**PREPARED STATEMENT OF GARY W. YOHE**

**Woodhouse/Sysco Professor of Economics**

**Wesleyan University**

**Middletown, CT 06459**

[**gyohe@wesleyan.edu**](mailto:gyohe@wesleyan.edu)

**Tuesday February 13, 2007**

Mr. Chairman, Senator Domenici, and Members of the Committee on Energy
and Natural Resources, thank you for your invitation to present
testimony on the *Stern Review on the Economics of Climate Change*. It
is indeed an honor to be here, today. It is especially an honor to be on
the same panel with Sir Nicholas Stern. His credentials speak for
themselves, but I would like to emphasize that Sir Nicholas is a world
class economist whose contributions to our knowledge extend well beyond
the issues of climate change and the specifics of his service to the
World Bank or to Her Majesty's Treasury.

I will try to tell a story with my testimony -- a story about how the
discipline of economics can play a significant role in understanding how
we should respond to the risks of climate change. The basic logic of the
story will be presented in statements highlighted in bold font, with
some supporting text offered for each in regular font.

1.  **I begin by expressing my appreciation to the Stern Team for taking
    on the enormous challenge of constructing a convincing economic
    argument in support of taking immediate action to reduce the
    emissions of greenhouse gases, in general, and carbon dioxide in
    particular.**

> The *Stern Review* goes a long way in demonstrating how economics has
> something to say in informing the climate policy debate. Its release
> amounted to a full employment act for economists who know something
> about climate (and some who do not). Its release also inspired some
> scientists who don't know much economics to enter the fray, but that
> is fine, too.
>
> To be honest, I am not convinced that the *Review* is the definitive
> word in this regard. Its numerical results are controversial and
> value-laden, but that is the nature of the economic science. Please do
> not interpret the controversy as anything more than *economists being
> economists* -- arguing over every point to make sure that the
> fundamental conclusions are sound. I have participated in that
> discussion, but I assure you that convinced that the *Review* provides
> sufficient evidence to support its fundamental conclusion with very
> high confidence: ***the economics of climate policy tell us
> unambiguously that it is time to act.***

2.  **The major messages of the *Review's* assessment of the current
    science are sound, and they are completely consistent with the
    conclusions presented by Working Group 1 in its contribution to the
    Fourth Assessment Report of the Intergovernmental Panel on Climate
    Change (the IPCC). They are consistent, in other words, with the
    conclusions about the underlying science that were unanimously
    accepted by representatives of the signatory nations of the United
    Nations Framework Convention on Climate Change who attended the IPCC
    plenary meeting in Paris two weeks ago. They include:**

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a.  **Climate is changing faster than was anticipated only 5 years ago
    (in the Third Assessment Report of the IPCC).**

b.  **Thresholds of climate risk have been calibrated in terms of
    multiple metrics (some are economic, but many are not), and they
    have been identified in terms of changes in global mean
    temperature.**

c.  **Many of the thresholds for critical impacts are now thought to be
    lower than anticipated only 5 years ago. It follows that we are
    approaching them more quickly than we thought, and so we will reach
    them sooner than we thought.**

d.  **Achieving any concentration threshold cannot guarantee achieving a
    specific temperature threshold; but achieving a concentration target
    can reduce the likelihood of crossing those thresholds at any point
    in time.**

e.  **Achieving any concentration threshold may, however, only delay the
    inevitable unless the rate of change in temperature is diminished by
    persistent policy intervention over the entire century and perhaps
    beyond.**

> Figure 2 in the Executive Summary of the *Stern Review* offers a
> concise portrait of the essential results of the most recent science.
> I attach a version here as Figure 1. Notice that temperature
> thresholds are identified for truly dangerous impacts in many
> dimensions in the lower portion of the figure; their location in terms
> of warming temperatures are the basis for believing Senator McCain's
> assertion last month that the debate over the science is over. The
> imprecise links between temperature targets and concentration targets
> is meanwhile illustrated in the upper portion. They summarize current
> understanding to show, for example, that holding concentrations

-   below 750 ppm means a greater than 95% chance of exceeding 2 degrees
    (Centigrade) of warming above current levels and a 70% chance of
    exceeding 3 degrees of additional warming,

-   below 650 ppm means a 95% chance of exceeding 2 degrees and a 60%
    chance of exceeding 3 degrees,

-   below 550 ppm means around a 70%-80% chance of exceeding 2 degrees
    and a 50% chance of exceeding 3 degrees,

-   below 450 ppm means a 50% chance of exceeding 2 degrees and a 25%
    chance of exceeding 3 degrees, and

-   below 400 ppm means roughly a 30% chance of exceeding 2 degrees and
    still a 5% chance of exceeding 3 degrees.

