8.2.3 Key Factors Affecting the Magnitude of Costs: Costs as a Function of Baselines and Policy Strategies

The above taxonomy suggests that assessing the costs of greenhouse gas mitigation strategies is not equivalent to adding up the direct costs of individual measures or policies. The cost of mitigation is always a net incremental cost (or a marginal cost) relative to a given scenario- usually called a baseline scenario. This means that the calculation of these net costs is determined in large part by both the assumptions underlying such baseline scenarios and the assumptions about mitigation policies.

8.2.3.1 Baselines and magnitude of the "no-regret" potentials

The most sensitive issue in the debates about how to interpret the results of the models is the way assumptions about the existence and the size of potentials for so-called "noregret strategies" are conveyed in specific modelling frameworks and baseline scenarios.

The discussion of "no-regrets" potential has triggered a sensitive policy debate which can be summarized rather simply, though rather abstractly, in graphical form (see Figure 8.2). To begin, we represent the whole economy as producing two sets of goods and services: (1) a composite good Q, namely an aggregate of all existing goods and services, and (2) a given level of environmental quality E, represented in this case by a certain amount of emission reductions. Given such an assumption, it is possible to construct a curve F(Q,E), called a theoretical production frontier by economists, which represents the trade-off between economic activity (Q) and emission reduction (E). For a given economy at a given time, each point on this curve shows the maximum size of the economy for each level of emission reduction; put another way, it shows the maximum emission reduction for each level of economic activity. If the economy is at a size and level of emission reduction that is below and to the left of this curve (e.g., point O in Figure 8.2), it is possible for that economy to move upwards (e.g., from O to B), producing more goods without increased emissions, or to move rightwards (e.g., from O to A), reducing emissions without reducing the size of the economy, or to move somewhere in between, increasing both economic activity and emissions reduction.

[Figure 8.2]

From the point of view of cost analysis, a key consideration is what is assumed about the location of the reference or baseline scenario with respect to this curve. If the baseline scenario assumes the economy to be located somewhere on the theoretical production frontier (curve F), it is clear that there is a direct and unavoidable trade-off between economic activity and the level of emissions. In effect, all increases in emission reduction (moving down the surface of the curve to the right) will decrease economic activity (i.e., increase costs). That is, there is no no-regrets potential: moving up to the left on the curve will increase economic activity but also increase emissions. In such a

context, an appropriate policy mix can minimize the net cost of lower emissions but can never offset it totally. Conversely, in a baseline scenario that describes an economy below the production frontier represented by curve F, no-regret strategies are possible, by moving from O to any point between A and B on curve F. Under these conditions, emissions can be reduced without reducing the size of the economy (i.e., without increasing overall costs) and possibly ean enhancewith some enhancement of economic activity.10

The critical question is, then, whether the reference or baseline scenario to which mitigation scenarios are compared is on this frontier or not. Assuming that a no-regrets potential exists implicitly suggests that any baseline scenario is below the frontier and that appropriate policies would move the economy up towards that frontier. The counterargument is that, if such a potential had existed, it would already have been adopted by the marketplace at least as long as there are no institutional failures preventing market forces from operating." This line of reasoning leads many analysts to assume that any cost-effective emission reduction is already embodied in any baseline scenario and to locate their baseline scenario on the frontier.12 In this sense the economic debate is as much about the location and characteristics of the baseline scenarios as it is about the nature and costs of specific mitigation measures."

In fact, the existence of a no-regrets potential implies (1) that markets and institutions do not behave perfectly because of market failures (lack of information, distorted price signals, lack of competition, etc.) and/or institutional failures (inadequate regulation, inadequate delineation of property rights, distortion-inducing fiscal systems, etc.); (2) that it is possible to identify policies that have the ability to correct these market and institutional failures without incurring implementation costs larger than the benefits gained; and (3) that a policy decision is made to eliminate selectively those failures that give rise to increased greenhouse gas emissions (since there may exist other market failures whose removal might increase these emissions).

In other words, the existence of market and institutional failures that give rise to a no-regrets potential is a necessary but not a sufficient condition for the development of strategies to realize that potential. The latter depends on the existence of significant political desire to realize the potential. In practice, in many fields of public policy making, countries will consider climate policies in a multiobjective decision-making framework, whereby greenhouse gas mitigation policies are likely to be a by-product or joint product of policies developed in part for other reasons. Few costing studies address these complexities; however, some bottom-up studies examine the additional environmental benefits of greenhouse gas mitigation policies, while some top-down studies examine the benefits of using carbon taxes to reduce other tax distortions in the economy.

The existence of these issues means that the results of any analysis of the relationship between cost and emission reduction are largely determined by a set of

underlying assumptions about negative cost potentials and the economic double dividend. Figure 8.3 illustrates two different views of this relationship that underlie the top-down and bottom-up debate. Both curves in Figure 8.3 show how total costs would increase for higher levels of emission reduction, given different underlying assumptions about the efficiency of existing energy markets. Both curves assume that there exist no environmental double dividends.

