Accounting for Uncertainty Affecting Technical Change in an Economic-Climate Model

The key role of technological change in the decline of energy and carbon intensities of aggregate economic activities is widely recognized. This has focused attention on the issue of developing endogenous models for the evolution of technological change. With a few exceptions this is done using a deterministic framework, even though technological change is a dynamic process which is uncertain by nature. Indeed, the two main vectors through which technological change may be conceptualized, learning through R&D investments and learning-by-doing, both evolve and cumulate in a stochastic manner. How misleading are climate strategies designed without accounting for such uncertainty? The main idea underlying the present piece of research is to assess and discuss the effect of endogenizing this uncertainty on optimal R&D investment trajectories and carbon emission abatement strategies. In order to do so, we use an implicit stochastic programming version of the FEEM-RICE model, first described in Bosetti, Carraro and Galeotti, (2005). The comparative advantage of taking a stochastic programming approach is estimated using as benchmarks the expected-value approach and the worst-case scenario approach. It appears that, accounting for uncertainty and irreversibility would affect both the optimal level of investment in R&D –which should be higher– and emission reductions –which should be contained in the early periods. Indeed, waiting and investing in R&D appears to be the most cost-effective hedging strategy.Stochastic Programming, Uncertainty and Learning, Endogenous Technical Change

Sustainable Cooperation in Global Climate Policy: Specific Formulas and Emission Targets to Build on Copenhagen and Cancun

We offer a framework to assign quantitative allocations of emissions of greenhouse gases (GHGs), across countries, one budget period at a time. Under the two-part plan: (i) China, India, and other developing countries accept targets at Business as Usual (BAU) in the coming budget period, the same period in which the US first agrees to cuts below BAU; and (ii) all countries are asked in the future to make further cuts in accordance with a common numerical formula to all. The formula is expressed as the sum of a Progressive Reductions Factor, a Latecomer Catch-up Factor, and a Gradual Equalization Factor. This paper builds on our previous work in many ways. First we update targets to reflect pledges made by governments after the Copenhagen Accord of December 2010 and confirmed at the Cancun meeting of December 2011. Second, the WITCH model, which we use to project economic and environmental effects of any given set of emission targets, has been refined and updated to reflect economic and technological developments. We include the possibility of emissions reduction from bio energy (BE), carbon capture and storage (CCS), and avoided deforestation and forest degradation (REDD+) which is an important component of pledges in several developing countries. Third, we use a Nash criterion for evaluating whether a country’s costs are too high to sustain cooperation.Cancun, Climate, Concentrations, Cooperation, Copenhagen, Costs, Developing Countries, Development, Emissions, Equity, Global Climate, Global Warming, Greenhouse Gas, Human Development, International, Kyoto, Sustainable, Treaty, United Nations, WITCH

Uncertain R&D, Backstop Technology and GHGs Stabilization

This paper analyses optimal investments in innovation when dealing with a stringent climate target and with the uncertain effectiveness of R&D. The innovation needed to achieve the deep cut in emissions is modelled by a backstop carbon-free technology whose cost depends on R&D investments. To better represent the process of technological progress, we assume that R&D effectiveness is uncertain. By means of a simple analytical model, we show how accounting for the uncertainty that characterizes technological advancement yields higher investments in innovation and lower policy costs. We then confirm the results via a numerical analysis performed with a stochastic version of WITCH, an energy-economy-climate model. The results stress the importance of a correct specification of the technological change process in economy-climate models.Climate Change, Information and Uncertainty, Environmental Policy, Optimal R&D Investments

Carbon Capture and Sequestration: How Much Does this Uncertain Option Affect Near-Term Policy Choices?

One of the main issues in the climate policy agenda, the timing of abatement efforts, hinges on the uncertainties of climate change risks and technological evolution. We use a stochastic optimization framework and jointly explore these two features. First, we embed in the model future potential large-scale availability of Carbon Capture and Storage (CCS) technologies. While non-CCS mitigation that reduces fossil energy use is modelled as exerting inertia on the economic system, mainly due to the durability of the capital in energy systems and to technology lock-in and lock-out phenomena, the implementation of CCS technologies is modelled as implying less resilience of the system to changes in policy directions. Second, climate uncertainty is related in the model to the atmospheric temperature response to an increase in GHGs concentration. Performing different simulation experiments, we find that the environmental target, derived from a cost-benefit analysis, should be more ambitious when CCS is included in the picture. Moreover, the possible future availability of CCS is not a reason to significantly reduce near-term optimal abatement efforts. Finally, the availability of better information on the climate cycle is in general more valuable than better information on the CCS technological option.Climate change, Uncertainty, Sequestration, Cost-benefit analysis

