A HIGH PRICE FOR IGNORING THE RISKS OF CATASTROPHE / THE FINANCIAL TIMES COMMENT & ANALYSIS

February 18, 2014 7:25 pm

A high price for ignoring the risks of catastrophe

By Robin Harding in Washington

Models of climate change all but assume it cannot have a huge effect on the economy, writes Robin Harding

©Ingram Pinn

After a catastrophic financial crisis plunged the world into recession five years ago, financial economists were pilloried for using complex models with flawed assumptions to value subprime mortgages. It took only a few years to expose the error, with drastic consequences. But similar flaws lurk in economic models of a far greater threat – climate change – that also underestimate our peril.

Floods in England and drought in California have brought another round of sterile arguments about whether climate change is to blame. Just as models of collateralised debt obligations all but assumed the impossibility of default, however, models of climate change all but assume it cannot have a catastrophic effect on the economy, no matter how bad global warming becomes. Far from exaggerating the threat, economists tend to understate it.

The financial crisis – and growing scientific evidence that there are small but real risks of extreme climate change – suggest a way forward. Rather than try to price the unknowable with precision, we should consider the uncertain odds but terrifyingly high costs of a catastrophe, then ask what we will pay for insurance against it. That might even be an easier way to sell stalled action on carbon emissions.

The judgment from academics on their existing models is damning. So-called integrated assessment models of climate change come “close to assuming directly that the impacts and costs will be modest, and close to excluding the possibility of catastrophic outcomes”, writes Nicholas Stern. According to Robert Pindyck of the Massachusetts Institute of Technology: “The bottom line here is that the damage functions in most IAMs are completely made up, with no theoretical or empirical foundation.”

These models matter. They lie behind the estimates that carbon has a social cost of $36 a tonne the Obama administration is using to regulate coal. Admittedly, that is better than nothing, and the world’s determination to ignore climate change means a higher estimate would not have much immediate impact. Lobbyists have already lined up to claim $36 is too much.

But the lessons of the financial crisis are clear: economists should strive to tell it like it is, then let fools, knaves and politicians try to justify inaction as best they may. History will judge harshly anyone who underplays the price of global warming.

The imperfection of the economic models is inevitable. To start with, they are only as good as the climate models that feed into them. There is a valid debate about how much we should sacrifice now to improve the lives of generations who are yet to be born. But their cheerily optimistic assumption that a warming climate will have modest effects on economic output is less justifiable.

This assumption arises in several ways. In most of the models climate change simply cannot slow down economic growth materially. Output keeps rising, but then a measure of damage is subtracted, depending on how hot the climate becomes. The trouble is that compound growth in output is so powerful it outweighs the damage almost automatically.

For example, if the world economy grows by 2 per cent a year for the next century, its size will increase more than sevenfold. Even if the damage estimate knocks off half that the economy would still be three-and-a-half times bigger. A different approach to the problem, which some economists are now exploring, would have climate change affect the growth rate.

The estimates of damage tend to be modest because the models are set up for the first few degrees of warming, based on empirical studies of small fluctuations. It is just like those analyses of the economy’s resilience to a small drop in house prices. Extrapolate to an extreme case of climate change – which the current path of emissions makes plausible – and the results can be ludicrous.

For example, one standard model only gives damage greater than 50 per cent of output with 20C of warming. Combine that with the assumption that the economy will be many times bigger in the future and the problem is clear. Your grandchildren might be cooking in their own fat on the London Underground, but rather than regarding them as dead, these economic models would regard them as wealthier than you.

It does not stop there. The reason most models have these estimates is because they barely even allow for extreme cases of warming. They take climate change as given and then turn it into an economic impact and a price for carbon today. If the estimate is 2C of warming, for example, they price carbon on that basis. It is like an analysis from the subprime era that ignores the possibility of all mortgages defaulting at the same time.

A better approach may be to focus on the risk of catastrophe and then update the models as more information emerges. Prof Pindyck draws an analogy to the cold war, when analysts considered the consequences of thermonuclear war – results they used when negotiating arms control treaties.

After the financial crisis, the world did not construct vastly complicated models to estimate the chances of another meltdown and the damage it would cause. Policy makers simply recognised that regulations such as the US Dodd-Frank Act are a small price to pay for preventing a repeat performance. It is time to take a similarly risk-based approach to the greater problem of climate change.

Copyright The Financial Times Limited 2014.