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The Economics of Climate Change

2 AEA PAPERS AND PROCEEDINGS MAY 2008 specific analysis of how climate will be affected regionally. Levels and variabilities of rain-fall depend on the functioning of ...

American Economic Review: Papers & Proceedings 2008, 98:2, –37
http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.2.

RICHARD T. ELY LECTURE

The Economics of Climate Change

By Nicholas Stern*

Greenhouse gas (GHG) emissions are exter- quickly as possible, because policy decisions are
nalities and represent the biggest market failure both urgent and moving quickly—particularly
the world has seen. We all produce emissions, following the recent United Nations Framework
people around the world are already suffering Convention on Climate Change (UNFCCC)
from past emissions, and current emissions will meetings in Bali in December 2007. The rel-
have potentially catastrophic impacts in the evant decisions can be greatly improved if we
future. Thus, these emissions are not ordinary, bring the best economic analyses and judge-
localized externalities. Risk on a global scale ments to the table in real time.
is at the core of the issue. These basic features
of the problem must shape the economic analy- A brief description of the scientific processes
sis we bring to bear; failure to do this will, and linking climate change to GHG emissions will
has, produced approaches to policy that are pro- help us to understand how they should shape the
foundly misleading and indeed dangerous. economic analysis. First, people, through their
consumption and production decisions, emit
The purpose of this lecture is to set out what GHGs. Carbon dioxide is especially important,
I think is an appropriate way to examine the accounting for around three-quarters of the
economics of climate change, given the unique human-generated global warming effect; other
scientific and economic challenges posed, and relevant GHGs include methane, nitrous oxide,
to suggest implications for emissions targets, and hydrofluorocarbons (HFCs). Second, these
policy instruments, and global action. The sub- flows accumulate into stocks of GHGs in the
ject is complex and very wide-ranging. It is a atmosphere. It is overall stocks of GHGs that
subject of vital importance but one in which the matter, and not their place of origin. The rate
economics is fairly young. A central challenge at which stock accumulation occurs depends on
is to provide the economic tools necessary as the “carbon cycle,” including the earth’s absorp-
tive capabilities and other feedback effects.
* London School of Economics and Political Science, Third, the stock of GHGs in the atmosphere
Houghton Street, London WC2A 2AE, UK (e-mail: traps heat and results in global warming: how
[email protected]). I am very grateful for the advice and much depends on “climate sensitivity.” Fourth,
comments of Claire Abeillé, Dennis Anderson, Alex the process of global warming results in climate
Bowen, Sebastian Catovsky, Peter Diamond, Simon Dietz, change. Fifth, climate change affects people,
Ottmar Edenhofer, Sam Fankhauser, Graham Floater, Su- species, and plants in a variety of complex ways,
Lin Garbett, Ross Garnaut, Roger Guesnerie, Geoffrey most notably via water in some shape or form:
Heal, Daniel Hawellek, Claude Henry, Cameron Hepburn, storms, floods, droughts, sea-level rise. These
Paul Joskow, Jean-Pierre Landau, James Mirrlees, Ernesto changes will potentially transform the physical
Moniz, Steven Pacala, Nicola Patmore, Vicky Pope, Laura and human geography of the planet, affecting
Ralston, Mattia Romani, John Schellnhuber, Matthew where and how we live our lives. Each of these
Skellern, Robert Socolow, Martin Weitzman, Dimitri five links involves considerable uncertainty. The
Zenghelis, and all of those who worked on and guided the absorption-stock accumulation, climate-sen-
Stern Review team. The views expressed here are mine and sitivity, and warming-climate change links all
do not necessarily reflect the judgements or positions of involve time lags.
those who kindly provided advice, or of the London School
of Economics, or of the UK Government, for whom I was The key issues in terms of impacts are not
working while leading the Stern Review on the Economics s­ imply or mainly about global warming as
of Climate Change. This is dedicated to my close friend, such—they concern climate change more
distinctive and distinguished economist and fine man, broadly. Understanding these changes requires
Andrew Glyn, who died on December 22, 2007, and whose
funeral took place in Oxford, UK, on the same day as the
Ely Lecture, January 4, 2008.

AEA PAPERS AND PROCEEDINGS MAY 2008

specific analysis of how climate will be affected is different from our usual examples in four key
regionally. Levels and variabilities of rain- ways: (a) it is global in its origins and impacts;
fall depend on the functioning of weather and (b) some of the effects are very long term and
c­ limate for the world as a whole. As discussed governed by a flow-stock process; (c) there is
below, temperature increases of 4–5°C on aver- a great deal of uncertainty in most steps of the
age for the world would involve radical and s­ cientific chain; and (d) the effects are potentially
dangerous changes for the whole planet, with very large and many may be irreversible. Thus,
widely differing, often extreme, local impacts. it follows that the economic analysis must place
Further, the challenge, in large measure, is one at its core: (i) the economics of risk and uncer-
of dealing with the consequences of change tainty; (ii) the links between economics and eth-
and not only of comparing long-run equilibria. ics (there are major potential policy trade-offs
Under business as usual (BAU), over the next both within and between generations), as well as
two centuries we are likely to see change at a notions of responsibilities and rights in relation
rate that is fast-forward in historical time and to others and the environment; and (iii) the role
on a scale that the world has not seen for tens of of international economic policy. Further, the
millions of years. potential magnitude of impacts means that, for
much of the analysis, we have to compare strate-
This very brief and oversimplified descrip- gies that can have radically different develop-
tion of the science carries key lessons for eco- ment paths for the world. We cannot, therefore,
nomics. The scientific evidence on the potential rely only on the methods of marginal analysis.
risks is now overwhelming, as demonstrated in Here, I attempt to sketch briefly an analysis that
the recent Intergoverrnmental Panel on Climate brings these three parts of economics to center
Change (IPCC) Fourth Assessment Report, or stage. It is rather surprising, indeed worrying,
AR4 (IPCC 2007). Like most of those here today, that much previous analysis of practical policy
I am not a climate scientist. As economists, our has relegated some or all of these three key
task is to take the science, particularly its analy- pieces of economics to the sidelines.
sis of risks, and think about its implications for
policy. Only by taking the extraordinary posi- The Structure of the Argument.—The struc-
tion that the scientific evidence shows that the ture of the argument on stabilization is crucial,
risks are definitely negligible should econo- and we begin by setting that out before going
mists advocate doing nothing now. The science into analytical detail. The choice of a stabili-
clearly shows that the probability and frequency zation target shapes much of the rest of policy
of floods, storms, droughts, and so on, is likely analysis and discussion, because it carries strong
to continue to grow with cumulative emissions, implications for the permissible flow of emis-
and that the magnitude of some of these impacts sions, and thus for emissions reductions targets.
could be catastrophic. The reduction targets, in turn, shape the pricing
and technology policies.
While an understanding of the greenhouse
effect dates from the nineteenth century, in Understanding the risks from different strate-
the last decade, and particularly in the last few gies is basic to an understanding of policy. Many
years, the science has fortunately started to give articulated policies for risk reduction work in
us greater guidance on some of the possible terms of targets, usually expressed in terms of
probability distributions linking emissions and emission flows, stabilization levels, or average
stocks to possible warming and climate change, temperature increases. The last of these has
thus allowing us to bring to the table analytical the advantage that it is (apparently) easier for
tools on economic policy toward risk. the general public to understand. The problem
is that this apparent ease conceals crucial ele-
The brief description of the science above tells ments that matter greatly to social and economic
us that GHG emissions are an externality which outcomes—it is the effects on storms, floods,
droughts, and sea-level rise that are of particular
Joseph Fourier recognized in the 1820s (Fourier 1827) importance, and a heavy focus on temperature
that the atmosphere was trapping heat; three decades later, can obscure this. Further, and crucially, tem-
John Tyndall (1861) identified the types of gases responsi- perature outcomes are highly stochastic and
ble for the trapping; and at the end of the century, Svante cannot be targeted directly. Emissions can be
Arrhenius (1896) gave calculations of the possible effects
of doubling GHGs.

