The Economics of Avoiding Dangerous Climate Change
The Economics of Avoiding Dangerous Climate Change
Climate Change
Terry Barker
June 2008
Abstract
The problem of avoiding dangerous climate change requires analysis from many disciplines.
Mainstream economic thinking about the problem has shifted with the Stern Review from a
single-discipline focus on cost-benefit analysis to a new inter-disciplinary and multi-disciplinary
risk analysis, already evident in the IPCC Third Assessment Report. I argue that this shift is
more evidence of the failure of the traditional, equilibrium approach in general to provide an
adequate understanding of observed behaviour, either at the micro or macro scale. The
economics of the Stern Review has been accepted by governments and the public as mainstream
economic thinking on climate change, when in some critical respects it represents a radical
departure from the traditional treatment. The conclusions regarding economic policy for climate
change have shifted from “do little, later” to “take strong action urgently, before it is too late”.
This editorial sets out four issues of critical importance to the new conclusions about avoiding
dangerous climate change, each of which have been either ignored by the traditional literature or
treated in a misleading way that discounts the insights from other disciplines: the complexity of
the global energy-economy system (including the poverty and sustainability aspects of
development), the ethics of intergenerational equity, the understanding from engineering and
history about path dependence and induced technological change, and finally the politics of
climate policy. I argue that equilibrium economics fails to provide an adequate and coherent
explanation of why human behaviour is leading to climate change (via economic choices and
the use of the atmosphere as free waste waste disposal) with the aim of guiding climate
policy. In contrast, the Stern Review considers traditional cost-benefit analysis as a marginal
approach inappropriately applied to global climate change, which is a significant,
multidisciplinary and systematic problem. This is one reason for the intemperate response
from some traditional economists to the Stern Review. Their criticisms illustrate the
sensitivity to the implied criticism of their methodologies and conclusions, when equilibrium
economics underlies most text books of economics and journals of economic theory.
Whilst they are commented on by Tyndallresearchers, they have not been subject to a full peer
review. The accuracy of this work and the conclusions reached are the responsibility of the
author(s) alone and not the Tyndall Centre.
1 This Working Paper is a preview. The original publication will be available at www.springerlink.com.
1 Introduction
Since the early 1990s, it has been internationally recognized that one consequence of
economic activity has been the accumulation of greenhouse gases and that this may lead to
climate change. This already threatens development in poor countries that are most
vulnerable to climate variability. If unchecked, it will threaten future generations with
unknown but potentially catastrophic climate events, given the availability of fossil carbon at
current prices relative to carbon-free alternatives, which could raise concentrations to levels
not seen for millions of years. At the same time the costs of reducing the emissions have
been agreed as negligible in relation to expected growth in incomes. Yet, after 17 years,
global action has been limited and emissions have continued to grow. Indeed, the political
recognition of the urgency of the problem has only become evident at a global scale since the
publication of the Stern Review of the economics of climate change in 2006.
One reason for this delay has been the response by a clique of economists, dating from the
publication of the first IPCC Report in 1990, to the concern and calls for action by the climate
scientists. The response came in the form of the mis-application of a tool developed by
equilibrium economists for prescriptive public policy: the cost-benefit analysis. This editorial
addresses the question of how and why the focus of the economics of climate change has shifted
from the single-discipline cost-benefit analysis, as in the IPCC Second Assessment Report in
1995, to the multi-disciplinary uncertainty analyses in the subsequent IPCC Reports of 2001 and
2007 and the radically different policy prescriptions of the 2006 Stern Review.
The application of traditional cost-benefit analysis has yielded, with some exceptions, policy
prescriptions of insignificant carbon taxes and delayed action until more information is available
on the problem and more R&D has been done to lower the costs of any response. The new
mainstream uncertainty analysis, in contrast, suggests that a political global decision needs to be
taken urgently on targets to avoid dangerous climate change and that cost-effective and equitable
policies and measures should be implemented strongly without delay to accelerate progress
towards a complete decarbonisation of the world economy.
Defining dangerous in this context is a social and political task. Implicitly some progress has
been made with the European governments’ 2˚C target for average long-term global
temperatures above pre-industrial levels, the G8’s 50% reduction in global GHG emissions
below 1990 levels by 2050 as agreed by the meeting in Heiligendamm, Germany, June 2007,
and the “deep cuts” of the UNFCCC Bali Action Plan of December 2007. The AR4 WG3
Summary for Policymakers gives an indication of just how deep the cuts will have to be. It
presents six scenarios from the literature on the scale of action required. For a chance less than
50:50 that the target will be met, the scenarios suggest that global CO2 emissions will have to be
between 50% to 85% below 2000 levels by 2050, and becoming negative (through sequestration
and storage) by 2070 and beyond. Therefore to be reasonably sure of avoiding dangerous
climate change defined as a 2˚C rise or less, the world should be aiming for complete
decarbonisation by 2050 or earlier, to be safer. All sectors in all countries should be aiming to
stop emitting GHG into the atmosphere as soon as possible without excessive cost2. Without
2 The carbon price associated with this target is not the topic of this paper, but it is of great interest. Without
sufficient literature to assess such a price, it is necessary to extrapolate from the AR4 literature on less stringent
targets (Barker et al, 2007, pp. 636, 648 and 659-661). A precautionary, provisional estimate for a global price
for the 2˚C target appears to start in the range $US80 to $US100/tCO2 by 2020 and earlier if possible, rising
after 2020 and all in year 2000 prices.
2
urgent action, the risks of losing coral reefs and pristine tropical rainforests appear significant,
e.g. for a rise above 1 to 3˚C, the AR4 WG2 Summary has “very high confidence” of
widespread mortality of coral reefs.
In this editorial I argue that this shift in thinking is more evidence of the failure of
equilibrium economics in general to provide an adequate and coherent explanation of observed
behaviour, from the personal (micro) to the global (macro) scales, with the aim of guiding
policy. Equilibrium economics underlies most textbooks of economics and journals of
economic theory. It is theory largely unsupported by formal scientific observation and empirical
data. Over the past 50 years, it has been increasingly recognised as dependent on false
assumptions about human behaviour and physical systems, and as based on a rigid and ill-
informed interpretation of utilitarian ethics. The continued use of the assumptions, most
pertinently in the application of cost-benefit analysis and computable general equilibrium
models for climate policy, strongly suggests that their only justification is that they are required
for the mathematics and computation to be tractable. Any empirical support for the theory has
been generally incoherent, ad hoc and rhetorical, with the most outstanding example the fact that
the multi-sectoral equilibrium modelling of GHG mitigation policy over the century, which
dominates the literature, is based typically on one year’s data (and this is simply to calibrate the
model to yield results of the right magnitude, rather than to provide empirical validation of the
results).
In contrast, the Stern Review considers cost-benefit analysis as a marginal analysis
inappropriately applied to a non-marginal multi-disciplinary systemic problem (p. 50). Both
Stern (p. 163) and the IPCC Reports after 1995 take a multi-criteria approach rather than a
narrowly monetary one and question cost-benefit analysis. This is one reason for the
intemperate response from some traditional economists to the Stern Review3. The effect of the
more general approach is to criticise, qualify, and generally undermine such equilibrium
thinking in the assessment of the costs and benefits of climate change and its mitigation. This is
not new4: government rejection of the cost-benefit valuation of human lives goes back to the
IPCC Second Assessment Report. What is new is that the economics of the Stern Review has
been accepted by governments and the public as mainstream and consensus economic thinking,
when in critical respects it represents a radical departure from a traditional deterministic
treatment and its messages for economic policy.
