The Economics of Climate Change

During the last ten years, one of the biggest drivers of public opinion and policy has been concern over global warming or climate change. The economics of climate change uses economic theory and computer models to study the interactions among government policies, the climate system, and the economy. In this article, I survey the field and some of its major controversies.

The IPCC

The Intergovernmental Panel on Climate Change (IPCC) is the world authority on climate change science. In 2007, the IPCC shared the Nobel Peace Prize with Al Gore for its contributions to the fight against global warming.1 Its periodic reports do not contain new research but, instead, “make policy-relevant—as opposed to policy-prescriptive—assessments of the existing worldwide literature on the scientific, technical and socio-economic aspects of climate change.”2

The latest edition of the IPCC’s work is the 2007 Fourth Assessment Report (AR4), which consists of three volumes by different “working groups.”3 The gist of the IPCC AR4 is that human activities4 are leading to increasing atmospheric concentrations of CO2, methane, and other greenhouse gases, which allow sunlight to pass through them but trap some of the lower-frequency infrared radiation that bounces back off the earth. This “enhanced greenhouse effect” leads to global warming, which many scientists and economists warn will have dramatic effects on human well-being over the next several hundred years.

When proponents of government intervention refer to the “consensus” on climate change, they have in mind the results documented in the IPCC reports. There are qualified people who passionately dispute the alleged role of human activities in the observed global warming (of about 0.7 degrees Celsius) since preindustrial times.5 However, this article focuses specifically on economic issues. Even if policymakers took the AR4 results as gospel, some of the popular policy recommendations, such as those being proposed by key Congressmen, are difficult to justify.

Market Failure, Government Solutions

If the physical science of manmade global warming is correct, then policymakers are confronted with a massive negative externality. When firms or individuals embark on activities that contribute to greater atmospheric concentrations of greenhouse gases, they do not take into account the potentially large harms that their actions impose on others. As Chief Economist of the World Bank Nicholas Stern stated in his famous report, climate change is “the greatest example of market failure we have ever seen.”6

To deal with climate change, many (perhaps most) economists favor an explicit Pigovian tax on emissions, ideally calibrated to reflect the “social cost of carbon.” This tax would cause firms to internalize the externality of (mostly future) climate-change damages.

Politically, an explicit Pigovian “tax on energy” would be very difficult to implement, especially in the middle of a global recession. Consequently, politicians have flocked to a “cap and trade” system, which has the supreme virtue of being utterly incomprehensible to most voters.

Under cap and trade, the government sets a total limit on annual emissions of greenhouse gases (the “cap”). Allowances to portions of this total limit are then either handed out to various groups or auctioned off to the highest bidder. Many people consider this approach a “market solution” because the permits can be traded. People who hold excess permits sell them to those who need more permits to cover their planned emissions.

Under ideal conditions, a carbon tax can mimic any cap and trade system. In the real world, transaction costs and various uncertainties cause the two approaches to have relative pros and cons. For example, because the damage from emissions is cumulative and long-term, while the compliance costs from emissions cuts are possibly acute and immediate, a predictable carbon tax might limit environmental damages at a much lower cost than a cap and trade system.7 On the other hand, it is much easier for outsiders to verify whether (say) China is adhering to its annual cap than to verify that it is appropriately taxing firms based on their individual emissions.8

Although most economists think that there is a case for government intervention to curb emissions of greenhouse gases, the actual calibration of such policies leads to controversies, some of which are discussed below.

Discounting

When economists differ on the “optimal” tax on a ton of carbon dioxide emissions, most of the variation is due to the discount rate each applies to the forecasted stream of benefits and costs.

Fighting climate change involves large, upfront costs in the form of foregone goods and services. Whether it taxes emissions or imposes a shrinking cap, the government takes away options from producers. Thus, measured GDP and per capita income will be lower, at least compared to what they would have been in the absence of emission curbs. This forfeited output is the cost of fighting global warming. Cost estimates vary because of different modeling assumptions. For example, if there are rapid innovations through “learning by doing,” then even onerous emission schedules won’t reduce (conventional) GDP figures very much, because people will quickly learn how to prosper without reliance on fossil fuels.

