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Slide 01
Economics of Climate Change
- Markets, Externalities, and the Price of Carbon
- How economic theory and policy tools can address the greatest market failure in human history.
- Environmental EconomicsPolicyExternalitiesSustainability
Slide 02
The Greatest Market Failure
- "Climate change is a result of the greatest market failure the world has seen."Nicholas Stern, The Stern Review, 2006
- Greenhouse gas emissions impose costs on society that are not reflected in market prices. This classic externality problem means that emitters do not pay the full social cost of their activities, leading to excessive emissions and inadequate investment in clean alternatives.
- $680B
- Annual climate damages (est. 2024)
- 421 ppm
- CO2 concentration (2024)
- 1.2C
- Warming since pre-industrial
Slide 03
Externalities and Public Goods
- Climate change involves two fundamental market failures simultaneously: negative externalities from emissions and the public good nature of climate stability.
- Negative Externality
- Every ton of CO2 emitted imposes costs (flooding, droughts, health impacts) on people worldwide, including future generations who have no voice in today's markets.
- The private cost of emitting is near zero; the social cost is estimated at $50-200 per ton of CO2.
- Global Public Good
- A stable climate is non-excludable (everyone benefits) and non-rival (one country's enjoyment does not diminish another's). This creates free-rider incentives at the international level.
- Each country prefers others to bear abatement costs, making international cooperation extremely difficult.
Slide 04
The Social Cost of Carbon
- The SCC estimates the total economic damage caused by emitting one additional ton of CO2. It is the central concept linking climate science to economic policy.
- Current Estimates
- The US EPA uses $51/ton (2020 dollars). Academic estimates range from $30 to over $200/ton depending on discount rates and damage functions.
- Calculation Method
- Integrated Assessment Models (IAMs) combine climate science, economic growth projections, and damage functions to estimate total discounted future damages per ton emitted today.
- Discount Rate Debate
- The most contentious parameter. Stern used 1.4% (implying high SCC); Nordhaus used 4.5% (implying low SCC). The choice reflects ethical judgments about intergenerational equity.
- Policy Application
- If the carbon tax equals the SCC, polluters internalize the externality, achieving the efficient emissions level. In practice, most carbon prices are far below estimated SCC values.
Slide 05
Carbon Pricing Mechanisms
- Economists broadly agree that putting a price on carbon is the most efficient way to reduce emissions. Two main approaches exist.
- Carbon Tax
- Sets a fixed price per ton of CO2
- Provides price certainty for investment decisions
- Quantity of emissions is uncertain
- Revenue can be recycled (dividends, tax cuts)
- Simple to administer
- Examples: British Columbia ($50 CAD/ton), Sweden ($130/ton)
- Cap-and-Trade
- Sets a fixed quantity of allowed emissions
- Provides emissions certainty
- Price fluctuates with market conditions
- Permits can be auctioned or allocated free
- More complex to design and administer
- Examples: EU ETS, California, RGGI
Slide 06
The Stern Review (2006)
- Sir Nicholas Stern's landmark report for the UK government was the first comprehensive economic analysis arguing that the costs of inaction vastly exceed the costs of action.
- Key Finding
- Unmitigated climate change could reduce global GDP by 5-20% per year. Mitigation would cost roughly 1% of GDP annually -- a vastly better investment.
- Low Discount Rate
- Stern used a near-zero pure rate of time preference (0.1%), arguing it is ethically indefensible to discount future welfare heavily simply because it occurs later.
- Controversy
- Critics (Nordhaus, Weitzman, Dasgupta) argued the low discount rate was inconsistent with observed market returns and implied implausibly high savings rates.
- Legacy
- Transformed the policy debate by framing climate change as an economic urgency rather than a distant environmental concern. Influenced the Paris Agreement framework.
Slide 07
Nordhaus and DICE
- William Nordhaus won the 2018 Nobel Prize for integrating climate change into long-run macroeconomic analysis through the DICE model (Dynamic Integrated Climate-Economy).
- The DICE Model
- Links economic growth, energy use, CO2 emissions, carbon cycle, temperature change, and economic damages in a single optimization framework. Solves for the "optimal" climate policy path.
- Recommends gradually rising carbon prices starting around $40/ton and increasing 3% per year in real terms.
