On climate change and economic growth

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Abstract

The economic impact of climate change is usually measured as the extent to which the climate of a given period affects social welfare in that period. This static approach ignores the dynamic effects through which climate change may affect economic growth and hence future welfare. In this paper we take a closer look at these dynamic effects, in particular saving and capital accumulation. With a constant savings rate, a lower output due to climate change will lead to a proportionate reduction in investment which in turn will depress future production (capital accumulation effect) and, in almost all cases, future consumption per capita. If the savings rate is endogenous, forward looking agents would change their savings behavior to accommodate the impact of future climate change. This suppresses growth prospects in absolute and per capita terms (savings effect). In an endogenous growth context, these two effects may be exacerbated through changes in labour productivity and the rate of technical progress. Simulations using a simple climate-economy model suggest that the capital accumulation effect is important, especially if technological change is endogenous, and may be larger than the direct impact of climate change. The savings effect is less pronounced. The dynamic effects are more important, relative to the direct effects, if climate change impacts are moderate overall. This suggests that they are more of a concern in developed countries, which are believed to be less vulnerable to climate change. The magnitude of dynamic effects is not sensitive to the choice of discount rate.

Introduction

In most studies of the economic impact of global warming the effects of climate change are assessed and valued separately sector by sector and then added up to form an estimate of the overall change in social welfare (e.g., Nordhaus, 1991, Cline, 1992, Fankhauser, 1995, Tol, 1995, Mendelsohn and Neumann, 1999). This is known as the enumerative approach.1 It is well known and widely documented in the literature that this method ignores potentially significant “horizontal interlinkages”, that is, the interaction of sectoral impacts such as the connection between agriculture (where irrigation needs may go up) and water (where supply may decrease). See Smith et al. (2001) and Tol et al. (2000) for a discussion.

Less well documented is the fact that the enumerative approach also neglects dynamic interlinkages. Enumerative studies are concerned with only one time period and ask how the climate observed in that period affects social welfare at that particular point in time. In doing so, they ignore intertemporal effects and fail to provide information on how climate change may affect welfare in the longer term. This paper seeks to close this gap by exploring, both theoretically and numerically, the dynamic effects that link climate change and economic growth.

The main dynamic effect is via capital accumulation. If we assume a constant savings rate, the amount of investment in an economy will be reduced if climate change has a negative impact on output (and vice versa if impacts are positive). Over the longer term this will lead to a reduction in the capital stock, a lower GDP and, in most cases, lower consumption per capita. In an endogenous growth context, this capital accumulation effect may be exacerbated if lower investment also slows down technical progress and improvements in labour productivity or human capital accumulation.

A second dynamic effect has to do with savings. In a world with perfect foresight we can expect forward-looking agents to change their savings behavior in anticipation of future climate change. This, too, will affect the accumulation of capital and hence growth and future GDP. It is unclear, a priori, whether this savings effect will be positive or negative. On the one hand, savings rates may go up because agents wish to compensate for the shortfall in future income. On the other hand, climate change reduces the productivity of capital and, faced with a lower rate of return, agents may prefer to invest less and consume more today.

Integrated assessment models with an economic foundation (e.g., Nordhaus, 1994, Peck and Teisberg, 1992, Tol, 1999) usually incorporate the capital accumulation effect and sometimes the savings effect because their design is based on neo-classical growth theory. But they do not normally separate the dynamic effects explicitly. In this paper we try to do so. Section 2 discusses the theoretical links between climate change and growth by looking at the steady state of a stylized growth model. In Section 3 we simulate the magnitude and direction of the dynamic effects using DICE, a relatively simple and widely used climate-economy model (see Nordhaus, 1994). We also investigate the sensitivity to alternative specifications of the mechanisms of growth. Section 4 estimates the effect of climate change on the rate of growth, and Section 5 concludes.

Section snippets

Model description

To study the basic interlinkages between climate change and economic growth, we use a standard Ramsey–Cass–Koopmans growth model, in which a social planner maximizes the utility of identical consumers in the following intertemporal optimization problem:max∫0∞u(c,T)e(n−ρ)tdt,subject to:K̇=F(K,L,T)−cL−δ(T)K,L̇=n(T)L,L0=1,where u denotes the utility function, c is the per capita consumption; F the output; K the capital, depreciating at rate δ; and ρ the discount rate.

L is labour supply, which

The magnitude of dynamic effects

To gain further insights on the relative importance of the dynamic effects we now turn to a numerical model of climate change. We choose the well-known DICE model developed by Nordhaus (1994) as the basis of our simulations. It should be noted that DICE does not distinguish the four channels through which climate change affects growth we identified in Section 2. Instead, it assumes that all impacts are channeled through the production function. This is acceptable as the concern in this section

The rate of growth

We next turn to the question of how significant climate change may be for long-term growth prospects, using the same model and model specifications as in the previous section. Fig. 3 compares the impact of climate change on growth rates for the four model specifications. The effect is smallest in the Solow–Swan model, although its results are again very close to those of Ramsey–Cass–Koopmans and Romer. The Mankiw–Romer–Weil model shows the greatest impact of climate change on growth. As before,

Discussion and conclusions

This paper draws attention to the fact that the direct impact of climate change on the economy is not the only way in which global warming affects future welfare. The prospect of future damages (or benefits) also affects capital accumulation and people’s propensity to save, and hence the rate of economic growth. In an endogenous growth model, this also means a different rate of technical progress, which enhances the savings and capital accumulation effect.

The theoretical analysis suggests that

Acknowledgements

Thanks to our friend and colleague Joel Smith for asking the question that led us to writing this paper. Kerstin Ronneberger, Charles Kolstad and an anonymous referee provided valuable comments on an earlier draft. The Volkswagen Foundation through the ECOBICE project, the US National Science Foundation through the Center for Integrated Study of the Human Dimensions of Global Change (SBR-9521914) and the Michael Otto Foundation provided welcome financial support. The views expressed in this

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