Wednesday, December 05, 2007

Sternly he said

UPDATED MATERIAL: An exchange between Wm Nordhaus and Nicholas Stern in Science 7/13/07

Testimony by Henry Jacoby to the US Congress 2/13/07

A Note on the Ethical Implications of the Stern Review on the Economics of Climate Change Charles Kenny in the Journal of Environment & Development, Vol. 16, No. 4, 432-440 (2007)

The 'Stern Review' and its Critics: Implications for the Theory and Practice of Benefit-Cost Analysis Daniel H. Cole Social Science Research Network

The Stern Review a Deconstruction, Richard Tol and Gary Yohe

The Stern Review on the Economics of Climate Change, William Nordhaus 5/3/2007

A missed opportunity: The Stern Review on climate change fails to tackle the issue of non-substitutable loss of natural capital, Eric Neumayer Global Environmental Change Volume 17, Issues 3-4, August-October 2007,Pages 297-301

The Journal of Economic Literature has two long reviews of the Stern Review. One by William (Ted) [as pointed out by Richard Tol] Nordhaus and one by Marty Weitzman (link correctred thanks to gz). Eli has read the Weitzman review, and will look at the Nordhaus one later this week. Weitzman finds the choices that Stern made for discount rates arbitrarily chosen to reach a predetermined conclusion.

We know that the choice of discount rate drives both the Stern Report and most other economic analyses of how to deal with climate change. This is related to the long period over which climate change happens.

Global climate change unfolds over a time scale of centuries and, through the power of compound interest, what to do now is hugely sensitive to the discount rate that is postulated. In fact, it is not an exaggeration to say that the biggest uncertainty of all in the economics of climate change is the uncertainty about which interest rate to use for discounting. In one form or another this little secret is known to insiders in the economics of climate change, but it needs to be more widely appreciated by economists at large. The insight that the strong conclusions of the Review are driven mainly by the low assumed discount rate has been picked up and commented upon already by several insider critics.[1]
and further
The present discounted value of a given global-warming loss from a century hence at the non-Stern annual interest rate of r = 6% is one hundreth of the present discounted value of the same loss at Stern’s annual interest rate of r = 1.4%. The disagreement over what interest rate to use for discounting is equivalent here in its impact to a disagreement about the estimated damage costs of global warming a hundred years hence of two orders of magnitude. Bingo!
Weitzman recognizes the fat tail risks, e.g. risks with extreme costs at the high end of the predicted global temperature change and the need for insuring against them.
This paper makes five basic points about the economics of climate change.
1: The discount rate we choose is all important and Stern’s results come from choosing a very low discount rate.
2: We are a lot less sure about core elements of discounting for climate change than we commonly acknowledge because critical puzzles, projections, and ambiguities are yet unresolved.
3: Standard approaches to climate change (even those that purport to treat uncertainty) fail to account fully for the implications of large consequences with small probabilities.
4: Structural parameter uncertainty that manifests itself in the thick tails of reduced-form probability distributions –not risk –is what likely matters most.
5: Gathering information about thick-tailed uncertainties representing rare climate disasters (and developing a realistic emergency plan were they to materialize) should be a priority of research.

To anticipate my main finding, spending money now to slow global warming should not be conceptualized primarily as being about optimal consumption smoothing so much as an issue about how much insurance to buy to offset the small chance of a ruinous catastrophe that is difficult to compensate by ordinary savings. While I am (along with most other economist /critics) skeptical of Stern’s formal analysis, I believe that the Review’s informal emphasis on climate-change uncertainty can be recast into sound analytical arguments that might justify some of its conclusions.
Still he does not accept how Stern valued them
Instead, the Review dances around the significance of the aggregative analysis of Chapter 6 by arguing that conclusions from IAMs [a type of economic model] are suggestively useful but not crucial to the basic story line that anything above ultimate stabilization at ~500 ppm CO2e and ~3 C is self evidently just too risky for the planet to bear.
but really never comes to detailed grips with what it is that has scared Stern about going beyond these limits, and which as Eli pointed out agrees with what has freaked out the WGII working group. Weitzman is not of the be happy go lucky crowd, but recognizes that Sern
. . .consistent with what an uncharitable critic might see as a philosophy of focusing on the gloomier outcomes in a heuristic-intuitive attempt to include extreme damages, because in Stern’s language “when we try to take due account of the upside risks and uncertainties, the probability-weighted costs look very large.” Actually, the Review goes well beyond 5% in its “multi-dimensional” approach by making numerous literary and numerical allusions to the dark possibilities lurking in the tails of the distribution of possible outcomes (and then, as it were, rubbing salt in the wound of numerical calibration by noting how centrist it is actually being by not choosing much higher probability-weighted distant-future damages, which could be as big as 20%-35% when one considers catastrophes that might materialize after 2105). Stern also estimates the annual costs of its ambitious abatement strategy as being equivalent to about 1% of GDP (which seems rather on the low side by maybe a factor of two or more, but that is not so relevant here).

