I mentioned this piece in comments a while ago and some interest was expressed. It should come out in the Australian Financial Review fairly soon, but there’s still time for me to benefit from comments and constructive criticism.
With the major scientific issues in the debate over global warming having been resolved, attention has turned to the economics of climate change, and of stabilising the global climate. The release of the Stern Review in the United Kingdom had a powerful effect on public debate in Australia, an effect that has been amplified by the recent Interim report of the Garnaut review.
Part of the impact was due to the dire assessments of the impacts of uncontrolled growth in emissions of greenhouse gases put forward by Stern and even more vigorously by Garnaut. Coming from mainstream economists with a longstanding reputation for cautious policy judgement, these assessments had a greater impact, for many, than similar assessments offered by environmentalists or climate scientists.
But Stern’s pessimism on the consequences of doing nothing was matched by striking optimism regarding the cost and feasibility of stabilising global climate. Stern concluded that the global climate could be stabilised with CO2-equivalent concentrations of 550 ppm.
Garnaut drew on more recent evidence suggesting both that the safe level of emissions was 450 ppm than Stern’s 550 ppm and that rapid growth in China and India had already made the achievement of such a target difficult, if not impossible, in the absence of immediate action. Still Garnaut endorsed Stern’s main point – the cost of stabilisation is far less than the cost of doing nothing.
The Stern review was highly controversial. Naturally, we heard from the noisy, but rapidly shrinking, group who still deny the reality of the problem. But the main dissent from economists focused on Stern’s estimates of the cost of doing nothing, and particularly on his treatment of the way in which future benefits and costs should be discounted.
This debate is exceptionally complex and unlikely to be resolved soon. Fortunately, at least for anyone willing to accept the view that massive changes in the climate are a bad idea regardless of the economic number attached to them, the problems of discounting can safely be left to the professionals to sort out.
There was much less criticism of Stern’s estimates of the cost of stabilising climate. Even the sharpest critics among economists only suggested that Stern’s estimates were at the optimistic end of a plausible range, the upper end of which might be 5 per cent of national income, or around two years of economic growth. That is, by 2050, a low-carbon economy might have the material living standards that would otherwise have been reached by 2048.
This is, on the face of it, a striking conclusion. We use energy in nearly everything we do, and it is, therefore, widely assumed that a modern economy is dependent on cheap energy. Yet mainstream economists, even those most critical of Kyoto, are unanimous in the view that we could greatly reduce emissions of carbon dioxide while continuing to improve living standards at much the same rate as in the past.
Stern’s optimistic view that CO2 emissions could be greatly reduced without a corresponding reduction in living standards is rejected by critics beginning from two diametrically opposed positions. Although deeply hostile to each other, the two groups find some surprising common ground.
The first group are ‘Deep Green’ pessimists who see the end of consumer capitalism as both inevitable and desirable. At least since the reports of the Club of Rome in the 1970s, members of this group have argued that continued economic growth is inherently unsustainable.
The Club of Rome initially focused on claims that stocks of various mineral and energy resources would be exhausted within a few decades, but claims of this kind have been refuted by experience. Most mineral resources have actually become cheaper. Even in cases where prices have risen, the economic impact has been marginal, relative to the long-run trend of increasing income.
As a result, most Deep Greens now focus on limits to the capacity of the natural environment to support continued growth and assimilate waste products like CO2. Their central claim is that economic growth depends critically on the use of the natural environment as a dump for our waste products.
The Deep Green position is qualitatively different from that of participants in the climate change debate, including James Hansen and Stephen Schneider, who argue that we are already close to, or perhaps past, a point where our activities will critically damage the environment. From the point of view of these commentators, damage to the environment is the result of mistaken (but hopefully reversible) policy choices, rather than an inherent consequence of modern civilisation.
The mirror image of Deep Green pessimism is that of the ‘Dark Brown’ pessimists who say that we should do nothing to stabilise the climate because to do so will wreck our standards of living. Dark Brown commentators from thinktanks like the Competitive Enterprise Institute warn of ruinous economic consequences even from modest first steps such as the implementation of the Kyoto Protocol.
As with the Deep Greens, the Dark Brown school must be distinguished from participants in the climate change debate, such as William Nordhaus, who recognise the necessity for large scale mitigation, but argue for a slower pace of initial action than is implied by the Kyoto process. Whatever the merits of this argument, it is driven by beliefs about relative costs and benefits, rather than an assumed fundamental conflict between the environment and the economy.
