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p. 935. The economics of climate changelocked

  • Stephen Smith


‘The economics of climate change’ discusses the most pressing environmental issue of our time — global climate change. Climate change policy involves costs and benefits — the abatement costs that will be incurred in reducing greenhouse gas emissions, and benefits in the form of reduced climate change damage. What is the economic case for action to limit global climate change? How can we assess the benefits of action for future generations? What scale of action is warranted and what form should it take? These questions are considered along with the role for pricing instruments such as carbon taxes and emissions trading in steering individual behaviour towards lower-carbon choices, and a potential successor to the Kyoto Protocol.

At the 1992 Earth Summit in Rio de Janeiro, more than 150 countries made a commitment to action to avert dangerous man-made effects on the global climate, by signing the UN Framework Convention on Climate Change. They were acting in response to the growing scientific evidence from the Intergovernmental Panel on Climate Change (IPCC) that rising levels of greenhouse gases in the atmosphere, arising from human activity, were starting to have a noticeable and potentially damaging impact on the global climate. Further negotiations then led to the Kyoto Protocol, agreed in 1997, under which a number of industrial countries took on binding commitments to reduce their emissions of a basket of the principal greenhouse gases.

The Kyoto target for emissions reductions was relatively small (a 5.2% cut in emissions by 2012, measured against 1990 levels), and applied only to the group of industrialized countries that signed the protocol. Although these countries are on track to achieve the target, global emissions have been growing rapidly, in particular because of spiralling energy demand in China and other fast-growing developing countries.

Against this background of continuing rapid growth in emissions, attempts to extend and broaden international agreement beyond the current scope and timescale of the Kyoto Protocol have been p. 94increasingly urgent and fraught. These discussions have been given added impetus by the increasing strength of the IPPC’s concern about climate change, based on the accumulating scientific evidence, and, in the UK, by the publication in 2006 of the Stern Review on the Economics of Climate Change, which advocated urgent and significant action.

What, then, are the distinctive issues raised by economic analysis of climate change? How do they inform our understanding of the case for action, and the form that climate change policy should take? Does a consideration of the economic issues shed any light on the prospects for successful agreement on meaningful international cooperation on climate change?

Greenhouse gases and climate change

Global climate change negotiations are driven by concerns about the process of global warming, which is likely to result from an increased accumulation of greenhouse gases (GHGs) in the atmosphere. The most significant greenhouse gas, in quantitative terms, is carbon dioxide, which contributes about two-thirds of the total global warming impact of greenhouse gas emissions. Human activity leads to carbon dioxide emissions principally through the combustion of fossil fuels – the use of coal, oil, and gas in industrial processes, to generate electricity, as motor fuels, and for domestic heating.

In addition to carbon dioxide, the other significant greenhouse gases include methane, nitrous oxide, and CFCs (chlorofluorocarbons, chemicals used as aerosol propellants, refrigerants, and in various industrial processes). Per tonne emitted, these gases vary widely in the harm they do. Each tonne of methane emissions has an impact on global warming equivalent to 23 tonnes of carbon dioxide, while some CFCs have a global warming potential equivalent to a thousand tonnes or more of carbon dioxide.

p. 95Levels of carbon dioxide and other greenhouse gases in the atmosphere have been rising steadily ever since the Industrial Revolution. In 1850, the atmosphere contained some 290 parts per million by volume (ppmv) of greenhouse gases, and this has now risen to 430 ppmv, and is increasing at some 2.3 ppmv annually. Over the course of the 20th century, the Earth warmed by about 0.7 degrees Celsius. The rate of warming appears to be accelerating, with a temperature rise of 0.2°C in each of the last three decades.

Forecasting the growth of emissions and the concentration of greenhouse gases in the atmosphere needs to take account of future economic growth – including the very rapid industrialization of China, India, and other developing countries – and the development of energy technologies. The Stern Review on the Economics of Climate Change summarized the available evidence and estimates. It suggested that future growth in emissions could lead to an atmospheric concentration of 550 ppmv by 2050, and that the annual rate of increase in concentration would by then have reached 4.5 ppmv, and would still be increasing. By the end of the century, atmospheric concentrations could exceed 850 ppmv, more than three times pre-industrial levels.

What this would imply for the climate cannot be the subject of a single projection but requires an assessment of probabilities, because greenhouse gas concentrations at this level are way beyond the range of historical experience. The Stern Review argues that the balance of current scientific evidence indicates that if greenhouse gas concentrations reach three times pre-industrial levels there would be at least a 50:50 chance that the rise in global temperatures above pre-industrial levels would then exceed 5°C.

Although people often talk about ‘global warming’ and ‘climate change’ interchangeably, climate scientists and policy-makers are increasingly conscious that the issues are not simply limited to a p. 96general rise in global temperatures. Some of the most important issues concern the uneven geographical distribution of climate changes, and the likely increase in climate instability. While global temperatures may rise on average, some areas may become very much warmer, while others may experience less rise in temperature. Effects on the pattern of rainfall may be large and uneven, with possibly drastic effects on the viability of agriculture in some areas. Above all, there is now a recognition that global climate change may involve increased instability in climate patterns, and increased frequency and severity of extreme events – hurricanes, floods, forest fires, and the like.

What is distinctive about climate change policy?

The structure of the economic issues reflects some key characteristics of the underlying physical processes and the nature of the scientific evidence about them. The problem is generated by an accumulation of emissions rather than the level of emissions in any one year, it is surrounded by substantial uncertainty about the scale and pattern of effects, there is a possibility of catastrophic and/or irreversible effects, and many of the effects of current emissions and policy measures will be experienced in the distant future.

The physical process of global warming is a dynamic process, developing over a long time scale, in which damage is done as a result of the stock of carbon dioxide and other greenhouse gases accumulated in the atmosphere, rather than the annual emissions flow. The stock is, of course, the result of past and current emissions. Each year’s emissions add a further increment to the stock, in other words to the concentration of greenhouse gases in the global atmosphere. This means, of course, that halting or reversing global climate change will be extremely difficult. Cutting the level of annual greenhouse gas emissions from now on, even quite sharply, may still not prevent increases in the stock of p. 97greenhouse gases in the atmosphere, albeit at a slower rate than without any emissions cuts.

