The Stern Review is right but for the wrong reason

Looking for love in all the wrong places, thus says the authors of a new RFF working paper.

An Even Sterner Review: Introducing Relative Prices into the Discounting Debate

Thomas Sterner and U. Martin Persson | July 2007 | 07-37

The Economics of Climate Change: The Stern Review has had a major influence on the policy discussion on climate change. One reason is that the report has raised the estimated cost of unmitigated climate damages by an order of magnitude compared to most earlier estimates, leading to a call for strong and urgent action on climate change. Not surprisingly, severe criticism has been levied against the report by authors who think that these results hinge mainly on the use of a discount rate that is too low. Here we discuss the Ramsey rule for the discount rates and its implications for the economics of climate change. While we find no strong objections to the discounting assumptions adopted in the Stern Review, our main point is that the conclusions reached in the review can be justified on other grounds than by using a low discount rate. We argue that nonmarket damages from climate change are probably underestimated and that future scarcities that will be induced by the changing composition of the economy and climate change should lead to rising relative prices for certain goods and services, raising the estimated damage of climate change and counteracting the effect of discounting. We build our analysis on earlier research (Hoel and Sterner 2007) that has shown that the Ramsey discounting formula is somewhat modified in a two-sector economy with differential growth rates. Most importantly, such a model is characterized by changing relative prices, something that has major implications for a correct valuation of future climate damages. We introduce these results into a slightly modified version of the DICE model (Nordhaus 1994) and find that taking relative prices into account can have as large an effect on economically warranted abatement levels as can a low discount rate.

http://www.rff.org/rff/Documents/RFF-DP-07-37.pdf

Comments

[Charles Young]

A better headline might have been "An additional reason why the Stern Review's conclusions are right". As the abstract and p. 6 of the pdf make clear, the authors agree with the near-zero rate of pure time preference which differentiates Stern from the earlier consensus of those who, like Nordhaus, are either less rigorous, or happier to assume that their grandparents' welfare counts for more than their grandchildren's.(Using the pure time preference rate from Nordhaus' "Warming the world" and a 30-year generation gap would make our grandparents' welfare about 15 - 20 times more important than our grandchildren's).

[Dan Cole]

Arrow reached essentially the same conclusion as Sterner and Persson, and without adjusting the Stern Review's damage estimates. Performing his own calculuations with Stern's numbers, Arrow found that action to mitigate climate change would be justified at any pure rate of time preference up to 8.5%. See Kenneth Arrow, "Global Climate Change: A Challenge to Policy, in The Economists' Voice (June 2007), available at www.bepress.com/ev.

[joshua corning]

Does any of this address the fact that stern used warming estimates at the top end of climate models?

Climate models which have shown temp far above those measured in the real world?

I doubt it.

[joshua corning]

We argue that nonmarket damages from climate change are probably underestimated and that future scarcities that will be induced by the changing composition of the economy and climate change should lead to rising relative prices for certain goods and services, raising the estimated damage of climate change and counteracting the effect of discounting.

Anyone care to describe what nonmarket damages and future scarcities would be?

and the logic and evidence that these would occur even if top end estimates for climate change are realized?

[joshua corning]

Why are you focusing on Stern John and ignoring Yale University economist William Nordhaus's "The Challenge of Global Warming: Economic Models and Environmental Policy"

[DCBob]

I'm glad you brought this paper up - I think it's a very intriguing piece of economics. It should be obvious that in a world with rapid productivity growth for produced goods and low productivity growth for environmental amenities, you'd expect huge changes in relative prices over century time scales, and that that would have serious implications for valuing and discounting future environmental damages. Somehow, though, nobody (including Nordhaus) seems to have thought that through very clearly until these folks did.

[Charles Young]

Joshua
The difference between Nordhaus and Stern's policy conclusions are that the former favours a carbon tax of $27 per tonne, the latter more like $90. As noted above, the difference arises essentially because of Nordhaus' - to me odd - assumption about time preference. But a carbon tax of only $27 would be a great deal better than nothing, and I am glad if you are pressing for that.

Like DCBob, I'd like to thank John for highlighting the Sterner/Persson paper. There are many ways of highlighting the absurdities of inappropriate use of discounting, and they have highlighted one of them.

[Dan Cole]

Marty Weitzman has also argued that Stern might be right for the wrong reasons. Weitzman's argument is that even if Stern's discount rate is too low (because it ignores observed behavior), his conclusions and recommendations might be sound because of the possibility of climate catastrophes that might reduce the rate of growth in consumption (the g in the Ramsey equation). Marty looks at the 18 studies on which the IPCC relied on its FAR, and finds a 5% probability of a global mean temp increases of 6 degrees C or higher between now and 120; and a 2% chance of global mean temp increases of 8 degrees C or higher. Noting that such temperature increases in such short time periods is unprecedented in human history, it makes sense to take the kind of risk averse position that the Stern Review adopts. Weitzman refers to this as a "generalized precautionary principle." Some of these arguments are presented in Weitzman's review of the Stern Review, which is forthcoming in the Journal of Economic Literature. Other aspects are presented in Weitzman's working paper on catastrophic climate change. Both papers are available on his website, here: http://www.economics.harvard.edu/faculty/Weitzman/papers.html. I think Weitzman is doing the most interesting and nuanced work on climate change of all the modelers.

[Dan Cole]

In the post immediately above, "120" should be "2150."