The Economics of Climate Change: Essential Knowledge

  • Date: 04/11/09

The slow moving Senate debate over climate change offers an opportunity to revisit the fundamentals of climate change. While the physical science about natural and anthropogenic forcings is the place to start, the economics of climate change is highly relevant for the policy debate. In this regard, a perfectly timed literature review in the Spring 2009 The Journal of Economic Perspectives is worth studying.

There have been 13 – count them, 13 – studies published in the peer reviewed literature that have wrestled with the economic implications of a doubling of atmospheric greenhouse gases (GhGs) on a CO2-equivalent basis. Those 13 studies have yielded 14 estimates of what will subsequently happen to global GDP. For those who are curious, 10 of those studies assume a subsequent warming of 2.5 C; two assume that a 1 C warming would follow; and two assume a 3 C warming would follow.

Here are the estimated changes to GDP relative to a baseline scenario where no CO2e buildup occurs: +2.5%, +2.3%, +0.9%, +0.1%, no change, -0.1%. -0.4%, -0.9% -1.3%, -1.4%, -1.5% -1.7% -1.9% and -4.8%. In short, climate change will either add or subtract about one year of economic growth from the global economy in the second half of this century.The positive findings in that dataset reflect the fact that temperature has an ambiguous effect on human health; that very little of the modern industrialized economy is weather dependent, that adaptation to climate change is relatively cheap, and that many clear benefits follow from CO2 saturation and warmer weather.

There are two interesting things to note about those studies. First, of the studies that tracked GDP change over time, all but one found that warming produces net benefits until warming exceeded 2 degrees C. Hence, the oft-heard claim that the world already groans under the miseries of climate change are without much foundation. Second, older studies produce higher cost estimates than recent studies.

You are now privy to the gist of the sum total of knowledge about the economic impact of climate change. While it is true that more than just those 13 studies have been published in the peer reviewed literature, those additional studies (which are primarily about estimating the marginal impact of future CO2e emissions) are derived from nine of the 13 studies discussed above.

Now, I look at these findings and conclude the following:

* it’s not obvious that climate change will prove to be a bad thing over any foreseeable time horizon;

* even if climate change proves to be a negative event, it will scarcely prove to be the equivalent of the environmental Book of Revelations prophesied by Al Gore; and

* there are far more important things to worry about at present.

Reasonable people, of course, might disagree. One of them, I should note, is the economist who compiled the literature review that I am summarizing for you in this post – Prof. Richard Tol.

What would they say in response to this? Nine complaints are frequently offered.

#1 – Discount Rates

First – and most importantly – the modest economic impacts found in these studies are predicated upon heavily discounting future losses. If we treated a dollar of losses tomorrow as we would a dollar of losses today – or likewise, if we treated the life of a child born in 20 years as we would the life of a person born 40 years ago – then the costs associated with climate change will be far greater.

Virtually the entire difference between the literature’s collective yawn over climate change and Nicholas Stern’s alarmist study for the British government can be explained by Stern’s use of a 0.1% discount rate (his estimate of the chance that, in any given year, the human race might go extinct from some other event) instead of the 1-3% discount rates used in the rest of the literature.

I am unimpressed with this argument, however, that discounting future dollars is unethical. That’s because discounting future losses is necessary if society is to maximize well-being. If alternative investments, for instance, can yield an average rate of return of 3%, then a 3% discount rate on future losses from climate change requires policy makers to pay for the opportunity costs associated with investments to head-off said climate change.

Of course, we have to guess about the rates of return we might gain from alternative investments. It’s worth noting, however, that over the past four decades, return on capital has averaged 7%. If we applied that discount rate to future losses, the case for a carbon tax disappears entirely. Given the unfunded liabilities imposed by governments on future generations, however, is unclear whether recent returns will continue to be realized.

#2 – Poor Statistical Analysis

Second, many contend that poor statistical analysis informs the low cost estimates. This argument can seem complicated, but it’s quite simple really. If one thinks of the published studies as a sample of data drawn from an unobserved population of millions of conceivable studies that could possibly be conducted on the economic costs of climate change, what type of underlying population is it? That is, if we could run a Monte Carlo simulation and could produce 1 million cost-benefits studies, what would the curve look like if we were to plot those findings on a graph? Economists often assume a normal distribution of results (the plotted results would look like a conventional bell curve), but there is reason to suspect that there is a “fat right tail” to the underlying population of unobserved, “potential” studies because seemingly anomalous high-cost estimates seem to pop up more frequently than we might suspect.

If there is a rightward skew to the date, that’s a pretty big deal. If we assume a “fat tail” to the distribution of studies that used a 3% discount rate, the mean cost of putting a ton of CO2e into the atmosphere is $50, not $18; the median cost is $20, not $8, and the upper bound cost estimate is $270, not $45.

Unfortunately, the underlying population of unreported studies is unknown and unknowable, so we can’t with full confidence say that the distribution has a fat tail or not. But given that the high-cost studies are much more likely to rely on old data, crude economic modeling, and lack of peer review, I am not convinced that undue weight should be given to those studies on the rightward tail of the distribution.

