We’ll all be rooned

John Quiggin32 Comments

Today’s Courier-Mail has a report pushing the Beattie Government’s plans for new dams, and threatening financial ruin if they aren’t built. Crucial quote:

As its efforts to win approval for the controversial Traveston Crossing Dam in the Mary River Valley move into top gear, the Government has used a consultant’s report on possible economic losses to the region to push its case for the project.

The lack of new water sources could end up costing southeast Queensland at least $55 billion and perhaps as much as $110 billion by 2020, according to the consultants ACIL Tasman.

Even before this episode, the name ACIL Tasman wasn’t one that filled me with confidence. All consultants like to produce reports that support their client’s preferred position, and my experience of ACIL Tasman is that the approach to this outcome is “whatever it takes”.

I haven’t been able to find the report yet, but the numbers seem way off-beam to me. This report says that the total revenue for SEQ Water and sewerage businesses was about $1.4 billion in 2005/06, growing at about 6 per cent a year. ACIL Tasman wants us to believe that limits on additional supplies could cost between $5 billion and $10 billion a year.

I find this implausible, at least as an economically meaningful cost estimate. A doubling of water prices would be enough to reduce demand significantly over time (even allowing for underlying growth in population and income), and make all sorts of supply options, such as desalination, economically feasible, without any need for new dams. The welfare cost of this would be around 0.5 billion a year (I’ll do a proper check on this number later). So, I’d say ACIL Tasman is out by a factor of 10 to 20.

I haven’t seen enough information to determine whether the proposed dams pass the cost-benefit test. But this report makes me think the case must be pretty weak.

If you can’t beat them …

John Quiggin11 Comments

Back in August 2005, Anita Quigley had this to say about blogging:

“Why some pimply-faced geek, sicko or average Joe Blow thinks someone else wants to read every random thought that crosses their mind is beyond me. Alongside the belief that we all have a novel in us – we haven’t – blogging is the ultimate form of narcissism.�

Hmm

The Stern Review and the long tail

John Quiggin25 Comments

My first post on the Stern review started with the observation that

the apocalyptic numbers that have dominated early reporting represent the worst-case outcomes for 2100 under business-as-usual policies.

Unfortunately, a lot of responses to the review have been characterized by a failure to understand this point correctly. On the one hand, quite a lot of the popular response has reflected an assumption that these worst-case outcomes are certain (at least in the absence of radical changes in lifestyles and the economy) and that they are going to happen Real Soon Now. On the other hand, quite a few critics of the Review have argued that, since these are low-probability worst cases, we should ignore them.*

But with nonlinear (more precisely strongly convex) damage functions, low-probability events can make a big difference to benefit-cost calculation. Suppose as an illustration that, under BAU there is a 5 per cent probability of outcomes with damage equal to 20 per cent of GDP or more, and that with stabilisation of CO2 emissions this probability falls to zero. Then this component of the probability distribution gives a lower bound for the benefits of stabilisation of at least 1 per cent of GDP (more when risk aversion is taken into account). That exceeds Stern’s cost estimates, without even looking at the other 95 per cent of the distribution.

An important implication is that any reasoning based on picking a most likely projection and ignoring uncertainty around that prediction is likely to be badly wrong, and to understate the likely costs of climate change. Since the distributions are intractable the best approach, adopted by the Stern review, is to take an average over a large number of randomly generated draws from the distribution (this is called the Monte Carlo approach).

To sum up, the suggestion that because bad outcomes are improbable, we should ignore them is wrong. If it were right, insurance companies would be out of business (not coincidentally, insurance companies were the first sector of big business to get behind Kyoto and other climate change initiatives)
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Milton Friedman: a brief appreciation

John Quiggin50 Comments

Milton Friedman has died at the age of 94. He made some huge contributions to macroeconomics, notably including his permanent income theory of consumption, which paved the way for the modern life cycle theory and his work on expectations and the Phillips curve.

