Climate Economics 101 and Policy Activism

Climate Economics 101 and Policy Activism

(1) The Discount Rate. Economists give wildly different estimates of the “social cost of carbon” and hence the “optimal” tax on an additional unit of emissions. These differences are not primarily due to the assumptions about climate systems or human vulnerabilities to warming. On the contrary, the main difference between, say, the policy recommendations of the Stern Review (very aggressive) and William Nordhaus’ DICE model (very moderate) is that Stern uses a very low discount rate, while Nordhaus plugs in an estimate of the market’s rate of return on capital.

Efforts to mitigate greenhouse gas emissions impose large, upfront costs on the economy (in terms of forfeited potential output of goods and services), while the benefits will not accrue until decades in the future (in the form of avoided climate change damage). Thus, the lower the interest rate used to evaluate present and future events, the greater the perceived net benefits of mitigating emissions.

(2) Modelling Uncertainty. One of the most popular lines of attack against the conventional carbon-pricing models concerns the treatment of uncertainty, or how they handle small-probability worst case scenarios. Martin Weitzman is the leader in this assault. Weitzman argues that the orthodox approach of people like William Nordhaus neglects the small probability of truly catastrophic outcomes. However, I think many people who are only vaguely familiar with economic models are misunderstanding the debate.

In a standard economics model in which there is uncertainty, the “expected utility” from a given course of action is computed as the sum of the realized utilities under various possible scenarios, weighted by their respective probability of occurring. Some people hear this and mistakenly assume that economists are therefore assuming that people are “risk neutral,” meaning that a guy would gladly pay $1000 to play a game where there is a 1/1000 chance to win $2 million. (The expected payout is $2 million x 0.1% = $2000, which is twice as much as the price of $1000 to play the game. So a person who didn’t care about risk would gladly play that game.)

However, rest assured that the standard economic models do not assume everyone is risk neutral; of course most people wouldn’t pay $1,000 for a 1/1000 chance to win $2 million. The point is a bit technical for the present post, but what happens is that the models have agents maximize not the expected payoff, but rather the expected utility. And so if a utility function (in terms of wealth) is concave (not linear), then a person is “risk averse” and would be willing to pay slightly higher than actuarially fair premiums for fire insurance, etc. To give the intuition, most economic models assume that a person does NOT get twice as many utils from twice as much money. It’s far more devastating to lose all of your wealth, compared to the gain from doubling your wealth. So that’s why people (in such models) are risk averse, and therefore it’s not true (as I think some climate activists believe) to say that standard economic models don’t appreciate improbable but damaging climate scenarios.

Nordhaus has written a great response [.pdf] to Weitzman’s formal work on this subject. Nordhaus has shown that Weitzman’s approach (which climate activists love, because it provides a justification for very aggressive limits on emissions) leads to apparent absurdities, such as justifying the expenditure of trillions of dollars to remove a 0.0001% probability of an asteroid’s destroying the planet.

(3) Differences in Wealth. One of the most ironic aspects to the debate over climate change is that, under all but the most catastrophic scenarios, the future generations who will benefit from our efforts to limit emissions will be much, much richer than we are. Of course, if there is a true “market failure” leading to an inefficient amount of emissions, then our great-grandchildren will be poorer than they otherwise would be. But the point is, that “poverty” is a relative concept–our great-grandchildren are going to be fantastically wealthy by our standards, even if they have to devote a portion of their GDP to more air conditioners and sea walls.

(4) Government Failure. The mainstream economics of climate change literature takes it for granted that greenhouse gas emissions constitute a “market failure,” requiring corrective government action (in the form of a carbon tax, a cap & trade program, etc.). Yet students of Public Choice and Austrian economics know that there are institutional flaws with government efforts to “fix” the market. Even if one takes the more alarmist climate models at face value, it still takes heroic assumptions to conclude that giving more money and power to bureaucrats will make things better. The Public Choice’ers know that it is very naive to assume that politicians will actually implement a policy lining up with what the climate scientists recommend, while the Austrians know that no group of experts can command all of the relevant knowledge when making such monumental decisions.

In conclusion, I refer readers to my earlier post on the cost/benefit calculations of Waxman-Markey, showing that its advocates have not demonstrated that its emissions targets are a good idea, even with textbook implementation.

This blog post originally appeared at MasterResource on July 22, 2009.

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