Climate Change Economics

Our February energy meeting was on the subject of climate change economics and specifically the Weitzman Nordhaus debate that was conducted in a series of papers in 2009: Weitzman, Nordhaus, Weitzman.

This debate is on the treatment of low probability, high impact events in cost benefit analysis (CBA). The standard approach to climate change economics as pioneered by Nordhaus is essentially deterministic. It evaluates the price of carbon that a social planner would have to set in order to implement the policy programme that maximises their objective function (usually lifetime CRRA utility), in a world where high temperatures damage production and production in the absence of abatement technology causes high temperatures. Weitzman's contribution was to show that if instead of calculating the carbon price by putting central assumptions into a deterministic model, we took the expected value of the carbon price given our uncertainty on the assumptions, then the price should be infinite.

This is a consequence of there being some non-zero probability of catastrophe and our infinite valuation of zero consumption (which is what catastrophe equates to in this framework). That there is a non-zero probability of catastrophe seems to be unarguable (*), so if we are to argue for anything other than the entirety of current output going towards climate change mitigation and prevention, then we must be arguing with some feature of the CBA framework. This also applies to other catastrophe risk like asteroid impacts. See also Millner and Ikefuji et al for recent work in this area.

A solution to the problem of infinite results is is to truncate the valuation of bad events i.e. so that we value another unit of consumption when we have a very low consumption level at a high but not infinitely high rate. However Weitzman shows that this truncation becomes the dominant factor in the CBA calculation (so for example the size of the median impact does not really effect the calculation, all weight is put on the impact at the extreme downside). This may be true (avoiding catastrophe perhaps should indeed be the policy target) but it is contrary to our usual understanding of the value of an investment program (e.g. the value that we might put on a company share will be closely related to the expected income stream rather than the tail of the income stream distribution).

An interesting side-issue to this debate is that Nordhaus's 1996 paper, 'The Value of Scientific Knowledge' which has a limited monte-carlo simulation of the deterministic CBA model, produces much higher estimates for the cost. My suspicion is that the value so produced was actually a function of the size of the grid over which it was estimated, and that as the grid got larger and more representative of the distribution of the parameters of the model, the the value would also have tended to infinity.

The criticisms that Weitzman effectively makes of the standard approach to climate change economics seem valid to me. However, my main problem with these models is that they produce 'optimal' projections of output, consumption, emissions and atmospheric CO2 that leads to CO2 concentration peaking at over 650ppm (see figure 5.7 of Nordhaus's 'A Question of Balance'). Despite the claimed inputs from IPCC projections etc to Nordhaus's models, I don't believe that many climate scientists would agree that this represented an optimum (see Hansen et al 2008) - rather it's a prescription for passing tipping points which are not in Nordhaus's models.

(*) Two recommendations for books credibly outlining future catastrophe:
# Hansen 'Storms of my Grandchildren' (2009)
Hansen is a climate scientist who has basically turned into an activist because he is so concerned. Has testified to Congress on numerous occassions. Works for NASA. Very credible guy who's at the top of his profession. A section from this book is copied below (**).
# Ward 'Under a Green Sky' (2008)
Ward is a paleontologist and astrobiologist who has studied mass extinctions and concluded that most of the extinction events in the geological record are 'greenhouse extinctions' associated with anoxic oceans. An amazon review (from the above link) outlines the thesis:
"That an asteroid caused the mass extinction at the end of the Cretaceous period is widely accepted and also widely disseminated to the public. Less well known to the public are the other mass extinctions. Ward contends that they all have a common cause: climate change caused by carbon dioxide increase. This can in turn release methane (a more powerful greenhouse gas than carbon dioxide) from methane hydrates creating a runaway effect. At the end of the Permian period 250 million years ago this was severe enough to kill over 90% of all species on Earth.
Now Ward is not the first to relate the devastation of the Permian-Triassic extinction to modern day human-induced climate change to show us what could happen (see for example When Life Nearly Died: The Greatest Mass Extinction of All Time), but just when you thought that the devastation could not possibly get any worse, Ward introduces a new element into the equation: photosynthetic sulphur bacteria.
The effects of the climate change causes the oceans to become increasingly anoxic. In these conditions the only life to thrive is sulphur-producing bacteria. The boundary between the oxygenated and anoxic water comes closer and closer to the surface, to the point where photosynthetic sulphur bacteria, which use the sulphur from below, thrive in the surface waters and give off large quantities of hydrogen sulphide. Apart from being very poisonous in itself to surface life, the hydrogen sulphide also destroys the ozone layer of the Earth. Ward paints a picture of the Earth at the end of the Permian: most life is dead; the oceans are purple from a thick layer of bacteria; the hydrogen sulphide has changed chemistry of the atmosphere such that cloud formation has altered drastically - clouds form in the upper atmosphere far above where clouds normally form, giving the sky a green colour."
Also consistent with this thesis is the recent New Scientist news story that almost all the fish in the sea have fresh water ancestors.

