CBO

A

S T U D Y

The Economics of Climate Change:

A Primer

April 2003

The Congress of the United States # Congressional Budget Office 
Note

Cover photo courtesy of the National Aeronautics and Space Administration.
Preface

A scientific consensus is emerging that rising atmospheric concentrations of greenhouse

gases are gradually changing the Earth’s climate, although the magnitude, timing, and effects

of the alteration remain very uncertain. The prospect of longterm climate change raises a variety

of domestic and international economic policy issues on which there is little accord. Considerable

disagreement exists about whether to control greenhouse gas emissions, and if so, how and by

how much; and whether to coordinate climaterelated polices at the international level, and if

so, through what mechanisms.

This Congressional Budget Office (CBO) study—prepared at the request of the Ranking Member

of the House Committee on Science—presents an overview of issues related to climate change,

focusing primarily on its economic aspects. The study draws from numerous published sources

to summarize the current state of climate science and provide a conceptual framework for

addressing climate change as an economic problem. It also examines public policy options and

discusses the potential complications and benefits of international coordination. In keeping with

CBO’s mandate to provide impartial analysis, the study makes no recommendations.

Robert Shackleton of CBO’s Macroeconomic Analysis Division wrote the study. CBO staff

members Robert Dennis, Terry Dinan, Douglas Hamilton, Roger Hitchner, Arlene Holen, Kim

Kowalewski, Mark Lasky, Deborah Lucas, David Moore, John Sturrock, Natalie Tawil, and

Thomas Woodward provided valuable comments and assistance, as did Henry Jacoby of the

Massachusetts Institute of Technology and Thomas Schelling of the University of Maryland at

College Park. The comments of Chris Webster and John Reilly of the Massachusetts Institute

of Technology and Mort Webster of the University of North Carolina at Chapel Hill were

particularly helpful in developing the discussion of uncertainty.

Leah Mazade edited the study, and Christine Bogusz proofread it. Kathryn Winstead prepared

the study for publication, and Annette Kalicki produced the electronic versions for CBO’s Web

site.

Douglas HoltzEakin

Director

April 2003

This study and other CBO publications

are available at CBO's Web site:

www.cbo.gov

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2

3

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CONTENTS

Summary and Introduction 1

Common Resources: Addressing a Market Failure 1

Balancing Competing Uses 2

Policy Options 3

International Coordination 3

The Scientific and Historical Context 5

The Greenhouse Effect, the Carbon Cycle,

and the Global Climate 5

Historical Emissions and Climate Change 9

What the Future May Hold 15

Potential Responses 19

Types of Uncertainty 20

The Economics of Climate Change 23

Common Resources and Property Rights 23

Economic TradeOffs 25

Distributional Issues 33

Trade-Offs Among Policy Options 35

Taxes and Permits: Similarities and Differences 36

The Distributional Effects of Regulation 37

Alternative Uses of Revenues 39

Regulation and Innovation 41

Ancillary Benefits of Greenhouse Gas Restrictions 42
vi THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

5 International Coordination of Climate Policy 43

International Policy Considerations 43

International Institutions to Address Climate Change 46

Actions by the United States 49

Alternative Approaches 49

Appendix

Economic Models and Climate Policy 53

References 57
CONTENTS vii

Figures

1. The Atmospheric Energy Budget and the Greenhouse Effect 6

2. Carbon Dioxide and Temperature 8

3. The Carbon Cycle 10

4. Uncertainty in Projections of Regional Population

and Economic Growth 13

5. Uncertainty in Projections of Regional Carbon Dioxide

Emissions and Emissions Intensity 14

6. Range of Uncertainty in Economic and Carbon Dioxide

Emissions Projections 16

7. Historical and Projected Climate Change 17

Boxes

1. Discounting and the Distant Future 28

2. An Example of Integrated Assessment 30

1

Summary and Introduction

Human activities—mainly deforestation and the

burning of fossil fuels—are releasing large quantities of

what are commonly known as greenhouse gases. The

accumulation of those gases is changing the composition

of the atmosphere and is probably contributing to a grad

ual warming of the Earth’s climate—the characteristic

weather conditions that prevail in various regions of the

world. Scientists generally agree that continued population

growth and economic development over the next century

will result in substantially more greenhouse gas emissions

and further warming unless measures are taken to con

strain those emissions.

Despite the general consensus that some amount of warm

ing is highly likely, extensive scientific and economic un

certainty makes predicting and evaluating its effects ex

tremely difficult. Because climate is generally a regional

phenomenon, the effects of warming would vary by re

gion. Moreover, some effects could be positive and some

negative. Some could be relatively minor and some severe

in their impact: warming could raise sea levels; expand

the potential range of tropical diseases; disrupt agriculture,

forestry, and natural ecosystems; and increase the vari

ability and extremes of regional weather. There is also

some possibility of unexpected, abrupt shifts in climate.

Actual outcomes will probably be somewhere in the mid

dle of the range of possibilities, but the longer that

emissions grow unchecked, the larger the effects are likely

to be.

A variety of technological options are available to restrain

the growth of emissions, including improvements in the

efficiency of people’s use of fossil energy, alternative energy

technologies such as nuclear or renewable power, methods

for removing greenhouse gases from smokestacks, and

approaches to sequestering gases in forests, soils, and

oceans. But those alternatives are likely to be costly, and

they are unlikely to be widely implemented unless mea

sures are taken to lower their price or to raise the price of

greenhouse gas emissions.

This Congressional Budget Office (CBO) study presents

an overview of the issue of climate change, focusing

primarily on its economic aspects. The study draws from

many published sources to summarize the current state

of climate science. It also provides a conceptual framework

for considering climate change as an economic problem,

examines public policies and the tradeoffs among them,

and discusses the potential complications and benefits of

international coordination.

Common Resources: Addressing

a Market Failure

The Earth’s atmosphere is a global, openaccess resource

that no one owns, that everyone depends on, and that

absorbs emissions from an enormous variety of natural

and human activities. As such, it is vulnerable to overuse,

and the climate is vulnerable to degradation—a problem

known as the tragedy of the commons. The atmosphere’s

global nature makes it very difficult for communities and

nations to agree on and enforce individual rights to and

responsibilities for its use.

With rights and responsibilities difficult to delineate and

agreements a challenge to reach, markets may not develop

to allocate atmospheric resources effectively. It may there

fore fall to governments to develop alternative policies for

CHAPTER
2 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

addressing the risks from climate change. And because

the causes and consequences of such change are global,

effective policies will probably require extensive coopera

tion among countries with very different circumstances

and interests.

However, governments may also fail to allocate resources

effectively, and international cooperation will be extremely

hard to achieve as well. Developed countries, which are

responsible for the overwhelming bulk of emissions, will

be reluctant to take on increasingly expensive unilateral

commitments while there are inexpensive opportunities

to constrain emissions in developing countries. But devel

oping nations, which are expected to be the chief source

of emissions growth in the future, will also be reluctant

to adopt policies that constrain emissions and thereby

limit their potential for economic growth—particularly

when they have contributed so little to the historical rise

in atmospheric greenhouse gas concentrations and may

suffer disproportionately more of the negative effects if

nothing is done.

Balancing Competing Uses

The atmosphere and climate are part of the stock of

natural resources available to people to satisfy their needs

and wants over time. From an economic point of view,

climate policy involves measuring and comparing the

values that people place on resources, across alternative

uses and at different points in time, and applying the

results to choose a course of action. An effective policy

would balance the benefits and costs of using the atmos

phere and distribute those benefits and costs among people

in an acceptable way.

Uncertainty about the scientific aspects of climate change

and about its potential effects complicates the challenge

of developing policy by making it difficult to estimate or

balance the costs of restricting greenhouse gas emissions

and the benefits of averting climate change. (Some of the

risks involved, moreover, may be effectively impossible

to evaluate or balance in pecuniary terms.) Nevertheless,

assessments of the potential costs and benefits of a warm

ing climate typically conclude that the continued growth

of emissions could ultimately cause extensive physical and

economic damage. Many studies indicate significant bene

fits from undertaking research to better understand the

processes and economic effects of climate change and to

discover and develop new and better technologies to re

duce or eliminate greenhouse gas emissions.

At the same time, such studies typically find relatively

small net benefits from acting to reduce greenhouse gas

emissions in the near term. In balancing alternative invest

ments, they conclude that if modest restrictions on emis

sions were implemented today, they would yield net bene

fits in the future; however, moreextensive restrictions

would crowd out other types of investment, reducing the

rate of economic growth and affecting current and future

generations’ material prosperity even more than the

averted change would. As income and wealth grow and

technology improves, the studies say, future generations

are likely to find it easier to adapt to the effects of a chang

ing climate and to gradually impose increasingly strict

restraints on emissions to avoid further alteration.

Those conclusions greatly depend, among other things,

on how one balances the welfare of current generations

against that of future generations. In assessments of costs

and benefits occurring at different points in time, that

process of weighting is typically achieved by using an

interest, or discount, rate to convert future values to pres

ent ones. But there is little agreement about how to dis

count costs and benefits over the long time horizons

involved in analyzing climate change. 

Whatever weighting scheme is chosen, consistency calls

for applying it to all longterm investment alternatives.

For example, applying a lower discount rate to give more

weight to the welfare of future generations implies that

society should reduce its current consumption and increase

its overall rate of investment in productive physical and

human capital of all kinds—not only those involved in

ensuring a beneficial future climate.

Government policies that deal with use of the atmosphere

inevitably affect the distribution of resources. Inaction

benefits people who are alive today while potentially harm

ing future generations. Reducing emissions now may

benefit future generations while imposing costs on the

current population and may benefit countries at relatively

higher risk of adverse effects from warming while hurting

those that stand to gain from it. Restraints on emissions

would impose costs on nearly everyone in the global
CHAPTER ONE SUMMARY AND INTRODUCTION 3

economy, but they would affect energyproducing and

energyintensive industries, regions, and countries much

more than they would others. However, many studies of

the costs and benefits of climate change fail to highlight

the extent to which differences in geographic and eco

nomic circumstances complicate the balancing of interests.

Policy Options

Governments may respond to climate change by adopting

a “waitandsee” approach, by pursuing research programs

to improve scientific knowledge and develop technological

options, by regulating greenhouse gas emissions, or by

engaging in a combination of research and regulation. The

United States has invested in research and subsidized the

development of carbonremoval and alternative energy

technologies. Furthermore, some programs that were in

tended to achieve other goals, such as pollution reduction,

energy independence, and the limitation of soil erosion,

also discourage emissions or encourage the removal of

greenhouse gases from the atmosphere. However, other

programs have opposing effects.

Should a government decide to control emissions, it may

choose from a broad menu of regulatory approaches. One

option is direct controls, which set emissions standards

for equipment and processes, require households and busi

nesses to use specific types of equipment, or prohibit them

from using others. A government could also adopt more

indirect, incentivebased approaches, either singly or in

combination—for example, by restricting overall quanti

ties of emissions through a system of permits or by raising

the price of emissions through fees or taxes. Incentive

based approaches are generally more costeffective than

direct controls as a means of regulating greenhouse gas

emissions.

Uncertainty about the costs and benefits of regulation

affects the relative advantages of different incentivebased

approaches. Some research indicates that such uncertainty

gives a system of emissions pricing economic advantages

over a quota system that fixes the quantity of emissions.

Those advantages stem from two facts: both the costs and

benefits of reducing greenhouse gas emissions are uncer

tain; and the incremental costs—the additional costs of

reducing an additional ton of emissions—can be expected

to rise much faster than the incremental benefits fall.

Under those circumstances, the cost of guessing wrong

about the appropriate level of taxes—and, perhaps, of fail

ing to reduce emissions enough in any given year—is likely

to be fairly low. But the cost of miscalculating the appro

priate level of emissions—and perhaps imposing an overly

restrictive and hence expensive limit—could be quite high.

A system of emissions pricing has several other advantages

over one of emissions quotas. Pricing could raise signifi

cant revenues that could be used to finance cuts in distor

tionary taxes—such as those on income—that discourage

work and investment. Moreover, emissions pricing more

effectively encourages the development of technologies

that reduce or eliminate emissions than direct controls

or strict limits on emissions do.

Restricting greenhouse gas emissions would tend to reduce

emissions of some conventional pollutants as well, yielding

a variety of ancillary benefits, such as improvements in

health from betterquality air and water. Those additional

benefits would partly offset the costs of greenhouse gas

regulations, particularly in developing countries that have

significant problems with local pollution.

The distributional effects of emissions regulations would

depend on the type and stringency of the regulations and

could be very large relative to how much the policy im

proved people’s wellbeing. Those potential effects might

spur the affected parties to engage in rentseeking—vying

for regulatory provisions that would provide them with

tax exemptions, access to permits, and so on. An emissions

pricing system (based either on taxes or on auctioned per

mits) would benefit different groups in different ways,

depending on how the government returned the receipts

to the economy. Certain ways of using the revenues could

offset some—but probably not all—of the costs of regula

tion. (For example, if the government issued permits free

of charge, even permit recipients who were heavily regu

lated could benefit from the regulation.)

International Coordination

Because the causes and consequences of climate change

are global in nature, effective policies to deal with it will

probably require extensive international coordination

among countries with very different circumstances and

interests. Coordination may involve formal treaties or
4 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

nonbinding agreements and could range from modest

commitments to engage in research to moreextensive

programs to restrict emissions, monitor compliance, and

enforce penalties.

Effective international agreements typically involve

straightforward commitments and distribute costs in a

way that is acceptable to participating countries. Binding

commitments with explicit penalties may be more likely

than nonbinding ones to ensure compliance, but nonbind

ing agreements may also significantly affect a nation’s ac

tions. Many factors will influence the effectiveness of inter

national cooperation, particularly the size and distribution

of the costs and benefits of mitigating climate change and

the strength of conflicting interests. Successful cooperation

would entail frequent interaction among national repre

sentatives and link discussion of climate issues with that

of related problems.

An international system of emissions controls could draw

on the same set of options that domestic regulation em

ploys—direct controls, emissions taxes or permits, or a

hybrid system—or it could allow each country to choose

its own independent system. Much of the international

debate in recent years has focused on strictly limiting

emissions through national quotas, with or without the

international trading of emissions rights. However, quan

titative limits are likely to prove more costly than ap

proaches that affect emissions indirectly by raising their

price. And because there are lowcost opportunities to

reduce emissions throughout the world and because fossil

fuels can be transported relatively easily, a system that

raised the price of emissions everywhere would probably

be more costeffective than one that applied only to a

limited set of countries.

International cooperation on the issue of climate change

has been developing since the Intergovernmental Panel

on Climate Change was created in 1988. And nearly all

nations, including the United States, are signatories to the

United Nations Framework Convention on Climate

Change, which commits them to undertake research and

prevent dangerous changes in the Earth’s climate. In 1997,

negotiators signed the Kyoto Protocol (a draft treaty) to

the convention, under which developed countries agreed

to limit emissions while developing countries remained

exempt from restrictions. However, subsequent negotia

tions collapsed in 2000 over details of implementation,

and the United States withdrew from the talks in 2001.

Ironically, that withdrawal made some of the positions

that the United States had advocated much more attractive

to the remaining parties and helped them reach agreement

on nearly all outstanding implementation issues. The

European Union and Japan ratified the protocol in mid

2002; it will go into force if Russia follows suit.

The protocol’s implementation would establish a complex

set of emissions rights for a limited set of developed coun

tries for the period 2008 through 2012. It would also put

into place institutions to oversee international financial

transfers amounting to several billion dollars per year for

the purchase of emissions allowances, mainly among the

developed countries. However, the protocol would limit

participating countries’ overall emissions by only a small

amount and would have essentially no effect on the growth

of emissions in the United States and in developing coun

tries.

Analysts have proposed a variety of alternatives to the pro

visions of the Kyoto Protocol to try to improve the poten

tial effectiveness of international cooperation and broaden

its appeal. Each alternative simultaneously addresses the

problems of limiting emissions and distributing the bur

den of regulation, which remain the crucial sources of dis

agreement. Each option reflects a distinct interpretation

of the available evidence about the net benefits of averting

climate change in different regions and for different gen

erations, as well as practical concerns about how climate

policy would affect the global economy.

Some analysts argue for a laissezfaire approach because

they believe that the amount of warming is likely to be

small and its effects largely benign, or that nearterm

action is unwarranted in the light of scientific uncertainty.

Other researchers have proposed systems of emissions taxes

or tradable emissions permits that would be auctioned at

fixed prices. In general, the permits would apply to devel

oped countries and exempt developing nations on the

grounds of equity. Still other analysts have proposed com

plex systems that are intended to impose roughly uniform

emissions prices throughout the world yet ensure that

developed countries bear most of the cost.
2

The Scientific and Historical Context

Scientists have gradually realized that a variety of

human activities are changing the composition of the at

mosphere and may significantly affect the global climate.1

During the past decade, scientific research has greatly im

proved the state of knowledge about climate change, but

substantial uncertainty about critical aspects of climate

science remains and will persist in spite of continued prog

ress. That uncertainty contributes to differences of opinion

within the scientific community about the potential for

significant climate change and about its possible effects.

The Greenhouse Effect, the Carbon

Cycle, and the Global Climate

As the Earth absorbs shortwave radiation from the Sun

and sends it back into space as longwave radiation, natur

ally occurring gases in the atmosphere absorb some of the

outgoing energy and radiate it back toward the surface

(see Figure 1). That phenomenon, which is called the

“greenhouse” effect, currently warms the surface by an

average of about 60o Fahrenheit (F), or 33o Celsius (C),

creating the conditions for life as it exists on Earth. Water

vapor is by far the most abundant greenhouse gas and

accounts for most of the warming effect. However, several

other trace gases also play a pivotal role in maintaining

the current climate because they not only act as greenhouse

gases themselves but also enhance the amount of water

vapor in the atmosphere and thus amplify the effect. Those

trace gases include carbon dioxide, methane (which also

contains carbon), and nitrous oxide, as well as the man

made halocarbons, which contribute to the breakdown

of stratospheric ozone and which, molecule for molecule,

are very powerful greenhouse gases.2

The geologic record reveals dramatic fluctuations in green

house gas concentrations and in the Earth’s climate, on

scales as long as millions of years and as short as just a few

years. The record suggests a complicated relationship

between greenhouse gas concentrations and the Earth’s

climate. Warmer climates have usually been associated

with higher atmospheric concentrations of greenhouse

gases and cooler climates with lower concentrations.

(Figure 2 illustrates how carbon dioxide concentrations

and the antarctic climate have varied together over roughly

the past halfmillion years.) However, the climate has oc

1. The discussion in this chapter is drawn mainly from a series of

reports prepared by the Intergovernmental Panel on Climate

Change, which summarize the current state of scientific and tech

nical knowledge in that area. The most recent set of reports, which

are cited in detail in the reference list beginning on page 57, are

Houghton and others (2001); McCarthy and others (2001); Metz

and others (2001); and Watson and others (2001). Other sources

are specifically noted. The Congressional Research Service (2001)

provides another summary. For a short history of scientific research

on climate change, see Weart (1997).

2. Greenhouse gases differ in their ability to trap energy; they interact

with each other, and they stay in the atmosphere for different and

varying lengths of time. By convention, scientists apply a standard

metric to the gases by comparing their 100year global warming

potentials, or GWPs (the amount of warming that an incremental

quantity of a given gas would cause over the course of a century),

with that of carbon dioxide. The convention is somewhat rough

because the GWP of each gas is affected by the quantity of other

gases, but it is used in international negotiations because of its sim

plicity. GWPs range from 1 for carbon dioxide to many thousands

for halocarbons. Using 100year GWPs, scientists convert quantities

of other greenhouse gases to metric tons of carbon equivalent, or

mtce.

CHAPTER
6 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

Figure 1.

The Atmospheric Energy Budget and the Greenhouse Effect

Source: Congressional Budget Office adapted from J.T. Houghton and others, eds., Climate Change 2001: The Scientific Basis (Cambridge, U.K.: Cambridge University

Press, 2001).
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 7

Figure 1.

