Many consider emissions of greenhouse gases to be what economists call a "negative externality," meaning that they are likely to impose a cost on society through climate change and ocean acidification. The cost of that externality should, in principle, be borne by the emitters, who should pay a price to emit. But what should that price be?
The long chain of connections to arrive at a price
A recent book by Yale economics professor William D. Nordhaus, The Climate Casino, represents a monumental effort to explain how that price should be determined. The book is exhaustive and pitched to the general reader. Readers who are knowledgeable about science or economics will be able to skim large sections.
The chain of causalities and implications leading to the determination of the price is long and tortuous. Some links are frailer than others, and some are extremely frail indeed.
The links in the chain are as follows:
- Greenhouse gases (GHGs) are emitted by industrial processes into the atmosphere.
- As a result, concentrations of these gases in the atmosphere increase.
- GHGs act in the atmosphere like the transparent roof and walls of a greenhouse: They allow short-wavelength solar radiation through but they impede longer-wavelength re-radiation from the surface of the earth.
- This tends to trap heat in the atmosphere and produce warming. It also causes secondary effects – feedback loops – that can lead to more warming or dampen warming.
- Long-term computer simulations, together with measurements of historical temperature trends, imply that changes in temperature and climate over future decades will be significant.
- Further computer simulations have attempted to project the future economic costs of those changes in climate.
- Finally, a means of discounting can be applied to collapse these projected economic costs into a single number, enabling comparison between the costs of taking action to prevent or adapt to those changes and those of not taking action.
The argument for the series of causalities represented by steps 1-4 is virtually airtight. As a result of the emissions of greenhouse gases (GHGs), most of them caused by the use of fossil fuels in the energy sector, atmospheric concentrations of these greenhouse gases increase. Carbon dioxide (CO2), in particular, is emitted in huge quantities by the burning of coal, oil, and natural gas. CO2 concentrations in the atmosphere have increased from about 315 parts per million (ppm) in 1958 to about 390 ppm now. It was this observation – measured at the Mauna Loa Observatory in Hawaii by a group led by Scripps Institute of Oceanography scientist Charles David Keeling – that first brought widespread public attention to the issue.
The basic mechanism of temperature rise caused by increased greenhouse gas concentrations, all else being equal, is irrefutable as a matter of science.
But steps 5, 6 and 7 are increasingly tenuous.
The computer estimates in step 5 are not airtight. Temperature alterations are the subject of the massive computer programs that attempt to simulate and project future temperatures and the climate changes resulting from them. Projections of computer simulations over the next 200 years of the earth’s atmosphere and its interaction with oceans and earth need to be taken with liberal doses of salt.
Nonetheless, these models have been validated through exhaustive backtests using historical temperature and climate data. The conclusions are robust enough that the vast majority of scientists agree that GHG emissions will bring about changes in climate that should cause concern.
Those in the investment field who are properly skeptical of backtests may be doubtful. But for climate models, past performance is much more likely to predict future performance than is the past performance of investment models.
Step 6, which attempts to convert temperature projections into economic costs to arrive at the “social cost of carbon” (SCC), is extremely shaky. Indeed, MIT economics professor Robert Pindyck titled a recent Journal of Economic Literature article “Climate Change Policy: What Do the Models Tell Us?” and then answered his titular question with the simple statement, “Very little.”
Step 7 is the most tenuous, pitting fundamental beliefs against each other and creating controversy that seems almost unresolvable. But without a resolution of step 7 – even if step 6 were sound, which it is not – it is almost impossible to draw any serious conclusion.
The result of this sequence of steps is an “integrated assessment model” (IAM) – a computer program that goes through the steps and comes up with an implied social cost of the emissions. Nordhaus’s DICE model (Dynamic Integrated model of Climate and the Economy) was the earliest of the IAMs. It is still one of the most prominent and widely cited.
Measuring the social cost of carbon
Measuring the SCC – the price that should be paid to emit CO2 or other GHGs – is the subject of steps 6 and 7. (“Carbon” is used as shorthand for all GHGs. GHG emissions are usually measured in “tons of carbon equivalent.”) Nordhaus takes us through the elaborate details of this measurement even though it should be abundantly clear that some of the impacts are not measurable in economic terms.
