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Confronting Climate Change: Economics, Fairness and Political Feasibility
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Hi, everyone. Welcome to the lse. It's my great pleasure to welcome you here to hear Professor Larry Goulder from Stanford talk to us about climate change. My name is Anthony Milner. I'm a Senior Research Fellow at the Grantham Research Institute. And you are currently attending a Grantham Research Institute public lecture, one of a series for the year. And we hope that we'll see you at some more later in the year. We have some very exciting speakers coming up, not least to say our current speaker, so Larry is Professor of Environmental and Resource Economics at Stanford University.
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University.
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He's had a very distinguished academic career over more than three decades. He's made fundamental contributions to the theory of environmental taxation, how you might design markets to regulate environmental externalities and things like green accounting and how you might measure sustainability. So Larry is uniquely well placed to speak to us about current policy and economic issues related to climate change. And the title of his talk reflects this Confronting Climate change, Economic fairness and political feasibility. So we're delighted to have him here from Stanford. Thank you very much for coming, Larry. So, just a couple of housekeeping points. So Larry's going to speak to us for roughly 45 minutes to an hour, after which we'll have a question and answer session. And when we have a question and answer session, we'll take questions from you, of course. And if you could just wait for the mic. So everything is being recorded and hopefully the lecture and the question and answer session will be as available on the website after the lecture. If you have mobile phones, please switch them to silent. However, you are encouraged to tweet about the lecture should you so choose during the lecture. And finally. No, that was finally. So let's get going. Thanks very much. Please join me in welcoming Larry Golda.
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Well, thanks very much, Anthony. It was really a pleasure when Anthony contacted me by email a while back and invited me to come to London and give this talk. I was at the Grantham Institute this afternoon talking with the researchers. I run a very small center at Stanford on climate policy and I'm very envious. I'm green in more than one way and now I'm green about how much good research gets done at the Grantham Institute. So it's great to be here. Look forward to your questions and comments and thoughts during the Q and A. But I'm going to talk for a while, for 45 minutes, 50 minutes, something like that, to try to introduce some of the big topics. Now, if you look at the title of my talk, you'll see there's an implicit premise here that climate change is a problem and that it's worth confronting. You can do three sorts of arguments to say it's not worth confronting, sort of the first line of argument would be that it's not occurring. I think it's pretty hard nowadays to make that claim, or at least to sustain that claim. The evidence is now overwhelming. There's been an upward trend in global climate, global surface temperature, for example, over the last, well, many decades. It's actually accelerated over the last few decades, although there has been a very recent slowdown for global average surface temperature. The 12 hottest years on record since 1880 have all come in the last 15. So, you know, we could go on and on and talk about the details here, but there's lots of evidence that global average surface temperature at least is rising, as is ocean temperature, by the way. Second argument might be, okay, temperature's changing, there's other changes to climate, but this isn't human caused, it's not anthropogenic. But the climate scientists together have now produced a lot of evidence that it does have a human fingerprint. Lots of uncertainties as to how much, in what ways, but the general tendency of climate to be caused by human activities, especially the emissions of greenhouse gases caused by human activities, that's pretty strong. The global circulation models that are used, the climate circulation models continue to improve. They have deal closely with water vapor, with aerosols. They have ever finer grids to look at atmospheric effects more finely. The one consensus statement is by the UN sponsored Intergovernmental Panel on Climate Change, or ipcc. Their latest report says, quote, it is extremely likely that human influence has been the dominant cause of the observed warming since the mid 20th century. And not only are they talking about what's happened in the past, but they're also expecting further climate change. In the absence of very serious changes to policy, the consensus statement by scientists is that there will be continuing increases in average global surface temperature and associated impacts on the globe. Changes in the frequency of storms and intensity of storms, more, greater frequency of temperature extremes as well. So a third argument then is, okay, maybe climate is changing and maybe humans are contributing to it, but okay, it's not necessarily worth confronting that the cure in the form of climate policy may be worse than the disease itself. It may just cost too much. That's an argument that cannot be simply dismissed. It's conceivable, at least, that the human costs of confronting climate change would in fact exceed the benefits. Benefits taking the form of avoided future damages from climate change. Where are economists on this. I'm an economist, I focus on these issues. We largely defer to the climatologists on the issue of how much the climate has changed and about whether humans are contributing to it. But in terms of the last issue, whether dealing with the problem is worth the cost, economists have a lot to say. In fact, they have a lot to say. In the simplest economic textbooks. There's a sense in which economists, with all these uncertainties, they know what to do. It's just a question of how to get it done, how to pass through the political filters. And I'm going to be talking about that in a second. So what do economists say? I'm going to throw a couple graphs at you. Here's sort of the basis of the economist's conclusion that it's worth tackling. Say you've got cement. This could have been some other industry, it could have been coal, it could have been oil, natural gas, whatever. But this is a product which in its production leads to significant emissions of carbon dioxide. Principal greenhouse gas says that cement is produced at marginal private cost, given by this. Let's try again. Given by this line here. That's the private cost of production. And here's your demand curve for cement and the absence