Many people may be misled by the official cost estimates, because these figures typically assume that governments use the extra revenues (from either allowance auctions or carbon taxes) in an efficient manner. For example, earlier this year critics of cap and trade legislation had taken an MIT study’s projections, and warned that such a plan could cost U.S. households $3,100 per year. They arrived at this figure by taking the projected annual auction revenues and dividing by the number of households. The author of the study came back with a much lower figure of only $800 per year. He wasn’t disputing that the prices of electricity and gasoline would rise, because (loosely speaking) businesses would pass on the $3,100 per household cost of emissions allowances. But his point was that these government revenues could be recycled back to households in the form of tax cuts or spending programs. His much lower figure referred merely to the deadweight loss of the hypothetical cap and trade program.9

Therefore he was unrealistically assuming that the money raised by the auctioned allowances would be spent as efficiently as it would have been spent if the households spent it themselves.

While the cost of climate change legislation is the reduction in goods and services, the benefit of these interventions is the avoided future damage from unrestricted climate change. The choice of discount rate has a tremendous impact because we are comparing costs over the next few decades with benefits that will not accrue for another century.

To borrow a calculation from David R. Henderson: If we stipulate that the “social cost” of a ton of carbon will be $300 in 100 years, at a six-percent discount rate, the correct current tax on gasoline would be 0.3 cents per gallon. At a lower discount rate of four percent, the same stipulated future damage from emissions would translate into an optimal current tax of two cents per gallon.10

William Nordhaus has shown that the Stern Review’s extreme penalties on emissions are due to the choice of discount rate. Using Stern’s parameters for his model’s utility function, Nordhaus explains the following apparent absurdity:

Suppose that scientists discover a wrinkle in the climate system that will cause damages equal to 0.1 percent of net consumption starting in 2200 and continuing at that rate forever after. How large a one-time investment would be justified today to remove the wrinkle that starts only after two centuries? Using the methodology of the [Stern] Review, the answer is that we should pay up to 56 percent of one year’s world consumption today to remove the wrinkle. In other words, it is worth a one-time consumption hit of approximately $30,000 billion today to fix a tiny problem that begins in 2200. [Italics in original]11

The actual exchange rate between present and future dollars depends on choosing utility function parameters for both the “elasticity of consumption,” which basically accounts for aversion to income inequality, and the pure discount to be applied to future utility. Both of Stern’s choices are at odds with estimates of actual preferences. Stern justifies his choice of a very low pure discount rate by ethical considerations: don’t future generations have the same right to their utility as we do to ours?

However, many economists argue that it is nonsense to theorize about the “correct” rate of discount to apply to potential future benefits from curbing emissions today. Like it or not, the market gives us actual real rates of return on investments, and these rates are much higher than the theoretical rates that Stern uses.

The justification for using actual market interest rates is simple: We can help future generations either by “investing” in fighting climate change or by investing in traditional assets and bequeathing more wealth (of a conventional form). It would be silly to forfeit potential consumption today, in the form of tighter emissions cutbacks, if our descendants would perceive a greater benefit from our channeling those savings into more traditional investments that would make them wealthier.

Uncertainty

Some advocates of aggressive government action reject traditional cost/benefit analysis (CBA) when it comes to fighting climate change. The theoretical leader in this area is Martin Weitzman, who has shown that with sufficiently catastrophic damages in the “fat tails” of a distribution, standard CBA breaks down.12 Weitzman argues that the standard models (such as those used by Nordhaus) do not assign enough importance to improbable but catastrophic risks.

Weitzman’s arguments, though correct as far as they go, do not justify “anything goes” in climate policy the way some enthusiasts believe.13As Nordhaus explains:

The [class of utility] functions that Weitzman analyzes … assume that zero consumption has utility of minus negative infinity (and unbounded positive marginal utility) as consumption goes to zero. This has the unattractive and unrealistic feature that societies would pay unlimited amounts to prevent an infinitesimal probability of zero consumption. For example, assume that there is a very, very tiny probability that a killer asteroid might hit Earth, and further assume that we can deflect that asteroid for an expenditure of $10 trillion. [Weitzman’s choice of] utility function implies that we would spend the $10 trillion no matter how small was the probability.14

Those who are concerned about destructive climate change should pause before throwing out CBA altogether. After all, just about every interest group desiring government funding could concoct a scenario, no matter how implausible, in which society suffers enormous harms because of inadequate prior funding.

Before leaving this section, let me clarify that the dispute between Weitzman and Nordhaus is not about risk aversion per se. When Nordhaus and others calculate the benefits of averting climate damage, their models already assume that people are risk-averse. For example, if there is a 5 percent probability that global GDP will drop by 10 percent because of massive drought, this implies an expected loss (the actual loss times its probability) of 0.5 percent of GDP. If we are risk averse, we would be willing to pay more than 0.5 percent of GDP (in the form of emission cutbacks) to avert this risk. Nordhaus’s cost/benefit climate change model incorporates this assumption, just as standard models of the demand for insurance do.

