Global Warming Policy: Some Economic Implications

Studies | Global Warming

No. 224
Saturday, May 01, 1999
by Stephen P. A. Brown


Evaluating Global Warming Policy: A Cost-Benefit Approach

Figure II - Estimated Benefits and Costs of CO2 Abatement

Cost-benefit analysis, as the name implies, is a comparison of the estimated costs associated with an action with its estimated benefits. Cost-benefit analysis is useful in determining whether an action should be taken and, if so, what action will produce the best results at the least cost. Thus cost-benefit analysis is vitally important in making decisions about whether and how to reduce the impact of global warming (e.g., carbon taxes, mandatory fuel rationing or conservation, subsidies to non-carbon-based energies or some form of tradable emission quotas).

"The expected benefits of reducing CO2 emissions are the avoidance of the environmental damages that might result from those emissions."

Estimating the Benefits of Reducing CO2 Emissions. The expected benefits of reducing CO2 emissions are the avoidance of the environmental damages that might result from those emissions. For example, fewer hurricanes mean less property damage; avoiding tidal flooding increases the value of coastal property; less crop destruction translates into lower food prices; fewer diseases mean lower health care costs. An emerging literature attempts to evaluate the economic costs associated with the potential environmental damage associated with CO2 emissions.8 The analysts and researchers working in this endeavor use climate models to relate CO2 emissions to global warming. They then attempt to relate global warming to possible environmental consequences and to estimate the economic costs associated with those consequences. Obviously, the analysts and researchers must contend with considerable uncertainty about the magnitude and direction of effect in each step of the analysis. That uncertainty is reflected in the analysis.

Comprehensive surveys of the emerging literature on the economic cost of global warming suggest that the worldwide marginal benefit of reducing CO2 emissions in 2010 plausibly ranges from $0 to $300 per metric ton (in 1995 dollars).9 To put this into context, consuming a barrel of oil results in the emission of 0.1133 metric tons of CO2, so the marginal benefit of reducing the emissions from one barrel of oil plausibly ranges from $0 to $33.75. Within this $0 to $33.75 range, the literature sugests that the most likely range of benefits (at a 95 percent confidence level) is 92 cents to $6.61 per barrel of oil equivalent, shown in Figure II. The mean estimate is $2.86 per barrel of oil equivalent.10

"The cost is expressed in the forgone economic opportunities from using less fossil feed."

Given the considerable uncertainty about the benefits of reducing CO2 emissions, some analysts have suggested that making the reductions is comparable to buying insurance. The costs of reducing emissions are fairly well known, but the benefits are not known and may not exist.

Estimating the Costs of Reducing CO2 Emissions. The cost is expressed in the forgone economic opportunities from using less fossil fuel. Completing the cost-benefit analysis requires estimating the costs of reducing CO2 emissions through the conservation of fossil fuels. Following several previous studies, estimates of marginal cost are obtained through the use of a welfare-theoretic framework (a method for measuring the cost of deviating from market efficiency) built on top of a simulation model of world energy markets.11 The resulting estimates assume that all nations comply with the treaty to the same extent as the United States.12

Figure III - Estimated Benefits and Costs of CO2 Abatement - Free Lunch Scenario

"Only about 14 percent of the emissions reduction the Kyoto accord requires can be cost-justified."

The first marginal cost curve, shown in Figure II, represents the marginal costs to the world of the U.S. fossil fuel conservation necessary to reduce CO2 emissions. Maximal economic well-being occurs at the level of CO2 abatement at which the marginal cost equals the marginal benefit (i.e., 65 million metric tons or $2.86 per barrel of oil equivalent). A risk-neutral approach equates marginal cost to the mean estimate of marginal benefit.13 An extreme precautionary approach to avoiding the risk of global warming uses the upper-bound estimate of the likely range as the measure of marginal benefit. As Figure II shows:

  • The estimated marginal cost of CO2 abatement equals the mean estimate of marginal benefit at about 14 percent (65 million metric tons) of the level set by the Kyoto accord.14
  • The estimated marginal cost of CO2 abatement equals the upper-bound estimate of marginal benefit at about 45 percent (200 million metric tons) of the level set by the Kyoto accord.

By comparison, both President Clinton's earlier proposal to reduce U.S. emissions to 1990 levels by 2010 and the Kyoto accord's requirement that the U.S. reduce emissions to 7 percent below the 1990 levels imply figures substantially higher than what is optimal under either measure of marginal benefits.

President Clinton's proposal implies 384 million metric tons of CO2 abatement. At this level, the marginal cost is more than $16 per barrel of oil equivalent, substantially more than the mean estimate of marginal benefits of $2.86 per barrel of oil equivalent or the likely upper-bound estimate of $6.61.

U.S. compliance with the Kyoto accord would require an estimated 478 million metric tons of CO2 abatement in 2010. If it all came from fossil fuel conservation, the marginal cost would be nearly $25 per barrel of oil equivalent. The accord allows international trading in emission reduction credits and allows offset credits for helping another nation reduce, limit or avoid emissions. U.S. officials expect to use offsets and credits to reduce the burden from conservation of fossil fuels to 3 percent below 1990 levels. This implies 424 million metric tons of CO2 abatement from the conservation of fossil fuels, at a marginal cost of just under $20 per barrel of oil equivalent.

