Climate Change

and Carbon Markets

An International Framework
September 2023
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Abstract
Climate change is one of the most challenging international policy problems the world has ever faced. This report
examines a wide range of issues surrounding climate change, including various aspects of the developing
international framework to address it and the state of global carbon markets.

Climatologists unanimously agree that unabated anthropogenic greenhouse gas emissions are already leading to
substantial changes in the earth’s climate and are threatening to push us across unknown tipping points. Human
activities are estimated to have caused approximately 1.0°c of global warming above pre-industrial levels, with a
likely range of 0.8°c to 1.2°c. Global warming is likely to reach 1.5°c between 2030 and 2052 if it continues to
increase at the current rate. The environmental costs of exploiting the world’s natural resources and raw materials
to meet the burgeoning demands of the 21st century are unsustainable.

In an effort to determine the best way to formulate an effective climate change policy, this assessment analyses
the economic, environmental, and social costs of climate change. This issue's complex and dynamic nature requires
an understanding of the science, impacts, technology options, economics, and ethics of climate change policy.

Only an all-encompassing approach will allow us to define and direct our goals vis-à-vis climate change
accordingly. Above all, climate change is a global problem, and thus, it must ultimately be addressed on a global
scale. Building upon this premise, this report surveys climate change policy's political, legal, and international
relations, including various global and regional carbon market frameworks and mechanisms.

While the Kyoto protocol acted as the initial platform for much of the carbon market activity, it has become
evident that the current framework of international climate negotiations and treaties has not yet yielded the
expected results. There is much to learn from the Kyoto protocol, which could not garner participation from
several large industrial polluters, including the United States. Some of the key issues that Kyoto and subsequent
climate negotiations have been unable to reconcile include free-riding, leakage, adaptation, the enforcement of
emissions targets and timetables, and how to account for fast-growing developing economies such as China, India,
and Brazil.

It is important to recognize that the Kyoto protocol established important flexible mechanisms that stimulated
mitigation efforts to help countries reach their compliance targets. Outside of the purview of the Kyoto protocol,
several other regional trading mechanisms, carbon markets, and climate change initiatives have been adopted
across the globe.

While climate policies have the potential to be effective on a domestic or even regional level, they face difficulties
on a global scale. This includes the distribution of emissions reductions across countries and the need for methods
to encourage developing countries to participate by eliminating incentives for freeriding and identifying low-cost
mitigation options.

The carbon offset market may need to grow by as much as 50 times if companies are to meet 2050 net-zero
greenhouse gas emissions goals. Offsets issued in 2020 were equivalent to 210 million metric tons of carbon
dioxide emissions, which is 0.4% of total global emissions. Achieving net-zero energy emissions by 2050 will
demand approximately 7.6 gigatons of carbon dioxide offsets or removal.

Estimates of the global emissions outcome of current nationally stated mitigation ambitions submitted under the
Paris agreement would lead to global greenhouse gas emissions in 2030 of 52–58 GTCO2eq/yr. Pathways
reflecting these ambitions would not limit global warming to 1.5°c, even if supplemented by very challenging
increases in the scale and ambition of emissions reductions after 2030. Avoiding overshoot and reliance on future
large-scale carbon dioxide removal (CDR) deployment can only be achieved if global CO2 emissions start to
decline well before 2030.
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Table of contents
Abstract 3
Chapter 1: 6
Science of Climate Change 6
1.1 What are greenhouse gasses, and how do they contribute to climate change? 6
1.2 What are the effects of global climate change? 7
1.3 How does human activity contribute to global climate change? 8
1.4 Projected GHG Emissions Growth. International Energy Agency (IEA) scenarios. 10
CHAPTER 2: ECONOMICS OF CLIMATE CHANGE 11
2.1 The Atmosphere as Global Public Good 11
2.2 Costs of Climate Change 11
2.2.2 Discount Rate 13
2.3 Estimated Costs of Climate Change Regulation 13
2.3.1 Stern Review: Projected Mitigation and Adaptation Costs 14
CHAPTER 3: POLICY AND REGULATORY OPTIONS FOR EMISSIONS REDUCTION 15
3.1 What is a cap-and-trade system? 15
3.2 Carbon Tax 16
3.3 RPS (Renewable Portfolio Standards) 18
3.4 Feed-in tariffs 18
3.5 Tax Credits 18
3.6 Subsidies

