents and countries cannot forever borrow or lend without undertaking the resource transfers necessary to service outstanding liabilities;

· short-run behaviour is a weighted average of neoclassical optimizing behaviour and ad hoc "liquidity constrained" behaviour;

· disaggregation of the real side of the model to allow for the production and trade of multiple goods and services within and across economies;

· full short-run and long-run macroeconomic closure with macro-dynamics at an annual frequency around a long-run Solow/Swan neoclassical growth model;

· the model is solved for a full rational expectations equilibrium at an annual frequency from 1993 to 2200.

The model consists of seven economic regions - the United States, Japan, the European Economic Community (EUR), the rest of the OECD (ROECD), oil-exporting developing countries (OPEC), Eastern Europe and states of the former Soviet Union (EFSU), and all other developing countries (LDCs) - with 12 sectors in each region. There are five energy sectors -electric utilities, natural gas utilities, petroleum processing, coal extraction, and crude oil and gas extraction - and seven non-energy sectors (mining, agriculture, fishing, and hunting, forestry and wood products, durable manufacturing, non-durable manufacturing, transportation, and services). This disaggregation enables us to capture the sectoral differences in the impact of alternative environmental policies.

G-Cubed's seven regions can be divided into two groups: four industrial regions and three others. For the industrial economies, the internal macroeconomic structure as well as the external trade and financial linkages are completely specified in the model.

Figure 3C.1 presents results from McKibbin and Wilcoxen (1993a). This simulation shows the path of gross national product (GNP) in the United States after the imposition of a permanent US$15 per ton carbon tax in the United States commencing in 1993. The results are expressed as percentage deviations from the model baseline; thus zero implies no change in GNP relative to the baseline path. Each line in figure 3C.1 is for a different assumption about how the revenue from the tax is used. The five alternative assumptions are:

1. deficit reduction;
2. a lump-sum rebate to households;
3. an investment tax credit (ITC) to all sectors except housing;
4. a cut in the household income tax rate;
5. a cut in the corporate tax rate.

It is clear from figure 3C.1 that the consequences of the different assumptions are important. For example, with a lump-sum rebate of the revenue (which is the standard assumption many studies use) GNP remains below baseline well past the year 2022. However, by giving an investment tax credit, GNP is back to baseline by 1995. Secondly, in each case the aggregate demand consequence of the policy is important in the short run and the production substitution is important in the long run. This supports Professor Amano's argument.

Figure 3C.2 presents the consequences for carbon emissions of the alternative assumptions about the use of the tax revenue. Although there are some differences between the resulting paths for carbon emissions, it is clear that in each case the policy is effective in reducing emissions. The reason is that the dominant effect of the carbon tax is to reduce carbon, especially in the coal industry. None of the alternative revenue assumptions stimulates the coal industry sufficiently to negate the carbon tax in that industry, because the policies are economy wide rather than sector specific. Thus they can change economy-wide production and income but not carbon emissions that are concentrated in the coal, oil, and natural gas extraction industries. The two figures together show that there need not be a linear relationship between carbon emissions and GNP. This is because of the sectoral substitution possibilities plus the differential impact across sectors of the policies.

Fig. 3C.1 Consequences for US real GNP of a US$15/ton carbon tax under alternative revenue recycling assumptions, 1993-2022 (Source: McKibbin and Wilcoxen, 1993a)

Fig. 3C.2 Consequences for US carbon emissions of a US$15/ton carbon tax under alternative revenue recycling assumptions, 1993-2022 (Source: McKibbin and Wilcoxen, 1993a)

Finally, the question of offset through trade flows resulting from unilateral carbon taxes has been assessed using the G-Cubed model in McKibbin and Wilcoxen (1993b). In that paper, we show that a unilateral US carbon tax reduces carbon emissions in the United States by about 15 per cent less than when all OECD countries also impose a carbon tax. Thus there is evidence of some offset from unilateral action but nowhere the complete offset suggested by the estimates discussed in Amano's paper.

References

McKibbin, W. and P. Wilcoxen. 1992. G-Cubed: A Dynamic Multi-Sector General Equilibrium Growth Model of the Global Economy: Quantifying the Costs of Curbing CO₂ Emissions. Washington, D.C.: Brookings Institution, Discussion Paper in International Economics No. 98, September.

McKibbin, W. and P. Wilcoxen. 1993a. "Global costs of policies to reduce greenhouse gas emissions II." Report prepared for the Office of Policy Analysis, US Environmental Protection Agency, on the 2nd-year results from a multi-year research grant.

