Economics of Climate Change

Climate change is moving to the top of humankind's priorities list as the debate over whether it exists or not gives way to the debate over how best to forestall and counteract its more onerous effects. In this regard, the possible economic impacts of action or inaction have been discussed far less than the science, for the fact of the matter is that no one really knows for sure what changes lie in store for producers, markets, and consumers. That there will be profound structural changes is less in doubt than whether we collectively are up to the task of successfully dealing with global warming. Here, fortunately, we have a large body of research to fall back on, most notably the welfare economics of Pigou and Hicks and sustainable-development theory, to guide our decision making.

Keywords Coase Theorum; Cost-Benefit Analysis; Externalities; Kaldor-Hicks Compensation Principle; Praeto Optimality; Sustainable Development Theory

Economics > The Economics of Climate Change

Overview

Although skeptics still contest that climate change exists and is a result of human action, the scientific evidence overwhelmingly supports these conclusions. As the perils of "irreversible" climate change loom ever larger and more imminent in the public's imagination, the calls for action grow ever louder, with good reason. As little as a two degree centigrade increase in the earth's average temperature by 2100 might well make fertile land arid, submerge densely populated coastal regions, and magnify the destructiveness of extreme weather. And therein lies a dilemma of the first order, because ours is a carbon economy. Humankind has prospered far more since the late eighteenth century from industrialization, powered first by coal and then by oil, than it ever did over the preceding millennia. To halt global warming, atmospheric emissions of carbon dioxide (CO₂) must be severely curtailed. But how can this happen without sacrificing the very productive capacity responsible for the high standard of living many enjoy and others aspire to? It is a daunting question.

Economics examines how resources are allocated in conditions of scarcity, so the ideas of constraints and trade-offs are hardly new. Nor, for that matter, are concerns about the potentially disastrous consequences of unrestrained economic growth. Early nineteenth-century economic theorists like Malthus and Ricardo feared such growth would bring a precipitous rise in population that would quickly deplete available food stocks. Pessimists like Malthus held that only war and famine could right the balance again; optimists like Ricardo believed agricultural imports and farm machinery might postpone but ultimately would not prevent widespread calamity. Convinced that future events can never be predicted with any real certainty, John Stewart Mill was more circumspect. He thought one of three outcomes possible (Pressman, 1999b):

• Increasingly expensive cultivation would continue to keep pace, with prices paid by workers and profits earned by landowners both rising;
• The division of labor and new technologies would more than keep pace, and workers' wages would increase; or
• Capital-intensive farming would keep pace, though just barely, with wages remaining constant, profits declining, and overall economic growth slowly grinding to a halt.

Economists pondering the likely economic impact of climate change face a far more complex problem set. To begin with, though there is growing agreement about why climate change is occurring, beyond sweeping generalities, the when, the where, and the how are still far from clear. What is clear is the sheer scale of the structural change the global economy faces, be it in heavy industry, energy, transport, or agribusiness. And with it will come new opportunities as well as threats. Though the impetus for change may in the end be political, the mechanism will always be economic. New green industries will supplant existing smokestack ones, renewable energy will replace fossil fuels, and so on—provided, that is, that the necessary changes are undertaken before the damage is irreversible and the social, political, economic, environmental, and humanitarian distress it brings becomes too great. But before this can happen, the very real question of who pays for the enormous upfront investments required must first be settled, and as yet no clear-cut consensus has emerged about the how to go about this. Fortunately or not, climate change is just a rather dissonant variation on a recurring theme in twentieth-century economics; the problem of externalities and a workable solution may well lie there.

Applications

Externalities

The term "externalities" was coined in 1920 by the English economist Arthur Pigou, welfare economics' first major theorist. This term stems from the fact that manufacturing any good creates not one but two outputs, a physical commodity and a waste byproduct, for matter can never be destroyed, only transformed. As long as the effect of these waste byproducts on the larger community is benign, the material and economic benefits of production outweigh its social costs. Customers pay for the former but rarely for the latter. Nor do producers whose prices cover only the private costs of production—the raw materials, plant, equipment, labor, and capital required to make a profit. What happens when the social costs, measured as the investment necessary to counter the harmful side effects of a given production process, outstrip manufacturers' private costs (Pressman, 1999a)?