of policy intervention, the supply and demand intersect at the quantity Q0. But as mentioned, in the process of producing cement, greenhouse gases are emitted, which means there's an additional cost beyond the private cost, namely the cost associated with the climate change, the climate damages associated with the emissions. So marginal social cost, which includes private cost, but also the external cost is above private cost, which means that in the absence of some policy at Q0, the cost to society at the margin exceeds the benefit given by the height of the demand curve. In fact, anything to the right of Q1 implies a cost to society above the value of that extra bit of cement to society. So what can you do? Well, one thing you can do is you can introduce a tax on the emissions associated with cement, which would raise marginal private cost. If you did it ideally and had all the information you needed, what it would do is it would raise the private cost up here to coincide with the intersection of marginal social cost and demand. And that would reduce the quantity of cement produced to Q1, because now the costs are higher. The producers have now internalized what otherwise would have been an external cost. And what is that? Is it worth it? Well, it sure is, because instead of going beyond where the private value equals the instead of going to the point where social costs exceed the value to consumers, now we're here. So we avoid this area A. We avoid that area where the excessive cost to society, it's in excess of the value to consumers, where the consumers may be industrial users of cement, for example. So what this simple diagram says, if you set the prices right, you curb demand or curb supply and demand, you're actually gaining something. You're gaining area A, which is what would have otherwise been a social loss. Now, you can also do it through cap and trade, which has the effect of raising the cost as well, because cap and trade raised the marginal cost of production as well by putting a cap on the amount of emissions that would also ideally get you to Q1. So it's all very simple. Of course, there's complications that we will add, like the uncertainties about how big these externalities are. And there's also a lot of political considerations. But there was a market failure in the absence of intervention. And in principle, if not in practice, you can create benefits that exceed the cost through public policy. Now, where economists disagree, they don't disagree on this idea that in principle you can have net benefits being positive, that they will be positive. If there is any disagreement among economists, it's about how much information the government has, whether they will be up to the job of doing the right thing. But the basic economics, you can take the most conservative economists and the most liberal, they all agree on this. Okay? It's very simple, very powerful, and it's actually broad, sweeping beyond the climate context. It applies, for example, to local air pollution. It says that the benefits from the cleanup from, for example, putting a tax on emissions of air pollutants or from somehow controlling air pollution to get the reductions would exceed the losses of profits, would exceed the value of the losses to consumers from prices going up. It applies to urban congestion. If you price the congestion externality associated with driving the value of the time that people save would exceed the higher cost of driving of the tax. Because of this wedge, this area A. It applies in the fisheries context. The U.S. food and Agriculture Organization says that 25% of marine fisheries currently are either depleted or overexploited, meaning that the stock is threatened or are very slowly recovering. If you price the stock, that is, if you price the externality associated with depleting the common pool, you're actually helping cause the right amount of harvesting and leads to a gain, despite the fact that the price of fish would go up. And individual tradable quotas, which is an important instrument for dealing with fishing problems with fisheries over expectation has now expanded in many places throughout the Globe, much to the benefit of the fishing industry. So the basic idea is to price the externality, in this case, the externality or the damages associated with emissions of greenhouse gases. And you can do it two ways. I'll be talking about both. One is a carbon tax, where the tax is the price. The other is through cap and trade, where you put a limit on the number of emissions allowances or emissions permits that can be used. And that has the effect of raising the price, too, because it makes the supply of permits, the permits, have a price, and people have to use or purchase those permits in order to operate. But we're not doing this. Why aren't we doing it? That's one thing I'm going to be looking at. If you. Not long ago, I think it was about a year and a half ago. About a year ago, the US government engaged 12 agencies, including the Environmental Protection Agency, Council of Economic Advisors, Department of Energy, several others, a total of 12, to try to think, to try to figure out how big is this externality? How big is the. What's called the social cost of carbon, the cost associated with emitting that last ton of carbon dioxide, not only the cost today, but the damages into the future. And they came up with, using the best models they could with, with distributions of these costs. And there's a wide distribution, there's a lot of uncertainty, but they centered at around $40 per ton. That was kind of the center of the distribution. That suggests that if you're introducing a carbon tax, the ideal carbon tax should be about $40. It also suggests that if you have cap and trade, you ought to limit the amount of permits so that the price of emissions allowances is about $40. How does that compare to what's actually being done? I've gone the wrong way. Well, here are cap and trade allowance prices in the places, some of the principal places where we have cap and trade around the world, in California, in green, in the European Union, in blue, under the Kyoto Protocol, in red. And you can see that the Prices today are $15 a ton or less, considerably less than what would be implied by the size of the social cost of carbon or the size of the externality. That suggests that the cap is too easy, that it should be tighter than it is in order to get the right amount of emissions, at least if you believe that $40 per ton is the true external cost. Another way of looking at prices is to look at the size of carbon taxes where they occur. Here are carbon tax rates in Great Britain, Finland, Norway and some other countries. And to a large extent they tend to be a bit below that $40 per ton, although in some cases, like Norway, they actually are above that amount. So that suggests that even more stringent climate policy than is going on in those countries that have climate