McKibbin, W. and P. Wilcoxen. 1993b. "The global consequences of regional environmental policies: An integrated macroeconomic, multi-sectoral approach." In: Y. Kaya, N. Nakicenovic, W. Nordhaus, and F. Toth (eds.), Costs, impacts and Benefits of CO₂ Mitigation. Austria: International Institute for Applied Systems Analysis, CP-93-2.

3. Kenji Yamaji

Many interesting topics are raised and discussed in part 3. Dr. Cline makes a persuasive argument for his two-phase policy approach with the first phase of CO₂ stabilization through the application of "integrated" economic analysis. By "integrated" I mean that both the cost of greenhouse gas control and the damage resulting from climate change are treated.

Professor Amano is rather neutral in a sense. He surveys the macroeconomic cost evaluations of a CO₂ tax and studies of its side-effects, and he also talks about his own study on the sensitivity of the optimal climate control using a version of the integrated model originally developed by Professor Nordhaus.

Mr. Ferriter is the most pragmatic and cautious of the three. He introduces an IEA study on the carbon tax with relatively high rates and regulatory approach for promoting energy efficiency improvements. He suggests that the regulatory approach would have effects equivalent to those that can be expected with a carbon tax of US$300/tC.

I would like to comment on three points related to these presentations.

The first point is the macroeconomic impact of a carbon tax. As Professor Amano points out, the macroeconomic cost varies depending on several factors, such as the time-horizons of the models and the treatment of tax revenues. He also mentions the difference in the types of model employed. I would like to emphasize here the influence of the basic structure of the models used. On the basis of actual past performances, the general equilibrium type model and a more explicit optimization model tend to produce a smaller macroeconomic cost compared with simulation models that simulate the performance of actual imperfect market functions.

My own study on carbon tax, which is included in Professor Amano's survey, is based on a simulation type model. The cost I obtained is rather high even when the tax revenue is assumed to be recycled through income tax reduction. Of course, there is also a regional difference. I think my result reflects the higher marginal cost of CO₂ reduction in Japan. But the difference of model type makes a more significant impact.

My second comment concerns the policy implications of integrated economic analysis, or optimal climate control with minimum total social cost. The uncertainties involved in damage cost evaluation are huge, particularly in the case of climate change. We have too little knowledge to do a full cost-benefit analysis of climate control. In this context, sensitivity analyses, as demonstrated by Dr. Cline and Professor Amano, are very interesting and important. However, optimal control may be very close to the business-as-usual case, and very far from CO₂ stabilization, which is the path many OECD countries (including Japan) are now choosing. But, as Dr. Cline says, CO₂ reduction, which is a more stringent control than CO₂ stabilization, could be the optimal path depending on the choice of discount rate and the time-horizon.

It is clear that more study should be done in this field. My personal feeling is that we should take action now to deal with climate change. There are two aspects that are not mentioned in the presentations: one is that there could be a catastrophic positive feedback such as triggering a burst of methane emission from tundra in Siberia, and the second is that technology development could, eventually, dramatically reduce the cost of CO₂ control. These issues are not short-term ones and therefore appear not to be suitable topics of discussion here. But I believe short-term policy should also be rooted in long-term considerations.

The last point I would like to raise is the global perspective of climate control, or more specifically the issue of "carbon leakage," which Professor Amano mentions as a side-effect. I think inter-regional equity is important as well as intergenerational equity. In this sense? the developed regions should take the lead in climate control and CO₂ limitation. However, unilateral efforts by developing regions are quite likely to be accompanied by leakage; i.e. CO₂ reductions in a developed region may result in CO₂ increases in other regions. And such leakages can be very large. On the other hand, the assertion that joint implementation between developed and developing regions can be one of the most effective and efficient schemes to reduce global CO₂ emissions is mostly maintained in qualitative terms; as far as quantitative analysis is concerned, there is not enough research in this field. Through analyses addressed to these global perspectives, pessimism about carbon leakage could be turned into positive opportunities.

Appendix to part 3 examining the macroeconomic effects of curbing CO2 emissions with the Project LINK world econometric model

Hung-yi Li, Peter Pauly, and Kenneth G. Ruffing

1. Introduction

Amid the considerable uncertainty surrounding the issue of global warming, two scientific facts are undisputed. The first is that carbon dioxide gas has been accumulating in the earth's atmosphere over the past 100 years. The second is that the gas traps heat from the sun's energy when it is absorbed by the earth and then re-radiated.

