The Economics of Climate Change

How much should countries spend today to avoid climate change impacts that may be far into the future?  A renown economist discusses the emerging discipline of climate economics and explores means of efficiently putting mitigation funds to work.

How much will global warming cost future generations, and how much should we pay today to avoid the damage a warming climate will cause? Economist Per Krusell, a visiting scholar at the Kleinman Center for Energy Policy and member of the Nobel Prize for Economics Committee within the Royal Swedish Academy of Sciences, discusses the challenge of accurately pricing future damages expected to arise from climate change, and how future costs are reflected through the social cost of carbon. Krusell also highlights how climate economics attempts to guide policymakers toward strategies that make best use of limited climate mitigation funds.

Andy Stone: Hello and welcome to the Energy Policy Now podcast from the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m Andy Stone. Two issues repeatedly stymie efforts to aggressively address the challenge of climate change. The issues, how much it will cost to curb warming and prepare for its effects and who will bear these costs, frequently play out in the political arena where divisions form between expected economic climate winners and losers.

While the science of climate change is generally understood. Understanding of the costs of global warming remains murky in the public eye. Today’s guest is Per Krusell, an economist whose focus is on understanding the economic impact of global warming. Per is here to shed some light on the cost of climate change and offer insights into policies that might help manage these costs. Per, welcome to the podcast.

Per Krusell: Thank you very much.

Stone: Per is a Professor of Economics at Stockholm University and a member of the Nobel Prize for Economics Committee within the Royal Swedish Academy of Sciences. He is currently a visiting scholar at the Kleinman Center for Energy Policy and he’s currently working on a long term project on the interaction between climate change and the economy. Per this is a timely topic. What specifically are economists referring to when talking about the costs of global warming?

Krusell: Yeah, that’s a good question. Actually, it’s a harder question than you might imagine because climate change changes the preconditions for production. It affects people’s health and so on. And so it’s very complicated to answer that question fully.

 And I think we know less about this question than we do about climate change as a natural science phenomenon, but economists have a number of ways to measure the costs. And for some regions it’s actually a benefit because it’s nicer with warmer weather. So, I think there’s just a long list of different things you can do as a researcher to narrow down these costs and they vary depending on which region you’re in.

Stone: Interesting. So in some places there are costs, in some places there are benefits?

Krusell: Yes.

Stone: How did you get involved in this?

Krusell: My background has no environmental economics in it. I simply have been working as a macroeconomist for many years, but what happened was that as a result of the Stern Review coming out, about 10 years ago, many economists and climate scientists decided to maybe start approaching each other and work together. And there was an initiative in Stockholm where somebody asked me, are you interested? And the reason they asked me is that I’m kinda good at the global economy and figuring out macroeconomic impact of things. So I was asked and then I thought, well, this seems like a good way to use my skills.

Stone: You mentioned the Stern Initiative. Was that an earlier research into economic studies?

Krusell: No, so the Stern Review is simply something that came about as a result of the Ministry of Finance in the UK. They decided to look into the issue of climate change from an economics perspective and Nick Stern, or I believe Lord Nick Stern, is a well-known economist who was put in charge of this. And then he wrote this long report referred to as the Stern Review. And it came up with pretty big numbers and big enough numbers that a lot of policymakers open their eyes to the topic. So a lot of people were influenced by his review.

Stone: The impacts of climate change in terms of the weather impacts the, the environmental impacts, are very complex, but the impact on economics and the cost of climate change are something that I think are, in certain ways, even more complex and not very well understood. How well are these understood by governments who have to deal with these issues?

Krusell: I would say not very well. I mean, what you can do, of course, is that you can read through the most recent literature and the most recent literature has numbers that you can use as, you know, guidance for what to do in policy. But to really understand the issue, you would have to really get down to the nuts and bolts of how we researchers measure these things. But I think governments are aware of the costs and that they can be substantial in some regions. And so I think there’s clearly an awareness. I think the challenge is maybe more on the implementation side, what to do.

Stone: Are the numbers out there at this point?

Krusell: Yeah, I think the numbers are out there, and they’re being discussed and there’s a lot of disagreement on numbers as well. So of course, and particularly because I think the economic side of climate change is the area where we know the least. So I think there the uncertainties even bigger than just in terms of the question of how much will earth warm as a result of emissions.

Stone: Okay. So let’s jump to the numbers here. How much does preparing for and mitigating climate change cost? And how much do we need to spend today? And this could be globally, nationally.

