Double Irreversibility and Environmental Policy Timing

The timing of environmental policy typically takes place within a framework in which uncertainty over the future impact of pollution and two different kinds of irreversibilities interact. The first kind of irreversibility concerns the sunk cost of environmental degradation; the second is related to the sunk cost of environmental policy. Clearly, the two irreversibilities pull in opposite directions: policy irreversibility leads to more pollution and a less/later policy, while environmental irreversibility generates less pollution and a more/sooner policy. Using a real option approach and an infinite time horizon model, this paper considers both irreversibilities simultaneously. The model first is developed by paying particular attention to the option values related to pollution and policy adoption. The environmental policy we consider consists in increasing the natural assimilation rate. Solving the model in closed form then provides solutions for both the optimal pollution level and the optimal environmental policy timing. Finally, we provide a numerical example with the purpose of appraising which irreversibility has the prevailing effect and what is the overall impact of both irreversibilities on pollution and policy timing.     

Optimal climate policy under the possibility of a catastrophe

This paper concerns optimal emissions of greenhouse gases when catastrophic consequences are possible. A numerical model is presented, which takes into account both continuous climate-feedback damages as well as the possibility of a catastrophic outcome. The possibility of a climate catastrophe is a major argument for greenhouse gas abatement even in absence of continuous damage. Special attention is given to the subjective probability of a catastrophe and the pure rate of time preferences, and implicit values of these parameters are calculated if an emissions stabilisation target is assumed optimal. Finally, the expected value of perfect information about the probability of a catastrophe is estimated.     

Factors affecting electricity generation in China: Current situation and prospects

China has attracted worldwide attention due to the global economic and environmental effects of its rapid economic growth over the last 20 years, with particular attention given to the country's accelerating energy consumption and resulting greenhouse gas emissions. China's electricity sector is particularly important for both of these issues as it accounts for nearly half of its greenhouse gas emissions and even greater proportions of the country's demands for primary fuel resources. In order to better understand how these issues may progress in an economy changing as fast as China's, this paper develops a framework that can be used to help model the electricity sector's future development. The framework builds upon key technological and socio-economic drivers, including those affecting electricity demand (e.g., economic growth, structure, energy efficiency, urbanization, and change in per capita income) and electricity supply (e.g., deregulation, initiatives to promote natural gas, nuclear and renewable energy, air pollution regulations, price developments for coal and natural gas, and changes in generation technology). The framework serves as a foundation for a scenario exercise on the greenhouse gas and fuel consumption impacts of different developmental paths for China's electricity sector. These scenarios and their implications for emissions and fuel consumption are presented in a subsequent article.     

Irreversibilities and the timing of environmental policy

The standard framework in which economists evaluate environmental policies is cost–benefit analysis, so policy debates usually focus on the expected flows of costs and benefits, or on the choice of discount rate. But this can be misleading when there is uncertainty over future outcomes, when there are irreversibilities, and when policy adoption can be delayed. This paper shows how two kinds of uncertainty — over the future costs and benefits of reduced environmental degradation, and over the evolution of an ecosystem — interact with two kinds of irreversibilities — sunk costs associated with an environmental regulation, and sunk benefits of avoided environmental degradation — to affect optimal policy timing and design.     

Econometric testing of the real option hypothesis: evidence from investment in oil tankers

This article presents an industry equilibrium framework for testing the real option hypothesis with aggregate data: uncertainty and irreversibility (Dixit and Pindyck, Investment under uncertainty, Princeton University Press, Princeton, 1994) raise the critical threshold at which it is optimal to invest, due to the option value of waiting. We propose and empirically test various structural models of investment for new ship orders in the oil tanker industry, which accommodate estimation of the implied real option value multiple. Because of the competitive characteristics of this industry, the property of myopic equivalence (Leahy, Quart J Econ 108:1105–1133, 1993) in a competitive equilibrium is applied, and the traditional serious problems of aggregation are foregone. The derived structural count specifications explain the data well, providing empirical evidence that investors systematically assign value in waiting.     

Preemption in a real option game with a first mover advantage and player-specific uncertainty

In this paper a two-player real option game with a first-mover advantage is analyzed, where payoffs are driven by a player-specific stochastic state variable. It is shown that there exists an equilibrium which has qualitatively different properties from those in standard real option games driven by common stochastic shocks. The properties of the equilibrium are four-fold: (i) preemption does not necessarily occur, (ii) if preemption takes place, the rent-equalization property holds, (iii) for almost all sample paths it is clear ex-ante which player invests first, and (iv) it is possible that both players invest simultaneously, even if that is not optimal. It is argued from simulations that real option games with a common one-dimensional shock do not provide a good approximation for games with player-specific uncertainty, even if these are highly correlated.     

