Economic Modeling of Contemporary Global Policy Issues:

Climate Change Policy

Warwick J McKibbinANU Centre for Applied Macroeconomic Analysis (CAMA)

and Lowy Institute for International Policy

And The Brookings Institution

ANU Contemporary Economic Theories for Policy March 21, 2007

Background papers are available from:

WWW.SENSIBLEPOLICY.COM

Or

WWW.GCUBED.COM

Overview

Part I• Thinking about the Uncertain Future

The need for a framework• What are models?• How to Use them• Economy Wide and Global Economic Models

Key Features Strengths and Weaknesses

• A peek inside a new generation of models (dynamic intertemporal general equilibrium models)

Overview

Part II• Using Dynamic Intertemporal General Equilibrium Models for

Scenario Analysis and Policy Design Climate Change Policy

Use of Models in Policy Evaluation

The world is an uncertain place Models are useful for

• Forecasting• Policy evaluation• Scenario analysis

Use of Scenarios

The most effective way to undertake scenario analysis is with an internally consistent and empirically relevant framework

We have developed a series of global economic models with many countries and many sectors based on new developments in intertemporal economics

The models form the analytical and empirical basis for designing alternative scenarios

Use of Scenarios (1)

Ask the question• What are the likely consequences of the Iraq War?

Design the scenarios that give different insights to the question• Examine history (Gulf War I, Afghanistan, Vietnam, Korea)

Wars always cost more than expected Costs are more than the fiscal outlays

• Shocks to Government spending for the war (US,Aust,UK) Government spending for the peace (Europe/Japan) Increased global risk

Impose the shocks in a consistent framework (a model) Interpret the results Assess the key sensitivities that drive the results

Do people expect it to be temporary or more permanent?

Use of Scenarios (2)

Ask the question• What are the likely consequences of an Influenza Pandemic?

Design the scenarios that give different insights to the question• Examine history (1918/19 Spanish Flu, 1957 Asian Flu, 1968 Hong Kong Flu)

Attack rate and case mortality rate are key epidemiological variables• Shocks to

Labor force – death and illnes Increase in business costs Shifts in consumer demand Re-evaluation of country risk

Impose the shocks in a consistent framework (a model) Interpret the results Assess the key sensitivities that drive the results

Fiscal intervention/ monetary responses/ attack rates

Scenario Examples www.economicscenarios.com

The Aftermath of the Sept 11 Terrorist Attacks What if Japan Adopted a Sensible Macroeconomic Policy? The Consequences of WorldCom and Enron Collapses The War with Iraq: the compounding Effects of Oil Prices, Budgetary

Costs and Uncertainty The SARS Outbreak: How Bad can It Get? Exploding Fiscal Deficits in the United States: Implication for the World

Economy What if China Revalues Its Currency China: The Implications of Policy Tightening Oil Price Scenarios and the Global Economy The United States Current Account Deficit and World Markets The Financial Effects of a Bird Flu Triggered Pandemic Bursting of the US Housing Bubble

What is an Empirical Economic Model?

A set of equations embodying the history of theoretical and empirical economic knowledge

Key bits• identities• behavioural equations• exogenous inputs

How to Use Economic Models

Very carefully!

Can get both quantitative estimates and new insights on complex issues

What Features are Important in a Model?

Does the model explain anything we observe today or in the recent past (VALIDATION)? ;

Is the model continually reviewed by experts who actually use it; is it published in the refereed academic literature; is a full listing of all equations available on request; and is it generally open to evaluation by others?;

What Features are Important in a Model?

Is the private market willing to purchase the model for the value it provides? ;

Do the model results pass the test of common sense?; Are the mechanisms in the model transparent to other

trained economists?

Types of Economic Models

Input Output Models• Examples:

United Nations Global models developed by Wassily Leontieff, Faye Duchin

Types of Economic Models

Input/output models Computable general equilibrium (CGE) models Old style macro-econometric models Modern macro-econometric models Dynamic intertemporal general equilibrium models

• New Keynesian macro models Micro-simulation models/ artificial life models

Types of Economic Models

Input Output Models• Trace the flow of resources between sectors;• Little role for relative price changes or substitution of inputs or

consumption bundles;• Tend to be static;• No allowance for capital accumulation or international financial

flows;• Ignore the role of money and asset prices;

Types of Economic Models

Computable General Equilibrium Models (CGE)• Examples:

