Economics of climate change

July 11, 2012, 8:48 pm
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Concern has grown in recent years over the issue of global climate change. In terms of economic analysis, greenhouse gas emissions, which cause planetary climate changes, represent both an environmental externality and the overuse of a common property resource.

The atmosphere is a global commons into which individuals and firms can release pollution. Global pollution creates a “public bad” borne by all — a negative externality with a wide impact. In many countries, environmental protection laws limit the release of local and regional air pollutants. In economic terminology, the negative externalities associated with local and regional pollutants have to some degree been internalized. Few controls exist for carbon dioxide (CO2), the major greenhouse gas, which has no short-term damaging effects at ground level. Atmospheric accumulations of carbon dioxide and other greenhouse gases, however, will have significant effects on world weather, although there is uncertainty about the probable scale and timing of these effects.

If indeed the effects of climate change are likely to be severe, it is in everyone’s interest to lower their emissions for the common good. But where no agreement or rules on emissions exist, no individual firm, city, or nation will choose to bear the economic brunt of being the first to reduce its emissions. In this situation, only a strong international agreement binding nations to act for the common good can prevent serious environmental consequences.

Economic Analysis of Climate Change

Scientists have modeled the effects of a projected doubling of accumulated carbon dioxide in the Earth’s atmosphere. Some of the predicted effects are:

  • Loss of land area, including beaches and wetlands, to sea-level rise
  • Loss of species and forest area
  • Disruption of water supplies to cities and agriculture
  • Increased costs of air conditioning
  • Health damage and deaths from heat waves and spread of tropical diseases
  • Loss of agricultural output due to drought

Some beneficial outcomes might include:

  • Increased agricultural production in cold climates
  • Lower heating costs
caption Figure 1. Global Temperature Trends Projected to 2100. (Source: IPCC, 2001)

In addition to these effects, there are some other, less predictable but possibly more damaging effects including:

  • Disruption of weather patterns, with increased frequency of hurricanes and other extreme weather events.
  • Sudden major climate changes, such as a shift in the Atlantic Gulf Stream, which could change the climate of Europe to that of Alaska.
  • Positive feedback effects, such as an increased release of carbon dioxide from warming arctic tundra, which would speed up global warming.

How can we evaluate such major possible economic impacts? We need to obtain information on the extent of the impacts, which in turn depends on projections of carbon emissions and climate change. As shown in Figure 1, there is considerable uncertainty about the expected global warming in the next century. We need to keep such uncertainties in mind as we evaluate economic analyses of global climate change. Even with the best data currently available, the actual effects cannot be precisely determined.

Given these uncertainties, economists have attempted to place the analysis of global climate change in the context of cost-benefit analysis. Others have criticized this approach as an attempt to put a monetary valuation on issues with social, political, and ecological implications that go far beyond dollar value. Here we examine economists’ efforts to capture the impacts of global climate change through cost-benefit analysis, then return to the debate over how to implement greenhouse gas reduction polices.

Cost-Benefit Studies of Global Climate Change

caption Figure 2. Projected Carbon Dioxide Emissions through 2025, by Region. (Source: U.S. Department of Energy, 2004)

Without policy intervention, carbon emissions will likely continue to rise as projected in Figure 2. Aggressive and immediate policy action would be required to stabilize, and perhaps reduce, total CO2 emissions in the coming decades. In performing a cost-benefit analysis, we must weigh the consequences of this projected increase in carbon emissions – consequences that will primarily occur in the future – versus the costs of current policy actions to stabilize or even reduce CO2 emissions. Strong policy action to prevent climate change will bring benefits equal to the value of future damages that are avoided. Then we must compare these to benefits to the costs of taking action. Various economic studies have attempted to estimate these benefits and costs. The results of one such study for the U.S. economy are shown in Table 1.

The study is based on an estimated doubling of CO2 over pre-industrial levels. When the monetized costs are added up, the total annual U.S. damages are estimated at approximately $60 billion (1990 dollars). This is about 1% of U.S. gross national product (GNP). Although different economic studies come up with different estimates, most of them are in the range of 1-2% GNP. Cost estimates for larger temperature change over the longer-term rise to around 5% of GNP (the far-right column of Table 1).

