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The economic cost of climate change mitigation

August 19, 2016

 

In other entries and pages of the site, I discussed the costs and financing need of the proposed plan. It is important, however, to keep in mind the difference between the financial and economic costs.

The proposed scheme’s financial costs are the payments that are made to participants by the Fund to incentivize them to curb emissions. These payments need to be financed by raising capital from private investors who will require a return, which adds to these financial costs.

On the other hand, the economic cost of climate change mitigation is the opportunity cost of the real resources used for the mitigation efforts. These resources, whether they are human or physical resources, are not available to produce other goods and services. These foregone goods, e.g. additional health care services, cars or iPads, represent the economic cost of mitigating climate change.

This distinction between financial and economic costs highlights the fact that economic costs are highly dependent on the state of the economy and the utilization of resources. As a result, financial costs might not be a good proxy for economic costs under certain circumstances. In an environment where resources are idle or underutilized, the economic cost of climate change mitigation will be smaller than suggested by the financial costs. In such a situation, using idle resources could even have a negative cost i.e. an economic benefit through creating additional income and demand, what economists describe as the multiplier effect.

Many economists consider the period that followed the 2007-2008 financial crisis and the Great Recession to be one characterized by a chronic underutilization of resources. Common descriptions of the economic situation – such as secular stagnation, structural shortfall of aggregate demand compared to the potential economic output, depressed real interest rates due to the imbalance between intended savings and investment – all imply that resources are idle. The fiscal multiplier, an indicator of the growth impact of additional spending and a measure linked to resource utilization levels, has also been revised higher.  In 2013, the IMF pointed out that there is evidence that fiscal multipliers are larger when monetary policy is constrained by the zero lower bound on nominal interest rates and the financial sector or the economy is weak.

This has important implications for the trade-off between climate action and economic welfare and growth. Under current conditions, the economic costs of climate change mitigation could be significantly lower than the financing requirement of the necessary adjustment and investment. Financial costs would still need to be incurred, however their impact on welfare or on measures such as total debt as a percentage of global GDP could be partially offset by the investment’s positive impact on economic growth.

 

 

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