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discount rate
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4
Policy Framework
The previous chapter clearly points out gaps in our knowledge
and understanding of key physical phenomena in greenhouse warming.
Nevertheless, current scientific knowledge seems to indicate that
unconstrained releases of greenhouse gases from fossil fuel
combustion and other sources would ultimately cause climate change.
There are no specific conclusions, however, about the regional and
local effects associated with increased atmospheric concentrations
of greenhouse gases. Nor is there much indication about how rapidly
the effects might emerge.
Our knowledge about other topics central to the analysis of the
greenhouse warming problem is at least as insecure. The number of
analyses of the overall impact on the economy of this country of
greenhouse warming is even smaller than the number of GCM runs
simulating an equivalent doubling of CO2. Economic experts differ in their
assumptions about future population and economic growth,
technological change, and a host of other factors. Because the
economic models must project trends far into the future, their
results are likely to remain controversial.
How then, in the midst of this uncertainty, can we begin to
evaluate policy options? Several concepts that can help us in that
task are presented in the next two sections.
Comparing Mitigation and
Adaptation
Many different policies could be adopted in response to the
prospect of greenhouse warming. In order to evaluate these policy
options, it is useful to categorize them into three types:
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1. Options that eliminate or reduce greenhouse gas
emissions.
2. Options that "offset" emissions by removing greenhouse
gases from the atmosphere, by blocking incident solar radiation, or
by altering the reflection or absorption properties of the earth's
surface.
3. Options that help human and ecologic systems adjust or
adapt to new climatic conditions and events.
In this report the first and second types of interventions are
referred to as "mitigation" since they can take effect prior to the
onset of climate change and slow its pace. Mitigation options are
discussed in more detail in Chapter 6 and Part Three. The third
type of intervention is referred to as "adaptation" since its
effects come into play primarily after climate has changed. A
fuller discussion of adaptation appears in Chapter 5 and Part
Four.
In comparing mitigation and adaptation, one consideration is
whether a given action will, in addition to providing adaptation or
mitigation benefits, also improve economic efficiency. Even
progressive societies find much of their economic activity falling
short of demonstrated "best practice." New, more efficient
practices are being developed continually, but it takes time for
them to diffuse throughout the economy. There are many obstacles to
more rapid diffusion of better practice, including lack of
information, insufficient supply of components or products,
political interests, inappropriate incentives, and simple human
inertia. In general, however, every society has many opportunities
to improve its overall situation by reducing the gap between
current practice and best practice. Many of the actions taken to
deal with potential greenhouse warming could also improve economic
well-being because they are more efficient than prevailing
practice. These options should be distinguished from another class
of actions: so-called "free-standing" actions, which satisfy other
social or environmental objectives (and may or may not contribute
to economic efficiency as such).
Figure 4.1 compares hypothetical mitigation and adaptation
actions in response to potential greenhouse warming. If climate
change occurs, and no mitigation or adaptation actions are
undertaken, a substantial reduction in real income is likely over
time. Initially, mitigation is likely to reduce real income more
than either doing nothing or taking adaptation measures as climatic
changes emerge. Ultimately, however, mitigation actions could
result in higher real income than waiting and taking adaptation
measures. In this scenario, investing in mitigation reduces
consumption now, but produces advantages in the future.
Expenditures on mitigation options should thus be seen as
investments in the future.
Many combinations of mitigation and adaptation actions are
possible. Choosing the best mix of mitigation and adaptation
strategies depends in part on the discount rate applied to the
investment. The higher the discount rate, the greater the case for
postponement of costly actions. Use of discount rates is one way of
assigning values to future outcomes.
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FIGURE 4.1 Schematic comparison of mitigation
and adaptation. The uppermost curve plots world economic
well-being, essentially the amount of real income available for
consumption, assuming that there is no climate change. The lowest
curve plots world economic well-being assuming that there is
climate change and no actions are taken either to prevent or to
cope with those changes. Notice that the axes are not defined
quantitatively. Thus the curves are only relative, and this figure
cannot be used to estimate the amount of economic welfare lost by
expenditures on mitigation. Similarly, it cannot be used to
estimate the time at which the return from expenditures on
mitigation would exceed the return from expenditures on
adaptation.
Assigning Values to Future
Outcomes
Most people have a time preference for money. They would rather
have, for example, $100 to use today than $105 a year from now.
Future costs and benefits are usually transformed into their
"present value" by using a discount rate, which is similar to the
interest on savings. Discount rates enable current and future
returns to be compared.