3.  **It follows the *Stern Review's* confirmation of the IPCC
    conclusions that some sort of policy intervention (based on the
    economics of risk management and not on a blind application of the
    precautionary principal) can be anticipated; indeed, it has started
    some places already.**

> It is important to note, however, that it is impossible to write
> climate policy in 2007 that will be valid for the entire century.
> Coping with thresholds and uncertainty over the long term will require
> adopting an adaptive risk management approach where series of
> medium-term policy decisions will be informed by the evolution of
> long-term objectives. Designing such a program will be difficult,
> because it will need to give clear signals of intention over the
> medium-term even as it maintains flexibility so that it can respond to

-   changes in scientific understanding,

-   changes in social valuations of impacts, and

-   changes in our expectations of how the policies are working.

> In every case, however, this flexibility must somehow be immune to
> political and/or economic manipulation.[^1]

4.  **As soon as it is recognized that some sort of policy will be
    required, simple economics says that taking the least cost approach
    means starting now.**

> This conclusion is true in large measure because atmospheric
> concentrations of greenhouse gases depend on cumulative emissions over
> time, so achieving a targeted concentration target (and thus a
> corresponding range of possible temperature increases and associated
> climate risks) is fundamentally an exhaustible resource problem. The
> long-standing Hotelling result that I teach my students in their first
> course on environmental and resource economics therefore applies (at
> least to a first approximation): to maximize the discounted value of
> welfare derived from an exhaustible resource (that is, to minimize the
> discounted costs of limiting cumulative emissions over the long-term),
> simply calculate the appropriate initial "scarcity rent" (an initial
> price for carbon for 2007) and let it increase over time at the rate
> of interest.
>
> Adjustments over time in the concentration target (borne of
> uncertainty about the climate system specifically and the future more
> generally) confound the issue, to be sure, but I have shown in Yohe,
> et al. (2004) that some hedging based on the Hotelling minimum cost
> result minimizes expected costs even if there is a chance that we will
> discover sometime in the future that the climate problem fixes itself
> and climate policy initiated now was unnecessary.[^2] Why? Not because
> it generated some energy independence for the United States, even
> though that would be a good idea. Rather, because the expected costs
> of adjusting to more pessimistic climate news sometime in the future
> if we delay taking action are higher than the expected costs of doing
> too much too soon (even with discounting at the market rate of
> interest).

5.  **Recognizing this application of fundamental economic analysis
    derived from economic efficiency means that opponents to policy have
    to guarantee that *the climate is NOT changing.* This they cannot
    do.**

> Taking a risk perspective, the case for immediate policy is made as
> soon as it is accepted that the climate is changing and the human
> activity is to blame. Acceptance of the Working Group 1 Report means
> acceptance of this responsibility and acceptance of the litany of
> impacts from which the Stern team drew its data. More importantly,
> taking a risk perspective makes uncertainty a reason to act rather
> than a reason to delay.

6.  **The inevitability of this acceptance across the populations of the
    world has begun to dawn on the opponents of climate policy, and I
    fear that they will therefore try to divert attention to the debate
    on the economics of climate policy and thus onto the cost estimates
    reported in *Stern Review* rather than the underlying insights upon
    which they were derived.**

> The estimates are controversial in part because they are highly
> dependent on underlying assumptions about discounting, aversion to
> risk, aversion to inequity, and the valuation of non-economic metrics
> of impact and significant risk (abrupt change and extreme events, for
> example).
>
> They are also difficult to understand, because the damage estimates
> are expressed in terms of a "certainty equivalent and equity
> equivalent annuity" metric that converts expected discounted welfare
> values computed across thousands of possible futures into a single
> number. The analysis underlying the computation of this metric is
> sound, if not brilliant. Its application to the climate problem is
> path-breaking. But it is vulnerable to the sort of misinterpretation
> that will make people roll their eyes and wonder if any of us know
> what we are talking about. The authors of the *Review* are careful to
> say that "total cost over the next two centuries.....***are
> equivalent*** to an average reduction in global per capita consumption
> of at least 5%, now and forever". When the results are reported in the
> popular press, the conditional phrase about equivalence phrase is
> deleted, and that is a problem. "It's now, and I don't see my 5.3%
> reduction in consumption. Where is it? It's still now! Still not
> here!"

7.  **I would respectfully ask members of the Senate, (specifically and
    members of the policy-making community in Washington more generally)
    not to fall into the trap of focusing on the numbers and missing the
    message. Instead, recognize the important insights of the *Stern
    Review.* Focus on the risks of climate change that it identifies.
    Understand the efficiency grounds for "buying insurance" against
    economic consequences of climate change and the economic
    consequences of rapidly ramped climate policy in the future if
    nothing is done now.**

