Category: Economics 10e: Ch 13

In December 2015, countries from around the world met in Paris at the United Nations Intergovernmental Panel on Climate Change (IPCC). The key element of the resulting Paris Agreement was to keep ‘global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius.’ At the same time it was agreed that the IPCC would conduct an analysis of what would need to be done to limit global warming to 1.5°C. The IPPC has just published its report.

The report, based on more than 6000 scientific studies, has been compiled by more than 80 of the world’s top climate scientists. It states that, with no additional action to mitigate climate change beyond that committed in the Paris Agreement, global temperatures are likely to rise to the 1.5°C point somewhere between 2030 and 2040 and then continue rising above that, reaching 3°C by the end of the century.

According to the report, the effects we are already seeing will accelerate. Sea levels will rise as land ice caps and glaciers melt, threatening low lying coastal areas; droughts and floods will become more severe; hurricanes and cyclones will become stronger; the habits of many animals will become degraded and species will become extinct; more coral reefs will die and fish species disappear; more land will become uninhabitable; more displacement and migration will take place, leading to political tensions and worse.

Two tragedies



 
The problem of greenhouse gas emissions and global warming is a classic case of the tragedy of the commons. This is where people overuse common resources, such as open grazing land, fishing grounds, or, in this case, the atmosphere as a dump for emissions. They do so because there is little, if any, direct short-term cost to themselves. Instead, the bulk of the cost is borne by others – especially in the future.

There is another related tragedy, which has been dubbed the ‘tragedy of incumbents’. This is a political problem where people in power want to retain that power and do so by appealing to short-term selfish interests. The Trump administration lauds the use of energy as helping to drive the US economy and make people better off. To paraphrase Donald Trump ‘Climate change may be happening, but, hey, let’s not beat ourselves up about it and wear hair shirts. What we do will have little or no effect compared with what’s happening in China and India. The USA is much better off with a strong automobile, oil and power sector.’

What’s to be done?

According to the IPCC report, if warming is not to exceed 1.5℃, greenhouse gas emissions must be reduced by 45% by 2030 and by 100% by around 2050. But is this achievable?

The commitments made in the Paris Agreement will not be nearly enough to achieve these reductions. There needs to be a massive movement away from fossil fuels, with between 70% and 85% of global electricity production being from renewables by 2050. There needs to be huge investment in green technology for power generation, transport and industrial production.

In addition, the report recommends investing in atmospheric carbon extraction technologies. Other policies to reduce carbon include massive reforestation.

Both these types of policies involve governments taking action, whether through increased carbon taxes on either producers or consumer or both, or through increased subsidies for renewables and other alternatives, or through the use of cap and trade with emissions allocations (either given by government or sold at auction) and carbon trading, or through the use of regulation to prohibit or limit behaviour that leads to emissions. The issue, of course, is whether governments have the will to do anything. Some governments do, but with the election of populist leaders, such as President Trump in the USA, and probably Jair Bolsonaro in Brazil, and with sceptical governments in other countries, such as Australia, this puts even more onus on other governments.

Another avenue is a change in people’s attitudes, which may be influenced by education, governments, pressure groups, news media, etc. For example, if people could be persuaded to eat less meat, drive less (for example, by taking public transport, walking, cycling, car sharing or living nearer to their work), go on fewer holidays, heat their houses less, move to smaller homes, install better insulation, etc., these would all reduce greenhouse gas emissions.

Finally, there is the hope that the market may provide part of the solution. The cost of generating electricity from renewables is coming down and is becoming increasingly competitive with electricity generated from fossil fuels. Electric cars are coming down in price as battery technology develops; also, battery capacity is increasing and recharging is becoming quicker, helping encourage the switch from petrol and diesel cars to electric and hybrid cars. At the same time, various industrial processes are becoming more fuel efficient. But these developments, although helpful, will not be enough to achieve the 1.5°C target on their own.

