Stern on the cost of climate stabilisation

As I said in the previous post, I plan to focus on the economics of responses to climate change from now on and the obvious place to start is the Stern report.

There’s a lot in the Stern report, and I’m going to assess it a part at a time, starting with the issue I’ve been most interested in, the cost of stabilizing atmospheric CO2 levels. I’ll focus on the case considered by Stern, and in my submission of stabilising levels at 550 parts per million, which implies a reduction in emissions of around 60 per cent, relative to business as usual, by 2050. This should be enough to avoid severe damage.

The Stern review report a wide range of estimates of the cost of stabilization. The range is summarized as 1 per cent of GDP, plus or minus 3 percentage points. In my submission to the review I gave a back-of-the-envelope estimate based on two parameters, the fossil fuel share of GDP (which I took as 6 per cent), and the elasticity of demand for fossil fuels, which I took as between 1 and 2. This gave a range of costs for a 60 per cent reduction in emissions of between 1.8 and 4.2 per cent, with a midpoint of 3 per cent, which is in the upper part of the Stern range.

One part of this discrepancy can be resolved easily. The Stern report estimates the fossil fuel component of GDP at 3-4 per cent. Using a value of 3 per cent would halve my estimated range to between 0.9 per cent and 2.1 per cent. Getting an accurate figure here is difficult, but its possible to explain a couple of reasons for our differing values.

The report observes, correctly, that the welfare-relevant variable in estimating the social cost of fossil fuels is the cost of extraction, not the market price which incorporates monopoly rents. Also, I looked at Australia, which has a more energy-intensive economy than the UK or the world average. So, the Stern number looks pretty reasonable.

Although Stern doesn’t quote elasticity estimates directly, the remaining divergence reflects an implied central estimate for the elasticity a little higher than mine. I was fairly conservative, not wanting to push to big a gap with older cost estimates that used long-run elasticity estimates below 1. Such low values are reasonable long-run estimates in the normal econometric usage of the term, that is to say around five years, but not over fifty years.

Turning from top-down approaches like this to bottom up assessments, it’s interesting to note that the Stern report puts a lot of weight on carbon sequestration. If this doesn’t pan out the costs could be higher. On the other hand, if we get some surprise breakthroughs in solar energy, costs could be lower, or even negative.

Overall, my assessment is that Stern’s central estimate, a cost of 1 per cent of GDP, is in the right ballpark. Stern is probably a bit on the optimistic side, but not wildly so.

49 thoughts on “Stern on the cost of climate stabilisation

  1. No, but a quick scan of the internet enlightened me. Growing high protein crops is not a bad idea, people in Italy for example love there Minestroni which makes good use of them. But does it solve the problem? Also, how successful in the nearterm can you see the transition to a vegetarian. It also does not get around the fundamental problem of growing enough of the essentials (wheat/barley/rice) and having enough water, to feed a rapidly growing population.

    I should point out that I do not think that one day manking will all end up being vegetarians. In his fictional book 3001, Arthur C. Clark wrote it would happen. However, he also wrote that by then the population had dropped back to 2 billion. Only time will tell of course….

  2. You’ve missed the pop culture allusion totally? Soylent green is people!

    Oh don’t worry about it…

    But, more seriously, how about this algae farm fed by CO2 from power stations, together with sun, water and nutrients, turning out proteins for food and oil for transport? Sounds win win win. Supposedly profitable (if you have the land) today. I am going to follow the demonstrator project closely.

  3. wilful wrote:

    The world banking on it? Or only John Howard up until the next election?

    Not just John Howard, the world.

    For example, Stern says:
    Even with very strong expansion of the use of renewable energy and other low-carbon energy sources, fossil fuels could still make up over half of global energy supply in 2050. Coal will continue to be important in the energy mix around the world, including in fast-growing economies. Extensive carbon capture and storage will be necessary to allow the continued use of fossil fuels without damage to the atmosphere.

    Gore sees CCS as a big part of the solution as well.

  4. The algae project is, of course, just another form of solar energy (that’s where the energy for the algae to reduce the CO2 to carbohydrates comes from), with the energy being stored in the form of diesel rather than in batteries. I wonder if they can also capture the free oxygen and stream it in to the furnace for greater burning efficiency? Maybe a solar cell-powered electrolytic cell could do the job as efficiently – you wouldn’t need the water then, which could be a big problem for large scale adoption. The “if you have the land” proviso above is of course the ultimate limit to solar power of any kind.