Continued

Note: Numbers represent watts per meter squared (W/m2). With an atmosphere, 492 W/m2 (instead of 318 W/m2) reach the Earth’s surface because the atmosphere

absorbs radiation from the Earth and radiates it back. That process constitutes the greenhouse effect.

a. Includes thermals and evapotranspiration.
8 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

160

200

240

280

320

-450 -400 -350 -300 -250 -200 -150 -100 -50 0

Thousands of Years Before the Present

-12

-8

-4

0

4

-450 -400 -350 -300 -250 -200 -150 -100 -50 0

Thousands of Years Before the Present

Atmospheric Carbon Dioxide

Carbon Dioxide Concentration (Parts per million)

Temperature Over Antarcticaa

Temperature Relative to Present Climate (°C)

Figure 2.

Carbon Dioxide and Temperature

Source: Congressional Budget Office based on J. M. Barnola, C. Lorius Raynaud, and N.I. Barkov, “Historical CO2 Record from the Vostok Ice Core,” and J.R. Petit

and others, “Historical Isotopic Temperature Record from the Vostok Ice Core,” in Department of Energy, Oak Ridge National Laboratory, Carbon Dioxide

Information Analysis Center, Trends: A Compendium of Data on Global Change (2003), available at http://cdiac.esd.ornl.gov/trends/trends.htm.

a. Variations in antarctic temperatures are roughly double average global variations.
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 9

casionally been relatively warm while concentrations were

relatively low and cool while they were high. Moreover,

climate change has occurred without alterations in green

house gas concentrations. Nevertheless, significant changes

in concentrations appear to be nearly always accompanied

by changes in climate.3

The link between greenhouse gases and climate is greatly

complicated by a variety of physical processes that obscure

the direction of cause and effect. Variations in the Sun’s

brightness and the Earth’s orbit affect the climate by

changing the amount of radiation that reaches the Earth.

Clouds, dust, sulfates, and other particles from natural

and industrial sources affect the way radiation filters in

and out of the atmosphere. Snow, ice, vegetation, and soils

control the amount of solar radiation that is directly re

flected from the Earth’s surface. And the Earth’s vast ocean

currents, themselves partly driven by solar radiation,

greatly influence climate dynamics. Moreover, the climate

system exhibits socalled threshold behavior: just as a

minor change in balance can flip a canoe, relatively small

changes sometimes can abruptly trigger a shift from one

stable global pattern to a noticeably different one (Alley

and others, 2003).

Fluctuations in those physical processes affect the complex

balance among the reservoirs of carbon dioxide and

methane in the atmosphere and the larger reservoirs of

carbon in the biosphere—which comprises soils, vegeta

tion, and creatures—and in the oceans. Large quantities

of carbon flow back and forth between those reservoirs,

regulated by the seasons, winds, and ocean currents.4

 The

flows maintain a rough equilibrium among the reservoirs,

which all gradually adjust to other influences—and to

influxes of carbon—over periods of decades to centuries.

Other greenhouse gases, such as nitrous oxide, are part

of similarly complex cycles. 

In the absence of human activity, other, even larger res

ervoirs of carbon adjust only over thousands to millions

of years. They include fossil deposits of coal, oil, and

natural gas, which hold 10 to 20 times as much carbon

as the atmosphere; deposits of methane hydrate in the

ocean floors, which contain perhaps 12 times as much

carbon; and rocks that contain much more carbon than

all of the surface reservoirs, or “sinks,” combined (see Fig

ure 3).

Over the past million and a half years, the Earth has ex

perienced a period of “ice ages”—hundredthousandyear

cycles of cooling and warming that are governed mainly

by variations in the Earth’s orbit around the Sun. That

period, which is unusual in geologic history, has been ac

companied by changes in greenhouse gas concentrations

that interact with and magnify the effects of the orbital

variations (Shackleton, 2000). Geologically speaking, the

most recent ice age just ended: less than 20,000 years ago,

large parts of North America and Eurasia were covered

by huge glaciers. Atmospheric concentrations of carbon

dioxide were only half of what they are today; average

global temperatures were roughly 7oF to 9oF (4oC to 5oC)

lower; and the global climate was apparently drier and

much more variable (Broecker and Hemming, 2001;

Crowley, 1996; and Ganopolski and Rahmstorf, 2001).

In addition, the trees and soils of the biosphere held per

haps onethird less carbon than they do now; tropical

forests were much less extensive; and sea level was hun

dreds of feet lower.

All of recorded human history, as well as the development

of agriculture, has occurred during a temporary interglacial

period that began about 12,000 years ago and that has

been warmer and unusually stable by comparison with

the preceding cold period. Even during that stable interval,

however, minor climatic changes have had substantial ef

fects on preindustrial economies throughout the world.

(For an extensive description of the effects of climate

change over history, see Lamb, 1995.)

Historical Emissions and 

Climate Change

With the onset of the industrial revolution more than two

centuries ago, people have begun to change the carbon

cycle significantly, increasing the amount of carbon diox

ide in the atmosphere by about a third, or from roughly

3. See Falkowski and others (2000); Veizer, Godderis, and François

(2000); Crowley and Berner (2001); and Zachos and others (2001).

4. Quantities of carbon in gases and elsewhere are measured in metric

tons of carbon, or mtc. Mtc differs from mtce, which measures

warming potential rather than quantities of carbon.
10 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

Figure 3.

The Carbon Cycle

Source: Congressional Budget Office adapted from D. Schimel and others, "Radiative Forcing of Climate Change," Chapter 2 in J.T. Houghton and others, eds., Climate

Change 1995: The Science of Climate Change (Cambridge, U.K.: Cambridge University Press, 1996). The figure draws on data from Mustafa Babiker and

others, The MIT Emissions Prediction and Policy Analysis (EPPA) Model: Revisions, Sensitivities, and Comparisons of Results, Report no. 71 (Cambridge,

Mass.: Massachusetts Institute of Technology Joint Program on the Science and Policy of Global Change, 2001); Department of Energy, Energy Information

Administration, Annual Energy Review 2000, DOE/EIA-0384(2000) (November 2001); P. Falkowski and others, “The Global Carbon Cycle: A Test of Our

Knowledge of Earth as a System,” Science, vol. 290, no. 5490 (October 13, 2000), pp. 291-296; J.T. Houghton and others, eds., Climate Change 2001: The

Scientific Basis (Cambridge, U.K.: Cambridge University Press, 2001); R.A. Houghton and David L. Skole, “Carbon,” in B.L. Turner II and others, eds., The

Earth as Transformed by Human Action: Global and Regional Changes in the Biosphere over the Past 300 Years (Cambridge, U.K.: Cambridge University

Press, 1990), pp. 393-408; Keith A. Kvenvolden, “Potential Effects of Gas Hydrate on Human Welfare,” Proceedings of the National Academy of Sciences,

vol. 96 (March 1999), pp. 3420-3426; Bert Metz and others, eds., Climate Change 2001: Mitigation (Cambridge, U.K.: Cambridge University Press, 2001);

Edward D. Porter, Are We Running Out of Oil? Discussion Paper no. 81 (Washington, D.C.: American Petroleum Institute, December 1995); and World Energy

Council, Survey of Energy Resources, 19th ed. (London: World Energy Council, 2001), available at www.worldenergy.org/wec-geis/publications.

Note: Reservoirs of carbon are in billions of metric tons (shown in parentheses); flows of carbon (shown as arrows) are in billions of metric tons per year.
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 11

600 billion to 800 billion metric tons of carbon (mtc)—

the highest amount in at least 400,000 years.5

 About 30

percent of the increase has come from cutting timber and

clearing land for agriculture; the rest stems from extracting

coal, oil, and natural gas from the fossil reservoir and

burning them.6

 Atmospheric concentrations of methane

and nitrous oxide have also risen over the past two cen

turies—by about 150 percent and 16 percent, respectively

—as a result of various agricultural and industrial activi

ties. More recently, halocarbons have begun to accumulate

as well. The combined effect of these additions to the

atmosphere has been to enhance the greenhouse effect

slightly by raising the amount of radiation at the Earth’s

surface by about 0.5 percent—with perhaps half of that

impact offset by the effects of other human activities, such

as the cooling influence of sulfate emissions.

Current evidence indicates that since the mid19th cen

tury, the average surface temperature of the Earth has risen

by between 0.7oF and 1.4oF (0.4oC and 0.8oC). The

warming trend has been most pronounced during the past

decade and in higher latitudes. Ocean temperatures are

also rising, expanding the volume of water, and that ex

pansion, combined with water from melting glaciers, has

raised global sea level by about four to 10 inches (10 to

20 centimeters) over the past century.

Scientists generally agree that the observed warming is

roughly consistent with the expected effects of changing

concentrations of greenhouse gases and other emissions.

However, other phenomena also appear to be influencing

the Earth’s climate—for example, variations in the Sun’s

brightness and magnetic field, and poorly understood

fluctuations in the circulation of the oceans. As a result,

although scientists have dramatically improved their

understanding of the atmosphere, oceans, and climate in

recent years, they are uncertain about how much of the

observed warming is due to greenhouse gas emissions.

They are even more uncertain about whether the warming

that has occurred has caused moreextreme weather, such

as more and bigger hurricanes, floods, and droughts.

However, some evidence suggests that unusually warm

conditions may have contributed to persistent droughts

in North America, Europe, and Asia between 1998 and

2002 (Hoerling and Kumar, 2003).

Some researchers believe that if people immediately halted

emissions of greenhouse gases, gradual warming of the

oceans would ultimately contribute to an additional warm

ing of the atmosphere of between 0.9oF and 2.7oF, or

0.5oC and 1.5oC (Mahlman, 2001, p. 8). Over the follow

ing centuries, the climate would return nearly to its pre

industrial state, as the oceans gradually absorbed most of

the extra carbon dioxide from the atmosphere and other

greenhouse gases broke down.

However, as the world’s population grows and the global

economy continues to industrialize, the pace of emissions

—particularly of carbon dioxide—is accelerating. The

period since World War II has seen 80 percent of all car

bon dioxide ever emitted from the burning of fossil fuels

—and twothirds of the entire increase in atmospheric

concentrations (Marland, Boden, and Andres, 2002). Dur

ing the 1990s, annual global emissions of greenhouse gases

ran at about 10 billion metric tons of carbon equivalent

(mtce; see footnote 2), and carbon dioxide concentrations

grew by more than 4 percent. Fossil fuels accounted for

about 6 billion mtc per year; of that total, oil claimed a

share of 45 percent, natural gas, 20 percent; and coal, 35

percent.7

 Net deforestation contributed roughly 1 billion

to 2 billion mtc annually (Watson and others, 2000,

p. 32). About 21⁄2 billion to 3 billion mtce per year of

other greenhouse gases, mostly methane, came from a wide

variety of sources, mainly agricultural activities but also

5. Atmospheric concentrations of carbon dioxide are usually measured

in parts per million (ppm). In those terms, atmospheric carbon

dioxide has increased from about 280 ppm to about 370 ppm.

6. Estimates of emissions and reabsorption of carbon from land use

are based on data for 1850 to 1990 from R.A. Houghton of the

Woods Hole Research Center and an extrapolation based on data

from Houghton and Skole (1990). Estimates of emissions from

fossil fuels are from Marland, Boden, and Andres (2002). Much

of the available data on greenhouse gas emissions, changes in

atmospheric concentrations, and changes in temperature is available

from the Carbon Dioxide Information Analysis Center at http://

cdiac.esd.ornl.gov/pns/pns_main.html. For a discussion of recent

research, see Schimel and others (2001).

7. Coal contains about 80 percent more carbon per unit of energy

than gas does, and oil contains about 40 percent more. For the

typical U.S. household, a metric ton of carbon equals about 10,000

miles of driving at 25 miles per gallon of gasoline or about one year

of home heating using a natural gasfired furnace or about four

months of electricity from coalfired generation.
12 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

fossil fuel production, diverse industrial processes, and

landfills.

The international distribution of emissions from fossil

fuels largely reflects the global pattern of economic devel

opment because fossil fuels have powered the dramatic

increase in industrial output and material wellbeing that

has taken place in many nations over the past two cen

turies. In the United States, for instance, fossil fuels pro

vided nearly 90 percent of all energy used in the 20th

century, and they account for about 85 percent of the

energy used today. Developed, industrialized countries—

the members of the Organisation for Economic Co

operation and Development (OECD) and of the former

Soviet bloc—are responsible for nearly 80 percent of

historical carbon emissions, even though they have only

about 20 percent of the world’s population. Historically

speaking, people in developed countries have emitted

roughly 10 times more carbon per person than people in

developing countries. Indeed, it is the technological access

to energy from fossil fuels that has helped make them

roughly 10 times wealthier.

Yet the relationship between the use of fossil energy and

economic prosperity is not a strict one. Countries that

have significant reserves of nonfossil energy, that rely on

imports for much of their fuel supply, or that tax the

consumption of fuel tend to have lower emissions levels.

Some highincome countries have emissions levels per

person that are quite low: for instance, Sweden maintains

roughly the same standard of living as the United States

does but emits only 30 percent as much carbon per person,

largely by relying extensively on hydroelectric and nuclear

power. In contrast, countries that have large reserves of

fossil fuels or that subsidize their population’s consump

tion of fuel tend to have higher per capita emissions levels.

Such nations include oilexporting countries and members

of the former Soviet bloc.

Nor is the relationship between economic growth and

emissions a smooth one. Developing countries in the ini

tial stages of industrialization tend to have fairly high levels

of emissions per dollar of output, because a large share

of their economic activity involves the energyintensive

manufacturing of metals, cement, and other basic com

modities. In contrast, developed countries devote an in

creasing share of their resources to the production of less

energy intensive outputs, including services. Economic

development therefore tends to involve rising energy in

tensity in its initial stages and falling energy intensity as

the efficiency of energy use and the service sector’s share

of economic activity grow (HoltzEakin and Selden,

1995). In the United States, for example, per capita emis

sions of carbon dioxide from fossil fuels grew nearly seven

fold between 1870 and 1920 but have grown by less than

onethird since then and are roughly the same now as they

were 30 years ago.

On a perperson basis, OECD countries currently burn

about 3 mtc of fossil fuels per year—three times the world

average—with national figures ranging from over 51⁄2 mtc

per person for the United States to less than 1 mtc for

Mexico and Turkey.8

 The former Soviet bloc countries

had very high per capita emissions levels before their eco

nomic collapse but now average about 2 mtc per person—

the figures range from nearly 3 mtc for Russia to less than

a third of a ton for Armenia. Developing countries average

only 1⁄2 mtc per capita annually—or onesixth the OECD

average and only onetenth that of the United States. The

poorest 2 billion people—onethird of the world’s popu

lation—average less than a fifth of a ton annually, or the

equivalent of about 80 gallons of gasoline. (Figures 4 and

5 compare different regions’ populations, per capita eco

nomic activity, and per capita emissions, as well as ranges

of uncertainty about those factors’ future growth.)

Because of their greater reliance on subsistence farming

and forestry, developing countries currently account for

most of the world’s carbon dioxide and methane emissions

from land use. Even so, on a per capita basis, people in

developing countries are responsible for far fewer green

house gas emissions than are their counterparts in the in

dustrialized countries, and their total emissions levels are

lower as well.

8. The United States accounts for nearly as many emissions as the

former Soviet bloc, the Middle East, Central and South America,

and Africa combined. Use of fossil fuel in the United States is split

roughly into three categories: commercial and residential buildings

and appliances, industry, and transportation. More than a third

of that fuel is used to generate electricity, twothirds of which goes

to buildings and onethird to industry (see Department of Energy,

2002a). Other developed countries have somewhat different con

sumption patterns for fossil fuel, depending on their income levels,

climates, and other factors.
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 13

Figure 4.

Uncertainty in Projections of Regional Population and Economic Growth

Source: Congressional Budget Office based on Department of Energy, Energy Information Administration, International Energy Outlook 2002, DOE/EIA-0484 (2002).
14 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

Figure 5.

Uncertainty in Projections of Regional Carbon Dioxide Emissions

and Emissions Intensity

Source: Congressional Budget Office based on Department of Energy, Energy Information Administration, International Energy Outlook 2002, DOE/EIA-0484 (2002).

Note: All emissions are from fossil fuels.
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 15

What the Future May Hold

Recent studies have estimated that the average global

temperature is likely to rise by between 0.5oF and 2.3oF

(0.3oC and 1.3oC) during the next 30 years (Zwiers,

2002). Most of the warming during that period will be

due to emissions that have already occurred. Over the

longer term, the degree and pace of warming will depend

mainly on future emissions. Given current trends in popu

lation, economic growth, and energy use, global emissions

are likely to increase substantially. The populations and

economies of developing countries are growing rapidly,

and their total greenhouse gas emissions could surpass

those of developed countries over the next generation or

so—although on a perperson basis, emissions from devel

oping countries will continue at much lower levels than

emissions from developed countries for a long time to

come.

Even with substantial research, development, and adoption

of alternative energy technologies, fossil fuels are likely

to remain among the cheapest abundant energy resources

for many years. There are roughly 1,500 billion to 1,700

billion mtc in proven coal, oil, and natural gas reserves

that can be extracted using current technology, along with

an estimated 7,000 billion to 16,000 billion mtc in re

sources that might ultimately be recovered using advanced

technology—not including reservoirs of methane hydrate

under the ocean.9

 Without some sort of intervention, in

creasing levels of emissions—mainly of carbon dioxide

from the use of fossil fuels—will continue to raise atmo

spheric concentrations of greenhouse gases for the foresee

able future.

To illustrate how concentrations might change over the

next century, a study for the Intergovernmental Panel on

Climate Change presented a series of scenarios of green

house gas emissions, with cumulative carbon dioxide

emissions from both developed and developing countries

ranging from under 700 billion mtc to nearly 2,500 bil

lion mtc (Nakiƒenoviƒ and Swart, 2000; see Figure 6). By

2100, under the scenario with the lowest levels of emis

sions, atmospheric concentrations of carbon dioxide would

be about onethird more than today’s levels; under the

highemissions scenario, concentrations would be nearly

triple today’s. Under the more likely scenarios in the

middle of the range, carbon dioxide concentrations could

roughly double during the next century, to levels not seen

in over 20 million years (Pearson and Palmer, 2000).

Concentrations of other greenhouse gases are also likely

to grow by a considerable amount. Under the above range

of emissions projections—to which the authors do not

assign any probabilities—the average global temperature

could rise over the next century by about 2oF (1oC) or

by more than 9oF (5oC).10

Other researchers have explicitly addressed a variety of

uncertainties in economic and climate forecasting; one

recent study projected an increase in the average global

temperature of 4.3oF (2.4oC) between 1990 and 2100,

with a 95 percent chance that the change will be between

1.8oF (1.0oC) and 8.8oF (4.9oC) (Webster and others,

2002; see Figure 7). The economic and physical factors

included in the study accounted for roughly similar shares

of the uncertainty surrounding the human contribution

to warming by 2100. Other factors, including variations

in solar radiation and volcanic activity, could also influ

ence the future climate in ways that are harder to quantify,

but those factors were not included in the study.

At the low end of the projected range, the effects of climate

change would probably be relatively mild—although even

modest warming might trigger an abrupt, largerthan

expected shift in weather patterns. At the high end of the

range—an unlikely but possible prospect—the world

could face an abrupt change in climate that would be

roughly as large as the one at the end of the last ice age

but much more rapid. In the more plausible middle of

the range, the effects of climate change might still be quite

significant. Moreover, even if emissions were eliminated

before the end of the century, the oceans would continue

to warm—and thus further warm the climate—for cen

turies thereafter. And, of course, continued emissions be

9. Those estimates are derived from Babiker and others (2001),

Department of Energy (2001), Metz and others (2001), Porter

(1995), and World Energy Council (2001).

10. The economic projections for developing countries that underly

those scenarios were criticized in an article appearing in the Febru

ary 15, 2003, issue of The Economist. The criticism appears to be

valid but does not undermine the study’s main conclusions about

the range of possible climate change.
16 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

Figure 6.