Videos and audio

Articles

Report

Questions

  1. Explain the extent to which the problem of global warming is an example of the tragedy of the commons. What other examples are there of the tragedy?
  2. Explain the meaning of the tragedy of the incumbents and its impact on climate change? Does the length of the electoral cycle exacerbate the problem?
  3. With the costs of low or zero carbon technology for energy and transport coming down, is there as case for doing nothing in response to the problem of global warming?
  4. Examine the case for and against using taxes and subsidies to tackle global warming.
  5. Examine the case for and against using regulation to tackle global warming.
  6. Examine the case for and against using cap-and-trade systems to tackle global warming.
  7. Is there a prisoners’ dilemma problem in getting governments to adopt policies to tackle climate change?
  8. What would be the motivation for individuals to ‘do their bit’ to tackle climate change? Other than altering prices or using regulation, how might the government or other agencies set about persuading people to ‘be more green’?
  9. If you were doing a cost–benefit analysis of some project that will have beneficial environmental impacts in the future, how would you set about adjusting the values of these benefits for the fact that they occur in the future and not now?

Last week was a rough week for Britain. The “Beast from the East” and storm Emma swept through the country, bringing with them unusually heavy snowfall, which resulted in severe disruption across nearly all parts of the country. Some recent estimates put the cost of these extreme weather conditions at up to £1 billion per day. The construction industry suffering the biggest hit as work came to a halt for the best part of the week. Losses for the industry were estimated to be up to £2 billion.

Closed restaurants, empty shops and severely disrupted transport networks were all part of the effect that this extreme weather had on the overall economy. According to Howard Archer, chief economic adviser of the EY ITEM Club (a UK forecasting group):

It is possible that the severe weather [of the last few days] could lead to GDP growth being reduced by 0.1 percentage point in Q1 2018 and possibly 0.2 percentage points if the severe weather persist.

 

Source: Jahn (2015), Figure 2

As the occurrence of freak weather increases across the globe due to climate change, so does the economic cost of these events. The figure above shows the estimated costs of extreme weather events in the USA between 1980 and 2012 and it is reproduced from Jahn (see link below), who also fits a quadratic trend to show that these costs have been increasing over time. He goes on to characterise the impact of different types of extreme weather (including cold waves, heat waves, storms and others) on different sectors of the local economy – ranging from tourism and agriculture, to housing and the insurance sector.

Linnenluecke et al (linked below) argue that extreme weather caused by climate change could influence the decision of firms on where to locate and could lead to a reshuffle of economic activity across the world and have important policy implications. As the authors explain:

Climate change-related relocation has been given consideration in policy-oriented discussions, but not in management decisions. The effects of climate change and extreme weather events have been considered as peripheral or as a risk factor, but not as a determining factor in firm relocation processes…. This paper therefore [provides] insights for understanding how firms can enhance strategic decision-making in light of understanding and assessing their vulnerability as well as likely impacts that climate change may have on relocation decisions.

The likelihood and associated costs of extreme weather events could therefore become an increasingly important matter for discussion amongst economists and policy makers. Such weather events are likely to have profound economic implications for the world.

Academic papers

Articles

Questions

  1. Explain how extreme weather can affect the decision of firms to locate between regions.
  2. Explain how extreme weather can affect the behaviour of consumers and the level of consumer spending.
  3. “The poorest countries are often the ones that are the most vulnerable to the effects of climatic change”. Discuss.

With first Houston, then several Caribbean islands and Florida suffering dreadful flooding and destruction from Hurricanes Harvey and Irma, many are questioning whether more should be spent on flood prevention and reducing greenhouse gas emissions. Economists would normally argue that such questions are answered by conducting a cost–benefit analysis.

However, even if the size of the costs and benefits of such policies could be measured, this would not be enough to give the answer. Whether such spending is justified would depend on the social rate of discount. But what the rate should be in cost-benefit analyses is a highly contested issue, especially when the benefits occur a long time in the future.

I you ask the question today, ‘should more have been spent on flood prevention in Houston and Miami?’, the answer would almost certainly be yes, even if the decision had to have been taken many years ago, given the time it takes to plan and construct such defences. But if you asked people, say, 15 years ago whether such expenditure should be undertaken, many would have said no, given that the protection would be provided quite a long time in the future. Also many people back then would doubt that the defences would be necessary and many would not be planning to live there indefinitely.

This is the familiar problem of people valuing costs and benefits in the future less than costs and benefits occurring today. To account for this, costs and benefits in the future are discounted by an annual rate to reduce them to a present value.

