The Green Swan

Conventional approaches to pricing carbon fail to capture risk of climate catastrophe

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“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

- John Maynard Keynes

There are two conventional approaches used by economists to determine the appropriate price of carbon, depending on what objective policymakers are trying to achieve.

The first is often associated with the economist Arthur C. Pigou and is set at the marginal social cost of carbon (SCC). The objective here is to internalise the cost of the negative externalities resulting from greenhouse gas emissions. The second was originally advocated by economist William Nordhaus. He was the first to use a dynamic integrated climate model (DICE) to estimate the carbon price necessary to attain a given temperature objective (e.g. 1.5 degrees of warming).

Both approaches use integrated assessment models that seek to quantify the link between economics (e.g. agriculture yields, human health and productivity) and the climate (e.g. temperature changes and biodiversity). Each involves applying an appropriate discount rate that translates the future net cost of climate damages and mitigation into equivalent values experienced today (see Everything you need to know about the Social Cost of Carbon (SCC)).

However, both approaches fail to price in the extreme uncertainty inherent in climate science; the impact that rising carbon concentrations will have on global temperatures, what this will mean on a regional level and the risk of extreme weather events, what this might for the economy and society at large given uncertain technological change and adaptation strategies. All we know is that things are going in the wrong direction.

For example, a recent meta analysis of 5,900 SCC estimates, across 207 papers, published over the course of four decades found assessments of climate change and its impacts have become much more pessimistic over time. According to Professor Richard Tol, professor of economics at the University of Sussex Business School and one of the authors of the report, "The central estimate is that the social cost of carbon becomes 2.2% larger every year. We have found that every ton of carbon is four times as damaging now as it was 10 years ago.”¹

Tail risks are the big problem, one that conventional models fail to tackle. Climate models are poorly calibrated to deal with the risk that climate tipping points could result in extreme adverse climate impacts, so-called non-linear impacts. At the far end of the risk curve, climate change could lead to ruin. Ironically for a book entitled The Climate Casino: Risk, Uncertainty, and Economics for a Warming World, it’s author, William Nordhaus devotes barely two pages to the subject of risk and uncertainty, concluding only that “A sensible strategy would suggest an insurance premium to avoid the roulette wheel in the Climate Casino.”

DICE models such as that developed by Nordhaus assume that societal risk preferences (i.e. our willingness to substitute consumption across states of nature) are equal to its willingness to substitute consumption over time. It’s known as the constant-relative risk aversion (CRRA) preference. Since the economic damage to societies consumption is assumed to occur far into the future, a CRRA utility function with a high level of risk-aversion results in a high discount rate and a low carbon price.

The outcome of both approaches is that carbon prices tend to start off very low and then increase gradually over time, as the damage arising from climate change begins to become clearer, and the cost of abating the marginal unit of carbon rises. Supporters suggest that small course corrections over time mean we will avoid hitting the proverbial iceberg. A low and steady carbon price doesn’t rock the boat too much with the voters, and so it’s politically acceptable too.

An alternative approach to pricing carbon - one that seeks to capture the risk of ruin - suggests that that prices should start at an extremely high level, and then only gradually fall over time as climate uncertainty dissipates. This view is centred on what is commonly known as “The Precautionary Principle (PP)”, developed and popularised by a number of experts in risk and complex systems, but most notably Nassim Taleb:²