A central, and controversial, issue is which discount rate to
use in weighing the relative advantages of present and future
impacts and costs. There are essentially three courses of action
with regard to responding to potential greenhouse warming: (1) we
can invest resources now to slow greenhouse gas emissions; (2) we
can invest in other projects that might yield a higher return; and
(3) we can defer any kind of investment in the future in favor of
current consumption. Applying a discount rate near the yield on
other investments—at least 10 percent per year in most
countries, in real terms—in
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evaluating responses to greenhouse warming would lead to the
conclusion that our investment dollars could be most efficiently
used in capital projects, education, or other sectors. It suggests
that we should not take costly, low-payoff actions to reduce
greenhouse gas emissions. High discount rates place a low value on
future outcomes. Applying a low discount rate to greenhouse
investment choices—say, 3 percent per year—would make
investing now to avoid greenhouse warming more attractive. But such
a low discount rate means that other investment opportunities have
been exhausted or are being ignored. It is likely that there will
be more investment opportunities with returns of greater than 3
percent than there are available funds. A low discount rate on
resources invested in response to potential climate change is
inconsistent with a high return on capital investment.
The panel makes no attempt to resolve this issue. This study
uses rates of 3, 6, and 10 percent in calculations to ensure that
unique circumstances that would alter assessment of the outcome are
not overlooked. Because consumers sometimes act in ways that
indicate an even higher discount rate in their purchases, a rate of
30 percent is also used in considering some mitigation options. For
the purposes of comparing options and arriving at recommendations
for action, the panel used a single real discount rate of 6 percent
per year. Use of a 10 percent discount rate would decrease the
present value of the low-cost options but would not change their
rankings.
A Method for Comparing Options
Using the concepts described above, we can compare options by
carefully enumerating the impacts of action and inaction and then
trying to find a course that minimizes the net costs of the impacts
of mitigation and adaptation.
More specifically, the anticipated consequences of greenhouse
warming (both adverse and beneficial) can be arrayed to produce a
"damage function" showing the anticipated costs and benefits
associated with projected climatic changes. The mitigation and
adaptation options can be similarly arrayed according to what they
would cost and how effective they would be. A well-designed
response will involve balancing incremental impacts and costs. A
sensible policy requires that the level of action chosen be
"cost-effective," which means that the total cost of attaining a
level of reduction of climate change should be minimized.
Ideally, the evaluation would consider the full costs associated
with each mitigation alternative. Called "full social cost
pricing," such an analysis would allocate to each option not only
the costs of its development, construction, operation, and
decommissioning or disposal, but also those of environmental or
health problems resulting from its use. Burning coal, for example,
not only emits greenhouse gases, but also contributes to a variety
of health
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problems (for nearby residents as well as coal miners) and to
environmental problems such as acid rain. All these would be
included in full social cost pricing. A different example involves
increasing automobile fuel efficiency by reducing the size and
weight of vehicles. Reducing vehicle size results both in reduced
emissions of greenhouse gases, a benefit, and in increased
likelihood of injury from collisions with larger vehicles, a cost.
Ideally, all costs and benefits would be considered.
In practice, such a framework can be used only in an approximate
manner. It is impossible to determine all of the costs of all
options today, much less of climatic changes that will not occur
for 50 to 100 years. Many of the important concerns are difficult
to measure and are not fully captured in prices or other market
indicators. Nevertheless, the panel finds this conceptual framework
to be a constructive way to organize the evaluation of policy
options.
Assessing Mitigation Options
Most mitigation options considered here use currently available
techniques and equipment that could be installed within 10 years.
Actions that reduce or offset emissions of greenhouse gases or
otherwise deal with greenhouse warming are evaluated in terms of
annualized costs and annualized reduction of CO2 emissions. Options addressing greenhouse
gases other than CO2 are translated
into the equivalent CO2 emissions.
Annualized costs (or emissions) are determined by estimating the
total costs in constant dollars (or emissions in CO2 equivalent) of that option over its
lifetime. This includes the so-called "engineering" costs of
construction, installation, operation, maintenance, and
decommissioning or disposal. The total discounted cost is divided
by the number of years the option is expected to last, resulting in
the annualized cost of that option. Annualized emission reductions
are calculated in a similar fashion.
The mitigation options in this menu are then ranked according to
their cost-effectiveness. Those achieving the reduction of CO2 or CO2-equivalent emissions most cheaply are
ranked highest. Finally, the overall potential of each option is
estimated because there are limits on how much can be achieved with
each option. For example, avoiding emissions by using hydroelectric
power generation might be comparatively cheap, but there are few
remaining locations in the United States where dams could be built.
