The economics of climate change

Speech delivered to Speech to the conference on climate change of the Association of British Insurers, Royal Society, Carlton House Terrace, London on Tue 7th Nov 2006

Until Sir Nick Stern's review of the economics of climate change, it would be fair to characterise the mainstream economic view on the issue as lukewarm. There was certainly acceptance of the consensus among scientists: the editor of Science himself has said that it is rare to find such a compelling consensus on any scientific debate. But Bjorn Lomborg and the economists of the so-called "Copenhagen consensus" went on to argue that nothing much needed to be done, because there were many far more pressing global priorities such as tackling world poverty.

Sir Nick has taken direct aim at that proposition, and in my view has holed it below the waterline. He has successfully stood the Lomborg position on its head and rightly argues that climate change is now so dangerous and potentially so costly that we cannot afford to delay taking action.

Let me take you through the essence of the economic argument. What's wrong with the Copenhagen consensus? Essentially, it uses the standard tool of investment analysis familiar in business and public policy to assess the costs and benefits of action. What could be more normal than discounted cash flow? You look at all the benefits on one side, discounted to their net present value by the application of a market interest rate. You look at all the costs on the other, again discounted to allow for the fact that costs today are worth more than the same costs tomorrow. If the benefits exceed the costs, you go ahead. Except that with climate change you do not. Immediate action to curb climate change has full costs. Far off benefits in the aversion of danger count for little because they are far off. As many business people know, looking at discounted cash flow analysis tends to mean that benefits that flow after more than about ten years are not worth much.

Sir Nick Stern, following work by Sir Partha Dasgupta and others, points out that such an analysis is quite correct if you are trying to assess an investment project or even a public infrastructure project such as the Jubilee line. The decision to build or not to build will not fundamentally change the world, as it is a marginal decision that leaves most other factors equal. That is not the case with the aversion of global warming. Here the changes if we do not act are enormous, far-reaching and potentially catastrophic. They are far from marginal.

You can see that in the effects on Britain alone. Insurance claims are mounting in leaps and bounds. All ten of the hottest years on record have been since 1990. This summer was the hottest since records began in 1659. We have suffered two floods in 2002 that were meant to occur only every 30 years. We have had the wettest six months since records began in the eighteenth century. The Thames barrier has been raised 55 times in the last five years compared with just 12 times in the previous five. Storm surges, flood damage and droughts are rising.

Precisely because the effects of climate change are far from marginal, the view that costs and benefits should be discounted by the interest rate is quite wrong. What that effectively does is to say that our own futures are worth far less than our present, and that our children and their children should not be taken into account in our calculus at all. That is quite untenable. Other than the most extreme misanthrope, I do not know of anyone who would seriously wish to argue for such an inter-generational indifference. Every time we leave a legacy rather than spend our money while we are alive we show that we care for our descendants. That is the natural position, and it is one that it is right to apply with climate change.

As Sir Nick argues, climate change "represents the greatest example of market failure we have ever seen". None of the collective impact that we are having on our future by emitting carbon from fossil fuels is taken into account in the price that we pay: all of the cost of being pushed onto future generations. Unlike almost all previous examples of market failure, the externalities - the side-effects - of the private decision are wholly global. They do not affect one river, a beach or a city. But a tonne of carbon emitted in Bangalore is just as dangerous as a tonne emitted in Birmingham, England or Birmingham, Alabama. Equally, the length of time that carbon endures in the atmosphere - one hundred years - means that the impact of every tonne is long-lived and almost impossible to reverse at least in the short term.

There is one other aspect of climate change that we also need to take into account in our calculus: its extraordinarily inequitable impact. The peoples who are most adversely affected by drought, storms, cyclones, flooding and crop failure are mainly in the developing world, where they are also least able to tackle such biblical vengeance. Yet the societies responsible for 70 per cent of all the carbon ever emitted by mankind into the atmosphere are developed countries, and here in Britain as the pioneer among industrial carbon-burners we are also among the most disproportionately responsible. Inequity matters in economics because ten pounds to a starving man is worth far more than ten pounds to a global rock star. And climate change is Robin Hood in reverse: it takes from the poor far more than from the rich.

Of course there are considerable uncertainties still in our understanding of the impact of carbon emissions on global warming, but the risks are sufficiently acute that any rational person should in my view be prepared to pay a substantial insurance premium against it happening. That is precisely the principle that everyone in this room adopts when it comes to buildings and contents insurance: the risk of the destruction of your home is small, but the consequences are so devastating if it happens that insurance is worthwhile. The risks that our planet will develop such dangerous weather systems that serious costs are imposed on our way of life is no longer so small.

