Appendix 12A: Climate-economy models

Climate policy has been held hostage to a tacit presumption that if saving a lot more energy were possible at an affordable price, it would already have been implemented. That's like an entrepreneur who abandons a good business idea because if it were sound, it would have been done earlier.

All economists know that real markets are far from theoretical perfection. But most climate/economy models assume that almost all profitable energy savings must already have been bought—as if a perfect market did exist. On this basis, the modelers suppose, buying significantly bigger savings will be worthwhile only at higher energy prices. They then use big computer models to calculate how high an energy tax is needed (based on historic elasticities), how much that will depress the economy, and hence what the "cost" of protecting the climate must be.

Those models have driven policy for the past two decades. Ever more elaborate models continue to be built on the same old assumption—that saving energy isn't profitable at present prices and hence will require higher prices that will burden firms and the national economy. They're like a model, popular in the Reagan-Bush years, that trumpeted the notion that meeting the Toronto carbon-reduction goals would cost the U.S. about $200 billion a year. Yet the empirical evidence of what energy efficiency actually costs showed that reducing fossil fuel use that much would save the U.S. about $200 billion a year compared with buying and burning that fuel.

Critics of climate protection often cast doubt on the elaborate computer models that simulate the physical processes of the earth's climate. Ironically, those physical models, which now closely fit the historic climate data, are far more detailed and realistic than the climate-economics models used to claim that climate protection is too costly. Pervasive barriers to buying energy efficiency, described below, make those economic models' perfect-market theory as otherworldly as if the physical climate models omitted atmosphere, clouds, and oceans.

Ignoring real-world conditions leaves most of the climate-economics models riddled with flaws. For example,

Most economic models are very sensitive to how fast, if at all, energy efficiency is assumed to improve by itself at present prices: one model, for instance, found that as this rate was increased from 0.5 to 1.5% per year (it actually averaged 1.54% per year during 1973–95¹), the calculated cost of cutting carbon emissions to 20% below 1990 levels fell from $1 trillion nearly to zero.²
Very few of the models take any explicit account of efficiency technologies, and those that do (like the government studies that show ways to save 20-25% of the carbon at negative cost, with much further potential at low cost³) are very conservative for many reasons⁴, including their use of outmoded, costly, incremental, component-based technologies rather than reflecting the modern whole-system approach that can often tunnel through the cost barrier and achieve bigger savings at lower costs, as we shall describe below.⁵
The economic models don't let technologies improve as price incentives increase, even though rising prices are well known to spur innovation.⁶
The economic models all forget that renewable sources get cheaper when produced in higher volumes, as they've been doing for decades.
Most models quietly assume that carbon-tax or -permit-auction revenues are simply rebated (which lowers GDP) instead of being used to displace the distorting taxes that discourage savings, work, or investment (which would raise GDP).⁷
The relatively few models that allow international trading of emissions and reductions assume that all countries have essentially perfect market economies—even those, like the former USSR and China with significant economic problems, and hence the biggest opportunities for improvement.

A lucid guide to 162 predictions by the 16 top climate/economy models⁸ found that seven underlying assumptions explained 80% of the differences in their results. Does a model assume there's any "backstop" energy source, such as renewables or nuclear, that can be widely adopted if fossil-fuel prices get high enough? Does it assume the economy responds efficiently to price signals and can make significant substitutions between fuels and between products? Can different countries trade their savings opportunities? Are revenues recycled efficiently? Does the model count the value of avoiding climate change (perhaps a relatively minor term, but enough, with efficient revenue recycling, to improve economic welfare)? ⁹ Does it count the benefit of abating associated forms of conventional air pollution¹⁰ as a free byproduct of burning less fossil fuel—benefits large enough to offset 30–100%¹¹ or more¹² of the assumed cost of carbon abatement? For (say) a 60% carbon reduction in 2020, these seven assumptions can predetermine whether the model shows by then a 7% decrease or a 5% increase in GDP.¹³ That noted economists should find such wildly divergent results underscores not only their lack of unanimity on whether climate protection is disastrous or beneficial for the economy, but also that the difference is due to divergent model structures and assumptions.

In sum, most economic models—especially the extreme ones publicized by fossil-fuel companies' intensive ad campaign—calculate large costs because they assume rigid, constrained, and unintelligent responses to economic signals. The few models that show economic benefit from protecting climate, even if they assume outmoded energy-efficiency techniques and impute no value to reducing carbon or other pollution, merely assume that people and firms behave with the ordinary sagacity and flexibility that market mechanisms offer—and can therefore adopt new techniques that can save far more energy, at far lower cost, at far greater speed, than most theorists can imagine.

¹ But with localized spurts, like New England's 6%/y gains during 1978-80 (the period of the second oil shock). To be sure, national improvements were much faster before the 1986 price crash than since, but if a lower-than-historic rate is to be assumed because greater energy efficiency will continue to lower energy prices, then the stimulative effect of that cheaper energy, and the resulting faster turnover of capital stocks, must also be considered.

² Manne, A.S. & Richels, R.G. 1990: "The Costs of Reducing U.S. CO₂ Emission: Further Sensitivity Analyses," En. J. 11(4):69–78.

