Nicholas Stern on the Role of Economics in Combating Climate Change

In 2006 climate economist Nicholas Stern published the Stern Review on the Economics of Climate Change, a report that offered the first systematic examination of the costs of addressing climate change and impacts on the global economy. The report marked a fundamental shift away from climate change being viewed primarily as an issue of science, to also being one of economics.

Fifteen years later Stern looks back on that seminal report to examine how economics, and markets, have failed to grapple with the unprecedented risks posed by a changing climate, and how the profession must change to guide policy toward rapid decarbonization on a global scale. Stern’s recording took place during his visit to the Kleinman Center for Energy Policy on April 19, where he received the center’s Carnot Prize for distinguished contributions to energy policy.

Full Transcript

Andy Stone: Welcome to the Energy Policy Now podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone. I’m very excited to be speaking with today’s guest on the podcast. Lord Nicholas Stern is an economist at the London School of Economics and the recipient of this year’s Carnot Prize, which is the Kleinman Center’s annual recognition of distinguished contributions to energy policy. Stern’s renown is based in part on a seminal report on the economics of climate change that he published in 2006. That report, The Stern Review on the Economics of Climate Change, is widely acknowledged as the first systematic examination of the costs of addressing climate change and of the impact of those costs on the global economy. The Stern Review marked a fundamental shift away from climate change being seen primarily as an issue of science to also being one of economics.

The Stern Review’s ultimate purpose was to help guide governments in setting impactful and cost effective policies to slow climate change. Yet, more than 15 years after its publication, we find ourselves in a world where emissions and temperatures continue to rise. Stern finds fault in the methods economists used to model climate risks, which by extension guide the decision of climate policymakers. In a recent analysis, Stern calls for the tools of economics and the field of economics itself to fundamentally change to meet the enormous challenge of the climate crisis. Nick, great to have you on the podcast.

Lord Nicholas Stern: Pleasure to be here, Andy. Thank you for having me.

Stone: And congratulations on receiving the Carnot Prize from the Kleinman Center.

Stern: It’s a great privilege. If you look back over the previous recipients, they’re a very distinguished crew of women and men. And, of course, the name Carnot itself carries great history around thermal dynamics, energy and the way in which societies are transformed by energy.

Stone: Well, again, we’re honored to have you here. You’ve come in from London. You’re the chairman of the Grantham Research Institute on Climate Change and Environment at LSC, the London School of Economics. And I wonder, to get started, if you could satisfy a curiosity of mine. And that is the problem of climate change really came into public view, I think, globally in the early 1990s with the first IPCC assessment report, two years after that, the real climate summit. And I wonder, can you fill us in? When did climate economics itself become a discipline and when did you become involved with the field?

Stern: Well, there were some early work on economics in right around that time. And Bill Nordhaus at Yale, wrote a paper called To Slow or Not Too Slow, which published an economic journal and was asking the question, Once you know that your production is damaging the environment, should you do less of it or, as he put it, to grow or not, to grow or to slow down. And so it did come in fairly early in a gross sense like that. And it also came in — really, it’s been there a long time in terms of the externality story, which goes back to Pigou, a famous Cambridge economist, 100 years ago, who said that if you’re doing something that is costly but you don’t pay, then you do too much of that. And that in particular, you know, emitting greenhouse gases. So that argument was there, has been there very early in environmental economics and was carried over to climate.

So I think those two questions were there from the beginning, taxing externalities, the so-called big of in tax and the question of should you slow down your growth? But both of those things were really resting on the idea that to do things clean was more costly. And it was actually embodied in the original United Nations Framework Convention on Climate Change of 92, which essentially said it is going to be more costly. So there’s a question of who pays. So that part of climate change economics, if you like, has more or less been there from the beginning. But as you know, I’ve tried to argue that that’s actually rather a narrow view and some ways misleading view to have in relation to climate change if you’re thinking about the right kind of policies.

Stone: I think we’re going to get into that conversation about how costly it is to act and not to act, right?