Joint Implementation: Strategic Reactions and Possible Remedies

This paper investigates the promising proposal of Joint Implementation (JI) to mitigate greenhouse gas emissions. This was ultimately the only concrete outcome of the Conference on Climate Change in Berlin, albeit restricted to a pilot phase. The basic idea, given the public's awareness of global warming, sounds economically plausible: The industrialized countries, the only ones required to stabilize and lower carbon emissions, can search for cheaper reductions of greenhouse gas emissions in developing countries and economies in transition. However, this proposal leads to strategic reactions by developing countries reinforced by the fact that this cheating coincides with the interest of the industrialized country. In short, this proposal will lead to cheating (given asymmetric information) and will thus produce largely faked reductions in emissions. On the constructive side, an efficient mechanism retaining the spirit of JI is derived, which deters strategic reactions. This differs from a usual principal-agent problem through an additional hierarchical layer: a global authority (e.g. the Conference of Parties on Climate Change), an industrialized country and a developing country. The unavoidable loss that is even associated with an optimal scheme due to strategic, behavioural reality (the first best optimum is unattainable, except at the top) leads, of course, to much less glamorous predictions in emission reductions. Moreover, the implicit subsidization scheme focuses and favours on already 'efficient' partners.     

Regional double dividend from environmental tax reform: An application for the Italian economy

The greenhouse effect forces national Governments to design environmental tax policies for facing not only global warming but also the negative economic consequences resulting from the reduction of emissions such as a negative change of GDP. This paper aims at verifying the impact of an environmental fiscal reform able to attain both the reduction of greenhouse gas emissions and the regional double dividend. We have decided to follow the computable general equilibrium approach for modelling the multisectoral income circular flow in the case of a bi-regional economy as described by a Social Accounting Matrix we have built for this purpose. The tools of analysis we chose represent suitable and consistent instruments in order to quantify the effects of an environmental tax reform. They can in fact highlight the possible differences in responses between macro regions in terms of regional GDP changes, regional prices and regional employment rate. In fact, the extended multi-sectoral framework, on which the model is developed, represents economic activities, imperfect labour market and institutional sectors behaviours in each macro region. The simulations performed concern the introduction of a progressive and proportional green tax on each type of commodity according to the corresponding level of CO₂ emissions. Furthermore all simulations introduce a recycling scheme of green tax revenues, whose aim is reducing both the income tax and the regional tax on activities (IRAP). The application is done on a bi-regional Social Accounting Matrix for Italy for the year 2003.     

Optimal climate change mitigation under long-term growth uncertainty: Stochastic integrated assessment and analytic findings

Economic growth over the coming centuries is one of the major determinants of today׳s optimal greenhouse gas mitigation policy. At the same time, long-run economic growth is highly uncertain. This paper is the first to evaluate optimal mitigation policy under long-term growth uncertainty in a stochastic integrated assessment model of climate change. The sign and magnitude of the impact depend on preference characteristics and on how damages scale with production. We explain the different mechanisms driving optimal mitigation under certain growth, under uncertain technological progress in the discounted expected utility model, and under uncertain technological progress in a more comprehensive asset pricing model based on Epstein–Zin–Weil preferences. In the latter framework, the dominating uncertainty impact has the opposite sign of a deterministic growth impact; the sign switch results from an endogenous pessimism weighting. All of our numeric scenarios use a DICE based assessment model and find a higher optimal carbon tax than the deterministic DICE base case calibration.     

The impact of demographic change on energy use and greenhouse gas emissions in Germany

This paper estimates the impact of demographic change on energy use and greenhouse gas emissions in Germany. Since old people display different consumption patterns than young people, an increase in the proportion of old people affects overall consumption patterns. Micro data from a household survey are used to identify age-specific consumption patterns and to project the impact of demographic change on the structure of total consumption expenditure up to the year 2030. The resulting final demand vectors are entered into an environmental input-output model, which allows the calculation of sectoral production, energy use and greenhouse gas emissions. The model results suggest that until 2030, demographic change raises the share of methane in total greenhouse gas emissions and does not contribute to reducing energy use and greenhouse gas emissions in Germany. The model is also used to explore the effects of redistributing income between age groups and a policy-induced switch from motor vehicle use to public transport.     

