Krugman on Environmental Economics

This is a really nice article by Krugman on the economics of climate change. There's not much new here for wonks who follow this stuff closely. But it's the nicest summary of issues that I know of written in a way that anyone can understand. I'll be making this required reading for my principles of economics class (ARE 201).

What I would liked to have seen in the article but didn't:

(1) Some discussion of carbon emissions besides burning of fossil fuels. Land use change, mainly deforestation, comprises about 20% of emissions worldwide. It's a lot harder to price sequestrations from trees, but that form of emission reductions is cheap. Without putting these emissions under the cap we'll have a large loss in efficiency, and possibly a big problem. For example, biofuel production could accelerate deforestation.

(2) Some discussion of how unequal the likely costs of inaction will be. The DICE model and nearly all others obscure distributional issues which is where a lot of the action is likely to be.

(3) A fleshed out argument for how Weitzman's doomsday scenario might actually play out. It is hard to believe that climate change could cause direct catastrophic consequences to the developed world under any scenario. If there is a possibility of truly catastrophic consequences, it will be for certain poorer regions in the world. A permanent dust bowl in the midwestern U.S. coupled with bad agricultural outcomes in other parts of the world, especially Africa, could cause commodity prices to rise a lot. We'll hardly notice higher commodity prices. But the developing world--the parts that remain largely agrarian and will get too hot and the urban poor who rely on cheap grains--could get hammered. This is the doomsday scenario that is most plausible and no model I know of even tries to consider it. Not even Weitzman. It's all representative agent modeling on a global scale. Of course, doomsday for part of the world could draw in a lot of the rest of the world via civil conflict.

Here [after jump] is a condensed version of the article (with an eye toward undergraduates):


If there’s a single central insight in economics, it’s this: There are mutual gains from transactions between consenting adults. If the going price of widgets is $10 and I buy a widget, it must be because that widget is worth more than $10 to me. If you sell a widget at that price, it must be because it costs you less than $10 to make it. So buying and selling in the widget market works to the benefit of both buyers and sellers. More than that, some careful analysis shows that if there is effective competition in the widget market, so that the price ends up matching the number of widgets people want to buy to the number of widgets other people want to sell, the outcome is to maximize the total gains to producers and consumers. Free markets are “efficient” — which, in economics-speak as opposed to plain English, means that nobody can be made better off without making someone else worse off....

...But what if a deal between consenting adults imposes costs on people who are not part of the exchange? What if you manufacture a widget and I buy it, to our mutual benefit, but the process of producing that widget involves dumping toxic sludge into other people’s drinking water? When there are “negative externalities” — costs that economic actors impose on others without paying a price for their actions — any presumption that the market economy, left to its own devices, will do the right thing goes out the window. So what should we do? Environmental economics is all about answering that question. ...

.....Enter Arthur Cecil Pigou, an early-20th-century British don, whose 1920 book, “The Economics of Welfare,” is generally regarded as the ur-text of environmental economics.

....What Pigou enunciated was a principle: economic activities that impose unrequited costs on other people should not always be banned, but they should be discouraged. And the right way to curb an activity, in most cases, is to put a price on it. So Pigou proposed that people who generate negative externalities should have to pay a fee reflecting the costs they impose on others — what has come to be known as a Pigovian tax. The simplest version of a Pigovian tax is an effluent fee: anyone who dumps pollutants into a river, or emits them into the air, must pay a sum proportional to the amount dumped...

...The initial reaction by many environmental activists to this idea was hostile, largely on moral grounds. Pollution, they felt, should be treated like a crime rather than something you have the right to do as long as you pay enough money. Moral concerns aside, there was also considerable skepticism about whether market incentives would actually be successful in reducing pollution. Even today, Pigovian taxes as originally envisaged are relatively rare. The most successful example I’ve been able to find is a Dutch tax on discharges of water containing organic materials.

