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Economists price the ravages of climate change
By Scheherazade Daneshkhu and Fiona Harvey
Published: February 2 2006 20:17 | Last updated: February 2 2006 20:17
The price of the US's "addiction to oil" goes far beyond the
dependence on politically volatile states cited by President George W.
Bush this week. According to the world's leading climate scientists,
reliance on fossil fuels is creating a global warming disaster that
could end up costing the earth.
Faced with these threats, rational people and governments might be
expected to reduce their greenhouse gas output.
But there is little appeal in taking costly action in the short term
to stave off a long-term threat � especially one that, by its nature,
is hard to calibrate.
Persuading individuals and businesses to take the action necessary to
tackle climate change caused by economic activity itself requires an
economic argument. But how to put a price on the world's climate and
the catastrophes that may follow from global warming?
Attempts to fill a policy vacuum as the expiry of the Kyoto protocol
in 2012 looms are suddenly turning environmental economics into one
of the hottest areas of the discipline. The challenge is to find
policies that will make the most efficient use of scarce resources
and provide a rational basis on which to build an international
consensus to address climate change among politicians and business
It has taken some time for the economics of climate change to enter
the mainstream. While scientific knowledge in this area has leapt
ahead, economic advances have been much slower. You do not have to
look far for the reasons. Most economics theory is designed to cope
with issues that are relatively short term or national. Even
international economics is ill-equipped to deal with trans-boundary
Economists find it hard enough to make an accurate forecast one year
ahead, let alone 100. Yet environmental economics must grapple with a
plethora of uncertainties � scientific and political � over a
dauntingly long timescale. Small wonder then that Michael Grubb,
chief economist of the UK's Carbon Trust, a government-funded
organisation that advises business, declares: "Understanding the
economics of climate change is like trying to understand the Big Bang
without Newtonian mechanics."
Dieter Helm, a fellow of economics at New College, Oxford, adds: "The
usual economists' toolbox looks puny against the scale of this
challenge." Just as the experience of the unemployment of the 1930s
required the reinvention of much of macroeconomics, so climate change
needs new thinking too, he says.
The drawback of the traditional approach notoriously emerged in the
mid-1990s when economists, commissioned by the Intergovernmental
Panel on Climate Change, used a cost-benefit analysis to assess the
damage to the environment. There was an outcry when it emerged that
the analysis involved valuing the life of an American at 15 times
that of someone in the industrially less-advanced world.
Another problem is that environmental goods � clean air and water, a
stable climate � are rarely taken into account by standard economic
analyses. For this reason, the United Nations has begun to promote
the idea of "natural capital", as a way of valuing environmental
goods so that they can be included in economists' equations.
As Klaus T�pfer, executive director of the UN Environment Programme,
describes it: "The goods and services delivered by nature, including
the atmosphere, forests, rivers, wetlands, mangroves and coral reefs,
are worth trillions of dollars. When we damage natural capital, we
not only undermine our life support systems but the economic basis
for current and future generations. Targeted investments in this
natural capital have a high rate of return in terms of development."
The UK can claim to be at the forefront of the debate, thanks in part
to a decision by Gordon Brown, chancellor of the exchequer, to
commission a review of the economics of climate change, headed by Sir
Nicholas Stern, a former World Bank chief economist and senior
Treasury official. Sir Nicholas's report will take a global view of
the economic risks and possible benefits of climate change and assess
the potential of economic instruments to address them. The findings
will carry weight internationally since they will be part of the
basis for UN discussions, due to begin this year, on the future of
Sir Nicholas spoke publicly about his review for the first time
earlier this week, in a lecture to the Oxford Institute for Economic
Policy. Outlining some of the complexities of establishing economic
solutions to climate change he went on: "It is an international
collective action problem . . . The simple standard theory of
externality" � on the spillover effects of production or consumption
for which no payment is made � "is useful but not a fundamental
answer to the problem".
