Climate change. Methods to internalize externalities

Table of Contents

List of Figures

List of Tables

List of Abbreviations

1 Introduction

2 Climate Change
2.1 Global warming
2.2 Greenhouse gases
2.3 Atmospheric carbon dioxide
2.4 Current and prospective future impacts and risks

3 Externalities
3.1 Externalities in the context of greenhouse gases
3.2 Market failure
3.3 Internalization of external effects
3.4 Public goods

4 Long-term policy problem
4.1 Free riders
4.2 Time inconsistency
4.3 Domestic politics problem
4.4 Interrelation

5 Economic instruments of environmental policy
5.1 Coase Theorem
5.2 Regulatory instruments
5.3 Market-based instruments
5.3.1 Pigouvian tax
5.3.2 Comparison of a regulatory instrument and the Pigouvian tax
5.3.3 Socially optimal level of pollution and the Pigouvian tax level
5.3.4 Deviation from the optimal tax level and the resulting welfare impact
5.3.5 Case study - Carbon tax in Switzerland
5.3.6 Tradeable property rights
5.3.7 Comparison between a carbon tax and tradable property rights

6 Global perspective
6.1 Addressing the long-term policy problem
6.2 Global coverage of emissions under a single carbon price
6.3 Implications related to partial implementation of carbon pricing
6.4 Global collaboration to increase responsible action

7 Conclusion and Discussion
7.1 Conclusion
7.2 Discussion

Bibliography

Abstract

Earth is threatened by severe damage if carbon-intensive human activities continue at the current rate. The fact that such activities are changing the climate is confirmed by recent research. The dissertation is therefore motivated to identify possible reasons for insufficient efforts to mitigate climate change. In addition, economic instruments to address the global problem are examined to find the most cost-effective and efficient solution. This thesis also aims to determine and address arising challenges related to the global implementation of climate policies. Based on empirical research, the main barriers to mitigation efforts include intangible results of the measures combined with high costs of affected sectors and potential benefits from free riders. Nevertheless, the results indicate that carbon pricing instruments should be at the heart of every climate policy portfolio. This is because these instruments help to adjust human behaviour in ways that reflect the external effects of their activities. The findings suggest that the most promising scenario to combat climate change would be a uniform global carbon price, yet, this is unlikely to be realized due to multiple factors at present. Considering that countries differ widely, the selection and design of instruments may vary. To improve the efficiency of the policies, a broad-based global collaboration is crucial. Research showed that the internalization of the greenhouse gas externality is one of the most difficult tasks humanity has faced so far, however, there is still a chance to save the environment - it just needs to be seized.

List of Figures

Figure 1, Average global mean surface temperature compared to climate model simulations ..

Figure 2, Atmospheric CO2 at Mauna Loa Observatory

Figure 3, Cost comparison of a regulatory instrument and the Pigouvian tax

Figure 4, Social optimum of environmental pollution

Figure 5, Tax differentials and their impact on social welfare

List of Tables

Table 1, Carbon taxes in operation at the end of 2015

Table 2, Emission trading systems in operation at the end of 2015

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

Anthropocene - this is what many scientists call the new geological era which has already begun. The name is derived from anthropogenic, which describes that something was created by the impact of humans. Precisely, this is what scientists want to portray, as there is ample empirical evidence that the earth is affected by human activities (IPCC, 2018, p.54). In fact, previous research has documented that there is a strong rise in the global carbon dioxide concentration since the mid-20th century. In recent years, several publications appeared documenting that many anthropogenic activities are altering climate (Hsiang and Kopp, 2018, p.5; Stocker et al. 2013; US Global Change Research Program 2017). Hsiang and Kopp (2018, p.4) define climate "as the joint probability distribution describing the state of the atmosphere, ocean, and freshwater systems (including ice)". Although this is a simplification, it includes key factors related to the change of climate like modifications in temperature, humidity, precipitation, sea level and extreme weather events like storms (Auffhammer, 2018, p.38). Apparently, climate change has a complex nature and leads to a multitude of mostly negative changes in the climate system. For this reason, the interest in preventing this damage has grown but responsible action is only occasionally seen. The first research question is therefore:

Why is no greater effort being made to mitigate climate change, even though it might lead to severe damage?

