Pareto Efficiency of the 2ºC Paris Agreement Climate Target

Kika Mueller
8275378

ECO4136 – Research Seminar in Economics of the Environment

Submitted to Professor Leslie Shiell

March 29, 2019
Kika Mueller ECO4136 Research Paper

Introduction

In 2015, 195 nations and the European Union came together in Paris to agree on

significant steps to reduce the impacts of climate change. One of the outcomes of these meetings

was an international commitment to keep average global warming under 2ºC, and more

preferentially, under 1.5ºC. This paper will only address the 2ºC target, as there is a history

behind this figure and insufficient research on the 1.5ºC recommendation, but the two numbers

are seen to represent a similar degree of climate urgency. The Paris Agreement is not legally

binding, but it represents a pledge from the participating countries to implement climate change

policies in line with the above target. In this paper, “climate change policies” refers to policies

enacted in order to curtail greenhouse gas effects, specifically by reducing CO2 emissions, with

the aim to limit global temperature increases. These policies can be quite varied, including taxes

on pollution, pollution control regulation, and even post-production extraction of pollutants from

the atmosphere (sometimes called geoengineering). Importantly, however, they all incur a cost

now for the country or countries implementing and a global benefit in the future. The question of

whether the target is Pareto efficient is primarily one of fairness. A Pareto efficient solution is

one in which no party can become better off without another party being made worse off. In the

context of climate targets, we often look at differences between countries, where countries with

less developed economies may be made worse off in the short run if very stringent climate

policies are implemented. In this paper, the source and justification for the use of 2ºC as a target

will be examined. Arguments as to whether the Paris Agreement targets are efficient or not will

be explored. Finally, the case for redistribution will be considered, with the view to determine

the suitability of a Kaldor-Hicks solution to climate change.

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I. Validity of 2ºC as a target

The first mention of 2ºC as a reasonable upper bound for climate change was in a paper

by economist William Nordhaus in 1975 and was reflective of the top of a range of temperatures

observed over the past hundred thousand years. This figure is also associated with a CO 2

concentration of double pre-industrial levels – this is not any significant benchmark, but merely

an intuitive marker. Since then, 2ºC has become shorthand for a significant global warming

threshold: it is a steady-state temperature that is tolerable, and likely attainable, but beyond

which catastrophic damage could be expected (Jaeger & Jaeger, 2010). Jaeger and Jaeger suggest

that the 2ºC target has three meanings or uses. The “catastrophe view” sees 2ºC of warming as

“an upper limit beyond which the risks of grave damage to ecosystems, and of nonlinear

responses, are expected to increase rapidly” (Jaeger & Jaeger, 2010, p. 18). This view draws on

research about “tipping points” for earth’s ecosystems and biodiversity, wherein damage caused

becomes exponential after about 2ºC of warming. It should be noted that some environments are

more or less sensitive to temperature increases: coral reefs, for example, will likely experience a

tipping point around 1ºC increase, and the thermohaline circulation will not experience shutdown

until 3ºC of warming (Rive et al., 2007, p. 377, and Tol, 2007, p. 429). Jaeger and Jaeger refer to

the “millions at risk” study which shows the human risks attributable to climate change (e.g.

from water shortages) also increase nonlinearly above around 1.5ºC-2ºC (2010, p. 19). In short,

the “catastrophe view” serves to highlight the potential severity of global damages if the 2ºC

threshold is exceeded.

The second perspective on the target is the “cost-benefit view”. In essence, this represents

the point at which the marginal benefit curve and marginal cost curve for climate change policies

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intersect. This equilibrium depends on the model quite significantly and will be examined in

more detail in the next section.

