Climate economics

Geoffrey Heal 09 June 2008

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While the science of climate change is settled, there is still some dispute about climate economics. The UK Government’s Stern Review caused a furore: it argued, contrary to prior conventional wisdom, that there is an economic case for prompt and powerful measures to mitigate changes in climate. This led to extensive sparring between the two camps. Here I want to review the recent debate and try to indicate where the argument is going. The debate revolves around three predictable topics: the choice of a discount rate, the weight one places on equity, and the measurement of the costs of climate change.1

The discount rate

The discount rate matters because of the timescale: even if the benefits of stopping climate change were to massively outweigh the costs, the fact that they occur many decades from now, while the cost start now, might mean that in present value terms the costs are greater. There are two discount rates that are relevant in any long-term economic analysis, the pure rate of time preference (PRTP) and the consumption discount rate (CDR). The former is the rate at which we discriminate against future people just because they are in the future. Ethically I regard discrimination against the future as indefensible, as do most economic theorists and philosophers, and so I take the PRTP to be zero. So does Stern, though most of his adversaries pick a much higher rate. The CDR is the rate of change of the valuation of an increment of consumption, and depends on the rate at which consumption is rising (or falling) and the rate at which the valuation of an increment of consumption declines with increasing consumption.

There has been a lot of discussion of the fact that the CDR, under certain assumptions, is equal to the return on capital: if this were so then it would help us to get some idea of the right value for the CDR. But the assumptions needed here are too strong to be palatable:

  • no external effects – an odd assumption in the context of climate change which Stern rightly called “the greatest external effect in history”,
  • perfect foresight in capital markets – also odd at a time of financial crisis arising precisely from lack of foresight, and
  • a single homogeneous consumption good.

The relevance of the first two to an analysis of climate economics is clearly questionable. The real issue behind the third is that in the face of climate change the levels of consumption of different goods may move in different ways. Goods that depend on the productivity and health of the natural environment – ecosystem services, agriculture, recreation – will fall in availability, so consumption will decline. But produced goods that do not use nature as an input will continue to be abundant. So different types of consumption will move in different ways, meaning that we cannot work with aggregative one-good models.

The bottom line: the PRTP should be zero, and if we recognize that there are many different types of goods whose consumption trends are different, then there will be as many different CDRs, none of which will equal a return on investment even with heroic assumptions about external effects and perfect foresight. They will depend on how fast the valuations of various different goods fall with respect to their own consumption levels and with respect to those of other goods. Here it will matter, for example, whether non-environmental and environmental goods are complements or substitutes.

Equity and climate change

Let’s talk about equity and climate change. There are two ways in which they are connected. Suppose the marginal utility of consumption falls more rapidly, so that we place more weight on equity. If consumption is growing over time, then this means that the marginal utility of future generations falls more rapidly and therefore we are less concerned about benefits or costs to future generations. We place less value on stopping climate change. A stronger preference for equality leads to a less aggressive position on the need for action on climate change.

There is a second offsetting effect, not visible in an aggregative model. Climate change is an external effect imposed to a significant degree by rich countries on poor countries. The great majority of the greenhouse gases currently in the atmosphere were put there by the rich countries, and the biggest losers will be the poor countries - though the rich will certainly lose as well. Because of this, a stronger preference for equality will make us more concerned about taking action to reduce climate change.

So the impact of a stronger preference for equity on our attitude towards climate change is ambiguous, with two offsetting effects. Current models capture only the first of these.

Costs and benefits of mitigating climate change

Finally, the costs and benefits of mitigating climate change. On the cost side, there is not a lot of disagreement: the latest IPCC report estimates the cost of keeping CO2 equivalent concentrations below about 450 parts per million (ppm) as less than 3% of world GDP by 2030 and less than 5.5% by 2050. The Stern Review estimates the costs of keeping these concentrations at less than 500-550 ppm as being within the range -1% to +3%, with a best estimate of 1%. And a recent McKinsey Global Institute study finds numbers that are consistent with 1-2% of GDP. So it’s reasonable to assume that we can solve the problem for 1 or 2% of national income.