The first area of uncertainty is how much the earth's climate would heat up in response to the further accumulation of carbon dioxide in the earth's atmosphere. Most studies based on computerized climate models have attempted to examine the impact of a doubling of atmospheric carbon dioxide from 1990 levels by the year 2100 (a plausible rate of increase in the absence of significant policy change). A United Nations scientific advisory committee concluded in 1990 and again in 1992 that the average global temperature by 2100 would increase within the range of 3-8°F, with a central value of 4.5° (IPCC, 1990; Houghton et al., 1992). A study by researchers at New York University and Lawrence Livermore National Laboratory of two ancient climates, one much colder and one much warmer than the current global climate, concluded that a doubling of atmospheric carbon dioxide was associated with an increase of 4°F in the average temperature of the atmosphere (Martin Hoffert and Curt Covery, cited by Stevens, 1993). Despite numerous critiques of such studies faulting the reliability of the data and the models used, most climate researchers believe that there is a greater than 50 per cent chance that the climate will warm up by at least 3.5° over the next century.

The second area of uncertainty concerns the effects of the anticipated warming in the absence of measures to prevent it. These effects bear mainly on the impact on agriculture and forestry of changes in weather patterns and on the impact of a potential rise of about 2 feet in the sealevel from melting polar ice. Studies of potential impacts on the United States based on the physical consequences associated with a doubling of CO₂ equivalent concentrations of greenhouse gases have been done by the Environmental Protection Agency of the United States and used as the basis for alternative calculations by others. Recent estimates by Nordhaus (1993), Cline (1992), and Fankhauser (1992) range from 1 to 1.3 per cent of annual national income. Morgenstern (1991) provides arguments that support a figure closer to the "high" end of the range as the more plausible.

Schelling (1992) has pointed out that all the estimates of potential losses have relied on models of gradual change. He raises the possibility that "some atmospheric or oceanic circulatory systems may switch to alternative equilibria, producing regional changes that are both sudden and extreme" He admits that "insurance against catastrophes is... an argument for doing something expensive about greenhouse emissions. But to pay a couple percent of GNP as insurance premium, one would hope to know more about the risk to be averted" (1992: 8), and he calls for climate research to focus on extreme possibilities rather than to continue to refine median projections.

Representative of the "no regrets" approach of policy advocates for modest action to curb carbon dioxide and other greenhouse gas emissions is the position of a panel of the US National Research Council. This body concluded in 1991 that "despite the great uncertainties, greenhouse warming is a potential threat sufficient to justify action now" (cited by Stevens, 1993). The emerging consensus on the seriousness of the threat of global warming and on the wisdom of adopting early measures resulted in the United Nations Framework Convention on Climate Change by which developed countries agreed to limit their CO₂ emissions in the year 2000 to their 1990 levels. The Convention entered into force on 21 March 1994.

The potential for emissions of carbon dioxide to change the global climate is prompting policy makers to examine the costs and benefits of a carbon tax. Research focuses on several aspects. Among the most important are: (a) the relation between the size of the tax and the quantity of carbon emissions that are abated and (b) the relation between the size of the tax and its effect on economic activity.

Understanding these aspects of a carbon tax is advanced considerably using computer simulation models (Weyant, 1993). Most often, the quantity of emissions abated by a tax is analysed using energy demand models, and the effect on economic activity is analysed using economic models. This schism is associated with the strengths and weaknesses of existing models (Beaver and Huntington, 1992). Energy demand models focus on the determinants of energy demand but many treat the level of economic activity as an exogenous variable. Conversely, economic models simulate economic activity endogenously but exogenize many of the important determinants of energy demand.

The use of energy demand models and economic models to analyse the quantity of emissions abated and the effect on economic activity forces the modellers to adopt several assumptions. Two of the most commonly used assumptions are that the pattern of international trade is constant and that energy prices are exogenous. These assumptions are required because most of the models cannot simulate endogenously how a carbon tax affects international trade or energy prices. One cause for the inability to simulate the change in trade is the geographic level of coverage and the level of aggregation. Many of the models used to analyse the effects of a carbon tax include one nation; therefore, these models cannot simulate the effects of trade. Conversely, models that include the entire world aggregate economic activity by countries into a few regions (Hoeller et al., 1990; Beaver and Huntington, 1992). Such aggregation prevents these models from simulating accurately the international pattern of trade. Finally, many models do not simulate energy supply, demand, or OPEC behaviour explicitly; therefore they cannot simulate energy prices endogenously.

