Climate Policy: On Buying Insurance, and Ignoring Cost-Benefit Analysis

By Frank Ackerman, principal economist at Synapse Energy Economics in Cambridge, Mass., and one of the founders of Dollars & Sense, which publishes Triple Crisis. Originally published at Triple Crisis

First in a series on climate change policy

The damages expected from climate change seem to get worse with each new study. Reports from the IPCC and the U.S. Global Change Research Project, and a multi-author review articlein Science, all published in late 2018, are among the recent bearers of bad news. Even more continues to arrive in a swarm of research articles, too numerous to list here. And most of these reports are talking about not-so-long-term damages. Dramatic climate disruption and massive economic losses are coming in just a few decades, not centuries, if we continue along our present path of inaction. It’s almost enough to make you support an emergency program to reduce emissions and switch to a path of rapid decarbonization.

But wait: isn’t there something about economics we need to figure out first? Would drastic emission reductions pass a cost-benefit test? How do we know that we wouldn’t be spending too much on climate policy?

In fact, a crash program to decarbonize the economy is obviously the right answer. There are just a few things you need to know about the economics of climate policy, in order to confirm that Adam Smith and his intellectual heirs have not overturned common sense on this issue. Three key points are worth remembering.

Worst-Case Risks Matter More Than Likely Outcomes

For uncertain, extreme risks, policy should be based on the credible worst-case outcome, not the expected or most likely value. This is the way people think about insurance against disasters. The odds that your house won’t burn down next year are better than 99 percent – but you probably have fire insurance anyway. Likewise, young parents have more than a 99 percent chance of surviving the coming year, but often buy life insurance to protect their children.

Real uncertainty, of course, has nothing to do with the fake uncertainty of climate denial. In insurance terms, real uncertainty consists of not knowing when a house fire might occur; fake uncertainty is the (obviously wrong) claim that houses never catch fire. See my Worst-Case Economics for more detailed exploration of worst cases and (real) uncertainty, in both climate and finance.

For climate risks, worst cases are much too dreadful to ignore. What we know is that climate change could be very bad for us; but no one knows exactly how bad it will be or exactly when it will arrive. How likely are we to reach tipping points into an irreversibly worse climate, and when will these tipping points occur? As the careful qualifications in the IPCC and other reports remind us, climate change could be very bad, surprisingly soon, but almost no one is willing to put a precise number or date on the expected losses.

One group does rush in where scientists fear to tread, guessing about the precise magnitude and timing of future climate damages: economists engaged in cost-benefit analysis (CBA). Rarely used before the 1990s, CBA has become the default, “common-sense” approach to policy evaluation, particularly in environmental policy. In CBA-world you begin by measuring and monetizing the benefits, and the costs, of a policy – and then “buy” the policy if, and only if, the monetary value of the benefits exceeds the costs.

There are numerous problems with CBA, such as the need to (literally) make up monetary prices for priceless values of human life, health and the natural environment. In practice, CBA often trivializes the value of life and nature. Climate policy raises yet another problem: CBA requires a single number, such as a most likely outcome, best guess, or weighted average, for every element of costs (e.g. future costs of clean energy) and benefits (e.g. monetary value of future damages avoided by clean energy expenditures). There is no simple way to incorporate a wide range of uncertainty about such values into CBA. The second post in this series will look more deeply at economists’ misplaced precision about climate damages.

Costs of Emission Reduction Are Dropping Fast

The insurance analogy is suggestive, but not a perfect fit for climate policy. There is no intergalactic insurance agency that can offer us a loaner planet to use while ours is towed back to the shop for repairs. Instead, we will have to “self-insure” against climate risks – the equivalent of spending money on fireproofing your house rather than relying on an insurance policy.

Climate self-insurance consists largely of reducing carbon emissions, in order to reduce future losses.[1] The one piece of unalloyed good news in climate policy today is the plummeting cost of clean energy. In the windiest and sunniest parts of the world (and the United States), new wind and solar power installations now produce electricity at costs equal to or lower than from fossil fuel-burning plants.

A 2017 report from the International Renewable Energy Agency (IRENA) projects that this will soon be true worldwide: global average renewable energy costs will be within the range of fossil fuel-fired costs by 2020, with on-shore wind and solar photovoltaic panels at the low end of the range. Despite low costs for clean energy, many utilities will still propose to build fossil fuel plants, reflecting the inertia of traditional energy planning and the once-prudent wisdom of the cheap-fuel, pre-climate change era.

Super-low costs for renewables, which would have seemed like fantasies 10 years ago, are now driving the economics and the feasibility of plans for decarbonization. Many progressive Democrats have endorsed a “green new deal”, calling for elimination of fossil fuels, massive investment in energy efficiency and clean energy, and fairness in the distribution of jobs and opportunities.