VOL. 98 NO. 2 richard t. ely lecture

more easily controlled by policy. However, it is most important in my view, it can help to clarify
the stocks that shape the warming. Thus, there key trade-offs and the overall logic and key ele-
are arguments for and against each of the three ments of an argument.
dimensions. We shall opt for stock targets, on
the basis that they are closest to the phenomenon A useful analogy is the role of Computable
that drives climate change and the most easily General Equilibrium Models (CGMs) in discus-
expressed in one number. sions of trade policy. These have much more
robust foundations than aggregative models on
An alternative focus for policy is the price the economics of climate change, yet their quan-
of GHGs rather than quantities. In a perfectly titative results are very sensitive to assumptions,
understood nonstochastic world, standard dual- and they leave out so much that is important to
ity theory says that price and quantity tools are policy. Thus, most economists would not ele-
essentially mirror images and can be used inter- vate them to the main plank of an argument on
changeably. However, where risk and uncer- trade policy. That policy would usually be bet-
tainty are important and knowledge is highly ter founded on an understanding of economic
imperfect, we have to consider the relative merits theory and of economic history, together with
of each. For the most part, we ignore the differ- country studies and particular studies of the
ence between risk and uncertainty here (where context and issues in question.
the latter is used strictly in the Knightian sense
of unknown probabilities), but it is a very impor- However, as the Stern Review stressed, such
tant issue (Claude Henry 2006; Stern 2007, 38– analysis has very serious weaknesses and must
39) and a key topic for further research. not be taken too literally. It is generally forced
to aggregate into a single good, and in so doing
We begin by setting out some of the major misses a great deal of the crucial detail of
risks from climate change, and argue that these impacts—on different dimensions and in differ-
risks point to the need for both stock and flow ent locations—which should guide risk analy-
targets, guided by an assessment of the costs sis. It is forced to make assumptions about rates
involved in achieving them. Long-term stabiliza- and structures of growth over many centuries.
tion (or stock) targets are associated with a range Further, it will be sensitive to the specification
of potential flow paths, although the stock target of ethical frameworks and parameters. Thus its
exerts a very powerful influence on their shape. estimates of marginal social costs of damages
The choice of a particular flow path would be provide a very weak foundation for policy. This
influenced by the expected pattern of costs over type of modelling does have an important sup-
time. The target flow paths can then be associ- plementary place in an analysis, but all too often
ated with a path for marginal costs of abatement, it has been applied naively and transformed into
if we think of efficient policy designed to keep the central plank of an argument.
flows to the levels on the path, in particular by
using a price for carbon set at the marginal abate- Our analysis of risks and targets points to the
ment cost (MAC). Essentially, the economics of need for aggregate GHG stabilization targets of
risk points to the need for stock and flow quantity below 550 parts per million (ppm) carbon diox-
targets and the economics of costs and efficiency ide equivalent 1CO2e 2 , arguably substantially
to a price mechanism to achieve the targets. below. This corresponds to cuts in global emis-
sions flows of at least 30 percent, and probably
A policy that tries to start with a price for around 50 percent, by 2050. These cuts may
marginal GHG damages has two major prob- seem large in the context of (we hope) a growing
lems: (a) the price estimate is highly sensitive to world economy, but are not ambitious in relation
ethical and structural assumptions on the future; to the risks we run by exceeding 550ppm CO2e.
and (b) there is a risk of major losses from higher And, given the avoided risks, the costs of around
stocks than anticipated, since the damages rise 1 percent of world GDP per annum (see Section
steeply with stocks and many are irreversible. IB below) of achieving this stabilization should
be regarded as relatively low. The carbon price
Formal modelling of damages can supple- required to achieve these reductions (up to, say,
ment the argument in three ways. First, it can 2030) would be around, or in excess of, $30 per
provide indicative estimates of overall damages ton of CO2.
to guide strategic risk analysis. Second, it can
provide estimates of marginal damage costs of This paper incorporates many important ele-
GHGs, for comparison with MACs. Third, and ments of the Stern Review, published on the Web









AEA PAPERS AND PROCEEDINGS MAY 2008

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Figure 2. BAU and Stabilization Trajectories for 450–550ppm CO2e

Source: Stern Review, Figure 8.4 (Stern 2007, 233).

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Figure 3. Reducing Emissions Requires Action across Many Sectors

Source: Stern 2007, 196.

close-to-zero emissions for much of transport. way of life to the extent of that brought by elec-
This would, however, require radical changes tricity, rail, automobiles, or the Internet.
to the source and use of energy, including much
greater energy efficiency. Achieving the neces- On the path for stabilization there would
sary reductions would also require an end to be different options for cutting emissions that
deforestation. The totality of such reductions would be more prominent at different times. In
would, however, not result in a radical change in the earlier periods, there would be greater scope
for energy efficiency and halting deforestation,

VOL. 98 NO. 2 richard t. ely lecture

and with technical progress there will be, and social cost of carbon (SCC) reflecting the
already are, strong roles for different technolo- future damage of an incremental emission. The
gies in power and transport. l­evels quoted here for the MAC are consistent
with ranges for the SCC indicated in the Stern
Various different options for abatement were Review along an abatement path for 550ppm
discussed in Chapter 9 of the Stern Review. CO2e stabilization.
McKinsey has recently carried out a more
detailed study (Per-Anders Enkvist, Tomas However, the SCC is very slippery numeri-
Nauclér, and Jerker Rosander 2007)—see Figure cally since it is so sensitive to assumptions
4. There are several important lessons from this about model structure, including future emis-
type of curve. First, there are many options for sion paths, carbon cycles, climate sensitivity,
reducing emissions that have negative cost; that future technologies, and ethical approaches to
is, they save money. Second, there is a whole valuation over the centuries to come. The SCC
range of options and each should be explored in at time t is the expectation of the integral over t
detail—for example, the costs associated with from t onward of:
combating deforestation in the McKinsey curve • the marginal social utility of consumption at
are, in my view, far too high. Third, the emis-
sions savings from any one option will depend t (embodying ethical values and a particular
on what it replaces. Fourth, given the broad path)
range of options, policy is very important—bad 3 the impact on consumption at t of all rel-
policy will lead to the uptake of more expensive
options. Fifth, technical progress will be impor- evant preceding temperature changes (and
tant and should be promoted so that the range resultant climate change)
of options is widened and costs are reduced. 3 the impact on a relevant temperature
Finally, and of special importance, starting now increase of increases in preceding carbon
in a strong way and with clear signals will allow stocks
more time for planned choices, discovery of 3 the impact on all relevant stocks of an
options, and exploration of the renewal periods increase in carbon emissions at t, where
and timings for equipment. This is the meas- “impact” in the above is to be interpreted
ured, lower-cost approach. Going more slowly as a partial derivative.
and then moving in haste when and if the sci- Given this sensitivity, it is remarkable how
ence is confirmed still more strongly, is likely to carelessly the SCC is often quoted—it is quite
be the expensive option. common, for example, for people to quote an
SCC without even referring to a reference emis-
Very importantly for policy, this type of fig- sions path, to say nothing of all the other rel-
ure gives us an understanding of where carbon evant assumptions that matter greatly.
prices (or GHG prices more generally) should Thus, the SCC is a very weak foundation for
be. By 2030, cuts at the world level would have policy. The target approach and the calculation
to be of the order of 20 Gt CO2e (see Figure 2) of the associated MAC is more attractive from
for stabilization at 550ppm CO2e. This suggests the point of view both of policy toward risk and
a CO2 price of around €30 per ton. of clarity of conclusions. It is also important,
however, to check prices derived from the MAC
A fairly clear idea of where the carbon price against SCC calculations and to keep policy
should be from the point of view of necessary under revision, as further information and dis-
abatement is of great help both to policymakers covery arrives. Some notion of the SCC is also
and to investors. It also provides the opportu- useful in examining the emissions savings from,
nity to check against estimates of the ­marginal
This sketch of the calculation assumes the simple
Illustrative MAC curves were provided in the Stern objective of the maximization of the integral of expected
Review, Figures 9.1 (Stern 2007, 243) and 9.2 (Stern 2007, utility.
249).

