Stern report’s key concepts

In: Uncategorized

8 Nov 2006

There follows a news analysis I wrote for the 6 November issue of Fund Strategy on the Stern report on the economics of climate change. Rather than taking a polemical line it simply outlines some of the key concepts in the report:

Despite the massive coverage of the Stern review on the economics of climate change, many of its key arguments have hardly been scrutinised. The discussion tends to focus on scary scenarios of what climate change could mean and proposals for solving the problem.

Relatively little attention has been paid to the link between the perceived problem and the proposed solutions. Yet economic reasoning, especially in relation to risk and uncertainty, is central to the discussion.

From the first page onwards there are striking claims that have not been properly investigated. On the first page of the main report the premise of its argument is stated baldly: “Climate change presents a unique challenge for economics: it is the greatest example of market failure we have ever seen.”

Such a claim would have been inconceivable a few years ago. In the days of the battle between capitalism and socialism it is hard to imagine a British government report conceding such a massive market failure.

Of course, Sir Nicholas Stern, the main author of the report and a former chief economist at the World Bank, is not advocating the replacement of the market with a socialist society. But his premise leads to the conclusion that intervention is needed to mitigate the impact of climate change.

This market failure takes the form of the existence of massive externalities related to climate change. For the benefit of those who have notstudied economics, an externality is a cost that is not embodied in the price of a good or service. For example, it could be argued that the environmental cost of carbonemissions from a car does not reflect the price paid to purchase and run the vehicle.

Externalities have gone from a relatively marginal concept in economics to centre stage. Both free marketeers and people who would regard themselves as more to the left often see externalities as central to their economic analysis nowadays. The debate tends to be more on how to reduce such externalities rather than on whether they are a useful way to conceptualise the impact of climate change.

From these assumptions the proposals put forward to tackle the problem of climate change follow logically. Stern proposes three sets of measures to mitigate the impact of change:

• Carbon pricing through tax, emissions trading or regulation. The effect of pricing is to make users pay the full costs of their energy use. For example, a green tax could raise the amount spent to run a car in line with the full environmental costs.

• Technology policy involves the use of new forms of low-carbon technology to reduce carbon emissions. For instance, forms of energy such as hydroelectric, nuclear, wind power and solar do not emit greenhouse gases. Technology is also available to capture carbon dioxide – for instance, at power stations – and store it.

• Public education to change behaviour. This includes all sorts of measures to encourage people to use energy in a more frugal and efficient way.

Although it has received little attention the report also sees a role for adaptation in coping with global warming. Such measures could include building modern flood defences and moving human settlements to higher ground. Although such moves would not stop climate change, they would reduce its impact on humanity.

Getting these policies implemented on a global scale is examined as a “collective action problem”. In other words, although everyone has an interest in mitigating climate change, individual nations also have an interest in “free riding” on others. Britain, for instance, could bear the costs of tackling climate change while another country could decide to let others take the burden. To examine this question the report enters arcane academic areas such as game theory and the prisoner’s dilemma game.

The report suggests several ways to overcome the collective action problem. These include developing a shared understanding of long-term goals for climate policy, building institutions for cooperation and creating conditions for collective action. Building on existing arrangements, such as the UN Framework Convention on Climate Change and the Kyoto Protocol, is seen is an important part of the process.

[Separate article in box]

Change or Catastophe?

One of the most confusing things about the discussion of global warming is the muddling of climate change with climate catastrophe. There is a broad scientific consensus that the earth is warming and that humans have played a role in the process. The idea that we are on the verge of a climate catastrophe is more controversial among scientists.

Even more confusingly, the British government and the Stern review do not agree on the question of climate catastrophe. The government, virtually unnoticed, has publicly committed itself to the idea of catastrophe. Tony Blair, along with his Dutch counterpart, Jan Peter Balkenende, recently wrote an open letter arguing that: “We have only 10-15 years to take the steps we need to avoid catastrophic tipping points.”

In contrast, the Stern review uses the scientific notion of feedbacks rather than the popular idea of a “tipping point”. It is also far more tentative than the government in its conclusions: “In the future, climate change itself could trigger increases in greenhouse gases in the atmosphere, further amplifying warming. These potentially powerful feedbacks are less well understood and are only beginning to be quantified” (p10). So for the Stern report the existence of feedbacks is uncertain rather than settled.

However, Stern comes to similar conclusions to Blair by invoking the precautionary principle in relation to uncertainty. Although the existence of powerful feedbacks is unclear, it is seen as prudent to act as if the world is facing catastrophe. Therefore, for Stern it makes sense to act as if a catastrophe is imminent even though it may not be. As the report argues: “Uncertainty is an argument for a more, not less, demanding goal, because of the size of the adverse climate change impacts in the worst-case scenarios” (pxvii).