ADDDckerman

WORKSHOPPROCEEDINGS
AssessingtheBenefitsofAvoidedClimate
Change:CostBenefitAnalysisandBeyond

TheNeedforaFreshApproachto
ClimateChangeEconomics

FrankAckerman
StockholmEnvironmentInstitute
StephenJ.DeCanio
UniversityofCalifornia,SantaBarbara
RichardB.Howarth
DartmouthCollege
KristenSheeran
EconomicsforEquityandtheEnvironmentNetwork

May2010


ThisworkshopwasmadepossiblethroughagenerousgrantfromtheEnergyFoundation.
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WorkshopSpeakers
DavidAnthoff,EileenClaussen,KristieEbi,ChrisHope,RichardHowarth,Anthony
Janetos,DinaKruger,JamesLester,MichaelMacCracken,MichaelMastrandrea,
SteveNewbold,BrianONeill,JonORiordan,ChristopherPyke,MarthaRoberts,
SteveRose,JoelSmith,PaulWatkiss,GaryYohe

ProjectDirectors
SteveSeidel
JanetPeace

ProjectManager
JayGulledge

ProductionEditor
L.JeremyRichardson

ContentEditors
JayGulledge,L.JeremyRichardson,LiwaywayAdkins,SteveSeidel

SuggestedCitation
Ackerman,F.,S.J.DeCanio,R.B.Howarth,andK.Sheeran.2010.TheNeedforaFresh
ApproachtoClimateChangeEconomics.InAssessingtheBenefitsofAvoidedClimate
Change:CostBenefitAnalysisandBeyond.Gulledge,J.,L.J.Richardson,L.Adkins,and
S.Seidel(eds.),ProceedingsofWorkshoponAssessingtheBenefitsofAvoided
ClimateChange,March1617,2009.PewCenteronGlobalClimateChange:
Arlington,VA.p.159181.Availableat:http://www.pewclimate.org/events/
2009/benefitsworkshop.

Thecompleteworkshopproceedings,includingvideoof17expertpresentations,thissummaryreport,
andindividualoffprintsofexpertpapersareavailablefreeofchargefromthePewCenteronGlobal
ClimateChangeathttp://www.pewclimate.org/events/2009/benefitsworkshop.

May2010

PewCenteronGlobalClimateChange
2101WilsonBlvd.,Suite550
Arlington,VA22201

160 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop

TheNeedforaFreshApproachto
ClimateChangeEconomics1

FrankAckerman2
StockholmEnvironmentInstitute
StephenJ.DeCanio
UniversityofCalifornia,SantaBarbara
RichardB.Howarth
DartmouthCollege
KristenSheeran
EconomicsforEquityandtheEnvironmentNetwork

Abstract
Theintegratedassessmentmodels(IAMs)thateconomistsusetoanalyzetheexpected
costsandbenefitsofclimatepoliciesfrequentlysuggestthattheoptimalpolicyistodo
relativelylittleintheneartermtoreducegreenhousegasemissions.Thisconclusion
seeminglyconflictswiththeemergingscientificconsensusabouttheirreversibilityof
climatechangeandtherisksofcatastrophicimpacts.Wetracethisdisconnectto
contestableassumptionsandlimitationsofIAMswhenappliedtoclimatechange.For
example,theytypicallydiscountfutureimpactsfromclimatechangeatrelativelyhighrates
thatareempiricallyandphilosophicallycontroversialwhenappliedtointergenerational
environmentalissues.IAMsalsomonetizethebenefitsofclimatemitigationonthebasisof
incompleteandsometimesspeculativeinformationabouttheworthofhumanlivesand
ecosystemsandfailtoaccountforthefullrangeofscientificuncertaintyabouttheextentof
expecteddamages.IAMsmayalsoexaggeratemitigationcostsbyinadequatelycapturing
thesociallydetermined,pathdependentnatureoftechnologicalchangeandignoringthe
potentialsavingsfromreducedenergyutilizationandotheropportunitiesforinnovation.
Abetterapproachtoclimatepolicy,drawingonrecentresearchontheeconomicsof
uncertainty,wouldavoidthelimitationsofthenarrowcostbenefitcomparisonsofIAMs
andreframethecostofmitigationasbuyinginsuranceagainstirreversibleand
catastrophicevents,theavoidanceofwhichwouldyieldlargebutunquantifiablebenefits.
Policydecisionsshouldbebasedonajudgmentconcerningthemaximumtolerable
increaseintemperatureand/oratmosphericcarbondioxideconcentrationsgiventhestate
ofscientificunderstanding.Inthisframework,theappropriateroleforeconomistswould
betodeterminetheleastcoststrategytoachievethattarget.

1
AmoretechnicalversionofthispapertitledLimitationsofIntegratedAssessmentModelsofClimateChangeis
forthcominginClimaticChange.
2
Thelistingofauthorsisalphabeticalanddoesnotimplyprecedence.

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 161


1.Introduction
Thescientificconsensusonclimatechangeisclearandunambiguous;climatechangeisan
observablephenomenonwiththepotentialforcatastrophicimpacts(Intergovernmental
PanelonClimateChange,2007a).Thelargescalecomputermodelsthathelpedbuildthe
scientificconsensusonclimatechangeanditsimpactshaveacquiredagoodreputationin
thescientificcommunity.Theleadinggeneralcirculationmodels(GCMs)demonstrateever
moredetailedandextensivedescriptionsofthephysicalprocessesofclimatechange,
whicharetestableeitherdirectlyorindirectlythroughcomparisonwithhistoricalclimate
data.Thesemodelsaregroundedinphysicallawsthatarewellestablishedboth
theoreticallyandempirically.
Economistsalsoemploymultiequationcomputermodelsintheirapproachtoclimate
change.Thesemodels,knownasintegratedassessmentmodels(IAMs),buildontheresults
ofGCMstoassesstheeconomicbenefitsandcostsofclimatepolicyoptions.Economistsuse
policyoptimizingIAMstoidentifythebestpolicyresponse,theoptionthatmaximizes
thedifferencebetweenbenefitsandcosts(i.e.netbenefits).3Asthedebateoverclimate
policyshiftsfromscientificuncertaintytobalancingcostsandbenefits,theresultsofIAMs
growinimportance.Economistssincethe1990shavelargelybeensupportiveofactionto
mitigateclimatechange;themaindisagreementtodayiswhethertoactaggressivelyto
minimizetherisksofclimateimpacts,ortomakeaslowtransitiontominimizethe
economicimpactsofpoliciestomitigateclimatechange.InterpretingIAMsproperlyis
criticalfordecisionmakersastheyweightheappropriateresponsetotheclimateproblem.
Whilemanyscientistsadvocatemorestringentemissionstargetsaimedatstabilizing
atmosphericgreenhousegas(GHG)concentrationsduringthiscentury,theresultsofIAMs
oftensuggestacautiousapproachthatinvolvesonlymodestearlyactiontolimit
greenhousegasemissionswiththelimitsbecomingmorestringentslowlyovertime(e.g.,
KellyandKolstad,1999;Tol,2002a;Manne,2004;Mendelsohn,2004;Nordhaus,2007a).
Forexample,theoptimalemissionsreductionrateaccordingtoeconomistWilliam
NordhausmostrecentversionofthewidelycitedDICEmodelisonly14percentcompared
toabusinessasusualornocontrolemissionscenarioin2015,risingto25percentby
2050and43percentby2100(Nordhaus,2007a).
Incontrast,theEuropeanUnionhascalledfortheglobalcommunitytoreducecarbon
emissionsto50percentbelow1990levelsby2050,withemissionsdecliningtonearzero
bytheendofthecentury.Thisgoalisbasedonascientificassessmentthattheriskof
climatecatastropheincreasesdramaticallyasgreenhousewarmingexceedsroughly2C
abovethepreindustrialglobalaveragetemperature.UnderNordhausoptimalpolicy,the

