Climate change and the global economy: policy responses
In the last of a series of four articles, our economists look at some popular policy responses, concluding that we should act sooner rather than later to avoid potential future costs.
29 July 2015
Please find a link to the full article, incorporating all four parts of this series, at the bottom of the page.
Climate change calls for a collective effort from governments, firms, shareholders and individuals to both adapt and implement measures to mitigate its effects.
As carbon dioxide emissions are the main culprit for global warming, any policy response must effectively target reduced emissions.
Since free markets fail to incorporate and price the negative externality1 of global warming, government intervention is required to realign resource allocation.
Without public policy looking to change private sector behaviour, economies run the risk of continuing to pollute to a point where it is too late and the economic costs are catastrophic.
Intergovernmental agreements that encompass all major economies will be the most effective in tackling climate change.
Without a collective policy response, the efforts of only a handful of countries looking to reduce carbon dioxide emissions will fall short of what is needed to make a material impact on a global level. We touch upon some popular policy responses below.
Decarbonising the world's energy supply through a rapid energy transition will reduce the risks of climate change.
The use of biofuels, hydrogen and clean energy can speed up decarbonisation alongside reducing demand through energy efficiency measures.
Putting a price on carbon emissions
Governments may offer subsidies to green energy providers to promote innovation and reduce the cost of energy from these sectors.
The Bank of England has recently committed to researching the risks to the financial system if climate regulation were to limit global temperature increases.
It follows on from comments made by Mark Carney during the 2014 World Bank seminar that referenced the possibility that the majority of proven coal, oil and gas reserves could be considered "unburnable" if regulation limited temperature increases to 2°C.
Amongst economists, it is recognised that to effectively stem the production of carbon dioxide, a globally recognised market-based approach is required. One of the most widely proposed measures is carbon pricing.
Placing a price on each tonne of carbon dioxide emitted or distributing tradable permits that licence a stated level of carbon dioxide emissions, is believed to be an effective measure to combat global warming.
Economically speaking, this internalises the negative externality (in other words, ensures that the company/entity that is emitting the carbon dioxide pays for the social costs) associated with burning fossil fuels.
Nevertheless, this method brings with it a host of questions primarily focused on determining appropriate emission levels, pricing and implementation measures. To work successfully it also requires global recognition.
Since an estimated carbon price of $100 per tonne is believed to be needed by 2030, few countries are willing to make their economies internationally uncompetitive by introducing carbon pricing.
In their second paper, Covington and Thamotheram (2015)2 propose an alternative method that places the responsibility on shareholders to initiate change.
Recognising that directors of fossil fuel companies are assessed, and remunerated, on short-term goals to create value, shareholders are able to use voting rights to place a greater emphasis on meeting long-term goals.
One such goal would be reducing carbon dioxide emissions. By setting goals consistent with a reduction in the level of emissions, directors would be measured and remunerated on meeting these goals.
Such a plan could redirect capital expenditure away from fossil fuel exploration to the development of clean energy projects.
For this concept to work, Covington and Thamotheram (2015).3 rightly highlight that it relies on sufficiently high carbon pricing (or low emission ceilings) to make the transition economically viable.
Meanwhile, investors concerned about the impact of climate change and the potential for carbon-based assets to be written down, will vote with their feet.
Monetary policy dilemma
Finally, let us briefly consider the monetary policy implications of climate change.
Climate change will reduce economic growth and create higher inflation. From a monetary policy standpoint, such a stagflationary environment will place the world's central banks in a dilemma: weaker growth will bring calls to stimulate the economy, but such efforts are only likely to aggravate inflation.
Monetary policy is not able to offset the shift in the supply curve and policy action will have to focus on the measures described above.
The long-time horizon means that we are unlikely to see much in the way of a visible effect until much later in the century.
Climate change will have an impact on the global economy. Attempting to understand, let alone quantify, these impacts is, however, a particularly difficult exercise subject to great error.
Despite this, from what we know today, we are able to make inferences about how global warming will influence various economic factors.
More extreme weather has the potential to weaken economic growth through damage to the capital stock and labour supply, and labour productivity will weaken as the world economy adjusts to higher temperatures.
Inflation will rise through the growing cost of food, energy and insurance. Monetary policy will be limited as it attempts to combat the stagflationary pressures of climate change.
The general consensus, which is supported by a growing amount of evidence, suggests we should act sooner rather than later to avoid potential future costs.
Successful mitigation policies will necessitate actions from all parties.
The insurance industry is already moving to incorporate some of these costs, but without a broader co-ordinated correct policy response, the world economy is unlikely to factor in one of the greatest negative externalities ever faced.
Recognising that quantifying the impact of climate change on shareholder’s investments is critical in creating an incentive to act, we will be looking to incorporate climate change effects into an extended long-run return forecast for different asset classes.
If you want to read more on the impact of climate change on the economy you can access the first three articles in the series by clicking on the links below:
1. A negative externality is a cost that is suffered by a third party as a result of an economic transaction that they were not directly involved in. Similarly, a positive externality is a benefit enjoyed by a third party who did not partake in the economic transaction from which they derive this benefit.↩
2. Covington. H and Thamotheram. R (2015), "The Case for Forceful Stewardship (Part 1): The Financial Risk from Global Warming", Available at SSRN: http://ssrn.com/abstract=2551478 or http://dx.doi.org/10.2139/ssrn.2551478↩
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