The 2018 Nobel laureate for economics shows how economic analysis can help us design economic policies to address the looming challenges of global warming As scientific and observational evidence on global warming piles up every day, questions of economic policy in this central environmental topic have taken center stage. But as author and prominent Yale economist William Nordhaus observes, the issues involved in understanding global warming and slowing its harmful effects are complex and cross disciplinary boundaries. For example, ecologists see global warming as a threat to ecosystems, utilities as a debit to their balance sheets, and farmers as a hazard to their livelihoods.
In this important work, William Nordhaus integrates the entire spectrum of economic and scientific research to weigh the costs of reducing emissions against the benefits of reducing the long-run damages from global warming. The book offers one of the most extensive analyses of the economic and environmental dynamics of greenhouse-gas emissions and climate change and provides the tools to evaluate alternative approaches to slowing global warming. The author emphasizes the need to establish effective mechanisms, such as carbon taxes, to harness markets and harmonize the efforts of different countries. This book not only will shape discussion of one the world’s most pressing problems but will provide the rationales and methods for achieving widespread agreement on our next best move in alleviating global warming.
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About the Author
William D. Nordhaus, winner of the 2018 Nobel Prize in Economics and Sterling Professor of Economics at Yale University, is the author of The Climate Casino: Risk, Uncertainty, and Economics for a Warming World. He lives in New Haven, CT.
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A Question of BalanceWeighing the Options on Global Warming Policies
By William Nordhaus
Yale University PressCopyright © 2008 William Nordhaus
All right reserved.
Chapter OneSummary for the Concerned Citizen
Often, technical studies of global warming begin with an executive summary for policymakers. Instead, I would like to provide a summary for the audience of concerned citizens. The points that follow are prepared for both scientists and nonspecialists who would like a succinct statement of what economics, or at least the economics in this book, concludes about the dilemmas posed by global warming.
Global warming has taken center stage in the international environmental arena during the past decade. Concerned and disinterested analysts across the entire spectrum of economic and scientific research take the prospects for a warmer world seriously. A careful look at the issues reveals that there is at present no obvious answer as to how fast nations should move to slow climate change. Neither extreme-either do nothing or stop global warming in its tracks-is a sensible course of action. Any well-designed policy must balance the economic costs of actions today with their corresponding future economic and ecological benefits. How to balance costs and benefits is the central question addressed by this book.
Overview of the Issue of Global Warming
The underlying premise of this book is that global warming is a serious, perhaps even a grave, societal issue. The scientific basis of global warming is well established. The core problem is that the burning of fossil (or carbon-based) fuels such as coal, oil, and natural gas leads to emissions of carbon dioxide (C[O.sub.2]).
Gases such as C[O.sub.2], methane, nitrous oxide, and halocarbons are called greenhouse gases (GHGs). They tend to accumulate in the atmosphere and have a very long residence time, from decades to centuries. Higher concentrations of GHGs lead to surface warming of the land and oceans. These warming effects are indirectly amplified through feedback effects in the atmosphere, oceans, and land. The resulting climate changes, such as changes in temperature extremes, precipitation patterns, storm location and frequency, snowpacks, river runoff and water availability, and ice sheets, may have profound impacts on biological and human activities that are sensitive to the climate.
Although the exact future pace and extent of warming are highly uncertain-particularly beyond the next few decades-there can be little scientific doubt that the world has embarked on a major series of geophysical changes that are unprecedented in the past few thousand years. Scientists have detected early symptoms of this syndrome clearly in several areas: Emissions and atmospheric concentrations of greenhouse gases are rising, there are signs of rapidly increasing average surface temperatures, and scientists have detected diagnostic signals-such as greater high-latitude warming-that are distinguishing indicators of this particular type of warming. Recent evidence and model predictions suggest that global mean surface temperature will rise sharply in the next century and beyond. Climate Change 2007, the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC 2007a, 2007b), gives a best estimate of the global temperature increase over the coming century as from 1.8 to 4.0°C. Although this seems like a small change, it is much more rapid than any changes that have occurred in the past 10,000 years.
Global emissions of C[O.sub.2] in 2006 were estimated to be around 7.5 billion tons of carbon. It will be helpful to bring this astronomical number down to the level of the individual. Suppose that you drive 10,000 miles a year in a car that gets 28 miles per gallon. Your car will emit about 1 ton of carbon per year. (While this book focuses on carbon weight, other studies sometimes discuss emissions in terms of tons of C[O.sub.2], which has a weight 3.67 times the weight of carbon. In this case, your automobile emissions are about 4 tons of C[O.sub.2] per year.) Or you might consider a typical U.S. household, which uses about 10,000 kilowatt-hours (kWh) of electricity each year. If this electricity were generated from coal, it would release about 3 tons of carbon (or 11 tons of C[O.sub.2]) per year. On the other hand, if the electricity were generated from nuclear power, or if you rode a bicycle to work, the carbon emissions of these activities would be close to zero. In all, the United States emits about 1.6 billion tons of carbon a year, which is slightly more than 5 tons per person annually. For the world, the emissions rate is about 1.25 tons per person.
