*Reason Public Policy Institute ORDER FORM*

Policy Study No. 252

February 1999

Climate Change

By Kenneth Green, D.Env., Richard McCann, Steve Moss, and Roy Cordato

Executive Summary

On November 1998, President Clinton signed the Kyoto Protocol, moving the United States one step closer to implementing a sweeping set of new measures to combat what is posited by some to be the looming environmental threat of our time: manmade climate change. While debate ranges over the impacts that the Kyoto Protocol on Climate Change might have, the sheer magnitude of potential implementation impacts, both intended and unintended, suggests that careful scrutiny should precede actions to reduce the risk of climate change. In signing the Kyoto Protocol, the President did more than signal a concern over manmade climate change: he put the United States on a course toward a specific set of strategies and tactics that proponents claim will head the risk of climate change off at the pass.

But there are many reasons to question the wisdom of the Kyoto Protocols approach to climate change policy, including questions about the scientific grounding of the protocol; questions about the feasibility of the proposed implementation mechanisms; questions about the efficacy of those measures; questions about the adverse consequences of diverting resources to address highly uncertain risks using tools with uncertain impacts; and questions about the impacts of proposed climate interventions on peoples standard of living and freedom of choice. This study examines these questions in three chapters.

In the face of claims that the Kyoto Protocol will make present and future generations safer and provide a healthier environment, Chapter 1 explores what should be the bottom-line question: Is the Kyoto Protocol likely to provide a real, net improvement in the environmental safety of present or future generations? Chapter 1 examines the scientific uncertainties in our understanding of climate change. These uncertainties also limit the effectiveness of measures aimed at forestalling such change. After reviewing the meager promise of the Kyoto Protocol to reduce greenhouse gas concentrations, stacking it up alongside the protocols impacts upon peoples health as it is tied to the economy, and examining the opportunity costs of premature or inappropriate resource allocation, Chapter 1 builds a balanced risk ledger which demonstrates that the near-term benefits of the Kyoto Protocol are scant while the long-term benefits are highly uncertain. Such benefits pale when compared to high near-term negative impacts and opportunity costs. At the bottom line, this risk ledger includes both pros and cons of protocol implementation, suggesting the protocol is likely to do far more harm than good.

Chapter 2 explores the most commonly discussed mechanism for implementing the Kyoto Protocol, namely emissions trading. The administration, and numerous proponents of the Kyoto Protocols approach to climate change policy, portray emission trading as a no-pain implementation mechanism that will let us have our cake and eat it too. But other analysts, notably those most experienced with the development and evaluation of emission-trading programs, point out that emission trading is not the panacea it is made out to be. Chapter 2 explores the factors which make emission trading less likely to work for greenhouse gases than for traditional air and water pollution problems. These factors include: 1) confusion over the "stock" and "flow" effects of air pollutants; 2) uncertainties about the influence of individual greenhouse gases; 3) uncertainty about forecasts; 4) uncertainty about outcomes; 5) problems with establishing and enforcing property rights; 6) and problems of high transaction c osts. Emission trading, as an approach to climate change, is plagued with difficulties that cast serious doubt on its reputation as a no-pain approach to climate change.

Chapter 3 explores the ramifications of imposing carbon taxes, the most likely alternative to emission trading, an alternative looking more and more likely as developing countries stymie attempts to even study implementation of emission-trading regimes. The main claim of those promoting carbon taxes as an approach to forestalling climate change is that the known adverse economic impacts of a present-day tax will be offset by far-future benefits. But such claims do not stand up to scrutiny, and Chapter 3 demonstrates that uncertainties about the impacts of climate change; uncertainties about future climate benefits; uncertainties about a more economically fragile society to deal with other pressing risks; and the risks of allowing for a return to centrally planned energy policy all undermine the claims that carbon taxes are either an equitable, effective, or efficient way to forestall the risks of climate change.

Table of Contents

CHAPTER 1: Evaluating Climate Change Policy?*

I. The Challenge?*

II. Picking a Basic Strategy?*

A. Why Resilience is the Default Strategy?*

B. Running Climate Change Through The Strategy Selector?*

III. Evaluating Proposed Anticipatory Measures?*

A. Evaluating the Anticipatory Kyoto Approach?*

B. Assessing Risk-Reduction Benefits?*

C. Assessing Risk-Reduction Liabilities?*

D. Balancing the Ledger?*

IV. Conclusions?*

CHAPTER 2: Markets and the Casino: Gambling on Greenhouse Gas Reductions?*

I. The Policy Setting?*

II. The Nature of the Climate Change Dilemma?*

A. "Stock" Versus "Flow" Effects?*

B. Uncertainty About the Influence of Individual Greenhouse Gas Constituents?*

C. Uncertainty About Forecasts?*

D. Uncertainty About Outcomes?*

E. Discrete Versus Continuous Outcomes?*

III. Turning to the "Marketplace" for a Solution?*

A. The Advantages of Marketable Emission Permits?*

B. The Messy World Meets The Ideal Market?*

IV. Basic Problems in Market Formation?*

A. Risks to Property Rights?*

B. Transaction Costs in the Market?*

V. The Mismatch of the Market with Policy Goals?*

VI. Conclusion and Policy Recommendations?*

CHAPTER 3: Climate Change and Carbon Taxes?*

I. Introduction?*

II. A Tax That Will Make You Better Off??*

A. Global Warming, Social Costs, and Carbon Taxes?*

B. The Insurmountable Information Problem?*

C. Compounding the Harm?*

III. Conclusion?*

About The Authors?*

Other Related Reason Public Policy Institute Publications?*

Chapter 1

Evaluating Climate Change Policy

By Kenneth Green, D.Env.

I. The Challenge

In November 1998, President Clinton signed the Kyoto Protocol, moving the United States one step closer to implementing a sweeping set of new measures to combat what is posited by some to be the looming environmental threat of our time: manmade climate change. While debate ranges over the impacts that the Kyoto Protocol on Climate Change might have, the sheer magnitude of potential implementation impacts, both intended and unintended, suggests that careful scrutiny should precede actions to reduce the risk of climate change.

