MANAGING THE GLOBAL COMMONS:

THE ECONOMICS OF CLIMATE CHANGE

William D. Nordhaus

Yale University

Full text available in this title from MIT Press, Cambridge, Massachusetts, USA

[Note from author in July 1998: This is the first chapter from the MIT Press volume on the economics of global warming. The full text is available in the printed version. The GAMS computer program used to generate the results (DICE-94) is available on line from this web site.]

PART ONE. MODELING THE ECONOMICS OF CLIMATE CHANGE

CHAPTER I. INTRODUCTION

"God does not play dice with the universe," was Albert Einstein's reaction to quantum mechanics. Yet mankind is playing dice with its natural environment through a multitude of interventions--injecting trace atmospheric gases like the greenhouse gases or ozone-depleting chemicals, engineering massive land-use changes such as deforestation, depleting species in their natural habitats even as we create transgenic ones in the laboratory, and accumulating stockpiles of nuclear weapons sufficient to destroy human civilization. As natural or social scientists, we need to understand the sources of these global changes, the potential damage they cause to natural and economic systems, and the most efficient ways of alleviating or removing the dangers. Just as villages in times past decided on the management of their grazing or water resources, so must we today and in the future learn to employ wisely and to protect our common geophysical and biological resources. This task of understanding and controlling interventions on a global scale can be called managing the global commons.

The particular issue analyzed in this book is the threat of greenhouse warming, which has received growing attention in recent years. Climatologists and other scientists have warned that the accumulation of carbon dioxide (CO₂) and other greenhouse gases (GHGs) is likely to lead to global warming and other significant climatic changes over the next century. Many scientific bodies, along with a growing chorus of environmental groups and national governments, are calling for severe curbs on the emissions of greenhouse gases, as seen for example the reports of the Intergovernmental Panel on Climate Change (IPCC [1990]). The culmination of international efforts to forge new approaches was the Earth Summit in Rio in June 1992, which agreed upon a framework treaty on climate and established a number of working groups to monitor compliance and propose next steps.

Many scientists have expressed deep concern about the threat of global warming and have proposed steps ranging from GHG emissions stabilization to deep cuts in GHG emissions to stabilizing climate. To date, the calls to arms and treaty negotiations have progressed more or less independently of economic studies of the costs and benefits of measures to slow greenhouse warming. Over the last few years, however, economists have engaged in a major effort to understand both the economic impacts of climate change and the costs of slowing climate change through reduced emissions. The evidence has pointed to the likelihood that greenhouse warming will have at most modest economic impacts in industrial countries over the next century, while programs to impose deep cuts in GHG emissions will exact substantial costs. These studies have led some to conclude that the best course today would be a modest reduction in GHG emissions -- perhaps using a carbon tax.

In earlier studies, I developed a simple cost-benefit framework for determining the optimal "steady-state" control of CO₂ and other greenhouse gases.⁽¹⁾ This earlier study came to a middle-of-the-road conclusion that the threat of greenhouse warming was sufficient to justify modest steps to slow the pace of climate change, but I found that the calls for draconian cuts in GHG emissions by 50 percent or more were not warranted by the current scientific and economic evidence on costs and impacts.

The earlier studies had a number of shortcomings, but one of the most significant from an analytical point of view was the inadequate treatment of the dynamics of the economy and the climate. The earlier work examined a "resource steady state," one in which all physical flows are constant (e. g., in which population, emissions, concentrations, and climate change have all stabilized in their steady state) although there might be improvements in real incomes because of resource-saving technological change. It then went on to examine the optimal control strategy in the resource steady state.

A complete analysis of the economics of climate change must recognize the extraordinarily long time lags involved in the reaction of the climate and economy to greenhouse gas emissions. Current scientific estimates indicate that the major GHGs have an atmospheric residence time of over 100 years; moveover, because of the thermal inertia of the oceans, the climate appears to lag perhaps half a century behind the changes in GHG concentrations; and there are long lags in the introduction of capital stocks and new technologies in human economies in response to changing economic conditions. Dynamics are therefore of the essence, and a study that overlooks the dynamics will produce misleading conclusions for the steps that we should take at the dawn of the age of greenhouse warming.