Finally, Jaeger and Jaeger posit that the most important role for the 2ºC target is as a

focal point. Other climate targets do exist, such as those proposed by the United Nations

Advisory Group on Greenhouse Gases:

 20–50 cm sea level rise above 1990 level

 Sea level rise of 2–5 cm/decade

 0.1–0.2°C/decade rate of temperature increase

but the complexity of these indicators means that they are more difficult to grasp and politicize

(Rive et al, 2007, and Jaeger & Jaeger, 2010). The 2ºC target allows for a straightforward

collective narrative that can motivate and structure practical steps for governments and other

actors. These three views of 2ºC don’t necessarily point to it being the only viable target, but they

illustrate some ways in which it can be a useful policy stimulator.

How credible are these results? Weitzman (2012) and Nordhaus (2012) both state that it

is highly unlikely that the risks of climate change have been overstated. Weitzman looks at the

possibility that the probability distribution function (PDF) for damages from global warming is

“fat-tailed”, in other words, that there are higher probabilities at the extremely high and

extremely low ends, compared to a normal distribution. In his model, very little depends on

values below the median. Given a fat-tailed PDF, the increased likelihood of extreme damage is

something that must be considered when choosing a climate change policy. Nordhaus concluded

that while environmental damages likely follow this type of distribution, there is no evidence of

upper-end tail dominance (Nordhaus, 2012, p. 199). Stern (2013) also cautions that climate

effects could be even more severe than currently anticipated. He notes that wars and natural

disasters could have a compounding effect in the future, when resources are more scarce than

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they are now (Stern, 2013, p. 845). Based on these arguments, we can expect that the risks stated

as justification for the “catastrophe view” of the 2ºC target are very unlikely to be exaggerated,

and are quite possibly an underrepresentation of the true risk.

II. Arguments for 2ºC being a Pareto efficient target

The argument that the climate target agreed upon in Paris is Pareto efficient is based on a

collective or global perspective. Overall, the benefits of limiting global warming will likely

outweigh the costs of the policies to do so (Tol, 2007, p. 425). For individual countries, the

effects will mostly be positive (compared to the current status quo), indicating that using the 2ºC

target to steer climate change policy would be Pareto efficient, but there could be some variation

in the benefits between the participating countries.

Will there be any benefits from the Paris Agreement objective? Yes, but they are tricky to

quantify because the potential damages avoided are difficult to predict. We do know, however,

certain sectors where benefits will be clear. For example, in the fishing sector, achieving the

agreement targets is projected to increase global fish catches by 7.3% per year – this comes to a

financial net benefit of $42 billion annually (Sumaila et al., 2019, p. 2). As nearly all of these

benefits appears on the individual/household scale, this is particularly interesting, as this could

alleviate some of the household burden of having to pay an additional (hypothetical) carbon tax.

Other benefits from achieving the Paris climate targets are related to avoided economic disasters,

as discussed by Nordhaus (2012). These include natural disasters and social/political conflicts

which arise due to resource scarcity from climate change, like the Syrian war, which was partly

caused by drought-related disputes. These disasters have real economic consequences, so their

avoidance would be a benefit of achieving the 2ºC climate target. Finally, Rive et al. (2007) find

that climate targets can provide help influence “positive policy” which focuses on institution-

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building and R&D in climate-friendly countries, leading to longer-lived climate (and non-

climate) benefits (p. 387).

According to the catastrophe view presented by Jaeger and Jaeger, this target is efficient

because it is necessary. Without

communication of the serious

damages that can occur beyond the

environment-specific tipping points,

the costs from global warming will

go underestimated, and the world

will suffer. This is due to a lack of

Figure 1 - Optimal climate change, using costs and benefits of
perfect information, where the full reduction. Jaeger & Jaeger, 2010, S19.

costs of climate damages are

unknown and therefore cannot correctly inform policy choices.