The inability to simulate the pattern of international trade or the determinants of world energy markets limits the models' ability to evaluate a carbon tax. A carbon tax has significant short- and long-run effects on the economic system. In the short run, its price and budgetary effects are important for an economy's cyclical position; in that it is no different from any other fiscal policy. In the medium to long term, it alters the competitive position of nations, which changes their structure of imports and exports and the composition of value added across sectors and the product spectrum. A carbon tax also changes the supply of and demand for energy and the price for energy, which affects the incidence of the carbon tax. These changes in trade and world energy markets have an important effect on the quantity of emissions abated by a carbon tax and the effect of a tax on economic activity. Models that cannot simulate the changes in international trade and world energy markets caused by a carbon tax tend to underestimate the quantity of emissions abated by the tax and misrepresent the effect of the tax on economic activity. For example, models that cannot simulate the determination of world energy prices endogenously cannot simulate the reduction in world energy prices due to the reduction in demand generated by a carbon tax, which offsets some of the incentive to lower carbon emissions. Similarly, models that cannot simulate the pattern of international trade endogenously cannot simulate the gains and losses to nations that do and do not adopt a carbon tax.

Part of this paper describes how changes in the pattern of international trade and changes in energy markets affect the quantity of carbon abated by a carbon tax and the effect of a carbon tax on economic activity. These effects are simulated endogenously using the world econometric model of Project LINK (LINK) with the trace gas accounting system (TGAS) (Kaufmann et al., 1991). In this system, the combination of a short- to medium-term globally consistent and complete international macroeconomic model with modules that endogenously simulate the world oil market (OIL-LINK) and international energy demands, inter-fuel substitution, and emission levels (TGAS) provides a modelling framework that is particularly suited to address problems of short- to medium-term adjustments to a carbon tax.

2. Carbon taxes, energy prices, and international trade

Most of the scenarios used to analyse the effectiveness of carbon taxes, and indeed the simulations presented in the next section, assume that the tax is adopted worldwide and that energy prices are exogenous. If these assumptions are relaxed, the forecast for economic activity and carbon emissions may change significantly. If carbon taxes are not adopted worldwide, the carbon tax may cause significant changes in the pattern of internal trade. If energy prices are determined endogenously by economic conditions, a carbon tax may cause significant changes in the pre-tax price of energy. Both of these changes have an important effect on the quantity of carbon emissions that are abated by a carbon tax and the effect of a carbon tax on economic activity.

The failure to simulate the effect of a carbon tax on the international pattern of trade causes models to omit an important mechanism that will determine, in part, the quantity of emissions abated by a carbon tax and the effect of a carbon tax on economic activity. A carbon tax affects the international pattern of trade regardless of the level of international cooperation. If all nations impose the same carbon tax, the fractional increase in the price of energy to end-users will vary among nations because of existing differences in energy taxes or subsidies (Kaufmann, 1991). Nations that have the highest level of existing taxes experience the smallest percentage increase in prices. Under these conditions, the competitive balance shifts slightly in favour of those nations that experience the smallest percentage increase in prices. But the effects on trade that result when the carbon tax is imposed universally are small compared with the effects that occur if only some nations adopt a carbon tax. Without global participation, energy prices rise significantly in nations that adopt a carbon tax (participating nations) relative to nations that do not impose a carbon tax (non-participating nations). This differential rate of change causes the cost of production to decline in non-participating nations relative to that in participating nations. Ceteris paribus, the change in costs tips the competitive balance among nations in favour of nations that do not adopt the carbon tax.

The shift in competitiveness generated by a carbon tax changes the pattern of international trade via two mechanisms. The relative decline in the cost of production allows non-participating nations to capture market share from participating nations. The differences in end-user energy prices generated by the carbon tax also induce some multinational firms to relocate production in non-participating nations. Both of these changes increase the level of exports and economic activity in non-participating nations relative to nations that adopt a carbon tax.

The failure to simulate world energy markets endogenously also causes existing models to omit an important mechanism that determines, in part, the quantity of emissions abated by a carbon tax and the effect of a carbon tax on economic activity. A carbon tax reduces the demand and/or price for energy. The effect on demand and/or price depends on the degree to which energy producers, especially members of OPEC, recognize and react to the change in demand. If producers do not recognize and/or anticipate the reduction in demand correctly and adhere to their original schedule for adding capacity, reduced levels of demand create excess capacity. This overhang exerts downward pressure on the wellhead price of oil, which also depresses the price for other forms of energy. Conversely, OPEC may recognize and/or anticipate the reduction correctly and slow its schedule for adding capacity. Under these conditions, lower levels of demand do not create over-capacity and prices may proceed along the path that was envisioned for a world without a carbon tax (Kaufmann et al., 1994).

