9. Policy mechanisms

What policy mechanisms are available to address the climate problem? Major options include:

Taxes and allowance trading — Either a tax or an allowance trading scheme puts a price on carbon emissions. How high should it be? How should it be designed? How should the tax revenues or the value of the allowances be allocated?
Public investment — What other government initiatives are needed? How can the public sector effectively intervene to reduce emissions and stimulate new research and development?

Rethinking Global Climate Change Governance
Scott Barrett
Economics: The Open-Access, Open-Assessment E-Journal (2009) 3(5): 1-12.
This paper explains why the approach taken so far to mitigate global climate change has failed. The central reason is an inability to enforce targets and timetables. Current proposals recommending even stricter emission limits will not help unless they are able to address the enforcement deficit. Trade restrictions are one means for doing so, but trade restrictions pose new problems, particularly if they are applied to enforce economy-wide emission limitation agreements. This paper sketches a different approach that unpacks the climate problem, addressing different gases and sectors using different instruments. It also explains how a failure to address the climate problem fundamentally will only create incentives for different kinds of responses, posing different challenges for climate change governance.

A Chinese sky trust?: Distributional impacts of carbon charges and revenue recycling in China
Mark Brenner, Matthew Riddle and James K. Boyce
Energy Policy (2007) 35(3): 1771-1784.
The introduction of carbon charges on the use of fossil fuels in China would have a progressive impact on income distribution. This outcome, which contrasts to the regressive distributional impact found in most studies of carbon charges in industrialized countries, is driven primarily by differences between urban and rural expenditure patterns. If carbon revenues were recycled on an equal per capita basis via a ‘sky trust,’ the progressive impact would be further enhanced: low-income (mainly rural) households would receive more in sky-trust dividends than they pay in carbon charges, and high-income (mainly urban) households would pay more than they receive in dividends. Thus a Chinese sky trust would contribute to both lower fossil fuel consumption and greater income equality.

Distribution of emissions allowances as an opportunity
Stephen J. DeCanio
Climate Policy (2007) 7(2): 91-103.
Much of the debate on climate policy in the USA focuses on the gain or loss to the macroeconomy of alternative policies to reduce greenhouse gas emissions. However, the economy is made up of multiple individuals, not a single representative agent. This article reports the results of alternative ways of distributing emissions allocations across citizens. Macroeconomic effects interact with the policy for distribution, but the distributional weights are more important for the welfare of individual agents than the economy-wide effects of the emissions reductions. Egalitarian distributions of the emissions allowances have the potential to increase the welfare of most people, even if significant emissions reductions are mandated. Focusing on the distribution of emissions allowances (or the revenues generated from an emissions tax) rather than on aggregate GDP may provide guidance in identifying and implementing politically viable solutions to the climate change mitigation problem.

Designing carbon markets. Part I: Carbon markets in time
Samuel Fankhauser and Cameron Hepburn
Energy Policy (2010) 38(8): 4363-4370.
This paper analyses the design of carbon markets in time (i.e., intertemporally). It is part of a twin set of papers that ask, starting from first principles, what an optimal global carbon market would look like by around 2030. Our focus is on firm-level cap-and-trade systems, although much of what we say would also apply to government-level trading and carbon offset schemes. We examine the “first principles” of temporal design that would help to maximise flexibility and to minimise costs, including banking and borrowing and other mechanisms to provide greater carbon price predictability and credibility over time.

Designing carbon markets. Part II: Carbon markets in space
Samuel Fankhauser and Cameron Hepburn
Energy Policy (2010) 38(8): 4381-4387.
This paper analyses the design of carbon markets in space (i.e., geographically). It is part of a twin set of papers that, starting from first principles, ask what an optimal global carbon market would look like by around 2030. Our focus is on firm-level cap-and-trade systems, although much of what we say would also apply to government-level trading and carbon offset schemes. We examine the “first principles” of spatial design to maximise flexibility and to minimise costs, including key design issues in linking national and regional carbon markets together to create a global carbon market.

Optimal timing of climate change policy: Interaction between carbon taxes and innovation externalities
Reyer Gerlagh, Snorre Kverndokk and Knut Einar Rosendahl
Environmental and Resource Economics (2009) 43(3): 369-390.
This paper addresses the impact of endogenous technology through research and development (R&D) on the timing of climate change policy. We develop a model with a stock pollutant (carbon dioxide) and abatement technological change through R&D, and we use the model to study the interaction between carbon taxes and innovation externalities. Our analysis shows that the timing of optimal emission reduction policy strongly depends on the set of policy instruments available. When climate-specific R&D targeting instruments are available, policy has to use these to step up early innovation. When these instruments are not available, policy has to steer innovation through creating demand for emission saving technologies. That is, carbon taxes should be high compared to the Pigouvian levels when the abatement industry is developing. Finally, we calibrate the model in order to explore the magnitude of the theoretical findings within the context of climate change policy.

An integrated analysis of policies that increase investments in advanced energy-efficient/low-carbon technologies
D.A. Hanson and J. A. Laitner
Energy Economics (2004) 26(4): 739-755.
A new analysis by the EPA Office of Atmospheric Programs and the Argonne National Laboratory (ANL), using the All Modular Industry Growth Assessment (AMIGA) system, indicates that a technology-led investment strategy, can secure substantial domestic reductions of carbon emissions at a net positive impact on the U.S. economy. However, a moderate energy policy, even supported by a carbon charge ranging from US$48 to US$93 per metric ton, is insufficient to reach the so-called Kyoto targets.