Atmospheric concentrations of greenhouse gases can be reduced in two ways. One would be to cut emissions below the level of natural ‘depreciation’ of the existing stock, an extremely tall order. The other would be to take measures to accelerate the removal of atmospheric carbon. These could include planting forests to act as ‘carbon sinks’, that would take a certain amount of carbon out of the atmosphere, and store it in the timber of the growing trees. A number of technologies for ‘carbon capture and storage’ (CCS) are also under development, although as yet unproven in large-scale applications. These will probably initially be used to capture the emissions of large-scale coal-fired power stations, and store the captured carbon underground, rather than to withdraw carbon from the existing atmospheric stock. Given that it will take time to slow the rate of growth of atmospheric concentrations, and that the scope for ‘undoing’ the effects of past emissions is limited, some global warming and climate change is inevitable.

The fact that the environmental effects of global warming are generated by the ‘stock’ of greenhouse gases in the atmosphere, rather than by annual flows, means that decisions about emissions abatement involve complex, dynamic considerations. We need to think about a time profile of abatement, and not just a single abatement level. A particular target level for the greenhouse gas concentrations in the atmosphere in 50 years’ time could, for example, be achieved in a number of different ways – by sharp initial reductions in emissions, by steady reductions in emissions over the whole time period, or by an accelerating pace of abatement towards the end of the period. If we assume – probably quite reasonably – that technological progress will increase the range of abatement options in future years and reduce abatement costs, then action now may be more costly than later action. On p. 98the other hand, it would also have earlier benefits, since the level of greenhouse gas concentrations would be reduced earlier.

These issues about the timing of abatement – about the urgency of action – interact with the scientific uncertainties surrounding global climate change. Some of the key uncertainties involve the risks of potentially catastrophic and irreversible changes to the global climate that might be triggered if greenhouse gas concentrations in the atmosphere reach a critical threshold. At some point, global warming could disrupt the deep ocean currents that underlie the climatic patterns of many areas of the world – including, for example, the Gulf Stream that gives the UK and western Europe much milder weather than places at a similar latitude on the eastern coast of North America. It is quite possible that this could then generate a chain reaction of adverse consequences which would not be reversed if greenhouse gas concentrations were subsequently brought back down to current levels. However, while it is clear that such a risk exists, it is far from clear when the critical threshold that would trigger such a disastrous chain of events would be encountered. If it is possible that we could be close to the level of greenhouse gas concentrations in the atmosphere that would trigger irreversible changes of this sort, this would be an argument for earlier action, as a precaution against this risk.

Indeed, scientific uncertainty is one of the key distinguishing features of climate change policy. This uncertainty is not the result of bad science, or inadequate research effort. It is inherent in the fact that we are moving into unknown territory, and can only speculate about the effects on the complex and possibly precarious balance of the Earth’s ecosystem using what we know from past and current experience. Devoting massive additional resources to a scientific research effort of the highest quality would certainly help us learn more about what is likely to happen, but it would not transform the basic situation. We do not have the option of waiting until the scientific uncertainty is resolved. Instead, we have to p. 99make huge, costly, and difficult choices, with far-reaching implications for humanity, in the face of unavoidable uncertainty about the scale, speed, and in some cases even the direction of effects. What is more, we are unlikely to find out where the truth lies until it is too late to do much about it.

Few public policy decisions involve this degree of uncertainty, and there is no other context which combines such uncertainty with such large costs stretching into the indefinite future. Whatever we do – taking action or doing nothing – will be a large gamble. One of the most telling contributions of the 2006 Stern Review on the Economics of Climate Change was to point out that this unique decision requires decision-making methods that take proper account of the extensive and irreducible uncertainty about the processes of global warming and the consequences of policy action. In particular, we should avoid analyses, and decision-making procedures, that collapse the wide range of possible developments too quickly into a single ‘best guess’ forecast, on which our attention then focuses. This is tempting: summarizing the evidence into a single point – a single forecast number – makes the discussion much easier to focus, and avoids the risk that people pick and choose between the range of scenarios to find the one that suits their interest or their existing preconceptions. However, concentrating attention on the ‘best guess’ trajectory is dangerous if it leads us to neglect the risk of low-probability developments involving large costs.

Future generations

In one other crucial respect, global warming is unlike any other major public policy decision. A huge part of the damage from global warming – and hence the benefits from any policy action taken now – would be borne by future generations, including many generations as yet unborn. When judging how much action we should take to control current emissions, how can we properly reflect the interests of future generations? On what basis should p. 100we weigh the interests of future generations against the interests of the current generation, who will have to bear substantial abatement costs, while not living long enough to experience many of the benefits?

Economists tend to think of policy measures which involve costs and benefits which arise at different times in terms of discounting. The usual context, of course, is one in which both costs and benefits are largely experienced by the current population. A project to build a dam or bridge would require an initial investment, and yield benefits in future years once the project was complete. The current generation forgoes some consumption now, in order to provide the resources for the project, but also reaps subsequent benefits. A cost–benefit analysis of the project would assess both the costs and the benefits in terms of their present values, in other words, their equivalent value in the current year. Discounting future benefits means valuing each pound’s worth of benefits experienced in some future year at a lower value than the equivalent benefits experienced in the current period; a discount rate of 3% would effectively reduce the value of future benefits by 3% for each year the benefits lie ahead.

The justification for this approach is that it reflects the way in which individuals in the population make similar choices. (As we discussed in Chapter 4, the whole philosophy of cost–benefit analysis is that it is trying to summarize the values held by the population as a whole, and not to impose some arbitrary ‘expert’ or ‘elite’ views and preferences.) We see individuals making choices that imply some preference for consumption now rather than an equivalent amount of consumption in the future. We can also think of possible reasons that might explain this. People may simply be impatient – they may genuinely prefer consumption now even if that means reduced consumption later – or they may realize that if they defer consumption to the future there’s always a risk that they may not be around to enjoy it. The risk that you might die in the meantime would be sufficient reason for a rational p. 101person to discount future benefits by on average some 1% per year or so, reflecting the average annual risk of death. A further reason for people to discount future benefits is that they may anticipate being better-off in the future, so that any given amount of consumption will tend to add less to their standard of living than it would if consumed now, while they are poorer. Incomes have risen steadily over the last century, and it would be reasonable to believe that this long-term trend will continue in the coming century; in these circumstances, some discounting of future benefits would be justified. Taken together, these various reasons for discounting might justify applying a discount rate of some 2% to 4% per annum to future benefits, in assessing public projects over ‘normal’ timescales.

