Climate Change Cost-Benefit Analysis

Conventional economic thinking poses a challenge to the perceived need for climate change risk management. Put most simply, the costs of aggressively mitigating climate change are biased toward the near-term, while the benefits of aggressively mitigating climate change area biased toward the long-term. Taking into account the time value of money, climate change can quickly seem to become an even more invisible problem than it already is.

In 2006, the British government published the so-called Stern Review (commonly named for the head economist, Nicholas Stern, in charge of the review group putting together the report). The Stern Review concluded that climate change threatens to reduce future global GDP by 5-20% in perpetuity. The Stern Report was criticized at the time for basing its conclusions on the use of an almost 0% discount rate. Employing typical societal discount rates of 3-4% (much less typical private sector discount rates of 10-20%), significantly change the Stern Report results.

But this begs the question according to some economists. The key question is whether typical cost-benefit analysis is appropriate for a problem of the scale of climate change. We usually don’t intentionally and explicitly make decisions that would fundamentally endanger future generations, just because the NPV of such decisions look favorable to today’s generation. Nuclear waste disposal, evaluated against the requirement that the waste be sequestered for thousands of years, is an interesting juxtaposition to climate change policy discussions.

There is another side to the economic debate over climate change. Many economists argue that focusing on total discounted dollars is the wrong way to think about climate risk. Even modest reductions in future GDP amount to huge changes in total dollars. But what if the question is phrased differently -- i.e. is it worth accepting a 95% increase in 2030 GDP, as opposed to a 100% increase in 2030 GDP, in order to make the investments necessary to manage climate change risk? This puts the question into an entirely different light that allows for a more risk- and values-based discussion. The Stern Report, for examples, contrasts its estimate of 5-20% of loss in annual GDP to the 1% of annual GDP required to avoid negative climate change outcomes through effective societal risk management.

Other economists argue that there’s a good chance the world economy would actually be better off in the future by tackling the climate change problem today, even without factoring in the costs of future climate change. They argue that moving to replace the high environmental, social, and security costs of today’s global energy systems with alternative energy systems would pay off quickly.

Economic analysis of climate change risk at the local and project-based level is still relatively rare, primarily because the ability to forecast the localized impacts of climate change is still evolving. One economic analysis, looking at hurricane risk to New York City, concludes that by 2030 climate change will increase the risk of a category 4 or 5 hurricane hitting New York City by as much as 25-30%,[iii] and that the city’s vulnerability to such an event is so great that the city should be willing to pay more than $47 billion per year in 2030 to avoid the increased risk. That is more than 50% of New York City’s annual expenditure budget ($60 billion in 2009), just to purchase a climate change insurance policy against climate change-induced increase in hurricane risk.

The same analysis concluded that investors funding hurricane-susceptible infrastructure should be prepared for a significant decline in their expected rates of return from such investments, for the same basic reason of increasing extreme event risk.For infrastructure with an estimated 12% return based on historical climate, future rates of return may prove closer to 4%.