The changes in the pattern of international trade and world energy markets that are generated by a carbon tax have an important effect on the quantity of carbon abated by a carbon tax and the effect of the carbon tax on economic activity. The effect on the quantity of emissions abated is measured by "leakages" from the tax. Leakages are defined as an increase in emissions by non-participating nations beyond levels that they would have emitted had no carbon tax been imposed. By definition, the quantity of carbon abated by a tax shrinks as the quantity of leakages increases. Leakages are minimized implicitly by models that treat the pattern of international trade and energy prices as exogenous variables. Endogenizing these variables allows a model to measure the size of leakages that are generated by several mechanisms. One important cause of leakages is the change in the pattern of international trade. The increase in economic activity by non-participating nations that is caused by expanding market share and location decisions by multinational firms increases carbon emissions by non-participating nations relative to a world in which there is no carbon tax. Another important source of leakages is the potential for changes in world energy markets. If energy producers do not recognize the reduction in demand and lower capacity accordingly, the reduction in price diminishes the incentive to reduce energy use per unit output, which increases carbon emissions relative to a world in which there is no carbon tax.

The changes in trade and world energy markets have offsetting effects on the impact of a carbon tax on economic activity. The increase in economic activity by non-participating nations exacerbates the negative effect of a carbon tax on economic activity in participating nations because the increase in economic activity is accomplished, in part, by moving production from participating nations to non-participating nations. On the other hand, the potential for lower energy prices may reduce the negative effect of the carbon tax on economic activity. If a carbon tax reduces energy prices, the reduction slows the transfer of money from energy-consuming nations to energy-producing nations. Retarding this flow increases income in energy-consuming nations, which increases demand and production (Marquez and Pauly, 1984). Even though trade effects offset the energy price effects, there is no a priori reason to believe that they cancel each other so that the net effect is small. As a result, models that do not simulate patterns of international trade and the formation of energy prices endogenously either underestimate or overestimate the negative effect of a carbon tax on economic activity by participating nations. In addition to overestimating the quantity of emissions abated by a tax and misrepresenting the effect of a carbon tax on economic activity, the failure to represent the effect of a carbon tax on the pattern of international trade and world energy markets causes the models to ignore the potential for strategic behaviours regarding a carbon tax. The potential for leakages from the tax reduces the effectiveness of the tax, but this loss of effectiveness creates winners and losers. Nations with the smallest rise in end-user prices or that do not adopt a carbon tax may "win" because they may reap the benefits of lower emissions while enjoying increased levels of economic activity and emissions. Conversely, nations with the largest rise in end-user prices may "lose" by reducing emissions less than they anticipated and suffering economic losses greater than they anticipated. The effect of a carbon tax on the world energy markets also creates winners and losers. Energy-consuming nations will "win" by shifting a portion of abatement costs to energy-producing nations, which will "lose" by paying for abatements accomplished by consuming nations via lower energy prices and/or lower levels of exports.

3. A policy simulation

The modelling framework

The LINK model has been described elsewhere, including in a paper prepared for the UNU Programme on Global Change and Modelling in 1991 (Hickman and Ruffing, 1991). It is a multi-country model that links separate national econometric models by means of models of merchandise trade, exchange rates, and commodity prices. We use the LINK-TGAS modelling system to study how changes in the pattern of international trade and world energy markets affect the quantity of emissions abated and the economic impact of a carbon tax. A detailed description of the basic structure of the system can be found in Kaufmann et al. (1991). The LINK-TGAS system is suited for this task because, in addition to standard domestic macroeconomic feedbacks and the modelling of energy use and emissions, it simulates endogenously the international pattern of trade, disaggregated by commodities, and world energy prices. The pattern of international trade is simulated on the basis of bilateral trade matrices by commodity groupings; trade shares can respond to technological changes, to changes in structures and preferences, as well as to changes in competitiveness. The LINK-TGAS system uses a combination of assumptions about monetary and fiscal policy, OPEC behaviour, and OPEC capacity to generate a forecast for economic activity and the pattern of imports and exports for the 79 nations and regions in the Project LINK modelling system. The modelling system also generates a forecast for carbon emissions by the 14 nations for which TGAS models are available (Canada, France, Germany, Italy, Japan, the United Kingdom, the United States, Brazil, China, Hungary, India, Korea, Mexico, and Poland). With the exception of the states of the former Soviet Union, this subset represents the most important emitters of CO₂. Finally, the modelling system also generates a forecast for energy prices. The effect of a carbon tax on the world energy markets is simulated endogenously and is based on the level of supply, demand, OPEC capacity, and OPEC behaviour (Kaufmann, 1995). Together, these variables constitute a baseline that can be compared with different scenarios to determine the effectiveness of a carbon tax.