Erin C. Myers (2007, 9–12) reviews the literature and
highlights the outlier status of the McKinsey deforestation
estimate; see also the discussion in Section IV.

This is not the place to speculate about euro-dollar
exchange rates over two or three decades.

10 AEA PAPERS AND PROCEEDINGS MAY 2008



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Figure 4. McKinsey Bottom-Up Approach to Abatement Costs
Source: Enkvist et al. 2007, 38.

for example, transport programs or policies. If The Stern Review (Chapter 10) also looked
the MAC and SCC were thought to be in very at top-down macro modelling of costs of
different ball parks for an anticipated path, it emissions reductions (see also Terry Barker,
would suggest strongly that policy revision is Mahvash Saeed Qureshi, and Jonathan Köhler
necessary. 2006). Both the bottom-up (Chapter 9) and
the top-down (Chapter 10) studies produced
Prices for abatement should be at a level that numbers in similar ranges—around 1 percent
supports carbon capture and storage (CCS) for of world GDP. There is, of course, consider-
coal. Without CCS for coal it will be difficult able uncertainty. Bad policy or delayed deci-
(and more costly) to achieve the necessary cuts, sions could give higher numbers. Stronger
given that many countries will rely heavily on technical progress could give lower numbers.
coal for power generation for the next 30 or Assumptions about ­substitutability between dif-
40 years (IEA 2006; 2007). China and India ferent goods and options matter, too. Since the
(Expert Committee on Integrated Energy Policy Stern Review was published, there have been
(ECIEP) 2006), for example, will be using coal a number of new studies, both bottom-up and
for around 80 percent of their electricity plants top-down. Significant examples of the former
for the next 30 years or so—for the simple rea- are those from McKinsey (Enkvist, Nauclér,
sons that coal is cheap and available within their and Rosander 2007) and the IEA (2007), both
own borders; that they are familiar with the of which indicated costs either in the region we
technologies; and that the plants can be erected suggested, or somewhat lower. Similar conclu-
quickly. Speed is of great importance for them, sions are drawn in the AR4 (IPCC 2007).
as the costs of electricity outages are very high.

VOL. 98 NO. 2 richard t. ely lecture 11

It is very important to recognize that costs reduce emissions, and thus risks. This is the
of 1 percent of GDP do not necessarily slow kind of judgement that people take when con-
medium- or long-term growth rates. They are sidering various forms of insurance, or design
like a one-off 1 percent increase in prices from of buildings or infrastructure, or new medical
“doing energy” in different ways. Further, there treatments. They try to be as clear as possible
is a real possibility that incentives to discov- on consequences and costs, bearing in mind
ery could generate a Schumpeterian burst of that both are stochastic and that risk is of the
growth—on such possibilities see recent work essence, while also being aware that it will often
by Philippe Aghion (2007). The scale of markets be difficult to put a price or money values on
for new technologies will be very large (IEA consequences and risks.
2006); see also Samuel Fankhauser, Friedel
Sehlleier, and Stern (2007) for an assessment It is also informative, however, to try to pro-
of investment and employment opportunities, duce, using aggregate models, quantitative esti-
which are likely to be positive.10 mates of avoided damages in order to compare
with costs. For climate change, that quantifi-
Finally, reducing GHGs can bring strong cation may be possible for some dimensions,
benefits elsewhere. Cleaner energy can provide for some locations, for some time periods, and
greater energy security and energy access. It can for some ranges of temperature increases.11
give reductions in local air pollution. Cleaner However, the avoidance of planet-transform-
transport policies can increase life expectancy. ing change by keeping down risks of 5°C and
Combating deforestation can protect watersheds, above is at the heart of the argument here and it
sustain biodiversity, and promote local liveli- is extremely difficult to provide plausible aggre-
hoods. Taking these associated benefits into gate numbers for the effects and overall dam-
account would reduce cost estimates further. ages of temperatures so far out of experience,
particularly when nonlinearities may be of great
In summary, looking back after a year, we importance. Nevertheless, formal modelling is
would suggest that subsequent evidence and central to the tools of our trade and the exercises
analysis have confirmed the range of our cost do have value in bringing out the logic of some
estimates for stabilization, or indicated that they important trade-offs.
may be on the high side. Good policy and timely
decision making are, however, crucial to keep- In making valuations of consequences, we
ing costs down. And we would emphasize that have to face very difficult analytical and ethical
taking a clear view now of a stabilization goal issues. How does one value the transformation of
allows for a measured and careful adjustment, the planet, the consequences of radical changes
allowing for the replacement cycles of capital in ways of life, and big movements of population
goods. To wait and see, or to rely on a “cli- and associated conflict? Our standard cost-ben-
mate policy ramp,” risks not only excessive and efit analysis (CBA) tools do not give us much
dangerous levels of stocks but also much more guidance. I have invested a lot of effort (e.g.,
costly abatement if, as is likely, there is a sub- Jean P. Drèze and Stern 1987, 1990), as have
sequent realization that the response has been many others, in developing these tools, and have
delayed and inadequate. some understanding of what they are and where
they can be applied. They are largely marginal
II.  Stabilization of Stocks of   methods, providing tools for analysis of big
Greenhouse Gases II:  changes in, say, one or two markets as a result of
a program. But when we are considering major
Modelling and Evaluation of Damages strategic decisions for the world as a whole, with
huge dynamic uncertainties and feedbacks, the
A. Introduction potential contribution of an approach to decision
making based on marginal methods is very lim-
The previous section looked directly at the ited. Rational decision making has to go back
risks from GHGs, and at the costs of action to to the first principles from which the marginal

10 These assessments refer to the potential shifts of 11 See, for example, Chapters 1, 3, 4 and 5 of the Stern
the demand side of labor markets—outcomes depend, of Review.
course, on market structures.

