Approaching global warming

How to analyze climate change policies

Apr 01, 2009

Sections Economics

Collections Climate Change

Finding the best policies for global warming requires a good understanding of economics and the role of markets. In a recent study, three economists dissect the relevant issues and take us through the underlying principles that will help lead policymakers to the right solutions.

The build-up of greenhouse gases caused by the burning of fossil fuels, deforestation, and other human activities is a major item on the public policy agenda. There is a lot of pressure today to take action to counteract its harmful effects. However, there is still much debate about the best policies to deal with this daunting environmental challenge.

Tackling global warming is likely to be very costly. As such, a key question is how much should be done today to mitigate future environmental damage created by the phenomenon. In order to evaluate this problem, policymakers must assess the current costs and potential future benefits of alternative policies and, more importantly, appropriately compare these costs and benefits. In a world where there is much uncertainty about how severe the impact of global warming will be, policymakers must also ask whether their proposed policies are effective under a wide range of circumstances, including the event of catastrophe caused by global warming. Moreover, proposals to mitigate climate change should be evaluated in terms of how well they will work in a global market environment. This is especially important when such policies are implemented by some countries but not by others.

All of these issues are amenable to economic analysis and are explored in “An Economic Perspective on Global Warming” by University of Chicago Booth School of Business professors Gary S. Becker, Kevin M. Murphy, and Robert H. Topel. The study provides an economic perspective on some of the crucial choices that policymakers must consider when forming strategies to mitigate the problem of climate change.

The Discount Rate Debate

A dollar today is not the same as a dollar 100 years from now. Thus, in comparing whether the future benefits of mitigating climate change are greater than the costs incurred in taking action today, one of the key things to think about is how to make both sides of the equation comparable, or put another way, choosing the rate at which to discount future benefits.

Complications arise because the effects of global warming are thought to affect generations hundreds of years from today, and discounting implies that the weight given to the welfare of cohorts in the distant future will be much smaller than those closer to the present. That may seem unfair. Consequently, some have argued for using a very low discount rate–one that is close to zero–on the grounds that it is not morally right to discount costs or benefits received by future generations. However, Becker, Murphy, and Topel argue that there is a bigger issue at stake. “Our point is that the use of a positive discount rate doesn’t have anything to do fundamentally with how much you value future generations relative to current generations,” explains Murphy. “It’s more of a reflection of the economic reality that there is a positive return on investment.“

The relevant question thus boils down to whether investments in climate change mitigation make sense today. The way to make that decision is to discount the benefits of investing in global warming by using the rate of return on capital–as opposed to a very low discount rate–and then compare that to the cost of putting such a policy in place. The rate of return on capital represents the opportunity cost of investing in all types of assets, including investments in global warming, making it an appropriate benchmark. If it turns out that the present discounted value of costs associated with a particular policy outweigh the present discounted value of benefits, then the resources that would be spent trying to slow the harmful effects of global warming would be better invested elsewhere–where they can earn the market rate of return. The proceeds from that investment would accrue to future generations and could then be used to pay for climate change mitigation policies in the future.

Whether or not it is worthwhile to wait on investing depends on how fast the costs of climate change policies rise over time compared with the rate of return on capital. If the cost of tackling global warming increases more slowly than the return on other investments, then it would be better to postpone investments in mitigation policies. In fact, that may be the case today. Climate change mitigation is a very technology intensive activity, but the technology is always improving. On the other hand, the rate of return on capital is fairly high. “Because of that, investing dollars in climate change mitigation today is relatively costly,” says Murphy. Using a discount rate that is lower than the rate of return on capital would naturally tilt the scale in favor of investments for mitigating global warming. However, if such policies only make sense at a discount rate that is far below the market rate of return, then it may be best to postpone those investments to the future.

Dealing with a Catastrophic Event

Experts have produced a very wide range of estimates of just how large the future effects of climate change are likely to be, ranging from modest to very severe. In a world with that much uncertainty, policies that compensate for this risk by preparing for an extreme event are likely to be particularly valuable.