This editorial takes an interdisciplinary approach to the economics of dangerous climate
change, contrasting the cost-benefit analysis (CBA) with the new economics of risk that
acknowledges and respects the insights and analysis from other disciplines, namely the other
social sciences, climate and geographical sciences, ethics, history, engineering as well as
3 Tol and Yohe (2007, p. 233-4) accuse Stern of “substandard analysis” and “dubious economics”; Nordhaus
claims that Stern is “political” (2007a, p. 5) and the discount rates used are “extreme” (p. 6); Dasgupta (2007, p.
7) accuses Stern of choosing parameter values so “that they yield desired answers.” Such charges are perhaps
more appropriately made against neoclassical economics as in (Mirowski, 1989, 2002; Barker, 1996b, 1998;
Nelson, 2001; DeCanio, 2003; Ackerman and Nadal, 2004; Foley, 2006; Nelson, 2006; Beinhocker, 2006). The
charges also contrast with the praise by leading mainstream economists and Nobel Laureates quoted in the
Review, such as Mirrlees, Sen, Stiglitz, and Solow, and support after publication from Arrow, DeLong and
Deaton among others. There are far too many references to include in the space permitted, so I have only
included examples of the mainstream literature and the last or later references in the new literature.
4 Previous academic critiques of the optimizing (Barker, 1996) and discounting (Hasselmann, 1999) approaches
of traditional cost-benefit analysis have had no discernible effect on the methodology or conclusions.
3
complexity and evolutionary theory 5. This editorial introduces the other papers in this issue on
the economics of climate change following the publications in 2006 of the Stern Review, and in
2007 of the critiques of the Review and the IPCC Fourth Assessment Report (AR4). The paper
by Quiggin consolidates the arguments relating to Stern’s use of the discount rate, claimed to be
the main reason for differences between the conclusions of Stern “take strong action urgently”
and those of the critics. The paper by Jaeger, Schellnhuber and Brovkin promotes the case of
other values than purely economic ones in social choices for the future climate system. The
paper by Hasselmann and Barker proposes a new international body to develop data and
modelling for mitigation policies to avoid dangerous climate change, based on risk analysis and
a systematic treatment of global energy-environment-economy time-series data.
This editorial sets out four issues of critical importance to climate policy, each of which have
been either ignored by traditional economic modelling of the problem, or treated in a misleading
way that discounts the insights from heterodox economics and other disciplines.
1) The global economy, with its use of energy and emissions of GHGs, is a complex, non-
linear dynamic system with technological change inherent in economic growth. Climate
effects and responses to climate policy are potentially non-marginal changes to the
system in the context of strong uncertainty.
2) The problem of intergeneration equity from climate change and mitigation is primarily
an ethical one, and should be informed by moral philosophy rather than economics in
isolation. Traditional economic models adopt an extreme form of utilitarianism, with a
questionable choice and use of discount rates, ignoring the philosophical literature and
the concept of justice.
3) Engineering and history inform GHG mitigation policy through studies of the production
processes involving the supply and demand of energy, in particular the technical
possibilities of accelerated decarbonisation of the energy system. Economic history is
critical in understanding the relationship between mitigation policies, economic
development and technological change because the time scales are long in relation to the
life-times of most energy-using capital, so that the technologies involved can respond to
carbon-price signals over the policy period. Traditional models assume continuity and
path independence.
4) The politics of mitigation implies unstable alliances and trade-offs between governments
and political parties. By the use of the social welfare function (required for the calculus),
traditional economists simplify social choices and pre-empt political negotiation,
claiming an optimality for their subjective assumptions and market interpretations.
This is an ambitious agenda and the issues can only be summarised, relying on the
underlying literature. The implications for new economic thinking are often unclear, provisional
and tentative in the face of the certainties of some cherished traditional beliefs. This editorial
covers the issues one by one, but first the economics needs to be further explained and the Stern
Review and IPCC Reports interpreted in the light of the shift in economic thinking.
5 Other disciplines are just as important, including the humanities, but I am restricting the discussion to a few
issues. In particular, I do not consider in any depth the analysis of development, which is crucial for adaptation
to climate change.
4
Understanding and solving the climate problem requires the synthesis and co-development of
many disciplines with different traditions and links between them. Economics is relevant
because it explains why human behaviour might lead to climate change (via economic choices
and the use of the atmosphere for free waste disposal) and it provides systematic methods for
assessing (and monetizing) costs and benefits of different activities and policies. However, it is
important to distinguish between a general definition of economics6 and the particular approach
used (pre-Stern) in most of the literature on the economics of climate change. Following
Beinhocker (2006) and Maréchal (2007) I shall call this particular approach “traditional”
economics defined as
“… the set of concepts and theories articulated in ... textbooks. It also includes concepts
and theories that peer-reviewed surveys claim, or assume, that the field generally agrees
on.” (Beinhocker, 2006, p. 24)7.
This traditional economics is epitomized by Samuelson’s Economics, now co-authored by
Nordhaus8, and based on the neoclassical mathematical synthesis promoted by Samuelson that
came to dominate mainstream economics thinking in the late 20thC. I shall contrast the
traditional economics with a “new” economics, as in the title of Boulding’s 1992 book,
including complexity, evolutionary and Post Keynesian theory and emphasising institutions,
non-linear dynamics, and deep uncertainty.
Neoclassical economics is defined as being characterized by an emphasis on rationality,
via the use of utility maximization, an emphasis on equilibrium, and by neglect of strong
kinds of uncertainty, particularly of fundamental uncertainty (Dequech, 2008, p. 290). The
traditional economic approach to modelling climate change has been almost exclusively and
narrowly neoclassical, adopting a version of expected utility theory with human welfare usually
6Economics is the study of social activity undertaken with its primary purpose the expectation of reward, which
usually involves money, the motivations of such activity and its consequences both good and bad, e.g. for equity
and the environment. In contrast the neoclassical economist Robbins (1932) defined economics as “the science
which studies human behaviour as a relationship between ends and scarce means which have alternative
uses” (p. 16), asserting that economics is a value-free science.
7 It has become debatable whether neoclassical equilibrium economics is mainstream anymore (Dequech, 2007).
This paper argues that Stern has shifted the mainstream away from the traditional neoclassical approach to
climate-change economics. See (Maréchal, 2007) for a supporting view. For a more general view see (Hodgson,
2007). Prominent economists are acknowledging that for macroeconomic growth “The right way to think about
this complex set of issues is not clear, but it is clear that the competitive paradigm cannot be fully
appropriate.” (DeLong and Summers, 2001). Arrow (2007) accepts the Stern estimates of costs and benefits,
quoting the range of GDP mitigation costs (3.4 to -3.9%) from the meta-analysis in (Barker et al, 2006). Akerlof
(2007), the 2007 President of the American Economic Association, exposes the weaknesses of neoclassical
macroeconomics and suggests that early Keynesian macroeconomic theory has more explanatory power. Deaton
(2007), the 2008 President of the AEA, supports the Stern treatment of discount rates: “Whatever it is that is
generating market behaviour, it is not the outcome of an infinitely lived and infinitely far-sighted representative
agent whose market and moral behaviours are perfectly aligned, and who we can use as some sort of infallible
guide to our own decisions and policies.” (p. 4)
8 Samuelson and Nordhaus (2001) is the 17th edition of a textbook originally published by Samuelson in 1948.
Yohe, another contributor to the traditional literature, has published a study guide to this textbook (1989).