Spatial and Temporal Efficiency in Climate Policy: Applications of FUND

FUND is an integrated assessment model of the interactions between climate and economy. Nine world regions emit greenhouse gases, and suffer damages from climate change. A number of greenhouse gas emission reduction policies are compared, including optimal and cost-effective strategies, strategies with early and late abatement, and strategies with and without international co-operation. The analyses confirm that co-operation matters, resulting in substantially lower costs or higher welfare. The real commitments of policy targets based on an absolute level (e.g., 1990 emissions) are hard to estimate because of the uncertainties in the baseline. Postponing action conflicts with minimising costs and maximising welfare, but so does sharp emission reduction at the short-term as proposed in the Kyoto Protocol.     

Economic growth and greenhouse gas emissions

Recent empirical research has examined the relationship between certain indicators of environmental degradation and income, concluding that in some cases an inverted U-shaped relationship, which has been called an environmental Kuznets curve (EKC), exists between these variables. Unfortunately, this inverted U-shaped relationship does not hold for greenhouse gas emissions. One explanation of the absence of EKC-like behavior in greenhouse gas emissions is that greenhouse gases are special pollutants that create global, not local, disutility. But the international nature of global warming is not the only reason that prevents de-linking greenhouse gas emissions from economic growth. The intergenerational nature of the negative impact of greenhouse gas emissions may have also been an important factor preventing the implementation of greenhouse gas abatement measures in the past. In this paper we explore the effect that the presence of intergenerational spillovers has on the emissions–income relationship. We use a numerically calibrated overlapping generations model of climate–economy interactions. We conclude that: (1) the intertemporal responsibility of the regulatory agency, (2) the institutional capacity to make intergenerational transfers and (3) the presence of intergenerationally lagged impact of emissions constitute important determinants of the relationship between economic growth and greenhouse gas emissions.     

The opportunity cost of land use and the global potential for greenhouse gas mitigation in agriculture and forestry

This paper analyses the role of global land management alternatives in determining potential greenhouse gas mitigation by land-based activities in agriculture and forestry. Land-based activities are responsible for over a third of global greenhouse gas emissions, yet the economics of land-use decisions have not been explicitly modeled in global mitigation studies. In this paper, we develop a new, general equilibrium framework which effectively captures the opportunity costs of land-use decisions in agriculture and forestry, thereby allowing us to analyse competition for heterogeneous land types across and within sectors, as well as input substitution between land and other factors of production. When land-using sectors are confronted with a tax on greenhouse gas emissions, we find significant changes in the global pattern of comparative advantage across sectors, regions, and land types. Globally, we find that forest carbon sequestration is the dominant strategy for GHG emissions mitigation, while agricultural-related mitigation comes predominantly from reduced methane emissions in the ruminant livestock sector, followed by fertilizer and methane emissions from paddy rice. Regionally, agricultural mitigation is a larger share of total land-use emissions abatement in the USA and China, compared to the rest of the world, and, within agriculture, disproportionately from reductions in fertilizer-related emissions. The results also show how analyses that only consider regional mitigation, may bias mitigation potential by ignoring global market interactions. For example, USA-specific analyses likely over-estimate the potential for abatement in agriculture. Finally, we note that this general equilibrium framework provides the research community with a practical methodology for explicit modeling of global land competition and land-based mitigation in comprehensive assessments of greenhouse gas mitigation options.     

A real options reasoning approach to hybrid vehicle investments

Long term increases of petrol prices and the threat of a global climate change have created in the automotive industry a new competitive environment based on the development of more sustainable technologies. Using the real option reasoning lens we provide a theoretical framework to better account for the technological and market uncertainties and irreversibilities that impact the investment and innovation decisions of automotive firms supporting the development of more sustainable vehicle technologies. We investigate the case of hybrid vehicles in a transitional perspective by insisting on their potential to influence the dynamic shaping of investment decisions of firms in the car industry. We consider the hybridization strategy as intra-project and inter-project compound growth options to manage the flexibilities and irreversibilities of investment decisions during the transition process. We provide four different-sometimes conflicting-strategic rationales structuring the investment efforts of firms in hybrid vehicles and illustrate them with numerous examples from the automotive industry.     

Long-Run Implications for Developing Countries of Joint Implementation of Greenhouse Gas Mitigation

Joint Implementation (JI) calls for cooperation between industrialized and developing countries in the mitigation of greenhouse gas (GHG) emissions. However, a major concern of potential host countries is that, if they utilize their low-cost options for JI now, they will be left with only high cost options in the future, thereby penalizing them at a time when they may be obligated to mitigate GHGs themselves. This paper formalizes this hypothesis by utilizing an optimal control framework analogous to the Hotelling model of non-renewable resource extraction. The results are that cumulative abatement effects can impose costs on the future, but that they can be offset by technological change, market power, or compensation.     

