Climate economics

1. Climate Economics

Climate economics is a field of economics that analyzes the economic aspects of climate change. It encompasses a wide range of issues, including the costs of climate change impacts, the costs and benefits of mitigation policies (reducing greenhouse gas emissions), the economics of adaptation to climate change, and the international economic dimensions of climate policy. This article provides an introduction to the core concepts and challenges within climate economics, aimed at beginners.

The Economic Problem of Climate Change

At its core, climate change presents a classic example of an external cost. An external cost occurs when the production or consumption of a good or service imposes a cost on a third party who is not involved in the transaction. In the case of greenhouse gas (GHG) emissions, the cost is borne by society as a whole – through more frequent and intense extreme weather events, sea-level rise, disruptions to agriculture, and impacts on human health – while the benefits of the activity causing the emissions (e.g., burning fossil fuels for energy) are enjoyed by the emitter.

Because the emitter doesn't fully bear the costs of their actions, they tend to emit *more* than is socially optimal. This is known as a market failure. Traditional economic models assume perfect information and rational actors, but the long-term, diffuse, and uncertain nature of climate change impacts makes it difficult for individuals and firms to fully internalize the costs of their emissions.

The key characteristics making climate change a unique economic challenge are:

• Global Public Good: The atmosphere is a global common. GHG emissions anywhere in the world contribute to the problem everywhere, meaning no single country can solve it alone.
• Long Time Scales: The effects of GHG emissions are felt over decades and centuries, creating challenges for both discounting (see section below) and policy design.
• Uncertainty: There is significant uncertainty regarding the magnitude and timing of climate change impacts, as well as the effectiveness of different mitigation and adaptation strategies. This requires robust and flexible policies.
• Irreversible Impacts: Some impacts of climate change, such as species extinction or the loss of major ice sheets, are potentially irreversible.

Damage Functions & Integrated Assessment Models (IAMs)

To understand the economic consequences of climate change, economists use damage functions. A damage function estimates the economic costs associated with different levels of warming. These costs can include:

• Agricultural Losses: Changes in temperature and precipitation patterns can reduce crop yields, leading to food insecurity and economic losses for farmers. See Agricultural Economics for more detail.
• Coastal Damage: Sea-level rise and increased storm surges can inundate coastal areas, damaging infrastructure and displacing populations. Coastal Risk Assessment
• Health Impacts: Heat waves, air pollution, and the spread of infectious diseases can lead to increased morbidity and mortality. WHO on Climate Change and Health
• Reduced Labor Productivity: Extreme heat can reduce worker productivity, particularly in outdoor industries.
• Ecosystem Services Disruption: Loss of biodiversity and degradation of ecosystems can reduce the provision of valuable services such as pollination, water purification, and carbon sequestration. UNEP Biodiversity

Damage functions are often incorporated into Integrated Assessment Models (IAMs). IAMs are complex computer models that combine economic, climate, and energy systems to project the future impacts of climate change and evaluate the costs and benefits of different policy scenarios. Examples include DICE (Dynamic Integrated Climate-Economy) and PAGE (Policy Analysis of the Greenhouse Effect). PAGE Model

However, IAMs are not without their limitations. They often rely on simplified representations of complex systems and may underestimate the potential for catastrophic events or non-market impacts. IAM Criticisms Further, they can be sensitive to assumptions about key parameters like the discount rate.

The Social Cost of Carbon (SCC)

A crucial concept in climate economics is the Social Cost of Carbon (SCC). The SCC is an estimate of the economic damages associated with emitting one additional ton of carbon dioxide into the atmosphere. It represents the present value of all future damages caused by that ton of CO2.

Calculating the SCC is incredibly complex and relies heavily on IAMs. It requires making assumptions about:

• Climate Sensitivity: How much the global temperature will rise in response to a doubling of CO2 concentrations. IPCC Special Report on 1.5°C
• Discount Rate: How much future damages should be discounted relative to present damages. This is particularly contentious (see section below).
• Damage Functions: Estimating the economic costs of climate change impacts.

The SCC is a vital tool for policy analysis. It can be used to assess the benefits of policies that reduce emissions, such as carbon taxes or regulations. Different SCC values lead to drastically different policy recommendations.

Discounting & Intergenerational Equity

Discounting is the process of converting future values into present values. In climate economics, discounting is used to compare the costs of mitigating climate change today with the benefits of avoiding future damages. The discount rate represents the rate at which future values are discounted.

