The Economics of Climate Change
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The Economics of Climate Change

Graciela Chichilnisky

Prepared by one of the leading academics in this pertinent and expanding field, this research review brings together critical essays on the economics of climate change, describing advances in the field ranging from the Kyoto Protocol carbon market, to sustainability criteria, international trade, and the management of catastrophic risks.
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Review Article

Chichilnisky Graciela

Natural resources are our lifeline. We cannot survive without air and water, nor can we survive without soil and seas that produce food. We need minerals for energy and materials to run our economies. And we are starting to understand that we are part of a complex web of species that makes life on earth. It seems natural therefore that public opinion is becoming increasingly concerned about the scarcity and vulnerability of critical natural resources such as clean air, water, soil, the oceans, even a stable climate. Through our actions we are precipitating major changes that could threaten the natural resources on which our lives depend. We may even be destroying our children’s future. The changes we are causing to the world’s atmosphere top the list, as they could precipitate catastrophic climate change. This book is about the changes we need to make in economic thinking to create a safer world, where we live and prosper in harmony with nature.

Awareness of these issues goes back a few decades. In the early 1970s a team at MIT rang an alarm bell about the exhaustion of natural resources, starting the Limits to Growth movement. Even though most of the world’s resources are used by rich nations, this team fueled fears that growing populations in poor nations could destroy the world’s resources. A response to these fears emerged from another global model of the world economy developed in Argentina, offering a perspective from the developing world where most humankind is housed. The Bariloche Model offered a new way to measure economic progress, introducing the Satisfaction of Basic Needs as a measuring stick of economic progress. With this new approach, it was possible to reconcile economic progress with a harmonious use of the world’s resources. The concept of Basic Needs spread fast, and became the cornerstone of efforts to define Sustainable Development. The goal of sustainable development is to satisfy the basic needs of the present without depriving the future of its own needs. One hundred and fifty nations voted sustainable development as the number one development priority in the 1992 United Nations Earth Summit in Rio de Janeiro, where the global environment emerged as a major topic of our times. The Summit led to the creation of the United Nations Framework Convention for Climate Change, which regulates global climate issues, and to the topic of these volumes. The collection identifies critical issues in the Economics of Climate Change and presents a collection of important pieces that address these topics.

Sustainable Development is an elusive concept but it is widely used today by the United Nations, the Group of 20, the US administration, many leading global businesses and the general public. One hears about it in schools, TV programs and the Internet. Conserving the global environment and preventing climate change are major priorities of sustainable development. The notion has become popular and yet it seems curiously out of step with the development of economics as a science. These volumes collect publications that are essential pieces in this puzzle. They address fundamental issues in economics that must be resolved to be able to change the course of history and develop our economies in a way that is harmonious with the earth’s resources, and prevents potentially catastrophic risks of climate change.

The Economics of Climate Change plays a crucial role in this transformation. Economics in the twentieth century saw unprecedented levels of growth and progress, the largest increase ever in human population and in globalization as well as the most extensive and deep use of natural resources in recorded history. As a result, following a stormy first decade in the twenty-first century, we are back to the debate on resources of the 1970s. The debate is once again between rich and poor nations, about who has the right to use the global resources. This time the fears are more concrete and for this reason there may be more room for action. Climate change, the topic of this book, is acknowledged now as a potentially catastrophic risk and most scientists believe is already happening today. Climate change could alter major physical properties of our planet, the atmosphere and the climate system, as well as of the web of life that the planet harbors. While the effects of climate change are physical and biological, the causes of climate change are found in economic organization, the way human societies use the earth’s resources, and in particular how we use fossil energy to produce goods and services. We emit carbon dioxide as we burn coal, oil and gas to heat our homes, run our factories, produce food and clothing, build our homes, and drive our cars. We use fossil energy in just about anything we do in our daily lives. Economics is all about the use of resources, and we need to question and reorganize the way we use resources and the way our economies work.

