Putting a price on climate change

There is a growing acceptance that climate change is inevitable. Less clear are the economic consequences of a warmer world. Our economics team has used the increasing body of academic research to try to quantify the financial effects, identify the main losers and highlight any winners, if there are any.

4 January 2016

The economic implications of climate change are already forcing themselves onto investors’ agendas. In this article we draw on the growing volume of academic work to look at the likely economic cost. Our conclusion is that climate change will reduce productivity and economic activity, while infl ation will increase. Effective policy response will require collective action. Shareholders have a role, but effective adjustment requires market-based mechanisms, such as carbon pricing and higher insurance premiums.

Global warming is expected to increase the frequency and severity of extreme weather, bringing with it property and infrastructure loss. Rising sea levels will also likely harm economic output. Whilst initial attempts to recover this damage may be positive for GDP in the short term, once it is recognised that such events are likely to be a permanent feature, the world economy faces an extreme challenge.

If we assume a steady reduction in capital stock as a result of climate-related damage, the productive capacity of the economy is likely to shrink. This can be demonstrated using a production function, as shown in the left-hand chart in Figure 1. Assuming all else stays constant, output would fall from Y1 to Y2. However, rising global temperatures may also affect food security, increase infectious diseases and impair those working outdoors. All are likely to reduce both the effectiveness and the amount of labour available to produce output.

This effect can also be expressed as a supply shock (Figure 1, right-hand chart). Global warming is likely to reduce supply at any given price, pushing back the supply curve (from S1 to S2). This will result in a lower level of output (Y2) and a higher price (P2). Preventive measures to reduce the long-term economic consequences are likely to represent an opportunity cost as resources are directed away from more productive purposes.

Our supply and demand diagram also shows an increase in the general price level. This inflation may come in a number of ways. For instance, more frequent droughts may reduce crop yields, while usable land may shrink. Some areas may become uninhabitable, forcing mass migration as the world’s population is forced to live in a smaller space. As with food inflation, however, this effect should be moderated by some areas becoming more habitable.

Higher energy costs look set to boost inflation. Not only is demand likely to grow, but supply may shrink as high temperatures reduce power station efficiency. Taxes on carbonbased electricity may also drive up prices. The secondary effects will be felt throughout the global economy, although the growing use of renewable energy could limit cost increases. 

The insurance industry recognises that it is likely to bear much of the risk of global warming. Already, 2011 appears to have been the most expensive year on record for natural disasters, with insured losses costing more than $126 billion. The industry has been at the forefront of assessing climate risk, with the costs soon likely to be felt in the form of higher premiums. We are already seeing a reduction in cover in areas like Florida and many US Gulf coast states.

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