12 AEA PAPERS AND PROCEEDINGS MAY 2008

methods of CBA are derived. This is not at all Let us start with the definition of a discount
to use a different theory. On the contrary, it is to rate in policy evaluations. It is simply the propor-
maintain the theory and to avoid a gross misap- tionate rate of fall of the value of the numeraire
plication of the special (i.e., marginal) case. used in the policy evaluation. In the simple case,
with aggregate consumption as the numeraire,
The centrality of nonmarginal changes and we have a social discount factor or SDF, l 1t 2 ,
of risk means either using the risk-analysis which measures the social value of a unit of con-
approach of Section IA, or using aggregate mod- Tsuhmepstoicoinalatdtiismcoeutnrterlaatteiv, eortoSaDuRn,iitsatthteinm2e zl· e /rlo..
elling with a social welfare function to compare
consequences. Both have their role, but for the A number of general conclusions follow
reasons given I would see the former as the main immediately from these basic definitions. First,
plank of the argument. The latter has a valuable the SDF and the SDR depend on a given refer-
supplementary role which we now investigate. ence path for future growth in consumption and
will be different for different paths. Second, the
In setting out a social welfare function to discount rate will vary over time. Third, with
evaluate damages and costs, the valuation of uncertainty, there will be a different discount
consequences on different dimensions—social, rate for each possible sequence of outcomes.
health, conflict, and so on—will be extremely Fourth, there will be a different discount rate
difficult. I do not go into these issues. I focus for different choices of numeraire. In imperfect
on one issue that has, understandably, received economies, the social value of a unit of private
considerable attention in discussion of the Stern consumption may be different from the social
Review—how to value benefits accruing to dif- value of a unit of private investment, which may
ferent people at different times. There are una- be different from the social value of a unit of
voidable ethical issues. They are the subject of public investment. And the rates of changes of
Section IIB. In Section IIC we examine some of these values may be different too.
the challenges, results, and sensitivities of for-
mal modelling, and comment on new evidence A further key element for understanding dis-
and discussions concerning the Stern Review’s count rates is the notion of optimality of invest-
damage estimates after one year. ments and decisions. For each capital good, if
resources can be allocated without constraint
B. Ethics between consuming the good in question and its
Discounting.—Much of the discussion of use in accumulation, we have, for that good, the
ethics in relation to the Stern Review has been result that the social rate of return on investment
focused on discounting. Sometimes, simplistic (the marginal productivity of this type of good
approaches to discounting conceal or obscure at shadow prices), the SRI, should be equal to
the underlying structural and ethical logic by the SDR in terms of that good (i.e., with that
shoehorning the issues into a simple discount good as numeraire). This is intuitively clear and
rate specified entirely externally to the problem. in optimal growth theory is a standard first-
However, careful use of theory and concepts is order condition. But where there are constraints
crucial. Some have argued that “the discount on this optimization, as there usually will be
rate of the Stern model” is too low in relation to in imperfect economies, this condition that the
market rates of return. This argument has gener- SRI equal the SDR is not generally applicable.
ally been thoroughly confused for a whole set of Drèze and Stern (1987, 1990), for example, show
reasons. It arises from inappropriate application how opportunity costs, and thus shadow prices
of a marginal method to a strongly nonmarginal and shadow rates of return, depend on which
context, failure to apply modern public econom- alternative use a unit of resource comes from.
ics, ignorance of the multi-good nature of this Further, in such economies it will not generally
problem, and, in some cases, ignorance of the be true that the private rate of return on invest-
difference between a social discount rate and ment (PRI) will be equal to the SRI. And simi-
a pure time discount rate. Given this pervasive larly, private discount rates (PDRs) can diverge
confusion about the basic theory of discounting, from SDRs. Such divergences can arise from all
it seems worthwhile to clarify briefly the logic forms of market imperfections, including exter-
of discounting as applied to climate change and nalities. In this case we have the additional com-
relate it to some simple empirical data. plication that key players, future ­ generations,





VOL. 98 NO. 2 richard t. ely lecture 15

and Weitzman (2007b)—implies that the util- Distributional Judgements.—Having seen
ity of a person born in 1995 (1985) would be the implausibility of importing a discount rate
“worth” (have a social weight) roughly half that from outside the model to sidestep ethical judge-
of a person born in 1960. This type of discrimi- ments, let us turn to the ethics relating to the
nation seems very hard to justify as an ethical distribution of consumption or income, at least
proposition and would be unappealing to many. in its very narrow form of h within the narrower
Indeed, the ethical proposition that d should be cases (as in the models that follow) where the
very small or zero has appealed to a long line social objective is the expectation of the inte-
of illustrious economists including Frank P. gTrhailnkoifnggabi ouut1 ci 2 e2dt (Stern 2007, 50–54).15
Ramsey (1928, 543), Arthur Cecil Pigou (1932, h is, of course, thinking about
24–5), Roy F. Harrod (1948, 37–40), Robert M. value judgements—it is a prescriptive and not
Solow (1974, 9), James A. Mirrlees (Mirrlees and a descriptive exercise. But that does not mean
Stern 1972), and Amartya Sen (Sudhir Anand that h is arbitrary; we can, and should, ask
and Sen 2000). I have heard only one ethical about “thought experiments” and observations
argument for positive d (Wilfred Beckerman that might inform a choice of h. In so doing we
and Hepburn 2007; Simon Dietz, Hepburn, and must remember that h plays three roles, guiding
Stern 2008) that has some traction—namely a (a) intratemporal distribution, (b) intertemporal
temporal interpretation of the idea that one will distribution, and (c) attitudes to risks. We look
have stronger fellow feelings for those closer at the relevance of empirical data for each of the
to us (such as family or clan) relative to those three in turn.
more distant. This is often explained in terms
of functionality for survival of groups. However, Intratemporal Distribution: Let us begin
this type of reasoning from evolutionary biol- with a thought experiment concerning direct
ogy does not have much relevance when we are consumption transfers in a very simple con-
thinking about the survival of the planet as a text. If A has k times the consumption of B, the
whole. social value of a unit of consumption to B is kh
times that to A for constant h. For example, for
For these reasons, the Stern Review followed k 5 5 and h 5 2, the relative value is 25 and a
the tradition established by the economists cited transfer from A to B would be socially worth-
above, adopting and arguing strongly for a d while even if up to 96 percent were lost along
that exceeds zero only in order to account for the way (the so-called “leaky bucket”—Arthur
the possibility of some exogenous event that M. Okun (1975)). While I might not regard that
would render future welfare calculations irrele- position as unacceptable, to take just one exam-
vant—the exogenous extinction of humanity (for ple, it appears inconsistent with many attitudes
discussion of this interpretation of d, see, e.g., to transfers. In this sense, many would consider
David Pearce and David Ulph (1995) and David an h of 2 to be very egalitarian. With h 5 1,
Newbery (1992)). On this basis, the Review the 96 percent in the example above becomes 80
adopted a d of 0.1 percent (although even this percent because the unit to B is worth five times
value for d appears to be quite large in relation that to A. Some might regard even this position
to this interpretation, implying a probability of as rather egalitarian.
exogenous extinction of around 10 percent in 100
years). For a project or program, the probability Value judgements are, of course, precisely
of exogenous extinction could be substantially that and there will be many different positions.
higher, and this is reflected in some cost-benefit They will inevitably be important in this con-
manuals or approaches; in our case, however, we text—they must be discussed explicitly and
are considering humanity as a whole. the implications of different values should be
examined. Examples follow of what we find
My overall assessment of the discussion of when we turn to empirical evidence and try to
discounting in the context of climate change is obtain implied values (the “inverse optimum”
that it is disappointing. All too often it has failed approach). Empirical evidence can inform, but
to come to grips with the basic concepts, with
the key nonmarginal and uncertainty elements 15 The summation is across individuals existing at time t
at the core of the issue, and with the theories of and ci is the consumption of individual i.
social cost-benefit analysis and modern public
economics of the last 30 or 40 years.

