A Free-Market Energy Blog

Climate Economics 101 & Policy Activism

In this month’s article at EconLib, I provide an introduction to the economics of climate change, and discuss some of its major controversies. Follow the above link for the full story, but in a nutshell here are the main issues:

(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.

7 Comments

I wish more free market/Austrian economists could be like Dr. Murphy here. Rather than trying to be scientists and attack the science, he’s addressing the policy typically associated with it and showing that even if global warming is a problem, statism is not necessarily the answer.

Splendid article! I would just add that the original purpose of discounting cost and benefit flows was (1) to find a way of comparing alternative projects where the time profiles of respective costs and benefits differed, and (2) to compare such projects with existing alternative investment projects, such as buying shares or bonds, where the time profiles also differ.

In shorthand, the concept here is “opportunity cost” – if I invest in project A which offers a positive return from benefits 100 years hence with costs upfront now only if the discount rate is 0 or 1% as in Weitzman when I could buy shares in Rio (paying out at c5% p.a. grossed up (tax) on respective current price since 1827) or in say BHP’s Olympic Dam, then I am forgoing 5% now against Stern/Weitzman’s 5% available only after 100 years (from averted climate damage that manifests only from 2100 disocunted at 0.1% p.a.). Stern has ever since I came across him in Nairobi in 1970-71 ignored the whole concept of opportunity cost (he said then that project’s benefits should be evaluated on what he called “shadow prices”, namely what he Stern said the price of tea, coffee, or cotton should be, not what it was; the World Bank bought this Little-Mirrlees theory and still applies it (thanks to Stern in his time there). If only I could get the ASX to value my portfolio at my shadow prices for Rio and BHP instead of the actual how rich would I be?). The outcome is that my grandson will do better from my share portfolio with its current ror of around 4-5% than on buying Stern’s which will yield only in 2100, and then only if I sell my portfolio to buy Stern’s.

[…] it is clear that the initial cap-and-trade legislation was insufficiently opaque. Numerous analyses of Waxman-Markey (HR 2454) on this site and others have shown that the proposed cap-and-trade […]

Point one I guess covers it but I would state clearly that liberty depends upon not feeding government with more taxes. The more you feed it the stronger it becomes and the more money it has to play with to regulate more aspects of individuals’ lives and economic activity.
One further point that does not appear to be covered – what about the cost of having such a tax removed? Backing out of such a complicated octopus like tax with tentacles everywhere would be extremely complex and disruptive when it is found that CO2 emissions are either not the significant player we are told they are or even if they are that it is too costly in terms of standard of living to tax (costs exceed benefits). I assume nearly everyone would prefer a higher standard of living and easier life (if not contact me and I will give a bank account for funds to be deposited) to the problem of turning up an air conditioner a notch – and that is assuming CO2 has a positive forcing effect greater than 1 on temperature – this has not been proved as yet and I doubt it will be. What if we survive as a species into the next ice age – and we are due for one now. Will a carbon tax make sense then? Unfortunately like a junky on heroin it will come to depend on its carbon tax fix and won’t be able to just do without the revenue when the time comes. Another tax will need to replace it and the overall economy contracts with compounding effects over time as worthwhile activity is channelled into mandated useless activity. With our present economy we may be say 50 years away from a completely new technology that makes current energy sources look like kids stuff but slowing the economy may push that discovery out a century or more depending upon the effects. Would taxing horse “emissions” in the 1700’s have sped up the development of a reliable internal combustion engine!? I somewhat doubt it.