In their cost-benefit analysis view, Jaeger and Jaeger draw on the concept of an “optimal”

amount of climate change. This is based on marginal costs to mitigate versus marginal benefits

of mitigation. In the Nordhaus model they use, marginal costs and benefits are around $1 trillion

per 0.5ºC of reduced global warming near the focal point (see Figure 1, above). At the point

where marginal costs and marginal benefits intersect, it is implied that measures to achieve this

point of warming are inherently efficient, so long as they are “good” policies (i.e. focused on

reducing emissions, and not corrupt) (Jaeger & Jaeger, 2010, pp. 19-20). As this point is near 2ºC

of warming, this target is considered to be an efficient one. The authors also review Stern’s

models, which assume that a limit of 3ºC will cost about 1% of GDP per year to implement

climate change policies, and the damage avoided from climate change (and so the benefit of

these policies) will be around 15% of GDP per year. While these assumptions seem somewhat
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incredulous, the important takeaway is that they also show that keeping temperatures low (in this

case anywhere below 5ºC of warming) has a net benefit for the planet, and is therefore efficient

(Jaeger & Jaeger, 2010, pp. 19-20). Notably, Stern’s models use a discount rate of zero

(indicating no preference for present consumption over future consumption), which is

controversial. The question of Pareto efficiency (where no actor is hurt through these moves) is

not addressed by the authors. However, these equations imply that if every country took part in

climate change policies, they would receive a net benefit, and thus the policy would be Pareto

efficient. Nevertheless, this is not a rational assumption to make, as countries with lower

incomes may not have the capacity to implement these costlier climate change policies without

crippling their economies in the short term.

In fact, Jaeger and Jaeger go on to address this problem – nations, they state, could not be

expected to seriously curb emissions if they fear a significant impact to their economy, and a

coalition of nations likewise cannot be expected to take that risk under the assumption that every

other nation will do the same. In reality, however, the multiple-equilibria structure of economies

means that some countries will in fact successfully reduce emissions without the cooperation of

other countries. They cite one nation or several taking a “leadership role” as something that

contributes to the greater uptake of climate change policies. This has occurred in other policy

contexts, such as the independent abolition of slavery, which made states less competitive in the

short run, but eventually catalyzed total abolition. (Jaeger & Jaeger, 2010, p. 24). These findings,

then, point towards the 2ºC climate target as efficient in the long run, although there may be

short-run negative consequences, especially for countries with weaker economies. The use of

international transfers or border tax adjustments, both of which will be discussed later in this

paper, may then be justified as supplementary measures in order to achieve Pareto efficiency.

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As discussed above, it is more likely that actual climate damages have been

underestimated by our models. For this reason, the presence of a low (2ºC) temperature target is

important to be able to keep these damages in check. Weitzman (2012) states that “the primary

purpose of keeping down GHGs is to prevent large damages from extreme warmings in the ‘bad’

tail, which is a much more powerful incentive to target low GHG levels than trying to keep down

the relatively modest damages from median temperatures” (p. 241). Nordhaus (2012) also

cautions that strong tail events could cause serious climate damage, but concludes that strong tail

dominance has so far not been discovered for global warming (p. 199).

III. Arguments against 2ºC being a Pareto efficient target

The most significant constraint to any kind of significant climate policy is the allure of the

“wait and see” factor – maybe climate change won’t be as bad as we expected, maybe we will

end up on the “lucky” side of the probability distribution. This is an issue because there are

significant costs to climate change policy, and an overestimation of the amount of policy

necessary could result in significantly increased costs compared to what is needed. If the climate

factors we are discussing were strongly reversible, Weitzman says, an optimal climate change

policy would involve waiting to learn how far along the “bad tail” of the distribution the planet

ends up, followed by midcourse corrections if it seems we are headed for catastrophe (Weitzman,

2012, 227). Lemoine and Rudik (2017) wrote about the potential benefits of waiting to

implement climate change policies. Their argument focuses on the cost-effectiveness of

implementing less rigorous climate change policies in the near future than prescribed by the Paris

Agreement, which would lead to a temporary overshoot of the steady-state CO2 level before

stabilizing. This hypothesis is based on two assumptions:

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1) Instead of spending money on reducing emissions today, the policymaker would invest

those savings and compensate by undertaking additional emission reductions t years in the

future.