But only parts of this logic apply to projects – such as the control of climate change – where a large part of the benefits would be enjoyed by generations as yet unborn. All of the current generation of voters and policy-makers will be gone by the time many of the benefits are experienced. Impatience cannot be a reason for discounting benefits in this case, nor does the risk of mortality apply in the same way. There therefore seems to be less reason to discount future benefits over this very long timescale. However, if we decide to apply a discount rate that is very much lower than the rate that would be applied to shorter-term projects, the implications are enormous.

At a high rate of discount, costs and benefits in the distant future become vanishingly small in a cost–benefit calculation, but with low discount rates (or no discounting at all) costs in the distant future exert a large influence on cost–benefit assessments. For example, a discount rate of 4% per annum would mean that £1,000-worth of benefits in 100 years’ time was worth only £20 now, while a discount rate of 1% would imply that it was worth £370 now, 19 times as much in present value terms as with the 4% discount rate. Without any discounting at all, of course, it would be worth exactly the same now, £1,000, as in 100 years’ p. 102time. Applied to calculations of the costs and benefits of policies to control global climate change, significant discounting would mean that benefits in the very distant future can be largely disregarded. By contrast, with a low discount rate (or no discounting at all) the interests of distant generations would dominate the overall calculation.

Ultimately, the issue is one of intergenerational equity: how much should we be prepared to leave for future generations to enjoy? The Stern Review takes a very strong ethical position on this question, arguing that there is no reason to favour the interests of the current generation over any other. Stern consequently applies a low discount rate to future benefits, with the effect of giving the interests of generations in the distant future a heavy weighting in the calculation of overall costs and benefits. Other economists, including the US economist William Nordhaus, one of the Stern Review’s sharpest critics, have argued for significantly higher rates.

The economic case for climate change policy

Climate change policy involves costs and benefits – the abatement costs that will be incurred in reducing greenhouse gas emissions, and benefits in the form of reduced climate change damage. We can use the economic framework set out in Chapter 2 to assess the reduction in emissions of carbon dioxide and other greenhouse gases that would be justified in terms of the environmental benefits achieved. In this framework, abatement is worthwhile up to the point where the marginal cost of abatement equals the marginal environmental damage – in other words, where the cost of reducing greenhouse gas emissions by one further tonne is just equal to the reduction in climate change damage achieved by that additional tonne of abatement. One factor determining how much abatement is justified will then be the pattern of abatement costs – in particular, how steeply marginal abatement costs rise as we seek greater abatement.

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13. Global marginal abatement cost curve for carbon emissions from power generation, 2030

Figure 13 illustrates marginal abatement costs in the electric power industry, one of the main contributors to carbon dioxide emissions. The schedule takes a ‘bottom-up’ approach, using estimates of the abatement potential and abatement cost for each of the principal options for reducing carbon emissions from electric power generation. These include renewables such as wind, biomass, and solar power, nuclear power, and the use of carbon capture and storage to reduce carbon emissions from fossil fuel power generation.

Given the long lead time in the construction of power plants, especially new nuclear capacity, and the long time horizon over which climate change policies will need to operate, the schedule looks forward to costs and abatement potential in 2030, rather than now. This inevitably is speculative. Renewable energy technologies are developing rapidly, and the costs of abatement using these technologies will almost certainly fall quite significantly between now and 2030, as a result of scale economies and cost-saving technological changes, though it is impossible to pin a precise figure on the abatement cost reduction. In addition, many factors will affect the ‘baseline’ level of activity and emissions p. 104in the power sector, against which abatement potential will need to be judged. More rapid economic growth, for example, will increase the baseline level of emissions, but would also be likely to increase fossil fuel prices, which could encourage a shift towards non-fossil-fuel generation in any case, even without any climate change policy measures.

The schedule shows some estimates of the marginal abatement costs that would be incurred in achieving emissions reductions below what would be expected in the absence of policy measures. Thus, for example, emission reductions by the global power sector of around 2 Megatonnes of carbon-dioxide-equivalent (MtCO2e) per year could be achieved at a marginal abatement cost of less than $40 per tonne of carbon. Doubling this level of abatement would increase marginal abatement cost to some $85, requiring use to be made of more expensive abatement options. It is interesting to note how the various different technologies compare in terms of abatement costs. On the estimates used in Figure 13, nuclear power comes out as a significantly cheaper way of cutting power sector emissions than carbon capture and storage per tonne of reduced carbon emissions. However, speculating about the costs of technology twenty years ahead is inevitably imprecise, and the estimated marginal costs are sufficiently close that relatively small additional improvements in costs for one or two generation technologies could radically change the overall cost ranking of measures.

Accepting more nuclear power as the price of controlling climate change is, of course, one of the most controversial issues in current energy policy. While focusing on climate change we should not neglect the potential external costs of nuclear power, in the form of the risk of a catastrophic nuclear accident, along the lines of the Chernobyl accident, or the disaster narrowly averted at Three Mile Island. The risk of such a disaster may be very low, but it would be foolish to claim that it is zero, and the costs of a large-scale disaster would be high and long-lasting. The difficulty, of course, is p. 105in placing any numerical value on the probability of such an accident, and hence in assessing the size of the nuclear risk externality.

Outside the power sector there are significant opportunities for greenhouse gas abatement in other industrial sectors, especially in iron and steel, cement, and chemicals manufacture. The transport sector has substantial – and rapidly growing – emissions, and a range of possibilities for reducing emissions from road transport and aviation. Carbon abatement in agriculture and forestry could include the possibility of planting new forests as carbon ‘sinks’. Reduced energy use by private households could also contribute considerable emissions reduction.

In principle, we could add all of these areas of possible abatement to the power sector diagram in Figure 13, to construct an overall economy-wide marginal abatement cost schedule. In practice, however, this is rarely done. Most analyses of global abatement potential and costs perform much the same calculation, but embedded in the inner workings of a large-scale simulation model, rather than summarized in a single graphic.

Some studies have suggested that a significant amount of carbon abatement could be achieved at zero or negative marginal cost – in other words, there are measures which would both cut carbon emissions and at the same time save money compared with the technologies that would otherwise be used. This has been controversial. If they really are cheaper, why would they not be used already by profit-seeking firms? It has been argued that there are various forms of barrier and market failure that sometimes prevent efficient decision-making by firms. Poor information, for example, might mean that some cheap low-carbon options are ignored, and that firms simply choose the technologies with which they are familiar. Action to improve the availability of good technology advice and information would then have a double benefit – firms would make higher profits, and carbon emissions p. 106would be reduced. Others, however, think this is rather too good to be true, and that there could be important hidden costs which are being missed when the costs of technologies are being compared.

