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close this bookClimate Protection Policies: Can We Afford to Delay? (WRI, 1997, 44 pages)
close this folder2. ACHIEVING THE TRANSITION TO A LESS CARBON-INTENSIVE ECONOMY
View the document(introduction...)
View the documentTiming and the Capital Stock
View the documentTechnological Change
View the documentThe Need for Credible Signals and Policies

The Need for Credible Signals and Policies

Even models that suggest emissions should rise in the short term require that changes in capital stock and technological development occur from the outset to meet the more stringent cuts needed later. However, this does not make for a consistent policy path. The very signal that emissions can rise in the short term removes the imperative for implementing the necessary policies. Subsequently, achieving future emissions reductions will be harder because nothing will have been done in the interim.

MAKING A CREDIBLE COMMITMENT

For changes to occur in capital investment and technological progress, investors need to be convinced that policy-makers are committed to a new direction. In the artificial world of modeling, it suffices to have the government simply declare its intention to start reducing emissions in a future year, perhaps over a decade away. Decision-makers in the model, blessed with perfect foresight and fully convinced of future policies, immediately alter their behavior.

BOX 2 ESTABLISHING CREDIBLE POLICIES - A LESSON FROM CONTROLLING INFLATION

· The need for credible policy signals is well understood by economists because such signals form the cornerstone of inflation control. Inflation needs to be kept low for the long-term health of the economy. However, doing so imposes a short-term cost in terms of lower immediate growth and potentially higher unemployment than would otherwise occur.

· The tension between inflation and employment especially means that establishing commitment to a policy of stable prices is difficult. There will always be a temptation for the government to take the easier option in the short term of relaxing monetary control, thereby lowering the cost of credit and loans, reducing highly visible mortgage interest payments, and temporarily boosting output and employment. Particularly near election time, when there is a premium on short-term popularity, this temptation may be irresistible. The adverse consequences will only be felt later, by which time elections will be over.a

a This is the well-documented 'time inconsistency' problem (Kydland and Prescott, 1977). Time inconsistency of policy refers to the breaking of a policy commitment in order to take advantage of benefits that are immediate and usually short term. More plainly, it is the difference between what policy-makers say they are going to do and what they end up doing.

· If a government is serious about controlling inflation, it must establish credibility by building a reputation for stable prices. Building a reputation, though, takes time. Only when the temptation to relax monetary policy has been repeatedly resisted does the government's commitment to stable prices become credible. In many countries, the only credible way to assure consumers and investors of a commitment to low inflation has been to pass control to an independent central bank sheltered from political pressure, as with the Federal Reserve.

· For climate change, as for inflation, the consequences are potentially severe but will only be felt later. In contrast, prevention measures may be costly and unpopular immediately. There are also key differences: the consequences of inflation are known with certainty, through bitter experience, and materialize in the short term not the long term.

In reality, such a framework is impossible to establish. Declarations of which policies will come into place many years hence are meaningless. Instead, investors' expectations are shaped predominantly by policies implemented now. Governments can signal long-term intent to decision-makers only through consistent and persistent policy action. In so doing, the government effectively builds a reputation for controlling carbon emissions. Establishing and maintaining a reputation are often key components of macroeconomic management. (See Box 2.)

Of course, reputations cannot be earned overnight. As long as the government's commitment is questioned, investments will not change markedly, even though policies are in place. This is because investors will factor in a probability that the commitment may waver and that the policy may be reversed. Gradually, as the commitment proves resilient to changing political and economic circumstances, so investors' doubts will diminish. This implies several things for policy implementation.

· First, given the delay while expectations form, policies will have a 'lead time' before the pattern of long-term investments fully responds to changed prices.

· Second, the building of a reputation may be hastened by careful policy design. In terms of establishing credibility, meeting a pre-announced schedule of incremental carbon tax increases which reaffirms commitment early and often would be preferable to a tradable permit program with long compliance periods. With the latter, commitment to the program can only be demonstrated at the end of the period by penalizing defaulters.

· Third, there is a trade-off between flexibility and credibility of policy. Policies that incorporate escape clauses such as the ability to "borrow from the future" - allowing permit holders to forego reductions now in return for more stringent reductions later - do not establish as strong a commitment to emissions reduction as less flexible policies.

· Fourth, a single policy is unlikely to convey commitment by itself. Instead, it would need to be buttressed by other policies that establish across-the-board consistency, lowering the likelihood of removal in the investors mind (Rodrik, 1989).

THE DANGER OF WEAK COMMITMENTS

If investors are skeptical of the commitment to emissions reductions, they may even feel that their behavior could force policy reversals. They may continue to make traditional investments, accepting the short-term impact of higher fuel prices, but knowing that such investments will prove to be the most profitable in the long-term when the policy that raised prices is removed. In these circumstances, it may quickly become impossible for the government to adhere to the initial policy target.

The Rio commitment serves as an example. Although there are three years remaining to meet that target, any political pressure to do so has long since vanished. Voluntary programs alone, though successful, were insufficient to alter investment and consumption patterns across the economy. To meet the target now would require abrupt and immediate change.

Reneging on commitments only makes it more difficult to establish a reputation later, setting in train a vicious circle of missed targets and resolution to start anew. Only if climate conditions become much more severe will this pattern be broken. But by then, it may be too late to avoid further severe conditions, or if not too late, vastly more expensive than if earlier preventive measures had been taken.

Conceding that emissions can rise in the short term removes the imperative for immediate change that is necessary even for "delay".

If credibility cannot be instantly assumed, then policy implementation is required early. Initially, this will require a sufficiently tough international signal from Kyoto to force the appropriate domestic response. Delay paths such as those in Figure 1A are not credible politically, because conceding that emissions can rise in the short term removes the imperative for immediate change that is necessary even for those paths. Subsequently, domestic policies need to be implemented as soon as possible to maximize the time available to meet national targets.