#3 – The Economic Models are Terrible

Third, we are told that the economic models are too poorly constructed to hang policy on. The economic models are crude, unsophisticated, static, and are untested by data. Moreover, there is little reason to suspect improvement. Economist Richard Tol explains why:

The proximate reason is that few people work in this area, and none full time, as funding is difficult to get. The ultimate reasons are, firstly, that the issues are complex and uncertain, and require broad multidisciplinary knowledge and, secondly, that the results are unpopular with climate policy makers.

Alas, the complaints are true. Climate models, however, are subject to much of the same criticism. If we’re going to throw-out the economic models, the same standards of “quality control” would compel us to throw-out the climate models. And then were would we be? Without an issue to discuss, that’s where.

#4 – Apocalypse Denied

Fourth, many economists think that these studies deal inadequately with low probability, high impact scenarios such as a potential shut-down of the Gulf Stream and a possible collapse of the West Antarctic ice sheet. Often times, they are not part of the cost-benefit examinations. When those possibilities are accounted, researchers plug-in expected values which, by their nature, produce low-cost estimates that might not reflect defensible risk-hedging investments.

All true. But hedging against low probability, high impact scenarios beyond expected value – the “Precautionary Principle” – with significant resources is not obviously a good thing. Those who endorse it in environmental discussions recoil when that very same principle is embraced in foreign policy discussions. In short, the same argument used to hedge our bets regarding climate change out of fear of a Gulf Stream shut-down could be marshaled to justify preemptive military strikes against Iran, North Korea, Russia, and China.

Many on the Left would reject such action outside of the environmental arena (rightly, in my opinion) because they make no sense from a cost-benefit perspective. I think the same logic should lead us to reject those actions in the environmental arena as well.

#5 – Poor Accounting

Fifth, critics maintain that there is a very incomplete accounting of all potential costs from climate change in these studies. For instance, many reportedly fail to fully consider the impact of increased tropical and extratropical storms. While that’s a defensible point, the same point can be made with regards to accounting on the benefit side of the ledger. For instance, few of those studies completely account for the potential benefits associated with opening-up the Artic to shipping and economic exploitation.

#6 – Uncertainty Cuts Primarily One Way

Sixth, most scientists maintain that, while there is lots of scientific uncertainty, uncertain “bad” events are more likely than uncertain “good” events, so while much is uncertain, things are likelier to be worse than we expect, not better. This is not, however, obviously true. What about the observation that we are overdue for an ice age and that warming may be delaying or even preventing the same? What about the fertilizing impact of CO2 which may prove crucial to providing for increased crop yields necessary to feed future generations?

#7 – Short Time Horizons

Seventh, the economic models tend to stop in 2100 and only look at a doubling of CO2e. But the effects of climate change will not stop in 2100. Accordingly, these models undercount total costs.

While that’s true, it’s not clear how we’re supposed to forecast the state of the global economy in the 22nd century and beyond. Solid projections about even basic things a decade hence are largely guess work. Consider, for instance, a 1910 projection undertaken by the best and the brightest regarding the nature of the economy circa 2010! Given that half of the economic costs associated with climate change that were identified in the Stern Review will occur after the year 2800, it’s clear that any attempt to look very far “over the rainbow” is unlikely to yield useful information.

#8 – Utilitarianism Unpersuasive

Eighth, critics note that modest economic impacts from climate change are not homogenous. Some will win (primarily countries in temperature latitudes) and some will lose big (primarily poor countries in equatorial latitudes). While the underlying science is unclear on this point (my colleague Pat Michaels, for instance, thinks that the equatorial regions will be largely untouched by warming given the uneven distribution of the same), it seems to me that compensation is almost certainly superior to emissions reduction when wrestling with the unequal distribution of impacts. Even if there is no compensation forthcoming, the negative externalities associated with climate change are almost certainly less than the positive externalities associated with western industrial enterprise.

#9 – The Case for Insurance

Ninth (and finally), many contend that low-cost insurance makes sense given uncertainties. But there is no low-cost insurance of consequence. As noted on this blog many times before, the Waxman-Markey bill (which calls for an 83% emissions reduction by 2050) would reduce global temperatures by 0.05 C in 2050 and 0.11 C by 2100. If the entire developed world signed-on to Waxman-Markey, temp reduced by 0.06C in 2050 and 0.2C by 2100. Similarly, California’s promise to cut GHG emissions 25% by 2020 simply plays a game of musical chairs with no net emissions reduction.


Some, of course, will argue that economists are poor referees regarding optimal public policy and that economic considerations should not dictate policy. If by that we mean that people may rationally embrace emissions reductions beyond what is theoretically optimal given their low tolerance for risk and elevated willingness to pay to reduce risk, that’s fine.

But if we mean that economics has little to contribute to the discussion, that’s not fine. That’s akin to saying that a tabulation of costs and benefits regarding public policy is something approximating crazy talk. I would argue that an unwillingness to consider such tabulations is nuts. And to the extent that those tabulations (as flawed as might be) are available to us, they suggest a rather weak case for mitigation.

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