(**) "As global warming continues, storm effects will ratchet upward in three major ways. One of these ratchetings will be the development of more powerful and destructive midlatitude or frontal cyclones. Frontal storms will be more powerful, because they depend upon the temperature difference between the cold and warm air masses as well upon the amount of moisture in the atmosphere behind a warm front. This intensification of frontal cyclones will be an effect of melting ice sheets, once ice sheets begin to disintegrate rapidly enough to keep regional ocean surface temperature from rising as fast as continental temperatures and temperatures at lower latitudes. The most important point is that there will be places and occasions in which the warm air masses will be loaded with far more water vapour than would be the case in a cooler world. ...

This first ratcheting, though, will pale in comparison to the effects of the second ratcheting: when ice sheets' rapid disintegration causes a sea level rise measured in meters. ...

Ice sheets eventually begin to disintegrate at rates of several meters of sea level per century, even with the slow pace at which natural climate forcings change. But predicting when ice sheet mass loss will accelerate in the twenty-first century is a notoriously difficult ``nonlinear'' problem. We could "lock in" disastrous sea level rise very soon, that is, create conditions that guarantee its occurrence, but it is likely to be several decades before a rapid sea level rise begins. On the other hand, we have been surprised by how fast some other climate changes have occurred - such as disappearance of Arctic sea ice ... For the moment, the best estimate I can make of when large sea level change will begin is during the lifetime of my grandchildren - or perhaps your children. ...

With the combination of a higher sea level, even of only a meter or so, and increased storm strength, the consequences of future storms will be horrendous to contemplate. ... Social and economic devastation could be unprecedented. It is not necessary to put the entire island of Manhattan under water to make the city dysfunctional and, given prospects for continuing sea level rise, unsuitable for redevelopment. ...

The timing of the third ratcheting effect of global warming, the melting of methane hydrates, is as unpredictable as the others. Warning signs are beginning to appear already, with bubbling of methane from melting tundra and from the seafloor on continental shelves. So far the amounts of methane released in this way have been small. The methane hydrates of greatest concern are those in sediments on the ocean floor, because of their great volume. ...

The flooding of the ocean floor with warmer Pacific Ocean water may have been a key factor in the melting of methane hydrates during the PETM [Paleocene-Eocene Thermal Maximum - 54 million years ago, when temperatures suddenly (i.e. over millennial rather than geological timescales) rose by between 5 and 9 degC]. Could a change of ocean circulation happen again in the near future? Global models of today's climate sometimes have a problem with spurious formation of deep water in the Pacific Ocean, which suggests that it would not take much change in the densities of ocean surface waters to alter the location of deep water formation. The instigation for such a change could be freshwater additions to both the North Atlantic and Antarctic Oceans, after the rate of ice sheet disintegration in both hemispheres has reached high levels. ...

When deep water formation begins in the Pacific Ocean, the inertia of the climate system, specifically ocean circulation, will be far too great for humans to stop, even if social systems are still in order. Once large sea level rises begin to devastate coastal cities around the world, creating hundreds of millions of refugees, there may be a breakdown of global governance. But regardless of that, if ocean circulation changes, such that warmer Pacific Ocean water begins sinking to the ocean floor and melting methane hydrates, there will be no plausible way for humans to reverse that change of ocean circulation.

While we can't predict the details of short-term human history, changes will be momentous. China, despite its growing economic power, will have great difficulties as hundreds of millions of Chinese are displaced by rising seas. With the submersion of Florida and coastal cities, the United States may be equally stressed. Other nations will face greater or lesser impacts. Given global interdependencies, there may be a threat of collapse of economic and social systems.

