The 2007 report of the Intergovernmental Panel on Climate Change (IPCC) projects that continued emission of greenhouse gasses (GHG) will raise the earth’s temperature by 1.8°C (3.2°F) and sea level by one foot by 2100. Projected climate changes, if they come to pass, will have a number of effects on society, though not all of those effects will be negative.
Although debate over the IPCC’s projections continues, less attention has been focused on the ultimately more important result: Cost-benefit analysis (CBA) implies we should do very little to prevent climate change. Instead, we should create wealth. Expanding the productive capacity of the economy will compensate future generations better than reductions in GHG will. A richer world in 2100, after all, will be able to afford to do things like relocating people affected by rising sea levels and constructing new port facilities and seawalls.
by the liberal Global Development and Environment Institute at Tufts University observes, “Economists frequently . . . calculate the optimal policy response [to climate change]. This calculation often leads to the conclusion that relatively little should be done for now.”
Businesses operate under the discipline of profit and loss based on market prices. Profit signals that an action generates benefits for the economy. Government does not face the discipline of profit and loss, but CBA, performed honestly, offers guidance about whether government actions benefit society.
Measures to reduce GHG emissions today typically fail a cost-benefit test due to the discounting of benefits. Discounting refers to applying a real interest rate to future values. Two arguments support discounting in CBA. The first is impatience, or what economists call time preference: $100 is worth more today than it is one year from now, even without inflation. The second is the return on savings and investment, or the opportunity cost of capital. Money spent now to reduce GHG could be saved and invested instead. The interest rate equates impatience and the return on investment on the margin, as investors must be compensated for delaying consumption.
The mathematics of discounting makes values more than about 50 years in the future worth little today. The federal government makes cost-benefit calculations using 3 percent and 7 percent annual real (or adjusted for inflation) interest rates, approximating the historical risk-free interest rate and the annual real return on stocks. The present value of $1 million 100 years from now is $52,000 at a 3 percent discount rate, and $1,150 at a 7 percent discount rate. To see how this affects climate change economics, suppose that spending $100 billion annually—starting right now—we could prevent $1 trillion in annual damage, beginning in 100 years. The ratio of $10 in benefits to every $1 in costs appears favorable, but this fails a benefit-cost test at either a 7 percent or 3 percent real discount rate.
Some observers respond to this math by arguing against discounting in climate change economics. Time preference is a questionable argument in intergenerational settings because future beneficiaries will not have to wait 100 years to realize climate benefits. But the opportunity cost argument remains. The Stern Commission in the U.K. applied an implausibly low discount rate
to its calculations. Others imagine current benefits from GHG reductions rendering discounting irrelevant. For example, the Environmental Protection Agency (EPA) included private benefits in a CBA of higher fuel economy standards to reduce GHG emissions, arguing that making people purchase higher-mileage cars than they prefer makes car buyers better off. Creating benefits today effectively makes reducing GHG a free lunch.
Wealthier is Healthier
Resources put into reducing GHG can’t be invested elsewhere, so the opportunity cost of GHG reduction amounts to the returns that could have been expected, based on historical rates. Maintaining opportunities to invest and create wealth for future generations requires the institutions of a market economy, or a high level of economic freedom, as the Fraser Institute’s Economic Freedom of the World: 2012 Annual Report
demonstrates. Bequeathing a higher standard of living to future generations also requires preserving economic freedom. Discounting mathematics ultimately tells us that economic freedom addresses climate change more effectively than energy central planning through carbon taxes or cap-and-trade.
Compensating the “victims” of climate change with extra wealth does have a potential limit. Extra resources provide inadequate compensation if climate change dramatically alters the world. Money will not typically fully compensate for a catastrophic injury; a quadriplegic is unlikely to enjoy the same level of utility or satisfaction after his injury, even if his medical bills and care needs are paid. Wealth accumulation would not adequately compensate future generations if climate change produced a world like those depicted in Waterworld and The Day After Tomorrow. Future generations would not be adequately compensated if climate change destroyed the economy’s ability to produce goods and services. Fortunately Waterworld is the stuff of Hollywood fiction; the largest of the upper range of sea level rise in any 2007 IPCC climate scenario is about 2 feet. That will have serious consequences, but it will hardly flood the entire world. It can be offset by wealth accumulation.
A Hundred-Year Plan?
Property rights and prices lead basically self-interested people to worry about the future. For example, property rights and markets for existing homes provide owners with incentives to keep their houses livable long after they plan to own them. And yet the mathematics of discounting implies that events too far in the future should not affect decisions much today. Growth, progress, and creative destruction limit the horizon for detailed planning in a market economy. Imagine a business in 1900 trying to plan its operations in 2000. The plan could not have included automobiles, planes, television and radio, satellites, computers, and many other conveniences of modern life.
Now let’s project ahead and consider planning for climate change. A number of fundamental innovations could substantially reduce if not eliminate the threat from climate change, such as effective, low-cost carbon sequestration or effective weather modification to smooth out precipitation patterns. And the development of a radical new clean energy source like nuclear fusion could render remaining stocks of fossil fuels uneconomic at any price.
A dynamic market economy will feature too much creative destruction to allow detailed planning for the distant future. Nothing is sure in a market economy 10 years from now, much less 100 years, and discounting in cost-benefit analysis simply reflects this reality. The economic future becomes more predictable when government controls economic activity, but then stagnation results. Discounting in climate change economics tells us to create wealth to protect future generations. Economic freedom and the institutions of the market economy, not central planning of energy use, are the prudent policy approaches to a changing climate.