Climate Change 2001: Working Group III: Mitigation

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9.4.2.7 Treatment of Environmental Damages

Most models are not able to incorporate the benefits of preventing climate change (or of the costs of doing nothing). Instead, modellers have only considered the economic impact of meeting some emission standard, which implicitly assumes (in the base situation) that climate change would have no economic impacts. Nevertheless, the potential costs caused by climate change are likely to be huge (even though some favourable effects are also expected) regarding: loss of human well-being, damage to property including agriculture and forestry, ecosystem loss, and risk of disaster, see Nordhaus (1991), Cline (1992, Chapter 3), Fankhauser (1995), Fankhauser and Tol (1995). This situation has been caused to some extent by two factors, the difficulties of economists in valuing environmental impacts, and the scientific uncertainty of predicting the physical effects of climate change¹³.

9.4.2.8 Recycling of Tax Revenues

Carbon taxes will generate significant tax revenues. The effects of these revenues in the economy will depend on how this money is recycled into the economy (in practical terms, some mechanism for recycling is always needed in order to avoid a general deflationary impact). If it is assumed that revenues will not be fully recycled, the models tend to find that any carbon tax will reduce GDP. Usually, modellers have tried to separate the economic impacts arising from this environmental policy from those arising from a tax cut, assuming that revenues will be returned in the form of lump-sum rebates (an unrealistic assumption). The alternative is to assume that revenues collected from the carbon tax are used in correcting economic distortions in the economy, e.g., taxation of employment, which would benefit society not only by correcting the externality but also by reducing the costs of the distorting taxes (the so-called “double dividend”). Obviously, if the benefits from reducing existing taxes on labour are incorporated into the modelling, the projected economic impacts can be substantially more optimistic than if a lump-sum revenue recycling is assumed, although the size of the effect depends on model specification¹⁴.

9.4.2.9 International Environmental Policy

Environmental policy to reduce climate change will be economically efficient when the incremental cost of emission reductions is equal in all complying countries. A way of achieving cost savings in the abatement policy is to allow emission sources to contract with each other to meet required emission reductions. In this sense, flexible instruments such as international emissions trading and JI are more efficient than a situation in which each country has to achieve its own emission reduction¹⁵. Usually, international emissions trading is modelled as if all countries set the same carbon tax rate, so that cost-effective emission reductions are advantageous to undertake in whatever country they arise. Hence, if models consider economic instruments for environmental regulation, the overall cost of controlling emissions should be lower as a consequence of cost savings in the control produced by these instruments¹⁶.

It is important to point out that this kind of modelling implicitly assumes an ideal scenario. However, in practice some problems arise with the basic theory, involving the operation and design of the market. Some important considerations here are:

• the degree of competition in the market (i.e., that neither buyers nor sellers have sufficient weight to influence the price of the permit);
• high transaction costs derived from inadequate information;
• airness in allocating the emission permits (auctioning versus “grandfathering”); and
• the institutional and administrative costs of implementing the system (are the costs negligible?)¹⁷.