policy would be appropriate in the sense that there are more net benefits that we could get by raising the price. What do I mean by that? I mean that the value of the avoided damage, the benefits would exceed the added cost. So we're not doing enough. Now, another way of seeing that we're not doing enough is that these are only a small fraction or subset of countries involved in climate policy. For most of the countries of the world, you could say that the effective price is zero because they're not engaging in climate policy, or they may have certain forms of regulation. But to a large extent the shadow cost or the effective price on carbon is close to zero. So this is just meant to be background to say, one, arguing it is a problem, and two, that we could be doing a lot more. So now to get to the essence of the lecture, I'm going to be looking at why it is that we're not doing enough and not to be just negative about it. I'm going to also suggest that there is a lot that can be done to make it to avoid some of the roadblocks that are currently in place to overcome them. Now, I can't say that I'm going to offer any perfect solutions, but I think a lot more can be done. There are windows of opportunity, so we can ask. Before I do that though, I want to, just for those of you who say, why is this guy so infatuated with emissions pricing, whether it's in the form of carbon taxes or cap and trade. Well, first of all, economists do tend to think that emissions pricing is the most cost effective way to go in terms of dealing with the issues. But there are other options. We can require certain technologies on the part of industry, mandate those technologies you can introduce. This has been done in many places, parts of the world, including in the US and Great Britain. You can put on efficiency standards. Why this focus on emissions pricing? And I'll just briefly say that there are really three reasons why economists tend to think it's the best approach. One is that it tends to be better targeted toward the externality. Let me give you an example. In the case of automobile, in US, for automobiles, we have corporate average fuel economy standards or requirements that miles per gallon be at least up to a certain amount on average for the fleet. Okay. Or you know, In Great Britain, you know, think kilometers per liter. Now, a colleague of mine, Mark Jacobson at University of California, San Diego, compared using an economic analysis, what would be the cost of achieving certain reductions in emissions of greenhouse gases through corporate average fuel economy standards as opposed to using a gasoline tax, which is emissions pricing. And he found that it costs about six times more per ton of emissions reduced than under the fuel economy than under gasoline tax. Why is that? Because the fuel economy standards, they do improve fuel economy, as would a gasoline tax, but they have one important liability, and that is by making it cheaper per mile or per kilometer to drive. Because your car is more fuel efficient, it means it's cheaper to drive. People tend to drive more. And as a result of driving more, there's an offsetting effect. By driving more, you tend to contribute to emissions. This is the so called rebound effect. So emissions pricing actually discourages extra driving as opposed to encouraging it. And that's one reason the cost per ton are much less under emissions pricing. It's better targeted. A second reason why emissions pricing tends to be valued over the other approaches is that it helps solve an important information problem. In order to get the most cost effective reduction. In order to achieve a given reduction at the lowest cost, you want those who can emit or can reduce most cheaply to do more of the work. You don't want some entity here for which it's really costly to reduce, to have to be doing a lot of the work. You want another entity that can do it cheaply to do it. It turns out that through cap and trade or through a carbon tax, you encourage those who can do it most cheaply to do more of the work. And the nice thing about cap and trade is that through the buying and selling of emissions allowances, even if you're doing more work, you kind of get compensated for it. So that's a reason why emissions pricing is good. It helps achieve what basically amounts to it helps equalize the marginal cost of emissions reduction across the entities. And some studies have suggested that in the US reducing sulfur dioxide emissions under the Clean Air act was about 30 to 40% cheaper under cap and trade than it would have been if we hadn't used cap and trade. And the final reason is kind of a dynamic reason that emissions pricing, as long as there's a price on emissions, you're constantly being goaded to find new technologies and reduce your emissions because that's going to save you. You won't pay as much carbon tax or equivalently, you won't have to buy as many emissions allowances. Whereas if there's a mandated technology, once you've met the mandate, once you've met that standard, there's no further incentive to to improve. So that constant dynamic impetus is a third reason. Now, if it turns out that in the US or the globe as a whole, we end up having serious reductions in greenhouse gas emissions by other means than emissions pricing, I would be very happy. To me, the most important thing is to reduce those emissions. But I still would suggest that in most cases, doing it through emissions pricing is going to get us there most cheaply. So what's getting in the way? I'm going to suggest four reasons and talk about how each of these can be at least partly overcome. One is, I'm going to suggest it has to do with a lack of awareness or understanding by the public. The public is not fully aware of this kind of analysis that says we've got an externality here, the cure is not worse than the disease actually can do this in a way that creates greater benefits than it costs us. I'm going to also suggest that this, I think, is the most difficult problem to overcome and I'm going to come back to it at the end. Second reason. You may agree that you know the benefits exceed the cost in the aggregate, but you think it's unfair that a lot of the costs are being borne by those that are least able to pay. It may be seen that a lot of these policies are going to put a disproportional burden on disadvantaged households or low income households. How do you deal with that? How do you avoid opposition by those who say this is patently unfair? Third, special interests, again, this area A means that the aggregate benefit is positive, that the benefits overall exceed the cost overall. It doesn't say that everyone enjoys net benefits. There's benefits and costs are unevenly distributed. And there are certain interests, obviously ones those in the carbon supplying and carbon using industries that could be hurt by this. How do you overcome their opposition? And finally, some might say, okay, it's