Domestic– ORANI model, Monash Model– Murphy 303

Multi-Country– MEGABARE, GIGABARE, GTEM– GTAP World Trade Model– Michigan World Trade Model

Types of Economic Models

Computable General Equilibrium Models (CGE)• Derived from microeconomic optimization theory;• Considerable attention to individual behavior;• Relatively easy to understand results given theoretical structure;• Inadequate macroeconomic behavior;• Tend to be comparative static or recursive dynamic;

Types of Economic Models

Computable General Equilibrium Models (CGE) Inadequate treatment of intertemporal saving and investment

decisions, capital accumulation, financial capital flows; Ignore the role of money and asset prices; Rarely validated with actual experience either econometrically or

through forecasting or shock replication.

Types of Models

Old Style Macroeconometric Models • Examples

Domestic– NIF Treasury Model– Reserve Bank Models I & II

International– Data Resources Inc (DRI)– Warton

Types of Models

Old Style Macroeconometric Models • Rely on correlations in time series data based on aggregate

economic theory;• Reasonably good for short term forecasting (tend to be quarterly)• Difficult to understand results because of lack of theoretical

structure;• Unclear long run properties;

Types of Models

Modern Macroeconometric Models • Examples

Domestic– Murphy model 2– Access Economics– Treasury TRYM model

International– IMF Multimod– Oxford Econometric Forecasting (OEF)– GEM model of LBS/ NIESR

Types of Models

Modern Macroeconometric Models • More tightly specified theory• Rational Expectations in some markets• short run data consistency with long run theoretical properties• tend to be quarterly

Types of Models

Dynamic Intertemporal GE Models• Examples

The MSG2 Multi-Country Model » (McKibbin & Sachs)

The GCUBED Multi-Country Model» (McKibbin & Wilcoxen)

– GCUBED Environment– GCUBED (Asia Pacific)– GCUBED (Agriculture)– The MSG3 Multi-Country Model

Types of Models

Dynamic Intertemporal GE Models• integrates the key features of the other types of models• mix of econometric estimation and calibration• annual frequency• problem with large degree of dis-aggregation because of complexity

of the numerical algorithms needs

Types of Models

New Keynesian Models (also called Dynamic Stochastic General Equilibrium models (DSGE)) • Since the publication of the Obstfeld and Rogoff textbook on

International Economics, macro modellers have discovered intertemporal models Sticky prices Mix of optimizing and rule of thumb agents Imperfect competition

Types of Models

Others• Micro Simulation Models (NATSEM)• Artificial Life Models (Sante Fe Institute, Brookings Institution)

Inside one class of models

Dynamic Intertemporal General Equilibrium Models

Overall model development strategy

Funding is both through research grants and private consulting Hub and spoke approach to coordinating a global research project

• The model is managed/developed in the core research team in Australia and Texas

• Users (researchers/ governments/ financial investors) in different countries feed back to the core group both their own developments of the model as well as funding the core for new developments. All of which which we are able to incorporate into the model over time

Features of DIGE models

Dynamic Intertemporal General Equilibrium Multi-Country Multi-sectoral Econometric Macroeconomic

The MSG2 Multi-country model

McKibbin and Sachs

Development and Subscription Funding

– McKibbin Software Group Inc– US Congressional Budget Office– The Brookings Institution– US Department of Commerce– US Government– United Nations– World Bank– Australian Treasury– Centre for International Economics– Nomura Research Institute– Daewoo Research Institute (Korea)– Warwick Modeling Bureau– Many Academic Colleagues

The MSG2 Model Countries

United States - Taiwan Japan - Malaysia Germany - Indonesia France - Thailand Canada - India United Kingdom -Philippines Italy - Hong Kong Austria - Singapore Australia - Korea New Zealand China

The MSG2 Model 1 Sector in each country macroeconomic focus International capital and trade flows Forward looking expectations by some agents Rigidities in physical capital formation but highly mobile

financial capital Unemployment is labour markets due to institutional factors

The G-Cubed Model

McKibbin & Wilcoxen

Development and Subscription Funding

• Major Funding The Brookings Institution United States Environmental Protection Agency United States National Science Foundation McKibbin Software Group Inc

• Minor Funding through consultancies United Nations Australian Dept of Environment New Zealand Department of Commerce Canadian Dept of Finance