Robert Pollin, an economist who has studied green new deal options, estimates that annual investment of about 1.5 percent of GDP would be needed. That’s about $300 billion a year for the United States, and four times as much, $1.2 trillion a year, for the world economy. Those numbers may sound large, but so are the fossil fuel subsidies and investments that the green new deal would eliminate.

In a 2015 study, my colleagues and I calculated that 80 percent of U.S. greenhouse gas emissions could be eliminated by 2050, with no net increase in energy or transportation costs. Since that time, renewables have only gotten cheaper. (Our result does not necessarily contradict Pollin’s estimate, since the last 20 percent of emissions will be the hardest and most expensive to eliminate.)

These projections of future costs are inevitably uncertain, because the future has not happened yet. The risks, however, do not appear dangerous or burdensome. So far, the surprises on the cost side have been unexpectedly rapid decreases in renewable energy prices. These are not the risks that require rethinking our approach to climate policy.

Costs of Not Reducing Emissions May Be Disastrously Large

The disastrous worst-case risks are all on the benefits, or avoided climate damages, side of the ledger. The scientific uncertainties about climate change concern the timing and extent of damages. Therefore, the urgency of avoiding these damages, or conversely the cost of not avoiding them, is intrinsically uncertain, and could be disastrously large.

It has become common, among economists, to estimate the “social cost of carbon” (SCC), defined as the monetary value of the present and future climate damages per ton of carbon dioxide or equivalent. This is where the pick-a-number imperative of cost-benefit analysis introduces the greatest distortion: huge uncertainties in damages should naturally translate into huge uncertainties in the SCC, not a single point estimate.

The next post in this series will examine the debates about the SCC, showing that there are indeed large uncertainties in its value, no matter how inconvenient that may be for economists and their models.


[1] Adaptation, or expenditure to reduce vulnerability to climate damages, is also important but may not be effective beyond the early stages of warming. And some adaptation costs are required to cope with warming that can no longer be avoided – that is, they have become sunk costs, not present or future policy choices.

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  1. Ignacio

    Yes CBA is no sense as a means treat this problem. That is my experience with households and SMEs. For instance, a week ago I made a presentation for a group of companies that share an office building near Madrid. The presentation was to make recommendations of the best ways to reduce energy consumptiom and produce renewables on site. I had to deal with the fact that electricity and energy bills accrue for well below 0.1% yearly expenses in these companies. Any micro-CBA analysis would say there is always another expenditure that will be more reasonable or interesting than energy saving and renewable investment. Besides, no company sees any noticeable reduction of any kind of risk with these investments. I was expecting, and found ,faces expressing boredom on the issue. Even if you make your best efforts to find and present solutions that will be amortized shortly people is not interested. They have plenty of other “more important” inmediate problems. You may always exceptionally find someone who is really worried by environmental issues.

    My opinion is that only regulatory obligations will force such investments. In this case I would suggest that office space renting should be conditional on not passing some normalized level of CO2 emissions, forcing companies invest in renewables/efficiency on the grounds of high emissions, no bussiness.

    1. notabanker

      This is where taxation could be a powerful tool. Not only remove fossil fuel subsidies, but further tax it’s consumption and the yawns will be transformed into brilliant tax avoidance strategies.

      1. Ignacio

        I believe that incentives like tax rebates associated with specific goals in CO2 emission reduction could help.

        1. BlakeFelix

          Just taxing CO2 seems much easier and more fair than setting goals and awarding rebates. Hell, IMO do that, slap an estimated carbon tariff on imports, then abolish payroll taxes. Taxes on income and real estate improvements too if you feel ambitious. It’s easy to hide income, much less so to hide a coal mine or oil refinery. And as long as we are going to tax something, it’s better to discourage pollution than quality construction or wages.

    2. a different chris

      for well below 0.1% yearly expenses in these companies. …. I was expecting, and found ,faces expressing boredom on the issue.

      But when you combine those two fact, you realize this is great. You can talk them into finding some chump change and letting somebody who is young and excited about it, and somebody they want to keep, to work on it. Here comes another (awful) analogy – but your Dad would buy you a whole fleet of model rockets but he isn’t going to buy you a motorcycle.

      Rich bored people are literally what you want. You don’t need all of them on your side, you just need most of them to be indifferent.

      1. Ignacio

        Rich bored people are literally what you want. You don’t need all of them on your side, you just need most of them to be indifferent.

        You have left me thinking and re-thinking about this.

  2. Parker Dooley

    I have been obsessing about this issue for many years, more so now since I have children and grandchildren whose future I worry about.

    First of all, I believe that the denialists suffer from two limitations in their thinking that are common to much conservative thought. One arises from an apparent inability to comprehend the fact that the processes under discussion are highly non-linear. This is the reason why the catastrophes are likely decades or years away, if not already upon us. The second problem arises from the unfortunately chosen term “positive feedback”. Climate denialist: “Positive– that must be a good thing.” Add to this the apparent unwillingness of the climate science community to present the worst case scenario to the political class, in the face of the already vicious reprisals by the PTB.

