Economics of climate change must be rooted in real world scenarios

This article appeared on the 18th January 2024 in the Irish Times as

Sometimes academics who focus (often quite competitively) on complex theories and problems miss the bigger picture. Take this joke, for instance: How do you confuse an economist? Ask them to explain the real world.

When it comes to the “real world”, it would appear that the overly cautious prescriptions for climate action given by the first generation of climate economists in the 1990s have not served us well in the real world that is governed by atmospheric physics.

An early phase-out of fossil fuels in line with the global carbon budget consistent with holding global warming at 1.5 degrees will require almost all remaining fossil fuel resources to be left in the ground. There is no getting around that basic fact, even when you factor in potential technologies to remove carbon dioxide from the atmosphere. A shift in investment away from the oil and gas sectors, if this transition is not properly planned for and regulated, will create stranded assets, which in turn will hurt the pockets of shareholders and petrostates.

There is, however, compelling evidence that shifting as rapidly as possible to a clean economy powered by renewables offers multiple economic and environmental benefits including energy security, low-cost non-polluting energy, and opportunities to create new green jobs. While individual firms and households may face the costs of a sooner-than-expected capital turnover, there are wider benefits to society and the economy as a whole, and lower climate-related risks.

Economic analysis is also interested in the structural incentives at work to drive investment and technology development, and for decades this has boiled down to two basic ideas: carbon pricing and the discount rate.

Policies that raise the cost of carbon generate an emissions price that, in theory at least, reflects the abatement cost associated with a given use of fossil fuels – such as the cost of energy-efficiency measures, alternative fuels or new technologies. As this “price” ripples through the economy in the cost of products and services, the alternatives become cheaper and thus more attractive, especially when combined with the (economically justified) subsidies to support renewable energy, retrofitting and industrial energy-efficiency measures.

The problem is that carbon taxes and even carbon trading schemes such as the European Union’s Emissions Trading System (EU ETS) have failed to bend the emissions curve at anything like the pace that is required. The truth is that carbon taxes were never designed to eliminate fossil fuels, just to make them more expensive. And strengthening these measures is perennially fraught with political barriers such as lobbying by vested interests, especially at EU level.

Carbon taxes were designed to work like a nudge, not a shove; they can be successful in shifting investment and rewarding efficiency over the long term but if they are too punitive they are destined to backfire. On the other hand, if taxes are not set high enough to phase out fossil fuels completely, they will not be remotely adequate as a mitigation measure.

I doubt that any economist would argue in 2024 that carbon taxes are the only solution to climate change. However, it is worth recalling that for decades, economists were vocal in their opposition to policies beyond carbon taxes. Nervous about the wider economic impacts of raising energy costs, successive Irish governments from the early 1990s delayed taking the advice of expert bodies such as the ESRI to introduce a carbon tax until 2010, when it was slipped in as an emergency fiscal measure in response to the financial crisis.

The other core issue is the discount rate applied to long-term investments, defined as the weighting attached to future consumption instead of spending your money today. A low discount rate – favoured by economists such as Nicholas Stern – considers the interests of future generations more equitably with respect to the present. The other leading climate economist of the 1990s, William Nordhaus, favoured a higher discount rate that dismissed the likelihood of non-linear or fat-tailed climate scenarios.

The argument raged for years. At this stage, it is decisively settled in favour of Stern. But Nordhaus’s work has left a lasting impact on the discipline of climate economics as a whole. Nordhaus, who later won the Nobel Prize for economics, was one of the chief developers of the integrated assessment models used by the Intergovernmental Panel on Climate Change (IPCC) in its climate scenarios. Raising global temperatures by as much as 3 degrees would in fact be economically “optimal”, he found, and it was cheaper to adapt to climate change than mitigate it up to that point. This would not matter except that it was absorbed into the academic research community and IPCC reports ever since, distorting the real cost of inaction and delay.

By contrast, climate scientists find 3 degrees of warming would take us on a course to a “hothouse” Earth. In a 2022 report titled “Climate Endgame: Exploring catastrophic climate change scenarios”, leading Earth systems and climate scientists concluded there is “ample evidence that climate change could become catastrophic … at even modest levels of warming”.

Now that is a dose of reality.

Sadhbh O’Neill is senior climate adviser to Friends of the Earth Ireland

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