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POLICY BRIEF: Economists Put Price on Climate Change

Prominent economists gathered at the University of Minnesota to advance research on economic models of climate change
October 15, 2014

KEY POLICY INSIGHT: New economic models of climate change are suggesting a price of approximately $125 per ton of CO2. The previous generation of models, which may not have sufficiently accounted for risk, estimated the price at $30 per ton of CO2. Even with a four-fold increase in price, solutions to climate change challenges are still well within reach of current policymakers.

Moving Toward Consensus

Carbon dioxide, CO2, is more than a catalyst for global warming. Greenhouse gases are heating the imaginations of economists.Picture a puzzle with so many solutions that picking the best choice becomes the next problem. Governments, manufacturers and consumers will face trade-offs, though not nearly as jarring as climate-change skeptics envisage, economic researchers are finding.

A White House report released in July illustrated the nature of the problem. It found that rising temperatures could become a growing drag on world economic welfare. If delay in checking carbon emissions leads to a 3-degree increase in temperatures above preindustrial levels – instead of past estimates of 2 degrees – the global economy takes a hit of 0.9 percent in output, each and every year. Put in perspective, that would mean about $150 billion year-after-year in incremental economic damage in the U.S. alone. The cost of averting such damages rises even faster – up 40 percent for each decade of delay in meeting a specified target on reduced CO2 emissions.

How might these damages be averted? The models on which the White House report is based suggest a tax on CO2 emissions of roughly $30 a ton would likely prevent severe climate outcomes. Such a tax would be equivalent to a rise in gasoline prices of 30 cents per gallon. Over a decade, the move would cut U.S. carbon emissions by about a third, according to the Carbon Tax Center, a Washington, D.C. group that champions a levy on fossil fuels.

"Some people think we solve this problem only if we go back to teepees and huts," said economist V.V. Chari. "Not so."

Chari is founding director of the University of Minnesota’s Heller-Hurwicz Economics Institute. It sponsored a September conference entitled, "Developing the Next Generation of Economic Models of Climate Change." More than two dozen prominent economists unveiled their current work to an audience of more than 70 experts. While their approaches varied, their conclusions were in harmony on key points.

Is climate change a problem with vast costs? Yes.

Are the costs so high that action becomes futile? No.

Ultimately, the costs of averting climate change damages one day may seem like a bargain.

“These are not giant policy changes,” Chari said. “They’re well within the realm of the possible.”

Tackling Moving Targets

Experts increasingly worry that widely used economic models of climate change do not sufficiently incorporate risk. The price of protection against climate change should account for the risk of catastrophe, even when that probability is small. Climate change stakes include increased illness and death, cities protected from and lost to rising oceans, hunger in the face of parched farm land and countless animals and plants going extinct.

"This is the problem from hell," Harvard University economist Martin Weitzman said at the conference.

Overestimate the prospects for global warming and today's generation will pay a steeper price than required to hold the line, he said. To underestimate the future concentration of greenhouses gases, already at a level not seen for three million years, he said, is to invite catastrophe. "At high carbon dioxide concentrations, there is a small but non-negligible probability that you might fry the planet."

The papers presented at the conference argued that, once risks are properly accounted for, estimates of the economic costs of carbon emissions are on the order of $125 a ton, four folds higher than the $30 a ton estimate from the previous generation of models. Even at $125 a ton – roughly $1.20 per gallon of gas – the problem is manageable. And importantly, incorporating risk into economic models contains an important message for policymakers – it raises the economic return of taking action sooner rather than later.

How Much Risk?

Ravi Bansal, a Duke University economist, co-authored a study that teased out estimates of declining growth rates by gauging how stock markets in 39 nations have performed in the face of rising average temperatures from 1970 to 2006. Controlling for a wide array of other variables that affect stock price values, their economic model showed a strong correlation between rising temperatures and declining economic performance, at the level of national income and corporate financial performance.

Why so? Investors are repelled by risk and uncertainty. As global temperatures rise, the prospects widespread economic consequences climb. Bansal found the pattern already has emerged. For every 1-degree Celsius rise in temperature – a trend already apparent in the second half of the 20th Century – asset values fell 3.6 percent from 1970-2006.

To avert that kind of drubbing, investors today may find their self-interest lies in supporting curbing climate change well into the future. Put another way, investors can be rewarded today for CO2 abatement results they won’t live to see.

Uncertainty is Certain

“There is a common fear that acknowledging uncertainty discourages action. But this should not be case,” said Lars Peter Hansen, Nobel laureate from the University of Chicago, who presented a paper on long-run risk at the conference.

“It does not follow from this perspective that we should do nothing until we know everything.”

A new forecast model presented at the conference takes into account a range of climate change scenarios that illustrate unfathomable uncertainties. It yielded prices of $39 to $800 as the annual price of damages done to the environment in years to come. That yardstick was prepared by Kenneth Judd, at Stanford University, and his fellow researchers. The Judd model prices the current cost at $125 a ton. By one estimate, 9.9 billion metric tons of carbon were added to the atmosphere last year. That adds up to a $1.2 trillion hit to the $75 trillion world economy.

Put a Price on It

In the 1970s, clouds carrying sulfur dioxide from Midwest power plants led to "acid rain," prompting a serious upswing in respiratory illnesses, damaging forests, waterways and wildlife, while corroding metals in everything from buildings to cars and trucks. Congress acted, nearly a quarter century ago, by setting limits on sulfur dioxide emissions. Using strategies that economists believe could work against today's CO2 pollution, acid rain has become a distant memory.