- Key Results
- Optimal warming of ~3.5C by 2100 (controversial)
- Gradual carbon tax ramp preferred to aggressive early action
- Higher discount rate (4.5%) implies less urgent action
- Damage function is quadratic (contested as too conservative)
- Updated versions yield higher SCC estimates
Slide 08
The Discount Rate Debate
- The single most important parameter in climate economics. Small differences in the discount rate lead to vastly different policy recommendations.
- Prescriptive Approach (Stern)
- The discount rate should reflect ethical principles. Future people matter almost as much as present people. Pure time preference near zero. Implies high SCC and urgent action.
- Descriptive Approach (Nordhaus)
- The discount rate should reflect observed market returns (~4-6%). Climate investments must compete with other uses of capital. Implies lower SCC and gradual action.
- Declining Discount Rates
- Weitzman and others argue for rates that decline over time due to uncertainty about future growth. Used by UK Treasury (3.5% declining to 1% over 300 years).
- Intergenerational Equity
- Future generations cannot participate in today's markets. Should their welfare be discounted? This is fundamentally an ethical question, not a technical one.
Slide 09
Damage Functions
- How much economic damage does each degree of warming cause? The damage function is the critical -- and most uncertain -- link between climate science and economics.
- Nordhaus Quadratic
- Damages = a*T^2, where a implies ~2.1% GDP loss at 3C warming. Critics argue this dramatically underestimates damages, especially at high temperatures.
- Tipping Points
- Ice sheet collapse, Amazon dieback, permafrost thaw -- catastrophic discontinuities that standard models miss. Weitzman's "fat tails" argument: even small probabilities of catastrophe dominate the analysis.
- Non-Market Damages
- Biodiversity loss, ecosystem collapse, forced migration, conflict -- many climate impacts resist monetary quantification but are enormously consequential.
- Distributional Effects
- Warming disproportionately harms poor tropical nations that contributed least to emissions. GDP-weighted averages mask severe localized suffering and potential civilizational disruption.
Slide 10
International Climate Cooperation
- Climate change is a global commons problem requiring unprecedented international coordination. Game theory reveals why this is so difficult.
- The Free-Rider Problem
- Each country benefits from a stable climate regardless of its own emissions reductions. The dominant strategy is to free-ride on others' abatement efforts. This prisoner's dilemma structure explains decades of inadequate collective action.
- Key Agreements
- Kyoto (1997): Top-down binding targets for developed nations only. US never ratified. Limited success.
- Paris (2015): Bottom-up voluntary pledges (NDCs). Universal participation but non-binding. Insufficient to limit warming to 2C.
- Glasgow (2021): Strengthened ambitions, methane pledge, phase-down of coal.
Slide 11
Carbon Border Adjustments
- When one country prices carbon and others do not, energy-intensive industries may relocate to avoid costs -- "carbon leakage." Border adjustments address this.
- CBAM (EU)
- The EU Carbon Border Adjustment Mechanism (2026) charges importers for the carbon embedded in goods like steel, cement, aluminum, and electricity. Levels the playing field.
- Economic Rationale
- Prevents leakage, maintains competitiveness of domestic industry, and creates incentives for trading partners to adopt their own carbon prices.
- Trade Law Concerns
- May conflict with WTO non-discrimination principles. Careful design (based on carbon content, not country of origin) aims to ensure legality.
- Climate Club Approach
- Nordhaus proposes a "climate club" where members share carbon pricing and impose tariffs on non-members. Creates positive incentives for participation rather than free-riding.
Slide 12
Green Finance and Investment
- Achieving net-zero emissions by 2050 requires approximately $4-6 trillion in annual clean energy investment -- a massive reallocation of global capital.
- Stranded Assets
- Fossil fuel reserves that cannot be burned within carbon budgets. The "carbon bubble" represents trillions in potentially worthless assets on corporate balance sheets.
- Green Bonds
- Over $500 billion issued annually to finance renewable energy, efficiency, and adaptation projects. Growing rapidly but still a fraction of total bond markets.
- ESG Integration
- Environmental, Social, Governance criteria increasingly guide investment decisions. Climate risk is financial risk -- physical damages and transition risks affect asset values.
- Central Bank Mandates
- Climate stress tests, green taxonomy, disclosure requirements (TCFD). Central banks recognize climate change as a systemic risk to financial stability.