Strictly speaking, externalities arise whenever consumers not party to a transaction either benefit or lose as a result of it. A lighthouse is a much-discussed example of a positive externality: shipping firms and their passengers benefit directly from something paid for from the public purse. Air pollution is an example of a negative externality: emitters profit at the expense of the public at large. The emitters' behavior is countenanced in the first place because the utility of the goods they produce exceeds or equals the utility of cleaner air. However, this seemingly straightforward trade-off is often much more one-sided. The benefit to the producer and the producer's customers is immediate; the cost to the community in worsening air quality is cumulative.

Negative Externalities & Free-Market Economies

Early proponents of welfare economics, such as Pigou and Hicks, saw negative externalities as market failures of the first order, ones that only government regulations, taxes, subsidies, or court action could correct. Laissez-faire marketplaces, they argued, have no built-in mechanism to effectively counter the so-called free-rider problem. This problem arises whenever too many economic agents ask, Why foot part of the bill for some public resource when others are sure to pay it off? Given the option, in other words, why not get something for nothing? Unscrupulous, perhaps, but it is a tempting proposition in any milieu where narrowly defined self-interest trumps all other considerations. Of course, if too many of us think this way, the bill is not paid, the benefit never materializes, and everyone is worse off. In the absence of government regulation, the temptation to leverage free or grossly underpriced environmental assets to lower production costs is always there—especially since, as public goods, their consumption by one party does not lessen the supply available to other parties, and once these goods are available, no party can be denied access to them. In addition, these nonrival, non-excludable characteristics make them unattractive private investments (Reinhardt, 1999). Without the outside stimulus of government funding or regulatory enforcement, essentially, a market for their development and upkeep would not materialize on its own.

Revisiting the issue decades later, economist Ronald Coase questioned the universality of this premise. Perhaps, he suggested, given certain circumstances, private solutions could remediate a negative externality more efficiently. When property rights are clearly established and transaction costs are low, the better option lies in contesting parties agreeing amongst themselves about what course of action to take, for the party that stands to gain the most economically has a vested interest in resolving a dispute quickly and cost-effectively. And the aggrieved parties have every reason to expect either relief through remedial action or reparations in keeping with the Kaldor-Hicks compensation principle, a major tenet of orthodox welfare economics, which maintains that overall utility is served even if some suffer from a change in the economy—provided, that is, that the injured parties are remunerated for their loss.

A market-based alternative to government-mandated solutions, the Coase theorem does not preclude the possibility of victims paying perpetrators to change their production processes, nor of perpetrators compensating victims for the ill effects that their ongoing operations cause. Of course, polluters may decide that in the long run it might be cheaper to invest in more environmentally friendly equipment, and victims believe that their health is more valuable. In either case, the parties choose to return to the bargaining table instead of the courts. A quick resolution where all parties benefit to one degree or another is preferable to a lengthy and costly legal impasse. Bargaining increases the chances of maximizing the utility of the ensuing outcome, which matters more in the Coasian hierarchy of values than who is to blame.

A very different notion of utility lies at the heart of conventional welfare economics. Here, the true test of the worthiness of any remedial course of action, whether government mandated or market inspired, lies in whether or not it achieves Pareto optimality. A marked contrast to the win-lose dynamic of zero-sum game theory, Pareto optimality is reached where there are winners but no losers. Its cardinal principle rejects any reallocation of resources that enriches some at the expense of others. In the best-case scenario, everyone benefits, perhaps a few more than most; in the worst-case scenario, only a few prosper, but nobody is poorer for it.