A Good Opening: The Key to Make the Most of Unilateral Climate Action

In this paper we argue that when a subgroup of countries cooperate on emission reduction, the optimal response of non-signatory countries reflects the interaction between three potentially opposing factors, the incentive to free-ride on the benefits of cooperation, the incentive to expand the demand of fossil fuels, and the incentive to adopt cleaner technologies introduced by the coalition. Using an Integrated Assessment Model with a game theoretic structure we find that cost-benefit considerations would lead OECD countries to undertake a moderate, but increasing abatement effort (in line with the pledges subscribed in Copenhagen). Even if emission reductions are moderate, OECD countries find it optimal to allocate part of their resources to energy R&D and investments in cleaner technologies. International spillovers of knowledge and technology diffusion then lead to the deployment of these technologies in non-signatory countries as well, reducing their emissions. When the OECD group follows more ambitious targets, such as 2050 emissions that are 50% below 2005 levels, the benefits of technology externalities do not compensate the incentives deriving from the lower fossil fuels prices. This suggests that, when choosing their unilateral climate objective, cooperating countries should take into account the possibility to induce a virtuous behaviour in non-signatory countries. By looking at a two-phase negotiation set-up, we find that free-riding incentives spurred by more ambitious targets can be mitigated by means of credible commitments for developing countries in the second phase, as they would reduce lock-in in carbon intensive technologies.Technology Spillovers, Climate Change, Partial Cooperation

Politics and Economics of Second-Best Regulation of Greenhouse Gases: The Importance of Regulatory Credibility

Modellers have examined a wide array of ideal-world scenarios for regulation of greenhouse gases. In this ideal world, all countries limit emissions from all economic sectors; regulations are implemented by intelligent, well-informed forward-looking agents; all abatement options, such as new energy technologies and forestry offsets, are available; trade in goods, services and emission credits is free and unfettered. Here we systematically explore more plausible second-best worlds. While analysts have given inordinate attention to which countries participate in regulation—what we call “variable geometry”—which has a strikingly small impact on total world cost of carbon regulations if international trade in emission credits allows economies to equilibrate. Limits on emission trading raise those costs, but by a much smaller amount than expected because even modest amounts of emission trading (less than 15% of abatement in a plausible scenario that varies the geometry of effort) have a large cost-reducing impact. Second best scenarios that see one sector regulated more aggressively and rapidly than others do not impose much extra burden when compared with optimal all-sector scenarios provided that regulations begin in the power sector. Indeed, some forms of trade regulation might decrease the financial flows associated to a carbon policy thus increasing political feasibility of the climate agreement. Much more important than variable geometry, trading and sectors is another factor that analysts have largely ignored: credibility. In the real world governments find it difficult to craft and implement credible international regulations and thus agents are unable to be so forward-looking as assumed in ideal-world modelling exercises. As credibility declines the cost of coordinated international regulation skyrockets—even in developing countries that are likely to delay their adoption of binding limits on emissions. Because international institutions such as treaties are usually weak, governments must rely on their own actions to boost regulatory credibility—for example, governments might “pre-commit” international regulations into domestic law before international negotiations are finally settled, thus boosting credibility. In our scenarios, China alone would be a net beneficiary of pre-commitment that advances its carbon limits two decades (from 2030, in our scenario, to today) if doing so would make international regulations more credible and thus encourage Chinese firms to invest with a clearer eye to the future. Overall, low credibility is up to 6 times more important in driving higher world costs for carbon regulations when compared with variable geometry, limits on emission trading and variable sectors. In this paper, we have not explored the other major dimension to the second-best: the lack of timely availability of the full range of abatement options, although our results suggest that even this will be less consequential than credibility.Greenhouse Gases, Second-best Regulation

Banking Permits: Economic Efficiency and Distributional Effects

Most analyses of the Kyoto flexibility mechanisms focus on the cost effectiveness of “where” flexibility (e.g. by showing that mitigation costs are lower in a global permit market than in regional markets or in permit markets confined to Annex 1 countries). Less attention has been devoted to “when” flexibility, i.e. to the benefits of allowing emission permit traders to bank their permits for future use. In the model presented in this paper, banking of carbon allowances in a global permit market is fully endogenised, i.e. agents may decide to bank permits by taking into account their present and future needs and the present and future decisions of all the other agents. It is therefore possible to identify under what conditions traders find it optimal to bank permits, when banking is socially optimal, and what are the implications for present and future permit prices. We can also explain why the equilibrium rate of growth of permit prices is likely to be larger than the equilibrium interest rate. Most importantly, this paper analyses the efficiency and distributional consequences of allowing markets to optimally allocate emission permits across regions and over time. The welfare and distributional effects of an optimal intertemporal emission trading scheme are assessed for different initial allocation rules. Finally, the impact of banking on carbon emissions, technological progress, and optimal investment decisions is quantified and the incentives that banking provides to accelerate technological innovation and diffusion are also discussed. Among the many results, we show that not only does banking reduce abatement costs, but it also increases the amount of GHG emissions abated in the short-term. It should therefore belong to all emission trading schemes under construction.emission trading, banking

Delayed Participation of Developing Countries to Climate Agreements: Should Action in the EU and US be Postponed?