Assessing the damage costs of climate change also has features which arouse controversy. The scientific uncertainties relating to the physical processes, and the fact that these go beyond the range of recent experience, makes it difficult to be at all precise about the relationship between greenhouse gas emissions and some of the key factors affecting climate change damage costs. In particular, we know little about the precise point at which major threshold effects such as the reversal of deep ocean currents would be encountered.

One of the most thoroughly researched categories of climate damage cost is the impact on agriculture. Agricultural production will be affected by changes in temperature, sunshine, and rainfall; in some colder regions, these changes may boost agricultural output, while agriculture would be severely harmed by higher temperatures and more severe water shortages in places which are already hot and dry. Climate change is likely to involve unpredictability in weather patterns and an increased frequency of hurricanes, droughts, and other severe weather events, and these will tend to harm agriculture, through more frequent crop failures and loss of harvests. There are, however, some offsetting benefits to crop growth from higher levels of carbon dioxide in the atmosphere. What is crucial in assessing the overall pattern of effects on agriculture is to take account of the adjustments and adaptations that can be made, as farmers switch to cultivating the most suitable crops for the changed climate in their region. If we simply assume that farmers in each region go on planting the same crops as they do now, we will exaggerate the adverse impact of climate change on agricultural output.

Climate change is likely to affect the availability of water supplies more generally. Water supplies in already-arid areas will become p. 107even more scarce. In southern Europe, for example, an increase in global temperatures of 2°C could lead to a reduction of between 20% and 30% in summer rainfall, exacerbating existing water-supply problems.

Energy requirements for heating will fall, but the energy needed for cooling and air conditioning will rise, especially in parts of the world where temperatures are already close to the limit of human tolerance.

More frequent and severe floods, storms, and hurricanes will damage homes and infrastructure. Costly investments may need to be taken to reduce these costs and risks – for example, in improved storm drainage and other defensive measures. As the polar ice melts, the rising sea level will increase the risk of coastal flooding, creating a need for major investments in flood defences. For example, more than £125 billion of buildings and other assets in London lie in the area that would be exposed to greater flooding, and the existing London flood defences, including the costly Thames Barrier, will eventually prove insufficient and will need to be strengthened.

Almost all of these costs are likely to bear disproportionately on poorer countries. They are more dependent on agricultural production, and many are in warmer and tropical locations where the effects will be more severe. In most developing countries, too, the economic system is less flexible, and will struggle to adapt to the changing circumstances. Some of the poorest countries will be particularly badly hit. A large part of Bangladesh, home to some 160 million people, already lies close to sea level, and without massive flood defences will be inundated when the sea level rises. As climate change becomes more severe, the costs of population displacement and conflict caused by rapid changes in climate and living conditions in different parts of the world could pose a major threat to social and political stability well beyond the countries most directly affected.

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14. A woman carries children away from her home after massive flooding in Bangladesh. Climate change is expected to increase the frequency and severity of floods, and sea level rise will inundate a large part of Bangladesh

p. 109One useful way of summarizing the total effect of all of these costs is by calculating the ‘social cost of carbon’ – in other words, the total damage caused by one more tonne of carbon emitted into the atmosphere at a particular point in time, expressed as a monetary value. The social cost of carbon can be calculated for emissions now, or at some future date. Typically the social cost of future emissions will be higher than of emissions now because damage is caused by the accumulation of emissions in the atmosphere. Estimates of the social cost of carbon for current emissions have a wide range. A survey by the UK economist David Pearce in 2005 found that most estimates of the social cost were rather low – between $4 and $9 per tonne of carbon, expressed in terms of year 2000 prices. However, many of these omitted the costs and risks of catastrophic outcomes, and are therefore likely to be underestimates. A study by UK government economists had proposed that a much higher figure of £70 per tonne (about $105 per tonne) should be used for the social cost of carbon in UK policy assessments. The Stern Review on the Economics of Climate change assessed the social cost of carbon under ‘business as usual’ at the even higher value of $312 per tonne. By contrast, William Nordhaus, a critic of the Stern Review, estimates the current social cost of carbon at about $30 per tonne.

Faced with such extraordinary disagreement, what should we conclude? Do we simply fall back on our prior beliefs and personal inclinations, picking the result that best suits our preconceptions? Do we dismiss all of the estimates on the grounds that environmental economics clearly has nothing useful to tell us, if it cannot agree on a calculation of critical importance for the most significant environmental policy decision of our time? Or does the diversity itself carry an important message, which we should investigate?

If we look more closely at the reasons that underlie these diverse results for the social cost of carbon, we can see that they reflect important differences in approach and judgment. One thing they p. 110reflect is the inherent uncertainty in global warming policy: we do not know enough about the science to eliminate imprecision about the risks and scale of various effects. They also reflect different approaches to analysing this uncertainty. In particular, Stern places greater weight on exploring the consequences of a wide range of scenarios, rather than focusing on a single central case, or a few variants. Taking proper account of some of the downside risks is something that Stern does thoroughly, and is one reason that Stern’s estimates are higher than earlier work.

But, above all, the estimates vary because they take different positions on some crucial ethical choices that have to be made in formulating policies towards global climate change. These include how effects on rich and poor are weighed up in the calculation, and how the interests of future generations are represented. The UK government economists’ study applies a significant ‘equity weighting’ which accounts for about half of the total estimated social cost. The aim of this is to assign a greater

15. The Thames Barrier, built in 1984 to protect London from the risk of flooding, at a cost of over £530 million. Rising sea levels due to global warming will require many such investments

p. 111weight to effects which fall on poorer countries than if we simply look at effects in terms of current money incomes and exchange rates.

The Stern Review, as already mentioned, takes a particularly distinctive position on the issue of discounting future costs and benefits, arguing that the interests of future generations should be weighted almost as heavily in the calculation as the interests of current generations. Many commentators on the Stern Review have pointed out that the rate at which Stern discounts future costs and benefits is a major reason why the Stern Review’s estimate of the social cost of carbon is so much higher than others. Sensitivity calculations published by the Stern team themselves show that their estimates of the costs of climate change are more than halved if the discount rate is raised by a single percentage point.