Range of Uncertainty in Economic and Carbon Dioxide Emissions Projections

Source: Congressional Budget Office based on Nebojša Nakiƒenoviƒ and Rob Swart, eds., Emission Scenarios (Cambridge, U.K.: Cambridge University Press, 2000).

Note: All emissions are from fossil fuels.
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 17

Figure 7.

Historical and Projected Climate Change

(Average Global Temperature (°C) Relative to 1986-1995 Average)

Source: Congressional Budget Office. Historical data are from the Hadley Centre for Climate Prediction and Research, available at www.met-office.gov.uk/research/

hadleycentre/CR_data/Annual/land+sst_web.txt and described primarily in C.K. Folland and others, “Global Temperature Change and Its Uncertainties Since

1861,” Geophysical Research Letters, vol. 28 (July 1, 2001), pp. 2621-2624. The projection is based on data provided by Mort Webster, University of North

Carolina at Chapel Hill, in a personal communication, December 11, 2002; the results are discussed in Mort Webster and others, Uncertainty Analysis of

Climate Change and Policy Response, Report no. 95 (Cambridge, Mass.: Massachusetts Institute of Technology Joint Program on the Science and Policy

of Global Change, December 2002).

Note: The projection, which is interpolated from decadal averages beginning in 1995, shows the possible distribution of changes in average global temperature as

a result of human influence, relative to the 1986-1995 average and given current understanding of the climate. Under the Webster study’s assumptions, the

probability is 10 percent that the actual global temperature will fall in the darkest area and 90 percent that it will fall within the whole shaded area. However,

actual temperatures could be affected by factors that were not addressed in the study (such as volcanic activity and the variability of solar radiation) and whose

effects are not included in the figure.

yond the next hundred years would contribute to addi

tional warming.

The potential effects of any particular amount or rate of

climate change over the next few centuries are very un

certain. Research on the connection between the climate

and economic wellbeing yields particularly ambiguous

conclusions. Humans generally appear to have prospered

during warmer (or warming) periods and suffered during

colder (or cooling) ones. People did not—perhaps could

not—begin farming until after the last ice age ended.

Agriculture spread rapidly 6,000 to 8,000 years ago, when

the Sahara was largely grassland instead of desert and

average global temperatures were warmer than they are

today by perhaps a degree Celsius. Conversely, numerous

episodes of cooling seem to have disrupted cultures
18 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

throughout history. Europe prospered during a warm

period that occurred in the Middle Ages, but it suffered

during the colder Little Ice Age of between 300 and 800

years ago.

Yet the past effects of climate change on preindustrial

societies may not provide much information about its

future effects on technologically advanced societies—

especially the effects of significantly greater warming.11

Researchers who study the sources of economic growth

consistently find that at least during the past halfcentury,

regions in temperate climates tended to prosper more than

regions in tropical ones, even after differences in levels of

income and education, rates of saving and investment,

and other factors were taken into account. (For example,

Masters and McMillan, 2000, and SalaiMartin, 1997,

discuss the positive correlation between temperate climate

and economic development.)

When considered as a whole, the historical and statistical

evidence suggests that a warmer global climate—as well

as the period during which warming occurred—could

have both beneficial and harmful effects. One global effect

would be generally harmful: sea levels would rise as glaciers

melted and the oceans warmed and expanded. The gradual

inundation of seashores would create problems for coun

tries (particularly lowlying island nations), regions, and

cities that were mostly near sea level. In the middle of the

range of climate change described earlier, sea level would

rise by up to 11⁄2 feet (50 centimeters) over the next cen

tury. And even if emissions were eliminated after 2100,

thermal expansion of the oceans could ultimately raise sea

level by roughly 6 feet (2 meters) over a few centuries.

Because climate is generally a regional phenomenon, how

ever, the effects of climate change would vary by region—

and be even more uncertain than the effects globally. If

warming followed recent patterns, it would tend to be

concentrated in colder areas and periods—near the poles,

in the winter, and at night—but daylight temperatures

in the tropics during the summer would also rise.12 A

somewhat warmer Earth would probably have more rain

fall, and the resulting moderately warmer, wetter climate

—combined with more carbon dioxide in the atmosphere

—would probably improve global agricultural produc

tivity overall. Nevertheless, dramatic warming could

reduce the yields of important food crops in most of the

world. Shifts in weather patterns would probably cause

more heat waves and droughts in some regions, which

would substantially reduce their crop yields and supplies

of drinking water as well as exacerbate the effects of urban

air pollution. Other areas would experience more flooding.

Moreover, as Alley and others (2003) discuss, the climate’s

response to rising concentrations of greenhouse gases could

involve unexpectedly large and abrupt shifts, which would

be much more disruptive and costly to adapt to than

would gradual changes.

People in developing countries are probably more vul

nerable to the damaging effects of climate change than

are people in developed countries, in large part because

they have fewer resources for coping with the impacts. In

addition, a number of developing countries have large

populations that are either concentrated in lowlying

regions vulnerable to a rise in sea level or flooding or that

subsist on marginal agricultural lands vulnerable to

drought.

In contrast, industrial economies can draw on many more

resources to ease the adaptation to changes in climate.

Moreover, recent comprehensive study of the potential

impacts of climate change suggests that for a 4.5/F (2.5/C)

increase in average global temperature, some developed

countries could actually experience economic benefits

because warming would improve climates for agriculture

(Nordhaus and Boyer, 2000). The United States could

experience a loss of about half a percent of total income;

the poorest developing countries could experience losses

of more than 2.5 percent—and from much lower levels

of income per person than those of developed countries.

11. Moore (1998) describes the potentially beneficial effects of warm

climates. Richerson and others (2001) discuss the relationship

between warming and the development of farming. Lamb (1995)

addresses the broader effects of climate over human history.

12. Until recently, evidence from fossils indicated that tropical weather

was relatively insensitive to global climate change. However, re

search by Kump (2001) suggests that tropical regions are, indeed,

affected.
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 19

But point estimates like those conceal a great deal of un

certainty. As an example, estimates of the effects on the

United States of a rise of 4.5/F (2.5/C) in average global

temperature range from a loss of 1.5 percent of gross

domestic product to a gain of 1.0 percent.13 For particular

temperate regions of the United States, the likely changes

in temperature and rainfall and the possible intensity of

extreme weather conditions are very poorly understood.

For example, recent reviews of the potential regional ef

fects of climate change in the United States (National

Assessment Synthesis Team, 2000, and Department of

State, 2002) found that rainfall and summer soil moisture

might rise significantly in much of the Midwest, or it

might fall significantly.

In addition, some researchers fear that climate change

might occur so rapidly that some types of plants—most

notably, in marginal ecosystems such as alpine meadows

and barrier islands and in immobile ecosystems such as

coral reefs—would not be able to adapt to the altered cli

mate and would disappear. Migratory animals, birds, and

insects could be similarly affected.14 Moreover, warming

would probably increase the natural range of insectborne

diseases that are now found mainly in warmer regions.

Finally, among the most worrisome possible consequences

of rising greenhouse gas concentrations is the potential

disruption of deep ocean currents that strongly influence

the global climate. Those currents are directed partly by

thermohaline circulation; that is, the evaporation or freez

ing of seawater in various regions leaves the remaining

water increasingly salty, and therefore dense, and it sinks

into the deep. Warmer weather could slow or even stop

the current pattern of thermohaline circulation by increas

ing rainfall and reducing the formation of sea ice in the

North Atlantic.

Northern Europe appears to be particularly vulnerable

to such a change because its relatively warm, rainy weather

depends on the northerly flow of warm water from the

Gulf Stream, which in turn is linked to thermohaline

circulation in the North Atlantic. An abrupt halt of that

circulation—such as the halt that occurred after the last

ice age, as the climate warmed up—could seriously disrupt

the flow of warm water into the North Atlantic, leading

to much colder weather in parts of North America and

Europe for decades or centuries coupled with greater

warming elsewhere in the world. (Clark and others, 2001,

discuss that scenario.) Most climate models project that

the North Atlantic thermohaline circulation will weaken

during the next century because of higher levels of rainfall

in a warmer climate. However, they do not predict a

complete shutdown over that period.

Potential Responses

To control the longrun growth of greenhouse gas con

centrations in the atmosphere, countries could either limit

emissions or develop means of drawing greenhouse gases

back out of the atmosphere after they were emitted. One

significant remedy would be to control the longrun

growth of fossil fuel use. There are many alternatives to

current patterns of energy use, including technologies that

could make that use more efficient and others that could

exploit alternative energy sources—for example, solar en

ergy, wind, biomass, and hydroelectric and nuclear power.

However, expanding the reliance on any of those alterna

tives is relatively expensive compared with the market cost

of using fossil fuels. Restrictions on such use would there

fore impose economic costs—costs that would rise with

the stringency of the restrictions and would climb particu

larly quickly if extensive controls were imposed in the

short run. Over the longer term, control of fossil fuel use

will depend on the development of relatively inexpensive

alternative energy technologies (Edmonds, 2002).

Because plants absorb carbon dioxide from the atmos

phere, countries could sequester carbon by planting and

growing trees and partly offset emissions from the burning

of fossil fuels. (Scholes and Noble, 2001, and McCarl and

Schneider, 2001, discuss the role of sequestration in limit

ing carbon dioxide emissions.) In theory, the potential

for sequestration in forests is very large: if people could

replant all of the forest land around the world that has

13. Nordhaus (1994, 1998a,b), Nordhaus and Boyer (2000),

Mendelsohn and Neumann (1999), and Moore (1998) discuss

those cost estimates.

14. That problem could be aggravated by the environmental stresses

of population growth and industrialization. As Field (2001)

discusses, under an intermediate definition of appropriation, human

beings already appropriate an estimated 10 percent to 55 percent

of the energy transferred from plants to other life on Earth, and

that fraction is expected to grow in the future.
20 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

been cleared in the past two centuries and then leave the

forests alone, the trees and soils could eventually trap

much of the carbon that has accumulated in the atmo

sphere since the beginning of the industrial revolution.

In practice, though, reforestation on that scale is infeasible:

people need much of the land to grow crops and to live

on. Furthermore, people would continue to use fossil fuels,

and all of the carbon sequestered in trees over several

decades would be replaced in the atmosphere by the con

tinued emissions. So carbon sequestration in forests and

agricultural soils can only partially offset past and future

carbon emissions from fossil fuels.

But forests can offer a partial alternative to fossil fuels as

a source of energy. Although burning wood releases carbon

into the atmosphere (and is relatively dirty and expensive

as well), the carbon is removed again as another tree grows

in place of the one cut down, a cycle that could be re

peated over and over. Thus, a wood lot capable of pro

ducing 1 mtc of renewable biomass fuel every 20 years

or so could, over a century, replace 5 mtc from fossil fuels

that would otherwise be emitted into the atmosphere.

Engineers have developed technologies to remove carbon

dioxide from the exhaust of a combustion process and to

store it underground or in the ocean. Those carbon

capture technologies appear to be relatively straightforward

for large emissions sources such as electric power gen

erating plants, but they also significantly increase the cost

of generating power (Department of Energy, 1997).15

Geoengineering solutions, such as adding iron to oceans

to fertilize the absorption of carbon by plankton, have also

been advanced. Some research suggests that iron fertiliza

tion may help reduce atmospheric concentrations of car

bon dioxide, although its effectiveness and cost are very

uncertain, as are its potential side effects (Boyd and others,

2000). Other geoengineering technologies, such as remov

ing greenhouse gases directly from the atmosphere, are

extremely expensive.

Some relatively simple and inexpensive options are avail

able for controlling some emissions of greenhouse gases

other than carbon dioxide. However, controlling those

gases in a costeffective manner is considerably compli

cated by the fact that they come from so many different

and widespread agricultural, industrial, and other activities

(Reilly, Jacoby, and Prinn, 2003).

Types of Uncertainty

As the preceding discussion emphasized, scientists and

economists are very uncertain about the potential eco

nomic threat posed by a changing climate. Some of the

uncertainty is scientific. For a given amount of greenhouse

gas emissions, what portion will accumulate in the atmos

phere? How much will a given change in those concen

trations affect the global climate? How will that global

change be distributed throughout the world, and how

rapidly will it occur? How much will regional climate

change affect sea level, agriculture, forestry, fishing, water

resources, disease risks, and natural ecosystems? Will rising

greenhouse gas concentrations increase the probability of

threshold effects, which could suddenly shift the climate

into a significantly different global pattern?

Other sources of uncertainty are essentially economic.

How rapidly will the world’s population and economies

grow? How energy and landintensive will human activi

ties be, and how much of the energy used for those ac

tivities will come from fossil fuels? How will policies to

control emissions of greenhouse gases or to encourage

technological developments affect the accumulation of

gases in the atmosphere? And how much will those policies

cost? At a deeper level, how will future generations value

the effects of averting climate change? Future generations

are likely to be wealthier, on average, than people are today

and thus better able to adjust to changes in climate. But

they might also have been willing to forgo some of their

affluence to have their natural surroundings and climate

preserved.

Researchers’ increased understanding of climate change

has often uncovered areas of inquiry whose importance

had previously gone unrecognized. In that respect, greater

knowledge has sometimes served to expand the range of

scientific and economic unknowns, even as it has resolved

15. An extensive discussion of technological options and the costs of

capturing and sequestering carbon dioxide from power plants can

be found at the Web site of the International Energy Agency’s

Greenhouse Gas Research and Development Programme at

www.ieagreen.org.uk/index.htm. 
CHAPTER TWO THE SCIENTIFIC AND HISTORICAL CONTEXT 21

specific issues (see Kerr, 2001, pp. 192194). Because of

that tendency, policymakers for the foreseeable future will

continue to face great uncertainty in determining the

potential costs and effects of different policies to address

the problem of climate change. Furthermore, policies that

explicitly take into account that range of uncertainty are

likely to be more effective than policies that do not.16

16. See Heal and Kriström (2002) for a more extensive discussion of

uncertainty and climate change.

3

The Economics of Climate Change

The Earth’s atmosphere and climate are part of the

stock of natural resources that are available to people to

satisfy their needs and wants over time. From an economic

point of view, climate policy involves measuring and com

paring people’s valuations of climate resources, across

alternative uses and at different points in time, and apply

ing the results to choose a best course of action. Effective

climate policy would balance the benefits and costs of

using the atmosphere and climate and would distribute

them among people in an acceptable way.

Common Resources and Property Rights

Prosperity depends not only on technological advances

but also on developing legal, political, and economic insti

tutions—such as private property, markets, contracts, and

courts—that encourage people to use resources to create

wealth without fighting over or, in the case of renewable

resources, significantly degrading them. The effectiveness

of those institutions depends in part on characteristics of

the resources. Market institutions do not work well when

resources have the characteristics of public goods—that

is, when it is difficult to prevent people from using the

resources without paying for them (consumption is “non

excludable”) and when the incremental cost of allowing

more users is near zero (consumption is “nonrival”).

Market failures also arise when the many people using a

resource affect each others’ use—for instance, when rush

hour drivers create congestion and air pollution. (In that

case, consumption is nonexcludable but rival.) Those

characteristics make property rights for public goods diffi

cult to create and enforce. Private industry finds it rela

tively unprofitable to produce such goods, and consumers

have relatively little incentive to maintain them.

The Earth’s oceans and air are particularly hard to carve

up into private property, and in the ongoing process of

attempting to develop effective institutions to manage

them, access to those resources has largely remained open

—for the most part, no one owns them, anyone can use

them, and no one has to pay. For most of human history,

open access to the oceans and air was appropriate because

the world’s population was too small and its technologies

too limited to deplete stocks of fish, degrade air quality,

or affect the climate.

But population growth and advances in technology have

changed the way people use natural resources and made

them vulnerable to overuse, depletion, and degradation.

If resources are free for the taking, people will tend to

overuse them; if nobody owns them, nobody will take care

of them. That phenomenon is referred to as the tragedy

of the commons: everyone wants to use free resources but

will degrade them if they do, to the detriment of all.

In the case of climate, people want to use the atmosphere

to absorb greenhouse gases so that they may benefit from

cheap food and timber and from plentiful fossil energy.

In the long run, however, that use may significantly de

grade the climate.

An Example: Common Fishing Resources

To keep from overusing a common resource, people must

negotiate and agree on rules about who may use it and

how much of which types of uses are acceptable. Fisheries

provide a common, straightforward example of the prob

lem: a fishing community may have to determine the sus

tainable level of fishing for each kind of fish and then limit

catches to those levels. Limits on fishing will reduce the

CHAPTER
24 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

market supply of fish and raise their market value. People

who are allowed to keep fishing will reap a windfall profit

on the fish they can legally catch. (Cheaters, or “free

riders,” who catch more than their allowance will also get

windfall profits.) In the meantime, anyone whose fishing

is restricted is likely to sustain a loss.1

 The community’s

challenge is to reach a consensus about who gets to fish

and how much; about whether, how, and how much to

compensate the losers to win their support; and about how

to prevent free riders from catching extra fish and breaking

down the agreement. In short, the challenge is to negotiate

and enforce a new set of property rights.

The task of developing and enforcing property rights gen

erally falls to governments—and it may be further compli

cated if several countries are involved and international

negotiations are needed to resolve conflicts. Governments

use a variety of approaches to regulate fisheries, many of

which explicitly involve the technology of fishing. For

instance, the government may restrict the size of fish that

can be taken, prohibit the use of large dragnets, or require

the use of handheld lines. Other regulatory strategies apply

more directly to the market for fish. One alternative is to

create and distribute a fixed number of fishing permits

that limit recipients’ catches (see, for example, Newell,

Sanchirico, and Kerr, 2002). Under that approach, fisher

men may lose part of their previously unrestricted catch,

but their losses are at least partly offset because greater

scarcity drives up the price of fish. Consumers lose by

paying more per fish for fewer fish. If the government

auctions off the limited fishing rights to the highest bid

ders, fishermen will have to pay to fish; they will thus lose

the profits they could have reaped from higher, scarcity

driven fish prices. However, the government will take in

revenue that it can use for various purposes, including

partially compensating consumers and fishermen.

Whether it distributes or sells them, a government can

create private fishing rights (which recipients can buy and

sell on open markets) or common property rights (in

which a restricted group of people own the fishery together

and can exclude everyone else from fishing). A government

can also keep or appropriate the common resource as a

public property under public management and create a

use right—such as a fishing license or a catch limit—that

gives recipients temporary or limited access to the

resource.

Another alternative for the government is to sell use rights

by levying a tax on fishing activity or a “landing fee” on

fish catches. Because the tax becomes a cost of catching

fish, fishermen will raise the market price of their fish,

consumers will buy fewer fish as the price rises, and the

government will receive tax revenues. As the demand for

fish falls, fishermen will make less money, and some of

them will be pushed out of the market. As in the case of

auctioned rights, the government will receive revenues that

it can use to partially offset consumers’ and fishermen’s

losses, and fishing will be maintained at a sustainable level.

A Second Example: Common Air Resources

As a resource problem, air pollution is typically more com

plicated than overfishing. Unlike markets for fish, in

which a product actually changes hands, people generally

do not buy and sell air, so there is no market price that

reflects the value of air. In addition, modest air pollution

may hurt only some especially sensitive people, or it may

contribute to health problems in ways that are hard to

trace back to it. Pollution levels may have to be very high

before many people notice a problem and demand a

remedy. Moreover, there may be many different types of

emissions from a variety of sources, so it can be difficult

or even impossible to trace particular problems to particu

lar origins.

For example, regional air pollution may come from power

plants, factories, buildings, trucks, and cars. Emissions

from cars alone can involve millions of drivers, each hav

ing a minor effect on the health of millions of people,

including each other. No practical way exists for each

inhabitant to bargain with each driver over the minor

effect that that driver has on him or her.

Nor is it simple to measure the economic tradeoffs

involved. The benefits from less pollution—improved

health, better visibility, and so on—are certainly real but

notoriously difficult to evaluate because they are generally

not bought and sold in markets. The relative costs of re

ducing emissions from different sources can also be hard

to determine. And the people who enjoy the benefits of

1. Under certain circumstances, limits on fishing may drive up the

market price for fish to such an extent that it raises the total value

of the catch. In that case, it may be easier to get fishers to agree

to restrictions—although limits will raise costs for consumers.
CHAPTER THREE THE ECONOMICS OF CLIMATE CHANGE 25

lower pollution levels may not be the ones who incur the

costs.

