Some benefits and costs from the UK climate change report

Here are the economic highlights from the WSJ's article on the UK climate change report:

Introducing the report, Prime Minister Tony Blair said unabated climate change would eventually cost the world the equivalent of between 5% and 20% of global gross domestic product each year. ... Report author Sir Nicholas Stern, a senior government economist, said that acting now to cut greenhouse gas emissions would cost about 1% of global GDP each year. "That is manageable," he said. "We can grow and be green." ... Sir Nicholas said the world must shift to a "low-carbon global economy" through measures including taxation, regulation of greenhouse-gas emissions and carbon trading. ... The British government is considering new "green taxes" on cheap airline flights, fuel and high-emission vehicles.

The subtitle over at the Daily Grist, "Ignoring climate change far more expensive than fighting it, says British report," got me wondering (the guesses below aren't from the UK report, which I haven't even glanced at yet ... it's more fun to speculate than to actually inform oneself):

That 20% of global GDP cost estimate sounds on the high side. Let's go with the low-end number given uncertainties (and no, I'm not a AGW-hater) and then we'll work our way to an increasing cost scenario:

• Benefits of avoiding climate change = 5% of GDP
• Costs of avoiding climate change = 1% of GDP

To keep the numbers simple, let's assume that GDP is $100 million so the costs are $1 million and the benefits are $5 million. Suppose we incur the costs each year for 100 years and we don't enjoy the benefits until the 25th year. With a discount rate of 2% the benefit-cost ratio (BCR) of climate change mitigation policies is 2.74. Climate change mitigation is a good idea (i.e., efficient). If the discount rate is 7%, the BCR is 0.92. Climate change mitigation is a bad idea (i.e., inefficient).

If the benefits are zero for 25 years, rise linearly to 5% in the next 25 years, and then rise linearly to 20% for the next 50 years the benefit-cost ratio is 3.76 (2% rate). Mitigation is a good idea. If the discount rate is 7%, the BCR is 0.59. Bad idea.

Given these simple comparisons, I wouldn't say ignoring climate change is "far more expensive" ... as always, the choice of the discount rate (and the time path of costs and benefits) matters. My feeling is that the 2% rate is most appropriate, especially for this long-lived issue (some economists would say don't discount at all), reflecting the long-term social rate of time preference.

And I might actually read the executive summary of the report later today!

Note: the NYTimes article on the Stern report mentions one number: 20%! I'm so upset I'm not even providing a link.

Comments

[Charles Young]

John is correct to focus on the issue of discounting, which is always crucial to this kind of assessment. The Stern report takes the view that one should only discount welfare to the extent of any uncertainty that future generations will actually exist. "While we do allow for the possibility that, say, a meteorite might obliterate the world, and the possibility that future generations might be richer (or poorer), we treat the welfare of future generations on a par with our own."

The issue of discounting is discussed in Chapter 2 of the report, from which this quote is taken and in its technical appendix.
http://www.hm-treasury.gov.uk/media/8A3/83/Chapter_2_A_-_Technical_Annex.pdf
(I wish I knew how to embed links).
The report spends considerable space arguing, in my opinion convincingly, for this point of view, which has been shared by many other economists such as Ramsey, Pigou, Solow, Sen and Harrod.

However, there are also many economists who share John's view that a discount rate of around 2% should be applied to future welfare - in other words, that our great-grandfathers' welfare was vastly more important than our own. I've previously pointed out that, if Alexander the Great or any of his contemporaries had once been offered an extra glass of wine, on the understanding that the consequences of taking it would be the complete obliteration of the world's capital stock in 2006, then John must feel that it would have been right to accept the offer. I don't. And Stern wouldn't either.

In reality, of course, Alexander the Great never had such a choice. We do. Of course, the future costs and benefits of our choices are not known with precision - Stern is rigorous about dealing with the uncertainties. But he makes a persuasive case that the likely risks outweigh the present costs.

[dWj]

If GDP is growing, though, this doesn't pan out; in fact, I think global GDP growth rates are a pretty good estimate of the appropriate discount rate. If so, 1% of GDP this year has the same present value as 1% of GDP 50 years from now, and just adding up GDP percentages year by year makes sense.

[Aaron_M]

Intergenerational distribution of costs

This is probably an easy question but I am not an economist. When, following the Stern report, will the net benefits of their proposed programme for GHG emissions stabilization arrive?

Let me explain what I mean.

I suppose that my children will be economically worse off following the Stern plan because the proposed costs over their lifetime will be outweighed by the benefits they will incur during their lifetime. However at some point in the future the benefits of past investment in GHG abatement will outweigh whatever investment is being made at that time.

My question is when, on the Stern model, will this happen? In other studies I have seen predictions for the arrival of net-benefits ranging from 2300-2080. Any pointers in the right direction will be greatly appreciated.

[Charles Young]

You must distinguish between discounting welfare and discounting consumption. As my quote indicates, Stern does take account of changing income levels, and, as dWj suggests, he is quite right to do so. $100 of extra consumption adds less to welfare if income is $100,000 than if income is $10,000, so should be discounted in the former case, as Stern does.

What Stern does not do, but many others do (such as Nordhaus and Boyer, until now the most commonly cited source on the economics of climate change) is discount welfare itself. To discount welfare is to assume that future generations' welfare is less important than ours (and hence that previous generations' welfare was more important).