Forecasting the costs of climate policy

About

Decision makers around the world debate the viability of new market-based climate policies, but our inability to accurately forecast their economic costs and consequences makes it challenging to determine which policies can deliver the best results. In some cases, program evaluation of similar past policies may be informative. However, when the policy of interest is relatively novel, policymakers often turn to economic models with poorly constrained primitive parameters. Previously existing methods to evaluate climate policies have been characterized by this dilemma, with different models producing a wide range of cost estimates.

We approached this problem by developing a new empirical method that allows us to forecast the cost of climate policies – specifically, cap-and-trade. Rather than relying on hard-to-test modeling assumptions, our approach leverages stock and prediction markets data to quantify the expected cost of proposed policies including the most prominent U.S. cap-and-trade policy considered to date, the Waxman-Markey Bill.

Approach

To more accurately estimate the cost of cap-and-trade policy, we developed a method for forecasting the marginal abatement cost (MAC) of climate policy using three features of the Waxman-Markey bill: a piece of federal legislation pertaining to the implementation of a cap-and-trade system in the US that failed passage in 2010. First, under standard theoretical assumptions, the MAC is revealed by the price of traded CO₂ emission permits. Second, we can estimate this permit price using a regression discontinuity design (RDD) comparing stock returns of firms on either side of the policy’s free permit cutoff rule. Third, because Waxman-Markey was never implemented, we can extend the RDD approach to incorporate prediction market prices, which normalize estimates by policy realization probabilities. 

Key Findings

We successfully developed a new method to estimate the cost of cap-and-trade policies, arriving at an estimate of MAC for the failed Waxman-Markey bill at $5 to $19 per ton CO₂e.