I am normally loath to publish someone else’s post more or less in its entirety, but Brad DeLong’s discussion of some of the more persuasive arguments for investing to arrest global warming is first rate. (And candidly, he references an article by Martin Weitzmen on the Stern Review, the UK report that was the first effort to estimate the costs of climate change, which I fully intend to read, but due to travel and other distractions, probably won’t get to before the weekend).
Three observations stood out for me. One is an argument made in the Stern Report: environmental change is a stock and flow problem. Once we put carbon in the atmosphere, we can’t remove it. That to me suggests it may not be as amenable to standard discounted cash flow analysis as some people like to think, because you can determine a relationship between future dollars and present dollars (you use a discount rate). Or maybe put it another way: environment and money are not substitute goods. If we don’t spend the money to make changes now, and we don’t like the way things turn out in the future, there is no amount of money we can spend to get back to where we were (that suggests this is an option problem rather than a DCF problem, but personally I find pretty much all option valuation models suspect).
The second comes from Weitzman. He says the climate change problem may be more analogous to an insurance problem than an investment problem. Martin Wolf of the Financial Times came to the same conclusion, and also added that one always pays more for insurance than the mere probability-weighted likelihood of loss, because the consequences of catastrophic situations, even if not high probability, were too unpalatable.
The final one is from DeLong. He notes our financial markets are “not well functioning” and “appear to be profoundly myopic in the sense that average opinion has a hard time peering into the future when calculating what average opinion expects average opinion to be.” One of our favorite themes is that markets aren’t all they are cracked up to be (see here, here, and here for examples), and we hope DeLong and his colleagues keep educating the public as to the limits of markets, and the dangers of seeing them as a cure-all, particularly in the public policy arena.
Felix Salmon goes to watch the Triple-S Team–Stern, Sachs, and Stiglitz–discuss the economics of dealing with global climate change:
Felixsalmon.com: a blog about economics and finance, mostly — Stern, Sachs, and Stiglitz on the Economics of Climate Change: And then came the barrage of very good reasons why it makes sense to spend money today for the benefit of future generations. First, from Stern: climate change is a stock-and-flow problem. We need to decrease the flow of carbon into the atmosphere now, in order to reduce the stock of carbon in the atmosphere in future. Once it’s there, you can’t take it out – in any case, it would be utter foolishness to assume that we might be able to do so at some point in the future. So climate change is irreversible. Once coral reefs die, glaciers melt, and cities drown, they’re gone forever, and no amount of future wealth can make up for that….
[T]hink of the world as being made up of two types of capital – physical capital and environmental capital. Since the Industrial Revolution, we’ve been growing our physical capital at the expense of running down our environmental capital. As a result… we value our environment much more highly now, in real dollar terms, than we did a couple of generations ago. If we continue to grow our physical capital at the expense of our environmental capital, that exchange rate will continue to rise… we’ll find that the cost of that wealth, in terms of spent environmental capital, will be seen to have been excessive. Environmental capital might be expensive now, but it will also never again be cheaper than it is today….
Sachs had another take. There’s no reason, he said, that spending $400 billion now means that we should reduce our consumption by $400 billion…. “The future would rather have abatement capital than non-abatement capital,” he said, adding that you can finance expenditure out of savings rather than consumption through the application of fiscal policy. “We are stewards of the future,” said Sachs – future generations aren’t around to speak to us, so we have to act on their behalf. “And they want less capital and a better climate.”
Then Stiglitz stepped in, to introduce the distinction between social return and financial return. Not everything, he said, could be measured with GDP-per-capita figures….
Jason Furman says that the best thing he has seen on this is Marty Weitzman (2007), “The Stern Review of the Economics of Global Climate Change,” forthcoming in the Journal of Economic Literature http://www.economics.harvard.edu/faculty/Weitzman/papers/JELSternReport.pdf. I agree: Weitzman’s paper is superb. My only disagreement is that Weitzman seems a little too agnostic in the arguments he derives from his observation that:
something fundamental is amiss in the paradigm framework for pricing assets and deriving the rates of return that we are relying upon to produce discount rates for evaluating new investment opportunities…
I think we are pretty certain why the configuration of asset prices does not match our economists’ intuitions about what asset prices should be in a world of well-functioning markets given our estimates of preferences and technologies. It doesn’t match because our financial markets are not well-functioning. They do a lousy job of mobilizing the risk-bearing capacity of society. And they appear to be profoundly myopic in the sense that average opinion has a hard time peering into the future when calculating what average opinion expects average opinion to be. As I result, I think, we shouldn’t be surprised that there are asset pricing puzzles out there (see http://delong.typepad.com/pdf/20070412_JEP_EP.pdf). And we shouldn’t take those puzzles to disable our ability to think long-term aboutr issues like global warming.
On the other hand, this from Weitzman seems to me to be completely right:
To its great credit the Review supports very strongly the politically-unpalatable idea, which no politician planning to remain in office anywhere wants to hear, that the world needs desperately to start confronting the expensive reality that burning carbon has a significant externality cost that ought to be taken into account by being charged full freight for doing it. (This should have been, but of course was not, the most central “inconvenient truth” of all in Al Gore’s tale about inconvenient climate-change truths.) As the Review puts it,”ìestablishing a carbon price, through tax, trading, or regulation, is an essential foundation for climate-change policy.” One can only wish that U.S. political leaders might have the wisdom to understand and the courage to act upon the breathtakingly-simple vision that a carbon price reflecting social costs (whether imposed directly through taxes or indirectly via tradable permits) could do much more to unleash the decentralized power of greedy, self seeking, capitalistic American inventive genius on the problem of developing economically-efficient carbon-avoiding alternative technologies than all of the command-and- control schemes and patchwork subsidies making the rounds in Washington these days…