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On Buying Insurance, and Ignoring Cost-Benefit Analysis

Posted on 10 February 2019 by Guest Author

This is a re-post from TripleCrisis by economist Frank Ackerman

First in a series of posts on climate policy.  

The damages expected from climate change seem to get worse with each new study. Reports from the IPCC and the U.S. Global Change Research Project, and a multi-author review articlein Science, all published in late 2018, are among the recent bearers of bad news. Even more continues to arrive in a swarm of research articles, too numerous to list here. And most of these reports are talking about not-so-long-term damages. Dramatic climate disruption and massive economic losses are coming in just a few decades, not centuries, if we continue along our present path of inaction. It’s almost enough to make you support an emergency program to reduce emissions and switch to a path of rapid decarbonization.

But wait: isn’t there something about economics we need to figure out first? Would drastic emission reductions pass a cost-benefit test? How do we know that we wouldn’t be spending too much on climate policy?

In fact, a crash program to decarbonize the economy is obviously the right answer. There are just a few things you need to know about the economics of climate policy, in order to confirm that Adam Smith and his intellectual heirs have not overturned common sense on this issue. Three key points are worth remembering.

Worst-case risks matter more than likely outcomes

For uncertain, extreme risks, policy should be based on the credible worst-case outcome, not the expected or most likely value. This is the way people think about insurance against disasters. The odds that your house won’t burn down next year are better than 99 percent – but you probably have fire insurance anyway. Likewise, young parents have more than a 99 percent chance of surviving the coming year, but often buy life insurance to protect their children.

Real uncertainty, of course, has nothing to do with the fake uncertainty of climate denial. In insurance terms, real uncertainty consists of not knowing when a house fire might occur; fake uncertainty is the (obviously wrong) claim that houses never catch fire. See my Worst-Case Economics for more detailed exploration of worst cases and (real) uncertainty, in both climate and finance.

For climate risks, worst cases are much too dreadful to ignore. What we know is that climate change could be very bad for us; but no one knows exactly how bad it will be or exactly when it will arrive. How likely are we to reach tipping points into an irreversibly worse climate, and when will these tipping points occur? As the careful qualifications in the IPCC and other reports remind us, climate change could be very bad, surprisingly soon, but almost no one is willing to put a precise number or date on the expected losses.

One group does rush in where scientists fear to tread, guessing about the precise magnitude and timing of future climate damages: economists engaged in cost-benefit analysis (CBA). Rarely used before the 1990s, CBA has become the default, “common-sense” approach to policy evaluation, particularly in environmental policy. In CBA-world you begin by measuring and monetizing the benefits, and the costs, of a policy – and then “buy” the policy if, and only if, the monetary value of the benefits exceeds the costs.

There are numerous problems with CBA, such as the need to (literally) make up monetary prices for priceless values of human life, health and the natural environment. In practice, CBA often trivializes the value of life and nature. Climate policy raises yet another problem: CBA requires a single number, such as a most likely outcome, best guess, or weighted average, for every element of costs (e.g. future costs of clean energy) and benefits (e.g. monetary value of future damages avoided by clean energy expenditures). There is no simple way to incorporate a wide range of uncertainty about such values into CBA. The second post in this series will look more deeply at economists’ misplaced precision about climate damages.

Costs of emission reduction are dropping fast

The insurance analogy is suggestive, but not a perfect fit for climate policy. There is no intergalactic insurance agency that can offer us a loaner planet to use while ours is towed back to the shop for repairs. Instead, we will have to “self-insure” against climate risks – the equivalent of spending money on fireproofing your house rather than relying on an insurance policy.

Climate self-insurance consists largely of reducing carbon emissions, in order to reduce future losses.[1] The one piece of unalloyed good news in climate policy today is the plummeting cost of clean energy. In the windiest and sunniest parts of the world (and the United States), new wind and solar power installations now produce electricity at costs equal to or lower than from fossil fuel-burning plants.

