Climate change as an Economic problem

Updated: Sep 17, 2019

When the UN announced the 2015 Paris Agreement, the world celebrated this milestone in diplomacy. Four years on, the world is not living up to its promise in the agreement. The US, considered the most powerful country, under Donald Trump withdrew from the agreement. This move could empower climate change skeptics around the world, and encourage already skeptic leaders to withdraw from the agreement.

There is a great deal of evidence gathered and analysed that proves the causes and effects of climate change. We all know that climate change is caused by greenhouse gases (GHGs), the most famous of which is carbon dioxide. The GHGs will be suspended in our atmosphere and trap the heat caused by sunlight inside our planet. Currently, we know that the world with 7.7 billion humans can only sustain a 1.5 degrees Celsius or above pre-industrial level. As of 2019, the Earth’s temperature has increased, on average, by 0.8 degrees since 1880 according to an ongoing temperature analysis conducted by scientists at NASA’s Goddard Institute for Space Studies.

The social and political dilemma…

Climate change is an issue that can be seen through different lenses. May it be a moral issue that humans must be a responsible steward of our only planet or a technical problem with scientific solutions. I have also read statements talking about how we owe it to the next generation to take care of our world. All of which are correct, and some appeal to human emotions which is an effective way of capturing people’s attention. But humans are complex creatures that create complex social and political paradigms. A problem like climate change requires the simplest of solutions but made complicated by the involvement of humans. The facts are already established using empirical methods of science, and yet we hear from heads of nation-states that they cannot abide by the rules created by the Paris accord. Why?

We understand that economic growth and development requires energy, which in our current technology, is generated by dirty sources like coal and oil. This means that cutting back on emissions will hamper economic growth as suggested. This is also a lifestyle problem for many people in the world. Currently, 1 billion people are living in the Developed world in which consumption is exorbitant, and higher than the developing world by a factor of 32 according to Jared Diamond. It’s not politically palatable to ask them to tone down their lifestyle. “A person who has always driven a car is less likely to give up driving than a person who hasn’t driven one.”

If we combine those premises, we will get a grasp of the magnitude of the problem. It is not impossible that emerging countries will be living a developed world lifestyle in the coming decades. This will mean that Africa, China, and India, each with a billion people will consume 32 times more than the average consumption of the current emerging countries. This will exacerbate the existing problem.

What if we view it as an economic problem?

To understand climate change, we need science. To apply those accumulated knowledge to understand the economic impact, we need Economics. To understand the incentives of the market participants with regard climate change, we need Economics. Here, let’s look at climate change as an economic problem. Because, in my opinion, looking at the issue through the lens of Economics will engage more stakeholders in solving the problem. Let’s take a look at megacities: New York, London, Sydney, among others. We can note that these are historical port cities. Centuries ago, these cities were built in ports due to economic reasons. Trade is done through ships and it’s more practical to build a city within that port. These thriving cities eventually evolved into Financial Centers of the world. And, climate change turned these cities into high-risk areas when oceans started rising, and extreme weather patterns start emerging.

When Hurricane Sandy struck Manhattan in 2012 shutting down Wall Street, the world woke up to a symbol of the real impact of climate change. This could threaten the world’s financial stability and could eventually cause a financial collapse if disasters simultaneously happen in global financial centers.

In 2017, the leaders of central banks created the Network for Greening the Financial System (NGFS), the main goals of which are to manage climate risks, improve climate performance, and account for climate actions. NGFS realised that climate-risks are a source financial risks. It is about time to involve the finance industry, with its trillion-dollar funding and political weight, in solving the problems created by climate change. This is a huge change in climate policy initiatives, as funding is one of the crucial factors in the world’s transition into green and low carbon economy. NGFS also advocates for a robust and internationally consistent climate and environmental disclosure framework which will also guide stakeholders to make economic decisions.

Proper accounting and accountability…

Three years ago, I wrote an opinion article about how our current Accounting methods fail to recognise the necessity to include the financial impacts of climate change on financial statements, may it be a factor in the calculation of fair value, or a provision sitting in the balance sheet. I mentioned at the time that this could be limited as the impact is immensely difficult to calculate, and climate models are too complex to be accounted for. Then in 2018, the New York Attorney General’s office filed a lawsuit against ExxonMobil for failing to completely account for the impact of climate change in their financial reports. This is a smart move from the Attorney General which attacked the lawsuit through Securities Fraud laws as the US has no law on punishing the enablers of carbon emissions. “Investors put their money and their trust in Exxon, which assured them of the long-term value of their shares, as the company claimed to be factoring the risk of increasing climate change regulation into its business decisions,” the Attorney General said. Exxon, failing to account for damages to the company due to the government’s climate change policies, effectively defrauded the investing public. This could set a precedent in which companies will now be compelled to account for the impact of climate change that is measured through government penalties, or in some cases, the carbon market.

In 2006, the British government presented a comprehensive study “The Stern Review on the Economics of Climate Change.” The study posits that if we don’t act, the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP each year, now and forever. If a wider range of risks and impacts is taken into account, the estimates of damage could rise to 20% of GDP or more. We can argue about the factors considered, formula used, or discounting they employed in calculating this estimate, but this is a government with political advocacy laying out the urgency of the matter at hand.

Why is it hard to create the necessary changes?