In order to improve our understanding of both the interaction of economy and climate and to design better approaches to economic policy, I have developed a model that links together in a simplified way the major economic and scientific elements involved in designing economic policies to slow global warming. It is called the Dynamic Integrated model of Climate and the Economy (the "DICE" model). The model itself is relatively small by the standard of both economics and the related natural sciences, but many of the components will be unfamiliar to those outside the disciplines from which the individual ingredients are derived. This new model is an advance over earlier studies in that it allows for different policies in the transition path from those in the ultimate steady state. It does this through adopting the standard approach of modern optimal economic growth theory and adding to this both a climate sector and a closed-loop interaction between the climate and the economy. It is an integrated model that incorporates both the dynamics of emissions and impacts and the economic costs of policies to curb emissions. The model is sufficiently small as to be transparent (or at least translucent), to allow a range of sensitivity analyses, and to be available for a number of further extensions.

The basic approach of the DICE model is to use a Ramsey model of optimal economic growth with certain adjustments and to calculate the optimal path for both capital accumulation and GHG-emission reductions. The resulting trajectory can be interpreted as either the most efficient path for slowing climate change given initial endowments or as the competitive equilibrium among market economies where the externalities are internalized using the appropriate social shadow prices for GHGs.⁽²⁾

The present monograph presents the detailed development as well as an extensive analysis of the DICE model and its results. The next chapter contains the development of the background equations of the DICE model, explaining how they are drawn from the relevant discipline and discussing their empirical support. The subsequent two chapters focusses on the uncharted terrain linking the behavior of the economy with the geophysical features of climate change. These chapters derive simplified equations that link emissions, concentrations, climate change, and economic behavior.

The subsequent chapter presents the results of the basic DICE model, analyzing the implications of the "best guess" assumptions about the structure of the DICE model. The last three chapters tackle the issue of the uncertainty about climate change. These chapters begin with a sensitivity analysis determining the robustness of the results to alternative assumptions about the major parameters; we also present an analysis of the inherent uncertainty about future economic outcomes and climate change. Finally, the uncertainty chapters investigate the impact of uncertainty on the optimal policy and find that uncertainties imply a more stringent set of greenhouse-gas controls than are implied by the best-guess case. These chapters allow us to consider how the uncertainties about climate change should affect the stringency and timing of our policies.

The need to address the potential issues raised by future climate change is one of the most challenging economic problems of today and is daunting for those who take policy analysis seriously. It raises formidable issues of data, modeling, uncertainty, international coordination, and institutional design. In addition, the economic stakes are enormous, involving investments on the order of hundreds of billions of dollars a year to slow or prevent climate change.

The studies presented here suggest that a massive effort to slow climate change today would be premature given current understanding of the damages imposed by greenhouse warming. At the same time, spurred by scientists to remember that the global circulation systems are incredibly complex and poorly understood, we must be ever alert to the possibility that the vast geophysical experiment that mankind is undertaking may trigger catastrophic and irreversible changes in droughts, monsoons, ocean circulation, river flows, and other climate-related systems. Economics does not rule out these outcomes. If scientific evidence indicates that calamitous consequences are likely to accompany global warming, then our economic models will not only signal that a strenuous effort to slow or prevent future climate change is necessary but will help devise the scope and timing of policy responses. Our future lies not in the stars, but in our models.

1. ¹ The steady-state model appears in abbreviated form in Nordhaus [1991a] and in greater detail in Nordhaus [1991b].

2. ² The "correspondence principle" between optimized systems and competitive economies was first described in Samuelson [1949] and has been analyzed in Gordon, Koopmans, Nordhaus, and Skinner [1988] for exhaustible resources.