The Stern Review and the role of benefit-cost analysis in climate change policy

March 9th, 2007 <-- by Joseph Aldy -->

Sir Nicholas Stern released in October 2006 the Stern Review: The Economics of Climate Change, the first major government-sponsored benefit-cost analysis of climate change. This report concludes that “the benefits of strong, early action on climate change outweigh the costs” – unmitigated climate change would impose damages equivalent to 5–20% of global per capita income, but stabilizing atmospheric greenhouse gas concentrations at 550 parts per million carbon equivalent would only cost the world about 1% of global GDP annually.

The Stern Review has received substantial attention in policy and academic circles. Stern testified before the U.S. Senate, and Resources for the Future and Yale University held symposia on the report. The Review of Environmental Economics and Policy will publish several papers reviewing the report. The Economist and the New York Times have reviewed the report. The Stern Review raises important questions about the evaluation and design of policy. Let me focus on just a few here – one on the benefits and one on the costs sides of the ledger, and two about policy design.

1. Do you care more about your grandchildren or your siblings?

In modeling the damages from climate change, Stern employed a very low social discount rate by assuming a near-zero rate of time preference (0.1%) and a modest benefit from a small increase in consumption. These two assumptions (recently defended by Stern) drive the conclusion that today’s generation should invest substantially in climate change mitigation for the future’s wealthier generations. Several economists have critiqued these assumptions, including Bill Nordhaus of Yale, Partha Dasgupta of Cambridge, and Marty Weitzman of Harvard. How much should we invest for 5 or 10 generations hence? How much should we invest for the poor of today? As Stern rightly points out, these are ethical questions. Stern’s analysis, as Nordhaus and Dasgupta point out, emphasizes fairness to future generations much more than fairness within our current generation. Placing more weight on intragenerational equity, consistent with many other economic analyses of climate policy, would commend a more modest climate policy – but make no mistake, any reasoned benefit-cost analysis of climate change would call for action now to limit greenhouse gas emissions.

2. Is it possible to be simultaneously optimistic and pessimistic about technology?

The Stern Review employs a so-called “bottom up” analysis of the costs of technology adoption through 2050 to generate its estimate that a 550 ppm stabilization goal would cost 1% of global GDP. Such analyses are valuable as a catalogue of the various feasible technologies for limiting emissions, but they do not adequately characterize economic behavior by firms and individuals. By failing to model the economy, these analyses do not account for interactions across markets that can also exacerbate costs, thereby yielding optimistically low costs. Such analyses are also pessimistic – they do not account for the economic incentives of higher prices (e.g., through an emissions trading program) that can induce innovation. Reducing greenhouse emissions will require substantial resources, but smart climate policies can also unleash the creativity to develop new technologies beyond the scope of current imagination.

3. Will governments implement the “smart” policies envisioned in the analysis?

One of the strengths of the Stern Review is its emphasis on policies that can achieve the greatest possible emissions abatement for a given cost. The least-cost policies require an efficient economy-wide emissions trading program or carbon tax. Auctioning emissions permits can further reduce the costs of climate policy by allowing governments to lower labor and income taxes. In contrast, the world’s largest greenhouse gas emissions trading program, the EU’s Emission Trading Scheme, covers only half of all EU sources and severely limits permit auctions – in phase one, only one-tenth of one percent of all permits were auctioned.

4. Can governments implement the “smart” policies envisioned in the analysis?

Is a global emissions trading program feasible? Is a harmonized global carbon tax feasible? With national sovereignty, how can countries develop multilateral agreements that would provide the proper incentives for participation and compliance? Can “small” trading programs – the EU ETS, the Regional Greenhouse Gas Initiative, the California law, Congressional proposals – evolve into a global regime that could deliver the substantial emissions abatement necessary to stabilize the global climate? The critical challenge lies in designing the international policy architecture to move the world to a more climate-friendly path of economic growth.

11 Responses to “The Stern Review and the role of benefit-cost analysis in climate change policy”

  1. Bruce Marshall Says:

    Who is the author of this note on the Stern review?

    [Response: I fixed the display. You should see who authored the post under the title now. Many thanks. -phiggins]

  2. Caspar Henderson Says:

    Some question whether stabilisation at 550ppmv will be enough to avoid “dangerous climate change” (e.g. an increase of more than 2C in global average temperature). For example: “Emission pathways leading to a 550ppm CO2e stabilisation are unlikely to meet the 2C target. In order to achieve such a target with a probability of more than 85% (60%) global greenhouse gas concentrations need to be stabilised at 400 (450) ppmv CO2e or lower.” (Michel den Elzen and Malte Meinhausen: Multi-gas emission pathways for meeting the EU 2C target in Defra 2006)