To answer this question, knowledge about climate change is required and will be presented in chapter two. Beyond that, the notion of externalities and their implications are explained in chapter three. Thereafter, a presentation of challenges that hinder actions will be given in chapter four to answer the question. In order to solve the problem, researchers have proposed various methods to reduce or stabilize the global carbon dioxide concentration. This raises the second question:

Which is the most cost-effective and efficient method to mitigate or stop climate change?

The fifth chapter of this thesis is devoted to this question and explains different methods for the mitigation of climate change. Furthermore, the socially optimal level of pollution is discussed, as well as possible welfare impacts which result from deviations from this level. In addition, regulatory and market-based instruments are compared, along with a case study to provide further insights. Since climate change is a global issue, the final question arises:

What are the challenges for climate policy from a global perspective?

This issue is covered in the sixth chapter of this thesis. Therefore, the long-term policy problem is addressed and the implications regarding the global coverage of emissions under a uniform carbon price are explored. It also discusses partial implementation issues and highlights the importance of global collaboration and responsible action. In summary, this thesis aims to present the most relevant economic concepts for solving the climate change problem and to give an overview of how these concepts can be implemented in practice. Moreover, it identifies reasons for a lack of efforts towards mitigating climate change and challenges that appear from a global perspective.

2 Climate Change

2.1 Global warming

To achieve a comprehensive understanding of the issues regarding climate change, the Intergovernmental Panel on Climate Change (IPCC) was founded in 1988. The IPCC is helping policy makers by providing research on climate change from scientists around the world. The aim is to reflect a wide range of views and knowledge. For this purpose, the IPCC evaluates scientific work and produces complete and objective summaries. The summaries are fundamental for many science-based decisions on potential options to solve or mitigate current and prospective future impacts and risks (About the IPCC, 2021). According to a recently published summary of the IPCC (2018, p.4), "[h]uman activities are estimated to have caused approximately 1.0°C of global warming above pre-industrial levels, with a likely range of 0.8°C to 1.2°C. Global warming is likely to reach 1.5°C between 2030 and 2052 if it continues to increase at the current rate." The term "likely" indicates the probability of the outcome of 66% to 100% (IPCC, 2018, p.77). Pre-industrial levels are defined as the average temperature in the years 1850 to 1900. Moreover, human activities are activities that produce greenhouse gases, which will be defined in the next chapter. These anthropogenic emissions will stay in the atmosphere for centuries or even millennia, depending on what kind of emission it is, and continue to change the climate. The magnitude of anthropogenic warming is illustrated in the climate model simulations of Figure 1. Climate models are numeric representations of the real highly complex climate system. The elements involve biological, physical and chemical characteristics and are used to research and simulate climate (IPCC, 2018, pp.543-556).

The left diagram of Figure 1 shows the change in the global mean surface temperature (GMST) in three different ways. First of all, the black line illustrates the observed average annual GMST. Secondly, the red area represents the range of the GMST from 90% of simulated climate models that impose anthropogenic emissions. Lastly, the blue area illustrates the same simulations but merely with natural emissions to control the result. While looking at it all together, it becomes obvious that the temperature observations are consistent with the red area and move far outside the blue range. In other words, the observed warming exceeds the limits of the natural fluctuation of the climate system. Scientists are virtually certain about the statement, this means that there is at least a 99% probability that the rising temperature is caused by humans (Hsiang and Kopp, 2018, pp.14-15).

Figure 1 Average global mean surface temperature compared to climate model simulations

Abbildung in dieser Leseprobe nicht enthalten

Figure 1, Average global mean surface temperature compared to climate model simulations (Hsiang and Kopp, 2018, p.15).

The diagram on the right side illustrates the change in GMST until the year 2100 with model projections in a moderate emission scenario. More specifically, in the moderate emission scenario, the CO2 emissions are settling close to their present level and decrease afterwards to roughly 40% of their current levels by 2080. The black line, which represents the observed temperatures, constantly remains in the area of the red projections. In this model, the GMST is likely rise to 1.7-3.3°C above pre-industrial levels. As it is not yet certain to what extent anthropogenic emissions will be emitted in the future, there are also lower and higher emission scenarios which will lead to lower or higher GMST (Hsiang and Kopp, 2018, pp.15-16).

