Royal Economic Society Endogenous growth, convexity of damages and - PowerPoint PPT Presentation

Interpretation  ‘Doomsday’ scenario has V A = 0, so the discount rate is increased  frantic consumption and less investment. Mr. Bean!  But if world goes on after disaster, precaution is needed. Since consumption will fall after disaster, SBC > 0 and the discount rate is reduced . This calls for precautionary capital accumulation (if necessary internalized via a capital subsidy)  The SBC is bigger if the hazard and size of the disaster are bigger. And if intergenerational inequality aversion ( CRIIA) is bigger.

Illustrative calibration of hazard function  Use H (826) = 0.025 and H (1252) = 0.067  So doubling carbon stock (rise in temperature with 3 degrees) brings forward expected time of calamity from 40 to 15 years.

After-disaster, naïve and before-disaster steady states EIS = Constant 0.8 After Naive hazard Linear Quadratic disaster solution hazard hazard h = 0.25 436 276 392 472 530 486 Capital stock (T $) 58.9 41.3 58.6 59.4 59.6 59.2 Consumption (T $) 7.7 7.3 10.4 11.0 9.7 7.7 Fossil fuel use (GtC/year) 11.8 Renewable use (million 8.2 11.7 12.4 12.7 12.2 GBTU/year) 1279 1218 1731 1838 1623 1281 Carbon stock (GtC) 0.57 0 0 0.76 1.24 0.99 Precautionary return (%/year) 51.0 0 0 0 22.4 56.9 SCC ($/tCO2)

Precautionary capital can be negative if hazard function is very convex  Steady-state pre-disaster K is bigger than naive K iff:    1     B      d *      . B      d *      This is always so if hazard constant and SCC zero.  With convex enough hazard function effects of SCC can outweigh effect of SBC , so inequality need not hold.  With quartic SCC is very high and SBC very low. The high carbon tax averts disaster so much that there is less need for precautionary capital accumulation. Put differently, precautionary capital is bad as it induces more fossil fuel use, more global warming and a relatively big increase in hazard of climate disaster. So avoid Green Paradox.

Role of intergenerational inequality aversion  Much debate is about discount rate but CRIIA = 1/  is at least as important.  Higher  or lower CRRA and CRIIA has two effects:  Lower CRRA , so lower SBC , less precautionary saving and thus less fossil fuel demand and emissions. Need lower carbon tax  Lower CRIIA so more prepared to sacrifice consumption and have a higher carbon tax.  With  = 0.8 and linear hazard first effect dominates: lower SCB and lower SCC so less capital before disaster and less sacrificing of consumption.

Gradual damages A ( Temp ) and the SCC  Before-disaster SCC has in general 3 components: s            H P s ds      ( ( ') A P s F s U C s e ds   t ' ( ) ( ) ' ( ) t ( )   U C t t ' ( ) conventional Pigouvian social cost of carbon s            H P s ds      ( ( ') A       H P s V K s P s e ds ( ) ( ) , , ( ) t   P U C t t ' ( ) 'raising the stakes' effec t s              H P s ds   ( ( ')  H P s B s A s e ds    V V t T ' ( ) ( ) ( ) t , 0 .   U C t t ' ( ) 'risk averting' effect

Catastrophic and marginal climate damages 20% shock in TFP 10% shock in TFP Naïve after after solution shock linear quadratic shock linear quadratic 378 271 492 465 323 431 421 Capital stock (T $) 57.1 40.8 58.3 58.2 48.7 57.8 57.8 Consumption (T $) 1502 1107 1287 1161 1303 1425 1320 Carbon stock (GtC) Temperature (degrees 4.00 2.68 3.33 2.88 3.38 3.77 3.44 Celsius) Precautionary 0 0 1.10 0.90 0 0.57 0.49 return (%/year) 15.4 11.0 54.8 71.2 13.2 29.8 41.5 SCC ($/GtCO2) 15.4 11.0 4.3 5.7 13.2 3.8 4.7 marginal 0 0 35.0 51.9 0 12.4 24.2 risk averting 0 0 15.4 13.7 0 13.7 12.5 raising stakes

Effect of climate sensitivity on damages

Carbon and capital catastrophes CS jumps from 3 to 4 Naïve 20% drop 20% drop solution in P in K After Before calamity calamity 382 Capital stock (T $) 379 372 381 433 Consumption (T $) 57.1 56.3 57.3 57.1 57.6 1400 Carbon stock (GtC) 1503 1374 1490 1534 3.69 Temperature (degrees Celsius) 4.00 4.82 3.96 4.09 0.05 Precautionary return (%/year) 0 0 0.03 0.57 26.5 SCC ($/GtCO2) 15.5 26.7 16.9 18.5 4.1 Marginal 15.5 26.7 3.8 3.8 2.2 risk averting 0 0 1.4 2.5 20.2 raising stakes 0 0 11.7 12.2

Conclusions  Small risks of climate disasters may lead to a much bigger SCC even with usual discount rates. Rationale is to avoid risk.  Also need for precautionary capital accumulation.  Need estimates of current risks of catastrophe and how these increase with temperature.  Recoverable shocks such as P or K calamities are less problematic.  Catastrophic changes in system dynamics unleashing positive feedback may be much more dangerous than TFP calamities .

