SANE Views

Vol.6 No.13, 05 April 2006

Will it cost the earth? How economists are pricing the ravages of climate change

Scheherazade Daneshkhu and Fiona Harvey

The price of the US's "addiction to oil" goes far beyond the dependence on politically volatile states cited by President George W. Bush. According to the world's leading climate scientists, reliance on fossil fuels is creating a global warming disaster that could end up costing the earth.

Faced with these threats, rational people and governments might be expected to reduce their greenhouse gas output.

But there is little appeal in taking costly action in the short term to stave off a long-term threat - especially one that, by its nature, is hard to calibrate.

Persuading individuals and businesses to take the action necessary to tackle climate change caused by economic activity itself requires an economic argument. But how to put a price on the world's climate and the catastrophes that may follow from global warming?

Attempts to fill a policy vacuum as the expiry of the Kyoto protocol in 2012 looms are suddenly turning environmental economics into one of the hottest areas of the discipline. The challenge is to find policies that will make the most efficient use of scarce resources and provide a rational basis on which to build an international consensus to address climate change among politicians and business people.

It has taken some time for the economics of climate change to enter the mainstream. While scientific knowledge in this area has leapt ahead, economic advances have been much slower. You do not have to look far for the reasons. Most economics theory is designed to cope with issues that are relatively short term or national. Even international economics is ill-equipped to deal with trans-boundary issues.

Economists find it hard enough to make an accurate forecast one year ahead, let alone 100. Yet environmental economics must grapple with a plethora of uncertainties - scientific and political - over a dauntingly long timescale. Small wonder then that Michael Grubb, chief economist of the UK's Carbon Trust, a government-funded organisation that advises business, declares: "Understanding the economics of climate change is like trying to understand the Big Bang without Newtonian mechanics."

Dieter Helm, a fellow of economics at New College, Oxford, adds: "The usual economists' toolbox looks puny against the scale of this challenge." Just as the experience of the unemployment of the 1930s required the reinvention of much of macroeconomics, so climate change needs new thinking too, he says.

The drawback of the traditional approach notoriously emerged in the mid-1990s when economists, commissioned by the Intergovernmental Panel on Climate Change, used a cost-benefit analysis to assess the damage to the environment. There was an outcry when it emerged that the analysis involved valuing the life of an American at 15 times that of someone in the industrially less-advanced world.

Another problem is that environmental goods - clean air and water, a stable climate - are rarely taken into account by standard economic analyses. For this reason, the United Nations has begun to promote the idea of "natural capital", as a way of valuing environmental goods so that they can be included in economists' equations.

As Klaus Töpfer, executive director of the UN Environment Programme, describes it: "The goods and services delivered by nature, including the atmosphere, forests, rivers, wetlands, mangroves and coral reefs, are worth trillions of dollars. When we damage natural capital, we not only undermine our life support systems but the economic basis for current and future generations. Targeted investments in this natural capital have a high rate of return in terms of development."

The UK can claim to be at the forefront of the debate, thanks in part to a decision by Gordon Brown, chancellor of the exchequer, to commission a review of the economics of climate change, headed by Sir Nicholas Stern, a former World Bank chief economist and senior Treasury official. Sir Nicholas's report will take a global view of the economic risks and possible benefits of climate change and assess the potential of economic instruments to address them. The findings will carry weight internationally since they will be part of the basis for UN discussions, due to begin this year, on the future of Kyoto.

Sir Nicholas spoke publicly about his review for the first time, in a lecture to the Oxford Institute for Economic Policy. Outlining some of the complexities of establishing economic solutions to climate change he went on: "It is an international collective action problem . . . The simple standard theory of externality" - on the spillover effects of production or consumption for which no payment is made - "is useful but not a fundamental answer to the problem".

The first step, he said, was to convince all the governments involved of the need to take urgent action on climate change. The difficulty of achieving an international consensus is reflected in the history of the Kyoto protocol, which has been rejected by the US and Australian governments, and dogged with delays and disagreements.

Countries such as the US have decided that the costs of compliance are too high. As Mr Helm points out, climate change is a global public "bad", creating incentives for individual countries to free-ride on others' emissions reductions: if one country reduces its emissions, the effect on global warming will be negligible but the effect on that country's competitiveness could be significant.

Jonathan Köhler, of the Department of Applied Economics in Cambridge, thinks it is not necessary for everyone to sign up to an international agreement for progress to be made on emissions reductions. Market forces will do some of the work, he indicates.

"If you think climate change is a big problem and the world will have to do something, at some point there will be gigantic markets out there and big export opportunities for low carbon production technologies." He cites the example of Denmark, which captured a large slice of the market in wind turbines through its early investment in that sector.

Policies to combat climate change need to take into account the impact of technological change on reducing the cost of renewable energy sources. Mr Köhler, who is also a manager at the Norwich-based Tyndall Centre for Climate Change Research, says economic models that take this into account suggest that the cost of switching over to a low carbon energy environment is not high compared with the cost of investment in energy systems that would anyway be needed. What is not clear is how quickly this would happen and how much government intervention would be required.

The policy instruments available to governments traditionally include a carbon tax, limits on emissions and incentives to encourage the development of clean fuel technologies. Most economists favour market-based solutions as the most effective way to drive change in business practice and encourage the development of new technology. In an open letter to Mr Bush in December, 25 US economists, including three Nobel laureates, urged the president to control greenhouse gas emissions through mechanisms such as setting limits on the amount of carbon dioxide countries could produce and allowing them to trade carbon allowances with one another.

Mr Helm believes that an alternative to subsidising a particular technology, such as nuclear fuel, in order to provide low carbon generation is to auction long-term carbon contracts. Under such a scheme, the government would auction carbon contracts for the supply of emission reductions over a long period - such as 20-30 years. The advantage for governments is that they are not obliged to evaluate industry claims about which technology is cheaper. Nor would they be obliged to sell a politically unpopular choice - such as nuclear technology - to a sceptical public. A similar scheme has been developed by the World Bank.

But bedevilling attempts to provide an authoritative analysis of the economic impact of climate change, and thus the economic instruments necessary to address it, is the high level of uncertainty that pervades the subject. Although the scientific evidence points clearly to the conclusion that human actions are having an effect on the climate, many important questions remain unanswered: for instance, the extent to which temperature will rise smoothly or in jumps and the probability of "high-impact" events such as the Gulf Stream changing direction.

Sir Nicholasbelieves his review, due in the autumn, will discover some of the answers. He said this week: "One of our key tasks is to find out whether you can be green and grow. There are a lot of arguments to suggest this is likely to be possible."

But, he hinted, the road to knowledge would not be easy: To understand the issues, "you need all the economics you ever learnt - and more".