The G-Cubed Model

• Countries United States Japan Australia New Zealand Canada Rest of OECD Brazil Rest of Latin America China Eastern Europe and Former Soviet Union Oil Exporting Developing Countries Other non Oil Exporting Developing Countries

The G-Cubed Model• Sectors

– Electric Utilities– Gas Utilities– Petroleum Refining– Coal Mining– Crude Oil and Gas Extraction– Other Mining– Agriculture, Fishing and Hunting– Forestry and Wood Products– Durable Manufacturing– Non Durable Manufacturing– Transportation– Services

The G-Cubed (Asia Pacific) Model

Countries United States Japan Australia New Zealand Rest of the OECD Korea Thailand Indonesia China Malaysia Singapore Taiwan Hong Kong Philippines India Oil Exporting Developing Countries Eastern Europe and the former Soviet Union Other Developing Countries

G-Cubed (Asia Pacific)

• Sectors Energy Mining Agriculture Durable Manufacturing Non-Durable Manufacturing Services

The G-Cubed (Agriculture) Model

G-Cubed (Agriculture)• Countries

– United States– Japan– Australia– EU12– Canada– Mexico– ROECD– China & Hong Kong– ASEAN– Taiwan– Korea– ROW

G-Cubed (Agriculture)

• Sectors Food grains (rice and wheat) Feed grains Non-grain crops Livestock and its products Processed food Forest and Fishery Mining Energy Textile and Clothing Other non-durable consumer goods Durable consumer goods Services

Agents and Markets

AGENTS MARKETS Households Goods & Services Firms Factors of Production Governments Money

Bond Equity

Foreign Exchange

Key Features

the demand and supply side of the major economies are explicitly modelled ;

demand and supply equations are based on a combination of intertemporal optimizing behavior and liquidity constrained behavior;

Households

• 2 types A) maximize an intertemporal utility function

consisting of all goods and services produced domestically and overseas, subject to an intertemporal budget constraint that the present value of consumption is bounded by the present value of after tax income from all sources

B)Base aggregate consumption expenditure on an optimal rule of thumb with current consumption of each good allocated so as to maximize contemporaneous utility

Firms• 2 types

A) Maximise their share market value (the present value of the future stream of dividends) subject to production technology, a cost of adjustment model of capital and taking prices as given. They base their calculation on a summary of the future measured by Tobin’s Q.

B)Base aggregate investment expenditure on a backward calculated Q

Apart from physical capital other factors of production are flexible

– Labor, energy, materials, resources in GCUBED

Governments

Governments provide public goods that enter into the utility functions on households (additively seperable) and transfer payments;

In MSG2 governments provide infrastructure that enters into the production function of firms with increasing returns

Governments

Collect a wide variety of taxes on income of firms households, imports, sales.

Governments are subject to the intertemporal budget constraint that the present value of spending and transfers is bounded by the present value of future tax collections.

Countries

Countries are collections of individual firms, households and governments that trade goods and services as well as financial assets;

Labor is immobile between countries but mobile within countries;

Financial capital is mobile within and between countries;

Physical capital is sector and country specific at any point in time and subject to adjustment costs over time.

Role of Money

Money is required for transactions between all agents. There is a technology that combines money with produced goods and services and the combined product is what is available in the market.

The supply of money is determined by the a central bank in each economy via an interest rate rule in conjunction with assumptions about the exchange rate regime.

Financial Markets

Financial markets exist for– Money– Government Bonds– Equity– Foreign Assets– Foreign Exchange

Each financial asset represents a claim over real resources– Money over purchasing power– Bonds are claims over future tax collections– Equity is a claim over the future dividend stream of a firm– Foreign assets are claims over the future exports of the

debtor country

Goods and Services Markets

Households, Firms and Governments trade goods and services and price for each is assumed to clear the markets at an annual frequency

Factor Markets

• Labor Markets Nominal wages are set by different institutional

structures in each country; Given the nominal wage and the market prices

for goods and services firms higher labor until the real wage in each sector equals the marginal product of labor;

Aggregate unemployment can result although over time it is assumed that unemployment tends to force the nominal wage towards the labor market clearing level.

Factor Markets

• Capital

once installed physical capital is costly to move;

Capital produces a flow of services for firms that have installed a capital stock through investment decisions in the past;

Investment is subject to rising marginal costs of installation and depreciation over time.