What do these assessments imply in terms of policy action? Here it may be interesting to compare the contrasting policy prescriptions of the Stern Review and its critic William Nordhaus. Despite their disagreement about discounting, both agree that climate change is a serious issue, requiring large adjustments in the global economy.

Despite its lengthy and controversial analysis of the costs of climate change and the impact on future generations, the final policy prescription from the Stern Review comes from a rather more direct observation. Stern argues that the accumulating scientific evidence indicates that allowing greenhouse gas concentrations to exceed 550 ppmv would be dangerous, and would expose humanity to an excessive risk of seriously damaging outcomes. Stabilizing at this level would require emissions to be cut by about 25% by 2050, measured against the current level. This is more drastic than it sounds, since growth in the world economy over the next 40 years would lead to substantial growth in emissions in the absence of any policy intervention. To achieve this emissions reduction, the p. 112rate of emissions per unit of output would in fact have to be cut by 75%, a drastic reduction in the carbon footprint of economic activity. The Stern Review argues that abatement costs for this target would however be small – about 1% of total global output annually. The Review suggests that might be considered a rather low insurance premium against a risk of a catastrophic climate outcome, which in unlikely but not inconceivable worst-case scenarios could wipe off 20% or more from global output and living standards. The Stern Review argues that early action to cut emissions would sharply reduce the costs of making this major adjustment in emissions. Delaying action would increase the risk of irreversible damage to the climate, and would mean that the world economy would continue to invest in power stations and other long-term energy projects on the basis of current high-carbon technologies.

William Nordhaus, by contrast, argues for a climate change ‘policy ramp’, which would initially seek rather modest emissions reductions, which would then build up over time. His estimates of the optimal policy would seek emissions reductions of 15% now, 25% against business-as-usual by 2050, and 45% against business-as-usual by 2100. Because of the growth in emissions that would occur without any policy intervention, these reductions in emissions against a business-as-usual baseline (that is, against a baseline without any policy intervention) would actually imply some continuing emissions growth, measured against current levels, albeit at a lower rate than would otherwise occur. One reason for Nordhaus’s slower rate of emissions reduction is the higher discount rate which he uses, of 4% compared with the 1.4% used by the Stern Review. This reduces the urgency of action, because it makes postponing abatement costs more attractive, while at the same time giving lower weight to the future costs of the increasing concentration of greenhouse gases. Nevertheless, while Nordhaus advocates a slower policy build-up than the Stern Review, he agrees with Stern that climate change is a cause for real p. 113concern. Sooner or later significant policy intervention will be required to achieve large cuts in carbon emissions.

Pricing carbon

How do we achieve the substantial reductions in energy consumption and carbon emissions that will be needed if we are to reduce the risk of severe climate change? What can we do, individually and collectively?

One way of looking at the problem is in terms of technologies and technological solutions. For example, we can discuss the saving in energy consumption that could be achieved through sophisticated household energy-management systems, new motor vehicle technologies, or greater use of public transport. We can consider how much of our electricity needs could be met from renewable sources such as wind and solar power. Low-carbon technologies exist, more will be developed in future, and their costs are likely to fall with mass production.

Another way of looking at the problem, which preoccupies economists, is to think about how we can get these things to happen. It is all very well having the technology. We need to ensure that there is a reason for people to use it.

Some part of the shift towards low-carbon technologies and reduced carbon consumption can be achieved through individual action by citizens and socially concerned businesses. Survey evidence shows that many people say they are willing to make changes in their consumption if it will benefit the environment, and some people are willing to make more drastic lifestyle choices to reduce or eliminate their individual carbon ‘footprint’. At the same time, however, private motoring, air travel, and the level of material consumption have risen steadily, even in those countries where public concerns about global warming are strongest. Part of the problem may be a difference between what people say in p. 114surveys and what they do in practice. As we saw in Chapter 4, surveys need to be designed very carefully if they are to uncover people’s true willingness to pay for environmental action.

The scale of the required reduction in carbon emissions is massive, and may be well beyond what people imagine when they say they are willing to make changes for the sake of the global climate. There also may be a natural – and entirely rational – individual reluctance to take action when other people do not. An individual’s actions make a truly negligible contribution to the reduction of climate change, whereas the actions of thousands of millions of people would make a real difference. Also, the carbon footprint of individuals is extraordinarily complex. Correctly calculated, it would include not only their direct purchases of fuel and power, and their journeys by car and plane, but also the energy that has gone into producing the goods and services that they consume, all the way back through the many stages in the production chain from raw materials production to the finished product. Efficient and effective action to reduce carbon emissions needs to be spread across all areas of energy consumption, both by industry and individuals, but also to focus on the particular areas where the greatest difference can be achieved, at the lowest possible cost. The concerned citizen might quite reasonably feel bewildered by the complexity and scale of the problem.

To rely on voluntary action by individuals will be insufficient to achieve the major changes needed. Governments will need to intervene to ensure that enough action is taken by both individuals and industry to achieve the necessary emission reductions. The analysis of instrument choice in Chapter 3 is then directly relevant to climate change policy decisions. What instruments are available for governments to use in climate change policy, and what are their relative merits?

To date, the climate change policies of most countries have relied heavily on conventional ‘command-and-control’ instruments p. 115which directly regulate emissions or technology choices. Through the existing regulatory regimes, many countries have instructed industry to adopt certain specific low-carbon equipment and processes. Similarly, governments have required households to make use of products that will reduce energy use or carbon emissions – for example by ending the sale of conventional incandescent lightbulbs, to ensure that households switch to low-energy alternatives. These forms of direct regulation have the disadvantage that they tend to be inflexible, one-size-fits-all solutions which do not take account of differing circumstances. As Chapter 3 showed, this inflexibility carries with it the risk of excessive costs, higher than the minimum needed to achieve the desired environmental outcome.

Market-based instruments have also been used to discourage fossil fuel use. Carbon taxes have been introduced by a number of European countries including Sweden, Norway, Finland, the Netherlands, and Denmark. Some countries have raised existing energy taxes or introduced new ones. The European Union introduced a Europe-wide emissions trading system for carbon dioxide in 2005, and some other countries have followed suit with similar arrangements. These market-based policy innovations have been controversial, and in some countries have been met with extremely hostile lobbying from industrial interests.

