A review of “A time for action on climate change and a time for change in economics” by Nicholas Stern

Last year, Nicholas Stern published an illuminating working paper about the economics of the climate crisis titled “A time for action on climate change and a time for change in economics”. It is a required reading not only for economists but also for policy makers, climate scientists, investors, and business leaders. Based on an analysis of alarming shortcomings within the current mainstream of climate economic, Stern makes a compelling case for an updated economic practice. This update would make the absolute necessity for near-term transition investments at a massive scale, supported by strong climate policies, unmistakably clear. In my view, the shortcomings of climate economics to date have been a significant underlying factor for the disappointing outcome of COP26 (alongside the perils of short-termism and nationalism). To begin with, I assume that the following points are — in a qualitative sense — already fairly well established, at least among most climate activists:

1. The grave urgency for a radical, timely and just transformation of our civilization’s carbon-based economy in order to prevent immense losses, damages and risks associated with the current business-as-usual GHG emissions pathway, calling for intense international collaboration (i.e. a ”new internationalism”).
2. The possibility of climate-positive economic value and job creation, enabled by low-carbon technologies becoming increasingly competitive at an unexpected pace — especially in connection with an opportunity to “build back better” pursuant to the COVID crisis that cannot be wasted.

With that said, what are the key takeaways?

• First, we need to embrace an outcome-oriented approach, starting with humanity’s primary objective of reducing global GHG emissions within the emission pathways required for stabilizing global temperatures between 1.5 C and 2.0 C as guardrails against extreme risk, and work our way backwards from there. Stern reminds us that we are dealing with multiple simultaneous market market failures that require “fundamental systemic change […] where optimisation is difficult to define, let alone achieve”. Since market and technology forces are too slow by themselves, a whole range of complementary policies is needed to deliver change at the required velocity. We need to ask ourselves: What does it take in terms of additional public investments and policies for human civilization to reach — and stay within — the “safe operating space” defined by these guardrails, while taking into account proper thresholds and allocations for a socially just and environmentally sound transition?

Stylised emissions pathways for 1.5°C and 2°C and the gap to emissions trajectories based on current NDCs.

• Second, Stern observes that until now, traditional climate economics has failed to provide adequate answers to two key questions in response to the climate crisis:

1. “ …how to approach analytically the challenge of managing immense risk, which could involve loss of life on a massive scale”?
2. “…how to chart and guide a response to this challenge which will involve fundamental structural change across a whole complex economy”?

On Integrated Assessment Models (IAMs)