Factor Markets

• Energy and Materials in GCUBED Firms purchase the output of other sectors as

inputs in production; Total demand for the materials and energy sectors

is final demand plus demand for intermediate inputs in each sector;

In contrast to standard CGE models (which assume Leontieff fixed coefficients between intermediate inputs and value added ) there is a CES production technology which allows substitution of capital, labor energy and materials in production.

Recent Applications

Global Demographic Change (Japanese Govt, IMF) Economics of Infectious Diseases (WHO) Global trade policy (WTO) Macroeconomic imbalances Climate Change Policy

Part II

Sensible Climate Policy

See “Uncertainty and Climate Change: The Challenge for Policy” Zillman, McKibbin and Kellow

www.assa.edu.au

Based on the book:

McKibbin W.J and P.J. Wilcoxen (2002) Climate Change Policy after Kyoto: A

Blueprint for a Realistic Approach

The Brookings Institution

www.notwrong.com

Overview

What is the climate change policy issue?• Managing Uncertainty in a sustainable way

Features of a Sustainable System What Has Been Done so far?

• The UN Framework Convention on Climate Change• The Kyoto Protocol

Fatal Problems with the Kyoto Protocol? An Alternative Approach: The McKibbin Wilcoxen Blueprint? Where to go from here?

We need to distinguish between two separate questions:

• Should the world take action against the threat of climate change?

• Should the world implement the Kyoto Protocol?

What is Climate policy about ?

• We know that carbon concentrations in the atmosphere have risen 30% since the industrial revolution.

• We know the science of the greenhouse effect.

Uncertainty is everywhere :Uncertainty is everywhere :

• UncertaintyUncertainty about link between carbon dioxide emissions and the timing and magnitude of climate change

• UncertaintyUncertainty about costs and benefits of climate change • UncertaintyUncertainty about costs and benefits of abatement

• UncertaintyUncertainty about the policy responses

Figure 2.1: Global Carbon Dioxide Emissions, 1751-1998

0

1000

2000

3000

4000

5000

6000

7000

1750 1770 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

Year

 

Some Illustrations of the uncertainties

Figure 2.7: Global Temperature Record, Vostok Ice Core Data

-12

-10

-8

-6

-4

-2

0

2

4

050,000100,000150,000200,000250,000300,000350,000400,000450,000

Years Before Present

Dif

fere

nce in

Mean

Tem

pera

ture

, C

Figure 2.6: Emissions of Carbon Under IPCC Scenario A1B

7.1

15.9

26.6

22.9

17.9

7.1

12.1

18.718.0

13.4

7.1

9.6

13.013.5

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30.0

1980 2000 2020 2040 2060 2080 2100 2120

Year

Gig

ato

ns o

f C

arb

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(G

t)

AIM

ASF

IMAGE

MARIA

MESSAGE

MiniCAM

What should be done given uncertainty?

Some proposals:• Do nothing

Problem may be small, avoiding it may be expensive (what if the problem is large and avoiding it is cheap?)

• Do something drasticProblem may be enormous, avoiding it may be cheap (what if the problem is small and avoiding it is expensive?)

A prudent policy would avoid extremes• Reduce emissions where possible at low cost

Features of a Sustainable System

• Extensive - all major carbon emitters need to participate

• Implementable in key countries• Equitable - across a range of dimensions• Efficient - minimum economic cost• Flexible - need to adjust as new information is

revealed• Low cost of implementation/administration• Must establish clear property rights over a long period of time to

provide the right incentives for all involved households, industry, governments

• Should be in all participants interest to commit current and future participants within each country involved

What has been Done so far?

The UN Framework Convention on Climate Change

Negotiated at the Earth Summit in 1992 in Rio Set Goals (not targets)

• “preventing dangerous anthropogenic interference with the Earth’s climate system”

• Annex I countries (industrial countries) were to adopt policies to “aim” to reduce their emissions

• Entered into force in March 1994

Set in process a series of meetings of the “Conference of the Parties” (COP)

The Kyoto Protocol

Protocol to the 1992 UN framework Convention on Climate Change, negotiated at COP3 in 1997

Annex 1 countries agreed to reduce emissions of 6 greenhouse gases to 5.2% below 1990 levels on average between 2008 and 2012

No commitments for Developing Countries (countries such as China ratify but have no targets!)

