Debating the Price of Global Warming

Participants at January's World Economic Forum annual meeting voted climate change to be not only the issue that will have the greatest global impact in coming years but also the one for which the world is least prepared. I voted differently, since I'm more worried about other threats to humanity, such as nuclear weapons and the persistence of abject poverty in many parts of the world. But I admit that the Davos vote reflects a shift in public opinion that's increasingly putting more pressure on governments and businesses to decisively address the consequences of human-induced climate change. However, since moving to a less fossil-fuel-dependent economy will not be without cost, it's essential that the policies and business decisions adopted rely on sound climate science and good economic analysis – a binomial that has heretofore been absent from many public discussions.

A valuable attempt at rectifying this deficiency became available last fall with the publication of a study commissioned by the U.K. government and headed by Sir Nicholas Stern, a respected British economist. The study, known as the Stern Review, summarizes the scientific findings on climate change caused by the accumulation of greenhouse gases (carbon dioxide and others) in the atmosphere; provides calculations of the economic impact of climate change and the possible cost of reducing emissions and eventually stabilizing the concentrations of those gases in the atmosphere; and explores a range of policy options for mitigating and adapting to climate change.

The Stern Review concludes that rising average temperatures constitute a serious global threat meriting immediate and drastic action. It claims that lack of such action will commit the world to overall costs – due to natural disasters of increasing ferocity, damage to food production, the spread of diseases and the destruction of ecosystems – equivalent to a loss of between 5% and 20% of global GDP each year. To prevent these catastrophic consequences, emissions need to be reduced soon so that the stock of greenhouse gases in the atmosphere never rises beyond twice the level it was prior to the Industrial Revolution. To stabilize at that limit by mid-century will require significant, sustained effort over a long period. Emissions per unit of GDP will need to be one-fourth current levels by 2050, and energy production will have to be up to 75% less dependent on hydrocarbons than it is today.

The review estimates that with the right policies the annual cost of achieving emissions stabilization will be around 1% of global GDP for the next 50 years and perhaps for as long as the next 100. Yet according to the review this cost is small, relative to the value of the economic and human losses avoided. Achieving these goals will require, above all, making emitters pay for the true social cost of their carbon emissions, either through direct taxation or the trading of emissions allowances. Carbon pricing would be complemented with incentives for the development of new low-carbon technologies, as well as the adoption of more stringent energy standards.

Cheers and Chills

The Stern Review has been applauded enthusiastically by environmentalists but received rather critically by more than a few of the leading climate-change economists. These researchers' analyses, best represented by the impressive studies of Yale professor William Nordhaus, have repeatedly concluded that although the risks of climate change must be mitigated, the economically optimal approach is to implement policies that first aim at small decreases in emissions rates, making them gradually greater over time. In their critiques Nordhaus and others rightly observe that the Stern Review's case for sizable and urgent action rests crucially on the use of too low a rate of discount throughout its cost-benefit calculations of climate-change mitigation.

The review's approach to discounting implies that the present generation should cut its consumption to benefit future generations – no matter that those generations, by virtue of economic growth, will be much richer than ours. In contrast, mainstream environmental economic analysis, in which the discounting of future costs and benefits is calculated with higher rates, suggests that our generation should certainly contribute to ameliorating the risk of global warming, but also that the proportion of resources diverted to this should be stepped up only as subsequent generations become richer. From this viewpoint it's better to invest now in solving growth and development problems, thereby bequeathing bigger economies to future generations who will be better endowed to mitigate and adapt to climate change.

Interestingly, an important caveat to this orthodox prescription is being developed by other mainstream economists. Professor Martin Weitzman of Harvard has suggested that if investing in climate-change mitigation were seen less as a problem of long-term cost-benefit analysis and more as a problem of deciding how much insurance to buy to offset the slight chance of a future catastrophe that could ruin the entire world, then perhaps it would be more efficient and fair for our generation to more seriously entertain harsher measures than those it's now willing to undertake. Weitzman thus suggests that Sir Nicholas may be right for the wrong reason!

What's clear is that the Stern Review has reignited the debate and serious study of the economics of climate change. And the debate has served to remind us that what is being done to address this issue is too little, even in the light of orthodox analysis.

Click here to see a video of the Yale Center for the Study of Globalization program, "The Stern Review and the Economics of Climate Change."