The Economics of Climate Change

We are now moving into the part of the course where we examine some topical issues in the area of energy and environmental economics. There is currently no issue in this sphere that is more topical, and of greater importance, than that of climate change. If you work, or desire to work, in the energy sector, it is safe to say that this will be the largest issue that you face. Regardless of one's stance on the issue, it is going to be there.

We will start by going through a few of the physical basics underpinning the concept of climate change. We will then examine some of the considerations that exist in this area.

The basics: we start with something called the Greenhouse Effect. Inbound solar radiation (energy from the sun) has short wavelengths and high energy contents. The wavelength is typically less than 4 µm. This energy, in the form of radiation, passes through the atmosphere. Some of the energy is absorbed by the ground, causing the ground to warm up (which, in turn, warms the air), and some of the energy is reflected back towards space. As it reflects off the earth’s surface, some of the energy is absorbed as heating and the resulting reflected radiation has lower energy levels and longer wavelengths, of 4-100 µm. The atmosphere is basically transparent to incoming radiation, letting about 50% through, but it is not transparent to the reflected waves, and about 80% of the outgoing radiation is trapped in the lower troposphere. The troposphere is the layer of the atmosphere closest to the earth's surface, extending up about 12 miles at the equator and about 4 miles at the poles. It is the layer of the atmosphere that contains clouds as well as most of the suspended particulate matter in the environment. The troposphere gets colder as you go upwards, which means that it is a very turbulent layer - because warm air rises, there is a lot of mixing in the troposphere.

As mentioned above, the troposphere is not transparent to the lower-energy reflected solar radiation, and more of this radiation is trapped in the troposphere. This energy sort of hits a roadblock, and just piles up. This extra energy causes the troposphere to warm up, which eventually causes warming of the surface. This is why it is called the "Greenhouse" effect: in a greenhouse, panes of glass stop heat from rising out of the building, keeping the inside warmer and allowing us to grow plants in cold weather. In the atmosphere, greenhouse gases serve as the equivalent of the pane of glass - causing warmth to be trapped beneath it. Just like in a glass greenhouse, the temperature underneath is warmer than it otherwise would be. Take the roof off your garden greenhouse and the inside will soon be at the same temperature as the outside. The same is true of the earth - if we did not have gases in the troposphere trapping solar radiation, our planet would be much colder. Scientists have calculated that without the greenhouse effect, the planet would have a mean temperature of about zero degrees Fahrenheit. However, with the naturally occurring layer of greenhouse gases, the average global temperature is about 60^oF. That is, the natural greenhouse effect makes the planet livable for us - without it, much more of our surface, and especially much more of our surface water, would be frozen.

The Greenhouse Effect was first described by French scientist Joseph Fourier, and quantified by Swedish physicist Svante Arrhenius in the 1890s. If you take any 300-level courses in mathematics, physics, or chemistry, you will hear those names quite frequently. Most of the greenhouse effect comes from “naturally occurring” greenhouse gases, including water vapor and carbon dioxide.

So far, so good - the greenhouse effect is something good for mankind. What does this have to do with climate change and global warming? Well, for most of the time of recorded human history, we have had more or less the same levels of greenhouse effect, and the average temperature of the planet has been reasonably steady. The amounts of greenhouse gases have performed a bit of a balancing act - trapping enough radiation to keep the temperature at 60 degrees, letting the rest out. Carbon dioxide was released into the atmosphere by decaying and burning plant life, and CO₂ was removed from the atmosphere by the growing of plants. There was a cycle that remained very stable over time. However, since the beginning of the Industrial Revolution in the 1800s, we have started burning fossil fuels - first coal, and then crude oil products and natural gas. Burning fossil fuels releases carbon dioxide that was previously locked away in coal or oil deposits for millions of years.

As we burn more fossil fuel, the atmospheric concentration of CO₂ is increasing; the most recent observations at the Mauna Loa observatory in Hawaii have the levels at about 419 ppm in 2022 (it was around 280 ppm about 150 years ago). At these levels, there is significant concern about trapping more outbound solar radiation, and thus warming the planet, with detrimental effects to many aspects of human life. This is referred to as “anthropogenic” global warming, with the word “anthropogenic” meaning “of human origin.” Intergovernmental Panel on Climate Change (IPCC), a group of 1,300 independent scientific experts from countries all over the world under the auspices of the United Nations, concluded that human activities have warmed the planet over the past 50 years, with more than 95% probability. It is estimated that anthropogenic greenhouse gases have led to an increase of a little over 1^oF over the past century.