3
Mastrandrea(2009)distinguishesbetweenpolicyoptimizingandpolicyevaluatingintegratedassessment
models.Ourpaperisprimarilyconcernedwithpolicyoptimizingmodelsthatareusedforformalcostbenefit
analysisofclimatemitigationpolicies(e.g.,theDICEmodel).

162 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


warmingexceeds3C,thusincurringmuchgreaterfutureriskcomparedtotheEUtarget.
OtherIAMshaveestimatedsignificantwelfarelossesintheUnitedStatesfromtherecent
suiteofCongressionalproposalstolimitcarbonemissionsto5080percentbelow1990
levelsby2050(Paltsevetal.,2007).StillotherIAMshaveevenestimatedapositivenet
benefitfromclimatechangeinOECDcountries,whileacknowledgingnetlossesinpoor
countries.ThishasledleadingresearcherslikeToltoconcludethatclimatechangeand
greenhousegasabatementpolicyisessentiallyaproblemofjustice(Tol,2002b).
Howcanwereconciletheapparentdisconnectbetweenthescience,whichprovidesan
objectivecharacterizationofthepotentiallycatastrophicimplicationsofclimatechange,
andtheresultsofIAMsindicatingthataggressivelymitigatingclimatechangeistoocostly?
Unlikephysicsdrivenclimatemodels,economicmodelsmixdescriptiveanalysisandvalue
judgmentsinwaysthatdeservecloseandcriticalscrutiny.Tobuildtheirmodels,
economistsmakeassumptionsthatreflectlongstandingpracticeswithineconomicsbut
thatnonethelessareassociatedwithwellknownconceptualandempiricalproblems.
Alternativemodels,builtondifferentsubjectiveassumptionsthatarejustasplausibleas
thoseembeddedincommonlycitedIAMs,leadtoqualitativelydifferentresults,illustrating
theunderlyinglimitationsofcostbenefitanalysisasappliedtoclimatechange(e.g.,Cline,
1992;Stern,2006;AckermanandFinlayson,2006).
Scientificunderstandingoftherisksofclimatechangeiscontinuouslyimproving.For
example,thereviewarticlebyHallandBehl(2006)highlightstheinabilityofpolicy
optimizingIAMstoincorporatetheconsequencesofclimateinstabilityandrapidlarge
scaleshiftsinglobalclimate.Lentonetal.(2008)identifyandcataloguepotentialtipping
elementsintheclimatesystemthatcouldleadtolargescaleshifts.Toaccountforthese
andrelatedanalyticalshortcomings,avarietyofdecisionmakingframeworksextending
beyondconventionalcostbenefitanalysishavebeenidentified(Tothetal.,2001).These
includetolerablewindowsandsafelandingapproaches,robustdecisionmaking,and
costeffectivenessanalysis,amongothers.Arecentconferencewasdevotedtothe
implicationsofavoidingdangerousanthropogenicinterferencewiththeclimatesystem
asaguidetopolicymaking(Schellnhuberetal.,2006).Ourobjectiveinthisarticleisnotto
provideeitheracomprehensivereviewofthemostrecentdevelopmentsinclimate
science,4oranallencompassingtreatmentofdecisionmakingwithregardtoclimate.
Rather,ourcritiquefocusesontheconceptualeconomicframeworkofthemostcommon
utilitymaximizingIAMsandonsomeofthemostimportantshortcomingsinhowthese
modelsrepresentclimateprotectioncostsandbenefits.Thefocusofthispaperis
conceptual.5

4
ExamplesofarticlesdealingwiththekindsofissuestreatedbyHallandBehl(2006)includeKennedyetal.(2008),
HoeghGuldbergetal.(2007),andBuffettandArcher(2004).
5
SeethepaperinthisvolumebyMastrandreaforinformationonhowpolicyoptimizingIAMsgoaboutestimating
climatedamagesorthebenefitsofavoidedclimatechange.

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 163


Weidentifythreeprincipalareasinwhichthestandardeconomicapproachasappliedto
climatechangeisarguablydeficient:thediscountedutilityframework,whichattachesless
weighttotheimpactsofclimatechangeonfuturegenerations;thecharacterizationand
monetizationofthebenefitsofmitigation;andtheprojectionofmitigationcosts,which
restsonassumptionsaboutthepaceandnatureoftechnologicalchange.Weaddressthese
issuesinthefollowingthreesectionsandconcludewithrecommendationsforan
alternativeapproachtotheeconomicsofclimatechangethatreflectsrecentadvancesin
theeconomicsofuncertainty.

2.TheDiscountedUtilityFrameworkanditsImplementationthrough
IAMs
TheeconomictheoryfromwhichIAMsarederivedstartsfromaparticularunderstanding
ofhumannatureandpreferencesandseekstoidentifythechoicesthatwillmaximizethe
satisfactionofthosedesires.Echoingnineteenthcenturyutilitarianmoralphilosophy,
economistsrefertosatisfactionasutilityandassumeittobequantifiableineconomic
termsinshort,anidealobjectiveformaximization.Climateoutcomesentertheanalysis
asfactorsthatincreaseordecreasehumansatisfaction.IAMsestimatetheclimatepolicy
scenariosthatmaximizesocialutility.
Theoptimaltargetthesemodelsidentifyisnotapredeterminedclimatecondition
judgedtobeconducivetohumanwellbeing,butratherthemaximumsubjective
satisfactionbasedonprojectedbutuncertaineconomicbenefitsandcoststhatthemodels
presumetobeforeseeable.Itisherethatthedisconnectbetweenthescienceandthe
economicsofclimatechangebegins.Maximizationofsatisfactionundertheseassumptions
doesnotnecessarilyyieldaclimatetargetclosetowhatscientistsconsidernecessaryto
avoidthemostseriousrisksofclimatechange.IfIAMsmischaracterizethebenefitsof
avoidedclimateimpactsorfailtoappropriatelymodelscientificuncertaintyaboutfuture
damages,theresultswillnotaccountforthemostseriousrisksthatscientistsidentify,yet
theserisksarethemostimportantonestoreduce.Moreover,inordertocompareutilities
acrossgenerations,economicmodelsinvokeassumptionsabouthowmuchadditional
weightpresentoutcomesdeserveoverfutureoutcomes.Avaluejudgmentabouttherateat
whichsocietyiswillingtotradepresentforfuturebenefitsisembeddedinthemodels
discountrate.Butwheneconomicmodelsdiscountfuturewellbeing,thepresentvalueof
theharmscausedbyfutureclimatechangecaneasilyshrinktothepointwhereitishardly
worthdoinganythingtodayinordertopreventclimatechange.
ThebasicconstructofthetypicalutilitymaximizingIAMinvolvesasocialwelfarefunction
thatstretchesintothedistantfuture(farenoughaheadtoexperiencesignificantclimate
change).Insimplestterms,thesocialwelfarefunctionmaximizesthesumtotalutility(or
welfare)ofindividualsovertime.Frequently,IAMsassumeasinglerepresentativeagentin
eachgeneration,orequivalently,thatallmembersofagenerationareidenticalinboth