What has caught on instead is a variant that most economists consider more or less equivalent: a system of tradable emissions permits, a k a cap and trade. In this model, a limited number of licenses to emit a specified pollutant, like sulfur dioxide, are issued. A business that wants to create more pollution than it is licensed for can go out and buy additional licenses from other parties; a firm that has more licenses than it intends to use can sell its surplus. This gives everyone an incentive to reduce pollution, because buyers would not have to acquire as many licenses if they can cut back on their emissions, and sellers can unload more licenses if they do the same. In fact, economically, a cap-and-trade system produces the same incentives to reduce pollution as a Pigovian tax, with the price of licenses effectively serving as a tax on pollution....
...Politically speaking, doling out licenses to industry isn’t entirely bad, because it offers a way to partly compensate some of the groups whose interests would suffer if a serious climate-change policy were adopted. This can make passing legislation more feasible....

....This is an article on climate economics, not climate science. But before we get to the economics, it’s worth establishing three things about the state of the scientific debate. The first is that the planet is indeed warming. Weather fluctuates, and as a consequence it’s easy enough to point to an unusually warm year in the recent past, note that it’s cooler now and claim, “See, the planet is getting cooler, not warmer!” But if you look at the evidence the right way — taking averages over periods long enough to smooth out the fluctuations — the upward trend is unmistakable: each successive decade since the 1970s has been warmer than the one before.

Second, climate models predicted this well in advance, even getting the magnitude of the temperature rise roughly right. While it’s relatively easy to cook up an analysis that matches known data, it is much harder to create a model that accurately forecasts the future. So the fact that climate modelers more than 20 years ago successfully predicted the subsequent global warming gives them enormous credibility.

And this brings me to my third point: models based on this research indicate that if we continue adding greenhouse gases to the atmosphere as we have, we will eventually face drastic changes in the climate. Let’s be clear. We’re not talking about a few more hot days in the summer and a bit less snow in the winter; we’re talking about massively disruptive events, like the transformation of the Southwestern United States into a permanent dust bowl over the next few decades....

....My initial reaction, which I suspect most economists would share, is that the very scale and complexity of the situation requires a market-based solution, whether cap and trade or an emissions tax. After all, greenhouse gases are a direct or indirect byproduct of almost everything produced in a modern economy, from the houses we live in to the cars we drive. Reducing emissions of those gases will require getting people to change their behavior in many different ways, some of them impossible to identify until we have a much better grasp of green technology. So can we really make meaningful progress by telling people specifically what will or will not be permitted? Econ 101 tells us — probably correctly — that the only way to get people to change their behavior appropriately is to put a price on emissions so this cost in turn gets incorporated into everything else in a way that reflects ultimate environmental impacts.
When shoppers go to the grocery store, for example, they will find that fruits and vegetables from farther away have higher prices than local produce, reflecting in part the cost of emission licenses or taxes paid to ship that produce. When businesses decide how much to spend on insulation, they will take into account the costs of heating and air-conditioning that include the price of emissions licenses or taxes for electricity generation. When electric utilities have to choose among energy sources, they will have to take into account the higher license fees or taxes associated with fossil-fuel consumption. And so on down the line. A market-based system would create decentralized incentives to do the right thing, and that’s the only way it can be done....

Now, despite the high credibility of climate modelers, there is still tremendous uncertainty in their long-term forecasts. But as we will see shortly, uncertainty makes the case for action stronger, not weaker. So climate change demands action. Is a cap-and-trade program along the lines of the model used to reduce sulfur dioxide the right way to go?

Yet that’s not the conclusion you might draw from the many media reports that have focused on matters like hacked e-mail and climate scientists’ talking about a “trick” to “hide” an anomalous decline in one data series or expressing their wish to see papers by climate skeptics kept out of research reviews. The truth, however, is that the supposed scandals evaporate on closer examination, revealing only that climate researchers are human beings, too. Yes, scientists try to make their results stand out, but no data were suppressed. Yes, scientists dislike it when work that they think deliberately obfuscates the issues gets published. What else is new? Nothing suggests that there should not continue to be strong support for climate research.

And this brings me to my third point: models based on this research indicate that if we continue adding greenhouse gases to the atmosphere as we have, we will eventually face drastic changes in the climate. Let’s be clear. We’re not talking about a few more hot days in the summer and a bit less snow in the winter; we’re talking about massively disruptive events, like the transformation of the Southwestern United States into a permanent dust bowl over the next few decades....