Physical science is easier to foresee. While the timing of the three ratcheting effects is difficult to predict, their effects are not. With methane hydrate emissions added on top of those from conventional and unconventional fossil fuels, the future is clear. Diminishing feedbacks that help to keep the magnitude of natural long-term climate changes within bounds, such as the ability of the long-term carbon cycle to limit atmospheric carbon dioxide, will have no time to counter amplifying feedbacks. The huge planetary energy imbalance caused by the high levels of atmospheric carbon dioxide and methane will take care of any remaining ice in a hurry. The planet will quickly get on the Venus Express. ...

A devastated, sweltering Earth purged of life may read like far-fetched science fiction. Yet its central hypothesis is a tragic certainty - continued unfettered burning of all fossil fuels will cause the climate system to pass tipping points, such that we hand our children and grandchildren a dynamic situation that is out of their control.''

End February Links

Money as store of wealth
Defending Independent Invention
Competitiveness is about capital much more than labor
Incentives Doublethink

One of the finest economics posts of all time

For my own future reference, a link to Noah Smith's post.

The Economics of Independence

I don't know, but perhaps the expectation that there are "tremendously negative economic consequences for Scotland" with independence, is the mainstream view? [Quote from an international MSc Economics student]. Is this a reasonable view? Let's analyse this from both short run and long run perspectives.

In the short run surely the most relevant way to answer the question is to take Scotland's capital stock and productivity as given and look at its current fiscal and external position relative to the UK as a whole. The fiscal position according to the latest GERS report (see p26) is that Scotland was running a net fiscal balance deficit of 10.6% in 2009-10 relative to a UK net fiscal balance deficit of 11.1%. So whilst neither Scotland nor the UK have particularly healthy public sector finances, the current situation reflects a small fiscal transfer (approximately 0.5% of Scottish GDP) from Scotland to the rest of the UK (this includes a geographic share of North Sea oil revenues).

Scotland's external position, its trade deficit, is in a similar position: it's not great, but it's not quite as bad as the position of the UK as whole (again taking the North Sea into account). The other short run indicator we might look at is productivity, here again Scotland does relatively well as the third highest ranked region of the UK in GVA per capita terms (after Greater London (which to be fair is way out in front), and SE England). The short run position then is fairly clear. Whilst independence could be associated with some transaction costs (in the main these will be job creating transaction costs since they will be incurred due to the fact that some functions of government have to be created here), the fiscal, external and productivity positions suggest that the economic situation would be broadly unchanged.

The other issue that impacts on the short run, but also on the long run, is monetary policy. The eurozone crisis has highlighted the risks of monetary union without fiscal integration - which given the stated policy of keeping Sterling initially, looks like an economic cost of independence. However, as Martin Wolf at the FT (and others) have pointed out, the best predictor of difficulties within the eurozone was balance of payments problems, where at a fixed price (exchange rate) the peripheral nations were net importers of goods and services funded by capital flows from the core. Scotland is not in this position: our economy is 'pre-adjusted' to this fixed exchange rate, and there are not massive balance of payments imbalances. Eventually, with policy divergence, this currency arrangement may no longer be appropriate. However, by then we will have a government with the power to change it and either join a reformed supranational currency area (Sterling or Euro) with transfer payments, or start a Scottish currency.

This brings us on to the long run. Energy resources and a favourable long term climate situation, as well as other advantages like a strong university sector and ownership of the Scotch label for putting on bottles of whisky(*) suggest that Scotland has the resources to prosper in the long term, at least as well as any other country of similar size. But what about the effects of being part of a country of 5 million relative to being part of a country of 60 million?

Economic theory, in the main, is pro free trade and the regime in which trade is free-est is within a single state/regulatory area. This theory underpins international moves towards globalisation, reductions in trade barriers and the creation of the EU and NAFTA etc. Two important contributions to these theories are increasing returns to scale, and a survival of the fittest mechanism that leads to only the more efficient firms surviving in larger economies. Both these mechanisms have a persuasive appeal and probably apply to some extent. However, if they were the dominant effects then we would expect to see a systematic effect of larger countries being wealthier than smaller countries. We do not see this relationship which suggests that there must be offsetting benefits that come with being small.

My favourite mechanism by which Scotland could benefit economically from independence is to do with agglomeration and increasing returns to scale. Currently I think that large UK companies are 'agglomerating' head office functions in London to realise economies of scale. This may produce some private efficiencies, but it has social costs at the level of the lifestyles that it imposes upon the workers in London (2 hour commutes for City workers, impossible living costs for public servants, and monopoly rents paid to landowners) and at the level of career opportunities that it leaves for people outwith London (move to London or never reach the top). I believe Scottish independence could lead to some companies 'agglomerating' their head office functions near policymakers in Scotland, so that we have a self-sustaining business ecology here too.

