Climate change economics

Climate change economics is back in the news, because of both the release of a new and dire IPCC report and the awarding of a Nobel in economics to William Nordhaus, perhaps the best known of economists studying climate change.

Nordhaus's work on the costs of climate change is based on integrated assessment models (IAMs), which integrate climate modeling with economics. IAMs provide a veneer of scientific objectivity to the study of optimal climate policy, but some healthy skepticism is in order. A recent article by Robert Pindyck does a good job laying out the limitations of IAMs as guidance for policy. In particular, the policy implications can be enormously sensitive to assumptions about key parameters that are simply unknown, controversial, or reflective of value judgements rather than objective measurement. A great example is the choice of discount rate, the "interest rate" at which future damages are weighed off against present costs. Whether a model implies drastic action against climate change, or rather complacency, hinges on the discount rate more than anything else. Pindyck:

Put simply, it is much too easy to use a model to generate, and thus seemingly validate, the results one wants. Take any one of the three IAMs that were used by the U.S. Interagency Working Group (2010, 2013) to estimate the SCC. With a judicious choice of parameter values (varying the discount rate is probably sufficient), these models will yield an SCC estimate as low as a few dollars per ton, as high as several hundred dollars per ton, or anything in between. Thus a modeler whose prior beliefs are that a stringent abatement policy is (or is not) needed, can choose a low (or high) discount rate or choose other inputs that will yield the desired results. If there were a clear consensus on the correct values of key parameters, this would not be much of a problem. But (putting it mildly) there is no such consensus.

The Interagency Working Group did not try to determine the “correct” values for the discount rate. Instead, it used middle-of-the-road assumptions about the discount rate (setting it at 3 percent) as well as other parameters and arrived at an estimate of around 33 dollars per ton for the SCC (recently updated to 39 dollars per ton). But other well-known studies have not used these middle-of-the-road assumptions and have arrived at very different estimates of the SCC. For example, using a version of his DICE model (one of the three models used by the Interagency Working Group), Nordhaus (2011) obtained an estimate for the SCC of 11 dollars per ton. On the other hand, using the PAGE model, Stern (2007) found an extremely stringent abatement to be optimal, a result that is consistent with an SCC of more than 200 dollars per ton. Although the models differed in a variety of ways (e.g., the degree of disaggregation and the choice of damage function), the main reason for their wildly different SCC estimates is that Nordhaus used a relatively high discount rate, while Stern used a relatively low discount rate.