Table 1. Estimates of Annual Damages to the U.S. Economy
from Global Climate Change (billions of 1990 dollars)
Type of Damage Short-term warming based
on doubling CO2 levels
(+2.5 degrees C)
Very long-term warming
(+10 degrees C)
Agriculture 17.5 95.0
Forest loss 3.3 7.0
Species extinctions 4.0 + X1 16.0 + Y1
Sea-level rise   35.0
-- Building dikes, levees 1.2  
-- Wetlands loss 4.1  
-- Drylands loss 1.7  
Electricity requirements 11.2 64.1
Non-electric heating -1.3 -4.0
Human amenity X2 Y2
Human life loss 5.8 33.0
Human morbidity X3 Y3
Migration 0.5 2.8
Increased hurricanes 0.8 6.4
Construction costs +/- X4 +/- Y4
Loss of leisure activities 1.7 4.0
Water supply costs 7.0 56.0
Urban infrastructure costs 0.1 0.6
Air pollution    
-- Tropospheric ozone 3.5 19.8
-- Other air pollution X5 Y5
Total 61.1 + X1 + X2 + X3 +/- X4 + X5 335.7 + Y1 + Y2 + Y3 +/- Y4 + Y5

Note, however, that there are also some “Xs” and “Ys” in the totals – unknown quantities that cannot easily be measured. The damages from species extinctions, for example, are difficult to estimate in dollar terms: the estimates used here show a cost of at least $4 billion in the short term and $16 billion in the long term, with additional unknown costs in both the short and long term.

Other monetized estimates could also be challenged on the grounds that they fail to capture the full value of potential losses. For example, oceanfront land is more than just real estate. Beaches and coastal wetlands have great social, cultural, and ecological value. The market value of these lands fails to capture the full scope of the damage society will suffer if they are lost.

In addition, these estimates omit the possibility of the much more catastrophic consequences that could result if weather disruption is much worse than anticipated. A single hurricane, for example, can cause over $10 billion in damage, in addition to loss of life. In November 1998, for example, a severe hurricane caused massive devastation and the loss of over 7,000 lives in Central America, and in 2004 Florida was struck by multiple hurricanes causing tens of billions of dollars in damages. If climate changes cause severe hurricanes to become much more frequent, the estimate here of less than one billion annual losses could be much too low. Another of the unknown values – human morbidity, or losses from disease – could well be enormous if tropical diseases extend their range significantly due to warmer weather conditions.

Clearly, these damage estimates are not precise, and are open to many criticisms. But suppose we decide to accept them – at least as a rough estimate. We must then weigh the estimated benefits of policies to prevent climate change against the costs of such policies. To estimate these costs, economists use models that show how economic output is produced from factor inputs such as labor, capital, and resources.

To lower carbon emissions, we must cut back the use of fossil fuels, substituting other energy sources that may be more expensive. In general, economic models predict that this substitution would reduce GNP growth. One major study showed GNP losses ranging from 1 to 3 percent of GNP for most countries, with higher potential long-term losses for coal-dependent developing nations such as China.

If both costs and benefits of an aggressive carbon abatement policy are both in the range of 1-3% GNP, how can we decide what to do? Much depends on our evaluation of future costs and benefits. The costs of taking action must be born today or in the near future. The benefits of taking action (the avoided costs of damages) are further in the future. How can we decide today how to balance these future costs and benefits?

Analyzing Long-Term Environmental Effects

Economists evaluate future costs and benefits by the use of a discount rate. The problems and implicit value judgments associated with discounting add to the uncertainties that we have already noted in valuing costs and benefits. This suggests that we should consider some alternative approaches – including techniques that incorporate ecological as well as economic costs and benefits.

Two major economic studies dealing with cost-benefit analysis of climate change have come to very different conclusions about policy. According to a study by William Nordhaus, the optimal policy strategy would be a small reduction in greenhouse gas emissions below current projections. This would require few changes in the carbon-based energy path typical of current economic development.

In contrast, a study by William Cline recommends “a worldwide program of aggressive action to limit global warming” including cutting back total carbon emissions well below present levels, and then freezing them at this lower level, with no future increase. What explains the dramatic difference between these two cost-benefit analyses?