Nordhaus is taken as the exemplar in this editorial (rather than a straw neoclassical man) because of his
economics, methods and distinction in the field. He provides full details of equations, exposing all his
assumptions. His approach is followed by many others and his models are widely used for climate policy
analyses. It is characteristic of his work, and of his school, that qualifications to the economics or results (e.g.
extreme events, recycling of carbon tax revenues or induced technological change) are introduced
independently, but subsequently there is usually a reversion to the core model even when the qualifications
produce radical effects on the results (Nordhaus, 1993, 2007b). Other problematic features one would expect in
a CBA, e.g. environmental co-benefits of GHG mitigation, are ignored. Eventually, if the qualification becomes
mainstream, it is accommodated in the model or analysis (Mirowski, 1989, 2002)
5
translating into private market consumption per head in the applied models. The theory is
applied to utility across countries with huge differences in consumption and over 100 years or
more into the future, when consumption can rise perhaps 20 or 30 times over. The formal
approach to the problem has been cost-benefit analysis beginning in the 1990s (e.g. Cline, 1991,
1992; Nordhaus, 1991a and b, 1994 and 2007b; Nordhaus and Boyer, 2000). In simplified
terms, the costs of climate change are set against the benefits of taking action in a way that
allows comparison with other potential uses of public revenues. The price of carbon (the CBA
literature is focused on the specific “social cost of carbon”) is calculated in a supply-demand
framework, such that the costs of climate change arising from the marginal addition of CO2 into
the atmosphere are matched in equilibrium with the benefits of not making the addition, i.e. the
mitigation or marginal abatement, giving the “maximum benefit” for humanity, discounted over
all future generations. The treatment of uncertainty and risk has been to ignore deep uncertainty
and convert the asymmetric risks of long-term irreversible damages into certainty-equivalent
damages, which are then discounted when compared to short-term costs of mitigation. The
outcome is an “optimal” price of carbon, an indefinite “optimal” rise in global temperatures, and
very modest prescriptions for action.
This method rests on the idea that individual preferences are fixed and utilities can be
aggregated and converted into well-behaved mathematical equations in a “social welfare
function”, and differentiated to give stable marginal properties, as the basis for climate policy. It
also crucially assumes that all natural services can be converted to money and back again at any
time, i.e. that there are no irreversible effects of climate change. These and other assumptions
render CBA inadequate and misleading for climate policy analysis (Azar and Lindgren, 2003; van
den Bergh, 2004; Ackerman and Heinzerling, 2004). In summary, CBA “does not yield
transparent or objective evaluations of benefits; rather, it renders the discussion of benefits
obscurely technical, excluding all but specialists from participation. At the same time, political
debate continues behind the veil of technicalities, as rival experts battle over esoteric valuation
problems.” (Ackerman, 2004). The approach (Arrow et al., 1996; Pearce et al., 1996) became
highly controversial in the IPCC Second Assessment Report, when the governments rejected an
assumption used in the analysis that the costs of human life should be different for different
countries, depending on their income levels. Since the CBA literature is voluminous, it is
covered in subsequent IPCC reports, but any implications for policy are heavily qualified and
extensive lists are given of damages that are not or cannot be monetised (IPCC 2007, Table
SPM3)
However CBA continues to be the theoretical basis for those advocating the traditional
climate policies. A leading example of the post-Stern CBA approach to the climate problem is
Nordhaus (2007b), who concludes that “the Gore and Stern proposals … are more costly than
[doing] nothing.”(p. 177) A peer-reviewed survey of the costs of “doing nothing” in the CBA is
to be found in (Tol, 2005), which covers 80 peer-reviewed estimates, i.e. fulfilling Beinhocker’s
definition of traditional economics. Tol concludes “One can therefore safely say that, for all
practical purposes, climate change impacts may be very uncertain but [it] is unlikely that the
marginal damage costs of carbon dioxide emissions exceed [$14/tCO2]9 and [they] are likely to
9To avoid confusion and conform to IPCC AR4 WG3 usage, all estimates have been converted to $/tCO2 in this
editorial. The price base is given where known. Despite their apparent precision, Tol’s estimates cover different
base years and price bases, because he does not appear to have converted the estimates to a consistent basis.
They are all in real terms in his original sources, but typically adopt different base years for the discounting and
prices. This lack of comparability in the underlying data renders his averages undetermined, a problem not
mentioned by Tol.
6
be substantially smaller than that.” (p. 2073, italics added). An update (Tol, 2007) covering 125
such studies confirms the median estimate of $4/tCO2. For comparison, a carbon tax of $5/tCO2
in 2005 dollars (arguably close to the starting rates of the “optimal” tax from this mainly 1990s
literature before any extra allowance for risks of dangerous climate change was introduced in
response to the issues raised by the Stern Review) converts to an increase of $2.5/bbl in US
crude oil prices in 2005, or about 2% in US gasoline prices. Such numbers from this established
body of literature appear unbelievably small if they are taken to be, as intended over the last 16
years, the estimated “optimal” costs of risking climate catastrophe10 .
In summary, the key policy messages, extremely stylized11, from traditional economics have
been: (1) introduce a small carbon tax, rising indefinitely in real terms and, if technological
change is considered, (2) wait rather than act now because the costs of mitigation will fall as a
result of technological change. These policy prescriptions have come from an approach relying
on deterministic cost-benefit analysis and high discount rates, assuming that technological
change is exogenous to the economic system or not affected by the carbon price, and ignoring
deep uncertainty.
Contrast the tone and implications of these statements with Stern’s conclusions: “the benefits
of strong early action far outweigh the economic costs of not acting” and “even at moderate
levels of warming, all the evidence … shows that climate change will have serious impacts on
world output, on human life and on the environment.” (pp. xv and xv1). Stern acknowledges
that technological change is partly driven by economic factors, such as the price of carbon,
implying that the benefits from waiting are replaced by benefits from acting so as to induce the
change and reduce the future costs (Köhler et al, 2006). Stern commissioned an application of
the PAGE model (Hope, 2003), which computes a probabilistic risk-based CBA, and considered
the CBA approach as one of three lines of evidence from the literature12. Stern asserts that the
economics of climate change are now more appropriately concerned with risk rather than return,
and with the development of technologies for mitigation, both features of the problem that has
been evident from the early 1990s, when the scientific assessments began in earnest. This in
turn implies that the economic problem is one of achieving political targets and lowest costs
compatible with equity and effectiveness, rather than with the political and scientific problem of
choosing the targets themselves.
10 They are also 5 times smaller that the carbon prices revealed by the market. Phase 2 of the EU emission trading
scheme has a carbon price over $20/tCO2 (March 2008), arguably to achieve a much weaker internal EU target than
that implied as optimal by the CBA literature.
11 Dasgupta (2007, p. 5) summarises the traditional view (incorrectly but reflecting academic and political
perceptions) as: “Nordhaus … has been studying the economics of climate change for over three decades. The
most remarkable conclusion of his studies - conducted on his Dynamic Integrated Model of Climate and the
Economy (DICE) - has been that, despite the serious threats to the global economy posed by climate change,
little should be done to reduce carbon emissions in the near future; that controls on carbon should be put into
effect in an increasing, but gradual manner, starting several decades from now. This conclusion has withstood
the many modifications Nordhaus and others have made to the climate science embodied in DICE. Their idea is
not that climate change should not be taken seriously, but that it would be more equitable (and efficient) to
invest in physical and human capital now, so as to build up the productive base of economies (including,
especially, poor countries), and divert funds to meet the problems of climate change at a later date.” Nordhaus
(2007b, p. 237) in fact has carbon taxes starting in 2005. Others using DICE (see note 13), but altering the
assumptions, come up with Stern-like conclusions.
12 It is significant that his critics have mainly criticized technical assumptions about discounting in a CBA and
have asserted that he has based his conclusions on this CBA. In fact the results of the CBA are to be viewed as
“indicative only” and to be “interpreted with great caution” (p. 174) and their discussion takes up only 16 out of
nearly 700 pages of the Review.