Those complexities make it very difficult to determine

the costs and benefits of reducing air pollution and to

balance or distribute them in a politically acceptable way.

Nor is it easy to develop standard property rights for air

resources. As a result, people find it extremely challenging

to use private markets to resolve conflicts over the use of

air resources. The fundamental problem is transaction

costs—the costs of motivating and coordinating ex

changes; too many parties are involved in too many inter

actions to negotiate agreement in private markets. High

transaction costs force governments to come up with other

approaches to managing air pollution.

The Atmosphere and Climate

The problem of climate change involves very large trans

action costs. Emissions come from the land and energy

using activities of practically everyone in the world, and

the potential burden of their effects will be borne through

out the world by generations of people who are not even

born. Moreover, many of the potential impacts of climate

change—the disruption of ecosystems and extinction of

species, for instance—are themselves public in nature.

Those factors make it very hard—if not impossible—to

clearly define individual rights and responsibilities for

many of the activities that may contribute to climate

change and the effects that may come from it. Certain

types of rights, such as rights to emit greenhouse gases by

burning fossil fuels, could be delineated without great

difficulty. Other rights, such as credits for carbon stored

in the soil and trees of a forest stand or in the ocean, would

be more complicated to define. Still others—such as the

right to enjoy a particular type of climate in a particular

part of the world at a particular time—would be impos

sible. Without clearly delineated, enforceable rights, indi

viduals cannot easily bargain with one another in markets

to resolve their conflicting claims. And as Chapter 2 dis

cussed, the scientific and economic uncertainty involved

makes climate tradeoffs extremely difficult to evaluate.

In sum, policymakers may be faced with the extraordi

narily complicated task of managing a resource that no

one owns, that everyone depends on, and that provides

a wide range of very different—and often public—benefits

to different people in different regions over very long

periods, benefits for which property rights would be very

difficult to define, agree on, and enforce. The causes and

consequences of climate change are international, and that

fact has several ramifications: governments will probably

have to cooperate for any management approach to be

effective; for some time to come, they will have only very

imperfect information on which to base decisions; and

their decisions may affect the world for centuries. If gov

ernments decided that the risks associated with climate

change called for action, they might have to persuade

people to make sacrifices today to benefit future genera

tions.

Reaching collective agreement on a policy involving use

of the atmosphere and climate change is an immense

challenge because everyone has an incentive to “free ride.”

A successful agreement need not require equal action by

all parties, but an agreement of any kind will break down

if some parties sacrifice to meet an overall goal and other

parties cheat, increasing their emissions in violation of the

goal. Moreover, without a clear sense of whether, when,

and by how much emissions should be constrained,

nations will find it very hard to agree on the appropriate

level of action. Equally important, nations have very dif

ferent historical and economic circumstances; they vary

widely in their ability and willingness to bear the cost of

reducing emissions—or the possible costs of climate

change. These factors help explain the great difficulty

nations are experiencing in trying to reach agreement on

a distribution of rights and responsibilities.

Further complicating any collective agreement is the fact

that governments generally are not subject to the market

forces that drive competitive firms to efficiently provide

the goods and services that consumers most want to buy.

Instead, governments tend to represent coalitions of pri

vate and bureaucratic interests that often engage in rent

seeking behavior—attempting to redirect the economy’s

resources to their own advantage. As a result, governments

do not necessarily provide the public services most desired

by consumers; nor do they provide them at the lowest cost.

There is consequently no guarantee that governments will

be better than markets at managing common resources.

Economic Trade-Offs

Economic valuation is inherently about measuring trade

offs—among people and resources and across time. Re
26 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

sources are limited, and people are forced to choose among

alternative uses, trading some things that they might like

to have for things of higher priority. The economic value

of a resource reflects those choices rather than something

intrinsic to it. Value is measured by people’s willingness

to pay for the benefits that a resource provides—or, nearly

equivalent, their willingness to accept compensation for

lost benefits.2

When markets work well, market prices communicate

people’s preferences—their choices among alternative uses

of resources and between using resources today (and

perhaps damaging or depleting them) and maintaining

them in their current state to be used later. For nonre

newable resources such as oil, the tradeoff involves

balancing the benefits of using them up now against the

benefits of preserving them so that they can be used later.

For renewable resources such as fisheries, the tradeoff

involves balancing the benefits of fish consumption today

against the benefits of maintaining a breeding stock for

tomorrow. In an efficient market, resources are used to

provide people with the goods and services that they most

want to have, when they most want to have them.

When markets do not work well, prices may not ade

quately reflect people’s willingness to pay for the benefits

that the use of a resource provides. That situation can arise

when property rights are poorly delineated or inherently

difficult to define, as in the case of public goods. It also

can arise when limited information makes it difficult or

impossible for individuals to decide what value they place

on a resource. For instance, even experts are uncertain

about the likelihood of abrupt changes in climate, or how

changes in climate might disrupt species and ecosystems,

or how those disruptions might affect society. Those fac

tors converge in the case of climate change, which involves

great uncertainty about a public good.

In attempting to manage such resources, policymakers

may simulate markets by estimating individuals’ willing

ness to pay, using proxy measures that economists have

developed for resources that are not directly bought and

sold. Even with those measures, however, policymakers

face the challenge of limited information, as well as the

impossibility of learning what values future generations

might assign to those resources.

Balancing Competing Uses of the Atmosphere

Effective management of the atmosphere involves bal

ancing the incremental benefits of using it as a sink for

greenhouse gas emissions—that is, the additional benefits

provided by the last ton of emissions—against the incre

mental costs (or benefits) of the climate change that may

gradually result from that ton of emissions.3

 Similarly,

effective management involves balancing the incremental

costs of investing in research on climate change against

the incremental benefits of the advancements in knowl

edge that result. That balancing of current costs and future

benefits also includes weighing the cost of reducing emis

sions to avert climaterelated problems in the future

against the cost of adapting to the climate change that oc

curs—that is, balancing mitigation and adaptation. If the

incremental costs of reducing emissions today are higher

than those of adapting to the consequences of emissions

in the future—say, by spending more on insect control

to prevent the spread of tropical diseases—then it would

be more costeffective to reduce emissions less and to

adapt more.

Put another way, effective climate policy involves making

investments today to yield future returns in the form of

a beneficial climate—with due regard for the scientific

and economic uncertainty involved. Those investments

could take several forms, such as restrictions on emissions

levels and research to improve understanding of the phy

2. People may express their beliefs about intrinsic values in their

willingness to pay for environmental benefits. For instance, they

may be willing to pay to ensure that a forest they may never see

is not cut down or that a species of animal does not become extinct.

They are expressing their willingness to sacrifice some other benefits

—cheap timber, for example—for the benefit of knowing that the

forest or species will be preserved.

3. The atmosphere is a partly renewable resource because the oceans

can indefinitely absorb only limited amounts of greenhouse gases.

Beyond those limits, the gases begin to build up in the atmosphere

and gradually affect the climate. (For carbon dioxide, the limit

appears to be roughly a billion metric tons of carbon per year.)

In that sense, the atmosphere is a depletable resource.
CHAPTER THREE THE ECONOMICS OF CLIMATE CHANGE 27

sical processes of climate change and to develop alterna

tives to fossil fuels.4

Climate policy thus involves balancing investments that

may yield future climaterelated benefits against other,

nonclimaterelated investments—such as education, the

development of new technologies, and increases in the

stock of physical capital—that are also beneficial. If cli

mate change turned out to be relatively benign, a policy

that restricted emissions at very high expense might divert

funds from other investments that could have yielded

higher returns. Conversely, if climate change proved to

be a very serious problem, the same policy could yield a

much higher return.

Since resources devoted to climate policy would be di

verted from other uses, the total benefit from all types of

investment would be greatest if the rates of return were

the same “at the margin”—that is, for the last dollar of

each type of investment. However, efforts to ensure equal

rates of return become extremely complicated in the case

of longterm issues such as climate change. Few other

investments compare with climate policy in yielding an

enormous variety of returns on a global scale and over such

long periods, or in having returns that are as uncertain.

Furthermore, very long time horizons render the results

of costbenefit analyses extremely sensitive to the rate of

return that is assumed for the analysis.

The appropriate course of action—and the appropriate

level of climaterelated investment—depends on how one

balances the competing interests of present and future

generations and how one accounts for the existing sci

entific and economic uncertainty. Those choices, in turn,

are expressed in the desired rate of return on that invest

ment—that is, the chosen discount rate (see Box 1). While

analysts have reached no consensus on what discount rate

should be applied, several of them have argued that it

should be lower than the rates assumed in typical cost

benefit analyses, for several reasons:

• Society’s investment opportunities over the long term

are uncertain; 

• There are no centurieslong financial markets in which

to invest risk free or from which to determine very

longterm rates of return; and 

• People’s attitudes toward the distant future may not

be correctly reflected in the assumption of a constant

discount rate based on historical market returns.5

The challenge is to come up with valuations that reflect

what people, taken together, may plausibly be said to

consider appropriate and that are also consistent with how

people may actually be able to transfer resources across

time (by making investments today that yield income in

the future).

If lower discount rates are deemed appropriate for evalu

ating very longterm costs and benefits, they justify taking

measures to increase society’s rate of investment not only

in preserving a benign climate but in expanding the stock

of all types of longlasting capital. By increasing invest

ment to the point at which the last investments all earn

rates of return that are consistent with the lower discount

rate, such measures would tend to reduce current genera

tions’ consumption in order to provide more wealth for

generations in the future.

Integrated Assessments of Costs and Benefits

Over the past 15 years, a large number of studies have

analyzed the potential costs and benefits of averting cli

mate change. Some researchers have attempted to incorpo

rate the studies’ results in global and regional models of

economic growth and climate effects and have used the

models to conduct socalled integrated assessments of

policy proposals related to climate change. They have also

estimated the costs of emissions control policies that would

yield the greatest net benefits in terms of economic

growth, reduced emissions, and the resulting climate

effects.

4. To the extent that they encouraged research or reduced emissions,

such investments might also yield benefits in the form of techno

logical side effects, or “spillovers,” or a decline in conventional air

pollution. And to the extent that greenhouse gas emissions also

contribute to conventional pollution, the costs and benefits of abat

ing such pollution need to be factored in as well.

5. Weitzman (1999, 2001) and Newell and Pizer (2001) discuss that

issue further; Cropper, Aydede, and Portney (1994) describe efforts

to determine people’s attitudes toward intergenerational equity

by measuring longterm discount rates.
28 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

Box 1.

Discounting and the Distant Future

For a variety of reasons, people place less value on the

future than they do on the present; a dollar today is

worth more to them than a dollar tomorrow. The

practice of valuing future income less highly than

current income is called discounting. A person who

greatly devalues, or discounts, future consumption and

hence does not save and invest much is said to have a

high discount rate. A person who places great value on

the future is said to have a low discount rate.

Such valuations are expressed in the market as interest

rates. Market interest rates balance everyone’s current

supply of and demand for savings—they represent the

market’s summing up of society’s competing preferences

for present and future income. Some people save part

of their income, thus accumulating wealth; others spend

more than their income, making up the difference by

borrowing or by running down their savings. Overall,

savers outpace dissavers; thus, society as a whole saves

a fraction of current income and invests it in activi

ties—such as conducting research, building physical

capital, and developing human skills—that will help

provide goods and services in the future.1

 Adjusted for

taxes and risk, interest rates also represent the marginal

rate of return on investment (the rate on the last dollar

of investment), or the rate—given the existing stock of

resources, capital, technology, and labor—at which sav

ings can be converted into future income.

If people had less of a preference for current consump

tion (a lower time preference)—and thus lower discount

rates—they would save and invest more of their current

income. Because highly profitable investment oppor

tunities are not unlimited, people’s pursuit of increas

ingly less profitable ones would drive down the marginal

rate of return. Ultimately, their lower time preference

would be reflected in a larger stock of capital, greater

output and income, and lower interest rates. Conversely,

greater preference for current income would be reflected

in lower future income and higher interest rates.

Economists who analyze public policy reason that if a

public investment is going to improve public welfare,

it should produce rates of return similar to those of the

private investments that it displaces. So in analyzing the

costs and benefits of policies intended to avert climate

1. Physical capital is land and the stock of products set aside to

support future production and consumption. Human skills—

education, training, work experience, and other attributes that

enhance the ability of the labor force to produce goods and

services—are sometimes referred to as human capital.

Those assessments and their findings are best thought of

as general illustrations rather than as exact calculations

of the cost of optimal policies. Analysts must make many

simplifying assumptions for such evaluations; conse

quently, every study excludes some potentially important

dimension—dealing with different gases, technologies,

countries, generations, environments, and so forth. None

theless, integrated assessments provide a sense of the rela

tive importance of different factors, highlight those of

greatest importance, and help policymakers focus on the

tradeoffs involved.

Integrated assessments of the potential costs and benefits

of averting climate change typically find relatively small

net benefits from stringent emissions controls in the near

term, even though they conclude that the continued

growth of emissions could ultimately cause extensive

physical and economic damage. In balancing alternative

investments, the assessments conclude, modest restrictions

on emissions today would yield net benefits in the future,

but extensive restrictions would crowd out other types of

investment. The loss of that investment would in turn

reduce the rate of economic growth and thus damage fu

ture generations’ material prosperity even more than the

avoided climate change would have.

Integrated assessments generally conclude that the most

costeffective way to respond to the risks of climate change

is through a gradual process of adjustment. Several con

siderations support that conclusion (see Wigley, Richels,

and Edmonds, 1996):
CHAPTER THREE THE ECONOMICS OF CLIMATE CHANGE 29

0 25 50 75 100

0

100

200

300

400

500

600

700

800

900

1,000 1000

At 3 Percent

At 5 Percent

At 7 Percent

Years in the Future

At 2 Percent

The Present Discounted Value of $1,000

Dollars

Box 1.

Continued

change, economists typically apply discount rates that

are similar to market interest rates, after adjusting for

taxes, risk, and inflation. Those discount rates reflect

the distributional choices that people in the economy,

taken together, actually make.

However, conventional discounting arouses a great deal

of controversy when it is applied to longterm issues

because at discount rates that approximate market rates,

even very large longterm costs and benefits are dra

matically devalued (see the figure).2

 The choice of dis

count rate therefore makes a huge difference in thinking

about longterm problems such as climate change.

2. For instance, imagine a stream of income equal to your current

income but beginning in the year 2200 and stretching into the

distant future. In one sense, that stream of income is not worth

anything to you today because you will not be around to enjoy

it. However, you might wish to make an investment today to

ensure that your descendants will have that income. If you

evaluated that extended stream of income at a discount rate of

2 percent, it would be worth one year of your present income

to you today. At 3 percent, it would be worth one month of your

current income. At 5 percent, it would be worth half a day’s

income, and at 7 percent, it would be worth 10 minutes of

income.

Longterm discounting has such a strong effect precisely

because private investments yield relatively high rates

of return. As long as society continues to have extensive

opportunities for investment, it will be able to set aside

modest resources today, continuously reinvest the earn

ings, and have enormous wealth in the distant future.

If income continues to grow at 20thcentury rates,

future generations will have much greater resources than

current generations have to offset a climaterelated loss

of wellbeing.

Source: Congressional Budget Office.

• Much of the energyusing capital stock is in the form

of very long lived power plants, buildings, and ma

chinery. Gradual adjustment would give people time

to use up the existing stock and replace it with more

efficient equipment.

• When viewed from the present, the cost of reducing

emissions in the future is cheaper because of dis

counting.

• Technological change will probably lower the cost of

controlling emissions. (In addition, it might take a long

time to develop alternative technologies, and there

would be more incentive to engage in research and de

velopment over the long term if it was fairly certain that

the policies in place were gradually going to create a

large market for nonfossil energy.)

• People are likely to be wealthier in the future and there

fore may find it easier to pay to reduce emissions. If

income and wealth grow and technology improves as

expected, future generations may find it relatively easy

to cope with the impacts of climate change and to

gradually impose increasingly strict restraints on emis

sions to avert further change.

• At least for carbon dioxide, emissions that occur sooner

rather than later will have more time to be absorbed

from the atmosphere by the oceans. As a result, any

given future target for concentrations could be met with
30 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

Box 2.

An Example of Integrated Assessment

A recent study by William Nordhaus, reported in 2000, illus

trates how integrated assessment can be used to analyze the

tradeoffs involved in climate policy.1

 Drawing on an extensive

review of the literature, the study concluded that modest

warming of up to 2.3o Fahrenheit (1.3o Celsius) would have

essentially no net impact on the world economy and might

even yield some net benefits. But the study also concluded

that in the absence of efforts to reduce emissions, the average

global temperature would rise by about 3.6oF (2.0oC) over

the next century and by 6.1oF (3.4oC) over the next two cen

turies. Those changes would inflict damages—measured as

a reduction in world economic output—of roughly 1.0 per

cent (about $1 trillion in 2000 dollars) in 2100 and about

3.4 percent (nearly $7 trillion) in 2200. Such damages would

include losses of agricultural land, forests, fisheries, and

freshwater resources; gradual inundation of coastal areas as

sea level rose; adverse effects on people’s health; and, to some

extent, possibly catastrophic surprises.

Yet the study concluded as well that those significant damages

would have only a relatively minor economic impact because

the world economy was likely to grow very rapidly over the

period. Under the study’s “best guess” assumptions, costs and

benefits would be best balanced by imposing a charge today

on greenhouse gas emissions throughout the world of roughly

$10 per metric ton of carbon (mtc) and gradually raising that

charge at a pace related to the rate of global economic growth.2

(Morerapid economic growth would lead to higher levels

of emissions and therefore require an emissions charge that

also grew more rapidly.) By 2100, the study’s recommended

policy would have reduced global emissions by only about

10 percent. The cumulative reduction in emissions over the

1. The estimates provided here, which are in 2000 dollars, come

from Nordhaus’s DICE99 model, available as an Excel spread

sheet file at www.econ.yale.edu/~nordhaus/homepage/homepage.

htm. The model is a recent update of the original DICE model

(described in Nordhaus, 1994), which was one of the seminal

integrated assessments of climate change. Both models address

emissions only of carbon dioxide rather than of all greenhouse

gases, but the results roughly generalize to policies that include

all gases.

2. An emissions charge of $10 per mtc would add about $5 to the

price of a short ton of coal, about 2.5 cents to the price of a gallon

of gasoline, and about 15 cents to the price of a thousand cubic

feet of natural gas. 

century would have little effect on average global warming,

reducing it from about 4.4oF to 4.2oF (2.5oC to 2.4oC).

The study found little net advantage in averting climate

change because the assessment balanced current prosperity

against future prosperity and the future benefits of economic

growth against the future benefits of a stable climate. To avert

climate change over the long run, society would have to

reduce emissions both today and later. That policy would

reduce current generations’ prosperity and slow the rate of

economic growth, thus leaving future generations less affluent,

too. Given the contribution of fossil fuel use to both economic

growth and climate change, the study found little benefit in

slowing warming.

Sensitivity to Assumptions

The study’s results were strongly influenced by its estimates

of how much warming would occur in the future and of the

impacts from such warming. Another important factor was

its assumptions about how future generations would value

those effects. Morerapid warming from a given quantity of

emissions would justify higher charges on emissions, as would

a higher level of damages from a given amount of warming.

But if those greater damages occurred sufficiently far in the

future, they would not justify higher charges on emissions

today. For instance, if warming of more than 4.5oF (2.5oC)

would cause an economic catastrophe, it would be cost

effective to impose very high emissions charges as warming

approached 4.5oF toward the end of the century to force the

economy to move away from its reliance on fossil energy

sources. Even in that case, however, the most costeffective

approach would still be to impose relatively small charges on

emissions today and then raise them rapidly in the future.3

Like the results of all such assessments, the Nordhaus study’s

findings were also strongly tied to its assumptions about the

sources of future growth and its weighing of the welfare of

current generations against that of future generations.4

 Apply

3. Keller and others (2000) come to a similar conclusion in a study

that explicitly considers the possibility of a shutdown of thermo

haline circulation.