-------------- THIS IS THE REST OF THE REPORT - AVAILABLE IN THE PAID VERSION --------------

CHAPTER 4: TECHNOLOGY OPTIONS FOR EMISSIONS REDUCTION 20

4.1 Combining technology options: What is the "wedge" theory, and how does it address sources and future
projections of greenhouse gas emissions and concentrations? 20
4.2 What are some examples of improvements in energy efficiency? 21
4.3 What is fuel switching? 22
4.4 Is Nuclear Energy renewable energy? 23
4.5 What are renewable energy technologies, and why are they important to the energy mix? 23
4.6 Forms of Carbon Sequestration 27
CHAPTER 5: UN: UNFCCC and the Paris Agreement 30
5.1 The Kyoto Protocol - The Paris Agreement 30
5.2 More on Flexible Mechanisms 32
5.3 Controversy surrounding Agriculture, Forestry and Other Land Use projects 37
CHAPTER 6: EU: THE EU ETS 38
6.1 THE EU ETS framework 38
6.1.1 Greenhouse gases leave sectors covered by the EU ETS 38
6.2. Results: Phase 1, 2, 3 and 4. 39
6.3 Better targeted carbon leakage rules 39
CHAPTER 7: OTHER NATIONAL AND REGIONAL APPROACHES 41
7.1 U.S. Federal level regulations 41
7.2 U.S. state and local regulations 43
7.3 Canada 45
7.4 Australia 46
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7.5 Germany - Energiewende 47

7.6 China 48
7.7 India 49
CHAPTER 8: THE CORPORATE RESPONSE 50
8.1 How does climate change impact corporations? 50
8.2 How are corporations addressing climate change? 50
8.3 What risk does climate change present to corporations? 50
8.4 How immediate are the risks from climate change? 51
8.5 Which corporations and industries are particularly at risk from climate change? 52
8.6 What is the business case for dealing with climate change? 58
8.7 What actions can corporations take to address climate change? 58
8.7.3 Capitalizing on Opportunities 60
CHAPTER 9: THE INVESTOR RESPONSE 61
9.1 Why are investors thinking about climate change? 61
9.2 What types of investments are considered "climate-change-related"? 62
9.3 What investments/amounts are currently being made now? What is the potential pool of money to be
invested? 62
9.4 What types of investors are involved in this business? 63
9.5 What are the barriers and risks to climate change mitigation projects? 64
CHAPTER 10: THE CARBON MARKET 66
10.1 Background 66
10.2 Tradable Carbon Commodities 66
10.3 The Primary Sellers of Carbon Credits 67
10.4 Main buyers of carbon credits. 67
10.5 Pricing EUAs - EU Emissions Allowances 68
10.6 The Voluntary Carbon Market & Pricing VCUs 69
10.7 How Retail (OTC) Carbon Markets Operate 70
10.8 Carbon Pricing Instruments (CPIs) - Global coverage on Carbon Taxes and Emission trading systems (ETS)
71
10.9 What Lessons from Phases I, II and III of the EU ETS can be Applied to Future Cap and Trade Schemes? 72
CHAPTER 11: CARBON FINANCE AND EMISSIONS REDUCTION PROJECTS 73
11.1 What is Carbon Finance? 73
11.2 What is an Emissions Reduction Project? 73
11.3 Who is typically involved in an Emissions Reduction Project? 73
11.4 What is the Project Life Cycle of an Emissions Reduction Project? 74
11.5 What are Typical Financial Structures for an Emission Reduction Project? 75
11.6 What Sources of Finance are Available for an Emission Reduction Project? 76
11.7 What are the Cost Categories associated with Various Stages of the Project? 78
11.8 What are Revenues and Typical Cash Flows for an Emissions Reduction Project? 78
11.9 What Risks are Involved in an Emission Reduction Project? 79
11.10 What Types of Risk Mitigation Procedures are Available for Projects? 80
11.11 How Does Carbon Finance contribute to the Economic Feasibility of a Project? 80
11.12 What are some Financial Products for Emission Reduction Projects? 82
ACRONYMS 84
CITATIONS 86
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Chapter 1:
Science of Climate Change
1.1 What are greenhouse gasses, and how do they contribute to
climate change?
The stability of the Earth’s climate depends on a delicate balance between inputs and outputs. Although a
number of factors influence local temperatures, the predominant component that controls globally average
temperatures is incoming and outgoing solar radiation. In a simplistic model of the Earth system, the cloud
cover reflects some of the incoming solar energy, but the rest reaches the Earth in wavelengths ranging
from ultraviolet (UV) to infrared (IR). However, it re-emits this energy, mostly in the form of IR radiation,
back into the atmosphere. Greenhouse gasses (GHGs), such as water vapor, carbon dioxide (CO2), methane
(CH4) and nitrous oxide (N2O), prevent much of this radiation from escaping the Earth’s atmosphere and
reaching space. Their molecular structure is such that they absorb IR radiation and some of it back towards
the Earth’s surface, effectively trapping heat and creating what is known as the “greenhouse effect” (Fig. 1).
Many GHCs have existed throughout the history of the Earth in fluctuating concentrations and have
contributed to the natural variability of average temperature over that time. They play an essential role in
the climate system by helping to maintain the Earth’s surface temperature at a level suitable to sustain life.
However, the dramatic increase in GHG emissions since the dawn of the industrial revolution has resulted
in an “enhanced greenhouse effect”, meaning that increasing concentrations of atmospheric GHGs are
disrupting the climate system in an unsustainable way.

