The Economics of Climate Change

Greenhouse gas (GHG) emissions are externalities and represent the biggest market failure the world has seen. We all produce emissions, people around the world are already suffering from past emissions, and current emissions will have potentially catastrophic impacts in the future. Thus, these emissions are not ordinary, localized externalities. Risk on a global scale is at the core of the issue. These basic features of the problem must shape the economic analysis we bring to bear; failure to do this will produce, and has produced, approaches to policy that are profoundly misleading and indeed dangerous. The purpose of this chapter is to set out what I think is an appropriate way to examine the economics of climate change, given the unique scientific and economic challenges posed, and to suggest implications for emissions targets, policy instruments, and global action. The subject is complex and very wide-ranging. It is a subject of vital importance but one in which the economics is fairly young. A central challenge is to provide the economic tools necessary as quickly as possible, because policy decisions are both urgent and moving quickly—particularly following the United Nations Framework Convention on Climate Change (UNFCCC) meetings in Bali in December 2007. The relevant decisions can be greatly improved if we bring the best economic analyses and judgments to the table in real time. A brief description of the scientific processes linking climate change to GHG emissions will help us to understand how they should shape the economic analysis. First, people, through their consumption and production decisions, emit GHGs. Carbon dioxide is especially important, accounting for around three-quarters of the human-generated global-warming effect; other relevant GHGs include methane, nitrous oxide, and hydrofluorocarbons (HFCs). Second, these flows accumulate into stocks of GHGs in the atmosphere. It is overall stocks of GHGs that matter and not their place of origin. The rate at which stock accumulation occurs depends on the “carbon cycle,” including the earth’s absorptive capabilities and other feedback effects. Third, the stock of GHGs in the atmosphere traps heat and results in global warming; how much depends on “climate sensitivity.”