Nevertheless, despite the real political difficulties and some economic obstacles, it seems clear that pricing measures of some sort (either in the form of carbon taxes or emissions trading) must inevitably form part of the long-term policy package, if significant reductions are to be achieved in the use of carbon-based energy. Reducing emissions of carbon dioxide sufficiently to halt the rise in atmospheric carbon dioxide concentrations will require far-reaching changes in patterns of energy use, and, more fundamentally, in patterns of human activity. Conventional regulation could only achieve changes in fossil fuel use on the scale required through intrusive intervention into the detailed workings p. 116of the economy, on a scale that risks clogging up the efficient functioning of the economic system. The essence of a market economy is that individual choices are guided most efficiently through the price mechanism. By incorporating systematic carbon-saving incentives into prices, through taxation or emissions trading, the millions of decentralized economic decisions made every day can reflect the true social cost of carbon emissions.

A carbon tax

A carbon tax works by taxing fossil fuels in proportion to carbon content. Per unit of energy, coal is taxed more heavily than oil and natural gas, while non-fossil-fuel sources of energy are untaxed. Burning fuel containing a given quantity of carbon leads predictably and unavoidably to a given amount of carbon dioxide emissions, so that a tax on the carbon content of fuels is almost equivalent to taxing carbon dioxide emissions themselves. With the exception of carbon-capture-and-storage technologies that may shortly become available for power stations no viable end-of-pipe cleaning technologies for carbon dioxide emissions are currently available.

Taxing carbon would encourage energy users to substitute away from high-carbon energy sources towards fuels with lower emissions per unit of energy. If levied on the fuels used by power stations, for example, a carbon tax would encourage a shift away from power generation using coal towards oil and gas, and even more strongly towards untaxed renewables (wind and wave power), and towards nuclear energy.

In addition to encouraging substitution away from high-carbon fossil fuels, a carbon tax would reduce energy consumption overall, since it would raise overall energy prices. Fossil fuel prices would rise because of the tax, while many of the non-fossil-fuel alternatives are, as we have already seen, more costly sources of power. As a result, overall energy consumption would be reduced, an effect which would arise through three main channels.

p. 117First, households and business would reduce their direct use of energy. If taxes make energy more expensive, householders might, for example, turn their central heating thermostat down and live in a slightly colder house, in order to save on fuel costs. Likewise, if the tax on motor fuels was increased, people might drive less, perhaps switching to public transport.

Second, higher energy prices would stimulate improvements in energy efficiency, for example through household insulation, and through the replacement of old central heating boilers and other energy-using equipment with new equipment performing the same function with less energy.

Third, higher energy prices on production of goods and services would feed through to higher prices for goods and services which require a lot of energy, directly or indirectly, in their manufacture. The price of a mobile phone, for example, includes an element reflecting the price of each of the materials and components used in production. One of these is copper. Its production uses a lot of energy, and a carbon tax on the energy used in copper production would raise the cost of copper to the phone manufacturers, and in turn raise the cost of mobile phones. The same will be true of the costs of all the other materials and components that go into manufacturing a mobile phone. In total, the effect of the carbon tax will be to raise the price of a mobile phone by an amount reflecting the total carbon used in its production, both directly by the phone manufacturer and indirectly in the production of materials and components. If a carbon tax increases the price of mobile phones sufficiently that consumers buy fewer of them, this would lead to reductions in carbon emissions at all stages in the production chain.

One of the attractions of charging for carbon through a carbon tax or other carbon pricing is that it naturally stimulates this wide range of behavioural responses throughout the whole economic system, rather than focusing on the more limited set of actions that p. 118can be directly regulated by government. Using carbon pricing to incentivize changes in behaviour is a clear example of how the flexibility offered by economic instruments can reduce the overall cost of achieving a given environmental outcome. Faced with the higher price, individuals cut their consumption – of fossil fuels and of goods produced using fossil fuels – if there are cheaper alternatives. If there are no satisfactory alternatives, or if the alternatives would be more costly, then they are not forced to take action. Pricing carbon in effect offers a safety-valve that avoids excessive costs in achieving the overall reduction in carbon emissions.

Carbon emissions trading

As we have seen in Chapter 3, emissions trading has very similar properties to emissions taxation. Carbon emissions trading offers an alternative way of using the price mechanism to discourage carbon emissions. By placing a cap on permitted carbon emissions – or equivalently on the use of fossil fuels – carbon emissions trading ensures that tradeable carbon emissions permits have a positive price. The price of carbon permits then functions in an almost identical way to a carbon tax, discouraging the use of fossil fuels, and raising the prices of goods and services produced using carbon-intensive production processes. The most significant application of emissions trading to date has been the EU Emissions Trading System, but its effectiveness has so far been somewhat mixed.

The EU Emissions Trading System covers the power sector and CO2-intensive industries (iron and steel, cement, pulp and paper, and similar), a total of around 10,000 plants across the EU, which together account for almost half of the EU’s total emissions of carbon dioxide. It began operation in 2005, for a first three-year trading period (2005–7), and Phase II (2008–12), which includes the deadline for meeting the Kyoto targets, is now under way.

Allowances were distributed free to existing firms in Phase I, but a small proportion have been auctioned in Phase II. For the third p. 119phase, beginning in 2013, the European Commission has proposed that a substantial proportion of allowances should be auctioned to generate revenues for member state governments.

The process within the EU ETS for determining the overall emissions cap and allocating allowances was curiously decentralized. The EU-wide cap on emissions emerged as a result of ‘National Allocation Plans’, formulated by member states, which determined the quantity of allowances to be allocated to their firms. The result of this decentralization was the absence of any clear debate about the EU-wide cap that should be placed on emissions. In the first phase, in particular, some countries made unduly generous allocations, without meeting any rigorous challenge from the EU. In the second phase, the EU was more active in challenging proposed allowance allocations, and the proposals for the third phase, to begin in 2013, envisage that the EU will take over responsibility for allowance allocations and enforce a tighter cap on emissions.

For Phase I, the allowance cap is widely regarded as having been too permissive, and CO2 emissions in practice were well below the cap. Some allowances remained unused at the end of the period, and once this was realized by market participants, the allowance price dropped to zero. There is some debate over the impact of Phase I on emissions, and about whether the surplus allowances were entirely due to over-generous allocations, or at least in part might have reflected greater-than-expected abatement. The evidence seems to point to a mixture of these effects, although the emissions reductions achieved by the first phase were probably rather modest – perhaps a 2% cut in emissions compared with what would have occurred in the absence of the ETS.