“If a utility reduced emissions by more than the predetermined cap, it could sell those to another utility that wasn’t able to achieve the cap,” said Richard Sandor, who set up a sulfur dioxide trading exchange in Chicago.

“Emissions were reduced by 85 percent from the baseline in the act,” Sandor said.

A new book by Sandor says that according to EPA studies, in 2010 alone, health care costs were reduced by $123 billion at a cost of approximately 1 to 3 billion dollars. Already, seven cities in China and a number of European nations have established similar trading exchanges for CO2. California and New England states are following the lead.

“Each state can potentially do it,” he said. “It may be that cap and trade will come from the bottom up and not the top down.”

Unequal Impacts

A major problem in addressing CO2 can be traced to the fact that climate damages are unlikely to be evenly distributed across the globe. Case in point: India. Rural areas in India are vulnerable to hot temperatures. For example, University of Chicago economist Michael Greenstone and his co-authors find that a year with a 1 standard deviation increase in the number of high temperature days, relative to the average, will lead to an annual 7.3 percent rise in mortality, 12.6 percent slide in crop yields, and 9.8 percent drop in wages.

In contrast, the effect of hot temperatures is much more muted in urban India. A similar increase in the number of “hot days” would not affect incomes and lead to a smaller 2.8 percent increase in the mortality rate. The differences in vulnerability between rural and urban areas are profound. According to the Greenstone paper, “Weather fluctuations introduce a lottery in the survival chances of Indian citizens. But this lottery only affects people living in rural parts of India where agricultural yields and wages are adversely affected by hot weather.”

The power of this paper is that it exploits the quasi-random inter-annual variation in weather. This provides an approach to confront the difficulties of trying to separate out the role of weather from other factors that determine these measures of human well-being. This approach was applied to detailed data on mortality, crop yields, and wages from 1957-2000 for all districts in India. The authors applied these results to projections of the changes in climate in India. With all else held constant, the estimates project that global warming will lead to meaningful reductions in life expectancy in rural India as soon as the 2015-30 period and quite large declines by the end of the century. The projected impacts in urban areas are much smaller.

Greenstone and co-authors conclude that even within a country the impacts of climate change may be very different.

A Call to Action

As economists begin to hone in on more accurate models, they encourage policymakers to consider the power of economic incentives in confronting the overarching challenge of climate change, a problem that knows no national borders.

"We have no international government structure (to deal with climate change)," said Litterman, co-chair of the conference. "It's the tragedy of the commons," he said. Everyone waits for someone else to take the first step. "We have to create incentives for change.”

Conference Papers

Setting Carbon Budgets in the Face of Parameter and Model Uncertainty Based on the Cumulative Climate Response: A Robustness Approach
Evan Anderson, Northern Illinois University; William Brock, University of Wisconsin-Madison; Lars Peter Hansen, University of Chicago; and Alan Sanstad, Lawrence Berkeley National Laboratory

Climate Change and Growth Risk
Ravi Bansal, Duke University; Dana Kiku, University of Illinois; and Marcelo Ochoa, Federal Reserve Board

Climate Change Adaption vs. Mitigation: A Fiscal Perspective
Lint Barrage, University of Maryland

Expecting the Unexpected: Emissions Uncertainty and Environmental Market Design
Severin Borenstein, University of California, Berkeley; James Bushnell, University of California, Davis; Frank Wolak, Stanford University; and Matthew Zaragoza-Watkins, University of California, Berkeley

The Unequal Effects of Weather and Climate Change: Evidence from Mortality in India
Robin Burgess, London School of Economics; Olivier Deschenes, University of California, Santa Barbara; Dave Donaldson, MIT; and Michael Greenstone, MIT

The Impact of Economic and Climate Risks on the Social Cost of Carbon
Yongyang Cai, Stanford University; Kenneth Judd, Stanford University; and Thomas Lontzek, University of Zurich

Applying Asset Pricing Theory to Calibrate the Price of Climate Risk: A Declining Optimal Price for Carbon Emissions
Kent Daniel, Columbia University; Bob Litterman, Kepos Capital; and Gernot Wagner, Environmental Defense Fund

A Global Economy-Climate Model with High Regional Resolution
Per Krusell, Stockholm University and Tony Smith, Yale University

Cooperation on Climate Change Mitigation
Charles Mason, University of Wyoming; Stephen Polasky, University of Minnesota; and Nori Tarui, University of Hawaii

Asset Pricing Implications of Macroeconomic Interventions: An Application to Climate Policy
Rajnish Mehra, Arizona State

Should Rational Climate Policy Account for Ambiguity? 
Antony Millner, London School of Economics and Geoff Heal, Columbia University 

Expecting a Black Swan and Getting a Dragon: Confronting Deep Uncertainty in Climate Change
Gernot Wagner, Environmental Defense Fund and Richard Zeckhauser, Harvard University

Can Negotiating a Uniform Carbon Price Help to Internalize the Global Warming Externality?
Martin Weitzman, Harvard University

Policy briefs from the Heller-Hurwicz Economics Institute are intended to convey policy relevant research done by researchers associated with the Institute and do not represent the position of the Institute.