164 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


consumptionandpreferences.Withslightvariationsbetweenmodels,thegeneric
frameworkistomaximize

W = e tU [ c (t )] dt [1]
0

whereWissocialwelfare,istherateofpuretimepreference,c(t)isconsumptionat
timet,andU[]istheutilityfunctionspecifyinghowmuchutilityisderivedfroma
particularlevelofconsumption.
Equation[1]andthetechniquesrequiredtomaximizeWembodyanumberofquestionable
assumptions.First,notethesignificanceofapositiverateofpuretimepreferenceinthe
model.Therateoftimepreferencereflectssocietysattitudestowardspresentverses
futureutility.Thetermetexpresseshowsocietyweightsutilitiesatdifferenttimes.Ifthe
parameterispositive,societyvaluestheutilityofpeoplelivingtodaymorethantheutility
ofpeoplelivinginthefuture.Thisimpliesthatthewellbeingofthisgenerationmatters
morethanthatofitschildren,whointurnmattermorethantheirchildren,andsoon.Ifa
generationis35yearsindurationand=0.05theweightgiventoaunitofutilityatthe
endofthesecondgenerationisonly3percentoftheweightgiventothesameunitofutility
today.Ifissufficientlyhigh,thefuturebenefitsofavoidedclimatechangeessentially
disappearfromtheanalysis,evenifthedamagesaregrave.
Asisstandardpracticeineconomics,mostIAManalysesassumethatispositive.Isit
appropriatetodiscountthewelfareoffuturegenerations,andifso,atwhatrate?
Economistshavelongstruggledwiththisquestion.Theclassicarticleonthissubjectwas
publishedin1928byFrankRamsey.Ramseyhimselfunderstoodthatreflectedanethical
weighingofthewellbeingofdifferentgenerationsandarguedonphilosophicalgrounds
forazerorateofpuretimepreference:
[I]tisassumedthatwedonotdiscountlaterenjoymentsincomparisonwith
earlierones,apracticewhichisethicallyindefensibleandarisesmerelyfromthe
weaknessoftheimagination;weshall,however,includesucharateofdiscount
insomeofourinvestigations(Ramsey,1928,p.543).
NumerouseconomistsandphilosopherssinceRamseyhavearguedthatweighingall
generationsequallybysettingequaltozeroistheonlyethicallydefensiblepractice(for
moderntreatments,seeCline(1992)andBroome(1994));yetIAMscontinuetoassume>
0.6
Second,implicitintheformulationofasocialwelfarefunctionistheaggregationof
preferencesacrossdifferentindividuals.Inequation[1],thisaggregationdependsonlyon
thetotalconsumptionofgoodsandnotonthedistributionofthatconsumption.Whatever

6
Thisisatleastinpartamathematicalnecessity:with=0,theintegralinequation[1]doesnotconvergeiffuture
utilityisconstantorgrowing(ormerelydecliningsufficientlygradually)(DasguptaandHeal,1979).

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 165


methodforaggregationisused,itnecessarilyinvolvesvalueladenassumptions.7Thisisan
inescapableconsequenceofthediscountedutilityapproach.Becausetheframework
requiresthatpreferencesbecomparedandaddedwithinandacrossgenerations,itforces
economiststomakenormativedecisionsregardingthecomparisonofindividualutilities
anddiscountrates.Thoughasocialwelfarefunctioncanbesolvedmathematicallytoyield
theoptimalsolution,thesolutionisdependentonthevaluesandbiasesthatare
unavoidablyembeddedinthemodel.Iftheseassumptionsarenotstatedexplicitlyand
oftentheyarenotdecisionmakersmaytakepolicyactions,unawareofsomeimportant
socialimplications.
Third,itisworthnotingthatthediscountedutilitycharacterizationofbehaviorfor
individualsthatunderliesthisformulationofthesocialpolicyproblemisnotwell
supportedbytheevidence(Fredericketal.,2002).Theoptimizingpsychologicaland
behavioralassumptionsadoptedbyeconomicmodelersdonothavethestatusoflawsof
nature.Theyaremattersofconvenienceandconvention,notdeepstructuralfeaturesof
humanaction(Laitneretal.,2000;KahnemanandTversky,2000).

3.Predictingtheunpredictableandpricingthepriceless
IAMsanalyzethecostsandbenefitsofclimatemitigation.Costbenefitanalysisassumes
thatcostsandbenefitscanbeexpressedinmonetarytermswithareasonabledegreeof
confidence.Atleastinprinciple,thecostsofenvironmentalprotectionconsistofwell
definedmonetaryexpenditures,althoughtherearesignificantproblemsinthestandard
approachtoprojectingmitigationcosts,asdiscussedattheendofthissection.Thebenefits
ofenvironmentalprotection,however,aregenerallymoredifficulttoquantify.Inthecase
ofclimatechange,economistsconfrontadoubleproblem:thebenefitsofmitigationare
bothunpredictableandunpriceable.
Theunpredictabilityofclimateoutcomesreflectsinpartwhatwedonotknow,because
climatechangeislikelytocausenonmarginaldisplacementsthatputusoutsidetherealm
ofhistoricalhumanexperience.Unpredictabilityisreflectedinwhatwedoknowaswell.
WeknowthattheEarthsclimateisastronglynonlinearsystemthatmaybecharacterized
bythresholdeffectsandchaoticdynamics.8Undersuchconditions,forecastsare
necessarilyindeterminate;withinabroadrangeofpossibleoutcomes,almostanything

7
Oneimplicationoftheaggregationmethodisthatifallmembersofsocietyhaveequalweightinthesocial
welfarefunctionandallexperiencediminishingmarginalutilitytothesamedegree,thesocialwelfareatanypoint
intimecouldbeincreasedbyredistributionofincomefromthewealthytothepoor,providedtheeffectsofthis
redistributiononincentivestoproduceandsaveareignored.Analternateapproachweightingindividuals
contributiontosocialwelfarefunctionbytheirwealthhasobviousdrawbacksfromanethicalpointofview.The
samekindsofproblemsregardingaggregationacrossindividualsandnationsplagueestimatesofthecostsof
mitigatingclimatechangethedistributionofthecostshasamajorimpactonboththeethicalevaluationof
proposedpoliciesandtheirpoliticalfeasibility.
8
SeethepaperinthisvolumebyMacCrackenfordetailsaboutthephysicalsciencebasedchallengesfor
quantifyingthebenefitsofclimatepolicy.