The task is challenging. There are now more people than ever on the planet, 6 billion at the last count and approaching 10. Over 80 percent of the world’s population lives in poor nations that produce a minority of the world’s economic output, using scanty energy and emitting a minority of the world’s carbon, about 40 percent as a whole. Most of the damage to the world’s atmosphere comes from regions with less than 20 percent of the world population who have relatively small population growth. It is not population but industrialization that drives climate change. Nevertheless, once again, rich industrialized nations fear poor nations’ use of resources. Despite their poverty and the small amount of resources that they use in comparison with the rich nations, many fear that the poor will destroy the world’s environment in their process of development. Forty years after the global environment issue emerged for the first time as a hot topic, we may have done a full circle. We are back to debating once again the North–South issue: who has the right to use the world’s resources?

The situation is different today because climate change is quickly becoming known as the most important risk of our times. The Pentagon has recognized climate change as the number one security risk in the USA. It is widely accepted that industrialization has changed the world’s environment, the composition of the planet’s atmosphere, its water bodies and the complex web of species that makes life on earth. It is not surprising, therefore, that climate change is starting to change the global economy and even the way we think and do economics. It can change public economic policy, how we use energy and generally how human societies are organized. It could even change capitalism as we know it.

The purpose of these volumes is to bring to the reader a collection of important articles that trace the fundamental change that climate change has caused and continues to cause to economic thinking. The pieces document how we are shedding veil upon veil of economic assumptions exposing dated ways of thinking that we built during the last few centuries, and now seem inadequate. This includes the very notion of economic progress, and how it is measured; the dynamics of economic growth, the notion of what constitutes the wealth of nations and the foundations of international trade among nations. It includes North–South relations between rich and poor nations, and even the foundations of market economics. It is a major change in the history of economic thought that is happening in front of our eyes.

These volumes’ important and timely articles could show the way to the future: how economics will be organized in response to global environmental needs. These articles anticipate the economics of the future and what this means for the global environment, and for the use of resources by rich and poor nations. How we do it is key. Some of these articles discuss the role of economics in the creation and distribution of knowledge – how we do things, what we do with our knowledge. This is the concept of the Knowledge Revolution1 and what it implies for the eventual survival of our species and many others in our planet, in harmony with nature.

To present to the reader a wide yet focused picture, the articles have been organized around four major themes. The first theme includes economic literature on world resources that emerged in the last few decades, which has increasingly focused on the pressing problem of climate change. The second theme includes economic policy in response to the global challenge of climate change. This includes the United Nations Kyoto Protocol and its carbon market, as well as other forms of public policy such as carbon taxes. The third theme is the new types of uncertainty that we face as we gradually come to understand the unique features of the global risks caused by climate change, and the decisions that we now face. The last theme covers a number of profound new methodological issues that alter the core of economic theory and help us rethink the notion of economic growth and the measurement of economic progress, such as sustainable development, sustainable international trade, new types of markets with privately produced global public goods, the Knowledge Revolution, and potential market solutions for the destruction of biodiversity in the planet. In each case, the collection presents the evolution of economic thinking along with the evolution of the problem itself. For this reason, the articles in these volumes are presented and discussed in approximately the historical order in which they emerged as part of the economic literature, and also in connection with the development of international events and major environmental agreements.

We start from the economic use of the world’s resources and their increasing vulnerability, a topic that at the beginning was somewhat marginal and seldom recognized as important in economics. Few mainstream economists contributed to the topic of global resources during the initial stage in the 1970s but in recent years, as globalization increased and became more widely recognized, environmental problems such as climate change have achieved more recognition and more and more publications have emerged on the topic. Many authors are discovering that the topic is important and transformational, and it is beginning to become part of mainstream economics.