The Stern review puts the overall costs and risks of climate change at 5 per cent of global GDP each year, now and forever. With a wider range of risks and impacts, taking into account feedback mechanisms such as melting permafrost and the dying-back of Amazon rainforest, that loss can quadruple. Against this risk of loss, the cost of the insurance premium at 1 per cent of GDP seems modest and worth undertaking.

Why if the costs are as Sir Nick has described them - and I for one think his study is the most thorough and convincing basis for policy yet - have we taken so long to wake up to the threat? I think there are three parts to the answer. First, the environmentalists have cried wolf before and been found wanting in the famous scare over the Club of Rome hypothesis of the early seventies that we were running out of natural resources. Second, the climate scientists were misled by a period of stable temperatures in the fifties and sixties - when the lesser impact of the sun offset the impact of global warming - into predicting a new ice age. When the message reversed, credibility was nevertheless dented.

Thirdly, the fossil fuel economy has the most extraordinary vested interests in the big companies that supply oil and gas and the car and plane companies that have found substitutes for their fuel difficult to develop. It is always hard to persuade someone of the truth of a proposition if their salary depends on the opposite.

The economics of climate change tells us more than just that we need to act. It also has something to say about freeriders. How do we enlist all the key global players into a framework that assures each of us that our efforts will not be in vain, because others will act too? This is a classic collective action problem. It is akin to the difficulty that the football fans among us face when our excited co-spectators decide to stand up to get a better view of the game. Soon the whole stand is on its feet, no-one has a better view of the game, and everyone is more uncomfortable. The good news, though, is that we have licked such a problem before with the Montreal protocol on chlorofluorocarbons in 1987, which is now helping to close up the hole on the ozone layer above Antarctica.

Global warming is more difficult, because there are greater vested interests, but it is still the case that just 20 key countries are responsible for 80 per cent of global emissions. We can tackle the freerider problem with a just solution where the developed world clearly sets the pace in carbon-free technologies, and shows the developing world that it can grow while leaping a generation of destructive carbon-burning.

The final question that economics can help to resolve is how we tackle climate change at least cost. I am not a Private Frazier in Dad's Army crying out that we are all doomed, and nor am I one of those despondent characters who believe that if it isn't hurting, it isn't working. Climate change policy should aim to deliver curbs in emissions where they are easiest to cut, and where they require the least change in our life-styles and aspirations. Sir Nick Stern's estimate of a cost of some 1 per cent of national income is modest, and is equivalent to foregoing half a year's British growth. We might reach the living standards we were anticipating in 2050 just six months later. But such an outcome depends on the adoption of sensible economic incentives to deliver gradual but persistent change.

In the hierarchy of policy instruments that go with the grain of the market, the most appropriate to this problem are cap and trade schemes. We need gradually to control or cap carbon emissions, so it makes sense to allocate the maximum amount in any given year and then let people buy and sell those allocations. Businesses that can cut their carbon use easily can generate surplus allocations, which they can then sell. Businesses that cannot cut easily - or whose business is growing rapidly - may have to buy more than their allocation. The result, though, of such a scheme - in effect, the European Union's Emissions Trading Scheme - is that the businesses that can cut carbon emissions most cheaply and quickly are given the incentive to do so, and we are assured as policy-makers that the end result will be what we plan.

In theory such a principle could be extended to individuals: we could each have a personal carbon allowance and sell our excess, or buy more if we have an insatiable appetite for a gas-guzzling car. However, the technology at present in my view is not available to make such a PCA scheme workable in the ten to fifteen years in which we need to act. So we must rely on existing technologies. And that means that cap and trade schemes such as the ETS are probably only workable in sectors of the economy where there are a few big players, and where the problems of measurement and monitoring can be relatively easily resolved. The EU ETS is far from perfect, but if the national allocation plans are made much tougher, as the Commission says it will ensure, it has the potential to deliver deep changes. And it also delivers a carbon price that can bring on a new generation of clean technology through private research and investment.

But what happens outside the power generation, steel and heavy industries that are covered by the ETS, but which are responsible for some 46 per cent of UK carbon emissions? We can and should extend and toughen the ETS as much as possible: we should put aviation, road freight and shipping in the scheme. But alone it is unlikely to resolve the problems of transport, which is the sector responsible for an 18 per cent rise in carbon emissions since the Kyoto base year of 1990 even though every other sector has cut its carbon emissions.