Figure 1: The Greenhouse Effect

If GHG concentrations continue to rise, more IR radiation is trapped in the Earth’s atmosphere, decreasing
the total amount of radiation leaving and changing the Earth’s energy balance. While there are certainly
other factors that affect temperatures at different times and in different regions, the dominant trend in
average global temperatures is warming. While some regions may benefit from climate change, most can
expect severe consequences, including erratic precipitation patterns, sea-level rise, and increased
frequency of extreme weather events.
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1.2 What are the effects of global climate change?

Climate change is a unique environmental problem in that, unlike conventional air pollutants, whose effects
are felt locally over relatively short periods of time, GHGs are diffuse and have a lifetime in the atmosphere
of several hundred years. A ton of a given GHG emitted in India has relatively the same warming effect as a
ton emitted in the US. Since GHGs subtly alter the composition of the global climate system, local effects
will depend on the factors that determine local weather patterns. The reality of the nature of GHGs makes
climate change one of the most painful collective action problems in history, as the majority of the costs of
regulation or decreased consumption must be borne by those who will not see most of the benefits.
Moreover, those who have contributed the least to the problem – developing countries – will generally be
the least able to cope with the impacts of climate change.

Among the many effects of climate change, some of the most likely and potentially harmful are:

Surface temperatures: Global surface temperature has increased faster since 1970 than in any other
50-year period over at least the last 2000 years. Temperatures during the most recent decade (2011–2021)
exceed those of the most recent multi-century warm period around 6500 years ago. Hot extremes have
become more frequent and more intense since the 1950s, while cold extremes have become less frequent
and less severe.

Precipitations on land: Globally averaged precipitation over land has likely increased since 1950, with a
faster rate of increase since the 1980s.

Rising sea level: Global mean sea level increased by 0.20 m between 1901 and 2018. The average rate of
sea level rise was 1.3 mm yr–1 between 1901 and 1971, increasing to 1.9 mm yr–1 between 1971 and
2006, and further increasing to 3.7 mm yr–1 between 2006 and 2018. This increase is largely due to the
warming of the oceans during this period, which causes thermal expansion. The rate of sea level rise is
expected to increase in the coming years due to the melting of mountain glaciers and ice caps in Greenland
and the Antarctic. By the end of the 21st century, sea levels are expected to rise another 28-101 cm),
displacing coastal populations, greatly accelerating coastal erosion, causing greater flooding, and increasing
levels of freshwater contamination. Small island nations like the Maldives and the Marshall Islands are at
risk of being completely submerged by rising seas in the future.

Receding snow pack: Mountain glaciers and snow cover have declined worldwide and are expected to
continue to shrink. Decreased snowfall will greatly affect freshwater availability for many people who
depend on the flow of rivers in the Himalayas, the Andes, the Rockies, and other mountain ranges for
freshwater supplies for agricultural, industrial, and domestic use.

Ocean warming and acidification: As atmospheric CO2 concentrations increase, the ocean absorbs CO2
from the air, making seawater increasingly acidic. Acidification, combined with warmer ocean
temperatures, is likely to be dangerous for a wide range of ocean species that have evolved to live within a
narrow temperature and pH ranges. Coral reefs, home to a quarter of the biological species in the ocean,
are especially at risk. Fisheries will likely be affected as well due to species migration.