The very same premise lies at the root of sustainable-development theory, an alternative to the conventional growth paradigm of neoclassical economics and its emphasis on yearly net increases in productive output as an end in itself. In this conventional paradigm, utility is considered nigh on synonymous with consumption, a linkage that sustainable-growth advocates reject. They too call for steady rises in per capita income, but only insofar as near-term increases do not deplete the physical, environmental, human, and social capital bequeathed to future generations. These assets must be left intact; otherwise, their Pareto optimality will be sacrificed before they are even born. In effect, the world's population must rely solely on the interest of their accumulated wealth, what welfare economists call their Hicksian income, to bankroll future consumption and investment. If they do not, someday their offspring will confront head-on a much starker, Malthusian limits-to-growth model (Davidson, 2000).

Remediation Mechanisms

The time when pure theory sufficed has ended. With the constraints, both real and imagined, of climate change more pressing with each passing day, attention has turned to finding efficient transition paths out of negative externalities for markets otherwise in equilibrium. Two diametrically opposed types of mechanisms are being contemplated, though the use of one in some markets does not exclude the use of the other elsewhere. Of the two, government-imposed command-and-control measures are the most direct. Uniform standards for emissions and for types of inputs and technologies used by manufacturers can be enforced, or quotas on outputs can be set (Mulder & Van Den Bergh, 2001). But critics charge that the fiats of regulators smack of central planning that, according to experience, only warps the overall efficiency of free markets. And though these measures may or may not deal effectively with a problematic externality, they almost certainly will dampen economic activity, slowing or reversing its growth.

Yet the externality arose from these very same markets and, so the counterargument goes, will only worsen if said markets are left to their own devices. A better approach, consequently, might be for governments to provide incentives for change rather than mandates: subsidies, tradable permits, and tax breaks to encourage compliance, with punitive taxes or levy cleanup costs as a last resort to sway the recalcitrant. However, for such market-based instruments to work, everyone affected has to have a very accurate idea of the pluses and minuses involved. Indeed, major environmental policy initiatives have been the subject of formal cost-benefit analysis since Eckstein's "Water Resource Development" and Krutilla and Eckstein's "Multipurpose River Development" of 1958 (Pearce, 2002). Standard accounting practices make the valuation of any tangible asset a straightforward exercise: a machine cost X and produces goods that earn sales of Y. Lacking a marketplace to set prices, the valuation of intangible assets such as air quality is much more difficult. At best, their monetization can only be approximated indirectly via observable changes in the prices of tradable commodities affected. A newly contaminated watershed, for example, will dramatically lower the resale value of a house. Environmental economists call this alternate approach revealed-preference valuation. When no such proxy exists, stated-preference valuation is relied on instead. In stated-preference valuation, individuals are queried about how much they are prepared to pay to improve a particular environmental problem.

No matter how rigorous, no cost-benefit analysis can predict with any real certainty what the long-term economic effects of climate change will be. According to the UN’s Intergovernmental Panel on Climate Change (IPCC), climate change of 2.5 degrees Celsius could cost the world 2 percent of global GDP (cited in Morales, 2014). For comparison, in 2013, output in industrial countries grew at around 3.5 percent over the preceding year (Central Intelligence Agency, n.d.); in the long run, then, unimpeded climate change will slow their future expansion, perhaps significantly. At first glance, it would thus seem that economically speaking, remediation is the less favorable option, since it would on the whole cost more. But these costs are largely derived from forecasts of the likely negative impact of the Kyoto Protocol on the US economy, by far the world's largest emitter of greenhouse gases, and some of these forecasts were grist for the mill in a contentious political debate. Forecasting is an imprecise science to begin with, in part because basic assumptions must always be made. When these assumptions are ideologically tinged, biases can be and are introduced, often unintentionally, making an already imprecise science only more so. Forecasts supporting pro or con positions on climate-change abatement, therefore, should not necessarily be taken at face value.

