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Climate change: What can we learn from finance?

There is considerable disagreement among economists and policymakers about how urgently we ought to be tackling the climate change problem. Broadly speaking, there are two schools of thought. The “act urgently now” school bases its thinking on the so-called Stern Review, which was conducted by Lord Nicholas Stern and is the name given to the comprehensive study on the economics of climate change commissioned by the British government in 2006. Members of this school believe that we need to take urgent and immediate action now to dramatically reduce our emissions of carbon dioxide.

In contrast, the “act modestly now” school bases its thinking on findings obtained from computable general equilibrium models associated most closely with the work of William Nordhaus. Members of this school believe that although we ought to act now, efficient policies generally involve modest rates of carbon emissions reductions in the near term followed by sharp reductions in the medium and the long term.

The dramatic difference in the perspectives of these two schools arises almost entirely from the different numbers used by Stern and Nordhaus to discount future costs and benefits. The logic of discounting is based on the combination of delayed gratification and risk. Put differently, having $1 today is worth more than having it tomorrow or at any other point in the future. So, the disagreement between the two schools is essentially a disagreement about the magnitude of the right discount rate. This matters because a low (or high) discount rate means that future climate damages will be more (or less) significant in today’s dollars and hence this favors strong (or weak) climate action today.

There is no obviously right answer to what the discount rate ought to be, and analysts fall into either the “descriptive camp” or the “prescriptive camp.” Those in the prescriptive camp believe that the discount rate ought to conform to some ethical ideal and they pay little or no attention to actual economic conditions. In contrast, those in the descriptive camp believe that the discount rate ought to be based on real-world markets and prices. As noted in the wonderful new book titled “Climate Shock” by Gernot Wagner and Martin Weitzman, modern finance helps those in the descriptive camp approach the task of selecting the right discount rate in an intellectually coherent manner.

The key point here arises from the capital asset pricing model. If an investment’s fortune rises in difficult economic times, then this investment will be more valuable than an identical investment that rises and falls with the market. This connection between the returns of an investment and the returns of the market is called the beta. A low beta connotes a weak connection and a weak connection increases the value of an investment.

What does this mean for selecting the discount rate? If we believe that climate damages are small and that they will be worse when the economy is strong, then the discount rate ought to be high. This is a perspective that supports the use of a relatively high discount rate. In contrast and more realistically, if we believe that climate damages will be large and that they will occur when the economy is doing poorly, then the discount rate ought to be low. But how low?

To answer this question, let us follow Wagner and Weitzman and use some reasonable numbers. Suppose there is a 10 percent chance of a climate catastrophe, which means that the Earth’s average surface temperature warms by 6 degrees Celsius (11 degrees Fahrenheit) and that this warming leads to economic losses of 10 to 30 percent of global output. Then, these climate damages ought to be discounted at a rate that is possibly lower than the risk-free rate of return on government bonds. Practically, this means the appropriate discount rate ought to be between 1 and 2 percent.

The use of insights from one field to answer questions in another seemingly disconnected field is not new. Even so, we will need to engage in a lot more of this kind of thinking if we are to solve the wicked problem that is climate change.

Amitrajeet A. Batabyal is the Arthur J. Gosnell professor of economics at Rochester Institute of Technology. These views are his own.

7/8/2016 (c) 2016 Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303 or email rbj@rbj.net.

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