Krusell: Yeah. So we think about it from the economics perspective by computing something we call the social cost of carbon, which is what is the net damage of emitting a unit of carbon into the atmosphere in terms of these costs that occur in a variety of places and in a variety of forms. And so per each unit we can comput, in dollar terms, what the cost is that the emitter, for example, you, when you drive your, I dunno, motorcycle to work.

Stone: I wish!

Krusell: How much should you pay extra for that unit that you emit? And the numbers in terms of dollars are, they go in a huge range because there’s not one number. And the reason is that there’s the philosophical input into the number, which is how much do we care about future generations? And that’s something that economists can’t decide.

I mean, we do the computations. If you tell me, I don’t care about future generations, then the number is kind of a low number. If you say, I care as much about future generations, as I care about this generation and myself, you got a huge number. So it’s not up to us to decide what that number is, but, you know, we can provide some guidance. We can say here are some frequently used ways of thinking about how you compare the welfare of future and current generations. And then based on that, I can give you a number. So I can tell you that the one that’s used in Sweden is actually $600 per gigaton of carbon and gigatons of carbon doesn’t maybe tell you very much.

Stone: You mean, each ton of gigaton of carbon causes $600 of damage?

Krusell: Of damage on net across the globe.

Stone: Okay, so it’s future damage?

Krusell: That’s current and future damage and it’s sort of occurring now. And then if you emit a unit or a gigaton of carbon, now it’s going to cause damage now, a little bit more in a few years because the warming takes a little bit of time. So the warming is a little higher in a few years, and then it’s gonna slowly decay, but it doesn’t decay to zero. There will be warming from that unit you emit today in 200 years from now 500 years from now.

And the reason is that carbon stays in the atmosphere very long, and that’s one of the issues. And that’s why it really matters if you put a big weight on future generations or not, because it stays in the atmosphere so long. So, the Swedish number we, or I shouldn’t say we, I mean, the Swedish government has decided to have a high number in their calculations. And they’ve also implemented a carbon tax that’s very high and that’s in line with their high number and they put high weight on future generations. And it means, actually I did the computation this morning, it means that you would basically add a dollar to each gallon of gas that you buy.

Stone: In Sweden?

Krusell: No here.

Stone: Okay.

Krusell: So suppose we were to use the tax used in Sweden, which is based on a high weight on future generations and the numbers of out there for the damages today and the damage in the future, it would be like a dollar more expensive to buy a gallon of gas.

Stone: Interesting. So there’s a moral part to that calculation?

Krusell: It’s a big moral part.

Stone: So the social cost of carbon, and interestingly enough, timely enough in the United States, there’s been discussion particularly within the Trump Administration of what that social cost of carbon should be. Can you give us a little bit of insight into what the conversation is here at this point?

Krusell: Well, I’m not sure I’ve followed the latest, but I think that there is a big range, first of all, of views in terms of the pure climate science of it. I think there, the economists don’t really participate much because it’s a matter of climate scientist A saying something and climate scientist B saying something slightly different that has to do with simply how much will temperature go up when you drive your motorcycle.

And I think there is clear uncertainty, and I think you can take the view that the temperature won’t go up very much. It just will not be a big problem. But the people who say that they are not really sure. So I think it’s kind of wise to go somewhere in like the middle of the range of what people think. And then I’d say, yes, there’s warming. So that’s, I think there’s debates over that.

Then there’s debates about how will this benefit say the U.S.? How will it benefit other countries? And there, I think that you could be influenced by whether you care about the outcomes for the U.S. only, or whether you care about the world. And I think there that’s another big source of disagreement between whoever participates in this debate. I think sometimes, maybe that is the focus simply on the U.S., simply on the international, that’s a big determinant of who thinks what, I think.

Stone: You’ve indicated there’s a lot of uncertainty here. If you’re looking into the future and damage that may come from coastal flooding, for example, what specifically are you looking at in terms of when you’re doing your calculations? What are you taking into account, a loss to business ,loss of revenue for the municipality, whatever it may be.

Krusell: So these kinds of calculations, I have to say first, I mean, I’m a researcher I have to answer. I don’t do them myself. I rely on the research that other people do. And I think that this particular question has attracted some attention, but hasn’t been researched enough.

So I think in the U.S. this would immediately make you think about what ways you might have of protecting yourself against the flooding and what the cost of that might be. But if you’re looking at Bangladesh, a country that’s populated by a huge number of people, they are under the threat of sea level rise. And there I think that the policies there that are contemplated don’t involve building walls or protections. It’s simply about how much is it going to cost when the flood comes and when people have to move to different areas.

