Economic Considerations: Cost-Effective and Efficient Climate Policies

In this chapter we discuss the economics of climate change. We begin with a discussion of economic considerations that are important to take into account when designing and evaluating climate policy, including cost effectiveness and efficiency. We then discuss specific policies at the state, national, and international level in light of these economic considerations. 

We have several recommendations for the path forward for climate policy. First, the goal of climate policy should be to reduce the damages caused by greenhouse gases. In addition to mitigation policy to reduce greenhouse gas concentrations in the atmosphere, one can also reduce the damages causes by greenhouse gases by adaptation measures that reduce our vulnerability to climate change impacts. 

Second, policy-makers should use incentive- (or market-) based instruments as opposed to command and control policies (including quantity-based mandates) whenever possible. Whenever unpriced emissions are the sole market failure, incentive-based instruments such as a carbon tax or cap and trade program are more likely to achieve the social optimum and maximize social net benefits. Lin and Prince calculate that the optimal gasoline tax for the state of California is $1.37 per gallon. 

Our third recommendation is to address the risk of emissions leakage, which arises when only one jurisdiction (e.g., California) imposes climate policy, but not the entire world. One way to reduce emissions leakage is to use the strategic distribution of emissions allowances to local producers. This method, known as “output-based allocation” or benchmarking, effectively subsidizes local producers and at least partially offsets the increase in their costs caused by an emissions cap. Importantly, only local production is eligible for an allocation of valuable allowances, providing a counterweight to the incentive for emission leakage.

Our fourth recommendation is that if they are used instead of incentive-based instruments, quantity-based mandates such as the federal Renewable Fuel Standard, California’s Low Carbon Fuel Standard, renewable portfolio standards, and the Clean Power Plan should be combined with a cost containment mechanism. The findings of Lade, Lin Lawell and Smith suggest that pure quantity-based mechanisms leave policies susceptible to large increases in compliance costs, particularly in the presence of capacity or production constraints that are inherent in energy markets. Given the experiences with the federal RFS2 in 2013, anticipating and designing climate policies in a way that can contain compliance costs is imperative. 

Our fifth recommendation is that for international leverage, we should develop a climate club backed by border tax adjustments to non-participants. University of California at Berkeley Professor Larry S. Karp has been proposing an agreement between the top 10 emitters as an alternative to the UN framework. Without international leverage or cooperation, unilateral climate policies, such as California’s AB 32 or the American Clean Energy and Security Act, are not only unlikely to fully combat climate change, but can also have other detrimental effects such as the reduction of economic competitiveness and the possible displacement of jobs from the U.S. to countries without carbon pricing.

Our final, and main, recommendation is that, as University of California at Berkeley Professor Severin Borenstein points out, California should focus on solving the problem of global climate change. The primary goal of California climate policy should be to invent and develop the technologies that can replace fossil fuels, allowing the poorer nations of the world – where most of the world’s population lives – to achieve low-carbon economic growth.