Climate and economics

John Hassler Professor of Economics

Introduction

Starting point: A ton of emitted fossil carbon mixes quickly in the atmosphere. Higher carbon dioxide (CO2) concentration affects global climate. Changed climate affects economy in many ways. Fossil fuel has benefits for the user but affects other people all over the world. Markets cannot deal with such a situation. Government policy and international

coordination required.

Purpose: present a transparent calculation of the external effects of fossil fuel use. Can be used to judge the value of reducing fossil fuel use and determine

optimal carbon tax.

Natural science background

Carbon dioxide (CO2) affects the global energy balance (difference between inflow to and outflow from earth) CO2 passes easily high frequency electromagnetic energy (sun light)

but less easily low frequency heat radiation. More CO2 acts like the roof of a greenhouse, reducing outflow and leads to warming.

Can easily be verified experimentally 1903 Nobel laureate in chemistry Svante Arrhenius described this already

(1896) and postulated an approximate relationship between the global mean temperature and the percentage increase in CO2 concentration. One per cent increase leads to 0.06 degrees warming. A doubling leads to an increase of 4 degrees. (Worlds in the making: the evolution of the universe, Arrhenius, 1908).

Natural science background:2

In reality, a large number of more or less known feedback mechanisms. Some reinforce and some weaken the direct effect. Positive: Less arctic ice reduces sunlight reflection, more water vapor (another

greenhouse gas). Negative: Cloud formation, airborne particles.

Total effect unclear, best guess that Global Average Temperature increases by 3° C for (each) doubling of CO2-concetration Arrhenius’ result still valid!

Effects are unevenly spread and include effects on precipitation and other characteristics of climate.

Thresholds and tipping points possible but no general consensus.

Fossil fuel externalitythree questions

In order to determine the (approximate) value today of the damages caused by one ton of fossil carbon emissions, we need to answer:

1. How much damages (per year) are caused by an extra ton fossil carbon in the atmosphere?

2. How long time does an extra ton emitted carbon stay in the atmosphere?

3. How should we value future losses of consumption?

Question 1Climate damages

We know less (and have researched less) on the economic consequences of climate change.

Effects are global, comes in many difference ways and are long-run. Existing research has used two complementary approaches:

1. Study different sectors (agriculture, forestry, health, coastal erosion, storm damages …) separately. Then sum all effects.

2. Statistical analysis on how natural variation in climate has affected the economy (GDP, growth).

Both leads to a climate damage function -- size of damage to GDP for different increases in temperature.

Limited knowledge, in particular about extreme climate change.

Climate damage:2 Large differences between effects in different regions, including very

large and moderate negative effects as well as some areas with positive effects (Northern Europe).

In larger regions/countries – perhaps less diversity. Example from Nordhaus RICE and DICE models.

Also substantial local externalities from fossil fuel extraction and use. Air quality and damages to land. Congestion and accidents (also for other fuels). Requires national policies but arguably not international policy coordination. These are abstracted from here but can be very substantial. Should be added to the global externality.

Climate Damage FunctionsNordhaus RICE 2007-10

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 60%

2%

4%

6%

8%

10%

12%

USEUChinaAfricaGlobal

Increase Global Average Temperature

Per cent loss of GDP

Damage per ton fossil carbon How large is the externality – how much damages are caused by an

extra ton carbon in the atmosphere? More carbon in atmosphere -> higher temperature -> larger

damages. First step has decreasing marginal effects. Temperature increase less than

proportionally with carbon emission. Second step has increasing marginal effects. Damages increase more than

proportionally.

The combined effect is approximately linear. 1 billion ton carbon (1 GtC) extra in the atmosphere reduces global

GDP by around 1/400 per cent. Today, we have around 200 GtC over preindustrial levels. Reduces global GDP

by ½ %.

Question 2How long does carbon stay in atmosphere?

One extra ton of carbon causes yearly damages at around US $2. BUT– an emitted ton of carbon stays in atmosphere and causes

damages over a very long time. A good approximation:

One share 1-φ0 (50%) disappears quickly to plants and surface ocean.