166 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


mayhappen.IAMs,forthemostpart,donotaccountforthisfullrangeofuncertaintybut
insteadadoptbestguessesaboutlikelyoutcomes,typicallyderivedfromthemiddlerange
ofseveralestimatesofclimateimpacts(KellyandKolstad,1999;Tol,2002a;Manne,2004;
Mendelsohn,2004;Nordhaus,2007a).TheSternReview(2006)representsanadvanceover
standardpracticeinthisrespect,employingaformaltechnique(MonteCarloanalysis)to
estimatetheeffectsofuncertaintyinmanyclimateparameters.Asaresult,theStern
Reviewfindsasubstantiallygreaterbenefitfrommitigationthanifithadsimplyusedbest
guesses.
Butunderneathonelayerofassumptionsliesanother.Evenifweassumeprecisionin
predictingclimateimpacts,theproblemofassigningmeaningfulmonetaryvaluestohuman
life,health,andnaturalecosystemsstillremains.Thisproblemaffectsallcostbenefit
analysis.Becauseanumericalanswerisrequired,environmentaleconomistshavelong
beeninthebusinessofconstructingsurrogatepricesforpricelessvalues.Economicpolicy
undertheClintonadministrationwastoestimatethevalueofhumanlifeonthebasisofthe
smallwagedifferentialsbetweenmoreandlessdangerousjobs.TheBushadministration
usedresponsestolongquestionnairesaskingpeoplehowmuchtheywouldpaytoavoid
smallrisksofdeathunderabstracthypotheticalscenarios.9Shouldthevalueofahuman
lifedependonindividualornationalincomelevels?Shouldnaturelocatedinarichcountry
beworthmorethanifitislocatedinapoorcountry?Theseapproachesareregularly
appliedinpolicyanalysestoestimatemonetaryvaluesforhealthandenvironmental
benefits(DiamondandHausman,1994;Hanemann,1994;Portney,1994).Valuationsof
humanlifedifferentiatedbynationalincomewereincludedintheIPCC'sSecondAssessment
Report(1996),butwereexcludedfromtheThirdAssessmentReport(2001).Similarvalues,
however,continuetoappearintheeconomicsliterature,makingtheirwayintoIAMs(Tol,
2002b;Boselloetal.,2006),wherethelivesofcitizensofrichcountriesareoftenassumed
tobeworthmuchmorethanthoseoftheirpoorercounterparts.IAMsthatdifferentiatethe
valueofhumanlifebyincomewouldrecognizegreaterbenefitsfrommitigationifclimate
changewereexpectedtoclaimmorelivesinrichcountriesthaninpoorcountries.The
highestmortalityandmorbidityratesfromclimatechange,however,willbefoundinthe
developingworld(IPCC2004).
Incomebiasisinherenttotheprocessofvaluation.Whenaskedhowmuchtheyarewilling
topaytoprotectsomesmallpartofthenaturalworld(atechniquecalledcontingent
valuation),theresponsesofpeoplecannothelpbutreflecthowmuchtheyareactuallyable
toafford.Thissurveymethodmayprovideplausibleinformationaboutsubjectivevalues
forlocalamenitiessuchasneighborhoodparks.However,itsappropriatenessbecomes
questionableinacomplex,interdependentworldwhereessentialecosystemservicesare
notalwaysvisibleorlocal,andwhereincomesandinformationareunequallydistributed.A
consequenceofcontingentvaluationisthatIAMsarelikelytofindnetbenefitsofnearterm

9
SeeAckermanandHeinzerling(2004),especiallyChapter4,pp.7581.

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 167


climatechangebecausepeoplelivingincoldernorthernclimatesaregenerallyricherthan
thoselivinginhottersouthernclimates.Evenifbenefitsarethoughttodisappearaftera
fewdegrees,orafewdecades,ofwarming,ahighdiscountrateensuresthattheearlyyears
ofnetbenefitsloomlargeinpresentvaluetermswhencomparedtothemoreremoteand
heavilydiscountedlateryearsofnetdamages.
Forexample,Nordhauslongmaintainedthatthereisasubstantialsubjectivewillingnessto
payforwarmerweatheronthepartofpeopleincold,richcountries.HeobservedthatUS
householdsspendmoreonoutdoorrecreationinthesummerthaninthewinterand,on
thebasisofthatsingularobservation,concludedthatsubjectiveenjoymentoftheclimatein
theUnitedStateswouldbemaximizedatayearroundaveragetemperatureof20oC(68
oF)(NordhausandBoyer,2000).Thisiswellabovethecurrentglobalaverageandis

approximatelytheaverageannualtemperatureofHoustonandNewOrleansintheUnited
States,orTripoliinLibya.TherearemanypeoplewholiveinareashotterthanHouston,
buttheyaregenerallymuchpoorerthanthepeoplewholiveinareascolderthanHouston.
Thusifwillingnesstopayislimitedbyabilitytopay,contingentvaluationwouldfinda
largenetglobalwillingnesstopayforwarming.Inthe2000versionofDICE,thisfactor
outweighedalldamagesandimpliednetbenefitsfromwarminguntilthemiddleofthis
century(NordhausandBoyer,2000).However,thatidiosyncrasyoftheearlierDICEhas
beencriticized(AckermanandFinlayson,2006)andthelatestDICE(2007)nolonger
allowsnetbenefitsfromwarming(Nordhaus,2007b).
Amorequantifiablebutequallycontestablebenefitfromwarmingisitsimpacton
agriculture.Earlystudiesofclimateimpactssuggestedsubstantialagriculturalgainsfrom
warming,asaresultoflongergrowingseasonsinhighlatitudesandtheeffectsofCO2
fertilizationonmanycrops.Mendelsohnetal.(2000)andTol(2002a)incorporatedlarge
estimatedagriculturalgainsfromearlystagesofwarming.Successivestudies,however,
havesteadilyreducedtheestimatedbenefitsastheunderlyingsciencehasdeveloped.
OutdoorexperimentshaveshownsmallerbenefitsfromCO2fertilizationthanearlier
experimentsconductedingreenhouses(IPCC,2007b).Recentresearchpredictsthatthe
negativeeffectsofgroundlevelozone,whichisproducedbythesamefossilfuel
combustionprocessesthatemitCO2,mayoffsettheimpactsofalongergrowingseasonand
CO2fertilizationandleadtoasmallnetdecreaseinagriculturalproductivityintheUnited
States(Reillyetal.,2007).Anotherrecentstudyfindsthatthemarketvalueofnon
irrigatedfarmlandishighlycorrelatedwithclimatevariables(Schlenkeretal.,2006).The
optimumvalueoccursatroughlythecurrentaveragetemperaturewithslightlymorethan
thecurrentaveragerainfall.Inthisstudy,projectionsofclimatechangetotheendofthe
centuryresultinsubstantiallossesinfarmvalue,dueprimarilytocropdamagefromthe
increaseinthenumberofdaysabove34oC(93oF).Theearlieranalysesalsoignoredthe
effectsofextremeweatherevents,andcroppestsanddiseasesthatarenowthoughttobe
likelytoincreaseinmanyplaces(IPCC,2007b).