The first step, he said, was to convince all the governments involved
of the need to take urgent action on climate change. The difficulty
of achieving an international consensus is reflected in the history
of the Kyoto protocol, which has been rejected by the US and
Australian governments, and dogged with delays and disagreements (see
Countries such as the US have decided that the costs of compliance
are too high. As Mr Helm points out, climate change is a global
public "bad", creating incentives for individual countries to free-
ride on others' emissions reductions: if one country reduces its
emissions, the effect on global warming will be negligible but the
effect on that country's competitiveness could be significant.
Jonathan K�hler, of the Department of Applied Economics in Cambridge,
thinks it is not necessary for everyone to sign up to an
international agreement for progress to be made on emissions
reductions. Market forces will do some of the work, he indicates.
"If you think climate change is a big problem and the world will have
to do something, at some point there will be gigantic markets out
there and big export opportunities for low carbon production
technologies." He cites the example of Denmark, which captured a
large slice of the market in wind turbines through its early
investment in that sector.
Policies to combat climate change need to take into account the
impact of technological change on reducing the cost of renewable
energy sources. Mr K�hler, who is also a manager at the Norwich-based
Tyndall Centre for Climate Change Research, says economic models that
take this into account suggest that the cost of switching over to a
low carbon energy environment is not high compared with the cost of
investment in energy systems that would anyway be needed. What is not
clear is how quickly this would happen and how much government
intervention would be required.
The policy instruments available to governments traditionally include
a carbon tax, limits on emissions and incentives to encourage the
development of clean fuel technologies. Most economists favour market-
based solutions as the most effective way to drive change in business
practice (see below) and encourage the development of new technology.
In an open letter to Mr Bush in December, 25 US economists, including
three Nobel laureates, urged the president to control greenhouse gas
emissions through mechanisms such as setting limits on the amount of
carbon dioxide countries could produce and allowing them to trade
carbon allowances with one another.
Mr Helm believes that an alternative to subsidising a particular
technology, such as nuclear fuel, in order to provide low carbon
generation is to auction long-term carbon contracts. Under such a
scheme, the government would auction carbon contracts for the supply
of emission reductions over a long period � such as 20-30 years. The
advantage for governments is that they are not obliged to evaluate
industry claims about which technology is cheaper. Nor would they be
obliged to sell a politically unpopular choice � such as nuclear
technology � to a sceptical public. A similar scheme has been
developed by the World Bank.
But bedevilling attempts to provide an authoritative analysis of the
economic impact of climate change, and thus the economic instruments
necessary to address it, is the high level of uncertainty that
pervades the subject. Although the scientific evidence points clearly
to the conclusion that human actions are having an effect on the
climate, many important questions remain unanswered: for instance,
the extent to which temperature will rise smoothly or in jumps and
the probability of "high-impact" events such as the Gulf Stream
Sir Nicholas believes his review, due in the autumn, will discover
some of the answers. He said this week: "One of our key tasks is to
find out whether you can be green and grow. There are a lot of
arguments to suggest this is likely to be possible."
But, he hinted, the road to knowledge would not be easy: To
understand the issues, "you need all the economics you ever learnt �
Multinationals nudged into action
Almost 2,000 company chairmen around the globe are this week being
asked some searching questions about climate change. The quiz comes
in a letter from the not-for-profit Carbon Disclosure Project � the
latest salvo in a campaign to encourage businesses to take climate
Acting in the name of 211 institutional investors with $31,000bn
(�17,400bn, �25,600bn) in funds under management, the organisation
asked companies to disclose their assessment of the risks to their
business from climate change and how much greenhouse gas they
emitted. The project is just one of a large number of initiatives
designed to alert businesses to their role in combating climate
Karina Litvack, head of governance and socially responsible
investment at F&C, the activist fund manager, says this makes good
business sense. "Sooner or later we will have to pay the price and
the sooner we move, the cheaper it will be to take corrective action."