7
Contrast also the pre-Stern traditional conclusion that “optimal” temperatures should rise
indefinitely (Nordhaus, 1994, p. 89; 1997, p. 324)13 with the potential impacts of such warming
from the IPCC: “Partial loss of ice sheets on polar land could imply metres of sea
level rise … projected to occur over millennial time scales, but more rapid sea
level rise on century time scales cannot be excluded.” (IPCC, 2007, p. 13). Baer
and Mastrandrea (2006) present a risk analysis of such dangers: “a precautionary approach
requires near immediate efforts to ‘bend the curve’ of global emissions, and much steeper
reductions [80% by 2050] than are currently contemplated” (p. 8). The traditional approach is
unsuitable mainly because it simplifies or just ignores such deep uncertainties of long-term
climate projections. It requires knowledge about the far distant future under climate conditions
radically different from those of today (van den Bergh, 2004), as well as many other
assumptions about human welfare and behaviour needed to make the mathematics tractable
(Nelson, 2006, p. 93).
However, the literature coming to the conclusions from traditional economists does not exist
in isolation from that of other disciplines addressing the same problem. Climate scientists
address the likelihood and risks of extreme events, and draw conclusions about what “one can
safely say, for all practical purposes”. Ethics considers issues of intergenerational equity, when
climate damages are uncertain and far in the future. Engineering and architecture give insights
into how the capital stock can be designed to reduce greenhouse gas emissions. Economic
geography and history provides understanding as to how economies grow and how technologies
diffuse and evolve. Political science considers how societies make decisions regarding public
policy. Furthermore, economics is not confined to the study of equilibrium in various guises,
assuming groups of identical representative agents, with entirely self-interested consumers and
known, quantifiable social welfare functions. All these economic assumptions and more are
standard in the traditional cost-benefit analysis that lies behind the conclusions of Nordhaus and
Tol14 (DeCanio, 2003). The weakening of the neoclassical analysis of climate change has been
accompanied by a more general undermining of the ideology and prescriptions of traditional
economics by deconstruction of the origins of the theory in physics and cybernetics (Mirowski,
1989, 2002). Behavioural economics going back to (Kahneman and Tversky, 1989) has
revealed key relevant empirical findings for risk aversion and utility maximisation that are
inconsistent with traditional treatments. Complexity theory and agent-based modelling has
developed a theory of economic evolution (Arthur, 1994; Beinhocker, 2006).
Traditional economics has developed an approach to climate change, which has persistently
ignored the conclusions and insights of other disciplines. The new economics, as it has
developed in the literature covered by Stern, is more pluralistic and respectful of other
disciplines. The CBA approach is formally replaced by a Multi-Criteria Analysis (MCA)
developed in management science and applied to sustainable development (Munda, 2005) in
which socio-economic, ecological, and ethical perspectives are taken into account. Most of the
insights and techniques of CBA can be incorporated into the market (monetised) criterion in
MCA, but as in the Stern Review and IPCC Reports, intrinsic values (non-monetised) of human
13“.. the optimal climate change policy reduces long-run global warming from 6.6˚C to 6.2˚C.” (Nordhaus,
1997, p. 324). His current “optimal” rate is closer to 3˚C, see below.
14 The literature covered by Tol requires the monetization of the costs of climate change and almost without
exception adopts the standard assumptions. Alternatives approaches are provided by Barker, 1996b; Barker et
al., 2006; Ackerman and Heinzerling, 2004; Padilla, 2004; Maréchal, 2007.
8
suffering, damages to nature, and risks and uncertainties are also taken into account as criteria
for social choice.
3 Uncertainty in economic systems: equilibrium versus complexity
A critical issue in the understanding of climate change and its mitigation is the treatment of
uncertainty. The use of the word “dangerous” in the UNFCCC objective15 is interpreted by the
IPCC (IPCC, 2007, p.19) in terms of risks of climate change being balanced against the risks of
threatening economic sustainability by the response measures. The problem is clearly one
entailing unknown risks (uncertainties) of the climate system responding to the anthropogenic
pulse of additional greenhouse gas, primarily CO2, into the atmosphere being compared to the
largely known risks associated with mitigation policies and the even lower risks of the co-
benefits of mitigation, such as improved air quality. The treatment of these risks and
uncertainties distinguishes the traditional and the new economic analysis.
The classic text (Knight, 1921) defines risk as the property of outcomes with quantifiable
probabilities and uncertainty as that with unknown probabilities. Keynes made a similar
distinction: ‘By uncertain knowledge I do not mean merely to distinguish what is known for
certain from what is only probable. About these matters there is no scientific basis to form any
calculable probability whatever. We simply do not know.’ (1973 pp. 113-14 quoted by Holt
(2007)). In the traditional CBA, the form of the probability density function is simply assumed,
deep uncertainties are set aside despite the complexity of the scientific understanding, the risks
are assumed to be symmetric despite the key feature of disproportionately higher risks from
higher temperatures, and average discount rates are used for both costs and benefits, despite the
differences in risks (Frederick et al., 2002). Many CBAs are simply deterministic, neither
converting uncertainty into “certainty equivalence” nor subjecting the final model to a sensitivity
analysis16. However, the shape of the damage function is uncertain and that the climate science
suggests a significant (i.e. more than 1%) chance of catastrophe, defined by Weitzman (2007) as
average global temperatures rising by more that 5˚C above pre-industrial. Weitzman has
extended the traditional CBA analysis to convert the uncertainty into a second-order risk and his
interpretation of the results is to question the validity of CBA: “Perhaps in the end the climate-
change economist can help most by not presenting a cost-benefit estimate for what is inherently
a fat-tailed situation with potentially unlimited downside exposure as if it is accurate and
objective.” Instead, he argues, economists should be “explaining better to policy makers that the
artificial crispness conveyed by conventional IAM-based CBAs is especially and unusually
misleading”. And that “in rare situations like climate change ... we may be deluding ourselves
and others with misplaced concreteness if we think that we are able to deliver anything much
more precise than this with even the biggest and most-detailed climate-change IAMs as
currently constructed and deployed.” (p.42)
The CBA estimates prevalent in the literature on the economics of climate change are highly
misleading because the studies set aside or ignore deep uncertainty in costs and benefits. A
critical example is that the global long-run growth rates are almost entirely exogenous in the
models (coming from labour supply and technology), so that the uncertainties of the effects of
climate change on labour and technologies and then on growth are ignored. The estimated costs
15 UNFCCC, 1992, states as its objective: “to achieve stabilization of greenhouse gas concentrations in the
atmosphere at a low enough level to prevent dangerous anthropogenic interference with the climate system.”
16 Dietz, et al. (2007) show how risk analysis can change the conclusions of the CBA.
9
of climate change and the optimal carbon tax rates from the CBAs are essentially the subjective
views of Nordhaus, Tol17 and others presented as scientifically precise results. Tol in 2005
presented quantified ranges although he repeatedly acknowledges the uncertainty of the results;
in contrast in 2007, responding to Weitzman’s analysis, he acknowledges that the upper bounds
to the costs may be unquantifiable.18 Another example is the conclusion from Nordhaus’ DICE
study (July 2007) that “The total discounted economic damages with no abatement are in the
order of $23 trillion” (p. 181). Such an estimate is much too precise because the uncertainties in
the projections include possible worlds with temperatures >5˚C above pre-industrial averages.
This matters because the economists who have made the calculations have developed a
“scientific” consensus in defending the approach. They have argued that the “social cost of
carbon” can be precisely estimated and ranges given with sufficient precision to form climate
policy. Wietzman’s point is that the upper boundaries in such ranges e.g. a top 95 percentile of
about $100/tCO2 in Tol’s 2005 study, are subjective and misleading. With notable exceptions19
the literature on the social cost of carbon, by ignoring some uncertain damages, truncating
probabilities and discounting risky outcomes, has been promoting an over-optimistic picture of
the uncertainties of climate damage for the last 16 years.
