Expert magazine

Putting a price on climate change

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 inflation 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.

01/09/2016

Keith Wade

Keith Wade

Chief Economist & Strategist

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 climaterelated damage, the productive capacity of the economy is likely to shrink. This can be demonstrated using a production function, as shown in Figure 1 below. 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, below). 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 carbon-based 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.

Quantifying the impact on economic activity

There have been a number of studies since the early 1990s looking at the likely cost of global warming on world GDP. Two academics, Howard Covington and Raj Thamotheram1, helpfully summarise some of the main ones using an analysis based on so-called “climate damage functions”. These try to predict the fractional loss in annual output at a given level of warming compared with no warming. Figure 2 summarises three of these estimates, named after their originators. It is clear from these and other forecasts that there is no consensus as to how damage evolves; however several predict that warming of between 3 °C and 4 °C will represent a “tipping point” when the process starts to accelerate.

To better compare the various predictions, we use the damage function estimates on an economy at 4 °C and translate them into how warming will affect economic growth over a given time frame. For this we assume warming of 4 °C level is reached in 2080 and that the world economy, in the absence of climate damage, grows at a rate of 3% per annum.

The “N-damage” climate damage function2 is the least concerning of the three. No tipping point is reached and damage would be progressive, giving the greatest time to offset any negative effects. By the time the world is 4 °C warmer, annual output will be just 4% lower than with no warming. Not surprisingly, under this forecast the economic impact is limited over the next couple of decades and agriculture is the most exposed sector. Although the cumulative effects would be noticeable at 4 °C, the year-by-year loss in growth would be extremely small and difficult to identify.

The “W-damage” function3 estimates that by the time 4 °C of warming is reached, 9% of annual economic output will be lost relative to no warming. Amongst those industries most exposed would be insurance, agriculture and forestry. Taking our assumptions of 3% underlying annual growth and 4 °C warming by 2080, actual growth would be pared back only marginally to 2.85% by that stage. The effective loss of 0.15% a year might be enough to warrant some attention from policymakers, but is unlikely to be sufficiently powerful to prompt a major response to climate change.

The final prediction, “DS-damage”4, is the most extreme. Under this scenario, as and when warming extends to 4 °C, annual economic output will be 50% lower than in a world where no warming occurs. If we use our assumptions of 4 °C warming by 2080, our 3% annual economic growth figures falls to just 1.9% a year. At this rate, climate change is set to have a noticeable impact on both output and living standards. Indeed, although Dietz and Stern estimate that warming will still only be around 3.5 °C by 2100, they believe the tipping point is much lower, at about 2 °C to 3 °C of warming.

Some of the other studies in this area arrive at damage estimates similar to the less extreme versions we have described. Thus, leaving aside the findings of an earlier review by Stern5 and the upper estimates of the Intergovernmental Panel on Climate Change (IPCC), the consensus is that the economic costs of marginal warming up to 2 °C will be small, but will begin to gather pace if we move toward 4 °C. The general view is that 2 °C will not be reached for another 30 years or more. Given the uncertainty over the projections, we would suggest investors use a range of damage functions.

Expressing future economic losses in today’s prices requires discounting the loss in output back to the present day. In view of the length of time involved, small changes in the discount rate will cause large changes in loss estimates. Covington and Thamotheram use a discount rate of 6.5%. In contrast the Stern review uses 1.4%, so it is not surprising that it forecasts greater costs of climate change than many other studies. In the light of the recent decline in interest rates, it would seem reasonable to use a rate towards the lower end of recent studies.

The developing world faces the biggest impact

Developing countries are likely to be disproportionately hit by climate change, which is reflected in the rising risk to their sovereign bonds from global warming expected by the Standard and Poor’s rating agency (Figure 3). The effects look set to be two-fold. Firstly, as developed countries face an increasing strain on domestic budgets, fewer resources will flow to developing countries. Secondly, developing countries will be forced to channel resources away from productive projects towards countering the costs of extreme weather. It is estimated that as much as 80% of the damages from climate change will be concentrated in low latitude countries, many of which are developing economies6. Highly vulnerable regions include sub-Saharan Africa and South and South East Asia, according to the World Bank.In contrast, northerly regions such as Canada, Russia and Scandinavia may enjoy a net benefit from modest levels of warming7. Higher agricultural yields and lower heating requirements and winter mortality rates are some of the benefits climate change may bring, although they may diminish as warming continues.

Policy responses

Since free markets fail to account for an outside economic influence like global warming, government intervention is likely to be needed to deal with it effectively. However, economists recognise that a market-based approach is also required. One widely proposed measure is carbon pricing, which forces the carbon dioxide emitter to pay for the associated social costs. However, since a carbon price of $ 100 per tonne is believed to be needed by 2030, few countries are willing to make their economies uncompetitive by introducing such pricing.

Covington and Thamotheram propose8 an alternative method that places more responsibility on shareholders. Under this approach, they would be encouraged to use voting rights to put greater pressure on managements to meet long-term goals, such as reducing carbon dioxide emissions. Directors would then be measured and remunerated accordingly.

Finally, if climate change creates a “stagflationary” environment of low economic growth and high inflation, it 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 will not be 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.

Conclusions

Attempting to quantify the economic impact of global warming is subject to great error. Despite that, we can make some inferences. More extreme weather has the potential to weaken economic growth through damage to the capital stock and labour supply, while cutting labour productivity. Inflation is likely to rise as food, energy and insurance costs grow. The effectiveness of monetary policy will be limited. Without a broader co-ordinated policy response, the world economy is unlikely to be able to withstand one of the biggest external impacts it has ever faced. For our part, we will be looking to incorporate climate change effects into an extended long-run return forecast for different asset classes.

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Footnotes

1 Covington, H and Thamotheram, R, “The Case for Forceful Stewardship”, Parts 1 & 2: the financial risk and managing climate risk, 19 January 2015.
2 Nordhaus, W, “The Climate Casino”, Yale University Press, 2013.
3 Weitzman, M, “GHG Targets as Insurance against Catastrophic Climate Damages”, Journal of Public Economic Theory, 14 (2), 2012.
4 Dietz, S & Stern, N, “Endogenous growth, convexity of damages and climate risk: how Nordhaus’ framework supports deep cuts in carbon emissions”, Centre for Climate Change Economics and Policy, Working Paper No.180, 2014.
5 Stern, N, “Stern Review on The Economics of Climate Change”, HM Treasury, London, 2006.
6 Mendelsohn, R, Dinar, A and Williams, L,
“The Distributional Impact of Climate Change on Rich and Poor Countries”, Environment and Development Economics 11, 2006.
7 See footnote 5 above.
8 See footnote 1 on page 8.

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