Like most of the actions we take to improve our safety, actions intended to reduce environmental health risks are rarely pure in their effects. We know that choices have consequences, and it is a true Pollyanna who thinks that any significant action, risk-reducing or otherwise, can have purely positive consequences. While some safety improvement may be wrought through the impact of a given risk-reduction measure, we know that, in many cases, the unintended consequences of the measure can produce countervailing impacts which erase some or all of the perceived benefit.

A recent example of such countervailing impacts gained visibility in the debate over automobile air bag requirements. Studies have confirmed that rather than being "pure" in its risk-reducing impacts, the airbag requirement created new risks for a significant part of the population (smaller women) and posed a particular threat to children, the physically fragile, and the elderly. The additional risk posed by airbags may not eradicate all of the safety gains stemming from their use, but logic dictates that this increased risk be taken off the bottom line of claims about increased safety stemming from airbag use to create, in effect, a "net-benefit" assessment of increased safety.

We also know that our available risk-reduction actions are not unlimited, but are constrained by the resources available to us as individuals and societies over a given span of time. We might like to pursue all risk-reduction measures at all possible speed at all times, but we know that such an approach is simply not possible in a constrained world. Constraints require that we make choices regarding where to invest our risk-reduction resources.

Some individuals may prefer simply to make choices based on sentiment rather than a careful weighing of risk information. However, decisions made in the public-sector regarding mitigation of commonly faced indivisible risks, of which climate change policy is but a specific example, require an easily understood framework for choosing a strategy, whether that strategy is intended to head off a specific risk in a specific way, or is intended to help society and its members prepare for suspected, but poorly defined risks looming in the distance. We must evaluate available policy options using a net-benefit framework for portraying both the nature of environmentally conveyed health risks and the consequences of proposed actions.

This chapter will explore, first, what basis we might use for selecting a basic strategy with regard to climate change, and second, how we might assess available policy options within a given strategy.

II. Picking a Basic Strategy

We have many available risk-reduction interventions that move us toward a bottom line goal of decreased risk to ourselves and our children as conveyed through the environment, whether climate-related or not. These available interventions vary widely in terms of degree of intervention, public and private-sector roles, and amount of information needed for successful implementation.

At the most generic level of classification, the options range from the resilient to the anticipatory. Resilient strategies are largely decentralized and non-regulatory, maximizing societys ability to cope with risks through research, and through the naturally risk-reducing function of a dynamic, market-based, knowledge-building social structure. Anticipatory strategies are those designed to prevent a risk from occurring. Generally, anticipatory strategies are implemented through regulations which require certain actions and prohibit or restrict others.

But how do we decide, for any given risk, whether an anticipatory approach is more likely to provide us with a good return for our safety investment than a resilient approach? A framework developed by risk-policy analyst Aaron Wildavsky provided a useful strategy selector based on levels of knowledge and predictability of change (for example, predictability of future harms):

Source: Adapted from Aaron Wildavskys Searching For Safety, Transaction Press, 1991.

Wildavsky observed that it is not our knowledge but our uncertainties which most strongly constrain the probability of success with a given strategy.

A. Why Resilience is the Default Strategy

Resilient strategies are often wrongly characterized as "do nothing" by environmental agencies or advocacy groups with a "regulation first" orientation. However, there is a difference between "do nothing" and adopting a resilient strategy.

First, "do nothing" is mostly a canard. Research regarding risks will not cease. People will not stop tracking climate change, because people are now, and always have been concerned with the dangers of changing climate, and with developing tools to help them anticipate that change.

Second, resilient strategies are responsive, constantly addressing specific problems as knowledge about those problems develops. Third, resilient strategies are dynamic: they emphasize building knowledge and resources so people are better able to cope with real problems as they materialize. Numerous studies show that there is an unmistakable linkage between a societys prosperity and its safety, and its environmental cleanliness. People instinctively seek to reduce risks as they perceive them using their own local knowledge of their own particular situation.

Fourth, resilient strategies often include very specific deregulatory strategies that remove obstacles to the natural resilient process of a market-based society. Regulations put in place which favor or disfavor various fuels or technologies can stand in the way of actions that would decrease the risk of climate change by harnessing the natural processes of decarbonization and dematerialization that are hallmarks of competitive market economics. Such strategies often fall into that category called "no regrets strategies."

Resilient approaches that maintain a market-based, knowledge-building, and dynamic investment strategy enhance our ability to respond over time to risks and to reduce risks. Reducing peoples ability to procure safety through resilient strategies poses a risk liability in itself. Therefore, departure from that default should require a demonstration, based on an assessment of evidence, that a proposed intervention reliably outperforms the default path of resilience sufficient to warrant overriding peoples individual choices.

B. Running Climate Change Through The Strategy Selector

At the heart of climate change theory is a relatively simple relationship between gases in an atmosphere and temperature of a closed system. That relationship is called the greenhouse effect. Scaling that relationship up to the globe as a whole gives us the theory of global warming. Trying to figure out whats going to happen with global climate based on one particular cause or change (such as manmade gas emissions) is what is generally meant by "climate change" when used in a public policy context. Climate change policy refers to proposed actions to prevent or mitigate harms from manmade climate change.

To understand the differences in certainty and predictive ability at each step toward greater complexity, consider this analogy: If you have a small vacuum chamber, and you drop ten different colored feathers, they fall straight down and land at the same time. Predicting the path, and intercepting say, the red feather is a simple task. Thats like the greenhouse effect, a simple cause / effect relationship.

But if you drop the same ten feathers out of an airplane, they dont fall straight down, and they dont land at the same time. Some of them, in fact, wont land at all, because theyll stay aloft for so long that theyll get brittle and disintegrate or be sucked into jet engines and destroyed. Still, one can assume that some of them do land eventually, since gravity is still a force in play. Global warming and the various potential causal factors, like greenhouse gases, embody a similarly complex set of interactions among many variables over time.

Consider another example. If you released ten different colored birds into the wild with all the other birds in the world, then tried to figure out where each of your birds would lose its feathers; where and when a specific feather would land; what damage the feather might cause; and how you might avoid that damage by preventing the growth of the food that fed the bird that produced the feather, youd be in a similar realm of complexity to climate change theory.

Between our incomplete understanding of the climate system and the difficulty of scaling up what we do know to the level of global climate effects, including effects involving oceans, ecosystems, mountains, rivers, groundwater, solar variation, greenhouse gas emissions, clouds, aerosols, water vapor, and historical variation, then trying to scale the impacts back down to the local and regional level, we are left with a view best characterized as "through a glass, darkly."

