? Climate Change from the Economic Point of View

Everyday we hear chilling stories about climate change in the media: In a dozen years or so humanity will certainly die out, forests will burn or wither, and the glaciers will melt, drowning us in the rapidly spreading oceans. It is necessary to react right now, as it may already be too late. We must switch to renewable energy immediately, media say. We must ban coal energy, burning wood, plastic disposables, eating meat, airplanes, and other sources of pollution. Politicians and environmentalists turn to tell you to prepare for great changes in your own lifestyle, because otherwise you will be doomed to a life in a contaminated desert not just by yourself, but also all future generations.

It all sounds extremely menacing, but acting under the influence of emotions is a bad idea. Luckily, we will clear things up a bit, and give you an opportunity to make a balanced and reasonable judgment for yourself.

What is climate change?

Climate change is not just some change in current weather. Changes in current weather are short and fleeting; in contrast, climate change is an alteration of average weather that occurs over as much as millions of years. The climate system consists of atmosphere, hydrosphere, cryosphere (i.e. glaciers and permafrost), biosphere, and lithosphere (or the outer shell of the planet). It receives most of its energy from the sun, and returns some of it into cosmos. Thus you can say that there is an energy budget of the planet: If the climate system retains more energy than it gives away, it will warm up. In the other case the climate will cool down.

According to the so-called scientific consensus¹ (which is mainly associated with the IPCC² reports) we are currently undergoing a period of global warming. Though fluctuations in solar, volcanic, or oceanic activity, among others, do contribute to the warming, the IPCC emphasizes that the growth of human economy is the main culprit. Humanity as a whole has been emitting greenhouse gases on a large-scale since the Industrial Revolution. And the average temperature measured in the current decade increased by about 0.93 degrees Celsius compared to the dawn of the Industrial Revolution in 1850–1900. Each of the last three decades has been getting warmer, that is the climate system has kept more energy than it gave away.

Rising temperature means that the other spheres of the climate system change as well. According to the latest IPCC report, the oceans are getting warmer (by 0.11 degrees Celsius per decade in 1971–2010), more acidified, and their salinity changes as well (this affects both evaporation of water forming clouds, and the circulation of oceanic currents), the atmospheric phenomena fluctuate to a greater degree, and melting glaciers cause global waters to rise (by 19 cm in 1901–2010). This means that rivers and other waters will flood more often, resulting in destroyed coastlines, more predominant droughts and forest fires. Forest and water ecosystems that include arable crops will be affected as well. This last category of damages may turn out to be the most important, as it may hurt economic prosperity more directly; nevertheless we should not forget other consequences, especially for health.

Why is it interesting?

The problem of man-made or anthropogenic climate change is important for two reasons. Firstly, since we caused it, we may be able to solve it. Secondly, it concerns us and our descendants.

Though the media are eager to scare us with tales of the destruction of both Earth and all known life, we must calm you down. Humanity is not that powerful. Even if politicians, the most dangerous creatures on the planet, decided to detonate all their nuclear stockpiles containing 15,000 warheads, they would not even pierce the planet’s mantle, i.e. its top layer. What about our supposed ability to destroy all life? The most resistant species such as rats, cockroaches, tardigrades, and especially organisms living at the bottom of the oceans and in hot sources of active volcanoes would survive the atomic Armageddon with ease. The fact that the cockroaches will live is not an especially soothing idea for humans. As a species we are more interested — and rightly so — in our own survival.

While the IPCC do pay attention to the other threats, it’s main focus rests with the assessment of the economic and social consequences of climate change. The IPCC thus alerts that decreasing productivity of food sources such as fisheries and grain, rice, and maize crops may lead to food shortages, and that lack of drinking water combined with increasing humidity, temperature, and pollution may harm our health. In addition, coastline-changing floods, heat waves, fires, pest plagues, outbreaks of diseases, sudden storms, or high humidity will wreak havoc on our capital, and even on entire economies and ecosystems. Rural areas face water and food shortages, as well as infrastructural and financial damages. According to IPCC experts the total damage to the economy is difficult to estimate, but they expect a slowdown in economic growth and impoverishment of poorer nations whose people will find it more difficult to migrate from particularly affected regions. Conflicts due to poverty and economic shocks are expected to be more frequent.

