Climate Change: A Question of Caves and Mansions 1?

A can’t count the number of moribund discussions I have had over the veracity of climate change. Having spent the best part of my career in the financial industry, it is impossible not to come across certain colleagues, clients and brokers who see global warming as an affront to free market economics and therefore something that could not possibly exist.

Such questioning of the science, however, doesn’t particularly bother me: a contrarian mindset is a prerequisite for a successful career managing money so the multitude of climate skeptics within the industry should not be a surprise. What does frustrate me, though, is that many of those who argue so vehemently that climate change is a product of statist scientists trying to secure government funding don’t feel the need to acquaint themselves with the basic tenets of what they are arguing against (and yes I have had the painful experience of reading through the standard skeptic offerings from Ian Plimer‘s ‘Heaven and Earth’, to Nigel Lawson’s ‘An Appeal to Reason‘, to Bjorn Lomborg’s ‘Cool It‘ and many more).

When engaging with many skeptics, it is like arguing with someone over the merits of a novel when my opponent has only read the reviews in a newspaper and not the original text.

So what would I recommend every skeptic read? If they only have an hour or two to spare, then it would have to be the Summary for Policy Makers of the Intergovernmental Panel on Climate Change (especially as the IPCC has become the Great Satan in the skeptic’s cosmology – given the generally unassuming and non-ideological nature of most climate scientists this must be one of the greatest calumnies in history). A weekend? Well perhaps David Archer and Stefan Rahmstorf’s ‘The Climate Crisis‘.

But this post is not an attempt to jump into the quicksand of the climate skeptic literature. In their brilliant book ‘Merchants of Doubt‘, Naomi Oreskes and Erik Conway show that nothing is quite what it seems within the skeptic meme, and the excellent site Skeptical Science  plays Whac a Mole with the generally recycled skeptic ideas.

Actually, what I want to do is turn the tables a little and ask what natural scientists (or for that matter the general public) should aim to read if they want to acquaint themselves with the thinking behind climate change economics. The first stop must be the first chapter of William Nordhaus‘ ‘A Question of Balance: Weighing Options on Global Warming Policies’ entitled ‘Summary for the Concerned Citizen’. You don’t actually need to buy the book since it is available in pdf format on line here. Nordhaus, probably the foremost economist publishing on climate change issues today, is steeped in the neoclassical economics tradition and is a current co-author of the seminal undergraduate text ‘Economics’, first published by the eminent economist Paul Samuelson. Few in the profession of a certain age have not come across this particular book since starting their study of the discipline.

I think that a close reading of this chapter is important for non-economists interested in climate change since it encapsulates how economists think about a problem—and the limits to that way of thought. Moreover, Nordhaus is certainly not a skeptic. Indeed, a group of skepical scientists mistook him for one of their own in a recent Op-Ed for the Wall Street Journal entitled ‘No Need to Panic about Global Warming‘, prompting a dismissive riposte from Nordhaus himself (see here). Nordhaus is, however, a fervent believer in markets (while recognising their limits) and a strong advocate of the power of correct pricing. Politically, I guess he would be somewhere in the centre of the US spectrum, which would put him to the right of centre in the rest of the developed world.

Nordhaus sees the problem in these terms:

Any well-designed policy must balance the economic costs of actions today with their corresponding future economic and ecological benefits. How to balance costs and benefits is the central question addressed by this book.

The benefits in this case are the climate change damages avoided through a carbon emission mitigation strategy. The costs are those investments made in emissions reductions and future climate change adaption.

While admitting that the current state of knowledge with respect to economic damage sustained from climate change is ‘very meagre’, Nordhaus produces what I view to be an extraordinarily low figure from his model for his ‘baseline case’; that is, one where we do nothing:

Measured mean global surface temperature in 2005 increased by 0.7°C relative to 1900 levels and is projected in the DICE model to increase by 3.1°C in 2100 relative to 1900…..The climate change associated with these temperature changes are estimated to increase damages by almost 3 percent of  global output in 2100….