16 AEA PAPERS AND PROCEEDINGS MAY 2008

not settle, discussions about value judgements— It is striking that there are some, such as
for further exploration see Dietz, Hepburn, and Nordhaus (2007b) and Weitzman (2007b), who
Stern (2008). In using such evidence, we must appear to argue for high h (equal to 2 or 3) in
constantly bear in mind two key issues. First, we intertemporal analysis yet do not bring out how
must ask about the relevance of individual deci- this is potentially inconsistent with standard
sions for the societal decisions about the prob- cost-benefit analysis treatments of intragen-
lem at hand—here social decisions by the world erational distribution (which effectively assume
community now, bearing in mind consequences h 5 0) or with some intratemporal tax and trans-
for future generations. And, second, if we infer fer policies.
values from decisions, we must ask whether we
have modelled well the decision processes, the Intertemporal Distribution: In discussions
objectives, and the perceived structure of the of h in an intertemporal framework, there has
problem as seen by the decision maker. been much focus on implied saving rates. Some
(Partha Dasgupta 2007, 6; Nordhaus 2007b,
Anthony B. Atkinson and Andrea Brandolini 694–96), following arguments in Kenneth J.
(2007) have produced an interesting set of Arrow (1995, 12–17), have criticized the rela-
examples on empirical income distributions and tively high weight placed by the Stern Review on
actual transfer schemes in relation to welfare the consumption of future generations (whether
weights.16 They conclude that constancy of h via h or d) by arguing that the Review’s param-
across a range of increases is difficult to “square eter choices can, in certain scenarios, imply
with” the way that many transfer schemes occur implausibly high optimal savings rates. As is
in practice; in addition, there are many exam- clearly explained in the Review (Stern 2007,
ples where policies appear inconsistent with h 54), with d 5 0, output proportional to capital,
greater than one. For example, given the cur- and no technical progress, the optimal savings
rent income distribution in the United States, rate is 1/h. With h close to one, this would lead
an h of two would imply that a redistribution to very high optimal savings rates. At the same
from the fifth-richest decile to the second-poor- time, the Review also states clearly (Stern 2007,
est decile would be welfare-improving even if 54) that this result is highly dependent on model
only 7 percent of the transfer reached the recipi- assumptions.
ent; for a transfer from the richest decile to the
second-poorest, virtually any redistribution Brad DeLong, in a short blog entry (DeLong
would be welfare-improving regardless of loss 2006), points out this flaw in the Dasgupta-
along the way, so long as the recipient received Nordhaus position and argues that techni-
some benefit (Atkinson and Brandolini 2007, cal progress would greatly reduce the optimal
14). Of course, interpretation of actual intratem- ­savings rate. Mirrlees and Stern (1972) ­presented
poral tax and transfer schemes will depend on a more fully developed argument. Using a
many assumptions about the structure of incen- standard one-good, infinite-horizon Ramsey
tives17 and policymaking procedures. Perhaps growth model, constant returns to scale, and a
people think that tax-transfer disincentives are Cobb-Douglas production function, they show
very strong and they oppose transfers for these that under one specification—with constant
reasons. Or notions of rights and duties may population, a competitive share of capital equal
influence them. The upshot is that empirical to 0.375, and 3 percent exogenous technologi-
estimates of implied welfare weights can give a cal progress—the optimal consumption path
wide range of h, including h below one and even for h 5 2 and d 5 0 involves a savings rate, s,
as little as zero. between 0.19 and 0.29 (or 0.23 if constrained to
a constant s). This is far below the 0.5 that would
16 The welfare weight on an individual with consump- be optimal with h 5 2 and d 5 0 in the simpler
tion c is taken here as the social marginal utility of con- case of output proportional to capital and no
sumption at that level. To keep things simple, we assume technical progress.
that this depends only on the individual’s consumption and
not on her preceding consumption or the consumption of Just as with intragenerational values, the
others. approach of the “inverse optimum” or implied
social values does not take us very far in this
17 See, for example, Stern (1976), who shows how sensi- context. We cannot really interpret actual sav-
tive tax calculations are to assumptions about substitutabil- ing decisions as revealing the collective view
ity between goods and leisure.

VOL. 98 NO. 2 richard t. ely lecture 17

of how society acting together should see its are comparing strategies that yield very differ-
responsibilities to the future in terms of distri- ent paths. Third, within this framework we may
butional values—too much depends on assump- focus the discussion on elasticities of marginal
tions about how decisions are made in a society social utility h and pure time discount rates d,
and on how the participants perceive the work- but in so doing we must recognize the ethical
ings of the future economy. Observed aggregate narrowness of this approach. Fourth, direct ethi-
savings rates are sums of individual decisions, cal discussion of h and d suggests a broad range
each taken from a narrow perspective. This is for h, although the consequences for simple
not the same thing as a society trying to work transfers suggest that many would regard h in
out responsible and ethical collective action— excess of 2 as unacceptably egalitarian; on the
the crucial issue for climate change. other hand, there appears to be little in the way
of ethical arguments to support d much above
Attitudes to Risks: “Guidance” on h from zero. Fifth, within a marginal analysis frame-
analyses of risk and uncertainty is even less work, the relevant concept for discounting here
informative. We can interpret h as the param- is the SDR. In the narrow h–d context, with h
eter of relative risk aversion in the context of an of 1 to 2, very low d, and growth at 1.5–2.5 per-
expected utility model of individual behavior. cent,19 we find an SDR of 1.5–5 percent, which
However, the expected utility model is unreliable is close to ranges for long-run consumer real
as a description of attitudes to risk. Further, we borrowing rates and (at least in the UK) govern-
see a whole range of behavior, from the accep- ment discount rates for program evaluations.
tance of “unfair risks” in gambling 1similar to h
, 02 to extreme risk aversion in insurance 1very C. Formal Modelling
high h 2. And even if behavior were somewhat
more “rational” in the narrow sense of conform- Aggregate models have been popular in the
ing to the expected utility hypothesis, it would economics of climate change. They attempt
still be unclear how sound a basis it would be for to integrate the science of climate change, as
the specification of a prescriptive value for use expressed, for example, via GCMs, with eco-
in this context. nomic modelling and are termed integrated
assessment models, or IAMs.
From this very brief discussion of empirical
information, which might help us to think about As I have argued, it is very hard to believe that
h in a prescriptive context, our conclusion is that models where radically different paths have to
there is very little to guide us.18 Again, we are be compared, where time periods of hundreds of
pushed back to the standard moral philosopher’s years must be considered, where risk and uncer-
approach of trying to think through simple tainty are of the essence, and where many cru-
examples, i.e., the thought experiment. It has the cial economic, social, and scientific features are
great virtue of facing the issues directly—it is poorly understood, can be used as the main quan-
transparent and clear. titative plank in a policy argument. Thus, IAMs,
while imposing some discipline on some aspects
What do we conclude about ethics and dis- of the argument, risk either confusing the issues
counting in this context when we clear the vari- or throwing out crucial features of the problem.
ous confusions out of the way? The answer is
fairly simple. First, we must address the ethics A related but different point is their use,
directly. There is no simple market information when modelling of costs of abatement is inte-
from intertemporal choices or otherwise that can grated with modelling of damages from emis-
give us the answers. Second, if we express the sions, as vehicles for optimization analysis. In
problem in standard welfare economic terms,
i.e., portray the objective as an expectation of an 19 In Section IIC we consider h in this range. Higher
integral of social utility, we cannot use marginal growth rates are not examined in detail. The modelling
approximations to changes in welfare since we would have to take account of a changed path of emissions
with earlier damages. With risk distributions appropriate
18 Thirty years ago (Stern 1977), I examined all three to current knowledge, our preliminary findings suggest
of these methods with no particularly strong conclusions, that estimated damages from climate change are likely to
other than that the results covered a broad range. be well above the cost of action to drastically reduce those
risks.









22 AEA PAPERS AND PROCEEDINGS MAY 2008

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Figure 5. Estimates of Climate Sensitivity from IAMs Compared to GCMs
Sources: Tol 2002; Nordhaus and Boyer 2000; Hope 2006a; 2006b; IPCC 2007; Meinshausen
2006.

is not so much why the Stern Review’s model- (b) The carbon cycle is likely to weaken as
ling obtained high damages under BAU, as why a result of, for example, the possible col-
the earlier literature made assumptions that give lapse of the Amazon forest at temperature
such low results. increases of above 3–4°C, or the decreas-
ing absorptive capacity of the oceans.
D. Damages and Sensitivity, Further, a thawing of the permafrost is
One Year On from the Review likely to result in strong methane release.
Looking back, I think the Review was
too cautious on all four of the key structural (c) The climate sensitivity assumed in the
e­ lements: (a) emissions growth, (b) carbon cycle, Review is likely to be conservative (as
(c) climate sensitivity, and (d) damages from a argued in Section I).
given temperature.
(a) The work of Ross Garnaut and his (d) The damages from given temperature
Commission, working for the new increases assumed in the Stern Review
Australian government on climate change, seem very low. The Review’s mean dam-
is revisiting the emissions scenarios in age loss (based on estimates in the eco-
the IPCC Special Report on Emissions nomic literature) from 5°C was around
Scenarios or SRES (IPCC 2000). In its 5 percent of GDP (Stern 2007, 180). As
Chapter 6 model (Stern 2007, 173–88), the argued in Section I, a temperature increase
Stern Review used the second highest of of 5°C would most likely result in massive
the four scenarios (called A2). Garnaut is movements of population and large-scale
now suggesting that the highest of the four, conflict.
A1F1, is likely to be the best description of
BAU (Garnaut 2007). Key among the rea- Considering these structural factors together,
sons is the growth rates of the developing the modelling of the Stern Review probably
world, particularly China and India, and underestimated significantly the risks of high
their continued strong emphasis on coal damages from BAU, perhaps by 50 percent
(ECIEP 2006). or more if one compares the first two rows of
Table 2. Much of the earlier literature grossly
underestimated the risks.