This paper analyses the cost implications for climate policy in developed countries if developing countries are unwilling to adopt measures to reduce their own GHG emissions. First, we assume that a 450 CO2 (550 CO2e) ppmv stabilisation target is to be achieved and that Non Annex1 (NA1) countries decide to delay their GHG emission reductions by 30 years. What would be the cost difference between this scenario and a case in which both developed and developing countries start reducing their emissions at the same time? Then, we look at a scenario in which the timing of developing countries’ participation is uncertain and again we compute the costs of climate policy in developed and developing countries. We findthat delayed participation of NA1 countries has a negative impact on climate policy costs. Economic inefficiencies can be as large as 10-25 TlnUSD. However, this additional cost wanes when developing countries are allowed to trade emission reductions from their baseline emission paths during the 30-year delay period. Thus, irrespective of whether NA1 countriesare immediately assigned an emission reduction target or not, they should nonetheless be included in a global carbon market. Technology deployment is also affected by the timing of developing countries’ mitigation measures. Delayed NA1-country participation in a climateagreement would scale down the deployment of coal with CCS throughout the century. Onthe other hand, innovation in the form of energy R&D investments would be positivelyaffected, since it would become crucial in developed countries. Finally, uncertainty about the timing of NA1-country participation does not modify the optimal abatement strategy for developed countries and does not alter policy costs as long as a global carbon market is in place.delayed action, climate policy, stabilisation costs, uncertain participation

Banking Permits: Economic Efficiency and Distributional Effects

Most analyses of the Kyoto flexibility mechanisms focus on the cost effectiveness of “where” flexibility (e.g. by showing that mitigation costs are lower in a global permit market than in regional markets or in permit markets confined to Annex 1 countries). Less attention has been devoted to “when” flexibility, i.e. to the benefits of allowing emission permit traders to bank their permits for future use. In the model presented in this paper, banking of carbon allowances in a global permit market is fully endogenised, i.e. agents may decide to bank permits by taking into account their present and future needs and the present and future decisions of all the other agents. It is therefore possible to identify under what conditions traders find it optimal to bank permits, when banking is socially optimal, and what are the implications for present and future permit prices. We can also explain why the equilibrium rate of growth of permit prices is likely to be larger than the equilibrium interest rate. Most importantly, this paper analyses the efficiency and distributional consequences of allowing markets to optimally allocate emission permits across regions and over time. The welfare and distributional effects of an optimal intertemporal emission trading scheme are assessed for different initial allocation rules. Finally, the impact of banking on carbon emissions, technological progress, and optimal investment decisions is quantified and the incentives that banking provides to accelerate technological innovation and diffusion are also discussed. Among the many results, we show that not only does banking reduce abatement costs, but it also increases the amount of GHG emissions abated in the short-term. It should therefore belong to all emission trading schemes under construction.Emission Trading, Banking, Welfare Distribution, Stabilisation Cost

Climate Change Mitigation Strategies in Fast-Growing Countries: The Benefits of Early Action

This paper builds on the assumption that OECD countries are (or will soon be) taking actions to reduce their greenhouse gas emissions. These actions, however, will not be sufficient to control global warming, unless developing countries also get involved in the cooperative effort to reduce GHG emissions. This paper investigates the best short-term strategies that emerging economies can adopt in reacting to OECD countries’ mitigation effort, given the common long-term goal to prevent excessive warming without hampering economic growth. Results indicate that developing countries would incur substantial economic losses by following a myopic strategy that disregards climate in the short-run, and that their optimal investment behaviour is to anticipate the implementation of a climate policy by roughly 10 years. Investing in innovation ahead of time is also found to be advantageous. The degree of policy anticipation is shown to be important in determining the financial transfers of an international carbon market meant to provide incentives for the participation of developing countries. This is especially relevant for China, whose recent and foreseeable trends of investments in innovation are consistent with the adoption of domestic emission reduction obligations in 2030.Energy-economy Modeling, Climate Policy, Developing Countries