Most models are not able to incorporate the benefits of preventing climate change (or of the costs of doing nothing). Instead, modellers have only considered the economic impact of meeting some emission standard, which implicitly assumes (in the base situation) that climate change would have no economic impacts. Nevertheless, the potential costs caused by climate change are likely to be huge (even though some favourable effects are also expected) regarding: loss of human well-being, damage to property including agriculture and forestry, ecosystem loss, and risk of disaster, see Nordhaus (1991), Cline (1992, Chapter 3), Fankhauser (1995), Fankhauser and Tol (1995). This situation has been caused to some extent by two factors, the difficulties of economists in valuing environmental impacts, and the scientific uncertainty of predicting the physical effects of climate change13.
Carbon taxes will generate significant tax revenues. The effects of these revenues
in the economy will depend on how this money is recycled into the economy (in
practical terms, some mechanism for recycling is always needed in order to avoid
a general deflationary impact). If it is assumed that revenues will not be fully
recycled, the models tend to find that any carbon tax will reduce GDP. Usually,
modellers have tried to separate the economic impacts arising from this environmental
policy from those arising from a tax cut, assuming that revenues will be returned
in the form of lump-sum rebates (an unrealistic assumption). The alternative
is to assume that revenues collected from the carbon tax are used in correcting
economic distortions in the economy, e.g., taxation of employment, which would
benefit society not only by correcting the externality but also by reducing
the costs of the distorting taxes (the so-called double dividend).
Obviously, if the benefits from reducing existing taxes on labour are incorporated
into the modelling, the projected economic impacts can be substantially more
optimistic than if a lump-sum revenue recycling is assumed, although the size
of the effect depends on model specification14.
Environmental policy to reduce climate change will be economically efficient when the incremental cost of emission reductions is equal in all complying countries. A way of achieving cost savings in the abatement policy is to allow emission sources to contract with each other to meet required emission reductions. In this sense, flexible instruments such as international emissions trading and JI are more efficient than a situation in which each country has to achieve its own emission reduction15. Usually, international emissions trading is modelled as if all countries set the same carbon tax rate, so that cost-effective emission reductions are advantageous to undertake in whatever country they arise. Hence, if models consider economic instruments for environmental regulation, the overall cost of controlling emissions should be lower as a consequence of cost savings in the control produced by these instruments16.
It is important to point out that this kind of modelling implicitly assumes
an ideal scenario. However, in practice some problems arise with the basic theory,
involving the operation and design of the market. Some important considerations
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