Nordhaus separates the impacts of climate change into those affecting “managed systems” like industrial processes or highly managed water and agricultural systems, and those affecting “unmanaged or unmanageable systems” such as natural ecosystems and oceans.
Managed systems are prevalent in economically developed countries. Nordhaus concludes that “most of the economy falls into the extensively managed area and is likely to experience relatively little direct impact from climate change.” Countries like the Netherlands will be able to increase the heights of their dikes to prevent damage, for example. “Managed systems,” he says, “are surprisingly resilient to climate changes if they have the time and resources to adapt.”
This may be part of the reason why Nordhaus’s bottom-line estimate of the SCC is not high enough to suit many environmentalists. They prefer the conclusions of the Stern Review, a massive project led by British economist Sir Nicholas Stern, which found that the cost of GHG emissions will be much higher than Nordhaus’s estimate – though much of the difference is explained by differences in the discount rates used, as we shall see below.
Nordhaus finds that “the real concerns about global warming lie elsewhere – outside economic sectors that are increasingly managed and insulated from adverse environmental conditions.”
It is extraordinarily difficult to quantify economic consequences of the impacts on unmanaged systems. These include the effect on ice sheets in Greenland and Antarctica, the effect on ocean currents and other global systems, and the effect of ocean acidification on coral.
But this raises the issue that really lies at the bottom of alarm over climate change: tipping points. There is concern that at some point, irreversible runaway processes could kick in with unknowable consequences. These could include spiraling temperatures due to releases of methane, a powerful greenhouse gas, from permafrost and oceans; calving away of the entire Greenland or western Antarctic ice sheet; and stoppage of the Gulf Stream that keeps northern Europe warm.
The problem is that the correct hypothetical cost to insure against the damages of these potential tipping points (really, the cost that would be warranted to prevent them from occurring) is virtually impossible to calculate. Hence, it is impossible to calculate the most important component of economic cost that is supposed to be determined in step 6 by IAMs models.
The discount rate
To make things worse, the discount rate that needs to be applied in step 7 is difficult to estimate and has dramatic impact. When projecting costs that will increase at an accelerating rate over 200 years in the future, the discount rate has a gigantic impact on the net present value.
The Stern Review uses a discount rate of about 1.4%, while Nordhaus’ is about 4%. Yet, there is no consensus as to the correct rate. Those who agree with Stern say it is immoral to count future generations as less valuable than our own. Those who agree with Nordhaus say that the proper discount rate is the “market rate,” as found in competing investment returns, and that future generations will be richer and therefore able to afford more.
I believe that Nordhaus and his adherents are right in using the higher discount rate, but they have done a poor job explaining the reasons for it. They should explain better how investments that go into technology R&D offering competitive returns may, for example, ultimately wind up spawning better climate-change-prevention or adaptation technologies in the future.
In any case, Nordhaus’s SCC of $25 a ton of carbon emissions is much closer to the price that is generally used in analyses of future fossil fuel costs than the Stern Review’s price, which is more than ten times as large. (According to the Energy Information Agency, about 19.64 pounds of CO2 are emitted by burning a gallon of gasoline, so a CO2 emissions charge of $25/ton would add 25¢ a gallon to the cost of gasoline. Nordhaus recommends a price that increases over time.)
Policy implications
Nordhaus then spends several chapters on policy implications, including the international negotiations carried out under the auspices of the United Nations that have tried to cement global government action and have largely failed.
It is surprising that Nordhaus’s thorough book says nothing about the only major global treaty that has been successful in limiting harmful emissions into the atmosphere, the Montreal Protocol of 1987. The Montreal Protocol required cessation of the use of CFCs (chlorofluorocarbons), which were chemicals used as propellants in aerosol cans and as refrigerants in air conditioners and refrigerators. CFCs were found to destroy stratospheric ozone, allowing increased ultraviolet radiation to reach the earth and posing a heightened risk of skin cancers.