There are also uncertainties associated with the costs of mitigation. In traditional economics,
the Marginal Abatement Cost (MAC) is the cost of abating the marginal emission of GHGs and
the Marginal Abatement Benefit (MAB) is the benefit, in terms of the reduction in the damages
caused by the emissions and converted into money. By assumption, as the level of abatement
rises, costs go down and benefits go up, so that there is an equilibrium solution for this level in
which the marginal cost equals the marginal benefit, utility is maximized and the optimal carbon
tax rate can be calculated. When used correctly, marginal means ‘vanishingly small’ since it is
calculated by differentiating cost curves that are required by the theory to be continuous, but in
equilibrium models of climate change ‘marginal’ is used, loosely, to refer to discrete, system-
wide changes, e.g. a shift from fossil fuel to hydrogen in transportation. The benefits in the MAB
are the avoided costs of “doing nothing” as discussed above, including the monetary estimates of
avoiding long-term catastrophe. The costs in MACs can be a large range of disparate, but
largely shorter-term, costs both private and public (or social) with and without market-based
valuations, but all associated with the abatement. It is clear that these costs do not normally
include any political costs of introducing abatement policies and measures. These economic
costs may be offset by ancillary environmental benefits or improvements in efficiency from the
use of tax revenues, but the CBA literature often either ignores these associated benefits or sets
them aside as being too uncertain or assumed to be managed by non-climate policies.
17 Tol ignores the value judgments underlying all cost-benefit analysis, namely that the equilibrium outcome of
rational self interest is in some sense optimal for society. He presents his survey of a set of essentially subjective
estimates, often done by the same clique of authors, as observations of probability density functions, when they
are basically undetermined (see note above), not properly sampled, or even independent.
18 “... the uncertainty is so large that a considerable risk premium is warranted. … More importantly, there is a
1% probability that the social cost of carbon is greater than $78/tC. This number rapidly increases if we use a
lower discount rate – as may well be appropriate for a problem with such a long time horizon – and if we allow
for the possibility that there is some truth in the scare-mongering of the gray literature.” Tol, 2007 (conclusion).
Tol (2005) does not mention a risk premium or that the damages may be unbounded, although the fat tail of
damages is emphasised as a feature of the analysis.
19Examples, using Nordhaus’ DICE model are the studies by Mastrandrea and Schneider (2001, 2004), Azar and
Lindgren (2003) and Ackerman and Findlayson (2007).
10
There are serious problems with the MAC concept and the total costs derived from the
models that use it 20. The first problem lies in the treatment of uncertainty and technology. The
reasoning assumes that the future schedules of costs are known in advance and independent of
policy. In fact they are uncertain and evidence shows that they are likely to respond to policy:
low-carbon technologies can be expected to develop in response to higher real prices of carbon,
just as energy-saving technologies have responded to energy prices (Popp, 2002). If so, the
MAC schedule is not independent of the cost of carbon, so the schedule is both uncertain and
unstable. As noted above, in general the risks and uncertainties of abatement are much less than
those of the damages. If decision-makers are risk averse, or wish to follow the Precautionary
Principle, the fact that abatement costs are less uncertain is likely to justify action involving
higher costs than what otherwise would be the case. Additionally mitigation reduces the risks of
the damages and of future adaptation, i.e. it reduces the cascade of risks from the emissions. A
deterministic equalisation of estimates of costs and benefits without taking into account these
uncertainties ignores fundamental differences between them.
A second problem is the one Stern identifies as the non-marginal nature of the economics.
As a result of discontinuities and path dependence in the economic system, the placing of system
changes within the apparatus of continuous cost schedules is misleading because different mixes
of old and new technological systems (e.g. a mix of oil-based and hydrogen-based systems)
appear to be highly unlikely because of economies of scale and specialization and lock-in
effects. The complex system effects may be large enough to achieve significant reductions in
costs under new technologies. If there are indivisibilities, e.g. a global electricity grid for low-
cost renewable generation, there is no longer a unique solution for the equilibrium carbon tax.
There is evidence for such system properties from the investigation of future costs of energy
systems undertaken by researchers at IIASA (Gritsevskyi and Nakicenovic, 2000). It is also
obvious at the micro scale that the technologies and costs of mitigation are not continuous. This
appears to be the case at the macro scale because of network economies and technological lock-
in. Not only are there significant discontinuities in the abatement cost schedule, the costs are
likely to go up or down for different levels of abatement depending on the technological system
under study.
The Stern Review’s assessment (p. 338) of escalating macroeconomic costs of mitigation as
targets become more stringent (450ppm CO2-eq and below) is also open to question, since the
underlying literature largely assumes continuity and exogenous technological progress.
Macroeconomic costs may not escalate when policies lead to decarbonisation, although carbon
prices, energy investments and the policy “effort” are all likely to rise, perhaps
disproportionately and the macroeconomic costs do become more uncertain at higher carbon
prices21. One of the key findings of the AR4 is that the literature on stringent mitigations is
insufficient to draw reliable conclusions (WG3, SPM, p. 16). All the available mitigation options
have not been investigated and included in the models in terms of the speed at which they need
to be implemented or their eventual scale. Extrapolation of the costs in the literature (Barker and
20 This is not to undermine the usefulness of the static incremental abatement schedule, showing abatement
options as a set of non-linear steps rising as the carbon price rises, and usually referred to as the MAC.
21 Tol (2007) asserts that high carbon taxes would bankrupt some countries. He seems to be confusing tax
revenues with tax payments. The tax revenues accrue to governments and benefit their finances; they benefit the
population if used wisely. One such use is to ensure that all home owners adopt low-GHG technologies. The tax
payments may not be a problem if safeguards to protect vulnerable social groups predate or accompany the
introduction of a carbon tax.
11
Jenkins, 2007) suggests that, depending on policies, macroeconomic costs for more stringent
mitigation will remain negligible, but risks of policy mistakes increase.
The modelling of economic risks in the context of climate change has been taken forward
with the post-Stern work of Dietz et al. (2007), in which the effects of adding risk to the CBA
are shown to increase the costs of climate change significantly. The key features of a risk
analysis of the problem are that the risks and uncertainties associated with the climate damages
are much greater, because of systemic irreversibilities and non-linearities, compare to those of
mitigation, which are largely known from past experience, and that the air quality benefits of
mitigation are even less risky, more immediate, and well-documented (Barker et al., 2007). A
more flexible “new economics” alternative modelling approach to CBA (Barker et al., 2006) is
based on the economic history of institutional structures. It emphasizes the importance of
accounting and economies of specialization and allows for increasing returns to scale in the
factor demand equations. In critical sectors, technology is modelled to allow for reductions in
unit costs as the scale of production increases and the markets develop. Scenarios incorporating
system-wide changes in technology, e.g. those involving the hydrogen economy, can be
developed consistently. This approach does not impose costs of mitigation by assumption,
unlike general equilibrium, so that an alternative low-carbon world economy may be less costly
than business as usual, depending on the reductions in costs that emerge when new technologies
come into widespread use.
Neoclassical economists claim that their work is value-free (Robbins, 1932), scientific
(Nordhaus, 2007b) or purely descriptive (Pearce et al, 1995; Nordhaus, 2007b). In doing so,
it has been plausibly argued that they are drawing on 19th Century science to promote a
secular, rationalist religion (Nelson, 2001, p. 133). Their faith is in the path-independence of
consumer preferences and producer technologies, a faith shown to be empirically false in
psychology, physics and history. Their thinking, apparently logical, is based on the fallacy
that “the pursuit of self interest is guided by objective laws to a socially beneficent outcome”
when instead this pursuit involves moral choices, at both personal and social levels (Foley, p.
xiii).
