Nicholas Stern’s review into climate change is one of the most significant pieces of economic policy analysis to make its way into the public realm, possibly ever. It generated a huge amount of controversy, and was both praised and attacked by fellow economists and other academics, scientists, environmentalists and policy commentators. Here, I will outline for a lay audience the major issues that were disputed amongst economists. (I’ll keep it as short as I can, which is still long, but I’ve done my best.)
The issues that the big-league economists dwelt on and argued about are, it should be said, issues in which economists have the most to say relative to other specialists. There are many scientific areas of contention regarding the potential impacts of global arming (as if that wasn’t already obvious), and for every person that said Stern’s assessments of the physical impacts was overly pessimistic, someone else could be found arguing that he was being too sanguine.
The debates around the scientific issues—and the extent of the sheer uncertainty surrounding the potential impacts—would bedevil anyone trying to do a Stern-type exercise. But here we won’t focus on that. Instead, the goal here will be to come to grips with Stern’s appraisal as an economist of the impacts and implications of climate change—and what other economists found to disagree about in Stern’s assessment.
Since an economist studying aspects of climate change would find plenty of particular topics and individual problems open to study, we should clarify what is meant by “the economics of climate change” as looked at by Stern. His was a big-picture analysis of the long-term global costs of climate change, and the potential for reducing those future costs by taking action now.
What caught people’s attention—and raised eyebrows—was that Stern found the costs to be considerably higher than most previous estimates, and based on this, he made a strong case for action now. There were, in short, two reasons for this finding. First were the scientific assumptions that went into the analysis: what would be the physical changes expected under warming, and what would their economic impacts be expected to be? Second, taking the first assumptions as given, how does one convert a whole stream of economic impacts (net costs of warming, and net benefits of action) over a long period of time and convert them into a single number—a present value—for purposes of comparison?
In short, oversimplifying somewhat, we can think of the first part as “getting the science right”, and we can think of the second as “getting the present value right (in practice, choosing the discount rate)”. Stern’s assessment of the science was dramatic—the impacts of warming would be big, and they would be bad—and was one reason for his result that the “costs of doing nothing” were significant. However, his discount rate choice was also a big influence in Stern’s final quantitative conclusions. It’s the second debate that occupied the attention of many economists, and where we shall focus our attention here.
This means I am not going to focus on whether his estimates of the costs measured over time are accurate—whether he underestimated the costs associated with Arctic ice-sheet melting, or miscalculated the risks of sea-level rise, or of changes in agricultural productivity. Instead I’ll focus on the discounting issue, because that’s where the economics profession got really fired up. And to understand the debate, we need to comprehend just one equation.
This equation, attributed to Frank Ramsey (Wiki link here), summarises the rationale for discounting in a parsimonious way, combining a few key variables. But before we unpack the equation, we need to talk about what discounting entails.
Imagine the following scenarios. These are totally made up, of course, but they are useful thought experiments to use when thinking about the issues raised by Stern.
In one scenario, you take $100 and put it in a hole in the ground. You come back the next day, dig it up, and find yourself with $1000!
In another scenario, you take $100 and put it in a hole in the ground, and you come back in 50 years (you can’t do this earlier!), to find yourself with $1000 when you dig it up.
In a third scenario, you bury $100, and the next day, somebody entirely separate to you comes along and digs it up to get $1000.
What these all have in common is that they are “investment scenarios”, where money set aside (diverted from being spent immediately on consumption) comes back as a larger amount.
What’s different about investment scenarios one and two? Perhaps nothing, right? You bury $100, which somehow magically grows, and you get back $1000. The only difference is that in one case the payoff is the next day, compared to the other one taking fifty years. Does this matter to you? It’s hard to imagine that it wouldn’t. If I knew that I could earn around 4.8% (real, meaning inflation-adjusted) per annum on an investment, then $100 invested now would yield me a bit more than $1000 (inflation-adjusted) in fifty years time. That’s OK, but it’s hardly amazing. I don’t think it’s obvious that I should divert every dollar I could into an investment that paid less than 5% p.a. However, the overnight investment is amazing! I don’t even know what that rate of return that would be per annum, because Excel spat the dummy when I tried to calculate it (it’s 900% per day). But if I could get $1000 overnight for every $100 I set aside, you can believe I’d be living on bread and water while I crammed every spare dollar I could into the Magical Money Expander in order to get it back tenfold the next day.
The point of these thought experiments is that money that arrives later is worth less to us, even when we adjust for inflation. The $1000 payoff in fifty years time is simply not as attractive as the $1000 payoff tomorrow. Not even close.
This provides a prima-facie rationale for discounting future dollars, such that at around a 4.75% rate of discount, $1000 received in fifty years’ time is the equivalent of approximately $100 today. In the lingo, $1000 in fifty years has a present value of $100 today (when discounted at 4.75%). (Note—and this is important where Stern is concerned—that the rate I use to discount matters a lot. The present value of $1000 in fifty years would have a present value of $290 if I discounted at 2.5% instead of 4.7%. Which means, working forward in time, I need almost three times the initial investment to receive a given payoff in fifty years.)