On the costs of climate change, which double as the benefits of stopping climate change, there is more of a range. Most of the integrated assessment models suggest costs of climate change of the order of 1-2% of national income. Stern suggests a larger number, at least 5% and possibly as much as 20%. His numbers are the annualized costs of climate change. I am inclined to think that Stern is much nearer the mark: it is impossible to read the IPCC reports and believe that the consequences of climate change along the business as usual (BAU) path are only 1 or 2 percent of national income. 1% is almost within the margin of accounting error, and the IPCC certainly gives the impression that climate change will have a far-reaching impact on many human activities, which is not consistent with so small a value. Recent work by Hanemann, Fisher and Schlenker (2006) suggests that climate change under the BAU scenario will have a dire impact on US agriculture, reducing the value of output by as much as 70% by the end of the century. Cline [2007] also suggests that climate change will have a severe harmful impact on agricultural output in many countries.2 And while agricultural output accounts for only a small fraction of GDP in the US, if food were to become scarce it is clear that prices would rise to the point where this could change drastically. Our current spending on food greatly understates our willingness-to-pay for food.

The Stern Review presents 5% of GDP as the lower bound for the cost of climate change under the BAU scenario, noting that “The estimated damages would be much higher if non-market impacts, the possibility of greater climate sensitivity, and distributional issues were taken into account.” So the Review leaves out any impact not reflected in market transactions, assumes a rather conservative value for the key climate sensitivity parameter, and does not take in to account the fact that many of the costs of climate change will fall most heavily on the poor. Stern has emphasized that if he and his team were to rewrite the Review today, given what we have already learned about the impacts of climate change since its publication, their estimates of the cost of climate change would be larger.

It is easy to see the kinds of issues omitted by not considering non-market effects of climate change. The IPCC estimates that about one third of all species could be driven to extinction along a BAU scenario. This would be a radical transformation and impoverishment of our biological environment, with far-reaching implications for the flow of ecosystem services to human societies as well as major ethical implications. Do we have the right to condemn to extinction many of the species with which we share the planet? For many people it is one of the most important issues associated with climate change.

Where does this leave us? With a zero PRTP, a concern for equity properly modelled, and estimates of the costs of climate change that are anywhere in the range suggested by Stern, the economic case for prompt and powerful measures to mitigate changes in climate is overwhelming.

References

Cline, William 2007. Global Warming and Agriculture: Impact Estimates by Country, The Peterson Institute, July 2007.
Guiteras, Raymond 2007. The Impact of Climate Change on Indian Agriculture, Working paper, Department of Economics, MIT.
Hanemann, W. Michael, Anthony C. Fisher and Wolfram Schlenker 2006. The Impact of Global Warming on US Agriculture: An Econometric Analysis of Optimal Growing Conditions, Review of Economics and Statistics, 88(1), February 2006, p. 113-125.
Heal, Geoffrey 2008. "Climate Economics: A Meta-Review and Some Suggestions," NBER Working Papers 13927.
Stern, Nicholas 2006. The Economics of Climate Change: The Stern Review, H.M. Treasury, UK.
Stern, Nicholas 2008. “Climate Change, ethics and the economics of the global deal,” VoxEU.org, 30 November 2007.
Guiteras, Raymond 2007. The Impact of Climate Change on Indian Agriculture, MIT.

 


 

Footnotes

1 I am not mentioning how one deals with uncertainty, which is another and rather technical topic. See Heal (2008).
2 A recent paper by Guiteras (2007) looks at the impact of climate change on Indian agriculture and predicts significant loss of output.

 

 

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Topics:  Environment

Tags:  climate change, discount rate, Stern Review

Paul Garrett Professor of Public Policy and Corporate Responsibility and Professor of Finance and Economics, Graduate School of Business, Columbia University

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