    Jimbo and carbonsink, we have overrun the earth (to the earth’s detriment) because we are far and away the most adaptable creatures ever seen on earth. Can you think of any other large creature that thrives in such radically different environments?. You are taking the position that we can never adapt – I am taking the position that we have to start adapting now if we want to make the adaptation less painful. Experience, not just theory, shows that the best way to do this is by getting the prices right, because getting the prices right gives billions of people incentives to think about solutions large and small that you and I currently have not thought of.

    The logical consequence of your view is no action – there’s nothing we can do. As Al Gore noted people seem to want to move straight from denial to despair, whereas both are equally lazy and equally lethal.

    As for the bits about phosphate, who knows? Maybe it’s true – but unless you’ve got a solution (a phosphate mining tax big enough to make phosphate recovery from sewage profitable? Grow genetically engineered cultivars of Australian natives that are all adapted to low-phosphate soils? Mine it from magma?) then so what? Undoubtedly the earth will disappear someday as the sun expands to beome a red giant, and it will undoubtedly be struck by numerous giant asteroids long before then, but I’m not losing sleep over that. You only lose sleep about problems you can make a difference to.

  5. The logical consequence of your view is no action – there’s nothing we can do.

    Not at all, but I think its naive to believe we can just sit around and wait for the market to work its magic and everything will be hunky dory.

    Three points:
    1. Oil is highly price inelastic
    2. We’ll need at least 20 years to overhaul our transportation infrastructure.
    3. There was no price signal before the peak in U.S. oil production in 1971

    Apart from those minor points, I’m sure the market will provide!

  6. derrida derider, I think may be missing my point. I do think that things should be priced to give an accurate representation of their real costs, but this will not happen if left to the power of the markets alone.

    Once again as an example, the potential for the salinity problem in the Western Australian wheatbelt was being discused and published in the 1920’s and the politicians new about it. Post war the land clearing rates were increased dramatically regardless of this, completely ignoring taking the option of a precautionary principle (i.e still clearing but do it with a bit of common sense and make use of he best science of the time). Now W.A. has the worst salinity problem and this will cost the future a lot. But the market alone does not have the vision for this, it requires some degree of government intervention.

    With regards to human ingenuity and ability to survive, I agree. But that does not neccesarily mean that the worlds 6.5 billion will all end up living like kings. All it means is that humanity will survive.

    Finally, the main crops which feed the worlds growing population are wheat/barley/rice etc. There are no native Australian crops which could do that with the size of the worlds population. I hope that science will give us enough time, but this will only happen if we also have some wisdom.

  7. Carbonsink,

    The oil price rise in the 1970s was preceded by a gold price rise of equal magnitude. The price rise of oil was not the result of US oil production peaking but rather a consequence of poor monetary policy brought on by Nixon.

    Regards,
    Terje.

  8. Terje, my point was there was no price rise prior to production peaking, so there was so signal to conserve or find alternatives. That left the U.S. at the mercy of OPEC and the rest is history.

  9. Actually OPEC was at the mercy of the US because much of there financial wealth at that time was denomiated in US dollars via US treasury bonds. When the USA started to devalued the dollar in 1971 the OPEC nations merely adjusted the nominal price of Oil to ensure that the real value of their income did not decline. Most commodity producers did the same thing.

    There were plenty of alternatives and they were found. The alternatives were foreign oil wells. The world price signal was entirely accurate in forcasting that there was not physical shortage.

    However there was an oil crisis in 1973. This was a supply shock that was not anticipated. However it was not the result of a predictable depletion of oil resources. It was a political response to the Yom Kippur War and the OPEC nations imposing trade sanctions on the USA (and some other western nations).

    The jolts to both oil supply and oil prices in the 1970s were entirely political in origin. They were the result of monetary fiddling, wars and trade blockades.

  10. That left the U.S. at the mercy of OPEC and the rest is history.

    What you seem to be saying is that the market is a failure because it can’t predict how stupid governments can be. Personally I think it is a pretty tall order. Given the circumstances I think that markets do a remarkable job predicting how stupid governments can be. The Wall Street stock exchange (amoungst others) predicted the great depression (another act of government stupidity) with stunning clarity.

  11. Actually all I am saying is there was no indication whatsoever from the oil markets in the late 60s and early 70s that U.S. oil production was about to peak.

    Of course there were alternatives in 1971 — foreign oil wells — but the U.S. was no longer the world’s “swing producer”, it could no longer control world oil supply by simply opening the taps. The inevitable consequence of that was the oil crisis of 1973.