It is not yet clear just how much of a mitigating factor new technologies will be in slowing or reversing climate change. Much indeed hinges on the kind and degree of "substitutability" of human for natural capital. Is our ingenuity and technological prowess up to the challenge of marshalling non-carbon-based sources of energy, of remaking our material world with non-petrochemical-based substances, of supplying enough fresh water to counter the salination of arable land and slake human thirst? And can all this and more be done in conditions of Pareto optimality? Or will efforts be too little and too late? Must a great and terrible price be paid by the earth's people generations hence? Alarmists raise that possibility to galvanize action, of course, but that does not mean their dire predictions will not come true. Even believers in sustainable development's viability are divided on the question of substitutability. Advocates of strong sustainability think no amount of human or economic capital can make up for the likely loss in natural capital, and present efforts must focus on their preservation. Conversely, advocates of weak sustainability think that technology and green investment can make a difference, and present efforts must focus on creating the required incentives. Only time will tell who is right.

Viewpoints

While little can be said with absolute confidence about the future economic effects of climate change, one such certainty is that it will occasion structural change of the first order. How exactly this restructuring will unfold is open to interpretation. Carbon-emitting industries are still the cornerstone of much of the world's economic output, and sudden and drastic change would throw markets into a disequilibrium that may take decades to reverse. By contrast, measured, incremental change might not reach critical mass in time to stave off catastrophic irreversibility. What is clear is that new government policies and market mechanisms will be needed, and soon, to deal with what is an already enormous and still-growing negative externality.

Terms & Concepts

Coase Theorem: A theorem that states that externalities are more efficiently remediated privately through bargaining among concerned parties rather than through government regulation or legal action, with the caveat that if property rights are not clearly established at the onset and transaction costs quickly mount, the chances for successful negotiations are practically nil.

Command-and-Control Measures: Government intervention in the marketplace to correct a negative externality via enforceable regulations and quotas.

Cost-Benefit Analysis: A quantitative assessment of the total value of all of a proposed investment's inputs and outputs, including its opportunity, marginal, and financing costs and its expected, marginal, and future utility.

Externalities: Occur whenever the social and the private costs of production diverge either positively or negatively. Problems arise in the latter case when the normal functioning of the marketplace fails to adequately redress the public's consequent burden.

Hicksian Income: The maximum amount of money that can be spent without taking away from preexisting capital.

Irreversibility: The idea that there is an upper limit to the amount of greenhouse gases the atmosphere can absorb, beyond which catastrophic global warming is inevitable.

Kaldor-Hicks Compensation Principle: A transfer mechanism intended to maximize overall utility wherein those who gain directly from a change in the economy reimburse those who suffer.

Limits-to-Growth Model: A model that states that finite supplies of natural resources and energy will eventually make continuously expanding productive capacity and consumption for consumption's sake economically untenable.

Market-Based Instruments: Subsidies, tradable permits, tax breaks, and other incentives to encourage private-sector solutions to negative externalities.

Monetization: Assigning a financial value to the outcomes of inherently intangible processes.

Pareto Optimality: When resources are allocated such that no one can be made better off without making at least one person worse off.

Sustainable Development: The idea that economic growth should not lessen the overall capital endowment (physical, structural, technological, social, human, etc.) bequeathed from one generation to another.

Welfare Economics: The branch of economics that examines the effects that free markets have on the well-being of the community at large.

Bibliography

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Suggested Reading

Nordhaus, W. (2001). Global warming economics. Science, 294(5545), 1283. Retrieved December 24, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=5690373&site=ehost-live

Parry, I. (2002). Are all market-based environmental regulations equal? Issues in Science & Technology, 19(1), 38. Retrieved December 28, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=7592749&site=ehost-live

Ratnatunga, J. (2014). Costing life: Air, water and food. Journal of Applied Management Accounting Research, 12(1), 1–12. Retrieved November 5, 2014, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=96300419&site=bsi-live

Scrieciu, S., Barker, T., & Ackerman, F. (2013). Pushing the boundaries of climate economics: Critical issues to consider in climate policy analysis. Ecological Economics, 85, 155–165. Retrieved November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=84764915&site=ehost-live

The climbing cost of climate change. (2001). Earth Island Journal, 16(2), 19. Retrieved December 28, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=4362272&site=ehost-live

Thorning, M. (2003). Heroes and villains? Power Economics, 7(4), 26. Retrieved December 24, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9696571&site=bsi-live