[MUSIC] Okay, so we have seen that pure price mechanisms do not always work as well as they're supposed to. This doesn't mean that price mechanisms do not work at all and they have no effect simply that they have possibly important limitations. So when do they work? And how do they work? Let's begin start with the how and let's begin looking a tiny bit at cap and trade. As I said, I'm not going to look at in great detail because it's going to be covered in a different part of the course. But it's important to have a bit of an idea. The overall thing to remember is that the ultimate goal of any price mechanism is to lower the emission at the lowest possible economic cost. So how does a cap and trade mechanism work? Energy firms are mandated to buy carbon allowances if they want to emit. Each allowance then gives the further permission to emit one tonne of CO2. Firms have to buy and pay money and the price of the allowances is set by the regulator, the government. The cap comes in because the maximum total number of allowances and therefore of emissions is set by the government. And then an established market enables trading of allowances amongst firms. The idea is very clever. If a system is well designed, low cost reductions are carried out first. Then every producer has to decide whether to buy one allowance and emit one tonne of CO2. Or two investors must spend some money in making emissions more efficient so that fewer allowances would be needed. Different producers face different emission reduction costs. So the low hanging fruit are reaped first. In addition, the regulatory burden is reduced. There are so called information ray symmetries, regulators do not know very well which are the most efficient ways of reducing CO2 et cetera. So just let the specialists decide whether to reduce the cost of emission by perhaps putting carbon sequestration or buying an allowance. The approach is technology agnostic. It doesn't say do a lot of carbon sequestration, do a lot of this and a lot of that. It just sets a price and say go and find the best way to achieve an equilibrium. Let's see why in principle, it's a very good idea and it can be efficient. With a mandated strategy for instance, emission standard, every firm, no matter of how efficient or inefficient it is, must comply with it. Now suppose that firm A can reduce the cost much more efficiently than firm B. If they both have to achieve a fixed reduction in a mission firmly firm B may have to spend a lot more money. Now the same total amount of spend by A plus B to meet the standard could have achieved a greater reduction in the emission. This goes against the grain. This goes against the goal over getting the lower emission at the lowest possible economic costs. With a direct tax system, CO2 emitting firms have to pay a fixed tax per ton of CO2 emitted. Therefore, the tax provides cost certainty. A cap and trade system provides certainty about the amount emitted because I grant a limited amount of permits. They look very different. Despite these differences that are deep similarities between the two. Implementation design above all, pricing of the allowances is far more important that they are theoretical pros and cons. So we've looked at cap and trade, we looked super, super quickly taxes. How do emission standards work? Well, emission standards specify at what level of performance, businesses or equipment must operate. We looked at the case where consumers do not buy energy efficient refrigerators unless they get payback of the extra costs in one or two years. Which is not reasonable. Therefore, we say, okay, tell you what refrigerators must comply with these energy standards. So the standards can be set at the device level, at the fuel level or at the sector level. For instance, fuel economy standards for vehicles, emission standards for coal power plants, efficiency standards for domestic appliances such as light bulbs or heating systems. In general, this provided binding constraint when the price is not an effectment inducement for action. As we have seen with situations where prices for reasons that economists don't understand well, but there nonetheless there, doesn't provide the correct signal. Then the idea is to make the standard more and more stringent to the time, making firms more energy efficient. In areas such as car emissions building standards, electrical lighting, et cetera. Progressive standard setting has been hugely successful. As usual, there are problems for instance, replacement of all the equipment. For instance, lightbulbs normally is not mandated and the turnover time can be very long. So when new light bulbs were introduced, they didn't say you must throw away all your light bulbs and the light bulbs can and an old light bulb can last several years. So I have many years to carry out the transition. There is no certainty about the cost implied by the standard and there is imprecise knowledge of how much emissions will be reduced. We mentioned as well research and development. This is more a compliment than an alternative to the other mechanisms. But I'm putting it all together because at the end of the day, it is all a call on resources. Putting a carbon tax costs in some way and we can look carefully who will pay for this. But there is a cost research and development, there is a cost cap and trade, there is a cost, so it competes for for resources. And the idea is to spend money that could go say to subsidies or for other energy, energy conserving or carbon emissions reducing initiatives for R and D. Remember that when it comes to the use of fossil fuel, as we said, there are three market failures. Greenhouse gas emissions are not correctly priced. There are what I call implausibly high discount factors implied by consumer choices. And the third one is that research and development is often underfunded. We have discussed in the case of nuclear fusion, remember the nuclear fusion in the United States. People spend more money on