a good idea. But what if we as a country get involved in these policies and even though the global benefits will exceed the cost that we undertake, we're not going to enjoy a lot of those benefits. Carbon dioxide being a uniformly distributed pollutant causing climate change throughout the globe. When California introduces cap and trade, it only enjoys a small fraction of the benefits in terms of avoided damage. Most of those benefits are dispersed. The rest of the world, how do you deal with that problem? So how do you make it more environmentally effective? Again I'm not going to have a perfect solution, but I do think we can make inroads along all of these dimensions. Okay, So you probably recognize this fellow Nick Stern mentions that climate change is the biggest market failure that the world has ever seen. Here in the US A senator from Oklahoma, James Inhofe, is perhaps one of the key spokesmen for saying that climate change is not a problem. In fact, he claims it's the greatest hoax ever perpetrated on the American people. So the public, in the US at least in other countries as well, often gets mixed messages. Let me, just to help start off, indicate how the public might be divided on this. This was a poll taken, the results of a poll taken by the Pew Research Center a little bit about a year ago. And first it's asking the question, is there evidence that the Earth is warming? And if you look at the left half here, you see that around two thirds of Americans say, yes, the Earth is warming. And you can see in the right half here that it's very much divided along political lines. Democrats tend to be more convinced that the Earth is warming, at least in response to this poll, Republicans much less. Independence in the middle. Now, that doesn't directly address the question of whether it's due to anthropogenic causes. Here's a question. What about the gap over whether human activity is the main cause of warming? Here again, it's split between Democrats and Republicans, independents in the middle. And it turns out if you average it out, about 44% of Americans putting all the parties together, think that human activity is the main cause. So there still is an issue of public perception. At least it's not in agreement with what the scientists would say. How do you deal with this? Well, I'm going to come back to it, but I think there are ways, but it's very difficult. I just want to say this is one of the problems that we face. Perhaps the most important is public perception. How does the world see climate change? I don't have. What this shows is percentage of residents of each country that say that global climate change is a major threat to their country. And the United States and Britain, actually, at least according to this Pew Research center poll, have a very small percentage relative to the rest of the world. Maybe during the Q and A, you can offer some thoughts as to why this is the case. But these countries are kind of behind other countries in terms of their perception of the seriousness of the threat. So I'm going to return to this. I just want to introduce this as kind of background now and get back to the issue of public perception later. But I would like to turn right now to a second issue, and that's the issue of unfairness. Recall that area A is an indication of the aggregate net benefit, but doesn't mean that everyone benefits or that the distribution of the benefits is what we call fair. What can you do about it? How can you make it fair? These are results from a study done by Gibb Metcalfe, who served in the Obama administration, is now at Tufts University and he's looking at the impact of a $15 per ton carbon tax in the US which would be the scenario was that it was introduced in the year 2015. And he's looking at the effects across these 10 deciles or these 10 household income groups with one being the lowest 10% of the population in terms of income, 10 being the highest 10%. And what you see here is that as a percentage of income, this $15 per ton carbon tax, which would raise the price of fossil fuels, gasoline, electricity, various consumer products, would actually hurt the poor disproportionately than it would hurt the richer households. So this does for many, this would say it's unfair, it's a regressive impact. And why is it regressive? It's because low income households pay a larger fraction in general, pay a larger fraction of their income on fossil based products like electricity, heating oil or transportation fuels. It occupies a larger share of their budget. So when those prices go up, they actually get hit more than the higher income households. Well, what do you do about it? Well, one thing you can do with a carbon tax is you can return the revenues or recycle the revenues in a way that's targeted especially toward lower income households. What Metcalf considered was taking the revenues from a carbon tax and use it to finance in an equal revenue fashion. That is so that the amount of revenue coming in would just be exhausted by the revenue cuts or the tax cuts. And here the tax cuts are on labor. He's lowering the payroll tax, which as it turns out is a fairly high tax relative to income on low income households compared to higher income households. So basically this is revenue neutral. The amount coming in is the amount going out in terms of lost revenue from lowering labor tax, and it completely offsets this regressive impact. Now, in fact, the low income households enjoying lower payroll taxes as a whole do better than under no policy at all. And it's the upper income households that actually do slightly worse than under no policy at all. Now this isn't a Panacea. It's not perfect solution because some low income households are not in the low labor force and you can't reach them that way. There are other ways you can try, you can try using it to change the marginal income tax schedule. But some low income households currently pay no income taxes. So there are other things one can try to do is target the revenues toward providing public goods and services toward low income. My point is that you can offset a lot of these adverse distributional impacts and deal with the unfairness issue, at least mitigate that problem. Now there is an issue here, many issues, but one is that in the US and maybe in some other countries as well, one of the things that's been proposed is to take the revenue from a carbon tax or from cap and trade where you auction the allowances and return it as a rebate check to every household. Same amount, everyone gets the same amount just so as to make it revenue neutral, which sounds very good. But in fact if you do it that way, rather than through cutting marginal rates, basic economic analysis says you don't get as much of a benefit. Because where you really save the economy, where you really help in terms of lowering the cost, is cutting marginal rates of taxes. Marginal rates are what cause distortion. So if you