Extension: North-South perspective  Carbon taxes and capital stocks  Non-coop bias in carbon tax, not in precautionary return on capital Regime shifts

Other extensions  Adaptation capital (sea walls, storm surge barriers) increases with global warming: trade-off with productive capital.  Positive feedback in the carbon cycle changes carbon cycle dynamocs (e.g., Greenland or West Antarctica ice sheet collapse).  Multiple tipping points with different hazard functions and lags (Cai, Judd, Lontzek). ‘Strange’ cost -benefit analysis (Pindyck).  Learning about probabilities of tipping points, but also about whether they exist all (cf. ‘email -problem ’). How to respond to a tipping point which may never materialize?  Second-best issues: Green Paradox can lead to ‘runaway’ global warming if the system is tipped due to more rapid depletion of oil, gas and coal in face of a future tightening of climate policy (Ralph Winter, JEEM, 2014).

Pure rate of time preference,  0.014 Elasticity of intertemporal substitution,  0.5 (and 0.8) Share of capital in value added,  0.3 Share of fossil fuel (oil, gas, coal) in value added,   0.0626 Share of fossil fuel in total energy,  0.9614 Share of energy in value added,  0.0651 Share of labour in value added, 1     0.6349 Depreciation rate of manmade capital,  0.05 Initial level of GDP, Y 0 63 trillion US $ Initial capital stock, K 0 200 trillion US $ Initial fossil fuel use, E 0 468.3 million G BTU = 8.3 GtC Initial renewable use, R 0 9.4 million G BTU Total factor productivity, A 11.9762 Cost of fossil fuel, d 9 US $/million BTU = 504 US $/tC Cost of renewable, c 18 US $/million BTU Initial stock of carbon, P 0 826 GtC = 388 ppm by vol. CO2 Pre-industrial carbon stock 596.4 GtC = 280 ppm by vol. CO2 Fraction of carbon that stays up in atmosphere,  0.5 Eventual climate shock,  0.2 (and 0.1) Equilibrium climate sensitivity 3 (and 4)

Royal Economic Society

Why finance ministers favor carbon taxes, even if they do not take climate change into account Ottmar Edenhofer, Max Franks, Kai Lessmann 01.04.2015

MOTIVATION MODEL SETUP RESULTS Ottmar Edenhofer, Max Franks, Kai Lessmann */18

The climate problem at a glance Resources and reserves to remain underground: • 80 % coal • 40 % gas • 40 % oil Source: Bauer et al. (2014), Jakob, Hilaire (2015) Ottmar Edenhofer, Max Franks, Kai Lessmann 1/18

The Globalisation Paradox: A Trilemma Ottmar Edenhofer, Max Franks, Kai Lessmann 2/18

The Globalisation Paradox: A Trilemma Ottmar Edenhofer, Max Franks, Kai Lessmann 2/18

The Globalisation Paradox: A Trilemma Source: Benassy-Quere et al. (2010) Ottmar Edenhofer, Max Franks, Kai Lessmann 2/18

Resource rents as solution Source: Jakob et al. (2015) Ottmar Edenhofer, Max Franks, Kai Lessmann 3/18

Research questions • Most economists agree on carbon pricing to address the climate externalty, many prefer taxes. Ottmar Edenhofer, Max Franks, Kai Lessmann 4/18

Research questions • Most economists agree on carbon pricing to address the climate externalty, many prefer taxes. • What is the role of a carbon tax under the assumption that no climate externality exists? Ottmar Edenhofer, Max Franks, Kai Lessmann 4/18

Research questions • Most economists agree on carbon pricing to address the climate externalty, many prefer taxes. • What is the role of a carbon tax under the assumption that no climate externality exists? • Can carbon taxes finance infrastructure more efficiently than capital taxes when input factors are mobile? Ottmar Edenhofer, Max Franks, Kai Lessmann 4/18