Nordhaus (2007b, p. 140-1) characterises economics as scientific in being peer-reviewed
and reproducible; he derives the discount rate from a pure description of the market rather
than from a consideration of ethics and moral philosophy. He contrasts his approach with
that of the Stern Review, which he finds unscientific22 . The many critiques of the Stern
22There is a literature devoted to the issue of whether economics is a science or not. See (Mirowski 1989, 2002;
Weintraub, 2002; Katzner, 2003). It is a science in that theory and observation are considered together when and
where possible or in that mathematics is a science (Samuelson’s position). However, neoclassical path-
independent economics as a mathematical science is strictly a branch of mathematics rather than economics,
since it violates a basic law of physics, the Second Law of Thermodynamics. Nordhaus (2007b) himself is
ambiguous about whether economics is a science or not, since he repeatedly distinguishes economics from
science.
12
Review have been dominated by the discussion of the discount rate23 (e.g. Nordhaus, 2007a;
Dasgupta, 2007a, 2007b; Tol and Yohe, 2007). The “pure rate of time preference” is one
component of the discount rate used in calculating the costs of doing nothing in relation to
climate change (see Quiggin below for an explanation). Stern adopts a pure rate of time
preference of near zero, drawing on moral arguments, compared with the rate adopted by the
traditional literature, e.g. 1.5%pa in (Nordhaus, 2007b) down from 3%pa in earlier applications
of his DICE model. The difference in discount rates between Stern and the traditional literature
is one of the reasons (cited by several of the critics as the main reason) for the much higher costs
of 5 to 20% of global GDP “now and forever” estimated by Stern (p. 15)24 for business-as-usual
of 2 to 5˚C warming or more, compared with the cost of 6% of GDP for a 10˚C warming from
Cline (1992), who also used a near-zero discount rate as quoted in the IPCC Second Assessment
Report (Pearce et al, 1995, p. 208), but had a different approach to risk, yielding lower costs.
The detailed deconstruction of this difference in the “costs of doing nothing” is covered by
the paper in this issue by Quiggin, so the discussion here can be brief. The first point is that
moral philosophers have long debated the relative weighting to be given in utility theory
between social groups living at different times. The Stern Review commissioned a review of the
ethics of climate change from Broome (2006), who had written earlier on the issue (1992). He
makes uncomfortable reading for traditional economists, partly because he insists, rightly, that
economics is not ethics-free, that basing economics on the ethics of individuals assumed to be
entirely self interested can go badly wrong, and that “willingness to pay” is invalid as a means of
valuation (Broome, forthcoming). This is in direct contradiction to the analysis of Pearce et al.
(1995, p. 196-7) and Nordhaus25, when they contrast prescriptive with descriptive valuations of
human life. In considering the ethics of climate change, Broome positions justice centre stage,
arguing that those who cause climate change should cease to do so because it is unjust, and if
they cannot cease, then they should compensate those who suffer.
Justice as a theory of ethics (Rawls, 1971) deserves serious attention as an alternative to
utilitarianism in climate-change analysis. Consider two population groups: a well-off urban
majority, burning fossil fuels, and a subsistence rural minority, dependent on the weather for
food and water. Assume that the costs of mitigation are negligible as the literature suggests.
Assume also that the rural minority do not share in average global growth; they can be said, in
Rawls’ words, to be the ‘least advantaged group’. In his theory, the standard of living of the
23 The use of a zero discount rate specifically for climate damages in a cost-benefit analysis of climate change
(Hasselmann et al, 1997) anticipated in some respects Stern’s use of low discount rates and also set off a fierce
debate with those supporting an aggregate discount rate for all types of damage (including loss of human life) or
sectors, which they justified by the traditional neoclassical treatment (Heal, 1997; Nordhaus 1997) relying on
the assumption of social groups being identical representative agents having full information and foresight. This
traditional approach also denies any significance to the empirical finding of differences between sectors in the
discount rates actually used (e.g. private rates being several times public discount rates). Hasselmann’s reply
(1999) also anticipates the emerging resolution of the post-Stern debate discussed here, specifically the
conclusions in (Hoel and Sterner, 2007) from a two-sector model.
24 It is not the only reason. Dietz et al (2007) provide four reasons for the higher costs in the Stern Report.
Previous studies, with important exceptions, have “(i) … mostly omitted to adequately employ the probabilistic
results of recent science; (ii) …tended to consider a narrow range of impacts, a product of focusing largely on
2°C–3°C warming, whereas we now know that there is a possibility of far higher temperatures; (iii) … not used
the economics of risk to the extent appropriate; (iv) … not paid adequate attention to the underlying ethics.” The
overall effect has been to give “on average, strong downward bias on damage estimates in the previous
literature”. (pp. 156-157)
25Nordhaus (2007b) claims that his 1.5%pa pure rate of time preference is “designed to provide the most
accurate projections rather than to be normative in nature.” (p. 40).
13
most advantaged would be justified only if their privileges maximised the welfare of the least
advantaged group, for example through the general effect of incentives on the economy. Let us
assume there is no such Rawlsian theory of justice in place. If policy were to be formulated
according to the traditional assumptions with the results described above, the outcome would be
a triple injustice:
1) The rural minority have not been responsible for today’s GHG concentrations causing
climate change, and have not benefited from the comfort and power given by the fossil
energy services, yet being dependent on the weather suffer most of the consequences.
2) The minority will suffer much more from future climate change because droughts and
floods threaten their subsistence income, and they cannot buy their way out of the
problems.
3) The minority’s future income is discounted by an average dominated by the well-off
majority’s income growth, so their future utility counts for much less in the CBA of global
climate-change policy. This outcome is a direct consequence of the discounting of average
consumption net of climate damages (including mortality) by Nordhaus and others,
supported by Dasgupta (2007a)26.
Since global inequalities over the last century have been increasing (Maddison, 2001) and a
subsistence minority of countries (and social groups within countries) may continue into the far
future, the assumptions may well be more realistic than those of the traditional model. Rawlsian
ethics would focus social policy on preventing the climate change and caring for the subsistence
minority. Instead, traditional models have been used to justify weak policies and inaction.
Broome (2006) also considers expected-utility theory alongside justice as a guide to social
policy. Importantly he distinguishes “value” from “utility” and allows for intrinsic value in
human life and nature. He considers the utilitarian view of climate change, arguing that (1) lives
should not be valued by the method of willingness-to-pay, which makes the value of people's
lives depend on how much they can afford to spend on prolonging them and (2) future lives
should not be discounted in value relative to present lives of similar quality 27. The argument
that because people in the future are expected to be better off in real money terms, so that we can
then discount a monetary value of their lives (or their health) runs into serious logical and moral
problems, which are not solved by recourse to the term “statistical lives”. Nordhaus (2007b, p.
47) is discounting the quantity and quality of human life when he includes valuations of
mortality and morbidity in the damages from catastrophe (which are stated to include health
damages)28. Implicitly, those who discount such damages at 1.5%pa and higher are valuing the
next generation’s lives and health at a fraction of their own. An equal valuation would transform
the policy prescriptions towards urgent action and high carbon tax rates.
26Like Broome, Dasgupta is an authority on economics and ethics, but he argues that traditional economics has
solved the ethical problems (2005). However, Dasgupta does not mention the ethical problems involved with the
averaging done in CBA, when the assumed monetary estimates of health and lives are discounted.
27Broome’s view on discounting is supported by the utilitarian philosopher R M Hare, who likewise argued that a
discount rate above zero cannot be justified ethically (Hare, 1981, p.100-101)
28Dasgupta (2007a) supported Nordhaus’s approach, but not his adopted pure rate of time preference. In
contrast, Stern argues that human lives and environmental quality should be treated separately (p. 165), although
the PAGE model (used to calculate the 5-20% range on costs) appears to include valuations of human life and
health implicitly in its damage functions. Dasgupta (2007b) no longer supports Nordhaus, and concludes that
“an optimum policy may not exist”, and (implicitly) that CBA is “an overly formal analysis” leading to
“misplaced concreteness” in its conclusions (since 1991) on climate change.
14
Nordhaus and others rely on the market to provide an estimate of the social discount rate.