But with costs and benefits occurring a long time in the future, especially from measures to reduce carbon emissions, the present value is very sensitive to the rate of discount chosen. But choosing the rate of discount is fraught with difficulties.

Some argue that a social rate of discount should be similar to long-term market rates. But market rates reflect only the current generation’s private preferences. They do not reflect the costs and benefits to future generations. A social rate of discount that did take their interests into account would be much lower and could even be argued to be zero – or negative with a growing population.

Against this, however, has to be set the possibility that future generations will be richer than the current one and will therefore value a dollar (or any other currency) less than today’s generation.

However, it is also likely, if the trend of recent decades is to continue, that economic growth will be largely confined to the rich and that the poor will be little better off, if at all. And it is the poor who often suffer the most from natural disasters. Just look, for example, at the much higher personal devastation suffered from hurricane Irma by the poor on many Caribbean islands compared with those in comparatively wealthy Florida.

A low or zero discount rate would make many environmental projects socially profitable, even though they would not be with a higher rate. The choice of rate is thus crucial to the welfare of future generations who are likely to bear the brunt of climate change.

But just how should the social rate of discount be chosen? The following two articles explore the issue.

Articles

How Much Is the Future Worth? Slate, Will Oremus (1/9/17)
Climate changes the debate: The impact of demographics on long-term discount rates Vox, Eli P Fenichel, Matthew Kotchen and Ethan T Addicott (20/8/17)

Questions

  1. What is meant by the social rate of discount?
  2. Why does the choice of a lower rate of social discount imply a more aggressive climate policy?
  3. How is the distribution of the benefits and costs of measures to reduce carbon emissions between rich and poor relevant in choosing the social rate of discount of such measures?
  4. How is the distribution of the benefits of such measures between current and future generations relevant in choosing the rate?
  5. How is uncertainty about the magnitude of the costs and benefits relevant in choosing the rate?
  6. What is the difference between Stern’s and Nordhaus’ analyses of the choice of social discount rate?
  7. Explain and discuss the ‘mortality-based approach’ to estimating social discount rates.
  8. What are the arguments ‘for economists analysing climate change through the lens of minimising risk, rather than maximizing utility’?

Following concerns about the market power of the Big Six energy suppliers in the UK and high prices for gas and electricity, the industry regulator, Ofgem, referred the industry to the Competition and Markets Authority (CMA) in June 2014. The CMA published its final report in June 2016. This argued that while there was sufficient potential for competition, consumers nevertheless needed further encouragement to switch suppliers. This would strengthen competition in the market.

To encourage switching, the CMA proposed the creation of a database that would include the details of customers who have been on a supplier’s standard variable tariff (SVT) for three or more years. Competitor energy suppliers would have access to this database to offer better deals for these customers.

There had already been calls for price caps to be imposed on suppliers. For example, in the run-up to the 2015 general election, the then Labour leader, Ed Miliband, proposed imposing a price freeze. This was criticised by the Conservatives for being too anti-market, that it would encourage energy companies to raise prices prior to the freeze and that it would be of no benefit in times of falling wholesale energy prices (which was the position in 2015).

Indeed, in its 2016 report, the CMA recommended price caps only for the 16% of people on prepayment meters and these would be variable caps not freezes. This was followed in February 2017, by Ofgem’s announcement that a temporary price cap for such customers would come into effect in April 2017. The level of the cap would vary by meter type and region. It would also be reviewed every six months to reflect changes in costs and remain in place until 2020. There would be no cap on other customers.

But in the run-up to the 2017 election, the Conservatives announced that they would, after all, introduce a price cap on SVTs – 66% of customers are on such tariffs. Before the details were announced, there was much speculation as to what form such a cap would take? It would not be a simple freeze. But there was debate as to whether caps would vary with wholesale costs or whether they would be relative to the company’s lowest tariffs or to those of its rivals.

As it turned out, the proposal was for a cap on standard variable tariffs. It would be set by Ofgem and reviewed every six months. The cap would be based on the cheapest standard variable tariffs in each part of the UK, taking into account the variable costs for transporting energy there. Ofgem will adjust the cap every six months to reflect changes in the wholesale cost of energy.

