Today in ContextRegulatory Instrument DesignAlternative Instrument TypesCAC vs. MBAllocation Problem with 2 SourcesAllocation Problem with 2 SourcesAllocation Problem with 2 SourcesAllocation Problem with 2 SourcesAllocation Problem with 2 SourcesCost-effectivenessExamples of Emissions TradingTax vs. Cap-&-TradeTax vs. Cap-&-TradeEfficient Abatement Under CertaintyWeitzman (1974)Steep MD: Price Uncertainty BiggerFlat MD: Quant. Uncertainty BiggerDilemma for the U.S.Modifications to Cap & TradeIssues in Cap-&-Trade DesignETS Price HistoryIssues in Allowance AllocationAnalysis of Current US BillsETS Price HistoryImpacts on Temperature ChangeMIT OpenCourseWare http://ocw.mit.edu15.023J / 12.848J / ESD.128J Global Climate Change: Economics, Science, and PolicySpring 2008For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.Today in ContextTopics to date:• Climate Science• Politics and Institutions• Economics– Emissions Projections– Mitigation Costs– Benefits– Policy Analysis (Certainty)Today Policy Instrument ChoiceRegulatory Instrument Design• Given a desired reduction in GHG emissions, how do you design the regulation?• What are the differences between alternative designs?• On what basis should the approach be chosen?– Environmental effectiveness– Cost-effectiveness– Distributional equity– Performance under uncertainty– Political feasibilityAlternative Instrument Types• “Command-and-Control”– Technology standards– Performance • “Market-Based”– Cap-and-trade system– Emissions fee (e.g., carbon tax)•R&D Based– Tax credits/subsidies– Direct R&D SpendingCAC vs. MB• Command-and-Control– Administrative Ease– Regulatory “certainty” (?)• Market-Based– Cost-effective -> Why?• Equalizes Marginal CostsAllocation Problem with 2 SourcesMAC1Abatement (tons CO2)$/ton CO2MAC2Allocation Problem with 2 SourcesMAC2A1:$/ton CO2A2:01055010MAC1Allocation Problem with 2 SourcesMAC2A1:$/ton CO2A2:01055010MAC1TC2TC1assume equal allocationAllocation Problem with 2 SourcesMAC2A1:$/ton CO2A2:0105501064MAC1TC2TC1trade 1 unitnet costsavingsAllocation Problem with 2 SourcesMAC2A1:$/ton CO2A2:01055010x10-xMAC1TC2TC1Trade untilMC’s are equalnet costsavingsCost-effectiveness• Cannot do better than equal marginal costs• Same analysis holds for– Different firms– Different industries– Different countriesExamples of Emissions Trading• US experience– Phasedown of leaded gasoline in 1980s– CFCs/Montreal Protocol– CAAA 1990 SO2permit trading– RECLAIM in S. CA (SO2and NOx)–NOxemissions under Ozone Transport Commission (OTC)• International experience– EU Emissions Trading Scheme– Kyoto ProtocolTax vs. Cap-&-Trade• Pros for tax?––––• Pros for cap-and-trade?––––Tax vs. Cap-&-Trade• Pros for tax?– No price volatility– Revenue allows for “double-dividend”– Can address distributional effects (consumers)– Uncertainty argument (flat marginal benefits)• Pros for cap-&-trade?– Emissions certainty– Can raise revenues through auctioning– Can address distributional effects (producers)– Political feasibility in U.S.Efficient Abatement Under CertaintyEmissions$/tonMarginal damageMarginal costEPWeitzman (1974)• When uncertain, which should we use?• Answer: Look at the relative slopes of marginal costs and marginal damages• If Marginal damages relatively STEEP, use QUANTITY instrument• If marginal damages are relatively FLAT, use PRICE instrumentSteep MD: Price Uncertainty BiggerUncertain Marginal CostsMore clear what you should reduceMarginal Damages/BenefitsLess Clear what the ‘right’ price isFlat MD: Quant. Uncertainty BiggerLess clear how much you should reduceUncertain Marginal CostsMarginal Damages/BenefitsMore clear what the ‘right’ price isDilemma for the U.S.• Marginal Climate Change Damages are FLAT(in emissions, the relevant var. for policy)• Given uncertainty, should use CARBON TAX•BUT…• U.S. is “allergic” to taxes• We like tradable permits (worked for SO2)Modifications to Cap & Trade•Safety Valve• Emissions Intensity Target• Banking and BorrowingIssues in Cap-&-Trade Design• Coverage–Sectors– Gases• Stringency of the target, and path• Method of allowance allocation• Banking and borrowing• Point of regulation• Safety valve• Revenue use• International linkage– Trade in goods– Trade in allowancesETS Price History€ 0€ 5€ 10€ 15€ 20€ 25€ 30€ 351/7/2005 4/7/2005 7/7/2005 10/7/2005 1/7/2006 4/7/2006 7/7/2006 10/7/2006 1/7/2007 4/7/2007 7/7/2007 10/7/2007Weekly observationsEurosDec 07 Dec 082005 2006 2007Issues in Allowance Allocation• Why does it matter?• Auction vs. distribute for free• Who should get permits if given away?– Economics– Politics• Revenue recycling and “double dividend”• Special issues of regulated utilitiesAnalysis of Current US Bills• Simplified versions to span the range– Emissions 2012-2050 for “core” examples– Safety valve version (not handed out)• Handling of actions abroad– Europe, Japan, Canada, Aus & NZ decline gradually from Kyoto period to 50% below 1990 by 2050– All others begin in 2025, to 2015 level by 2030, hold 2000 level 2035-2050• Ignore command-&-control features800060004000200001990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050Lieberman-Warner 2007*Sanders-Boxer 2007Waxman 2007Bingaman-Specter 2007*Bingaman-Specter 2007 NationalUdall-Petri 2006Lieberman-Warner 2007 NationalAllowance Allocation: Congressional Bills and Core CasesEmissions, mmt CO2-eYear287 bmt 203 bmt 167 bmtFigure by MIT OpenCourseWare.GHG Emissions and Allowance Allocation020004000600080001000012000140002005 2010 2015 2020 2025 2030 2035 2040 2045 2050YearTotal GHGs, mmt CO2-e 203-Allowances 203-Emissions RefETS Price History€ 0€ 5€ 10€ 15€ 20€ 25€ 30€ 351/7/2005 4/7/2005 7/7/2005 10/7/2005 1/7/2006 4/7/2006 7/7/2006 10/7/2006 1/7/2007 4/7/2007 7/7/2007 10/7/2007Weekly observationsEurosDec 07 Dec 082005 2006 2007CO2-e Prices 0501001502002502015 2020 2025 2030 2035 2040 2045 2050YearPrice, $/tCO2-e287 bmt203 bmt167 bmtWelfare Changes-1.80-1.60-1.40-1.20-1.00-0.80-0.60-0.40-0.200.002015 2020 2025 2030 2035 2040 2045 2050YearWelfare Change, %203 bmtCase with bankingEffects on Petroleum Prices00.511.522.52005 2010 2015 2020 2025 2030 2035 2040 2045 2050YearPrice Index, 2005=1.0 Ref203 bmtEffect of