    Clive Bates and I have discussed this here: http://jebin08.blogspot.com/2007/02/21st-century-greenhouse-gas-budget.html and here http://baconbutty.blogspot.com/2007/02/climate-change-what-ipcc-tells-us-and.html)

    Others caution with regard to risks associated with stabilisation scenarios (see Stainforth et al: http://www.stabilisation2005.com/22_David_Stainforth.pdf)

    [Response: ALDY RESPONSE: The EU has stated a political goal of stabilizing atmospheric concentrations of greenhouse gases consistent with a temperature increase of no more than 2°C above pre-industrial level. The EU has also focused on a concentration stabilization goal of 550 ppm CO2-equivalent as a part of this effort. Uncertainties about climate sensitivity and various feedbacks complicate efforts to connect a given concentration level with a specific temperature increase. I will defer to the atmospheric scientists who can speak with greater authority about this. I will note, however, that the determination of “dangerous anthropogenic interference in the climate system”, as called for in the UN Framework Convention on Climate Change, is a fundamentally value-laden question. To understand what constitutes “dangerous interference,” we need to draw from a variety of disciplines to inform the public and their representative policy-makers. Economics can clearly play an important role in this by informing the public and policy-makers about the benefits and costs of climate change and actions that can be undertaken to mitigate the risks of climate change. END ALDY RESPONSE.]

  3. Jeff Norman Says:

    “any reasoned benefit-cost analysis of climate change would call for action now to limit greenhouse gas emissions”

    Is this an example of the “No true Scotsman” logical fallacy?

    Does this “benefit-cost” analysis include adaptation?

    I find it interesting that the author elected to emphasize the benefit side of what is normally termed a “cost-benefit” analysis.

    Have fun with your project.

    [Response: ALDY RESPONSE: Let me be clear about what I mean by a “reasoned benefit-cost analysis.” I would consider a reasoned benefit-cost analysis one that considers an array of options (not just extremes of the set of options, such as banning fossil fuel combustion tomorrow or do nothing), accounts for the latest climate science (including the uncertainties), and employs modeling assumptions that conform with historical observation. For example, Bill Nordhaus is critical of the modeling assumptions in the Stern Review, but he also finds in his most recent benefit-cost analysis that the optimal price for a ton of carbon in 2005 should have been $17 per ton of carbon (which is in the ballpark of 5 cents per gallon of gasoline and one-tenth of a cent per kilowatt-hour of electricity). In other words, a carbon tax at $17 per ton or carbon cap-and-trade program with a permit price of $17 per ton would have been preferred to what we had in the United States in 2005 – no regulation or tax on greenhouse gas emissions. The key question, to borrow from the work of Alan Manne and Rich Richels, is how much are we willing to pay for an insurance policy to deal with climate change? This is a tall challenge, considering that we do not have actuarial tables for the impacts of global climate change. But, I am not familiar with any formal benefit-cost analysis that suggests that the correct premium to pay is $0. The uncertainties of climate change commend taking action now; not inaction.]

    The issue of adaptation is important. The Stern Team indicates that their analysis does include some adaptation, although some critics such as Rob Mendelsohn of Yale University has challenged their accounting for adaptation. The Stern Team has provided a recent response here.]

    Finally, the term for this analytic tool goes by both benefit-cost analysis and cost-benefit analysis. In the U.S. Government, the term benefit-cost analysis is frequently used. END ALDY RESPONSE. ]

  4. John A Says:

    Stern’s analysis, as Nordhaus and Dasgupta point out, emphasizes fairness to future generations much more than fairness within our current generation. Placing more weight on intragenerational equity, consistent with many other economic analyses of climate policy, would commend a more modest climate policy – but make no mistake, any reasoned benefit-cost analysis of climate change would call for action now to limit greenhouse gas emissions.

    This is such a travesty of the arguments that it barely deserves a reasoned response. The analysis of Nordhaus and Dagupta is that the Stern Review’s discount rate is absurd and unrealistic. Added together with the Report’s slavish adherence to the most alarmist of predictions of Global Warming means that the Stern Report represents the most preposterous scenarios with the worst of all possible economic fixes to “fix” the problem.

    The first question is whether “greenhouses gases” are causing very much in the way of warming. The second is whether those changes are on balance deleterious, and the third is, if so, what are the cost/benefits of addressing them versus encouraging economic expansion.

    If you think the first is a given, then I’m afraid you’ve skipped the important part.