You should recognize this as a public goods problem: If we assume there is an "optimal" range of atmospheric CO₂, then staying in this optimal range is a benefit that is neither rival or excludable - the benefits that I get from having an Earth at 60 degrees do not stop you from enjoying the same benefits, and nobody can force me to pay to keep the atmosphere at this level. We also have what appears to be a pretty large externality: by burning fossil fuel, private wealth is generated, both by the person burning the fuel, and by the person consuming the product of that burning fuel. The external effect is that greenhouse gas concentrations are rising, and these rising levels may cause a real deterioration in the quality of life for some people. The unusual thing about this externality is that the people benefiting from this private wealth creation are basically everybody alive today, and the people who will likely suffer are basically everybody who will be alive at some point in the future.

Costs of climate change

There is a variety of ways in which climate change can affect our existence on earth. Some of these effects are listed below.

Extreme weather events

Temperature rise causes changes to the earth’s atmosphere. As temperature has increased, the probability of extreme weather and climate events occurrence, such as hurricane, severe storm, heat wave, flood, and drought, has gone up.

Agriculture

A rise in temperature will affect agriculture in several ways. Warmer weather will speed up the early development of plants, making it more difficult for plants to reach maturity - this is a phenomenon that I have discovered attempting to raise tomato seedlings in my basement - too much heat too early on, and the plants obtain energy from the heat in the ground, and do not develop sufficient leaves to allow them to use photosynthesis. Plants are generally closely adapted to their environments, and changes in the environment can stress plants in ways which upset the normal development of such plants. One plant that is grown in large amounts in the US that is susceptible to such stresses is corn, and it is forecast to be one of the plants hardest hit by a meaningful increase in temperatures. Another effect is on soil moisture - higher air temperatures mean more evaporation of water from soil, and drier soil supports less agriculture or, at least, different types of agriculture. Climate change will lengthen and improve growing seasons at higher latitudes, but greatly reduce yields in regions closer to the equator. The net effect is expected to be negative, at least in the near-term, as we would lose more arable farmland than we would gain. Global food yields under climate change have been modeled to be lower by 20% in the US and 7% in the world, with a wide distribution of changes on a country-by-country basis. I should reiterate that agriculture in some regions will exhibit gains in yield and productivity on a warmer planet, but these increases are not presumed by any serious modelers to be larger than the losses observed in other regions.

Forests

Like agriculture, a warmer planet will likely drive the forests more towards the poles and away from the equator. It would also likely change the composition of our forests. Some scientists have estimated that up to 40% of the biomass currently stored in trees in the US could be lost under a "doubling of carbon" scenario. The greatest economic effect would fall on the forestry industry and on sectors that consume wood products, such as construction.

Species Loss

There has not been much work done on quantification of the economic benefits of what is called "biodiversity", and the general effects of climate changes on many species are not known.

Sea-level Rise

Global warming is expected to raise sea levels by melting of land-based glaciers, most specifically in Antarctica around the southern pole. Since the Northern icepack around the North Pole is floating ice, melting should not have a meaningful effect on water levels. Another source of sea-level rise is that water at higher temperatures expands. It has been estimated that under "business as usual" conditions, global temperatures could rise by as much as 6^oF by 2100, and this would cause an average sea level rise of 66 centimeters, or about two feet. There are costs assumed to be associated with construction required to protect low-lying areas from encroaching seawater, such as levees, dikes and seawalls. There will also be a significant effect on coastal freshwater wetlands and marshes which is significantly harder to quantify. Several poor nations have large populations that live at or near current sea level, the frequently cited example being Bangladesh, in which about 10,000 square miles of the country (about 15% of its land) would be lost to a 3-foot rise in the seas, with the subsequent displacement of 20 million people. Another country in jeopardy is the Maldives, a nation consisting of 1,200 islands in the Indian Ocean, in which the highest point is only 8 feet above sea level. Even a modest sea-level rise will put much of this nation underwater.

Space-cooling Costs

The EPA has estimated that the additional electricity that would be consumed for purposes of air conditioning under a 6^oF temperature rise by 2050 would cost on the order of \$45 billion per year for additional fuel consumption and capital costs to build new power plants to meet the extra demand.

