Flexible Design for Global Climate Change Policy ESD.71 Engineering Systems Analysis for Design Application Portfolio December 2009 Nidhi R. Santen Engineering Systems Division Massachusetts Institute of Technology Application Portfolio Nidhi R. Santen Page 2 Submitted: December 8, 2009 Abstract Current climate change policy decisions are based on relatively deterministic views of the future events and are dominated by considerations of “an” optimal carbon emissions path. This optimization approach encourages the false notion that carbon emissions policy in the distant future should (and can) be set today. However, many aspects of the future remain highly uncertain, creating the need for flexible climate policies—those than can incorporate learning and retain an ability to shift decisions in future periods. This flexibility is particularly important when considering the long time‐horizons involved in climate change mitigation and that the potential for irreversibility of decisions is high. The following project examines the opportunities that flexible globa l climate change policy can have on the overall net present welfare of the global macroeconomy. The system under study cons ists of an aggregated global economy, specified through a climate change lens, and includes the population’s preference for consumption versus investment, and possible damages to the physical environment from carbon emissions. The underlying evaluation model used for determining system values is the Dynamic Integrated model for Climate and the Economy (DICE‐99) and the timeframe studied is 2015 through 2335. The overall hypothesis under investigation suggests that implementation of a R&D‐inducing carbon tax policy today provides a form of “insurance” against future carbon‐emissions related climate damages (costs), and therefore represents a form of flexibility. Specifically, two variants of a carbon policy are studied in this project, considering different uncertainties and using two different methods of analysis. The first major exercise is an investigation to determine the value of flexibility between a policy that implements a carbon tax today with the opportunity to shift the tax level later and a business‐as‐usual no carbon tax case. The second exercise is an investigation to determine the value of a call option to implement a carbon tax policy when the system deems appropriate and examine how long we should wait to implement a carbon tax or not. Uncertainties considered in this project include the growth rate of total factor productivity, the growth rate of emissions intensity, and the sensitivity of the climate to carbon emissions. Results from a decision tree analysis for the first exercise show that a flexible carbon‐tax based policy path is the optimal strategy over two periods over all possible scenarios, and that the value of this flexibility is $0.019316 trillion. Results from a dynamic programming solution for the second exercise show again that the flexible strategy is preferred to the inflexible strategy at all risk levels, and that the value of the call option to implement a carbon‐tax when deemed appropriate is $0.51 trillion. Overall, these results confirm the underlying hypothesis under investigation. Application Portfolio Nidhi R. Santen Page 3 Submitted: December 8, 2009 Table of Contents I. ......................................................................................................................................................Introduction5 Overview5 System Description 5 Research Motivation 5 Principle Design Levers 7 System Benefits7 Available Evaluation Models 8 Key Contextual Factors—Uncertainties 8 Research Question Statement 9 II. .....................................................................................................................................................Sources of Uncertainty 10 Total Factor Productivity Growth Rate10 Emissions Intensity Growth Rate 12 Climate Feedback 14 III. ....................................................................................................................................................System Designs 16 Description of Flexibility 16 Design Alternatives 17 IV.
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