In Phase II, the overall cap looked tighter, and there was initially an expectation that it would achieve significantly greater emissions reductions. However, this hope has been undone by the p. 120recession, which has led to a significant fall in energy demand and consequently emissions, for reasons unconnected with the ETS. Again, the decline in ETS allowance prices is evidence that the system is not significantly constraining emissions – prices have fallen from €30 per tonne at the start of Phase II to around €15 per tonne in late 2010.

At the same time, even though the EU ETS has so far failed to achieve major cuts in emissions, it has had dramatic effects on energy prices. Allocating allowances for free meant the system did not add to the total costs of industry as a whole. On the other hand, it did make using carbon expensive for individual firms. Unused allowances could always be sold, and using allowances then has an opportunity cost, in the reduced profits from selling unused allowances. Electricity producers, in particular, recognized that the costs of additional production had effectively risen, and increased electricity prices to reflect this. Power companies’ profits rose sharply following the introduction of the EU ETS, because prices had risen to reflect the market value of allowances used in generation, while at the same time the system had supplied generators with free allowances sufficient to cover most of their needs.

Despite the difficulties that the EU ETS has so far experienced in establishing significant and durable price incentives to reduce carbon dioxide emissions, the underlying structure of the system (apart from the decentralized cap-setting) is very similar to that of the successful system of sulphur dioxide trading under the US Acid Rain Program, discussed in Chapter 3. In principle, if a tighter cap can be set on emissions, the EU ETS offers the possibility of establishing a significant and broadly spread incentive for carbon emission reductions across a very wide range of economic activity, and on a common basis throughout the EU.

Obstacles to price instruments

One major barrier to using carbon pricing or taxation to reduce industrial emissions of greenhouse gases has been vocal opposition from industry groups, concerned that the additional costs to industry would harm the competitiveness of firms in international markets. If European countries levy a carbon tax on industrial energy use while other countries do not, European firms will have to compete with firms from outside Europe that do not bear the same carbon tax burden. Much the same concerns have been raised about auctioning carbon permits: industry will have to pay more for its energy, and this may harm its ability to compete.

The rhetoric from industry lobbyists on this issue has been insistent and influential, but economists are in general very sceptical about this line of argument, for two main reasons. One is that it tells a partial story. Any revenues from carbon taxes will permit other taxes to be reduced, and the net effect on industry as a whole could therefore be easily offset by reductions in other taxes paid by industry – such as the payroll taxes on employment. The second reason is that it neglects the possibility of exchange rate adjustments, which would act to offset the higher costs of production. Taking both of these offsetting factors into account, a carbon tax would still be likely to reduce the competitiveness of carbon-intensive industries and firms, but by less, while low-carbon sectors of industry would actually gain more from the adjustments than they would lose in carbon tax.

A second political obstacle to high carbon taxes is the impact on the living standards of poorer households. In the cold, damp climate of northern Europe, energy for heating may be almost a necessity, and spending on energy can take up a large part of the total budget of poorer households. Increasing the tax on energy will then hit poorer households proportionately harder than those on average incomes and the better-off, for whom energy is a p. 122much smaller component of total spending. However, as with taxes on industrial energy use, it is a one-sided analysis to focus only on the extra energy taxes paid. Taxes on household use of energy or carbon would raise substantial revenues, and these can be used to finance reductions in other taxes that could substantially offset the adverse impact on the living standards of poorer households.

Non-price instruments

Despite these arguments, concerns about the effects of carbon taxes on industrial competitiveness or on poorer households may still place political constraints on how much use can be made of carbon taxes and pricing to reduce greenhouse gas emissions. It may then be attractive to look for instruments that would supplement energy pricing, particularly those which will increase the carbon savings achieved by any given level of taxation.

As already observed, the pace of development of low-carbon and zero-carbon technologies will determine how far and how fast the world can hope to reduce carbon emissions. Placing a significant price on the use of carbon will, in itself, encourage more rapid carbon-saving innovation. In addition, measures to accelerate the development of low-carbon technologies will widen the scope for industry and households to reduce their energy consumption, by offering low-carbon alternatives to existing industrial and household equipment. Government subsidies can speed up programmes of scientific and industrial research and development, and if publicly supported innovations are made generally available, this will encourage more rapid diffusion of the new technologies than if they had been privately financed and patented for private profit.

In some areas of energy use, there are concerns that even existing energy-saving technologies are not being used to their full potential. There are often concerns, for example, that both p. 123households and industries have been slow to make use of technologies that improve energy efficiency. This may be because of poor information, or because not all the benefits can be captured by the person making the investment (a landlord who insulates a flat may not be able to let it at a higher rent to recoup the insulation costs, even though tenants could find that their energy bills were reduced), or because some households or businesses simply cannot afford to finance the up-front costs of energy-efficiency investments. Some of these barriers can be traced to various forms of ‘market failure’, and there are good reasons for governments to try to correct this market failure through various forms of policy intervention. These have often included things like information campaigns, free energy-efficiency advisers, tougher building regulations to enforce higher standards in new houses, ‘home energy ratings’ so that prospective tenants or purchasers of houses can see the energy running costs of the property, and loans or grants to people otherwise unable to afford energy-efficiency investments.

However, a word of caution is needed about energy-efficiency policies. They seem to hold out the promise of relatively cheap and guaranteed emissions reductions, without some of the adverse social impacts that might arise from high-energy taxes. Supplying households with low-energy lightbulbs, for example, seems to offer guaranteed and quantifiable reductions in energy consumption: a 20-watt low-energy bulb offers much the same light output as an old 100-watt incandescent bulb, and thus seems to offer the potential to reduce energy consumed by domestic lighting by 80%. But this purely technical estimate of energy savings neglects possible consumer responses, and these may offset some or all of the energy savings. In effect, what more energy-efficient equipment does is reduce the price of heating, lighting, and the other services supplied by energy-using appliances. If the cost of lighting is cut by 80%, households may choose to have brighter lights, or to leave lights on for longer, and these responses would reduce the savings. Likewise, some part of the gains from better p. 124home insulation might be taken in increased comfort, by turning the thermostat up, rather than entirely in lower bills. Only if energy-efficiency improvements are accompanied by higher energy prices can we expect that this so-called ‘rebound’ effect on consumption will be neutralized, and that improving energy efficiency will reduce energy consumption and carbon emissions.