Stern: Yeah. But, basically, I think that picture of the slow growth or not to slow growth and to use carbon taxes or externality taxes, to be fair, that was probably there from the beginning. But I think it’s also fair to say it didn’t develop very fast from that.

Stone: So late last year, you published a paper in the title that was A Time For Action on Climate Change and A Time for Change in Economics. And it argues that the traditional economic framework that you started to introduce right now is not really suitable for addressing the type of risk that’s inherent in the problem of climate change and that a reinvention to discipline is actually necessary. So it seems to me there are two components or sides to this. One is that you know, I’d like to ask you a couple of questions into related questions here. First, how is climate change different from most of the problems that economics tries to solve; and related to that, what is it about the traditional economic framework that is fundamentally unequal to the task of addressing climate change?

Stern: First, it’s the scale of risk. We’re right on the edge now at one point one degree centigrade, of global surface, average surface temperature above the late 19th century when the industrial revolution was getting underway. That’s the usual benchmark. The Holocene period, the period after the last Ice Age, when we warmed up after the last Ice Age eight, nine, 10000 years ago has seen roughly plus or minus one. And that was the period when we grew up as human beings, in the sense of we cultivated grass and turned them into grains, which meant that instead of just hunting and gathering, we planted the plant. And so you wait. And so you have villages where people are stationary while they look after their crops. And then they have a surplus so that they don’t have to devote all their time and energy to just hunting and gathering. And from that surplus you can have academics and [Inaudible] and so on.

So that’s who we are. That’s who we became. And that’s really a very short period of time. Now, homo sapiens may be 250 or 300, 000 years old, but the way of living, our own civilizations are young and they’re all concentrated in that period. The places where we live emerged during that period. And what this now involves is a fundamental change in where we can live, how we can live, what we can do. And if it goes much further than where we are, loss of life on a very big scale. You know, two degrees is very dangerous. That’s why the Paris target was set well below two degrees. We’re probably headed for something like three degrees on current plans, and that would be dramatic if we haven’t seen three degrees around three million years, sea levels 10 to 20 meters higher.

Stone: Existential issue here.

Stern: For very big parts of the world existential. We don’t know what the carrying capacity of the world would be. You know, we’re eight billion or so now, probably headed for another one or two billion on top of that. What’s the current capacity of a three or four degree world? We don’t know. But we know enough from the kind of examples I gave to suggest that the carrying capacity well could be a lot lower. So, well, how do you go from nine or 10 billion down to, say, five billion? Or we don’t know what it might be. What does that process look like? I mean, that looks pretty horrific, pretty existential. If many coastal areas where we live, you know, most of our cities are close to, for good reasons, ports and where rivers reach the sea and so on. That’s where our cities are. And many of those would not be able to withstand the kind of battering that would come as a result of climate change, sea level rise, storm surges, hurricanes, storms and so on. So if hundreds of millions, perhaps billions of people start to move, then the conflict consequences of that would be intense.

So what I’m trying to describe is a whole range of risks which are existential for many, which involve conflict for many, which are absolutely transformative. And normal economic policy deals with if we raise this interest rate, if we raise that tax, if we adjust that regulation, some people will be a bit worse off. Some will be be a bit better off. Our analysis is devoted to saying, “Well, who are they, by how much?” And then we have our policy discussion on that basis. So this is different in scale and nature of the consequences that we’re trying to tackle. And because those consequences are so big, the analytical methods that we use can’t just be the traditional ones of a bit extra here and a bit less therefore for her or him. It has to be about how we think about immense risk, and it also has to be about how do we change in a fundamental way, what we do right across the economy.

And can we do it fast because the climate is changed by the total of emissions over time. Our emissions are very high. If we don’t get it down quickly, then that accumulates to more than is consistent with two, 2.5 or even three degrees. So speed is of the essence. So it’s those reasons really, the magnitude of the risk beyond any kind of policy discussion we normally have. The fundamental nature of the change that we have to make redesigning our cities, redesigning our land use, redesigning our energy transport system. Huge changes and the pressure of time. We really are in a hurry. If you put those things together, then the normal kind of shifting of a general equilibrium model as a result of a tweak on a policy can’t be the right way to get at this.

