Global ChangeIntersection of Nature and Culture

Economists agree on climate warming but are still stuck on how much it costs

Wednesday, November 4th, 2009

A new policy brief, Economists and Climate Change: Consensus and Open Questions, from the Institute for Policy Integrity (NYU School of Law) is getting a lot of headlines today.

Most reports are picking up on the statistics:

• 84% or economists surveyed agree that global warming represents a serious risk to the U.S (7.6% are neutral, 5.6% disagree, and 2.8 % have no opinion).
• 86% believed that agriculture would be the sector most at risk.
• 92% preferred market-based solutions like a cap-and-trade or carbon tax.

This is significant because it shows that most economists have aligned with the natural scientific consensus of the IPCC.  Questions of whether climate is warming and its potential seriousness are over.  The current problem is how we deal with it.

Today’s report shows there is still a point of contention with the economics of climate warming…

The hard part that economists are struggling with, echoed once again in this report, is how to come up with estimates of the costs of warming impacts and the costs of dealing with this problem, specifically, how to handle the value of money over time using what we call the discount rate.

This is such a key concept to the debate that it’s worth a bit of explanation. [Note: For a more technical discussion of discount rate as it apples to economic models of climate warming, please see this paper by Harvard economist, Martin Weitzman.  Instead, I'm going to take a personal finance approach to make this subject more intuitive.  The end result is roughly the same, but the math is different].

The short answer is that a dollar today is worth more than a dollar in the future. Why is this?

Imagine I could give you $100 today or $100 one year from now.  Which would you prefer?   At first, this sounds like a trick question.  After all…$100 is $100, right?

Actually, no.  $100 now is more valuable to us for three reasons:

• The prices of goods and services usually go up every year (inflation).  We see this as we pay more for things like gasoline.  For illustration, let’s say inflation goes up 3% per year,  and gas costs $1 per gallon today.  A year from now (with 3% inflation), it would be $1.03/gallon.  Thus, it would be better to take the $100 now and buy 100 gallons of gasoline rather than waiting a year and only being able to buy 97 gallons of gasoline.  Put another way, your $100 a year from now is only worth $97 today. Economists like to say this in a fancier way:  The present value of $100 one year from now is $97.
• You could also choose to invest it in the stock market, a savings account, or other account that will pay you interest or earnings on that $100.  Let’s say you stick it in a savings account with a 6% interest rate.  After a year, you have $106.  Because of our 3% inflation, we have to remove about $3 from this total, so we end up with $103, for a net gain of 3% (3 = 6 – 3).  $103 is better than $97, so it’s clear that money is more valuable to us today than in the future.
• A third reason is that money burns a hole in our pockets—people generally prefer to consume now rather than later,  so having $100 would allow people to treat themselves to a great bottle of wine and diner rather than waiting for a year to do so.

Because money is worth more to us today than in the future, we discount the future value of money because of factors like inflation, interest rates, and personal desire for consumption now.  In our example, the discount rate includes inflation (3%) and the net rate of return on investment (3%) for a total discount rate of 6%.

When inflation is high, or if we can make a lot of money from investments because interest rates are high, we say that the discount rate is high and the present value of money a year from now goes way down.  In both of these scenarios, we want money NOW because it is a lot more valuable today than it would be a year from now.  Conversely, if there is no inflation, or interest rates are low, we say that the discount rate is low and the present value of money a year from now is pretty much the same as it is today.

Here’s where a major problem comes in…

To calculate the economic costs climate warming, we need to  make a guess of costs many years into the future, say from years 2009-2100.  This includes costs associated with damage from warming if we did nothing to stop it, such as crop losses or the cost to build sea walls.

As we saw above, the idea of discounting has to come into play because we need to figure out the present value of these costs for years 2010, 2011, 2012…all the way to 2100.  In practice, this means economists have to make a guess at what they think the discount rate should be, and that’s hard because there’s a lot of disagreement.

If we apply a high discount rate (6-12%), this means that we strongly discount the value of money in the future.  Intuitively, it means we want money now to invest or spend.  It also means that the present value of these future costs is low.  If we apply a low discount rate (0-3%), this means that we don’t discount the value of future costs, which means the present value of these future costs is high.

Here’s why this is critical:  By using a high discount rate, we make the future costs of climate change appear to be less than if we used a low discount rate.

Here’s how Harvard economist, Martin Weitzman put it:

[I]t is not an exaggeration to say that the biggest uncertainty of all in the economics of climate change is the uncertainty about which interest rate to use for discounting. In one form or another, this little secret is known to insiders in the economics of climate change, but it needs to be more widely appreciated by economists at large.

How big an impact?  Big enough to ignite a vigorous debate in 2007 between Yale economist, William Nordhaus, and adviser to the British government, Nicholas Stern.  To cut to the chase, Stern argued that the discount rate must be set low (1.4%) to reflect the fact that more value needs to be given to future generations and to show that the impact costs of climate warming are large.  In contrast, Nordhaus and others  have argued that it should be more like 6%, reflecting current realities of consumer choice and economic markets.

Another quote from Weitzman illustrates the significance of this gap:

Stern’s discount rate…is r = 1.4 percent. The present discounted value of a given global-warming loss from a century hence at the non-Stern annual interest rate of r = 6 percent is one hundreth of the present discounted value of the same loss at Stern’s annual interest rate of r = 1.4 percent. The disagreement over what interest rate to use for discounting is equivalent here in its impact to a disagreement about the estimated damage costs of global warming a hundred years hence of two orders of magnitude. Bingo!

And so the battle has raged for the last two years on how much climate warming will cost.  How does the new NYU report released today weigh in on this issue?

• Although we saw earlier that a large majority of economists agree that climate warming is serious, they differ quite a bit on how to handle the discount rate.  This means that we still don’t have consensus on how to value the economic impacts of climate warming.
• When asked what discount rate would be appropriate, the range was 0-12%.  That’s huge.  The median was about 2.4%, which is much closer to Stern’s (1.4%) assessment than Northaus’ (6%).
• Interestingly, about 17% of economists believed that discounting should not be used; rather, we should use moral arguments rather than economic benefit-cost analyses to determine how we deal with climate change.   This is significant because it frames climate change mitigation as a matter of ethics—a point long argued by philosophers like Dale Jamieson and others.
• Those economists who thought we should use a fixed discount rate over time (about 38% of economists) believed the discount rate should be 3.8%.  Those who thought the discount rate should vary and decline over time (about 37% of economists) thought it should average 2.7%.  and those who thought that moral inquiry was the best way to go —when pushed—thought that the discount rate should be 1.1%.

These are significant differences that lead to large differences in how much climate warming will cost us.  So while it’s nice to see economists reach a near consensus about the problem, we still have a bit more to go in assessing the impact costs and solutions.

Photo credit:  http://www.flickr.com/photos/wheatfields/ / CC BY 2.0