pet grooming their own research for nuclear fusion. It doesn't look like very efficient allocation of resources to me. In general, economists agree that more R and D funding would would as a positive NPV. That's the way economic things and therefore there should be more R and D funding, but there isn't. And now we're moving to a policy mix, as I said at the beginning, no single approach by itself works perfectly for everything. So the question is, where can we get the biggest bang for the buck? Five types of initiatives, as we can see in this picture here have a substantial potential for abatement. Improving energy efficiency, improving fuel efficiency, several disparate opportunities in various industries and sectors expanding and enhancing carbon sinks and reducing carbon intensity of electric power production. So this is when we do all of this, we can achieve a reduction of up to a quarter of emissions. So these are the things we would like to achieve. What kind of policies can best achieve these reductions? So that's the reason I can make, I know believers I have to pull in order to make a difference. What policies can affect can achieve these goals? As far as improving energy efficiency in buildings and appliances, standards are very effective. As far as improving fuel efficiency in vehicle and transportation, again, standards are effective. In the case of several disparate opportunities in vary what they called fragmented opportunities. Well, you have two distinct equipment are great standard settings, process changes, price mechanism and standard setting. Initiatives which have a direct bottom line benefits but compete for capital, what needs incentive for R and D to receive funding. One of the other big levers was expanding and enhancing carbon sinks. Here the linkage to the carbon offset mechanism to accept capital can be very useful. A carbon offset is a reduction in CO2 emissions to compensate for emissions made elsewhere and they can be traded. Reducing company intensity of electric power production, price mechanisms are effective plus subsidies for R and D. In the following pictures here, this is a very interesting picture from a Mckinsey report and of course we're not going to go through every single entry one at the time. But there are two pictures here, in the first one, it's a blind picture with no labeling, but we can understand what, how it is organized. All the bars which are below the XX is referred to initiatives which have a positive NPV, a negative cost to put in place. And as usual, the area of a rectangle means how much energy saving can be achieved. So if we look in the estimate of real opportunities here, it isn't very sobering and stark analysis. Because there is a huge amount of initiatives which have positive NPV which have negative cost. So irrational consumers and rational producers and rational industry should have done all of this yesterday. And this is energy efficiency and other initiatives for residential electronics, for commercial electronics, residential buildings, cladding, et cetera. When we move to the right hand side, we have policies which have a not positive NPV. And therefore there has to be, there is a cost, a positive cost and this is linked to a carbon tax. And there is a threshold there you see in the picture where these rectangles become white and they become white when the cost is above $50 per ton. But as you can see, there are lots of initiatives,advanced forest management, nuclear, new build, et cetera. Which with modest subsidies, become effective. So summarizing, I'm going to give a super simplified example of policy, an initiative portfolio mix. So what I mean by initiative, how can we get most efficiently emission reduction? As we have seen over reliance on intimidated renewables requires over scaling because it is intimidated, is not there all the time. So it's very inefficient. However, intermittent sources of energy are ideal to provide time, insensitive energy. What do I mean by that? Energy that is produced perhaps a time where there is no demand from the electricity grid. And therefore this energy can be used in other ways charging batteries energy for direct carbon removal. That as we saw is very energy intensive et cetera. So as we have seen a limited background, constant capacity nuclear or gas and carbon with sequestration plus renewable provides a very efficient mix of initiatives. Then energy efficiency in cars, heating light et cetera. Put together get the biggest bang for the buck. That's what we would like to achieve. What mixed of policies can best achieve this? Well, this is just an example. Clearly I can't do into slime but it's just to give a flavor an example of policy mixes for wind and solar. They can benefit from tax credits and subsidies, which is price signals and R and D. Given consumer inertia regulation and standards work way work well. Sequestration is an established technology that have been around from 1902 and from the 1930s. But currently is costly in this R and D and price incentives. Power producers can become more effective with price signals such as cap and trade. The choice of effective policies is key to achieving economically acceptable reduction in CO2 emission. Unfortunately, all policies come with what I refer to as an ideological package. And as I have said, free marketeers from the riots, people seem to believe that only market measures work. And people who believe more in the role of the government and the state seems to believe that only regulation taxes and mandating emissions is the way to go. In reality, the best policy is to look empirically at what works in different areas and creating a portfolio of initiatives. You will not be surprised because one of the key messages that I'm trying to convey is that also from the point of view of what should we do, no single initiative works perfectly in isolation. So we have the ideal thing is a portfolio of initiatives and a portfolio of policies. [MUSIC]
