Letter from America: Rethinking climate policy

11 Apr 2022

Despite its utopian elements, Kim Stanley Robinson’s sci-fi bestseller, Ministry for the Future, does not make easy reading, especially if you are an economist. The book starts in the near future with a massive heatwave in India, killing more than 20 million people. The book leaves the reader in no doubt that this is the result of continued emissions of greenhouse gases (GHGs) by industrialized nations, against all scientific evidence of their destructive effects. It also takes economists to task, for ignoring the problem of climate change and providing excuses to wealthy nations and powerful corporations to continue to destroy the climate.

While many might think we should not listen to criticisms of our discipline from a sci-fi writer, I think our profession, and perhaps the world, would be better off if we took note.

Climate change is one of the existential risks we are currently facing, and our profession has not taken it seriously. Global temperatures have increased by 1.2°C above pre-industrial levels, and promises in the COP26 meeting in Glasgow notwithstanding, some estimates see this trend continuing towards a 5°C increase in the next eight decades. Robinson’s book may be science fiction, but there is no doubt that billions of people’s lives will be severely impacted by climatic changes of this magnitude.

The economics profession has not entirely ignored the climate, and the number of papers on environmental issues has multiplied over the last two decades. There has even been a Nobel Prize awarded to William Nordhaus for environmental economics. Nevertheless, our profession’s approach has been woefully inadequate, in my opinion, for several reasons.

First, Nordhaus’s approach has become a benchmark, but has a built-in bias against meaningful climate action. Perhaps most importantly, it values future outcomes using an exponentially discounted utility - or social welfare - function. Following the common practice in macroeconomic models, it utilizes a (pure) discount rate of between 1% and 4%, in order to be consistent with a real rate of return of 6% to capital (under perfect capital markets). But this means that for all practical purposes, our objective function does not care too much about what happens in 100 years. For example, with a 4% discounting, it is not worth paying $17 million today in order to avoid a damage of $1 billion in 100 years. With such steep disregard for future generations, it is not surprising that the policy implications of early economic models are highly conservative.

In fact, Nordhaus himself viewed the conclusions that followed from this type of discounting as one of the main lessons from economic models, writing in 2007 “One of the major findings in the economics of climate change has been that efficient or ‘optimal’ economic policies to slow climate change involve modest rates of emissions reductions in the near term, followed by sharp reductions in the medium and long term.” These modest reductions are a direct consequence of the high rate of discounting: it is only worth paying costs of reducing future emissions in the future. Nordhaus was in fact criticizing the UK government report, led by Nick Stern, which called for more significant responses, precisely because it deviated from this type of aggressive discounting.

This debate raises a broader issue. Perhaps, aided by the climate change crisis, we should question the discounted welfare function when thinking about policies that impact the future.

The second problem with the conventional models of climate change, including those developed by Nordhaus, is that they ignore tipping points — meaning extreme adverse outcomes that occur once GHG concentration in the atmosphere or the temperature increases above preindustrial levels exceed a threshold. Tipping points are almost surely relevant, even if there is uncertainty about where the thresholds are, and some economic models have already incorporated them. But much more needs to be done here, especially since modeling the types of uncertainties and discontinuities that are naturally associated with tipping points will require new ways of thinking about economic dynamics and policy.

The third problem is equally important. The majority of the economic work on global warming does not take into account that what needs to change is the direction of technological progress. The trade-off is not between reducing production to cut emissions vs. increase production to reduce poverty. Rather, GHG emissions can be taxed heavily in order to induce a transition to clean energy. My own work shows that when this endogenous direction of technology is incorporated into our thinking, the nature of optimal economic policy changes significantly. There is now a reason for immediate action (delayed policy increases the gap between fossil fuel-based energy and clean technology that is currently behind). Even more importantly, optimal policy requires not just aggressive carbon taxes but also generous research subsidies to clean energy alternatives, such as renewables.

The final issue may be the deepest one. A cherished principle of economic policy comes from the Dutch economist Jan Tinbergen, and states that each policy instrument should focus on dealing with a well-defined source of market failure. It became conventional wisdom in economic policy that it is unwise to mix instruments. So to deal with GHG emissions, we should use a tool such as the carbon tax, and not distort other policies, including those that influence innovations or monetary policy.

This principle may need to be abandoned as a benchmark when dealing with systemic issues, such as climate change. In fact, the endogeneity of the direction of technology already tells us that carbon taxes need to be combined with policies that explicitly change the direction of innovation (between clean and dirty technologies).

But the issue is broader and deeper than that. Basic public finance theory is founded on competitive markets, so indirect effects working through competitive prices take the form of “pecuniary externalities” and tend to be second-order. This justifies their omission from the social welfare calculus. Economists, of course, know that competitive markets are a convenient simplifying assumption. Nevertheless, indirect effects are often still thought to be small. This no longer applies when we are dealing with systemic challenges.

We may need to develop an alternative, more holistic, perspective that recognizes that many instruments should be used when dealing with such systemic issues. In the case of climate change, this might mean that monetary and macroeconomic policy should explicitly recognize its impact on emissions; Covid-19 rescue funds should not go to airlines, or to car companies that have not invested enough in electric vehicles; and financial regulation should discourage credit going to oil and coal companies.

Ironically, Kim Stanley Robinson may have a few tricks to teach us: In the utopian part of his novel, transition away from fossil fuels is aided by a quantitative easing policy that creates new fiat money, “carbon coins”, distributed to producers and energy companies that cut fossil fuel emissions and generate clean energy.

Daron Acemoglu, 1 March 2022