Slide 13
The Green Transition
- Decarbonization creates economic winners and losers. Managing this transition fairly is as much an economic challenge as a technological one.
- Economic Opportunities
- Renewable energy is now cheapest in most markets
- Electric vehicle manufacturing boom
- Energy efficiency retrofits create millions of jobs
- Green hydrogen for hard-to-decarbonize sectors
- Carbon capture and direct air capture industries
- Just Transition Challenges
- Coal communities face structural unemployment
- Developing nations need financing for clean development
- Energy poverty risks from premature fossil phase-out
- Regional inequality within countries
- Skills mismatch requiring massive retraining programs
Slide 14
Adaptation Economics
- Even with aggressive mitigation, significant warming is already locked in. Adaptation -- adjusting to climate impacts -- is an economic necessity, not a substitute for mitigation.
- Cost-Benefit of Adaptation
- Every $1 invested in climate adaptation yields $2-10 in avoided damages. Sea walls, drought-resistant crops, early warning systems, and urban heat management all have high returns.
- Adaptation Limits
- Some impacts cannot be adapted to at any cost. Coral reef loss, species extinction, and ice sheet collapse are irreversible regardless of economic resources deployed.
- Adaptation Finance Gap
- Developing countries need $300+ billion annually for adaptation by 2030. Current flows are under $30 billion. The gap between need and provision is growing.
- Maladaptation
- Poorly designed adaptation can increase vulnerability. Air conditioning raises emissions; sea walls create moral hazard for coastal development.
Slide 15
Climate and Inequality
- Climate change is profoundly inequitable: those least responsible suffer most, both between and within countries.
- 50%
- Global emissions from richest 10%
- Emissions from poorest 50%
- Climate death rate disparity (poor vs rich nations)
- Environmental Justice
- Within countries, low-income communities and communities of color face disproportionate exposure to pollution, heat, and flooding. Climate policy must address existing inequalities or risk deepening them.
Slide 16
The Innovation Argument
- Some economists argue that directed technological change -- not just carbon pricing -- is essential because clean energy creates positive externalities (knowledge spillovers) in addition to negative externalities from emissions.
- Two Market Failures
- Acemoglu et al. show that when both pollution and innovation externalities exist, optimal policy requires both a carbon price AND clean energy subsidies. One instrument alone is insufficient.
- Learning Curves
- Solar PV costs fell 99% since 1976, 89% since 2010 alone. Each doubling of installed capacity reduces costs by 20-30%. Early subsidies paid for themselves through cost reductions.
- Path Dependence
- Economies lock into fossil-fuel infrastructure (roads, pipelines, power plants) with 30-50 year lifetimes. Early intervention avoids costly lock-in.
- Mission-Oriented Policy
- Mazzucato argues the green transition requires active public investment similar to the space race or internet development -- not just correcting market failures.
Slide 17
Weitzman's Fat Tails
- "The economic consequences of fat-tailed structural uncertainty about climate change may be so serious as to swamp other considerations."Martin Weitzman, 2009
- If there is even a small probability of catastrophic warming (6C+), standard cost-benefit analysis breaks down. The expected value of damages becomes infinite or undefined under plausible distributions.
- The Dismal Theorem
- Under fat-tailed uncertainty about climate sensitivity, the marginal benefit of emissions reductions is potentially infinite. No finite carbon price is "too high." This challenges the entire framework of optimal carbon pricing.
- Policy Implications
- Precautionary principle justified by economics, not just ethics
- Insurance framing: we pay to avoid catastrophic risk
- Aggressive early action as risk management
- Focus on avoiding worst-case scenarios, not optimizing average outcomes
Slide 18
Carbon Markets in Practice
- EU Emissions Trading System
- World's largest carbon market. Covers 40% of EU emissions. Price rose from under 5 EUR (2017) to 80+ EUR (2023) after reforms tightened the cap. Demonstrated that political will drives price effectiveness.
- China's National ETS
- Launched 2021, covers power sector (4 GT CO2 -- world's largest by volume). Initial prices low (~$8/ton) but scope expanding to industry, aviation.
- Voluntary Carbon Markets
- Companies buy offsets for net-zero claims. Market integrity concerns: additionality, permanence, double-counting. Integrity standards evolving rapidly.