This is not an extreme or "skeptical" view: one need not look beyond the landmark 1995 reports of the Intergovernmental Panel on Climate Change (IPCC) themselves (the often-thumped but rarely read bible of climate change) for expressions of that uncertainty. Even a cursory review of the accepted uncertainties surrounding climate change show that we are clearly in a state of limited knowledge, not only about what to do, but about the nature of the risk itself:

Uncertainties about potential impacts that we wish to see averted and uncertainties as to whether any given action will have a reasonable probability of succeeding indicate appropriateness of a resilient strategy rather than an anticipatory strategy. Such resilient strategies might include additional research to reduce uncertainties in the predictive elements of climate change study; regional and local responses to regional or local manifestations of climate change (regardless of cause); "no regrets" energy policies; deregulation to remove barriers which inhibit better environmental performance; and so on.

III. Evaluating Proposed Anticipatory Measures

Though a resilient strategy might be sensible, currently proposed policies are largely anticipatory, including those emerging from the Kyoto Protocol.

Environmental advocacy groups, international commissions, and various state and federal agencies generally favor an anticipatory strategy to dealing with climate change policy. Proposals focus on heading possible problems off at the pass through what might be called a "fast-drive / fixed-target" approach. These proposals advocate the selection of a series of fixed targets for greenhouse gas reductions and then a rapid drive toward those targets through aggressive use of industrial policy, taxation, marketable permit trading, regulations, or a combination of these approaches. The Clinton administrations signature of the Kyoto Protocol, in November 1998, whether implemented through ratification or by executive action, has placed the United States on an anticipatory pathway. The various tactics mentioned by the administration and supporters of the Kyoto Protocol give us a set of plans to evaluate as public policy options. How do we evaluate the proposed anticipatory approaches to determine their li kely impacts? How do we assess the likelihood that these approaches will achieve in practice what they are postulated to achieve in theory?

Unlike selecting a basic strategy, which depends largely on ones state of knowledge about a potential risk, evaluating specific tactics within a given strategy is more complex. However, some guiding principles should control the overall evaluation process:

2. There must be a valid framework for evaluating alternative interventions in terms of: 1) their likelihood of providing real, quantifiable, net risk-reduction benefits; 2) the information constraints that shape implementation of any anticipatory measure; and 3) the behavioral complexities that may result in a gap between the ideal and the actual.

To a very large extent, various environmental agencies and advocacy groups advance these principles as necessities in assessing not only environmental risks, but the efficacy of proposed compliance measures for dealing with various environmental policies.

A. Evaluating the Anticipatory Kyoto Approach

While portrayed as a "step in the right direction" by many environmental agencies and advocacy groups, scientists involved in climate change research have characterized the impacts of the actual accord reached in Kyoto as negligible in terms of near-term risk-reduction benefit. Yet, this 15-year step will span nearly a third of many peoples 47-year working lifetime. Given that longer-term benefits from future steps are highly speculative, while present-day impacts are more concrete, we should view the pros and cons of this first step on its own merits. Various analysts, agency researchers, and environmental advocacy group representatives claim a variety of benefits from greenhouse gas reduction measures that are either unrelated to risk-reduction, including amenity values and species protection, or are only indirectly related, as co-benefits of other existing air quality measures. But the justification for climate-change programs is almost exclusively future-generational risk reduction. The anci llary benefits that are offered in defense of climate change policies could be produced directly through specific resource-use policies if those goals are valued by enough people to allow their enactment.

B. Assessing Risk-Reduction Benefits

The belief that fully implementing the Kyoto Protocol by itself is unlikely to provide meaningful risk reduction benefits is widespread among those people cited as experts by proponents of the protocol at the 1997 Kyoto conference on climate change:

Jerry Mahlman, Director of the Geophysical Fluid Dynamics Laboratory at Princeton University, told the Washington Post that, "The best Kyoto can do is to produce a small decrease in the rate of increase." In a post-Kyoto Science news brief, Mahlman says that "it might take another 30 Kyotos over the next century" to cut global warming down to size.

Bert Bolin, outgoing chairman of the United Nations Intergovernmental Panel on Climate Change, assessed the impact of Kyoto as a 0.4 percent reduction in greenhouse gas emissions compared to a no-protocol alternative and concluded: "The Kyoto conference did not achieve much with regard to limiting the buildup of greenhouse gases in the atmosphere."

Robert Repetto at World Resources Institute acknowledges that the Kyoto accord is little more than a tiny step toward a distant end rather than a significant step in itself: "Nobody thought in their wildest dreams that Kyoto would solve the climate problem….If implemented, the achievement at Kyoto will be to get nations off a business-as-usual trajectory, and onto a path that peaks, and then starts going down."

As Tom Wigley, a climate researcher at the National Center for Atmospheric Research in Colorado, puts it, "A short-term target and timetable, like that adopted at Kyoto, avoids the issue of stabilizing concentrations [of greenhouse gases] entirely."

In other words, benefits of the Kyoto Protocol, at least in the short term, are described more in political terms—as initiating a shift in energy-use patterns—than in terms of tangible environmental or risk-reduction benefits.

C. Assessing Risk-Reduction Liabilities

1) Accounting for the income-risk relationship

Although regulatory costs and job losses are not often considered risk-relevant in themselves, they should be. The idea of a linkage between income and risk may be subtle, but it is also intuitive. We know, for example, that people with large families face lower risks of suffering from severe depression or of becoming homeless due to economic dislocation. Having a large family seems to lessen ones risk of serious depression or homelessness. We know that people with many friends are in less danger of becoming mentally ill than are "loners." Thus, having a strong social network lessens ones risk of mental illness. Likewise, we know that peoples safety is related to peoples income. Those with less income are proportionately less able to take the safety measures that higher-income earners can. Families with high income levels can better withstand short-term health problems than those with less income. Families with higher incomes eat higher quality foods, drive safer cars, live in safer neighborhoo ds, train their children for safer jobs, and so on.

Peer-reviewed studies over two decades have examined the question of such economic risk modifiers and generally concluded that people use their disposable income to weave a personal safety net around themselves and their loved ones. The more disposable income they have, the tighter the weave of their personal safety net. The less disposable income they have, the looser the weave.