A higher discount rate gives less weight to future damages, making mitigation policies seem less attractive. This is because a higher discount rate implies that people today place a lower value on the well-being of future generations. Conversely, a lower discount rate gives more weight to future damages, making mitigation policies more appealing.

The choice of discount rate is a deeply ethical and economic question. Some argue that a low discount rate is justified because climate change impacts are potentially catastrophic and irreversible. Others argue that a higher discount rate is appropriate because of the uncertainty surrounding future climate impacts and the opportunity cost of investing in mitigation today.

The debate over discounting raises fundamental questions about intergenerational equity: how should we balance the interests of current generations with those of future generations? NBER Working Paper on Discounting

Mitigation Policies

Mitigation refers to actions taken to reduce greenhouse gas emissions. Common mitigation policies include:

• Carbon Pricing: Putting a price on carbon emissions, either through a carbon tax (a direct tax on emissions) or a cap-and-trade system (setting a limit on emissions and allowing firms to trade emission permits). World Bank Carbon Pricing Dashboard
• Renewable Energy Standards: Requiring a certain percentage of electricity to be generated from renewable sources. Renewable Energy Explained
• Energy Efficiency Standards: Setting minimum efficiency standards for appliances, vehicles, and buildings.
• Regulations: Directly regulating emissions from specific sources, such as power plants.
• Subsidies: Providing financial incentives for the adoption of low-carbon technologies. IRENA - International Renewable Energy Agency

The effectiveness of mitigation policies depends on a variety of factors, including the stringency of the policy, the availability of low-carbon technologies, and the responsiveness of consumers and firms to price signals.

Adaptation Policies

Adaptation refers to actions taken to reduce the vulnerability of human and natural systems to the impacts of climate change. Adaptation policies include:

• Building Sea Walls: Protecting coastal areas from sea-level rise and storm surges.
• Developing Drought-Resistant Crops: Ensuring food security in areas prone to drought.
• Improving Public Health Systems: Preparing for the health impacts of climate change, such as heat waves and the spread of infectious diseases.
• Relocating Communities: Moving communities away from areas at high risk of climate change impacts. UNDP Adaptation
• Investing in Early Warning Systems: Providing timely warnings of extreme weather events.

Adaptation is essential, even if ambitious mitigation efforts are undertaken, as some level of climate change is already locked in. However, adaptation is often costly and may have limitations. Climate Adaptation Knowledge Portal

International Climate Economics & Agreements

Climate change is a global problem that requires international cooperation. The United Nations Framework Convention on Climate Change (UNFCCC) is the primary international forum for negotiating climate agreements. Key agreements include:

• Kyoto Protocol (1997): The first international agreement to set binding emission reduction targets.
• Paris Agreement (2015): A landmark agreement in which countries pledged to limit global warming to well below 2°C, preferably to 1.5°C, above pre-industrial levels. Paris Agreement
• Conference of the Parties (COP): Annual meetings of the UNFCCC member states to review progress and negotiate new commitments.

International climate agreements often face challenges related to free-riding (countries benefiting from the efforts of others without contributing themselves) and the distribution of costs and benefits. Climate finance – the provision of financial resources from developed to developing countries to support mitigation and adaptation efforts – is a critical aspect of international climate cooperation. Climate Funds Update

Emerging Trends & Challenges

Several emerging trends and challenges are shaping the field of climate economics:

• Green Finance: The growing importance of financial instruments and investments that support climate action. UNEP Finance Initiative
• Stranded Assets: The risk that fossil fuel assets will become economically unviable as the world transitions to a low-carbon economy. Stranded Assets
• Climate Risk Disclosure: Increasing pressure on companies to disclose their climate-related risks. Task Force on Climate-related Financial Disclosures (TCFD)
• Geoengineering: Controversial proposals to deliberately manipulate the Earth's climate system to counteract the effects of climate change. Geoengineering Research
• Just Transition: Ensuring that the transition to a low-carbon economy is fair and equitable for all, particularly for workers and communities that are dependent on fossil fuels. ILO Just Transition
• Carbon Capture, Utilization, and Storage (CCUS): Technologies to capture CO2 emissions and either store them underground or use them in industrial processes. IEA on CCUS

Climate economics continues to evolve as our understanding of climate change and its economic consequences improves. Addressing this complex challenge requires a combination of economic analysis, policy innovation, and international cooperation. Understanding Environmental Economics is also crucial.