Calibration bias in the analysis of environmental taxes
Richard B. Howarth
American Journal of Agricultural Economics (2004) 86: 813-818.
This article explores the role of preexisting taxes in gauging the costs and benefits of taxing CO₂ emissions to slow the rate of climate change. In a numerically calibrated model of the world economy that involves a 33% personal income tax, stabilizing emissions at year 2000 levels would yield present-value net benefits of $10.7 trillion. When the model is recalibrated based on the counterfactual assumption of zero taxes and public expenditures, present-value net benefits fall by 87%. This gap arises because the no-tax calibration both overstates people’s true time preference and understates the disutility of increased CO₂ levels. Thus, calibration bias adversely affects efforts to gauge the costs and benefits of environmental taxation.

Optimal environmental taxes under relative consumption effects
Richard B. Howarth
Ecological Economics (2006) 58: 209-219.
This paper explores the interactions between carbon dioxide emissions taxes and a pre-existing income tax in a numerically calibrated model of climate change and the world economy. Based on evidence from the recent empirical literature, the model allows for the presence of relative consumption effects in the specification of preferences. In the absence of relative consumption effects, optimal emissions taxes would rise from $44 to $229 per tonne of carbon (in year 2000 U.S. dollars) over the course of the next century. These tax rates, which arise when emissions tax revenues are used to reduce taxes on personal income, are slightly above the present value marginal benefits of emissions control. Given realistic assumptions concerning the empirical magnitude of relative consumption effects, the optimal emissions tax rises to $63 per tonne in 2005 and $384 per tonne in 2105. Accounting for relative consumption effects reduces the perceived social benefits of consumption, thus increasing social willingness to pay for environmental quality while reducing both the costs of tax interaction effects and the benefits of efficient revenue recycling. Taken together, these factors support the implementation of comparatively high environmental taxes in the face of relative consumption effects.

Technology diffusion under contraction and convergence: A CGE analysis of China
Michael Hüble
Energy Economics, in press
This paper introduces a mechanism of international technology diffusion via FDI and imports into recursive-dynamic CGE modeling for climate policy analysis. As a novel feature, the mechanism distinguishes spillovers from foreign to domestic capital within sectors and across sectors within the production chain. The paper applies the mechanism to the analysis of a contraction and convergence type climate policy focusing on China. The mechanism of international technology diffusion leads to an increase in China’s energy productivity an a decline in China’s economic growth rates in a convergence process. In this case, inter-regional emissions trading could (more than) compensate China’s welfare losses due to climate policy. Otherwise, China’s welfare losses due to climate policy could be significant.

Post-2012 climate policy dilemmas: A review of proposals
Onno Kuik, Jeroen Aerts, Frans Berkhout, Frank Biermann, Jos Bruggink, Joyeeta Gupta and Richard S J Tol
Climate Policy (2008) 8(3): 317-336.
This article assesses a wide range of alternative proposals for post-2012 international climate policy regimes. We believe that these proposals will serve as a basis for debates about how to configure post-2012 climate policy. The article characterizes and assesses the policy proposals along the lines of five key policy dilemmas. We argue that (1) many proposals have ideas on how to reduce emissions, but fewer have a solution on how to stimulate technical innovation; (2) many proposals formulate climate policy in isolation, while there are fewer proposals that try to mainstream climate policies in other policy areas; (3) many proposals advocate market-based solutions, while fewer realize that there are certain drawbacks to this solution especially at the international level; (4) most proposals have a preference for a UN-based regime, while a more fragmented regime, based on regional and sectoral arrangements may be emerging; and (5) most proposals have ideas about mitigation, but not many have creative ideas on how to integrate mitigation with adaptation.

Design and implementation of carbon cap and dividend policies
Catherine M. Kunkel and Daniel M. Kammen
Energy Policy (2011) 39(1): 477-486.
An important concept in discussions of carbon management policies is cap and dividend, where some fraction of the revenues of an auction on emission allowances is returned to citizens on an equal per capita basis. This policy tool has some important features; it emphasizes the fact that the atmosphere is a common property resource, and it is a highly transparent measure that can be effectively used to protect the income of low-income individuals. In this paper we examine this policy in the California context, and focus on the costs and impacts of a cap and dividend scheme when applied to carbon emissions associated with electricity, natural gas and transportation services. We find that cap and dividend can effectively be used to address the economic impacts of carbon management policies, making them progressive for the lowest-income members of society. We find that the majority of households receive positive net benefits from the policy even with the government retaining half of the auction revenue. If auction revenues are instead dedicated only to low-income households, the majority of low-income households can be fully compensated even with the state government retaining upwards of 90% of auction revenues for other purposes.

Distributional effects of taxing transport fuel
Thomas Sterner
Energy Policy, in press
This paper takes as its starting point the observation that fuel prices — and thus taxes — are important for good management of climate change and other environmental problems. To economists this should be no surprise yet it seems that the role of fuel taxation as an instrument of climate policy has not been fully appreciated. It is however one of the few policy instruments that, since several decades, has actually reduced fuel consumption appreciably. Thanks to taxation (mainly in Europe and Japan), carbon emissions are considerably lower than they would have been otherwise. In future where carbon emissions are to be cut drastically, this instrument will be crucial. There is however much opposition to the instrument. This opposition uses various arguments, for instance that fuel taxes hurt the poor since they are strongly regressive. We however find that the choice of country and methodology turns out to be of great consequence. We study seven European countries — France, Germany, United Kingdom, Italy, Serbia, Spain and Sweden and do find some evidence of regressivity but the evidence is very weak. It does not apply when lifetime income is used and it does not apply to the poorest country in the group. The best one-line summary is probably that the tax is approximately proportional.