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Journal of Economic Literature 2010, 48:4, 903–934 http:www.aeaweb.org/articles.php?doi=10.1257/jel.48.4.903

903

1.  Introduction

Global warming is one of the most criti-cal, and also most daunting, challenges  facing policymakers in the twenty-first cen- tury,  (e.g.,  World  Bank  2010).  Assessing  a  globally  efficient  time  path  for  pricing  or  controlling  greenhouse  gas  (GHG)  emis- sions is difficult enough, with huge scientific  uncertainties,  disagreement  over  the  ulti- mate  goals  of  climate  policy,  and  disagree- ment  over  which  countries  should  bear  most  responsibility  for  emissions  reduc- tions. On top of this, domestic policy design  is  inherently  difficult  because  of  multiple,  and  sometimes  conflicting,  criteria  for  pol- icy evaluation. And at an international level, 

there are multiple approaches to coordinat- ing  emissions  control  agreements.  What  should  be  a  rational  policy  response  for  such an enormously complex problem? 

This  paper  attempts  to  provide  some  broad  answers  to  this  question,  and  to  pin- point  the  main  sources  of  controversy,  by  pulling  together  key  findings  from  diverse  literatures  on  mitigation  costs,  damage  valuation,  policy  instrument  choice,  tech- nological  innovation,  and  international  cli- mate  policy.  Given  that  our  target  audience  is  the  broader  economics  profession  (rather  than the climate specialist), our discussion is  highly succinct and avoids details.

We  begin  with  the  broadest  issue  of  how  much  action  to  price  or  to  control  GHGs 

Designing Climate Mitigation Policy

Joseph E. Aldy, Alan J. Krupnick, Richard G. Newell,   Ian W. H. Parry, and William A. Pizer*

This paper provides (for the nonspecialist) a highly streamlined discussion of the main issues, and controversies, in the design of climate mitigation policy. The first part of the paper discusses how much action to reduce greenhouse gas emissions at the global level is efficient under both the cost-effectiveness and welfare-maximizing paradigms. We then discuss various issues in the implementation of domestic emis- sions control policy, instrument choice, and incentives for technological innovation. Finally, we discuss alternative policy architectures at the international level. (JEL Q54, Q58)

*  Aldy:  Special  Assistant  to  the  President  on  Energy  and  the  Environment;  his  work  on  this  paper  was  com- pleted  while  he  was  a  full-time  fellow  at  Resources  for  the Future. Krupnick: Resources for the Future. Newell:  Nicholas School of the Environment and Earth Sciences,  Duke University. Parry: Resources for the Future. Pizer:

his  work  on  this  paper  was  completed  while  he  was  a  full-time  senior  fellow  at  Resources  for  the  Future.  The  authors  are  grateful  to  Carolyn  Fischer,  Roger  Gordon,  Charles  Kolstad,  Knut  Rosendahl,  Kenneth  Small,  and  Brent  Sohngen  for  helpful  comments  and  to  Michael  Eber for research assistance.

Journal of Economic Literature, Vol. XLVIII (December 2010)904

is  warranted  in  the  near  and  longer  term  at  a  global  level.  There  are  two  distinct  approaches  to  this  question.  The  cost-effec- tiveness  approach  acknowledges  that  policy- makers  typically  have  some  ultimate  target  for  limiting  the  amount  of  projected  climate  change  or  atmospheric  GHG  accumulations,  and  the  question  is  what  policy  trajectory  might  achieve  alternative  goals  at  minimum  economic  cost,  accounting  for  practical  con- straints, such as incomplete international coor- dination. The other approach is to weigh the  benefits and costs of slowing climate change,  which introduces highly contentious issues in  damage  valuation,  dealing  with  extreme  cli- mate risks, and intergenerational discounting.

The  second  part  of  the  paper  deals  with  issues in the implementation of climate pol- icy. At a domestic (U.S.) level, these include  a  comparison  of  alternative  emissions  con- trol  instruments  and  how  they  should  be  designed to simultaneously promote admin- istrative  ease  and  minimize  efficiency  costs  in  the  presence  of  other  policy  distortions,  abatement  cost  uncertainty,  and  possible  distributional  constraints.  We  also  discuss  the  extent  to  which  additional  policies  are  warranted to promote the development and  deployment  of  emissions-saving  technolo- gies.  And  we  briefly  summarize  emerging  literature  on  alternative  international  policy  architectures.  A  final  section  discusses  key  areas for future research.

2.  Policy Stringency

2.1.  Emissions Pricing to Stabilize Global Climate

The  cost-effectiveness  approach  to  global  climate  policy  uses  models  of  the  economic  and  climate  system  (known  as  integrated  assessment  models)  to  estimate  the  emis- sions  price  trajectory  that  minimizes  the  discounted  worldwide  costs  of  emissions  abatement, subject to a climate  stabilization 

target  and  possibly  other,  practical  con- straints  like  delayed  developing  country  participation. These models range from bot- tom-up  engineering–economic  models  with  considerable  detail  on  adoption  and  use  of  energy  technologies  to  computable  general  equilibrium models with a more aggregated  and  continuous  structure  that  better  repre- sents  demand  responses,  capital  dynamics,  and  factor  substitution.  Many  models  are  hybrids  containing  substantial  technological  detail in the energy sectors and more aggre- gate  representation  in  others.  Typically  the  suite  of  existing  and  emerging  technologies  is  taken  as  given,  although  some  models  capture  induced  innovation  through  learn- ing-by-doing  and  a  few  have  incorporated  R&D-based  technological  change  (e.g.,  Lawrence  H.  Goulder  and  Koshy  Mathai  2000). 

The  choice  of  model  structure  is  gener- ally  less  important  than  assumptions  about  future baseline data and technology options.  Future  mitigation  costs  are  highly  sensitive  to business-as-usual (BAU) emissions, which  depend  on  future  population  and  GDP  growth,  the  energy-intensity  of  GDP,  and  the fuel mix. They also depend on the future  availability and cost of emissions-saving tech- nologies  like  nuclear  and  renewable  power,  carbon  capture  and  storage,  and  alternative  transportation  fuels.  Considerable  uncer- tainty surrounds all of these factors.   

Given the difficulty of judging which mod- els  give  the  most  reliable  predictions,  we  discuss  a  representative  sample  of  results,  beginning with studies that assume emissions  reductions  are  efficiently  allocated  across  countries and time, and use the least expen- sive  technological  options  (this  is  known  as  “where,  when,  and  how”  flexibility).  The  results,  summarized  in  table  1,  are  from  the  U.S.  Climate  Change  Science  Program  (CCSP, Product 2.1A), based on results from  three  widely  regarded  models  (see  Leon  E.  Clarke et al. 2007 for details), and from the 

905Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

Stanford  Energy  Modeling  Forum’s  EMF- 21  study  (reported  in  Francisco  C.  de  la  Chesnaye  and  John  P.  Weyant  2006)  based  on sixteen models. 

2.1.1. Reference Scenarios

Global  CO2  emissions  from  fossil  fuels  have  grown  from  about  2  billion  (metric)  tons in 1900 to current levels of about 30 bil- lion  tons  and,  in  the  absence  of  mitigation  policy,  are  projected  to  roughly  triple  2000  levels by the end of the century (table 1). The  huge bulk of the projected future emissions  growth  is  in  “non-Annex  1”  (nonindustrial)  countries—CO2 emissions from these coun- tries have just overtaken those from “Annex  1” (industrial) countries.1 These rising emis- sions trends reflect growing energy demand  from  population  and  real  income  growth  outweighing  energy-  and  emissions-saving  technological change—traditional fossil fuels  still  account  for  around  three-quarters  of  global primary energy consumption by 2100  (Clarke et al. 2007, table TS1).2 

About  55  percent  of  CO2  releases  are  immediately  absorbed  by  the  upper  oceans  and  terrestrial  biosphere  while  the  remain- der  enters  the  atmosphere  and  is  removed  by  the  ocean  and  terrestrial  sinks  only  very  gradually  (Intergovernmental  Panel  on  Climate Change 2007). The longer term rate  of  removal  of  CO2  from  the  atmosphere  is  around  1  percent  a  year  (i.e.,  CO2  has  an  expected  atmospheric  residence  time  of 

1  The  1990  U.N.  Framework  Convention  on  Climate  Change  grouped  countries  into  either  Annex  1  or  non- Annex 1 according to their per capita income at that time.  Only Annex 1 countries agreed to reduce emissions under  the 1997 Kyoto Protocol. 

2  Land-use  changes  currently  contribute  about  an  additional  5.5  billion  tons  of  CO2  releases  (primarily  through  deforestation  in  developing  countries  for  agri- culture  and  timber)  though  these  sources  are  projected  to  grow  at  a  much  slower  pace  than  fossil  fuel  emissions  (Intergovernmental  Panel  on  Climate  Change  2007).  Land-use  CO2  emissions  are  not  priced  in  the  models  in  table 1.

about a century), and even this very gradual  decay  rate  might  decline  as  oceans  become  more  saturated  with  CO2.  Stabilizing  atmo- spheric  CO2  concentrations  over  the  very  long term essentially requires elimination of  fossil fuel and other GHG emissions. 

Atmospheric CO2 concentrations in creased  from  preindustrial  levels  of  about  280  parts  per  million  (ppm)  to  384  ppm  in  2007,  and  are projected to rise to around 700–900 ppm  by  2100  (table  1).  Accounting  for  non-CO2  GHGs,  such  as  methane  and  nitrous  oxides  from  agriculture,  and  expressing  them  on  a  lifetime  warming  equivalent  basis,  the  CO2-equivalent  concentration  is  about  430  ppm  (Intergovernmental  Panel  on  Climate  Change 2007). Total GHG concentrations in  CO2-equivalents  are  projected  to  reach  550  ppm  (i.e.,  about  double  preindustrial  levels)  by around mid century.

Globally  averaged  surface  temperature  is  estimated  to  have  risen  by  0.74°C  between  1906  and  2006,  with  most  of  this  warming  due  to  rising  atmospheric  GHG  concentra- tions, as opposed to other factors like changes  in solar radiation, volcanic activity, and urban  heat  absorption  (Intergovernmental  Panel  on  Climate  Change  2007).  Figure  1,  from  Intergovernmental Panel on Climate Change  (2007),  shows  the  projected  long  run  warm- ing  associated  with  different  stabilization  levels  for  atmospheric  CO2-equivalent  con- centrations  (the  climate  system  takes  several  decades  to  fully  adjust  to  changing  concen- tration  levels,  due  to  gradual  heat  diffusion  processes  in  the  oceans).  If  CO2-equivalent concentrations  were  stabilized  at  450,  550,  and 650 ppm, mean projected warming over  pre-industrial  levels  is  2.1,  2.9,  and  3.6°C  respectively.  Figure  1  also  indicates  “likely  ranges”  of  warming  about  the  mean  projec- tion,  which  refer  to  an  approximate  66  per- cent confidence interval, based on sensitivity  analysis from scientific models—for example,  the  likely  warming  range  for  550  ppm  CO2- equivalent stabilization  is  1.9–4.4°C.  The 

Journal of Economic Literature, Vol. XLVIII (December 2010)906

TABLE 1 Least-Cost Policies to Stabilize Global Climate

2025 2050 2100

CCSPa MERGE Mini- CAM IGSM MERGE

Mini- CAM IGSM MERGE

Mini- CAM IGSM

Global CO2 emissions, relative to 2000   Reference 1.27 1.46 1.70 1.59 1.98 2.59 3.42 3.21 3.45   450 CO2 stabilization 0.92 0.97 0.86 0.53 0.57 0.64 0.24 0.39 0.55   550 CO2 stabilization 1.25 1.35 1.22 1.32 1.56 1.20 0.79 0.71 0.81

CO2 concentration, ppm b

  Reference 422 430 436 485 507 544 711 746 875   450 CO2 stabilization 412 416 408 434 440 430 426 456 451   550 CO2 stabilization 421 427 421 478 490 472 535 562 526

CO2 price, $/ton c

  450 CO2 stabilization 41 36 88 157 127 230 166 173 1,651   550 CO2 stabilization 3 6 26 10 19 67 127 115 475

% reduction in world GDP d

  450 CO2 stabilization 0.8 0.5 2.6 1.8 1.6 5.4 1.4 1.4 16.1   550 CO2 stabilization 0.0 0.0 0.7 0.2 0.2 1.8 0.7 1.0 6.8

U.S. CO2 emissions,    relative to 2000   Reference 1.25 1.10 1.40 1.27 1.20 2.00 1.63 1.34 2.93   450 CO2 stabilization 0.79 0.83 0.88 0.42 0.43 0.54 0.02 0.27 0.40   550 CO2 stabilization 1.24 1.05 1.04 1.02 0.98 1.13 0.29 0.37 0.59

EMF-21e lower end median upper end lower end median upper end lower end median upper end Global CO2 emissions,    relative to 2000   Reference 1.33 1.48 1.64 1.64 1.88 2.23 2.11 2.93 3.52   550 CO2 stabilization 1.17 1.25 1.41 1.13 1.25 1.41 0.66 0.90 1.25

CO2 price, $/ton c

  550 CO2 stabilization 3 13 21 12 33 99 31 92 166

% reduction in world GDP d

  550 CO2 stabilization 0.1 0.1 0.8 0.2 0.6 3.1 0.3 5.1 8.2

U.S. CO2 emissions,    relative to 2000   Reference 1.19 1.26 1.38 1.31 1.65 1.97 0.95 1.85 2.29   550 CO2 stabilization 1.05 1.14 1.22 0.76 1.02 1.26 0.36 0.53 1.05

Notes: a  Results are from the Integrated Global Systems Model (IGSM), the Model for Evaluating Regional and  Global Effects (MERGE), and MiniCAM Model. See Clarke et al. (2007) for details.

  b  The models stabilize concentrations of all GHGs, rather than CO2 alone (i.e., the CO2-equivalent concen- tration level is higher than the CO2 concentration). Actual CO2 concentrations may temporarily overshoot  the long run targets.

  c  In year 2000 dollars or thereabouts.   d  GDP losses are not broken out by region in the models. Losses include those from pricing CO2 and other 

GHGs on an equivalent basis. The figures do not account for the benefits of reduced climate change.   e  Modeling results from Stanford’s Energy Modeling Forum, reported in de la Chesnaye and Weyant (2006). 