Some flexibility allowed through • permit trading• clean development mechanism (CDM)• joint implementation

The Kyoto Protocol

legally binding when 55 countries accounting for 55% of developed country emissions ratify

USA and Australia have rejected Massive dilution of the original targets to encourage

countries such as Japan, Canada, NZ and Russia to ratify Russia was the key country that will determined if the

Protocol enters into force

Kyoto-style Permit Trading Emission permits are issued equal to the Annex 1 target Each country receives an allocation of permits Countries/firms

• buy permits if they wish to increase emissions • sell permits if they wish to reduce emissions

Trading allows original country targets to be tightened or relaxed depending on the costs• Abatement differs across countries depending on costs of

abatement relative to the price of permits• The permit price will be determined by demand and supply and will

equal the cost of preventing the emission of an additional unit of carbon

Advantages of Kyoto trading

Global target is met but differential country response allowed through the market

Cost of removing an additional unit of carbon is equal everywhere (efficient)

Compensation (across countries and within countries) can be built into the initial permit allocation

A fundamental problem with targets and timetables

What is the correct target for each country and the world? What is the optimal period?

• targets impose unknown cost for given outcome for emissions

permit trading gives greater flexibility across countries but no flexibility in total

Problems With Kyoto Approach

Problems With Kyoto Approach

If costs are low we miss the opportunity to cut emissions quickly (in total) because we have a fixed target

If costs are high we might create severe problems that would destroy the commitment to Kyoto

Permit trading more widely implemented could cause economic and political problems with large wealth transfers between economies and large fluctuations in trade balances and real exchange rate

Some historical examples• Dutch Disease – e.g. North Sea Oil Discovery in 1970s• Keynes classic “transfer problem” related to German Reparations

after WWI

Problems With Kyoto Approach

If one large country reneges the permit system would likely collapse since the price depends on all countries supply and demand

This requires a very strong monitoring and enforcement mechanism in all participating countries.

If developing countries participate in permit trading the price of carbon would be the same as in industrial countries – why would they want this structural shock even with payments for permits?

Problems With Kyoto Approach

Carbon taxes Subsidies to technologies Mandatory targets for renewables

Alternatives to permit trading?

A carbon tax:

A fixed price for carbon with revenue going to the government

Emission outcome is unknown but the cost of carbon is known with certainty

Problems• Tax payments are enormous• If optimal reduction is 20% of emissions, firms must pay tax on 80%

of original output.

• Very unpopular with industry and politicians!

Subsidies for the Best Technology ?

Clean Coal? Renewables? Problem is that the solution will be technological

but are governments the best placed to pick the winners?• The subsidies will likely go to those with the greatest

lobbying power

Mandatory Targets for renewable energy

Evidence is that this is a high cost approach Targets and timetables approach yet again

Other options?

Reform coal markets (see Anderson and McKibbin (1998)

Address direct problems such as black carbon in developing countries

Black Carbon

Important issue particularly in developing countries• Significant short run climate impacts• Significant health impacts• Significant negative impacts on agriculture productivity

Major issue in China

Features

Released when carbonaceous fuels incompletely combust Hard to measure China is 17% of global emissions Mostly emitted by burning of raw coal, coal briquettes and

bio-fuels in the residential sector

Sources of Black Carbon in China

Residential83%

Industry7%

Power1%

Transport - diesel3%

Transport - other0%

Field Combustion6%

Source: Table 2 page 7 of Streets (2004)

Are there any other alternatives to the standard economic instruments?

Need a policy with best features of permits, taxes and subsidies

Like a tax:• Should guarantee that costs won’t be excessive

Like permits:• Should avoid huge transfers to the government

Like subsidies:• it should encourage the search for technological solutions

Importantly it should make property rights clear over a long period and provide incentives for industry,households and governments to reduce emissions at low cost

The Blueprint (a hybrid policy) Each participating country would:

• Require that producers of energy within their borders have an annual emission permit for each ton of carbon embodied in their energy produced and sold domestically or imported

• Issue long term emissions permits equal to a specified fraction of a base period emissions with declining emission if required.

• Be allowed to sell additional annual permits to firms within its borders at a stipulated price ($P per ton of carbon), where $P could be $US10 per ton of CO2.

