Economics of global climate change

Policymakers rely on natural scientists to explain the causes and likely physical consequences of climate change, but they also need economists to provide estimates of the costs of mitigation strategies and to offer guidance on balancing costs in the present against potential damages in the future.

Background

Many scientists argue that human activities release greenhouse gases (GHGs) that cause climate changes that will impose harm on future generations. Economists classify such activities as negative externalities that may require corrective policies. Measures that reduce carbon dioxide (CO₂) emissions will cause economic hardship in the present, but their benefit will be lower damages from climate change in the future. Economists already have tools to analyze trade-offs between present costs and future benefits.

Benefits of Reducing GHG Emissions

The primary benefit of reducing GHG emissions is the expected reduction in damages from climate change in the future. In order to combine various types of damage—such as increased mortality from heat stress, reduction in crop yields, and loss of coastal property—economists must reduce the impacts to a common denominator, namely money.

The monetary damages from future climate change can be quite broad. For example, if climate change leads to more intense hurricanes, the total damages could include not just the money spent rebuilding damaged property but also the monetary value of the lives lost and even an estimate of the psychological harm suffered by people living with a greater fear of hurricanes. In general, economists prefer cost estimates tied to objective measures to limit the bias of an individual analyst.

Many economists would not include the creation of new, green industries and jobs as a net benefit from policies that reduce GHG emissions. While a tax on CO₂ may create jobs in the manufacture of and solar panels, it would also destroy jobs in the manufacture of SUVs and coal-fired power plants.

Costs of Reducing GHG Emissions

The costs of climate change policies are the reduced outputs of various goods and services. For example, if the government levies a tax on every ton of CO₂ emitted by a factory, this will increase the cost of production, leading to smaller output and higher prices for the goods produced in the factory. If the factory produces components used in other processes, then the tax will ultimately lead to higher prices for those goods as well.

When a carbon tax or a cap-and-trade program is put in place, the economy will adjust to the new incentives. Producers will strive to maximize their profits, workers will flock to the jobs with the highest salaries, and consumers will shop for the cheapest products. However, any new policy that causes GHG emissions to be lower than they otherwise would have been will necessarily impose economic hardship in the near term. In the absence of such climate policies, the economy would have produced goods and services that emitted a greater amount of GHGs.

Unregulated business does not purposely seek to cause climate damage; it rather seeks to maximize profits by providing consumers with the products they desire at the lowest prices. If government policies force businesses to change their behavior, this results in a lower quantity or quality of output. For example, if it truly were more efficient (disregarding climate change issues) for African nations to build an infrastructure reliant on solar and wind power, then industry would not need special incentives to cause this outcome. The present costs of policies to mitigate climate change may well be justified in light of the future benefits (reduced climate change damages). Even so, policies leading to lower GHG emissions are costly.

Proper Discount Rate to Compare Future Benefits with Present Costs

In order to determine the relative merits of various climate change policies, including the policy of doing nothing about climate change, economists can first reduce the varied and often qualitative harms of future climate change into an aggregate figure of total monetary damage at each future date. They can perform a similar calculation for the total expected monetary costs of compliance with a given policy for every time period. At each interval of time (for example, every year or every decade) from the onset of the new policy into the future, an economist would then have an estimate of the net costs or benefits from the proposed policy.

Typically, climate change policies impose net costs in the beginning, but at some point in the future yield net benefits because technology allows for easier compliance with low emission targets and also because the benefits from reduced climate change grow larger as time passes. The more aggressive the policy—in other words, the harsher the penalties it places on GHG emissions—the higher the net costs in the earlier years, but also the higher the net benefits in later years. By definition, a baseline laissez-faire policy imposes no compliance costs but eventually yields the largest damages from climate change because of unrestricted GHG emissions. The problem of choosing the most efficient or optimal policy can thus be reduced to choosing the most preferred stream of net costs and net benefits accruing at respective time intervals.

A central concept in economics is the discount rate, which allows one to translate costs and benefits accruing at a future date into their present value. For transactions in the marketplace, the relevant market rate of interest is often used. For example, the owner of a building might consider the installation of insulation that will cost $10,000 up front but that will reduce heating expenses by $1,200 per year for the next ten years, after which time the insulation will have to be replaced. If there were no discount on future dollars, the insulation would clearly be profitable; it would yield a lifetime savings of $12,000, in contrast to its initial expense of $10,000. However, if the owner could alternatively invest his money in low-risk bonds earning 3.5 percent or more per year, then the insulation would be a poor investment, based purely on monetary considerations. In general, the higher the discount rate, the more present-oriented investors will be; projects that require large upfront expenses or that do not yield benefits until distant dates in the future will be penalized because the early expenses will weigh more heavily than the later benefits.