VOL. 98 NO. 2 richard t. ely lecture 23




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Figure 6. The Modelled Damages from Climate Change with Increasing Global Temperatures

Source: Dietz et al. 2007a.

Looking at both g and h, with the benefit the reasons that some earlier studies have lower
of hindsight, my inclination would be to place damage estimates than the Stern Review are
the base case from which sensitivity analy- twofold: they badly underestimate all four of the
sis is undertaken farther down the diagonal of elements just described, and in many cases their
Table 2—that is, with higher g and higher h. As approach to pure time discounting discrimi-
indicated in Section IIB, the “weight in the far nates, unjustifiably in my view, very strongly
future” from h 5 1 and d 5 0.1 percent sug- against future generations.
gests that there is a case for raising h, although
it remains true that many would see the implica- III.  Policy Instruments
tions of h 5 2 for intragenerational distribution At the heart of good policy will be a price
as very egalitarian. In a sense, moving down the for GHGs—this is a classic and sound approach
1h 2 g2 diagonal is taking on board the positions to externalities and is crucial for an incentive
of two commentators on the Review—Weitzman structure both to reduce GHG emissions and
(2007a, b) argued for greater emphasis on risk to keep costs of abatement down. Indeed, in a
and uncertainty, and Dasgupta (2007) for more world without any other imperfections, it would
egalitarian values than those captured by h 5 1. be a sufficient instrument for optimal policy.
But it will not be enough in our world, given
In summary, one year on from the Stern the risks, urgency, inertia in decision making,
Review, with the benefit of new scientific evi- difficulty of providing clear and credible future
dence and valuable economic discussions, my price signals in an international framework,
views would have been modified as follows. First, market imperfections, unrepresented consum-
the case has been strengthened that the bottom- ers, and serious concerns about equity. A second
up, disaggregated, less formal, risk-­evaluation plank of policy will have to embrace technology
approach is preferable to aggregate modelling and accelerate its development. Third, policy
in investigating the case for action. The latter should take account of information and trans-
is particularly weak in relation to formal opti- actions costs, particularly in relation to energy
mization. Second, within aggregate modelling, efficiency. Fourth, it should provide an interna-
we have learned still more clearly that the key tional framework to help with combating defor-
issues are ethics and risks and that we have to estation, which is subject to a number of market
look at them together to form a serious view on failures. And fifth, policy should have a strong
damages. Third, our own modelling probably
underestimated the risks from BAU. Fourth,

24 AEA PAPERS AND PROCEEDINGS MAY 2008

international focus, to promote collaboration, less so than others and allow the balance of taxes
take account of equity, and reduce global costs. to adjust away from other taxes such as income
or VAT; alternative uses of revenue are possible
Careful analytical investigation by econo- too, including those related to climate change.
mists of policies on climate change involves the We should beware, though, of arguments about
whole range of the tools of our trade, including double dividends: environmental taxes have
the economics of risk and uncertainty, innova- dead-weight losses in addition to their benefi-
tion and technology, development and growth, cial effects in addressing externalities. Taxes on
international trade and investment, financial GHGs would require measurement of GHGs,
markets, legal issues, ethics and welfare, as well just as in trading, but taxes on petroleum prod-
as public and environmental economics. It will ucts, coal, or other fossil fuels can act as fairly
no doubt require the development of further good approximations, avoiding direct emission
analytical methods. And it necessitates close measurement, which can be relatively costly to
collaboration with scientists and other social small enterprises.
scientists.
As discussed in Section IA, where the world
Our focus here in this very brief discussion is perfect other than in relation to the tax in
of policy will be on price-oriented mechanisms question, quantity controls and price measure-
and on technology, but we should also note a ments can have dual and essentially identi-
sixth key element that is often overlooked in dis- cal effects. Where there is risk, uncertainty,
cussions of economic policy, namely how pref- and imperfections in this market and in other
erences change as a result of public discussion. parts of the economy, there will be price uncer-
This was an integral part of John Stuart Mill’s tainty, quantity uncertainty, or both, depend-
(Mill 1972 [1861], 262) perception of democracy ing on the policies chosen and the nature of the
and policy formation (see also the discussion in uncertainty. Both price certainty and quantity
Chapter 9 of Stern, Jean-Jacques Dethier, and F. certainty are important: firms would like clear
Halsey Rogers 2005). In this context, it involves and simple price signals for decision making;
a change in public understanding of responsi- quantity overshooting on emissions is danger-
ble behavior. Thus, people will spend time on ous. With learning and readjustment of pol-
separating out different elements of waste for icy (although not so frequently as to confuse
recycling, or they will drive more carefully, not structures and issues), the difference in effects
only because there may be a financial incen- between a tax-orientated policy and a quan-
tive for recycling or penalties for bad driving, tity/carbon-trading policy may not be so large.
but also because they have a view of responsible Given where we start, however, in my view the
behavior. danger of overshooting emissions targets is of
great significance.
Pricing an externality can be done in a number
of ways. First, there is carbon taxation; second, Tradable quotas, the second method of estab-
carbon trading on the basis of trade in rights lishing a price for GHGs, have the advantage
to emit which are allocated or auctioned; and of providing greater certainty about quantities
third, implicit pricing via regulations and stan- of emissions than taxes. The European Union
dards which insist on constraints on actions or Emissions Trading Scheme (EUETS) has shown
technologies which involve extra cost but which that a big part of the economy can be covered
imply reductions in emissions. Each of the three (currently around one half of European emis-
has different advantages and disadvantages and sions) with relatively low administrative bur-
all three are likely to be used. Understanding the dens by focusing on major emitting industries,
pros and cons, where the different mechanisms such as power.
can and should be used, and how to deal with
problems of overlaps, are all very important By starting with allocations that are not paid
issues. We have the space to look briefly only at for and moving to auctions, trading can build
a few of the relevant considerations. acceptance by industry because it allows for a
less dramatic adjustment. Free allocations based
Taxes have the advantage of being imple- on historical emissions do have important prob-
mentable by individual governments without lems, however: they are likely to slow adjustment
international agreement. All taxes are conten- since immediate profit pressures are lower; they
tious but those on recognized “bads” such as can give competitive advantages to incumbent
tobacco, alcohol, or carbon emissions may be