³ OTA 1991: "Changing by Degrees: Steps to Reduce Greenhouse Gases: Summary," OTA-0-482, Office of Technology Assessment, U.S. Congress, U.S. Government Printing Office, Washington, DC; Evans, J.C., ed. 1992: Policy Implications of Greenhouse Warming, U.S. National Academy of Sciences, Academy Press, Washington DC, Academy Press, Washington DC, summarized by Rubin, E.S. et al., "Realistic Mitigation Options for Global Warming," Science 257:148ff, 10 July 1992.; IPPC 1996: The Economic and Social Dimensions of Climate Change, Vol. 3 of Intergovernmental Panel on Climate Change, Climate Change 1995:IPPC Second Assessment Report, Cambridge University Press, Cambridge, England; Interlaboratory Working Group 1997: Scenarios of U.S. Carbon Reductions: Potential Impacts of Energy Technologies by 2010 and Beyond, Lawrence Berkeley National Laboratory (Berkeley CA) and Oak Ridge National Laboratory (Oak Ridge TN), LBNL-40533, ORNL-444 September, available at www.ornl.gov/ORNL/Energy_Eff/CON444.

⁴ Krause, F. 1996: "The Cost of Mitigating Carbon Emissions: A Review of Methods and Findings from European Studies," En. Pol. 24(10/11):899–915;

⁵ Lovins, A.B. 1995: "The Super-Efficient Passive Building Frontier," condensation of Centenary address, ASHRAE J. 37(6):79–81, June, RMI Publication #E95-28, www.rmi.org; Lovins, A.B. 1996: "Negawatts: Twelve Transitions, Eight Improvements, and One Distraction," En. Pol. 24(4), April, RMI Publication #U96-11, www.rmi.org. Lovins, A.B. 1996a: "Hypercars: The Next Industrial Revolution," Procs. 13th International Electric Vehicle Symposium (Osaka), October, RMI Publication #T96-9, www.rmi.org.

⁶ Newell, R.G., Jaffe, A., & Stavins, R. 1996: "Environmental Policy and Technological Change: The Effect of Economic Incentives and Direct Regulation of Energy-Saving Innovations," Working Paper, Kennedy School, Harvard University, Cambridge MA 02138; Grubb, M., Chapuis, T., & Duong, M.H. 1995: "The Economics of Changing Course—Implications of Adaptability and Inertia for Optimal Climate Policy," En. Pol. 23(4/5):417–432. Goulder, L.H. & Schneider, S.S.1996: "Induced Technological Change, Crowding Out, and the Attractiveness of CO₂ Emissions Abatement," working paper, Stanford University, Stanford CA.

⁷ Repetto, R. & Austin, D. 1997 at 23–26: The Costs of Climate Protection: A Guide for the Perplexed, World Resources Institute, Washington DC, www.wri.org/wri/climate/.

⁸ Ibid.

⁹ Nordhaus, W.D. 1993: "Optimal Greenhouse Gas Reductions and Tax Policy in the 'DICE' Model," Am. Ec. Rev. 83(2):313–317, Papers and Proceedings, May; Nordhaus, W.D. 1994: Managing the Global Commons: The Economics of the Greenhouse Effect, MIT Press, Cambridge MA; Nordhaus, W.D. & Yang, Z. 1996: "A Regional Dynamic General Equilibrium Model of Alternative Climate-Change Strategies," Am. Ec. Rev. 86(4):741–765, September; Jorgenson, D., Goettle, R., Gaynor, D., Wilcoxen, P., & Slesnick, D. 1995: "Social Cost Energy Pricing, Tax Recycling and Economic Change," August final report #68-W2-0018 to USEPA, Harvard University, Cambridge MA.

¹⁰ EPA's 1994 Emission Trends Report states that conventional energy use causes 95% of U.S. CO₂ and NO_X emissions, 73% of volatile organic compounds, and 70% of CO, so as The Economist remarked in June 1990, "Using energy in today's ways leads to more environmental damage than any other peaceful human activity."

¹¹ IPCC 1996. op. cit.

¹² Ekins, P. 1995: "Rethinking the Costs Related to Global Warming: A Survey of the Issues," Envir. Res. Ecs. 6(3):231–277, Oct.; Jorgenson et al. 1995 op. cit., Boyd, R., Krutilla, K., & Viscusi, W.K. 1995: "Energy Taxation as a Policy Instrument to Reduce CO₂ Emission: A Net Benefit Analysis," J. Envir. Ecs. Mgmt. 29:1–24; Statistics Norway 1995: Norwegian Emissions of CO₂ 1987–93: A Study of the Effect of the CO₂-tax, Report 95/14, §10, Oslo.

¹³ Repetto & Austin 1997 op. cit.. Such a long-term change is quite small in annual terms: a review of nearly 100 modeling studies showed that holding long-term CO₂ emissions at about current levels (much more stringent than current proposals for stabilizing emissions) "may if carried out in an efficient manner be expected to reduce…average GNP growth rates over the period [to the mid-21^st century] by less than 0.02–0.03% per year": Grubb, M., Edmonds, J., ten Brink, P., & Morrison, M. 1993 at 472: "The Costs of Limiting Fossil Fuel CO₂ Emissions: A Survey and Analysis," Ann. Rev. En. Envt. 18:397–478.

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