There are other arguments that follow from analogy with ecology, for example: multi-polar centres of power, or a diversity of localities with political and economic power, could lead to a diversity of opinions and strategies. In the same way as genetic and species diversity leads to robust ecosystems, a diversity of economic strategies, policies and companies is more likely to lead to a robust global economy.

Therefore, the main conclusion that I draw on the subject of the economics of independence for Scotland, is that the evidence is probably consistent with making an argument in either direction, but that the central expectation should probably be for little impact either way. Independence or union are both economically feasible, and our choice between these options is political rather than economic.

(*) Personally I think this is overvalued but if other countries are willing, in aggregate, to pay vast sums for a product that could be produced anywhere but just not labelled 'Scotch' then that's up to them!

Modelling Peak Oil

On Wednesday 18th January we had another of our Energy Journal Club meetings. Sean was talking about Hamilton (2011) - Oil Prices, Exhaustible Resources, and Economic Growth, Jelte talked to Murphy & Hall (2010) - Year in review—EROI or energy return on (energy) invested, Sebastian covered Greene et al (2005) - Have we run out of oil yet? Oil peaking analysis from an optimist’s perspective, Erkal spoke to Hamilton (2005) - Oil and the Macroeconomy, and I talked about Holland (2008) - Modeling Peak Oil.

To summarise the Holland paper:
# It started from the usual no-arbitrage Hotellings condition (prices must move in such a way so that the owners of exhaustible natural resources are indifferent between: extracting the resources, selling them and investing the financial proceeds;  and just sitting on the unextracted resources), but presented 4 models that were sufficient to generate a peak in production. You may have thought that since oil production started from zero in the mid nineteenth century and rose to the present day, and since oil is a finite resource, then any good model would show a peak in production. But most economic models of the oil market, including the basic Hotelling model, have peak production at time zero since this is when prices are lowest and demand is highest.
# The 4 models are models of cost reductions through technological change, demand growth, endogenous reserve additions, and site development. This last model in particular is novel to this paper, and is consistent with the story described in Hamilton (2011) - Oil Prices, Exhaustible Resources, and Economic Growth.
# I have two objections to this paper:
(a) It uses a partial equilibrium approach. This means that the interest rate, that the Hotelling mechanism says is the rate at which the oil price rises, is independent of the aggregate oil supply.
(b) It assumes that oil that is uneconomic to exploit now will be economic to exploit at a higher price. This ignores the possibility that the capital goods with which this future oil can be exploited do not change in price (or at least that their price doesn't rise faster than the oil price).

I'm being slightly unfair in my objections since the paper is following standard assumptions in the literature. However these objections essentially form the basis of my own work.

Limits To Growth

The New Scientist recently had an article on Limits To Growth, and this week's issue features a letter from me in response to this article. They've edited my letter somewhat, the original is reproduced below:

"The article states that economists' objections were that future innovation was not included in the model. This is to misrepresent economists' concerns to a certain extent: what is missing from LTG are prices and incentives.

LTG is essentially a 'fixed factor' model so that output is associated with certain inputs. Assuming a path for output and some endowment of input factors, we can always make the model overshoot and collapse, no matter how abundant we choose these input factors to be.

Economic models on the other hand require that these inputs be purchased by the sectors creating output. Under standard assumptions, scarcity drives up prices - a continuously rising price may spur innovation, but if it doesn't then it will instead restrict demand. Rising prices incentivise innovation, substitution or a smooth contraction in activity. Because of this, it is quite hard to construct an economic model that displays overshoot and collapse i.e. in most economic models we are automatically in the 'stabilising scenario'.

I think LTG is likely to prove closer to the truth than e.g. the endogenous growth models with exhaustible resources of Dasgupta & Heal, Stiglitz, and Solow. However, this is not because LTG is right and economists are wrong. It is because prices and and incentives have not responded to the finite nature of resources in a manner consistent with a model with rational and perfectly foresighted agents. These are wrong assumptions in much the same way that a model without prices and incentives contains the wrong assumptions.

Non-economists will get nowhere in convincing the economists, by producing models that lack economic mechanisms and incentives. Instead economists and non-economists alike have to work together to tease out the correct economic mechanisms and incentives."

Just Testing

Just testing whether I can put videos into this blog - but I'm sure there's an economics angle here: asymmetric information maybe...