2) Atmospheric CO2 decays at rate δ over those t years, and the decayed CO2 has no

negative impact on global temperatures.

By these actions, the policymaker will have earned interest at rate r over t years, and has also

seen the required carbon mitigations decline at the rate δ. In order for the policymaker to be

indifferent to this deviation,

the marginal cost of emission

reductions must grow at rate

r + δ (Lemoine & Rudik,

2017, 2948). They therefore

find that the least-cost option

of dealing with climate

change as set out in the Paris

Agreement is to invest now,

Figure 2 - Four views of the least-cost path vs Hotelling (conventional) path, projected wait, and spend on climate
until the year 2200. Lemoine & Rudik, 2017, 2955.
change policy later. This

would lead to some overshoot of both the temperature cap and the CO 2 cap, as shown above

(panels B and C). This least-cost path relies on the inertia of CO 2 decay and of carbon pricing

schemes to bring carbon levels down with minimal effort. Under Lemoine and Rudik’s scenario,

the Paris agreement target is not efficient, because it is not least-cost.

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However, as Weitzman (2012) explains, global warming actually has very limited

reversibility potential. This is due to factors such as the saturation of carbon sinks, albedo

changes from ice sheet melt, the possibility of methane stocks being released from permafrost,

and many other physical and biological processes that are “extremely slow to respond to attempts

at reversal” (Weitzman, 2012, p. 227). One illustration provided states that even if all

anthropogenic emissions ceased immediately, atmospheric CO2 would still increase by around

70% of the current trajectory. These figures seem to disprove Lemoine and Rudik’s predictions,

which do not discuss how realistic their reversibility assumption is.

As demonstrated above, the potential benefits of

implementing climate change policies are uncertain

and may be discounted as they occur in the relatively

distant future (Nordhaus, 2014, p. 287). The costs of

these policies, however, are incurred now, and so are

very visible. This means that the costs tend to be

emphasized compared to the benefits, despite this not

being a rational view. Rive et al. (2007) illustrate the

Figure 3 - Causal chain of climate change from emissions to
damages. Rive et al, 2007, 375. frustrating uncertainty of predicting climate change

damages in Figure 3. They discuss whether a long-

term vision of the climate can positively shape near-term action, and find that due to these

uncertainties, a target may only have partial influence on any near-term mitigation strategy (Rive

et al., 2007, p. 387). Because only part of the effects from a climate change policy is realized,

Rive et al. argue that temperature targets such as the 2ºC target are inefficient.

One of the issues of approaching a large goal like the 2ºC target is that it is difficult to

mobilize multiple countries into acting together – essentially, it is a prisoner’s dilemma with
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many actors. In the case of climate change policies, countries can be unwilling to forgo current

GDP for future potential benefits, and this is a major challenge that is currently playing out.

However, as discussed in section II, one country taking a leadership role can have a strong

impact on allowing a multiple-equilibria solution (Jaeger & Jaeger, 2010, p. 24). Nevertheless,

before climate change policies gain broader acceptance and most countries sign on, the first

movers may lose out, rendering this action Pareto inefficient.

IV. Adapting 2ºC to be an efficient target

While the 2ºC Paris target may not be Pareto efficient, some economists believe that it

could be made efficient under a cooperative international structure. The Kaldor-Hicks criterion is

an extension of the Pareto criterion wherein those who are made better off can compensate those

who are made worse off. In the case of the Paris climate targets and the necessary policies that

will be enacted to achieve them, some actors and countries will be winners, earning net benefits,

and some will be losers, incurring net costs. For these policies to be Kaldor-Hicks improving,

their benefits must necessarily outweigh their costs. The winners can then compensate the losers,

leading to a state where no actors are worse off than before the policy interventions. International

adjustments can take the form of a direct transfer, or through border tax adjustments (BTA), both

of which are explored as methods by which to make 2ºC an efficient target.