4. The study imposed a discount rate that gradually declined from

over 4 percent today to under 3 percent in 100 years. Those rates

led the model to assign a present value of about $25 billion—one

fortieth the future value—to a trillion dollars of damages a cen

tury from now. The rates had two components. The first and
CHAPTER THREE THE ECONOMICS OF CLIMATE CHANGE 31

(2000 dollars per person)

2000 2040 2080 2120 2160 2200 2240

-100

0

100

200

300

400

500

Market Discount Rates

Below-Market Discount Rates

Box 2.

Continued

Projected Benefits of Climate Mitigation

Under Different Discount Rates

Source: Congressional Budget Office, using the DICE99 model.

ing a lower discount rate gives more weight to the wellbeing

of future generations, shifting the balance of costs and benefits

in favor of investing more to reduce emissions today (and

investing more in other kinds of capital formation as well).

An extreme case would be to apply a discount rate that took

into account only the expected gradual increase in future

generations’ wellbeing that sprang from economic growth.

Such a rate would still discount events a century from now

by about twothirds, but it would justify much higher current

charges on emissions—on the order of $160 per mtc—to

balance current and future costs and benefits. That stringent

a policy would slightly reduce the consumption of people alive

over the coming century but greatly increase the consumption

of succeeding generations (see the figure).5

 Conversely, a higher

discount rate would give more weight to the present and shift

the balance of costs and benefits in favor of less investment

and more consumption today.

The study’s recommended policy is much less sensitive to

estimates of costs for abating emissions than to the choice of

discount rate.6

 If abatement turned out to be considerably

cheaper (or considerably more expensive) than the study’s

dominant one simply reflected current generations’ preference

for income today over income for future generations. The second,

relatively minor, component took into account that future gen

erations would be wealthier than current generations, so an addi

tional dollar of income would be worth less to them than to

people alive now.

“best guess,” the recommended charge would still be roughly

$10 per mtc, but it would induce greater (or fewer) reductions

in emissions.7

Evaluating the Integrated Assessment Method

The Nordhaus study illustrates both the usefulness and the

limitations of integrated assessment. On the plus side, the

study assesses different aspects of the climate problem in a

consistent, relatively simple framework. It also provides a

point estimate based on best guesses about global economic

growth, energy use, and emissions; the climate’s response to

rising greenhouse gas concentrations; the economic value of

the resulting impacts; and the discount rate. The model’s

simplicity helps analysts understand how changes in those

assumptions affect estimates of costs and benefits.

On the minus side, the assessment includes only energy

related carbon dioxide emissions. Moreover, it ignores distri

butional issues within generations, in part because it combines

all impacts into a single estimate—which offers little insight

into the extent to which positive and negative effects might

offset each other or might be experienced by different groups

of people. (Nordhaus, 2000, addresses some international

distributional issues in an extension of the model discussed

here.) The model is also based on crude guesses about the

value of changes in unmanaged ecosystems, for which there

are no market measures. Perhaps most important, it does not

explicitly consider the wide range of uncertainty that exists

on many dimensions—which, if incorporated into an assess

ment, can strongly influence its conclusions.

5. Lower discount rates would also justify much higher rates of

investment than society currently undertakes, so they would not

be consistent with the market’s balancing of the welfare of current

and future generations.

6. Compared with the range of cost estimates in the literature, the

Nordhaus study assumed that it would be relatively inexpensive

to reduce emissions and that technological improvements would

make such reductions even easier over time.

7. In the Excel version of DICE99, raising marginal abatement costs

tenfold reduces the abatement rate by a factor of eight but raises

the currently costeffective charge on carbon by only 3 percent.

Reducing marginal abatement costs by a factor of 10 raises the

abatement rate by a factor of six; however, it reduces the cost

effective charge by only about 20 percent.
32 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

somewhat greater total emissions over the next century

if the bulk of the emissions occurred early on.

Box 2 on pages 30 and 31 summarizes findings from a

particularly wellknown integrated assessment model

developed by William Nordhaus. The study illustrates how

integrated assessment can be used to provide a “best guess”

of the climate policy that would yield the greatest net

benefits and how sensitive that sort of estimate is to the

assumptions built into the assessment. However, the study

does not explicitly consider the wide range of uncertainty

about scientific and economic aspects of climate change—

the topic of the next section.

Coping with Uncertainty

The extensive scientific and economic uncertainty dis

cussed in Chapter 2 greatly complicates assessment of the

costs and benefits of averting climate change. No one

wishes to undertake extensive, expensive actions to solve

a problem that turns out to be relatively mild—or to take

no action to solve a problem that later proves catastrophic.

Policymakers are thus forced to hedge their bets and pre

pare for more than one possible outcome, with the addi

tional complication that whatever outcome occurs is likely

to be largely irreversible.6

In general, uncertainty about a problem may indicate the

need for more, or less, action to address it, depending on

the nature of the unknowns (Webster, 2002). The amount

of appropriate action also depends on how riskaverse

people are—that is, how much they are willing to pay to

avoid an uncertain but costly outcome. The greater their

degree of risk aversion, the more people will be willing

to sacrifice today to reduce the likelihood of adverse

changes in climate.

Studies that explicitly account for uncertainty generally

recommend greater effort to avert climate change than

do analyses that do not account for it—mainly because

the studies include the longterm discount rate as an

uncertain variable.7

 However, the way those studies treat

uncertainty about the discount rate in effect simply applies

greater weight to future generations and therefore recom

mends more action. Because the issue of discounting is

mainly a distributional one, many analysts question

whether it should be treated as a matter of uncertainty in

the same sense that, say, the sensitivity of the climate to

carbon dioxide concentrations is uncertain.

Another area of uncertainty—often ignored in economic

analyses—involves the actions of governments in the fu

ture. Integrated assessments that conclude that only mod

est actions are called for today assume that policymakers

will in fact take morestringent action in the future, should

it prove prudent. However, governments may not be able

to commit themselves to increasingly stringent future poli

cies. That problem is part of a broader difficulty in ad

dressing longterm challenges: current generations have

few means to constrain the behavior of succeeding genera

tions.

Because of uncertainty and the long time frame involved,

climate policy will inevitably involve a sequence of deci

sions. At each stage, policymakers would determine a near

term plan, based on the information accumulated to that

date and composed of both research to further improve

knowledge and action to reduce risk. The information

uncovered during the succeeding period would set the

stage for the following round of decisionmaking.

Because better information can help policymakers make

better choices, there are likely to be benefits to conducting

climaterelated research and developing technological

options to reduce the cost of controlling emissions. One

6. Climate policy involves a degree of irreversibility in both mitigation

and impacts. On the one hand, expensive investments to reduce

emissions will be impossible to recoup if warming proves modest

or largely beneficial. On the other hand, emitted greenhouse gases

are likely to be difficult to withdraw from the atmosphere if

warming proves to be very damaging.

7. An analysis of climaterelated uncertainty can be found in

Nordhaus (1994); two analyses that expand on that work are Pizer

(1997) and Newell and Pizer (2001). Because small changes in

the discount rate can significantly shift the balance of current and

future values, uncertainty about the discount rate dominates those

analyses. Under the studies’ assumptions, costs and benefits would

be balanced by imposing an international charge on greenhouse

gas emissions of roughly $15 to $20 per metric ton of carbon

equivalent (in today’s dollars) and raising the charge gradually over

time. That estimate is nearly double the estimated charge when

uncertainty is not taken into account. Evidence from a wide variety

of estimates of mitigation costs suggests that such a charge would

reduce global emissions by roughly 4 percent (Lasky, forthcoming).
CHAPTER THREE THE ECONOMICS OF CLIMATE CHANGE 33

recent analysis estimated that the potential benefits of

research to reduce uncertainty about the risks of climate

change could total roughly $1 billion to $2 billion per year

in 1990 dollars ($1.3 billion to $2.6 billion in 2002 dol

lars).8

 About half of those benefits of research would come

from better information about the value of damages from

different amounts of climate change. Another quarter

would come from better information about how much

it would actually cost to reduce emissions. Relatively little

of the total benefit would come from better information

about future growth of the global population or particular

nations’ economies, or about the functioning of the cli

mate system.

Other studies suggest that research to accelerate the devel

opment and deployment of lowemissions technologies

might yield net benefits, given the current range of

uncertainty about future technological advances (see, for

example, Papathanasiou and Anderson, 2001). The bene

fits would flow from lowering the cost of such tech

nologies and thus making the transition to nonfossil en

ergy less expensive than it would otherwise have been if

potential damages from climate change had turned out

to be large.

Distributional Issues

Crafting climate policy involves not only balancing costs

and benefits but also distributing them—within and

among countries, regions, and generations. Policies that

balance overall costs and benefits do not necessarily bal

ance them for every person, and policies that maximize

the net benefits to society do not necessarily provide bene

fits to each individual. A policy may yield positive net

benefits by causing both very large aggregate losses and

only slightly larger aggregate gains.9

Distributional concerns are at the heart of much of the

controversy about climate policy. For example, imposing

controls on emissions today would cut coal mining com

panies’ profits but would benefit manufacturers of solar

energy equipment. Preventing climate change in the future

might greatly benefit countries at very high risk of damage

but might actually hurt countries that stood to gain from

a warmer climate. Similarly, emissions control policies

would impose costs on people today and yield benefits

to people in the future.10

Issues Among Generations 

Acting to prevent climate change today would place a bur

den on people now alive and would probably leave coming

generations with a climate more similar to today’s—but

with somewhat less wealth—than they would have had

otherwise. In contrast, not acting would benefit people

today and probably yield somewhat more wealth in the

future—but it might also leave the world with a different

and possibly worse climate for many generations to come.

Choosing among policies is not purely a matter of bal

ancing costs and benefits but also a question of how to

distribute the benefits of energy consumption, land use,

and climate among generations. Policy recommendations

from the integrated assessments described earlier are very

sensitive to such intergenerational choices. (Howarth,

2001, provides an example of an integrated assessment

that explicitly considers intergenerational equity.)

Instead of restricting emissions, current generations could

address these distributional concerns by making additional

capital investments to benefit future generations, with the

intention of offsetting potential future damages from cli

mate change or of compensating future generations for

8. Nordhaus’s and Popp’s analysis (1997, pp. 147) measures only

the expected benefits of research and not what the required studies

would cost.

9. In studying economic problems, economists seek policies that will

improve economic efficiency—that will make at least one person

better off without making anyone worse off. Such policies are

termed Pareto improvements. However, many policy proposals

whose net benefits exceed their net costs also have substantial

distributional effects. That is, the improvements are worth more

than the losses, all told, but some people are made worse off even

while others are made better off. Economists refer to such policies

as potential Pareto improvements: in principle, the winners could

compensate the losers for their losses and still be better off. Such

a policy passes a standard costbenefit test but could still make

many people worse off unless it also provided for their compen

sation.

10. Gradually rising emissions taxes or permit prices would also effec

tively imply a particular distribution of emissions rights across gen

erations.
34 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

those damages. However, because of uncertainty about

the kind of damages climate change would cause, it is un

clear whether (or how much) more capital would be neces

sary—or useful—to offset them. Also uncertain is whether

intervening generations would pass the additional re

sources on to subsequent generations or consume the re

sources themselves.

Concerns Within and Among Countries

Dealing with the issue of climate change is likely to involve

difficult decisions about distributing costs and burdens

within countries. Some workers and industries—coal pro

ducers, electric utilities, and others—would probably bear

a disproportionate share of the burden of restrictions on

domestic emissions, as would the regions of a country that

produced fossil energy. (The Congressional Budget Office

discusses issues of equity in domestic climate policy in its

2000 report on carbonallowance trading.)

Distributional concerns also dominate discussions of inter

national climate policy and are likely to play at least as

important a role in its development as the balancing of

costs and benefits will. Policymakers in many developing

countries emphasize that developed countries are respon

sible for the bulk of historical emissions and that many

developing countries are apparently more vulnerable to—

and less able to cope with—the more damaging effects

of climate change. Such leaders tend to argue that devel

oped countries should not only shoulder any nearterm

burden of reducing emissions but also compensate devel

oping countries for climaterelated damages. They also

tend to be skeptical of arguments that favor balancing net

economic costs and benefits, recognizing that such rea

soning may be used to gloss over both distributional issues

and disparities in impacts.

In contrast, other policymakers in both developed and

developing countries tend to be less concerned about

climaterelated issues because they believe that their

nations are not particularly vulnerable to potential changes

in climate or will be able to adapt to whatever changes may

occur.
4

Trade-Offs Among Policy Options

Governments may respond to the challenge that

climate change poses by adopting a “waitandsee” ap

proach or by pursuing research programs to improve

scientific knowledge and develop technological options,

regulating emissions, or engaging in a combination of

research and regulation. Should policymakers decide to

act, they can choose from among a wide variety of ap

proaches to regulate emissions and encourage the develop

ment of lowemissions and emissionsremoval technolo

gies.

Several characteristics of greenhouse gases make it possible

to lower the costs of regulation by allowing for a great deal

of flexibility in controlling emissions. Different greenhouse

gases, measured in metric tons of carbon equivalent, have

essentially the same effect on climate; they mix uniformly

throughout the atmosphere and will only gradually affect

the climate as they accumulate over time. Consequently,

which gas is controlled and where—and, to some extent,

whether a given reduction in emissions occurs this year

or next—are immaterial. That principle is often referred

to as “what, where, and when” flexibility in discussions

of climate policy.

Governments could control greenhouse gas emissions in

a variety of ways. Under direct commandandcontrol regu

lation, the government could specify the types of equip

ment and technology that may be used, or it could specify

energyefficiency or emissions standards for buildings,

vehicles, and equipment. Alternatively, the government

could impose emissions taxes or fees, which would dis

courage emissions by increasing their cost. It could also

directly control emissions through a system of emissions

permits, or allowances, that would strictly limit the total

quantity of emissions.

Another option combining elements of taxes and permits

would be a hybrid permit system under which the govern

ment allocated a fixed quantity of permits but sold an

unlimited number of additional permits at a set “trigger”

price. In such a system, if the cost of reducing emissions

rose above the trigger price, emitters would simply buy

additional permits rather than reduce emissions further.

The system would thus cap the incremental cost of emis

sions at the trigger price—acting, in effect, like a tax.

Although U.S. environmental regulations are largely of

the commandandcontrol type, most economists agree

that as a general rule, taxes or permits—loosely termed

“marketbased” systems—can control emissions while

offering greater flexibility and lower costs. In contrast to

direct controls, marketbased systems give firms and

households stronger incentives to find lowcost ways to

reduce emissions through behavioral changes and inno

vative technologies.

In the case of carbon dioxide emissions from the burning

of fossil fuels, the most direct approaches would involve

taxes or permits based on the carbon content of fossil

fuels.1

 Under either system, fossil fuel suppliers—pro

1. The quantity of carbon dioxide emitted is directly proportionate

to the carbon content of fuels and is therefore easy to measure.

Carbon taxes fall most heavily on coal, which is composed almost

entirely of carbon; they fall somewhat less heavily on petroleum

products and least heavily on natural gas because those fuels also

contain hydrogen. An emissions tax of $100 per metric ton of

carbon equivalent translates to roughly $50 per short ton of coal,

25 cents per gallon of gasoline, and $1.50 per thousand cubic feet

of natural gas. Other taxes on fuels—for instance, ad valorem (or

valueadded) taxes in proportion to sales prices or energy taxes in

proportion to the energy content of fuels—would not be targeted

CHAPTER
36 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

ducers and importers of coal, oil, and natural gas—would

have to pay taxes or acquire permits in proportion to the

carbon content of the fuel they sold. Such systems would

be relatively simple to administer, monitor, and enforce

if they were applied at the point of import or first sale

because relatively few companies actually import or

produce fossil fuels. The system would impose price in

creases or restrictions on output that would filter down

the distribution chain, but it would avoid the administra

tive difficulties of a system that directly taxed “down

stream” retailers and consumers.2

The relative ease of regulating energyrelated emissions

contrasts with the difficulties of regulating emissions from

most other sources, particularly the substantial fraction

that originates from forestry and farming. Because those

other emissions come from many different kinds of mainly

small sources under highly variable conditions, they tend

to be much more difficult to track and measure. Although

some such emissions could be regulated in a costeffective

manner (Reilly, Jacoby, and Prinn, 2003), controlling

those sources would generally require different and varying

approaches. That could complicate the regulatory process

and might easily swamp the relatively low engineering

costs of controlling some nonenergyrelated emissions.

For instance, carbon emissions from fossil fuels could be

partly offset by paying landowners to plant trees to absorb

and sequester carbon, thus reducing net emissions. Some

tree planting is already supported for other purposes, such

as soil conservation, and expanding those policies would

be relatively straightforward. However, for the purposes

of carbon sequestration, such policies are complicated by

issues that do not arise in regulating fossil fuels. They

include the costs of monitoring tree growth to determine

how much carbon is absorbed and the difficulty of deter

mining whether landowners would have grown the trees

anyway. Another complicating factor is how sequestration

activities might ripple through markets and affect carbon

flows on agricultural and forest land not dedicated to

sequestration. For instance, a decision to set aside a certain

amount of forest for sequestration might lead to another

area of forest being cleared that otherwise would have

remained untouched. In that case, the carbon sequestered

in the setaside area would simply be offset by clearing

elsewhere.

Taxes and Permits: Similarities

and Differences

Taxes and permits affect a regulated activity in similar

ways as long as people can buy and sell the permits on

open markets. A tax on the carbon content of fuels directly

raises the price of those fuels for the end user; a strict per

mit system indirectly raises the price by reducing the

quantity of fuel that suppliers can sell. (As noted earlier,

a fixedprice permit system works like a tax.) Either way,

higher prices lead people to reduce their fuel consumption

and thus their emissions. So for any level of emissions

restrictions in a permit system, there is a corresponding

tax level that will achieve the same purpose. In principle,

both approaches should lead to identical levels and prices

of emissions.

In practice, however, uncertainty about the costs and

benefits of restricting emissions can greatly influence the

relative costeffectiveness of the two approaches. The gov

ernment could impose a tax, expecting some level of re

duced emissions; but emissions could end up higher or

lower than it expected. Likewise, the government could

impose a permit system with a cap on emissions and ex

pect a given cost for meeting the cap; but that cost could

end up being much higher or lower. And in either case,

the price might not be consistent with the uncertain

benefits of mitigating climate change. Which system is

preferable depends on which type of uncertainty is the

greatest and how rapidly costs rise—and benefits fall—as

the government tightens restrictions on emissions.

Some research indicates that climaterelated uncertainty

gives an emissions tax (or fixedprice permit system) sig

nificant economic advantages over a system of strictly fixed

permits, or allowances. Those advantages stem from two

factors: both the costs and benefits of reducing carbon

specifically toward the carbon content and would therefore be

somewhat less costeffective in discouraging carbon emissions.

2. The characteristics of such emissions permit systems are discussed

in greater detail in two studies published in 2000 and 2001 by the

Congressional Budget Office. Another CBO study, published in

2002, discusses the relative merits of different approaches to

regulating gasoline consumption, including a carbon tax.
CHAPTER FOUR TRADE-OFFS AMONG POLICY OPTIONS 37

emissions are uncertain, and the incremental costs can be

expected to rise much faster than the incremental benefits

fall as regulation becomes more restrictive. Because climate

change will result only from the longterm buildup of

gases over many years, incremental benefits are essentially

flat in any given year; that is, the incremental benefits of

the millionth ton of carbon reduced are essentially the

same as those of the billionth. In contrast, the incremental

costs of reducing emissions are likely to rise sharply the

more emissions are constrained.3

 Thus, choosing to strictly

limit the quantity of emissions could prove very expensive

compared with the potential benefits, but choosing to

impose a tax whose level reflected the expected benefits

probably would not. A pricing system—of either taxes

or fixedprice permits—is therefore likely to constrain

emissions more costeffectively than will a system with

fixed limits on emissions.4

The Distributional Effects of Regulation

Regulatory systems generally create winners and losers,

even when the benefits of less pollution are ignored. Bal

ancing the distributional effects of such systems can be

more complicated and controversial than balancing their

costs and benefits. Economic analysis provides several

useful insights about the distributional issues involved in

regulating greenhouse gas emissions.5

Regulations Impose Costs

Regulations come with a price: one way or another, some

one ends up paying for the environmental benefits they

may generate. Households and firms, for instance, may

have to make do with less energy, paying higher prices

either directly or indirectly (in the form of lower wages,

salaries, and profits)—or both.

