7.3 System Boundaries: Project, Sector, and Macro

Researchers make a distinction between project, sector, and economywide analyses. Project level analysis considers a "stand-alone" investment assumed to have insignificant secondary impacts on markets. Methods used for this level include CBA, CEA, and life-cycle analysis. Sector level analysis examines sectoral policies in a "partial-equilibrium" context in which all other variables are assumed to be exogenous. Economy-wide analysis explores how policies affect all sectors and markets, using various macroeconomic and general equilibrium models. A trade-off exists between the level of detail in the assessment and complexity of the system considered. This section presents some of the key assumptions made in cost analysis.

A combination of different modelling approaches is required for an effective assessment of climate change mitigation options. For example, detailed project assessment has been combined with a more general analysis of sectoral impacts, and macroeconomic carbon tax studies have been combined with the sectoral modelling of larger technology investment programmes.

7.3.1 Baselines

The baseline case, which by definition gives the emissions of GHGs in the absence of the climate change interventions being considered, is critical to the assessment of the costs of climate change mitigation. This is because the definition of the baseline scenario determines the potential for future GHG emissions reduction, as well as the costs of implementing these reduction policies. The baseline scenario also has a number of important implicit assumptions about future economic policies at the macroeconomic and sectoral levels, including sectoral structure, resource intensity, prices, and thereby technology choice.

7.3.2 Consideration of No Regrets Options

No regrets options are by definition actions to reduce GHG emissions that have negative net costs. Net costs are negative because these options generate direct or indirect benefits, such as those resulting from reductions in market failures, double dividends through revenue recycling and ancillary benefits, large enough to offset the costs of implementing the options. The no regrets issue reflects specific assumptions about the working and the efficiency of the economy, especially the existence and stability of a social welfare function, based on a social cost concept:

• Reduction of existing market or institutional failures and other barriers that impede adoption of cost-effective emission reduction measures can lower private costs compared to current practice. This can also reduce private costs overall.
• A double dividend related to recycling of the revenue of carbon taxes in such a way that it offsets distortionary taxes.
• Ancillary benefits and costs (or ancillary impacts), which can be synergies or trade-offs in cases in which the reduction of GHG emissions has joint impacts on other environmental policies (i.e., relating to local air pollution, urban congestion, or land and natural resource degradation).

Market Imperfections
The existence of a no regrets potential implies that market and institutions do not behave perfectly, because of market imperfections such as lack of information, distorted price signals, lack of competition, and/or institutional failures related to inadequate regulation, inadequate delineation of property rights, distortion-inducing fiscal systems, and limited financial markets. Reduction of market imperfections suggests it is possible to identify and implement policies that can correct these market and institutional failures without incurring costs larger than the benefits gained.

Double Dividend
The potential for a double dividend arising from climate mitigation policies was extensively studied during the 1990s. In addition to the primary aim of improving the environment (the first dividend), such policies, if conducted through revenue-raising instruments such as carbon taxes or auctioned emission permits, yield a second dividend, which can be set against the gross costs of these policies. All domestic GHG policies have an indirect economic cost from the interactions of the policy instruments with the fiscal system, but in the case of revenue-raising policies this cost is partly offset (or more than offset) if, for example, the revenue is used to reduce existing distortionary taxes. Whether these revenue-raising policies can reduce distortions in practice depends on whether revenues can be "recycled" to tax reduction.

Ancillary Benefits and Costs (Ancillary Impacts)
The definition of ancillary impacts is given above. As noted there, these can be positive as well as negative. It is important to recognize that gross and net mitigation costs cannot be established as a simple summation of positive and negative impacts, because the latter are interlinked in a very complex way. Climate change mitigation costs (gross and well as net costs) are only valid in relation to a comprehensive specific scenario and policy assumption structure.

The existence of no regrets potentials is a necessary, but not a sufficient, condition for the potential implementation of these options. The actual implementation also requires the development of a policy strategy that is complex as comprehensive enough to address these market and institutional failures and barriers.

7.3.3 Flexibility

For a wide variety of options, the costs of mitigation depend on what regulatory framework is adopted by national governments to reduce GHGs. In general, the more flexibility the framework allows, the lower the costs of achieving a given reduction. More flexibility and more trading partners can reduce costs. The opposite is expected with inflexible rules and few trading partners. Flexibility can be measured as the ability to reduce carbon emissions at the lowest cost, either domestically or internationally.

7.3.4 Development, Equity, and Sustainability Issues

Climate change mitigation policies implemented at a national level will, in most cases, have implications for short-term economic and social development, local environmental quality, and intra-generational equity. Mitigation cost assessments that follow this line can address these impacts on the basis of a decision-making framework that includes a number of side-impacts to the GHG emissions reduction policy objective. The goal of such an assessment is to inform decision makers about how different policy objectives can be met efficiently, given priorities of equity and other policy constraints (natural resources, environmental objectives). A number of international studies have applied such a broad decision-making framework to the assessment of development implications of CDM projects.

There are a number of key linkages between mitigation costing issues and broader development impacts of the policies, including macroeconomic impacts, employment creation, inflation, the marginal costs of public funds, capital availability, spillovers, and trade.

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