Its overall potential is therefore relatively small.
This method has distinct advantages and disadvantages. One
advantage is that it enables options with different lifetimes to be
compared. The costs (and benefits) of a natural gas-fired
electricity plant may accrue over 25 to 30 years, a much longer
period than the periods associated with vehicle efficiency
improvements, since the typical life of a car is probably not
more
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than 10 years. A disadvantage is that because implementation of
the high-priority options would change the pattern of emissions
over time, the cost-effectiveness of various options during the
later portion of their operating life might be different. For
example, programs to use electricity more efficiently appear quite
cost-effective in the panel's current analysis. If such programs
were aggressively implemented, the need for new electricity
generating capacity over the next few decades would be reduced.
Thus the cost-effectiveness of investments in power generation in,
say, 2010 could be altered by electricity conservation programs
today. This study makes no attempt to account for such
possibilities, but they could be examined in future studies.
Each time a new analysis is performed, a new series of "least
cost" options will emerge. This circumstance allows policymakers to
regularly adjust actions to ensure the most efficient use of
resources.
Assessing Adaptation Options
Options intended to help people and unmanaged systems of plants
and animals adapt to future climate change are more difficult to
assess than mitigation programs. First, we must speculate about
future climatic conditions. GCMs are currently unable to accurately
predict local and regional events and conditions of greatest
interest to policymakers.
Second, we must predict how the affected systems are likely to
react to the changing conditions. Sensitivity to climate change
depends on many things, including physiological response to
temperature or moisture stress and dependency on other components
of the system. A crucial concept in the assessment is the speed at
which the system adjusts. If adjustments are made more rapidly than
climatic conditions change, the system should be able to adapt
without government assistance, although not without cost.
In the panel's analysis of adaptation options, "benchmark" costs
were developed on the basis of the costs of contemporary extreme
weather events or conservation and restoration programs. These
estimates were used to develop a measure of the magnitude of the
costs that might be associated with climate change.
But the panel recognizes that many issues cannot be quantified.
This is especially true for impacts, and the impacts of concern are
of three fundamentally different kinds.
First are the consequences, either beneficial or harmful, for
things that are exchanged in markets. Agriculture, for example,
will be affected by changes in precipitation patterns and dates of
frost in ways that will be captured in prices and other market
indicators. These are reasonably easy to quantify, and adding up
the market effects gives a clear picture of the impacts.
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Second are things whose values are not well captured in markets.
Genetic resources are generally undervalued because there are few
property rights in genetic resources and people therefore cannot
capture the benefits of the investments they might make in
preserving biodiversity. Many species are unlikely ever to have
marketable attributes, and it is virtually impossible to predict
which ones may ultimately have economic value. These consequences
are not well identified in current accounting systems.
Third are items that some people value for reasons that have
little to do with their ''usefulness" or economic worth. This
"ecocentric" valuation assigns intrinsic value to the living world.
Species loss, in this view, is undesirable regardless of any
economic value that may derive from those species. Humanity, it is
held, should not do things that alter the course of natural
evolution.
The panel recognizes the difficulty of measuring these
noneconomic criteria in the quantitative method described above.
Since such values are codified, to some extent, in laws (e.g.,
those to protect biodiversity), potential greenhouse warming
responses must be consistent with protection of the noneconomic
values. These may be among the most difficult values to accommodate
if climates change substantially. In spite of the difficulties
outlined above, the panel believes this cost-effectiveness approach
is the most useful method for evaluating policies involving
response to greenhouse warming.
Other Factors Affecting Policy Choices
about Greenhouse Warming
Once policy options have been ranked, certain factors not
directly related to greenhouse warming come into play in the
decision-making process.
One such factor concerns risk perception. People differ in their
willingness to take risks. We can expect people to differ in their
reaction to the potential and uncertain threat of greenhouse
warming as well. Some people may be distressed by the possibility
that cherished parts of their cultural heritage or natural
landscapes might be lost. Others might be unwilling to accept some
aspects of proposed adjustments—perhaps abandoning their
traditional homeland and moving elsewhere. In any case, people and
organizations will differ in their judgments about how much society
should pay to reduce the chance of uncertain climate change.
Another factor is the constraint of limited resources. The
United States is a large, wealthy country. Many other nations are
severely constrained in their ability to act because of limited
financial and human resources.
