Incentives, risk and decision-making in mitigating climate change

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Responding to climate change is made complex by several sources of uncertainty but greater certainty may come at the expense of policy flexibility, says William Blyth in a June 2007 paper for Chatham House.

The author observes how investment decisions are made in the power sector and how they are affected by the different layers of regulatory risks and uncertainties. While companies need policy certainty to encourage investment, decision-makers tend to prefer flexibility in carbon abatements policies. This trend is due to uncertainties on scientific evidence and international co-operation and lead to a complex and even dysfunctional system. 

The three levels of the decisions making process – global climate policy decisions, national climate and energy policy decisions, and company-level investment decisions – are affected by different uncertainties, risks and incentives, according to the author. Each country’s commitment to action depends on other countries’ commitments and company investment will depend on expectations about coming national regulation while these regulations depend on companies’ willingness to act. 

The author illustrates the structure of this complex decision-making process through the example of the EU Emission Trading Scheme (ETS) which is set over a five years period. Companies are confronted with a too-short planning period to make investment decisions in the power sector, notes the paper. When the EU announced the 20% reduction target for 2020, it suggested that it would make further reduction to 30% if other countries follow this commitment. As a result, conditional offer like this may accelerate action at international level while being unworkable internally. 

However, the transition to a sustainable energy system will require that decisions be taken at global, national and company levels in a co-ordinated way, states the paper. The author therefore recommends further studies to be conducted to help policymakers understand the allocation of risks between the actors involved, design more effective policies and avoid simply transferring private-sector economic risk into more general economic risks. 

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