The Economic Approach to Climate-Change Policy
This book uses an economic approach to weighing alternative options for dealing with climate change. The essence of an economic analysis is to convert or translate all economic activities into a common unit of account and then to compare different approaches by their impact on the total amount. The units are generally the value of goods in constant prices (such as 2005 U.S. dollars). However, the values are not really money. Rather, they represent a standard bundle of goods and services (such as $1,000 worth of food, $3,000 of housing, $900 of medical services, and so forth). So we are really translating all activities into the number of such standardized bundles.
To illustrate the economic approach, suppose that an economy produces only corn. We might decide to reduce corn consumption today and store it for the future to offset the damages from climate change on future corn production. In weighing this policy, we consider the economic value of corn both today and in the future in order to decide how much corn to store and how much to consume today. In a complete economic account, "corn" would be all economic consumption. It would include all market goods and services, as well as the value of nonmarket and environmental goods and services. That is, economic welfare-properly measured-should include everything that is of value to people, even if those things are not included in the marketplace.
The central questions posed by economic approaches to climate change are the following: How sharply should countries reduce C[O.sub.2] and other GHG emissions? What should be the time profile of emissions reductions? How should the reductions be distributed across industries and countries? Other important and politically divisive issues concern how to impose cuts on consumers and businesses. Should there be a system of emissions limits imposed on firms, industries, and nations? Or should emissions reductions be imposed primarily through taxes on GHGs? What should be the relative contributions of rich and poor households or nations?
In practice, an economic analysis of climate change weighs the costs of slowing climate change against the damages of more rapid climate change. On the side of the costs of slowing climate change, countries must consider whether, and by how much, to reduce their GHG emissions. Reducing GHGs, particularly if the reductions are to be deep, will primarily require taking costly steps to reduce C[O.sub.2] emissions. Some steps involve reducing the use of fossil fuels; others involve using different production techniques or alternative fuels and energy sources. Societies have considerable experience in employing different approaches to changing energy production and use patterns. Economic history and analysis indicate that it will be most effective to use the market mechanism, primarily higher prices on carbon fuels, to give signals and provide incentives for consumers and firms to change their energy use and reduce their carbon emissions. In the longer run, higher carbon prices will provide incentives for firms to develop new technologies to ease the transition to a low-carbon future.
On the side of climate damages, our knowledge is very meager. For most of the time span of human civilizations, global climatic patterns have stayed within a very narrow range, varying at most a few tenths of a degree Celsius (°C) from century to century. Human settlements, along with their ecosystems and pests, have generally adapted to the climates and geophysical features they have grown up with. Economic studies suggest that those parts of the economy that are insulated from climate, such as air-conditioned houses and most manufacturing operations, will be little affected directly by climatic change during the next century or so.
However, those human and natural systems that are "unmanaged," such as rain-fed agriculture, seasonal snow-packs and river runoffs, and most natural ecosystems, may be significantly affected. Although economic studies in this area are subject to large uncertainties, the best guess in this book is that the economic damages from climate change with no interventions will be on the order of 2.5 percent of world output per year by the end of the twenty-first century. The damages are likely to be most heavily concentrated in low-income and tropical regions such as tropical Africa and India. Although some countries may benefit from climate change, there is likely to be significant disruption in any area that is closely tied to climate-sensitive physical systems, whether through rivers, ports, hurricanes, monsoons, permafrost, pests, diseases, frosts, or droughts.
The DICE Model of the Economics of Climate Change
The purpose of this book is to examine the economics of climate change in the framework of the DICE model, which is an acronym for Dynamic Integrated model of Climate and the Economy. The DICE model is the latest generation in a series of models in this area. The model links the factors affecting economic growth, C[O.sub.2] emissions, the carbon cycle, climate change, climatic damages, and climate-change policies. The equations of the model are taken from different disciplines-economics, ecology, and the earth sciences. They are then run using mathematical optimization software so that the economic and environmental outcomes can be projected.
The DICE model views the economics of climate change from the perspective of economic growth theory. In this approach, economies make investments in capital, education, and technologies, thereby abstaining from consumption today, in order to increase consumption in the future. The DICE model extends this approach by including the "natural capital" of the climate system as an additional kind of capital stock. By devoting output to investments in natural capital through emissions reductions, reducing consumption today, economies prevent economically harmful climate change and thereby increase consumption possibilities in the future. In the model, different policies are evaluated on the basis of their contribution to the economic welfare (or, more precisely, consumption) of different generations.