The disappearance of Arctic sea ice: GHG-related climate change is causing temperatures to increase more
at high northern latitudes than in other parts of the world. This high-latitude warming of high northern
latitudes has resulted in a reduction in Arctic sea ice, especially in late summer and early fall when ice
extent reaches its seasonal minimum. In 2011–2020, the annual average Arctic sea ice area reached its
lowest level since at least 18502. Several recent independent estimates of Arctic sea ice indicate that there
has been a 40% loss of sea ice in the last 40 years alone3. Climate modelling studies indicate that this trend
will continue; according to some projections, late summer sea ice is expected to disappear entirely before
the end of the 21st century. Populations and wildlife that depend on sea ice for hunting and fishing are
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threatened by this change. The disappearance of Arctic sea ice could become a source of political conflict as
different countries compete for access and ownership of these newly opened shipping lanes.

Heavier storms and more intense droughts: The frequency and intensity of heavy precipitation events
have increased since the 1950s over the most land areas . In recent decades, storms over land have become
more intense and more frequent. Conversely, more intense droughts have been observed over wider areas
since the 1970s. The increase in drought intensity and duration has occurred mainly in the tropics and
subtropics, and these trends are expected to continue, especially in Northern Africa, the Sahel, the
Mediterranean and Central America. Climate projections also indicate that the trend of increasing intense
precipitation events is likely to continue, with potential dangers of flooding and agricultural damage.
According to a scientific rule of thumb linking crop ecology to climate change, “every 1-degree Celsius
increase in temperature above ideal levels reduces grain yields by 10 percent.”

1.3 How does human activity contribute to global climate

change?
Climate scientists are convinced that man-made GHG emissions are the primary cause of global climate
change. GHG concentrations are increasing due to fossil fuel combustion, industrial manufacturing,
agricultural practices, and other human activities.

Since 1750 atmospheric concentrations of CO2 have increased by 47%, CH4 by 156% and N2O by 23% .
GHG concentrations have reached annual averages of 410 parts per million (ppm) for carbon dioxide (CO2),
1866 parts per billion (ppb) for methane (CH4), and 332 ppb for nitrous oxide (N2O) in 2019 2. Reaching
this threshold represents a powerful and concerning symbol of the growing human influence on the Earth’s
climate.

Figure 2: Carbon Dioxide Concentration at Mauna Loa Observatory

The increasingly severe impacts of rapidly rising emissions on climate underscore the need to reduce
anthropogenic GHGs.
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1.3.1 Which economic sectors are most responsible for GHG emissions?

Globally, the primary sources of GHG emissions are electricity and heat (31%), agriculture (11%),
transportation (15%), forestry (6%) and manufacturing (12%). Energy production of all types accounts for
72 % of all emissions (Fig. 3) .

Figure 3: Global Man-Made Greenhouse Gas Emissions by Sector, 2013

Global emissions trends over time, by emission type and region are presented in Fig.4. Today, the United
States, China, and India account for nearly half of the world’s carbon pollution.

Figure 4: Global Carbon Dioxide Emissions by Region

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1.4 Projected GHG Emissions Growth. International Energy

Agency (IEA) scenarios.
Global GHG emissions are expected to increase in the future due to population growth, energy
consumption and economic development. A global average surface temperature increase of 2°C above the
pre-industrial average is considered safe and does not lead to dangerous climate change. In its Sixth
Assessment Report, the Intergovernmental Panel on Climate Change described a number of scenarios that
could unfold under different policy options .

The 450 Scenario sets out an energy pathway consistent with the goal of limiting the global increase in
temperature to 2°C by limiting the concentration of greenhouse gases in the atmosphere to around 450
parts per million of CO2. To be consistent with the required trajectory in the 450 Scenario, energy-related
CO2 emissions must begin to decline this decade, even though the level of energy demand is expected to
increase by 0.5% per year, on average: CO2 emissions peak by 2020 and then decline by 2.4% per year on
average until 2035.

Current Policies Scenario assumes no changes in policies from the mid-point of the year of publication
(previously called the Reference Scenario).

New Policies Scenario takes account of broad policy commitments and plans that have been announced by
countries, including national pledges to reduce greenhouse-gas emissions and plans to phase out
fossil-energy subsidies, even if the measures to implement these commitments have yet to be identified or
announced.

Deferred Investment Case analyses how global markets might evolve if investment in the upstream industry
in the Middle East and North African countries were to fall short of that required in the New Policies
Scenario over the next few years.

Low Nuclear Case examines the implications for global energy balances of a much smaller role of nuclear
power than that projected in any of the three scenarios presented in the WEO-2011.

