Economics

Predicting Economic Costs

May 7, 2012, 6:47 pm
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Global average discount rate on consumption (percentage per year) as a function of year in the analyses of Nordhaus and Stern. This is equivalent to the rate of return on capital assuming no inflation, risk, or taxes. After Nordhaus 2008b.

Predicting the influence of global climate change on the world’s economy requires computer modeling. [1] These models incorporate at least a rudimentary global climate model or general circulation model (GCM).

GCMs vary in methodologies (e.g., finite differences versus spectral transforms) and assume different scenarios about future human greenhouse gas emissions (e.g. A1FI versus B1). This variation in climate futures, added to the complexities of market economics and governmental fiscal policies, results in a broad range of possibilities.

Nordhaus Versus Stern

In 1999, William Nordhaus (William D. Nordhaus, born 1941, is the Sterling Professor of Economics at Yale University) published; an economic analysis of global climate change that he prophetically entitled “Requiem for Kyoto.” He reached the following conclusions.

1. Costs of implementing strong mitigation measures such as the Kyoto Protocol (an international agreement reached in 1997 in Kyoto, Japan to address the problems of climate change) would exceed their benefits by between $1.1 trillion; and $2.2 trillion (in year 2007 $U.S.).

2. Strong mitigation policies, in comparison to business-as-usual policies, would decrease damages from climate change by only 6%.

3. Strong mitigation policies would have dire economic consequences because they would reduce global GDP (gross domestic product) by 6%.

4. The United States would bear almost two-thirds of the costs of the Kyoto Protocol but enjoy only a small portion of the benefits. [2] People who oppose greater U.S. participation in international efforts to mitigate greenhouse gas emissions commonly cite this.

 

Economic damages from potential temperatures anticipated during this century in the analyses of Stern and Nordhaus in 1999 (blue and green lines in the Nordhaus analyses represent two methods of weighting impacts). After Stern 2007.

 

 

Six years later, the British government commissioned Nicholas Stern (Lord Nicholas H. Stern,is the Patel Chair at the London School of Economics and Political Science and the former chief economist of the World Bank) to review the same issue. His report, the Stern Review, made the following points.

1. The benefits of implementing strong mitigation policies would exceed their costs by about $2.5 trillion (in year 2007 $U.S.).

2. A business-as-usual policy would increase the risk of accelerated economic damages from climate change and would diminish global GDP by at least 4%.

3. The expenses for stabilizing greenhouse gas concentrations in the atmosphere would amount to only about 1% of global GDP and would not inhibit future economic growth. [3] Advocates for greater international efforts to mitigate greenhouse gas emissions regularly cite this study. 

It is somewhat disconcerting that two eminent economists who use similar tools and who live on the same planet should reach such divergent conclusions. But despite their divergent conclusions, Nordhaus’s and Stern’s analyses differ in only a few aspects. One of these—is their choice of discount rate.

Nordhaus assumes that low income countries have a discount rate of nearly 6% and that high-income countries have an initial rate of 3%, which declines linearly to 2.3% by 2100 and to 1.4% by 2300 (Nordhaus and Boyer 1999). In contrast, Stern assumes a discount rate that starts just above 3% but lowers exponentially to 1.4% by 2100. Economists most commonly name 2% as an appropriate long-term discount rate for projects to mitigate potential global climate change; therefore, Nordhaus chooses a higher discount rate and Stern a lower discount rate than most economists. The sensitivity of the world’s GDP (gross domestic product) to average global temperature is similar in the Nordhaus and Stern analyses. Nordhaus, however, selects a single temperature value  for the year 2100, 2.8°C warmer, whereas Stern uses a range of values, 1.5° to 4.5°C warmer for the year 2100. Consequently, global warming decreases global GDP by about 2% in the Nordhaus analysis and by as much as 4% in the Stern analysis.

 

Total abatement costs (year 2000 $USD) to maintain atmospheric CO2 levels at 450 ppm with and without explicit technological change, derived from the computer model in the Stern Review. After Alberth and Hope 2007.

 

 

Another difference between Nordhaus and Stern is their treatment of technical change. Research and development incur costs today but yield benefits in the future; therefore, Stern’s lower discount rate encourages research and development and thereby accelerates technological change. Moreover, Nordhaus does not explicitly account for the influence of market forces on the rate of technological change, whereas Stern does. Total abatement costs for maintaining atmospheric CO2 concentrations at a certain level are initially higher in an economic model that incorporates technological change versus one that does not, but technological change significantly decreases these costs in the longer term.

[1] Mendelsohn, R., W. Morrison, M. E. Schlesinger, and N. G. Andronova (2000) Countryspecific market impacts of climate change. Climatic Change 45:553-569.

[2] Nordhaus, W. D. and J. G. Boyer (1999) Requiem for Kyoto: an assessment of the economics of the Kyoto Protocol The Energy Journal Special Issue:93-130.

[3] Stern, N. H. (2007) The Economics of Climate Change: the Stern Review, Great Britain Treasury, Cambridge University Press, Cambridge, http://www.hmtreasury.gov.uk/independent_reviews/stern_review_economics_climate_change/stern_review_report.cfm.

This is an excerpt from the book Global Climate Change: Convergence of Disciplines by Dr. Arnold J. Bloom and taken from UCVerse of the University of California.

©2010 Sinauer Associates and UC Regents

Glossary

Citation

Bloom, A. (2012). Predicting Economic Costs. Retrieved from http://www.eoearth.org/view/article/51cbf03a7896bb431f6a0c7e

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