2.2 Greenhouse gases

Greenhouse gases (GHGs) describe a range of different gases, that can occur natural or through anthropogenic activities. These gases can trap heat and impact the radiative balance of earth. This process leads to warming and is called greenhouse effect. The most important anthropogenic greenhouse gas is called carbon dioxide (CO2). CO2 is released by human activities like deforestation or the burning of fossil fuels like oil or gas. It also occurs in natural processes, such as respiration and volcanic eruptions. Methane is another GHG which is mainly produced in agriculture and animal husbandry. Other primary GHGs in the atmosphere are water vapour, nitrous oxide and ozone. These and other gases are also referred to as CO2 equivalents (CO2e) and differ both in their residence time in the atmosphere and in their impact (IPCC, 2018, pp. 543-557).

2.3 Atmospheric carbon dioxide

Scientists found, that in the last 3 million years, the global temperature never exceeded 2°C above pre-industrial levels. Moreover, they found that never before in the entire reconstructible history of climate, the carbon dioxide content has been as high as today (Willeit et al, 2019, p.5). The longest record of atmospheric CO2 started with the Scripps Institution of Oceanography in 1958. Therefore, a facility of the National Oceanic and Atmospheric Administration (NOAA) in Mauna Loa in Hawaii is used to measure and control the carbon dioxide content until today. Figure 2 illustrates the full record of the global atmospheric CO2 level in parts per million (ppm). The red line represents the monthly average concentrations. It moves up and down due to seasonal fluctuations. The black line shows the same but it contains corrections for the average seasonal cycle. After the pre-industrial period (1850-1900), the timeline starts in 1958 with 315 ppm. In the following years it increases steadily (Tans and Keeling, 2021).

According to scientists, the concentration of CO2 has not changed significantly in the last 800 thousand years before the pre-industrial era (Willeit et al, 2019, p.1). The highest previously found concentration in that timeframe was 300 ppm - significantly lower than the current concentration of 415ppm in January 2021 (Tans and Keeling, 2021; Climate Change: Atmospheric Carbon Dioxide | NOAA Climate.gov, 2021).

Figure 2 Atmospheric CO2 at Mauna Loa Observatory

Abbildung in dieser Leseprobe nicht enthalten

Figure 2, Atmospheric CO2 at Mauna Loa Observatory (Tans and Keeling, 2021).

Concludingly, these records show a strong and fast increasing atmospheric CO2 trend that exceeds the rates of natural change. From the year 2000 until today, the increase is about ten times faster compared to the 800,000 years before. This is equivalent to a growth rate of roughly 20 ppm per decade (Bereiter et al, 2015 cited in IPCC, 2018, p.54).

2.4 Current and prospective future impacts and risks

If anthropogenic emissions increase further or continue to the extent that is happening right now, there will be consequences. Life on earth will differ from the relatively stable life during the Holocene which began 11,700 years ago (IPCC, 2018, p.54) and lasted until 1950 (ibid, p.551). The consequences affect not only humankind but also animals and nature in general. The environment we know today will have less biodiversity in the future. Animals will be threatened and a number of species become extinct (Rao, 2010, p.4). In addition, the weather is going to be more extreme. This becomes noticeable by an increasing average total precipitation because the warmer atmosphere is able to absorb more water vapor (Hsiang and Kopp, 2018, p.17). Thus, increased rainfall contributes to a more frequent occurrence of floods. Furthermore, the global mean sea level is going to rise. This is primarily due to melting glaciers and an increasing water mass that is caused when the water warms up and thus expands. On the other hand, the opposite effect of extreme periods of drought is also intensifying, especially in dry areas (Hsiang and Kopp, 2018, pp.18-21).