Policies that have been implemented, or are now being pursued, suggest that the long-term average
temperature increase is more likely to be between 3.6 °C and 5.3 °C (compared with pre-industrial levels),
with most of the increase occurring this century. While global action is not yet sufficient to limit the global
temperature rise to 2 °C, this target still remains technically feasible, though extremely challenging. The
International Energy Agency publication WEO-2021 highlights four key measures that can help to close the
gap between today's pledges and a 1.5 °C trajectory over the next ten years and to underpin further
emissions reductions post-2030:

● A massive push for clean electrification that requires a doubling of solar PV and wind
deployment relative to the APS, a major expansion of other low-emissions generation,
including the use of nuclear power, a huge build-out of electricity infrastructure including
from hydropower and a rapid phase-out of coal.
● A focus on energy efficiency, together with measures to temper energy service demand
through materials efficiency and behavioural change.
● A broad drive to cut methane emissions from fossil fuel operations.
● A boost to clean energy innovation.
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CHAPTER 2: ECONOMICS OF CLIMATE

CHANGE
2.1 The Atmosphere as Global Public Good
Global public goods are goods that are non-rival and non-excludable. A non-rival good is a good whose
consumption by one individual does not prevent its consumption by others. A non-excludable good is one
whose one individual does not prevent its consumption by others. Examples of public goods include
moonlight, sunlight, the atmosphere, and climate change.

Climate change is a global public good because each country’s GHG emissions contribute to the overall
concentration in the atmosphere, which affects every individual on the planet. Any policy measure
implemented by one country to reduce carbon emissions inherently benefits all others, not just the country
attempting to reduce its carbon emissions. As a result, solving the problem of climate change is hampered
by the free rider problem, in which some countries actively seek the benefits of reducing emissions without
having to pay for it.

2.2 Costs of Climate Change

The economic impacts of climate change are wide-ranging. This review analysed several impacts of climate
change, such as access to water distribution, agricultural crop yields and food security, health and
malnutrition, heat stress and diseases. They include costs to the government and society, as well as costs to
businesses and the environment. An estimate of the economic risks and costs from global warming is a 10%
loss in the global gross domestic product (GDP) by 2050. The loss would be around 4% only if the Paris
Agreement targets on climate change are met. In a scenario in which temperatures rise by 3.2°C by 2050,
with no action to combat climate change, global GDP would be 18% smaller than in a world without
warming.

Both physical and transition risks impact the economy in the context of climate change. Physical risks are
related to property damage, disruption to trade and destruction and insurance premium increases that
result from severe weather events such as hurricanes, tornadoes, droughts, floods, and storms. Costs have
also been accrued for clean-up of leakage and site contamination, property devaluation caused by
conventional fossil fuel and some renewable energy generation, and displacement of people and
ecosystems by flooding from hydroelectric dams.

Transition risks are related to the higher cost of doing business in a low-carbon economy. Compliance with
climate change regulation also imposes unique financial burdens, at least initially, at the corporate, state,
and federal levels.

The model for calculating the real cost of natural disasters for an economy is continually developing as
extreme weather events become more frequent and more intense. The resulting losses to the production
and consumption chain and everything in it are long-term. In addition to infrastructural damages, many
growing economies are facing massive disruptions to their development. Unlike their better-developed
counterparts, the ripple effects of a disaster may extend and deepen over time.

In the absence of policy interventions, emitters of greenhouse gasses have no incentive to reduce their
emissions because they have no direct market impact. In fact, business-as-usual in goods manufacturing
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and power production has a greater economic benefit to emitters than paying the costs associated with
replacing or retrofitting carbon-intensive facilities, even after accounting for the benefits associated with
corporate social responsibility and public image. The introduction of fines for emitting greenhouse gasses
and financial gains through permit trading and environmental credit products provides a disincentive for
companies to emit.

2.2.1 How do we estimate this?

Because of the large number of underlying assumptions that must be taken into account when calculating
the cost of climate change, the figures vary significantly. According to the World Development Report, the
cost of climate change from 2010 to 2050 is expected to be between 30 to 100 billion dollars per year. 17
The World Bank estimates the figure to be higher, putting it in the range of 70 to 100 billion dollars per year.
U.S. budget proposal for 2022 to fight global climate is more than $36 billion, $14 billion more compared
with 2021. According to the insurance broker Aon, the total damage caused by weather disasters was $329
billion in 2021, the third-costliest year on record after 2017 ($519 billion) and 2005 ($351 billion).

