The economics of climate change

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On the 8th of October 2018, the Nobel Prize of Economics was given to William Nordhaus, from Yale University, and Paul Romer, currently working for New York University. They have respectively won the Prize for “integrating climate change into long-run macroeconomic analysis” and for ” integrating technological innovations into long-run macroeconomic analysis». It is the first time that the winning subject revolves around climate change, even though it has been one of the most urgent and discussed global issues since the 70’s.

Who is William Nordhaus, and what has he done?

Arthur Cecil Pigou, an economist in the late 20th century, prefigured environmental economics.  Indeed, he introduced the idea that, by making the polluters pay the value of the externalities they were causing, it would create an incentive to reduce pollution. However, his work mainly focused on welfare economics and externalities, not so much on integrating environmental problems into economics. From Plato to Karl Marx to Arthur Cecil Pigou, we can find a myriad of philosophers, thinkers and economists, before William Nordhaus, who included environmental aspects in their work. Nevertheless, Nordhaus was one of the first to focus on the economics of climate change, by estimating the cost and benefits of environmental measures in the future. William Nordhaus is undoubtedly a pioneer in his field. His greatest work so far might be the DICE model, or Dynamic, Integrated Climate and Economics model. This model uses a complex algorithm that reveals potential scenarios of the world according to several variables. Indeed, DICE displays the trends of human emissions, global temperature, gross output and the costs of reducing carbon emissions, and many more graphs.  The variables, inter alia, include the emissions control rate (if the rate is equal to one, it represents a situation where we are taking drastic measures for climate change), a coefficient of aversion to social inequality and the most important and controversial one: the discount rate.

What does the discount rate represent?

In 2015, students from the Political Institute of New-York gathered a list of 289 top economists who specialized in climate change. 144 of those economists responded to the students’ survey. A strong majority (92%) of those 144 economists, agreed that most of the burden of climate change will fall on our grandchildren. 

The discount rate measures the investment of our generation to reduce our carbon emissions for future generations. This investment depends on how politics address global warming. For example, if the discount rate equals 3%, a worth of 2000$ of climate damage in 100 years is worth 105$ now. A discount rate of 0,1% would mean that 2000$ in 100 years would correspond to 1809$ at the present time. In conclusion, if the discount rate is high, the damage in the distant future is given little weight today. However, if the discount rate is low, the damage in the future is considered enormous in the present.

William Nordhaus’s discount rate

William Nordhaus has been criticized for using an important discount rate amounting to 3%. He considers that the cost of the future should not influence our present policy too much. Furthermore, he posits that investors should give small importance to the cost of an additional ton of carbon in the atmosphere now. Nordhaus also implies that the preferred policy, the climate policy ramp, is to stabilize the quantity of our CO2 emissions, and then gradually increase the price of carbon later in the century. Even though we would reach a temperature rise of 3%, we would optimize our expenses. Moreover, this temperature raise should not affect public welfare much, since the future generations will be wealthier than us because of economic growth. Consequently, their wealth will “compensate” or “absorb” the cost of climate change.

William Nordhaus’s preferred policy is partly supported by Paul Romer’s work. Indeed, one of Romer’s statements is that technological advances will lift the burden of environmental costs in the future. Because of technological progress, we will develop great innovations and inventions to combat the consequences of climate change. However, on a side note, if we continue to invest so little in research and development, technological advances will not be as efficient as predicted. In average, we only invest 2,27% of the world GDP in R&D. 

Why is there a debate on the value of the discount rate?

Of course, Nordhaus’s choice of high discount rate is based on observed behaviors, how actual politics are reacting to the climate change situation. Politics are currently, like Nordhaus suggests, not giving a lot of importance to future generations’ well-being. However, Nicholas Stern, the ex-British vice-president of the World Bank, strongly advocates a discount rate of 0,1%, stating that the well-being of the future residents of Earth should weigh as much as the one of today’s population. Therefore, Stern opts for immediate and aggressive actions to limit emissions, implying that public policy should take coercive measures on private markets.