I should explain that DICE stands for Dynamic Integrated Model of Climate and the Economy. A concise summary of the DICE model is provided by Stephen Newbold of the US National Center for Environmental Economics here. The model incorporates economics, ecology and earth sciences and then uses optimisation techniques to predict different economic and environmental outcomes based through varying the underlying parameters of the model.

Now the DICE model adopts a discount rate to allow us to translate future damages (that 3% lost output in 2100) to a present value. The figure adopted is a relatively high 4%, which means that $1,000 worth of damage in 100 years is only the equivalent to $20 today. Why? Because we have a choice: we can reduce carbon emissions today (and so limit damage in the future) but by so doing we divert capital away from investments that would grow the economy. In his words:

Although $20 may seem like a very small amount, it reflects the observation that capital is productive. Put differently, the discount rate is high to reflect the fact that investments in reducing future climate damages to corn and trees should compete with investments in better seeds, improved equipment and other high yield investments.

Nordhaus then goes on to explain the key concept of the ‘social cost of carbon’. Currently, the emission of carbon results in future damage to society that are now born by the emitter (a so called externality in economic terms), and as of the book’s publication this was estimated to be $30 per ton of carbon.

The preferred method to deal with such a cost, according to Nordhaus, is to apply a carbon tax.

This is the price on carbon emissions that balances the incremental costs of reducing carbon emissions with the incremental benefits of reducing carbon emissions.

Further, the tax should be ramped up from a relatively small $27 per metric ton in 2005  to $90 by 2050 and $200 by 2100, in the process cutting carbon emissions by 25% by 2050 and 45% by 2100. The result? A total cost of emission abatement of $2 trillion which would secure a reduction of climate damage of $5 trillion (for a net gain of $3 trillion). To put this in context, global GDP was around $45 trillion in 2005. Note that under the DICE model, a more aggressive tax policy would result in a lower net gain since the reduction in climate damage sustained would be worth less than the present value of the lost economic output in the future.

The chapter then goes on to explain why a carbon tax is preferable to any other type of emission mitigation approach and what form the tax should take to be most effective. I leave these issues for interested readers to follow up by themselves.

Overall, the most counter-intuitive finding from the DICE model for a non-economist is the link between growth and high climate change outcomes:

High climate change outcomes, as measured by temperature change, are positively correlated with consumption. This lead to the paradoxical result that there is actually a negative risk premium on high climate change states.

This is basically ‘the get dirty and clean-up’ approach to economic development. It also echoes Lawrence Summer notorious leaked memo (see here) while he was Chief Economist of the World Bank suggesting that poor countries needed more pollution not less, because their growth return to pollution was so much higher than that for rich countries.

Nordhaus, being somewhat more diplomatic than Summers, gets his point across with a slightly more user–friendly parable:

A homey example might clarify this paradox. Assume that in the future low-economic-growth outcome, we are living in caves, while in the future high-economic-growth outcome we have four stately mansions. As a result of the global warming associated with the high-growth outcome, one of our four mansions burns down, while on the low-growth outcome our caves remain unscathed.

He then goes on to argue that we would be happy to accept the risk of the high-economic growth, major climate change outcome (indeed he postulates that there maybe a negative risk premium in this scenario), rather than accept the opportunity cost of a benign global warming outcome that consigns us to living in caves.

A non-economist might be shocked that the model’s preferred outcome (that is the welfare-maximising one) could consign large sections of the eco-system to the scrap heap with resulting mass species extinctions. The response to this would be that we price our own lives implicitly through our own actions anyway. Value of life studies suggest that we are willing to accept a marginally higher likelihood of death if compensated correctly. So if we are willing to do that with our own lives, why not the lives of other species?

Putting the moral philosophy question to one side, the more interesting question for me is why a leading natural scientist such as Lonnie Thompson could claim that  the majority of scientists working in the field “are now convinced that global warming poses a clear and present danger to civilization” (see his paper paper entitled ‘Mitigate, Adapt or Suffer’ here ) , while one of the leading economists on climate change, William Nordhaus, is still talking in terms of global warming knocking off a few percentage points of GDP. This dichotomy of opinion is a topic I will return to soon.

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