Another share (20%) stays very long (thousands of years). Rest trickles down to deep oceans quite slowly (a few per cent per decade φ).

Remaining question – how to evaluate future losses of consumption?

Question 3How to evaluate future consumption losses?

Three aspects:

1. Under the (arguably reasonable) assumption that losses are proportional to GDP, a larger future economy is hit by larger damages.

2. If we (future generations) are richer the welfare loss of a lost consumption unit is smaller.

3. How to evaluate future welfare relative to today’s, all else equal (e.g., with same consumption). A subjective and moral issue.

• Larger income in future leads to more consumption loss (aspect 1) but with less value per unit of consumption (aspect 2). Under standard assumptions in macroeconomics, these two aspects cancel each other and the current value of future proportional damages is independent of future income.

A formula for the carbon externality

Current global GDP

Share of ton carbon that stays ”for ever”.

Share of carbon trickling down to deep ocean.

Subjective discount rate for future welfare Rate of trickling down

Flow damage per ton carbon

Carbon externality

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 20.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

0

100

200

300

400

500

Externality costRMB/Liter gasoline

Yearly discount rate per cent

US$/ton carbon

Are optimal taxes high?

The optimal tax is fairly low relative to gasoline price and to other externalities.

Estimates of externalities from driving cars on fossil fuel point to other externalities being larger. Around RMB 1.50 /ltr in US and 2RMB/ltr in UK. China?

The world market price of coal is around 5 times lower per unit of energy. The optimal tax relative to this is higher, making coal mining less attractive.

Global Carbon Debt Our approximate formula can also be used to calculate the ”Global

Carbon Debt”, i.e., the discounted value of future damages that will come in the future from the carbon that has already been emitted (largely by the rich Western world).

We have an excessive amount of carbon in the atmosphere at 200 GtC. Of this half will stay for a very long time according to our approximation.

Using the formula and a yearly discount rate of 1%, the carbon debt is US $30 trillion, or around 40% of current world yearly GDP or equal to the sum of EU and US yearly GDP.

Who should pay this debt?

Tax vs. quantity restrictions The tax gives incentives for agents to make the right tradeoff

between private benefits and collective damages.

Our formula requires much less knowledge than quantity restrictions. For the optimal quotas, we also need to predict technology, alternative energy, population growth….

EU emission trading severely overestimated cost of reducing emissions.

But, markets needs to work well for tax to be sufficient. Some heavy polluters might be less constrained by market forces.

Qualifiers

We generally, and in particular regarding economic effects, face large degrees of uncertainty and our knowledge is continuously changing.

If we find threshold effects or tipping points in climate system, carbon circulation or the economy (yet to be found). Quantity restrictions may become preferable.

In general, market does not make the right incentives for research and development. Government involvement important but poses many difficult problems. Who is best at picking the winners?

Is a carbon tax a threat to growth?

In the short run, energy use almost proportional to production.

In the longer run, substantial possibilities to increase energy efficiency. Swedish energy consumption constant since 1973 while real GDP is up by 75%.

Last 20 years, 1.5% yearly growth in energy efficiency in west.

Large differences in energy efficiency also among countries at similar level of development. Example from my part of the world. GDP/kg oil equivalent:

Iceland $2, Sweden $6, Denmark $10, Switzerland $12.

In the (little) longer run, energy can be disconnected.

8 propositions

1. Burning fossil fuel leads to climate change, unclear how much.

2. Substantial, but likely not catastrophic, costs.

3. Catastrophic effects possible but currently impossible to evaluate.

4. Uneven distribution of costs, poor countries likely most effected.

5. Market failure, global policy coordination needed, global tax likely to be best. R&D policy likely to be needed too.

6. Optimal tax is modest, no threat to growth.

7. Conventional oil is not the problem, coal and unconventional is.

8. Very substantial additional local costs of fossil fuel use. Requires policy, but not (much less) international coordination.