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What is the economics of climate change?
Discussion Paper
31 January 2006
Sir Nick Stern
HM Treasury, Stern Review


Executive summary

Climate change is a serious and urgent issue. The underlying science of global warming through greenhouse gases has been understood for more than a century. There is now an overwhelming body of scientific evidence that human activity is increasing the concentrations of greenhouse gases in the atmosphere, and causing warming. We are already seeing significant impacts. There remain uncertainties about the nature and scale of impacts in the longer term, but the most recent science indicates that some of the risks are more serious than had first appeared.

The problem is global in its cause and consequences. Greenhouse gases have broadly the same impact on the climate wherever in the world they are emitted. And in terms of its consequences, no region will be left untouched. But impacts will be unevenly felt throughout the world. Some of the most severe impacts will be felt in the poorest countries that are least able to adapt to the changes.

The economic challenges are complex. At its most basic level, climate change is an externality: the emission of greenhouse gases damages others. But these costs will be felt over a long period and over the entire globe; their exact nature is uncertain; they interact with other market failures and imperfections; and those most affected future generations are not able to speak up for their interests. This points to a long-term international collaborative response. Effective collaboration will require a shared understanding of the incentives and institutions needed, and careful attention to the complex ethical issues involved.

The current pathway of emissions is unsustainable. Economic growth, particularly in the developed world, has driven past increases in greenhouse gas emissions including from energy use, agriculture and deforestation. Much of the future growth in emissions will be in developing countries. It is clear that we will have to go far beyond the actions currently agreed if we are to stabilise greenhouse gases at any acceptable level.

Climate change itself may impede growth and development. Climate change has profound implications for the environment in which social and economic activity takes place. We need to understand how economic growth and other indicators of human development may be affected. Some of the most severe impacts will be felt in the poorest countries, which strengthens still further the case for international action to fight poverty and promote development. All countries will want to take account of the implications of climate change for future growth.

We can still take action to avoid the worst impacts of climate change. In the energy sector, energy conservation, changes to the mix of economic activity, and the development and deployment of technologies will all play a role. Some sectors will be more challenging than others.

Effective action requires an understanding of how mitigation may affect economic growth. This depends on how quickly current energy production and consumption patterns are shifted, on how co-ordinated countries are in their actions, and on how far action eliminates energy inefficiencies and promotes innovation.

A combination of policies, institutions and changes in preferences will be needed. Key policy instruments include taxes, property rights and regulation; all three play a role in most advanced countries. Strong institutions are needed to underpin the response to climate change, along with discussion and education to shift preferences over time and build an understanding of the benefits of a stable climate, and of collaboration if this is to be achieved.

The private sector will respond if governments set clear, long-term and credible incentives. Policies should take into account the complexities and imperfections in energy markets, including possible responses of fossil fuel prices, and the importance of other energy policy goals including security of supply and access to energy.

Uncertainties and irreversibilities permeate the story. Uncertainty over the consequences of climate change poses a challenge for international collective action, and may influence the choice of different policy instruments. The possibility of serious adverse consequences may justify more extensive action now than central projections alone would suggest. Irreversibilities are also a key part of the story, both in terms of the potential for irreversible changes in the climate, and in terms of large, long-lived capital investments that will lock in emissions for decades to come.

Climate change requires an international response. This should be based on a shared understanding of the implications for different countries of the consequences of different arrangements. If groups of countries act together, the impacts of particular policy instruments on the competitiveness of individual sectors can be managed more successfully.

Incentives need to be in place to support action in fast-growing developing countries. We must find ways of tackling climate change that are consistent with continued economic growth and development. Developed countries, which bear most of the historical responsibility for the problem, should show leadership. The UK and EU have a vital role to play in generating the multilateral action that is crucial for an effective response.

An equitable international response to climate change must include action on both adaptation and mitigation. Adaptation and mitigation are not choices: substantial climate change is already inevitable over the next 30 years, so some adaptation is essential.

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