As systems engineer Ralph L. Keeney points out in Estimating Fatalities Induced by the Economic Costs of Regulations:

Though environmental advocacy groups and agencies generally dismiss such ideas as being unconventional, the implications of this understanding are straightforward: less income, less safety. Nor is this relationship inherently unquantifiable. We can estimate the impact by determining how much a proposed action will cost an individual in terms of disposable income and then correlating that loss of disposable income with personal safety.

The costs of the Kyoto Protocol may be significant. Most moderate economic analyses with moderate assumptions show economic impacts of around a two percent reduction in U.S. gross domestic product (compared to a no-protocol scenario) in order to bring U.S. greenhouse gas emissions to 1990 levels by the time frame called for in the Kyoto Protocol.

But for the sake of this analysis, let us make a few more optimistic assumptions. The Kyoto Protocol actually obligates the United States to cut its greenhouse gas emissions seven percent below that of 1990. Moreover, most studies showing a two percent reduction in GDP estimate costs exceeding $200 billion annually. However, let us assume that the full cost of compliance with the Kyoto Protocol might only cost $100 billion annually to present a conservative estimate of impacts.

Using a model of induced fatality developed by Ralph Keeney at the University of Southern California, we can model the impact of taking $100 billion out of peoples own risk-reduction budgets and spending it elsewhere on anticipatory actions such as those needed to reduce the emission of greenhouse gases. Depending on whether one assumes that regulatory costs are borne equally by all households (the high end of the range), or proportionally with household income (the low end of the range), $100 billion (in 1990 dollars) spent each year to comply with the new standards will lead to induced fatalities of 9,000–22,000 Americans each year.

2) Opportunity cost of investment: accounting for missed opportunity to save lives through alternative risk-reduction investments

As Harvard risk-researcher Tammy Tengs demonstrated in her study of cost-effectiveness of risk-reduction regulations, all investments in risk-reduction do not yield equal results. Table 1-1 shows the median cost of intervention for five regulatory agencies, each charged with reducing risk within its sphere of authority. To date, saving lives through environmental regulations has been, in the aggregate, more expensive than saving lives through other types of safety regulation, though some individual environmental measures may be highly cost-effective ways to reduce risk.

As discussed earlier, the costs of the Kyoto Protocol will likely amount to at least $100 billion dollars per year. The same amount of money spent on some of the demonstrated, cost-effective health and safety risk reduction measures could, hypothetically, save the lives of many people if we would get comparable return on our investment to historically proven interventions. Of course, such high returns on risk-reduction investments are rare. Furthermore, high returns are not likely to be maintained over time as the low-hanging fruit of any given risk-reduction is plucked and as more marginal risk-reduction measures are pursued. And one should not think of saving lives as one would think of toting up the cost of preserving oranges. Still, even if we break a given risk group into thirds, such as the roughly 41,000 people who die in automobile accidents each year, and assume that saving the second third is five times more expensive than the first, and saving the final third is five times more expensive than t hat, we could save all 41,000 for about $33 billion, while inducing between 3000 and 7,300 fatalities, for a net benefit of 33,700–38,000 lives saved annually.

Table 1-1 —Median Value Of Cost/Life-Year Saved For Five Regulatory Agencies.
Regulatory Agency	Median cost/ life-year saved
Federal Aviation Administration	$23,000
Consumer Product Safety Commission	$68,000
National Highway Traffic Safety Administration	$78,000
Occupational Safety and Health Administration	$88,000
Environmental Protection Agency	$7,629,000

Source: Tammy O. Tengs, et al., "Five-Hundred Life-Saving Interventions and Their Cost-Effectiveness," Draft, Harvard Center for Risk Analysis, Harvard University, Boston, MA, July 25, 1994.

If policy makers are unwilling to allow people to retain all their earned resources to procure safety for themselves, they should consider whether we are getting better value for our governmentally administered safety investments than that which can be obtained by people on their own. They should also consider whether were getting the biggest risk-reduction available through established intervention pathways.

D. Balancing the Ledger

When we account for the lack of demonstrable near-term, risk-reduction benefits from the Kyoto Protocol approach to climate change policy, the risk-reduction liabilities of the income-risk relationship, and lost opportunities to use proven risk-reduction interventions, we find that a net-benefit assessment shows considerably higher liabilities than benefits for the near term. And given the long-term uncertainties involved, even putting the speculative long-term range of benefits into the risk-ledger doesnt contribute much more information to facilitate evaluating whether were on the right track.

IV. Conclusions

People do not face risks in isolation. Rather, at any given moment, each individual has a portfolio of risks and faces a constant challenge in managing that portfolio and in selecting from the various risk-altering actions available individually or through collective action. Man-made climate change may well be a risk in that portfolio, to ourselves, or to future generations.

But to empower individuals to make informed personal and public-policy risk-management choices, we need a method of selecting a risk-reduction strategy and a method of portraying risk and potential benefits of risk-reduction measures that retain the complexities that reality imposes, while providing an understandable basis for decision making.

Table 1-2
KYOTO PROTOCOL RISK-REDUCTION BENEFITS —NEAR TERMa
Reduced risk of harm from changing weather patterns:	NONE
Reduced risk of harm from extreme weather events:	NONE
Reduced risk of harm through famine avoidance:	NONE
Reduced risk of harm through disease prevention:	NONE
Reduction in other proposed climate change hazards:	NONE
Reduced risk of harm through avoided economic impacts of climate change:	NONE
KYOTO PROTOCOL RISK-REDUCTION BENEFITS —LONG TERMb
Reduced risk of harm from changing weather patterns:	NONE – HIGH
Reduced risk of harm from extreme weather events:	NONE – HIGH
Reduced risk of harm through famine avoidance:	NONE – HIGH
Reduced risk of harm through disease prevention:	NONE – HIGH
Reduction in other proposed climate change hazards:	NONE – HIGH
Reduced risk of harm through avoided economic impacts of climate change:	NONE – HIGH
KYOTO PROTOCOL RISK-REDUCTION LIABILITIES —NEAR TERMc
Induced fatalities from income-risk relationship:	Approx. 9,000 – 22,000/yr.
KYOTO PROTOCOL OPPORTUNITY COSTS —NEAR TERMc
Lives not saved through other risk-reduction investments:	Approx. 0 – 3.5 million/yr.
Resources not available for other social uses:	$100-200 billion/yr.