The DICE model takes certain variables as given or assumed. These include, for each major region of the world, population, stocks of fossil fuels, and the pace of technological change. Most of the important variables are endogenous, or generated by the model. The endogenous variables include world output and capital stock, C[O.sub.2] emissions and concentrations, global temperature change, and climatic damages. Depending upon the policy investigated, the model also generates the policy response in terms of emissions reductions or carbon taxes (these are further discussed later). One of the shortcomings of the DICE model is that, as in most other integrated assessment models, technological change is exogenous rather than produced in response to changing market forces.
The DICE model is like an iceberg. The visible part contains a small number of mathematical equations that represent the laws of motion of output, emissions, climate change, and economic impacts. Yet beneath the surface, so to speak, these equations rest upon hundreds of studies of the individual components made by specialists in the natural and social sciences.
Good modeling practice in the area of climate change, as in any area, requires that the components of the model be accurate on the scale that is used. The DICE model contains a representation of each of the major components required for understanding climate change during the coming decades. Each of the components is a submodel that draws upon the research in that area. For example, the climate module uses the results of state-of-the-art climate models to project climate change as a function of GHG emissions. The impacts module draws upon the many studies of the impacts of climate change. The submodels used in the DICE model cannot produce the regional, industrial, and temporal details that are generated by the large specialized models. However, the small submodels have the advantage that, while striving to accurately represent the current state of knowledge, they can easily be modified. Most important, they are sufficiently concise that they can be incorporated into an integrated model that links all the major components.
For most of the submodels of the DICE model, such as those concerning climate or emissions, there are multiple approaches and sometimes heated controversies. In all cases, we have taken the scientific consensus for the appropriate models, parameters, or growth rates. In some cases, such as the long-run response of global mean temperature to a doubling of atmospheric CO2, there is a long history of estimates and analyses of the uncertainties. In other areas, such as the impact of climate change on the economy, the central tendency and uncertainties are much less well understood, and we have less confidence in the assumptions. For example, the impacts of future climate change on low-probability but potentially catastrophic events, such as melting of the Greenland and Antarctic ice caps and a consequent rise in sea level of several meters, are imperfectly understood. The quantitative and policy implications of such uncertainties are addressed at the end of this summary.
The major advantage of using integrated assessment models like the DICE model is that questions about climate change can be answered in a consistent framework. The relationships that link economic growth, GHG emissions, the carbon cycle, the climate system, impacts and damages, and possible policies are exceedingly complex. It is extremely difficult to consider how changes in one part of the system will affect other parts of the system. For example, what will be the effect of higher economic growth on emissions and temperature trajectories? What will be the effect of higher fossil-fuel prices on climate change? How will the Kyoto Protocol or carbon taxes affect emissions, climate, and the economy? The purpose of integrated assessment models like the DICE model is not to provide definitive answers to these questions, for no definitive answers are possible, given the inherent uncertainties about many of the relationships. Rather, these models strive to make sure that the answers at least are internally consistent and at best provide a state-of-the-art description of the impacts of different forces and policies.
The Discount Rate
One economic concept that plays an important role in the analysis is the discount rate. In choosing among alternative trajectories for emissions reductions, we need to translate future costs into present values. We put present and future goods into a common currency by applying a discount rate on future goods. The discount rate is generally positive, but in situations of decline or depression it might be negative. Note also that the discount rate is calculated as a real discount rate on a bundle of goods and is net of inflation.
In general, we can think of the discount rate as the rate of return on capital investments. We can describe this concept by changing our one-commodity economy from corn to trees. Trees tomorrow (or, more generally, consumption tomorrow) have a different "price" than trees or consumption today because through production we can transform trees today into trees tomorrow. For example, if trees grow costlessly at a rate of 5 percent a year, then from a valuation point of view 105 trees a year from now is the economic equivalent of 100 trees today. That is, 100 trees today equal 105 trees tomorrow discounted by 1+.05. Therefore, to compare different policies, we take the consumption flows for each policy and apply the appropriate discount rate. We then sum the discounted values for each period to get the total present value. Under the economic approach, if a stream of consumption has a higher present value under policy A than under policy B, then A is the preferred policy.
Excerpted from A Question of Balance by William Nordhaus Copyright © 2008 by William Nordhaus. Excerpted by permission.
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Table of Contents
Summary for the Concerned Citizen 1
Background and Description of the DICE Model 30
Derivation of the Equations of the DICE-2007 Model 38
Alternative Policies for Global Warming 65
Results of the DICE-2007 Model Runs 80
The Economics of Participation 116
Dealing with Uncertainty in Climate-Change Policy 123
The Many Advantages of Carbon Taxes 148
An Alternative Perspective: The Stern Review 165
Summary and Conclusions 192
Equations of the DICE-2007 Model 205