• A main reason for the malfunction of economics to provide sound policy advice lies in the failure of Integrated Assessment Models (IAMs) — which are commonly used to inform the economic assessments summarized by the IPCC — to properly account for the damages and losses of climate inaction relative to the costs (and gains) of climate action. Nicholas Stern laments that “…much of this literature, which has dominated so much work on the economics of climate change, has been misleading and biased against strong action, because climate damage specifications are implausibly low and costs of action implausibly high, and subject to diminishing returns.” Personally, I’m convinced that the continued reliance on flawed cost-benefit-analyses to inform climate politics may well be remembered as the greatest failure in the history of economics one day.
• Regarding the losses and damages of climate inaction Stern points out that “…It is profoundly implausible that numbers around 10% of GDP offer a sensible description of the kind of disruption and catastrophe that 6°C of warming could cause. We cannot be sure of the probabilities of different scales of catastrophe, but it would seem deeply unwise, indeed reckless, to assume that catastrophe of immense proportions would not be associated with temperature increases of this magnitude…”. This fatal modeling error, which can be traced back to the use of an excessively conservative quadratic damage function, has been thoroughly criticized by the economist Steve Keen. Another report by a group of leading climate scientists (to which Stern contributed) titled “The missing economic risks in assessments of climate change impacts” further criticizes the narrow and incomplete scope of many climate risk assessments to date. Perhaps one of the most important blind spots has been the increasing risk of devastating nuclear conflicts driven by rising global temperatures.
• Regarding the cost (and gains) of climate action Stern states that “…By embodying diminishing returns and modest technical progress, the IAMs systematically overstate the costs of climate action. Further, they distort the theory of policy which is much more complex when we have increasing returns to scale; particularly in the context of risk…”. Indeed, over the past years, continuously declining cost-curves have allowed many climate solutions to become increasingly competitive, while often delivering a range of co-benefits. This aspect serves as a foundation for Saul Griffith’s compelling decarbonization roadmap, and it has also been embraced by the IEA in its “World Energy Outlook 2021”.
• At the heart of the problem with most IAMs are fundamental methodological flaws. Standard utility functions and quadratic damage functions cannot adequately capture the nature and scale of extreme risks and catastrophic outcomes, involving severe, even deadly, harm to billions of human lifes (not to mention the collapse of entire ecosystems and the possibility of a long-lasting decline of the global economy). Stern refers to Martin Weitzmann’s “Dismal Theorem” which argues that “standard approaches quickly run into problems of utility functions going to minus infinity” as consumption approaches zero. The publication of Weitzmann’s paper was followed by an insightful dispute with William Nordhaus, who published a critique of the Dismal Theorem, to which Weitzmann offered a compelling response. The dispute boils down to the shape of the probability distribution of climate damages and losses: Whereas Nordhaus postulates a thin-tailed distribution, Weitzmann argues in favor of a fat-tailed distribution. This is important because the actual shape of the probability distribution determines how much human societies should be willing to pay to prevent a catastrophic outcome for public welfare.

On social discount rates

• Another reason for the shortcoming of traditional climate economics can be found in the way social discount rates are being understood and applied. In the context of the climate crisis, the social discount rate represents the value assigned to the welfare of young and future generations in relation the value assigned to the welfare of present generations. The challenge of balancing the preferences of different stakeholders across large time scales is an ethical one and very different in nature from conventional net present value analysis, which usually examine the relation between future and present value for the same agent. It is difficult to justify why the damages and losses affecting one group of humans in the future should be worth less than damages and losses affecting present humans. But positive social discount rates are doing just this: they trivialize future damages and losses of even the greatest magnitudes at an exponential rate as they rather quickly converge to zero. Hence, there is a clear ethical argument for applying a social discount rate of zero in the context of the climate crisis. The idea that human suffering in the future could somehow be offset or even overcompensated by present economic growth is simply incompatible with the idea of intergenerational fairness. In Stern’s words: “Pure-time discounting is essentially discrimination by date of birth.”
• Moreover, conventional net present value analyses operate under the assumption of constant economic growth based on a stable earth-system. In contrast, the climate crisis has largely been driven by economic activities of present/past generations that have yielded short-lived consumer benefits while collectively causing long-lasting cumulative damages at a planetary scale for generations to come, including a possibly irreversable transition of the earth system to drastically lower levels of ecological carrying capacity. Indeed, as Stern argues, “if we act recklessly on climate change, future generations could be much poorer than ours”. He doesn’t elaborate much further on this point but it occurs to me that another way to look at positive social discount rates is that (in the context of the climate crisis) they represent an unrealistic counterfactual of perpetual economic growth. This assumption is the primary justification why financial value today is considered to be worth more than financial value in the future. Moreover, since climate damages are typically expressed as a share of an exponetially growing economic output (a metric that does not work well as a measure for improved quality of life anyway), it is difficult to account for the possibility of a global economy that is eventually forced into decline by the unfolding of systemic risks of water scarcity, food shortages, migration pressures, state failures and geopolitical conflicts. If the business-as-usual scenario could turn into a declining global economy at some point in the future, wouldn’t it be more accurate to express the social discount rate as a dynamic function with the possibility to turn negative?

