Climate change studies focus on the cost assessment of activities through their presentation on the markets. The GHG emission sources considered, on this basis, are predominantly those represented in official economic and sectoral statistics, and the prices used to value the resources are derived on a market basis. Such information, however, is incomplete for developing countries for which markets are incomplete, property rights are not well established, and a significant part of the exchange process belongs to the informal economic sector. This section discusses the implications of these specific features for climate change studies.

GHG emissions in the energy and agriculture sectors are greatly influenced by present subsidies. Subsidy removal in the energy sector, if supported by improvements in managerial efficiency, could reduce CO₂ emissions and other pollutants by up to 40% in developing countries with very low or even negative costs (Anderson, 1994; Halsnæs, 1996). It should be recognized that general macroeconomic policies, such as structural adjustment programmes, already include a number of subsidy removal policies.

Most major markets in developing countries are characterized by supply constraints, but the labour market is an exception for unskilled labour is frequently in excess supply. Examples of such supply constraints are seen in the financial sector, power production, and infrastructure development. This results from high transaction costs that originate from weak market linkages, limited information, inadequate institutional set-ups, and policy distortions. Such market imperfections make it difficult to establish reliable parameters such as price elasticity of demand.

In many developing countries and EITs, commodity prices, including those of energy resources, are regulated and are not market determined. The consequent market distortions are often not adequately captured by models. There is therefore a need to apply some price-correcting rules to reflect social costs.

Traditional cost–benefit analysis suggests the use of shadow prices to correct for market distortions (see Section 7.2.3.1). Such a procedure is in line with the approach of CGE models. In both these approaches mitigation policies and related costs are assessed in relation to an “optimal resource allocation case”, in which markets are in equilibrium and prices (and thereby cost) reflect resource scarcities. However, these conditions are far from those currently found in these countries, so studies should consider how a transformation to the optimal resource allocation case is likely to take place over a certain time frame. Developing countries are presently undergoing market-oriented economic reforms. However, the price distortions are only partially and gradually being remedied because of the high social costs associated with speedy reforms. The complexities in modelling this process cannot be underestimated, and it should therefore be recognized that only part of the transformation can be captured.

Integration of market transformation processes in cost studies should include an assessment of barrier removal policies. Such policies include efforts to strengthen the incentives for exchange (prices, capital markets, international capital, and donor assistance), to introduce new actors (institutional and human capacity efforts), and to reduce the risk of participation (legal framework, information, and general policy context of market regulation). Some of these policies can be reflected in cost studies, such as barrier removal policies that address market prices, capital markets, and technology transfers, while other areas like capacity building need to be addressed in a more qualitative way.

A number of important interrelationships and spillovers occur between the informal and formal sectors with regard to climate change mitigation policies. An example is the potential to introduce advanced production technologies in the energy and agriculture sectors that, on the one hand, use domestic resources (e.g., biomass) in a more sustainable way and, on the other, improve efficiency and create capacity in local companies and institutions. The impact of introducing policy instruments such as carbon taxes or energy subsidy removal also depends on potential substitutions to non-commercial wood fuels that might be unsustainable. Mitigation cost studies for developing countries should, as far as possible, include an assessment of energy consumption and biomass potential in the informal sector and apply assumptions about price relations and substitution elasticities between the formal and informal sectors. Similarly studies should consider the capacity of enterprises in both the formal and informal sectors to adapt and manage the advanced technologies that are suggested as cost-effective mitigation options in national programmes.

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