VOL. 98 NO. 2 richard t. ely lecture 25

firms that may succeed in getting large quota Further, difficulties arise in trading with coun-
allocations, thus reducing competition and pro- tries that are not taking strong measures, price-
moting rent-seeking; and they forego public based or otherwise, against climate change.
revenue. Thus, moving to auctioning over time There is, in principle, a case for levying appro-
has strong advantages and should be a clear and priate border taxes on goods from countries
transparent policy. that do not otherwise embody a carbon price. A
system analogous to the operation of the border
An aspect of quotas and trading that is crucial procedures for VAT could be envisaged. My own
is their potential role in international efficiency view is that this should be a last resort. There
and collaboration. Developing countries (see are many searching for arguments on protection
next section) have a strong and understandable that might climb on the bandwagon. The best
sense of injustice. They see rich countries hav- way forward is to build international collabora-
ing first relied on fossil fuels for their develop- tion with a positive and constructive approach.
ment, and thus being largely responsible for the
existing stocks of GHGs, then telling them to Regulation and standards can give greater cer-
find another, and possibly more costly, route to tainty to industry. This can accelerate responses
development. They feel least responsible for the and allow the exploitation of economies of
position we are in, yet they will be hit earliest scale: lead-free petrol and catalytic converters
and hardest. are probably good examples. Misguided regula-
tion, on the other hand, could reduce emissions
International trading provides for lower costs, in very costly ways. Again urgency points to a
from the usual arguments about international role for regulation/standards, and careful eco-
trade, and provides an incentive for poor coun- nomic analysis can keep costs down. In thinking
tries to participate. These arguments on cost and about these costs, however, we should remark
collaboration are central to my view that there that there are a number of examples in the his-
should be a very substantial focus on carbon tory of the motor industry where innovations on
trading in the policy of rich countries, with open- safety or pollution were resisted by industry on
ness to international trade, backed by strong rich cost grounds, only for compliance costs to turn
country targets for reductions, in order to main- out to be much lower than manufacturer pre-
tain prices at levels that will give incentives both dictions; for Environmental Protection Agency
for reduction at home and purchase abroad. Rich (EPA) vehicle emission control programs,
and poor country targets will be discussed in the industry stakeholders predicted price changes
next section. to consumers that exceeded actual changes by
ratios ranging from 2:1 to 6:1 (John F. Anderson
Price volatility is sometimes said to be a prob- and Todd Sherwood 2002).
lem with quotas and trading, and the EUETS is
cited as an example. But that scheme provided While taxation, trading, and regulation will
some basic simple lessons that have been learned: all have roles to play, it is important to think
in its first stage (2005–2007), giving away too carefully about how they might interact. For
many quotas collapsed the price. Quotas have example, if taxation and carbon trading overlap,
been allocated with greater rigor and stringency there are likely to be problems in establishing a
in the second phase (2008–2012) and the price clear and uniform price for carbon, leading to
for that phase is currently above €20 per ton, confused signals and inefficiency. And strong
already approaching the type of range indicated regulatory targets such as renewables percent-
as necessary. Volatility can be reduced by (a) ages could, without care, result in low demand
clarity, (b) firmness of quotas, and (c) broader on carbon markets.
and deeper markets—greater trading across sec-
tors, periods, and countries. Particular measures Our discussion of technology will be very
for dealing with volatility should be analyzed in brief, but in my view, policy in this area will
relation to, or after, these broader more market- be of great importance—we cannot simply leave
friendly approaches. And care should be taken the correction of externalities to carbon mar-
not to restrict international trade as a result; for kets or taxation. There is a standard argument
example, differences in caps on prices in differ- on knowledge and technology which sees ideas
ent regions might, because of attempts to arbi- and experience as having positive externalities.
trage where prices are different but fixed, make Figure 7 shows that experience is indeed impor-
open trade difficult or impossible. tant in the electricity industry—it seems that in a







VOL. 98 NO. 2 richard t. ely lecture 29



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Figure 9. Per Capita CO2 Emissions 1in tons 2

Source: CDIAC 2007.

years. That is one indication of the urgency of CO2e as a reservoir sized 270ppm CO2e, which
finding a global response quickly. the world will get close to exhausting over the
200 years between 1850 and 2050. If we start
But let us keep focused on equity. With 80 the clock in the late 1980s or now, it would be a
percent reductions by 2050, Europe and Japan reservoir sized around 140ppm CO2e or 120ppm
would be around the required two-ton global CO2e, respectively.
average level. An 80 percent reduction by the
United States, Australia, and Canada by 2050 From this perspective, equalizing the per cap-
would leave them around four tons, twice the ita flows of emissions—or the size of the glass
required average level. Thus, a 50 percent over- drawn per person per year from the reservoir—
all reduction and an 80 percent rich country by 2050, shortly before it is dry, is a very weak
reduction would still leave average rich country notion of equity. It takes no account of all the
flows above the world average in 2050. guzzling that took place by the better-off over
the preceding 50–200 years (depending on when
Turning to stocks, let us think about the path we start the clock). There is a very big difference
from some initial level to a stock stabilization (to between a stock and a flow notion of equity. An
be specific, suppose that level is 550ppm CO2e), 80 percent reduction of flows by rich countries
and about who consumes what along the way. We by 2050, in the context of a 50 percent reduction
can think of the initial level as 280ppm CO2e, overall, is not a target for which rich countries
corresponding to preindustrial times (around should congratulate themselves warmly as dem-
1850); or we could start 20 years ago (around onstrating a splendidly powerful commitment
390ppm CO2e), when the problems of climate to equity. And the contract-and-converge argu-
change began to receive strong policy attention; ment for some common flow level, or for using
or we could start now (around 430ppm CO2e). such a level as the eventual basis of trading, on
One perspective on equity would be to see the the asserted grounds that there are “equal rights
difference between 280ppm CO2e and 550ppm

30 AEA PAPERS AND PROCEEDINGS MAY 2008

to emit or pollute,” does not seem to me to have and pace required. They feel the inequities of
special claim on our attention.29 Rather, the tar- the situation and phenomena acutely. Just when,
get of equalizing by 2050 (allowing for trade) they argue, they are beginning to overcome pov-
may be seen as being a fairly pragmatic one, on erty, in part by rapid growth, they should not be
which it might be possible to get agreement, and asked to slow down. Financing, together with
one that, while only weakly equitable, is a lot technology demonstration and transfer, will
less inequitable than some other possibilities, be needed to convince them that moving to a
such as less stringent targets for rich countries. low-carbon growth path is not the same thing as
moving to a low growth path.
If we take any particular good, it will gener-
ally be true that rich people consume more than The third element refers to the short- and
poor people. That is simply an expression of medium-term approaches to trading between
their being richer. In the case of the reservoir, rich and poor countries. The current system, the
or the “contents of the atmosphere,” it is hard Clean Development Mechanism (CDM), was
to think of an argument as to why rich people established by Kyoto and operates at the level
should have more of this shared resource than of a project in a poor country (a so called non-
poor people. They are not exchanging their labor Annex 1 country in the Kyoto Protocol). If a firm
for somebody else’s and they are not consuming in a rich country (an Annex 1 country) is part of
the proceeds of their own land, or some natu- a trading scheme (such as the EUETS) which
ral resource that lies beneath it. I do not have recognizes the CDM, then that firm can buy
any special “correct” answer to the challenge of an emissions reduction achieved by the project,
understanding equity here, but it is a challenge subject to the project using technologies or
we cannot avoid discussing. Any global deal will approaches from an admissible list. The amount
have to involve some implicit or explicit under- of the notional reduction comes from compar-
standing over the sharing of this “reservoir.” ing the project with a counterfactual—what the
entity doing the project might otherwise have
The key elements of the global deal have, with done. Approval of a project goes through the
one exception, now been raised and ­discussed. poor country authorities and a special institu-
Let me express the deal or framework in terms tional structure, currently in Bonn. The system
of two groups of three headings, the first cover- is slow, cumbersome, and very “micro.”
ing targets and trade and the second covering
programs for which public funding is likely to Trading on the scale required to reach the
be required. This set of six policies or programs type of targets discussed (see Table 3) requires
is the international part of a deal. The domestic a much simpler, “wholesale” system.30 At the
policies will vary across countries, using dif- same time, to get agreement with poor coun-
ferent combinations of policy instruments and tries, it will have to continue to be “one-sided,”
technologies as discussed in Section III. The six as in the CDM, i.e., you can gain from innova-
elements of a global deal are expressed in bullet tion, but are not penalized for BAU. Wholesale
point form in Tables 3 and 4. measures can include technological benchmarks
such as employing CCS (currently excluded
The first element of the first group covers the from CDM), or sectoral benchmarks such as
targets. The global target was explained and jus- getting below a certain amount of CO2 per ton
tified in Section I and the distribution of targets of cement. As one-sided trading measures, the
above in this section. The second, the impor- benchmarks could be set ambitiously.
tance of emissions trading, was emphasized in
Section III: the justification for a major focus on After these trading mechanisms have been in
GHG trading in policy lies in its promotion of place (with associated technology sharing) for
both efficiency and collaboration. Unless financ- a while, developing countries will be able to
ing flows for the extra costs of reducing emis- have confidence that a trading system can work
sions are available to poor countries, they are on an appropriate scale. Then it would be rea-
extremely unlikely to join the effort on the scale sonable to ask them to accept targets ­consistent

29 Asserting equal rights to pollute or emit seems to me 30 This scale is derived from preliminary calculations
to have a very shady ethical grounding. Emissions deeply using a trading model at the UK Department of Environ­
damage and sometimes kill others. Do we have a “right” ment, Food, and Rural Affairs (DEFRA).
to do so?