Putting aviation into the ETS will not be enough because air travel is not even taxed fairly compared with other items of consumer spending: there is no kerosene tax and no value added tax on tickets. The EU should move rapidly to do both, and we should restructure the air passenger duty to apply not to passengers but to the emissions caused by the flight. That would provide much needed incentives on the airlines to fly full not half empty, and also to invest in more fuel efficient aircraft. That is one of the proposals that the Liberal Democrats put forward this year and voted at our Brighton conference.

The other transport area where green taxes are essential is cars. The carmakers voluntary agreement is a broken reed: at present progress, the average emissions target to which they signed up by 2008 will only be delivered in 2022. Self-regulation has failed, and there should be a legislative approach to regulation at EU level and national incentives to shift our national car fleet towards much lower emission models. That is why we in the Liberal Democrats have put forward plans for a steeply graduated vehicle excise duty. New cars bought in Bands A and B would be pay nothing. New cars in Band G - emitting more than twice as much as the most economical - would face an annual VED on new cars of £2000, a figure found by MORI research to encourage more than two thirds of new car buyers to switch to lower emission models.

We have rejected, however, the idea of applying quickly a climate change levy or carbon tax to households precisely because of the likely inequities that it would involve. Among the poorest households, fuel use varies by a factor of six because of differences in the vintage of boiler and the energy efficiency of the home. So we have to work directly on energy improvements in the built environment: households after all account for more than a quarter of carbon emissions. Through information, subsidies where necessary and strong incentives, we should be able to deliver a scheme as thorough and far-reaching as that undertaken by the Merkel government in Germany that is undertaking to deal with 5 per cent of the pre-1978 housing stock each year.

On new build, which represents just 0.8 per cent of the housing stock each year, we need to give due weight to the likely long life of the asset and set sustainable standards for 2005. It is quite unacceptable that our energy efficiency standards are 65 per cent below those of new build in Sweden, or that our households should be responsible for 27 per cent of total UK emissions when in much colder countries they have already reduced this to a fraction: in Sweden just 4.7 per cent of emissions are now from housing and in Finland it is 9.8 per cent.

Let me briefly mention another crucial sector: electricity generation. We are not tempted by the lure of new nuclear power for the simple reason that it is a tried, tested and failed technology. Not a single nuclear power station has been built anywhere in the world without lashings of government subsidy since Chernobyl in 1986 because investors have judged the risks too great and the rewards too remote. Remember that not a single nuclear reactor ever built in this country came in on time or to budget, and that smallest cost overrun at Torness was an extraordinary 35 per cent in real terms.

Germany and Sweden are right to opt for a non-nuclear future, as the renewable technologies notably wind, tidal and solar are capable of gradually reducing what is bound to be a greater dependence on gas in the next ten years. In the Netherlands, some 40 per cent of electricity is generated on small scale in homes or distributed combined heat and power plants, cutting transmission costs and heat waste. That is the right strategy to adopt. In the power sector, the renewables obligation is delivering a rising share for renewables although we feel it needs to be tweaked to encourage more marginal technologies than onshore wind.

And let me finally mention adaptation, often the Cinderella subject of the climate change debate. The report published today by the ABI underlines the madness of cutting back the maintenance of our flood defences, the first bulwark of our protection against storms and rising sea levels. I am also concerned that, contrary to ministers' assurances, capital programmes are being cut and that fewer feasibility studies will make future capital projects more difficult. The adaptation agenda must include not just flood defences, but also our response to increases in heat related deaths, food poisoning, waterborne and tropical-style diseases, lower summer rainfall and more droughts, not to mention damage to road and rail infrastructure from more extreme whether events. Given the impacts of climate change, the Government needs to adopt a comprehensive programme of adaptation that deals with the full range of likely impacts.

So cap and trade, green taxes, regulation and public spending all have a part to play in the fight against global warming depending on the sector and its characteristics. The challenge for policy-makers will be to ensure extraordinary team work in government, because we need to decarbonise every aspect of our economic life. I am far from impressed with the gap between the Government's rhetoric on climate change, but I remain an optimist. Quite extraordinary opportunities will open up to those developed economies that pioneer the change. Zero carbon developments in transport, housing, commercial building and the development of renewable are the future.

In short, we have everything we need to begin resolving this crisis. We have the analysis. We have the technologies. We have the policy instruments. All we now need is the political will to act. The time for words is over. We now need action.

Ends