Other, less severe or harder-to-quantify costs include the costs of reduced human comfort, increased morbidity from disease caused by more insects carrying communicable diseases, migration costs from regions losing land to sea rise or reduced agriculture (and the related political difficulties that generally arise from mass migrations), costs from a hypothesized increase in the number of hurricanes, loss of leisure activities such as skiing, and stresses on the water supply.

A number of studies have been performed trying to estimate the costs of climate change. Needless to say, making such estimates requires a large number of assumptions, and involves a large degree of uncertainty. These studies typically claim that the costs of climate change, if we follow a "business as usual" approach, will be on the order of 1-3% of global GDP by mid-century. How big is this? Well, 2% of US GDP today is \$294 billion- less than \$1,000 per person per year, or about \$78 per month. While not a trivial amount, it is also far from our largest expenditures, such as defense, education, or health care.

Like all public goods problems, and like most large-scale pollution-type externalities, we look to governments for solutions. This is because these problems have to be addressed collectively, and government is the way in which we act in a collective manner. The larger problem here is that climate change is not a regional or national concern, but a global concern, and there is no such thing as a global government.

The details and questions around climate change are very political, an area I do not wish to get into here. I wish to address the economic effects of combating climate change on the energy industry.

The default assumption is that we need to reduce carbon emissions. This can be done by a command-and-control method, whereby CO₂ producers are limited by their governments in how much they can emit, but this is generally thought to be generally ineffective. Instead, economics are to be employed: if we wish to lower the demand for something, we need to raise its cost of production. Thus, to lower the “demand” for carbon (which is really a demand for the things that are produced by processes that emit carbon, such as electricity and transportation), we need to increase its cost of production. Putting carbon into the environment is basically free, but if we can assign a cost to depositing carbon into the atmosphere, then there will be less carbon produced, and fewer carbon-producing goods will be consumed. Think of carbon production as a side-effect of economic activity: We burn fossil fuels to make things or to facilitate transportation, and based upon the aggregate of all of those private choices concerning consumption of goods and travel, some amount of carbon is deposited into the environment. We can call this the “private” quantity of carbon, because it is based upon a sum of private, individual consumption choices. However, this quantity of carbon is felt to have negative effects – the result of the aggregate of all of these private decisions is creating problems for some other members of society. In this case, the sum of carbon placed into the environment is thought to cause climate change. Thus, we need to reduce carbon output. We do not want to reduce it entirely, because the decrease in economic activity that would result from such a decision would harm human welfare more than having some amount of emissions. Our goal is to find some point where we balance the costs and benefits of carbon production. Using language that has been previously employed in this course, we are looking for the socially optimal amount of carbon emissions. We need to “internalize the externality” - some people call climate change the ultimate externality. We strive to make sure that the appropriate costs are applied to carbon – not just the private costs, but also the external social costs.

So how do we put a price on carbon? First, it is necessary to figure out how much carbon we want to put into the environment. When a number has been agreed upon, then a cost must be applied.

We can raise the cost of carbon by simply applying a tax to it. This is called the Pigouvian approach, named after Pigou, the economist who devised this idea. However, the application of a tax is not the optimal mechanism for incentivizing technology development. It is preferable to allow individuals to profit from the reduction of carbon, and the best way to do this is to adopt a Coasian property-rights approach. This method has been used successfully to address the problem of sulfur dioxide emissions in the US. A brief summary of this method is as follows:

• A government assigns to itself the “right” to put emissions, such as SO₂, NOx, particulates or CO₂, into the environment.
• The government defines what it believes to be the socially optimal quantity of emissions.
• The government generates a number of permits equal to the amount of allowable emissions. For example, if the government sets the emissions of SO₂ at 10 million tons per year, it will create 10 million permits, each one good for one ton.
• These permits are allocated to emitters, such as power plant or steel mill operators. If a company wants to emit a ton of pollution, they need a permit. Allocation can be done on a free basis or by auctioning off the permits or some combination of the two, as is the case in SO₂.

The permit recipients can then either use the permits or trade them (Cap and Trade). A market for the permits is formed, and in this market, the people who value them the most will pay the highest price. This is the very definition of economic efficiency. It also means that there is an incentive to others to develop technology that would allow one to reduce carbon emissions at a cost lower than that of buying a permit, which spurs innovation and technological development. A permit system also allows something that a tax does not: an interested individual or group can purchase emission permits and then retire them without emitting carbon. This enables a real reduction in output if there are enough groups of people willing to “put their money where their mouth is”.