The baseline scenario

One of the difficulties in constructing a baseline scenario is predicting CO₂ emissions for the next decade in the absence of additional policy measures. There are several reasons for this. First, there is the question of the overall rate of GDP growth that might be expected over the eight years to the year 2000. The LINK reference scenario was 2.7 per cent per year (2.4 per cent for the decade as a whole). This is close to the baseline scenario described together with high and low variants in a recent study by the United Nations (UN, 1992) making use of the Global Input-Output Model (GIOM). Secondly, over periods of a decade or more, the sectoral composition of output can be expected to change both within and among countries. Thirdly, the energy intensity of production in each sector can also be expected to change as economic agents continue to adjust with a long response lag to past changes in energy pricing policies and other measures.

As a consequence of the interplay of these factors, the United Nations study concluded that carbon from fossil fuels emitted by the developed market economies would increase only slightly under the baseline scenario, cumulatively by only 8 per cent between 1990 and 2000 (0.8 per cent per year) but by 36 per cent under the high-growth scenario (3.1 per cent per year). In the high-growth scenario, emissions of carbon dioxide per unit of GDP are assumed to fall by 16 per cent in the developed market economies between 1990 and 2000. This implies an overall income elasticity of 1.0. Without the change assumed in the energy intensity per unit of output, the income elasticity would be nearly 1.5. There are other studies that suggest low rates of growth of CO₂ emissions in the United States. Several widely quoted studies cited in Morgenstern (1991) suggest a rate of growth of only 0.9 per cent per year in the United States from 1987 to 2000 with current policy commitments. In the LINK baseline, overall CO₂ emissions by the G7 countries are projected to increase by 3.3 per cent per year from 1993 to 2000 (cumulatively by 30 per cent). Since the aggregate GNP of the same countries is projected to increase by 2.7 per cent per year over the same period, the implied income elasticity is about 1.2.

A macroeconomic policy simulation using the world econometric model of Project LINK

In the LINK policy simulation prepared for this paper, a carbon emission tax was imposed on each G7 country. The tax was set at US$30 per metric ton of carbon equivalent (tC) in 1993 and increased to US$100/tC in 2000. There are considerable variations in the percentage reductions in CO₂ emissions per country, ranging from a cumulative decrease of 3 per cent in the case of Japan to 11 per cent in the case of the United States. For the G7 countries as a group the reduction from the 2000 baseline figure is 8 per cent. This is not quite a third of the reduction that would be necessary to freeze emissions in 2000 to their 1990 levels. Yet the reduction in GDP would be about 2 per cent. Recently, Weyant (1993) reported that studies undertaken for the Energy Modeling Forum 12 suggest that the long-term costs of stabilizing global carbon emissions could be in the neighbourhood of 4 per cent of world GDP by the year 2100.

Several studies reviewed by Morgenstern (1991) estimate that a 10-20 per cent reduction from base levels would require a carbon tax of US$10-75/tC. Some more recent studies suggest levels of carbon taxes toward the higher end of this range. The Edmonds-Reilly model, for example, calculated that a 14 per cent reduction in CO₂ emissions from baseline levels in OECD countries in 2005 would require a carbon tax of US$55-56/tC in that year (Barns et al., 1992). The Global 2100 model developed by Manne and Richels calculated that an 11 per cent reduction in the baseline CO₂ emissions of OECD countries in 2000 would require carbon taxes in the range of US$60-70/tC in the terminal year (Manne, 1992). The LINK calculations appear to be on the high side as far as the level of tax required to induce significant CO₂ emissions reductions is concerned. However, it should be borne in mind that most other studies employ a general equilibrium framework to calculate the fully adjusted response to a hypothetical tax, as if there were no adjustment lag. The smaller response suggested by a dynamic econometric model suggests that the task of reducing CO₂ emissions may be greater than commonly thought.

As may be seen from table 3A.1, the macroeconomic effects are fairly strong. A carbon tax that rises to US$100/tC by 2000 would leave GDP in G7 countries 2 per cent lower than in the baseline. Growth elsewhere would also be reduced but by less because in this scenario no direct taxes were imposed on these countries. The fact that inflation increases by an average of only about 0.35 of a percentage point over a period to 2000, while unemployment increases by about 0.6 of a percentage point in 2000, suggests that there would be scope for offsetting reductions in other taxes to mitigate the negative impact of a carbon tax on output and employment.

Table 3A.1 The LINK model scenario (impact expressed as percentage deviation from baseline)

	GDP in world	GDP in G7 countries	World trade volume	Inflation in developed market economies	Unemployment in developed market economies	CO2 emissions in G7 countries
1993	-019	-0.21	-0.24	0.69	0.09	- 0.7
1994	-0.67	-0.87	-0.55	0.28	0.54	-3.7
2000	-1.39	-2.04	-0.76	0.47	0.59	-8.1

Note: A carbon tax of US$30 per metric ton of carbon equivalent is imposed in 1993 rising to US$100 in 2000.