    Another issue I think is insufficiently emphasized is that of ocean acidification, and its consequences on the food web. The discussion is too much about “global warming” while ignoring the independent effects of CO2 chemistry on the environmental services we all depend upon. Somewhere at the very bottom of the chain is some anonymous, relatively unstudied organism or group of such that is the ultimate food source for all oceanic life; another such may be responsible for 70% of the oxygen cycle so our doom may consist of asphyxia as well as heat stroke.

    Drumlin Woodchuckles & I had some discussion recently (sorry, can’t find the link) about carbon capture, and I had some concerns about the energy requirements and necessary scale of the process. I’m looking at one possible pathway that is less emphasized than solar and wind. I’m in Ecuador right now (sorry, had to fly to get here). The country is is littered with active volcanoes. the so-called terra firma is like a potato chip floating on a sea of fire, thus a potentially unlimited source of superheated steam, not only for generation of electricity but for concentration of atmospheric CO2 and production of transportation fuels by the Sabatier process or similar. This is already being done in Iceland, and on sufficient scale could free any region with sufficient geothermal resources from any need for petroleum based energy.

    Sorry about such a long post, but I think this is the existential question for our species. We have got to stop sh*tting in the only nest we will ever have.

      1. Some Guy

        Firstly, thank you for the link. Fascinating stuff.

        Secondly, I think you’re not far off the mark on your first point. It’s easy for climate skeptics to point to the various failures of the past, such as the worries over an incoming ice age in the 70’s, statements that Florida would be underwater by 2000 in the 1980’s, etc. James Hansen, doing the best he could with what we knew in the 80’s with a rather less advanced knowledge base, wasn’t quite right with his projections. In their minds, this translates as an invalidation because we haven’t seen catastrophic real-world results. Likewise, since they were so wrong for so long, why should we believe them now? This, I think, is the hurdle that activists have to overcome.

        1. Parker Dooley

          Our situation may be like the samurai joke:

          First samurai: “My sword is very sharp.”
          Second samurai: “Ha ha you missed.”
          First samurai: “Try nodding your head.”

  3. juliania

    This article isn’t directly about climate change, but it brought home to me very forcibly what climate change could bring us. This is a place on our planet that I would describe as experiencing constant extreme weather events. Maybe what we face is different, but on a scale between habitable and inhabitable, this would seem to be worth contemplating (gorgeous photos notwithstanding.)

  4. Susan the Other

    Insurance is absurd when we are faced with extinction. How to parse “extinct, extincter and extinctest” – to use Dimitry Orlov’s phrase. Clearly by the CBA, extinctest would be the most expensive policy to purchase. But only by the slim chance that somebody can actually survive.

  5. Adam Eran

    Typical mainstream response: The Green New Deal Would Spend the U.S. Into Oblivion

    The author (Noah Smith) derides MMT as happy talk…ignoring that the MMT guys were the ones who correctly predicted the Great Recession while the neoclassicals both right (Mankiw) and left (Krugman) didn’t.

    One interesting side note: I made a comment on the article to that on Bloomberg’s site (its origin) and it no longer appears there. Censorship? Fear? Neoclassical moderation?

  6. TG

    Well, sure. We really need to increase greenhouse gas emissions! Absolutely! And anyone saying different is racist, and fascist, and Literally Hitler!

    The Untied States MUST increase its population to a billion and more. Canada MUST increase its population to 100 million and more. Japan simply cannot allow its population to stabilize, it MUST increase its population to 300 million and more! Because more is better! Always better!

    And when the world has been jammed filled full of people, and there are no more resources left – then sure, THEN we must make the average person poor. THEN we must levy heavy taxes on meat, and energy, and alcohol, and anything else that the cattle might want (of course, the elites will still be flying on private jets drinking champagne and caviar – what, are you a racist?). Because don’t you want to save the planet?

  7. Peter Lynch

    I love analysis as much as anyone ( I have been an analyst and investment banker for over 30 years).

    But this is not an issue of CBA, insurance or constantly using the insane word “COULD”

    Bottom LIne – Climate Change will and IS currently destroying our world. If you possess minimal awareness you can see it all around you. This is NOT the time for a useless debate – but it IS the time, for a NEW PRESIDENT to declare an immediate national emergency.

    If I look at this situation based upon my understanding of how the stock market works – once it is clear that there are BIG problems (I would guess 2-5 years) the market will react in a negative way (i.e. CRASH) and it will start a worldwide recession that could lead to a depression – causing TRILLIONS of asset losses far exceeding any of these make-believe numbers.

    It is VERY simple – the threat is real and it is NOW and if we do not act in an appropriate speed ( ie National Emergency ) our ONLY world will get very hostile very quickly and there will NOT be any magic technology to save us.

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