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Must Read Climate Report from Lehman Brother

Lehman Brothers has just released a terrific report, The Business of Climate Change II. The theme is, “Policy is accelerating, with major implications for companies and investors,” but the piece has a lot of breadth, with cogent comments on everything from the social/damage cost of carbon to auctioning vs. granfathering to the Stern Report. Here are some extended excerpts:

What are the chances for a global climate agreement?

The probability of some sort of international greenhouse-gas-limiting agreement in the next three to five years involving the US, China, and perhaps India, which earlier this year we put at 50%, will continue to rise. We now put the probability at around 75%.

Why does climate change matter to business now?

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Many clients have asked for our view on the argument that, even assuming that scientists’ projections of the likely effects of climate change are broadly correct, the effects will be felt only slowly, with little effect on asset prices over most investors’ time horizons.

We judge this argument as flawed, for three, linked, reasons. First, markets anticipate even slow-moving variables, such as climate change. Second, policy made in the name of climate change could have an almost immediate, up-front effect on asset prices. And third, markets anticipate policy itself. In this way, expected future effects of climate change become brought right forward to the present.

Fundamentally, the economic case for considering climate change ultimately depends on the science. Our judgement is that the science will increasingly be seen as broadly correct; that this view will be progressively accepted by the weight of market opinion; and that, while the adjustment of asset prices has begun, full adjustment will take years, rather than months.

What is the “social” or “damage” cost of carbon?

Given these studies, we currently take as a central working estimate of the ‘social’ cost of carbon a figure of $50 per tonne today (‚¬40), rising to perhaps $100 per tonne by 2050.

… society might rationally have reason to abate more than would be suggested by such a cost-benefit analysis, and hence to pay a price above the calculated ‘social’ cost of carbon. Specifically, we said, society might want to pay an insurance premium, to reduce the risk of an unforeseeable non-linearity, discontinuity, or catastrophe. Having thought and read about this matter further, we realise that, in the terminology of much — though not all — of the literature, we used the wrong word: what is at issue is a risk premium, rather than an insurance premium.

Did the Stern Review on the Economics of Climate Change get it right? Did Stern choose a reasonable discount rate?

Our conclusion now, after reading further into the issue [of discount rates], and reporting on it below, is that while neither Stern, nor economists, nor philosophers more generally have had the last word on this issue, Stern’s cost estimates arguably were not biased upwards and hence warrant continued serious consideration.

Equity issues

The United States, the European Union, Japan, and Russia are estimated to have accounted jointly for nearly 70% of the build-up of fossil-fuel CO2 between 1850 and 2004. Developed countries are also, directly or indirectly, responsible for much of the destruction of the world’s carbon sinks, most notably its forests. By contrast, India and China are estimated as having contributed less than 10% of the total.

Developing countries are already making the point that the ‘social’ cost of carbon — and therefore the total abatement cost — is as high as it is because of past emissions. Hence, they argue, the developed countries should be paying for the amount by which the ‘social’ cost of carbon is higher than it would have been but for their actions….

[T]hose nations responsible for the bulk of the release of CO2 into the atmosphere in the past could agree to pay for these responsibilities by paying into a global warming ‘superfund’. That fund could in turn be used to reduce the amount that would otherwise be paid by the emerging countries in respect of their future emissions — or, of course, to pay for example for research and development, or adaptation.

Auctioning vs. grandfathering

Although auctioning presents clear and demonstrable economic advantages overgrandfathering — in terms of equity, distribution, dynamic efficiency, and price stability, among others — businesses usually argue that, in the particular case of the EU ETS, no more auctioning than already agreed should be implemented, mainly on the argument that auctioning permits would damage firms’ price competitiveness, at least in the absence of a global agreement.

While it is a mistake to think that only auctioning increases the marginal cost of production — marginal cost rises regardless of the means whereby carbon emissions are limited — it is true that the way that allowances are allocated has an impact on who gets the revenue resulting from the price increase. The revenue is absorbed by firms when permits are grandfathered, whereas it is received by governments, and hence is available for redistribution, when permits are auctioned.

The example of the European Union Emissions Trading Scheme shows that economic principles are not always a good guide to which policy will be adopted. However, this may change and, in negotiations for the regime post-2012, full auctioning could be agreed, at least for sectors facing little or no international competition. It could be even more the case if, as we think likely, a federal and EU-ETS-compatible cap-and-trade scheme is implemented in the United States (and possibly in Canada), which could well auction a greater proportion of permits than the 10% prevailing under phase II of the EU ETS.

Carbon trading and competitiveness

The disastrous impacts of a carbon trading scheme on firms’ competitiveness, as they are often described, are likely to be more fairy tale than reality. While the impacts of cap-and-trade scheme might seem likely to be the most significant for energy-intensive sectors and for those facing international competition, as far as the EU ETS is concerned, several of these sectors have been able to profit from the trading scheme through their large free allocation of permits….

This loss of international competitiveness could be resolved by the region (Europe in this case) imposing a border tax on imported goods according to their carbon content; or by other economies raising the relative price of carbon, whether by joining the carbon trading scheme or otherwise. The risk with a border tax is of retaliation, and the potential for a trade war. More likely, we judge, is that some sort of global scheme to limit carbon emissions, and quite possibly a global cap-and-trade scheme, will be in place within the next five years.