Stone: Well, I don’t want to dove too much into the minutiae of this, but one of the things that you point out in the most recent paper is that the modeling that economists use to understand risks and eventually guide policymakers on their decisions around climate change and how to address it, it has difficulty accounting for the large risk that you’ve just spoken about. And also, climate change involves something which is called increasing returns to scale which, per my novice understanding, is something that many economists are not so accustomed to using or it’s not a normal part of modeling. Can you explain increasing returns to scale and why they pose a challenge to the traditional economic framework?

Stern: So constant returns to scale says that if you double all your inputs, you double your output. So you can imagine that like replication. Diminishing returns to scale says that as you put more input in, then the bit of extra output that you get from each extra bit of input goes down. And if there’s some kind of constraint, now you’ve just got one piece of land and you can’t change that, you can’t change other inputs like labor and fertilizer and so on. So if you’ve got something that’s constraining you, then you’d expect to find diminishing returns to scale because there’s a tightness there that stops you getting those kind of constant returns to scale or replication that I describe. Increasing returns to scale says that, well, if you double your inputs, you more than double your output. And there’s some natural examples. If you’re making a pot, then your costs are roughly associated with the surface area of the pot. But what the pot holds goes up like not just the square of the linear dimension, which is the surface area, but the cube of the linear dimension.

If you just take a square pot that’s got a size X, then the volume of the pot is X cubed. But the surface areas of the pot is like X squared. So you can see that those kinds of examples are natural, increasing returns to scale. There’s also phenomena called learning by doing that is related in the sense that your experience of doing things means you get better. So the next one is cheaper than what went before. So there’s lots in here which could well involve increasing returns to scale. And we’ve seen, for example, in the cost of solar panels that’s come off by a factor of 10 or more in a decade or so decreased by 90 percent or roughly over a decade or so. And you start to make them on scale as opposed to just in small places. You learn a lot about how to do it on the way. So we’ve seen increasing returns to scale. And for these very big changes, increasing returns to scale is really quite likely. Now, that’s the concept. So what’s the problem of increasing returns to scale for economics?

Well, your first year economic says if you are in a market, and you’re a producer and you can get some price for whatever it is you’re making, you’ll go and making a bit more each time the cost of a bit more is less than the price you get. So and if you’re getting 10 and it costs only five to make a bit more then you’ll make a bit more. And you go on doing that, you’d expand your output up to the point where the cost of the last bit is just equal to that price, because that’s about the point where the last one just about breaks even. So you can see for that kind of model of people behaving in competitive markets as if prices were fixed and then expanding their output in this way, can work only if you have diminishing returns to scale. Because if you’ve got increase in returns to scale and you see a price in the market, and if that price stays that way, however much you produce, then you’d go on producing more and more and more. And you wouldn’t have an answer to the question.

Stone: It’s infinite.

Stern: It’s infinite. What tells you how much anybody produces? Now, in what we call the economics of industry or industrial economics, you start to tell stories about prices not being independent of what you do. We talk about monopoly and we talk about oligopoly and we talk about oligopolies competing against each other where each one is aware of the effect on price. And that’s a different kind of model of imperfect competition, and it’s one that has been really quite interesting and helpful in industrial economics. How the firms behave. The trouble is that when you try to run that at the level of the whole economy, it’s not easy to describe increasing returns to scale. And most of the story that people have told in these general equilibrium models have been of diminishing returns to scale or constant returns to scale. So that basic competitive model, if you’re building it for the economy as a whole, is difficult to handle unless you have diminishing returns scale. Just analytically, it’s difficult to handle.