168 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


Astheseexamplesofpotentialbenefitssuggest,thereisasignificantdegreeofjudgment
whichmaybepurelysubjectiveorscientificallyoutdatedinvolvedinestimatingthevalue
ofclimatedamages.ItisnotsurprisingthenthatIAMsarecompletelydependentonthe
shapeoftheirassumeddamagefunctions.Itisconventionaltoassumethatdamages
increasenonlinearlyasaquadraticfunctionoftemperature,basedonthecommonnotion
thatdamagesshouldrisefasterthantemperature.TheSternReview(2006)madethe
exponentonthedamagefunctionaMonteCarloparameter,rangingfrom1to3(i.e.,
damagesrangedfromalineartoacubicfunctionoftemperature).EventhoughSterns
modalestimatewasonly1.3,thecaseswithahigherexponenthadalargeeffectonthe
outcome.Inlatersensitivityanalysesinresponsetocritics,theSternReviewresearchers
showedthatiftheassumeddamageswereacubicfunctionoftemperature,theresultwas
anenormousincreaseintheestimateofclimatedamages,changingtheirpredictionby
morethan20percentofworldoutput(Dietzetal.,2007).Giventhatanalystsdonotknow
whichexponentiscorrect,theabilityofIAMstoestimatedamagesisseverelylimitedby
currentunderstandingofhowfutureimpactswilldevelop.Inshort,unlikethephysics
basedmodelinginvolvedinGCMs,theresultsofIAMsaretiedtoarbitraryjudgmentsabout
theshapeofthedamagefunctionaswemoveintotemperatureregimesthatareunknown
inhumanorrecentplanetaryhistory.10
Inestimatingthecostsofmitigatingclimatechange,IAMsrestagainonproblematic
assumptions.WehavegoodreasontobelievethatmostIAMsoverestimatethecostsof
achievingparticularstabilizationtargets.MostIAMsexcludethepossibilityfornoregrets
optionsinvestmentsthatcouldreduceemissionswithoutimposingsignificant
opportunitycosts.Theseoptionsdoexist,largelyintheareaofimprovedenergyefficiency
(IPCC,1996;InterlaboratoryWorkingGroup,2000;Lovins,2005;Elliottetal.,2006;
ShipleyandElliott,2006;Laitneretal.,2006;McKinseyGlobalInstitute,2007).
Whileestimatingmitigationcostsindollartermsshouldbemorestraightforwardin
principlethanestimatingmitigationbenefits,theevolutionofnewtechnologiesneededfor
reducingfutureclimatechangeisuncertain,particularlyoverthelongtimeperiods
involvedinclimatemodeling.Forecastsofmitigationcosts,therefore,dependon
assumptionsaboutthepaceofdevelopmentofnew(andexisting)technologiesandtheir
costs.ManyIAMsassumeapredictableannualrateofproductivityimprovementinenergy
use,and/orapredictablerateofdecreaseinemissionsperunitofoutput.Thusa
paradoxicalresultemergesfromthemodelsoverlymechanisticstructure.Becauseclimate
changeisalongtermcrisis,andpredictable,inexorabletechnologicalchangewillmakeit
easierandcheapertoreduceemissionsinthefuture;itseemsbettertowaitbefore
addressingtheproblemofclimatechange.Hence,mostIAMsadvocateacautiousapproach
thatinvolvesonlymodestearlyactiontolimitemissionswithgraduallyincreasinglimits
overtime,butthisconclusionrestsonuntestedassumptionsaboutfuturetechnologies.

10
ThepaperinthisvolumebyMastrandreadiscussesIAMdamagefunctionsinmoredetail.

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 169


Modelsthatassumeendogenoustechnologicalchange,whereintechnologicaldevelopment
respondstopolicyoreconomicsignalswithinthemodel,reachdifferentconclusionsand
frequentlyrecommendmoreaggressivecarbonabatementpolicies,withresultsvarying
accordingtohowthemodelsare(e.g.,GoulderandSchneider,1999;Gerlagh,2007;for
recentsurveysofthisliterature,seethespecialissueofResourceandEnergyEconomics
editedbyCarraroetal.,2003;Edenhoferetal.,2006,andthespecialissueofTheEnergy
Journal(IAEE2006)inwhichitappears;andGillinghametal.,2007).Incontrast,IAMsthat
adoptmoreconservativeassumptionsaboutthepaceoftechnologicalchangetypically
estimatehighermitigationcostsbecausetheyabstractawayfromthepotentialfor
learningbydoingandthepositiverolepublicpolicycanplayinsteeringinvestment
choicesandpromotingtechnologicalchange.Butevenmodelsthatincludeendogenous
technologicalchangearenotempiricallybased.Westilldonotreallyknowhowbigthe
spillovereffectswillbe,orhowsignificantlyresearchanddevelopmentwillrespondtoa
pricesignal.Ingeneral,however,economicmodelshavetendedtounderestimatethepace
oftechnologicalchangeandtooverestimatethecostofsolutionstoenvironmental
problems(Ackermanetal.2009).
Ultimately,welldesignedclimatepolicywillplayadecisiveroleindeterminingthepace
anddirectionoftechnologicalchange,howthecostsofmitigationwillbedistributed,and
whattheoveralldragontheeconomywillbefromhigherfossilfuelprices.Assumptions
abouthowclimatepolicyisformulatedarekeydeterminantsofIAMresults.

4.DiscountingandUncertainty
EvenifIAMScouldquantifytheavoideddamagesofclimatechangeandthecostsof
emissionsmitigation,theirresultswouldstillhingeonthefundamentalphilosophicaland
empiricalproblemsinherenttodiscountingfutureconsumption.Byanalogywithshort
termfinancialcalculations,itistypicallyassertedthatfutureincomesandconsumption
shouldbediscountedattheinterestrater(incontrasttoutility,whichisdiscountedatthe
rate).Inthiscase,wecanthinkofrastherateofreturnonriskfreeassets.Intheabsence
ofuncertainty,themarketrateofinterestthatemergesinamodelbasedonthe
maximizationoftheWofequation[1]isgivenbytheRamseyruleusedinmanyIAMs:11
r = + g [2]
whereistherateofpuretimepreference,gistherateofgrowthofconsumption,andthe
parameterdescribeshowrapidlythemarginalutilityofconsumptiondecreasesas
consumptionincreases.12Thelargerthegrowthrateofconsumption,thewealthierfuture

11
Toarriveatthesimpleformofequation[2],itistypicallyassumedthattheutilityfunctionhastheformofthe
1
constantrelativeriskaversiontype,thatis,u(c)=(c 1)/(1).Ordinarilyitisassumedthatispositiveandhasa
valueof2orgreater.
12
Inotherwords,embodiesthediminishingmarginalvalueofincome,thenotionthatthevalueofeach
additionaldollarofincomedecreasesasanindividualgetsricher.