cut the labor tax rate, that's great. If you just give a rebate check, you're losing that. And some work I've done has suggested that there's a big difference between a carbon tax depending on what you do with the revenue. Here what we see, this is the percentage reduction in GDP from the baseline. That's the no policy case, depending on how you return the revenue. And here I'm not factoring in the environmental benefit. So we're only looking at one side of the equation. If you return it lump sum, that is through rebate check, it's about a half of a percentage point loss of GDP from here over the next 30 years or so. In contrast, if you use it to pay for cuts in personal income taxes or corporate taxes, you can reduce the cost a lot. Well, this suggests we have kind of a trade off. On the one hand, you might, for distributional reasons, want to give a lot of the money back as a lump sum. But the more you do it as a lump sum, the more you're going to cost the economy overall. So perhaps the best thing to do is to cut it back as marginal rate cuts. But to focus those marginal rate cuts to the low income households in British Columbia, they have a carbon tax. As you know, it was $10 a ton initially and it's been growing. In order to address the distributional or fairness issue, 23% of the revenue coming in was used to cut, was devoted to low income households as a lump sum. So you're not getting this efficiency benefit because it's a lump sum. It's like a rebate check. But then they did get a lot of the efficiency benefits through the rest. That is, the rest of the revenue was in the form of marginal rate cuts. Personal income taxes rates were cut by 42% of the revenue was devoted to personal income tax cuts, 22% to corporate tax cuts, 14% to tax cuts for small businesses. So perhaps the best solution is to do a combination, some lump sum or some rebate checks especially targeted to low income households, especially households that would not pay any taxes to begin with. That's the only way of reaching them. Then reserve as much revenue as you can to cutting marginal rates. Same issue applies to cap and trade. If you auction the allowances and bring in revenue, if you want to expand the economic pie the most, use it to cut marginal rates. But if you want to deal with fairness issues, at least devote some of the revenues, perhaps in lump sum to low income households. And that's really consistent with what British Columbia has done. Okay, having talked about the fairness question, what about the very, very difficult issue of reducing opposition from industrial stakeholders? The fossil fuel supplying industries and the fossil fuel intensively using industries are highly concentrated industries. They have a lot at stake. Under simple policies they would lose a lot. The carbon tax would really give pack a wallop to the coal industry in the US for example. What can you do? How can you try to design a cap and trade or carbon tax policy to overcome this opposition? I'm going to suggest that you can, that you can design emissions pricing policies in a way that helps overcome their opposition and deal with the issue of special interests. Now I'm going to qualify this. It's not necessarily going to solve every political problem, but I think it makes political feasibility somewhat greater. So I'm going to throw another diagram at you which will try to provide at least an intuition for how this is possible. And I'll do it in the context of cap and trade. So here the industry in question is coal. We have coal output on the horizontal axis. We have a demand for coal, for example, by electric utilities that are purchasing coal fired generators that are purchasing coal, and a supply curve for coal. And the initial equation of supply and Demand is at P0 and Q0. Now let's say we introduce a Cap and trade system which puts a limit on the emissions from coal combustion below what is the case under business as usual. So that, among other things, is going to cause coal output to be reduced because now there's a limit on how much emissions of coal combusted coal can. Emissions from coal combustion can happen. And in fact, in the case of coal, the emissions are strictly proportional, almost all uses to coal. So the only way to get total emissions from coal down is to reduce coal output. And so coal output will be reduced based on the stringency of the cap. Under cap and trade, what's that going to do? Well, if you reduce the supply of coal to Q1, that's going to mean that there's going to ration this limited demand for coal and the price is going to go up. Now the price is going to go up even though you haven't really changed the supply curve. You've just in effect, the government has in effect created a cartel. It's forced the coal industry to cut back on coal. Prices are going to go up. If the emissions allowances under cap and trade are being given out free, that increase in price is something that is going to be pure enjoyment for the coal industry. They're going to get monopoly rents or cartel rents. That's the area R. And for those of you with more economics background, there is a small loss of producer surplus given by this trapezoid. But overall these rents are going to exceed this loss of producer surplus. That's if you give the allowances out free. If you auction the allowances, then what would have been rent to the coal industry coal suppliers ends up being a bit away as there's competition for these scarce allowances and that ends up going to the auctioneers, that is to the government, to the taxpayers. The important thing here is that under free allocation, coal suppliers actually do better than if there was no cap and trade system at all. This area R exceeds the gross loss of producer surplus in this diagram and a lot depends on the supply and demand. But in general it's going to look like this. In contrast, if you auctioned out the allowances not the case, then it would be like having a harder tax than the coal industry wouldn't do as well. So what does that mean? It means that if we want to protect or at least prevent a profit loss by these energy suppliers, a way to do it is to have a cap and trade system with free allowances, because that's going to create rents that more than offset the loss of producer surplus. Now, when my colleague Lance Bovenberg And I, about 10 years ago proposed this about 12 years ago. I think some folks thought of this as an academic curiosum. But in fact now we have empirical evidence from the European Union and elsewhere that when you give all the allowances free, you actually create windfalls to the key suppliers. There's good news behind this, which says you don't have to give all the allowances out free. That would create a windfall. You just need to give out enough to create enough rent to avoid the loss, to overcome or to offset the loss of producer surplus. And in some work with a colleague of mine who's at Resources for the Future named Mark