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.