Since the modelling of temperature changes is not as complicated as modelling the exact resulting effects, there is a degree of uncertainty. However, there is a broad consensus among various models that tropical cyclones and storms in general will not substantially increase in number but in intensity (Kossin et al, 2017, cited in Economist p. 20). All changes in the environment will also lead to a greater instability of socio-economic nature. Just to name a few examples: climate change will put pressure on water resources, plant and livestock farming will increasingly run into difficulties and the risk for human health will increase, for instance by a growing incidence and spread of diseases (IPCC, 2018, pp. 179-180).

3 Externalities

3.1 Externalities in the context of greenhouse gases

Nicholas Stern (2008, p.1) states, that "Greenhouse gas (GHG) emissions are externalities and represent the biggest market failure the world has seen.". According to this statement, all impacts and risks mentioned above are actually caused by the externality GHG emissions - and those explained before are by far not complete.

Externalities can also be called external effects. Those external effects occur whenever someone benefits from something or is harmed by something - caused by a third party. Moreover, the additional benefit or harm is not compensated by the causer. This means that the causer neither receives compensation for benefits provided nor must pay for harm occurred (Rao, 2010, p.162). Hence, externalities can be either positive or negative. A negative externality is for instance, the greenhouse effect, which is caused by continuous emissions of CO2 and leads to global warming. The effect is therefore harmful to the uninvolved third party, which is the environment in this case (ibid, p.20). In conclusion, negative externalities cause the market to provide a quantity that is above the socially desirable level (Mankiw et al, 2018, p.329).

On the other hand, a positive externality of climate change is less common and controversial but there are a few. Since the greenhouse effect is responsible for melting the arctic ice gradually over time, new, untouched territory with abundant natural resources is emerging. This effect significantly reduces the effort required to access natural resources such as oil, gas and minerals (IPCC, 2007, p.657). The effect is thus beneficial to the uninvolved third party, which could be, for instance, an oil company. In the case of positive externalities, the free market realizes a quantity that is below the socially desirable level (Mankiw et al, 2018, p.331).

3.2 Market failure

According to Nicholas Sterns citation above, the GHG emissions externality is a market failure. A market normally serves to determine the price and quantity for services and goods. Because of externalities, markets often miss the right price and quantity which represent the true costs and benefits of the whole society. If externalities lead to harm and that harm is not reflected in the market price, the resources are not allocated efficiently. The quantity might be efficient for an individual but not from a macro social perspective. This is exactly what happens with the externality GHG emissions - they have been generated for a long time and are not compensated. This conduct leads to a market distortion, as the market price deviates from the actual economic scarcity (IPCC, 2018, p.554).

Furthermore, the GHG externality has four key characteristics which make it particular - and therefore more complex to handle than usual externalities. First, it does not matter where it is produced, its effects are global. Second, most impacts are long-term. Third, there is still a great deal of scientific uncertainty and lastly, the effects are probably extensive and irreversible (Stern, 2008, p.2). Externalities are not the only factors that can lead to a market failure, another example are public goods which will be defined in chapter 3.4.

3.3 Internalization of external effects

In order to remedy market inefficiencies, measures should be taken to adjust the behaviour of people in such a way that they consider the external effects of their activities. It can be a challenge to find a measure that eliminates those externalities. In economics, this is called internalization of external effects (Mankiw et al, 2018, p.329). The aim of internalization is to ensure socially optimal production and consumption patterns by enabling economic units to adapt prices and markets. State intervention or market-based instruments are possible approaches to improve the market performance (Rao, 2010 pp.117-118). These instruments will be discussed later. In advance, the characteristics of the good "climate with low GHGs" and the arising problems will be clarified.

3.4 Public goods

Typically, the market provides goods and services and the arising demand is an indicator of benefit and value to the buyer. The offer equals the costs of the seller and the price indicates the limitation of the resource. For some goods, however, this market force does not work. These particular goods are used without people having to pay for them directly. For this reason the market cannot allocate the resources effectively which may lead to a market failure (Mankiw et al, 2018, p.303). One of these certain goods is called a public good. It has two characteristics that make it differ from typical goods. The first is that no one can be excluded from the goods, whether they pay for them or not. Secondly, there is no rivalry existing in the use of the good (Mankiw et al, 2018, p.304). The good "climate with low GHGs" complies with these characteristics. People that contribute to a climate with less GHGs will create a benefit for everyone else, including the future generations. That means that nobody can be excluded from this benefit. Furthermore, people that profit from a climate with low GHGs, do not take the possibility of others to profit from it. Concludingly, there is no rivalry in the consumption of this public good.

