IPCC Fourth Assessment Report: Climate Change 2007
Climate Change 2007: Working Group III: Mitigation of Climate Change

2.4 Cost and benefit concepts, including private and social cost perspectives and relationships to other decision-making frameworks

2.4.1 Definitions

Mitigation costs can be measured at project, technology, sector, and macro-economic levels, and various geographical boundaries can be applied to the costing studies (see a definition of geographical boundaries in Section 2.8).

The project, technology, sector, and macro-economic levels can be defined as follows:

  • Project: A project-level analysis considers a ‘stand-alone’ activity that is assumed not to have significant indirect economic impacts on markets and prices (both demand and supply) beyond the activity itself. The activity can be the implementation of specific technical facilities, infrastructure, demand-side regulations, information efforts, technical standards, etc. Methodological frameworks to assess the project-level impacts include cost-benefit analysis, cost-effectiveness analysis, and lifecycle analysis.
  • Technology: A technology-level analysis considers a specific GHG mitigation technology, usually with several applications in different projects and sectors. The literature on technologies covers their technical characteristics, especially evidence on learning curves as the technology diffuses and matures. The technology analysis can use analytical approaches that are similar to project-level analysis.
  • Sector: Sector-level analysis considers sectoral policies in a ‘partial-equilibrium’ context, for which other sectors and macro-economic variables are assumed to be given. The policies can include economic instruments related to prices, taxes, trade, and financing, specific large-scale investment projects, and demand-side regulation efforts. Methodological frameworks for sectoral assessments include various partial equilibrium models and technical simulation models for the energy sector, agriculture, forestry, and the transportation sector.
  • Macro-economic: A macro-economic analysis considers the impacts of policies across all sectors and markets. The policies include all sorts of economic policies, such as taxes, subsidies, monetary policies, specific investment programmes, and technology and innovation policies. Methodological frameworks include various macro-economic models, such as general equilibrium models, Keynesian econometric models, and Integrated Assessment Models (IAMs), among others.

In comparing project, technology, sector, and macro-economic cost estimates it is important to bear in mind that cost estimates based on applying taxes in a macro-economic model are not comparable with abatement costs calculated at other assessment levels. This, for example, is because a carbon tax will apply to all GHG emissions, while abatement costs at project, technology or sector level will only reflect the costs of emission reductions.

Private and social costs: Costs can be measured from a private as well as from a social perspective. Individual decision-makers (including both private companies and households) are influenced by various cost elements, such as the costs of input to a production process, labour and land costs, financial interest rates, equipment costs, fuel costs, consumer prices etc., which are key private cost components. However, the activities of individuals may also cause externalities, for example emissions that influence the utility of other individuals, but which are not taken into consideration by the individuals causing them. A social cost perspective includes the value of these externalities.

External costs: These typically arise when markets fail to provide a link between the person who creates the ‘externality’ and the person who is affected by it, or more generally when property rights for the relevant resources are not well defined.[7] In the case of GHG emissions, those who will eventually suffer from the impacts of climate change do not have a well-defined ‘property right’ in terms of a given climate or an atmosphere with given GHG concentrations, so market forces and/or bargaining arrangements cannot work directly as a means to balance the costs and benefits of GHG emissions and climate change. However, the failure to take into account external costs, in cases like climate change, may be due not only to the lack of property rights, but also the lack of full information and non-zero transaction costs related to policy implementation.

Private, financial, and social costs are estimated on the basis of different prices. The private cost component is generally based on market prices that face individuals. Thus, if a project involves an investment of US$ 5 million, as estimated by the inputs of land, materials, labour and equipment, that figure is used as the private cost. That may not be the full cost, however, as far as the estimation of social cost is concerned, because markets can be distorted by regulations and other policies as well as by limited competition that prevent prices from reflecting real resource scarcities. If, for example, the labour input is being paid more than its value in alternative employment, the private cost is higher than the social cost. Conversely, if market prices of polluting fuels do not include values that reflect the environmental costs, these prices will be lower than the social cost. Social costs should be based on market prices, but with eventual adjustments of these with shadow prices, to bring them into line with opportunity costs.

In conclusion, the key cost concepts are defined as follows:

  • Private costs are the costs facing individual decision-makers based on actual market prices.
  • Social costs are the private costs plus the costs of externalities. The prices are derived from market prices, where opportunity costs are taken into account.

Other cost concepts that are commonly used in the literature are ‘financial costs’ and ‘economic costs’. Financial costs, in line with private costs, are derived on the basis of market prices that face individuals. Financial costs are typically used to assess the costs of financing specific investment projects. Economic costs, like social costs, assess the costs based on market prices adjusted with opportunity costs. Different from social costs, by definition they do not take all externalities into account.

  1. ^  Coase, 1960, page 2 in his essay on The Problem of Social Cost, noted that externality problems would be solved in a ‘completely satisfactory manner: when the damaging business has to pay for all damage caused and the pricing system works smoothly’ (strictly speaking, this means that the operation of a pricing system is without cost).