The results are from 16 models for CO2 prices and 12 models for GDP. Lower and upper ends correspond  to lower and upper two-thirds of model results. Atmospheric CO2 concentrations are not reported.

907Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

fundamental  concern  is  that  warming  might  greatly  exceed  these  ranges  due  to  poorly  understood  feedbacks  not  represented  in  these  models,  such  as  heat-induced  releases  of  methane  stored  under  the  oceans  and  in  the permafrost. 

2.1.2. Least-Cost Pricing

Most  economic  analysis  has  focused  on  climate stabilization targets that are approxi- mately  consistent  with  limiting  atmospheric  CO2 concentrations to either 450 or 550 ppm  (with other GHGs included, CO2-equivalent concentrations  stabilized  at  approximately  530 and 670 ppm respectively). The  studies 

in  table  1  examine  globally  cost-effective  pricing  of  all  GHGs  that  are  approximately  consistent with these goals.3 

Across the models and stabilization scenar- ios in table 1, CO2 emissions prices (in year  2000 dollars) rise steadily (beginning around 

3 The G-8 countries recently adopted a target of limit- ing  projected  warming  to  2oC  above  preindustrial  levels.  This  would  require  ultimately  stabilizing  CO2-equivalent  concentrations  at  450  ppm,  which  is  considerably  more  stringent than the 450 ppm CO2 target discussed here. In  fact, with current technologies, it is difficult to see how the  more stringent target could be achieved (even allowing for  transitory  overshooting),  given  that  current  concentration  levels are already approaching this target.

E qu

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o C

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9

8

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4

3

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1

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–

–

–

–

–

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–

–

–

GHG Concentration Stabilization Level (ppm CO2 equivalent)

350 550 750 950 1150

– – – – –

Figure 1. Steady State Warming above Preindustrial Temperatures from Stabilization at Different  GHG Concentrations

Note: The  black  curve  indicates  the  central  case  projection  and  the  grey  curves  indicate  the  66  percent  confidence interval.

Source: International Panel on Climate Change (2007), table 10.8.

Journal of Economic Literature, Vol. XLVIII (December 2010)908

year 2012) at approximately 5 percent a year,  where  this  figure  is  the  consumer  discount  rate  plus  the  atmospheric  CO2  decay  rate  (Stephan  C.  Peck  and  Y.  Steve  Wan  1996).  However,  one  striking  feature  in  table  1  is  the considerable price variation across mod- els  within  a  stabilization  scenario,  reflecting  different  assumptions  about  future  BAU  emissions growth and future costs of carbon- saving  technologies.  The  other  striking  fea- ture is the dramatic differences between the  550  and  450  ppm  CO2  stabilization  targets.  In  the  550  ppm  case,  CO2  prices  are  $3–26  and $10–99 per ton in 2025 and 2050 respec- tively,  with  global  emissions  17–41  percent  and 13–56 percent above 2000 levels at these  dates, respectively. In the 450 ppm case, CO2  prices are 3–16 times those in the 550 ppm  case  to  mid  century,  while  emissions  are  3–14 percent and 36–47 percent below 2000  levels in 2025 and 2050 respectively.4 

Although GDP losses may be an unreliable  proxy  for  efficiency  losses  we  discuss  them  here as they are the least common denomi- nator  reported  by  the  modeling  groups.  Under the 550 ppm CO2 target, most mod- els project global GDP losses (from reducing  both CO2 and non-CO2 GHGs) of less than  1 percent out to 2050, though some models  suggest GDP losses could reach 2–3 percent  by  this  date.  In  present  value  terms,  these  losses  amount  to  about  $0.4–12  trillion  out  to 2050 when applied to a world GDP that is  $60 trillion and growing (Richard G. Newell  2008, p. 12). Under the 450 ppm CO2 target,  GDP  losses  are  about  1.0–2.5  percent  and  1.5–5.5  percent  in  2025  and  2050  respec- tively or about $8–43 trillion in present value  from 2010 to 2050. 

Under  both  450  and  550  ppm  CO2  sta- bilization  scenarios,  the  energy  system  is  transformed  over  the  next  century  (though 

4 Some analysts express prices per ton of carbon rather  than  CO2.  To  convert  to  $  per  ton  of  carbon,  multiply  by  the ratio of molecular weights, 44/12=3.67.

at  very  different  rates),  through  energy  conservation,  improved  energy  efficiency,  and  particularly  reductions  in  the  carbon  intensity  of  energy.  Most  of  the  emissions  reductions  in  the  first  two  to  three  decades  occur  in  the  power  sector,  largely  through  the  progressive  replacement  of  traditional  coal plants by  coal with carbon  capture  and  storage,  natural  gas,  nuclear,  and  renew- ables  (wind,  solar,  and  biomass).  However,  the  projected  fuel  mix  is  highly  sensitive  to  speculative  assumptions  about  the  relative  costs and availability of future technologies.  For  example,  there  are  considerable  prac- tical  obstacles  to  the  expansion  of  nuclear  power (because of safety issues), renewables  (because  sites  are  typically  located  far  from  population centers), and carbon capture and  storage (because of the difficulty of assigning  sub-surface property rights).5 

As  for  U.S.  CO2  emissions,  in  the  BAU  case they increase by about 30–100 percent  above 2000 levels (of approximately 6 billion  tons)  by  mid  century  (table  1).  Under  the  550 CO2 ppm target, emissions initially rise,  then fall to roughly 2000 levels by 2050, and  fall  rapidly  thereafter.  Under  the  450  ppm  target,  U.S.  emissions  are  rapidly  reduced  to  roughly  half  2000  levels  by  2050.6  U.S.- specific  GDP  losses  are  not  reported  in  the  studies in table 1, but allocating a quarter of  the  global  cost  to  the  United  States  (based  on its share in global GDP) implies a present 

5  The  transition  away  from  coal  reflects  not  only  the  range of substitution possibilities in the power sector, but  also the disproportionately large impact of emissions pric- ing on coal prices. A $10 price per ton of CO2 in the United  States would increase 2007 coal prices to utilities by about  60 percent, wellhead natural gas prices by 9 percent, retail  electricity and crude oil prices each by 7 percent, and gaso- line prices by 3 percent (from Clarke et al. 2007, table TS5,  and www.eia.gov). 

6  As  of  2009,  proposed  climate  policies  in  the  United  States  embody  emission  reduction  targets  approximately  equivalent  to  about  of  80  percent  below  2000  levels  by  2050.  However,  actual  reductions  in  U.S.  CO2  emissions  would  be  about  60  percent  if  provisions  to  use  domestic  and international emission offsets were fully exploited. 

909Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

value cost to the United States through mid  century of about $0.1–3 trillion (0–1 percent  of  the  present  value  of  GDP)  for  the  550  ppm target and $2–11 trillion (1–3 percent of  present value GDP) for the 450 ppm target.7

2.1.3.  Deviations from Least-Cost Pricing

Aside  from  the  uncertainty  surrounding  modeling  assumptions,  a  key  qualification  to the studies in table 1 is that they assume  globally  efficient  abatement  policies.  More  likely,  particularly  given  the  “common  but  differentiated  responsibilities”  recognized  in the Kyoto Protocol, participation in global  mitigation  efforts  among  major  developing  country  emitters  will  be  delayed,  causing  marginal  abatement  costs  to  differ  across  regions.  For  a  given  climate  stabilization  scenario,  to  what  extent  does  this  affect  worldwide abatement costs and appropriate  policies in developed countries?

James  A.  Edmonds  et  al.  (2008)  explore  these  issues  assuming  Annex  1  countries  agree  to  impose  a  harmonized  emissions  price starting in 2012, China joins the agree- ment at a later date, and other countries join  whenever  their  per  capita  income  reaches  that of China at the time of China’s accession.  In  one  scenario,  they  assume  new  entrants  immediately  face  the  prevailing  Annex  1  emissions  price,  while  in  another  the  emis- sions price for late entrants converges gradu- ally  over  time  to  the  Annex  1  price.  The  analysis accounts for emissions leakage, that  is, the increase in emissions in nonparticipat- ing countries due to the global relocation of  energy-intensive firms, and increased use of 

7  U.S.-specific  models  project  emissions  price  ranges  that  are  broadly  consistent  with  those  in  table  1.  For  example,  analyses  by  Sergey  Paltsev  et  al.  (2007),  U.S.  Environmental Protection Agency (2008), U.S. Department  of  Energy,  Energy  Information  Administration  (2008a),  and CRA International (2008) project emissions prices of  around $40–90 per ton of CO2 in 2025 for climate legisla- tion  that  would  reduce  U.S.  CO2  emissions  by  about  20  percent below 2000 levels by that date. 

fuels elsewhere as decreased demand in par- ticipating countries lowers world fuel prices.

Under  the  550  ppm  CO2  target,  even  if  China  joins  between  2020  and  2035,  the  implications for Annex 1 policies can be sig- nificant but are not that striking. Compared  with  the  globally  efficient  policy,  near-term  Annex 1 emissions prices rise from between  a few percent to 100 percent under the dif- ferent  scenarios,  and  discounted  global  abatement  costs  are  higher  by  10–70  per- cent.  However,  under  the  450  ppm  CO2  target,  essentially  all  of  the  foregone  earlier  reductions in non-Annex 1 countries must be  offset by additional early reduction in Annex  1  countries  (rather  than  more  global  abate- ment  later  in  the  century).  This  can  imply  dramatically higher near-term Annex 1 emis- sions prices, especially with longer delay and  lower  initial  prices  for  late  entrants.  Under  these  scenarios,  discounted  global  abate- ment costs are about 30–400 percent higher  than  under  globally  efficient  pricing,  and  near and medium term emissions prices can  be an order of magnitude larger with China’s  accession delayed till 2035.

A  further  key  point  from  Edmonds  et  al.  (2008)  is  the  potentially  large  shift  in  the  global  incidence  of  abatement  costs,  under- lying  the  disincentives  for  early  developing  country  participation.  In  the  globally  effi- cient policy, without any international trans- fer  payments,  developing  countries  bear  about  70  percent  of  discounted  abatement  costs  out  to  2100,  while  they  bear  “only”  17–34  percent  of  global  abatement  costs  when  China’s  accession  occurs  in  2035  and  new entrants face lower starting prices.  

Finally, insofar as possible pricing non-CO2  GHGs is also important. According to mod- eling  results  in  de  la  Chesnaye  and  Weyant  (2006), GDP costs are 20–50 percent larger  when only CO2, as opposed to all, GHGs are  priced,  for  the  same  overall  limit  on  atmo- spheric  CO2-equivalent  concentrations.  This  reflects  opportunities  for  large-scale,  

Journal of Economic Literature, Vol. XLVIII (December 2010)910

low-cost  options  for  non-CO2  abatement  in  the  first  half  of  this  century,  though  practi- cal difficulties in pricing other GHGs are not  factored into the models. 