Climate with low GHG emissions has a value but not a price. If people or businesses contribute to a climate with low GHGs, for instance by reducing carbon emissions, they must pay for the measures that are necessary for it. In contrast, the global population will freely benefit from it. Accordingly, reducing GHG emissions creates a positive externality. On the other hand, increasing GHG emissions create a negative externality. As discussed before, in the case of positive externalities, the free market realizes a quantity that is below the socially desirable level. Concludingly, the public good climate with low GHGs would only be provided by the free market in a socially desirable level, if the positive effects of reducing emissions were internalized. Nevertheless, there are some factors, that make the internalization of the external effects difficult. One aspect is, that the atmospheric CO2 has already reached high rates. Furthermore, GHGs remain in the atmosphere for an enormous period of time. This makes climate change a long-term problem. Moreover, there is a time lag between the cause and effect (Hovi, Sprinz and Underdal, 2009, p.1). As a result, effects of reducing GHGs will concern future generations in the first place.

4 Long-term policy problem

All these factors contribute to a major problem which the world is facing. The problem is called long-term policy problem and has three features that climate change shares. First, climate change will endure for at least one human generation. Moreover, there is a deep uncertainty involved and finally, it evokes the characteristics of a public good as discussed before. Despite these features, the circumstance that it can be irreversible makes it a substantial long-term policy problem. In fact, the problem involves three challenges, each of them is different but interrelated. The challenges are free riders, time-inconsistency, and the domestic policy problem (ibid, pp.1-2). Each challenge is going to be explained subsequently.

4.1 Free riders

The first challenge draws attention to free riders. Some people might be tempted to become free riders by the fact, that the public good climate with low GHG levels is freely accessible, along with the evidence that there is a time lag in effects that occur (Hovi, Sprinz and Underdal, 2009, p.11). The free rider problem refers to the use of positive externalities. A free rider profits from a good without providing a corresponding counterpart. As long as the free rider does not get excluded, he or she can use the respective good free of charge. Thus, the free rider has no incentive to contribute to the costs of the good (Mankiw et al, 2018, pp.306-307).

This behaviour can be illustrated by the participation in climate policy agreements, such as the Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC). It was signed in December 1997 in Kyoto in Japan and it was the first international agreement for reducing greenhouse gas emissions (IPCC, 2018, p.553). For the first commitment period until 2012, 37 from at that time 165 ratified countries and the European Union (EU) had set emission reductions targets. Since meeting the targets would involve considerable costs, some countries, such as the United States, refused to ratify them, partly because they expected damage to the economy. Only some countries fulfilled their goals, others had difficulties or did not attempt to achieve them. Apart from that, the Kyoto Protocol only included industrialized countries or those in transition for emissions reduction targets (Hovi, Sprinz and Underdal, 2009, p.32).

Countries that do not comply with agreements like this might get economic and political gains in comparison to participating countries, since they do not have to spend money and introduce new policies to fulfil their goals. Additionally, the impacts of climate change will mostly occur in the future. These reasons drive the decision of the countries to become free riders and refuse to participate or fulfil their commitments (ibid, pp.30-35).

4.2 Time inconsistency

The second challenge that the long-term policy problem implies is time inconsistency. This challenge is about making decisions that make sense and are optimal at one point of time but might not be optimal at another point of time. Even if the decision is well-considered and truly displays the preference of a person or politicians right now, over time, the decision can become inconsistent. This happens because preferences can change when the circumstances change (Kydland and Prescott, 1977).

This phenomenon can be explained by decisions about policies. When policies are planned far into the future, they get approved when everything is optimal. Although the policy was approved, when the future period arrives, it might be not ideal anymore. For instance, anthropogenic emissions are causing climate change and therefore, a long-term plan is needed to encounter that problem. Even if we imagine that there is an optimal and ambitious long-term plan, it is likely that over time some events will occur, so that short-term goals become dominant. If an event like a financial crisis or a pandemic takes place, it might be tempting to postpone, reposition or cancel the ambitious long-term plan about the climate. The reason is that it becomes less credible to use the resources for something that will happen in the future, when there are resources needed for a problem right now. Concludingly, the effects of climate change may not be as credible at the moment as a pandemic or a financial crisis but the paradox is that, in retrospect, we would probably have preferred to avoid it (Hovi, Sprinz and Underdal, 2009, pp.21-23).