The preferences underlying the rate are assumed to be fixed and to take into account far-future
climate damages. Such assumptions are not empirically valid and the procedure short-circuits
the political process, in which for example democratically elected politicians aim to lead and
change preferences (see below). The preferences are also assumed to take a particular form, in
which no ethical preferences are allowed, although in fact people might prefer that natural
resources be preserved as a matter of principle, even though they have no utility for them.
Finally these authors are assuming fungibility of natural and man-made assets, i.e. that they all
have monetary values and can be exchanged. Irreversible changes, e.g. warming of the oceans
leading to loss of coral reefs for the indefinite future, means that such exchange is impossible.
Hoel and Sterner (2007) have explored an extension to the traditional model allowing for human
and natural services and the likelihood that as the natural services become scarcer, their prices
will rise. They conclude that under reasonable assumptions the discount rate could become
negative.
It is the implicit assumption on the part of traditional economists of a ‘moral’ superiority of
the market that is at the heart of this debate. Utilitarian philosophers will have none of it.
Traditional economists evade this implication of their analysis, claiming that they are being
descriptive rather than prescriptive, but their logic does not stand up to scrutiny 29. This is
economics as a religion (Nelson, 2001), in which society is composed of self-interested
individuals, whose behaviour is to be assumed rational, then to be interpreted and described by
economics as a mathematical science, e.g. in finding and using the pure rate of time preference,
or the value of human life. The underlying fallacy is that market forces lead by themselves to
intrinsically good outcomes (Foley, 2006), a fallacy explored in more detail by Jaeger et al
below. A “new economics” approach is to acknowledge that there are ethical, aesthetic and
other values, and that all life should not be converted into money, with the exchangeability that
money permits (Ackerman and Heinzerling, 2004; Gowdy, 2005). The use of the discount rate to
account for time preference and risk should be re-thought to allow for subjective time preference
and a risk analysis independent of the return (Price, 2005). Climate change economics should
learn from organizational sciences applied to management of high-risk activities (Nelson, 2008).
The distribution of rights consistent with sustainable development should be considered (Padilla,
2004). The anti-utilitarian moral philosopher Bernard Williams has criticised the reductionism of
“utilitarian thought” and “the device of regarding all interests, ideas, aspirations and desires as
on the same level, and all representable as preferences of different degrees of intensity, perhaps,
but otherwise to be treated alike… The assimilation does not give our convictions enough
weight in our own calculations. At the same time, it can give other people’s convictions too
much weight” (Williams, 1985, p86). The utilitarian approach has much to offer, but its claims
should be qualified and limited by considerations other than that of utility, such as those of
justice, well-being of future lives, and benevolence.
5 Engineering and history: induced technological change and the costs of GHG mitigation
The costs of GHG mitigation in traditional economics are derived from the production function,
a concept basic to the determination of the allocation and growth of economic output,
29 See Broome (forthcoming). Nelson (2008) reveals other hidden value judgments that may underlie the
traditional neoclassical approach to climate change, leading to the tendency to rigidity and blindness to errors
evident in the critical responses to the Stern Review.
15
conventionally measured as marketed output, i.e. GDP in national accounts. In the models this
function takes special forms, typically Cobb-Douglas or Constant Elasticity of Substitution
(CES) with tractable properties: they are continuous, typically with constant returns to scale, and
reversible in that outputs can be expressed in terms of their inputs of labour, capital, materials,
and vice versa, a feature that contradicts path dependence, i.e. the second law of
thermodynamics30. This economics has been derived by analogy with physical process of the
first law of thermodynamics by Walras drawing on 19thC textbooks of physics (Mirowski, 1989;
Beinhocker, 2006) without an adequate treatment of time or the later second law with the
underlying physical requirement that all processes involve increasing entropy. In the case of the
burning of fossil fuels, this means the return into the atmosphere of the original CO2 captured by
plants and fossilised over millions of years as fuels.
More striking still, technological change has been assumed in the traditional muti-industry
treatment to be independent of production change, implying no learning by doing or by
researching (Barker et al., 2007, 11.5). If the general equilibrium models are to include such
endogenous technological change it is usually grafted on to the neoclassical production function
by linking it with an engineering model, typically for the energy supply and demand sectors. The
outcome is inconsistent in that endogenous technological change is allowed for energy output
but not other sectors (as well as carbon prices, many other relative prices will change as an effect
of climate policies) nor for other economic variables, such as exports, employment or even
consumption. It is also incomplete, in that it ignores the potential interaction between the
information economy, energy and new low-GHG technologies, which accelerates their adoption
and diffusion throughout the world economy.
The aggregate production functions, used in the equilibrium economic models, have been
subject to detailed and severe criticism over many years, both of the underlying theory
(Mirowski, 1989; Felipe and Fisher, 2003; DeCanio, 2003) and of the validity of the empirical
estimates (Felipe and McCombie, 2005). Theoretically, the use of an aggregate production
function requires two (heroic) assumptions: 1) that it is a meaningful exercise to combine the
processes of e.g. furniture-making, oil-refining, and food-retailing, and 2) that ALL markets are
perfectly competitive. Empirically, the use of National Accounts data on flows in current prices
to estimate production functions is usually flawed, because the dataset imposes an accounting
identity on the monetary value of production and the combined values of the inputs to
production (namely materials, labour and capital), when capital services are measured as
residual profits. The estimates in the literature are often based on accounting identities, not
causal relationships, and hence the very good fits obtained are entirely artefacts of the data31.
The implication of the production function in the traditional models, both the one-sector
models of Nordhaus and others and the multi-industry general-equilibrium models, is that
because the functional form assumes that the economy is at full employment and maximal
efficiency, any climate policy leads to costs in the form of loss of potential output. It is this
feature that leads to the contrast between the energy-engineering, bottom-up models, providing
30 The second law of thermodynamics is an expression of the universal law of increasing entropy, stating that the
entropy of an isolated system which is not in equilibrium will tend to increase over time, approaching a
maximum value at equilibrium. (Wikipedia, 15.01.08)
31 See (Felipe and McCombie, 2005). The empirical basis of the functions actually included in the climate-policy
models is even more compromised, being no more than a collection of guess-estimates from an inconsistent
literature (DeCanio, 2003).
16
estimates of some 6 GtCO2-eq mitigation potential by 2030 at net negative costs, i.e. “no regret
options”, compared with no such unrealized potential estimated by the top-down equilibrium
models (IPCC, 2007, p. 14-16). The potential for energy saving assessed by countless
engineering studies is simply ignored in the equilibrium models by assuming full information,
maximum efficiency and full employment, now and forever, in violation of the facts. New
evolutionary economics can provide insights into the non-economic barriers to energy efficiency
and how they may be overcome (Maréchal, 2007, p.5183-5184).
The traditional treatment of production also normally rules out of court any modelling
outcome that increases the growth rate of the economy as an outcome of climate policy. There
are many conditions under which GDP may increase, e.g. use of carbon tax revenues to reduce
distortionary taxes, the effect of policy in reducing the widespread under-employment in
developing countries, and the possibilities of more productive technological pathways.
Although documented in the theoretical and empirical literature (Barker et al., 2007, 11.4 and
11.5), these conditions are routinely and implicitly set aside by assumption in the traditional
treatment.
However, complexity economists (Arthur, 1994) strongly argue for path dependency and
increasing returns and economic historians have long argued that technological change and
economic growth are intimately related (Maddison, 2001) and path dependent (David, 2000).
The scientific requirement to decarbonise the global energy system is in effect suggesting the
need for another technological revolution, implying major structural shifts in the energy
industries and requiring the diffusion of low-carbon technologies, particularly across the
developing world, which holds the greatest potential for adoption, radical changes and
impacts. In contrast to the 18th and 19thC changes, the context is now one of the global
spread of almost free information, instantaneously. The potential for global, induced
technological change to reduce costs and even increase GDP is recognised in the Stern
Review and AR4, as is the modelling that relaxes the assumption of constant returns to scale.