The question for the Stern Review analysis then effectively becomes: is it worthwhile to sacrifice costs~1% of GDP now to remove damages ~5% of GDP a century from now?
and how this plays out in the uncertainty of economic modeling
If the conclusion from the last section –that what to do about global warming depends over whelmingly on the imposed interest rate –is seen as disappointing, then a second conclusion is likely to seem downright unnerving. As noted, the choice of appropriate discount rate is itself extraordinarily sensitive to seemingly-arcane modeling details like the value of the climate-change investment beta and how the asset-return puzzles are resolved. One interpretation of the asset-return puzzles, which could also have some relevance for the economics of climate change, is the idea that investors are disproportionately afraid of rare disasters. These rare disasters are not fully re‡flected in the available data samples that, being limited, are naturally deficient in coverage. Besides, even if we had an infinite time series of past observations, they are of restricted relevance in an evolving world whose features are always changing and whose past never fully repeats itself.
and most clearly in
The IPCC does not extend its projections beyond 2105 on the basis that predictions into the 22nd century are too uncertain, but it seems unavoidable that the reduced-form probability of Delta T > 6 C increases substantially above 3% after the next century just from the enormous inertial lags for what by then will be in the climate-change pipeline. Societies and ecosystems whose average temperature has changed in the course of a century or so by Delta T > 6 C located in the terra incognita of what any honest economic modeler would have to admit is a planet Earth reconfigured as science fiction, since such high temperatures have not existed for some tens of millions of years.
It is important to note that 6C is a red herring, because seriously bad things happen even at 3 C. 6C would be a total disaster. Weitzman concludes that
it is much better to go directly through the front door with the legitimate concern that there is a chance, whose subjective probability is small but diffuse (thereby resulting in a dangerously-thickened left tail of comprehensive-consumption growth rates), that global warming may eventually cause disastrous temperatures and environmental catastrophes. If one accepts that global climate change is as likely an arena as any for a valid application of the general principle that thickened tails from uncertain structural parameters must dominate expected-discounted- utility calculations, then many hard questions need to be asked.
And of course we meet at the end in the middle.
In my opinion, public policy on greenhouse warming needs desperately to steer a middle course, which is not yet there, for dealing with possible climate-change disasters. This middle course combines the gradualist climate-policy ramp of ever-tighter GHG reductions that comes from mainstream mid- probability -distribution analysis (under reasonable parameter values) with the option value of waiting for better information about the thick-tailed disasters. It takes seriously whether or not possibilities exist for finding out beforehand that we are on a runaway-climate trajectory and –without “leaving it all up to geoengineering”– confronts honestly the possible options of undertaking currently politically incorrect emergency measures if a worst-case nightmare trajectory happens to materialize. The overarching concern of such a middle course is to be constructive by having some semblance of a game plan for dealing realistically with what might conceivably be coming down the road. The point is to supplement mainstream economic analysis of climate change (and mainstream ramped-up mitigation policies for dealing with it) by putting serious research dollars into early detection of rare disasters and by beginning a major public dialogue about contingency planning for worst-case scenarios perhaps akin to the way Americans (at their best) might debate the pros and cons of an anti-ICBM early warning system. It may well turn out that the option value of waiting for better information about catastrophic tail events is negligible because early detection is impossible, or it is too expensive, or it comes too late (this is Stern'’s line, and it might, or might not, happen to be true), or because nothing practical can be done about reversing greenhouse warming anyway –so we should stop stalling and start making serious down payments on catastrophe insurance by cutting CO2e emissions drastically. But these are conclusions we need to reach empirically, rather than prejudging them initially.
Hopefully many will read the Review.

12 comments:

Andrew Dessler said...

You might be interested in a paper by a colleague of mine on discounting ... it's a view of discounting by a non-economist and I find it really convincing.

here or here

SCM said...

I'm pretty sympathetic to the critiques of discounting from ecological economists like Herman Daly. By choosing a low discount rates Stern is effectively placing more (some!) value on the impacts of CC for our descendents than economists generally do.

bigcitylib said...

