Will mankind save from a climate catastrophe gradual measures, for example, the introduction of moderate carbon prices, or does climate change require more revolutionary approaches? The author of the article sets himself the task of determining this very “moderate price” per ton of carbon dioxide emissions.
NEW YORK – Today, in many political issues, there is a rivalry between the “realists” and the “radicals.” For example, this can be said about the primaries of the Democratic Party in the USA now. However, for a long time this rivalry has been determining the course of discussions on climate change. Will gradual measures save us from catastrophe, for example, introducing moderate carbon prices, or will climate change require more revolutionary approaches?
Attempts to answer this question usually rely more on intuition and political instincts than on rigorous analysis. And in these discussions, you can often see a generational split: between young idealists and experienced proponents of temperate solutions. Just recently, US Treasury Secretary Steven Mnuchin dismissed criticism from Greta Thunberg, a 17-year-old Swedish climate activist, inviting her to learn the economics first.
Being the science of finding a compromise balance, the economy is really capable of assisting decision-making in circumstances that are determined by the presence of mandatory constraints and deep uncertainty. At least in theory, economists have tools to calculate the costs and benefits of reducing carbon dioxide emissions. Nevertheless, the task of finding the right method for conducting these calculations has been haunting economists for several decades.
In 2018, William Nordhouse of Yale received the Nobel Prize in Economics for his pioneering efforts to calculate the optimal carbon price. The logic of his approach (and generally the standard model for determining carbon prices) seems infallible: to calculate the estimated damage from climate change, and then compare the result with today’s cost of reducing emissions. However, this is easier said than done. The inertia of the climate system means that the greatest damage will be done in the distant future (in decades or even centuries), while the bulk of the cost of reducing emissions arises today.
In addition, there is a natural asymmetry in how benefits and costs are calculated. There is considerable uncertainty on both sides of the balance, so solving the problem requires heroic extrapolations and frank fortune-telling. But when calculating the benefits, only the “known known” fall into the final figure, while when calculating the costs, the bias is the opposite: the rapid progress achieved in clean energy technologies is largely ignored, despite the likely cost reduction.
This bias does not prevent economists from confidently proposing their cost-benefit analysis results. Nordhouse, as you know, did this with a model that requires less than 20 basic equations. He concluded that every ton of today’s carbon dioxide emissions should cost about $ 40. Meanwhile, in a large report published in 2006, Nicholas Stern of the London School of Economics calculated that the price should exceed $ 100 per ton in today’s dollars.
The significant gap between these two assessments is due to two different approaches to discounting, that is, to how society evaluates (or should evaluate) its future. The Nordhouse starts with an annual discount rate of about 4.25%, which it decreases slightly over time, and in the Stern Report the discount rate is set at 1.4%, that is, more emphasis is placed on future damage relative to today’s costs the fight against climate change.
Both analyzes were the result of tremendous work done, given their global scale, distant time horizon and level of uncertainty. However, none of the approaches took into account the likelihood of irreversible turning points on a planetary scale, for example, the complete disappearance of the Greenland ice sheet or the bleaching of coral reefs. As the late Martin Weizmann of Harvard University argued at that time, the Stern Report was “right, but for the wrong reasons.”
Weizmann’s work focused on the unlikely climate risks that could potentially completely discount any standard cost-benefit analyzes. Although he tried very hard to show that – already by definition – extreme and truly catastrophic events are unlikely, he still believed that it was the potentially colossal consequences of such events that should determine our decisions. And that is why Weizmann stubbornly refused to evaluate the optimal carbon price throughout his career. In the 2015 book “Climate Shock,” which we co-authored, we only talked about the fact that, given the uncertainty, the carbon price of about $ 40, obtained at that time from the results of a standard cost-benefit analysis, should be considered absolutely lower bound.
So how do you approach this problem? In traditional economic models, the interaction of climate risks with the state of the economy is largely ignored. But what if investment in election cuts follows the same logic used by professional financial asset managers? There are good reasons why investors invest in bonds, although their average yield is much lower than stocks: bonds have less risk. And therefore, even when the economy is in poor condition, some investments still bring returns.
In Climate Shock, one of our main characters was Robert Litterman, a former senior risk manager at Goldman Sachs. He was shocked to learn how the standard analysis of the costs and benefits of climate change takes risks and uncertainties into account. Litterman and I, along with Kent Daniel of Columbia Business School, set about creating a simple climate and economic model that takes seriously the knowledge and experience gained in the financial industry.
Unlike the Stern Report, where the discount level was chosen simply dogmatically, in our approach, we made the discount rate the final result, and not the initial indicator. Considering atmospheric carbon to be an “asset” (albeit a negative return), we calibrated the price of carbon according to the methods used in the financial industry to evaluate assets. In the end, no matter how hard we tried, we could not get a carbon price below $ 100 per ton.
Meanwhile, the results of new analyzes are appearing in which carbon prices range from $ 200 to $ 400 or more per ton. Meanwhile, even if you set the price of carbon at $ 100 per ton, it will lead to an increase in gas prices by about $ 0.90 per gallon (3.8 liters). Such a price increase at a gas station will be perceived as a revolution rather than a moderate political measure.
However, a likely social reaction does not make this figure “erroneous” or even any particularly radical. Economics may be a science of compromise, but planetary physics sets tight budget constraints that economists cannot even — or especially — ignore. And in this context, the real radical is one who ignores physics and continues to hide behind completely inadequate cost-benefit analyzes that completely ignore the obvious risks of a rapidly warming planet.
Gernot Wagner teaches climate economics at New York University. Together with the late Martin Weizmann, he is a co-author of Climate Shock: The Economic Consequences of a Hotter Planet.