The economics of climate change

The economic stakes of climate policy

A failure to address climate change will lead to uncertain yet undoubtedly high costs. The official scenarios forecast an annual 5% loss in global GDP, which could escalate to 20% when newer risks are taken into account (a decrease in biospheric carbon absorption, release of methane by melting permafrost). 

Stabilizing the atmospheric CO2 concentrations within a range of 450 -550 parts per million (ppm) by 2050 (i.e. a 25% reduction from current emissions levels) should be enough to limit the negative impacts of climate change. However, an 80% reduction from current levels will be necessary in the long term.

If early steps are taken, the cost of climate protection may not exceed 1% of global GDP, thus resulting in a net benefit as compared to the cost of inaction.

GHG emissions are a negative externality: they are a byproduct of economic activities that is harmful to the rest of society. As long as no political steps are taken to regulate these, they do not influence actors’ economic anticipations. Pricing them is a way to “internalize” their cost in actors’ behaviors and overcome the so-called “market failure” (absence of any economic framework accounting for GHGs) leading to uncontrolled emissions.

The characteristics of the greenhouse effect are such that, in terms of climate quality:

  • If one actor reduces its GHGs emissions all the others will benefit from it (“non rivalness”: consumption of the good by one actor does not imply reduced availability for another); on the contrary if one actor increases its GHGs emissions, all the others will bear the consequences

Climate policy is subsequently a « pure public good », it can only be produced within a cooperative and global framework involving the whole of human society. Unilateral actions would only have a limited impact.

The economic instruments of climate policy subsequently have two purposes:

  • Enabling GHG emitters to internalize the cost of their emissions and thus provide them with an incentive to emit less
  • Proving efficient enough (i.e. maximizing abatement while minimizing cost of action) to convince all actors to engage in climate policy and reduce their emissions.

Climate change mitigation: tax or market?


One can create an incentive to reduce emissions by taxing them, or “regulating with prices” an idea proposed by economist Arthur Pigou in the early 1900s. The European Commission proposed such a tax at the end of 1991, when it suggested that fossil fuels be taxed 10 dollars US per (oil) barrel equivalent.

This sort of tax, known as a “Pigouvian tax”, will be efficient so long as it is set at a level equivalent to the marginal cost an economic actor faces in reducing pollution. However, because it is very difficult for regulators to obtain accurate information about actors’ marginal abatement costs, Pigouvian taxes can rarely be set at economically efficient rates. 


In 1968, Canadian economist Dales suggested to regulate pollution « with quantities », that is by assigning actors emissions targets corresponding to a limited number of permits and allowing them to trade these permits.

A market system not only ensures environmental integrity by setting a cap on emissions, but it also gives actors flexibility in choosing how to meet their emissions targets. Actors may either reduce their own emissions or purchase permits from other actors, depending on which option is most cost-effective.

The first emissions permits market was implemented in 1995 in the USA to regulate sulfur dioxide emissions from power plants and reduce acid rain. The « acid rain » program is mandatory and its implementation is entirely centralized by the American Environment Protection Agency.

In theory, in a pure and perfect competition regime, taxes and tradable permits are equally efficient in regulating externalities.

However, the importance of long term damage costs combined with the availability of new technologies and, above all, the lower acceptability of tax as compared to that of tradable permits (above-mentioned difficulty of setting an optimal tax) led in practice to the choice of market mechanisms.

The Kyoto Protocol

The 1997 Kyoto Protocol established an international GHG emission permits market under the aegis of the United Nations Framework Convention on Climate Change. It requires 38 industrialized countries (the so-called “Annex B” countries) to reduce their emissions by 5.2% below 1990 levels. The burden is shared between countries depending on their economic situation. 

Due to the choice of 1990 as the baseline year East European countries have emissions targets above their actual emissions levels (that shrunk with the economic slowdown after the collapse of the Soviet Union), a surplus referred to as « hot air », while developing “non-Annex B countries” have no emissions targets.

The international Kyoto market is based on the allocation of Assigned Amount Units (AAU) to Annex B countries: each receives a quantity of AAUs corresponding to its “emissions budget” (1 AAU = 1 teCO2) under Kyoto. If emissions are higher or lower than the fixed objective, countries can purchase or sell AAUs on the international market. The reductions must be achieved within the 2008-2012 period.

The Kyoto Protocol also provides for two “project mechanisms” that add flexibility to the GHG allowances market: the Clean Development Mechanism (CDM) and Joint Implementation (JI).

The economics of climate change - Clean Development Mechanism (CDM)

An Annex B country, or the developer of a project based in an Annex B country, can obtain Certified Emission Reductions (CERs). These reduction units correspond to emissions avoided through emissions reduction projects funded in non-Annex B countries. CDM projects result in the net creation of reduction units and contribute to the liquidity of the market while reducing actors’ compliance costs, thus making emissions targets easier to reach.

CDM projects promote investment flows from developed to developing countries as well as the transfer of low-emissions technology. All projects must be approved and registered by the UNFCCC Secretariat.

-Joint Implementation (JI)

JI projects take place between two Annex B countries. They generate GHG Emission Reduction Units (ERUs). JI projects do not create credits, but rather transfer reduction units from one country to another.