Some analysts have argued that the regulation of energy

markets might not be costly because energy conservation

pays for itself. According to that point of view, people fail

to use energy efficiently, either because they do not make

sensible decisions about energy use or because they are

poorly informed, or because they face a variety of market

failures or barriers that deter them from making more

sensible decisions or becoming better informed. Propo

nents of that view believe that the government may be able

to regulate energy use and emissions at a net savings to

the economy by providing information, overcoming

market barriers, and correcting market failures—for ex

ample, by including energyefficiency requirements in

standards governing buildings and appliances—and that

the resulting energy savings may more than pay for the

additional costs of moreefficient equipment.6

Although energy markets do not necessarily function with

textbook perfection—for instance, energy use produces

pollution, the electricity distribution system is largely

composed of regulated monopolies, and the electricity

industry remains heavily regulated—neither are govern

ments always able to correct energy market failures with

out imposing other costs that offset or even exceed the

savings that the corrections might achieve. For example,

inefficient electricity consumption is sometimes the result

of regulations that are intended to prevent monopoly

behavior by utilities. Nevertheless, governments may be

able to intervene in some circumstances—for instance,

by setting standards in markets in which reliable product

information is hard to obtain or in situations in which

specific regulatory failures may constrain businesses and

households from making the most costeffective capital

3. In technical terms, price controls dominate when the marginal cost

curve is steep or very uncertain and the marginal benefit curve is

flat; quantity controls dominate when the marginal cost curve is

flat or well understood and the marginal benefit curve is steep.

A permit system would be more appropriate than a tax system if

the unit cost of reducing emissions was relatively constant while

the incremental damages from emissions increased very quickly

with rising emissions levels. Weitzman (1974) and Pizer (1997,

1998, 1999) discuss these issues in more detail.

4. The balance could shift in favor of a strict permit system if

technological advances made large reductions in emissions possible

at a low unit cost that was more or less fixed.

5. Congressional Budget Office (2000) discusses the distributional

impacts of different control policies for greenhouse gases.

6. Sutherland (2000, pp. 89112) examines the differences between

this “energy conservation” view and that of mainstream economics.

A recent report from the energy conservation standpoint, prepared

by five U.S. Department of Energy national laboratories, can be

found in Interlaboratory Working Group (2000). The Energy

Modeling Forum, in a 1996 report, offers a comprehensive

discussion of the difficulties of identifying and measuring market

failures and barriers in the energy sector.
38 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

investments. Economists find it difficult, however, to

determine the circumstances in which standards clearly

induce people to reduce their use of energy at no cost or

with net savings.7

Consumers Bear Most of the Direct Costs

in the Long Run

Producers who are required to pay a tax will not neces

sarily bear the burden of the tax if they can pass it on to

others. Characteristics of the markets for fossil fuels would

enable producers to pass on most of the costs of emissions

taxes—or the burden of higher prices under a permit sys

tem—to consumers.8

Nevertheless, producers would still bear some of those

costs in the short run. And many firms and workers in

the energy sector—coal mine operators and miners, oil

companies, and electricity producers that rely on fossil

fuels for generation—would bear a disproportionate

burden in lost profits and wages. (In the oil sector, how

ever, foreign oil producers would probably bear a signifi

cant portion of those losses.) So would companies and

workers in energyintensive industries such as petroleum

refining, primary metals, chemicals, and paper.9

 In con

trast, alternative energy suppliers would tend to benefit

from higher demand for their products, as would natural

gas producers (since natural gas contains much less carbon

per unit of energy than coal does).

Regulations and Taxes Have Substantial

Distributional Effects

A third important insight is that the distributional conse

quences of pricing and permit systems can be very large

compared with their costs and benefits. Whenever the gov

ernment restricts something of value, people will bid up

the market price in trying to obtain it. The difference be

tween the supply, or production, price and the higher

market price is known as a scarcity rent.

If the government restricts emissions by imposing a tax,

it will receive the scarcity rent as tax revenues. By contrast,

if it imposes a permit system and gives the permits away,

the permits’ recipients will receive the scarcity rents as

higher profits—because they can either charge higher

prices for the fuel they sell or sell the permit. The income

received as tax revenue or scarcity rents can be many times

larger than the net efficiency loss.10 One important conse

quence of that fact is that efforts to restrict emissions may

encourage the affected parties to seek regulatory provisions 7. In recent years, the U.S. government has tried to restrain the

growth of emissions through a system of voluntary programs that

attempt to identify opportunities for lowcost or costless emissions

reductions and to promote them in the private sector. However,

the programs have not been very successful in controlling emissions.

For example, the Climate Change Action Plan developed in 1993

by the Executive Office of the President projected that voluntary

programs would nearly stabilize U.S. greenhouse gas emissions at

1990 levels in 2000. (The plan is available at www.gcrio.org/

USCCAP/toc.html.) In fact, emissions were roughly 12 percent

higher in 2000 than they had been at the beginning of the decade.

The plan’s failure was due in part to unexpectedly high levels of

economic growth and low energy prices. Nevertheless, the voluntary

programs’ successes are very difficult to evaluate because it is nearly

impossible to determine what businesses and households would

have done in the absence of the program. Welch, Mazur, and

Bretschneider (2000) present a rigorous study that concludes that

one such program had relatively little effect on emissions. 

8. The supply of fossil energy is fairly elastic: for example, coal sup

pliers can easily raise or lower their production in response to small

changes in coal prices. Moreover, demand for fossil energy is fairly

inelastic because currently there are few cheap, plentiful substitutes

for it. Inelastic demand and elastic supply together imply that

energy producers can pass on taxes to consumers.

9. The Department of Energy (1997) notes that those four industries

accounted for about 22 percent of manufacturing gross product

originating in 1994 but 78 percent of manufacturing energy use.

Yuskavage (1996) also treats this issue; updated data can be found

at www.bea.doc.gov/bea/dn2/gpo.htm.

10. Tax revenues equal total emissions under the tax times the tax,

whereas the net economic costs from the tax (called the efficiency

loss, or the deadweight loss) are roughly onehalf the tax times the

reduction in emissions. A higher tax raises more revenues, but it

reduces emissions even more; so the income loss rises faster than

the tax revenues, and the ratio of revenues to income loss declines.

For example, based on the analysis of the potential costs of the

Kyoto Protocol by Lasky (forthcoming), a reduction of 5 percent

in U.S. carbon dioxide emissions in 2010 would involve direct costs

of just over $1 billion but would raise almost $50 billion in reve

nues. However, a reduction of 15 percent would cost $12 billion

(10 times as much) and raise over $150 billion in revenues (less

than four times as much); a reduction of 30 percent would cost

almost $60 billion and raise $330 billion in revenues. In those

examples, tax revenues (or permit values) are between six and 40

times the direct costs.
CHAPTER FOUR TRADE-OFFS AMONG POLICY OPTIONS 39

that provide them with tax exemptions or access to per

mits—that is, they may engage in rentseeking behavior.

For example, fossil fuel suppliers might advocate a system

in which they were given emissions permits free of charge

—so that they would receive the entire scarcity rent re

sulting from the emissions limits.

Distributional Effects Depend on How the

Government Regulates Emissions

Under a system of taxes or auctioned permits, the govern

ment would receive revenues, and it could redistribute

some of them in various ways—by cutting other taxes,

reducing government debt, or funding new programs.11

Each method of “recycling,” or returning revenues to the

economy, would benefit different groups of consumers

and suppliers in different ways. Some of those approaches

could offset some of the costs of regulation but probably

not all of them.

The case of permits is more complicated than that of taxes

because permits can be distributed in different ways: the

government could auction them and receive revenues, it

could give the permits away, or it could use a combination

of the two approaches.12 Auctioned permits are similar

to emissions taxes in their distributional effects.13 In

contrast, freely allocated emissions permits would greatly

benefit their recipients, who could reap profits from the

nowscarce right to sell fossil fuels (while passing on most

of the costs to fuelconsuming businesses and households)

or from the sale of permits to a fuel supplier. One possible

approach to a permit system, known as grandfathering,

would be to give all the permits to fossil fuel suppliers in

proportion to their historical sales. Another method would

be to distribute permits free to households and require

that fuel suppliers buy them. Suppliers would then include

the cost of the permits in the price of fuel. That approach

would spread regulatory costs more evenly across the

population but would also involve high transaction costs.

Alternative Uses of Revenues

Most government revenues are collected from income,

payroll, and sales taxes, which tend to distort taxpayers’

behavior by discouraging people from working or saving.

The government also uses tax incentives to encourage

certain types of activities—for example, home ownership,

through the home mortgage interest deduction. Such

subsidies distort households’ and businesses’ behavior by

encouraging greater spending on taxfavored goods and

services, relative to spending on other items. In economic

terms, taxes and tax incentives impose significant losses

of economic efficiency.14

In contrast, emissions restrictions are intended to correct

existing market failures—and thus improve economic effi

ciency—by discouraging harmful emissions. (When those

restrictions take the form of taxes, they are referred to as

Pigouvian taxes.) Of course, the restrictions also discour

age productive activity to some degree and so impose a

direct cost on the economy. However, if the restrictions

11. Not all of the revenues from an emissions tax would be available

for redistribution. The tax would curb economic activity, reducing

other tax revenues and raising government spending for income

related programs. The tax would also raise the government’s costs

for purchasing fossil energy and energyintensive goods. As a conse

quence, some emissions tax revenues would be needed to cover

higher spending and lost revenues from other taxes. However,

emissions tax revenues would generally be greater than policy

induced increases in government expenditures and revenue losses

from other taxes, so net government revenues available for redis

tribution would rise.

12. Regarding auctions of permits for greenhouse gas emissions,

Crampton and Kerr (1998) show that a standard ascendingclock

auction is the most effective system to ensure that all bidders pay

a uniform price that reflects the market value of the standard emis

sions permit. Under that kind of system, the auction would begin

at a low asking price, and in each succeeding round, the price would

rise and bidders would reveal the number of permits they wanted

to buy at that price. The process would continue until the number

of permits demanded was exactly equal to the number being

auctioned.

13. Even if the government gave permits away, it would collect some

revenues because permit recipients would pay taxes on their higher

income. However, the government would also lose revenues from

other taxes and would spend more on transfers, fossil energy, and

energyintensive goods.

14. Congressional Budget Office (1996) and Gravelle (1994) examine

the distorting effects of taxes on labor supply and on saving and

investment, respectively.
40 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

were set at an appropriate level, their cost would be bal

anced by the benefits of lower levels of emissions.

But there is a catch: emissions controls—be they taxes,

permits, or oldfashioned commandandcontrol regula

tions—also interact with the existing tax system and tend

to aggravate its distortions. For instance, emissions restric

tions would raise the prices of energyintensive products,

thus lowering real (inflationadjusted) wages and further

discouraging people from working. Through that sort of

tax interaction effect, any regulation that raised the prices

of products and lowered income would also impose

additional, hidden costs by enhancing the distortions

caused by the existing tax system. The more distortionary

the existing system, the larger the interaction effect—and

the higher the hidden costs—tend to be.15

However, policymakers could offset at least part of the

interaction effect by using the revenues from the emissions

tax (or auctioned permits) to reduce the marginal rates—

the rate on an additional dollar of taxed activity—of some

existing distortionary taxes.16 Some analysts (for example,

17

Jorgenson and Goettle, 2000, and Shackleton and others,

1993) argue that emissions taxes could even yield a

“double dividend” of fewer emissions and more output

if the revenues were used to eliminate particularly distor

tionary taxes in the current code—especially taxes that dis

courage saving and investment.17 The existing research

on the question is not definitive, however.

Emissions restrictions that raised revenues, coupled with

reductions in distortionary marginal tax rates, would im

pose significantly lower economic costs than emissions

controls would in two circumstances: if the controls did

not raise revenues (as in the cases of commandandcontrol

regulations or freely allocated permits) or if they returned

revenues to the economy in ways that did not reduce dis

tortionary marginal rates. Policymakers would face a trade

off between using such revenues to offset some of the

distributional effects of emissions controls (by making

payments to affected producers and consumers) and using

the revenues to offset some of the controls’ effects on eco

nomic efficiency (by reducing marginal tax rates). As a

general rule, policymakers cannot fully achieve both goals.

These points are true for any sort of regulation, but they

are particularly applicable to climate change policy because

greenhouse gas regulations could involve so much money.

The United States alone emits roughly 1.5 billion metric

tons of carbon annually, so every dollar of tax per mtc

would raise up to $1.5 billion per year. A carbon tax of

$100 per mtc would raise about 15 percent as much reve

nue as the individual income tax and nearly 80 percent

as much as the corporate income tax. Those large amounts

suggest that some of the revenues from a carbon tax could

be used to finance cuts in marginal income tax rates.

Emissions could also be reduced by eliminating subsidies

and tax incentives that encouraged the production and

consumption of fossil fuels or that encouraged deforesta

tion. In the United States, such subsidies and incentives

are fairly modest, and removing them would have rela

tively little impact on emissions (Congressional Budget

Office, 1990).18 But many developing countries heavily

15. For discussions of the tax interaction effect, see Congressional

Budget Office (2001), Parry (1997, 2002), Parry and Bento (1999),

Parry and Oates (1998), and Parry, Williams, and Goulder (1996).

16. That “revenue recycling” effect could be particularly strong in the

presence of tax incentives such as the home mortgage interest

deduction (see Parry, 2002). However, as discussed in Babiker,

Metcalf, and Reilly (2002), if the existing tax system was sufficiently

distortionary, some forms of revenue recycling might actually en

hance the interaction effect, so that the negative economic effects

of the emissions tax would actually outweigh the positive environ

mental benefits.

17. Proponents of the “strong” version of the hypothesis argue that

substituting appropriately set environmental fees for existing taxes

would more than offset the tax interaction effect and thus improve

both the environment and the economy. Proponents of the “weak”

version argue that such a substitution would offset at least part of

the tax interaction effect. The potential for a double dividend de

pends mainly on the distortions of the existing tax system and is

thus more a statement about the existing system than about the

benefits of emissions taxes. In principle, policymakers could also

reduce the existing system’s distortions by replacing it with other,

less distortionary taxes. That alternative would tend to lower the

potential for a double dividend from an emissions tax.

18. Using a conservative definition, the Department of Energy’s Energy

Information Administration (1992, 2000) estimates that federal

subsidies and tax incentives to the energy sector amounted to about
CHAPTER FOUR TRADE-OFFS AMONG POLICY OPTIONS 41

subsidize energy use and land development. In those

economies, the elimination of subsidies might lead to both

reduced emissions and higher output.

Proposals for emissions taxes sometimes include a provi

sion that the revenues be used for environmental purposes,

such as an investment tax credit for energyefficient equip

ment. Some studies suggest that such tax credits are con

siderably more effective than equivalent energy price

changes in encouraging users to purchase such equipment,

perhaps because purchasers focus more on upfront capital

costs than on longerterm operating costs or because they

are more uncertain about longerterm costs (see Jaffe,

Newell, and Stavins, 2000, pp. 5152 and 63).

However, such tax credits also have disadvantages. An

emissions tax is intended to signal polluters to cut emis

sions; in effect, a tax credit for abatement distorts that

message. Tax credits can cost the government a great deal

per unit of reduced emissions, since purchasers who would

have bought the equipment even without the credit receive

it, too. Taken together, the literature on environmental

taxation and revenue recycling suggests that using revenues

from emissions taxes to finance a general reduction in taxes

on all sorts of investment would be more costeffective

than using them to target investments for environmental

purposes (Oates, 1992; and Baumol and Oates, 1988).19

Regulation and Innovation

To a great extent, the cost of controlling greenhouse gas

emissions and stabilizing atmospheric concentrations will

ultimately depend on technological developments over

the next century. Innovation that dramatically reduces the

cost of producing energy from nonfossil sources or of

sequestering carbon dioxide emissions will ease the process

of controlling emissions; innovation that tends to reduce

the cost of finding, extracting, and using fossil fuels will

complicate it.

Although technological innovations over the long run are

impossible to predict with any reliability, relative energy

prices have influenced the direction and pace of research

and development (R&D). For instance, when energy

prices rose in the 1970s, not only did people use less en

ergy and install more energyefficient capital goods but

businesses shifted resources into the development of

energyefficient equipment, moreefficient ways of finding

and extracting fossil fuels, and alternative energy sources

(Newell, Jaffe, and Stavins, 1998; Jaffe, Newell, and

Stavins, 2000; and Popp, 2001).20

Emissions controls that raised the prices of fossil fuels

would be likely to have somewhat similar effects, tending

to redirect R&D efforts from finding more fossil fuels to

improving energy efficiency, developing alternative sources

of energy, and removing greenhouse gases from the atmo

sphere. Over time, those efforts would tend to lower the

incremental cost of controlling emissions, reducing the

tax (or permit price) needed to achieve a given emissions

target and inducing more reductions at a given tax rate.

Moreover, emissions controls are likely to induce more

innovation if they exact a payment from emitters, as emis

sions taxes and auctioned permits do. In contrast, com

panies would have less incentive to innovate under a sys

tem of freely allocated permits—and even less under a

commandandcontrol regulatory system.21

Although the inducement effect would tend to lessen the

incremental costs of controlling emissions, analysis sug

gests that such benefits would be offset to some extent by

the costs of research and development (Goulder and

Schneider, 1996). Some of the resources used to finance

R&D projects would simply be redirected from the fossil

$7.3 billion in 1992 and $6.2 billion in 1999 (both in 1999 dol

lars)—or roughly 1 percent of total energy expenditures. Applying

a much broader definition, a study funded by the Alliance to Save

Energy and reported by Koplow (1993) estimates that subsidies

in 1989 totaled from $21 billion to $36 billion in 1989 dollars—or

from 5 percent to 8 percent of total energy expenditures.

19. Gravelle (1994, Chapter 5) provides a broader discussion of the

costeffectiveness of investment tax credits.

20. Some research—for example, Nordhaus’s 1997 study—suggests

that the innovation inducement effect of higher energy prices will

not be very large, compared with the more basic inducement to

substitute capital and labor for energy.

21. Under certain circumstances, which are discussed at length in

Fischer, Parry, and Pizer (1998), freely allocated permits may

induce more innovation than taxes or auctioned permits. However,

the case of climate change does not involve such circumstances.
42 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

fuel sector, but some would probably be redirected from

other economic activities.

Basic research is often considered to be a public good.

Private firms have relatively little incentive to undertake

basic scientific research on the functioning of the climate

or on the costs and benefits of averting climate change

because they cannot easily reap profits from the wide

spread, longterm public benefits of learning about or

averting such change. Nor does industry have sufficient

incentive to develop lowemissions and emissionsfree

energy technologies as long as the prices of fossil fuels do

not reflect the potential costs of the damages to the climate

that fossil fuel use may cause. Because of the disparity be

tween private incentives and public benefits, the govern

ment may be able to play a useful role by investing in—or

encouraging private industry to invest in—basic and

applied R&D projects that will yield widespread public

benefits. However, constraints on emissions would tend

to enhance private incentives to undertake such projects

and weaken that rationale for governmentsponsored

research.

Ancillary Benefits of Greenhouse

Gas Restrictions

By reducing the use of fossil fuels, restrictions on green

house gas emissions would also reduce emissions of other

pollutants such as sulfur dioxide from coal burning and

nitrous oxide from automobiles. Those reductions, in

turn, could yield a variety of benefits such as improve

ments in health, visibility, and water quality. Thus, the

costs of mitigating emissions of greenhouse gases would

be partially offset by the ancillary benefits of reducing the

problems caused by conventional pollutants.

