Economics of climate change


Governments and academics are deeply divided over the economic costs and benefits of combating climate change and moving towards a low-carbon economy. The Stern Review, an influential enquiry into the issue, concluded in 2006 that fighting global warming would cost 1% of global GDP, while non-action could lead to a 20% loss of GDP in the long term. In comparison, research published in January 2009 shows that avoiding dangerous climate change could cost as little as 0.5% of global GDP.

Financing climate change policies aimed at tackling global warming is a contentious issue, as reliable and accurate information on the costs and benefits of such measures is difficult to collect. 

Although there is now a wide consensus that the world must stop global temperatures from rising and maintain them below 2°C to escape dangerous climate impacts, calls to reserve government funds for the cause have not been universally welcomed. In particular, the recent financial meltdown is putting a strain on public finances.

Nevertheless, proponents of stringent climate policies argue that combating climate change now will come at a much lower cost than dealing with negative and even irreversible effects later on.

The first real controversy over the costs of climate change began when US President George W. Bush announced in 2001 that his country would not sign the Kyoto Protocol on the grounds that it "would cause serious harm to the US economy".

Although there was no economic impact assessment underpinning the US administration's U-turn on Kyoto, previous studies had pointed to high economic costs for the American economy, like 'Impacts of the Kyoto Protocol on US Energy Markets and Economic Activity,' which was carried out by the US Energy Information Administration in 1998.

Stern Review

The most comprehensive cost analysis was carried out for the UK government by former World Bank chief economist Lord Nicholas Stern. The Stern Review on the Economics of Climate Change, presented in October 2006, concluded that were the world to take no action on climate change, it would lose between five and 20% of its GDP, while the costs of tackling the risks could be limited to 1% of annual global GDP.

The 700-page review underlined that urgent action is imperative and offered an economic motivation by demonstrating that the benefits of immediate measures outweigh the costs. "Our actions over the coming few decades could create risks of major disruption to economic and social activity, later in this century and in the next, on a scale similar to those associated with the great wars and economic depression of the first half of the 20th century," the report stated (for a good overview, see BBC News).

Furthermore, the secretariat of the UN Framework Convention on Climate Change (UNFCCC) published a study in August 2007 on the costs related to climate change mitigation and adaptation. It concluded that dealing with climate change would require significant changes to global investment patterns, including much greater investment flows to the developing world of up to 1.7% of global GDP by 2030 (EURACTIV 06/09/07).

McKinsey's cost abatement curve

The most recent contribution to the debate came from consulting firm McKinsey, which argued that investing in the shift to a low-carbon economy would be significantly cheaper than the cost of inaction as presented in the Stern review. 

Should the most cost-effective green technologies be implemented urgently across the world, global warming could be kept under the crucial 2°C threshold with possibly as little as 0.5% of global GDP, the 'Pathways to a Low-Carbon Economy' study concluded. This figure compares favourably to the Stern Report's estimates of the costs of inaction (EURACTIV 27/01/09).

The report included an updated version of McKinsey's greenhouse gas cost abatement curve, first published in 2007, which analysed over 200 opportunities for reducing emissions by 70% from business-as-usual levels in 2030.

Potential of energy savings and renewables for fighting climate change

The McKinsey report concluded that the biggest cuts in greenhouse gases, 14 Gt of CO2 per year in 2030, can be made through energy efficiency improvements in vehicles, electrical appliances and buildings. These investments would also be most likely to be recouped over time. In addition, it detailed low-carbon energy supply and halting tropical deforestation as cost-effective opportunities.

The International Energy Agency's (IEA) latest assessment echoed these findings (EURACTIV 12/11/09).

In its annual World Energy Outlook, published in November 2009, the agency outlined that energy efficiency would bring more than half of the CO2 cuts by 2030. Deployment of renewables would account for another fifth, while using biofuels in the transport sector would bring cuts of about 3%, according to the report. Finally, carbon capture and storage (CCS) technologies and nuclear could each slash emissions by 10%, it said.

The IEA called for $10.5 trillion of investment globally in energy efficiency and low-carbon energy to avoid runaway climate change.

The agency foresees that a global agreement to cut greenhouse gases would lead to massive investment in renewables, which would soak up 60% of the projected total investment in power generation between 2010 and 2030.

Wind power would be the biggest beneficiary of the injection of money while hydropower, concentrating solar power (CSP) and biofuels would also see large increases, the IEA predicts. Moreover, large-scale photovoltaic (PV) electricity generation would increase considerably, although PV in buildings will remain the dominant form, it added.

The EU has shifted its energy research priorities towards offshore wind and solar power in order to reach its target of producing 20% of its energy from renewable sources in 2020 (EURACTIV 07/10/09).

Problems and challenges

The problems of calculating costs and benefits of climate change policies are linked to the fact that there are many complexities and uncertainties, including how  potential freak weather can be predicted and what the long-term costs and benefits of prevention are.

Another point of contention is the "social discount rate," which calculates the value placed on the welfare of future generations relative to the present. In the Stern Review, the authors started from a near-zero discount rate (0.1% per year), arguing that from an ethical point of view, future generations should not be discounted.

Although political leaders have embraced the Stern Review, its findings have been contested by some of the world's leading economists, despite a consensus that the need to tackle climate change exists.

