The Stern Report Is it the Answer?

The Stern ReportIs it the Answer? Christopher Bliss christopher.bliss@nuffield.ox.ac.uk The Hayek Society 31st January 2007

Where I am Coming From • Nick Stern (forget the Sir Nicholas in this context) is a long-standing close friend • But some of his critics are friends too (Dasgupta and Nordhaus)

Sources The Report is huge, and although I have spent many hours reading it, I confess that parts have been skimmed rather than studied deeply. Even my light reading shows me that some media accounts are inaccurate or confused. The text can be downloaded, free of charge, from the HM Treasury Home Page Comment from Partha Dasgupta (FBA and FRS) may be found at: www.econ.cam.ac.uk/faculty/dasgupta/STERN.pdf Comment from Bill Nordhaus may be found at: nordhaus.econ.yale.edu/SternReviewD2.pdf

A Cautionary Note The Report admits to uncertainty concerning the future, but this is mostly expressed as quantitative uncertainty, concerning in particular the size of National Product. It does not write about the qualitative uncertainty that arises from life-changing technological alteration. This is beautifully depicted by Tom Schelling in his 2002 Presidential Address to the American Economic Association.

Tom Schelling on Climate Change “"Even if we had confident estimates of climate change for different regions of the world, there would still be uncertainties about the kind of world it is going to be in 50, 75 or 100 years from now. Imagine it were 1900 and the climate change associated with a three-degree average temperature increase were projected to 1992. On what kind of world would we superimpose either a vaguely described potential change in climate, or even a specific description of changes in the weather in all seasons of the year, even for our own country. There would have been no way to assess the impact of changing climates on air travel, electronic communication, the construction of skyscrapers, or the value of California real estate. Most of us worked outdoors; life expectancy was 47 years (it is now 75); barely a fifth of us lived in cities of 50,000 or more. Anticipating the automobile we might have been concerned about whether wetter and drier weather would bring more or less mud, not anticipating that the nations roads would become thoroughly paved. The assessment of the effects on health would be without anti-biotics or inoculation. And in contrast to most contemporary concern with the popular image of hotter summers to come, I think we would have been more concerned about warmer winters. later frost in autumn, and earlier thaw in the spring.”

The Science • I am no expert on the science of global warming. Yet the basic Physics is rock-solid, and some of the worrying projections in the Report (and elsewhere) look reasonable to me. That there is no new science in the Report does not concern me. • The scientific point that puzzles me most is the high level of carbon re-absorption that is posited. It is claimed that long-run stabilization of atmospheric carbon concentration is feasible, notwithstanding huge and continuing world economic growth. • There is more than one scientific projection involved. The Report mixes long-run projections, sometimes to the end of this century, or into the next, with the claim that extremely urgent action is demanded (tipping points). • The science concerned with tipping points in the fairly near future is far more speculative than the claim that long-term temperature rise with continued emissions is inevitable.

Politics Notwithstanding Stern’s stellar academic standing, this is not an academic study. It is an intensely political document. It proposes and justifies a program for world-wide emissions control. It argues that the costs of doing nothing are massive; the cost of dealing with the problem are modest. The economic modelling is tailored to support the above case. There is no sensitivity analysis.

Social Welfare Function The Report is based on cost-benefit analysis. So it a maximizes a Social Welfare Function. The function chosen is something like: ∑t ∑iU(cit) (1) Where t is the time period and i an index of individuals alive at t. I have set the utility time discount rate to zero. Stern has it equal to 0.001, the probability of extinction, but that is zero in effect. The objective (1) is not necessarily utilitarian in the sense that U measures utils enjoyed by different people. It could be that U measures the UK Treasury’s relative valuation of consumptions by different parties. What matters is that all generations are treated symmetrically, and that the curvature of U measures the UK Treasury’s aversion to inequality, within and between generations. The above approach is non-standard, because there is no third summation over states of the world, weighted by probabilities. For the way in which Stern treats uncertainty, see below.