- Article 6 (Paris Agreement)
- Rules for international carbon credit trading. Aims to avoid double-counting while allowing countries to cooperate on emissions reductions. Finalized at COP26.
Slide 19
The Kaya Identity
- A simple but powerful decomposition of total CO2 emissions into four driving factors:
- CO2 = Population x (GDP/Population) x (Energy/GDP) x (CO2/Energy)
- Emissions = People x Affluence x Energy Intensity x Carbon Intensity
- Historical Drivers
- Population and GDP growth have consistently pushed emissions upward. Energy intensity has improved 1-2%/year. Carbon intensity barely changed until recently.
- Path to Net Zero
- With population and GDP still growing, carbon intensity must fall at unprecedented rates (~10%/year) to reach net zero by 2050. This requires massive electrification and clean power deployment.
Slide 20
Climate Policy Instruments
- Carbon Pricing
- Taxes or cap-and-trade. Economically efficient but politically difficult. Currently covers only 23% of global emissions at prices mostly below SCC.
- Regulations
- Vehicle emission standards, building codes, appliance efficiency rules. Less efficient but more politically feasible. Can address non-price barriers.
- Subsidies
- Tax credits for renewables, EVs, efficiency. US IRA ($369B), EU Green Deal. Address innovation externalities and accelerate adoption.
- Information
- Disclosure requirements, labeling, carbon footprint transparency. Reduces information asymmetries and empowers consumer choice.
- R&D Investment
- Public funding for breakthrough technologies: fusion, advanced geothermal, next-gen batteries, green hydrogen, direct air capture.
- Phase-Out Mandates
- ICE vehicle bans (EU 2035, UK 2030), coal phase-out timelines. Provide investment certainty and overcome lock-in.
Slide 21
The US Inflation Reduction Act
- The largest climate investment in US history ($369 billion in energy and climate spending) took a dramatically different approach from carbon pricing.
- Design Philosophy
- Instead of imposing costs through carbon taxes (politically toxic in the US), the IRA uses tax credits and subsidies to make clean energy cheaper. "Carrots, not sticks." Projected to reduce US emissions 40% below 2005 levels by 2030.
- Key Provisions
- $7,500 EV tax credit (domestic manufacturing required)
- 30% solar/wind investment tax credit extended 10 years
- $3/kg clean hydrogen production credit
- $85/ton carbon capture tax credit (45Q)
- Methane fee for oil and gas operations
Slide 22
Loss and Damage
- Developing nations increasingly demand compensation for climate damages they did not cause. The COP27 agreement (2022) to establish a Loss and Damage Fund was a breakthrough.
- The Moral Case
- Historical emissions are concentrated in wealthy nations. Vulnerable countries face existential threats (sea level rise, extreme weather) despite minimal contributions to the problem.
- Economic Estimates
- Loss and damage in developing countries could reach $290-580 billion annually by 2030 and $1-1.8 trillion by 2050. Current pledges are a tiny fraction.
- Liability Concerns
- Developed nations resist legal liability framing, preferring "solidarity" language. The fund's financing mechanism remains contentious and underfunded.
Slide 23
Climate Risk and Financial Markets
- Climate change poses two types of financial risk that central banks and regulators increasingly recognize as systemic threats.
- Physical Risk
- Extreme weather damages to property and infrastructure
- Agricultural yield losses from drought and heat
- Supply chain disruptions
- Insurance market retreat from high-risk areas
- Chronic risks: sea level rise, water scarcity
- Transition Risk
- Policy changes (carbon prices, regulations) devalue fossil assets
- Technology shifts strand existing capital
- Litigation risk for high-emitting companies
- Reputation and market access changes
- Potential for disorderly transition causing market shocks
Slide 24
Degrowth vs. Green Growth
- A fundamental debate in climate economics: can we decouple economic growth from emissions, or must growth itself be abandoned?
- Green Growth
- Mainstream position: clean technology, efficiency gains, and structural change allow continued GDP growth with falling emissions. Evidence: many developed nations have achieved absolute decoupling (GDP up, emissions down).
- Critics argue decoupling is too slow and does not account for resource use beyond carbon.
- Degrowth
- Radical position: perpetual growth is incompatible with planetary boundaries. Wealthy nations should deliberately reduce throughput while improving well-being through shorter work weeks, public services, and sufficiency.