The track record of Dark Brown pessimists is no better than that of the Club of Rome. Time after time, Dark Browns have opposed environmental improvements as too costly, repeatedly overestimating the costs and underestimating the benefits. The debate over CFCs and the ozone layer provides a good example, since it was one of the first issues to be addressed on a global scale. The doomsayers repeatedly attacked both the science behind the ban on CFCs and the economics of the policy, claiming it would cause massive economic damage. In reality, even without taking account of health benefits, it seems likely that the CFC ban yielded positive net economic benefits.
Although many Dark Browns got their start in the CFC debate, there have been some new entrants to the camp. For example, Bjorn Lomborg has taken up the mantle of the late Julian Simon, and has repackaged Simon’s arguments with some success. More importantly in political terms, the Dark Browns are now part of the Republican party establishment in a way that wasn’t true when Richard Nixon signed the Clean Air Act. But the central arguments haven’t changed.
Both groups engage in a fair bit of wishful thinking about their position, the Greens arguing that we’ll all be happier in the long run and the Browns claiming that the environmental problems will solve themselves if we ignore them. But these opposing claims are secondary to the shared presumption that economic growth depends on increasing exploitation of the natural environment and, in particular, on the burning of fossil fuels.
Underlying both Deep Green and Dark Brown positions is a fundamental misunderstanding of the nature of economic progress and of economic activity in a modern society. The concept of economic growth is so firmly embedded in our thinking that we forget it is just a metaphor. The idea of growth implies physical expansion, and any process of physical expansion has limits.
Economists have contributed to these misunderstandings. The traditional model of economic growth is based on the accumulation of capital equipment, capable of converting an ever-larger volume of natural resources into physical products for human consumption.
Such a model leads naturally to the conclusion that economic growth cannot continue indefinitely. The classical economists of the 19th century, beginning with Malthus, were the first to reach this conclusion, which they phrased in terms of the idea of diminishing returns.
The central idea is most easily seen in terms of agriculture. The output of a given piece of land can be improved by the application of fertiliser, the use of more agricultural machinery and more labour. Initially the returns to such increases in intensity may be high. But the total amount that can be grown on a given plot of land is bounded, and eventually the benefit of additional inputs must decline or become negative.
The same logic applies in industrial capitalism. Productivity can be increased by investing in more capital equipment but if the labour force is held fixed, the marginal return to additional investment must eventually decline. It was this that led the classical economists (notably including Marx) to talk about the inevitability of a declining rate of profit.
Long experience of sustained growth suggested that the classical economists were missing something. For a long time, growth models made to fit by adding an unexplained and exogenous source of growth called technological change, but this was always unsatisfactory. Technological change is itself the product of economic activity, and therefore subject to the same logic of diminishing returns. Something was missing.
It has gradually been recognised that the missing ingredient was information, embodied in technological improvements and in the minds of skilled and educated workers. Unlike physical inputs to production, information is not subject to diminishing returns. Once some piece of information, such as an improved way of producing a good or service is discovered, it can be used and reused indefinitely. Use by one person does not diminish its availability to others. This insight led to the development of ‘endogenous growth theory’ as opposed to older theories based on exogenous technological change.
The public-good nature of information explains how economic progress can continue without additional resources. Most obviously, improvements in information technology allow more and faster communication which in turn allows for yet more technological improvements. There is no apparent indication of diminishing marginal returns in this field; if anything the opposite.
Once we think in terms of information, it is natural to think of economic progress, not as more of everything, but as a set of qualitative improvements. This can be seen most obviously by looking at the areas of the economy that are growing most rapidly, such as health services. Health care is all about information, from the skill and expertise of doctors and nurses to the information embodied in medicines and medical equipment. By contrast, the physical resources required are modest. Even a hugely expensive piece of medical equipment, such as a CT scanner, embodies less raw materials, and consumes less energy, than a passenger car.
As new treatments become available, and as the knowledge available to medical workers expands, the capacity of the health sector to improve both the length of life and the quality of life increases. The length of human life may be bounded, but there is no reason to suppose that limits to growth in the quantity and quality of health services are going to be reached any time soon.
What is true of health care is even more true of education, the information service par excellence. The only limit to our capacity for education is the capacity of the human mind. And while some have always argued that this limit is tight enough to mean that more extensive education should be confined to an elite few, supposedly tight limits have regularly been broken. High school completion, once a rarity except for the upper-middle class is now the norm, and the numbers going on to universities have increased massively. Yet the demand for educated workers, and for more skilled workers of all kinds, continues to outpace the supply.