A better approach

Nicholas Stern provides a number of suggestions for an improved and more realistic climate economics practice:

1. First, “economic analyses of climate change must first capture extreme risk, including possible large-scale and unforeseeable consequences”. Damage functions must be designed to be better aligned with the physical and geopolitical reality described by the climate science. A notable example is provided by a recent article titled “Climate economics support for the UN climate target” in which the authors updated the parameters of William Nordhaus’ original Dynamic Integrated Climate–Economy (DICE) IAM by some of the latest contributions in social and climate science. The updated IAM confirms that stabilizing mean global temperatures at “well below 2C” is actually optimal from a cost-benefit point of view, in contrast to Nordhaus’ original recommendation for a climate policy path with a trajectory towards 3.5 °C by the end of the century. Building on this, IAMs need to be further improved to account for the existence of tipping points and secondary effects of climate disruptions (e.g. mass migrations, food system failures, armed conflicts, …), as well as the possibility of societal destabilization and economic decline.
2. “ Second, [economic analyses] should recognize that many key markets have critically important failures (beyond that of the GHG externality), that crucial markets may be absent, and that there are limits on the ability of government to “correct” these market failures or absences.” Here, Stern refers to the fact that not only markets but also regulators have failed humanity. Thus far, climate policies have been severely underutilized due to the mistaken belief that fossil fueled near-term growth was more valuable than the long-term preservation of the earth system’s stability, and that stronger climate action could be postponed decades ahead into the future. The challenge is that governments “may have short time horizons, they may have different, narrower, objectives, and they face major administrative and political constraints”. Therefore, Stern suggests that “In thinking about public policy, we have to put all these considerations together and take into account how policies are constrained, might shift and can go wrong. And we can ask how to build strong institutions, which can survive across different parties in power and pressures of vested interests.”
3. “Third, [economic analyses] should embody rapid technical and systemic change, often in very large and complex systems such as cities, energy, transport, and land use, and allow for increasing returns to scale.” The business case for human societies to massively invest into rapid decarbonization - supported by strong climate policies - becomes even more obvious when considering substantial co-benefits and quality of life improvements in addition to avoided climate damages and risks.
4. “Fourth, they should examine rapid changes in (endogenously determined) beliefs and preferences“. Indeed, we are already witnessing a significant shift in political values, investor sentiment, and consumer behaviors, giving reason for some hope in the existence of “social tipping points dynamics”, for example. Stern points out that “There has been a huge amount of progress in the literature in economics on behaviour, institutions, and political economy over the last 20–30 years. […] Important areas for continued research include: behaviour change in the face of adjustment costs and missing information; and incentives and nudges”
5. “Fifth, [economic analyses should] take into account distributive impacts and risks, both at a moment in time and over time, and including those associated with structural change.” Emphasizing the need for a just transition, Stern points out a reality that many politicians may not like to acknowledge: Social inequality has increased in recent years and we now are now obgliated to suficiently address social justice issues in the interest of our common destiny. “Some jobs will disappear; others will change radically. Some locations may be partially affected. There will be many new opportunities. Managing change so that all have a chance of benefiting will be not only an issue of justice, but also of political feasibility. Much of this will involve investment in people and places. And in some cases, direct income support.”

In conclusion, I hope that in particular economists and policy makers take heed of Nicholas Stern’s urgent call to rethink and elevate climate economics from its current state. More realistic economic analyses should convince at least some fiscal and/or patriotic conservatives that bold climate policies and a “new internationalism” do not simply represent a burden for present generations. They are as much a necessity as they are an opportunity to preserve decent living standards for all. The increased fiscal spending needed to accelerate private capital allocations, climate-positive development cooperation and just transition efforts does not represent a “burden” for young generations but the logical conclusion of a categorical imperative to safeguard their future well-being, within the context of an extraordinary emergency: Not only have we unwittingly set the house they are supposed to inherit on fire, we have been recklessly adding fuel to the flames and still continue to do so.