The Economics of Climate Change

This is currently a very controversial subject, with widespread disagreement among mostly self-appointed experts on the subject.

The simple truth is that extant economic theory is simple not sophisticated enough to deal with issues like this, that ultimately involve the physical environment, instead of just markets.

Moreover, there are many potential dimensions of economic impact and forecasting their relative magnitudes is difficult:

The World Bank is an excellent source of white papers and consulting drafts. From a 2006 draft the following 4 points emerged:

• Adaptation to a 2C warmer world will be costly. The study puts the cost of adapting between 2010 and 2050 to an approximately 2C warmer world by 2050 at $75 billion to $100 billion a year. ( note that this is less than 1% of the World GDP )

• Second, the world cannot afford to neglect mitigation. Adapting to an even warmer world -on the order of 4C above pre-industrial levels by the end of the century-would be much more costly. Adaptation minimizes the impacts of climate change, but it does not tackle the causes. If we are to avoid living in a world that must cope with the extinction of half of its species, the inundation of 30 percent of coastal wetlands, and a large increase in malnutrition and diarrheal and cardio-respiratory diseases, countries must take steps immediately to sharply reduce greenhouse gas emissions.

• Third, development is imperative, but it must take a new form. Development is the most powerful form of adaptation. It makes economies less reliant on climate-sensitive sectors, such as agriculture. It boosts the capacity of households to adapt by increasing levels of incomes, health, and education. It enhances the ability of governments to assist by improving the institutional infrastructure. And it dramatically reduces the number of people killed by floods and affected by floods and droughts. But adaptation requires that we go about development differently: breeding crops that are drought and flood tolerant, climate-proofing infrastructure, reducing overcapacity in the fisheries industry, and accounting for the uncertainty in future climate projections in development planning. Countries may have to shift patterns of development or manage resources in ways that takethe potential impacts of climate change.

• Fourth, uncertainties are large, so robust and flexible policies and more research are needed. The imprecision of models projecting the future climate is the major source of uncertainty and risk for decision makers. Thus, it is crucial to undertake research, collect data, and disseminate information so that if climate change turns out to have worse impacts than anticipated in 20 or 30 years, countries can respond more quickly and effectively. In the meantime, countries should pursue low-cost policies and investments on the basis of the best or median forecast of climate change at the country level.

Okay, so what the hell does all that economic clap trap policy babble mean?

1. Nominally we just allocate the BAU tax as some percentage of GDP goes to some central "climate bank" that finances adapation strategies.

2. The choice is clear: invest now in adapation vs investment in mitigation. This means change out fossil fuels the primary fuel sourc for transport and electricity generation. It doesn't mean anything else. Clarity on this issue has not been forthcoming.

3. Have the balls to make a plan within the known uncertainies. Minimize the risk of going into the most disastrous cell in your truth table.

Risk analsyis: let's start with what we know?

• 2-5 C increase in global temperature in the regime 2030 - 2060.

• BAU leads to 3-10 C increase by 2100 (Raisins instead of wine)
  

• High temperatures: plant/soil sink decreases; permafrost thaw to methane and methane relase from hydrate deposits would substantially amplify temperature increase Avoid This possibility!

• High latitude rainfall increases; mid-latitude decreases; hurricane intensity may increase (frequency not likely to increase)

• Increasing climate volatility (as we have discussed) due to seasonal jet stream disruptions.

• Greenland/West Antarctic Ice sheet permanent loss could be putting us on a path of 5-10 m sea level rise over the next few centuries. Who bears the cost of population relocation? This is the major global policy issue that needs to be decided by some global enforcing institution that doesn't yet exist!

Risk Analsyis involves determining the probablility of some event happening and then determining if it is worth the investment to avoid that event happening.

We did not do very well on this score with Katrina and New Orleans! What makes us think we will do better on global scales?

An example:

Which probability curve do you want to bet on? The tail in the above PDF's represents the consideration of large positive feedbacks from clouds and/or methane releases.

This is a very good way to perform a risk analysis and state the problem in terms of "truth tables" and reasoning:

In terms of targets for Stablization of CO₂, here is a summary of basic estimates of the equilibrium temperature in the year 2100 that illustrate the extremes. (Note that there is little difference between the 2001 and 2007 IPCC reports in this regard).