170 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


generationswillbe,andthehigherthemarketrateofinterestwillhavetobetoinduce
savingsinsteadofcurrentconsumption.Iffutureconsumptionisexpectedtobelow,the
marketrateofreturnonsavingsdoesnothavetobehightoinducesavings.Similarly,with
ahighrateofpuretimepreference,ahigherrateofreturnonsavingsisnecessaryto
compensateforforgoneconsumptioninthepresent.
Withrgreaterthanzero,distantfutureoutcomestakeonreducedimportanceineconomic
calculations.Butthisshrinkageoffuturevaluesisnotaninevitableconsequenceof
equation[2].Ifenvironmentaldamageissufficientlygreatsoastoreduceconsumptionin
thefuture,thengmaybenegativeandthediscountratewillactuallybelessthanthepure
rateoftimepreference(Tol,1994;Amano,1997;Dasguptaetal.,1999).Asufficiently
negativegcouldevenmakernegativeinthissituation.
TheRamseyruleofequation[2]doesnotrepresentthelastwordaboutdiscounting,
however.First,equation[2]needsmodificationiftheeconomyconsistsofmultiplegoods
withdifferentgrowthratesofconsumption.Ifwedefinetheeconomytoinclude
environmentalservices,theproperdiscountrateforevaluatinginvestmentsin
environmentalprotectionwillbeconsiderablylowerthanr,andpossiblyevennegative.
Therateofreturnoninvestmentsinenvironmentalprotectionwillbelowaslongas
societyviewsenvironmentalservicesasweaksubstitutesforproducedgoods,andthe
growthrateofproducedgoodsisgreaterthanthatoftheenvironmentalservicessector,
whichmaybeconstantorevendeclining(HoelandSterner,2007).
Second,andmoreimportant,whenuncertaintyentersthepicture,equation[2]isnolonger
valid.Intherealworld,wedonotobservethemarketrateofinterest,butrathera
multitudeofdifferentratesofreturntoassetshavingdifferentcharacteristics.Themain
thingthatdistinguishesassetsfromeachotherandaccountsfortheirdifferingratesof
returnisthattheydonotcarrythesamedegreeofrisk.
Theimportanceforclimatepolicyofthesimpleempiricalfactthatdifferentinterestrates
areobservedinthemarketplacewaspointedoutbyHowarth(2003).13Ignoring
uncertaintyabouttheconsequencesofclimatechangeisaseriousomissionthatis
inconsistentwiththeevidence(CommitteeonAnalysisofGlobalChangeAssessments,
2007).Inparticular,thediscountrate(orexpectedreturn)attachedtoaparticular
investmenthastotakeintoaccountthecovariance(orstatisticalinterdependence)
betweentheassetsreturnandoverallconsumption.14Cochrane(2005,pp1314)putsit
thisway:

13
Anumberofothereconomistshavebeguntoexploretheconsequencesofuncertaintyfordiscounting(e.g.,
NewellandPizer,2003;Ludwigetal.,2005;Howarth,2009;HowarthandNorgaard,2007;Sandsmarkand
Vennemo,2007;Pesaranetal.,2007).
14
Thetheoryhereisgenericandattheheartofmodernfinance.Standardexpositionscanbefoundin Cochrane
(2005),Mehra(2003)andHowarth(2003,2009).Therelationshipbetweentheexpectedreturnonanassetandits
covariancewithconsumptionis [thisfootnotecontinuedonnextpage]

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 171


Investorsdonotlikeuncertaintyaboutconsumption.Ifyoubuyanassetwhose
payoffcovariespositivelywithconsumption,onethatpaysoffwellwhenyouare
alreadyfeelingwealthy,andpaysoffbadlywhenyouarealreadyfeelingpoor,
thatassetwillmakeyourconsumptionstreammorevolatile.Youwillrequirea
lowpricetoinduceyoutobuysuchanasset.Ifyoubuyanassetwhosepayoff
covariesnegativelywithconsumption,ithelpstosmoothconsumptionandsois
morevaluablethanitsexpectedpayoffmightindicate.Insuranceisanextreme
example.Insurancepaysoffexactlywhenwealthandconsumptionwould
otherwisebelowyougetacheckwhenyourhouseburnsdown.Forthisreason,
youarehappytoholdinsurance,eventhoughyouexpecttolosemoneyeven
thoughthepriceofinsuranceisgreaterthanitsexpectedpayoffdiscountedatthe
riskfreerate.15
Thisobservationimpliesthateveniftheexpectedrateofgrowthofconsumptionispositive
onaverage,considerationsofprecautionarysavingsandinsurancecanlowerthediscount
rateappropriateforvaluingclimateprotectioninvestments(Howarth,2007).Thediscount
rateunderuncertaintyisquitedifferentfromtheRamseyrulediscountrategivenby
equation[2].
Uncertaintyabouttheunderlyingstructureoftheinteractionbetweenclimatechangeand
theeconomycreatesadditionalproblemsforthediscountedutilityframework.Inaseries
ofpathbreakingpapers,Weitzman(2007a,2007b,2009)hasshownthatclimate
catastropheswithlowbutunknownprobabilitiesandveryhighdamagesdominate
discountingconsiderationsinformulatingapolicyaimedatreducingtheserisks.This
uncertaintylowersthediscountratesignificantlybecausethepossibilityofveryhigh
damagesimpliesthatfutureconsumptionmaydecrease.
Finally,itshouldbenotedthatthereareseriousempiricalproblemswithallofthe
discountingformulas.Evenifplausibleand/orhistoricalvaluesoftheparameters
underlyingthecalculationsofdiscountrates(thecoefficientofrelativeriskaversion,the
growthrateandvarianceofconsumption,thecovariancebetweenreturnsandthe
marginalutilityofconsumption,andthesubjectiverateoftimepreference)areused,these
formulasdonotyielddiscountratesthatmatchthoseactuallyobservedinthemarket.
Theseanomaliesbetweenmodelassumptionsandobservedmarketratesgobynamessuch

cov[u ' (ct +1 ), rti+1 ]

E[r i ] = r f
E[u ' (ct +1 )]
i f
whereE[r ]istheexpectedmarketdiscountrateforassetoftypeorriskclassiandr istheriskfreediscountrate.
i
Equation[6]requiressomeinterpretation,becauseE[r ]movesintheoppositedirectionasthepriceofasseti,and
themarginalutilityofconsumptionu'decreasesasconsumptionincreases.
15
Or,considerthecaseofequities.Equitieshavehighreturnswhenconsumptionishigh,sothecovariance
betweentheequitydiscountrateandthemarginalutilityofconsumptionisnegative(becausethemarginalutility
ofconsumptionislowerwhenconsumptionishigh).Hencetheequitydiscountrateishigherthantheriskfree
ratebecauseofthenegativesignonthecovariancetermintheequationoffootnote8.

