My erstwhile co-blogger Sarah raised some questions about the costs of climate change in comments to my previous post:
Question - is the 2% total per year inflation adjusted? Because a 3% real loss in GDP by 2100 translates into a much higher nominal GDP loss.
Additionally, I'm very skeptical at this assessment. Temperature changes will have overarching economic and non-economic effects. Food and water supplies will shift and could decrease. Maybe the better way to look at the 2% of Global GDP cost of C02 reduction is like an insurance premium. If we have a pretty good idea of what it costs to protect us but a not-so-fail-proof idea of what it would cost if we did nothing, than buying insurance is a rational choice.
Dealing with the last part first, buying insurance is only rational if the expected NPV is greater than or equal to the cost of the insurance. Further, insurance is never geared at prevention; only mitigating the effects of something after it happens. In this discussion, "buying insurance" would be closer to doing nothing to stop climate change and instead using the economic gains to deal with the situation then.
But I want to focus on the crux of my first point: the costs of prevention are much, much greater than people tend to think. After all, when people say that we can mitigate the costs of global warming by spending one or two percent of GDP, it doesn't sound like very much. But it is actually quite a bit when you compound those costs over time. In my previous post, I presented an obviously unrealistic model in which there is no economic growth. Let's flesh it out a little more with some more realistic assumptions. First, let's assume that the U.S. economy will grow at its trend rate (roughly 3%/year) from now until 2100. If we do nothing about climate change, then our economy will grow from $14tn to over $200tn by 2100. According to the CBO report, we will lose 3% of that, or $6tn, due to the effects of climate change. Let's look at two scenarios where we combat climate change to look at the costs:
1. If we sacrifice just 1% of GDP growth per year (not actual GDP) over that time to combat climate change, so we grow at 2% instead of 3%, then what have we given up? In 2100 our GDP will be $83tn, or $117tn less than it would have been otherwise. In other words, our standard of living in 2100 would be halved. Of course, our standard of living from years 2011 - 2099 would also be lower at greater and greater rates. This is quite a lot to give up.
2. But maybe we can spend more now and less later, as Nicholas Stern suggests. If we follow his recommendation and sacrifice 2% of GDP from 2010-2020 and then (presumably) nothing after that, then where are we? From 2010-2020 our economy grows at 1% per year instead of 3% per year and in 2020 our GDP would be $15.46tn, After that, growth returns to 3% per year until 2100 when our GDP would be $165.5tn, or $35tn less than it would have been if we'd done nothing. This represents roughly 17% of potential 2100 GDP, and also does not include the lower standard of living in years 2010-2099.
In both of the above the scenarios, the costs are actually much, much higher. For example, if we do nothing and have GDP of $200tn in 2100 and stay at the same trend rate of growth (3%), in 2200 our GDP would be roughly $3,844tn. If we follow scenario #1, but stop spending on climate change in 2100 and return to 3% growth, then our 2200 GDP would be $1,595tn, or roughly 40% of what it could have been. If we follow scenario #2, then our 2200 GDP would be $3,180. In both cases, the divergence between actual and potential GDP will increase over time with an upper bound of infinity. We never get that lost growth back, and in fact we lose more and more the further out into time we go.
All of this, of course, assumes that we can actually slow or stop climate change by spending this money. In practice, that will be very difficult to do without getting major concessions from the BRICs, the oil-exporting states, and the rest of the developed and developing world. Such concessions are not likely achievable. But even if we lived in a perfect world where international cooperation was easily achievable and our actions to slow climate change were effective, it still might not be worth it. A very high bar must be cleared before it makes sense to give up even a little bit of economic growth. That's why looking at compounding rates of growth is so important.
Now, the CBO report could be completely wrong; maybe climate change will cost the economy much more than 3% in 2100. Some people certainly think it will, and they may be right: there is a lot of uncertainty built into the climate models. But in order for it to be economically productive, the difference would have to be extreme; even in the less-costly Stern model (scenario #2), the CBO would have to be wrong by 600% in order for it to make sense to follow Stern's recommendations. I find that to be unlikely.
And I still haven't mentioned discount rates.