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The New Economics of Climate Change

by Stephen DeCanio • July 8, 2010 @ 11:50 am

Almost unnoticed inside the Beltway, where attention is focused as usual on politics and the ins and outs of legislation, economic thinking about climate policy has undergone a fundamental shift.  In the past, economists who worked on climate usually were interested in balancing the costs against the benefits of reducing greenhouse gas emissions.  The economic debate centered on issues such as how to measure the macroeconomic impact of cap-and-trade or carbon taxes, how large is the potential for energy savings that would be profitable even without accounting for their environmental benefits, and measuring the effects of climate change on agriculture, recreational opportunities, land values, health care expenditures, electricity demand, and other specific sectors of the economy. 

The scientists who study climate change have always been aware of the possibility that climate change might set off discontinuous or catastrophic changes in earth systems.  Collapse of the Antarctic or Greenland ice sheets, shutdown of the Atlantic ocean current that brings warm water to European latitudes, and the nightmare scenario of higher temperatures triggering massive release of the methane trapped in offshore seabed clathrates all are low probability events, but those probabilities are not zero.  A global temperature increase of 2º C or more might very well bring us closer to the tipping points that would make these or other irreversible catastrophes much more likely.

Economists did not pay much attention to these low-probability disasters, partly because there was no easy way to quantify their effects.  The conventional cost-benefit framework was familiar, and has a professional and institutional infrastructure supporting it.  But how can the economic consequences of changes that lie far beyond human historical experience be measured?  There is no econometric method for estimating the price and income effects of unprecedented events that bear little or no resemblance to anything that has been observed to date. 

The new economic approach is to recognize that it is more appropriate to think about climate policy as taking out insurance against disaster than as trying to equate marginal costs and marginal benefits.  Healthy parents buy life insurance to protect the well-being of their children in the unlikely event that the parents die, and feel that their purchase has been worthwhile if the insurance policy never pays out a penny.  The insurance premiums are a real cost, and the “benefit” is zero, if benefit is defined as a tangible payoff to the buyer.  Of course, the probabilistic expected value of the insurance payout is positive, but the money would accrue to the next generation, not the purchasers of the insurance.

This shift in perspective has been moved to the forefront of climate economics by the theoretical work of scholars like Martin Weitzman, Graciela Chichilnisky, Richard Howarth, and others.  It does not diminish the contributions of these thinkers to recollect Ronald Reagan’s quip to the effect that an economist sees something working in practice and then seriously wonders if it works in theory.  Academia is characterized by tremendous inertia.  Advances in economic theory are essential to changing applied practices over time.  The new perspective of climate economics as a matter of risk management rather than cost-benefit analysis is working its way through the peer-reviewed journals, and will soon become dominant in the policy debate.

By Stephen J. DeCanio, Professor Economics, Emeritus, University of California, Santa Barbara


  1. What is required is new economic thinking. Press my name to find out about my evolving project of Transfinancial Economics. The following too may be of interest…

    i) TFE (ie. Transfinancial Economics) is a transitional system towards the ultimate aim of a moneyless world.

    ii) Phase I TFE could be undertaken very quickly by special banks concerned with sustainability, and green products/services. These banks are called Facilitator Banks, or FBs (term not yet used in the entry on this subject at the p2pfoundation).With so-called grant interest as an incentive they would be able to electronically create new non-repayable money (like governments but be tracked, and monitored by the Central Bank, or some other body to prevent fraud) for some project which could in part also include investors using earned money ofcourse. It is similiar to the concept of Advanced Market Commitment, or AMC. FBs would have powers to create subsidies, and other ways to ease finance in some project (especially those with little, or no obvious commercial incentive but have high humanitarian, environmental, and sustainable value so to speak). Objective checks on the capacity of the relevant suppliers of products, and services would be undertaken to ensure that there is no disallocation of resources which could lead to serious rises in the free market price as well as shortages. If necessary investment by FBs could be made to increase capacity where, and when necessary.

    iii) Phase II TFE involves the gradual introduction of new, or upgraded computers, and new computer programming into the banking system. FBs (and the normal banking sector) would start to in part to monitor the volume, and sales of products,and services directly from the real economy. If there is any serious problems of inflation these could be subject to an instant electronic price controls. Moreover, if this leads to a serious loss in profit to a business this would be instantly compensated by new non-repayable money created electronically to the relevant bank account(s). However, every attempt would be made to avoid serious price distortions.