172 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


astheequitypremiumpuzzleandtheriskfreeratepuzzle,andtheyshowupstrongly
notonlyindatafortheUnitedStates,butalsoindataforothercountrieswithwell
developedassetmarkets(Campbell,2003;MehraandPrescott,2003).Despitean
enormousamountofeffortbythebesteconomiststoresolvetheseparadoxes(literally
hundredsofscholarlypapershavebeenpublishedonthesepuzzles),thereisno
professionalconsensusonhowthetheorymightbereconciledwithobservations.AsMehra
andPrescott(whooriginallydiscoveredtheequitypremiumpuzzle(1985))comment,
The[equitypremium]puzzlecannotbedismissedlightly,sincemuchofour
economicintuitionisbasedontheveryclassofmodelsthatfallshortso
dramaticallywhenconfrontedwithfinancialdata.Itunderscoresthefailureof
paradigmscentraltofinancialandeconomicmodelingtocapturethe
characteristicthatappearstomakestockscomparativelysorisky.Hencethe
viabilityofusingthisclassofmodelsforanyquantitativeassessment,say,for
instance,togaugethewelfareimplicationsofalternativestabilizationpolicies,is
thrownopentoquestion(MehraandPrescott,2003,p.911).
MehraandPrescottwerereferringtopoliciesformacroeconomicstabilization,buttheir
admonitionappliesequallytotheuseofIAMstoguideclimatepolicy.

5.Insurance,precaution,andthecontributionofclimateeconomics
Inthethreeprecedingsections,wearguedthatmostIAMsrelyonananalyticalframework
thatprivilegesimmediate,individualconsumptionoverfutureorientedconcerns;thatthe
benefits,oravoideddamages,fromclimatemitigationarebothunpredictableindetailand
intrinsicallynonmonetizable;andthattheconventionaleconomicviewoftechnology
misrepresentsthedynamic,sociallydeterminednatureoftechnologicalchange.Notmuch
isleft,therefore,ofthestandardeconomicapproachanditsambitionstoperforma
competentcostbenefitanalysisofclimatepolicyoptions.Inlightofthesecriticisms,how
shouldwethinkaboutpolicyoptionsandtheeconomicsofclimatechange?
Theoptimalcontrolapproachtoclimatepolicyembodiedinequation[1]aboveisnotthe
onlyoneproposedintheliterature.Forexample,theearlygrowthliteratureproposedthe
notionoftheGoldenRulesteadystategrowthpath(Solow,1970).Inthissimplemodel
withthesavingsrateastheonlypolicyvariable,optimalgrowthisthepathyieldingthe
highestlevelofconsumptionpercapitaamongallsustainablegrowthpaths.Sustainable
growth,inthiscontext,isapaththatdoesnotsacrificetheconsumptionoffuture
generationsbydepletingsocietyscapital(includingnaturalcapital)forthebenefitofthe
presentgeneration.Insuchamodel,themarketrateofinterestisequaltotherateof
growthofconsumption.Ifthewillingnesstopayonbehalfoffuturegenerationstoavert
environmentaldestructionisdirectlyproportionaltoincome,thentheeffectivediscount
rateontheGoldenRulegrowthpathiszero(DeCanio,2003).ThenotionoftheGoldenRule
growthpathhasbeengeneralizedtoGreenGoldenRulegrowth,withdifferent

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 173


implicationsforthediscountratedependingontheassumptionsmadeaboutthe
interactionbetweentheenvironmentandthemarketeconomy(Chichilniskyetal.,1995;
Bella,2006).
Whetherandhowmuchpeoplecareaboutfuturegenerationscanberepresentedin
variouswaysthroughtherateofsubjectivetimepreferenceinoptimalgrowthmodels,
throughtheweightingofdifferentgenerationswelfareinoverlappinggenerationsmodels
(HowarthandNorgaard,1992;Howarth,1996),throughthoughtexperimentsinwhichthe
generationsareabletotransactwithoneanother(DeCanioandNiemann,2006)andthe
results,notunexpectedly,willreflectthedepthandstrengthoftheintergenerationalties.
Theupshotofthesealternativewaysofcharacterizingtheintergenerationaldecision
makingproblemisthatthenormativeassumptionsthataremadeabouthowfuture
generationsaretreatedareasimportantasthetechnicaldetails.Nothavinghappenedyet,
thefutureisunobservable;moreover,therearenoreliable,universallyacceptedeconomic
lawsthatshapeourunderstandingofthefutureinthewaythatthelawsofnaturedofor
thephysicalrealityofclimatechange.Inaddition,consciousnessandintergenerational
concernareinfluencedbysocialandpoliticaldiscourse.Thereisnofundamentalreason,
therefore,thatsocialpreferencesshouldbeimmutableinthefaceofnewknowledgethat
presentdayconsumptionmayadverselyaffectfuturegenerations.
Oneofthemostinterestingnewareasofeconomictheoryasappliedtoclimateinvolvesthe
analysisofdeepuncertaintyregardingfutureoutcomes.Iftheprobabilitiesofarangeof
possibleoutcomeswereknown,asincasinogamesorhomeworkexercisesinstatistics
classes,thentherewouldbenoneedforanewtheory;itwouldbeastraightforwardmatter
tocalculatetheexpectedvalueofclimateoutcomesandeconomicconsequences.However,
thisapproachisinadequateformanagingtherisksofclimatechange.16Whenprobability
distributionsthemselvesareunknown,theproblemofuncertaintyismuchmoredifficultto
address.Thecombinationofunknownprobabilitydistributionsandpotentiallydisastrous
outcomesprovidesastrongmotivationtopurchaseinsuranceagainstthosedisasters.As
notedinarecentreviewofscientificknowledgeaboutpotentialtippingelementsofearth
systems,[s]ocietymaybelulledintoafalsesenseofsecuritybysmoothprojectionsof
globalchange.presentknowledgesuggeststhatavarietyoftippingelementscouldreach
theircriticalpointwithinthiscenturyunderanthropogenicclimatechange(Lentonetal.,
2008;seealsoCommitteeonAbruptClimateChange,2002).Forexample,uncertainty
abouttheclimatesensitivity,akeyparameterinassessingtheprobabilityforrangesof
potentialequilibriumglobaltemperaturechanges,isintrinsicallyresistantto
improvementsinscientificunderstanding(RoeandBaker,2007).
Severaleconomistsworkingatthetheoreticalfrontierhaveproposednewwaysofdealing
withthesekindsofdeepuncertainties(e.g.,Gjerdeetal.,1999;Chichilnisky,2000;Halland
Behl,2006;Dasgupta,2008;Weitzman,2007a,b,2009).Forexample,inWeitzmansmodel

