The New York Review of Books

The New York Review received many letters concerning “The Question of Global Warming” by Freeman Dyson [NYR, June 12]. Following are comments by William D. Nordhaus, whose book A Question of Balance: Weighing the Options on Global Warming Policies, was reviewed in the article, as well as letters from two other readers, along with a reply by Freeman Dyson.

—The Editors

I have little to quarrel with in Freeman Dyson’s review of my study A Question of Balance: Weighing the Options on Global Warming Policies. However, his review provoked a small eruption of letters that complained in equal measure about my study and his review, and these comments provide an opportunity to revisit some of the major controversies.

1.

The economics of climate change is straightforward. Virtually every activity directly or indirectly involves combustion of fossil fuels, producing emissions of carbon dioxide into the atmosphere. The carbon dioxide accumulates over many decades and leads to surface warming along with many other potentially harmful geophysical changes. Emissions of carbon dioxide represent “externalities,” i.e., social consequences not accounted for by the workings of the market. They are market failures because people do not pay for the current and future costs of their actions.

If economics provides a single bottom line for policy, it is that we need to correct this market failure by ensuring that all people, everywhere, and for the indefinite future are confronted with a market price for the use of carbon that reflects the social costs of their activities. Economic participants—thousands of governments, millions of firms, billions of people, all making trillions of decisions each year—need to face realistic prices for the use of carbon if their decisions about consumption, investment, and innovation are to be appropriate.

The most efficient strategy for slowing or preventing climate change is to impose a universal and internationally harmonized carbon tax levied on the carbon content of fossil fuels. The carbon content is the total amount of carbon dioxide emissions that are emitted, for example, when people use a kilowatt-hour (kwh) of electricity or burn a gallon of gas.

To understand a carbon tax, consider an average American household, which consumes about 12,000 kwh of electricity per year at a price of about $0.10 per kwh. If this electricity were generated from coal, that would lead to about three tons of carbon emissions. If the carbon tax were $30 per ton, it would increase the annual cost of coal-electricity purchases from $1,200 to $1,290. By contrast, the costs of nuclear or wind power would be unaffected by a carbon tax because these forms of energy use no carbon fuels.

Raising the price on the use of carbon through a carbon tax has the primary purpose of providing strong incentives to reduce carbon emissions. It does this through four mechanisms. First, it will provide signals to consumers about what goods and services produce high carbon emissions and should therefore be used more sparingly. Second, it will provide signals to producers about which inputs use more carbon (such as electricity from coal) and which use less or none (such as electricity from wind), thereby inducing them to move to low-carbon technologies. Third, it will give market incentives for inventors and innovators to develop and introduce low-carbon products and processes that can replace the current generation of technologies.

Finally, a market price for carbon will reduce the amount of information that is required to do all three of these tasks. Ethical consumers today, hoping to minimize their “carbon footprint” (the amount of carbon they use), would have serious difficulties making an accurate calculation of the relative carbon emissions that result from, say, driving versus flying. With a carbon tax, the market price of all activities using carbon would rise by the tax times the carbon content of fossil fuels. Many consumers would still not know how much of the market price is due to the carbon content, but they could make their decisions confident that they are paying for the social cost of the carbon they use.

Some would argue that a carbon tax is just another sad example of a “tax and spend” economic philosophy. This argument fundamentally misunderstands the economic rationale. Those who burn fossil fuels are enjoying an economic subsidy—in effect, grazing on the global commons and not paying for the costs of their activities. A carbon tax would improve rather than reduce economic efficiency because it would correct for the implicit subsidy on the use of carbon fuels.

However, the major economic question remains: What is the appropriate price of carbon? It is at present infeasible (or at the least ruinously expensive) to prevent any and all future warming; yet unchecked warming poses serious threats to human and especially natural systems. We need therefore to strike a balance between the competing objectives of preventing climatic damage, maintaining economic growth, avoiding catastrophic risks, and not imposing undue hardships on poor people or future generations.

Calculations of climate damages include not only impacts on market outputs like food and forestry but also estimates of losses from nonmarket impacts. The most comprehensive damage studies include such factors as the greater intensity of hurricanes, impacts of changes in temperature and precipitation on food production, recreation, and amenities, and the increased burdens of disease. The estimates also include adjustments for the risk of low-probability, high-consequence events such as abrupt climate change. It has proven challenging to provide reliable estimates of many uncertain future impacts, but it is obviously essential that they not be omitted from the estimates of the damages from climate change.