In order to build the most accurate cost model for climate change, it is imperative to examine real estate
losses, hurricane damage, energy costs and water scarcity. Although there is overlap with each category, by
obtaining data from these four categories, we can obtain an estimation of the cost of climate change.

Hurricanes

While one of the biggest debates amongst the scientific community is the effect of global warming on
hurricanes, recent studies using computer models have shown that warmer waters mean that future
hurricanes will be stronger, increasing flooding and erosion damage in the Caribbean and along the Atlantic
coast. Hurricanes such as Katrina and Sandy have caused extensive damage, costing billions of dollars in
taxpayers’ money.

Real Estate Losses

Much of the real estate loss will come from flooding of low-lying properties near bodies of water. Even if the
property is above water, it will only take a hurricane or rainstorm to cause more damage by creating surges
of floodwater. In addition to the costs associated with damages, there are other further costs associated
with improving the resilience of real estate to the effects of climate change.

Energy Costs

Continued rising temperatures will lead to increased energy demand for air conditioning and refrigeration.
In addition, economic development in developing countries such as China and India will also contribute to
increased energy demand. This increased demand could outstrip supply and result in higher energy costs.

Water and Agriculture

In addition to causing massive hurricanes and melting glaciers, climate change is also causing droughts,
which can have a huge impact on agriculture and the global food supply. The southern and southwestern
U.S. are already experiencing reduced precipitation, which has not only created a water shortage problem
but also increased costs in cultivating crops and the price of food.

Conclusion

Looking at these four impacts of climate change along with historical data gives a fairly accurate picture of
the cost of climate change over time. According to studies conducted by the U.S. National Resource
Defense Council (NRDC), the “true cost of all aspects of global warming—including economic losses,
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non-economic damages, and increased risks of catastrophe—will reach 3.6 percent of U.S. GDP by 2100 if
business-as-usual emissions are allowed to continue.”

2.2.2 Discount Rate

The discount rate compares two different economic events that occurred at different times. It, therefore,
converts future economic costs into present value. By using the discount rate to consider today’s value,
climate change prevention can be considered an investment.

Unfortunately, it is difficult to arrive at an accurate discount rate due to imperfect information and the fact
that people value future consumption differently. It is important to note that a high discount rate will result
in too little investment, while a low discount rate will result in too much investment in climate change
mitigation.

2.3 Estimated Costs of Climate Change Regulation

Climate change regulations generate two major types of costs: compliance costs for the regulated
industries and administrative costs for the government agencies responsible for implementing regulations.
Regulated industries may also face fines for non-compliance. For instance, the largest existing
cap-and-trade market, the EU Emissions Trading Scheme (EU-ETS) has raised its penalty for
non-compliance. They will also have to bear the cost of purchasing additional allowances. Companies must
conduct cost-benefit analyses to determine whether changes in emissions practices are economically more
attractive than penalties for non-compliance. Even when compliance is the chosen option, decisions must
be made as to whether it is more financially advantageous to act immediately to reduce emissions through
retrofits and purchase allowances to offset the remaining emissions or to pay penalties in the short term
while accumulating the capital necessary to make major changes to production or build entirely new
facilities at a later date. This relates to what economists call the marginal abatement cost faced by a given
entity (see Figure 4).
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2.3.1 Stern Review: Projected Mitigation and Adaptation Costs

Figure 5: Illustrative Emissions Paths to Stabilize at 550ppm CO2e

Achieving these deep emissions reductions will come at a cost. The Stern Review estimates the annual costs
of stabilizing at 500-550ppm CO2e to be around 1% of GDP by 2050 – a level that is significant but
manageable. The costs of inaction could be 5% of global GDP each year, now and forever.

In order to combat climate change, greenhouse gasses must be mitigated and reduced from the current rate
of emissions. Emissions can be reduced in the following four ways:

1. Increase energy efficiency, which reduces emissions and saves money.

2. Decrease demand for energy-intensive goods and services.
3. Increase the use of energy from renewable sources.
4. Engage in carbon sequestration and preventing deforestation.
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CHAPTER 3: POLICY AND REGULATORY

OPTIONS FOR EMISSIONS REDUCTION
3.1 What is a cap-and-trade system?
Under a cap-and-trade system, a cap is placed on the amount of carbon that can be emitted into the
atmosphere. Once the cap is set, carbon allowances are distributed, and a trading market is established
between companies that wish to emit more and those that wish to make a profit by selling their remaining
carbon allowances.

