In this session, we want to understand what are the main possible policy options are to curb emissions. We're going to ask such question as is any one type of policy superior? Or is there perhaps a portfolio of policies that all put together works most effectively? What are the pros and cons of the various policies? I would like to make a clear distinction in my presentation between policies. They produce certainty of cost. So I have an outcome and I know how much this will cost. Policies that provide certainty of abatement. Is very difficult, perhaps impossible to get with two at the same time. However, the two sets of policies can be combined, and doing it in the most efficient way is the goal of Energy Policy Design. We can think about what the problem is if we can call it a problem. Suppose that we have established, perhaps using the levelized cost of energy or an integrated assessment model or whatever, all the NPVs of different policies and renewables, coal sequestration, nuclear, etc. Well, if the market worked perfectly and everybody were rational and there were no externalities, we could just let the market find automatically the best NPV options and we are done. However, for very many reasons that we'll partly explore in the course of this session, these positive NPV options are not automatically embraced. The goal of energy policy design is, how can we encourage the optimal adoption of these positive NPV strategies? We're not going to go into the details of policies such as cap and trade because they're very important they're going to be covered in another part of the course. We are now going to take a purely theoretical approach. You can go very deep in the weeds of general equilibrium, etc. I'm not sure that this type of study is important as they are in their own rights. Tell us something very useful from the practical policy perspective. We will mix theory and observation. It will not be in a theoretical isolation, but we will mix theory and isolation to see which policies we can expect, we can hope to work best in practice. What do I mean when I say work in practice? Reduce CO_2 emission in a cost-efficient way. As you know me by now, let's look at the big picture. 75 percent approximately of CO_2 emissions are due just to 20 countries. Especially if we focus in these 20 countries, we see that energy combustion accounts for 75 percent of emissions. It goes into power generation, electricity and heat, transportation, and buildings. Twenty percent, altogether that makes 95 percent, goes in various industrial processes, including agriculture, that make up the remaining 20 percent. Well, this means that if we get a grip on electricity, industry, transportation, and buildings in the top 20 countries, we really have a handle on the problem. Note it's easier said than done, but at least we see where we should concentrate our efforts. Therefore, from conceptualizing the problem in this manner, it is clear that finding an effective strategy means finding a set of policies that bring about a reduction in electricity demand for buildings, carbon intensity. How much carbon do I need for one unit of energy? Emissions from transportation and emissions from the non-electricity industry sectors. We've got to focus this in the top 20 countries. Well, that's a tall order. How can we achieve this? The main policy design options are price mechanisms, setting of emission standards, and research and development. We're going to look them in turns. Let's begin with price-based mechanisms. What are these? The best known is probably cap and trade, and then carbon taxes. Incentives and subsidies can be looked at as negative taxes. Increasing the cost of capital for a sinful firm. That is what is achieved, for instance, where investment manager divests from sinful industry. They all have different pros and cons, but they all share a common philosophy. The philosophy is, yes, perhaps there are some imperfections in the market, but once we make some adjustments, externalities, or for the irrationality of consumers, will come to see what that means, then the market mechanism is the best way to achieve the socially optimal goals. That's the basic idea. Let's now understand how economic incentive works. They can be structured in two ways. Either the amount of incentive is specified today, or the incentive value is to be found via mechanism established by a given policy. Economic incentive assume either a known quantity, for instance acceptable emission, or a known price, in acceptable economic cost, and rely on the market to find the other. Let's have some examples. Supposedly we can quantify precisely the damage in dollars brought about by CO_2 emissions. There is for instance what an integrated assessment model can do. We'll look at that later on. Then taxes and subsidies can be based on the price. Indeed, the social cost of carbon is one of the outputs of an integrated assessment model. Then the market can find the optimal quantity of activity, so how much you should travel, how much energy should be produced compatible with that price. The energy industry will be motivated to increase in efficiency up to the point where the further emission reduction costs more than the tax. That's the idea. We can also take a complimentary view. Suppose that instead, we can quantify precisely how much CO_2 we can afford, perhaps to stay within 1.5 of 2-degree target. Then the price mechanism will identify the mix of activities that will achieve this level of emission at the lowest cost. The desired level of emissions is achieved by construction but at an unknown cost. An example is reverse auction, where suppliers of renewable electricity bid against each other for the lowest subsidy they're willing to accept. Price mechanisms often but not exclusively rely on the internalization of the externalities imposed by carbon. What is an externality? Externality is a damage imposed on a third party. There is a transaction between two-party, and the third party suffers a damage for which that it does not pay compensation. When I buy an air ticket, I travel somewhere, the British Airways, or Delta, whatever make a certain profit, but the pollution is suffered by a third person who is not compensated by the price of the ticket that I have bought. The idea now is once the externality has been properly priced, then regulators who stand aside and let the market achieve its optimal allocation of resources. Economists like these solutions because they are conceptually elegant, but they come with a heavy ideological baggage, and not surprisingly, from the left and from right they are looked at in very different ways. Free marketeers claim that this is a silver bullet, it is the best thing in the world. People who believe more in government control say they're basically little shorter than a pact with the devil. As usual the truth is somewhere in the middle, and we want to understand why. An important side, economists tend to say that taxes have a distortionary effect. What does this mean? It means that they divert resources from the supposedly optimal location provided by the market. However, even if you are an efficient market person, free marketeer etc, this is not true for sin taxes, because sin taxes are taxes that try to correct for non-priced externalities. Now, taxes may or may not be the best way to correct an externality, but the outcome after the sin tax can be closer to the optimum than before. Let's go back to the price mechanism. Broadly speaking, they can be categorized in three groups as I said, cap-and-trade, carbon taxes, and raise the cost of capital for emitters or producers. Carbon taxes and cap-and-trade stimulate energy efficiency. Raising the cost of capital for sinful firms has limited effect on efficiency, mainly a higher cost of capital makes marginal projects such as drilling and other oil field less profitable and therefore abandoned. Ultimately, all these measures translate in higher costs for consumers. Higher costs for consumers are clear they're not welcome, but they send a signal. The signal they send should increase the efficiency of producers and consumers, and at the same time limit the use of energy. In economic theory, after the externality of CO_2 emissions have been internalized, the price mechanism should automatically solve a problem via the attainment of a new equilibrium. As we shall see, reality is more complex.