• Create domestic markets in the long term and annual permits

Long TermPermit

Looking at the policy in more detail:

Allows one unit of emission per year for a long period

Distributed once at enactment Can be leased or sold within a country Quantity can set by treaty: QT

Price will be set by the market

AnnualPermit

Allows one unit for one year Sold by government as demanded Price set by treaty: PT

Supply of each type of permit (for use in a given year)

$

SS

QP

Annual permits for sale

PT

Long Term permits for lease

SL $

QP QT

Overall supply of permits (for use in a given year)

S

$

QP

PT

QT

If abatement is easy:

MAC rise slowly Low D for permits P below threshold No annual permits Hit target QT

S

$

Q Permits

D P

PT

QT

Revenue to permit owners

If abatement is difficult:

MAC rises rapidly High D for permits P at threshold PT

Annual permits used Emissions exceed QT

S

$

Q Permits

D

P, PT

QT

QA

Revenue to permit owners

Revenue to government

Overall

Creates incentives for investment• Raises the marginal cost of emissions into the future

Incentives are credible• Built-in constituency of long term permit holders• Robust to accessions and withdrawals• Operates within existing institutions

Provides a foundation on which to build• Completely consistent with technology policies• Provides incentives for adoption and diffusion

Expandable

Because it is a domestic system, other abatement activities can be included as a way to generate annual permits with the revenue going to these activities instead of the government

Main Concept

• The long term permits are the medium term goals for emissions without a timetable of when they are reached

• The short term permits are the economic costs to the economy

• Move through a low cost path from the short run to the longer run in decadal steps with profit incentives to reduce emissions wherever cost effective

A Partial Analogy – Bond markets

• Long term government bond market prices interest rates over long horizons given a stock of government debt (like long term permits)

• Central banks set the short term interest rate - the supply of financial liquidity is generated by the market (like annual permits).

• The long term interest rate (which is flexible) is the expected value of future of short term interest rates (which are fixed in any period)

Encouraging Non Fossil Fuel Energy and carbon capture technologies

• Relative price of carbon higher in the short term and the longer term

• Clear pricing over long time periods gives a clear signal of the return to investment in non-fossil fuel energy sources or capture of carbon from fossil fuels

• Could allow non-fossil fuel energy producers and carbon capture to generate annual permits in proportion to the amount of carbon not emitted (does not require international negotiation while the price cap is binding)

Is early action a good idea?

Australia could adopt the Blueprint today in advance of the rest of the world both for a direct economic gain and to encourage the rest of the world to adopt similar policies

Most models ignore uncertainty and therefore do not incorporate wealth generated from risk management

What about competitiveness?

The cost of carbon is not the largest cost even in aluminium production – the cost of capital is more important

Under the Blueprint, the cost of carbon that affects direct competitiveness is controlled by the government and is kept low until other countries impose carbon prices in which case the competitiveness issue disappears over time

The increased ability to manage asset risk will be more positive for a company’s balance sheet than the negative effect of a slightly higher short term carbon price

What about carbon leakage?

Why would a fossil fuel intensive industry move away from an economy in which the risk to their capital is hedged, into an economy with greater political risk and no carbon policy when you know that over the next decade or so carbon policy will be inevitable.

A small rise in the carbon price can be more than offset by the gains of risk reduction on protecting capital

Early Action is critical

Australia should act now in creating markets with long term price signals that:• That enable energy generators and energy intensive industries to

protect their capital value against change in the climate and changes in climate policy

• Give clear profit signals to alternative generating technologies and other technologies such as carbon capture and storage

Early Action is critical

R&D in only a partial but a necessary part of the solution • but without a market price there is little incentive for technologies

to be implemented and diffused through the economy

Key Points

Each system is run within a country using that country’s own imperfect monitoring and enforcement mechanisms and its own legal and accounting systems

No international trade in the assets • only domestic markets• Short run efficiency guaranteed by a common price• Long run efficiency driven by structural change

Incentives for all actors are internalized within countries

Developing Countries ...

Negotiate a perpetual permit allocation that is larger than current emissions

Price of annual emission permits zero in the short run because more permits than needed

Price of perpetual emission permits will be non zero giving important signals for investment projects

Over time the permit price in countries will equalize as developing countries “ability to pay rises”

An Example: Australia and China

What would the markets look like in Australia versus China?