    [Response: ALDY RESPONSE: First, let me note that Scott Barrett’s recent post goes into more detail about the intergenerational/intragenerational tradeoff in the modeling assumptions in the Stern damage model. Second, climate scientists have concluded that climate change is occurring. The Intergovernmental Panel on Climate Change in its most recent assessment of the science stated: “Most of the observed increase in globally averaged temperatures since the mid-20th century is very likely due to the observed increase in anthropogenic greenhouse gas concentrations” (page 10). The IPCC has also concluded that the future will be warmer relative to current temperatures: “For example, the best estimate for the low scenario (B1) is 1.8°C (likely range is 1.1°C to 2.9°C), and the best estimate for the high scenario (A1FI) is 4.0°C (likely range is 2.4°C to 6.4°C)” (page 13). Third, the Stern Review does not advocate for the “worst of all possible economic fixes.” Despite all of its warts, the Stern Review does a good job reviewing the literature and proposing cost-effective policies to mitigate emissions, such as a carbon tax and a carbon cap-and-trade program. These are clearly superior in delivering emission reductions at least cost to policies that would mandate technology standards or impose a ban on the use of specific fossil fuels. The basic problem with climate change is that individuals and firms do not bear any cost for imposing damages on the global climate through their emissions of greenhouse gases. “Putting a price” on carbon, via a tax or cap-and-trade program, would correct this problem and provide the proper incentive for the abatement of these emissions. END ALDY RESPONSE.]

  5. Bill Wadford Says:

    One should take the “Stern Review” with a gain of salt. The author himself has conceded that uncertainties remain on both the science and economics of climate change.
    For a different take see:
    Bjorn Lomborg, “Stern Review,” Wall Street Journal, November 2, 2006

  6. Paulina Essunger Says:

    “The least-cost policies require an efficient economy-wide emissions trading program or carbon tax. Auctioning emissions permits can further reduce the costs of climate policy by allowing governments to lower labor and income taxes.”

    Could you please say a bit more about this? Yes, auctioning permits is better than giving them away. But I’m not clear on why auctioning permits “can further reduce costs” when compared to a carbon tax. Why wouldn’t a carbon tax also allow for lowered labor and income taxes? Perhaps I’m just misinterpreting the text or else missing something, but please let me know.

    Thanks,
    Paulina

    [Response: ALDY RESPONSE: I was not clear in this text. You are correct that a carbon tax would also provide revenues to allow the government to reduce labor and income taxes. My intended comparison was between a system that gave away emission permits versus a system that auctioned emission permits. My colleague Ian Parry has written substantially on this topic, and I recommend his 2002 paper as a good initial, non-technical take on this issue. END ALDY RESPONSE.]

  7. David Schnare Says:

    Previous post was incomplete. Here is the intended post.

    The gravitas of the Stern Report rests entirely with his choice of discount rate. He has previously been rebuked about his use of worst case assumptions, including the increasingly discredited assumption that greenhouse cases are the predominant driver of forecast temperature changes. Nevertheless, if we assume the worst, it all comes back to discount rate.

    In effect, Stern argues for spending the money to cut emissions because future generations have as much claim on our resources today as current generations. This argument is nonsense. As David Leonhardt, of the New York Times, points out, “The problem is that none of us actually behave this way.” (Although the original posting mentions the Yale discussion and the forthcoming journal articles, a serious writer would have provided links. Here are two valuable links to this issue: Yale symposium – http://www.ycsg.yale.edu/activities/events_video.html
    William Nordhaus’s Response http://nordhaus.econ.yale.edu/SternReviewD2.pdf)

    To resume, we will not grant our children and grandchildren the same status as we do ourselves because we have no confidence that the alarmism is real and no basis for any confidence. Choice of discount rates decends as much from our expectation of future pay-off as from the amount of that future profit, and, as Harvard economist Martin L. Weitzman explained, with regard to global warming, and particularly with regard to the economics of climate change, “If ever there was an example where there was uncertainty, this is it.” (Heres a link to the excellent Weitzman article: http://www.economics.harvard.edu/faculty/Weitzman/papers/JELSternReport.pdf)

    If we are to take the Stern report for real, the proper question is not numbers (2,3 or 4) above. The proper question is this: What do you do if you think the end of civilization is at hand?

    Short answer – take sensible steps toward adaptation, ones that themselves will create future profit, regardless of whether or not the alarmist predictions are true. For a more complete discussion of this (with comments from others) see: TheHardLook.com and specifically, follow this link: http://thehardlook.typepad.com/thehardlook/2007/02/an_inconvenient.html

    If there is one thing we should NOT do, it is to waste effort on trying to prevent warming through unilateral governmental control of greenhouse gases by the western society. China’s growth will erase every reduction we might make in the west. And, to deny Africa the opportunity to develop is simply racist, yet only by doing so would the west’s preventive controls have any meaning. Finally, even if we met the Kyoto goals, it would do no more than push off the warming by three years.