2.1.4. Summary

There  is  a  large  difference  in  the  appro- priate  starting  prices  for  GHG  emissions,  depending  on  whether  the  ultimate  objec- tive  is  to  limit  atmospheric  CO2  concentra- tions  to  450  or  550  ppm—targets  that  are  approximately  consistent  with  keeping  the  eventual,  mean  projected  warming  above  preindustrial levels to 2.7 and 3.7oC respec- tively  (assuming  non-CO2  GHGs  are  also  priced).  The  450  ppm  target  implies  emis- sions prices should reach around $40–90 per  ton of CO2 by 2025, while the 550 ppm target  implies  prices  should  rise  to  $3–25  by  that  date. Securing early and widespread partici- pation  in  an  international  emissions  control  regime  can  also  be  critical  for  containing  costs under the 450 ppm target, while under  the  550  ppm  target  there  is  greater  scope  for offsetting the effect of delayed participa- tion through greater emissions reductions in  the latter half of the century. Given the con- siderable  difference  in  GDP  losses  at  stake  between  the  two  targets  ($8–43  trillion  in  present  value  under  cost-effective  pricing  out to 2050 compared with $0.4–12 trillion),  it is important to carefully assess what start- ing prices might be justified by avoiding cli- mate change damages. 

2.2. Welfare-Maximizing Emissions Pricing

2.2.1. Marginal Damage Estimates

Estimates  of  the  marginal  damages  from  current emissions begin with a point estimate  of  total  contemporaneous  damages  from  warming,  usually  occurring  around  2100.  Total  damage  estimates  from  a  number  of  studies are roughly in the same ballpark for a  given amount of warming. According to rep- resentative estimates in figure 2, damages are 

in  the  range  of  about  1–2  percent  of  world  GDP for a warming of 2.5oC above preindus- trial levels, though some estimates are close  to  zero  or  even  negative  (the  prospects  for  negative costs diminishes with greater warm- ing).  For  warming  of  about  4.0oC,  damage  estimates  are  typically  in  the  order  of  2–4  percent of world GDP. However, similarities  in aggregate impacts mask huge inconsisten- cies  across  these  studies,  which  reach  strik- ingly different conclusions about the size of  market  and  nonmarket  damage  categories  and expected catastrophic risks. 

Very few studies attempt to value the dam- ages from more extreme warming scenarios,  given  so  little  is  known  about  the  physical  impacts  of  large  temperature  changes.  Two  exceptions  are  William  D.  Nordhaus  and  Joseph  Boyer  (2000)  and  Nicholas  Stern  (2007)  who  put  expected  total  damages  at  10.2  and  11.3  percent  of  world  GDP,  for  warming  of  6.0oC  and  7.4oC  respectively,  though  these  figures  are  necessarily  based  on  extrapolations  and  subjective  judgment.  Again,  there  is  little  consistency  across  the  estimates.  In  Nordhaus  and  Boyer  (2000),  catastrophic  risks  and  market  damages  account  for  about  60  and  40  percent  of  total  damages  respectively,  with  nonmarket  impacts  roughly  washing  out  (for  example,  the gains from leisure activities offset losses  from  the  disruption  of  ecosystems  and  set- tlements).  In  contrast,  nonmarket  impacts  account for about half of Stern’s overall dam- age estimate.

Marginal  damage  estimates  are  based  on  assumptions  about  emissions/concentra- tion  relationships,  climate  adjustment  and  sensitivity,  damages  from  climate  change  (inferred from a point estimate of total dam- ages  using  functional  form  assumptions),  and  discount  rates.  Richard  S.  J.  Tol  (2009)  conducts  several  meta-analyses  of  marginal  damage  estimates,  reporting  median  esti- mates of $4.1–20.2 per ton of CO2 (individ- ual studies are not independent however, as 

911Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

they  often  draw  from  the  same  sources  and  from  each  other).  Although  individual  esti- mates are highly divergent, most are on the  low side (see also Stephen C. Newbold et al.  2009).  Especially  striking  is  the  difference  between  Stern  (2007)  at  $85  and  Nordhaus  (2008)  at  $8  per  ton  of  CO2—a  difference  largely dependent on discount rate assump- tions (see below).8

There  is  some  consensus  that  marginal  damages grow at around 2–3 percent a year  in  real  terms  (approximately  the  rate  of  growth in output potentially affected by cli- mate change) or about half the rate as under  cost-effective  emissions  pricing.  Marginal 

8  Some  of  the  differences  in  marginal  damage  esti- mates  reflect  different  assumptions  about  the  year  for  which emissions are being priced, and about the extent of  future  warming.  Most  estimates  of  near-term  Pigouvian  taxes (i.e., marginal damages from the globally optimized

damages  rise  with  the  extent  of  warming  (suggesting a faster rate of increase), but an  offsetting factor is that warming is a concave  (logarithmic)  function  of  atmospheric  con- centrations.  Although  CO2  concentrations  ultimately  reach  650  ppm  in  the  twenty- second century in Nordhaus’s (2008) optimal  policy,  constraining  CO2  concentrations  to  550  ppm  affects,  only  modestly,  the  emis- sion  price  trajectory  to  2050.  Thus,  optimal  near  and  medium  term  emissions  prices  in  Nordhaus  (2008)  are  in  the  same  ballpark  with  those  for  cost-effective  stabilization  of  CO2  concentrations  at  550  ppm,  while  starting  prices  in  Stern  (2007)  are  broadly  

emissions trajectory) are similar to marginal damage esti- mates  at  BAU  emissions  levels.  One  exception  is  Stern  (2007, p. 344) where marginal damages are considerably  reduced  when  aggressive  climate  stabilization  goals  are  achieved.

5

4

3

2

1

0

–1

–2

–3

P er

ce nt

o f

fu tu

re w

or ld

G D

P, o

ut pu

t w

ei gh

te d

2.5oC

4.6–7.1oC 2.5–5.2oC

2.5oC 2.5oC

2.5oC 2.5oC

4.0oC

3.9oC

1.0oC

Fankhauser 1995 Mendelsohn & Williams 2004*

Mendelsohn & Williams 2007*

Nordhaus 1991** Nordhaus & Boyer 2000

Nordhaus 2008** Nordhaus 2008** Stern 2007** Tol 1995 Tol 2002**

Market Catastrophic Non-market

Figure 2. Selected Estimates of Contemporaneous World GDP Damages from  Global Warming Occurring around 2100

Notes: * Only market damages were estimated in these studies. The above figure is the midpoint of a range of   damage estimates. ** Market/nonmarket impacts are not precisely delineated in these studies.

Journal of Economic Literature, Vol. XLVIII (December 2010)912

consistent  with  cost-effective  prices  to  sta- bilize  CO2  concentrations  at  450  ppm,  or  lower. 

2.2.2  Controversies in Marginal Damage Assessment

Differences in marginal damage estimates  are  largely  explained  by  fundamentally  dif- ferent  approaches  to  discounting  rather  than  differences  in  total  damages  from  a  given amount of warming (Nordhaus 2007).  However,  the  valuation  of  catastrophic  and  noncatastrophic  damages  is  also  highly  contentious.

Discounting.  The  descriptive  approach  to  discounting  argues  that  we  can  do  no  better  than  using  observed  market  rates,  typically  assumed  to  be  about  5  percent.9  According  to  this  approach,  market  rates  reveal  individuals’  preferences,  as  best  we  understand  them,  about  trade-offs  between  early  and  later  consumption  within  their  lifecycle, as well as their ethical or intergen- erational  preferences.  And  they  reflect  the  return  earned  by  a  broad  range  of  private  and  public  investments—the  opportunity  cost  against  which  other,  even  intergenera- tional,  investments  ought  to  be  measured.  Proponents of the descriptive approach view  discounting  at  market  rates  as  essential  for  meaningful, consistent policy analysis and to  avoid  highly  perverse  implications  in  other  policy contexts. 

In  contrast,  the  prescriptive  approach  argues  that  market  rates  cannot  be  used  when  looking  across  cohorts  (rather  than 

9 There are many market rates, from the long-term pre- tax real return to equities (about 7 percent) to the after-tax  return to government bonds (about 2 percent). Converting  all  values  into  their  consumption  equivalents,  and  dis- counting at the consumption rate of interest, narrows the  possible  range  of  choice  (e.g.,  Robert  C.  Lind  1982).  In  fact,  Ellen  R.  McGrattan  and  Edward  C.  Prescott  (2003)  suggest  that  the  divergence  in  effective  rates  of  return  is  actually  small,  with  an  average  real  debt  return  during  peacetime  over  the  last  century  of  almost  4  percent  and  the average equity return somewhat under 5 percent.  

within  individuals’  lifetimes).  Instead,  the  discount  rate  (r)  is  decomposed  as  follows:  r = ρ + x·η, where ρ is the pure rate of time  preference, x is the growth rate in consump- tion,  and  η  is  the  elasticity  of  marginal  util- ity  with  respect  to  consumption.  In  Stern  (2007),  for  example,  ρ  =  0.1,  x  =  1.3,  and  η =  1,  implying  r  =  1.4.  Choosing  a  value  for ρ,  the  rate  at  which  the  utility  of  future  generations  is  discounted  just  because  they  are in the future, is viewed as a strictly ethi- cal  judgment.  And  ethical  neutrality,  in  this  approach,  essentially  requires  setting  the  pure  rate  of  time  preference  equal  to  zero.  Discriminating  against  people  just  because  they  are  in  the  future  is  viewed  as  being  akin  to  discriminating  against  people  in  the  present  generation  just  because  they  live  in  different  countries  (Geoffrey  Heal  2009).  There is also controversy over the appropri- ate value for η, which is almost as important  as  ρ.  For  example,  Partha  Dasgupta  (2007)  argues for using a value of 2 to 4 on norma- tive grounds, while Anthony B. Atkinson and  Andrea  Brandolini  (2010)  suggest  a  value  below  unity  is  plausible,  based  on  observed  government behavior.10 

Catastrophic Risks.  Although  Nordhaus  and  Boyer  (2000)  and  Stern  (2007)  include  catastrophic  risks  in  their  damage  assess- ments,  the  numbers  are  best  viewed  as  highly  speculative  placeholders.  Nordhaus  and  Boyer  (2000)  put  the  annual  willing- ness to pay to avoid catastrophic risks at 1.0  and 6.9 percent of world GDP, for warming  levels  of  2.5  and  6.0oC  respectively,  based  on  subjective  probabilities  (from  an  expert 

10  Besides  ethical  arguments,  Thomas  Sterner  and  U.  Martin  Persson  (2008)  argue  for  discounting  the  non- market  impacts  of  climate  change  (e.g.,  ecosystem  loss)  at  below  market  rates.  This  is  because  the  value  of  non- market  goods  (which  are  essentially  fixed  in  supply)  rises  over time relative to the value of market goods (for which  supply  increases  along  with  demand),  assuming  market  and   nonmarket  goods  are  imperfect  substitutes  for  one  another.   

913Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

elicitation  survey)  for  these  warming  levels  permanently  wiping  out  about  a  third  of  world GDP. In his central case, Stern (2007)  assumes  the  chance  of  catastrophic  climate  change is zero up to a warming of about 5oC,  beyond which the annualized risk of regional  GDP losses of 5–20 percent rises by about 10  percent for each additional 1oC of warming. 

Martin L. Weitzman (2009a) takes a radi- cally different perspective. He shows that, if  the  probability  of  increasingly  catastrophic  outcomes  falls  more  slowly  than  marginal  utility  in  those  outcomes  rises  (with  dimin- ished  consumption),  then  the  certainty- equivalent  marginal  damage  from  current  emissions  becomes  infinite.  These  condi- tions apply if the probability distribution for  climate sensitivity is a fat-tailed t-distribution  (i.e., approaches zero at a less than exponen- tial  rate)  and  utility  is  a  power  function  of  consumption.  Although  marginal  utility  is  probably  not  unbounded,  Weitzman  shows  that with probabilities of a 20oC temperature  change  inferred  from  Intergovernmental  Panel  on  Climate  Change  (2007),  and  assuming  this  temperature  change  would  lower world consumption to 1 percent of its  current level, expected catastrophic damages  could easily dwarf noncatastrophic damages  (even  with  these  impacts  delayed  a  century  or more and discounted at market rates).11

There  are  several  responses  to  the  Weitzman  critique.  One  is  that,  most  likely,  the  probability  distribution  for  climate  sen- sitivity  may  have  thin  rather  than  fat  tails.  If  the  distribution  is  thin-tailed,  Newbold 

11  The  Intergovernmental  Panel  on  Climate  Change  report  provides  probability  distributions  from  twenty- two  scientific  studies.  Combining  these  distributions,  Weitzman (2009a) suggests that there is a 5 percent and 1  percent probability that eventual warming from a doubling  of  CO2  equivalent  concentrations  will  exceed  4.5°C  and  7.0°C respectively. However, making an (extremely crude)  adjustment for the possibility of feedback effects he infers  a  distribution  where  the  probability  of  eventual  tempera- ture change exceeding 10°C and 20°C is 5 percent and 1  percent respectively.

and Adam Daigneault (2009) and Robert S.  Pindyck  (2008)  find  that  damage  risks  from  extreme  global  warming  are  typically  under  3  percent  of  consumption  (rather  than  infi- nitely large). 