VOL. 98 NO. 2 richard t. ely lecture 31

Table 3—Key Elements of a Global Deal: Targets and Trade

• Confirm Heiligendamm 50 percent cuts in world emissions by 2050 with
rich country cuts at least 75 percent.

• Rich country reductions and trading schemes designed to be open to
trade with other countries, including developing countries.

• Supply side from developing countries simplifed to allow much bigger
markets for emissions reductions: “carbon flows” to rise to $50–$100
billion per annum by 2030. Role of sectoral or technological benchmar-
keting in “one-sided” trading to give reformed and much bigger CDM
market.

Table 4—Key Elements of a Global Deal: Funding Issues

• Strong initiatives, with public funding, on deforestation to prepare for
inclusion in trading. For $10–15 billion per annum could have a pro-
gramme which might halve deforestation. Importance of global action
and involvement of IFIs.

• Demonstration and sharing of technologies: e.g., $5 billion per annum
commitment to feed-in tariffs for CCS coal could lead to 301 new com-
mercial size plants in the next 7–8 years.

• Rich countries to deliver on Monterrey and Gleneagles commitments
on ODA in context of extra costs of development arising from climate
change: potential extra cost of development with climate change upward
of $80 billion per annum.

with overall global goals in the context of a The public funding requirements are grouped
strong set of goals by rich countries. If we look in three elements in Table 4. Each would require
for targets from poor countries now, the only a paper in itself for appropriate treatment,
ones that would be accepted would be far too and we can give only headlines. Deforestation
loose and would knock the bottom out of inter- accounts for up to 20 percent of current emis-
national trading, i.e., collapse the price. And in sions; the numbers are not easy to specify pre-
the future these loose targets would be likely to cisely—probably 5–8 Gt CO2e per annum. These
form a base-line for subsequent discussion. That flows could be roughly halved, in my view, for
is why a staged approach is essential if currently around $5 per ton of CO2, ­taking into account
poor countries are to accept participation in opportunity costs of land and the institutional,
responsible global stabilization so that by 2050 administrative, and enforcement measures nec-
their emissions average around 2 tons per capita. essary. Some have estimated higher costs (e.g.,
Recall that this is a half or a third of China’s McKinsey—Enkvist, Nauclér, and Rosander
current level. It is very unlikely to be possible 2007) but there appear to be large amounts of
to find financial flows on the scale required to “initial” reductions available at lower costs, par-
incentivize appropriate action from the public ticularly if programs are large-scale and coordi-
sector of rich countries. Witness the difficulty nated across countries (for further discussion see
in getting resources for Overseas Development Myers 2007; Daniel Nepstad et al. 2007; Niels
Assistance (ODA), which will be strained still Anger and Jayant Sathaye 2007). This would
further by the challenge of adaptation (see help to avoid reduced deforestation in country
below). The trading system provides for private A simply displacing activity and thus increasing
flows. deforestation in country B. Public sector flows

32 AEA PAPERS AND PROCEEDINGS MAY 2008

can be combined with private sector flows as the United Nations Development Programme
avoided deforestation is brought into the carbon (UNDP) estimated additional costs for develop-
trading process so that all countries are given ing countries of around $85 billion per annum
incentives. Indeed, one of the responsibilities of by 2015 (UNDP 2007, 15). And they will pre-
the publicly funded program would be to work sumably rise after that.
toward trading.
Such extra financing will be hard to find. It
The second element in this second group, the may be compared with the $150–200 billion per
demonstration and sharing of technologies, is annum extra that would arise if the Organisation
urgent; financial resources must be made avail- for Economic Co-operation and Development
able and institutional arrangements designed. (OECD) countries moved to 0.7 percent GDP in
This is an important area for economic research. ODA by 2015, as many of them have promised.
One problem of particular urgency, for reasons The ODA promises of the 2002 UN International
described above, is the demonstration of CCS Conference on Financing for Development in
for coal. There are no current plants using CCS Monterrey, Mexico, in connection with the
for coal-fired generation on a commercial scale. Millennium Development Goals, and of the
From 2015 or 2020 on, the world will need most 2005 UK-chaired G8 Gleneagles summit on
of its new coal-fired electricity generation plants Africa, and preceding EU commitments in
to be operating with CCS if it is to have any July, were powerfully argued and justified at the
chance of realizing its targets. If CCS cannot time. They took little account of climate change.
work on the necessary scale, then we need to If that aspect is added, as it should be given
know soon and follow alternative strategies. At the magnitude of the challenge, and combined
present, however, it does look promising. There with the historical responsibilities for stocks of
is geological work to be done to identify storage GHGs and the implied consequences for poor
capacity, and careful legal and regulatory work countries, then the argument for 0.7 percent, in
to be done to allocate risk and responsibility. my view, becomes overwhelming. The Stern
Geology and coal vary greatly across the world Review left the argument at that point, although
and many demonstrations of commercial-scale a case could have been made for increasing the
plants are necessary. Feed-in subsidies, world- ODA targets.
wide, of around $5 billion per annum could sup-
port 301 such plants over the next 7–8 years The framework I have now described does, in
and cover a broad range of examples.31 my view, meet the criteria of: effectiveness—it
is on the right scale; efficiency—it relies heavily
There should also be support for many other on markets and market-orientated innovation;
technologies. We do not know what the most effi- and equity—it does at least give some specifi-
cient clean technologies will be in the future, and city to the “common but differentiated responsi-
the answers are likely to vary with location. CCS bility” already accepted internationally. It builds
is emphasized here simply because we can be on existing commitments and some aspects of
fairly confident that BAU will involve a great deal the current discussions in international fora. It is
of coal for electricity over the next 20–30 years. also designed to give some realistic opportunity
Perhaps it will be a medium-term technology and for the major developing countries to become
be replaced by others over the longer term. strongly involved, as they must if serious targets
are to be agreed and achieved.
Finally, in the global deal, I would emphasize
an element that has not been discussed here and It is a framework that could allow all coun-
that will be of great importance. Even with very tries to move quickly along what they see to be
responsible policies, the world is likely to see a responsible path. What is very striking here
an additional 1–2°C of warming over and above is how broadly basic understanding has already
the 0.8°C it has already experienced. Adaptation been established. Country by country, we see
will be necessary worldwide and will be par- targets being erected and measures being set
ticularly difficult for poor countries. Recently, by individual countries recognizing their own
responsibilities as they see international agree-
31 Own calculations using, for example, the McKinsey ment being built. People seem to understand
cost curve, and working with power stations of a few hun- the arguments for action and collaboration on
dred megawatts. I am grateful to Dennis Anderson for his climate change much more readily than they
advice. do for international trade. But I do not want to







36 AEA PAPERS AND PROCEEDINGS MAY 2008

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