NOTES:

1. These values derive from the consensus scientific view that Kyoto compliance, of itself, will produce no environmental benefit, as discussed above.
2. This range of values flows from the consideration that if the pessimistic scenarios of climate change as discussed in the IPCC reports on climate change are true, and if the anticipatory approach is effective, averted risks could be significant.
3. Induced fatality values calculated by author using income-risk relationship as modeled in Keeney & Green, 1997. "Lives not saved" values calculated by author from values in Tengs, et al., 1994.

Based on uncertainties about the impacts of climate change, our analysis suggests that, pending improved understanding of the probable impacts of climate change, policymakers should reconsider their selection of an anticipatory strategy, as exemplified by the Kyoto Protocol. Instead, while keeping a wary eye out for more precise information about the risks posed by man-made climate change, our analysis suggests that policymakers should explore more proven, more resilient risk-reduction strategies.

In a net-benefits framework, pursuing the Kyoto Protocol approach may well do more harm than good in the near term and offer only uncertain benefits in the longer term.

In the next chapter, we will examine the most frequently discussed tactics to be used in driving down greenhouse gases: emission credit-trading programs and carbon taxes. While potentially less problematic than carbon taxes, the credit-trading approach is fraught with unique difficulties and uncertainties which prevent us from making a meaningful assessment of potential benefits, but do suggest the potential for significant countervailing harms from either unanticipated, or unconsidered consequences of implementing a trading scheme.

Chapter 2

Markets and the Casino: Gambling on Greenhouse Gas Reductions

By Richard J. McCann and Steven J. Moss

I. The Policy Setting

Concerns over the potential for global climate change caused by human activity began to arise in the late 1980s. Global climate models, made possible by advances in supercomputer technology, forecast large temperature increases not seen since the Age of Dinosaurs. These forecasts were corroborated, in the publics eye at least, by data showing a recent reversal of the global cooling trend that occurred from 1940 to 1975, and by the record heat experienced in the summer of 1988. These events led to the issuing of numerous international scientific and policy studies on global climate change.

These studies have prompted a series of international conventions, protocols, and treaties to control the emission of greenhouse gases. The initial agreement to establish emission control targets was signed in 1992 at the Earth Summit in Rio de Janeiro. After a series of conventions under United Nations sponsorship, a more specific protocol was negotiated in December 1997 in Kyoto, and signed by President Clinton in November 1998. This protocol more specifically assigns responsibility for reducing greenhouse-gas emissions and establishes rules and methods for crediting and trading such reductions.

The debate over global climate change, or "global warming" as it was called initially, has at least two foci. The first and primary focus has been over the scientific basis of the climate-change predictions and the level of risk posed by climate change given those forecasts. This debate has primarily taken place among scientists, with policy analysts entering the fray with their own take on the quality of the scientific process, and the possible socio-economic and ecological consequences from both climate change and policies undertaken to control greenhouse gas emissions. The second focus has been on the allocation of required emission-control responsibility among nations and industries. Because this debate has obvious "hard" dollar implications, it has been much more political in nature and has set the developed and energy-producing nations, which have historically had the highest rate of greenhouse-gas emissions, against the developing and transforming economies, which view such cont rols as serious constraints on their future growth. While the two debates often occur in separate forums, they are in fact intricately linked because of the wide disparity both in the expected impacts and risks from climate change and in the economic consequences of controlling emissions.

One of the centerpieces of the Kyoto Protocol is the establishment of an international mechanism to trade emission reductions. Trading programs have long been advocated by economists to solve a variety of environmental problems, and several such programs have been established around the world. The purported advantage of such a "market-based" approach is that reductions can be garnered at the least economic cost. Several so-called joint implementation trades have already taken place to reduce emissions in developing countries, where control costs are likely to be lower. However, such programs require a specific set of conditions to be successful, and in the case of global climate change, those conditions may not be met.

II. The Nature of the Climate Change Dilemma

The environmental risks and consequences of global climate change differ from the standard environmental problem in several ways. These differences can lead to important departures in how the threat of global climate change should be approached versus other environmental issues.

A. "Stock" Versus "Flow" Effects

For most environmental pollution, such as air emissions or water discharges, the damages are almost immediate and transient, i.e., the damages occur as the pollution arrives once emissions reach a certain threshold level. If the pollution ceases, the damages would end almost as quickly. Think about smog: if there were no more cars, air quality would improve rapidly within days. These types of relationships are known as "flow" effects because they are associated almost directly with the flow of pollutants. Global climate change theory, on the other hand, pertains to the total amount of greenhouse gases, or the stock, existing in the atmosphere. The emissions in any one year have only a small impact on the potential effect—it is the accumulation of these gases which is the critical driver. As a result, reducing emissions will not lead to an immediate reduction in the risk. Nor are small annual reductions likely to have a substantial effect for some time. The focus of controlling greenhouse gases n eeds to be on the total stock in the atmosphere and the growth rate of that stock, not on the annual flow as in the case of air and water pollution.

B. Uncertainty About the Influence of Individual Greenhouse Gas Constituents

"Greenhouse gases" are a collection of various gases which have differing effects and half-lives. Most of these gases are released in large quantities by nature, but human activity appears to have added small increments that may lead to increased accumulations in the future for specific types of emissions. Carbon dioxide (CO₂) is usually claimed as the predominant source of the greenhouse effect. Its main anthropogenic sources are from burning fossil fuels and forestlands. However, human-induced emissions are dwarfed by the natural output of CO₂ from plant life and erosion. Methane (CH₄) is considered the next largest source of greenhouse gases, and human sources of methane generally come from fuel use, cattle, and rice paddies. Other sources, including chloro-flurocarbons (CFC), which are now controlled by the Montreal Protocol, constitute smaller but significant sources.