The Log Function The Report sometimes uses a special case of (1): ∑t ∑ilogcit (2) This has the implication that the extra consumption it is necessary to give to Bill Gates to justify taking $1’s worth of consumption away from a poor Indian farmer, is equal to the ratio of Gates’ consumption to the farmer’s consumption. This represents moderate aversion to inequality. Also, if all per-capita incomes will grow at 2% per annum for the next 50 years, marginal increases in incomes 50 years in the future are valued at about one-third the same marginal change in incomes in 2057. That implies that income protection in the medium distant future, paid for by present generations, has to extremely effective. Stern argues that this test is met. The Report argues that marginal changes, such as that detailed above, are not what the economics of climate change are about. However, marginal mental experiments do test the plausibility of objective functions.

Investment and the Ramp The previous slide looked at the cost-benefit of the present generation reducing consumption a little to save the generation in 50 year’s time over three times as much. That is a simplistic account of the picture painted by Stern. He has all those alive over the next decade reducing consumption to avoid a permanent reduction in consumption in the medium future at least ten times as large. As an alternative to using the present reduction in consumption to reduce emissions, the present generation could invest instead. With a return of about 4%, this appears to beat emissions reduction, at least over early years from now. This leads to The Ramp, the idea that emissions reduction can wait until later, if human and physical capital investment is increased. Against this approach Stern seems to favour the Fire-Insurance View.

Pessimistic Assumptions and the Fire Insurance View Stern has been widely criticized for choosing the most pessimistic assumptions from the menu of possibilities. For example, his favoured prognosis is far more dire than that of the UN’s IPCC. A possible justification for this is that the worst outcomes have enough probability weight attaching to them to justify just calculating whether the present cost of avoiding any possibility of those outcomes is worthwhile. I call this Fire Insurance because it is similar to exactly that. Destruction of an uninsured home by fire is such a huge disaster that one readily pays a significant premium to avoid it, even though the probability of a fire is tiny. Stern argues for a precautionary principle. The probabilities are only guesses. Just in case the disaster outcome is more probable than it seems, let us treat it as near certain (my way of explaining it, not the Report’s). Finally, note that the fire-insurance analogy is misleading in one respect. If I insure my house against fire, I pay the fee, and I get the benefit. Emissions control means that the present generation pays the fee, and future (richer) generations are protected.

Climate Change and the Prisoners’ Dilemma Prior to the publication of the Stern Report my own position was as deeply pessimistic as is possible. I believed that climate change is a real and large problem, and I thought that practically nothing could be done about it. It seemed to me that climate change is a huge global Prisoners’ Dilemma problem, and that defection all-round is the only equilibrium outcome. So when press reports of the line to be taken by the forthcoming Stern Report began to appear, I said to myself: “Surely Nick understands the Prisoners’ Dilemma”.

The Prisoners’ Dilemma and Cooperation The Stern Report is well-aware of the Prisoners’ Dilemma, and this is discussed explicitly in Part VI, Chapter 21. The discussion is not as sharp as one might wish. There is reference to changing the climate of thinking, so that nations and voters become more aware of their collective responsibilities. The theory of repeated games is also cited, and there is a light discussion of punishment strategies and their problems.

Is Global Warming a Repeated Game? The Stern Report recourse to the theory of repeated games is problematical. The global warming problem differs from the repeated version of the Prisoners’ Dilemma problem in at least the following respects: • If one thinks of each round of the game as one year of policy, then each year changes the game. The stock of CO2 in the atmosphere alters, and long-term (more than one year) investment projects are part-finished. • In reality the game is not a full-information, common-knowledge, game. Players do not make a simple bi-modal choice: (Cooperate,Defect). They can choose from a wide range of actions, defecting to any degree desired. And they can dissemble and cheat. Punishment systems in this sort of game are difficult. Punishing even small-scale defection is not credible. So selfish players will always go right up to the trigger level of defection. • The EU emissions control protocol was initially ineffective because national governments cheated blatantly.