4.3 Domestic politics problem

The third challenge is termed domestic politics problem and the focus is on political systems that are usually complex and involve many processes. There is always competition over positions, influence and of course the electorates. For this reason, it is of relevance to meet expectations and demands from supporters or potential ones. The difficulty here is, that there is a limited political capital and there are several goals. This aspect is causing politicians occasionally to modify or even abandon targets (Hovi, Sprinz and Underdal, 2009, pp.25-26). A climate change policy would require to be maintained over several years or even decades. During this period the government will change and with it political concerns and preferences. Beyond that, it is likely that the interests of the population will undergo change, too (ibid, p.26). According to Downs (1972, pp.52-53), the attention of the population does not always keep a sharp focus. He explains this with three different conditions that enhance the likelihood of a decline in interest. Firstly, it is likely that interest in matters which people are not always reminded of, for example by suffering themselves, will decline. The same applies, when an issue requires continuous efforts and profound changes in the behaviour of the population or social institutions, such as the market economy or school education. Finally, interest can be expected to decline if the problem does not appear regularly in the media, e.g. in the news or on cover pages.

Referring to climate change, Downs (1972, pp.53-54) says that it fulfils at least two of the three conditions. As explained before in section 2.4, there will be several impacts of climate change if emissions continue to the current extent. Since the consequences of climate change will occur over time, there is largely no constant reminder. Most of the people are not suffering themselves at present. Furthermore, climate change requires large changes in behaviour to reduce anthropogenic emissions. These two reasons can lead to a loss in interest of the population. Nevertheless, the impacts of climate change will intensify, and therefore extreme events are likely to increase the amount of news about climate change and, thus, raise awareness.

Another aspect concerns the cost and benefit situation. Researchers studied the behaviour of decisions under risk and found that many people have a tendency to respond stronger to the expectation of a certain loss compared to the expectation of an equivalent gain (Kahneman and Tversky, 1979, pp.263-291). Accordingly, the population that will experience a loss through a mitigation measure might have a strong influence. In terms of a climate change policy, both the costs of mitigation policies and the impacts of climate change might be considered as losses. The benefits that can be achieved from such policies are widespread because of their collective nature and impossible to calculate. This makes the gains of a climate change policy hardly tangible. On the other hand, the costs are often concentrated towards certain sectors, mostly those that produce GHGs. In summary, interest in, demand for, and expectations of climate change policies are not very high and it often requires less effort and resources to continue the established political course. For these reasons, environmental policies are not easy to implement (Hovi, Sprinz and Underdal, 2009, pp. 26-28).

4.4 Interrelation

All three challenges of the long-term policy problem are significant in themselves. The fact that they interact, and in some cases, reinforce each other complicates the process of the development and implementation of a climate change policy. For this reason, addressing all challenges at once would be the most effective way to establish such a policy. However, a solution for all challenges at once is difficult to create and implement due to the involvement of many parties and factors that need to be considered. A positive aspect is, nonetheless, that resolving one challenge can facilitate attempts to address another (ibid, pp.34-36).

Hovi, Sprinz and Underdal (ibid, pp.35-36) say that for instance, binding participation in a climate policy agreement, such as the Kyoto Protocol, with an effective enforcement system could help not only against free riders but also against domestic political pressure for an ambitious climate policy. When a government is bound, even if it changes, it can act more credibly against people who are criticising these policies. This is because non-compliance or failure to comply with international obligations will result in punishment and loss of prestige, which can also be important in reaching agreement on other policies of relevance. Concludingly, coping with the GHG externality is difficult - in fact, it is one of the most difficult tasks humanity has faced so far (Rao, 2010, p.12). For this reason, the following chapters are discussing different possibilities and theories of internalising the GHG externality.

[...]