A 2017 report from the International Renewable Energy Agency (IRENA) projects that this will soon be true worldwide: global average renewable energy costs will be within the range of fossil fuel-fired costs by 2020, with on-shore wind and solar photovoltaic panels at the low end of the range. Despite low costs for clean energy, many utilities will still propose to build fossil fuel plants, reflecting the inertia of traditional energy planning and the once-prudent wisdom of the cheap-fuel, pre-climate change era.

Super-low costs for renewables, which would have seemed like fantasies 10 years ago, are now driving the economics and the feasibility of plans for decarbonization. Many progressive Democrats have endorsed a “green new deal”, calling for elimination of fossil fuels, massive investment in energy efficiency and clean energy, and fairness in the distribution of jobs and opportunities.

Robert Pollin, an economist who has studied green new deal options, estimates that annual investment of about 1.5 percent of GDP would be needed. That’s about $300 billion a year for the United States, and four times as much, $1.2 trillion a year, for the world economy. Those numbers may sound large, but so are the fossil fuel subsidies and investments that the green new deal would eliminate.

In a 2015 study, my colleagues and I calculated that 80 percent of U.S. greenhouse gas emissions could be eliminated by 2050, with no net increase in energy or transportation costs. Since that time, renewables have only gotten cheaper. (Our result does not necessarily contradict Pollin’s estimate, since the last 20 percent of emissions will be the hardest and most expensive to eliminate.)

These projections of future costs are inevitably uncertain, because the future has not happened yet. The risks, however, do not appear dangerous or burdensome. So far, the surprises on the cost side have been unexpectedly rapid decreases in renewable energy prices. These are not the risks that require rethinking our approach to climate policy.

Costs of not reducing emissions may be disastrously large

The disastrous worst-case risks are all on the benefits, or avoided climate damages, side of the ledger. The scientific uncertainties about climate change concern the timing and extent of damages. Therefore, the urgency of avoiding these damages, or conversely the cost of not avoiding them, is intrinsically uncertain, and could be disastrously large.

It has become common, among economists, to estimate the “social cost of carbon” (SCC), defined as the monetary value of the present and future climate damages per ton of carbon dioxide or equivalent. This is where the pick-a-number imperative of cost-benefit analysis introduces the greatest distortion: huge uncertainties in damages should naturally translate into huge uncertainties in the SCC, not a single point estimate.

Frank Ackerman is principal economist at Synapse Energy Economics in Cambridge, Mass., and one of the founders of Dollars & Sense, which publishes Triple Crisis. 

The next post in this series will examine the debates about the SCC, showing that there are indeed large uncertainties in its value, no matter how inconvenient that may be for economists and their models.

[1] Adaptation, or expenditure to reduce vulnerability to climate damages, is also important but may not be effective beyond the early stages of warming. And some adaptation costs are required to cope with warming that can no longer be avoided – that is, they have become sunk costs, not present or future policy choices.

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Comments 1 to 9:

  1. Great read. Agree with the need to base risk analysis on worst case scenarios even if they are low probability. This is the entire planet we are talking about, so you have to be very cautious.

    Article says "Robert Pollin, an economist who has studied green new deal options, estimates that annual investment of about 1.5 percent of GDP would be needed. That’s about $300 billion a year for the United States, and four times as much, $1.2 trillion a year, for the world economy. "

    To put this in context, America spent approx. the following last year as a percentage of GDP: Military 3.1%, education 4.9%, healthcare (private plus government) 17%, and pensions 7.4%. These numbers are easily googled.

    It just seems that a Green New Deal investment of 1.5% is very manageable. Even if it was 3% its manageable.

    So why is the world in such a state of apathy and slowness on the whole thing? I think it's not really economic. It's psychological apathy and confusion.  It's denial campaigns, and poor communication to the public of costs. Its political capture by corporate lobby groups.

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  2. >>In the windiest and sunniest parts of the world (and the United States), new wind and solar power installations now produce electricity at costs equal to or lower than from fossil fuel-burning plants<<

    A statement which on its own looks good, but comes without any parameters.