    [Response: ALDY RESPONSE: An optimal climate policy should include a broad set of policies, including those promoting adaptation, emissions mitigation, and long-term R&D. There is no policy or technological silver bullet. No one policy is sufficient to mitigate the impacts of climate change. Focusing on just one policy option, such as adaptation, risks spending too much for the benefits from adaptation and too little on the benefits from emissions mitigation. Developed countries can take action now to mitigate their emissions and not have to worry that every ton of abatement in their programs would be offset by an increased ton of emissions in China. To say that there would be no so-called “emissions leakage” would also be incorrect, but well-designed policies in developed countries – such as a cost-effective carbon tax or cap-and-trade program across the entire economy with modest near-term targets – would limit the extent of this leakage. Regarding uncertainty, Weitzman makes several key points on this issue. First, uncertainty about the future discount rate commends the use of an effectively lower discount rate than what would be used if we knew the long-term discount rate with certainty. Second, uncertainty about climate impacts – especially climate catastrophes – suggests that we should put more weight on them in our analysis. This second point is why Weitzman concludes that the Stern Review may be “right for the wrong reasons.” In other words, Weitzman has doubts about the choice of parameters that drive the low social discount rate in the Stern analysis, but believes that uncertainty about possible climate catastrophes supports the view that action should be taken now to mitigate climate change risks (and specifically lauds the Review’s call for putting a price on carbon via a tax or cap-and-trade program). Finally, thank you for providing the Yale link – the Yale Center for Globalization had only posted a press release at the time that I drafted that part of my post. And for those interested in the various papers referred to in my post, click on the names of the economists – Nordhaus, Dasgupta, and Weitzman – these take you to their commentaries on the Stern Review. The U.S. Senate link also provides links to the testimonies by Jake Jacoby of MIT and Gary Yohe of Wesleyan on the Stern Review. My apology if this was not clear to all readers. END ALDY RESPONSE.]

  8. Hans Erren Says:

    cost-effective, clean and reliable?
    Nuclear, nuclear and nuclear

    Don’t waste your money on sun and wind.

  9. Nigel Goddard Says:

    The argument that China and India emissions will dwarf ours is misdirected. True, they will. So it is in our interest to act to reduce their as well as our future emissions (if you believe the IPCC – and if you don’t then why are you wasting your time reading this?). Since for the majority of the world’s population, including China and India and not insignificant fractions of developed societies, poverty and economic security are much more immediate and central concerns than climate change, the rich (us) are going to have to pay them to act in our interest (which eventually they will realise is their interest too – and that’s happening already to some extent). It seems that industrial society may finally have given the poor a stick to beat the rich over the head with! Or perhaps a better metaphor would be a pot of water to slowly boil the rich in (slowly enough we don’t notice until it is too late).

  10. Nigel Goddard Says:

    “The critical challenge lies in designing the international policy architecture to move the world to a more climate-friendly path of economic growth.”

    There is also the nagging question of whether conventional notions of economic growth can ever be climate-friendly. Ignoring development of non-earth resources, we are stuck with this planet. It is a closed system (other than radiation input/output). We may be able to design an economic system that includes growth for ever and ever, but it would have to cost in every use of resources and planetary support systems. And the only way to do that in a principled manner is to build models of the entire planet and economy so that the (predicted) effect of resource use can be determined – hence giving prices for non-market resources like fisheries and oxygen. Since market systems allocate production to those enterprises that use costed resources most efficiently (in theory), if we can cost all the resources then we may be able to retain market economics and economic growth as organizing principles. But it basically means we are going to have to instrument the entire planet and every aspect of the economy and run really, really giant computer models of the whole system.

    Another alternative is to abandon economic growth as an objective once per-capita income is over some level (studies suggest $10,000 -$12,000 per annum). Past that point the studies show measures of welfare don’t increase much with income – it’s mostly just keeping up with the Jones’s, ie improving relative position. So while the developing and underdeveloped world should keep on pursuing economic growth, the developed world should turn to other goals, including making sure everyone has the cut-off point of income.) It’s not clear how to get to there from here!

  11. Anonymous Says:

    Many of the options offered by “Green” movements around the world are not userfriendly to the environment,very costly, and increase CO2 output. For examaple biofuels drive up the cost of living for everyone due to the fact that more carbon energy is required to produce 1 gallion of biofuel than it prevents. Growing corn takes a lot of fuel consumption and to plant and is 1/3 less efficent that regular gasoline. Croplands put into corn prevent the planting of food crops due to government incentives thus driving up the cost of food. All of this for naught as the Space and Science Research Center just released a major news release on July 1, 2008 catagorically delcaring that global cooling has begun in earnest. This release can be read at; http://www.spaceandscience.net/id16.html. The Space and Science Center represents many highly qualified Astro-physicist PHD’s whose job is to get research accurate and right. I do not think that I will be investing in land in Anartica to build a nudist camp anytime soon.

Leave a Reply


Close
E-mail It