> It is enough to specify an initial tax on carbon (or perhaps setting
> targeted permit price for a cap and trade system). This tax should be
> designed to get the attention of American business and to show
> political leadership in the face of a serious problem. It need not,
> however, be set so high that it would cause undo economic harm in the
> short-run. Allowing the tax to increase at the rate of interest year
> after year (following Hotelling) and acknowledging that adjustments
> for new knowledge about performance and risk will have to be
> accommodated over time will give the policy traction.
>
> I personally favor a tax because permit markets can be volatile, and
> because responding to this volatility by building in a "safety value"
> on the price of permits could be manipulated. Indeed, it undermines
> the power of the policy. A tax, increasing at the rate of interest,
> would produce a persistent and predictable increase in the cost of
> using carbon that would inspire cost-reducing innovation and fuel
> switching in the transportation, building, and energy supply sectors
> of our economy.[^3] Be assured that providing incentives for American
> business to prepare for a carbon scarce future will put them in a good
> position when it comes time to compete in world markets, especially if
> their competitors in China and India do not follow suit. This is why
> 10 major corporations are on record in support of a U.S. (federal)
> climate policy that has some teeth and is predictable. There is money
> to be made, but only if uncertainty about climate policy is reduced. .

8.  **Setting the initial tax can be an exercise in determining the
    appropriate short-term incentives for carbon-saving investments and
    energy conservation rather than an exercise in "solving the climate
    problem".**

> Since no policy created in 2007 will "solve the climate problem", it
> is possible and even desirable for this Committee to step out from
> under that burden to confront a more manageable problem (while still
> making progress towards an ultimate solution to the climate problem).
> You are not trying to "Solve the climate problem." You are trying to
> "Acknowledge and confront the climate problem in 2007 with the best
> information available." More specifically, your problem is "What do we
> do now?"
>
> The answer is to design something for the near-term that will
> discourage long-term investments in energy, transportation, and
> construction that would lock in high carbon intensities for decades to
> come. Moving decisions in that direction would be consistent with
> long-term programs designed to "solve" the climate problem (however
> our understanding of it evolves) and with the minimization of
> long-term economic costs of the policies..
>
> As an example, one might consider investments that are pending to
> replace coal-fire power plants along the eastern seaboard of the
> United States. Tens if not hundreds of power plants will be replaced
> there over the next 4 or 5 decades. They might be replaced with
> coal-fired plants, because that would be the efficient choice given
> current expectations of alternative fuel prices (absent any climate
> policy) over the next few decades. All or some of these plants could,
> however, be replaced by plants that burn natural gas with a 60%
> reduction in carbon emissions per unit of electricity.
>
> People who know the business claim that a \$30 per ton tax on carbon
> dioxide (a \$110 per ton tax on the carbon content of fossil fuel)
> would make natural gas the more economical choice, but it is not
> necessary to impose a \$30 tax in 2007 to inspire complete conversion
> to natural gas. Since investment decisions turn on the discounted
> value of returns over 50 or 60 year time horizons, the price of carbon
> would not have to reach \$30 per ton for another 15 or 20 years to
> make natural gas the economical choice this year. Of course, Hotelling
> tells us to increase the tax by the rate of interest, and that helps.
>
> Assume for the moment that private investors use a 5% discount rate in
> their present value calculations. So what are the options? The \$7 per
> ton of carbon dioxide charge envisioned in the legislation being
> considered in this Committee would reach \$30 per ton in 2036 --
> probably too late to capture plants being designed this year, but
> sufficient to bring most of the plants constructed between now and
> 2050 over to a lower carbon technology. A \$15 per ton charge in 2007
> would reach the decision threshold in 2020.
>
> That would do if the goal were to achieve 100% fuel switching, but
> what would it cost? It would add almost \$6 to a barrel of oil. We
> have seen monthly variation in oil prices bigger than that, recently;
> the difference here is that it would be predictable, and it would
> affect different fossil fuels differently. It would add 14 cents to a
> gallon of gasoline. Given current fuel configurations for electricity
> generation in the United States, it would increase electric bills by
> 10% to 30% depending on location, but that percentage would decline
> over time. It would generate something like \$90 billion in tax
> revenue in 2007 if it were paid on every ton of carbon embodied in
> every gallon of fossil fuel consumed in the United States. This is
> revenue that could be used to offset the regressive nature of an
> energy tax, invest in alternative energy sources that could lower the
> \$30 per ton threshold, and otherwise reduce our dependence on foreign
> sources of oil without looking to domestic sources like the Alaskan
> wilderness.

**Figure 1:** Stabilization levels and probability ranges for
temperature increases. Source: Figure 2 from the *Stern Review.*

![](media/image1.png){width="5.520833333333333in" height="7.65625in"}

[^1]: It strikes me, as an aside, that the Federal Reserve System of the
    United States (the FED) is an example of an institution designed to
    accomplish all of these tasks. While surely in a different context,
    the FED confronts the same sorts of short-term versus long-term
    tensions with the same sorts of price or quantity policy tools and
    protected from political manipulation by carefully designed
    insulation.

[^2]: Yohe, G.W., Schlesinger, M.E., and Andronova, N. (2004), "To Hedge
    or Not Against an Uncertain Climate Future", *Science* **306**:
    416-417.

[^3]: The tax should increase, in real terms, at the real rate of
    interest. If expressed in nominal terms downstream, then it should
    increase at the nominal rate of interest.