    You say the jolts to oil supply in the 1970s were entirely political in origin, and that is true, but it could not have happened if U.S. oil production had not peaked. OPEC had no political power without a physical shortage of oil in the U.S.

    So back to my point, if the oil markets didn’t tell us in the late 60s/early 70s that the U.S. was about to enter a new and dangerous era of energy insecurity, why should today’s oil markets tell us we are close to global peak oil? (I might add that the term “market” should be used loosely when applied to oil). Because we are going to need a very loud bell about 20 years out if we are going to transition away from oil.

  12. Yes I accept that the markets did not anticipate the political risks associated with a dependence on foreign oil. Although after the event many consultancies did spring up in the private sector to help investors and consumers better predict political risks. So in that sence the market place did adapt to it’s weaknesses rather quickly.

    Whilst the market failed in this regard it does not seem to be that any other significant organising force within US society did any better.

    It is worth noting that prior to 1971 the dollar was tied to gold. And using gold as a benchmark for value there was no net increase in the price of oil during the 1970s.

  13. WRT carbon dioxide, remember that those volume figures are at standard temperature and pressure.

    Suffice to say that we’ll compress it to something much closer to a liquid (and possibly to a liquid, or converting into a carbonate), before storage.

  14. Terje –

    you really need to read a little history of the Great Depression. If the stock market ‘anticipated’ the depression, why did it bid equity prices up so high in the first place? And what happened on the morning of October 24, 1929 that suddenly informed the equity markets that a period of utterly unprecedented negative growth was in the offing? (And no – Smoot-Hawley is not an answer: that legislation was in the congress for 2 years prior, non-US stock markets suffered similarly, and non-US economies went through the same depression, while Japan did not). Government reaction to the downturn was entirely ‘orthodox’ from a the point of view of a classical economist. It’s only with the benefit of hindsight that features like over-aggressive money supply controls, pro-cyclic fiscal policy, and

    I’m not going after your broader point about the interplay of the ‘marketplace and the senate’, except to note that you can cherry-pick examples to support either conclusion. Also – you might google (“Equity premium puzzle”) for a useful empirical antidote to the myth that the equity markets are good at predicting returns.

    FWIW – the passing of peak US oil production and the introduction of OPEC oil quotas seem to be to be co-incident events, rather than inter-related ones. No one really ‘knew’ peak US oil production had passed for almost a decade (long and variable lags in bringing new supply on-line), and OPEC is viewed by historians as having more nationalist and regionalist motivations than economic ones.

    But we digress ….

  15. I think the fact that Smoot Hawley made the front page of newspapers in the days before the crash with statements that it now looked like a political certainty was what changed. I think the fact that 1000 economists had previously signed a petition saying that if passed the act would ruin the economy contributed to the markets assesment. But most significantly the fact that the economy subsequently went into a large scale resession confirms that a downward reassesment of the value of company stock appears with hindsight to have been a very rational decision. At least when the market gets it so massively right give it a little bit of credit.

  16. WRT carbon dioxide, remember that those volume figures are at standard temperature and pressure.

    True, but I was trying to illustrate the scale of the problem. We still have to capture and compress ~16km3 of CO2 per day, and probably a whole lot more by the time CCS is working on a commercial scale given the growth of coal around the world. “Clean coal” roll off a politicians lips so easily…

    Suffice to say that we’ll compress it to something much closer to a liquid (and possibly to a liquid, or converting into a carbonate), before storage.

    Yes, but compression/liquefaction requires a considerable amount of energy. Not forgetting the costs of building the infrastructure to move the CO2 (compressed or not) from the source to the sequestration site.

    Nukes start to look like the easy option the more you learn about CCS.

  17. FWIW – the passing of peak US oil production and the introduction of OPEC oil quotas seem to be to be co-incident events, rather than inter-related ones. No one really ‘knew’ peak US oil production had passed for almost a decade (long and variable lags in bringing new supply on-line), and OPEC is viewed by historians as having more nationalist and regionalist motivations than economic ones.

    I agree to a point. I don’t think OPEC knew in advance how powerful they were (no-one did, and that’s my point), but they quickly realised that the U.S. was unable to respond to the embargo of 1973, because U.S. production capacity simply wasn’t there.

    Again, the point I am really trying to make here is that the market did not anticipate the peaking of U.S. oil. Prior to 1970 the U.S. oil production chart was on an ever upwards trend, and prices were flat for more than a decade. I don’t believe that if oil traders knew that the U.S. was about to become dependent on foreign oil that prices would have remained flat.