Research questions • Most economists agree on carbon pricing to address the climate externalty, many prefer taxes. • What is the role of a carbon tax under the assumption that no climate externality exists? • Can carbon taxes finance infrastructure more efficiently than capital taxes when input factors are mobile? • What are the supply side dynamics when resource importing countries tax carbon? Ottmar Edenhofer, Max Franks, Kai Lessmann 4/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Both taxes subject to race to the bottom. Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Both taxes subject to race to the bottom. Carbon tax captures part of the Hotelling rent. Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Both taxes subject to race to the bottom. Carbon tax captures part of the Hotelling rent. 2. No green paradox: Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Both taxes subject to race to the bottom. Carbon tax captures part of the Hotelling rent. 2. No green paradox: Demand side fully determines extraction. Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Both taxes subject to race to the bottom. Carbon tax captures part of the Hotelling rent. 2. No green paradox: Demand side fully determines extraction. Carbon taxes postpone extraction, Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Both taxes subject to race to the bottom. Carbon tax captures part of the Hotelling rent. 2. No green paradox: Demand side fully determines extraction. Carbon taxes postpone extraction, and reduce cumulative emissions. Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

Results 1. In Nash equilibrium, carbon tax more efficient than capital tax. Both taxes subject to race to the bottom. Carbon tax captures part of the Hotelling rent. 2. No green paradox: Demand side fully determines extraction. Carbon taxes postpone extraction, and reduce cumulative emissions. 3. Both results are robust under different strategic settings: (Non-)cooperative importers, (non-)strategic exporter. Ottmar Edenhofer, Max Franks, Kai Lessmann 5/18

MOTIVATION MODEL SETUP RESULTS Ottmar Edenhofer, Max Franks, Kai Lessmann */18

Ottmar Edenhofer, Max Franks, Kai Lessmann 6/18

Ottmar Edenhofer, Max Franks, Kai Lessmann 6/18

Household: T U ( C t / L t ) � max C / L W = (1 + ρ ) t , t =0 C t (1 + τ C , t ) = w t L t + r t K t − I t + Π F t + Tax transfer t Ottmar Edenhofer, Max Franks, Kai Lessmann 7/18

Firm: K , R , L Π F = F ( K , G , R , L ) − r (1 + τ K ) K − ( p + τ R ) R − w (1 + τ L ) L max Household: T U ( C t / L t ) � max C / L W = (1 + ρ ) t , t =0 C t (1 + τ C , t ) = w t L t + r t K t − I t + Π F t + Tax transfer t Ottmar Edenhofer, Max Franks, Kai Lessmann 7/18

Firm: K , R , L Π F = F ( K , G , R , L ) − r (1 + τ K ) K − ( p + τ R ) R − w (1 + τ L ) L max = ⇒ F K = r (1 + τ K ) , F R = p + τ R , F L = w (1 + τ L ) Household: T U ( C t / L t ) � max C / L W = (1 + ρ ) t , t =0 C t (1 + τ C , t ) = w t L t + r t K t − I t + Π F t + Tax transfer t Ottmar Edenhofer, Max Franks, Kai Lessmann 7/18

Government: T L t U ( C / L ) � max τ ζ W = (1 + ρ ) t , ζ ∈ { K , R , C , L } t =0 I G + Tax transfer = r τ K K + τ R R + τ C C + w τ L L G t +1 = G t (1 − δ ) + I G t Firm: K , R , L Π F = F ( K , G , R , L ) − r (1 + τ K ) K − ( p + τ R ) R − w (1 + τ L ) L max = ⇒ F K = r (1 + τ K ) , F R = p + τ R , F L = w (1 + τ L ) Household: T U ( C t / L t ) � max C / L W = (1 + ρ ) t , t =0 C t (1 + τ C , t ) = w t L t + r t K t − I t + Π F t + Tax transfer t Ottmar Edenhofer, Max Franks, Kai Lessmann 7/18

Ottmar Edenhofer, Max Franks, Kai Lessmann 8/18

Ottmar Edenhofer, Max Franks, Kai Lessmann 8/18

Ottmar Edenhofer, Max Franks, Kai Lessmann 8/18

Resource exporter: Resource market: R supply = � R demand T j p t R t − c t � max j � t s =0 (1 + r s ) R t t =0 p = p j ∀ j Ottmar Edenhofer, Max Franks, Kai Lessmann 9/18

Resource exporter: Capital market: Resource market: R supply = � R demand � K supply � K demand = T j j j p t R t − c t � max j j j � t s =0 (1 + r s ) R t t =0 p = p j ∀ j r = r j ∀ j Ottmar Edenhofer, Max Franks, Kai Lessmann 9/18

Nash equilibrium, two sub-games, Ottmar Edenhofer, Max Franks, Kai Lessmann 10/18

Nash equilibrium, two sub-games, Ottmar Edenhofer, Max Franks, Kai Lessmann 10/18

