Economists Price the Ravages of Climate Change

The price of the US’s “addiction to oil” goes far beyond the dependence on politically volatile states cited by President George W. Bush this week. According to the world’s leading climate scientists, reliance on fossil fuels is creating a global warming disaster that could end up costing the earth.

Faced with these threats, rational people and governments might be expected to reduce their greenhouse gas output.

But there is little appeal in taking costly action in the short term to stave off a long-term threat – especially one that, by its nature, is hard to calibrate.

Persuading individuals and businesses to take the action necessary to tackle climate change caused by economic activity itself requires an economic argument. But how to put a price on the world’s climate and the catastrophes that may follow from global warming?

Attempts to fill a policy vacuum as the expiry of the Kyoto protocol in 2012 looms are suddenly turning environmental economics into one of the hottest areas of the discipline. The challenge is to find policies that will make the most efficient use of scarce resources and provide a rational basis on which to build an international consensus to address climate change among politicians and business people.

It has taken some time for the economics of climate change to enter the mainstream. While scientific knowledge in this area has leapt ahead, economic advances have been much slower. You do not have to look far for the reasons. Most economics theory is designed to cope with issues that are relatively short term or national. Even international economics is ill-equipped to deal with trans-boundary issues.

Economists find it hard enough to make an accurate forecast one year ahead, let alone 100. Yet environmental economics must grapple with a plethora of uncertainties – scientific and political – over a dauntingly long timescale. Small wonder then that Michael Grubb, chief economist of the UK’s Carbon Trust, a government-funded organisation that advises business, declares: “Understanding the economics of climate change is like trying to understand the Big Bang without Newtonian mechanics.”

Dieter Helm, a fellow of economics at New College, Oxford, adds: “The usual economists’ toolbox looks puny against the scale of this challenge.” Just as the experience of the unemployment of the 1930s required the reinvention of much of macroeconomics, so climate change needs new thinking too, he says.

The drawback of the traditional approach notoriously emerged in the mid-1990s when economists, commissioned by the Intergovernmental Panel on Climate Change, used a cost-benefit analysis to assess the damage to the environment. There was an outcry when it emerged that the analysis involved valuing the life of an American at 15 times that of someone in the industrially less-advanced world.

Another problem is that environmental goods – clean air and water, a stable climate – are rarely taken into account by standard economic analyses. For this reason, the United Nations has begun to promote the idea of “natural capital”, as a way of valuing environmental goods so that they can be included in economists’ equations.

As Klaus Töpfer, executive director of the UN Environment Programme, describes it: “The goods and services delivered by nature, including the atmosphere, forests, rivers, wetlands, mangroves and coral reefs, are worth trillions of dollars. When we damage natural capital, we not only undermine our life support systems but the economic basis for current and future generations. Targeted investments in this natural capital have a high rate of return in terms of development.”

The UK can claim to be at the forefront of the debate, thanks in part to a decision by Gordon Brown, chancellor of the exchequer, to commission a review of the economics of climate change, headed by Sir Nicholas Stern, a former World Bank chief economist and senior Treasury official. Sir Nicholas’s report will take a global view of the economic risks and possible benefits of climate change and assess the potential of economic instruments to address them. The findings will carry weight internationally since they will be part of the basis for UN discussions, due to begin this year, on the future of Kyoto.

Sir Nicholas spoke publicly about his review for the first time earlier this week, in a lecture to the Oxford Institute for Economic Policy. Outlining some of the complexities of establishing economic solutions to climate change he went on: “It is an international collective action problem . . . The simple standard theory of externality” – on the spillover effects of production or consumption for which no payment is made – “is useful but not a fundamental answer to the problem”.

The first step, he said, was to convince all the governments involved of the need to take urgent action on climate change. The difficulty of achieving an international consensus is reflected in the history of the Kyoto protocol, which has been rejected by the US and Australian governments, and dogged with delays and disagreements (see right).

Countries such as the US have decided that the costs of compliance are too high. As Mr Helm points out, climate change is a global public “bad”, creating incentives for individual countries to free-ride on others’ emissions reductions: if one country reduces its emissions, the effect on global warming will be negligible but the effect on that country’s competitiveness could be significant.

Jonathan Köhler, of the Department of Applied Economics in Cambridge, thinks it is not necessary for everyone to sign up to an international agreement for progress to be made on emissions reductions. Market forces will do some of the work, he indicates.

“If you think climate change is a big problem and the world will have to do something, at some point there will be gigantic markets out there and big export opportunities for low carbon production technologies.” He cites the example of Denmark, which captured a large slice of the market in wind turbines through its early investment in that sector.

Policies to combat climate change need to take into account the impact of technological change on reducing the cost of renewable energy sources. Mr Köhler, who is also a manager at the Norwich-based Tyndall Centre for Climate Change Research, says economic models that take this into account suggest that the cost of switching over to a low carbon energy environment is not high compared with the cost of investment in energy systems that would anyway be needed. What is not clear is how quickly this would happen and how much government intervention would be required.

The policy instruments available to governments traditionally include a carbon tax, limits on emissions and incentives to encourage the development of clean fuel technologies. Most economists favour market-based solutions as the most effective way to drive change in business practice (see below) and encourage the development of new technology. In an open letter to Mr Bush in December, 25 US economists, including three Nobel laureates, urged the president to control greenhouse gas emissions through mechanisms such as setting limits on the amount of carbon dioxide countries could produce and allowing them to trade carbon allowances with one another.

