Fat-Tailed Uncertainty in the Economics of Catastrophic Climate Change

http://scholar.harvard.edu/files/fattaileduncertaintyeconomics_0_0.pd

Oh no, it's by someone from Harvard!

I seriously suggest that you read the paper.  It is really more of a philosophy piece attacking economics than an economic paper, but it is very convincing.

Although Weitzman was skeptical of the low discount rate and high cost of carbon from the Stern report, he sought to justify a higher cost of carbon on the premise that the uncertainty can increase the risk of a low-probability catastrophe.  His first argument is that we have already exceeded the maximum carbon dioxide levels in the last 800,000 years.  Conventional climate economics yields an optimal policy of stabilization at around 700 ppm while the previous high was 300 ppm.  This could potentially be very dangerous.

Of course, vastly increasing carbon dioxide does not necessarily mean that global temperatures are going to be unmanageable, but the greater the concentration, the greater the risk.  The IPCC had only modeled warming up to 4.5 degrees Celsius.  Depending on the type of curve projecting warming, the probability of low-probability events can be significantly different.  Using a pareto (power) distribution, the probability of high-warming is significantly greater than using normal distribution.  This lies in the "fat tail" of a power distribution that yields higher probability for extreme events.

There are real reasons for having concern for catastrophic warming.  A big concern among climate scientists is the possible release of massive amounts of methane.  We have large methane deposits stuck in permafrost that may slowly leak out methane as the permafrost melts from higher temperatures.  This positive feedback could be potentially devastating.  This article was written before the shale gas revolution, but there is concern now about methane leakage from natural gas deposits negating the lower carbon dioxide emissions from natural gas relative to coal.

Another concern is that the damages of catastrophic warming are underrepresented in standard models.  For William Nordhaus' damage function, 10 degree warming in only supposed to lead to a 19% decline in world output.  Over 200 years, this would mean only an average of 2% decline in output per year, not quite world-ending.  Weitzman posits that some standard assumptions for economic modeling may not hold with extreme warming.  He mentions that substitutability of goods.  I am not quite sure that I understand, but there is a difference between utility being multiplicatively separable and additively separable.  For example, material wealth is not easily substitutable for biodiversity.

The final concern is the discount rate.  Weitzman says that the choice of discount rate is largely normative (not scientific).  Discounting future value means that damage in the future is not as important as damage today.  If you don't know what I'm talking about, think of putting $50 in the bank today.  You expect it to be worth more in 50 years, so its future value in 50 years is much higher.  We will probably have a stronger, more robust economy in 50 years that is better able to deal with climate change, so there is economic sense in not doing everything today.  How much we should discount though is the difference between saying that we should do nothing to having a carbon price of $300 per ton of carbon dioxide, which I think is about $3 per gallon of gas.

Weitzman's analysis also divulges into a discussion of infinity.  Essentially, the possible damages from catastrophic climate change can be thought of as unbounded (eg complete destruction).  Thus, people's willingness-to-pay to avoid climate change can also approach infinity (or at least a very large number).  Weitzman has a "dismal theorem" on the importance of fat tails-if the probability of catastrophy is increased even slightly, then the WTP increases significantly.  Some other jargon is VSL or value of a statistical life (willingness to pay).

He concludes that the risk of inaction is great if his "fat-tail" assertions are correct.  Carbon dioxide emissions languish in the atmosphere for hundreds of years, so if we put ourselves on a path of destruction there is no turning back.  This means that we should be more willing to start reducing emissions now if there is a higher chance of catastrophe than current estimates.  Overall, a little dense, but mostly understandable and highly provocative.

Stern Review

Note that this report came out in 2006.  It was reading for my class, but a pretty important (and controversial) body of work.  I'll try to be brief in going over some of the highlights and criticisms.

I think most of you know the basics of climate science, so I will not harp on that nor try to convince anyone of the reality of climate change.  According to the Stern Report, there is between a 77% chance and 99% chance of 2 degree warming.  Just recently, Stern has said that the chances of limiting our losses to only 2 degrees are much lower; we should prepare for closer to 5 degrees Celsius warming.  Here are some of the economic costs mentioned:

• Melting glaciers and rising sea levels will lead to greatly increased flooding (200 million permanently displaced by mid-century!)
• Food production will go down due to warming, leading to increased malnutrition
• Diseases like malaria will become more prevalent
• Possible mass extinction, destruction of ecosystems (including hurting fishing)
• Possible collapse of ice sheets

One tragic consequence is that climate change is going to affect poor people more.  The very poor depend more on farming and cannot afford to adapt to rising temperatures. This means that climate change will exacerbate global inequality.

The Stern Report predicts future GDP losses of 0-3% with less than 2 degree warming and 5-10% with 5-6 degree warming.  It warns that we need to take into account potentially catastrophic warming that will completely devastate the planet (keep this in mind for a later post).  Some would say that the projected impact is overblown.  Stern takes it further by stating that "estimates, based on modelling a limited increase in this responsiveness, indicate that the potential scale of the climate response could increase the cost of climate change on the BAU path from 5% to 7% of global consumption, or from 11% to 14% if the non-market impacts described above are included." This is taken even further to 20% if inequality is included.  