Hafstead, we used a computer model to figure out, well, how many allowances do you have to give out free just to keep profits from falling and help avoid the political resistance? And this table suggests that this is looking over a time horizon of about 40 years and it's under a cap and trade system, where it was a cap and trade system. It leads ultimately to a price of allowances of about 25 or, or $30 a ton. And consistent with what I said earlier, if we just auction the allowances, well, that's going to hurt various industries. This is the percentage loss of profit on average over that 40 year period. The coal industry, coal miners and coal fired electric generators would lose about 30% of their profit. Profits would decline about 30% over this period and then other industries would lose as well, depending on how intensively they they use fossil fuels or produce them. In contrast, if we gave all the allowances out free, they make out very well. In fact, the coal mining industry experiences about almost three times as much profit as it would in the absence of any regulation at all. Similarly, for coal fired electricity generation, and I'm not going to go to the mechanical for these specific numbers, these exact numbers, but I think qualitatively they do tell you that you don't need to, that giving all the allowances out free, as was done by the way in the eu ets, creates windfalls. So then we did another experiment. We said what fraction of the allowances would we need to give out free just to keep profits from falling over this 40 year period? That's the middle. So by construction there's no change in profit here. And in parentheses we show what fraction of the total allowances have to be given out free and when we add them all up, turns out it's less than 15%. So if you allocate a relatively small share of the allowances free, that leaves 80, 85% of the allowances that can be auctioned and then you can use that revenue for other purposes. So I think this is good news. And what I'm very gratified by is the fact that policy is now moving in this direction. It's recognizing you don't have to do 100% free allocation. Phase one of the EU ETS, virtually 100% free allocation. Now they're moving somewhat to auctioning, recognizing they can still make whole the industries without 100% free allocation. In California, the same thing. I was on an advisory committee of the California EPA and we argued for significant focus on auctioning, relatively small focus on free allocation. And the California system is in fact moving that way. There's lots of revenues that you can get by the way from auctioning these allowances in California. If you were to do in 2013, the revenue from the system cap and trade, which only doesn't involve more than 50% auctioning, was a billion dollars. It's about 1% of the state budget. So it really can help with budget needs. There is squabbling in California over how to use these precious revenues. Originally it was the plan in California to devote 75% of the revenue to projects called environmental projects and 25% was reserved to help households called or disadvantaged communities. Recently, Governor Jerry Brown created some dismay among environmentalists and representatives of disadvantaged communities by basically taking away a lot of the revenue that had been earmarked for other purposes and now moving it to the general fund or the general treasury to help with the budget issue. So there still is squabbling about these revenues, which is a problem. But the good news I think is that there is a lot of revenue coming in because it's recognized that you can auction a significant share of the allowances and still make whole or prevent significant loss to the highly fossil fuel intensive industries. Now some of you might be a little uneasy about this, say, you know, free allocation. We're sort of giving producers a break. You know, why should they have their profits protected after all they're creating? They're producing goods and services, they're supplying fuels that are leading to climate change causing great damage today and in the future. Shouldn't they have to pay for all the emissions? Why should they be getting some of it free? Well, it's true that the extent you're giving these allowances out free, you're getting less revenue in to help the general tax paying public, to help the general consumer. But my view is that producers, yes, they're partly responsible for climate change, but so Are we consumers of the products that they make, that we're all in this and that they shouldn't necessarily be seen as evil for because the market is now creating a demand for their products. Furthermore, I have to say I sort of take a pragmatic approach which is if you don't do this, we may not be able to overcome the political obstacles. And better to have something which makes perhaps some people a little uneasy in terms of compensating these businesses than to have no policy that does that and be stuck with all these emissions. So I think pragmatism is an issue here. And by the way, the same approach applies to a carbon tax. People usually think of a carbon tax, it's going to hurt the oil and gas and coal industries. Not necessarily. You can do the same thing under a carbon tax. I won't go into the details, but it's analogous formally to giving out free allowances. In this case you're giving out free, you're giving out tax free emissions. You say the coal industry can supply up to QE in output and the associated emissions without having to pay for those emissions. It's only at the margin for the additional emissions beyond some level that they actually have to pay. That also creates rents. So I think this is actually, it's under recognized that there is a way to make coal industry actually do fine under a carbon tax by having what's called infra marginal emission tax exemptions. All right, the last of the areas where I'd like to suggest there's ways that we can at least partly overcome the roadblocks or deal with the bottlenecks. It's dealing with the question of whether local policies will be environmentally effective. Many in Europe say why should the EU take an aggressive action on climate change when in fact it's going to raise prices in the EU and it's just going to, among other things, it will reduce demand for oil and it might end up lowering the world oil price which will just cause other countries to increase their demand for oil. It will cause so called leakage. Or in California we have another problem. Say you introduce in California, as we have cap and trade and it raises the price of electricity produced in the state, then the utilities, the electric utilities that are purchasing wholesale electricity might simply divert their purchases and purchase dirty electricity produced outside of the state so as to avoid the regulations. So we might have a reduction in electricity produced in the state, generate in the state, but it's only going to be offset by