Mr Helm believes that an alternative to subsidising a particular technology, such as nuclear fuel, in order to provide low carbon generation is to auction long-term carbon contracts. Under such a scheme, the government would auction carbon contracts for the supply of emission reductions over a long period – such as 20-30 years. The advantage for governments is that they are not obliged to evaluate industry claims about which technology is cheaper. Nor would they be obliged to sell a politically unpopular choice – such as nuclear technology – to a sceptical public. A similar scheme has been developed by the World Bank.

But bedevilling attempts to provide an authoritative analysis of the economic impact of climate change, and thus the economic instruments necessary to address it, is the high level of uncertainty that pervades the subject. Although the scientific evidence points clearly to the conclusion that human actions are having an effect on the climate, many important questions remain unanswered: for instance, the extent to which temperature will rise smoothly or in jumps and the probability of “high-impact” events such as the Gulf Stream changing direction.

Sir Nicholas believes his review, due in the autumn, will discover some of the answers. He said this week: “One of our key tasks is to find out whether you can be green and grow. There are a lot of arguments to suggest this is likely to be possible.”

But, he hinted, the road to knowledge would not be easy: To understand the issues, “you need all the economics you ever learnt – and more”.

Multinationals nudged into action

Almost 2,000 company chairmen around the globe are this week being asked some searching questions about climate change. The quiz comes in a letter from the not-for-profit Carbon Disclosure Project – the latest salvo in a campaign to encourage businesses to take climate change seriously.

Acting in the name of 211 institutional investors with $31,000bn (£17,400bn, €25,600bn) in funds under management, the organisation asked companies to disclose their assessment of the risks to their business from climate change and how much greenhouse gas they emitted. The project is just one of a large number of initiatives designed to alert businesses to their role in combating climate change.

Karina Litvack, head of governance and socially responsible investment at F&C, the activist fund manager, says this makes good business sense. “Sooner or later we will have to pay the price and the sooner we move, the cheaper it will be to take corrective action.”

Fund managers have sought this information in order to build up a picture of the risks of climate change to companies in their portfolios, and an assessment of the liabilities those companies might face if their output of greenhouse gases were to be limited in the future.

F&C prides itself on having had a hand in persuading General Electric to adopt a climate change strategy – its much-publicised “Ecomagination” initiative – through a five-year dialogue. In a letter to GE in November 2002, F&C warned that lagging behind on climate change and greenhouse gas emissions was a “serious business risk”.

Under Ecomagination, GE will increase its research and development of technologies that reduce greenhouse gas output and double its revenues from such technologies by 2010.

Other large companies have also been active. HSBC has just become the first “carbon-neutral” bank, offsetting its emissions through tree-planting and carbon trading.

Meanwhile in 2004 BT, the telecommunications provider, became the world’s biggest company to take all its energy from environmentally sound sources. DuPont, the chemicals manufacturer, has predicted it will save $2bn by reducing its greenhouse gas emissions by 65 per cent by 2010, relative to 1990 levels.

Ms Litvack says the main stumbling block for business is the need to justify to shareholders the – sometimes large – investments needed to reduce emissions.

For that, companies need assurance from governments that such investments will pay off. “At the moment there isn’t enough incentive to cut emissions, which is why companies are becoming more vocal about their needs,” she says.

Most businesses that have taken up the cudgels over climate change have called on governments to take action using market-based mechanisms – such as emissions trading schemes – along with long-term policies and targets to reduce emissions.

It is a rare company that goes looking for government regulation but in this instance some multinationals are doing just that. Without an international level playing field, they fear that rivals with operations in areas without restrictions will gain a competitive advantage.

Rick Samans, managing director at the World Economic Forum, which last year convened a meeting on climate change between 24 leading companies and Tony Blair, UK prime minister, says: “What companies are seeking is certainty.”

Emissions trading provides a framework

The Kyoto protocol came into force in February 2005, more than seven years after it had been negotiated in 1997 and only seven years before its provisions were due to expire. Its lengthy and tortuous passage illustrates the enormous difficulties of achieving international consensus on action to combat climate change.

The UN-brokered treaty requires developed countries to reduce their greenhouse gas emissions by 2012 by an average of about 5 per cent compared with 1990 levels. But the US – the world’s biggest emitter – and Australia have rejected the accord, arguing that it mitigates unfairly against them by placing no binding emission reduction targets on developing countries.

Even if the terms of the treaty are met, the effect on overall global emissions will be small. Atmospheric concentrations of carbon dioxide will continue to rise, albeit at a slightly slower rate than they would otherwise. But proponents argue that the value of Kyoto lies in setting up a framework for international co-operation on emissions reduction. There is no other such framework: the only comparable alliance, between the US, Australia, Japan, China, India and South Korea, sets no targets or timetable for emissions reduction.

Enshrined in the protocol is the concept of emissions trading. For instance, developed countries can meet their greenhouse gas reduction targets by financing projects in poorer nations that reduce emissions there. This has the added advantage of transferring low-carbon technology to countries that could not otherwise afford it. The UN estimates that €10bn ($12bn) in capital will flow from developed countries to poorer nations by 2012 as a result.

A similar trading system was adopted by the European Union in January 2005. Its greenhouse gas emissions trading scheme places limits on the amount of CO2 that businesses in certain energy-intensive industries may emit. Companies that emit less than their allowance – by increasing their efficiency or investing in low-carbon technologies – can sell their excess allowances for cash, while laggards can buy extra allowances on the open market. In successive phases of the scheme, the total amount of CO2 that businesses may produce is lowered.

The price of emissions allowances under the EU system has risen markedly since it was introduced, reflecting rising gas prices. As gas grows more expensive, cheaper coal-fired power becomes more attractive. But as coal produces much more CO2than gas, generators need to purchase more allowances, pushing up their price.