Rübbelke (2011) provides the reasoning for why developing countries might receive

compensation, for three connected reasons. First, developing nations will be disproportionately

affected by environmental damages, due to their geographical location and comparative lack of

infrastructure. Second, industrialized nations have disproportionately contributed to the

accumulation of greenhouse gases in the atmosphere, thereby causing more of the climate

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change. Third, industrialized nations have the most capacity to invest in climate change policies,

due to their larger economies (Rübbelke, 2011, pp. 1471-1472).

Rübbelke further argues that because mitigation activities tend to be less costly in

developing countries, and climate protection is a global public good, industrialized countries

should fund mitigation activities within developing countries (p. 1478). The explanation for these

activities being less expensive is that the cheapest policies will have already been undertaken in

industrialized countries. This would be a Pareto efficient solution if industrialized countries fund

the mitigation activities directly, via multinational entities, and could be a Kaldor-Hicks efficient

solution if the developing country funds the mitigation themselves, and are compensated by the

industrialized country for their net costs.

The 2012 International Monetary Fund (IMF) paper by Keen and Kotsogiannis looks at

whether border tax adjustments (BTA) should be part of a global response to climate change.

BTA are tariff structures that reflect differences in national carbon prices. This adjustment can

take the very simple form of setting a charge on imports representing the carbon tax ‘not paid’

abroad on imports and remitting tax on exports in a similar fashion. They discuss adjustments

between

a) a country with constrained carbon taxation where the carbon tax is arbitrarily set at a

level that does not accurately address the externality of pollution that is trying to be

addressed. For example, this could be a country where there are political constraints to

setting carbon taxation at the Pigouvian (corrective) level.

b) a country with unconstrained carbon taxation where the carbon tax is freely set, initially

at the internal first-best Pigouvian level, and can also be freely adjusted later on.

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The authors propose that BTA could offset carbon leakage by reducing the producer price of

“dirty” goods in the constrained country, to discourage their production there, and setting a tariff

that offsets the incentive for the unconstrained country to import more of the dirty goods (Keen

& Kotsogiannis, 2012, p. 12). This solution allows for countries with different levels of carbon

pricing to still be able to trade, but eliminates the negative pollution effect of carbon leakage.

Tariffs can also play a role in cross-country distributional equity. Limitations of the BTA

approach are that it may not be implementable due to its scale, and that it is not necessarily

viable under World Trade Organization regulations (Keen & Kotsogiannis, 2012, pp. 4-5).

Conclusion
The 2ºC target from the Paris Agreement finds its origins in economics papers from the

1970s when it simply represented a limit of climate observances through history. Since then, this

figure has become a focal point for the very complex issue of climate change. It communicates in

a simple manner the significant ecological risk that is associated with elevated levels of CO 2

concentration, and can be used to guide long-term policy toward efficient solutions.

There are economists on either side of the argument as to whether the target is Pareto

efficient or not. Those who believe it is, look at the cost-benefit analysis of the optimal amount

of climate change and find that the avoided future damages outweigh the current costs of

implementing policies. Due to the long-term nature of this problem, these calculations are highly

sensitive to discount rates. Other economists have cautioned against underestimation of risk

using narrow models and in fat-tailed distribution scenarios. Economists who believe that the

agreement is not Pareto efficient primarily are concerned with the uncertainty of the benefits of

mitigation policies. However, these economists who advocate a “wait and see” approach make

assumptions about the reversibility of climate change that are not adequately substantiated by

scientific research.
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Finally, this paper addressed some ways in which the current 2ºC climate objective could

be manipulated to ensure either a straight Pareto-efficient solution, or otherwise a Kaldor-Hicks

solution where, after compensation, no party is worse off than their initial allocation. Using these

methods, observing the potential damages that would occur if the target is ignored, and looking

at the many reasons for which the target was chosen, it is clear that all appropriate efforts should

be made to limit temperature increases to 2ºC.

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