The economics of climate change is an investment analysis problem. Investment analysis is a branch of economics that calculates the expected risk and expected profitability of an investment. This is exactly what we are facing when talking about climate change. I will argue that investing into fighting climate change should be analysed like any other investment opportunity: whether it maximizes global capital, constraint to adverse risks. First, I will outline how we should measure global capital and how that links to the environment. Secondly, I will explain the Net Present Value (NPV) of an investment and whether we should take measures to invest into a greener future. Next, I will discuss concerns of uncertainty and risk in these models. Lastly, I will conclude that we should move to an investment-analysis-based policy approach rather than an emotional response to climate change.
(Image shows the Dice Model by William Norhaus, a complicated model, based on investment analysis (The Dice Model will not be discussed in this blog))
Before we start discussing any policies, we need to define what we want we want to maximize. One approach is to define our outcome variable (the measure we want to maximize) as global capital. This measure encompasses a variety of factors including the quality of life, quality adjusted life years, peoples’ health, as well as animal wellbeing. We can convert all these factors into monetary value via various measurements (I have discussed this in my blog post “Corona and the Value of Life”). We need to put numbers on things we like, and the most salient way of doing that is by pecuniary evaluation (See salience in Experimental Economics). Thus, our outcome variable is Global Capital. This needs to be maximized. It includes everything we value, thus that we spend money on, thus giving us a single number.
Now that we have defined what we need to maximize we can think of how to best maximize it. In investment analysis one calculates with Net Present Values (NPV). The NPV discounts gains in the future with expected risk free interest rates. Let us assume that the risk-free interest rate is 20%. If you invest 100 Euro into a stock today and expect 110 in a years time, this was a bad investment. Your Net Present Value is negative. You could have gotten 120 by saving it in a bank with interest but you chose to invest it and only made 110, thus 10 euros less. This is how you discount future gains. We can do the same thing for Global Capital. We have 100 Global Capital now. Lets assume that there are two investment scenarios:
(a) We invest 10 of our global capital to fight climate change and we expect to get 50 global capital in 20 years. (The gain constitutes: We live healthier lives, air pollution went down, the ecosystem is in tact…)
(b) We invest nothing into fighting climate change but instead invest 10 of our global capital into the economy at an interest rate/return. If the interest rate is above 8.4% (=10*(1.084^20)=50) then we should not invest into a greener planet and rather invest elsewhere (This gain might constitute more money for innovation, R&D for deadly diseases…)
Thus, we should invest into global warming based on our best assumptions on what this investment will yield (a), compared to what the next best alternative investment will yield (b). The highest NPV wins. This can be extrapolated further… If the return on investing into the economy is even higher, then we should abandon restrictions and taxes on coal-based energy and pollute even more. We can offset the negative externalities of cheap coal power, with an extremely strong economy, leading to more capital gain. Interest rate (return on economy investment) must be pretty high for this to be true.
Every time I outline this theory, people immediately jump to the uncertainties in this model. The argument always is: “Well what if we miscalculate the costs of not investing into greener energy and the world goes to complete shit”. I agree that we should not only focus on the expected value of (a) and (b) but also on how bad thing could get in (a) and (b). This would introduce a volatility or risk variable; A sort of Sharp Ratio (Risk-Return measure) should be implemented. That being said, we only have certain expected value and risk estimates and we should work with them. We don’t know the costs and benefits of investing into a greener world, or interest rate on investing into the economy for the next 20 years. For the former we must rely on different scenarios that scientists predict and the probabilities of those happening. That will give us an expected value (risk adjusted- here arbitrarily denoted with scenario (a)). In the latter case (scenario b) we also need to calculate an expected return on interest rate and the economy. These aren’t fixed estimates. They are constantly updating with current information. We should calculate their risk and return and come to a conclusion: how much we should invest into a greener future.
My main point is that investing into greener future, is just another investment that must be analysed and compared to opportunity costs (next best alternatives). Our best estimates, including risk and return, must inform our macro decisions, and our micro activities. If you are the person involved in environmental activism, demanding that “more” should be done for the environment, you should also know how much “More” should be, and investment analysis should be the way to calculate it.
This is the simplest model of economics of climate change. More complicated models like the Dice Model earned William Nordhaus the Nobel Prize in 2018.
In theory maybe, practically not without oversimplifying it. There is way too many variables with way too many dependencies. Not only on the climate-science-part but also with people as pseudo-rational actors in an uncertain environment. Even if they would consider all humans currently living, they do not have the necessity to think for many generations but can simply maximize the utility up to their death.
Hi Giov, I disagree with your first point. I think one can calculate the NPV of any investment even if all investment opportunities have a negative cash flow. In general I proposed a binary option in which one can invests into a greener world or into something else. Looking at the benefit of these investments in NPV terms I think is still valid even if they were both net losses (as you call them "merely expenditures")
I agree with your further points. In practice there are many problems. I do still think that one can calculate how much investment should be dedicated to environmentalist causes. Thereafter one can calculate how much a single country (Your point 1: geography) should contribute…
I feel you are mixing up many different topics: For calculating an NPV you need future cashflows that you discount to the current date. As many public investments do not generate any cashflow but are merely expenditures, this may be very, very tricky.
The general problem with economics of climate change is that in most cases, the market is not pricing in the externalities of polluting . This is the go-to example of market failure. This failure is caused by three main reasons:
1. There is not one global market, but many different ones. Often with geographic boundaries.
2. How do you price something you know very little about? The impact of climate change if the famous two degrees are…