Modeling the Cost of Climate Policy: Distinguishing Between Alternative Cost Definitions and Long-Run Cost Dynamics

Interest groups and experts debate the cost of greenhouse gas (GHG) reduction, and policy-makers do not know whom to believe. The confusion stems from differing definitions of costs and divergent assumptions about key uncertainties, especially the role of policy in influencing the long-run evolution of technologies and consumer preferences. Analysis could be more helpful to policy-makers by combining technological explicitness with behavioral realism in hybrid models. With such a model, we demonstrate how GHG reduction cost estimates vary depending on whether the analyst focuses just on the financial costs of technologies or combines this with other relevant components of consumer and business preferences, such as option value and consumers’ surplus. We also show how this type of model can allow policy-makers to explore the uncertain relationship between policies and the evolution of technologies and preferences, which are critical factors in the long-run cost dynamics of GHG emission reduction. We explore these generic methodological issues with a case study of GHG reduction costs in Canada.