The Economics of CO2 mitigation

We are at a point in human history where we must consider investing in CO2 mitigation. Environmentally, mitigating CO2 has clearly been the wisest course of action for some time, both because of catastrophic weather systems such as Hurricane Katrine and deadly heat waves across Europe (Power, 25), and global destruction of natural habitat that has led to mass extinction all over the world (Quammen). But economically, things have been less clear. This is because investing in CO2 mitigation actually means slowing GDP now, primarily though higher carbon costs, in order to avoid the negative effects that higher CO2 levels will have on the economy in the future. Until recently, it has not been clear that this investment would pay off.

However, as Marilyn power points out in her unpublished essay, “The Economics of CO2 Mitigation: the Stern Review and its critics,” “economists of all schools of thought” now believe that mitigating CO2 is a wise investment (Power, 1).

As Marilyn goes on to explain, economists have reached this conclusion using a mainstream cost-benefit analysis, in which the potential benefit of the investment is weighed against placing that money in a risk-free, interest-bearing account. In the case of investing in CO2 mitigation, the investment is the amount of GDP that will be lost because of increased carbon costs, among other things, and placing that money in a risk-free, interest bearing account is the amount of GDP that will be lost because of the negative effects of CO2 in the atmosphere if we continue with “business as usual”(Power, 2). This is because it has become clear to economists that the cost of investing in CO2 mitigation is nowhere near as high as the negative effects that higher CO2 levels will have on the economy, because of increased flood risks during the wet season, strongly reduced dry season water supplies, and declining crop yields, even in higher altitudes, due to Global Warming, and because of lower fish stocks due to Ocean Acidification (Stern, 56).

The equation to determine the value of placing a sum of money in a risk-free, interest-bearing account is FV = PV(1+r)^t, where FV is future value, PV is present value, r is rate of interest, and t is units of time. However, using this equation as the bar against which to measure the value of an investment in CO2 mitigation is inherently problematic because not mitigating CO2 will lower the value of r – the rate of interest – because of the negative effects that growing levels of CO2 in the atmosphere will have on the economy.

Yet even using this equation, doing “business as usual” will cost the global economy 5-20% by 2050 because of the negative effects of increased CO2 in the atmosphere, and it would require significantly less of an investment in CO2 mitigation to counteract these effects. This is why economists agree that an investment in CO2 mitigation will be more profitable than doing business as usual; the only thing economists disagree about is what type of investment in CO2 mitigation is economically wisest. Some economists, such as Sir Nicholas Stern, head author of the Review on the Economics of Climate Change, commonly referred to as the Stern Review, believe that making a small, decisive investment of 1% GDP is wisest. Others economists, such as environmental economist William Nordhaus, believe that making a smaller investment now, and depending on future generations to ramp up that investment would be economically wiser.

The primary reason these two camps disagree on the wisest type of investment in CO2 mitigation despite using the same equation to determine the FV, future value, of not investing in CO2 mitigation, is because they disagree on the degree to which the value of investing in CO2 mitigation should be discounted.

It is standard economic practice to discount investments that lower current GDP in hopes of future returns because economists believe that societies prefer immediate wealth to future wealth, and that future generations will be richer, and thus a similar investment will be less of a burden in the future than it will be now.

This discount rate is determined using the equation r = ∂ +n(g), where r is the discount rate, ∂ is pure time preference, n is the elasticity of marginal utility, and g is the growth rate of GDP. When considering an investment in CO2 mitigation, this equation proves even more problematic than that for FV because this investment will not mature for over 100 years, and thus all of its variables must be assumed: while ∂ is normally determined by our willingness to save, we can’t accurately assume how willing our grandchildren will be to save; while n is typically determined by the distribution of wealth in a static moment, we can’t assume that the distribution of wealth in 100 years will be the same or even similar to what it is now; and the same problem that arose with r in the standard equation for FV in the case of an investment in CO2 mitigation arises with g in this equation for discounting the future – because of the negative effects on the economy that will result if we do not invest in CO2 mitigation, the growth rate of GDP will most likely not be positive over the next 100 years, but negative. If this alone were accounted for, and a negative number were used for g, the discount rate would actually be negative, meaning future wealth would have to be considered more desirable than present wealth. This seems accurate considering the catastrophic effects that higher CO2 levels in the atmosphere will have on non-monetary forms of capital (which will be discussed later), but it does not fit into the economic assumptions about societal preference.
In response to these problems, the Stern Review chose to set ∂ at 0.1%, implying that we should not prefer profit for our generation over profit for the next; to set n at 1, implying that economic distribution will remain as disparate as it is today; and set g between 1.5 and 2%, which reflects a small percentage of the negative effects on the GDP that increased CO2 in the atmosphere will have. This resulted in an overall discount rate between 1.6 and 2.1%. Using these numbers, the Stern Review’s calculations show that the optimum investment in CO2 mitigation for world GDP is 1% of that GDP by the year 2050 (Power, 10), obviously significantly less than the 5 – 20% GDP that “business as usual” will cost.

In contrast, Nordhaus and economists of his camp do not alter the variables in this equation to account for the problems that arise in applying it to investing in CO2 mitigation, and instead use the standard overall discount rate of 4%. This difference leads Nordhaus to believe that a progressive investment starting at a fraction of a percentage and ramping up from there is the wisest way to invest in CO2 mitigation. This would lead to higher CO2 levels in the atmosphere than will be reached if we invest 1% immediately, but Norhaus argues that this is justified because the initial investment could be put toward research and development of low-emissions technologies, and that this investment will lead to a more affluent society (Power, 11). Essentially, he is saying that the Stern Review’s measures are drastic, because the loss of environmental capital lost by the destruction of higher CO2 levels will be offset by an increase in technological capital. This highlights another difference between Nordhaus’ camp, and that of the Stern Review, and an issue central to determining the value of investing in CO2 mitigation: the commensurability of different forms of capital.

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