Second,  setting  a  modest  emissions  price  now  does  not  preclude  the  possibility  of  a  mid-course  correction,  involving  a  rapid  phase-down  in  global  emissions,  should  future  learning  reveal  we  are  on  a  cata- strophic  trajectory  (e.g.,  Gary  W.  Yohe  and  Tol  2009).  This  argument  assumes  policy- makers can avoid the catastrophe—it breaks  down  if  this  would  require  reversing  previ- ous  atmospheric  accumulations  because  an  abrupt climate threshold has been crossed. 

Finally,  a  costly,  rapid  stabilization  of  GHG  concentrations  is  a  highly  inefficient  way  to  address  the  very  small  probabil- ity  of  extreme  outcomes,  if  a  portfolio  of  last-resort  technologies  could  be  success- fully  developed  and  deployed,  if  needed,  to  head  off  the  catastrophe.  These  include  “air  capture”  technologies  for  atmospheric  GHG removal and “geo-engineering” tech- nologies  for  modifying  global  climate.12  Moreover,  these  R&D  efforts  can  be  led  by  one  or  several  countries,  avoiding  the  challenges  endemic  in  organizing  a  rapid  emissions  phasedown  among  a  large  num- ber  of  emitting  countries  with  widely  dif- fering  interests.  Nonetheless,  public  R&D  into  last-resort  technologies  (virtually  non- existent  at  present)  is  highly  contentious.  One  objection  is  that  advancing  last-resort  technologies  could  undermine  support  for  emissions mitigation efforts. Another is that  geo-engineering  (though  not  air  capture) 

12  Besides  rapid  reforestation  programs,  air  capture  might  involve  bringing  air  into  contact  with  a  sorbent  material that binds chemically with CO2 and extraction of  the CO2 from the sorbent for underground, or other, dis- posal. Geo-engineering technologies include, for example,  deflection  of  incoming  solar  radiation  through  shooting  particles  into  the  stratosphere  or  blowing  oceanic  water  vapor to increase the cover of reflective clouds. 

Journal of Economic Literature, Vol. XLVIII (December 2010)914

could  have  extreme  downside  risks  (e.g.,  from  overcooling  the  planet  or  radically  altering  precipitation  patterns)  that  may  be difficult to evaluate prior to widespread  deployment.  Whether  effective  institutions  could  be  developed  to  prevent  unilateral  deployment  of  climate  modification  tech- nologies  prior  to  rigorous  assessment  of  their risks is also unclear (e.g., Scott Barrett  2008; David G. Victor 2008).

In short, the implications of extreme cata- strophic risks for emissions pricing are highly  controversial. So long as there is some posi- tive  likelihood,  no  matter  how  small,  that  the  climate  sensitivity  function  is  fat-tailed  then catastrophic risks can still swamp non- catastrophic  impacts.  Mid-course  policy  corrections  may  come  too  late  to  prevent  a  catastrophe,  given  that  it  may  take  several  decades for the full warming impacts of pre- vious atmospheric accumulations to be real- ized.  And  the  future  viability  of  last-resort  technologies  is  highly  uncertain  at  present.  All of these issues—the nature and extent of  damages from extreme warming, the feasibil- ity  of  future,  mid-course  policy  corrections,  and the efficient balance between mitigation  and investment in last-resort technologies— are badly in need of economic analysis.

Noncatastrophic Impacts.  Although  on  a  different  scale  than  catastrophic  risks,  controversies  abound  in  the  valuation  of  noncatastrophic  damages.  These  include  agricultural impacts, costs of increased storm  intensity  and  protecting  against  rising  sea  levels,  health  impacts  from  heatwaves  and  the  possible  spread  of  vector-borne  disease,  loss  of  ecosystems,  and  so  on.  Box  1  pro- vides  a  very  brief  summary  of  attempts  to  value these damage categories (see Michael  Eber and Alan J. Krupnick 2009 for a more  detailed  discussion).  However,  due  to  the  rapid  outdating  of  prior  research,  daunting  methodological  challenges,  and  the  small  number of economists working on aggregate  damage  assessment,  the  valuation  literature 

remains  highly  inconsistent  and  poorly  developed,  as  a  few  examples  illustrate  (W.  Michael Hanemann 2008).  

Damage  assessments  (like  those  in  figure  2) assume losses in consumer and producer  surplus  in  agricultural  markets  are  equiva- lent to anything from a net gain of about 0.1  percent to a net loss of 0.2 of world GDP for  warming  of  about  2.5oC  occurring  in  2100.  However  more  recent,  country-specific  evi- dence suggests that output losses could be a  lot larger than those assumed in the damage  assessments to infer welfare costs to agricul- ture.  For  example,  William  R.  Cline  (2007)  suggests total losses of agricultural output in  developing countries in the order of 30 per- cent,  while  Raymond  Guiteras  (2008)  esti- mates agricultural losses of 30–40 percent for  India.  Even  for  the  United  States,  Wolfram  Schlenker,  Hanemann,  and  Anthony  C.  Fisher  (2005)  suggest  that  the  output  of  individual  crops  could  fall  by  up  to  70  per- cent  by  2100.  Similarly,  recent  evidence  on  ice melting suggests that sea level rises over  the next century may be more extreme than  the  25–60  cm  assumed  in  most  previous  damage assessments (box 1). And estimated  ecosystem losses of about 0.1–0.2 percent of  world GDP seem inconsistent with Andreas  Fischlin et al.’s (2007) projection that 20–30  percent  of  the  world’s  species  (an  enor- mous amount of natural capital) faces some  (though possibly slight) extinction risk. 

More  generally,  scientific  models  cannot  reliably predict local changes in average tem- perature, temperature variability, and precip- itation, all of which are critical to crop yields.  The baseline for impact assessment decades  from  now  is  highly  sensitive  to  assumptions  about  regional  development  (including  the  ability  to  adapt  to  climate  change),  future  technological change (e.g., into climate- and  flood-resistant  crops),  and  other  policies  (e.g.,  attempts  to  eradicate  malaria  or  inte- grate  global  food  markets).  Controversies  surround  the  valuing  of  nonmarket  effects 

915Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

Box 1. Valuation of Noncatastrophic Climate Damages (for Warming of 2.5oC or Thereabouts Occurring Around 2100)

Agriculture. Estimates of consumer and producer surplus losses in agricultural markets from pre- dicted changes in regional temperature and precipitation use evidence on crop/climate sensitivity  from  laboratory  experiments  and  on  regressions  of  land  values  or  farm  performance  on  climate  variables  (e.g.,  Adams  et  al.  1990;  Reilly  et  al.  2001;  Mendelsohn  et  al.  1994,  2001).  Laboratory  studies can control for confounding factors like soil quality and the fertilizing effect of higher CO2  concentrations, while regression analyses account for farm level adaptation (e.g., changes in crop  variety  and  planting/harvesting  dates).  Worldwide  agricultural  impacts  have  been  built  up  using  extrapolations  from  U.S.  studies,  adjusting  for  differences  in  local  agricultural  composition  and  climate, and, more recently, country-specific evidence that captures local factors like adaptive ca- pability. Studies show a pattern of gains in high latitude and temperate regions (like Russia), where  current temperatures are below optimum levels for crop growth, counteracting damages in tropical  regions, where current temperatures are already higher than optimal.

Sea Level. The annualized costs of future global sea level rises, due to thermal expansion and melt- ing  of  sea  ice,  have  been  estimated  using  projections  of  which  coastal  regions  will  be  protected,  engineering data on the costs of dikes, sea walls, beach replenishment, etc., and estimated losses  from abandoned or degraded property in unprotected areas. Some studies assume efficient behav- ior by local policymakers in their choice of which areas to protect and at what time, while others  assume all currently developed areas will be protected (Yohe 2000). Nordhaus (2008) also includes  an estimate of property losses from increased storm intensity due to greater wind speed and waves  coming off a higher water level. Whether storm frequency will increase with more humid air is un- certain (IPCC 2007). Worldwide sea level impacts have been extrapolated from U.S. evidence, ad- justing for the fraction of local land area in close proximity to the coast, though recently there have  been  some  local  studies  that  account  for  the  slope  and  elevation  of  coastal  land  and  prospective  population growth (e.g., Ng and Mendelsohn 2005 on Singapore). Overall, estimates are relatively  modest, for example they amount to 0.32 of world GDP in Nordhaus (2008).

Some  scientists  project  that  sea  levels  could  increase  by  several  meters  by  2100  (Hansen  2007)  rather than the 25–60 cm projected by IPCC (2007). This would have major impacts on New York,  Boston, Miami, London, Tokyo, Bangladesh, the whole of the Netherlands, and so on, and would  completely inundate several small island states. Based on extrapolations from sea level protection  costs in Holland, the  global  costs  of  this  more  extreme  sea  level  rise may  be  at  least an  order of  magnitude or more greater than for a moderate sea level rise, especially if coastal protection can- not be constructed expeditiously (Nicholls et al. 2008; Olsthoorn et al. 2008). Another possibility  is that warming may cause changes in ocean circulation patterns. However, IPCC (2007) projects  that warming from climate change will dominate any cooling effect on Europe from a weaker Gulf  Stream.

Other market sectors. Studies suggest other market impacts are relatively minor. With most forests  along the increasing part of the inverted-U relation between forest productivity and temperature,  Sohngen et al. (2001) find positive overall impacts from warming on global timber markets. Most  studies find a net loss for the energy sector, as increased costs for space cooling dominate savings  in space heating (e.g., Mendelsohn and Neumann 1999). Impacts on water availability also tend to  be negative, as increased evaporation reduces freshwater supplies, and the value of these losses is  compounded with greater demand for irrigation (Mendelsohn and Williams 2007).

(continued)

Journal of Economic Literature, Vol. XLVIII (December 2010)916

(e.g.,  the  value  of  mortality  in  poor  coun- tries, how much people in wealthy countries  value  ecosystem  preservation  in  poor  coun- tries). There is scant evidence on additional  risks,  such  as  extreme  local  climate  change  (e.g.,  from  shifting  monsoons  and  deserts)  and  broader  health  effects  (e.g.,  malnutri- tion  from  food  shortages,  the  net  effects  of  milder  winters  and  hotter  summers,  and  diarrhea  if  droughts  reduce  safe  drinking  water  supplies).  Most  of  the  impact  assess- ment  literature  is  based  on  extrapolations  from  U.S.  studies—country-specific  studies  that account for local factors (e.g., ability to  adapt  farm  practices  to  changing  climate)  have only recently begun to emerge. Finally,  worldwide  results  mask  huge  disparities  in 

regional burdens, and there is disagreement  on  how  to  aggregate  impacts  across  regions  with very different per capita income.13

2.2.3  Further Issues Posed by Uncertainty

Finally, we touch on some additional com- plications  for  emissions  pricing  posed  by  uncertain  discount  rates,  risk  aversion,  and  irreversibility. 

In  damage  valuation,  the  time  path  of  future  discount  rates  is  usually  taken  as 

13  Most  studies  aggregate  regional  impacts  using  weights equal to the region’s share in world GDP or world  population.  More  generally,  use  of  distributional  weights  can increase total damage estimates up to about 300 per- cent (e.g., David Pearce 2005).

Box 1 Valuation of Noncatastrophic Climate Damages (for Warming of 2.5oC or Thereabouts Occurring Around 2100) (continued)

Health. There have been some attempts to quantify future health damages. For example, using sta- tistical evidence on climate and disease, Nordhaus and Boyer (2000) put health risks from the possi- ble spread of vector-borne diseases like malaria at 0.10 percent of world GDP. Broader health risks  are even more speculative. According to McMichael et al. (2004), there were 166,000 excess deaths  worldwide  in  2000  from  climate  change  to  date.  Of  these,  “only”  16  percent  were  from  malaria,  46 percent reflected greater malnutrition due to food shortages, another 28 percent more diarrhea  cases as droughts reduce safe drinking water supplies and concentrate contaminants, while 7 per- cent were from temperature extremes (most in Southeast Asia). However, malnutrition projections  are extremely sensitive to assumptions about whether, over the next century, currently vulnerable  regions develop, become more integrated into global food markets, and are able to adopt hardier  crops.  And  increased  incidence  of  water-borne  illness  might  be  counteracted  by  future  develop- ment and adoption of water purification systems. Monetizing mortality effects is also contentious as  there are very few direct estimates of the value of a statistical life for poor countries. 

Ecosystems. All aspects of future climate change are potential stressors to natural systems. Com- bining projections of ecosystems at risk from climate change with evidence on the medicinal value  of  plants  and  willingness  to  pay  for  species  and  habitat  preservation,  Fankhauser  (1995)  and  Tol  (1995) put the value of ecosystem loss in 2100 at 0.21 and 0.13 percent of world GDP respectively.  Nordhaus  and  Boyer  (2000)  put  the  combined  risks  to  natural  ecosystems  and  climate-sensitive  human settlements at 0.17 percent of world GDP in 2100, assuming the capital value of vulnerable  systems is 5−25 percent of regional output, and an annual willingness to pay equal to 1 percent of  capital value. These estimates are highly speculative, given that very little is known about ecological  impacts and how people value large scale (as opposed to marginal) ecosystem loss. 

917Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

given. However, the discount factor applied  to  damages  is  a  convex  function  of  the  future discount rate, so discount rate uncer- tainty (for a given expected value) increases  the  certainty-equivalent  discount  factor  (Weitzman  1998).  Newell  and  William  A.  Pizer  (2003)  estimated  that  discount  rate  uncertainty  (inferred  from  U.S.  historical  evidence)  almost  doubles  estimates  of  mar- ginal emissions damages. 

Leaving aside extreme risks, should mar- ginal  damage  estimates  include  a  risk  pre- mium?  This  would  be  appropriate  if  the  marginal  utility  of  consumption,  net  of  cli- mate damages, were larger in high-damage  outcomes, in which case a mean-preserving  increase  in  the  spread  of  possible  damages  outcomes  would  increase  expected  disutil- ity. However, if gross consumption is greater  in  high-damage  scenarios  (for  example,  because  rapid  productivity  growth  leads  to  both  high  consumption  and  high  emission  rates), then the marginal utility of consump- tion  net  of  damages  is  lower,  and  possibly  even  lower  than  marginal  utility  in  low- damage  states.  Simulations  by  Nordhaus  (2008, chapter 7) suggest this might in fact  be  the  case,  implying  the  risk  premium  is  actually negative, though empirically small.  On  the  other  hand,  we  do  not  know  what  the  probability  distribution  over  damage  outcomes  is.  If  policymakers  are  averse  to  such ambiguity this may, under certain con- ditions,  imply  a  higher  near  term  price  on  emissions, though how much higher is diffi- cult to quantify (Andreas Lange and Nicolas  Treich 2008). 

Returning  to  the  issue  of  irreversibility  and future learning, is there an option value  (which  should  be  reflected  in  the  emis- sions  price)  gained  from  delaying  atmo- spheric  GHG  accumulations  until  more  is  known  about  how  much  damage  they  will  cause?  Option  values  arise  if  such  delay  increases  the  potential  future  welfare  gains  from  responding  to  new  information  about 

damage  risk  (Pindyck  2007).  If  damages  are  linear  in  GHG  concentrations,  changes  in  the  inherited  concentration  level  do  not  affect  marginal  damages  from  additional,  future  accumulations.  In  this  case,  the  wel- fare  effects  of  policy  interventions  at  differ- ent time periods are decoupled (at least from  the  damage  side),  and  there  is  no  option  value.  If  instead,  damages  are  convex  in  atmospheric  GHG  accumulations  the  pros- pect  of  future  learning  reduces  the  optimal  near-term abatement level, to the extent that  the  damages  from  near-term  emissions  can  be  lowered  through  greater  abatement  in  future, high-damage scenarios. Moreover, to  the  extent  that  current  abatement  involves  (nonrecoverable)  sunk  investments  in  emis- sions-saving  technologies,  there  is  another  source  of  option  value,  from  delaying  long- lived  emissions-saving  investments  until  more  is  known  about  the  benefits  of  emis- sions reductions (Charles D. Kolstad 1996a).  For  these  reasons,  theoretical  analyses  sug- gest  that  the  prospect  of  future  learning  justifies  less  near-term  abatement  (Kolstad  1996b;  Fisher  and  Urvashi  Narain  2003;  Pindyck  2007).  However,  as  already  noted,  the critical exception to this is when there is  a possibility of crossing a catastrophic thresh- old  in  atmospheric  concentrations  prior  to  future  learning,  which  is  essentially  nonre- versible  given  the  nonnegativity  constraint  on future emissions.

2.2.4  Summary

Most  estimates  of  near-term  marginal  damages are in the order of $5–$25 per ton  of  CO2.  This  range  is  in  the  same  ballpark  as near-term emissions prices consistent with  least-cost  stabilization  of  atmospheric  CO2  concentrations  at  550  ppm.  These  prices  represent  a  lower  bound  on  appropriate  policy  stringency.  Much  higher  prices  (that  are  consistent  with  450  ppm,  or  even  more  stringent,  CO2  stabilization  targets)  can  be  implied  by  low  discount  rates  and,  possibly, 

Journal of Economic Literature, Vol. XLVIII (December 2010)918

extreme catastrophic risks (depending on the  shape of the climate sensitivity distribution).  Thus, whether moderate or aggressive emis- sions  pricing  is  currently  warranted  largely  hinges on one’s view of discounting, whether  radical mid-course corrections in response to  future  learning  about  catastrophes  are  fea- sible,  and  the  prospects  for  development  of  last-resort technologies.

3.  Policy Design

3.1. Choice Among, and Design of, Domestic Emissions Control Instruments

Debate  over  the  choice  of  instrument  for  a  nationwide  carbon  control  program  is  no  longer about the superiority of market-based  approaches  over  traditional  forms  of  regula- tion  (like  technology  mandates)  but  rather  between  the  two  market-based  alternatives,  emissions  taxes  and  cap-and-trade  systems.14  In  a  world  where  the  emissions  external- ity  is  the  only  market  distortion,  and  there  is  no  uncertainty,  either  instrument  could  achieve  the  first-best  outcome,  if  the  emis- sions  cap  at  each  date  equals  the  emissions  that  would  result  under  the  Pigouvian  tax.  Whether  allowances  are  auctioned  or  given  away for free has distributional consequences  but  does  not  affect  efficiency  in  this  setting,  so  long  as  firm  behavior  does  not  influence  their  future  allowance  allocations.  If  firms  were  free  to  bank  and  borrow  emissions  allowances, the policies would still be equiva-

lent, if the permit trading ratios across differ- ent time periods were equivalent to the ratio  of  Pigouvian  emissions  taxes  at  those  dates  (Catherine Kling and Jonathan Rubin 1997). 

The  equivalence  between  the  two  instru- ments  potentially  breaks  down  in  the  pres- ence  of  preexisting  tax  distortions,  when  distributional  impacts  are  a  concern,  and  when  there  is  uncertainty.  Despite  these  complications,  to  a  large  extent  permit  sys- tems  can  be  designed  to  mimic  the  effect  of  a  tax,  and  vice  versa,  and  therefore  the  choice of instrument per se is less important  than  whether  the  chosen  instrument  is  well  designed (Goulder 2009). Aside from policy  stringency,  key  design  features  relate  to  the  point and scope of regulation, the allocation  of  policy  rents,  and  possible  provisions  to  limit price volatility. 

3.1.1  Point of Regulation

Either  a  CO2  tax  or  cap-and-trade  sys- tem  can  be  imposed  upstream  where  fuels  enter the economy (the minemouth for coal  or wellhead for oil and natural gas) accord- ing  to  a  fuel’s  carbon  content  or,  as  in  the  European  trading  program,  to  downstream  emitters  at  the  point  where  fuels  are  com- busted.  Upstream  systems  would  require  monitoring some 2,000–3,000 entities in the  United  States  or  European  Union,  while  downstream systems would apply to 10,000  or  more  power  plants  and  large  indus- trial  smokestacks  (Daniel  S.  Hall  2007).15 

14  Market-based  instruments  equalize  marginal  abate- ment  costs  across  all  abatement  opportunities  within  the  firm,  across  heterogeneous  firms,  across  production  sec- tors,  and  across  households  and  firms,  by  establishing  an  economy-wide emissions price (J. H. Dales 1968; Allen V.  Kneese  and  Blair  T.  Bower  1968;  William  J.  Baumol  and  Wallace  E.  Oates  1971;  W.  David  Montgomery  1972).  In  contrast, for example, a requirement that all electric utili- ties  generate  a  fraction  of  their  power  from  renewables  will  not  achieve  any  of  these  efficiency  conditions.  Some  opportunities at the firm level (e.g., substituting natural gas  and  nuclear  power  for  coal),  are  not  exploited;  marginal  costs  will  differ  across  heterogeneous  power  companies;  

household electricity prices will not reflect the cost of the  remaining  (unpriced)  emissions;  and  abatement  opportu- nities  outside  of  the  power  sector  are  unexploited.  For  a  broad  reviews  of  the  literature  on  environmental  policy  instrument  choice,  see  Cameron  Hepburn  (2006)  and  Goulder and Ian W. H. Parry (2008).

15  If  introduced  at  the  same  points  in  the  economy,  CO2  taxes  and  cap-and-trade  systems  are  likely  to  have  very  similar  administrative  costs.  Under  cap-and-trade,  costs  also  include  those  from  administering  trading  markets,  as  well  as  the  transactions  costs  of  the  trades  themselves, though these are relatively small (Robert N.  Stavins 1995).

919Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

For  a  given  total  emissions  reduction,  the  estimated  economic  costs  of  downstream  programs  out  to  2030  are  not  dramati- cally  larger  than  those  for  comprehensive  upstream systems—about 20 percent larger  according  to  Goulder  (2009)—even  though  downstream  programs  cover  only  about  half  of  total  U.S.  and  EU  CO2  emissions.  This  is  because  the  huge  bulk  of  low-cost  abatement  opportunities  are  (initially)  in  the  power  sector.  Moreover,  the  infeasibil- ity  of  monitoring  emissions  from  vehicles,  home  heating  fuels,  and  small-scale  indus- trial boilers in a downstream system can be  largely  addressed  through  supplementary  midstream  measures  targeted  at  refined  transportation and heating fuels, which fur- ther  narrows  the  cost  discrepancy  between  upstream  and  downstream  systems. 

There  are  a  couple  of  other  notable  dif- ferences  between  the  two  systems.  One  is  that  upstream  programs  must  be  combined  with a crediting system to encourage devel- opment  and  adoption  of  carbon  capture  and  storage  technologies  at  coal  plants  and  industrial  sources.  (The  tax  credit  should  equal the amount of carbon sequestered, as  measured  by  continuous  emission  monitor- ing systems, times the emissions price). The  other  is  that,  at  least  for  the  United  States  where  many  states  retain  cost-of-service  regulation,  the  opportunity  cost  of  freely  allocated  emissions  allowances  to  electric  utilities  in  a  downstream  system  may  not  be  passed  forward  into  higher  generation  prices.  As  a  result,  incentives  for  electricity  conservation  could  be  a  lot  weaker,  result- ing in a significant loss of cost-effectiveness,  compared with upstream programs or down- stream programs with full allowance auction- ing (Dallas Burtraw et al. 2001). 

3.1.2  Scope of Regulation

Domestic  programs  that  fail  to  cover  embodied carbon in products imported from  countries  with  suboptimal  or  no  emissions 

controls may cause significant emissions leak- age. The problem is most relevant for down- stream, energy-intensive firms competing in  global  markets  (e.g.,  chemicals  and  plastics,  primary  metals,  petroleum  refining),  where  reduced production at home may be largely  offset by increased production in other coun- tries with higher emissions intensity than in  the  United  States.  According  to  some  mod- els,  as  much  as  15–25  percent  of  economy- wide  U.S.  CO2  reductions  could  be  offset  by  extra  emissions  elsewhere,  although  the  majority  of  the  leakage  stems  from  changes  in global fuel prices rather than relocation of  footloose  capital  (Sujata  Gupta  et  al.  2007;  Mun S. Ho, Richard Morgenstern, and Jhih- Shyang Shih 2008; Carolyn Fischer and Alan  K. Fox 2007, 2009). Possible policy responses  to the latter source of leakage include impos- ing  taxes,  or  permit  requirements,  accord- ing  to  embodied  carbon  in  product  imports  (and symmetrical rebates for exporters) or to  subsidize the output of leakage-prone indus- tries  (e.g.,  through  output-based  allocations  of  free  emissions  allowances).  However,  all  these  approaches  may  run  afoul  of  interna- tional trade obligations.  

Certain  non-CO2  GHGs  are  easily  moni- tored  (e.g.,  vented  methane  from  under- ground coalmines, fluorinated gases used in  refrigerants  and  air  conditioners)  and  could  be directly integrated into a CO2 mitigation  program  through  taxes,  or  permit  trading  ratios, reflecting their relative lifetime warm- ing potential. Other gases are far more diffi- cult to monitor, and are better incorporated,  insofar as possible, through offset provisions,  where the onus falls on the individual entity  to  demonstrate  valid  reductions  relative  to  a  credible  baseline.  For  example,  meth- ane from landfills and livestock waste might  be  collected,  using  an  impermeable  cover,  and  flared  or  used  in  onsite  power  genera- tion,  while  nitrous  oxide  might  be  reduced  through  changes  in  tilling  and  fertilizer  use  (e.g., Shih et al. 2006; Hall 2007). 