He was also the most effective advocate for free-market policies since Adam Smith. As has been said several times over at Crooked Timber recently, everyone, and particularly everyone with a leftwing view of the world, should read Capitalism and Freedom at least once. As Mill said, beliefs you hold merely because you haven’t been exposed to the strongest possible critique of those views, aren’t really well-founded. Certainly, my own views were changed in some respects by exposure to Friedman, and where they were not, I was forced to reconsider the basis for my positions.

Friedman was effective in part because he was obviously a person of goodwill. I never had the feeling with him, as with many writers in the free-market line, that he was promoting cynical selfishness, or pushing the interests of business. He genuinely believed that economics was about making people’s lives better and that disagreements among economists were about means rather than ends and could ultimately be resolved by careful attention to the evidence.

Stern on the costs of climate change, Part 1

John Quiggin31 Comments

The standard (expected utility) approach to assessing the cost of climate change is to
(i) derive a probability distribution for possible rates of climate change under some given projections,
(ii) attach a cost (or benefit) number to each possible outcome, expressed in utility terms,
(iii) calculate the expected utility gain (or loss)
(iv) express the calculated number as a percentage change in some income aggregate (usually GDP)

In this post, I’m going to look at step (ii). In most respects, the Stern review has adopted assumptions that favour strong action to mitigate climate change – relatively optimistic regarding the costs of stabilising CO2 levels, and relatively pessimistic regarding projections of changes in climate. But the cost calculations are conservative, probably because the previously published estimates of Mendelsohn, Nordhaus and Tol have been way too low.
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Stern on discounting and risk

John Quiggin21 Comments

One of the crucial issues in any assessment of climate change policy is how to handle discounting and risk. The Stern review (Ch 2) goes back to first principles and gets the main issues exactly right. The reason for both discounting and risk premiums, in economic analysis, is that the marginal value of a dollar of income is lower when we are rich than when we are poor. Hence, we’re prepared to pay for insurance when we are well off in order that it will pay out when we are badly off. Similarly, if we expect income to rise over time, a dollar of income now is worth more, at the margin, than a dollar in the future. The same points are relevant in considering income distribution but this isn’t covered in the parts of the report I’ve read so far.

In addition, there’s a justification for “inherent discounting”, reflecting the fact that some future event (most probably bad, but perhaps good) may mean that “all bets are off” in relation to future consumption levels. Individuals should have reasonably high inherent discount rates, since we may not be around next year, but the appopriate rate for a community is much lower, being confined to the risk of catastrophes like nuclear war.

The Stern review also has a good discussion of probabilities, including the recent literature on problems where there do not exist well-defined probabilities.

The quality of the economics here is very high, and sets a new bar for discussion of these issues.

There’s more on Stern from James Wimberley

Stern on the cost of climate stabilisation

John Quiggin49 Comments

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.
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The debate really is over now

John Quiggin115 Comments

The scientific debate over the reality of anthropogenic global warming has been over for some time, but as long as the opponents of science continued to dominate the political process, it was necessary to combat their claims.

But with the Howard government now supporting emissions trading, at least in principle, and with the overwhelming majority of the public convinced of the need for action, that necessity has now passed, at least in Australia. The main task now is to encourage the government to adopt the most efficient and effective strategies for mitigation and adaptation, in co-operation with other countries. That obviously includes signing Kyoto (with the latest change in position and with Bush a lame duck there’s no reason not to), but it could also include getting the (so-far merely decorative) AP6 process to do some work.

Of course, at least some of the denialists will keep on denying. But they’re in a hole and I’m happy to let them keep on digging. At this point, they’ll do less harm banging on about the hockey stick than they would if they accepted the reality of global warming and used what’s left of their credibility in an attempt to derail any positive response.

So from now on, I’m not going to bother refuting the absurdities of Bolt, the Lavoiser Group and other denialists. Rather than make all those who’ve enjoyed the stoush here go cold turkey, I may put up more open threads from time to time, but my future posts will be about the economics and politics of our response.