Whenever we think of climate change and its impact, it’s hard not to think why we are not doing anything about it. The answer is the lack of immediate feedback. Any person who emitted GHGs doesn’t experience immediate feedback like those of accidents where we feel immediate pain. The greenhouse effect was only recognised after humans emitted tons of greenhouse gases over the course of a century. This lack of feedback doesn’t provide individuals, or nations, with incentive to alter their behaviour.

We can also view carbon emissions as a “free-rider” problem. The free-rider problem is a type of market failure that occurs when those who benefit from resources, public goods, or services of a communal nature do not pay for them. GHG emissions can be viewed as a good that should have a pricing mechanism before usage. Currently, in most parts of the world, humans and companies can emit GHGs freely and with no repercussions, thus, ‘free-riders’.

GHG emissions from consumption also create negative externalities. An externality is a cost or benefit that affects a party who did not choose to incur that cost or benefit. For instance, a cigarette smoker creates negative externalities every time he puffs, may it be second hand smoking or annoying the people around him with the smell. Climate change also has a similar phenomenon, albeit global in scale. The exorbitant consumption in the developed world creates negative externalities on the other side of the globe. The developed world, with their industrial revolution and first-world lifestyle, accelerated climate change that affects the whole earth.

The disproportionate impact between rich and poor countries…

The negative externality is one reason why there is a lack of feedback in the first place. The costs of industrialization were spread thinly around the world, while the benefits are concentrated in a few countries. Climate justice is often a topic on the world stage such as the UN. Not surprisingly, the talks about climate change shifted from environmental damage, melting ice caps, whitening coral reefs, to its impact on inequality and how it exacerbates poverty especially in tropical developing countries which are witnessing more of the adverse effects of climate change. The Intergovernmental Panel on Climate Change (IPCC) published its fourth assessment (AR4) in 2007 noting that “socially and economically disadvantaged and marginalized people are disproportionally affected by climate change.” Similarly, Narzul Islam and Winkel published a report for the UN noting that there are three dimensions on how climate change exacerbates inequality:

  1. increase in the exposure to climate hazards;

  2. increase in the susceptibility to damage caused by climate hazards; and

  3. decrease in the ability to cope with and recover from the damage.

These evidence-based findings were published and frequently cited. We can actually observe these in our ordinary lives. Let’s have a thought experiment: Imagine a poor family in the Philippines (a developing tropical country) that relies on farming for a living. Assuming a thunderstorm hits their province and damages their crops, not to mention heavily damaging their home made with flimsy materials. This is not comparable to the damage of a meteorologically similar thunderstorm in the US where infrastructure is resilient and aid is easily accessible. I am sure that there are tons of data lying around to prove the hypothesis. Narzul Islam and Winkel also showcased a positive relationship between Net GINI and GHG emissions per capita in OECD countries. The numbers don’t lie.

It requires huge behavioural changes

Addressing the risks of climate change requires an insurmountable effort on governments and citizens alike. This would be an unpopular opinion, but campaigns that say “It all starts with you” is not effective. It’s foolish to think that changing one’s behaviour will create a change big enough to mitigate climate change. Even if we raise the number to 100 million individuals (which is currently not possible) with previously first-world lifestyle not taking planes, not driving, not eating beef, and living off sustainable energy, this is only 1.3% of the world’s population. A problem of this magnitude requires huge behavioural changes, and this is where behavioural economics come into play. Richard Thaler and Cass Sunstein introduced libertarian paternalism to where they want to “influence choices in a way that will make the choosers better off, as judged by themselves.” This, in no way, “burden those who want to exercise their freedom.” We need to nudge people to make choices that will help mitigate the risks of climate change at a larger scale. Making it easy to bike around is one thing cities should start replicating. Nudging people to take public transportation is also crucial in this move. Not only these are impactful at a global scale, these are also easily favoured by the population.

Carbon tax is also popular among Economists. This will solve the problem of “lack of feedback” by introducing carbon tax as a pricing signal that the product you are consuming has a cost on the environment. As the fight against tobacco showed us, humans respond best on prices. Price shocks tend to reduce consumption of a certain good. This is also unpopular to the population due to human’s aversion to losses. Humans do not like seeing direct taxes in their consumption as it is viewed as a loss. Direct taxation on carbon will also affect the prices of basic commodities. This is probably hard to swallow for the meantime, but if we take it by baby steps, i.e. using tax revenues to support green economy initiatives, will do more than direct taxing. France showed us this when the population rejected taxes on fuel passed by its government in the spirit of the Paris agreement.

Another solution that policy makers developed is the establishment of Carbon markets. This will solve the free-rider problem I mentioned above. Establishing carbon markets, at a global scale, will not just put a cost on carbon emissions but also put gains on non-emission. The World Bank is a key player in developing these markets and encourage participation of state and non-state actors. There are carbon markets in the EU, Canada, UK, and Australia. China, the world’s biggest carbon emitter, also has plans to create a carbon market.

Sure, these are elegantly design solutions to address a problem this complex. But, these propositions all assume one thing: that societies will have the political will and elect the proper leaders; and authoritarians will put forward climate change as a significant issue. There are different facets in case of a democracy: the majority of the electorate faces different problems (such as economic development, unemployment or retirement), low voter turnout among the young, and (most importantly) disruptive changes are hard sell. But, that is a whole other topic and of a different expertise.

Climate change is a technical, economic, and social problem. Currently, this is the greatest existential threat that we are aware of, in my opinion. As with all other crises we endured and survived, human ingenuity will prevail in solving the problems of the generation.

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