increased generation out of the state to supply more imports to California, how can you deal with that so called leakage problem? Because what you want is you want emissions for the country or for the world as a whole to go down. You don't want to just reduce emissions in California if that's going to be offset by increased emissions outside the state. Well, California has approached this problem. One response is to include so called imported emissions in the cap and trade system. An electric utility cannot escape the regulations by simply deciding now to divert its purchases away from California generated electricity to electricity that's generated in Utah. The Utah generated electricity is going to count. Emissions is going to be counted as well. And there's a lot of details here which I'll skip over, but there's some challenges. It's really hard to identify exactly how much emissions are coming from the imported electricity or associated with that generation because electrons are about as fluid fungible a commodity as you can imagine. It all goes into one sort of common pool. It's hard to know when California imports electricity whether it was produced by that extra amount was produced by a dirty generator, a coal fired generator or by a wind power generator. So what California's done is it's sort of used an average emissions intensity to try to estimate the emissions intensity, but it's not perfect. Another problem is called contract reshuffling, which is that out of state producers can just shift their contracts so that a clean generator will export to California and a dirty generator which had been exporting to California will now be exporting somewhere else. The net effect is that nothing's really changed in terms of global emissions and this is something that has to be dealt with. But I think there's ways at least partially addressing this problem. Another leakage challenge is that only a fraction, as I mentioned earlier, of the climate benefit from domestic action is enjoyed domestically. If I keep using California as an example. But let's say if Peru or any country, Chile, any small country, decides to reduce emissions suffering costs, but it's not enjoying benefit, it's not enjoying much benefit, it's only getting some small fraction of the climate benefit because as I mentioned, greenhouse gases are globally dispersed pollutant. The effects are all throughout the world. How do you deal with this problem? Well, it's very, very difficult. In fact, I'm from California, as you can, you know, and I think it's pretty hard to justify California's taking more aggressive action than the rest of the country or much of the globe. If you didn't think that somehow by taking action now you're hastening the arrival of a more global policy that in some way it's acting as a catalyst for broader action. That I think is what folks in favor of these local actions are banking on. But there's other good news here as well. A colleague of mine, he's at the International Monetary Fund now, Ian Perry has said, let's think about so called co benefits. What are some of these other correlated benefits from climate policy that may be local? For example, when you reduce demand for fossil fuels, combustion of fossil fuels, you not only deal with the climate change problem, but you're dealing with local pollution of sulfur dioxide and carbon monoxide, other particulate matter. So there's a lot of local benefits as well that is associated with climate action. And I think this is absolutely important because it can actually provide a motivation for many countries of the world that would only enjoy a small fraction of the climate benefits to enjoy other benefits. And in fact, Ian Perry, who is at the International Monetary Fund, he did the following experiment. He said, let's forget about the climate benefits. Let's imagine though a tax, carbon tax or cap and trade, and let's just figure out what the benefits are in terms of the benefits from lower air pollution and other local benefits, compare that with the cost and see how it stacks up. So we're kind of, we're putting climate policy in sort of the worst possible position by not even including the climate benefits. And what you see here is that virtually every country, these are 22 of the highest emitters in the world. If you take into account these so called co benefits or ancillary benefits, they all benefit. I think when the word gets out on that, it can be a real impetus to deal with this as another form of leakage here. The kind of leakage is that the benefits of the climate benefits from domestic policy leak out to the rest of the world. But Perry is saying, don't worry about it, look at these other local benefits. It's enough to make it worthwhile. So I think this is very, very promising. Now, of course, a lot of these leakage problems wouldn't exist at all if we had a global policy that's also a solution to competitiveness problems. But we don't. And how can we make policies more global? Well, one I already suggested was to take into account these local benefits. I think a lot of the reason China is engaging more and more in climate policy is because it recognizes the connection with air pollution and other local problems, which are devastating problems in China, many of the big cities in China. And also it ultimately can be a threat to the Party. But how can you encourage developing country participation? Well, one way is through a cap and trade system in which you are generous with emissions allowances. Let me give the example here. The numbers, the magnitudes here are just taken out of nowhere, but I hope it demonstrates the issue. Take the country of China. Here's China's emissions. Say this is China's emissions under business as usual, this easy road, some period of time or over some interval of time. And originally China's facing a zero allowance price because it's not part of the system. Suppose that the cap and trade system globally, whether it's for Kyoto or the eu, ETS or California, there's an allowance price given by this horizontal line. Now, suppose you said to China, if you join the Party, join the Climate Policy Party, we're going to give you emissions allowances of allocation A. That's what we're giving you free. It's still less than what you're emitting today. You'd have to cut back. Will it be in China's interest to do so? Well, yeah, because in fact, if it cuts back to here, it's going to suffer some cost of abatement. But the amount that it can sell these allowances for is going to exceed, in fact, the amount that revenues will exceed its cost by the difference between the green triangle and the red. So you don't have to. You can basically still require China to contract, but by giving it enough emissions allowances, it can become a net seller and it will more than pay for its abatement costs. So that's one way to do it. Up to now, we've been just relying on offsets and I think I'm not going to spend time on offsets