And what we’ve got here is very rapid change where we’re scaling up. You know, we’re transforming the whole electricity industry, where really scaling up offshore wind. We’re scaling up solar. We’re looking at different grid systems, which can function much better if you’ve got bigger scale and more people involved. So these are the kinds of changes that we’re contemplating. And the simple equilibrium model of the entire economy that we can eventually adopt, it just doesn’t fit the nature of the challenge.

Stone: So the outputs of this are not something that’s practically usable by policymakers?

Stern: I think that the general equilibrium models with underlying growth, which is what’s dominated climate change modeling, are not fit for purpose. Because it’s assumption of underlying growth couldn’t withstand the dramatic changes in the environment the climate change could bring. It wouldn’t simply be where you’re losing a little bit. It’s actually you’re transforming what can be done, the nature of the economy. And that’s a fundamental importance. And, similarly, an economy with a given structure which works in equilibrium is not the story that we know we have to deal with, which is fundamental fast change on scale.

Stone: Can you tell me a little bit about the modeling that you did in 2006 for the Stern review? What were the inputs into that model? What were the outputs for the outputs that you expected and how do those outputs translate into policy decisions? And I want to ask one other important component of this, is the idea of of guardrails. So all of the decision making in the model has to work within this guardrail, which is the guardrail of addressing climate change, slowing it down before we have irreparable damage.

Stern: The Stern review is embarrassingly long. It was about —

Stone: 700 pages.

Stern: It was about 700 pages. You’ve read them all, Andy. And we looked at the problem from the point of view of the big risks of technological progress, the ways in which market failure occurred and so on. And that was this, if you like, in many ways, the centerpiece of what we were doing, building up that story. Because it was a Stern review, we had a review of the modeling. And in so doing, we used some of the standard models, a lot of those we’re these so-called integrated assessment models. So one chapter did use those, and we focused particularly on some aspects of uncertainty. But the formal modeling of the whole economy was based on that literature because at that time it was a review. But the bigger story in the Stern review where I think we were perhaps a bit more original, we built up the whole set of challenges. We tried to talk about the magnitude of the risks. We tried to talk about technical progress and and how you encourage the kind of technical progress that you need or encourage kind of investment you need.

But looking back, I think that we underestimated the risks. Looking back, we didn’t go far enough down the road of taking on immense risks. We could have been still stronger on guardrails. So what I’ve come to see in the 15 years or so since the Stern review, is that this is a story about transformation with enormous potential for growth and discovery. But in looking back, the stern review was, I think at the end of the period where that kind of modeling might have been appropriate, perhaps even beyond the end.

Stone: The modeling that goes back to Nordhause in 1990 or so?

Stern: Yes. So when Bill was setting up that kind of challenge, he said, “Look, here’s a new thing to think about. How do we fit it in with growth theory? How do we fit it in with the theory of externalities? There was a reasonable way to start, actually. But by the time we are now at 30 years since Bill’s original piece, I think it’s fair to say that we now see that the kind of risks that are at issue here are just too big for that kind of modeling. So the guardrail is an attempt to grapple with the idea that the risks that we’re inflicting on ourselves and those who come later are immense. And that the simple cost benefit framework of who benefits, who loses by how much do you balance those things is not going to work. So you’re going to have to try to get your head around the question of just how much risk could we possibly take and what’s reasonable to accept knowing that the precise consequences of what we are generating for future generations are very difficult to be precise about.

So that’s the kind of judgment that you have to make. So you have to look at the consequences as best you can, knowing that there are immense risks out there. It’s very hard or impossible to quantify, but knowing that the loss of life on an immense scale could well be part of that story. And then you look at what you can do, and how much you can bring that down and you come onto what it looks like when you do work to bring them down. And you ask yourself the question how much is too dangerous to handle? And that is the guardrail. Now, it’s what we would in philosophy call the consequentialist approach, as opposed to approaches about Aristotle. What it means to be good or kind of what is a categorical imperative about behavior. They’re different from simply consequentialist approach, but economics has generally followed consequentialism. You know, it’s generally ask the question what are the consequences of our actions? And we judge our actions according to their consequences.

