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IMFSurvey Magazine: Policy

WORLD ECONOMIC OUTLOOK

The Economics of Climate Change

By Ben Jones, Michael Keen, John Norregaard, and Jon Strand
IMF Fiscal Affairs Department

October 26, 2007

  • Long-term temperature change likely to have negative impact on output
  • Fiscal pressures as well as revenue opportunities from carbon pricing
  • Global coordination problem complicated by uncertainty and asymmetric impacts and responsibilities

Climate change resulting from man-made increases in atmospheric greenhouse gas concentrations presents a serious challenge to human welfare.

Understanding of both the issue and policy responses has developed rapidly in recent years, but much remains to be learned, including the nature, extent, likelihood and timing of the macroeconomic and fiscal effects of climate change and responses to it.

The IMF's October 2007 World Economic Outlook (WEO) briefly outlines what is known about the science of climate change, to set the scene for a review of its economic impact. It also discusses adaptation policies, to reduce the damage from climate change, and mitigation policies, to limit the emissions that cause it. The April 2008 WEO will explore these issues in greater depth.

The challenge

The global average temperature increased by about 0.7°C between 1906 and 2005, and existing greenhouse gases are expected to cause further increases in the coming decades. The Nobel Peace Prize-winning Intergovernmental Panel on Climate Change projects that—without any policy response—emissions will lead to average global temperature increases of between 1.1°C and 6.4°C by 2100. The greatest increases in temperature are projected for the northern parts of North America, Europe, and Asia, with smaller—but still sizable—increases in tropical areas.

Several, more specific, climate effects are expected. The global pattern of rainfall is likely to change, with many already dry areas expected to become even drier. There are further possible effects on rainfall in many tropical zones as well as on seasonal patterns, potentially affecting the livelihoods of large human populations, and critical natural resources. Flood risk is projected to increase due to more intense rainfall and sea-level rise. The frequency and/or severity of extreme weather events, including hurricanes, floods, heat waves, and droughts, are expected to increase, most seriously in Africa, Asia, and the Caribbean.

Beyond these effects, there may exist "tipping points," which, if passed, would result in more dramatic and irreversible climate effects. These include the potential for rapid glacial melting, reversal of the Gulf Stream, and large-scale tundra thawing in Canada, China, and Russia.

Macroeconomic and fiscal impacts

The macroeconomic and fiscal impacts of climate change is potentially substantial, and could include the following effects:

• Direct negative impact on output and productivity from long-term temperature change and more intense and/or frequent extreme weather events, particularly for agriculture, fisheries, and tourism.

• Costs from sea-level rise and increased severity of flooding.

• Increased risk of widespread migration and conflict, resulting from long-term climate deterioration and greater damage from extreme weather events.

• Deteriorating fiscal positions arising from weakening of traditional tax bases and/or increased expenditure on mitigation and adaptation.

• Costs arising from efforts to mitigate carbon emissions, including higher energy prices and increased investment, are becoming important in many countries.

• Balance of payments problems in some countries owing to reduced exports of goods and services or increased need for food and other essential imports. Damage to ports and roads may disrupt trade flows.

• Adverse "nonmarket" effects associated with the loss of biodiversity and ecological systems, and the effects of climate change on human health and the quality of life.

• More positively, there is potential revenue to be gained from mitigation schemes—a double dividend, with benefits to the public finances as well as to the environment, from reduced reliance on more distortionary taxes. Depending on implementation scheme, some low-income regions may in the future also benefit financially from international trading of GHG emissions rights.

Determining an effective response to climate change requires calibrating the nature, extent, and distribution of these effects. Climate scientists have naturally focused on the uncertainties associated with the climate change process as such.

Determining effective response to climate change requires calibrating nature, extent, distribution of effects (photo: CMSP)

But there are also substantial uncertainties in assessing the associated economic and wider welfare effects. Aggregating effects over time also requires a choice of the discount rate, on which there is wide disagreement in recent debate. Consequently, estimates of the economic impact of climate change vary considerably.

Several studies address these challenges, using models that emphasize different effects and linkages. The recent Stern Review, for example, projects potential losses rising substantially over time, with the range of the central estimates from 1 to 2 percent of GDP in 2050, 2 to 8 percent by 2100, and 5 to 14 percent by 2200 (rising to 20 percent in 2020 if account is taken of the disproportionately high burden of climate change borne by poorer parts of the world)

Policy responses

While views differ on the appropriate extent and urgency, there is broad consensus on the need for some action to reduce the high economic risks posed by expected levels of warming under "business as usual" projections. This can take the following two main forms, with action on both fronts now widely seen as needed:

• adapting behavior and investment to reduce the economic and social impact of climate change, for example, by constructing flood defenses in response to rising sea levels; and

• mitigating the extent of climate change by reducing greenhouse gas emissions through improved energy efficiency; carbon capture and storage; increased reliance on nuclear and renewable energy sources; and reduced deforestation.

While certain policies to address the climate change problem are in place, their scale and coverage need to be increased. The question of quite how much policy intervention would be desirable, however, has generated a lively debate, reflecting the differing assessments of relative costs and benefits of action and inaction, and uncertainty associated with these.

A fundamental obstacle to gaining broad support for mitigation policies, for example, is a lack of consensus on the appropriate discount rate in evaluating alternative outcomes—a low discount rate places a high weight on the benefits of current action, which largely come far in the future, relative to the more immediate costs, thus warranting a high immediate effort.

Problems of coordination, implementation

A core challenge is to reach agreement among major emitting countries on objectives and/ or polices to limit future greenhouse gas emissions (in addition, for example, to those designed to reduce the costs of climate change through adaptation). Significant problems of international coordination here arise given that the consequences of GHG emissions, by any one country affect everyone globally. These are exacerbated by the fact that climate change is caused by increases in the stock of greenhouse gases in the atmosphere, for which industrialized countries bear primary historic responsibly, while a much larger share of future emissions are expected to come from emerging markets and developing countries. In addition, the impacts (and therefore the benefits of mitigation) are unevenly distributed, with low-income countries likely to be most seriously affected.

Initial steps toward international cooperation—most notably the Kyoto Protocol—have had only limited success. The United States was assigned an emissions reduction under the Protocol, but has not ratified the Protocol and is therefore not committed to it. And, several ratifying countries are currently some way from achieving their commitments.

Early agreement

Early agreement on new climate policy commitments, beyond 2012 when the Kyoto Protocol expires, is critical, not least given the long lead time for many energy investments and the consequent need for reducing uncertainty about likely future carbon prices. It will also be a major challenge to broaden any new policy framework, to include policy commitments also for major emitters in emerging market and developing countries.

A number of more local efforts are undertaken to limit GHG emissions, notably within Australia and the United States which are not bound by the Kyoto Protocol. These include support to the development and diffusion of new technologies, or schemes to promote energy efficiency. Some countries have made efforts to reform their energy pricing and reduce deforestation, thereby also increasing energy security and reducing local air pollution, in each case deriving important cobenefits in constraining the growth of greenhouse gas emissions.

These efforts need to be extended significantly in breadth, depth, and efficiency, while paying due regard to their burden-sharing implications. Speaking at an October 19 World Bank—IMF Annual Meetings panel discussion, Yvo de Boer, Executive Secretary of the United Nations Framework Convention on Climate Change, said that the next step is a political response, beginning with the conference in Bali in December, to establish formal negotiations for a new climate change accord.

The main task of the Bali conference is to "get the process going," but if it fails to do that, "public interest will slip away, which means trouble because most scientists think there is a 10-15-year window to deal with the emissions issue."


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