In contrast to the equilibrium approach, such modelling has the great advantage that it aims to
explore technological and institutional options that give rise to opportunities rather than costs,
making the problem for international negotiations much more tractable (sharing out the
benefits of a technological revolution, to put it crudely, but a revolution that will only happen
if countries co-operate). At the same time it should be recognized that badly designed
policies and regulatory frameworks, as in banking, could lead to potential inflation or
financial collapse of investments and programmes.
6 Social choice
The switch in policy required to address the climate change problem is an issue of social choice.
Traditional economics approaches this problem by the use of the social welfare function, which
is a mathematical equation, or a set of equations, in an economic model, intended to represent
the social good. However, the concept is fundamentally flawed. When national governments
act, it is much more likely to be ‘in the national interest’ than in any formal manner capable of
being represented as a ‘criterion function’, an ‘objective function’ or a ‘social welfare function’
as some key concepts are known in equilibrium modelling of the economy and the environment.
As Arrow (1967, p. 736) remarks about Samuelson’s neoclassical treatment, ‘Whose behaviour
or whose judgement is referred to in the social welfare function is never clarified.’
17
In theory, the concept depends on the validity of adding up the welfare of households or
people such that the aggregate social welfare function is stable and predictable over time. Arrow
(1950) showed that for a set of reasonable assumptions (inter alia: a heterogeneous population,
universality, “independence of irrelevant alternatives”) such aggregation is impossible except
under extremely restrictive conditions. Traditional economics has resorted to assuming that
members of the population, or social groups such as households or firms, are in fact identical
“representative agents”, whose welfare and behaviour can be aggregated. This assumption,
required for the macroeconomic equilibrium models to be theoretically valid in relation to
microeconomic behaviour, is ‘both unjustified, and leads to conclusions that are usually
misleading and often wrong.’ (Kirman, 1992, p.117). The aggregate approach also often ignores
specific issues of equity and the distribution of wealth, which are especially important for
climate change economics because the costs tend to be met disproportionately by those who
cannot afford insurance, re-location or adaptation investments.
In addition, the social welfare function is not politically viable. The idea that there is a
stable relationship between different policy objectives such as reduction of greenhouse gases,
economic development, growth in consumption, reduction in unemployment or in the rate of
inflation, does not make sense when the actual political process of policy formation is
considered, whatever the political complexion of the government or the prevailing consensus
about sound policy promoted by international organizations such as the OECD, the IMF or the
World Bank. Institutional decision-making (e.g. that by national governments) is normally
characterised by the achievement of consensus between people and groups with potential
conflicts of interest. If this is so, it is quite easy to envisage the simultaneous pursuit of
conflicting goals, and the sudden alteration of policies as different interest groups gain
precedence. There is no escaping the fact that the goals of national, economic and social policy
are different for different interest groups, and that the national interest cannot be restricted to a
fixed formula. In the face of these difficulties, traditional economists have resorted to another
counter-factual assumption (usually implicit, but required for an optimal solution), that of a
global planner, i.e. a policy dictatorship for good or bad32.
Social choice regarding the climate policy involves social groups, “stakeholders”, such as
government, industry, NGOs, and political parties, in a process of consensus (Ostrom 1990). But
it also involves information and the law (Heinzerling and Ackerman, 2007). A real choice
requires the equal and simultaneous presentation of feasible alternatives. When a policy is the
subject of political debate and possible implementation by government, policy advisors consider
the benefit that such implementation would produce in each of various mutually exclusive
‘states of nature’ that might follow it, the good being considered for each group affected over
space and time.
The actual process of developing such information for the global community has been
chaotic. Different governments have produced their own analysis, sometimes as in the case of
the US Administration in 2001, selectively choosing scenario results to meet obvious political
32 The traditional cost-benefit analysis has been taken up by Lomborg in the “Copenhagen consensus” to
promote the idea that global problems other than climate change (e.g. HIV) are more worthy of funding. It is
inherently unlikely that the national interest can be identified with the functions for aggregate utility in the
equilibrium models and then solved to obtain ‘optimal’ set of policies. If an attempt were made to elicit the function
by asking a series of hypothetical questions of governments, rather than Lomborg’s selection of economists, it would
fail because the answers would most likely be inconsistent in terms of the equation. In any case, politicians would
refuse to commit themselves on hypothetical questions.
18
requirements. The paper by Hasselmann and Barker below discusses a way forward to improve
the information basis in developing international climate policy under the UNFCCC and the
IPCC. These bodies have arisen out of the international political process and are in keeping with
decentralised and varied political structures. This process has brought questions of equity to the
fore as witnessed by the crisis in the IPCC’s adoption of the Second Assessment Report in 1995,
with the neoclassical economists’ insistence on valuing human life on an insurance basis. The
use of values of “statistical lives” came into conflict with a perception that human life at present
and in the future should be valued equally irrespective of income or circumstance, for the
purpose of agreeing international policy. The governments of the developing countries arguing
their case for equality prevailed over the expert IPCC economists advising them. However, it is
perfectly feasible that a consensus approach in international negotiation can help to establish
policies and social values in difficult and controversial areas, such as abatement of climate
change, where the interests of different countries and future generations are to be taken into
account. For example, the IPCC’s Summaries for Policy Makers are agreed by all governments
explicitly at international meetings.
The IPCC’s sceptical approach to the use of cost-benefit analysis (CBA) as the sole basis for the
economics of climate change has been supported by Stern. The CBA of climate change after
Stern has been developed by Weitzman (2007) to the point of destruction. Just as a central bank,
faced with the risk of the collapse of the banking system, will act on perceived risks rather than a
monetary CBA, so governments have eschewed CBAs in which the “optimal” solution involves
risks of dangerous climate change. The intemperate and rushed reaction by a clique of
neoclassical economists criticizing the economics of the Stern Review illustrates the sensitivity
to the implied criticism of their conclusions.
The subsequent development of the literature in supporting Stern’s conclusions illustrates
how radical the shift in mainstream economic thinking has been. It is now acknowledged that
the economics of climate change is now more appropriately concerned with uncertainty rather
than return, a feature of the problem that has been evident from the early 1990s, when the
scientific assessments began in earnest. It can also reasonably be argued that CBA is useless for
the climate problem because of the uncertainty and risks of catastrophe. The discounting of costs
and benefits in which risks are converted into certainty equivalents and discounted at market
rates has been shown to be misleading and biased. This in turn implies that the economic
problem is one of achieving political targets, based on scientific evidence, at lowest costs
compatible with equity and effectiveness, rather than with the economics of choosing the targets
themselves.
The new information and evidence on the increasing risks of climate change has reinforced
earlier perceptions about the dangers, and raised scientific and political alarm, but the general
message has been to strengthen the evidence, and bring it home to the public through debate on
weather-related catastrophes. In summary, the problem is clear and the solution appears to be
almost costless in macroeconomic terms, but requires the long-term transformation of the global
energy system. Decarbonisation of the global energy system by 2050 seems to be feasible at
reasonable carbon prices (at least 100$/tCO2 by 2020 in year 2000 prices and continuing to rise
thereafter), with benefits to health and negligible effects on economic growth, but it will require
unprecedented global co-ordinated action.
19
ACKNOWLEDGEMENTS
I would like to thank Frank Ackerman, Eric Beinhocker, John Broome, Simon Dietz, Klaus
Hasselmann, Richard Lewney, John McCombie, John Quiggin, Serban Scrieciu, David Taylor
and Rachel Warren for providing helpful comments on earlier versions of this paper. I also
acknowledge the support of the UK Research Councils in funding my work as part of the
Tyndall Centre for Climate Change Research.
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