How much does climate change cost? What will be the impact on our wallets?
The latest report from the Intergovernmental Panel on Climate Change’s (IPCC) Working Group II has concluded that global warming of 2.5˚C would cost the equivalent to losing between 0.2-2.0% of annual income.
This seems in sharp contrast to the Stern Review of the Economics of Climate Change, which found it would cost 5-20%. How can that be?
The Stern Review was prepared by a team of civil servants and never reviewed (before publication) by independent experts. Some argue that the Stern Review served to bolster Gordon Brown’s credentials with the environmental wing of the Labour Party in preparation for his transition to party leader and prime minister. And in fact next week IPCC Working Group III will conclude that the Stern Review grossly underestimated the costs of bringing down greenhouse gas emissions.
While interested parties can self-publish whatever they want, such informally published grey literature has no place in the IPCC’s work. Although the Stern Review’s findings were not included in the IPCC’s current, Fifth Assessment Report (AR5), the Stern Review draws heavily on the climate change impact estimates of Chris Hope of Cambridge University, whose numbers are peer-reviewed, and were included in the IPCC’s work. Hope calculated a economic loss of 0.9%, slightly lower than the IPCC’s central estimate of 1.1%. So the Stern Review and IPCC AR5 do not contradict one another. If anything, the Stern Review is slightly more optimistic.
Playing with numbers
So how did the Stern Review reach its figure of 5%-20% of income, when in fact its calculations started with an estimate of less than 1%? The reason is an arcane bit of welfare economics. Dr Hope’s 0.9% is a conventional impact estimate. If the world warmed by 2.5˚C, the average person would feel as if they had lost 0.9% of her income. If the world warmed by more, the impact would be higher; if warming is less, the impact is lower.
The Stern Review’s 5% is generated like an annuity, taking a stream of payments that vary over time (in this case the predicted impact of climate change) and converting it into fixed annual payments. The Stern Review thus replaces the impact of more than 200 years of climate change – effects that start low and end high – with a number that is the same for each year. Most people find it confusing to replace numbers that vary over time with a single fixed number.
In order to calculate an annuity economists apply a discount rate, effectively representing the change in value of money over time. The Stern Review (as it was originally published in 2006) uses a discount rate of about 1.4% – far below what most people use, and indeed far lower than the official discount rate of Her Majesty’s Treasury of 3.5% (and falling further to 1% for those effects more than three centuries into the future). Using such a low discount rate inflates the annuity, and so the reported costs of climate change.
Stern’s argument for a low discount rate is a paternalistic one. People’s value judgements are wrong, according to the Stern Review, and the government has the right to overrule them. Stern puts himself in the position of a colonial ruler, governing the savages against their will – but in their own interest, of course.
The costs of uncertainty
Stern’s 5% figure also reflects the uncertainties about future climate change and its impact on our welfare. Combined with the low discount rate, this means that the headline number of the Stern Review is dominated by unlikely events in 200 years’ time. It does not reflect climate changes' impact in the near term, or even the best estimate over a century. It is, by and large, a prediction based on the worst case scenario of two centuries from now.
Unfortunately, this worst case is internally inconsistent. It assumes both high greenhouse gas emissions and high vulnerability to the effects of climate change. That does not make sense. Essentially, it assumes that, for example, Africans will be rich enough to drive highly emitting SUVs, but too poor to buy mosquito nets to protect their children against malaria spread by increased numbers of insects that the warmer, wetter climate global warming would bring.
So while Stern reports a range of 5-20%, those figures do not truly represent upper and lower bounds. The 5% is their best estimate, reflecting all uncertainties. The 20% is an arbitrary number – it is based on assumptions on greenhouse gas emissions, climate change and climate impacts that the authors themselves find less credible.
Both studies agree that the economic impact of climate change is small – half a century of climate change at this rate would do perhaps as much damage as losing one year of economic growth. Unfortunately, the Stern Review hides this reasonably optimistic conclusion behind accounting tricks and dubious assumptions, creating a sense of disagreement that is not there.
Richard Tol is Professor of Economics at University of Sussex.
Richard Tol receives funding from 7th Framework Programme of CEC DG Research & Innovation. He is an independent adviser to a wide range of organisations, including charities (e.g., the Global Warming Policy Foundation), the governments of Germany, Ireland, the Netherlands and the USA, multilateral organisations (e.g., European Commission, World Bank), investment banks, energy companies (both renewable and fossil), engineering companies, political parties across the spectrum (from Freedom Party to Greens), activist groups (e.g., both pro- and anti-wind power), and academic organisations (e.g., Royal Irish Academy, Global Trade Analysis Project). He is a Member of the Academia Europaea, a Fellow of the Tinbergen Institute, and the Fellow of CESifo.