One needs to consider the extreme events in proper risk management strategy.

Given that the oceans have absorbed 80-85% of the industrial produced warming over the last 40 years, there is still "warming in the pipeline" available to the atmosphere as the ocean/atmosphere system reaches a new equilibrium. This warming is roughly equivalent to adding an extra 50-100 ppm to the atmosphere.

We are presently at about 420 ppm equivalent CO₂ thus a minimum realistic level is about 500 ppm.

An Economic Framework:

Climate change is an externality associated with greenhouse-gas emissions: but it entails costs that are not paid by those who create the emissions (which is mostly the consumer, and secondarily the power industry).

In contrast to what is generally considered an externality in economics:

• This one is global in cause and consequence as any "local" emission of say a ton of Carbon essentially goes global immediately

• The impacts of climate change are long-term and persistent.

• The impacts of climate change are very broad and given the global supply chain situation, can drastically alter global economic dynamics (some of this may be occurring now).

• Avoidance costs are a necessary part of dealing with the climate change externality this is hard to do on a global scale

As a result, there is a economic tension between the what economists refer to as the "Social Cost of Carbon" (SCC) compared to what economists refer to as the Marginal Abatement Cost (MAC: cost associated with reductions in emissions). Note, as near as I can tell, if the word Marginal is part of the descriptor then its not economics!

There is much published on the tradeoff between SSC and MAC but most of it is nonsense, for two reasons:

• You can not sensibly calculate the SCC change with time without a realistic future emissions scenario.
  Pick One

  

• the MAC approach works on a regional level (fix that coal plant, or whatever) but how can it operate on a global level?

So while one can construct a dynamical curve related to SCC and MAC, the whole approach remains qualitative, and not quantitative:

This is primary because of the difficulty in determining the cost of carbon. One can think of at least 5 ways to determine this cost:

1. The adaptation/mitigation cost of climate-change damage,
2. The cost of reducing CO₂ emissions by any mechanism (e.g. CCS, alternative energy, biofuels, etc)
3. The social cost of carbon - which is mostly a theoretical notion and of little practical value due to the very large range of uncertainty
4. The politically negotiated value - this might result in an agreed upon real carbon tax
5. The Carbon Market

At the moment, there is huge globality inequity in terms of who contributes to SCC and MAC. The hard reality is that even if the US today dumps everything into MAC in order to shut off its GHG channel to the atmosphere - the rapidly developing world can easily make up the difference, in a hurry.

This would seem to be a basic problem associated with believing that we have some long term economic policy that can manage GHG emission, by treating it as a market commodity.

But what we can gleam from extant economic theory is the following:

Externality requires there to be a price for carbon emissions!

The first requirement is therefore to introduce taxes or prices for GHGs. According to standard economic theory: An appropriate tax would be equal to the social cost of carbon at the point where it is equal to the marginal abatement cost. Faced with this tax, the emitters would choose the appropriate level of abatement.

One way this dilemma can be stated is as follows: (from The Stern Report)

However, the inevitable absence of total credibility for GHG pricing policy decades into the future may inhibit investment in emission reduction, particularly the development of new technologies. Action on climate change requires urgency, and there are generally obstacles, due to inadequate property rights, preventing investors reaping the full return to new ideas. Specifically, there are spillovers in learning (another externality), associated with the development and adoption of new low-emission technologies that can affect how much emissions are reduced. Thus the economics of mitigating climate change involves understanding the processes of innovation and the required investment in achieving innovation.

Economic Modeling Needs An Ethical Dimension!

Two Key points:

• Modelling over many decades, regions and possible outcomes demands that we make distributional and ethical judgements systematically and explicitly. who the hell is going to actually do this?

• A disproportionate burden of climate change impacts fall on poor regions of the world. this is the true cost of progress and the true manifestation of global inequity.

The overall chain looks something like this:

where the bottom box influences the top box, even though it looks well removed in this characterization. That seems to describe the problem - the individual consumer acts in a disconnected way from the environment - see Cronon!

Finally, below are two economic models based on risk analysis of today. The top one is the lowest cost one (in terms of % GDP) and the bottom one is the highest. Which do you choose? The top and hope for the best, or the bottom and prepare for the worst?