[Figure 8.3]

Curve A (traditionally associated with a top-down perspective) assumes that there exist no reducible market imperfections (i.e., no negative cost potential), or that reducible market imperfections are already incorporated in the base case, or that the costs of reducing market imperfections outweigh the benefits. It also assumes there is no economic double dividend. As a result, the greater the level of emission reduction, the higher the costs. In this perspective, the net costs may be even higher than the gross costs because of inefficient recycling of carbon tax revenues.

Curve B (traditionally associated with a bottom-up perspective) starts below the xaxis because it assumes that there exists some combination of (1) market failures in the energy, transportation, or agricultural systems that can be corrected by (or are corrected in parallel with) emission reduction policies at negative cost, and (2) economic double dividends that offset the costs of emission reduction policies. Thus Curve B shows the existence of some no-regrets or "worth doing anyway" potential below the x-axis.

The differences between Curves A and B represent different underlying views of the efficiency of the economy. Since many current models can adopt either view of the economy, such underlying assumptions are often the main reason for the differences in quantitative results among different analyses.

8.2.3.2 Target setting: Level and Timing

The growth rate of CO2 emissions is determined by the growth rate of GDP, the ratio between GDP and the required level of end-use services (energy, transport, food), and the level of greenhouse gas emission per unit of each of these services.1

When targets are set for levels of emissions calculated from a given benchmark year in the recent past, the level of baseline emissions is critical because higher rates of economic growth increase the gap between baseline and target emissions, thus making any given target more costly to achieve. The higher the rate of growth, the bigger the emission reductions that are required to meet the target. This tendency is obviously less strong if the baseline incorporates some decoupling between economic growth and

emissions and assumes many flexibilities in the system (e.g., high responsiveness of consumption to price and nonprice signals, or availability of low carbon-intensive techniques).

With emissions growing over time, a target of constant emissions implies that larger emission reductions are required in every future time period, requiring recourse to more and more expensive measures. Conversely, if a model embeds optimistic assumptions about technological progress in the long run, this tendency may be counterbalanced and the costs in the short term may be higher than over the long run.

For given assumptions about technical progress the time profile of the abatement may be a key determinant of differences in cost estimates. In discussing these timing issues, there is a key distinction between the transition period and the backstop period.

The transition period comes first and is characterized by an existing capital stock and limited technological options for replacing existing techniques with less carbonintensive or carbon-free techniques. In effect, much of the infrastructure and technology is fixed. The backstop period is entered after sufficient time elapses to allow the entire capital stock to be replaced and for carbon-free backstop technologies to become available, in other words, technologies available for widespread adoption at the end of the economic life of existing equipment.

One of the most important determinant of costs during the transition period is the turnover of the capital stock. Over the backstop period the cost of carbon-free technologies places an upper limit on how great the costs of reducing carbon emissions can be. Successful research and development that accelerates the availability of less carbon-intensive and carbon-free technologies can reduce costs in the backstop period.

What policy instruments are used to trigger modifications in consumption and technical adoption behaviours and how they are accounted for in the models can also affect the models' results. The types of policy instruments that have been studied in detail are energy taxes and quotas on the one hand and a collection of regulatory programmes, efficiency standards, incentives, information programmes, and voluntary programmes that are intended to bring about adoption of specific technical measures to reduce energy use on the other. Significant differences exist among different models as to which instruments are considered and how they are treated.

To date the focus of macroeconomic models has been on carbon or energy taxes (the focus of new generations of sectoral technico-economic analysis has been on the impact of other types of incentive instruments), and significant differences in the results come from the way the revenues of a carbon tax are recycled in an economy. In the earlier models, many simulations were made that assumed no tax recycling. Such an

assumption amounts to treating a carbon tax as an external shock such as an oil shock and places an upper bound on the macroeconomic costs. In later analyses, most of the models represented recycling in the form of a lump-sum process, namely, without modifying the rest of the fiscal structure. This method makes comparison easier but does not describe the recycling techniques that have the highest probabilities of being implemented. In a third stage, models tried to exemplify other ways of recycling a tax by changing the level of payroll taxes, income taxes, and corporate taxes, or simply by reducing public deficits. This methodological development complicates comparisons, because the outcome depends on the ways the existing distortions of fiscal structures (or subsidies) are accounted for in the baseline, but it is more meaningful from a policymaking viewpoint.

Theoretically, the recycling of a carbon tax may result in either an economic double dividend or an added tax burden (Bovenberg and Van der Mooij, 1994; Goulder, 1994). Rectangle B in the right-hand diagram in Box 10.1 represents the additional cost of a tax when it is levied on top of existing distorting taxes. In these circumstances, emission taxes would yield an economic double dividend if the added tax burden they cause is lower than the decreased tax burden they make possible by reduced taxes on other factors of production (labour, capital, rent). Otherwise, emission taxes would increase the costs to the economy.

[Figure 8.4]

[THE TEXT DESCRIBING FIGURE 8.4 WAS DELETED. THERE IS NOW NO REFERENCE TO THIS FIGURE IN THE TEXT, ALTHOUGH THE FIGURE HAS BEEN RETAINED. WE SHOULD PROBABLY TRY TO MENTION IT AT LEAST BRIEFLY, SO THAT IT IS INTEGRATED WITH THE TEXT AND NOT ORPHANED.]