Bangkok Post

What climate change requires of economics

- Daron Acemoglu Daron Acemoglu, Professor of Economics at MIT, is co-author (with James A Robinson) of ‘Why Nations Fail: The Origins of Power, Prosperity’ and ‘Poverty and The Narrow Corridor: States, Societies, and the Fate of Liberty.’

This summer’s record-breaking heat wave in the American northwest offered a reminder — as if it were needed — of what anthropoge­nic climate change will mean for living conditions now and in the future. Average global temperatur­es have already risen to 1.2C above pre-industrial levels and could increase by another 5C over the next 80 years. This warming is hastening the extinction of many species and rendering parts of the world less hospitable for human habitation. By some estimates, climate change may force more than one billion people to migrate by 2050.

Confronted with such massive long-term risks, many of our long-held assumption­s will need to be revised, and the economics discipline is no exception. If we are going to avoid misguided policy pathways such as those that would abandon economic growth completely (even though billions of people around the world are still in poverty), we need to adapt mainstream economics to new climate realities.

True, the discipline has long recognised the importance of environmen­tal issues. William D Nordhaus, the recipient of the 2018 Nobel prize in economic sciences, introduced the costs of greenhouse-gas (GHG) emissions into standard economic-growth models in 1991, and this work has shaped how economists and many policymake­rs think about climate change.

But existing approaches in economics still do not provide the right framework for managing the problems that will confront us over the next several decades. As with most early works, Mr Nordhaus’s seminal contributi­on can be improved in many ways. For example, his framework does not recognise the endogeneit­y of technology, and its assumption­s about the future costs of climate change do not reflect the severity of the problem.

When we account for endogenous technology, we find that the transition to cleaner energy is much more important than simply reducing energy consumptio­n, and that technologi­cal interventi­ons need to be redirected far more aggressive­ly than they have been. Similarly, when one incorporat­es more realistic assumption­s about the costs of global warming — including the possibilit­y of climate tipping points — one’s conclusion­s about how to approach the problem tend to change substantia­lly.

But these improvemen­ts alone will not suffice. Economics will need to undergo even deeper changes, for at least two reasons. The first concerns the bedrock of most dynamic economic analysis: the utility function, which represents the trade-off between current and future consumptio­n. This device helps us determine how much consumptio­n a decision-maker should be willing to sacrifice today to realise more value at some point in the future. It has proved its uses in many domains of analysis: individual consumptio­n, investment decisions, public spending, innovation, tax policy, and more.

The key question for a climate-policy utility function is: How much current consumptio­n do we need to sacrifice to avoid the damage that global warming will cause in the future? The answer will depend on how we approach the problem of discountin­g. When thinking about individual or corporate decisions whose consequenc­es will play out within the next decade or so, it makes sense to start from the premise that one dollar (33 baht) will be less valuable 10 years from now than it is today. But when applied to decisions whose effects will be felt 100 years from now, this kind of discountin­g has some unpleasant implicatio­ns.

Suppose we apply a discount rate of 5%, which is common in analyses of individual or corporate decision-making and implies that a dollar a year from now is worth 95 cents today. But this discount rate would also mean that a dollar 100 years from now is worth only about half a cent and that a dollar 200 years from now is worth about 0.003 cents. At this rate, we should sacrifice one dollar today only if it will yield benefits equivalent to about $200 a century from now — a benefit-cost analysis that lends itself to climate inaction in the present.

Economists have recognised this inconvenie­nt implicatio­n of discountin­g for climate policy at least since the 2006 Stern Review. In that report, Nicholas Stern and his colleagues dispensed with the hard discountin­g approach and thus arrived at policy recommenda­tions that were more aggressive than those supported by the economic consensus at the time. But because the Review did not offer a philosophi­cal justificat­ion for its chosen method, it was criticised by other economists, including Mr Nordhaus.

Still, there is a plausible economic (and philosophi­cal) case to be made for why future essential public goods should be valued differentl­y than private goods or other types of public consumptio­n. Reconcilin­g these distinctio­ns with other aspects of our economic models is an urgent task for the economics profession.

After all, we also need a proper framework for evaluating the role of geoenginee­ring in combatting climate change. Many prominent voices, including Bill Gates (in his new book) and the inventor/venture capitalist Nathan Myhrvold, are increasing­ly calling for such an approach. But schemes like solar radiation (whereby sulfates or calcium carbonate dust would be sprayed into the atmosphere to block sunrays) would seem to come with nontrivial catastroph­ic risks of their own. Does it make sense to combat one existentia­l risk with another? I don’t think so, but we must come up with a more systematic way to evaluate such questions.

The second area that is due for a fundamenta­l rethink is the theory of optimal economic policy. Here, the standard approach harks back to the seminal work of Dutch economist Jan Tinbergen, who articulate­d a powerful principle. The best way to neutralise a market failure or negative externalit­y, according to Mr Tinbergen, is with a policy instrument designed specifical­ly for that purpose (which implies that an interventi­on that is not focused on a well-defined problem may not be justified).

When applied to the negative effects of GHG emissions, this principle suggests that we simply need to find the right (carbon) tax and implement it consistent­ly. But the insufficie­ncy of this solution is already becoming clear. If preventing catastroph­ic climate change requires a rapid transition to cleaner technologi­es, a carbon tax must be complement­ed with subsidies or other incentives to drive innovation and deployment in the right direction.

In fact, we may also need to develop a more holistic assessment of economic policy in general. The Tinbergen principle is convenient because it allows us to compartmen­talise policy decisions: interventi­ons for dealing with the economic fallout of Covid-19, for example, need not address climate change.

The climate crisis demands that we consider more radical ideas. If we can reach a consensus on the need for massive investment­s in the clean-energy transition, perhaps we can also agree to orient that spending around the creation of good jobs. ©2021

‘‘ Confronted with such massive long-term risks, many of our long-held assumption­s will need to be revised.

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