Carbon Trading and its Regulation The Stern Report advocates Carbon Trading, as the efficient way to reduce emissions at minimum cost. In principle carbon trading makes sense. But how is it to be implemented? Two simple systems have been discussed. • Existing emitters are allocated rights to emit, proportional to, but at a reduced level, to their existing emissions. If existing emitters cannot cut back to the required extent, or anyone wanting to start-up new plant that will emit, must buy certificates on a world market for emission rights. • All certificates giving a right to emit greenhouse gases must be purchased from an international agency that will auction off the right number of certificates to fix world emissions at the appropriate level. The first scheme rewards old emitters relative to new enterprises. The second places huge sums of money into the hands of an international body. How are these funds to be disbursed? Will they help poor countries to pay for their emissions, or will they partly pay for development aid?

Transfer, Bureaucracy and Politics The previous slide indicates that the control of emissions, in particular in combination with carbon trading, raises the possibility of substantial transfers to the poorest nations. However, such transfers could happen anyway, if aid is deemed to be effective, and if the politics of rich countries allows it. The Stern Report advocates large-scale assistance by rich countries for poor countries, to help the latter adapt. How would the politics of that play out? Imagine a populist politician saying: “Why should the taxes paid by my poor voters be used to feather-bed the Chinese, given their repeated violations of human rights?” Any carbon trading scheme needs to be policed, to ensure that illicit emission of CO2 does not occur. This should require a huge international bureaucracy, and will imply endless possibilities for argument and friction. What will the ultimate penalties be? The Stern Report cites successful international cooperation in the case of the outlawing of ozone-depleting chemicals. But this is a relatively easy field. What about the Nuclear Non-Proliferation Treaty, that was undermined by non-compliance from the start, and is now dissolving before our eyes?

Another Dragon: Protectionism Suppose, for the sake of this slide at least, that the Stern message is entirely right, and that it can be sold to the world. The Global-Warming Dragon is slain. But another dragon is lurking in a corner. Already, in the European Union, voices are heard asking how emerging country exports can be allowed access to Union markets, when the production of these exports pollutes far more than the Union production that competes with it.

The Costs of Carbon Stabilization To my inexpert eye, two features of the Stern Report appear as remarkably optimistic. • Carbon concentration can be stabilized while economic growth continues, and emissions remain positive, although at a greatly reduced level. This depends upon natural re-absorption. Forests are mentioned. But it is only net growth of forest carbon that is absorption. How can this continue indefinitely? A similar question arises with regard to absorption by the World’s oceans. • The cost of stabilization is strikingly low – 3% of GDP at the high end. The Report does not justify this estimate. It mentions several technologies, talks about cost reduction via experience, and cites some outside studies.

Costs and Benefits Now and in the Future Recent rapid economic growth in Brazil, China, India, and elsewhere, has lifted millions of people out of poverty. Nothing can be considered that would put those gains at risk. Where that growth has been an effective means of poverty reduction, international aid, generally, has not been. Its scale has been small, and it can be defective as an instrument for poverty reduction. Usually it transfers money to governments, which typically means to ineffective and corrupt governments. The Report proposes a different kind of international aid, involving costs paid largely by the current rich to the benefit particularly of future poor people. No direct monetary transfers are required. Some big problems are untouched by actions on global warming. Even if the control of emissions is of particular importance for sub-Saharan Africa (SSA), that control will not solve the catastrophic condition of the SSA region. And if the auctioning of emission rights produces big monetary transfers to SSA, that could inhibit economic growth there, because transfers have the same effect as resource abundance.

Concluding Remarks The Stern Report is an impressive piece of work. If my claim that it is a political document is correct, then it is a political document with more academic references than any previously seen. The report relies heavily on the insurance principle to justify the urgency of action, and to reject the Ramp. Its benign conclusions concerning costs and benefits depend heavily on surprisingly low estimates of the costs involved. Can it happen? The argument gets quite “hand-waving” where implementation is concerned. The recourse to Repeated Game theory is dodgy. And the apparent need for a huge international bureaucracy is not confronted.

The Stern Report Is it the Answer?