Thursday, October 15, 2009

Blog Action Day Post: The Risk-Return Tradeoff in Climate Change Action

Ezra Klein has alerted me that today is Blog Action Day, "an annual event held every October 15 that unites the world’s bloggers in posting about the same issue on the same day with the aim of sparking discussion around an issue of global importance." This year's issue is climate change.

So in doing my part I thought I would highlight a large study lead by Oxford trained economist Sir Nicholas Stern on the economic costs and benefits of global warming action. The study concluded that large expenditures to combat global warming were more than paid for by the economic benefits of avoiding potentially extreme global warming costs to the world.

One of the criticisms, though, was that Stern's team applied too low a discount rate to future economic benefits of decreased global warming. And some of these benefits are far in the future. For example, the report has forecasts of GDP in the year 2100.

If you look at the Wikipedia entry on the Stern study. You see several counters to the low discount rate criticism. Nobel Prize winning economist Kenneth Arrow says that the large investment in global warming action may be justified even with a discount rate up to around 8%. And in the face of somber new evidence, Stern in June doubled his estimate of the justified amount of spending on global warming (the original study was in 2006).

You also see a lot of discussion of things like pure time preference rates, not favoring the current generation over future ones, and comparison to market rates of return. But what I did not see, at least not explicitly and clearly, is the risk-return tradeoff. And this is something I have rarely seen in global warming  articles and discussion. But it's crucial (an outstanding exception is a 2007 article in the Economists' Voice by Nobel Prize winning economist Thomas Schelling, "Climate Change: The Uncertainties, the Certainties and What They Imply About Action").

The risk-return tradeoff says that the higher the risk of an investment, the higher an average rate of return you will, or should, require. But it also says, conversely, that the lower the risk of an investment – or the more risk decreasing an investment – the lower an average rate of return you will happily accept.

What average rate of return do people happily accept for fire insurance for their home? A negative one, not just a low one, a very negative one. People even accept a very negative return for insurance on their car.

So what return would you accept for fire insurance on the planet you, and your children, and your grandchildren will live on? Scientists aren't that sure what exactly will happen with global warming. The feedback effects could get out of control and devastate the planet.

Stern's study justifies large spending on global warming even using positive rates of return (or discount rates). But when you use a negative, insurance like, rate of return, then clearly it becomes far more than worth it to spend at least moderate sums combating global warming, sums much greater than anything that's currently being discussed.