So what I’m describing is still a consequential approach, but it’s not a narrow as it were, well, for rest or cost benefit approach in the usual sense because the risks are just so big. So you try to form a view thinking about the risks, thinking about what you can do and say we must try to prevent ourselves going beyond that point. Sometimes when you have dangerous cliffs, you rope off those cliffs. You will have seatbelts in cars to limit the risk. You’ll have cut off points in air pollution beyond which you should not go. And all of those examples of guardrails in this case, of course, we’re playing for risks which are so much bigger than those other risks. But I think we frawned as human beings trying to take decisions together that guardrails actually are a helpful way of thinking about the management of very big risks.

And that’s why I think in an international discussion, we’ve set targets like well below two degrees or as in Paris, or 1.5 degrees which was the central target or limit that people were thinking about in Glasgow in November of 2021 COP26. So in a sense, the international community and public discussion have come to an approach which is like that. And economics, I think, is catching up in some ways in saying, well, yeah, that’s what people have said is reasonable. That seems to be a judgment that people can come to collectively. So what’s the underlying structure of models or ideas? Models may be too strong. The structure of series and ideas that could point us towards that kind of approach.

Stone: So it’s very interesting what you just said. So you mentioned the Stern review came out at the end of this period where, and I’m going to go back to word that I used, a simplified word, an incrementalist approach to solving or addressing the issue of climate change. And then we realized from that point until today that we’ve got a much more dramatic problem that needs to be addressed. One of the interesting things that comes to mind as I’m thinking about this is, it appears to me that markets were intended to be the lever or the tool to solve many of these problems. Markets, I would assume, guided by policy. But you have said that climate change is the biggest example of a market failure and I assume not just was, but continues to be. Can you explain the concept of market failures and how you’re thinking may have changed from 2006 to today on the role, the capability of markets and the role of governments to guide the policy that shapes those markets?

Stern: Yeah. Market failure arises when markets do not signal the costs associated with decisions. So if you’re producing something, you expect to pay for the raw materials, for the fuel, for the rent of the land, and you expect to pay for what you use. But in the case of climate change, you’re not paying for the damage you do to others. So that’s an example of a market failure. If you make very loud noises on your radio and you disturb the person next door, then you’re thinking about the cost of the radio and whatever is involved, your subscription to Spotify or whatever it might be, but you’re not thinking about the damage that it does to the person next door. So that’s a market failure where there’s a cost that is real, but is not faced by the person who is driving that decision. That’s an example of a market value. And here this is, of course, a very big one because we all do it and the consequences are potentially immense. That’s why it’s the biggest market failure the world has seen.

But economics has quite a lot to offer in those circumstances. But how do you manage market failures? What I think I’ve come to see still more as time goes by, is that that’s not the only one. You’ve got R&D was extremely important. And, of course, ideas are public goods in the sense that anybody can pick them up and use them. And you don’t necessarily have to pay. You’ve got problems in capital markets where they really don’t handle risk all that well, do they? They do it to some extent. You’ve got all the problems of networks like public transport, electricity grids, where what one person does in those networks affects what happens to other people. You have to manage those through public policy. They’re all the important questions about information, what is in what you buy? You don’t know unless there’s some public policy that requires you to be told. And of course, there’s air pollution, not just air pollution, but it’s extremely important.

So what I think we’ve seen develop much more strongly and certainly has influenced me is this whole range of market failures. And within market absences, we can’t buy the technologies that we reckon we’re likely to need because you don’t quite know what they are 20 years from now. So they’re big market failures and market absences. But my reaction to that is not to abandon the markets, but do your best to bring policies which deal with those market failures. If you abandon markets, then you put enormous constraints on control systems which are supposed to know everything and when you tell people what to do. And our experience of abandoning markets is not very good. I mean, look at what happened in the former Soviet Union. Look how much more productive China got, what it went from a fully controlled economy to a much more or let’s say fair economy. So abandoning markets is not the way forward, trying to get the markets to work better and benefit from the tremendous entrepreneurship that there is out there, that’s the way forward.

