My Two Cents

The economics of global climate change

Chris Farrell Jun 9, 2009

The sustainability and global climate change debate is shifting from science to political economy. I’m probably late to this paper, but I just read the keynote address by Yale economist William Nordhaus at the Climate Change conference in Copenhagen, Demark, March 10-12. In Economic Issues in a Designing a Global Agreement on Global Warming, Nordhaus calls for an international carbon tax. His argument for the tax is compelling, as are his concerns over a cap-and-trade system.

Climate change involves a tale of two cultures. The natural sciences are doing an admirable job of describing the geophysical aspects of climate change. The science behind global warming is well established. While the exact trajectory of climate change is imprecisely known because of cascading uncertainties from economic activity through emissions, the carbon cycle, and earth-ocean systems, economic analysis should take the scientific findings as inputs.

But designing an effective political and economic strategy to control climate change will require the second culture – the social sciences – to analyze how to harness our economic and political systems to achieve our climate goals effectively and at low cost. This second task involves a very different set of issues from the natural-science questions. It requires examining questions such as the impacts on the economy and on non-market activities, the costs of slowing or mitigating climate change, the strength and timing of emissions reductions with an eye to the costs and benefits of slowing climate change, the risks of asymmetric and irreversible damages, and the policy instruments for implementing such emissions reductions.

He goes on to say that if economics provides a single bottom line for policy, it’s the need to ensure that everyone faces a market price for the use of carbon.

Economic participants–thousands of governments, millions of firms, billions of people, all making trillions of decisions each year–need to face realistic prices for the use of carbon if their decisions about consumption, investment, and innovation are to be appropriate.

He then unpacks the benefits of raising the market price of carbon:

First, it provides signals to consumers about what goods and services produce high carbon emissions and should therefore be used more sparingly. Second, it provides signals to producers about which inputs (such as electricity from coal) use more carbon, and which inputs (such as electricity from wind) use less or none. It thereby induces producers to move to low-carbon technologies. Third, high carbon prices provide market signals and financial incentives to inventors and innovators to develop and introduce low-carbon products and processes which can eventually replace the current generation of carbon-intensive technologies. Finally, and most subtle of all, the use of carbon pricing economizes on the information requirements that market participants need to undertake each of these three tasks. Of course, placing a market price will not work magic. There remain many further externalities and market imperfections in energy and other markets. But without a strong price signal, there is simply no hope for making the vast number of decisions in a remotely efficient manner.

Why doesn’t he like cap-and-trade that is a centerpice of the Kyoto model for coping with global warming on an international level?

..It is completely untested in the international context; it has been unable to attain anything close to universal participation; it loses precious fiscal revenues; it leads to volatile prices; and it is an invitation to rent-seeking. It is unlikely that the Kyoto model, even if strengthened, can achieve its climate objectives in an efficient and effective manner.

There is much virtue in simplicity. The case for a “harmonized international carbon tax” for responding to the threat of climate change is strong.

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