Bridge over ocean
1 January 2018 CFA Institute Journal Review

The Economics of the Climate (Digest Summary)

  1. Butt Man-Kit, CFA

Global warming could be disastrous to productivity and inflict massive costs on society in the future. Policymakers must strike a balance between economic growth and environmental sustainability. This decision is not easy to make because of uncertainties in constructing forecasts, choosing model parameters, and building international trust. The author reviews the major literature in this area and recommends specific policy choices.

How Is This Research Useful to Practitioners?

The use of fossil fuels converts oxygen into carbon dioxide. These greenhouse gases boost the global mean surface temperature (GMST). Research has shown that a one-degree (Celsius) increase could lead to a decrease in output of 2%–4%. A five-degree increase could drag agricultural output down by 50%. Consuming more today through exploitation of fossil fuels implies future economic loss. Therefore, policymakers face trade-offs between current consumption and future consumption.

Governments could optimize climate policies by using cost–benefit analysis to compare the discounted utilities of various policies. A few challenges must be overcome to make the analysis reliable. First, it is not easy to estimate the social discount rate, which converts future consumption into present value. A lower discount rate values future consumption more and is prone to environment-friendly climate policies. Because the discount rate is partly an ethical and partly a political parameter, it cannot be determined conclusively. Second, economists use a damage function to estimate the output losses from climate change, but there is no consensus on the specification of the damage function.

The estimation becomes more complicated when scientists are uncertain about the climate models. Most of these models are nonlinear and thus very sensitive to inputs, which makes the estimates vary widely. Integrated assessment models (IAMs)—formed by integrating a climate model with a damage function—are used to relate temperature changes to the corresponding economic losses. The author notes that although IAMs can provide qualitative insight, they provide less accurate quantitative insight into understanding how complex systems behave.

Despite uncertain forecasts, the author still advocates strong action to abate greenhouse gas emissions, because in the last few years, estimates of the damage function have only gone up, making the future look even bleaker. And there is a chance (around 2%–10%) that the GMST could rise by six degrees in this century, with catastrophic consequences.

Although the author does not directly relate climate change to investment analysis, these findings and the degree of regulatory interventions could have a significant impact on the inputs and outputs of long-range macroeconomic and security valuation models.

How Did the Author Conduct This Research?

The author reviews the major challenges faced in studying the economics of climate. He describes, evaluates, and critiques prior research, particularly the literature on the choice of discount rate, uncertainty in climate models, and the problems of IAMs. After consolidating these prior findings, the author discusses policy choice.

The economics of the climate was first studied in 1960. Owing to the complexity of the problem, few tools were available to analyze it. Two seminal books in this area—Sustainability for a Warming Planet (Harvard University Press 2015) and Climate Shock: The Economic Consequences of a Hotter Planet (Princeton University Press 2015)—address key issues and provide insights into forming climate policy.

One of the major contributions of Sustainability for a Warming Planet was to drop the damage function in IAMs, replacing it with a globally accepted constraint. The proposed constraint does not allow any GMST increase to exceed two degrees, which ensures no major damage to the environment. This simple suggestion shifts our attention away from the endless disputes about the damage function. And Climate Shock reminds us that the tail risk of climate change, with its devastating impacts, should not be overlooked.

Abstractor’s Viewpoint

As the author mentions, natural capital is limited and cannot be fully replaced with other forms of capital. In my opinion, the depletion of natural capital caused by climate change would also reduce the marginal products of other factors of production, especially in industries that rely heavily on natural resources. Investors should evaluate the “weather sensitivity” of possible investments and request higher risk premiums if necessary.

Governments all over the world are now using market-based tools to regulate such carbon emission activities as pollution taxes and tradable pollution permits, which penalize firms that have high levels of pollution. The cost of taxes and permits eventually reduces the profitability of the business. ESG (environmental, social, and governance) ratings can help investors screen out firms with high pollution costs.

Climate change may create some opportunities for the finance industry. For example, firms could raise capital by issuing social impact bonds, in which the coupon rate is contingent on the carbon footprint. Governments can be the lead investors in such bonds, which provide firms with incentives to strike a balance between business development and carbon reduction.

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