The two studies used similar economic methodologies to assess benefits and costs. The main differences were that the Cline study considered long-term effects and used a low discount rate (1.5%) to balance present and future costs. Thus even though costs of aggressive action appeared higher than benefits for several decades, the high potential long-term damages sway the balance in favor of aggressive action today.

The present value (PV) of a long-term stream of benefits or costs depends on the discount rate. A high discount rate will lead to a low present valuation for benefits that are mainly in the longer-term, and a high present valuation for short-term costs. On the other hand, a low discount rate will lead to a higher present valuation for longer-term benefits. The estimated net present value of an aggressive abatement policy will thus be much higher if we choose a low discount rate.

caption Figure 3. Long-term Costs and Benefits of Abating Climate Change. (Source: Cline, ''The Economics of Global Warming'', 1992)

While both the Cline and Nordhaus studies used standard economic methodology, Cline’s approach gives greater weight to long-term ecological effects. These effects are significant both for their monetary and non-monetary effects. In the long term, damage done to the environment by global climate change will have significant negative effects on the economy too. Thus these long-term effects have a high monetary value, as shown in Figure 3. But the use of a standard discount rate in the 5-10% range has the effect of reducing the present value of significant long-term future damages to relative insignificance.

An ecologically oriented economist would argue that the fundamental issue is the stability of the physical and ecological systems that regulate the global climate. This means that stabilization of the global climate should be the goal, rather than economic optimization of costs and benefits. Stabilizing greenhouse gas emissions is not sufficient, since at the current rate of emissions carbon dioxide and other greenhouse gases will continue to accumulate in the atmosphere. Stabilizing the accumulations of greenhouse gases will require a significant cut below present emission levels.

Any measure taken to prevent global climate change will have economic effects on gross domestic product (GDP), consumption, and employment, which explains the reluctance of governments to take drastic measures to significantly reduce emissions of CO2. But these effects may not necessarily be negative.

A comprehensive review of economic models of climate change policy shows that the economic outcomes predicted for carbon reduction policies are very much dependent on the modeling assumptions that are used. The predicted effects of stabilizing emissions at 1990 levels range from a 2 percent decrease to a 2 percent increase in GDP.

The outcomes depend on a range of assumptions including:

  • The efficiency or inefficiency of economic responses to energy price signals.
  • The availability of non-carbon “backstop” energy technologies.
  • Whether or not nations can trade least-cost options for carbon reduction.
  • Whether or not revenues from taxes on carbon-based fuels are used to lower other taxes.
  • Whether or not external benefits of carbon reduction, including reduction in ground-level air pollution, are taken into account.

Thus policies for emissions reduction could range from a minimalist approach of slightly reducing the rate of increase in emissions to a dramatic CO2 emissions reduction of 40 or 50%. Most economists who have analyzed the problem agree that action is necessary, but there is a wide scope of opinion on how drastic this action should be, and how soon it should occur. The nations of the world have acknowledged the problem, and are negotiating over plans to achieve emissions reductions. The scope of the reductions now being discussed, however, falls well short of what would be required for climate stabilization.

Whatever the outcome of these negotiations, any serious effort to reduce carbon emissions will require the kinds of economic policies to deal with negative externalities. We will now turn to an analysis of some possible policies.

Policy Responses to Climate Change

Two general policy responses can be used to address climate change; preventive measures tend to lower or mitigate the greenhouse effect, and adaptive measures deal with the consequences of the greenhouse effect and trying to minimize their impact. Preventive measures include:

  • Reducing emissions of greenhouse gases, either by reducing the level of emissions-related economic activities or by shifting to more energy-efficient technologies that would allow the same level of economic activity at a lower level of CO2 emissions.
  • Enhancing carbon sinks. Forests recycle CO2 into oxygen; preserving forested areas and expanding reforestation have a significant effect on net CO2 emissions.

Adaptive measures include the following:

  • Construction of dikes and seawalls to protect against rising sea level and extreme weather events such as floods and hurricanes.
  • Shifting cultivation patterns in agriculture to adapt to changed weather conditions in different areas.