As can be seen from these estimates and from Figure II, the amount of CO2 abatement that a Kyoto treaty would require from the United States is well above the optimum. The marginal benefit of emission reduction would remain $2.86 per barrel of oil equivalent, but the marginal cost of compliance would rise to $20 to $25, depending on whether the United States is able to use offsets or credits. Thus the marginal cost of compliance would be seven to nine times the marginal benefit. At the upper-bound benefit estimate of $6.61 per barrel of oil equivalent, the marginal cost would be three to four times the marginal benefit.

Figure IV - Estimated Benefits and Costs of CO2 Abatement Including Hidden Costs

"The net effect of compliance would be to reduce total U.S. energy consumption by about 25 percent below the amount that would otherwise occur."

By my estimate, compliance with Kyoto would necessitate a reduction of about 30 percent in U.S. fossil energy consumption below that projected for 2010 by the U.S. Department of Energy. Non-fossil energy consumption would rise slightly. The net effect would be to reduce total U.S. energy consumption about 25 percent below that projected for 2010 by the Department of Energy.

To give an idea of the impact of a reduction of that magnitude, 26 percent of the total consumption of all fossil and non-fossil energy in the United States in 1996 was for transportation, 36 percent for residential and commercial use and 38 percent for industial and miscellaneous use.

Improved Terms of Trade. If the United States and other developed countries consumed less oil and natural gas, the prices of these fossil fuels would drop. As an importer of oil and natural gas, the United States would benefit from lower prices for those two fuels and simultaneously would shift some of the costs of its conservation to oil and natural gas exporters. In economics parlance, this shift of costs is known as "improved terms of trade."

Because it can shift some of the costs of its oil and natural gas conservation to other countries, the United States would incur a lower cost for reducing CO2 emissions than would the world. Some analysts would incorporate this cost shift into the analysis, and as shown in Figure III, the lower marginal cost implies that a greater reduction in CO2 emissions would be optimal. Such a conclusion is flawed, however. Optimality cannot be found by equating the marginal benefit to the world with the marginal cost to the United States. This is like comparing apples to oranges. Sound analysis requires consistency in defining the incidence of costs and benefits.

"Analysts who believe in the 'free lunch' use conceptually flawed studies to support their claims."

Free Lunch: There Is No Such Thing. A number of energy analysts argue that the United States can cut its energy consumption by 25 percent and achieve a cost saving at the same time. The curve labeled "Free Lunch" in Figure III shows that President Clinton's pre-Kyoto target for reducing CO2 emissions would be very close to optimal if a free lunch did exist. Some analysts who consider this cost curve accurate and who favor the extreme precautionary approach to reducing CO2 emissions have criticized the president's target as too conservative. As shown in Figure III, reducing CO2 emissions from fossil fuels to 3 percent below 1990 levels would have a marginal cost that is above the mean estimate of marginal benefit but below the likely upper bound.

Analysts who believe in the free lunch use conceptually flawed studies to support their claims.15 Also they are unable to explain why a free market would leave such cost saving on the table rather than adopt conservation measures without government prodding. Instead, they offer vague explanations of market barriers including inappropriate lifestyle choices and demand government regulation to reduce what they see as wasteful use of energy.16

Hidden Costs of Policy. Economic policy often carries costs that are not captured by traditional welfare-theoretic measures. Regulatory inefficiency is one way costs can escalate. When regulation instead of broad market incentives such as taxes is used, the lowest-cost methods of energy conservation can be ignored.

Interference in free trade is another way policies to reduce CO2 emissions can have hidden costs. Broad programs of energy conservation permit energy-importing countries to improve their terms of trade with energy-exporting countries a fact that has not been lost on the Organization of Petroleum Exporting Countries. The countries that are the most dependent on imported energy have been the most aggressive in promoting global cooperation to reduce CO2 emissions. More self-sufficient countries, such as the United States, have been more reluctant to participate. Within the United States, energy conservation has a decided tilt toward the conservation of oil, the fuel for which we are most import-dependent.

Rent-seeking behavior using government to gain what could not be obtained in a free market is a third source of hidden costs. Changes in policy create winners and losers. Both groups have an incentive to expend real resources to achieve their objectives by influencing the political process, which can add sizable costs to policy.

A method for estimating the costs of rent-seeking behavior was first suggested by economist Gordon Tullock.17 Using his approach, I estimate the potential hidden costs of policy, which captures only the costs of rent-seeking behavior. As shown in Figure IV, these costs can be sizable. With the hidden costs incorporated, the marginal cost of reducing U.S. CO2 emissions is more than $30 per barrel of oil equivalent at zero abatement and more than $80 at full compliance with the Kyoto accord. If the potential for hidden costs were taken seriously, the cost of reducing CO2 emissions would greatly outweigh its benefits at any level of attainment.


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