Table 2-2: Exchangeable Flows of Carbon in the Environment
	Range (Gt/yr)	% of Total (out of 158 Gt/yr)
Natural Sources
Oceans	90–92	57–58
Land biota	60–61	36–39
Natural Source Total	150–153	93–97
Human Sources
Burning fossil fuels	5.0–6.0	3.4–3.8
Deforestation	0.6–2.6	0.01–0.02
Human Source Total	5.6–8.6	3.5–5.4
Total	157–160	100%

Notes: a) 1 Gt, or gigaton, is a billion metric tons. 1 Gt/yr is one gigaton of carbon moved from one pool to another over the course of one year. b) Land biota includes emissions from all plant life on the earth as well as soils and detritus.

Source: Data drawn from IPCC, Climate Change 1995, The Science of Climate Change, p. 77.

Table 2-3: Sources of Methane Found in the Atmosphere	Range (M)	IPCC Value	Percent of IPCC Total
Natural Sources
Wetlands	100–200	115	22
Termites	10–50	20	4
Ocean/freshwater	6-45	15	3
Methane hydrates	0–5	5	1
Natural Source Total	117–325	150	30
Human Sources
Energy use	70–120	100	19
Rice paddies	20–150	60	12
Enteric fermentation	65–100	80	15
Human / Animal wastes	20–60	50	10
Landfills	20–70	30	6
Biomass burning	20–80	40	8
Human Source Total	215–580	360	70
Total	332–905	515	100

Notes: A) 1 Mt, or megaton, is one million metric tons. B) Column three shows the values deemed most likely by the IPCC. C)"Enteric Fermentation" constitutes gaseous emissions from animals. The IPCC considers all animal emissions as being caused by activities of mankind.

D) Calculations of percent contribution by Green, using IPCC 1992 data. The 1995 report did not break out the individual contributions, important information for understanding the relative contributors of methane to the atmosphere. Changes in the actual numerical assessment of the methane budget, however, are not substantial in the newer report.

Source: Data drawn from R.T. Watson, L.G. Meira Filho, E. Sanhueza, and A. Janetos, "Greenhouse Gases: Sources and Sinks," in Climate Change 1992, J.T. Houghton, B.A. Callander, and S.K. Varney, eds. (Cambridge, Mass: Cambridge University Press), p. 35.

The estimation of climate change potential of these gases is constantly changing as new information and modeling results are published. In some ways, the estimation method is an iterative process (not necessarily toward an equilibrium) between chemists and climate modelers. In addition, how emissions are released may influence climate change as well. For example, burning fossil fuels often releases sulfates which increase the albedo in the atmosphere and can create cooling that offsets the warming effect of CO₂. Also, the expected half-lives of these gases have changed with further analysis. This uncertainty is not surprising given our evolving understanding of atmospheric science and the inherent complexities of climate processes. Similar problems have arisen in studies of the formation of tropospheric ozone, which is both the prime constituent of smog and a greenhouse gas. With any complex system, whether its the climate or the national economy, we need humility in our understanding of how it works. To date, we simply do not know how changing one variable in the climate system will affect the Earths climate.

C. Uncertainty About Forecasts

Economists and demographers universally acknowledge that long-term forecasts—of five years or more—are highly uncertain. Since most forecasts are based on historical patterns of behavior, when this underlying behavior substantially changes, and it almost always does, forecasts typically turn out to be inaccurate. The problem of forecasting error is particularly acute for climate change and associated economic models, for five primary reasons:

Greenhouse-gas emission uncertainty can be highlighted by comparing historical estimates, which in themselves display significant variation. Table 2-4 displays carbon dioxide emission data developed by different government agencies. As indicated in the table, there is over a 10 percent difference between the U.S. Environmental Protection Agencys (USEPA) and U.S. Department of Energys Energy Information Administration (EIA) 1992 CO₂ emission estimate, even though these estimates were made in 1994, two years after the estimating period, and they should be using common data sources. As discussed above, since emission forecasts to a large extent will determine actual dollar responsibility for emission reductions, it can be expected that forecast differences among nations will be even larger than those between U.S. agencies and departments.

Table 2-4: Differences in Historic CO2 Emission Estimates (Million Metric Tons of Carbon or Carbon Equivalent)
	1989	1990	1991	1992	1993	1994
EIA, 1994	1,387	1,375	1,362	1,383	1,409	N/A
USEPA, 1994	N/A	1,335	1,319	1,339	N/A	N/A
USEPA, 1994	N/A	1,233	1,218	1,239	N/A	N/A
USEPA, 1995	N/A	1,336	1,320	1,340	1,369	1,390
EIA, 1996	1,384	1,372	1,359	1,380	1,405	1,481

Source: Energy Information Administration, Emissions of Greenhouse Gases in the United States 1987-1992, DOE/EIA-0573 (Washington, D.C.: U.S. Department of Energy, Energy Information Administration, Office of Energy Markets and End Use, October,1994); Energy Information Administration, Emissions of Greenhouse Gases in the United States 1995, DOE/EIA-0573(95) (Washington, D.C.: U.S. Department of Energy, Energy Information Administration, Office of Energy Markets and End Use, October,1996); U.S. Environmental Protection Agency, Inventory of U.S. Greenhouse Gas Emissions and Sinks:1990-1993 (Washington, D.C.: U.S. Environmental Protection Agency, Office of Policy, Planning and Evaluation, September,1994); U.S. Environmental Protection Agency, Inventory of U.S. Greenhouse Has Emissions and Sinks:1990-1994 (Washington, D.C.: U.S. Environmental Protection Agency, Office of Policy, Planning and Evaluation, November,1995).

Because the potential effects of greenhouse gases devolve from the stock of gas rather than the flow, the forecast rate of emissions and their accumulation become important for policy making. Because mistakes in forecasting are also cumulative, choosing strategies that allow for mid-course corrections are paramount. Relying on todays forecast for setting reduction targets without a means to make mid-course corrections will guarantee large errors in the future. Because the errors are cumulative, corrections could require many years.

D. Uncertainty About Outcomes

The mechanism of "climate forcing" is still being understood and refined as illustrated by the repeated lowering of forecast temperature increases, which reflects the natural evolution of scientific investigations. As an example, a recent study has found that forests increase carbon dioxide uptake from the atmosphere with rising temperatures, contrary to the assumptions used in existing climate models.