Stone: So what would the prescription be for markets to better support innovation, to better manage risk, as you just mentioned? Carbon pricing is the most apparent one clearly. But are there prescriptions for solving those problems.

Stern: Yeah, carbon pricing is very important because that’s a basic market failure and it can be pretty powerful.

Stone: And some economists say that’s the whole solution right there, right?

Stern: But that’s just wrong because it ignores all these other market failures that are there and it ignores increasing returns and uncertainty. So some things you can do. Like, you can say, as we’ve done in the UK, you will not sell internal combustion engine vehicles off to 2030 or in Europe 2035. Or you say that we will make our whole electricity system zero carbon by 2040. Now, as those are very powerful markets signals, you’re not telling people what is going to be the right alternative to the internal combustion engine. You just saying you can’t do that because it’s so bad and so dangerous and so damaging. So you’re letting the markets determine what it is that comes forward to replace it. We have some ideas what it will be, but the markets will determine what it will be. So very clear, strong signals like that give people the confidence when there’s lots of uncertainty and increasing returns to scale, to go off and do their thing. To find, to be entrepreneurial and to create. So that’s the kind of ways in which markets are going to be the big solution to all this, and it’s going to be private investment on the back of discovery and innovation that’s going to drive us forward.

Stone: You know, there’s one other issue I think it’s really important to bring up as well, and that’s justice. And I want to ask, how do wealth and racial inequality change the context in which these systems operate?

Stern: Well, rich people, because they consume more, emit far more greenhouse gases than poorer people. Africa’s contribution to greenhouse gases is pretty minimal. United States probably emits per capita something like five, eight, 10 times what India does. And so we have an injustice in that the people who are the biggest movers of the problem, the biggest causes of the problem are not the people who suffer the biggest consequences. It’s poor people who are hit earliest and hardest. It’s children and women who are hit particularly hard by climate change in all sorts of ways. They often find it very difficult to move quickly when there are extreme weather events and and so on. So what you got is an injustice that the people who caused the problem, of course, they will suffer, but the people who suffer much more earliest and hardest are poorer people, and there’s a great inequity there. And, of course, there’s an inequity across generations. Is that the people who are going to be living 30 or 40 years from now are not the people who’ve emitted the greenhouse gases which are causing the problem. So there is a great injustices in terms of inequality and great injustice in terms of damages done to people who are not responsible for the problem.

Stone: Let me ask you a final question here, if I may. Are you optimistic that the reframing of economics you’re talking about will occur and that the solutions it will suggest are within our grasp?

Stern: I think economics is a very rich subject. And many of the issues I’ve been describing here, increasing returns to scale, uncertainty, discovery, innovation, there’s lots in economics about that. So what we have to do is to take our problem, look at transforming cities, look at transforming energy, look at transforming transport, look at transforming land and say, “How do we change these big systems? What collection of policies is going to help us change those big systems?” And then we have to stand back and say, given all these bits, what’s our judgment about how to put them all together? I wouldn’t try to force the whole thing through into one big model, but I would use a whole collection of rich models, ways of thinking about it, analytical approaches from economics. We have to develop some more along the way, but we’ve got to be clear, it’s immense risk, it’s fundamental change, and it’s real time.

Stone: Nick, thanks for talking. And once again, congratulations on receiving the Carnot prize.

Stern: It’s a real pleasure to be here. If I look at the predecessors, there are wonderfully distinguished group of women and men and a Carnot giant in this whole history and Pennsylvania a wonderful university.

Stone: Today’s guest has been Lord Nicholas Stern, chairman of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics. Did you know that transcripts of all energy policy now episodes are available on the Kleinman Center’s website? It’s true. The website has a lot of other useful information too, including blogs, policy research and a list of upcoming events from the center. To make it easy to keep up with us, subscribe to our monthly newsletter on our site or to our feed on Twitter. Thanks for listening to energy policy now and have a great day for.