Market Forces

How newer research is building off Nordhaus’ past contributions

Äntligen! (Swedish—my native tongue—for “Finally!”) Last week, the Royal Swedish Academy of Sciences awarded the Nobel Prize in Economic Sciences to William Nordhaus for his pioneering work on “integrated assessment modeling” (IAM) – a framework which has made it possible to analyze the interplay between the economy and climate change, and the consequences of climate policies. And while the recognition of Nordhaus’ achievements is an encouraging sign that mainstream economics is starting to recognize the important contributions of environmental economics to the field, it’s critical that economists continue to build on and strengthen the research Nordhaus initiated.

Nordhaus started his research – in what was to become the now very active and expanding field of climate economics – already in the 1970s. His fundamental contribution came in the early 1990s when he introduced his Dynamic Integrated model of Climate and the Economy (DICE), which became the foundational framework for the IAMs used today by the Intergovernmental Panel on Climate Change (IPCC) as well as by an Interagency Working Group to develop estimates of the Social Cost of Greenhouse Gas Emissions during the Obama Administration.

The novelty of DICE was the integration of findings across disparate disciplines including physics, chemistry, and economics to model the link between economic activity and carbon emissions, leading to higher atmospheric carbon concentration and related higher global average temperatures. Furthermore, his model linked this increase in average temperature to economic damages. This integrated framework laid out the principles for estimating the damaging impacts of greenhouse gas emissions (GHGs) on human welfare, and could therefore be used to calculate the social cost of greenhouse gas emissions and to study the consequences of climate policy interventions such as carbon pricing.

In awarding him the Nobel Prize, The Royal Swedish Academy of Sciences recognized Nordhaus’ research as a methodological breakthrough and critical step forward – but one which does “not provide final answers.” While DICE, an acronym which nods to the perilous game we’re playing with the planet, laid the groundwork for the development of robust estimates of the social cost of GHGs by the Interagency Working Group (which experts agree reflect a lower bound), his research has also served to highlight how newer and ongoing research can further strengthen these estimates.

Such enhancements which further strengthen integrated assessment modeling include:

• Incorporating more of the many non-market health and environmental impacts which are still omitted in IAMs by constructing more detailed damage functions (the assumed relationship between climatic changes and economic damages) founded in empirical studies of climate impacts using real-world data and taking into account that the value of environmental assets relative to other goods and services may increase as they suffer a larger share of the damages from climate change.
• Strengthening how inter- and intra-generational equity is taken into account.
  • The highly influential Stern Review commissioned by the UK government in 2005 argued persuasively that Nordhaus put too little weight (through his choice of parameter values related to the discount rate) on the welfare of future generations which resulted in lower estimates of economic damages, and spurred an academic debate leading to recommendations that governments instead use declining discount rates when evaluating public projects and policies with long term impacts.
  • Climate change will impact different regions of the world very differently, with poorer regions generally hit worse than richer parts of the world. How well economists represent the spatial distribution of damages across regions of the world and the functional form and parameter values they choose for weighting differences in such damages significantly impact estimates of the social cost of greenhouse gas emissions.
• Strengthening the way IAMs deal with risk and uncertainty – an inherently crucial element in any analyses of climate change – and the representation of so-called “tipping points” beyond which damages accelerate or become irreversible. This more recent research shows that such model enhancements also significantly increase estimates of the social cost of greenhouse gases, and underscore the vital importance of drastically reducing GHG emissions to insure against high‐temperature catastrophic climate risks.

Nordhaus shares the Nobel Prize with Paul Romer, who is separately awarded for integrating technological innovations into long-run macroeconomic analysis and his analyses of how markets develop new technologies. This is a very appropriate choice considering the importance of technological change for addressing climate change and gives this year’s prize the common theme of how to achieve both sustained and sustainable economic growth.

It is extremely timely that the Nobel Prize in Economics to Nordhaus’ work highlighting the critical role of carbon pricing and Romer’s work on the importance of technological innovation for long-run welfare was announced on the same day as the IPCC released its special report on the impacts of global warming of 1.5 °C showing the urgency of addressing climate change, and how both carbon pricing as well as technological innovation and diffusion have important roles to play.

This post is co-authored with Steve Koller

To tackle dangerous climate change at the pace and scale the science demands, we must take advantage of every cost-effective opportunity to cut pollution now. Several recent analyses from leading experts on the impacts of carbon pricing demonstrate once again why flexible, market-based policy is the most effective and efficient tool we have to address dangerous climate change.

These studies reaffirm that penalizing pollution and requiring companies to pay for their contribution to climate change can help the United States achieve needed reductions while generating substantial revenue. What’s more, none of these studies even account for the enormous benefits of averting climate change impacts.

While these studies examine carbon taxes (which place a price on pollution and allow the economy to respond), approaches that establish overall declining pollution limits and allow the market to determine the price can achieve similar pollution reductions and economic outcomes. But since uncertainty about market factors and technological trends prevent even the most robust economic modeling from providing guarantees, it is crucial that any carbon tax policy be linked to clear, concrete pollution reduction goals and include transparent provisions to help ensure those goals are met. A policy where the price is derived from overall enforceable pollution limits already includes those assurances.

The analyses by the Stanford Energy Modeling Forum (EMF 32, comprising 11 leading modeling teams), Columbia University’s Center on Global Energy Policy (CGEP) and the U.S. Energy Information Administration (EIA) examine a range of scenarios with price paths from $15  to $50 per ton and annual price escalators from 1 to 5 percent, along with various ways of distributing the revenue. In addition, Resources for the Future and Columbia modeled the carbon tax bill recently introduced in the House by Representative Curbelo and co-sponsors, which includes a starting price of $24 per ton and rising 2 percent annually.