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Finally, CO2 abatement through forest car- bon sequestration (e.g., from reducing defor- estation,  reforesting  abandoned  cropland  and harvested timberland, modifying harvest  practices to reduce soil disturbance) appears  to  be  relatively  cost  effective.  According  to  Stavins  and  Kenneth  R.  Richards  (2005),  as  much  as  30  percent  of  U.S.  fossil  fuel  CO2  emissions  might  be  sequestered  at  a  cost  of  up to about $20 per ton of CO2. Coupling a  domestic mitigation program with offset pro- visions  for  forest  carbon  sequestration  will  require measuring regional forest inventories  to  establish  baselines,  monitoring  changes  in  forest  use  (through  remote  sensing  and  ground-level  sampling)  relative  to  the  base- line, and inferring the emissions implications  of these changes based on sampling of local  tree species and age. However, even if these  monitoring challenges can be overcome, fur- ther  problems  remain.  One  is  that,  without  an international program covering major for- ested countries, domestic reductions can be  offset through emissions leakage via changes  in  world  timber  prices  (Brian  C.  Murray,  Bruce  A.  McCarl,  and  Heng-Chi  Lee  2002  estimate the international leakage rate could  be  anywhere  from  less  than  10  percent  to  over  90  percent  depending  on  the  type  of  activity  and  location  in  the  United  States).  Another  is  that  sequestered  carbon  in  trees  is not necessarily permanent if trees are later  cut  down,  decay  or  burn,  requiring  assign- ment of liability to either the offset buyer or  seller for the lost carbon. 

3.1.3  Allocation of Policy Rents

In  their  traditional  form,  emissions  taxes  raise  revenues  for  the  government,  while  cap-and-trade  systems  create  rents  for  firms  receiving  free  allowance  allocations.  However,  through  allowance  auctions,  cap- and-trade systems can generate comparable  revenues to a tax, while rents can be provided  under  a  tax  through  inframarginal  exemp- tions for emissions or carbon content. Under 

either instrument, the fraction of policy rents  accruing to the government rather than pri- vate  firms,  and  how  revenues  are  used,  are  extremely  important  for  efficiency  and  dis- tributional incidence.

Fiscal Linkages.  The  implications  for  emissions  control  policies  of  preexisting  tax  distortions  in  factor  markets  have  received  considerable  attention  in  the  broader  envi- ronmental  economics  literature  (e.g.,  A.  Lans Bovenberg and Goulder 2002), though  these distortions are typically not integrated  into energy–climate models. This raises two  issues:  to  what  extent  is  there  a  cost  saving  from  policies  that  raise  revenues  and  use  them to offset distortionary taxes like income  and payroll taxes, and to what extent do mod- els  that  ignore  prior  tax  distortions  produce  inaccurate estimates of policy costs?

The  efficiency  gain  from  recycling  rev- enues  in  other  tax  reductions  (relative  to  returning  them  lump  sum  or  leaving  policy  rents  in  the  private  sector)  is  simply  the  amount of revenue raised times the marginal  excess  burden  of  taxation.  Although  there  is  uncertainty  over  behavioral  responses  in  factor  markets,  a  typical  assumption  is  that  the  marginal  excess  burden  of  income  taxes  (with  revenue  returned  lump  sum)  is  around  $0.25  for  the  United  States,  or  per- haps  as  high  as  $0.40  if  distortions  in  the  pattern  of  spending  created  by  tax  prefer- ences  (e.g.,  for  employer  medical  insurance  or  homeownership)  are  taken  into  account.  For  modest  carbon  policies,  the  efficiency  gain  from  revenue  recycling  can  be  large  relative  to  the  direct  efficiency  cost  of  the  policy, or Harberger triangle under the mar- ginal abatement cost schedule. For example,  if a $30 tax on U.S. CO2 emissions (currently  about  6  billion  tons)  reduces  annual  emis- sions  by  10  percent,  the  Harberger  triangle  is  $9  billion,  while  the  revenue-recycling  benefit is roughly $40–65 billion per year.  

However,  this  does  not  necessarily  mean  that revenue-neutral CO2 taxes, or auctioned 

921Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

allowance  systems,  produce  a  “double  divi- dend”  by  reducing  the  costs  of  the  broader  tax  system,  in  addition  to  slowing  climate  change.  There  is  a  counteracting,  “tax- interaction”  effect  (e.g.,  Goulder  1995).  Specifically,  the  (policy-induced)  increase  in energy prices drives up the general price  level,  which  reduces  real  factor  returns,  and thereby (slightly) reduces factor supply  and  efficiency.  Most  analytical  and  numeri- cal  analyses  of  environmental  tax  shifts  find  that  the  tax-interaction  effect  exceeds  the  revenue-recycling  effect,  implying  no  double  dividend,  and  that  abatement  costs  are  actually  higher  due  to  the  presence  of  preexisting  tax  distortions.  A  rough  rule  of  thumb  from  these  models  is  that  the  costs  of revenue-neutral emissions taxes are about  15 percent greater, due to interactions with  prior  tax  distortions,  implying  the  optimal  tax  is  15  percent  lower  than  the  Pigouvian  tax  (e.g.,  Bovenberg  and  Goulder  2002).  However, the cost increase is far more sub- stantial  for  policies  that  do  not  exploit  the  revenue recycling effect (i.e., cap-and-trade  with  free  allowance  allocation  or  CO2  taxes  with revenues not used to increase economic  efficiency). According to formulas derived in  Goulder  et  al.  (1999),  the  increase  exceeds  100  percent  when  the  emissions  reduction  is below 30 percent.16 

More  generally,  there  are  many  ways  that  carbon  policy  revenues  might  be  used,  such  as  funding  technology  programs,  cli- mate  adaptation  projects,  deficit  reduction,  energy efficiency programs, rebates to elec- tricity  consumers,  and  any  number  of  com- plex  adjustments  to  the  tax  system,  though  the  efficiency  implications  of  these  recy- cling options are often not well understood.  Although  in  recent  years  there  has  been  more  interest  in  permit  auctions,  in  some  cases  it  is  unclear  how  the  revenues  will  be  spent.17 Unless legislation accompanying car- bon policies specifies offsetting reductions in  other  distortionary  taxes,  there  is  ambiguity  to what  extent this shift implies a reduction  in the overall costs of carbon policies. 

Distributional Considerations.  The  distri- butional  impacts  of  emissions  control  poli- cies are potentially important for both equity  and feasibility.

On  equity  grounds  the  difference  between  (revenue-neutral)  CO2  taxes/auc- tioned  allowances,  and  allowance  systems  with  free  allocation  to  firms,  can  be  quite  striking.  Under  the  latter  policy,  permit  rents  are  reflected  in  higher  firm  equity  values,  and  therefore  (through  dividend  and capital gains income) ultimately accrue  to  shareholders,  who  are  concentrated  in  upper  income  groups.  Terry  Dinan  and 

16  There  are  some  caveats  here.  One  is  that  the  pro- portionate  increase  in  abatement  costs  may  be  much  smaller  in  other  countries  if  tax  wedges  in  factor  mar- kets  are  smaller  than  those  in  the  United  States,  or  if  labor  markets  are  dominated  by  institutional  wage  set- ting (e.g., Francesco Bosello, Carlo Carraro, and Marzio  Galeotti  2001).  Another  is  that  the  tax-interaction  effect  is  weaker  if,  due  to  regulated  pricing  and/or  infra- marginal  rents  on  coal  technologies  that  bear  some  of  the  burden  of  emissions  pricing,  there  is  incomplete  pass  through  of  emissions  prices  into  electricity  prices  (Antonio M. Bento and Mark Jacobsen 2007; Parry 2005).  Finally,  the  revenue-recycling  effect  can  dominate  the  tax-interaction  effect  when  tax  preferences  cause  sig- nificant  distortions  or  when  a  large  share  of  revenues  are  used  to  cut  taxes  on  capital  as  opposed  to  labor

(see  Parry  and  Bento  2000  and  Bovenberg  and  Goulder  1997 respectively). 

17 For example, in the first two phases of the European  Union’s CO2 trading program (2005–07 and 2008–12), over  95 percent of the allowances were given away free to exist- ing emissions sources. However, partly in response to the  large windfall profits earned by power companies, the plan  is to transition to full allowance auctions for that sector by  2020, with the decision on how to use revenues largely left  to the member states (Jos Sijm, Karsten Neuhoff, and Yihsu  Chen  2006;  Commission  of  the  European  Communities  2008).  In  the  Regional  Greenhouse  Gas  Initiative  in  the  United States, covering power sector CO2 emissions from  ten  Northeastern  and  Mid-Atlantic  states,  allowances  are  auctioned  with  revenues  earmarked  for  energy  efficiency  and other clean technology programs.

Journal of Economic Literature, Vol. XLVIII (December 2010)922

Diane  Lim  Rogers  (2002)  estimated  that,  for  a  15  percent  reduction  in  CO2  emis- sions, U.S. households in the lowest-income  quintile  would  be  worse  off  on  average  by  around  $500  per  year,  while  households  in  the  top-income  quintile  reap  a  net  gain  of  around  $1,000  (i.e.,  increased  stock- holder  wealth  overcompensates  this  group  for  higher  energy  prices).  This  inequitable  outcome  could  be  avoided  under  emis- sions  taxes  and  auctioned  allowance  sys- tems  if  revenues  were  recycled  in  income  tax  reductions  tilted  toward  the  poor  (e.g.,  Gilbert E. Metcalf 2009). 

As  regards  feasibility,  compensation  for  adversely  affected  industries  may  be  part  of  the  political  deal-making  needed  to  first  initiate, and progressively tighten, emissions  controls  (e.g.,  A.  Denny  Ellerman  2005).  Compensation, through free allowance allo- cation or tax relief, may be required for both  formally  regulated  sectors  and  downstream  sectors  vulnerable  to  higher  energy  prices  (e.g.,  energy-intensive  firms  competing  in  global  markets).  However,  given  the  ten- sion  between  providing  industry  compensa- tion,  and  the  fiscal  and  (household)  equity  reasons  for  raising  revenue,  it  is  important  to know how much compensation is needed  to  keep  firms  whole.  At  least  for  a  moder- ately  scaled  CO2  permit  system,  only  about  15–20  percent  of  allowances  are  needed  to  compensate  energy  intensive  industries  for  their  loss  of  producer  surplus,  so  the  huge  bulk  of  the  allowances  could  still  be  auc- tioned (Bovenberg and Goulder 2001, Anne  E. Smith, Martin T. Ross, and Montgomery  2002). Although there are reasons for phas- ing  out  compensation  over  time,  firms  may  still be amenable to this if they receive excess 

compensation  in  the  early  years  of  the  pro- gram (e.g., Stavins 2007).18 

3.1.4  Price Volatility

Another  reason  CO2  taxes  and  cap-and- trade  systems  may  produce  different  out- comes  stems  from  uncertainty  over  future  abatement  costs  reflecting,  for  example,  uncertainty  over  energy  prices,  technologi- cal advances, and substitutes for fossil fuels. 

Price Versus Quantity Instruments in their Pure Form. If the goal is welfare maximiza- tion,  abatement  cost  uncertainty  strongly  favors  emissions  taxes  over  cap-and-trade  systems  in  their  pure  form.  This  is  most  easily  seen  in  a  static  setting  where  the  marginal  benefits  from  abatement  are  con- stant.  In  this  case,  a  Pigouvian  emissions  tax  automatically  equates  marginal  benefits  to  marginal  abatement  costs,  regardless  of  the position of the marginal abatement cost  schedule.  In  contrast,  when  emissions  are  capped  to  equate  marginal  benefits  with  expected  marginal  abatement  costs,  ex  post  abatement will either be too high or too low  depending  on  whether  the  marginal  abate- ment  cost  schedule  is  higher  or  lower  than  expected  (Weitzman  1974;  Marc  J.  Roberts  and Michael Spence 1976; Yohe 1978).

This basic result carries over to a dynamic  context with a sequence of annual (Pigouvian)  taxes  or  emissions  caps,  and  where  environ- mental damages depend on the accumulated  atmospheric  stock  of  emissions.  Here,  we  have  strong  reasons  to  believe  that  the  mar- ginal  benefits  from  global  emissions  reduc- tions  are  essentially  constant,  as  abatement  in  any  one  year  has  minimal  impact  on  the  atmospheric  stock.  In  fact,  with  abatement  cost  uncertainty,  simulation  analyses  suggest 

18  One  reason  for  phasing  out  allowance  allocations  is  that they must initially be based on a firm’s historical emis- sion rates (prior to program implementation), which may be  viewed as increasingly unfair as firms grow or contract at dif- ferent rates, or change their fuel mix, over time. However, 

any  updating  of  baselines  based  on  firm  performance  will  likely  introduce  distortions  in  firm  behavior  (Knut  Einar  Rosendahl 2008). Free allowance allocation may also retard  the exit of inefficient firms from an industry if firms lose their  rights to future allocations when they go out of business. 

923Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

that discounted welfare gains under (globally  imposed)  CO2  taxes  might  be  several  times  those  under  (equivalently  scaled)  permits  (e.g.,  Pizer  2002;  Michael  Hoel  and  Larry  Karp 2002). A qualification to this is that the  welfare advantage of taxes is less pronounced  if abatement cost shocks persist over time and  the emissions cap can be adjusted in response  to  those  shocks  (e.g.,  Karp  and  Jiangfeng  Zhang 2005; Newell and Pizer 2003). 

Stabilizing Allowance Prices.  Emissions  price  volatility  under  cap-and-trade  systems  can  be  contained  by  allowing  firms  to  bank  permits  when  permit  prices  (and  marginal  abatement  costs)  are  low,  and  borrow  per- mits  from  future  periods  when  prevailing  prices  are  high.  In  fact,  if  banking  and  bor- rowing were completely unlimited and cost- less, expected allowance prices would rise at  the  interest  rate,  and  the  system  would  be  largely equivalent to that of an emissions tax  growing  at  the  interest  rate.  Alternatively,  through  establishing  appropriate  ratios  for  trading  permits  across  time,  the  allowance  price  trajectory  could  mimic  the  growth  in  marginal emissions damages over time (e.g.,  Kling and Rubin 1997).

In  fact,  most  existing  cap-and-trade  sys- tems  (e.g.,  the  federal  SO2  and  regional  CO2  programs  in  the  United  States  and  the  European Union’s CO2 program) now incor- porate  banking  and  borrowing  provisions,  though in response to concerns about default  risk, borrowing is penalized through unfavor- able trading ratios and/or quantitative limits.  Harrison Fell, Ian A. MacKenzie, and Pizer  (2008) estimate that banking and borrowing  provisions contained in leading U.S. federal  climate  proposals  obtain  about  one  quarter  to one half of the cost savings from emissions  taxes over equivalent cap-and-trade systems  without these provisions. 

An  alternative  approach  is  to  limit  price  volatility  through  a  “safety  valve,”  where  the  government  sells  additional  permits  at  a  fixed  price  to  prevent  allowance  prices 

from rising above a ceiling price (e.g., Henry  D.  Jacoby  and  Ellerman  2004).  Expected  welfare  under  this  policy  is  maximized  by  essentially designing it to mimic a Pigouvian  tax—that  is,  setting  the  safety  valve  price  equal  to  marginal  emissions  damages  and  the emissions cap tight enough so the safety  valve binds nearly all the time (Pizer 2002).  Intermediate cases (with higher safety valve  prices  and/or  less  stringent  caps)  generate  intermediate  welfare  gains  between  those  of  the  pure  tax  and  emissions  quota.  A  fur- ther alternative is a collar which combines a  price ceiling with a price floor. This approach  encourages  additional  abatement  when  allowance  prices  are  low  (to  offset  reduced  abatement  when  allowance  prices  are  high)  and  avoids  the  potentially  harmful  impacts  of  the  price  ceiling  only  on  incentives  to  invest  in  emissions-saving  technologies.  According  to  Fell,  MacKenzie,  and  Pizer  (2008)  the  annualized  cost  savings  between  emissions taxes and fixed emissions quotas in  the United States would be about $4 billion  for an emissions price of around $20 per ton  of  CO2,  with  safety  valves  and  price  collars  yielding intermediate cost savings. 

One  final  twist  in  instrument  choice  is  that  the  price  flexibility  afforded  by  a  cap- and-trade  system  with  (unhindered)  allow- ance  borrowing  and  banking  could  actually  be  advantageous  from  a  social  welfare  perspective,  when  there  is  learning  about  future damages and emissions taxes can only  be  adjusted  at  discrete  intervals  (Murray,  Newell,  and  Pizer  2009).19  Under  the  for- mer policy, new information about damages  will  be  immediately  reflected  in  the  time  path  of  current  and  expected  future  allow- ance  prices,  as  speculators  anticipate  an 

19 Uncertainty over the marginal benefit schedule, in the  absence of learning, would not affect the choice between  emissions  taxes  and  cap-and-trade  because,  on  average,  cumulated emissions reductions, and hence expected envi- ronmental benefits, are the same under both instruments  (e.g., Stavins 1996). 

Journal of Economic Literature, Vol. XLVIII (December 2010)924

adjustment  of  future  emissions  targets  in  response  to  that  information.  In  contrast,  it  may  take  some  time  before  emissions  taxes  can  be  adjusted  to  reflect  new  information,  leaving  emissions  prices  suboptimal  during  the period of policy stickiness. 

3.2  Promoting Technology Development and Diffusion

Several  studies  have  demonstrated  the  central  role  that  the  availability  and  cost  of  advanced energy technologies plays in deter- mining  the  future  costs  of  GHG  emission  targets  (e.g.,  Clarke  et  al.  2006;  Edmonds,  Joseph M. Roop, and Michael J. Scott 2000;  Kenneth  Gillingham,  Newell,  and  Pizer  2008).  For  example,  Clarke  et  al.  (2006)  found that if ambitious goals for technology  development  are  achieved,  this  can  reduce  discounted global abatement costs by 50 per- cent  or  more.  Establishing  a  price  on  CO2  emissions is the single most important policy  for  encouraging  the  innovation  that  might  bring  about  advanced  technology  develop- ment. However, additional measures to pro- mote  applied  R&D,  more  basic  research,  and technology deployment, may be justified  to the extent they address market failures at  different stages of the innovation process.  

3.2.1  R&D Policy

One market failure stems from the inabil- ity of private sector inventors or innovators to  fully  appropriate  spillover  benefits  to  other  firms  that  might  copy  a  new   technology, 

 imitate  around  the  technology  if  it  is  under  patent,  or  otherwise  use  knowledge  about  the technology to advance their own research  programs  (Adam  B.  Jaffe,  Newell,  and  Stavins  2003).  Numerous  empirical  stud- ies  suggest  that  technology  spillovers  cause  the (marginal) social return to (commercial)  R&D to be several times the (marginal) pri- vate return.20 

The  appropriability  problem  implies  that  R&D  incentives  will  be  suboptimal,  even  under  Pigouvian  emissions  pricing.  One  response  would  simply  be  to  set  emissions  prices  at  a  level  higher  than  warranted  by  externalities.  However,  this  would  generate  efficiency  losses  from  excessive  short-term  abatement,  and  would  not  differentiate  incentives  across  technologies  that  might  face  very  different  market  impediments.  In  fact, no single instrument—either emissions  pricing  or  R&D  incentives—can  effectively  correct  both  the  emissions  externality  and  the  knowledge  appropriability  problem:  using  one  instrument  alone  may  involve  considerably  higher  costs  than  employing  two  complementary  instruments  (Fischer  and  Newell  2008;  Goulder  and  Stephen  H.  Schneider 1999).

Unfortunately,  available  literature  pro- vides  limited  guidance  on  the  design  of  complementary  R&D  instruments.  It  is  not  clear which instrument among, for instance,  research  subsidies,  strengthened  patent  rules,  or  technology  prizes,  is  most  effi- cient,  as  this  depends  on  the  magnitude  of 

20 For example, Zvi Griliches (1992), Edwin Mansfield  (1985),  Charles  I.  Jones  and  John  C.  Williams  (1998).  Although  there  is  a  possibility  of  excessive  competition  for  a  given  amount  of  innovation  rent,  analogous  to  the  excessive  competition  for  open-access  resources,  this  problem  is  generally  thought  to  be  dominated  by  the  imperfect  appropriability  effect  (Griliches  1992).  In  fact,  the  problem  of  suboptimal  innovation  incentives  may  be  especially severe for GHG-saving technologies, compared  with  commercial  technologies.  For  example,  skepticism  over  long-term  commitments  to  emissions  pricing,  and 

the  desirability  of  retaining  policy  discretion  to  respond  to  future  scientific  knowledge,  undermines  the  durable  and substantial incentives needed for encouraging GHG- saving  technology  investments  with  high  upfront  costs.  Limited  patent  lifetimes  may  also  discourage  firms  from  launching  R&D  programs  until  a  high  enough  emissions  price  is  established  (Reyer  Gerlagh,  Snorre  Kvendokk,  and Rosendahl 2008).

Still, efficiency gains from correcting the R&D market  failure appear to be smaller than those from correcting the  CO2 emissions externality (Parry, Pizer, and Fischer 2003).

925Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

technology spillovers, the scope for monop- oly  pricing  under  patents,  and  asymmetric  information between governments and firms  about  the  expected  benefits  and  costs  of  research  (e.g.,  Brian  Davern  Wright  1983).  And  just  how  much  applied  R&D  in  the  energy sector should be expanded is difficult  to  estimate,  given  uncertainty  over  the  pro- ductivity of research and the risk of crowding  out  socially  valuable  research  elsewhere  in  the economy (e.g., Nordhaus 2002; Goulder  and Schneider 1999). 

3.2.2   Basic Research

Appropriability problems are most severe  for  more  basic  research,  which  is  largely  conducted  by  universities,  other  nonprof- its,  and  federal  labs,  mostly  through  central  government funding. While it is not practical  to  assess  the  efficient  allocation  of  funding  across individual programs, Newell (2008, p.  32)  suggests  that  a  doubling  of  U.S.  federal  climate  research  spending  (currently  about  $4  billion  a  year)  is  likely  warranted,  based  on  plausible  assumptions  about  the  rate  of  return  on  such  spending.  To  avoid  crowd- ing  out,  this  should  be  phased  in  to  allow  a  progressive  expansion  in  supply  of  college  graduates in engineering and science.

3.2.3  Deployment Policy

In  principle  there  are  several  possibilities  for market failures at the technology deploy- ment  stage.  For  example,  through  learning- by-doing early adopters of a new technology  (e.g.,  a  cellulosic  ethanol  plant  or  solar  pho- tovoltaic  installations)  may  lower  produc- tion costs for later adopters (e.g., Arthur van  Benthem,  Gillingham,  and  James  Sweeney  2008). But, since the potential for these spill- overs may vary greatly depending on industry  structure, the maturity of the technology, etc.,  any case for early adoption subsidies needs to  be considered on a case-by-case basis.

Another  possible  market  failure  is  con- sumer  undervaluation  of  energy  efficiency, 

which  has  been  a  key  motivation  for  regu- lations  governing  auto  fuel  economy  and  household  appliances.  However,  although  there  is  an  empirical  literature  suggest- ing  that  households  discount  savings  from  energy  efficiency  improvements  at  much  higher rates than market rates, whether this  is  evidence  of  a  market  failure  as  opposed  to  hidden  costs  or  borrowing  constraints  remains an unsettled issue (e.g., Gillingham,  Newell, and Karen Palmer 2009). Other mar- ket imperfections might include asymmetric  information between project developers and  lenders,  network  effects  in  large  integrated  systems,  and  incomplete  insurance  markets  for liability associated with specific technolo- gies.  However,  because  solid  empirical  evi- dence is lacking, little can be said about the  seriousness  of  all  these  market  failure  pos- sibilities, and whether or not they might war- rant additional policy interventions. 

3.3  International Policy Design

Proposed  architectures  for  international  emissions control regimes can be loosely clas- sified into those based on bottom-up versus  top-down  (i.e.,  internationally  negotiated)  approaches  and  cap-and-trade  systems  ver- sus  systems  of  emissions  taxes  (e.g.,  Joseph  E. Aldy and Stavins 2007). There is disagree- ment over which type of architecture is most  desirable, and most likely to emerge in prac- tice.  In  the  bottom  up  approach,  norms  for  participation might evolve from small groups  of  countries  launching  regional  programs  that  progressively  expand  and  integrate,  or  by explicit linking of domestic cap-and-trade  programs  (e.g.,  Carraro  2007;  Judson  Jaffe  and Stavins 2008; Victor 2007). Alternatively,  countries  might  regularly  pledge  emissions  reductions  with  periodic  reviews  by  a  for- mal institution (e.g., Thomas Schelling 2007;  Pizer  2007).  Here  we  focus  on  top-down  approaches, given that advocates of rapid cli- mate  stabilization  tend  to  favor  internation- ally binding commitments. 

Journal of Economic Literature, Vol. XLVIII (December 2010)926

The  most  daunting  challenge  is  design- ing  an  architecture  that  encourages  par- ticipation  among  some  three  or  four  dozen  of  the  world’s  largest  GHG  emitters—the  Kyoto  framework  failed  to  do  this  as  non- Annex  1  countries,  including  China,  Brazil,  South  Africa,  Mexico  and  Indonesia,  had  no  emissions  control  obligations,  while  the  United  States  withdrew  from  the  agree- ment.21  Broad  participation  is  needed—at  least  over  the  longer  term  and  possibly  also  the near term under a stringent climate sta- bilization  target  (see  above)—to  promote  the  cost-effectiveness  of  any  international  agreement,  and  limit  concerns  about  inter- national competitiveness and emissions leak- age.  Participation  of  developing  countries  through the Clean Development Mechanism  (CDM), as at present, does not reduce global  emissions—it  only  lowers  the  cost  to  devel- oped  countries  of  meeting  their  emissions  goals  by  allowing  firms  to  purchase  (lower  cost)  emissions  reductions  elsewhere  on  a  project-by-project  basis.  Moreover,  there  is  considerable  concern  that  some  CDM  credits  may  not  represent  truly  additional  reductions, due the difficulty of establishing  a  baseline  against  which  reductions  can  be  measured,  in  which  case  the  CDM  serves  to  increase  global  emissions  (e.g.,  Andrew  Keeler  and  Alexander  Thompson  2008;  Rosendahl and Jon Strand 2009). 