Nash equilibrium, two sub-games, Ottmar Edenhofer, Max Franks, Kai Lessmann 10/18

Nash equilibrium, two sub-games, Ottmar Edenhofer, Max Franks, Kai Lessmann 10/18

Nash equilibrium, two sub-games, solved for non-cooperative behavior or W i , given τ j K , τ j max R , i � = j τ i K ,τ i R Ottmar Edenhofer, Max Franks, Kai Lessmann 10/18

Nash equilibrium, two sub-games, solved for non-cooperative behavior or cooperative behavior of governments W i , given τ j K , τ j max R , i � = j max W 1 + W 2 τ i K ,τ i { τ i K ,τ i R } i =1 , 2 R Ottmar Edenhofer, Max Franks, Kai Lessmann 10/18

MOTIVATION MODEL SETUP RESULTS Ottmar Edenhofer, Max Franks, Kai Lessmann */18

MOTIVATION MODEL SETUP RESULTS • Numerical solution due to high complexity (dual game structure, intertemporal optimization, two international markets, etc.) • Calibration: Two symmetric countries to avoid that results are driven by asymmetries. • Flexibility of modelling framework also allows for calibration to setups with specific regions (e.g. USA, EU, Australia, and OPEC). Ottmar Edenhofer, Max Franks, Kai Lessmann */18

Single instrument portfolio Ottmar Edenhofer, Max Franks, Kai Lessmann 11/18

Single instrument portfolio Ottmar Edenhofer, Max Franks, Kai Lessmann 11/18

Mixed portfolio Ottmar Edenhofer, Max Franks, Kai Lessmann 12/18

Timing and volume effects Ottmar Edenhofer, Max Franks, Kai Lessmann 13/18

Timing and volume effects Ottmar Edenhofer, Max Franks, Kai Lessmann 14/18

No green paradox: Demand for infrastructure fully determines supply side dynamics The optimal financing of infrastructure with a carbon tax from an importing τ R , t +1 − τ R , t government’s perspective implies < r t − δ . Thus, extraction is τ R , t postponed (see, e.g., Edenhofer and Kalkuhl, 2011). Ottmar Edenhofer, Max Franks, Kai Lessmann 15/18

Assumptions about strategic behavior of exporter • Portfolios, which include the carbon tax τ R yield higher NPV of consumption in importing countries. • This finding is independent of whether the exporter may interact strategically or not. Ottmar Edenhofer, Max Franks, Kai Lessmann 16/18

Summary of results 1. Carbon tax more efficient than capital tax. Ottmar Edenhofer, Max Franks, Kai Lessmann 17/18

Summary of results 1. Carbon tax more efficient than capital tax. asymmetry between capital and carbon as tax base, Ottmar Edenhofer, Max Franks, Kai Lessmann 17/18

Summary of results 1. Carbon tax more efficient than capital tax. asymmetry between capital and carbon as tax base, only the resource stock gives rise to rent. Ottmar Edenhofer, Max Franks, Kai Lessmann 17/18

Summary of results 1. Carbon tax more efficient than capital tax. asymmetry between capital and carbon as tax base, only the resource stock gives rise to rent. 2. Carbon tax delays extraction, reduces cumulative emissions. Timing of infrastructure demand fully determines supply side dynamics. Ottmar Edenhofer, Max Franks, Kai Lessmann 17/18

Summary of results 1. Carbon tax more efficient than capital tax. asymmetry between capital and carbon as tax base, only the resource stock gives rise to rent. 2. Carbon tax delays extraction, reduces cumulative emissions. Timing of infrastructure demand fully determines supply side dynamics. 3. Results are robust under different sorts of strategic behavior: Cooperating importers, strategic exporter. Ottmar Edenhofer, Max Franks, Kai Lessmann 17/18

Policy conclusions • Carbon pricing can help to mitigate the race to the bottom. Ottmar Edenhofer, Max Franks, Kai Lessmann 18/18

Policy conclusions • Carbon pricing can help to mitigate the race to the bottom. • The supply side dynamics of carbon pricing matter, but pose no environmental problem. Ottmar Edenhofer, Max Franks, Kai Lessmann 18/18

Policy conclusions • Carbon pricing can help to mitigate the race to the bottom. • The supply side dynamics of carbon pricing matter, but pose no environmental problem. • Rethink role of environmental policy: Not only environmental ministers should favor carbon pricing, but also finance ministers. Ottmar Edenhofer, Max Franks, Kai Lessmann 18/18

Backup slides Ottmar Edenhofer, Max Franks, Kai Lessmann 19/18

There is far more carbon in the ground than emitted in any basline scenario Source: Edenhofer, Hilaire, Bauer Ottmar Edenhofer, Max Franks, Kai Lessmann 20/18