Factors Influencing Corporate Environmental Protection Activities for Greenhouse Gas Emission Reductions: The Relationship Between Environmental and Financial Performance

This paper analyzes the relationship between a firm??s greenhouse gas (GHG) emissions and its profitability in Japanese manufacturing. Defining the difference between the marginal revenue and cost of reducing GHG emissions as the ??net benefit,?? which is endogenously characterized by various factors, we estimate a switching regression model where the sign of the net benefit determines the relationship between GHG emissions and profitability. Our empirical analysis focuses on ISO 14001 adoption, market competition, uncertainty, financial flexibility, and share ownership structure as the factors, and indicates that firms with low firm-specific uncertainty, high financial flexibility, and a high proportion of large shareholders tend to have a nonnegative net benefit, so that the positive relationship between their GHG emissions and profitability is mitigated. On the other hand, although ISO 14001 adoption is generally considered to be an indicator of a firm??s stance on environmental proactiveness, it does not provide a sufficient incentive to reduce emissions. Factors such as uncertainty, financial flexibility, and share ownership structure are more important to GHG emission reductions.     

Real options and demographic decisions

The theory of real options is used to incorporate the influence of uncertainty on demographic decision-making. The decision to have children is formulated as an investment using portfolio theory. The timing of the decision to have a child is modelled as a real options decision, with uncertainty affecting a woman's ability to exercise the ‘option to wait’ in order to delay or space births. An increase and reduction in uncertainty on this option is explored. Compared to the widely used net present value (NPV) framework, the real options approach (ROA) better explains the process of demographic decision-making in poor countries.     

Managing exotic pests under uncertainty: optimal control actions and bioeconomic investigations

Using a real options framework in continuous time, we examine two problems associated with the management of exotic pests under uncertainty. First, we analyze the optimal timing of investing in a control action. Given fixed control costs, we obtain a closed-form solution for when to control an exotic pest whose density varies randomly. Second, we define an analytical framework for finding the optimal expenditures for obtaining the relevant bioeconomic data. Our numerical results, based on a wide range of bioeconomic parameters, highlight the importance of accounting for uncertainty and irreversibility when developing simple rules to manage exotic pests.     

Greenhouse Gas Abatement Cost Curves of the Residential Heating Market: A Microeconomic Approach

In this paper, we develop a microeconomic approach to deduce greenhouse gas abatement cost curves of the residential heating sector. Our research is based on a system dynamics microsimulation of private households’ investment decisions for heating systems to the year 2030. By accounting for household-specific characteristics, we investigate the welfare costs of different abatement policies in terms of the compensating variation and the excess burden. We investigate two policies: (i) a carbon tax and (ii) subsidies on heating system investments. We deduce abatement cost curves for both policies by simulating welfare costs and greenhouse gas emissions to the year 2030. We find that (i) welfare-based abatement costs are generally higher than pure technical equipment costs; (ii) given utility maximizing households a carbon tax is the most welfare-efficient policy and; (iii) if households are not utility maximizing, a subsidy on investments may have lower marginal greenhouse gas abatement costs than a carbon tax.     

The design of optimal climate policy with air pollution co-benefits

This paper develops a model of an optimal regulatory program for greenhouse gases (GHGs) emissions that accommodates the benefits due to reductions of co-pollutants including: sulfur dioxide (SO₂), nitrogen oxides (NO_x), volatile organic compounds (VOC), and fine particulate matter (PM_2.5). Employing per ton damage estimates for the co-pollutants produced by an integrated assessment model, co-pollutant damage estimates per ton carbon dioxide equivalent (CO₂e) are developed for over 10,000 sources of GHGs in the lower 48 states including both transportation sources and electric power generation. For coal-fired electric power generation, the co-pollutant damages are larger in magnitude than recent peer-reviewed estimates of the marginal damage for GHGs. The co-pollutant damage per ton CO₂e varies considerably across source types and source location. The paper estimates the welfare gain from adopting a policy that encompasses the spatially variant co-pollutant damage to be between $1 million and $85 million annually. The range depends on the slope of the marginal abatement cost curve. The paper also shows that a distortionary aggregate emission cap reduces the advantage of differentiated policy. Provided an excessively strict cap, the spatially differentiated policy may reduce aggregate welfare. This result has important implications for GHG policy in the United States; although co-pollutant benefits of abating GHGs have been shown to be significant in magnitude, tailoring climate policy to reflect these source-specific co-benefits is not necessarily socially beneficial. This bolsters arguments for upstream policy designs.