now just to save time. So finally I want to say that I've talked a lot about emissions pricing and pricing is crucial. But I want to emphasize for those of you technologists out there, in fact, for all of you out there, it's not the whole solution. There's also something called innovation market failure. There are really two market failures here. Up to now I've been focusing on the emissions market failure, which stems from the externality from fossil fuel use, from the emissions of greenhouse gases and the damages they do. And as in that diagram we saw before, meant that prices would be below social cost in the absence of intervention. But there's another market failure called the innovation market failure. It stems from the fact that when any inventor innovates, he or she creates new knowledge, some of which often will spill over to others. So the innovator can't fully appropriate all the benefits from that new knowledge. And basic economics says as a result, the incentives to innovate are below. What is optimal from society's point of view may have still incentives to innovate, but not enough. And that gives a rationale for direct technology innovation policies such as R and D subsidy, subsidy to research and investment. To deal with this spillover issue, in fact, I've done some work. I was close friends with and collaborated with Steve Schneider, who passed away some years ago from cancer. And we did a paper where we compared the cost of reducing emissions in the US by a certain amount, either through cap and trade, through carbon tax alone or through an RD subsidy alone or through the combination. And we found that the costs were about 40% smaller if you use the combination of the two, consistent with this, with what I've said here, because now you're using two instruments to deal with two market failures. So if you rely exclusively on emissions pricing, you're not dealing with the innovation market failure sufficiently. Relying on both direct technology policy and emissions pricing gets it. Both the two market failures provide justification for the two types of externality. Okay, so let me conclude that I promise to get back to the issue of public awareness and understanding and I will in a second. I've offered some suggestions of how you can at least partly tame the climate change issue or at least help open the door to support for policies. In terms of the unfairness issue, I suggested progressive recycling of the revenues can make the effects more proportional or less regressive. It's not perfect, but that's one way of getting at it. In terms of special interests, I argued that free allocation under cap and trade can preserve profits. You don't have to allocate all the allowances free, just part of them, or similarly under a carbon tax in for marginal exemptions. In terms of environmental ineffectiveness. The problem of leakage. There's two kinds of leakage issues. One is when, let's say electric utilities substitute for power outside of the state relative to power in the state that is controlled. There are ways of dealing with that through border adjustments or something else called output based updating. And then another kind of leakage is the fact that any given entity isn't going to enjoy all the climate related benefits from its action. I think the work done by Ian Perry and others at the World bank is really important in expressing in realizing the value of these co benefits that can make it in an individual country's interest, even ignoring the climate benefits. But that takes us to the very first thing mentioned and yet haven't really gone into it. And to me, this is the most worrisome of all the problems and that is lack of awareness and understanding by the public. And there is a clear rift between what the scientists tell us in academic journals and the public perception. Let me show you the results from one summary study and there are several now. Study by Cook et al. In Environmental Research Letters about a year ago. He looked at the academic literature of journals, published literature, where they either they took a position or didn't take a position on agw. That stands for Anthropogenically Caused Global Warming or Human Caused Global Warming. So it's really on the issue of whether humans are contributing in quote, a significant way to climate global warming. And what you see here stretching back from around 1990 to 2012 is that among these studies, and I forget how many there were, but there were several hundred, very few of these published studies that referred to anthropogenically caused warming rejected it. Almost zero. It might have been three or four of the published literature. There was a lot that referred to it but didn't take a position because they were largely talking about the scientific, the chemistry, but not really on the human contribution. And then there are a large number that basically support the view that humans are causing, significantly causing climate global warming. There's other studies of this sort. One number that gets bandied about, I think it's slightly. There are different ways to measure it is that 97% of the scientists that are directly involved will affirm, not just be agnostic, but will affirm that humans are significantly contributing to global climate change. So if you believe that there would be a rift between the public polls, awareness that we saw and what the scientists are saying, and I don't see an easy way out on this, what's behind this rift? I think part of it is due to a combination of special interest or, sorry, technology and, well, it's the way the media present our news. Technology now means that we have available to us hundreds, thousands really of sources of news. You can go to cable, you can go to the Internet, you can go to tv, you can go to anything. And there's just an abundance of different news channels of different political persuasions. And any individual with a given view can always select for whatever channel will tend to reinforce his or her opinion. And I think that makes it harder for people to be informed because people like to get their own views reconfirmed. And if you add to that the fact that many news organizations, you know, they are profit makers, and they have to worry about advertisers. And advertisers include companies that have an interest in at least casting doubt on climate. And if in the US for example, you'll often see two people talking about climate, one representing the overwhelming scientist view and another person given equal time, that's casting doubt. So the public doesn't know what to say. They say, well, you know, it's not clear, so I don't have a solution to that. If anyone does, be wonderful. But I think that that's the most difficult of these problems to really make headway on. And hopefully we will, we will, before climate change is so much that it becomes hard, even harder to ignore. So I'll stop there. And we have about half an hour for Q and A.