Interesting that Tol has been convinced by Weitzman (according to this weeks New Scientist) and seems to be modifying his earlier "it will all be wonderful" views. Interesting too that Pielke Jr. seems to have moved lately into the "alarmist" camp. Is an economic consensus following on the heels of a climate science consensus?

Anonymous said...

It seems to me that the unknown discount rate can be treated just as one treats other unknowns in a expectation analysis.

One assumes various scenarios, each having a different associated discount rate. As long as one can assign a probability to each discount rate, one can still do the risk analysis.

There may be considerable uncertainty involved in estimating "The ACTUAL" discount rate over the long term, but expectation is clearly the best way to deal with that.

John Mashey said...

I'll catch up in detail later, but I think that there is nothing foreordained about positive or even zero discount rates, in the face of Peak Oil and other issues. "Everybody will be richer, smoothly" isn't at all clear to me when cheap oil (and fertilizer, and water) go away, and as (some of us) have to invest big-time in economic deadweight dikes and dams and seawalls just to stay even.

A related discussion came up in:
http://www.desmogblog.com/you-might-die-but-it-will-cost-too-much-too-do-anything-so-lets-not

and I wrote a long post (Thu, 2007-12-06 18:16.) that covered some of this.

I've read a bunch of the economic analyses mentioned here, and I really wish I found Peak Oil mentioned more, rather than hardly ever. I do find the following Ayres&Warr paper useful:

http://www.iea.org/Textbase/work/2004/eewp/Ayres-paper1.pdf

Put that together with Peak Oil, and it looks like the developed world has a workable, but hard scramble to keep GDP/capita going up in a few decades, assuming fairly constant population. Technology helps (+); energy efficiency helps a lot (+), but less oil/gas hurt (-), until there's enough renewable energy around to keep the exergy (efficiency * energy) rising.

I have no idea how the developing world, with 2X population estimated by 2050, is going to get rich then. Many of the poor of the world are farmers, and even FAO's (optimistic, I think) estimates of 2030 only put 25% of Sub-Saharan Africa farmland as being done with tractors, and only 55% of the whole developing world. Unless solar-electric tractors get cheap, or biofuels, they won't even have those tractors then, if they can't afford them now. More later.

Richard Tol said...

Eli: William Nordhaus and Ted Nordhaus are two different people.

BigCityLib: Please read my work rather than believe a half hour interview summarised in a single sentence.

bigcitylib said...

Richard,

I have read your work, and I must say its improved lately. You certainly seem to have come around on the Stern review. Mind you, that still doesn't make up for that piece where you argue warming temperatures will turn parts of Northern Canada into vacation hotspots. And, dude, when someone from the Western Standard calls you, throw down the phone and run away screaming.

EliRabett said...

John, in his young, very young, and foolish, well a bit foolish days, Eli used to read a lot of history. There are many examples of countries and societies that failed catastrophically leaving their citizens poorer and deader for many generations. I agree fully with your point.

Anonymous said...

BCL

Some are moving because they have no choice.

Pundits and economists are like sharks.

If they do not keep moving, they will die.

John Mashey said...

Pursuant to my earlier comments, the cover story on The Economist (Dec8th-14th, 2007) that just arrived is:

"The End of Cheap Food", pp81-83.

"In early September, the world price of wheat rose to over $400 a tonne, the highest ever recorded."

Rising demand for meat (1kg of cereals; 3kg cereal => 1kg pork; 8kg cereal => 1kg beef.); ethanol.

"...if food prices rise by one-third, they will reduce living standards in rich countries by about 3%, but in very poor ones by over 20%."

Of course, natural gas -> nitrogren-based fertilizer, and we haven't yet hit Peak Gas. [Of course, there are farming practices that allow less use of such fertilizer, which also reduce the amount of N2O and fertlizer runoff in water, but it will take hard work to keep yields up as natural gas gets more expensive.]

More and more, I think that "everybody will be richer in 2050, 2100, etc" is bogus, especially if everybody = 9B people... Sounds more like a negative discount rate to me.

gz said...

The link to the Weitzman paper is wrong--it goes to the front page of Brad DeLong's blog. I found it easily enough from there, but the correct link is
http://www.economics.harvard.edu/faculty/weitzman/files/JELSternReport.pdf

EliRabett said...

Sorry, I thought I had changed it. DeLong has the nasty habit of redirecting links from his blog to his blog, or something like that. I had forgotten that you have to search for the link separately rather than just copy over. Corrected.