Articles before details were anniunced
U.K. Energy Industry Faults May’s Election Pledge to Cap Prices Bloomberg, Rakteem Katakey (23/4/17)
Conservatives promise to cap prices in UK energy market Financial Times, Jim Pickard and Nathalie Thomas (23/4/17)
How might an energy price cap work? BBC News, Brian Milligan (24/4/17)
UK government vows strong action to rein in energy companies The Guardian, Adam Vaughan (19/4/17)
Energy bills: what’s the difference between Tory cap and Miliband freeze? The Guardian, Adam Vaughan (23/4/17)
Capping energy prices? Still a bad idea Adam Smith Institute blogs, Sam Dumitriu (25/4/17)
Bulb becomes ‘first’ provider to cut energy prices this year Moneywise (24/4/17)
Experts slam Conservative plans to cap energy bills as ‘clumsy and counterproductive’ The Telegraph, Lauren Davidson (23/4/17)
Capping energy tariffs isn’t a one-way ticket to Venezuelan-style economic ruin Independent, Ben Chu (25/4/17)

Articles after details were anniunced
Conservatives defend plans to cap UK energy bills Financial Times, Jim Pickard and Nathalie Thomas (9/5/17)
What is the energy price cap – and what does it mean for bills? The Telegraph, Jillian Ambrose (9/5/17)
The new energy price cap con? The Telegraph, Jillian Ambrose (9/5/17)
May defends plan to cap ‘rip-off energy bills’ BBC News (9/5/17)
Q&A: The Tory plan to cap energy prices BBC News, Brian Milligan (9/5/17)
Energy prices could still go up under Theresa May’s price cap plans, admits Business Secretary Greg Clark Independent, Rob Merrick (9/5/17)
Tory claims over energy price cap are just hot air The Guardian, Nils Pratley (9/5/17)

Video and audio
UK government energy price cap ‘sheer politics’: Bernstein CNBC, Deepa Venkateswaran and Andrew Sentance (25/4/17)
Energy UK: price cap could backfire Sky News, Lawrence Slade (24/4/17)
Scottish Power: Capping prices ‘damages customers’ BBC News, Keith Anderson (24/4/17)
Tories to pledge energy bill cap BBC News, Michael Fallon (24/4/17)
Tories: Energy cap will protect vulnerable people BBC Today Programme, Business Secretary Greg Clark (9/5/17)
Energy cap: good or bad for consumers? Sky News, Stephen Fitzpatrick and James Kirkup (9/5/17)

Questions

  1. What scope is there for tacit collusion between the Big Six energy suppliers?
  2. What is meant by the RPI–X price cap? How does it differ from proposals being considered by the government?
  3. Why are people often reluctant to switch energy supplier?
  4. How could people be encouraged to switch supplier?
  5. What are the advantages and disadvantages of imposing a price cap for SVTs (a) relative to costs; (b) relative to lower-priced tariffs?
  6. Comment on Centrica’s chief executive officer Iain Conn’s statement that “price regulation will result in reduced competition and choice, and potentially impact customer service”.
  7. Comment on the statement by Lawrence Slade, chief executive officer of Energy UK, that intervention would create “huge uncertainty around government intentions, potentially putting at risk the billions in investment and jobs needed to renew our energy system”.
  8. Would an announcement of the introduction of a price cap in the near future necessarily encourage energy companies to raise their price now?

The UK government has finally given the go-ahead to build the new Hinkley C nuclear power station in Somerset. It will consist of two European pressurised reactors, a relatively new technology. No EPR plant has yet been completed, with the one in the most advanced stages of construction at Flamanville in France, having experienced many safety and construction problems. This is currently expected to be more than three times over budget and at least six years behind its original completion date of 2012.

The Hinkley C power station, first proposed in 2007, is currently estimated to cost £18 billion. This cost will be borne entirely by its builder, EDF, the French 85% state-owned company, and its Chinese partner, CGN. When up and running – currently estimated at 2025 – it is expected to produce around 7% of the UK’s electricity output.

