House of Lords - Economic Affairs

Select Committee on Economic Affairs Written Evidence

Memorandum by International Council for Capital Formation (ICCF)

1. SUMMARY

1.1 Comprehensive economic modeling is essential to the world's understanding of climate change and the development of optimum, realistic solutions to address the issue. Only by including analysis of the macroeconomic impacts of alternatives policies such as the Kyoto Protocol, can the best policy solutions—on a national and international level—be identified and developed.

1.2 The International Council for Capital Formation[37] (ICCF) has researched and developed robust evidence, which is presented here for the House of Lords' Select Committee on Economic Affairs. This evidence is based on detailed comparisons that have been made between the various economic assessments used by the UK government, the European Commission, the Intergovernmental Panel on Climate Change (IPCC) and, by stark contrast, the United States government.

1.3 This evidence and analysis shows that attempts to constrain European greenhouse gas emissions (GHGs) at the rate required by Kyoto will have large economic costs, which have been severely underestimated by European and UK policymakers to date. These economic impacts could drastically cripple these developed economies over the next decade and further beyond. Further, pursuing policy that undermines growth actually limits the ability of both developed and developing countries to engage protective, environmental measures.

1.4 The ICCF is an established think tank focusing on developing sound research and workable solutions to global problems affecting the environment, energy, tax policy, intellectual property rights and private pension plans for retirement security and trade.

1.5 The ICCF circulates its publications, commentary, and ideas around the globe to reach public officials on both sides of the Atlantic as well as in the Pacific Rim. The ICCF Board of Directors includes business leaders and opinion makers from around the globe. Founding board members include: Mr Rudi Bogni, Sir Richard Greenbury, Mr Robert L. Hamburger, Dr Friedrich Hoess, Dr Vincenz Lichtenstein, Sir Ralph Robbins, Hon. George P Schulz, Mr Peter Spira, Hon. Robert S Strauss, Sir Kenneth Warren and Hon. John C Whitehead.

2. What has been the approach within the IPCC to the economic aspects of climate change, and how satisfactory has it been?

2.1 Notably, the IPCC's approach to the economic aspects of climate change has largely ignored the results of a range of macroeconomic modeling showing the impacts of its advocated climate change policies, including Kyoto. Further, in many of its published papers,[38] the IPCC has argued that project and sectoral level cost models are more accurate than the use of macroeconomic models[39]. However this core assumption and many of the other assumptions underpinning its "Special Report of Emission Scenarios"; (SRES) have been challenged by leading economists.

2.2 A range of macroeconomic models can be used to reveal the potential costs of various climate change policies. The IPCC itself admits, "The implied costs of different climate change policies are quite sensitive to the underlying model used."[40]

2.3 As a recent study by Dr Michael Canes[41] illustrates, (figure 1)[42], an accurate portrayal of the costs of complying with GHG emission reduction targets depends largely on choosing an economic model that captures the entire short and medium-term costs of adjusting to higher energy prices or regulatory mandates on the economy as a whole.

Figure 1.

2.4 Bottom-up energy models are constructed from engineering data applied to specific technologies whereas top-down energy models are based on statistical analysis of past data. Both can be useful in understanding the effects of policy on energy markets, but bottom-up models often neglect certain costs that reduce returns on investment below what is predicted, resulting in unrealistic estimates of what will occur if energy markets are shocked. Top-down models are based on technology and institutions existing at the time their data applies to and hence may underestimate the ability of markets to adapt, but such models often incorporate technology parameters, induced technological change, or explicit changes in technology in order to avoid such bias, thus incorporating bottom-up features within a top-down approach. Because these models are based on actual behavioral responses rather than simulation under somewhat idealized conditions, they appear to be the most realistic way to accurately estimate the consequences of climate change policy.

2.5 For example, a "bottom-up" model, such as the PRIMES model used by EU environmental agencies is designed only for measuring sectoral effects and not economy-wide effects. PRIMES, a partial equilibrium model, is primarily designed to show the effect of policy changes on energy markets. It can calculate the direct cost implications of reduced energy use, but not the economy-wide impact on gross domestic product (GDP), employment and investment. Thus, the results of this model, which show a reduction of only 0.12 per cent in GDP to the EU in 2012 from complying with Kyoto, are not an accurate measure of the total costs.