Suppose China receives double versus triple 2002 emissions

Figure 5: Annual Permit Price

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$US

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2

Annex B China double China triple

AustraliaChina Double

China Triple

Figure 6: Value of Long Term Permits (r=5%)

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Annex B China double China triple

Australia China Double

China Triple

Developing Countries ...

Will developing countries ever agree?• Depends on who is expected to get the valuable assets

called permits• Will they ever agree to Kyoto style interventions?

Advantages of the Blueprint policy

Guarantees that compliance costs would not be too high• Passes the test that Kyoto fails

Can be justified on cost-benefit grounds• Current knowledge about climate risks justifies slowing emissions at

low cost

Advantages of the Blueprint policy

Avoids huge transfers to the government• Each government can decide how to hand out perpetual permits but

once these property rights are distributed they are not revisited (like land contracts)

• Permits act as transition relief for industries (and affected workers) and will reduce opposition

• Also, easy for industry to understand -- like grandfathering

Reduces emissions wherever cost-effective• Prudent: eliminates emissions where possible below a fixed price

More advantages ...

Maintains national sovereignty• Important for US and developing country participation

Incorporates an explicit mechanism for developing country commitments with no short term costs but clear incentives for future investment in less carbon intensive activities

Provides a futures market (long term permit market)• Allows individual risk management

More advantages ...

No direct international transfers of wealth• Trading is national, rather than international• Less disruptive to exchange rates and foreign aid

budgets

Gives incentives for early action• Perpetual permits could be distributed now, even without

a treaty!• The private sector is already doing this but property

rights unclear

More advantages ...

Built-in incentives to monitor and enforce• Annual permits generate government revenue• Owners of perpetual permits do not want permit prices to

erode

Credible• Less draconian so more likely to be enforced into the

future

Still more advantages ...

Relatively easy to modify as information arrives• Can raise or lower the world price as risks become better

known

Easy to add countries over time• Does not require re-negotiation of treaty• New countries don’t hurt existing permit owners

Creates a future market in carbon (the perpetual permit market)• Gives a long term price signal but with a fixed short term cost

An Illustration of how Uncertainty impacts on the costs

of Kyoto versus Blueprint

Suppose Russia grows at 1% per year faster from 2000 to 2012 than our baseline forecast (4.4% rather than 3.3%)

What is the cost of Kyoto versus the Blueprint under the baseline scenario versus the alternative scenario of higher Russian growth?

Both Kyoto and the Blueprint assume non participation by developing countries even though the Blueprint has a clear mechanism for getting developing country participation!

The G-Cubed Model• Countries

United States Japan Australia New Zealand Canada Europe Rest of OECD Brazil Rest of Latin America China India Eastern Europe and Former Soviet Union Oil Exporting Developing Countries Other non Oil Exporting Developing Countries

The G-Cubed Model• Sectors

– Electric Utilities– Gas Utilities– Petroleum Refining– Coal Mining– Crude Oil and Gas Extraction– Other Mining– Agriculture, Fishing and Hunting– Forestry and Wood Products– Durable Manufacturing– Non Durable Manufacturing– Transportation– Services

Figure 1: Cumulative World Carbon Emissions1999-2015

100000

110000

120000

130000

Unconstrained Kyoto Blueprint

mmt of carbon

BAU Russian growth High Russian growth

Europe

-1.6

-1.2

-0.8

-0.4

0.0

1999 2004 2009 2014 2019 2024

OPEC

-2.8

-2.4

-2.0

-1.6

-1.2

-0.8

-0.4

0.0

1999 2004 2009 2014 2019 2024

Strong Russian Growth - BlueprintMod Russian Growth - Blueprint

Strong Russian Growth - KyotoMod Russian Growth - Kyoto x

Change in GNP:

Change in GNP under KyotoAlternative Russian Growth Assumptions

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025

US Japan

Europe Australia

Russia China

LDC OPEC

% pts

GNP under MWAlternative Russian Growth Assumptions

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025

US Japan

Europe Australia

Russia China

LDC OPEC

% pts

Where to go from here?

The current approach as embodied in the Kyoto protocol does not deal with uncertainty and is not sustainable

The Blueprint dominates in terms of• the extent of emissions reductions; • risk management; • sustainability.

The Blueprint can be implemented within countries and is consistent with moving towards Kyoto if a country ever wanted to.• Just have the government pull out of the annual permit market and

allow these asset to be traded internationally

Background Papers

www.sensiblepolicy.com

www.notwrong.com