In the United States, some economic studies (for example,

Burtraw and others, 1999; and Burtraw and Toman,

1997) have found that ancillary benefits from modest

restrictions on carbon dioxide emissions in the electric

utility sector could offset a significant part of the restric

tions’ cost. Those side benefits would include lower costs

for complying with current and impending regulations

that restrict conventional air pollution, and healthrelated

benefits from reduced emissions of conventional pollutants

that are not already strictly controlled. Morerestrictive

limits on greenhouse gases could also lead to reductions

of conventional emissions beyond those already mandated,

yielding further ancillary benefits. However, the more

emissions were reduced, the smaller the share of total costs

that the ancillary benefits would offset—mainly because

the additional benefits from reducing conventional air

pollutants would decline while the additional cost of re

ducing carbon emissions would continue to rise.

In developed countries that already control pollution,

ancillary benefits from restricting greenhouse gas emissions

are likely to be similar to those found in the United States.

But in developing countries with extensive conventional

pollution problems that remain unaddressed, ancillary

benefits—such as improvements in people’s health—could

be significant.
5

International Coordination of Climate Policy

Because the causes of climate change are global,

the stabilization of greenhouse gas concentrations in the

atmosphere will ultimately require international coopera

tion. However, the nature of the climate problem will

make agreement difficult to reach. Nearterm, concen

trated costs of regulation combined with diffuse, long

term future benefits make it easy for countries to postpone

action. The scientific and economic uncertainty discussed

in earlier chapters also makes it difficult to reach a con

sensus about the appropriate response. Although nations

have found it relatively easy to agree to expand, coordinate,

and report climaterelated scientific and technological re

search, they have found it very hard to agree about whether

and how much to restrict the growth of greenhouse gas

emissions.

That lack of agreement may stem in part from uncertainty,

but it also reflects nations’ differing circumstances and

conflicting interests. Policymakers in countries vulnerable

to potential changes in climate favor dramatic action to

avert warming, while policymakers whose countries appear

to be less vulnerable are correspondingly less concerned.

Countries with significant fossilfuel production or high

levels of emissions tend to oppose policies that would re

strict the use of fossil fuels. Five countries (the United

States, China, Russia, Saudi Arabia, and Canada) produce

more than half of the world’s fossil carbon, and five coun

tries (the United States, China, Russia, Japan, and India)

account for about half of all fossil carbon consumption.

Thus, a small group of nations can strongly influence the

structure and effectiveness of any agreement related to

climate change.

But the fundamental differences at the global level are

between more and less affluent countries. Developed

countries have contributed the majority of historical

emissions, but countries that are now in the early stages

of development will account for the bulk of emissions over

the next century. Even so, on a per capita basis, developing

countries will continue to have much lower income and

levels of emissions than developed countries will have, and

they appear to be more vulnerable to damage from climate

change. As a consequence, policymakers in many devel

oping countries favor significant action to reduce global

emissions—but only by developed nations. Put another

way, they maintain that developed countries have already

used up a large portion of their rightful allotment of emis

sions and that developing countries now have a strong

claim to the bulk of emissions to be allowed in the future

—those that are unlikely to cause serious damage to the

climate.

Because of the global nature of the climate problem and

competing national interests, countries have little incentive

to act unilaterally to reduce emissions, and every nation

has an incentive to free ride and let other countries

shoulder most of the burden. As a result, the development

of effective coordination of international climate policy

is likely to be gradual, as was the 50year process that

brought the World Trade Organization to its current

form.

International Policy Considerations

In addition to considering the nature of the climate change

problem and the distribution of interests, policymakers

CHAPTER
44 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

who seek to foster effective international coordination may

draw from a wide range of past experience in the design

and implementation of international environmental and

other treaties, and of domestic regulatory systems as well.

Some of the factors to be considered are purely inter

national in scope. Other factors, which have been dis

cussed in previous chapters, are common to domestic and

international regulatory systems alike.

Cooperation among sovereign, independent nations can

involve a variety of formal structures. Governments can

agree to formal treaties, which are considered binding

instruments under international law; or they can agree to

less rigorous, nonbinding instruments—referred to as ex

ecutive agreements in the United States—that serve as

guidelines to action rather than as legal requirements.1

Cooperation can range from modest commitments to

share information and undertake coordinated research,

to more extensive agreements to restrict emissions, moni

tor compliance, and enforce penalties.

Several other institutional considerations can influence

the effectiveness of international agreements (Victor and

others, 1998). Such agreements tend to be more effective

when they:

• Encourage relatively frequent interaction and extensive

sharing of information among national delegates; 

• Help link the solutions of related problems, such as

climate change and energy security or climate change

and biodiversity;

• Give countries incentives to continue to participate

even if other countries refuse to;

• Allow new countries to enter with relatively little effect

on the system; and

• Distribute the cost of the response in a way that is

acceptable to participating countries.

Regulatory Approaches

To regulate the global growth of emissions, international

negotiators can draw on essentially the same set of options

as domestic policymakers can: commandandcontrol

regulations, emissions taxes or permits, or a hybrid system.

Negotiators would need to consider whether and how to

coordinate such policies among countries. Alternatively,

they might allow each country to choose an independent

system but still coordinate action in the form of agreed

upon national targets.

As Victor and others (1998) have noted, agreements are

more likely to succeed if they involve commitments that

are relatively straightforward to apply and enforce. Nations

may find it easier to commit to undertake research pro

grams than to adopt uniform technologies, complex regu

latory policies, or specific targets for emissions. Targets

may be particularly difficult to decide on or achieve in the

face of uncertainty about implementation costs.

Past international agreements have called for varying levels

of effort by different countries, but they have not usually

called for formally differentiated commitments. Instead,

countries tend to interpret their commitments in ways

that reflect their different national circumstances and

domestic goals. Given the complexities that policymakers

face in securing domestic political agreement about im

plementation, the more ambitious the commitments, the

more varied the implementations are likely to be.

Countries with relatively large absolute or per capita emis

sions, or with large fossilfuel industries, are likely to insist

on some degree of costeffectiveness before committing

themselves to restrictions on emissions—although political

and distributional considerations may lead nations to ig

nore costeffectiveness. An international commandand

control approach would be much more costly and difficult

to monitor and enforce than would other approaches and

is therefore unlikely to secure much backing.

Uniform international incentives are likely to be more

costeffective than countryspecific regulations because

every country has at least some lowcost opportunities to

reduce emissions, whereas the incremental cost of con

trolling emissions in any given country is likely to rise

steeply with increasingly tight restrictions. Developing

countries have particularly extensive lowcost opportuni

1. This distinction is particularly important in the United States,

where the terms of treaties, once ratified, take on the force of federal

legislation within the U.S. legal system. Under international law,

however, both types of agreements are considered binding.
CHAPTER FIVE INTERNATIONAL COORDINATION OF CLIMATE POLICY 45

ties, for several reasons: many of the costs of production

there tend to be relatively low; energy use is rarely taxed

and often subsidized; and energy efficiency is cheaper to

build into new infrastructure in developing industries than

to retrofit in industries in developed nations. Restricting

emissions in only a few countries—particularly developed

ones—would therefore significantly raise the cost of

achieving almost any global goal for emissions.

Differences between countries’ emissions control policies

can also lead to “leakage” of energy consumption—and

therefore emissions—from one country to another. For

instance, if only developed countries controlled emissions,

they would consume less oil. International oil prices would

fall in response, and developing countries would be able

to increase their oil consumption. Similarly, corporations

in emissionsintensive industries could simply reduce their

investments in countries with stricter controls and increase

their investments in countries with less strict or no con

trols, gradually transferring their production to them. That

potential leakage effect would raise the cost and reduce

the effectiveness of morerestrictive countries’ commit

ments.

Independent action would allow each country to tailor

policies to its national circumstances. But a system of inde

pendent approaches would still require international agree

ment about what constituted an acceptable degree of

action and of burden sharing. It would also be unlikely

to minimize emissions control costs, could lead to exten

sive leakage, and might present difficult problems in

monitoring and enforcement.

Much of the debate about international climate policy has

focused on national quotas, or allowances, for emissions.

Under such a system, nations would agree to allocate emis

sions rights in the form of strict limits, or caps. The limits

could apply to one, five, or 10year periods, or indefi

nitely; nations would be free to meet the caps by using

the domestic regulatory system of their choice. Some pro

posals would allow nations to trade emissions allowances.

That feature would tend to equalize permit prices—and

thus the incremental costs of mitigation—among partici

pating countries and result in the most costeffective

achievement of the overall emissions cap.

A system of quotas would make the international alloca

tion of rights transparent. If quotas could be enforced,

they would ensure that a strict emissions cap was met in

participating countries. Given a strict limit, the inter

national trading of emissions allowances could equalize

incremental costs, and the system would be relatively

straightforward to implement—at least it would be if it

was limited to carbon dioxide from fossil fuels—once

countries determined how to allocate emissions allowances

domestically.

However, an international cap on emissions could entail

unnecessarily high costs if the cap was tighter than was

warranted for balancing the overall costs and benefits of

averting climate change. That pitfall could be avoided by

implementing a hybrid permit system with a price cap

—but only at the cost of abandoning strict emissions

limits and clear emissions rights.

In contrast to quotas, a price mechanism—a system of

uniform emissions taxes or fixedprice permits—would

guarantee equal incremental costs for emissions controls

at a fixed price without requiring any international trading

of emissions allowances. Furthermore, as discussed in

Chapter 4, price mechanisms are likely to constrain emis

sions more costeffectively than strict quotas, given the

uncertainty about the net benefits of doing so.

But price mechanisms also present problems. A system

of taxes would not, by itself, address issues of international

burden sharing. And maintaining strictly uniform taxes

on emissions would be difficult in the face of fluctuating

exchange rates. Moreover, in negotiating a uniform price

mechanism, countries might want to consider the exten

sive variation in their existing energy taxes: even in the

absence of price or quantitybased controls, the effective

price of carbon from fossil fuels differs significantly among

countries and across fuels. Gasoline prices in western

European countries, for example, are about three times

higher, on average, than in the United States, largely be

cause of taxes. In contrast, gasoline prices in many devel

oping countries are lower. Countries that implicitly taxed

emissions through their gasoline levies might argue that

their existing systems constituted sufficient action and no

further efforts were necessary.
46 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

Compliance

International agreements are particularly difficult to moni

tor and enforce because the parties to them are sovereign

nations that tend to resist international oversight of do

mestic policies—and whose participation is ultimately vol

untary. Few international environmental agreements have

provisions for enforcement, and as a general rule, inter

national organizations lack the jurisdiction or the resources

to enforce them (General Accounting Office, 1999). To

many observers, binding treaties with penalties seem more

likely than nonbinding ones to ensure compliance, and

experience shows that nearly all countries do, in fact, fulfill

their binding commitments. However, given the uncer

tainty of politics and markets, governments cannot in

variably ensure that they will be able to meet such com

mitments. They generally do so, not because they would

face penalties for noncompliance but because they would

not have agreed in the first place to commitments that

they were unlikely to fulfill.

Some observers argue that for a problem as complex as

climate change, international enforcement would require

some form of penalty that involved trade and therefore

indirectly the World Trade Organization (WTO). Recent

decisions by the WTO have allowed nations to enforce

environmental rules by penalizing imports on the basis

of the processes used in their production (Victor, 2001,

pp. 8789). But some experts worry that entangling the

WTO in complex environmental issues could endanger

the international trade system.

Yet experience also shows that countries tend to be more

willing to adopt clear, ambitious commitments when those

commitments are nonbinding, especially when uncertainty

about costs makes nations unwilling to accept binding

agreements that they might not be able to fulfill. (Escape

clauses in binding commitments can perform the same

function.) Moreover, a nonbinding framework allows

subsets of countries to undertake deeper cooperation with

out excluding others from an agreement and promotes

learning by doing. The evidence thus suggests that in

practice, nonbinding agreements may significantly influ

ence behavior (Victor and others, 1998, p. 685).

Restrictions on greenhouse gases vary in the ease with

which emissions can be monitored and the limits on them

enforced. Under binding agreements, carbon dioxide

emissions from the use of fossil fuels would be relatively

easy to monitor, although in countries that had serious

problems with law enforcement and tax evasion, compli

ance with the established limits could be difficult to

achieve. For most other types of greenhouse gas emissions,

the high costs of monitoring would reduce the likelihood

of strict compliance—or even of accurate documentation

—in all countries.

International Institutions to Address

Climate Change

International cooperation to address the prospect of

climate change has been developing since 1988, when the

United Nations and the World Meteorological Organiza

tion created the Intergovernmental Panel on Climate

Change (IPCC) to collect information and report on

climaterelated issues. Shortly thereafter, negotiations

began on the United Nations Framework Convention on

Climate Change (FCCC), which was signed in 1992 and

subsequently ratified by nearly all the world’s nations. The

convention provides for a permanent standing bureaucracy

dedicated to coordinating international climate policy and

for a Conference of the Parties to meet roughly once a year

to review and reconsider countries’ commitments in light

of the most recent findings on climate change.

The FCCC commits its signatories to undertake extensive

research (to better understand the climate system) and to

stabilize atmospheric concentrations of greenhouse gases

at levels that would prevent dangerous climate change.

The convention calls for managing the global climate in

a manner that is both efficient and equitable, stipulating

that climaterelated policies should be costeffective, but

it also urges greater effort from a set of 35 developed

countries that are listed in the FCCC’s Annex I.2

 However,

the convention does not specify any targets for greenhouse

gas concentrations or a time frame for achieving stabiliza

2. Specifically, the document states that “policies and measures should

be costeffective so as to ensure global benefits at the lowest possible

cost. To achieve this, such policies and measures should take into

account different socioeconomic contexts, be comprehensive, cover

all relevant sources, sinks and reservoirs of greenhouse gases and

adaptation, and comprise all economic sectors” (United Nations,

1997, article 3, section 3).
CHAPTER FIVE INTERNATIONAL COORDINATION OF CLIMATE POLICY 47

tion. Nor does it commit any country to specific limits

on emissions or to specific actions to reduce emissions.

The Kyoto Protocol

After five years of international negotiations following the

FCCC’s adoption, the third Conference of the Parties

adopted the 1997 Kyoto Protocol to the convention. The

protocol calls for strict quantitative limits (or allowances)

on emissions from 38 developed countries—largely the

same ones listed in Annex I of the convention.3

 Those

complicated limits, which are specified in Annex B of the

protocol, are generally somewhat below the countries’

1990 emissions levels and are scheduled to take effect dur

ing the socalled First Budget Period, from 2008 to 2012.

NonAnnex B countries remain exempt from overall emis

sions constraints.

Under the protocol, countries are allowed a significant

degree of flexibility in meeting their commitments. Each

country may:

• Use any policies or technologies it prefers to meet its

targets;

• Achieve its overall target by reducing emissions over

a “basket” of six different greenhouse gases rather than

just reducing carbon dioxide emissions;

• Average its emissions across the entire fiveyear period

rather than meet a specific target every year;

• Earn a limited quantity of credits (that is, additional

allowances) for forestry and agricultural projects that

sequester carbon;

• Receive credits by financing emissionsreducing proj

ects in other Annex B countries through a process

called Joint Implementation;

• Receive credits by financing projects in nonAnnex B

countries through another process known as the Clean

Development Mechanism;

• Buy, sell, or trade emissions allowances to an undeter

mined extent; and

• Join with other countries to reduce emissions as a

group.4

The protocol explicitly mentions that countries should

pursue research and development programs but does not

require a specific level of expenditures.

To enter into force, the Kyoto Protocol must be accepted,

approved, acceded to, or ratified by at least 55 signatories

to the convention, including countries that together in

1990 accounted for at least 55 percent of total carbon

dioxide emissions from Annex I countries. In effect, the

provision means that the protocol must be ratified or ap

proved by either the United States or Russia, which to

gether accounted for over 50 percent of emissions from

Annex I countries in that year. It also means that a handful

of countries with high levels of emissions could, if they

acted together, effectively veto the protocol.

Subsequent Negotiations

The negotiations that followed those in Kyoto brought

a substantial shift in direction. Talks collapsed in 2000

over a dispute between U.S. and European delegates about

the use of international emissions trading and forestry pro

grams to meet their commitments, with the United States

arguing in favor of much greater flexibility than European

3. All of the countries listed in Annex B of the protocol are also listed

in Annex I of the FCCC; however, a handful of Annex I countries

are not in Annex B. The protocol specifies an annual limit on emis

sions, measured as metric tons of carbon equivalent for each An

nex B country. The limit is figured as a percentage of the country’s

baseyear emissions level. The base year is generally 1990, but

countries can choose 1995 as the base year for hydrofluorocarbons,

perfluorocarbons, and sulfur hexafluoride. In addition, former

Soviet bloc nations, under some circumstances, can choose an alter

nate base year for all gases. The specified limits are 93 percent of

baseyear emissions for the United States, 92 percent for the

countries of the old European Community, and 94 percent for

Japan. The countries of the former Soviet bloc have limits ranging

from 92 percent to 100 percent of their baseyear emissions levels.

Other Annex B countries have limits ranging from 92 percent to

108 percent of their baseyear emissions.

4. The countries of the European Union (EU), for example, intend

to meet their individual targets as a group, with some countries

reducing emissions by more than the amount required by their

targets to allow emissions to increase in other countries while still

meeting the overall EU cap.
48 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

countries would accept. In early 2001, the Bush Adminis

tration indicated that it would not continue to negotiate

the terms of the protocol or submit the protocol to the

Senate for ratification. Following the effective withdrawal

of the United States from the process, the other parties

decided to move ahead. In November 2001, they reached

agreement on nearly all outstanding implementation

issues, largely along the more liberal lines of interpretation

that the United States had originally advocated. (Without

U.S. participation to potentially drive up the demand for

emissions credits, the liberal interpretation allowed the

remaining parties to dramatically lower their likely imple

mentation costs; Babiker and others, 2002, provide a de

tailed discussion.) The European Union ratified the pro

tocol in May 2002, and Japan followed suit in June. As

of March 2003, 106 countries had ratified or acceded to

the protocol, and the ratifying countries accounted for

44 percent of the carbon dioxide emissions from Annex I

countries in 1990 (United Nations, 2003). Ratification

by Russia would bring the treaty into force.

Assuming ratification under the current terms of the pro

tocol, participating Annex B countries would probably

be able to meet their commitments at very little cost. They

would have two sources of lowcost emissions credits: they

could earn substantial credit for forestry projects, and they

could supplement reductions of domestic emissions with

purchases of emissions allowances and credits from other

countries. A few nations are expected to have substantial

amounts of surplus emissions allowances during the 2008

2012 period—particularly Russia and the Ukraine: their

emissions fell dramatically during the economic collapse

of the 1990s, and they have experienced substantial forest

growth. (The expected surplus is often referred to as “hot

air.”) Without U.S. participation to boost demand, the

remaining Annex B countries will be able to buy the sur

plus allowances and forestry credits at a low cost and meet

their commitments without undertaking extensive domes

tic emissions reductions.

The upshot of these developments—assuming ratification

and implementation by the remaining parties and full use

of the treaty’s many flexibility provisions—is that the pro

tocol will result in relatively few commitments to under

take research, a complex set of emissions caps for a limited

set of developed countries for the 20082012 period, fi

nancial transfers among the parties amounting to several

billion dollars per year for the purchase of emissions allow

ances, unlimited emissions rights for most countries, and

a very limited reduction in the growth of global green

house gas emissions.

Implementation Costs

The international negotiations surrounding the protocol

inspired a large number of analyses of the cost to the

United States of meeting its proposed commitments. Such

analyses are complicated by uncertainty about how the

details of implementation might have been negotiated in

an agreement that included the United States. In a recent

review of a number of studies, Lasky (forthcoming) has

estimated U.S. mitigation costs under three different sets

of implementation rules.