My economic studies, reported in A Question of Balance, suggest that a balance would be achieved with a price on carbon in the range of $30 to $50 per ton, rising over time. The low end of this range is the pure economic cost-benefit optimum. The high end adds an additional constraint that global temperature or atmospheric concentrations of carbon dioxide should not exceed “dangerous” levels.

For the US, such taxes would lead to tax revenues of around $50–80 billion per year. To put this in terms of the average household, a carbon tax of $30 per ton of carbon would involve a tax on gasoline of about seven cents a gallon; it would increase the price of fossil fuels and goods dependent on such fuels by about 5 percent, an increase that is significantly smaller than those experienced over the last five years.

2.

With this background, I will comment on two questions raised in Freeman Dyson’s review and in letters and comments I have received about it: first, regarding the discount rate, and second regarding low-cost technologies to reduce carbon emissions.

One of the deepest issues in climate-change policy involves the appropriate discount rate to use in comparing present costs and future benefits. This becomes important because society would incur today, through reducing the use of fossil fuels, the abatement costs of reducing emissions, while most of the damages avoided lie far in the future. (Recall, as noted above, that damages are a comprehensive concept including market, nonmarket, and ecological impacts, along with adjustments for high-consequence risks.) Even The Stern Review on the Economics of Climate Change, by Lord Stern, which took a pessimistic view of damages, found that there would be relatively little damage from climate change over the coming century and that most damages would occur after 2200. We need therefore to find an appropriate discount rate to balance present abatement costs with the reduced damages that would occur a century or more from now.

We can illustrate the question posed by discounting with the following example. Suppose someone of sterling character approaches you with the following proposition. He is establishing a trust that will confer a $100 million benefit (corrected for inflation) to your heirs in two hundred years in return for a current contribution of a certain sum of money, x dollars, today. The $100 million return might be the benefit of reduced climate damages. Alternatively, it might involve owning part of Manhattan Island. What is the maximum amount that you would be willing to contribute?

A person relying on arithmetic intuition might reason as follows: “I know that money invested will accrue interest and grow over time. If I take an interest rate of 5 percent times two hundred years, that would total 1,000 percent, or growth by a factor of ten. So, by this calculation, to get $100 million in two hundred years, I would need $10 million today. In other words, if I assume that money invested over the time period will grow ten times in value, I would contribute to the trust no more than $10 million today. Perhaps the interest rate would be higher. If the fund grows one hundred times in value, I should contribute no more than $1 million.” Thus might our arithmetic intuition proceed.

In fact, this approach is not even close to the right calculation. The intuitive calculation forgets that interest is compounded—that is, interest is paid on the total amount, not just the original amount. A financial consultant would advise you to calculate the appropriate current contribution by taking the $100 million and “discounting” it to the present using an appropriate interest rate or discount rate. That discount rate should reflect the amount you could earn on your investments over the period.

Moreover, in our example, the $100 million is inflation-corrected, so we are in effect getting paid in future goods. For this reason, we want to use the discount rate on goods in making the present-value calculation. (Again, recall that we are using a comprehensive measure of goods in this analysis; also, goods whose prices are rising relative to the average will have a lower discount rate.) A discount rate on goods is the rate we would apply when converting the inflation-corrected values of goods consumed in the future into today’s values. The rate should reflect not only the underlying return on social investments but also risk factors such as that the “sterling character” might be Freddie Mac rather than Uncle Sam, or that we might have no heirs, or that part of Manhattan Island might be under water.

Based on historical studies and projections, the inflation-corrected return on investment has been in the range of 3 to 6 percent per year depending upon time period and risk. In my modeling, I have used a 4 percent discount rate. Applying this discount rate to the trust would lead you to propose a present payment of x = $39,204. Over two hundred years, as the interest on that sum is paid and compounded, the value of the trust would reach $100 million.

Many people are shocked that anyone would propose such a small sum. How can we care so little about the future? Are we not shortchanging future generations? The answer is not that we are indifferent to the future but that we have a vast array of productive investments in an economy with rapid technological change. The power of compound growth turns tiny investment acorns into giant financial oaks over a century and more. It is always a useful reminder about compound interest that at a 6 percent money-interest rate, the $26 paid for Manhattan in 1626 would yield $120 billion today, an amount approximately equal to the entire land value of this most valuable real estate.