    Does the electricity get measured in Kw, or Kwh? (Power or energy?) Does the cost include decommisssioning costs or replacement? There are other criteria but you get my point.

    Deniers always bring up the "sun doesn't shine all the time" and "wind doesn't blow all the time" arguments - which are, with the paucity of power storage, valid. A statement such as this is no counterargument without the full facts being available.

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  3. "Does the electricity get measured in Kw, or Kwh? (Power or energy?) Does the cost include decommisssioning costs or replacement? There are other criteria but you get my point."

    Levelised costs of virtually all forms types electricty generation here and here. (comparing like with like, and including lifetime costs and maintainance etc). Includes data on battery storage as well.

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  4. nigelj @3: Thanks. I was going to complain that externalities aren't considered costs but the Wikipedia article does address them. Whether the piece we are referring to does I don't know, but a 20 - 30% extra cost would change the argument substantially.

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  5. nigelj @1: It is very manageable. Spending 3.1% on the military primarily buys us enemies; better to spend the money on really defending ourselves from what is really threatening us. The defense money could easily be diverted — making the net costs $0.

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  6. An excellent explanation, clearly hitting the main points and making an appeal to easily grasped parallels. 

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  7. Wol,

    I noticed that the article also left out that all matter is made of atoms and that electricity is caused by the flow of electrons.

    Clearly the OP does not have enough space to reinvent all of science. Mr. Ackerman has to leave out things that are well known to be true.   As Nigelj has shown, the statement that renewable energy is cheaper than any other energy source is easily confirmed with a simple GOOGLE search.

    In addition, the cost of renewable energy is still going down. Costs of fossil fuels will only go up as they are used up. Distractions like questions about storage, which have been answered in the peer reviewed literature, while leaving out the immense current and future costs of fossil fuels (coal alone kills over 10,000 Amenican citizens and causes over $40 billion in health costs per year, not to mention sea level rise and stronger storms) is simply stalling reasoned discussion.

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  8. Michael @ 7:

    >>Clearly the OP does not have enough space to reinvent all of science. Mr. Ackerman has to leave out things that are well known to be true. As Nigelj has shown, the statement that renewable energy is cheaper than any other energy source is easily confirmed with a simple GOOGLE search.<<

    Passing quickly over the intended irony/sarcasm of the first paragraph, there are all sorts of things that come into the equations and many can legitimately add or subtract them. Storage is very relevant: producing energy when it's not needed is wasteful without it and sans storage the deficit on windless nights has to be made up by conventional means, which often mean spinning reserves.

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  9. Wol,

    I am glad that we agree that all the costs of each technology need to be considered.  For fossil fuels that would include the 500,000 people killed each year in the EU by pollution from internal combustion engines (uprated for the entire world), costs to rebuild every port city in the world due to sea level rise and replace the 10% of world farmland at risk from sea level rise, all extreme storm damage like the 500,000 cattle killed in recent Australia rains, firestorm damage like recent California damage and other damage caused by burning fossil fuels.

    Calculations counting health damages but ignoring the rest of my list indicate that renewable energ ywit hstorage is cheaper than fossil fuels.  

    From an economic viewpoint the only choice is to convert to renewable energy as soon as possible.  The Stern review was the first of many reports I am aware of that costed out the damage from fossil fuels and concluded that we must switch to renewable energy.  Since then the costs of renewable energy have dropped over 50%.  Please cite a serious economic review that supports your suggestion that renewable energy is not the most economic choice.  

    Spinning reserve is a problem for fossil fules and the nuclear industry (especially the nuclear industry).  It is generally not an issue for renewable energy except for the possibility of transmission line failure, which can be covered by a smart grid.  Night-time lack of solar power can be anticipated in advance by suppliers so spinning reserve is unnecessary.  Likewise, in practice, operators have found wind and solar can be forecast in advance so spinning reserve is not needed.  Nuclear plants require 100% spinning reserve at all times since any fault causes an immediate emergency shutdown of all generation.  Recent hot and cold waves have caused critical shutdowns of fossil fuel plants in Australia and the USA while wind and solar continued uninterupted.

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