One of the debates about climate change is whether the uncertainty of the consequences of climate change should discourage us from taking actions, since we don’t know for sure what will happen in the future. In the survey from the Political institute of New-York, 73% of respondents agree or strongly agree that “uncertainty, given some risk aversion, increases the value of emissions control measures”. Paul Krugman, an influent American economist, explains in his article “Building a green economy” (April 7, 2010, New-York Times), that he leans toward the view of Stern, because of that previous statement. For Krugman and Stern, the possibility of a catastrophic scenario in the future should outlaw by far the scenarios displayed by modelling, costs and benefits previsions and other measurements.

The free-rider problem

For a dramatic change to happen, the creation and implementation of a unanimous international coalition is needed. Nevertheless, the previous climate change COPs have proven to be inefficient. Regarding international agreements, the free-rider problem is problematic. This problem occurs when an economic agent benefits from others without bearing the consequences and costs of the effort. If a country decides to impose a heavy carbon tax, thus increasing prices nationally, other countries benefit from the tax because it increases their own competitivity. That said, that scenario implies that nothing is being done to force those countries to do the same environmental effort. Moreover, a heavy carbon tax would lead to an increase in offshoring from countries with a strict green economy to laxer ones. The search for low production cost and high profit will always drive firms to look for the best opinion they have in that matter. Another problem of the free-riding, as explained in Jean Tirole’s “Economie du bien commun”, is that if a country leads a 100% green economy, it will only get 1% of its politics’ benefits if the country represents 1% of the global population. In other words, would you rather consume 100$ today or give 99$ tomorrow? Again, if there are no supranational entity guaranteeing the respect of rules, then no one wants to be part of the game.

A carbon tax, the solution for climate change?

The current system regarding pollution regulations is the “cap and trade” policy. This market of “rights” to pollute, operates as follows: “The government determines a ceiling amount of pollution allowed for one year. Then, the governement creates permits of rights to emit a certain amount of carbon dioxides and sells it to firms. At the end of the year, if a firm polluted more than its permits allowed, it is forced to buy the difference with the market price. If the firm polluted less than its permits allowed, than it sells its excess permits in the market”. It is generally considered a fairly good incentive to reduce pollution. However, James Hansen, a physicist specialized in climatology, argues that the cap and trade system isn’t good enough. According to him, buying less permits allows others to pollute more. In the end, individually, no one has taken measures to reduce pollution.

Carbon pricing, another method to reduce global-warming emissions, is massively recognized to be more efficient than the “cap and trade” system. The government charges those who emit CO2 for their emissions. However, all countries using this method impose a tax below the “social cost of carbon” (except Sweden). The “social cost of carbon” is the cost that would force economic agents to reduce carbon emissions enough to achieve the 1,5-2°C target. To give an example amongst others, France applies a tax of 14,5 euros per tons of CO2, yet the Quinet report estimated that a 45 euros tax would be the minimum price to successfully put climate in the right trajectory. Furthermore, governments wouldn’t want to scare off important firms by creating a carbon tax that is too important.

Immediate needs vs. climate altruism

In 1900, an astounding 70% of the global emissions were European, 25 % were American and only 5% were from the rest of the world.

Today, Europeans and Americans account for 50% of the global emissions. For the same amount of output, developing countries pollute more than the developed countries, because they lack infrastructures. However, most developing economies rely solely or heavily on their industrial sector. If we were to impose a global high carbon tax, wouldn’t it be unfair to developing countries? Developed countries financed their industrialization by polluting, why would developing countries be impeded to do the same?

As Alexandre Delaigue said in his article published in France Info, today, in India, 700 000 workers depend on coal extraction and on the access to electricity in an urgent manner. Can we blame developing countries for giving more importance to their immediate needs rather than focusing the well-being of futuristic people they will not know?

William Nordhaus’s discount rate is actual as opposed to ideal, his rate considers the selfishness created by immediate necessity. This necessity can be superficial, caused by mass consumption for example, or it can be real, such as the need to have access to electricity. This eagerness for immediate necessity explains why countries are not investing more in research and development. Investing for a distant future seems unattractive compared to consuming now. 

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