An economic approach suggests that we should apply cost-effectiveness analysis in considering such policies. This differs from cost-benefit analysis in having a more modest goal: rather than attempting to decide whether or not a policy should be implemented, cost-effectiveness analysis asks what is the most efficient way to reach a policy goal.

In general, economists favor approaches that work through market mechanisms to achieve their goals. Market-oriented approaches are considered to be cost-effective – rather than attempting to control market actors directly, they shift incentives so that individuals and firms will change their behavior to take account of external costs and benefits. Examples of market-based policy tools include pollution taxes and transferable, or tradable, permits. Both of these are potentially useful tools for greenhouse gas reduction. Other relevant economic policies include measures to create incentives for the adoption of renewable energy sources and energy-efficient technology.

Policy Tools: Carbon Taxes

The release of greenhouse gases in the atmosphere is a clear example of a negative externality that imposes significant costs on a global scale. In the language of economic theory, the market for carbon-based fuels such as coal, oil, and natural gas takes into account only private costs and benefits, which leads to a market equilibrium that does not correspond to the social optimum.

Table 2. Alternative Carbon Taxes on Fossil Fuels
  Coal Oil Natural Gas
Tons of carbon
per unit of fuel
0.605/ton 0.130/barrel 0.016/ccf
(hundred cubic feet)
Average price (2003) $17.98/ton $27.56/barrel $4.98/ccf
Carbon tax amount per unit of fuel:
$10/ton of carbon $6.05/ton $1.30/barrel $0.16/ccf
$100/ton of carbon $60.50/ton $13/barrel $1.60/ccf
$200/ton of carbon $121/ton $26/barrel $3.20/ccf
Carbon tax as a percent of fuel price:
$10/ton of carbon 34% 5% 3%
$100/ton of carbon 340% 47% 32%
$200/ton of carbon 673% 94% 64%
Source: adapted from Poterba, 1993. Price data from
U.S. Department of Energy, 2003.

A standard economic policy for internalizing external costs is a per-unit tax on the pollutant. In this case, what is called for is a carbon tax, levied exclusively on carbon-based fossil fuels. Such a tax will raise the price of carbon-based energy sources, and so give consumers incentives to conserve energy and to shift demand to alternative sources. Demand may also shift from carbon-based fuels with a higher proportion of carbon, such as coal, to those with relatively lower carbon content, such as natural gas.

Carbon taxes would appear to consumers as energy price increases. Clearly, a carbon tax creates an incentive for producers and consumers to avoid paying the tax by reducing their use of carbon-intensive fuels. Contrary to other taxed items and activities, this avoidance has social benefits – reduced energy use and reduced CO2 emissions.

Most analysts conclude that a $10/ton carbon tax would be insufficient to promote a major shift away from fossil fuels. According to several studies, stabilizing global CO2 emissions would require a carbon tax in the range of $200/ton. This would approximately double the price of oil and increase the price of coal by nearly a factor of seven (see Table 2). That would certainly affect consumption patterns. In addition, the long-term elasticity of demand would be significantly greater, as higher prices for carbon-based fuels promoted development of alternative technologies.

Policy Tools: Tradable Permits

A second policy response to climate change is a system of tradable pollution permits. In the international negotiations over greenhouse gas reduction, the United States has advocated the implementation of a tradable permit system for carbon emissions. Such a system would work as follows:

  • Each nation would be allocated a certain permissible level of carbon emissions. The total number of carbon permits issued would be equal to the desired goal. For example, if global emissions of carbon are 6 billion tons and the goal is to reduce this by 1 billion, permits for 5 billion tons of emissions would be issued.
  • Permit allocation would meet agreed-on targets for national or regional reductions. For example, under the Kyoto Protocol of 1997, the U.S. agreed to set a goal of cutting its greenhouse gas emissions 7% below 1990 levels by 2008-2012. Japan agreed to a 6% cut, and Europe to an 8% cut.
  • Nations could then trade permits among themselves. For example, if the U.S. failed to meet its target, but Europe exceeded its target, the U.S. could purchase permits from Europe.
  • The permits might also be tradable among firms, with countries setting targets for major industrial sectors, and allocating permits accordingly. Firms could then trade among themselves, or internationally.
  • Nations and firms could also receive credit for reductions that they help to finance in other countries. For example, U.S. firms could get credit for installing efficient electric-generating equipment in China, replacing highly polluting coal plants.