• Under moderately restrictive implementation rules—

that is, with some trading of emissions allowances

among Annex B countries and modest reductions in

emissions by nonAnnex B countries—Lasky estimates

that the United States could have met its Kyoto com

mitment in 2010 for an incremental cost ranging from

$44 to $245 per metric ton of carbon equivalent (in

2002 dollars) and an overall economic cost of between

0.4 percent and 1.5 percent of gross domestic product.

• Under a loose set of rules that permitted Annex B

countries to pay for large emissions reductions in non

Annex B countries and allowed extensive credit for the

net absorption of carbon dioxide by forests, the United

States would have been able to meet its targets at almost

no cost and with little effect on its economy.

• Under a very restrictive set of implementation rules

that prohibited international trading of emissions al

lowances or credits and permitted only limited credit

for forestry projects, the United States could have faced

incremental costs for emissions reductions ranging

from $171 to $297 per mtce. Annual tax revenues (or

the annual value of auctioned emissions permits) could

have totaled between $261 billion and $452 billion,

and the policy might have reduced GDP by nearly

2 percent.
CHAPTER FIVE INTERNATIONAL COORDINATION OF CLIMATE POLICY 49

Actions by the United States

Over the past 15 years, the federal government has made

substantial investments in research to understand the

global climate system and the potential effects of climate

change, and to subsidize the development of carbon

removal and alternative energy technologies. The United

States has also continued a variety of longstanding pro

grams that tend to discourage emissions or encourage the

removal of greenhouse gases from the atmosphere—but

that were originally intended to achieve other goals, such

as pollution reduction, energy independence, and the

limitation of soil erosion. The programs include corporate

average fuel economy (CAFE) standards, taxes on gasoline,

air quality improvement programs, and the Conservation

Reserve Program. However, the United States has not

adopted taxes or quotas that explicitly address the restraint

of greenhouse gas emissions.

After negotiating and signing the Kyoto Protocol in 1997,

the Clinton Administration did not offer it to the Senate

for ratification. It presented a plan for meeting the United

States’ commitment, but many analysts raised concerns

about whether the plan could accomplish its goal. The

Bush Administration, having withdrawn the United States

from subsequent protocol negotiations, has largely con

tinued the previous administration’s level of climate

related expenditures: the President’s budget for fiscal year

2003, for instance, proposed $4.5 billion of climate

related spending, with $1.7 billion dedicated to climate

science (including potential impacts of climate change)

and $1.3 billion to the development of energy and seques

tration technologies.5

 The Bush Administration currently

defines its goals in terms of a modest acceleration in the

rate of decline of emissions per dollar of GDP rather than

the achievement of an emissions target at some point in

the future.6

 In the meantime, and largely independently

of federal action, some states and firms are adopting

policies that are intended to reduce their emissions.

Alternative Approaches

The problems associated with the Kyoto Protocol have

inspired researchers to propose a variety of alternative

policies for coordinating international efforts related to

climate change. Each approach represents a distinct inter

pretation of the available evidence about the likely benefits

and costs of climate change, the uncertainty surrounding

it, and practical concerns about how climate policy would

affect domestic economies and the world economic sys

tem. Many of the approaches offer novel ways to address

the simultaneous problems of limiting emissions and dis

tributing the burden of regulation.

Some researchers (for example, Michaels, 2001) conclude

that the rate of climate change is likely to be at the low

end of the current range of estimates and the effects largely

benign, and they argue for a laissezfaire approach.7

 Such

a policy would take no affirmative steps to avert potential

damages from climate change or to develop institutions

to help coordinate international action.

Other analysts have proposed systems of emissions taxes

or tradable emissions permits with fixed prices to limit

the costs of mitigation. One such proposal envisages a sys

tem of auctioned emissions permits for the United States

5. The Clinton Administration’s policies are enumerated in Con

gressional Budget Office (1998), and the Bush Administration’s

in Executive Office of the President (2002). Relatively little sci

entific research is dedicated to understanding the potential effects

of climate change on society, the area that studies suggest would

yield the largest economic benefits. According to the National

Science and Technology Council (2001), the U.S. Global Change

Research Program allocated over 80 percent of its $1.6 billion

budget for fiscal year 2002 to basic climate science and less than

20 percent to research on the human and ecosystem dimensions

of climate change.

The federal government spent approximately $69 billion (in 2001

dollars) between 1978 and 2001 on energyrelated research and

development, with expenditure levels currently running at roughly

onethird of their pre1980 level. Roughly 41 percent of the cumu

lative spending was focused on nuclear energy, 27 percent on fossil

energy, and 32 percent on conservation and renewable energy. See

Department of Energy, Energy Information Administration (2000),

Table C1, pp. 114115, as well as the Budget of the United States

Government for fiscal year 2003, p. 171.

6. The Administration has released a draft research plan for comments

(Climate Change Science Program, 2002) and stated that it will

release a revised plan in June 2003.

7. In this view, the Framework Convention on Climate Change and

the Kyoto Protocol are “based on a naive interpretation of . . .

science” and their benefits are “undetectable.”
50 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

that would require producers to purchase permits for the

right to sell fossil fuels. The permits would be required

at the point of import or first sale, and the revenues would

be returned to households and states. The charge would

start at $25 per metric ton of carbon in 2002 and rise by

7 percent per year (after inflation) through 2007.8

 That

approach would be relatively costeffective, although it

would not be as costeffective as using the revenues to re

duce distortionary preexisting taxes. The option would

also address distributional concerns but only at the domes

tic level. A similar system could be envisaged for other

countries, and several proposals for an international system

call for both setting national targets for emissions and

establishing a maximum price (or “safety valve”) at which

governments provide additional permits for domestic

emissions (see Aldy, Orszag, and Stiglitz, 2001, pp. 2528;

McKibbin and Wilcoxen, 2002, pp. 199221; and Victor,

2001, pp. 101108).

Another researcher (Nordhaus, 1998) has proposed a sys

tem in which countries with per capita income of more

than $10,000 (in 1990 dollars) impose emissions taxes

on domestic sales of fossil fuels. Under that approach,

countries would use a complex voting scheme to decide

on a price path for emissions over time, and developing

countries would join the system once their per capita

annual income rose above the trigger level. Participating

nations would enforce the system through duties on im

ports from nonparticipating countries, which would be

levied on each such country in proportion to the carbon

content of its total exports. The approach has several ad

vantages: it provides a method for deciding on a uniform

emissions price in the face of conflicting views about the

appropriate price and allows for gradual implementation

and enforcement through international trade institutions.

For simplicity’s sake, the proposal ignores emissions from

nonfossilenergy sources and exempts countries with low

per capita income for distributional reasons. The system

would yield an estimated twothirds of the net benefits

that could be realized by an ideal system covering only

emissions from fossil energy use. Furthermore, nearly all

regions would share in the system’s beneficial effects on

the climate.

An alternative approach (Bradford, 2002) differs from the

preceding one by advocating explicit emissions rights, the

equivalent of a uniform international emissions tax, and,

at the same time, a system of international burden sharing

that would be institutionally separate from the allocation

of property rights. The approach calls for countries to

negotiate and agree on countryspecific, longterm, pro

jected “businessasusual” trends in emissions. For each

country, its agreedupon trend would serve as its emissions

quota, which it could allocate domestically as it saw fit.

Countries would also contribute financial resources to an

international bank that would purchase and retire emis

sions allowances from their owners at a fixed, negotiated

price, which could be renegotiated from time to time in

the light of new information. The approach thus involves

three elements: allocating emissions, determining a price

trajectory, and distributing burdens.9

Yet another proposal (McKibbin and Wilcoxen, 2000,

2002) would create and distribute among nations two

related types of explicit property rights for emissions. A

longterm emissions endowment, which would be valid

in only one country, would give its owner a permanent

right to receive annual emissions permits. A limited num

ber of endowments would be allocated to each country

on the basis of the Kyoto targets for domestic distribution.

Each government could also sell an unlimited number

of permits every year at a price that would be fixed each

decade by international agreement. There would be no

international trading of emissions allowances or credits.

8. Kopp, Morgenstern, and Pizer (1997) describe the original proposal

by Resources for the Future (RFF), a nonprofit research group

specializing in environmental economics. Another version can be

found in Sky Trust (2000). According to RFF researchers’

estimates, the program would reduce U.S. emissions by roughly

16 percent in 2007, yielding a substantial fraction of the emissions

reductions needed to meet the original U.S. commitment under

the Kyoto Protocol. Using Lasky’s (forthcoming) estimates of U.S.

mitigation costs, that system would reduce emissions by between

5 percent and 8 percent. A number of other proposed domestic

programs are described in detail in Congressional Budget Office

(2000, 2001).

9. Short of controlling emissions directly, developed countries could

slow emissions growth in developing countries by helping finance

the installation of energyefficient and nonfossilenergy tech

nologies during the development process. Such a plan is proposed

by Schelling (2002, p. 8).
CHAPTER FIVE INTERNATIONAL COORDINATION OF CLIMATE POLICY 51

The system would yield two distinct markets in every

country: a market for permits, with the permits’ price fixed

by international accord and their number determined by

market demand; and a market for endowments, with the

number of endowments set internationally and their price

determined by the market’s expectations about future

permit prices. If the demand for permits in a country rose

above the number of endowments in a given year, the gov

ernment would sell enough permits to meet demand at

the fixed price. If demand did not exceed the number of

endowments, the permits’ price would be lower.

To address developing countries’ distributional concerns,

Annex I countries would receive endowment levels that

were below their total current emissions; nonAnnex I

countries would receive endowments above their current

levels. That distribution would lead to different prices for

permits and endowments in the two groups of countries.

But even if developing countries’ permit prices were zero

in a given year, their endowments would reflect the per

mits’ expected future value—which would send a long

term signal to investors in those countries about the cost

of emissions in the future. That signal could help encour

age investment in energyefficient technologies and pro

cesses in the long term and discourage emissions “leakage”

from Annex I countries.

If the risks of climate change proved to be significant,

countries could negotiate an increasingly higher world

price for emissions that would gradually reduce each coun

try’s to the level of its endowments. After that, the coun

try’s government would have to buy back endowments

to further constrain emissions and be consistent with the

negotiated permit price.

By allowing different permit prices in different regions,

possibly for an extended period, the proposed system

would trade away some costeffectiveness to accommodate

distributional concerns. Governments could also address

domestic distributional concerns through their allocations

of emissions endowments. At the same time, the system

would build a constituency of endowment owners in both

developed and developing countries who would hold

property rights for emissions—and who would therefore

benefit from a rise in permit prices.

The system would be decentralized but coordinated

through the initial international allocation of endowments

and the establishment of permit prices. As a result, prob

lems in one country would generally not affect markets

for permits and endowments in others. The system would

be flexible enough to adapt both to changing political and

economic circumstances and to shifts in the rate of climate

change. Permit prices could be rapidly adjusted in re

sponse to new information, and endowment prices would

adjust accordingly. Countries could enter the system

simply by agreeing to an internationally negotiated emis

sions endowment and permit price, allocating their en

dowments domestically, and enforcing the fixedprice

permit system.

Economic Models and Climate Policy

The economics literature contains hundreds of esti

mates of the costs or benefits (or both) of slowing, miti

gating, or adapting to changes in the global climate result

ing from human activities. Those estimates are derived

mainly from a variety of computer models of economic

activity that have been developed for other purposes and

adapted to climate policy analysis. The variety of analytic

approaches used makes it difficult even for modelers to

interpret the differences among results from different

studies. Researchers and policymakers are forced to inte

grate information from many sources and develop a syn

thesis based on a range of studies and approaches, each

of which provides insight into some aspects of the problem

while ignoring others.

Like their climaterelated counterparts, modern models

of the economy are composed of systems of mathematical

equations that represent distinct but interacting processes

in the real world and that are solved together to represent

the simultaneous interaction of the parts within the whole.

Even the most complex models of the physical climate

or the economy inevitably lack detail. For example, many

studies focus on the costs of mitigating climate change

and ignore the potential benefits. Others focus only on

costs in one sector or only on certain kinds of costs. Engi

neering studies evaluate the direct costs associated with

adopting specific efficient technologies but tend to ignore

largerscale economic issues such as macroeconomic costs

and impacts on international trade. Economic studies at

tempt to include a wider range of direct and indirect eco

nomic costs associated with emissions controls or with

the effects of climate change, but they tend to use simple

representations of technology. Some integrated assessment

studies go further and try to incorporate both the costs

of mitigation and the economic impacts of climate change.

But to capture those very largescale aspects of the prob

lem, they rely on simplistic representations of many

economic and environmental details.

Types of Models

Economic analyses yield a wide range of cost estimates

for a given climate change mitigation policy, but most

of the variation in results is due to identifiable differences

in the approaches and assumptions that the studies use.

Many analyses use one of several “topdown” approaches

that represent the entire economy in an internally consis

tent way: they account for more or less all production and

consumption; inputs of capital, labor, and energy; invest

ment, taxes, and government spending; international

trade; prices; interest and exchange rates; and so on. Top

down approaches allow researchers to account for many

of the indirect economic effects of climate change policies

that would primarily affect markets for energy; but they

often ignore important details involving the gradual turn

over of energyusing equipment, the choice of equipment,

energy market barriers, and other factors. Nevertheless,

they tend to produce fairly reasonable projections of over

all energy use and thus emissions.

In contrast, “bottomup” models draw on engineering cost

studies to represent the details of specific energyrelated

technologies, but they tend to include much less detail

about nonenergy sectors and other aspects of the economy.

Unless constrained to do otherwise, bottomup models

always choose the most costeffective technologies (from

an engineering standpoint)—and therefore tend to pro

duce rather unrealistic results.

Topdown modeling approaches, which as a class are

sometimes referred to as macroeconomic models, generally

fall into one of two groups. The traditional macro

APPENDIX
54 THE ECONOMICS OF CLIMATE CHANGE: A PRIMER

econometric, or “macro,” forecasting models that make

up the first group are particularly useful in simulating the

gradual adjustment of the economy to various kinds of

shocks, such as changes in monetary and fiscal policy,

higher energy prices, and exchange rate fluctuations.

Macro models are particularly helpful in studying short

term (for example, fiveyear) responses and adjustments

to economic shocks, but they do not represent specific

markets in detail. Nor do they represent forwardlooking

expectations and behavior—an important element of eco

nomic activity, as discussed in the next section.

In contrast, computable general equilibrium (CGE)

models, which form the second group, are useful in ana

lyzing longterm responses to policies, over a decade or

more. Stateoftheart CGE models incorporate forward

looking behavior, fairly detailed markets for specific factors

and products, some types of gradual adjustment, aspects

of longrun growth and technological progress, and de

tailed representations of the tax system and of international

trade and finance. Some CGE models also include differ

ent groups and generations of households so that they can

analyze the distributional impacts of climate change poli

cies. Their disadvantage is that they do not capture gradual

adjustments or elements of the business cycle very well.

In particular, they have a hard time representing the grad

ual process through which industries and households re

place equipment that is outmoded by policy shifts (as

when consumers replaced cars that used leaded gas) and

the gradual process through which a market economy ad

justs to the economywide inflation that could result from

significant increases in energy prices brought on by re

stricting emissions.

Many researchers combine several different models within

a single modeling framework. For example, the Energy

Information Administration’s National Energy Modeling

System integrates a set of models of particular energy sec

tors, a national macroeconometric model, and an inter

national econometric model. Other frameworks add

models of the agriculture and forestry sectors to simulate

flows of carbon dioxide and methane in those areas of the

economy. Models that treat in detail the economy’s

energy or carbonintensive subsectors tend to provide

greater insight into those sectors’ responses to climate poli

cies than do less complex approaches.

Treatment of Expectations

One of the most complicated aspects of economics is that

people decide what to do today in part on the basis of their

expectations about the future. Modeling people’s expecta

tions is crucial to forecasting, but there is no simple form

ula to describe how people form them. Economists

typically model expectations in one of two almost polar

ways. One method represents behavior as adaptive: in that

representation, people do not have an explicit under

standing of how the economy will evolve and simply

extrapolate from past experience into the future. The other

approach represents people’s behavior as forwardlooking,

which is also termed modelconsistent or rational: in that

representation, people correctly anticipate the future evolu

tion of the economy unless the modeler engineers an

explicit shock.

The assumption of adaptive behavior, which is generally

used in macroeconometric models, yields forecasts in

which people fail to anticipate known developments—for

example, they will fail to prepare for a change in policy

that is announced 10 years in advance. In contrast, the

assumption of forwardlooking behavior, which is used

in a number of sectoral and generalequilibrium models,

yields forecasts in which people perfectly anticipate all

developments. Both assumptions are extreme, and they

yield significantly different results.

When models with adaptive expectations are used to esti

mate the costs of a tax on emissions or a permit system,

they tend to produce somewhat higher cost estimates than

models with forwardlooking expectations, all else being

equal. That happens because people in forwardlooking

models have time to adapt to any policy that is announced

in advance. Modelers who use adaptive expectations adjust

for that limitation by gradually phasing in the policy, to

simulate the anticipation of forwardlooking individuals.

A more difficult problem for models that use adaptive ex

pectations is how to represent the gradual turnover of the

capital stock in response to a policy shift. A few modelers

combine adaptive and forwardlooking assumptions,

yielding results that in many ways are between the two

extremes.
APPENDIX ECONOMIC MODELS AND CLIMATE POLICY 55

Technological Change

To model future economic growth and the effects of emis

sions restrictions, modelers have to guess what kinds of

technologies are going to be available at various points

in the future and simulate their effects under scenarios

that include and exclude policies to reduce emissions.

Forecasting the use of particular technologies for the near

to medium term is relatively straightforward, for two rea

sons: much of the capital stock (especially energyusing

capital) lasts a long time, and innovations usually take a

fairly long time to make their way into the market. Never

theless, analysts have often failed in the past to anticipate

technological advances that seem fairly obvious in retro

spect, such as the relatively rapid development of the Inter

net in the 1990s, or—an innovation that is closer to the

issue of climate change—the adoption of naturalgas

powered combinedcycle electricity generation. As fore

casters look forward over two or more decades, their ability

to anticipate technological developments becomes increas

ingly weak.

Most models represent the pace and direction of tech

nological change in a fairly simple way because the under

lying forces of change are not well understood. The models

typically assume that independent developments will grad

ually reduce the amount of capital, labor, and, in particu

lar, energy required to produce goods and services. The

process of reducing energy inputs per unit of output is

often represented by a parameter called the autonomous

energy efficiency improvement (AEEI) parameter.1

 For

given rates of growth of gross domestic product and

energy prices, an assumption of a higher AEEI implies

that energy efficiency will improve more quickly and

emissions will grow less quickly. A lower AEEI implies

the reverse. Such a model can be used to analyze how

changes in energy prices might encourage more or less use

of energy, relative to the autonomous trend. Somewhat

more complex models extend that basic process by pro

jecting a menu of technologies that are expected to be

available in the future and then analyzing how changes

in energy prices would encourage people to switch to more

energyefficient types of equipment.

However, as discussed in Chapter 4, technological devel

opments also respond to shifts in relative prices. Virtually

no model simulates the effect of energy prices on the

autonomous trend or on the menu of available tech

nologies. Although the size of that socalled inducement

effect is controversial, cost estimates that ignore it prob

ably overestimate the incremental cost of reducing

emissions over the longer run—say, 20 years or more.

Integrated Assessment

A consistent analysis of both the costs and benefits of

policies related to climate change requires a modeling

framework with certain characteristics: it should cover

national and international greenhouse gas emissions from

many sectors of the economy; it should translate emissions

of greenhouse gases into changes in the atmospheric and

global climate; and it should evaluate the impacts of

climate change on people and ecosystems. A number of

socalled integrated assessment models are under develop

ment, as are simplified reducedform models based on

more complicated frameworks. To analyze distributional

issues, some models separate the world into a number of

regions or include several overlapping generations of

households. A few of the models also incorporate a range

of uncertainty in their choice of parameters or in their

solution procedures (see Chapter 3).

1. The simpler models also use the same representation to account

for the fact that as people’s income rises, they use more and more

of it to buy services that do not require as much energy to produce

as do manufactured goods.

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