The Economics of Climate Policy 
                            Charles D. Kolstad and Michael Toman 
                            June 2001 • Discussion Paper 00–40REV 
                                 
                                   
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                    The Economics of Climate Policy 
                     Charles D. Kolstad and Michael Toman 
        Abstract 
           Economics has played an increasingly important role in shaping policy, in the United States and 
        elsewhere. This paper reviews some of the dimensions of the economic approach to analyzing, 
        understanding, and developing solutions to the problem of climate change. We then turn to the issue of 
        designing regulatory instruments to control the problem. The paper concludes with a discussion of the 
        political economy of greenhouse gas control in an international context. 
         
        Key Words:   climate change, climate policy design, integrated assessment, environmental 
               policy coordination 
        JEL Classification Numbers:  Q28, Q48, D61, D62, D63 
            
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                     Contents 
                      
                     I.   Introduction....................................................................................................................... 1 
                     II.  Overview of the Climate Change Issue........................................................................... 1 
                          A.   Nature of the Challenge............................................................................................... 2 
                          B. The Potential Physical and Socioeconomic Consequences of Climate Change............ 4 
                          C.    Mitigation and Adaptation.......................................................................................... 6 
                               1. Emissions Control......................................................................................................6 
                               2. Sequestration..............................................................................................................7 
                               3. Geoengineering..........................................................................................................8 
                               4. Adaptation..................................................................................................................9 
                          D.    International Policy Toward Climate Change........................................................... 11 
                     III. Benefits and Costs of Greenhouse Gas Control........................................................... 14 
                          A. Costs of Greenhouse Gas Control................................................................................ 14 
                               1. A Cost Taxonomy....................................................................................................15 
                               2. Bottom-up vs. Top-Down........................................................................................17 
                               3.  Costs are Relative ...................................................................................................18 
                               4.  Estimates of Control Costs......................................................................................19 
                          B. Benefits of Greenhouse Gas Control............................................................................ 21 
                               1.  Scope of Benefits....................................................................................................21 
                               2.  Quantitative Estimates of Benefits..........................................................................22 
                     IV.  Fundamental Economics of the Climate Issue............................................................ 25 
                          A.   Simple Models of Greenhouse Gas Emissions and Climate Change ........................ 26 
                          B. Uncertainty, Irreversibility, Learning, and Insurance.................................................. 31 
                          C. What Integrated Assessment Models Say.................................................................... 33 
                          D. The Optimal Timing of Emissions Control.................................................................. 36 
                          E. Philosophical Justifications for Climate Policy............................................................ 38 
                     V.  Designing Climate Policy Instruments.......................................................................... 41 
                          A. Designing Incentive-Based GHG Abatement Policy: Fundamentals.......................... 43 
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                      B. Price Versus Quantity Policies: “Hybrids” .................................................................. 45 
                      C. Intertemporal Flexibility and GHG Policy Design ...................................................... 46 
                      D. International GHG Policy Design................................................................................ 48 
                      E. Emission Trading in the Kyoto Protocol...................................................................... 50 
                      F. Nonincentive-Based Policies........................................................................................ 52 
                  VI.     Economics and International Climate Agreements............................................... 53 
                      A. The Paradox of International Agreements................................................................... 54 
                      B. Designing Climate Agreements to Draw in Developing Nations................................ 56 
                  VI. Conclusions...................................................................................................................... 59 
                  References.............................................................................................................................. 62 
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