Fund managers have sought this information in order to build up a
picture of the risks of climate change to companies in their
portfolios, and an assessment of the liabilities those companies
might face if their output of greenhouse gases were to be limited in
F&C prides itself on having had a hand in persuading General Electric
to adopt a climate change strategy � its much-
publicised "Ecomagination" initiative � through a five-year dialogue.
In a letter to GE in November 2002, F&C warned that lagging behind on
climate change and greenhouse gas emissions was a "serious business
Under Ecomagination, GE will increase its research and development of
technologies that reduce greenhouse gas output and double its
revenues from such technologies by 2010.
Other large companies have also been active. HSBC has just become the
first "carbon-neutral" bank, offsetting its emissions through tree-
planting and carbon trading.
Meanwhile in 2004 BT, the telecommunications provider, became the
world's biggest company to take all its energy from environmentally
sound sources. DuPont, the chemicals manufacturer, has predicted it
will save $2bn by reducing its greenhouse gas emissions by 65 per
cent by 2010, relative to 1990 levels.
Ms Litvack says the main stumbling block for business is the need to
justify to shareholders the � sometimes large � investments needed to
For that, companies need assurance from governments that such
investments will pay off. "At the moment there isn't enough incentive
to cut emissions, which is why companies are becoming more vocal
about their needs," she says.
Most businesses that have taken up the cudgels over climate change
have called on governments to take action using market-based
mechanisms � such as emissions trading schemes � along with long-term
policies and targets to reduce emissions.
It is a rare company that goes looking for government regulation but
in this instance some multinationals are doing just that. Without an
international level playing field, they fear that rivals with
operations in areas without restrictions will gain a competitive
Rick Samans, managing director at the World Economic Forum, which
last year convened a meeting on climate change between 24 leading
companies and Tony Blair, UK prime minister, says: "What companies
are seeking is certainty."
Emissions trading provides a framework
The Kyoto protocol came into force in February 2005, more than seven
years after it had been negotiated in 1997 and only seven years
before its provisions were due to expire. Its lengthy and tortuous
passage illustrates the enormous difficulties of achieving
international consensus on action to combat climate change.
The UN-brokered treaty requires developed countries to reduce their
greenhouse gas emissions by 2012 by an average of about 5 per cent
compared with 1990 levels. But the US � the world's biggest emitter �
and Australia have rejected the accord, arguing that it mitigates
unfairly against them by placing no binding emission reduction
targets on developing countries.
Even if the terms of the treaty are met, the effect on overall global
emissions will be small. Atmospheric concentrations of carbon dioxide
will continue to rise, albeit at a slightly slower rate than they
would otherwise. But proponents argue that the value of Kyoto lies in
setting up a framework for international co-operation on emissions
reduction. There is no other such framework: the only comparable
alliance, between the US, Australia, Japan, China, India and South
Korea, sets no targets or timetable for emissions reduction.
Enshrined in the protocol is the concept of emissions trading. For
instance, developed countries can meet their greenhouse gas reduction
targets by financing projects in poorer nations that reduce emissions
there. This has the added advantage of transferring low-carbon
technology to countries that could not otherwise afford it. The UN
estimates that �10bn ($12bn) in capital will flow from developed
countries to poorer nations by 2012 as a result.
A similar trading system was adopted by the European Union in January
2005. Its greenhouse gas emissions trading scheme places limits on
the amount of CO2 that businesses in certain energy-intensive
industries may emit. Companies that emit less than their allowance �
by increasing their efficiency or investing in low-carbon
technologies � can sell their excess allowances for cash, while
laggards can buy extra allowances on the open market. In successive
phases of the scheme, the total amount of CO2 that businesses may
produce is lowered.
The price of emissions allowances under the EU system has risen
markedly since it was introduced, reflecting rising gas prices. As
gas grows more expensive, cheaper coal-fired power becomes more
attractive.But as coal produces much more CO2than gas, generators
need to purchase more allowances, pushing up their price.
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