That is, there is nothing in the nature of economic progress in a modern society that inherently requires increased volumes of physical output. Most growth will occur in activities where information is the crucial factor. But, it might still be argued, energy is essential to all of these activities, so a reduction in energy use must bring growth to a halt. The first part of this claim is true, but the second is false.
The most common problem with ‘energy fundamentalism’ is the failure to understand prices. As Hayek observed long ago prices are the critical information generated by a market economy. Even where explicit prices are not present, for example within firms and government agencies, increasing scarcity of any resource is reflected in higher implicit prices.
Before considering the future, we can use prices to assess the importance of energy in existing activity and the extent to which our current prosperity depends on readily available supplies of cheap energy. At current prices, primary energy accounts for less than 5 per cent of total expenditure. An immediate implication is that a doubling of the cost of primary energy, arising from a switch to more expensive sources of energy could cost no more than an additional 5 per cent.
But this is a substantial overestimate. An increase in the cost of carbon emissions would provide signals to users, from energy suppliers to industry to final consumers, of the need to become more efficient in using energy. Decades of cheap energy have produced a system characterized by inefficiencies at every stage of the process from production to final consumption.
Where the scope for efficiency improvement is limited, prices will signal the fact that some kinds of consumption are more costly than others. Consumers will respond, as they always have done, by changing consumption patterns to favor items that are relatively cheaper. Of course, this will entail social change, but relative prices change all the time, in many cases by much more than the likely change in energy prices. The plummeting cost of computers and the rapidly rising cost of healthcare provide two of the most important examples.
Taking account of efficiency improvements and substitution effects, it seems likely that a doubling of energy prices over a long period would reduce average income by no more than 2 to 3 per cent. Optimists like Stern can easily justify a lower number on the basis of plausible estimates of potential efficiency improvements and the like. Pessimists can argue for higher numbers. But even the most pessimistic cost estimates of economists are an order of magnitude away from those offered or implied by the Deep Green and Dark Brown doomsayers.
Would a doubling of energy prices be sufficient to permit a switch to a low-emission or zero-emission technology over several decades? As far as electrical energy is concerned, almost certainly it would be. Some renewable sources of electricity, such as wind, are already competitive in many locations at existing prices or with a modest subsidy. With a substantial further increase in prices, output from these sources would increase. Other energy sources including geothermal energy and (assuming safety concerns can be resolved) nuclear energy would become competitive, as would long-distance transmission lines which would permit more effective use of existing sources of renewable energy.
A doubling of prices would also provide incentives for innovation in a range of technologies including solar photovoltaics, solar thermal and carbon capture and sequestration. It’s unlikely that all of these technologies will turn out to be economically feasible, but it’s equally unlikely that none of them will.
As far as transport is concerned, the rise in oil prices over the past five years has already converted the purchase of fuel-efficient hybrid cars from a piece of conspicuous environmentalism to an economically sensible choice. It will take a long time for carmakers to retool their systems, and some laggards will surely fail along the way, but a shift towards hybrids is inevitable in the long run. With a further substantial increase in the cost of carbon emissions will come a move towards plug-in hybrids and then to electric or fuel-cell vehicles powered by renewable sources.
Of course, it would be mistake to leave prices to do all the work. The case of lighting provides an obvious example. Lighting accounts for around 17.5 per cent of global electricity use. According to the International Energy Agency, using compact-fluorescent in place of incandescent lamps, deploying high- in place of low-efficiency ballasts and phasing-out mercury vapour HID lamps would reduce global lighting demand by up to 40%. More gains could be made by improving installations and using automatic controls.
All these steps make economic sense even at current prices, but for a variety of reasons the switch has been slow to take place. In these circumstances, it makes sense for governments to give the market a push, by developing standards and, if necessary, announcing a phase-out date for incandescents, as has been done in Australia. What is needed is a clear commitment reflected both in the price we pay for energy and in a broad range of public policy settings.
But only an international agreement embracing all major countries will suffice, and the search for such an agreement is stalled until next January, when George W. Bush finally leaves office. His successor will face the task of turning around US policy and then achieving an international agreement that includes developing countries like China and India.
Despite the claims of Dark Browns and Deep Greens, we can, if we choose, have both a stable climate and steadily improving standards of living throughout the world. But the fact that we can achieve these things does not mean we will. At this stage, failure seems all too possible, as does a half-hearted response that will imply the need for much more costly action in the future.