The role of oil prices

The scenario described in the previous section compares the effects of a unilateral carbon tax on economic activity, carbon emissions, and energy prices. These results are generated via an exogenous tax assumption under exogenous energy prices, and we can identify the ways in which changes in the pattern of international trade and energy prices that are generated by a carbon tax affect the quantity of carbon abated by the tax and the effect of the tax on economic activity. The comparisons are also used to identify the gains and losses that are associated with adopting a carbon tax and the cost of emissions reductions borne by emitters as opposed to energy producers.

The following scenario uses all of the assumptions about monetary and fiscal policy from the reference scenario, but now is based upon a uniform US$40 carbon tax with an endogenous oil price response. This change in the size of the shock is of little consequence for the multiplier properties of the system. This scenario calculates the first-purchase price of energy endogenously using the assumptions about OPEC behaviour and capacity used in the reference scenario. The price of crude oil in this scenario is different from the price calculated in the reference scenario because the carbon tax changes the demand for oil. Demand is changed because the end-user price of energy increases in nations that impose a carbon tax and the increase in end-user prices changes the pattern of international trade, the level of economic activity, and the quantity of energy consumed per unit of economic activity.

In this scenario, all variables are solved endogenously. Because it uses the same assumptions about OPEC behaviour and additions to OPEC capacity, this scenario represents the effect of a carbon tax on world energy markets if OPEC ignores the effect of the carbon tax on oil demand. Under these conditions, oil prices fall owing to lower levels of capacity utilization. This reduction in energy prices allows the scenario to identify how changes in world energy markets affect the quantity of emissions abated by the tax and how changes in world energy markets affect the impact of the carbon tax on economic activity. The effect of a carbon tax on world energy markets and the impact of these effects on the quantity of carbon abated and the level of economic activity can be gleaned from this scenario in three steps. In the first step, the results from this scenario are used to determine the effect of a carbon tax on energy prices by comparing the price forecasts generated by this scenario with those of the reference scenario.

In the second step, the results of this scenario are used to determine the quantity of carbon abated by a tax and how changes in energy prices affect this quantity. The total amount of carbon abated by the tax is determined by the difference in total carbon emissions between the reference scenario and this scenario. The leakage from the tax through world energy markets is determined by subtracting the total amount of emission reductions forecast by this scenario from the total amount of emission reductions forecast by the reference scenario. A positive value indicates a leakage from the tax. A similar process is used to determine the effect of a carbon tax on economic activity. The total effect of a carbon tax on economic activity is determined by comparing the level of economic activity forecast by the reference scenario with the level forecast by this scenario. The effect of changes in world energy markets on the economic impact of a carbon tax is determined by subtracting the level of economic activity forecast by the reference scenario from the level of economic activity forecast by this scenario. A positive value indicates that changes transmitted through world energy markets reduce the negative effects of a carbon tax on economic activity.

The quantity of emissions abated by the tax depends on changes that occur in both participating and non-participating nations. In participating nations, the carbon tax reduces the quantity of carbon emitted by reducing emissions per unit output. This reduction may be reinforced or offset by changes in the level of economic activity by participating nations and by changes in the first-purchase price of energy. In non-participating nations, the carbon tax changes the quantity of emissions abated by changing the level of economic activity and by reducing the first-purchase price of energy. The sum of these effects determines the quantity of emissions abated in toto.

Endogenizing the oil price has several effects. The relative increase in G7 activity associated with a carbon tax per se would increase the oil price, but the tax provides incentives to substitute away from oil. On balance, this depresses the oil price. By the year 2000, the price path lies about US$3 per barrel below the exogenous price path of the original scenario. This exerts a slightly positive impact on the participating countries in terms of lower imported inflation, even though it depresses activity in non-participating energy-producing countries (mostly developing countries). In addition, the implied change in the relative price of energy induces an increase in the use of carbon energy sources and thus reduces the efficiency of the tax.

The quantity of emissions abated by participating countries is given by the level of emissions forecast by the endogenous scenario relative to the level of emissions forecast by the reference scenario. The size of these reductions varies from 1.5 to 4.7 per cent in 2000. The largest reductions occur in the United States and the smallest reductions occur in Japan and Germany. This differential rate of reduction is caused by differences in the fuel mix, the mix of economic activities, the size of the elasticities estimated from the historical record for individual nations, and differences in the percentage increase in end-user prices generated by the carbon tax. This last effect seems to be the most significant determinant of the reduction in emissions. For example, the United States has the largest percentage increase in end-user prices in 2000 whereas Japan and Germany have the smallest percentage increase in end-user prices.