    To mitigate a global peak we’d need to know 20 years out, and I don’t think the market will do that for us, just as today’s plunge in oil prices is saying: “Forget climate change, forget oil depletion, party on and buy that SUV!”

    Anyway, I recommend watching the interview with Robert Hirsch here:
    http://abc.net.au/4corners/special_eds/20060710/default_full.htm

  18. Terje –

    So the great depression was the media’s fault?

    Are you, with a straight face, telling me that the movers and shakers on Wall Street hadn’t factored Smoot-Hawley into their valuations before they read the headlines on the morning of October 22nd, 1929? And at the same time, you claim that equity markets accurately value future returns?

    Any way you want to slice it, the future return on capital didn’t abruptly decline by 80%, any more than it blew up in the 1920s or 1990s. Those were markets in the grip of speculative bubbles, a feature of markets since the year dot, and driven by the psychology of the players rather than a sober assessment of ‘risk weighted expected returns’.

    Let’s review the two most recent market declines. Between 2000 and 2002, the DJIA fell by ~40%. It has only just recovered to the the level it was in 2000. Yet the 4 years since then have seen high corporate profits, and decent GDP growth. Or “Black Monday”, October 19, 1987 when the DJIA in one day fell ~22%. The real economy, meanwhile, kept chugging along. 20%+ declines in ‘risk weighted future returns’ accompanied by, well, no change in actual returns.

    The origins of the Great Depression are complex. But they are certainly, at least in large part, to be found in factors tied to the underlying real economy.

  19. Paul,

    I suspect that we are getting way off topic but I will persist a little.

    So the great depression was the media’s fault?

    No. The media was the conduit for news about government intentions. New information will change peoples assesment of things and will move markets. It is why people read newspapers, so they can know what is going on in the world. The fault lays with the government initiative not those that brought the news about the initiative.

    Are you, with a straight face, telling me that the movers and shakers on Wall Street hadn’t factored Smoot-Hawley into their valuations before they read the headlines on the morning of October 22nd, 1929?

    I’m claiming that their assesment of Smoot-Hawley now happening were changed. There was a lot of expectation that the president wanted tariff reductions. When it became clear that he would in fact support a huge increase in tariffs that altered the outlook. When you get new information you change your assessment of a situation. The newspapers obviously thought that there was a change in the outlook otherwise they would not have bothered to report on it.

    Are you, with a straight face, telling me that stock holders woke up that day and decided to toss out their share portfolio on an irrational whim?

    And at the same time, you claim that equity markets accurately value future returns?

    Not accurately. I merely claim that they involve a rational attempt at assessing future returns and that the assesment process is pretty efficient. To accurately guess what the government will do next year would require a crystal ball. If the markets new with accuracy what the RBA was going to do on interest rates every time it met then there would never be any surprise response. However people can not see into the future. They can only rationally assess the information available today and try and anticipate what the future may bring.

    Those were markets in the grip of speculative bubbles, a feature of markets since the year dot, and driven by the psychology of the players rather than a sober assessment of ‘risk weighted expected returns’.

    No decision maker can set aside their own psychology. And I don’t claim that markets are immune from the influence of psychology and flawed perceptions about reality (although these factors are over rated) . After all it is a process that involves humans. However on the whole most speculative bubbles make rational sence given the prevailing information. They collapse when the information changes. This is true more often than not even in the case of Tulips.

    Between 2000 and 2002, the DJIA fell by ~40%. It has only just recovered to the the level it was in 2000.

    I have not looked closely at this example. However in the middle of those two years there were these Arabs that crashed some airplanes into US buildings and set off a chain of political events and caused a lot of uncertainty about the future. And yes a lot of that assesment was based on psychology just as the political response itself was based heavily on psychology. The market got it wrong but it was hardly irrational to revalue stock downwards until the geopolitical outlook became clearer.

    In 1987 the Louve accord had just collapsed. However I am not sure that this explains it entirely. However saying that it happened because people are essentially just lemmings is a little cynical.

    The origins of the Great Depression are complex. But they are certainly, at least in large part, to be found in factors tied to the underlying real economy.

    So we agree. The Great Depression was driven by real economic factors. Economic output is effected by things like monetary policy, trade policy, tax policy, droughts and disasters. Given that the Market made a revaluation of future prospects before the main event then doesn’t it get any credit for making the right assesment about the future? Even if it was dumb luck the decision to revalue stock downwards was still correct. You could argue that the market is irrational and on that day it just made a lucky guess about the future, but it is hard to argue that the markets got it wrong.