A second major contentious point lies in Stern's estimate of the cost of drastic emission reduction.  He states that in order to stabilize carbon dioxide at 550 ppm, GHG emissions would have to be 25% lower than today by 2050 (and 70% lower to achieve 450 ppm).  There are four ways of reducing emissions: reducing demand, increasing carbon sinks (reforestation instead of deforestation), increasing energy efficiency, and increasing clean energy.  Stern estimates that only 1% more of GDP must be spent on emissions-reduction in order to stabilize at 550 ppm.  He states that "[t\he power sector around the world will have to be least 60%, and perhaps as much as 75%, decarbonized by 2050 to stabilize at or below 550 ppm CO2e."  Even though solar energy is getting much cheaper, I don't think that it will be easy to make a fairly rapid transition to a mostly zero carbon economy.  Unfortunately, a resonating note is a warning as to the impact of inaction. The longer we wait to do something, the more it will cost us.  Stern mentions benefits to technological change and lower emissions, including energy security and health benefits due to likely lower air pollution.

Stern estimates the 2006 social cost of carbon to be $85 per ton of carbon dioxide (or about $300 per ton of carbon), far more than most economic literature.  Famed environmental economist William Nordhaus puts the cost of carbon at closer to $30-$40 per ton, about 1/10th of Stern's estimate.  Stern argues that uncertainty means that we should use a higher carbon price than the estimated average due to uncertainty in risks.  

Stern's basic policy proposals are fairly noncontroversial among economists: "Policy to reduce emissions should be based on three essential elements: carbon pricing, technology policy, and removal of barriers to behavioral change."  Stern recommends a massive increase in incentives for innovation, 2 to 5 times the ~$30 billion spent in 2006.  He appears to endorse efficiency standards and labeling as effective tools for behavioral change.  An important section is given to the need for adaptation, as some impacts are unavoidable.  We need to plan for climate warning (unlike North Carolina, which just outlawed sea level rise) and develop in a sustainable manner.

The rest of the report focuses mostly on international cooperation.  We need a global carbon market, global regulations rather than varying regulations by country, aid to developing countries for mitigation and adaptation, and removal of trade barriers to low carbon technology.  (Oops, Obama imposed a tariff on Chinese solar panels just last year.  Another example of the fruitless pursuit of preserving American jobs at the expense of the global economy and the environment).

Inauguration Speech and Climate Change

I didn't really intend to watch the inauguration, but Obama did talk a little about climate change, so I will devote some time to giving my analysis of it. Of course, it was lacking in specifics, but it did hint at some future actions and I am not too impressed.

We really need a price on carbon and Obama hasn't shown a willingness to expend political capital on pushing for it, even saying that carbon taxes are only an option if Republicans push for them. I am also disturbed by this quote: "But America cannot resist this transition; we must lead it. We cannot cede to other nations the technology that will power new jobs and new industries – we must claim its promise." Climate change is not a jobs issue or something that should lead to us trying to defeat China. We should welcome cheaper emission-reduction technology and clean energy no matter where it comes from, not ensure that every policy must increase US jobs.

Bottom line: it is good lip service to the issue, but I don't see any indication that he'll force legislation through a hostile Congress, even though it could lead to fewer regulations and lower taxes than his current economic proposals.  Instead, he seems willing to push for increased spending on clean technology and linking it to employment, increased regulations from the EPA and new efficiency standards, and increasing trade regulation with China.  Of course, the last policy will increase costs and increase emissions, like this tariff on Chinese solar panels.  If Obama is serious, he won't pay as much attention to where the technology is coming from as to how we can reduce emissions in the least-costly way possible.

Viewpoints: Cap and trade should look to broader goals

http://www.sacbee.com/2012/11/02/4956023/cap-and-trade-should-look-to.html
This is another discussion of California's cap-and-trade program that I think I have read a while back.

Although it is great that California is a leader in reducing carbon dioxide emissions, no one should kid themselves into thinking that AB 32 will make a difference in limiting climate change.  I think that someone at the conference said that California and Australia produce the same amount of GHG emissions, just over 1% of the world's total.  Even eliminating our emissions would barely make a dent.

There is not much substance to the piece; it is mostly a call for conservatism and moderation.  If California shows that it can significantly reduce GHG emissions while maintaining a thriving economy, then perhaps the rest of the world will be more willing to undertake market-based climate policy (eg a carbon tax or cap-and-trade).  In addition, California can collaborate with other nations and develop a collaborative carbon price.

The key here is that other countries need to follow our lead in developing a policy that will reduce emissions. If California screws up and cripples its economy or just creates massive leakage, there is little prospect in advancing the case for action.  Fortunately, there did seem to be a realization at the carbon pricing conference at the need for cooperation.  Hopefully California will be fairly successful, although even the best-designed carbon pricing schemes have (British Columbia's revenue-neutral carbon tax) failed at getting majority support.