One of the most critical responses to the Stern Review came from environmental economist Richard Tol (Hamburg and Carnegie Mellon Universities). Tol believes that Stern seriously overestimated the potential damage of global warming and underestimated the costs of cutting greenhouse gases.

"The Stern Review is very selective in the studies it quotes on the impacts of climate change. The selection bias is not random, but emphasises the most pessimistic studies. In this sense, it reminds one of Lomborg (2001). The discount rate used is lower than the official recommendations by HM Treasury. Results are occasionally misinterpreted. The report claims that a cost-benefit analysis was done, but none was carried out. The Stern Review can therefore be dismissed as alarmist and incompetent," Tol concludes. 

In a later evaluation, Tol admitted that the Stern Review had rightly "put the economics of climate change on the public agenda". He said the economic case for emission reduction can be made, but that Stern's assessment had "missed the chance to make it".

American economist  William Nordhaus also attacked Stern's conclusions, saying that the review should be viewed "as a political document" lacking serious peer review. His main criticism was the extremely low social discount rate used in the report. "This magnifies enormously impacts in the distant future and rationalises deep cuts in emissions, and indeed in all consumption, today," Nordhaus wrote.

The McKinsey study 'Pathways to a Low-Carbon Economy' on the other hand was greeted as a welcome contribution to international climate negotiations.

EU Environment Commissioner Stavros Dimas welcomed the study as a "timely contribution to the Copenhagen process". He said it enables policymakers to consider the appropriate tools for different sectors and provides valuable analyses for world leaders negotiating a global deal, which he claimed will have to include effective funding mechanisms to finance the required emission cuts.

WWF Director General James Leape said the study provided a "more rigorous fact base than we have seen before". He emphasised the implications of the study for the stimulus packages created around the world in response to the financial crisis. He said the findings demonstrated that investments in infrastructure should be designed to improve energy efficiency and to bring down the price of renewables, "laying the foundations of a low-carbon economy and in the meantime creating jobs".

The renewable energy industry sees great potential to provide a large junk of European electricity from clean sources in the next few decades with smart investment.

The European Wind Energy Association (EWEA) said that the industry already had 100 GW of offshore wind projects under planning, which alone could cover 10% of Europe's electricity needs. "This shows the enormous interest among Europe's industrial entrepreneurs, developers and investors," it argued in a report published in September 2009.

But a lack of grid infrastructure and liquidity problems will prevent the development of some of them, the offshore wind industry warned, setting its sights on sights on 40GW of offshore generating capacity by 2020 instead.

The European photovoltaic industry estimates that it could meet up to 12% of Europe’s electricity demand by 2020 if it gains the support of a favourable policy framework in the coming years. The SET for 2020 study published by the European Photovoltaic Industry Association (EPIA) in June 2009 showed that photovoltaic electricity will become competitive in parts of southern Europe by 2010.

"Europe now needs to recognise the important role photovoltaic power can play in meeting its energy sustainability goals," said Adel El Gammal, EPIA secretary-general.

In a July 2011 report entitled 'The costs of delay', the ClimateWorks Foundation, a US non-profit group based in San Francisco, argues that delaying action will escalate the risks and multiply the costs of dealing with climate change.

The authors acknowledge that it would be "prohibitively expensive" to rapidly replace the world's power plants, the chief culprits for emitting planet-warming gases, with lower carbon energy sources, estimating the cost at about $15 trillion — or more than a quarter of global GDP. But it argues that an early start on the transition to clean energy means that natural turnover, replacing equipment at the end of its useful life, will pay much of this bill.

"The world has a window of about 10 years to bend carbon emissions curves downward and avert a climate catastrophe," argue the authors, Hal Harvey and Sonia Aggarwal. "The math of historical CO2 accumulation gives us no choice but to slash emissions to very low levels. Earth's natural carbon sinks are becoming saturated, so our safety valve is slowly closing," the authors warn, claiming that the full impact of historical emissions is yet to be felt.

"The longer we wait, the more drastic the cuts — and associated costs — will be. If we delay action for even a decade, CO2 concentrations will likely blow right past 450 ppm (parts per million) and unleash the dangers of nonlinear ecological and geophysical responses."

  • 30 Oct. 2006: Release of Stern Review on the Economics of Climate Change.
  • 3-14 Dec. 2007: UN negotiations for a post-Kyoto climate agreement start at the Bali climate conference (COP 13).
  • Dec. 2008: Poznan, Poland climate conference (COP 14) marks the mid-way point of the negotiations. 
  • Jan. 2009: New US administration takes office, with President Obama pledging strong US engagement in international climate negotations.
  • 7-18 Dec. 2009: Copenhagen climate conference (COP 15) to set the framework for an international post-2012 climate deal.
  • End 2012: Deadline for ratification of any new climate deal and expiry of Kyoto Protocol.
  • By 2020: EU to cut emissions by 20% and increase the share of renewables in its energy mix to 20%. 


Life Terra

Funded by the LIFE Programme of the EU

The content of this publication represents the views of the author only and is his/her sole responsibility. The Agency does not accept any responsibility for use that may be made of the information it contains.

Subscribe to our newsletters