2.6 Such reliance on results from PRIMES, which is a useful tool for understanding the impact of changes on energy markets but does not give the "big picture," has led Europeans to believe that the costs of achieving Kyoto targets will be relatively small. This is inaccurate. General equilibrium and macroeconomic models paint a very different picture of the impact of Kyoto on GDP levels in the EU. General equilibrium models measure the "big picture" impacts on an economy after it has had time to adjust, perhaps over three or four decades, to higher energy prices and regulatory mandates. General equilibrium models, such as MERGE3, ABARE-GTEM or MS-MRT, show GDP losses of about 1 per cent per year from 2010 onwards in the EU as a result of Kyoto.

2.7 Macroeconomic models, such as Oxford or DRI-WEFA (now Global Insight), are general equilibrium models that explicitly account for market disequilibria caused by economic shocks. In addition to identifying long-term costs, these models provide the most complete near and intermediate-term analysis of the costs of Kyoto-implementing policy. Results in Figure 1 indicate such models provide cost estimates, for European compliance with Kyoto, that are 50-100 per cent higher than those from pure general equilibrium models.

2.8 Results of ICCF analysis, conducted within the 3 years, show that real GDP across European member states would fall 1 to 1.5 per cent below predicted levels during the 2008-12, without materially reducing global concentrations of greenhouse gases. These results, supported by a range of independent think tanks and research bodies[43], show that the real cost to European economies, of implementing Kyoto, could be between 10 to 15 times greater than current EU predictions.

2.9 In November 2004, UNICE, the pan-industry, pan-European employers group, which represents more than 20 million small, medium and large businesses across Europe, also published results of a study on the economic costs of Kyoto. The study, conducted by Cowi Consultants using a general equilibrium model, reveals that current EU policies to meet Kyoto targets would most likely shave 0.48 per cent off the bloc's GDP by 2010, rather than the 0.1 per cent reduction initially forecast by the European Commission.[44]

2.91 These few examples are part of a growing volume of robust evidence, (presented by a range of respected organizations with varying interests), which indicates that the real costs of IPCC-supported policies—including the Kyoto Protocol—have been severely underestimated. Policymakers have been deprived of key findings needed to accurately weigh the costs and benefits of near-term targets and timetables to reduce GHGs in the EU. As long as the IPCC continues to ignore this evidence, its approach to the economic aspects of climate change will remain unsatisfactory. Policymakers need to have access to cost estimates based on appropriate climate policy models in order to develop plans for the post 2012 period that will not undermine job and industry growth across the wider European economy.

3. Could IPCC member governments, and the UK in particular, do more in future to contribute to the robustness of the economic analysis?

3.1 One of the advantages of using macroeconomic models to perform robust and comprehensive economic analysis lies in their ability to capture near and intermediate-term adjustment costs, as well as the longer term costs associated with the market shocks of implementing the Kyoto Protocol. Some of the advantages of using macro-economic models are illustrated by making direct comparison between the approaches taken by the EU and the US.

3.2 Macroeconomic models provide an assessment of the overall costs of meeting emission targets where the short-term, frictional costs of adjustment are included. These models were used by US scholars and climate policy modelers in the early 1990s to measure the impact of Kyoto on the US economy. They quantify the impact on employment, investment, budget receipts and GDP growth when an economy is "shocked" by having to make quick changes in its capital stock, production processes and lifestyles.

3.3 In contrast to the EU "target and timetables" approach to climate change, the US has chosen a different path, one based on gradually reducing energy intensity. The main reason that the Bush Administration rejected the Kyoto Protocol approach was that they had analyzed the costs of sharp, near-term emission reductions and found that the economic costs were significant and the benefits (in terms of reduced global concentrations of CO2) were negligible. A range of credible macroeconomic models showed that Kyoto would have negative effects on the US economy in the range of 2 per cent to almost 4 per cent of GDP in 2010.

3.4 This approach has since been supported by factual comparison between both the economic and the environmental performances of the EU and US economies. According to data from the US Department of Energy's Energy Information Administration, the US—using a voluntary approach—has reduced its energy intensity (or the amount of energy required to produce a dollar of GDP) by a significantly larger percentage than has the European Union (see figure 2.) The EU, which ratified the Kyoto Protocol and thus faces mandatory emission reductions, has reduced energy intensity by only 7.5 per cent compared to the 15.8 per cent reduction achieved by the US over the 1999-2001 period.

3.5 Similarly, the ratio of CO2 emissions per dollar of output has decreased faster in the US than in the EU over the past decade—15.3 per cent for the US compared to 13.8 per cent in Europe. By adopting its voluntary approach to emission reductions, the Bush Administration balances multiple policy objectives, including maintaining strong economic growth and enhanced environmental quality. In contrast, EU economic growth is weak and unemployment high (about 10 per cent in recent years).