The authors find that the expected benefit from climate change policies is actually more sensitive to a very small probability that global warming results in a catastrophe than to a change in the discount rate. As a result, it pays to focus on looking for “scalable technologies” that can be adapted to very different circumstances when a particular type of catastrophe looms.

“One of the things that economics tells us that makes a lot of sense is to invest in technology that can be scaled up and used if and when we need it,” says Murphy. The idea comes from option theory. In order to prepare to eliminate a bad outcome without having to incur large costs when that bad outcome does not occur, policymakers need to have the option of calling on certain technologies that would be readily available in the event that the costs of mitigating the harmful effects of global warming rises more rapidly than anticipated. This implies that economically useful policies would encourage research and development into finding such scalable technologies.

Expanding options and figuring out a way to deal with potentially extreme events would make climate change management much more effective. If such a contingency plan were available to deal with an environmental catastrophe, then a slow–and–steady approach to respond to expected and more modest outcomes would become more feasible. Becker, Murphy, and Topel argue that such a slow-and-steady approach would probably start in the relatively near future with a very low tax on carbon emissions that would be ramped up over time. A carbon emissions tax must also be applied on a broad basis because a tax with a narrower scope can potentially cause more harm than good.

Looking at the Big Picture

When evaluating climate change policies, it is important to consider the impact on the entire market or on the global economy to determine if certain policies might lead to unintended and perverse effects.

For instance, suppose there is a unilateral policy that required the United States and the European Union to consume less fossil fuel in an effort to curb global warming. “The big weakness of this kind of policy is that the fossil fuel that would have been consumed by developed countries will flow to other countries that will go ahead and use them anyway,” says Murphy. “Where there’s a relatively fixed supply of fossil fuel, it’s going to get burned by someone whether we burn it or not.” Moreover, the United States and the European Union will still have to use other sources of energy. If the alternative fuel they use contributes carbon to the atmosphere– even if lower than for fossil fuels–then the policy could actually increase the total amount of carbon released rather than reduce it.

Policymakers must recognize that there is a market for fossil fuel. If some countries demand less of it, then that will push down the price of the fuel and encourage others to consume more. Unless there is a way to depress the price of fossil fuel sufficiently so that it does not get produced, then somebody else will surely buy the supply that comes in the market. “If you think about all that oil in the Middle East, whether we burn that oil or not, somebody’s probably going to burn that oil, absent a worldwide policy that will prevent that from happening,” says Murphy. “It’s hard to imagine what that policy would be.”

One implication of recognizing the role of markets is to shift the emphasis away from policies that require using less fossil fuel–which may be fruitless–and toward policies that encourage technologies that would reduce the impact of carbon emitting activities. For example, carbon sequestration techniques would reduce greenhouse gas emissions into the atmosphere but would not necessarily require a reduction in the use of fossil-based fuels. This would be a policy approach that recognizes and accommodates market realities.

The mistake of not looking at the big picture extends to other examples as well. One of the pitfalls of the Kyoto Protocol, for instance, is that it includes developed countries but excludes many developing nations like China and India. The high costs imposed on companies to meet the protocol’s requirements in developed economies will give these companies a strong incentive to shift their production overseas, without doing much to diminish the total amount of environmental harm. To the extent that companies in developing countries pollute more for every unit of production, such a policy could actually increase the environmental harm it was meant to reduce.

Moreover, it is not clear that many of the developing countries have a strong interest in preventing climate change today, says Murphy. They are more focused on economic growth–as they understandably should be.

“ An Economic Perspective on Global Warming.” Gary S. Becker, Kevin M. Murphy, and Robert H. Topel.

Gary S. Becker is University Professor of Economics and of Sociology at the University of Chicago Booth School of Business and the University of Chicago, and Senior Fellow at the Hoover Institution. Kevin M. Murphy is the George J. Stigler Distinguished Service Professor of Economics at the University of Chicago Booth School of Business and the University of Chicago. Robert H. Topel is the Isidore and Gladys J. Brown Professor in Urban and Labor Economics at the University of Chicago Booth School of Business, and Director of the University of Chicago Energy Initiative.

April 2009

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