What about scenarios one and three? Now the difference between the payoffs is not when they occur, but to whom. Now, the Magical Money Expander takes your $100 and creates $1000 from it, but somebody else—some random person that you don’t know—gets the proceeds, not you. Under what circumstances would you think it is reasonable for you to give up $100 in order that someone else receives $1000?
Now think about it from the point of view of the Hypothetical Benevolent Social Planner (HBSP), an imaginary person whose job it is to make (potentially major) changes in society for society’s overall benefit. The HBSP can take $100, stick it in the Magical Money Expander, and create $1000 of benefit for someone else other than you. If the recipients were poorer than you, would you think it a reasonable sacrifice to make—you lose $100 for some poorer people to get $1000? (The HBSP might think so!)
What if the recipients were richer? The HBSP would need to trade off the fact that $100 has been turned into $1000 (a good thing), while the transfer involved was from poorer to richer (let’s call this a bad thing). In what circumstances might a HBSP think the sacrifice was still worth it? What if the Magical Money Expander only turned $100 into $150, instead of $1000? Would the increase in overall wealth compensate for the fact that the rich have received a transfer from the poor?
All major public investment issues—involving benefit-cost analysis—involve transfers of resources across time, and among different people. (I’ve represented these here in simplified fashion using thought experiments involving an imaginary Magical Money Expander.) It is benefit-cost analysis that helps make sense of these transfers; to decide whether the effects of the project in question (the “Magical Money Expander”) create sufficient benefits, once the effects of transfers through time and between people are properly taken into account.
In this situation, climate change mitigation action plays the role of the Magical Money Expander (to the extent that undertaking global mitigation actions will require sacrifices now that will result in reductions of large costs of warming that we would otherwise incur in the future), and Stern plays the role of the HBSP. The transfers that Stern considers occur over large spans of time, large enough that the main beneficiaries of our costly actions now will be people not yet born. And, by and large, those people will also be the beneficiaries of the economic growth that occurs between now and then, so they will be, on the whole, richer than us. Whatever sacrifices we make (for a problem we have contributed to, but that really kicked off well before we came along) will mainly benefit richer people, well into the future. How should Stern apply discounting in this situation?
Let’s go back to the Ramsey equation.
The left hand side, p, is the rate of discount to be applied to future net benefits of mitigation actions taken now. It is the sum of two terms on the right hand side which are governed by two key parameters. The first, the delta, is the “pure rate of time preference”, dealing with our scenario two above—the fact that the benefits arrive later in time relative to the costs of the sacrifice that generated them. The second term is the multiple of two measures. The eta symbol is the “inequality aversion parameter” that deals with scenario three above—the fact that most of the costs of mitigation will be incurred by people poorer than those to whom the benefits will accrue. The term g measures economic growth, more or less.
(You could argue that the future impacts of climate change, if unchecked, will hit poorer countries harder, and so we in the West are not transferring to our richer descendants by taking mitigating actions; rather, we are, by mitigating, making progressive transfers from richer to poorer countries. But then, should we be taking $100 from citizens of richer countries today and turning it into a $1000 benefit for citizens of poorer countries in 50 years’ time—or should we just give that $100 to the citizens of poorer countries now and let them do what they want with it?)
Re-capping: Stern found high future damages resulting from climate change, based on comparatively heavy emphasis on future downside risks. But the significant point that fired up economists was that he found high present values of damage, such that there was a clear case for undertaking actions now. That aspect was driven in large part by Stern’s choice of discount rate p, which involved in turn making choices for delta and eta. The choices Stern made were low, meaning that p was on the low side, which means future impacts were not as heavily discounted as they might have been. The long time frames involved meant that the choice of a low discount rate had a major influence on his conclusions. This meant that the choice of a low discount rate was a prime area for controversy.
Dasgupta, P. 2007, ‘Commentary: The Stern Review’s economics of climate change’, National Institute Economic Review, vol. 199, pp. 4–7.
Jensen, P. and Webster, E. 2007, ‘Is Stern Correct? Does Climate Change Require Policy Intervention?’, The Australian Economic Review, vol. 40, no. 4, pp. 421–31
Nordhaus, W. D. 2007, ‘A review of the Stern Review on the Economics of Climate Change’, Journal of Economic Literature, vol. 45, pp. 686–702.
Stern, N. 2006, Stern Review: The Economics of Climate Change, viewed January 2007, http://www.hm-treasury.gov.uk/independent_reviews/stern_review_economics_climate_change/sternreview_index.cfm.
Sterner, T. and Persson, M. 2007, ‘An even Sterner Review: Introducing relative prices into the discounting debate’, Resources for the Future Discussion Paper RFF DP 07-37, Washington, DC.
Weitzman, M. L. 2007, ‘A review of the Stern Review on the Economics of Climate Change’, Journal of Economic Literature, vol. 45, pp. 703–24.