    Regards,
    Terje.

  20. Terje –

    I find myself agreeing with a lot of what you say. So I’ll limit myself to a couple of clarifying comments.

    “Are you, with a straight face, telling me that stock holders woke up that day and decided to toss out their share portfolio on an irrational whim?”

    No. I’m saying that stock holders built up an irrational, distorted view of “risk weighted expected returns” before the crash. Then, in response to something small and trivial–it might just as easily have been the collapse of the French government (No more wine! Sacre bleu! Sell!) or the invention of colour TV, or a galling typographic error on the NYT crossword page–they began a self-reinforcing downward spiral that over-compensated.

    Logically, the market’s assessment was either i. wrong before, ii. wrong after, or iii. wrong both before and after. My bet is on iii., and I invite you to work the following experiment. Invest $1 in shares on October 1st, 1929, and $1 in baseball cards. Then invest another $1 in shares on 31st October 1932 and $1 in baseball cards on that day too. DJIA grew from (say) 300 on 01/10/1929 to 11000 today ($1 turns into $36). It grew from 50 on 01/10/1932 ($1 turns into $275). That’s a whole lot of 7 difference. Meanwhile, your 1929 baseball cards (Say – collection of New York Yankees) has grown from $1 to (say) about $105, and your 1932 cards to about $100.

    More seriously, US GDP was $(US2002)865.2 Billion in 1929 ($(US2002)635 in 1932), and is $(US2002)11,048 in 2005. So the market’s pre-crash consensus was wild over-estimate, and the post crash consensus a wild under-estimate (Data: BEA in the US).

    And slightly more harshly, I utterly reject your statement “However on the whole most speculative bubbles make rational sence given the prevailing information.” Speculative bubbles are irrational by definition.

    As much as certain theoreticians would like to have us assume rationality on the part of economic agents, the bulk of the evidence from the study of psychology suggests that we are not. I thoroughly recommend reading Kahneman and Tversky and something in the field of ‘Prospect Theory’. It’s illuminating stuff.

  21. It seems we have hijacked this thread, however I don’t feel too guilty because it does not appear that it was getting used for much else.

    Logically, the market’s assessment was either i. wrong before, ii. wrong after, or iii. wrong both before and after.

    That does not necessarily logically flow from the comment that preceded it. And you have not offered an exhaustive list of possiblities. It is possible that the market was right both before and after the crash. For instance if in the morning I decide that it looks like a nice day for the beach and in the afternoon I decide it is too cold for the beach it may be that I was right both times but in the interum the weather changed. I think the point is that you are using a narrow criteria for “right” and “wrong” that relies on an accurate prediction of the future rather than an accurate assessment of the data available. I think the crash represents an accurate reassesment of the data that was based on new information (ie the tariff act would be passed into law).

    DJIA grew from (say) 300 on 01/10/1929 to 11000 today ($1 turns into $36). It grew from 50 on 01/10/1932 ($1 turns into $275). That’s a whole lot of 7 difference. Meanwhile, your 1929 baseball cards (Say – collection of New York Yankees) has grown from $1 to (say) about $105, and your 1932 cards to about $100.

    Several points to make.

    Firstly your maths appears wrong. The difference is a factor of 6 (ie 300/50) and not a factor of 7. However this is a minor technical point.

    I notice gold has gone up about 30 fold since 1932 so I think a lot of the change over the last 70 years has to do with a declining value of the dollar more than any major increase in the average value of stocks. However what happened since 1932 is common to both investments so all that really concerns us is what happened between 1929 and 1932.

    Baseball cards don’t pay any form of income return to the holder (unlike interest on a bond or dividends on share stock) so I’m not sure what you would regard as a rational valuation of a baseball card. I note from your example that a baseball card, that produces no income, would appear to have changed little in value between 1929 and 1932. However I wouldn’t expect a three year old baseball card to change in nominal value much unless we were in a period of inflation. Meanwhile stocks, whos value derives primarily from their ability to pay an income that is dependent on the general state of the economy, declined significantly in value (dropping by a factor of 6). Subsequently the general state of the economy declined significantly.

    Between 1929 and 1932 GDP declined by about 30%. However stock prices during this period fell by 80% (300 to 50) according to your figures above. However stock valuations are based on the value of profits not the value of output and I’m not sure that it would be that hard to close the gap. I can think of a lot of businesses today where a 30% decline in output (ie sales) would easily lead to a 100% or greater decline in profit.

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