But wait a minute: Why did the experts focus so much on the economic impact? The answer is simple. Economics is second to none in measuring the social importance of such adversities. Monetary values such as costs of living, potential profits and wages, or capital assets tell us much about the well-being of society. Even health loss can be appraised by looking at costs of insurance and treatment. To some extent even forest damage or wildlife mortality translates into money through gain-and-loss analyses in the wood, agriculture, or livestock industries. Without economics, we would have to rely on subjective qualitative assessments that lack a common denominator. Instead, we can use prices or such indicators as GDP or CPI to make intersubjective evaluations that aggregate multiple individual preferences.

A bit of economics

American economist Robert P. Murphy points out³ that the climate change impact calculated by using IPCC models is not as terrible as the picture painted in the media or even in summaries of the very same models. For example, according to the IPCC report, despite climate change in fifty years after 2000 the total number and percentage of malnourished children in developing countries will fall by 9.4 million. According to WHO, by 2030 the health effects of diseases are expected to decrease by 30% as compared to 2004. Even if some of the worst IPCC scenarios will come true, within a century from now our descendants will be ‘only’ 8.5 times richer than us as compared to 9.5 times if no harmful climate change would occur.⁴ Our children will still be healthier than us, and the technological development along with the accumulation of wealth will make it easier for them to cope with climate change.

According to Murphy’s calculations, in the IPCC’s worst-case scenario⁵ of temperature increasing by 2.5 degrees Celsius by 2050 the expected cost in terms of impact on GDP (and that includes health effects and mortality rate) would reach at most 2.5%. At the same time, according to the IPCC report, the cost of programs that aim at limiting temperature increase due to greenhouse gas emissions up to 2 degrees Celsius during this period is about 3.4% of GDP.

In short, this means that if politicians would choose not to act at all, allowing temperature to rise by 2.5 degrees Celsius by 2050, the cost would be smaller (equal to at most 2.5% of GDP) than the cost of programs aiming at limiting temperature increase to 2 degrees alone (equal to at least 3.4% of GDP).

The perspective up to the year 2100 is similar: In the IPCC’s worst-case scenario a rise in temperature by 4.9 degrees Celsius causes damage of around 4.6% of GDP. Meanwhile, the cost of restricting emissions is about 4.8% of GDP in 2100. So, even ignoring all other costs or effects of climate change, the implementation of these programs would still cause a net loss both in 2050 and in 2100.⁶

As an exercise, try to think whether a complete elimination of emissions means zero temperature increase or a return to pre-nineteenth century levels.

Additional threats

Some critics argue that the IPCC models either do not take into account the risk of unforeseen catastrophic effects of climate change,⁷ or that they overestimate costs while underestimating possibilities of reducing emissions.⁸ Let us consider both arguments.

The late mathematician, physicist, and economist Martin Weitzman was an unyielding advocate of the first claim. In short, he argued that current cost-benefit models do not take into account unlike shocks that lead to the most violent of disasters. Let us assume that in the case of one in a million, the next gram of CO₂ emitted by humans will destroy humanity. According to Weitzman, we should recognize that the destruction of humanity constitutes an infinite cost. Thus, the expected value of such a situation despite its negligible probability equals… yes, you have guessed it: It is equal to infinite loss, because when you multiply a low probability of 0.000001 by infinite cost it still equals infinite cost! Thus, the math compels us: any action that prevents this small possibility is profitable as long as it has less than infinite cost. Even if such action entails an immediate return of humanity to caves and the destruction of the entire CO₂-producing economy.

Although this reasoning may seem interesting as a morbid mathematical exercise, we should approach such far-fetched propositions with caution. Economics is not an experimental science. Weitzman’s thought experiment seems artificial and dubious because it models a closed world instead of an open one — it allows only two pre-existent alternatives, and it assumes that no innovative ways of overcoming the problem exist.

Moreover, any economist should investigate how Weitzman calculated the expected value. Did Weitzman consider time preference⁹ and subjectivity of human valuations?¹⁰ Maybe the fact that we usually do not care about highly improbable threats is not a proof of human irrationality, but precisely of human common sense? Or perhaps our internal cost and benefit calculations disregard such threats off-hand, because we know that otherwise all our actions would be hopeless? Instead we push on to solve our daily problems in hope that there is a tomorrow.