....Just as there is a rough consensus among climate modelers about the likely trajectory of temperatures if we do not act to cut the emissions of greenhouse gases, there is a rough consensus among economic modelers about the costs of action. That general opinion may be summed up as follows: Restricting emissions would slow economic growth — but not by much. The Congressional Budget Office, relying on a survey of models, has concluded that Waxman-Markey “would reduce the projected average annual rate of growth of gross domestic product between 2010 and 2050 by 0.03 to 0.09 percentage points.” That is, it would trim average annual growth to 2.31 percent, at worst, from 2.4 percent. Over all, the Budget Office concludes, strong climate-change policy would leave the American economy between 1.1 percent and 3.4 percent smaller in 2050 than it would be otherwise....

....But while it’s unlikely that these models get everything right, it’s a good bet that they overstate rather than understate the economic costs of climate-change action. That is what the experience from the cap-and-trade program for acid rain suggests: costs came in well below initial predictions. And in general, what the models do not and cannot take into account is creativity; surely, faced with an economy in which there are big monetary payoffs for reducing greenhouse-gas emissions, the private sector will come up with ways to limit emissions that are not yet in any model.

What you hear from conservative opponents of a climate-change policy, however, is that any attempt to limit emissions would be economically devastating. The Heritage Foundation, for one, responded to Budget Office estimates on Waxman-Markey with a broadside titled, “C.B.O. Grossly Underestimates Costs of Cap and Trade.” The real effects, the foundation said, would be ruinous for families and job creation.

This reaction — this extreme pessimism about the economy’s ability to live with cap and trade — is very much at odds with typical conservative rhetoric. After all, modern conservatives express a deep, almost mystical confidence in the effectiveness of market incentives — Ronald Reagan liked to talk about the “magic of the marketplace.” They believe that the capitalist system can deal with all kinds of limitations, that technology, say, can easily overcome any constraints on growth posed by limited reserves of oil or other natural resources. And yet now they submit that this same private sector is utterly incapable of coping with a limit on overall emissions, even though such a cap would, from the private sector’s point of view, operate very much like a limited supply of a resource, like land. Why don’t they believe that the dynamism of capitalism will spur it to find ways to make do in a world of reduced carbon emissions? Why do they think the marketplace loses its magic as soon as market incentives are invoked in favor of conservation?

....The truth is that there is no credible research suggesting that taking strong action on climate change is beyond the economy’s capacity. Even if you do not fully trust the models — and you shouldn’t — history and logic both suggest that the models are overestimating, not underestimating, the costs of climate action. We can afford to do something about climate change.

But that’s not the same as saying we should. Action will have costs, and these must be compared with the costs of not acting. Before I get to that, however, let me touch on an issue that will become central if we actually do get moving on climate policy: how to get the rest of the world to go along with us....

....While there may be some benefits from a warmer climate, it seems almost certain that upheaval on this scale would make the United States, and the world as a whole, poorer than it would be otherwise. How much poorer? If ours were a preindustrial, primarily agricultural society, extreme climate change would be obviously catastrophic. But we have an advanced economy, the kind that has historically shown great ability to adapt to changed circumstances. If this sounds similar to my argument that the costs of emissions limits would be tolerable, it ought to: the same flexibility that should enable us to deal with a much higher carbon prices should also help us cope with a somewhat higher average temperature...

So how can we put a price tag on the effects of global warming? The most widely quoted estimates, like those in the Dynamic Integrated Model of Climate and the Economy, known as DICE, used by Yale’s William Nordhaus and colleagues, depend upon educated guesswork to place a value on the negative effects of global warming in a number of crucial areas, especially agriculture and coastal protection, then try to make some allowance for other possible repercussions. Nordhaus has argued that a global temperature rise of 4.5 degrees Fahrenheit — which used to be the consensus projection for 2100 — would reduce gross world product by a bit less than 2 percent. But what would happen if, as a growing number of models suggest, the actual temperature rise is twice as great? Nobody really knows how to make that extrapolation. For what it’s worth, Nordhaus’s model puts losses from a rise of 9 degrees at about 5 percent of gross world product. Many critics have argued, however, that the cost might be much higher.
Despite the uncertainty, it’s tempting to make a direct comparison between the estimated losses and the estimates of what the mitigation policies will cost: climate change will lower gross world product by 5 percent, stopping it will cost 2 percent, so let’s go ahead. Unfortunately the reckoning is not that simple for at least four reasons.