In addition to incurring the cost of the purchase of additional allowances, companies need to conduct
cost-benefit analyses to determine whether changes in emissions practices are economically more
attractive than the penalties for non-compliance. This relates to what economists refer to as the marginal
cost of abatement faced by a given entity. An example of the marginal cost of abatement under a carbon tax
and a cap-and-trade system is shown Figure 6.

Assume that there are only two electrical companies, that company A’s emissions are historically 150,000
tons per year, while company B’s emissions are historically 50,000 tons per year. Assume that a federal
mandate has established that each company may only emit 100,000 tons of carbon dioxide per year from
electricity generation or face being shut down for non-compliance. Company A can either purchase unused
permits at US$100 per ton from company B to meet its cap or pay for physical changes in its operations that
would produce fewer emissions and ensure full compliance with the new regulations. Company A must
determine which option is more cost-effective.

The cost of upgrading Company A's current operations to make them cleaner may cost US$40 million in a
single payment and reduce emissions by 100,000 tons per year (which complies with current regulations)
while purchasing permits from company B will cost US$10M per year through a purchase agreement In the
4th year, the two costs will be approximately equal, but until then the cost of purchasing from company B is
less than the cost of retrofitting, and after the 4th year, the cost of retrofitting would have been less than the
cost of purchasing from company B. What is unknown to either company is whether the mandate will
decrease, remain unchanged or even increase.

Additionally, company A cannot be sure that company B will not increase the price of its excess permits
after the 4th year. Financial risks that regulated entities will face in their decision-making processes may
have benefits; however, an upfront payment is almost always required when moving away from the
operational status quo. Should company A choose to invest in upgrading its own operations, the structural
change may generate 10,000 excess permits that may be sold annually to a third company entering the
market with highly polluting practices. Often the company costs associated with regulatory compliance are
recovered through increases in operating efficiency, as in the example above, combined with the transfer of
costs to the consumer who buys the electricity, automobile, or paper products the company produces.
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Figure 6: Tax vs. Cap-and-Trade

From the graph above, it is clear that companies A and B have different marginal abatement cost curves.
The cost of reducing carbon emissions is much higher for firm A than for firm B. Therefore, the firm least
able to reduce its emissions due to a higher marginal abatement cost curve is firm A. Firm A, faced with a
relatively high marginal abatement cost, will have to pay up to $xA to achieve the optimal level of abatement
(as desired by the government), but firm B will be able to do so for only $xB. Since the marginal abatement
cost is higher for firm A than for firm B, both firms have the opportunity to trade. Firm B would therefore
sell permits to firm A for between $xB and $xA.

3.2 Carbon Tax

In addition to cap and trade, another method the government can implement to limit carbon emissions is a
carbon tax. While a carbon tax is a simple way for many companies to assess their current level of emission
reductions, if the tax is too low, companies may choose to pay the tax and forgo emissions, or if the tax is too
high, companies will not be profitable. If the government is able to set the carbon tax at an appropriate
level, it has the opportunity to reduce emissions without harming the overall economy. Although a carbon
tax does not determine the precise amount of carbon emissions, it does generate revenue for the
government, which can be invested in clean energy.
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Figure 7: The Marginal Cost of Abatement

In an unregulated economy, firms most interested in their profit margins will choose not to reduce carbon
units and avoid any additional costs (which are shown in the B + C + D areas underneath the MCA curve). In
the absence of reduction efforts, the firm's profit-maximizing level of emissions is the highest, i.e., at ‘e-max’,
the level at which the firm does not reduce its emissions and where the marginal cost of abatement is,
therefore, zero.

To achieve the desired reduction level (e*), the government sets a unit tax ‘T’ on carbon emissions, where
MB = MCA. It will be cheaper for firms to reduce carbon emissions only when the MCA curve is lower than
the tax. Graphically, as long as the overall tax bill, represented by areas A and B, is greater than the marginal
abatement cost bill, represented by area B, the firm will choose to reduce emissions because it is cheaper
than paying the carbon tax. The marginal cost (C + D) exceeds the overall tax (D). As a result, the firm will
opt to pay taxes beyond e* rather than reducing its emissions.

It will therefore pay a total tax given by the rectangle marked D and incur a total abatement cost given by
triangle B under the MCA curve to the left of e*. This cost is less than the tax that the firm would have paid if
it had not reduced emissions at all. The total cost (cost of abatement and emissions tx) to the firm is B + D
(considering it is only abating e* and paying a tax on emissions which are greater than e*), and the total
government revenue is D.

