Economists are getting to grips with how global warming will change the way we do business. For once, the dismal science may be overly optimistic.
Events such as holidaymakers fleeing wildfires on the Greek island of Rhodes make it increasingly difficult to ignore the effects of climate change. Calls for action are growing louder and economic policies to incentivise change are finally catching up.
But for decades, while the scientific community warned us about climate change, economists saw it as too far in the future, too insignificant and too uncertain to model with confidence.
Late to the party, economists are finally getting their arms around the complex interactions between climate change and the economy, and what this could mean under a range of different climate change scenarios.
Ostrich economics
In 2018, William Nordhaus received the Nobel Prize for Economics for tackling some of the fundamental questions about how we can create long-term, sustainable economic growth.
His pioneering work on economic-climate systems in the 1970s produced the ‘integrated assessment models’ still widely used in climate modelling. However, his research suggested that the economic effects of global warming would be trivial and the cost of emissions abatement would outweigh the benefits until global warming reached 4°C above pre-industrial levels.[1]
So while Nordhaus’s Nobel plaudit shone a light on climate change, it also celebrated one of the key proponents of climate gradualism, a view that did much to delay action and legitimise complacency and denial.
Time to get Stern
Since the 1970s, a growing body of research has reached conclusions vastly different to Nordhaus’s, but its champions struggled to be heard until the publication of the Stern Review on the Economics of Climate Change in 2006. Commissioned by the UK government and led by British economist Nicolas Stern, the Stern Review was a significant and influential breakthrough for those calling for more urgent action.
Stern estimated that if no action were taken, then climate change could reduce the global economy by 5% per year over the next two centuries. Under a worse-case scenario the global economy could shrink by as much as 20%.[2]
Alternatively, investing to reduce the worst of climate change could cost just 1% of global GDP per year. The Stern Review called for immediate action.
An international effort
Today, the drive to understand the interactions between climate change and the economy is an international project, ensuring greater commitment and accountability from countries around the world. It is led by the Network for Greening the Financial System (NGFS), a voluntary body of 118 central banks and regulators.
Uncertainty is inevitable in any long-term multi-disciplinary study, and the more complex the subject, the more uncertainty there will be. Needless to say, climate change is a complex area, and its potential interactions with economies vastly increases this complexity.
For this reason, the NGFS presents alternative scenarios for estimating economic impacts, based on the extent of warming from the pre-industrial age to the end of this century. They are not intended to be forecasts.
Its most optimistic scenario is “Net Zero 2050”, in which we achieve net zero by 2050 and, in accordance with the Paris Agreement, global warming remains within 1.5°C.[3] Under this scenario the NGFS estimates a 4% reduction in global GDP by 2050. The costs would be a mixture of adaption costs, comprising:
- Transition costs incurred in making the global economy less carbon intensive by reallocating resources from consumption to investment.
- Physical costs due to damage to capital stock and labour supply caused by chronic risks (such as lower agricultural yields and rising sea levels sea) and acute risks (e.g. cyclones and floods).
An arguably more realistic scenario is “Current Policy Trajectory”, in which the global economy would be around 8% smaller by 2050 and 20% smaller by 2100.
No model is perfect
The NGFS’s scenarios are being widely adopted by policymakers and regulators, and are increasingly used as a common reference for assessing climate risks. Like all models, they have a number of limitations that give pause for thought.
First, the models do not account for potential tipping points that could accelerate warming. For example, collapse of the West Antarctic and Greenland ice sheets and melting of permafrost in the Arctic could lead to abrupt rises in sea levels and an acceleration in global warming.
Second, the models’ assumptions may not capture all the relevant ways in which climate change will affect the economy. Nor do they account for feedback loops between climate and economy that could intensify climate change effects.
Third, modelling the damage and knock-on effects of physical risks is highly complex. The NGFS’s models do not attempt to model societal impacts caused by migration, climate refugees and conflict arising from physical risks such as water scarcity and crop failures.
Finally, there is the question of intergenerational equity and the assumptions used in the models’ calculations. Some assumptions give results that show climate change having a greater effect on future generations than on the current generation, implying a more urgent need to cut emissions as quickly as possible. Similarly, different assumptions about technological advancements that could mitigate climate change also alter the calculus.
For these reasons, it can be argued that the NGF’s least optimistic scenario of a GDP loss of 8% by 2050 may be an underestimate and should be seen as the likely minimum loss. Furthermore, the effects of climate change may take effect sooner rather than later, and be concentrated into shorter time periods.
Poorest most vulnerable
Headline GDP estimates aside, global aggregates conceal significant differences across countries. While emissions are a global problem, the physical and transition costs of climate change are particularly severe in developing countries.
These countries not only face more extreme weather risks; their economies also tend to be more dependent on climate-sensitive sectors such as agriculture, forestry and tourism. At the same time, tight fiscal budgets and pressing development needs make transition more difficult for these economies to achieve.
Who will pay?
Decarbonisation will inevitably mean higher prices for households and firms as the cost of carbon emissions is included in production costs and the prices paid by consumers for goods and services. Models from the NGFS suggest that a global carbon price of $200 per ton would be needed over the next 10 years to incentivise transition towards net zero by 2050, well above the current price of €90 euros per ton in the EU.[4]
This suggests that headline inflation could be 0.5% higher in Europe versus the baseline, and potentially more if a delay in transition necessitates a more rapid restructuring of the economy. We are also likely to experience higher food price inflation as agricultural yields become more volatile in response to the changing climate.
Lessons for investors
The NGFS’s scenarios provide a helpful common framework for gauging the economic effects of climate change, but many questions remain. We must bear in mind that the magnitude, variability and rapidity of the changes we will experience over the coming decades could defy our best efforts to model them.
Rather than presenting us with a definitive outlook, the NGFS’s work highlights the need for greater global commitment to achieving carbon reduction targets. It also underscores the need for vast levels of investment to facilitate the transition towards a lower-carbon economy.
For investors, this raises questions about the durability of their existing portfolios, the need for risk modelling tools such as Sarasin’s Climate Value at Risk (CVaR) and how to identify companies that will thrive in a radically changed global economy.
[1] Source: A Nobel Prize for the creator of an economic model that underestimates the risks of climate change, London School of Economics, 02.01.2019.
[2] Source: The Stern Review, The Economics of Climate Change, Summary of Conclusions, The National Archives, 2006.
[3] Source: all material relating to NGFS climate scenarios in this article is sourced from NGFS Scenarios for Central Banks and Supervisors, September 2022.
[4] Source: Ember Carbon Price Tracker, 01.08.2023
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