Dynamic modeling and the climate

Frank Ackerman is the coauthor, with Joseph Daniel, of (Mis)understanding Climate Policy: The role of economic modeling, prepared for Friends of the Earth (England, Wales & Northern Ireland) and WWF-UK.

Under the Climate Change Act 2008, the UK government sets “legally binding” carbon budgets, which cap the country’s total emissions for five-year periods.

The size of the fourth carbon budget, covering 2023-2027, is topic of debate. The budget was set by Government back in 2011 but Chancellor George Obsorne secured a commitment to review it in 2014 and discussions are currently taking place in government regarding its new level. One important aspect of that debate is estimating the economic cost of reducing carbon emissions in the middle of the next decade.

The approach taken by the UK government to estimate the effects of the carbon budgets on economic growth uses the HMRC CGE (“computable general equilibrium”) model. (See the 2011 carbon plan, p.181). This model has proved controversial for its use in assessing tax cuts but its use in climate change policy also warrants scrutiny.

Here is how it works:

First, calculate how the economy would work under a few simplifying assumptions.

Suppose there is never any unemployment or idle capacity.

Suppose there is no risk or uncertainty about the future.

Imagine there is no financial system or monetary policy.

Don’t look at pollution problems or climate damages, so economic activity has no visible health or environmental impacts.

Ignore the rest of the world: no changes ever occur in the balance of trade, and no foreign investment, inward or outward.

Assume everyone is perfectly informed and logical, never bogged down by fads, fashions, mistakes, or laziness, but constantly performing complex calculations about the ideal choices for consumption, savings, labour, and leisure.

Now try out a proposed policy, such as the fourth carbon budget, under those assumptions.

Any model has to simplify reality; the map is not the territory. But if the assumptions are too numerous and one-sided, we are looking at a map of a completely different territory.

It is only fair to note that HMRC CGE resembles other CGE models and draws on conventional economic theories. Yet pointing out that others have made the same mistake does not always earn a passing grade in school. The HMRC CGE approach fails in three important ways to provide an unbiased evaluation of the fourth carbon budget.

First, the model fails to recognise that reducing carbon emissions, especially from coal plants, also reduces other harmful pollutants. Conversely, their supposed benefits are much less than commonly thought when these pollutants are taken into account. The economist Nicholas Muller and his colleagues have found that, using conventional values for health damages, the economic value created by US coal plants is worth less than the harm done to human health. Similarly, if we were to take the values for the health impacts of UK coal plant emissions from an officialDepartment of Environment study or from the European Environment Agency, the health improvements linked to the fourth carbon budget would offset most or all of the reported economic costs of that budget. HMRC CGE, however, overlooks this entire category of benefits. The model also ignores other impacts of climate change itself, such as greater incidence of flooding in the UK. And what is the point in a model about the climate that doesn’t properly address externalities?

Second, the model assumes that the UK economy operates on full employment with or without new climate policies. If everyone already has a job, new initiatives can only obtain workers by hiring them away from existing, profitable enterprises. Any gains from new policies are offset by the (usually greater) loss of useful products and services formerly produced by the same workers. Starting from the top of the mountain, there is nowhere to go but down. In contrast, when there is significant unemployment, new initiatives are at least partially competing with the dole rather than with profitable enterprises – and new policies can often lead to a net increase in jobs. The model is biased towards producing negative employment outcomes from policies linked to reducing emission.

Finally, it is shortsighted to ignore the international dimension of climate policies, as HMRC CGE does. On the one hand, worldwide cooperation is needed to achieve the goal of climate protection. On the other hand, there are valuable “first-mover” advantages for countries that move quickly into the new, low-carbon industries of the 21st century. But such advantages will not accrue to those who exaggerate the costs and delay the implementation of much-needed, entirely affordable climate policies.

This blog is cross-posted on the Financial Times' "Off Message" blog.