16
SeealsothepaperinthisvolumebyYoheregardingariskmanagementcontextforclimatepolicy.

174 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


(applicabletofinancialmarketsaswellasclimatechange)peoplelearnabouttheworld
throughrepeatedexperiences,butiftherelevantstructureoftheworldischangingrapidly
orgreatlyenough,onlythemostrecentexperiencescanbereliedontoinformourfuture
expectations.Inthiscircumstance,wedonothavesufficienthistoryorexperiencetorule
outthepotentialforcatastrophicrisksfromclimatechange.AsWeitzmanargues,fine
tuningtheestimatesofthemostlikelylevelofclimatedamagesisirrelevant;whatmatters
ishowbadandhowlikelytheworstextremesofthepossibleoutcomesare.The
consequencesofclimatechangearepotentiallysodisastrousthatconventionalcostbenefit
analysisisinadequateforpolicymaking.
Intuitively,thisisthesamelogicthatmotivatesthepurchaseofinsurance,aprecautionary
decisionthatpeoplemakeallthetime.Themostlikelynumberofhousefiresthatanygiven
homeownerwillexperiencenextyear,oreveninherlifetime,iszero.Veryfew
homeownersfindthisacompellingreasontogowithoutfireinsurance.Similarly,healthy
youngadultsoftenbuylifeinsurancetoprotecttheirchildren'sfutureintheworstpossible
case.Residentialfiresanddeathsofhealthyyoungadultshaveannualprobabilities
measuredinthetenthsofonepercent.Inotherwords,peopleroutinelyinsurethemselves
againstpersonalcatastrophesthatcouldwellhavealowerprobabilityofoccurringthan
theworstcaseclimatecatastrophesfortheplanet.17ChichilniskyandSheeran(2009),
usingfiguresfromtheglobalreinsurancecompanySwissRe,reportthattheworldalready
spends3.1percentofglobalGDP$250perpersonannuallyonnonlifeinsurance
premiums.Thisincludesinsurancepoliciestocoverlossesfromnaturaldisasterssuchas
floods,fires,andtyphoons,andmanmadedisasterssuchasplanecrashes,raildisasters,
andshipwrecks.ThreepercentofglobalGDPiswhatmanyIAMsestimateasthecostsof
mitigatingclimatechange(IntergovernmentalPanelonClimateChange,2007c).Ifthe
worldalreadyspendsthismuchtoinsureitselfagainstlowprobabilitybutcostlydisasters,
whywouldwenotapplythesamelogictopotentialclimatechangedisasters(Chichilnisky
andSheeran,2009)?
Howwouldthisperspectivechangeourapproachtoclimateeconomicsandpolicychoices?
Economicswouldnolongerbechargedwithdeterminingtheoptimalorutilitymaximizing
policy.Instead,adiscussionofscientificinformationaboutcatastrophicpossibilitiesand
consequenceswouldpresumablyleadtothechoiceofmaximumsafetargets,expressed
intermsofallowableincreasesintemperatureand/orCO2levels.Oncesafetargetshave
beenestablished,thereremaintheextremelycomplexandintellectuallychallenging
tasksforwhichthetoolsofeconomicsarebothappropriateandpowerfulof
determiningtheleastcostglobalstrategyforachievingthosetargets,designingpolicies

17
Ironically,giventhesubsequentfocusoncostbenefitanalysis,oneoftheprecursorsofcurrentIAMsappeared
inabooktitled,BuyingGreenhouseInsurance:TheEconomicCostsofCO2EmissionsLimits(ManneandRichels,
1992).

PewBenefitsWorkshop|Ackerman,etal.:FreshApproachtoClimateChangeEconomics 175


thateffectivelyandwithconfidencemeetthetargets, 18andsharingresponsibilityforthe
costsandimplementationofthatstrategy.
Thiscosteffectivenesstask,despiteitsdauntingdifficulty,ismoremanageablethanthe
costbenefitanalysisattemptedbypolicyoptimizingIAMs,andthereducedscopeavoids
manyoftheproblemswehavediscussed.Discountingislessofanissuebecausethecosts
ofmitigationandadaptation,whilestillspreadoutintime,generallyoccurmuchsooner
thanthefullrangeofanticipateddamages.Preciseestimationandmonetizationofbenefits
isnolongernecessary;costeffectivenessanalysistakesthebenefitssideasfixed,or,inthe
languageofeconomics,assignsaninfiniteshadowpricetotheconstraintofmeetingthe
chosentargetanotherwayofsayingthatcostcalculationsarenotallowedtooverridethe
priorchoiceofasafestandard.

6.Conclusions
Therearetwomessagesoffundamentalimportancehere.Thefirstisthatpolicymakers
shouldbeskepticalofeffortsbyeconomiststospecifyoptimalclimatepolicypathsonthe
basisofthediscountedutilityframeworkembodiedinthecurrentgenerationofoptimizing
IAMs.Thesemodelsdonotembodythestateoftheartintheeconomictheoryof
uncertainty,andthefoundationsoftheeconomiccomponentoftheIAMsaremuchless
solidlyestablishedthanthegeneralcirculationmodelsthatrepresentourbestcurrent
understandingofphysicalclimateprocesses.NotonlydotheIAMsusedinclimate
economicsentailanimplicitphilosophicalstancethatishighlycontestable,theysuffer
fromtechnicaldeficienciesthatarewidelyrecognizedwithineconomics.IAMsshouldnot,
therefore,belookedtoastheultimatearbiterofclimatepolicychoices.Second,economists
dohaveusefulinsightsforclimatepolicy.Whileeconomicsitselfisinsufficientto
determinetheurgencyforprecautionaryactioninthefaceoflowprobabilityclimate
catastrophes,ormakejudgmentsaboutintragenerationaljustice,itdoespointtheway
towardsachievingclimatestabilizationinacosteffectivemanneroncedesignateddecision
makershavemadeinformedvaluejudgmentsabouttheactionssocietyshouldtaketolimit
therisksofclimatechangeasunderstoodandcommunicatedbythescientificcommunity.

Acknowledgements
WehavebenefitedfromcommentsbyJohnGliedman,SarahA.Kruse,RajnishMehra,
RichardB.Norgaard,CatherineS.Norman,MartinWeitzman,andtworeferees.
Responsibilityforanyerrorsisours.

18
Thetolerablewindowsapproachisonepromisingdevelopmentinthisdirection.Thismethodology
concentratesonafewkeyattributes(e.g.,acceptableimpactsandcosts)andprovidesanenvelopeforfuture
action.Whichcourseshouldbetakenwithintheenvelope?(Tothetal.2003,pp.5455).Aspecialissueof
ClimaticChange(2003,nos.12;seeToth2003)containsanumberofpapersembodyingthisapproach.

176 Ackerman,etal.:FreshApproachtoClimateChangeEconomics |PewBenefitsWorkshop


Abbreviations
CO2:carbondioxide
DICE:DynamicIntegratedmodelofClimateandtheEconomy
GCMs:GeneralCirculationModels
GDP:GrossDomesticProduct
GHGs:greenhousegases
IAMs:IntegratedAssessmentModels
IPCC:IntergovernmentalPanelonClimateChange
OECD:OrganisationforEconomicCooperationandDevelopment

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