Once the appropriate discount rate is selected, the various climate change policies can be ranked according to their present value. The lower the discount rate used, the more aggressive the optimal policy will be. This is because aggressive GHG reductions impose higher upfront costs in exchange for greater future benefits, and so their present value increases as a lower discount rate is applied. In contrast, if a high discount rate is adopted, then the optimal policy typically will involve only modest GHG reductions in the early years, gently increasing over time as the atmosphere becomes more concentrated with GHGs and climate change damages become less distant in the eyes of policymakers in those time periods.

There are two major controversies among economists regarding this framework for analyzing climate change policies. The first involves adequately dealing with the problem of risk or uncertainty. Unlike stylized scenarios involving cost-saving insulation, climate change involves many unknowns. Many economists argue that the method described above of selecting the best policy may be too risky, and instead they would recommend erring on the side of caution by implementing a more aggressive policy to reduce GHG emissions.

A second controversy lies in the choice of discount rate to be used in the context of climate change trade-offs. Many economists believe market interest rates are inappropriate for matters of public policy, especially ones involving future generations. After adjusting for inflation and specific risks, the “real” rate of return on capital investment in Western economies is estimated at roughly 4 percent per year. This discount rate implies that a climate change policy that imposes compliance costs of $21,000 to people living in the year 2022, but that reduces environmental damages for the people in the year 2122 by $1 million, will be dismissed as too expensive by the earlier generation. Outcomes such as this strike many as selfish.

On the other hand, many economists defend the use of market discount rates. Some discount must be applied because future generations may be far wealthier than people in the present; it strikes some analysts as unethical to impose compliance costs on today where many do not have clean water or electricity, in order that (the equivalent of) multimillionaires in the year 2120 might live in a slightly cooler world. There is also the remote possibility that an asteroid collision, nuclear war, or other catastrophe unrelated to climate change could reduce future populations, in which case the total benefits to future humans from reduced GHG emissions would be much lower. In light of these considerations and others, a future dollar in benefits must be weighed less heavily than a present dollar of compliance costs. Many economists favor the choice of the market’s discount rate, despite its possible flaws, because it is objectively measurable.

Context

One of the earliest yet comprehensive works on the economics of climate change was William Nordhaus’ 1979 book, The Efficient Use of Energy Resources. Since its publication, a growing number of economists have devoted their attention to the many issues involved, ranging from estimates of compliance costs and future damages to fairly technical issues of modeling uncertainty.

Economists can generally be divided into three broad groups in terms of their attitude to climate change. The first group believes that GHG emissions constitute a negative externality, and they recommend a modest or other penalty on emissions, which grows over time as climate change damages become more severe. A second group of economists believes the situation is far more serious, and they therefore urge more drastic penalties on emissions. The difference could be due to their reliance on more severe forecasts of future damages or their use of a lower discount rate than the first group. Finally, a third group of economists does not believe the government should take any particular actions regarding climate change, either because they dispute the science underlying the policies or because they believe that politicians cannot be trusted to implement an efficient solution. For example, these skeptics might argue that without worldwide controls on GHG emissions, industries will simply move to unregulated regions, a process known as leakage.

Key Concepts

• cap and trade: a system in which the government limits total carbon dioxide emissions but allows individual emitters to buy and sell permits giving legal permission to portions of the total cap
• carbon tax: a tax on activities that lead to carbon dioxide emissions, designed to “internalize the externalities” of such emissions
• discount rate: the percentage discount to be applied per unit of time in order to account for the higher weight given to costs and benefits that occur sooner
• inefficiency: preventable waste in the use or distribution of resources
• leakage: the shortfall in targeted greenhouse gas emissions reduction caused by industries relocating to jurisdictions with weaker regulation
• negative externality: a situation in which market prices do not reflect the full social costs of some behavior

Bibliography

Bradley, Robert. Climate Alarmism Reconsidered. London: Institute of Economic Affairs, 2003.

Gordon, Oliver. "Can a 2% 'Social Discount Rate' Transform Global Climate Policy?" Energy Monitor, 28 July 2023, www.energymonitor.ai/regulation-policy/can-a-2-social-discount-rate-transform-global-climate-policy/. Accessed 9 Dec. 2024.

Mendelsohn, Robert, and James Neumann, eds. The Impact of Climate Change on the United States Economy. New York: Cambridge University Press, 1999.

Nordhaus, William. The Efficient Use of Energy Resources. New Haven, Conn.: Yale University Press, 1979.

‗‗‗‗‗‗‗. A Question of Balance: Weighing the Options on Global Warming Policies. New Haven, Conn.: Yale University Press, 2008.

Schoenmaker, Dirk. "Which Discount Rate for Sustainability?" Journal of Sustainable Finance and Accounting, vol. 3, Sept. 2024, doi.org/10.1016/j.josfa.2024.100010. Accessed 9 Dec. 2024.

Stern, Nicholas. The Economics of Climate Change: The Stern Review. New York: Cambridge University Press, 2007.