Let’s take a look at four key takeaways across analyses:

1. National policy that puts a price on carbon could significantly reduce climate pollution

In all scenarios that examine a price across the economy, pollution reductions are achieved consistent with meeting or exceeding the U.S. Paris Agreement climate commitment by 2025 of 26 to 28 percent reductions below 2005 levels. On our current path, we will almost certainly fall short of meeting those goals, according to recent analysis from the Rhodium Group.

However, the analyses also show that to achieve deeper reductions aligned with long-term, science-based targets (for example, net-zero emissions by mid-century), we will likely need pricing paths at the more ambitious end of the spectrum—as well as companion policies to help the most difficult sectors decarbonize.

Of course, a key advantage of pricing pollution is that it will spur innovation—encouraging new technologies and approaches to slashing emissions that today’s models cannot foresee. These advances could allow us to meet our goals at lower costs than anticipated—exactly what’s happened with the well-designed, market-based U.S. acid rain program.

The EMF 32 results also underscore that the starting price matters for reductions in the short term, while the rate of increase over time is important for bending the emissions curve down in the long term. For example, in the first decade, the $50 plus 1 percent price achieves roughly 40 percent more cumulative emissions reductions than the $25 plus 5 percent scenario. However, by 2038 cumulative reductions in the $25 plus 5 percent price exceeds the $50 plus 1 percent price, and cumulative emissions through 2050 are similar. This dynamic is important since cutting pollution now is good for the climate, but we also need to sustain the pollution decline over the long term. Ultimately, the total cumulative climate pollution in the atmosphere is what matters.

2. Carbon pricing has extremely minor impacts on the economy—without accounting for the economic benefits of avoided climate change

Both EMF 32 and CGEP’s results suggest that GDP would continue to grow at historical or near-historical rates across scenarios—and could be net positive, depending on how revenue is used. Additionally, despite misleading rhetoric from opponents of climate action, a carbon price would have an extremely small net effect on employment. A recent analysis from Resources for the Future suggests that the net impact of a $40 tax would be less than half of one percent or even lower. And while many other studies confirm that net impacts on employment are likely to be small, they note that even mainstream modeling efforts tend to overestimate the impacts by a factor of 2.5 or more. Meanwhile, national climate policy would mean investing in the clean energy revolution: the economic engine of the future.

None of these analyses even consider the economic benefits associated with slashing climate pollution. Citibank estimates that climate change will cause tens of trillions of dollars in damages if left unchecked. These analyses also do not account for the additional associated benefits such as improvements in air quality. Taken together, these benefits make an overwhelming economic case for reducing pollution as soon as possible.

3. The lion’s share of reductions occur in the power sector, underscoring the importance of companion policies in other sectors

All analyses of an economy-wide price find that the vast majority of reductions occur in the power sector, driven primarily by declines in coal consumption. In the analyses examining $50 per ton scenarios, Columbia shows that approximately 80 percent of economy-wide emissions reductions occur in the power sector with a significant shift towards renewable energy, and EMF 32 results predict that coal demand reaches near-zero by 2030. This is consistent with modeling analysis conducted by the United States Mid-Century Strategy for Deep Decarbonization in 2016.

Some other sectors, notably transportation, tend to be less responsive to carbon pricing in the models—at least in the short term. Both Columbia and EMF 32 find that transportation sector emissions only drop a few percentage points relative to 2005 levels by 2030 even in the higher pricing scenarios. These results underscore the importance of policies that put a firm limit on pollution across the economy as well as companion policies that can help address specific barriers to change in sectors that will be more difficult to decarbonize.

4. How revenue is used matters

Carbon pricing has the potential to raise significant revenue—for example, just under a trillion dollars over the first 5 years with a $40 price, rising at 5 percent. How revenue is used plays a significant role in overall economic impacts as well as the distribution of those impacts across regions and populations.

For example, CGEP’s analysis finds that certain revenue recycling approaches—including the use of revenues to reduce payroll taxes or the national debt—result in larger long-run economic growth than scenarios without a carbon price. EMF results find that using revenues to reduce capital income taxes generally achieve the highest GDP growth of the scenarios they considered, but these gains are disproportionately captured by the wealthy.

Alternatively, revenue can be directed to not only avoid this sort of inequitable distribution of benefits, but also protect low-income families and disadvantaged communities who already bear a disproportionate share of the burden of climate change and air pollution, and are more sensitive to changes in energy costs. For example, Columbia’s analysis shows that approaches putting even a small portion of revenue back into the pockets of American households can compensate those in the lowest income quintile from potential increases in energy costs. The Center on Budget and Policy Priorities has also demonstrated how carbon pricing can be designed to fully offset impacts of the policy on the most vulnerable households and provide considerable support for others while leaving significant revenue to spare.

While assumptions and model structures may differ, bottom line findings all point in the same direction: well-designed, national carbon pricing policy can spark deep reductions in climate pollution alongside economic growth, while spurring technological innovation and protecting vulnerable populations.

The “price” itself is only one part of effective climate policy. We need firm declining limits on pollution to accompany a price and ensure environmental outcomes, as well as a portfolio of approaches working together to ensure that investment and innovation are happening where it matters. A pricing program can be a catalyst for driving additional climate solutions at the federal, state, and local level, while other policies can share the burden and tackle the problem from multiple angles. This model has already proven itself in California, where the state has hit pollution reduction targets even earlier and at lower cost than anticipated.

To be successful, we need bipartisan leadership and a serious discussion about meaningful solutions. The United States can and must address the challenge by working together in the best interest of all Americans to put in place ambitious, effective, and fair climate policy.