First, substantial global warming is already “baked in,” as a result of past emissions and because even with a strong climate-change policy the amount of carbon dioxide in the atmosphere is most likely to continue rising for many years. So even if the nations of the world do manage to take on climate change, we will still have to pay for earlier inaction. As a result, Nordhaus’s loss estimates may overstate the gains from action.

Second, the economic costs from emissions limits would start as soon as the policy went into effect and under most proposals would become substantial within around 20 years. If we don’t act, meanwhile, the big costs would probably come late this century (although some things, like the transformation of the American Southwest into a dust bowl, might come much sooner). So how you compare those costs depends on how much you value costs in the distant future relative to costs that materialize much sooner.

Third, and cutting in the opposite direction, if we don’t take action, global warming won’t stop in 2100: temperatures, and losses, will continue to rise. So if you place a significant weight on the really, really distant future, the case for action is stronger than even the 2100 estimates suggest.

Finally and most important is the matter of uncertainty. We’re uncertain about the magnitude of climate change, which is inevitable, because we’re talking about reaching levels of carbon dioxide in the atmosphere not seen in millions of years. The recent doubling of many modelers’ predictions for 2100 is itself an illustration of the scope of that uncertainty; who knows what revisions may occur in the years ahead. Beyond that, nobody really knows how much damage would result from temperature rises of the kind now considered likely.

You might think that this uncertainty weakens the case for action, but it actually strengthens it. As Harvard’s Martin Weitzman has argued in several influential papers, if there is a significant chance of utter catastrophe, that chance — rather than what is most likely to happen — should dominate cost-benefit calculations. And utter catastrophe does look like a realistic possibility, even if it is not the most likely outcome.

Weitzman argues — and I agree — that this risk of catastrophe, rather than the details of cost-benefit calculations, makes the most powerful case for strong climate policy. Current projections of global warming in the absence of action are just too close to the kinds of numbers associated with doomsday scenarios. It would be irresponsible — it’s tempting to say criminally irresponsible — not to step back from what could all too easily turn out to be the edge of a cliff.

... There is a broad consensus that we need to put a price on carbon emissions, that this price must eventually be very high but that the negative economic effects from this policy will be of manageable size. In other words, we can and should act to limit climate change. But there is a ferocious debate among knowledgeable analysts about timing, about how fast carbon prices should rise to significant levels....

....As a professional economist, I find this debate painful. There are smart, well-intentioned people on both sides — some of them, as it happens, old friends and mentors of mine — and each side has scored some major points. Unfortunately, we can’t just declare it an honorable draw, because there’s a decision to be made.

Personally, I lean toward the big-bang view. Stern’s moral argument for loving unborn generations as we love ourselves may be too strong, but there’s a compelling case to be made that public policy should take a much longer view than private markets. Even more important, the policy-ramp prescriptions seem far too much like conducting a very risky experiment with the whole planet. Nordhaus’s preferred policy, for example, would stabilize the concentration of carbon dioxide in the atmosphere at a level about twice its preindustrial average. In his model, this would have only modest effects on global welfare; but how confident can we be of that? How sure are we that this kind of change in the environment would not lead to catastrophe? Not sure enough, I’d say, particularly because, as noted above, climate modelers have sharply raised their estimates of future warming in just the last couple of years.

So what I end up with is basically Martin Weitzman’s argument: it’s the nonnegligible probability of utter disaster that should dominate our policy analysis. And that argues for aggressive moves to curb emissions, soon....

.....So the immediate prospects for climate action do not look promising, despite an ongoing effort by three senators — John Kerry, Joseph Lieberman and Lindsey Graham — to come up with a compromise proposal. (They plan to introduce legislation later this month.) Yet the issue isn’t going away. There’s a pretty good chance that the record temperatures the world outside Washington has seen so far this year will continue, depriving climate skeptics of one of their main talking points. And in a more general sense, given the twists and turns of American politics in recent years — since 2005 the conventional wisdom has gone from permanent Republican domination to permanent Democratic domination to God knows what — there has to be a real chance that political support for action on climate change will revive.