So I think depending on where this occurs, the way to do calculations about it is a bit different depending on if it’s a rich country that can take some sort of precaution to prevent damages. How much does that precaution cost? Or if it’s poor countries that probably can’t afford to do that. And they just have to kind of, we have to calculate, what do we think is going to happen when the flood really comes. A flood, or when the sea level rise will make it more frequent to see floodings in highly populated areas.

Stone: Again, is there a number, global GDP, what we would have to spend to address climate change? And a range?

Krusell: The way I think about it is that I’m a believer of the use of social cost of carbon to guide the policy choice of how to address limiting the warming. I don’t think we should stop the warming entirely because it is efficient to use fossil fuel, so I think adding a tax is a good idea in principle. And so that’s, I think the right way to address global warming, add this tax that I think should pay because you incur costs on other people by emitting fossil fuels.

Of course, when a flooding occurs, you have to deal with it. It occurs even today. So, you know, we should take precautions against those regardless, and rich countries do a better job. They’re richer, they can do it. So I think the way to think about climate change maybe is more mitigation. We should make sure that you pay the price of, the real price of emitting carbon. And then it’s about this carbon price. You don’t need to use a tax on carbon. There are alternatives but that’s kind of the primary way of thinking about it. At least I think.

Stone: You’ve written it certain investments in certain areas in mitigation actually bring better returns. For example, investing in a rich country versus getting mitigation efforts in an emerging country or an economically developing country. Can you tell us about that?

Krusell: Yeah, so I think, again, I’ll use my country of birth Sweden as an example because we didn’t really stand out in terms of having a very high tax on carbon and most politicians stating clearly they care a lot about this issue. They want to do something.

So in Sweden, you pay very high taxes for every unit of carbon that you admit and there’s currently, seems to be an agreement among all major parties that we should cut our say gasoline use to zero by 2030. I think that’s a crazy policy because I think the Saudi oil, for example, is very cheap to produce. It’s enormously beneficial for us in creating energy and it’s efficient to use it. So I think that the notion that everybody should go to zero, everybody should cut their own emissions to zero, is just not a reasonable rule of thumb.

Instead, you should cut it where it’s not very efficient. And I think there are plenty of examples, even close to Sweden in Europe, where they use very inefficient sources of fuel. I mean, where, for example, coal, that’s very expensive to produce. It produces a manager, but that business is barely profitable. Just put a tiny tax there and that coal won’t be used. That will be socially beneficial because the cost is too high. So I think looking outside of your own backyard is a good idea, in this case.

You should cut the use of fossil fuel where it’s not very efficient and that can be in poor countries, but there are many examples where in poor countries, they really need some source of energy and they don’t really have an alternative. And then I think they should use it there. But so I think it varies from area to area. You should think, where is it, where’s the best place to cut. And as an economist, I just have to use economic efficiency here. I mean, I’d rather than other rules of thumb.

Stone: We have a range of renewable subsidies today in the United States, but no carbon price, are a carbon price and subsidies for clean energy and efficiency, actually the opposite side of the same coin?

Krusell: Well, you might, you might think they are, but I would, first of all say that if you use a carbon price, if you use a tax on carbon, then it’s not clear, you have to subsidize a green technology because, green technology lives its own life. If it’s efficient it will be produced by firms. They will realize that there’s a tax on coal, okay. That opens up for alternative energy sources and maybe we don’t even need to subsidize them. So if we tax carbon, I think you’ll see automatically the emergence of green technology. That’s number one.

But if you don’t use a tax on carbon, then I think you do need to subsidize green technologies. The problem I see with subsidies to green technologies is that it opens up for kind of a lobby of green technology firms that claim that they are the best new energy form, but they’re really not that good. And unless they become good enough that they challenge say the coal industry, or worldwide I’m referring to not specifically the U.S. coal, but unless the green technology becomes so good as a result of these subsidies, that it really beats the fossil competition. It’s not really of use from the climate perspective. You see that what we need to do to limit warming is to limit fossil fuel emission. And if we don’t, we don’t manage the problem. So it has to be that this green technologies beat the bad fossil fuels, the ones that are not so efficient.

Stone: Can countries go at it alone on carbon pricing? If one country introduces a carbon price, can it still be globally competitive with other countries that don’t?

Krusell: This is a frequently asked question. It’s a good question. I think the empirical data-oriented way to answer this question would be to say, let’s try to randomly make some countries use a high carbon price and see what happens to them. Okay. We don’t have these experiments. So I can’t tell you, yes we know. We know we do have Sweden again as a little bit of an experiment, because for whatever reason, Swedish, governments decided to do this. So you could see how Sweden faired and I think Sweden faired very well, actually, we’ve experienced the same great recession as you have here in Europe.