Yet there is another range of uncertainty in the linkage between climate change and the consequences of a change. We do not understand how dynamic and resilient either the earths biosystem is or the worlds economic system. However, scientists are finding precedents for rapid cooling and warming associated with the ice ages. The rapid transformation of the worlds economy in this century probably is a testament to the adaptability of our societies to large changes. Nevertheless, it is the uncertainty over the outcomes, and how this uncertainty is compounded by the chain of scientific uncertainties back to human activities which should be the focus of policy responses.

A useful way to think about the distribution of possible outcomes is to examine two matrices relating emissions to potential warming, and warming to potential outcomes. These matrices can then be combined to link emissions to outcomes. Table 2-5 shows a hypothetical relationship between average annual emission growth (as a proxy for the stock of greenhouse gases in the atmosphere) and the probability of increased global mean temperatures. This relationship is the one most often conveyed to policymakers and the public, although the actual distribution is often ignored.

Table 2-6 shows a hypothetical relationship between increased temperatures and potential outcomes. Economic and ecological analyses often present a range of outcomes, sometimes associated with different levels of temperature increase, but none has related the probability of an outcome given expected temperatures. Of course, making such an assessment is quite difficult and perhaps impossible, but we do know that the relative probabilities will change with changes in temperatures.

With this these two matrices, a relationship between emission increases and outcomes can be developed, as shown in Table 2-7. This matrix is more informative to policymakers because it shows the direct linkages between policy decisions and potential outcomes. In this way, the policymaking can shift its focus from the process-oriented method used by scientists toward the outcome-oriented approach that politicians are more comfortable with.

As Table 2-7 shows, a 1 percent per year growth in emissions might have a 33 percent chance of producing negative effects; and a 5 percent chance of producing catastrophic effects.

E. Discrete Versus Continuous Outcomes

Although linking emissions to outcomes represents a necessary improvement, it does not convey one of the most important aspects of climate change uncertainty—the likelihood that the relationship between emissions and outcomes is probably highly nonlinear and perhaps even discontinuous, i.e., climate change will either be benign or catastrophic. That is, the geophysical system probably has substantial inertial balance which can accommodate large infusions of greenhouse gases. Such a system is likely to experience large discrete changes when that balance shifts. Such systems are more likely to have a "bimodal" (or double-peaked) distribution of outcomes rather than the classic single-peaked "normal" or bell-shaped curve.

This bimodal distribution has an important implication for policymakers: global climate change could have rather benign implications or lead to catastrophic outcomes. For this reason, the appropriate measures also will vary significantly—in other words the optimal policy choices will be discrete and bimodal. If the outcome is likely to be benign, then little needs to be done. However, if the outcome is likely to have severe consequences, worldwide emissions will have to be reduced dramatically and quickly—the Intergovernmental Panel on Climate Change (IPCC) estimates that annual emissions would have to be reduced by 50 percent to 70 percent to simply stabilize current atmospheric concentrations.

While it might make sense on first impression to pursue the most risk-averse or "safety-first" (precautionary principle) strategy, such an approach is more likely to lead to disastrous results. First, the technology does not yet exist—nor will it be available in the next decade at least—to achieve these magnitudes of reductions and also to preserve a semblance of our way of life. We would simply have to stop using any type of energy in our daily lives. Even as new technologies come on line they would be quite expensive initially and would have significant economic consequences if forced into widespread use prematurely. Government expenditures might be able to accelerate dispersion, but such spending will have little influence on the creative process of inventing these technologies. The second problem is the irreversible nature of these type of investments. Once committed to the draconian reduction path, turning back is extremely difficult. If the economy is forced to suffer such grave measures a nd then climate change turns out to be a benign outcome, we will not be able to return to our previous economic vigor for some time.

Nevertheless, a middle course of moderate reductions is unlikely to result in either the least economic disruption or adequate protection if the threat is serious. Unfortunately, the reduction targets laid out in the Kyoto Protocol fall into the moderate-course category. We can illustrate this conundrum by examining how the appropriate policy responses conflict with a moderate course chosen too early on:

• In the first case, moderate 5 percent to 20 percent annual reductions are pursued for a 10- to 20-year period in response to the threat of climate change. These actions reduce worldwide economic output due to increased costs. However, after 20 years, the scientific forecasts show that the effects of global warming are likely to be de minimus or benign. Governments immediately respond by eliminating any programs that restrict greenhouse gas emissions. However, world economies have foregone a higher level of output for 20 years, and the now-unneeded energy infrastructure must still be paid off.
• In the second case, again moderate reductions are in place until scientific forecasts show that climate change is likely to be catastrophic to the worlds biosystem and economy. Annual world emissions must be cut immediately by 70 percent or more to stabilize existing greenhouse gas concentrations. These levels of reductions require drastic restructuring of the worlds energy infrastructure and economic order. Unfortunately, the moderate reductions had two effects: first, greenhouse gas concentrations are likely to be only 10 percent to 20 percent lower after 20 years than they would be without any restrictions—buying only a two- to four-year delay in the expected temperature increase. Second, the moderate reduction targets will have accelerated the replacement of long-lived energy infrastructure with technology that meets the moderate targets. Since this infrastructure is relatively "young" and the drastic reductions will now "strand" these investments, much of it, particularly for energy production, will now have to be replaced quickly.

In the first scenario, the intermediate reductions provide no net benefits (at least beyond the so-called no regrets strategies which generate other non-climate change benefits) at substantial cost. In the second scenario, the accelerated turnover in capital stock actually makes it more costly (and probably more politically difficult) to institute further reduction targets because the capital stock is newer, with more outstanding investment. As an example, an electric utility could meet a 20 percent reduction target by replacing its 30-year old steam boiler that uses 10,000 British thermal units (Btus) of natural gas to generate a kilowatt-hour with a new combined-cycle turbine that uses 8,000 Btus per kilowatt-hour (kWh). However, if a further reduction is needed 20 years later, the combined-cycle plant would be only half-way through its expected service life, and the utility will be reluctant to replace it with the 4,000 Btu per kWh fuel cell needed to meet the new reduction targets. On the other hand, if the utility had simply extended the steam boilers life by 20 years, the fuel cell probably would be an attractive option. The net result is that the so-called moderate reductions provide only a costly sense of false security.

The "irreversibility" of infrastructure investment, as with the draconian strategy, acts to penalize a middle course of action. The moderate reduction path does not prepare investors, producers, or consumers for the likely changes in that path that may be necessary. Similarly, investors are likely to perceive the increasing risk as more is learned about the potential for climate change, and this will tend to reduce the amount of investment in current technologies no matter what their emission-reduction benefit.