- Critics argue degrowth is politically impossible and would harm the poor most.
Slide 25
Key Economists and Contributions
- Pigou (1920)Developed the concept of externalities and corrective taxation. The carbon tax is a Pigouvian tax.
- Coase (1960)Showed that with clear property rights and low transaction costs, private bargaining can solve externalities. Foundation for cap-and-trade.
- Nordhaus (1970s-present)Built first integrated assessment models linking climate and economy. Nobel 2018.
- Stern (2006)Argued the economics overwhelmingly favor immediate, strong climate action.
- Weitzman (2009)Demonstrated that fat-tailed catastrophic risk dominates standard cost-benefit analysis.
- Acemoglu et al. (2012)Showed directed technical change requires both carbon prices and clean R&D subsidies for optimal transition.
- Pindyck (2013)Criticized IAMs as deeply flawed, with damage functions that are essentially arbitrary.
Slide 26
Carbon Removal Economics
- Net-zero targets require removing CO2 from the atmosphere in addition to reducing emissions. The economics of removal technologies are rapidly evolving.
- Direct Air Capture (DAC)
- Currently $400-1000/ton CO2. Needs to fall below $100/ton for large-scale deployment. Energy-intensive but scalable and permanent.
- Nature-Based Solutions
- Afforestation, soil carbon, wetland restoration: $5-50/ton but face permanence risks (fires, land-use change) and compete with food production.
- BECCS
- Bioenergy with carbon capture and storage. Negative emissions but requires vast land area and has sustainability constraints.
- Enhanced Weathering
- Spreading crusite minerals on farmland accelerates natural CO2 absorption. Potentially low-cost ($50-200/ton) and co-benefits for agriculture.
Slide 27
The Economics of 1.5C vs 2C
- 1.5C
- Paris Agreement aspirational target
- Paris Agreement ceiling
- 2.7C
- Current policies trajectory
- The difference between 1.5C and 2C of warming represents trillions of dollars in avoided damages: 10 million fewer people exposed to sea level rise, 50% less reduction in crop yields, preservation of most coral reefs. But holding to 1.5C requires halving global emissions by 2030 -- an unprecedented economic transformation in less than a decade.
Slide 28
Stranded Assets and the Carbon Bubble
- If carbon budgets are respected, the majority of proven fossil fuel reserves cannot be burned. This creates a potential financial crisis.
- The Numbers
- ~80% of coal reserves must stay unburned
- ~50% of gas reserves are stranded
- ~33% of oil reserves are stranded
- Total stranded value: $1-4 trillion
- Pension funds, sovereign wealth heavily exposed
- Financial Stability Risks
- If markets suddenly reprice fossil fuel assets (a "Minsky moment"), the resulting wealth destruction could trigger financial crisis. Gradual repricing through policy certainty is preferable to sudden disorderly adjustment.
- Mark Carney's "Tragedy of the Horizon": climate damages materialize beyond typical financial planning horizons.
Slide 29
Behavioral Economics and Climate
- Standard rational-actor models miss crucial features of how people actually think about climate change.
- Hyperbolic Discounting
- People heavily discount the future in ways that are time-inconsistent. Climate benefits are distant; costs are immediate. This biases individual decisions toward inaction.
- Framing Effects
- "Carbon tax" polls far worse than "carbon dividend" or "pollution fee" despite identical mechanisms. Language matters enormously for political feasibility.
- Status Quo Bias
- Defaults are powerful. Green defaults (opt-out renewable energy, automatic enrollment in carbon offset programs) dramatically increase participation.
- Social Norms
- Showing people their neighbors' energy use reduces consumption. Visible signals of climate action (solar panels, EVs) create positive feedback loops through social influence.
Slide 30
Summary and Outlook
- Climate economics has evolved from a niche concern to the central challenge of 21st-century economic policy.
- Consensus Points
- Emissions are a massive externality. Carbon pricing is necessary (though insufficient alone). The costs of action are far below the costs of inaction. Early action is cheaper than delay.
- Open Debates
- Discount rates, damage functions, role of growth, optimal speed of transition, responsibility allocation between nations, and the balance between markets and mandates.
- The Path Forward
- Effective climate policy requires combining carbon prices, technology policy, regulation, international cooperation, and just transition support. No single instrument suffices for a challenge this complex.
