Clarity is Crucial
Lord Stern. Article in the Financial Times Climate Change magazine, 2 December 2008.
Can business “save the planet”? The answer is unquestionably “no”, if one means by this “business, on its own”. Businesses respond to incentives. But climate change is what economists call an “externality”. Businesses will respond – or, in the technical jargon, “internalise” externalities – only if it is in their interests to do so. It is government's job to ensure that it is.
It is not in the interest of profit-seeking businesses to internalise externalities, since they will then be unable to compete with competitors who do not. It is particularly hard to do so when internalising the relevant externality is costly and the externality is generated by the activities of a large number of producers.
In the case of climate change, both conditions apply with extreme force. This, many would argue, is the ultimate externality. It will affect not only all human beings, but all life. Moreover, it will do so not just over centuries, but, given the possibility of mass extinction, forever. Not just every business, but every human being is part of the anthropogenic carbon cycle. Moreover, it will be costly for individual producers to lower emissions dramatically.
Thus, effective action to “save the planet” from climate change requires political action. Only if the right global policies are in place will business play its part in delivering the desired outcomes.
The question then is how such policies should be designed. Starting from this point is to ignore the still lively debate on whether man-made climate change is plausible or its dangers correctly assessed.
I, at least, find persuasive the argument of Professor Martin Weitzman of Harvard University that it is worth paying a great deal to eliminate what seems to be an appreciable risk of what might prove, some decades hence, an irreversible journey towards catastrophe – a change in the climate system so drastic as to destabilise the biosphere.
It should be stressed that use of conventional discounting collapses in the context of such widely divergent outcomes for the entire economy. The discount rate is not a constant, but depends on the path of future incomes (or, more broadly, of utility). On any path on which incomes collapse at some point in future, appropriate discount rates are likely to be negative, not positive.
So what are the policy options? Lord Nicholas Stern of the London School of Economics, author of the UK government's 2006 report on climate change, has analysed the issues in a recent paper.
Lord Stern starts from a few simple propositions: first, the concentration of CO2 equivalent in the atmosphere is now 430 parts per million and is rising at the rate of two parts per million a year; second, the aim should be to stabilise concentrations at between 450 and 500 parts per million; finally, to achieve this, global emissions of greenhouse gas equivalents must peak in the next 15 years and fall by at least 50 per cent, relative to 1990 levels (which are themselves about 90 per cent of 2005 levels), by 2050, when global average emissions per head must be as low as two tonnes per head.
Historic trends and current emission levels indicate how big a change from “business as usual” these goals are: two tonnes per head is 10 per cent of recent US levels and half of China's. Yet, argues Lord Stern, this must happen if one takes the risks seriously. Worse, the longer the world waits, the bigger reductions must be, because the gases stay in the atmosphere for centuries.
How is this to be achieved? Any set of policies has to be effective, efficient and equitable. Let us examine each of these criteria in turn.
To be effective, the policy will need to reduce emissions sharply. The implication is that every activity and virtually every country will be affected. Developing countries, which will contain close to 90 per cent of the world's population and generate the bulk of the world's emissions by 2050, must make a substantial contribution. On this, US insistence is correct. The long-run world average of two tonnes of CO2 equivalent per head is so low that no country can go much above it.
The challenge is huge. in order to achieve such objectives, emissions from high-income countries need to fall by a factor of five. But their economies are also expected to expand two or three fold. So emissions per unit of output need to fall by a factor of 10 to 15. These are extraordinarily demanding objectives that will demand a transformation in the carbon intensity of all economic activities and across the whole of business.
The sectoral implications are also dramatic: big efforts will be needed to halt deforestation, for example, which currently contributes some 17 per cent of man-made emissions; electricity generation, the largest single emitter, will need to be carbon-free by 2050; and the global vehicle fleet, projected by the International Monetary Fund to increase by 2.3bn vehicles between now and 2050, must become largely carbon-free, as well.
Efficiency is as easy to define as it is hard to accept: the marginal cost of reducing emissions should be the same in all activities everywhere. The price of carbon – whether set by a “cap-and-trade” scheme on emissions, a carbon tax or a hybrid – should also be the same everywhere. That China is now the world's single largest emitter shows how vital it is for emissions to be priced there, too.
China's emissions per unit of gross domestic product (at purchasing power parity) are double those of the US and three times those of Japan. So far as possible, therefore, the best technology must be used everywhere. Yet the existing set of low-emitting technologies is not fully diffused across the globe.
Achieving this could, argues Lord Stern, reduce emissions by between five and 10 gigatonnes per annum by 2030 (10-20 per cent of 2005 emissions). Big efforts must also be made to develop and scale up nearly commercial technologies and create new ones. The fact that all the needed technologies do not yet exist makes estimates of what it will cost to achieve the targets an educated guess. This includes Lord Stern's figure of 1 per cent of global gross output. It might turn out to cost considerably more.
If such changes are to be achieved, policy will need to do substantially more than impose a price on carbon, important though that is. It will also have to use co-ordinated regulatory standards and subsidisation of the development and application of new technologies. Fortunately, many (though not all) of the relevant technologies will be energy saving and will, therefore, kill two birds – reducing use of increasingly scarce energy resources and lowering the risks of climate change – with one policy stone.
Yet the most intractable challenge of all is equity. Emissions have to be reduced everywhere, but the cost of doing so need not be borne by everyone. There are three powerful arguments why costs should be borne mainly by high-income countries: first, they created the current problem; second, they still emit far more per head; and, third, they can afford it. Three-fifths of the stock of man-made greenhouse gases was emitted by the high-income countries. In 2005, US emissions per head were also five times those of China and 17 times those of India.
So how is it possible to ensure the same price for carbon everywhere, while imposing the costs on rich countries? One answer is by paying for reductions in emissions in developing countries, while not penalising them for failure to meet targets. Such a scheme exists: the “clean development mechanism”. Its principle is reasonable. The difficulty is defining and measuring benchmarks, monitoring achievement and covering entire economies.
Yet this, however difficult, is the way Lord Stern suggests the world should go up to 2020, when developing countries should also adopt limits. He suggests, specifically, that the current mechanism needs to move from a projects-based one to a “wholesale mechanism, perhaps based on sector-specific efficiency targets or on technology benchmarks”.
Can this be made workable in China, India and other emerging economies? To be honest, it is not obvious. But it seems to be the only way forward. Moreover, persuading developing countries to accept binding limits even in 2020 is bound to be hard, given the gross inequity of the starting point.
What does this mean for business? The most obvious answer is that business cannot be certain, because the policies government intends to adopt are themselves still uncertain. But, for far-sighted businesses, the plausible view is that both climate change and ever-tightening climate change policies are realities. Businesses should plan both their long-lived investments and their research and development in this light.
This is much the most complex collective action problem in human history. Solving it requires concerted action among unequal participants over at least a century. But humanity will have to try and business will have to play its part. But first business must demand from government what it will most need: a clear and consistent global policy framework.
Martin Wolf is the FT's chief economics commentator