On becoming Prime Minister in July 2016, Theresa May announced that the approval for the plant would be put on hold while further investigation of its costs, benefits, security concerns, technological issues and safeguards was conducted. This has now been completed and approval has been granted subject to new conditions. The main one is that the government “will be able to prevent the sale of EDF’s controlling stake prior to the completion of construction”. This will allow the government to prevent change of ownership during the construction phase. Thus, for example, EDF, would not be allowed to sell its share of Hinkley C to CGN, which currently has a one-third share in the project. EDF and CGN have accepted the new terms.

After Hinkley the government will have a ‘golden share’ in all future nuclear projects. “This will ensure that significant stakes cannot be sold without the Government’s knowledge or consent.”

In return for their full financing of the project, the government has guaranteed EDF and CGN a price of £92.50 per megawatt hour of electricity (in 2012 prices). This price will be borne by consumers. It will rise with inflation from now and over the first 35 years of the power station’s operation. It is expected that the Hinkley C will have a life of 60 years.

Critics point out that this guaranteed ‘strike price’ is more than double the current wholesale price of electricity and, with the price of renewables falling as technology improves, it will be an expensive way to meet the UK’s electricity needs and cut carbon emissions.

Those in favour argue that it is impossible to predict electricity prices into the distant future and that the certainty this plant will give is worth the high price by current standards.

To assess the desirability of the plant requires an assessment of its costs and benefits. In principle, this is a relatively simple process of identifying and measuring the costs and benefits, including external costs and benefits; discounting future costs and benefits to give them a present value; weighting them by their probability of occurrence; then calculating whether the net present value is positive or negative. A sensitivity analysis could also be conducted to show just how sensitive the net present value would be to changes in the value of specific costs or benefits.

In practice the process is far from simple – largely because of the huge uncertainty over specific costs and benefits. These include future wholesale electricity prices, unforeseen problems in construction and operation, and a range of political issues, such as pressure from various interest groups, and attitudes and actions of EDF and CGN and their respective governments, which will affect not only Hinkley C but other future power stations.

The articles look at the costs and benefits of this, the most expensive construction project ever in the UK, and possibly on Earth..

Articles

Hinkley Point: UK approves nuclear plant deal BBC News (15/9/16)
Hinkley Point: What is it and why is it important? BBC News, John Moylan (15/9/16)
‘The case hasn’t changed’ for Hinkley Point C BBC Today Programme, Malcolm Grimston (29/7/16)
U.K. Approves EDF’s £18 Billion Hinkley Point Nuclear Project Bloomberg, Francois De Beaupuy (14/9/16)
Hinkley Point C nuclear power station gets government green light The Guardian, Rowena Mason and Simon Goodley (15/9/16)
Hinkley Point C: now for a deep rethink on the nuclear adventure? The Guardian, Nils Pratley (15/9/16)
Hinkley Point C finally gets green light as Government approves nuclear deal with EDF and China The Telegraph, Emily Gosden (15/9/16)
UK gives go-ahead for ‘revised’ £18bn Hinkley Point plant Financial Times, Andrew Ward, Jim Pickard and Michael Stothard (15/9/16)
Hinkley Point: Is the UK getting a good deal? Financial Times, Andrew Ward (15/9/16)
Hinkley Point is risk for overstretched EDF, warn critics Financial Times, Michael Stothard (15/9/16)
Hinkley C must be the first of many new nuclear plants The Conversation, Simon Hogg (16/9/16)

Report

Nuclear power in the UK National Audit Office, Sir Amyas Morse, Comptroller and Auditor General (12/7/16)

Questions

  1. Summarise the arguments for going ahead with Hinkley C.
  2. Summarise the objections to Hinkley C.
  3. What categories of uncertain costs and uncertain benefits are there for the project?
  4. Is the project in EDF’s interests?
  5. How will the government’s golden share system operate?
  6. How should the discount rate be chosen for discounting future costs and benefits from a project such as Hinkley C?
  7. What factors will determine the wholesale price of electricity over the coming years? In real terms, do you think it is likely to rise or fall? Explain.
  8. If nuclear power has high fixed costs and low marginal costs, how does this affect how much nuclear power stations should be used in a situation of daily and seasonal fluctuations in demand?
  9. How could ‘smart grid’ technology smooth out peaks and troughs in electricity supply and demand? How does this affect the relative arguments about nuclear power versus renewables?