If it does, the economic analysis will be ready. We know how to limit greenhouse-gas emissions. We have a good sense of the costs — and they’re manageable. All we need now is the political will.

Comments

  1. I'm curious: If you had only a few sentences to tell lay people the most important things they should understand about climate change, what would you say?

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  2. I don't think it's moral to only consider the effects of climate change on humans.

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  3. do you really think anything can still be done about the runaway so-called "greenhouse gases"?

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  4. Justin:

    This issue is just too politically charged to explain the economics in just a few sentences. There are too many sound bites as it is. In one sentence: Read Paul Krugman's article.

    Patrica:

    My focus here is on economics, not morality. But I think it is a fallacy to believe that thoughtful consideration of human costs and benefits ignores impacts on other species. This is fallacy in at least two ways: (1) Humans are ecologically linked to all other species so what affects them can often affect us; (2) Humans often care about other species, so what happens to other species has economic value to humans. I think few economists would deny that these two values are important. The difficulty is measuring them. This is the kind of thing a lot of environmental economists try to do.

    RJS:

    Yes, we can stop growth of CO2 emissions. The questions are: (1) at what cost and (2) do we have the political will. If we cut emissions gradually over the next 40 years or so it's unlikely to be very costly at all. It will be more costly if we try to do it more quickly.

    But to some extent, a substantial amount of global warming is already baked in.

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  5. dr roberts, as i tried to point out in my article, it also looks like there is quite a bit of uncontrollable feedback from thawing permafrost already baked in...our human hubris aside, it looks like its already beyond our control, today or 40 years hence...

    but being just a blogger (neither an economist nor a climate scientist) i can only go on what ive learned from reading others...

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  6. RJS:

    Yes, there is a lot of uncertainty. Yes, many if not most climate scientists think that keeping warming below an irreversible feedback where we continue to warm well beyond 2 or 3 degrees Celsius is going to be difficult if not impossible.

    What you are pointing out is pretty much Weiztman's point: that we are going into truly unchartered territory in CO2 concentrations and are already in unchartered territory with regard to growth in CO2 concentrations. This means uncertainty is very large. This means there is a small but very real possibility that this could be really, really bad, so it's worth the cost to spend more to stop CO2 emissions quickly.

    There's a lot of fancy math to go with Weitzman's point, but that's the essence of it.

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  7. Michael,

    Great article by Krugman…but I was disappointed that he didn’t discuss agriculture’s role more extensively, both as a contributor to and in mitigation of greenhouse gases. Of course, that is my focus so I like to see more of that.

    He mentions that American agriculture is strongly energy-intensive, but he doesn’t mention agriculture’s potential role in the mitigation of greenhouse gas emissions. Indeed, not much on mitigation in general in the article. What’s on the other side of the trade? (I ask rhetorically.)

    Also, I agree, that rural poor in developing countries will get hammered by higher commodity prices. But, there are folks in the U.S. that are impacted by higher food prices as well as illustrated by movement to buying groceries at Big Box retailers etc. during this recession.

    Also, because I know that you have an interest in this. The effect of climate change on crop production: We recently published a long-term study (almost 60 years) on increasing temperature on wheat production in the Northern Great Plains. One interesting thing about the study was that the researchers were able to keep the cultivar constant (this factors out genetic crop differences) over a long time. So, it is not just a modeling study, but actual real-world results. The other interesting thing to note in the study was that growers have started planting almost two weeks earlier to avoid higher temperatures during fruit set and grain filling stages during the summer.

    Article can be found here: https://www.crops.org/story/2010/mar/fri/climatic-change-and-performance-of-wheat-from-1950-to-2007


    Best regards,
    James Giese

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  8. Thanks for your comment James Giese
    (Note to readers: James Giese is the Director of Science Communications
    American Society of Agronomy)

    I agree with you about the need for more focus on agriculture. I don't think Nordhaus or the other big-name economists are looking at agriculture as closely as they should be. That's really on the front lines of where climate impacts will occur.