Two Approaches to Policy Design

Due to the issues raised above, the current literature involves two different approaches to climate policy design.15 One approach looks at the expected costs and benefits of increasingly stringent penalties on emissions, and then prescribes a policy that equates the marginal benefits (in terms of avoided future climate change damage) with the marginal costs (in terms of forfeited economic output). This is the approach of theorists such as William Nordhaus, and it results in a “policy ramp” where the equilibrium path involves only modest emission cutbacks in early decades, so that the weaning away from fossil fuels is much more gradual compared to other proposals.16 This “ramp” occurs because distant climate damages are heavily discounted for the first few decades, and because of technological improvement over time, which makes emission reductions relatively cheaper if they are postponed.

In contrast to this Pigovian approach, another popular method takes certain climate objectives—such as a declining ceiling on emissions or an upper bound on atmospheric concentrations—as a given, and then works backwards to find the least-cost policies that will satisfy these objectives. This is a sensible approach if the climate system contains “tipping points” beyond which we will suffer a runaway greenhouse effect.

Using a standard cost/benefit approach, the policy recommendations generated by stipulating unacceptable “tipping points” appear very inefficient. For example, the current Waxman-Markey bill pending in Congress requires an 83-percent reduction in U.S. emissions (relative to the 2005 base level) by the year 2050. Yet, most models show that if the whole world were to adopt such an aggressive target, the costs would far outweigh the benefits. The latest calibration of Nordhaus’s “DICE” model indicates that such strict cutbacks would yield more than $15 trillion in net costs, that is, costs net of benefits. The other models (which use CBAs) studied by the IPCC show similar results.17

Government Failure?

The above discussion has largely taken the mainstream economics of climate change literature on its own terms. But anyone versed in Public Choice economics should realize that the case for “mitigating climate change” is much weaker than most of its experts presume.

Most of the theoretical benefits of government intervention assume worldwide and consistent enforcement of the policies. But if, say, China exempts key domestic industries, or if the world relaxes the controls due to a severe recession in, say, 2045, then much of the modeled benefit would disappear. To the extent that there are any gaps in worldwide enforcement, greenhouse gas emitters will have an incentive to relocate their operations to unregulated jurisdictions. (In the literature on global warming, this phenomenon is called “leakage.”) Even if countries representing half of current global emissions suddenly banned all operations tomorrow, therefore, the long-run reduction in global emissions would not be halved. Further, if there were a temporary respite granted because of an economic downturn, emitters would rush to exploit the gap, just as businesses would concentrate their activities if Congress granted a one-year income tax amnesty. Years of steady progress in curbing emissions could be for naught if major governments relaxed the emission controls in a moment of political weakness.

Fans of Austrian economist Friedrich Hayek—who warned against the “pretense of knowledge”—should be even more concerned about the sheer audacity of the field of climate economics. After all, it is rather absurd to argue about the impacts of present tax policies on global temperatures in the year 2150. Yet, it is precisely these projections that provide the foundation for policy recommendations.

Many critics have raised this objection before, but it bears repeating: We have no idea what the world economy will be like in the 22nd century. Had people in 1909 adopted analogous policies to “help” us, they might have imposed a tax on buggies or a cap on manure, needlessly raising the costs of transportation while the U.S. economy switched to motor vehicles. This is not a mere joke; “serious” people were worried about population growth, and the ability of large cities to support the growing traffic from horses. Had someone told them not to worry, because Henry Ford’s new Model T would soon transform personal locomotion without any central direction from D.C., these ideas would probably have been dismissed as wishful thinking. As famed physicist Freeman Dyson has mused, future generations will likely have far cheaper means of reducing atmospheric concentrations of carbon dioxide, if the more alarming scenarios play out.18

In the climate change debate, people often forget that under all but the most catastrophic scenarios, the future generations who will benefit from our current mitigation efforts will be much richer than we are. For example, Nigel Lawson points out that even under one of the worst case scenarios studied by the IPCC, failure to act would simply mean that people in the developing world would be “only” 8.5 times as wealthy a century from now, compared to 9.5 times as wealthy if there were no climate change.19

Although it is probably true that the “best evidence” suggests a connection between human activities and a warming globe, this fact about the natural world does not automatically justify aggressive government interventions into the economy. Given the historical corruption of governments and the demonstrated resilience of free entrepreneurs, proponents of such measures have a much harder case to make