3.6 These models offer decision makers, who are concerned with maintaining healthy GDP, employment and other economic indices over the next several years, the most complete understanding of what to expect. For this reason, they are essential in contributing to the development of sound environmental policy that does not endanger the economies of the countries in or across which it is implemented.

Figure 2.

4. What would be the relative costs and benefits of using resources, otherwise expected to be allocated to climate change control, instead to expand international development assistance?

4.1 Academics and scholars at public policy think tanks in the US have devoted considerable effort to measuring the costs and benefits of near-term emission reduction targets. According to scholars such as Brookings Institution economist, Dr Robert Crandall, setting targets and timetables for US greenhouse gas emissions is premature. He bases this conclusion on:

— The uncertainty about whether or not the extent to which global warming is occurring; new data from climatologist and UN Intergovernmental Panel on Climate Change author Professor John Christy, University of Alabama, demonstrates that while surface-based measures show warming, satellite data shows little warming; and

— The high cost of foregone investment if the US sacrifices badly needed economic growth to reduce emissions.

4.2 In a 1999 report, Dr Crandall observes that the economic estimates of the costs and benefits of reducing emissions to 1990 levels that are in the literature are not particularly supportive of going ahead immediately with any policy of abatement. For example, as an analysis by Brookings Institution Fellows Drs Warwick McKibben and Peter Wilcoxen points out, the estimates of the costs of capping emissions at 1990 levels generally range from 1 to 2 per cent of GDP per year, while the benefits, estimated at most to be 1/3 per cent of GDP, will not arise for at least 30 to 50 years. Dr Crandall notes that "Every dollar dedicated to greenhouse gas abatement today could be invested to grow into $150 in the next 50 years at a 10 per cent social rate of return, even at a puny 5 per cent annual return, each dollar would grow into $12 in 50 years. Therefore, we need to be sure that the prospective benefits, when realized, are at least 12 to 150 times the current cost of securing them. Otherwise, we should simply not act, but use our scarce resources in other ways." Moreover, the climate models generally forecast that it would require far greater reductions than a return to 1990 emissions to stabilize the climate. Dr Crandall concludes, "We cannot justify a return to 1990 emissions based on the average estimates in the literature, no matter how efficiently it has done."

4.3 It is clear that the marginal costs of abatement in low-income societies such as China and India are substantially below those in developing countries, Dr Crandall notes. Economists envision a marketable permits program as being global in scope. The United States, France, Japan and Germany, for example, would buy permits from China, India or Bangladesh. The latter would, in turn, reduce their CO2 or other greenhouse gas emissions by this amount over the levels that would have occurred without the permits policy in all future years. The difficulties involved in such a future program would be immense: measuring emissions from millions of sources from motor scooters to bovine animals; forecasting emission levels for the uncontrolled scenario; and finally, enforcing the reductions from these myriad sources. If enforcing nuclear nonproliferation treaties is difficult, enforcing a global greenhouse gases trading program would be incomparably more complicated.

4.4 Yale University Professor, William D Nordhaus, has also analyzed the costs and benefits of CO2 emission limits. Dr Nordhaus's research shows that the costs of even an efficiently designed emission reduction program exceed the value of environmental benefits by a ratio of 7 to 1 and that the U.S. would bear almost two-thirds of the global cost. As EU scholars examine the costs of near-term GHG emission limits to the EU versus the benefits (in terms of reductions in global emissions), they are likely to reach conclusions similar to those above. As the May 2005 Copenhagen Consensus forum in Denmark concluded, the world's most acute problems are HIV-AIDs and lack of sanitation and clean drinking water in developing countries. More aid for these critical problems, from which literally millions are dying yearly, would yield greater benefits than efforts to try and force down GHG emissions in the developed world. Climate change is an important issue and it should continue to receive funding for new energy technologies, carbon sequestration and the study of climate science, but it should not take priority over funding more urgent global problems.

4.5 Increased economic freedom is the best way to promote cleaner energy use in developing countries. Economic freedom positively impacts economic growth; faster economic growth is linked with reduced energy intensity and lower emissions per dollar of output. In other words, a focus on economic growth is a surer path forward in addressing climate change. Policies like the Kyoto Protocol are not a step forward; they're actually a step backward because they impede economic growth with virtually no positive environmental benefits. For example, if China and India installed new industrial equipment, as efficient as that currently employed by Japan and the United States, their emissions intensity per dollar of output would drop much faster and global concentrations of CO2 would fall much more rapidly (see Figure 3)[45].

Figure 3.