Thursday, July 19, 2007

Kenneth Arrow and Thomas Schelling on Climate Change

The latest issue of The Economists' Voice is out, with two articles on the economics of climate change by Nobel Prize-winning economists.

The first is an excellent primer on climate change by Kenneth Arrow: Global Climate Change: A Challenge to Policy. I'd really recommend reading it as a backgrounder to the issue:

Two factors deserve emphasis, factors that differentiate global climate change from other environmental problems. First, emissions of CO2 and other trace gases are almost irreversible; more precisely, their residence time in the atmosphere is measured in centuries. Most environmental insults are mitigated promptly or in fairly short order when the source is cleaned up, as with water pollution, acid rain, or sulfur dioxide emissions. Here, reducing emissions today is very valuable to humanity in the distant future.

Second, the scale of the externality is truly global; greenhouse gases travel around the world in a few days. This means that the nation-state and its subsidiaries, the
typical loci for internalization of externalities, are limited in their remedial ability.

The detail in the article is on the issue of discounting future costs, which is central to the findings in the Stern Report on The Economics of Climate Change that susbstantial immediate action on climate change is likely to be much cheaper over the long-term than inaction. Discounting is something I need to cover in a future Oikos 101 column, but for now I'll just observe that Stern has been criticised for using a zero rate of pure social time preference - which is consistent with the idea of inter-generational equity but inconsistent with observations by economists of how people actually behave.

Arrow conducts a sensitivity analysis, plugging different social time preference rates into Stern's figures, and finds that using a higher social time preference rate doesn't change the fundamental finding of the Stern Report, that action will cost less than inaction.

Thomas Schelling discusses what uncertainty surrounding climate change implies for policy responses and makes some sensible observations in Climate Change: The Uncertainties, the Certainties, and What They Imply About Action:

In some public discourse, and in sentiments emanating from the Bush Administration, it appears to be accepted that uncertainty regarding global warming is a legitimate basis for postponement of any action until more is known. The action to be postponed is usually identified as “costly.” (Little attention is paid to actions that have been identified as of little or no serious cost.) It is interesting that this idea that costly actions are unwarranted if the dangers are uncertain is almost unique to climate. In other areas of policy, such as terrorism, nuclear proliferation, inflation, or vaccination, some “insurance” principle seems to prevail: if there is a sufficient likelihood of sufficient damage we take some measured anticipatory action.

At the opposite extreme is the notion, often called the “precautionary principle” now popular in the European Union, that until something is guaranteed safe it must be indefinitely postponed despite substantial expected benefits. Genetically modified foods and feedstuffs are current targets. (One critic has expressed it as, “never do anything for the first time.”) In this country the principle says that until a drug has proven absolutely safe it must be deferred indefinitely.

Neither of the two extreme principles—do nothing until we are absolutely sure it’s safe; do nothing until we are absolutely sure the alternative is dangerous—makes
economic sense, or any other kind. Weigh the costs, the benefits, and the probabilities as best all three are known, and don’t be obsessed with either extreme tail of the distribution.


Eilleen said...

Thank you for this post. I have learnt somewhat. I agree too that the stance of conservative governments to do nothing until something (or alternative) is known, does not make sense - and not just economic sense but also common sense.

I have to say, I'm a tad confused over the term you used - "social time preference". From your inference it has something to do with discount rates. I don't have any economic background (well, I did Economics I at Uni but that was a looooong time ago). I'm assuming we're talking of social values being given some sort of economic/monetary value here but not exactly sure. So when you say zero rate of pure social time preference, are you in fact saying that Stern doesn't want any discount rating?? Or am I completely off track?

(sorry for the rambling comment)

David Jeffery said...

Eilleen, my understanding of discounting is pretty basic but as I understand it there's two main reasons for 'discounting' future costs and benefits, ie, treating them as worth less or less important than costs and benefits which occur now.

The first is based on the fact that you can invest money in productive activities and earn a return which effectively makes future costs less expensive. For example, I'd rather face a cost of $10,000 in 10 years than $10,000 now because I could put say $7,000 in the bank now and with compounding interest it would be worth $10,000 in 10 years, so a $10,000 hit in 10 years is really equivalent to $7,000 today. Put another way, society in say 100 years is expected to be substantially wealthier than we are now, so that costs to them will be worth less than the same costs to us now.

More controversial is the idea of a 'pure' time preference; I'd like to defer costs into the future not just because I'll be better equipped to deal with them in the future but simply because I prefer benefits now and costs in the future.

People's saving and spending decisions have been found to be consistent with the idea that they have a 'pure' preference for good things sooner rather than later.
However, it's much more controversial to say that society as a whole has a preference for benefits now rather than in the future (this is what I mean by a 'social' time preference): why should we think that benefits to our generation should be worth more than benefits to future generations. I think the response given by economists is simply that society is made up of individuals who, collectively, exhibit this preference for benefits now rather than in the future, so if I'd prefer benefits now than in 10 years and in 10 years people will prefer benefits then to in another 10 years and so on, then you should infer that society as a whole has a pure time preference that is not zero.

Eilleen said...

Thank you for taking the time to explain that to me David. It makes sense.

I wonder if there are any examples then of actual situations where there is a zero rate of pure social time preference.

That in itself is something to ponder on....