To  be  successful,  each  country  must  per- ceive  an  emissions  control  agreement  as  equitable  in  terms  of  sharing  the  burden  of  global  mitigation  costs.  Usually  this  means  that  industrial  countries  bear  a  dispropor- tionately  greater  cost  burden  due  to  their  higher  per  capita  income  and  greater  con- tribution  to  historical  GHG  accumulations. 

21  China’s  CO2  emissions  now  exceed  those  for  the  United  States,  while  India’s  exceed  those  of  Japan  (U.S.  Department  of  Energy,  Energy  Information  Administra- tion 2008b, table A10). In fact, fifty non-Annex 1 countries  now have per capita income greater than that of the poor- est Annex 1 countries.

However,  as  noted  above,  under  a  glob- ally  cost-effective  pricing  agreement  with  no  side-payments,  developed  countries  may  bear  two-thirds  or  more  of  discounted  global abatement costs over the next century.  Negotiations  are  further  hampered,  under  a  Kyoto  type  of  framework,  by  the  need  to  agree  on  emissions  quotas  for  every  partici- pating country, and to periodically renegoti- ate these quotas, which can be contentious if  economies  expand  at  different  rates  during  interim periods. 

Jeffrey Frankel (2008) offers a global cap- and-trade  proposal  that  addresses  equity  through  imposing  no  cost  burden  on  devel- oping  countries  in  the  early  years,  and  sub- sequently a cost burden comparable to those  previously borne by others at a similar stage  of economic development. Global cost effec- tiveness is preserved, and emissions leakage  avoided, by establishing a harmonized emis- sions  price  through  immediately  incorpo- rating  all  countries  into  the  global  trading  system,  with  low-income  countries  initially  allocated  emissions  caps  equal  to  their  pro- jected  emissions.  Effectively,  the  pattern  of  stringent  and  lax  quota  allocations  among  developed and developing countries creates  a  system  of  side  payments  from  developed  countries (who are net permit buyers) which  compensates  developing  countries  (who  are  net permit sellers) for the costs of their emis- sions  reductions.  Furthermore,  negotiations  are  greatly  simplified  by  the  establishment  of  simple  formulas  that  automatically  start  reducing  developing  country  quotas  once  their per capita income, or per capita emis- sions, cross certain thresholds. 

A  globally  harmonized  CO2  tax  can  be  designed  to  essentially  replicate  this  cap- and-trade  system,  so  there  appears  to  be  little  reason,  in  this  regard,  for  preferring  one  instrument  over  the  other.  Instead  of  agreeing on a global emissions cap, and how  it adjusts over time, countries would need to  agree on a harmonized tax rate, and how this 

927Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

rate  is  increased  over  time.  And  instead  of  negotiating  over  rules  relating  quota  alloca- tions to the evolution of per capita income (or  emissions)  over  time,  countries  would  need  to  agree  on  rules  for  explicit  side  payments  related  to  a  country’s  per  capita  income  (or  emissions). 

However,  under  either  the  cap-and-trade  or  tax-based  approach,  there  is  an  obvious  tension  between  compensating  developing  nations  and  policy  stringency.  For  example,  Jacoby  et  al.  (2008)  estimate  that,  under  a  global  policy  that  stabilizes  CO2  concentra- tions  at  (approximately)  450  ppm,  compen- sation for developing countries would entail  (explicit  or  implicit)  side  payments  by  the  United States of $200 billion in 2020 (or ten  times current U.S. development assistance),  which  calls  into  question  the  credibility  of  such compensation schemes. Even with less  than  full  compensation,  the  international  transfers are of unprecedented scale. A criti- cal lesson here is to keep down compensation  to  the  minimum  amount  needed  to  entice  developing  country  participation.  In  this  regard, granting these countries initial quota  allocations  equal  to  their  BAU  emissions  is  wasteful,  as  it  provides  roughly  twice  the  compensation  needed  to  cover  abatement  costs  (in  the  absence  of  other  distortions,  excess compensation is the integral between  the emissions price and the marginal abate- ment cost curve). 

As  regards  verification  of  policies,  one  potential  problem  with  an  emissions  tax  is  that  countries  may  undermine  its  effect  through  reductions  in  other  energy  taxes.  In  principle,  countries  might  be  pressured  to  adjust  their  emissions  tax  rate  to  offset  changes in other energy tax provisions, based  on  periodic  reviews  of  country  tax  systems,  and progress on emissions reductions, by an  independent  agency  like  the  International  Monetary Fund. Measuring other energy tax  provisions  in  terms  of  their  equivalent  tax  (or  subsidy)  on  CO2  would  be  contentious 

however,  because  of  opaque  systems  of  tax  preferences for energy investments, the pos- sible role of energy taxes in correcting other  externalities  like  local  pollution  and  road  congestion,  and  the  possibility  of  non-tax  regulations that further penalize or subsidize  energy (e.g., fuel economy standards, energy  price regulations). On the other hand, most  countries have established tax ministries that  would  be  able  to  implement  a  new  tax  on  (the  carbon  content  of)  fossil  fuels.  In  con- trast,  many  developing  countries  may  lack  the capacity to enforce permit requirements  and  property  rights  due  to  weak  environ- mental agencies and judicial institutions. 

Finally,  although  not  incorporated  in  most  energy/climate  models,  the  forest  sec- tor appears to offer some of the easiest and  least expensive opportunities for cutting CO2  emissions.  For  example,  under  a  550  ppm  CO2  stabilization  target,  Massimo  Tavoni,  Brent Sohngen, and Valentina Bosetti (2007)  estimate that forest sinks can contribute one- third of total abatement by 2050 and thereby  decrease  the  required  price  on  CO2  emis- sions  by  around  40  percent.  This  is  mainly  achieved  through  avoided  deforestation  in  tropical forests, though it could be sustained  in  the  second  half  of  the  century  through  aforestation  and  enhanced  forest  manage- ment.  Emission  credits  for  slowed  defores- tation  were  not  permitted  under  the  1997  Kyoto  framework,  but  since  then  analysts  have  become  somewhat  more  optimistic  about  the  feasibility  of  integrating  defores- tation  into  an  international  emissions  con- trol regime, despite the practical challenges  noted above (e.g., Ruth DeFries et al. 2006).  However,  broad  participation  in  any  agree- ment  among  major  tropical  forest  regions  would be critical to avoid the risk of serious  emissions leakage.

3.4  Summary

A  revenue-neutral  CO2  tax  has  multiple  desirable  properties  from  an  efficiency 

Journal of Economic Literature, Vol. XLVIII (December 2010)928

standpoint.  Although  allowances  can  be  auctioned,  and  emissions  price  volatility  contained,  why  implement  a  more  elabo- rate  cap-and-trade  system  if  its  purpose  is  to  largely  mimic  the  advantages  of  a  tax?  A  likely  answer  is  that  political  factors  appear  to favor the latter instrument (e.g., Goulder  2009). Emissions taxes, at least in the United  States, appear to be highly unpopular, while  cap-and-trade  systems  are  popular  among  environmental  advocates  given  their  focus  on  binding  emissions  targets  and  they  also  have  active  supporters  in  the  financial  sec- tor,  who  see  them  as  opportunities  to  make  money. But whichever instrument is chosen,  getting the design details right is critical for  cost-effectiveness—especially  broad  cover- age of emissions, raising and efficiently using  revenues, and containing price variability. 

While most analysts agree that mitigation  policies should be supplemented with addi- tional policies to promote basic and applied  research  into  emissions-saving  technologies  at  government,  university,  and  private  insti- tutions, the level of support and the specific  instruments that should be employed are far  less clear. And there is little consensus about  the case for further policy intervention at the  technology deployment stage—this depends  on the specifics of the industries or processes  involved  and  assumptions  about  consumer  behavior that are in need of further study. 

At  an  international  level,  the  choice  between cap-and-trade and emissions taxes is  also nuanced. Either system can be globally  cost-effective and accommodate transfers to  developing  countries.  And  while  cap-and- trade  systems  are  immune  to  the  possibility  of  offsetting  changes  in  the  broader  energy  tax  system,  they  may  face  larger  implemen- tation obstacles in developing countries. The  biggest  problem  in  transitioning  away  from  the CDM toward an integrated global emis- sions  trading  system  is  the  possibility  of  a  large  gap  between  the  compensation  that  might be demanded by developing  countries 

in  exchange  for  their  participation  and  the  amount  of  compensation  that  developed  countries  are  willing  to  provide—a  gap  that  could  be  especially  large  under  rapid  atmo- spheric  stabilization  targets.  Finally,  inte- gration  of  carbon  forest  sequestration  into  international  emissions  control  agreements  is  potentially  important  for  containing  the  burden of mitigation costs.

4.  Research Priorities

While a great deal has been learned about  climate policy design over the last couple of  decades, much economic analysis remains to  be done.

Energy/climate  models  provide  some  rough  bounds  on  near-term  emissions  pric- ing  trajectories,  and  associated  GDP  losses,  implied  by  climate  stabilization  scenarios,  and the range of uncertainty may narrow as  more is learned about the costs of new tech- nologies  and  behavioral  responses  to  emis- sions  pricing.  Nonetheless,  there  are  many  research priorities in this area, such as trying  to narrow disagreement over BAU emissions  assumptions  (e.g.,  through  better  popula- tion  projections);  improving  the  represen- tation  of  endogenous  technological  change,  prior policy distortions, and possible market  power  in  world  oil  and  natural  gas  markets;  quantifying the benefits of major technologi- cal breakthroughs to guide R&D efforts; and  further exploring the cost and distributional  implications of deviations from globally effi- cient emissions pricing.

Some of the biggest challenges facing cli- mate  economists  are  to  develop,  and  apply,  methodologies for valuing the wide array of  market  and  non-market  impacts  across  dif- ferent  regions,  time  periods,  and  scenarios  for  climate  change  (ecological,  health,  and  extreme  sea  level  impacts  in  particular,  are  poorly  understood).  However,  in  terms  of  shedding  more  light  on  whether  there  is  a  solid  economic  basis  for  aggressive,  as 

929Aldy, Krupnick, Newell, Parry, and Pizer: Designing Climate Mitigation Policy

opposed to more moderate, near-term emis- sions pricing, the most critical issues in need  of study appear to be the nature and magni- tude of damage risks from extreme warming  scenarios and the extent to which the possi- bility of future, mid-course corrections, and  deployment  of  last-resort  technologies,  in  response to future learning, lowers the near- term emissions price. More research on dis- count rates might also be valuable, especially  in  trying  to  reconcile  different  approaches  (e.g.,  Wilfred  Beckerman  and  Hepburn  2007). 

On  the  design  of  domestic  mitigation  schemes,  one  topic  badly  in  need  of  study,  given  the  potentially  large  revenues  from  carbon  policies,  is  the  efficiency  and  distri- butional implications of the diverse array of  options for revenue use. Additional research  priorities include the design of practical, and  cost-effective,  provisions  to  address  inter- national  emissions  leakage  and  incorporate  incentives for abatement of non-CO2 GHGs  and forest carbon sequestration. 

As  regards  complementary  technology  policy, research is needed on both the appro- priate  level,  and  the  relative  efficiency,  of  alternative instruments to encourage applied  R&D, as well as the amount and composition  of basic energy R&D. Empirical research is  also needed to ascertain whether or not there  are additional market failures that justify fur- ther  policy  intervention  at  the  technology  deployment stage. Even if the empirical basis  for such market failures is weak, research is  still needed on the interactions, and possible  redundancies,  between  all  kinds  of  increas- ingly  prevalent  climate  and  energy-related  regulatory  interventions.  For  example,  in  the transportation sector this would include  interactions  between  carbon  policies,  fuel  taxes,  fuel  economy  standards,  low-carbon  fuel  standards,  hybrid  vehicle  purchase  subsidies,  and  subsidies  and  mandates  for  renewable  fuels.  In  the  power  sector  it  would  include  interactions  with  regulations 

 governing  the  efficiency  of  buildings,  appli- ances,  and  lighting  and  inducements  for  renewable and other low-carbon fuels.  

Finally,  a  critical  issue  at  an  international  level is the design of rules for accession and  graduated  responsibilities  for  developing  countries that are widely perceived as being  fair.  At  the  same  time,  agreements  should  minimize  deviations  from  cost-effective  emissions  pricing  as  well  as  minimizing  the  risks  of  excessive  transfers  to  developing  countries. 

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