    But I also think it's important to keep rich vs. poor countries in perspective. Even you're buying your food at Walmart, the vast majority of the price you pay in food is labor. I once calculated that if corn prices go up 10-fold the price of a big mac would go up by about a dollar. That's a pretty big price increase, but I don't think it would materially change the lives of most people in the U.S. But if corn prices went up 10 fold a large portion of the poorest third of the world would be in seriously bad shape. These are several order of magnitude differences.

    Thanks for the link, too.

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  9. Here is a part of Krugman's article I don't like:

    The policy-ramp advocates argue...costs that far in the future should not have a large influence on policy today. They point to market rates of return, which indicate that investors place only a small weight on the gains or losses they expect in the distant future, and argue that public policies, including climate policies, should do the same... As a professional economist, I find this debate painful. There are smart, well-intentioned people on both sides — some of them, as it happens, old friends and mentors of mine — and each side has scored some major points.

    End Quote

    This argument should not be given nearly this much respect. Krugman often chastises economists for not understanding things from intermediate undergrad econ. Well, the argument above shows a lack of understanding of finance 101!! The rate of return demanded is dependent on the risk of an investment. You expect, and demand, the stock market rate of return for an investment that is as risky as the stock market portfolio, not for any investment. If the investment is less risky, then it's a good deal with a lower expected return. If the investment is even better than zero risk, if it decreases the existing risk you have, like insurance, then it can even be worth it if it has a negative return.

    And people practice this all the time. Almost everyone buys homeowners insurance even though the expected return is highly negative. But it's so decreasing of catastrophic risk that it's still well worth it. It's still considered a great investment.

    Obviously planetary devastation is a catastrophic risk, so obviously insurance against this is not just low risk, but negative risk, so the required rate of return should be far lower than the required rate of return for a diversified stock portfolio, it should in fact be negative. With such an appropriate interest rate any credible model clearly shows we should be spending far more on anti global warming measures.

    I made this point in my blog action day post last October (at: http://richardhserlin.blogspot.com/2009/10/more-evidence-risk-return-tradeoff-in.html), but it's not being made nearly enough. This should be said vociferously every time someone says we should use the market discount rate for global warming insurance.

    Let me be clear here: What is the required rate of return used by Nordhaus? From "The Challenge of Global Warming: Economic Models and Environmental Policy", 2007, by William Nordhaus:

    The approach in the DICE model is to use the estimated market return on capital as the discount rate. The estimated discount rate in the model averages 4 percent [real, inflation adjusted] per year over the next century. (page 19)

    at: http://nordhaus.econ.yale.edu/dice_mss_072407_all.pdf

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  10. Richard Serlin:

    I'm afraid I must disagree with your basic finance.

    You are assuming that we should discount the future based in interest rates typically received historically on capital investments. But as we all know from basic general equilibrium theory, interest rates are tied to expected economic growth and covariance with growth. So we cannot think about the discount rates that should be applied to costs and benefits of climate change without thinking about how climate change will affect economic growth.

    But another way, your point about the discount rate is incorrect in at least two ways: (1) It assumes the economy will continue to grow as it has in the past, which it may not if global warming turns out to be truly catastrophic. (2) We need to adjust the discount rate for risk. In this case the rate adjustment is negative because investments in curbing global warming are like insurance: they pay off most under the bad circumstance that climate change turns out to be much worse than expected. Notice that this is opposite of capital investments, which pay off most in good times and thus have a positive risk premium.

    In short, it is easy to justify a zero discount rate using standard principles of finance.

    John Quiggin has a nice discussion of these issues.

    http://johnquiggin.com/wp-content/uploads/2006/12/sternreviewed06121.pdf

    I've also discussed them on this blog on several occasions.

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  11. Michael, you read my comment too fast. I agree with you. We should adjust the discount rate for risk, and because anti-global warming measures are insurance against catastrophic risk we should use a negative discount rate, not the stock market discount rate. Maybe you read the quote I was criticizing fast and thought it was my words.

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  12. Richard:

    You're right--I read much too quickly. I'm *VERY* sorry. I need to be more careful. And get more sleep...

    ReplyDelete

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