This precedent should be analyzed to search for policy measures to further the goal of reaching international agreement on GHG emissions. Yet not only does Nordhaus not mention it, it is also not mentioned in two reviews that I read of Nordhaus’s book, one by Martin Wolf and one by Paul Krugman. Surprisingly, the impetus for the Montreal Protocol was driven by the leadership of the United States and under the administration of the supposedly environment-unfriendly Ronald Reagan.
Study of the process that led to the Montreal Protocol does produce an important insight. For years after the scientific discovery that CFCs could be causing damage to the stratospheric ozone layer, the chemical companies that produced CFCs, a $700 billion industry, vehemently opposed limits on CFC emissions. But as those companies began to see that the damages were real and could be serious, they began finding substitutes.
As an excellent article by Art Hobson, a professor emeritus of physics at the University of Arkansas, reports: “In September 1986, after 12 years of opposition to CFC restrictions, an alliance of 500 U.S. CFC producer and user companies unexpectedly issued a statement supporting international regulation of CFCs. The industry group’s chair stated that the scientific assessment had changed industry’s evaluation and that ‘large future increases in CFCs would be unacceptable to future generations.’ This announcement was greeted with consternation by European CFC users and producers.”
Thus, perhaps surprisingly in today’s atmosphere, it was the United States during a Republican administration that spearheaded action and the European countries that initially objected.
The important implication is that international corporations can lead a turnaround in international policy on climate change. That turnaround does indeed seem to be in the works. Nordhaus says that “a survey of twenty-one electric utilities in 2012 in the United States found that sixteen had built a positive CO2 price into their planning, with the average price for 2020 being slightly below $25 per ton of CO2.” A recent New York Timesarticle reports that “More than two dozen of the nation’s biggest corporations, including the five major oil companies, are planning their future growth on the expectation that the government will force them to pay a price for carbon pollution as a way to control global warming.”
This represents a turnaround, especially for oil companies, many of which had been lobbying and fueling information campaigns intended to forestall any regulation of CO2 emissions. It could be the breakthrough that paves the way for a universal tax or other charge on GHG emissions, which virtually all economists believe should be imposed.
A thought experiment
I am in complete agreement with the economic theory of externalities (in Wikipedia’s definition, “an externality is a cost or benefit which affects a party who did not choose to incur that cost or benefit”) and agree that it should be applied to create a price for the right to emit GHGs.
Nevertheless, I believe a thought experiment is in order. There is an underlying assumption inherent in almost all discussions of climate change, an assumption that is insufficiently examined. That assumption is that anything nature does is good, while anything humans do to alter natural processes has the potential to do harm.
This assumption infects discussions of “geoengineering” solutions to climate change – solutions in which humans could do something to stall climate change besides, or in addition to, reducing emissions toward pre-industrial levels. Geoengineering solutions include, for example, simulating the results of globe-cooling volcanic eruptions by spreading reflective particles or gases in the atmosphere to reflect sunlight, or seeding oceans with iron to promote photosynthesis, producing more biological growth that can absorb CO2. But most environmentalists frown on geoengineering as tampering with the earth. Admittedly, they have a point, because many of the proposed solutions would involve massive experiments with uncertain consequences.
The thought experiment I propose is this: Instead of anthropogenic GHG emissions causing global warming and climate change, indicating that these emissions should be curtailed, suppose that the shoe were on the other foot. Suppose that humans had been emitting only a constant and stable level of GHGs but that nature, not humans, was causing global warming. Humans could mitigate this natural climate change, however, by reducing their GHG emissions to subnormal levels.
Could failure to do so then be labeled an “externality”? What economic theory would support imposing a charge on GHG emissions? Presumably, anthropogenic emissions were not causing any problem, i.e. any negative externality, until some shift took place in natural processes.
I believe it would be appropriate to engage in this exercise in thinking about the unthinkable. Perhaps it could even contribute to the formulation of a solution.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a partner and chief investment officer of Denver-based Fair Advisors, and a project consultant at the Fung Global Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri, and George Peacock, will be published by Berrett-Koehler in spring 2014.
Read more articles by Michael Edesess