International climate negotiations: prospects for success

Global warming is a global problem. Emissions contribute equally to damage regardless of their source: a tonne of carbon dioxide emitted from the US or Europe is no more or less damaging than a tonne emitted from China or India. Likewise, the damage experienced by any country is a function of global emissions. Individual countries’ emissions or abatement affect the level of climate change damage they experience only through their impact on the concentration of greenhouse gases in the global atmosphere. The global nature of the problem calls for corresponding global action if the risk of catastrophic climate change is to be tackled effectively.

The need for coordinated international action is even more pressing than in the case of European acid rain policies discussed in Chapter 2. In the acid rain case, there was at least some reason for a country to take unilateral action, based on its own domestic costs and benefits. If international negotiations failed, the default position would thus be some level of national abatement, albeit on a smaller scale than the ideal level. In the case of global climate change, countries gain negligible benefit from their own abatement, because the effect on the global climate is determined by the total stock of greenhouse gases in the atmosphere. Cuts by any individual country acting alone can only make a trivial dent in this total stock, and although the total worldwide benefit from a country’s actions may be enough to warrant the abatement costs it would incur, the proportion of the p. 125total worldwide benefit that the country itself would experience would be so small that – to all intents and purposes – the country would have incurred abatement costs but received no benefits in return.

International agreement is thus indispensable to effective action on the scale required. Although some countries, under popular pressure, committed to national actions on climate change even before any international agreement, no country acting alone can make any meaningful impact on the process of climate change. The Kyoto Protocol, agreed in 1997, made a first step towards coordinated international action, but the only binding emissions reduction targets it set were for industrialized countries, and the largest emitter, the United States, stayed outside the agreement. The lifespan of the Kyoto Protocol comes to an end in 2012, and international negotiations in recent years have aimed for a successor agreement that would have a much broader membership, a longer time horizon, and a commitment to substantial emission reductions.

Ideally, the international agreement needs to encompass all countries, since this would spread the burden of carbon abatement costs most widely, and hence reduce the costs that each country needs to bear. However, getting countries to sign up to an agreement is made difficult by the temptation of free-riding. For any country, staying outside an international agreement on climate change offers the prospect of benefits without costs. A non-signatory avoids incurring any abatement costs, but would still experience all of the benefits from greenhouse gas abatement measures undertaken by those countries that do sign up to the agreement. All countries experience the same process of global climate change, and the benefits of policy action cannot be restricted in any way to those countries that have shouldered the burden of carbon abatement. This is an immense obstacle to achieving a broadly based international programme of coordinated policy action.

p. 126Even where pressure from concerned citizens and voters at home and diplomatic pressure from countries abroad encourages countries to sign up to an international agreement on climate change policy, the temptation of free-riding remains a problem. Countries may sign but take little effective action, calculating that any penalties for breaking the terms of the agreement would be less than the saving in abatement costs, and probably largely unenforceable as well. Realizing this, other countries may be tempted to free-ride too. After all, the worst outcome for any country is to incur the costs of abatement, but find that so few other countries have done so that there are no benefits to be gained in return. With these temptations, the coalition of countries taking action might prove unstable, and unable to persuade power generators and others to make the long-term financial commitments required for renewable energy, carbon capture and storage, and other expensive carbon-reducing investments.

Reaching a comprehensive global agreement is also complicated by the great differences between countries. Some countries are much more vulnerable than others to climate change, especially low-lying countries which are at risk of sea level rise, and countries whose current climate provides high agricultural yields, which could be at risk if the climate becomes more unstable. On the other hand, there are some countries which might even stand to benefit from modest climate change.

Carbon abatement costs vary across countries too, and any agreement should ideally ensure that carbon reductions take place where they can be made most cheaply. In the Kyoto Protocol, this was reflected in various ‘flexibility mechanisms’, which were intended to allow countries to pay for carbon reductions elsewhere, where this would be less costly than their own abatement. These have been controversial, partly because it is difficult to ensure that these mechanisms always achieve genuine emission reductions that would not otherwise happen.

p. 127But the most crucial difference between countries is in current emissions per head of population, with rich countries responsible for much higher carbon emissions, relative to their population size, than poorer countries. On average, energy-related carbon dioxide emissions were 4 tonnes per head of population across all countries in 2002, but three times this level (11.7 tonnes) in the industrialized member countries of the OECD, and barely half this level (2.2 tonnes per head) in developing countries. Emissions in the USA, the world’s largest economy, exceeded 20 tonnes per head. Given this variation in emissions levels, a central focus of controversy underlying the international negotiations on climate change has been how the burden of achieving a global cut in emissions should be shared between countries. What target for emissions cuts should be given to countries with different levels of emissions per head – and different levels of income and living standards?

One option – though clearly unrealistic – would be to ask for equal percentage cuts in emissions against the baseline of current emissions levels. Then, if emissions were to be cut by half, for example, the abatement required of the USA per head of population would be almost ten times the abatement required in developing countries. But it would also leave the USA with emissions ten times higher than developing countries, and would condemn developing countries to permanent energy-constrained under-development. Also, developing countries might observe that they were being asked to contribute to solving a problem that they had not created through their past emissions.

An alternative would be to agree that all countries would be awarded the same per capita carbon budget (say 4 tonnes per head), which would permit some growth – and emissions growth – in developing countries, while concentrating nearly all abatement in the richest industrialized countries. Perhaps this solution might seem fairer – though judgments about fairness in this situation do seem particularly subjective. However, by p. 128concentrating abatement actions in a relatively small group of countries it runs the risk that they will perceive the agreement to involve costs which exceed their own benefits. Ultimately, countries only sign up to international agreements when it is in their interests to do so, and an agreement which loads too much of the cost on one group of countries is almost certain to fail.

The obstacles to reaching a successful climate change agreement are real and substantial: both the temptation of free-riding and disagreement about burden-sharing pose major challenges. Despite the large measure of scientific agreement about the growing risks of climate change – as reflected in the increasingly urgent tone of the reports from the Intergovernmental Panel on Climate Change – the 2009 summit in Copenhagen which was intended to agree a successor to the Kyoto Protocol failed to reach any meaningful deal on coordinated action. Environmental economics cannot sidestep the negotiating realities – any more than the extensive scientific evidence has done. But it can provide evidence that the scientific case for action is matched by a convincing economic case that the long-run benefits of action will be greater than the costs of carbon abatement. Equally importantly, it has helped to show how policy instruments such as emissions trading and taxation can provide the market signals that will be needed to steer the global economy towards a low-carbon future.