    Taxes, and interest would also be gradually phased out altogether. Interest would be paid for by an independent public body.

    iv) Phase III TFE is the full global introduction of electronic monitoring of goods, and services. The key aim of this is not only to keep inflation in check if necessary but also to have highly accurate data of how much in the way of real resources are being used up on our “small” planet. Such knowledge will become increasingly important as this will give growing green businesses (subsidised mainly by FBs rather than by governments) to make the best use of limited resources. Furthermore, we would unlike now have a far more adbvanced understanding of the mechanics of the economy itself.

    At this stage, taxes, and interest would no longer exist.

    v) During Phase II, and Phase III TFE there would be a huge increase in automation. This would ultimately end the need for wage slavery. With the help of carefully targeted subsidies virtually all businesses would have become responsible as far as the environment, and sustainability is concerned. At the same time, there would be unemployment on a huge scale. But people would be able to indulge in “leisure-like” pursuits, and receive a form of financial benefit created by new non-repayable money. NGOs would become far more powerful, and influential in society, and would spearhead changes on a mass scale to create a new, saner world no longer based on greed, and money. They would be able to challenge centralized power structures as never before, and will find getting grants alot easier to come by. The upshot of all this is a moneyless world but one in which open democracy, and respect for universal human rights acts as the basis of an evolved technocratic world..

    Anyway, food for thought..

    Comment by Robert Searle — July 9, 2010 @ 2:20 am

  2. I should add that TFE is slowly gaining credence. For example, there was a presentation on it in April of this year at the International Conference of Engineering, and Meta-Engineering,or ICEME held in Florida.

    Comment by Robert Searle — July 9, 2010 @ 2:25 am

  3. Steve,while insurance is the right franework, the question I have about the insurance paradigm is this: how does one determine the WTP for an insurance product that has a limited and unknown chance of delivering the insured outcome? That is: how much would one pay for fire insurance if upon the fire event, the policy might pay the full value, something in-between, or nothing at all? If we think of mitigation investments in this light, even ignoring the free-rider problem, we don’t really know the payoff to those investments, even within a wide-range.

    Comment by Eban Goodstein — July 9, 2010 @ 11:03 am

  4. Goodstein’s comment points to what is wrong with the insurance analogy. We are not buying insurance because there is no entity that will pay off (or not pay off) if disaster occurs. Rather, we are considering what incremental steps to take to avoid a disastrous outcome, even if that outcome has low probability.

    Think of it more this way. If we all had vehicles that we could drive at any speed there would be a certain probability of fatal accidents. But we could, for example, fit them with brakes (at a cost), we could establish stoplights, stop signs, speed limits, driving lanes, etc. Each of these may impose some costs but the expected benefits in terms of reduced fatal (and other) accidents are greater. How far should we go in this direction? Till marginal costs exceed marginal benefits. And that’s what we’re doing or will do with regard to reducing GHG emissions. I don’t see a problem with calling this risk management, but it’s incorrect to characterize it as purchasing insurance.

    Comment by Mike Canes — July 9, 2010 @ 12:20 pm

  5. I’m not convinced that ‘insurance’ is a good framework. Wouldn’t a more relevant framework would be related to the costs of investing in health care, or anti-smoking efforts.

    How does one estimate the economic cost of, say, efforts to build new preventative medicine centers, when it is difficult to estimate outcomes in advance? The hope is that people are healthier, and then the costs of health care will go down in the future. Of course, it hasn’t been demonstrated to work, but the vast majority of professionals in the medical field think it will.

    Economists must have thought about this, have they not?

    Comment by Eric Steig — July 9, 2010 @ 12:28 pm

  6. Eban, it’s a good guestion. The science suggests that if we can keep the global temperature increase below 2 degrees C, we can avoid the most serious of the risks. This will require global action, however; the US, the EU, or Japan (or all of them together) can’t do it alone. Therefore, the uncertainty about the effectiveness of buying the insurance arises from not knowing if we can get a truly global agreement. For this reason, intelligent diplomacy, including appropriate and equitable incentives for developing countries that are not yet large emitters of greehnouse gases, is as important if not more important than domestic emissions reduction legislation.

    Comment by Stephen DeCanio — July 9, 2010 @ 12:36 pm

  7. Good to hear you think there is a shift in perspective, but what you say (action as an insurance policy – the precautionary principle) has been pretty obvious and around for how long? decades at least. So, even if there is more recognition in certain parts of the economic literature is there any convincing evidence this will change global policy? I am sceptical

    Comment by Colin Butler — July 10, 2010 @ 1:12 am

  8. [...] the most significant damages from climate change are likely to be associated with extreme events. Risk assessment and risk management are more appropriate frames for evaluating climate policy for these [...]

    Pingback by Building the Economic Case for Climate Action « Real Climate Economics — May 2, 2011 @ 12:21 pm

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