Another question: which one of many possible threats should we focus on? Should we forget about climate change and develop space technologies as soon as possible to avoid a catastrophe caused by a possible asteroid impact? Or maybe we should switch the entire economy to the construction of some orbital shield protecting us from potentially catastrophic solar storms? And what about improbable though possible invasions from the outer space? Or maybe we should turn against Weitzman’s programs, as there is also a small probability that they could destroy humanity? Is it worthwhile to consider every possible, though clearly absurd scenario? We encourage you to rethink these questions in the context.

And what about the problem of overstating costs and understating possibilities of emissions reductions by the existing models? The problem was described in Nature by Alexander Barron, who dealt with it at the American Congress and later under the umbrella of the Environmental Protection Agency (EPA). It is particularly noteworthy because it suggests a new line of inquiry: On the one hand, the scientific consensus models usually ignore potential for technological innovations and market adaptation to climate change (Barron provides an example of the coal market). On the other, these models disregard existing opportunities for low-cost emission reductions.

The problem of economic planning

Here we encounter the fundamental problem faced by all economists who try to design the future economy — even with the best intentions in mind. It so happens that precise economic planning based on even the best economic models is as unreliable as an attempt to plan a long-term trip abroad based on even the best weather models. The great economists Ludwig von Mises¹¹ and Friedrich Hayek¹² have pointed out that top-down economic planning — especially if the plan spans tens and hundreds of years into the future — is a fool’s errand.

Of course, you can easily notice that most of the political programs proposed by politicians and economists are a far cry from socialism. These people do not want to set all prices and exchanges. Their ambitions are more modest than that — and rightly so!

Many of them think that the best solution is the so-called Pigovian tax, that is a tax on undesirable behavior such as emitting greenhouse gas. The level of the tax is set in accordance with the chosen emission target. But herein lies the problem. In order to set the tax accurately, the policymaker needs to determine how valuable are future revenues from climate change mitigation programs to us right now (economists call it the net present value or simply NPV),¹³ and compare this evaluation with the present cost of these programs. This is problematic because this present value may fluctuate arbitrarily depending on how important we deem the future revenue streams — i.e. depending on the choice of the discount rate used to calculate their present monetary value. The more importance politicians assign to the fate of future generations, the higher the tax that present generations have to pay today. If the bureaucrats underestimate these future revenues, then even some small costs of some rudimentary climate protection would still be too high. As you can see, the amount of the tax depends on the preferences of officials.

Meanwhile, the entire society’s preferences regarding future income streams is clearly demonstrated in the actual market rates of return on investment. Market participants continually demonstrate their preference regarding the future by making investments, that is by sacrificing present consumption to increase future consumption. When our entire community recognizes that the fate of future generations is highly important, then we can simply acknowledge that the climate change mitigation or adaptation is a valuable investment. Political choice thus disregards social choice regarding the future.

We already have such means of evaluating relative importance of climate change to different individuals in a decentralized and bottom-up way as the insurance market and, given proper structure of laws, class actions lawsuits against poisoners (similar to the past lawsuits against the tobacco industry). We can also use arguments raised by such state institutions as the IPCC — if these were enough to convince politicians, then why not use them to convince juries and judges in trials against polluters?

The last problem is the inherent inefficiency of broad political projects. We cannot afford to delude ourselves. The indolence and incompetence of bureaucracy in any sphere is a fact. And in practice even a proper political consensus can be successfully undermined by a small group of governments that want to gain competitive advantage and maximize tax revenues by lowering emission limits to win over pollutant businesses. Such practice has a tendency to spread — this “regulatory leakage” can quickly invalidate any political consensus regarding emission limits. Just look at such examples as contemporary China or the United States. It may soon turn out that political restrictions on entrepreneurial activity are a futile effort that succeeds only at bringing down innovation. And innovation brings forth the very inventions that can fight the harmful effects of climate change.

We may still avoid the catastrophe by abandoning central planning in favor of market solutions. Consistent application of property rights allows us on the one hand to use such instruments of the judicial system such as class action lawsuits to jump-start proper gain-and-loss analysis, and on the other to use entrepreneurial innovation to mitigate or to adapt to climate change.

The author of the script is Jan Lewiński from University of Wrocław

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