From an economic point of view, the advantage of a tradable permit system is that it would encourage the least-cost carbon reduction options to be implemented. Depending on the allocation of permits, it might also mean that developing nations could transform permits into a new export commodity by choosing a non-carbon path for their energy development. They would then be able to sell permits to industrialized nations who were having trouble meeting their reduction requirements.

Policy Tools: Subsidies, Standards, R&D, and Technology Transfer

Although political problems may prevent the adoption of sweeping economic policy response to climate change such as carbon taxes or transferable permit systems, there are a variety of other policy measures which have potential to lower carbon emissions. These include:

  • Shifting subsidies from carbon-based to noncarbon-based fuels.
  • The use of efficiency standards to require utilities and major manufacturers to increase efficiency and renewable content in power sources.
  • Research and development (R&D) expenditures promoting the commercialization of alternative technologies.
  • Technology transfer to developing nations.

The future course of energy and global climate change policy will undoubtedly be affected by further scientific evidence regarding the impact of atmospheric carbon dioxide accumulation. Political barriers that prevent significant policy action may eventually be overcome. Some combination of the policies discussed in this article will certainly be centrally relevant to energy policies for the next half-century and beyond.

Further Reading

  • Cline, William R. The Economics of Global Warming. Washington D.C.: Institute for International Economics, 1992. ISBN: 088132132X
  • Dower, Roger C. and Zimmerman, Mary. The Right Climate for Carbon Taxes, Creating Economic Incentives to Protect the Atmosphere. Washington D.C.: World Resources Institute, 1992. ISBN: 0915825783
  • Fankhauser, Samuel. Valuing Climate Change: the Economics of the Greenhouse. London: Earthscan Publications, 1995. ISBN: 1853832375
  • Intergovernmental Panel on Climate Change (IPCC). Climate Change 1995, Volume 1: The Science of Climate Change. Cambridge, UK: Cambridge University Press, 1996. ISBN: 0521564336
  • Intergovernmental Panel on Climate Change (IPCC). Climate Change 2001, Volume 1: The Scientific Basis. Cambridge, UK: Cambridge University Press, 2001. ISBN: 0521807670
  • Manne, Alan S. and Richels, Richard G. Buying Greenhouse Insurance: The Economic Costs of CO2 Emissions Limits. Cambridge, Mass: The MIT Press, 1992. ISBN: 026213280X
  • Nordhaus, William D., 1993. “Reflections on the Economics of Climate Change,” Journal of Economic Perspectives, Vol. 7 No. 4 (Fall 1993), pp. 11-25.
  • Poterba, James. 1993. “Global Warming Policy: A Public Finance Perspective,” Journal of Economic Perspectives, Vol. 7 No. 4 (Fall 1993), pp. 47-63.
  • Repetto, Robert and Austin, Duncan. The Costs of Climate Protection: A Guide for the Perplexed. Washington, D.C.: World Resources Institute, 1997. ISBN: 1569732221
  • Roodman, David M. Getting the Signals Right: Tax Reform to Protect the Environment and the Economy. Worldwatch Paper # 134. Washington, D.C.: Worldwatch Institute, 1997. ISBN: 187807136X
  • Trenberth, Kevin E. “Stronger Evidence of Human Influence on Climate: The 2001 IPCC Assessment,” Environment 43 (May 2001): 8-19.
  • U.S. Department of Energy, Energy Information Administration. International Energy Outlook 2004, Report No. DOE/EIA-0484 (2004), 2004.
  • U.S. Department of Energy, Energy Information Administration. Annual Energy Review 2003. Report No. DOE/EIA-0384 (2003).


This is a chapter from Environmental and Social Issues in Economics (collection).
Previous: Environmental dimensions of macroeconomic measurement  |  Table of Contents  |  Next: Policy responses to climate change




Harris, J., Codur, A., & Institute, G. (2012). Economics of climate change. Retrieved from


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