The direction and size of the change in emissions depend on changes in economic activity caused by the tax, changes in world energy markets that reduce the first-purchase price of energy, and changes in economic activity caused by changes in world energy markets. The results of the three scenarios can be used to identify the change in emissions associated with each mechanism. Changes in the world energy markets that reduce the first-purchase price of energy are the second mechanism that changes the quantity of carbon abated by the tax. The effect of reductions in the first-purchase price of energy on the quantity of carbon abated is evaluated by calculating the percentage change in the emissions/GDP ratio forecast by the reference scenario relative to the ratio forecast by the endogenous scenario. An increase in the carbon emissions/real GDP ratio forecast by the latter relative to carbon emissions/real GDP ratio forecast in the former indicates that the reduction in first-purchase prices reduces the incentive to reduce energy use, which generates a leakage from the carbon tax in participating nations.

The third mechanism for leakages in participating nations is a change in economic activity caused by changes in world energy markets. The reduction in the first-purchase price of coal, oil, and natural gas changes economic activity (including imports and exports) and these changes affect emissions. The change in emissions caused by this effect is evaluated by calculating the percentage change in economic activity forecast by the endogenous scenario relative to the change forecast by the reference scenario.

Leakages in non-participating nations depend on the same mechanisms that cause leakages in participating nations: changes in economic activity caused directly by the carbon tax, changes in the first-purchase price of energy that cause changes in the quantity of carbon emitted per unit of economic activity, and changes in economic activity caused by changes in world energy markets.

The effect of a carbon tax on the international pattern of trade and world energy markets creates the potential for an array of strategic behaviours. Changes in trade make non-participating nations better off and their gains are reinforced by the negative effects of the tax on participating nations. Changes in world energy markets redistribute the costs of the tax such that a carbon tax reduces the economic well-being of energy-producing nations and, in some cases, energy-consuming nations are able to reduce the negative impacts of the tax by shifting a significant portion of the costs to energy-producing nations.

A carbon tax presents energy producers with a range of strategies that vary between two extremes. At one extreme, producers can ignore the effect of the tax on demand and add capacity at the rate that would have prevailed in a world without a tax. Under these conditions capacity utilization drops and the resultant overhang depresses the price of oil and other forms of energy. At the other extreme, producers can anticipate perfectly the effects of the tax on demand and retard additions to capacity so that utilization rates and real prices evolve along the same path that would have prevailed in a world without a tax. Under these conditions, the demand for oil and other forms of energy drops. Regardless of the strategy chosen. the economic well-being of energy producers is reduced. These issues are explored in detail in Kaufmann et al. (1993).

4. Conclusions

This study has been concerned with unilateral (non-global) carbon tax policies, and with an evaluation of the effects of the response on the world oil market on the efficiency of such a policy, i.e. the extent of oil-related carbon leakages and the short-run adjustment costs of such a policy. The results are based on simulations with the LINK-TGAS system, which combines a global macroeconometric model with modules for energy use and emissions analysis and energy price determination. The results are, of course, preliminary, but they con firm and complement studies of a longer-term nature (McKibbin and Wilcoxen, 1992; Piggott et al., 1993).

Among the findings of the study are the following:

· A unilateral (G7) carbon tax induces reductions in emissions in these countries; the effect of such a policy on non-OECD emitters is diverse, ranging from a slight reduction to increases up to 15 per cent.

· The results are critically dependent upon the responses of international energy prices, in particular the world oil price. A carbon tax in the G7 countries induces a medium-term reduction in the real price of crude oil by approximately US$2 per barrel.

· The oil price reduction generates a positive stimulus in G7 countries that significantly tends to reduce the short- to medium-term GNP loss to G7 countries.

· A unilateral G7 policy generates a trade balance improvement in these countries, at the expense of non-participating countries; oil-exporters among the G7 (Canada and the United Kingdom) experience deteriorations in the trade balance.

· The results are sensitive to assumptions about the strategic behaviour of energy producers, in particular of OPEC.

It is, of course, possible to reduce or even eliminate the negative activity effects of a carbon tax through the recycling of revenues and parallel stabilizing policies, such as a mild monetary expansion. In general, such policies increase the short-run effectiveness of a tax, but at a price of increased inflationary pressure. The results obtained in single-country analyses (Shackleton et al., 1992) have to be confirmed in future multi-country simulations. The present results already point towards a substantial potential for improvement in the efficiency of international carbon taxation through international cooperation.

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