Economic Models of Climate Change

The responsibility of the present to the future is an abiding concern in human affairs. Much of our best effort is devoted to the upbringing of children, and they exercise a primary claim on our love and affection. The care, socialization, and education of the young is by far the largest “investment project” undertaken by any society. We work and build for the future, and strive to leave behind tangible legacies even beyond what we bequeath to our offspring. The onset of anthropogenic climate change challenges our link to the future in a very direct way — actions that are taken (or not taken) today will have an impact, possibly a decisive impact, on the condition of the natural world that will be inherited by those who follow us. While this is not a uniquely new “policy problem” (many of the great social and political issues have to do with matters affecting succeeding generations), climate change threatens human well-being across very long time spans in ways that are historically unprecedented.

The general equilibrium models used for climate policy analysis are stylized representations of the activities of the millions of individuals and organizations that constitute the economy. The models themselves are made up of systems of equations that represent production and consumer demand, and spell out the market conditions that determine the prices and quantities of goods bought and sold. In some cases, key features of the models are determined outside the interactions they describe, or “exogenously.” For example, technological progress (which can be measured as the increase in output that can be obtained from given inputs as time goes on) is often specified as a constant percentage rate of change independent of other variables in the model. Technical progress can also take the form of entirely new products or services. The conditions of general equilibrium determine how the structural and behavioral equations are to be solved to yield the prices and quantities that emerge within the economy. The meaning of “general equilibrium” is that all markets clear in the sense that the plans and intentions of consumers and producers are fulfilled.

Climate change takes place over decades, centuries, and millennia. The consequences of actions taken now also work themselves out on time scales covering multiple generations. The persistence of CO₂ in the atmosphere depends on the long-term response of the biosphere to increased temperatures and concentrations, and the atmospheric lifetimes of many of the non-CO₂ greenhouse gases are over 100 years. The achievement of thermal equilibrium between the surface layers of the ocean and atmosphere takes decades, and achievement of equilibrium between the different layers of the ocean requires even more time (IPCC 2001a).1 These physical facts mean that the treatment of events and policies that unfold over very long stretches of time must be a central feature of the economic analysis of climate change. Not only do policies have long-lasting consequences, but the basic conceptualization of the economic system itself has to reflect the lengths of time involved.

“Tastes” and “technology” are the fundamentals upon which neoclassical general equilibrium models are built. While the representation of tastes is expressed through utility and demand functions, the underlying productive technology of the economy is represented by production functions that relate various quantities of various inputs to the output produced by firms. This approach requires a behavioral theory that describes the activity of firms as they carry out the processes of production. The behavioral theory is profit maximization, which parallels the utility maximization of consumers on the demand side of the economy. While some of the conceptual and mathematical difficulties that plague the representation of preferences are common to the treatment of production in the models, there are several important differences.

The predictive performance of economic-energy models has a direct bearing on their usefulness in the climate policy debate. One of the salient aspects of that debate is that some opponents of action to reduce GHG emissions are willing to make confident assertions about what the “cost to the economy” of various policy proposals (such as compliance with the Kyoto Protocol) would be. Yet at the same time these skeptics doubt the validity of the science that underlies forecasts of global warming, and claim that the observed century-long trend of increasing temperatures is indistinguishable from the “noise” of natural variation. They are willing to base strong policy recommendations on the forecasts of economic/energy models that purport to predict output, employment, prices, and emissions decades into the future, while denying the predictive power of physical science models of climate dynamics.

The previous chapters have shown that by downplaying or ignoring the issues of distribution, multiple equilibria, and dynamics, the economic analysis of climate policy has missed (or mischaracterized) essential aspects of the problem. Most analysis has concentrated on matters of efficiency that are more suitable for small-scale environmental problems (such as where to locate a landfill or what to do about pollution of a river by an industrial plant) than for a global issue like climate change. By implicitly taking the existing definitions and distribution of property rights for granted, policy advice has been skewed towards the status quo. Some of the possibilities that are opened up by the creation of climate rights or alternative evolutionary paths for the economy have been ruled out arbitrarily, when they may actually offer the most hopeful potential routes to climate stabilization.