One other drawback of the moderate-reduction approach is that it tends to push renewable, non-greenhouse-gas emitting technologies into the marketplace before they are ready. Virtually none of these technologies is cost-competitive with fossil-fueled choices, and most still have significant technical hurdles. American consumers already suffered through "not-ready-for-prime-time" alternative energy technologies in the 1970s and 1980s when federal and state governments offered tax incentives to install solar and conservation technologies. Many of these failed badly and consumers are still wary of using these systems. Renewable energy technologies could suffer the same fate if they are introduced too early. As a result, if advanced technologies are really needed at a later date to meet more-stringent reduction targets, consumers may be reluctant to adopt these technologies.

All of these uncertainties—component effects, climate forecasting, economic forecasting, the distribution of possible outcomes—combined with the stock effects of both greenhouse gases and infrastructure investment create a situation where a cautious approach to climate control policies is necessary. The year-to-year expected costs are not uniform and tend to rise as the impending event nears. In addition, the uncertainty and stock effects combine to encourage delayed action.

III. Turning to the "Marketplace" for a Solution

Politicians are cognizant that reducing greenhouse gas emissions could be quite costly and may lead to substantial change in the broad activities, such as fossil fuel use, on which our world society and economy are built. In this context, policymakers are looking to economists for a "quick fix" to limit the potential for catastrophic costs. Economists have long argued for the use of so-called market incentives or mechanisms either to obtain the greatest environmental benefits or to use the least cost to achieve an environmental goal. Market incentives include:

• pollutant-specific charges, fees or taxes;
• beneficial technology subsidies;
• deposit-refund programs for harmful products; and

• tradeable permits or allocations of pollutants.

The economists argument goes as follows:

Policymakers have only recently turned to using market incentives as the rising costs of meeting environmental objectives have become more apparent.

The Kyoto Protocol signed in November 1998 formally established means for participating nations to trade "emission reduction units" and to credit those trades toward each countrys stated goals. The protocol clearly expects that such trading will greatly reduce the compliance costs with the reduction objectives specified in Annex A. Articles 3, 4, 6, 11, 12 and 17 specify rudimentary rules and responsibilities for participants in such trades. These rules make distinctions between trades among "Annex I" nations, which include those in the Organization for Economic Cooperation and Development (OECD) and the former Soviet Union states, and those between Annex I and nations with "developing and transforming economies."

A. The Advantages of Marketable Emission Permits

Among the various market-based instruments, technology subsidies and tradeable permits have probably been the more politically popular, and taxes the least:

• Subsidies are a quite prevalent form of government intervention, and, for example, are a substantial component of state and federal transportation policies (e.g., highway and railroad subsidies). Subsidies appeal to particular interest groups which gain them at the expense of the general public which pays the subsidies. Subsidies also can increase pollution by actually encouraging the damaging activity.
• Taxes are unpopular for one immediate reason—they effectively confiscate the "rights" to pollute being currently exercised. Taxes are generally set for the entire pollutant output, and polluters are not compensated for the economic value they implicitly placed on their ability to freely dispose of their by-products.
• Tradeable permits provide a means of addressing this problem of confiscation. Individuals and firms are allocated "property" rights to their emissions at historical levels or by some other method. These rights can then be bought and sold with the "owners" retaining the economic rents rather than the government, as is the case with taxes. Under tradeable permits, a quantity target of pollutants can be established, which is done more easily than setting monetary targets for taxes that are expected to achieve certain levels of pollution reduction.

Under a tradeable permit scheme regulators establish an overall emissions reduction target, allocate emission "rights," and allow emitters to trade among themselves for the right to emit potential pollutants, with permits essentially sold to the highest bidder. Under the right circumstances, a well-crafted permit program can minimize overall pollution-reduction costs, for two primary reasons:

Tradeable permit programs have gained popularity among global policymakers because of their ability to combine strict emission-reduction standards with decentralized decision-making related to how the emissions can be reduced. This feature bypasses the need to estimate the value of fees, taxes, or charges, which otherwise have been viewed by some as attractive alternatives to command and control policies. Tradeable permits are also more operationally flexible than fees. For example, if emission regulations are tightened within a trading market, permits will become scarcer, and permit prices will "automatically" rise. If higher prices act to accelerate technological innovation, control costs will ultimately fall, as will prices. Under the same circumstance, using a fee approach, regulators would have to explicitly act to change the fee structure to meet air quality goals.

There are a number of tradeable permit variations, including cooperative or joint implementation schemes, in which one party can gain the rights to an environmental resource—air pollution credits or water rights—by subsidizing the adoption of more efficient or cleaner production processes by the entity that initially owns the rights. Recent examples of joint implementation approaches include the Metropolitan Water District-Imperial Irrigation District investment in water conservation, and the Sacramento Municipal Utility District-Sacramento County Rapid Transit District purchase of natural gas-fueled buses.

Although marketable permit programs have been demonstrated to be more efficient in achieving pollution-reduction goals than command and control policies in the economic literature, real-world experience with these programs has been limited. As indicated in Table 2-8, only a dozen environmental marketable permit programs appear to have been implemented to date, none of which operates on a worldwide, or even multinational, basis.

Table 2-8: Past and Existing Marketable Permit Programs for Environmental Protection
Type of Program	Program Structure/Location
US EPA Acid Rain Emission Allowance Trading Provision of the Clean Air Act Amendments	Nationwide SO2 trading by electric utilities and industrial facilities.
US EPA New Source Review—Emission Reduction Credits Trading	Nationwide ROG, NOx, PM, SOx, CO netting or internal trades; offsets.
US EPA Leaded Gasoline Phase-Down	Nationwide limited trading among oil refineries
SCAQMD RECLAIM	Southern California NOx and SOx trading.
SMUD-RTC Natural Gas Bus Purchases	Joint implementation program for air pollution credits in Sacramento, California
US EPA Chloroflurocarbon Fee Program	Nationwide quota trading and escalating fees on CFC emissions, with revenue dedicated to the U.S. Treasury.
Home Fireplace Devices	Two permits must be purchased from existing stock to install a fireplace in Telluride, Color