Stone: How far back do the Swedish taxes go?

Krusell: Well, they started with a tax already in the 1990s and they have then raised it initially, some industries were exempt, but now I think pretty much all the industries pay this price. We don’t just pay it at the gas pump. I mean, it’s paid by industry. And as a result, you might expect that these companies try to relocate abroad where the price of energy is lower, but that hasn’t happened so far.

We are in a fortunate situation, or Sweden is in a fortunate situation, in that we have quite a bit of hydro-power and we have nuclear. So it’s not like we were completely dependent on fossil fuels, but I think the Swedish example suggests that you can go at it alone, probably, or to a larger extent than we may think. I think the answer to why this might be is that there’s a lot of energy saving that can be done, low hanging fruit.

Stone: It just doesn’t cost much.

Krusell: It doesn’t cost that much. And then there’s green technology. So we, of course, Sweden has adopted various forms of, various forms of green technology. Some of which are very efficient, some of which, you know, we’re still trying out. So I think the answer is probably yes, but I, you know, I would want to see more countries try it before I’m absolutely sure. But my belief is that yes, it would be possible to actually go at it alone, but it would be better if all countries or more countries did it at the same time.

Stone: A price on carbon shows up generally in two different ways. The way we think about it, one is a carbon tax. One is cap and trade. From an economist’s perspective, is one better than the other?

Krusell: The economist would say actually, the economists would typically say, well, let’s assume this and let’s derive, a theorem that says they are equivalent. So they are in some ways equivalent, namely if you set the cap on these trading of emission rights, set it in such a way that the price in the market of an emission right, so a firm would need to buy an emission right to emit the unit. If the market price becomes the same as the tax, they would have had to pay under the tax system. You know, it’s, it’s the same it’s equivalent.

So under some assumptions that economists make, yeah, they’re equivalent. But in the EU, this system was adopted and the price of this emission rights was initially, kind of at the medium level, it was almost somewhat costly for firms to use them. But then as a result of the great recession and low demand, firms didn’t use so much energy and the price went down all the way to almost zero. So now there effectively is no tax on carbon in Europe, even though there is a cap-and-trade system.

So I would say no, that didn’t work very well in practice. You could imagine ways of fixing it, but the fixing it would have to involve, okay, lower the cap would just withdraw a lot of trading rights from the market. I mean, you could imagine a central bank that transacts in the market for trading rights and just buys up a lot of trading so the price goes up. So as to hit the appropriate price of carbon that, you know, you would have, if you had a tax. I think tax is easier for that reason. It looks too complicated to run a cap-and-trade system. But by all means if a region wants to do that and does it well, it’s okay.

Stone: Here’s the million-dollar question. Is there a politically feasible way to price carbon?

Krusell: I think political feasibility is yes, a million-dollar question. And I know that a tax on carbon can be viewed as very threatening. I think one idea might be that if you use revenues locally, so suppose you tax it at the pump, but the revenue doesn’t go to Washington, the revenue goes to the local community, maybe to be used towards schools, or what have you. Then I think people might feel a bit more like they’re actually in charge of themselves.

They participate in the fight against global warming, but they actually get some benefits back, which is that they get more revenue for whatever needs you might have and different local communities could use this money in different ways. So I think that’s an idea. It’s a way of thinking about a tax that is, I think, less problematic, but I think it’s an open question, really. I think one that would be a good attempt, you know, try it out, try out the local version, why not.

Stone: Per thanks for talking.

Krusell: Thanks a lot, Andy.

Stone: And thanks to our listeners for tuning into Energy Policy Now. If you like the show, please get the word out by giving us a positive review on iTunes or whatever platform you use to listen to podcasts. Energy Policy Now is on iTunes, Google Play Podcast, Stitcher, SoundCloud, and others. And for updates on research and events from the Kleinman Center, subscribe to our Twitter feed @KleinmanEnergy. Have a great day.


Per Krusell

Professor, Stockholm University
Per Krusell is Professor of Economics at Stockholm University. His research focuses broadly on macroeconomics, and the impacts that result from technological change and economic policy.

Andy Stone

Energy Policy Now Host and Producer
Andy Stone is producer and host of Energy Policy Now, the Kleinman Center’s podcast series. He previously worked in business planning with PJM Interconnection and was a senior energy reporter at Forbes Magazine.