It is clear from this model that by implementing an appropriate carbon tax, the government is able to
achieve its goal of reducing emissions and increasing revenue. The amount of revenue represented by D
could be used to fund the REDD project and reward developing nations that choose to develop in a
sustainable manner.
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3.3 RPS (Renewable Portfolio Standards)

RPS is a policy mechanism that encourages energy producers to deliver a certain amount of energy that is
created from renewables like solar, wind, geothermal, hydropower, biomass, biofuels, wave and tidal.
Directive 2009/28/EC, revised in 2021, aims at reducing GHG emissions by at least 55% in 2030 by raising
the overall renewables target (proposed to be increased to 40%), but also with measures for transport or
heating and cooling.

The Commission is also aiming at more energy efficiency and circular energy that facilitates
renewable-based electrification and promotes the use of renewable and low-carbon fuels, including
hydrogen, in sectors such as transport. Within the United States, the designated renewable resources were
mostly derived from biomass, geothermal, wind, solar and hydroelectricity. Unlike feed-in tariffs, which
guarantee the purchase of renewable energy despite fluctuating costs, the RPS allows price competition
between different renewable energy sources. Proponents of RPS argue that the introduction of the market
will allow for maximum efficiency and increase the speed at which renewables can reach parity.

3.4 Feed-in tariffs

A feed-in tariff is a policy measure that encourages the adoption of renewable energy sources such as solar
and wind through long-term contracts that provide monetary payments for every kWh of electricity
produced. The amount of payment is largely dictated by the cost of producing the electricity from a
renewable source. Homeowners, small business owners, private investors or even large electric utility
companies can be paid to provide electricity from renewables to the grid. The price of a kWh of electricity
generated from wind power is generally lower than a kWh of electricity produced from solar, reflecting the
higher cost of generating electricity from the latter. Feed-in tariffs have become the preferred renewable
energy support mechanism in many markets as they provide greater certainty of remuneration for
investors aiding 64% of all wind and 87% of all photovoltaic solar deployment since 2010. China has
successfully implemented feed-in tariffs in its economies and has significantly increased its reliance on
renewable energy sources (RES) over traditional fossil fuels. In 2011 China initiated policies to promote the
adoption of solar photovoltaic (PV) using feed-in tariff policies. Since then, the PV domestic market has
expanded substantially.

3.5 Tax Credits

Tax credits are simply a deduction from the total amount of money an individual or company owes the
government. Tax credits are given on investments made in renewable energy such as solar, wind, biomass,
geothermal, hydro, wave and tidal energy. In the United States, a 26% tax credit is provided for solar
photovoltaic systems installed in 2020-2022 and 22% for systems installed in 2023 Investments made in
“geothermal, microturbines and combined heat and power” are eligible for similar tax credits. Tax credits
for investments made in renewables take effect when the installation is completed. It is important to note
that a company must have significant tax liabilities to qualify for tax credits.

3.6 Subsidies
Energy subsidies are policy mechanisms implemented by the government that reduces the cost of
purchasing energy by consumers and the cost of selling energy producers. The provision of subsidies
ensures the availability and affordability of energy sources, whether from traditional fossil fuels or
renewable energy sources. In the U.S., most current federal subsidies support the development of
renewable energies (biofuels, wind, and solar) and reduce energy consumption through energy efficiency. In
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2016, 45% of federal energy subsidies were associated with renewable energy, while 42% were associated
with energy end uses.

Subsidies to coal, oil and natural gas have been responsible for increased carbon emissions, while subsidies
to nuclear, biodiesel, solar and wind have reduced carbon emissions. While subsidies can be used to
implement policies that benefit a country as a whole, they typically come at a high cost. It should be noted
that “subsidies cost taxpayers money, distort energy markets, and give some companies and some forms of
energy an artificial advantage at the expense of others.” Estimates put U.S. direct subsidies to the fossil fuel
industry at roughly $20 billion per year, with 20 percent currently allocated to coal and 80 percent to
natural gas and crude oil. According to the International Monetary Fund, "fossil fuels account for 85
percent of all global subsidies," and reducing these subsidies "would have lowered global carbon emissions
by 28 percent and fossil fuel air pollution deaths by 46 percent, and increased government revenue by 3.8
percent of GDP." In part, lobbyists of wealthy oil companies lobby for subsidies that serve to improve their
profit margins.