A starting point is the economics of global resources, a follow-up from the Limits to Growth movement and the creation of Basic Needs in the late 1970s, the new concept that attempted to change the notion of economic progress offering a measure of welfare that is more direct and perhaps more relevant to humankind than the narrow measure of gross domestic product (GDP) that has been used almost universally since the 1950s. The need to replace GDP as a measure of progress became a very topical issue in 2009, in part because of the global financial crisis that started in 2008 and exposed the weakness of current forecasting and measurement methods, and this need is high in the economic agenda of the Group of 20. The first publication in this direction is the Bariloche Model where the editor of the volumes (from here on GC), introduced Basic Needs as reported in the 1976 book published by the International Development Research Center (IDRC) of Ottawa, Canada, authored by Amílcar Herrera et al. within a multidisciplinary team (Chapter 1, Volume I), and in a 1977 article ‘Development Patterns and the International Order’ by GC (Chapter 2, Volume I) in a special issue of the Journal of International Affairs that was dedicated to the Future of the Global Economy. These pieces offered a response to the Limits to Growth debate, focusing on the North–South issue of who should use the global resources – the rich or the poor nations. They report on the results of a mathematical economic model created by GC for this specific purpose at Fundacion Bariloche, Argentina. Basic Needs policies and the attendant use of resources were simulated in five continents, and shown to yield a more harmonious use of resources than the optimization of Gross Domestic Product, GDP, which was the prevailing measure of economic growth. A critical question emerging from these works was how to measure and document the economic importance of resources and environmental degradation to the world economy. It was important to document the potential costs of climate change to the world economy, a topic that was particularly thorny since GDP typically does not measure the loss of water sources, trees, biological species, nor the depreciation of the stock of natural resources (petroleum, forests, mineral deposits, water bodies) caused by the extraction and exports of natural resources. Leading this field is the modeling work of William Nordhaus; his work and others’ is reported in the excellent 1991 Energy Journal publication ‘The Cost of Slowing Climate Change: A Survey’ (Chapter 3, Volume I). The impact of natural resource export policies on poor and rich nations was analyzed in a 1991 book Oil and the International Economy by Geoffrey Heal and GC, from which two chapters, Chapter 7, ‘Oil as a Double-Edge Sword: the Development of Oil-Producing Countries’ and Chapter 8, ‘Oil and the Developing Countries’, are presented as Chapter 4 in Volume I.

By 1992 the UN Earth Summit in Rio de Janeiro had voted basic needs as a cornerstone of efforts to define sustainable development as an international development priority, and gave birth to the main international body in charge of negotiating global solutions, the 1992 United Nations Framework Convention for Climate Change (UNFCCC). A 1994 publication in the American Economic Review, ‘North–South Trade and the Global Environment’ by GC (Chapter 5, Volume I) explained the origin of the global environmental problems at stake, tracing them to international trade in resources between industrialized rich nations who have private property in resources, and poor agricultural nations who have typically common property rights in resources. The trade between these groups was greatly enhanced by the creation of the Bretton Woods Institutions following World War II. In this article the difference in property rights regimes in industrial and developing nations explains trade among nations beyond the classic view of David Ricardo that viewed specialization as the foundation for trade. This piece shows why trade magnifies extraction and exports of natural resources in nations with common property resources beyond what is optimal, creating a global tragedy of the commons: a pattern of trade by which the South extracts and exports more resources than is optimal, selling them below replacement costs and exporting them to a voracious international market for overconsumption in the rich industrial nations. By highlighting the critical role played by property rights on resources, this article led the way to a solution through the creation property rights on the atmosphere across nations, a movement that culminated in 1997, with the creation of carbon limits and the carbon market of the Kyoto Protocol of the UNFCCC.

Several publications in these volumes document the process and the results of the global climate negotiations leading to the Kyoto Protocol, such as the 1997 UNFCCC piece, ‘The Kyoto Protocol of the United Nations Framework Convention on Climate Change’ (Chapter 6, Volume I), and an interesting 1998 piece by the Kyoto Protocol’s Lead Negotiator, Ambassador Raúl Estrada-Oyuela’s, ‘A Commentary on the Kyoto Protocol’ (Chapter 7, Volume I), that discloses the difficulties and subtleties of the creation of this important agreement from the view of a man who had the mandate of negotiating the solution, both appearing in the book Environmental Markets: Equity and Efficiency published by Columbia University Press in 2000, and in Chapter 3, ‘The Road to Kyoto’, by GC and Kristen Sheeran in their 2009 book Saving Kyoto, published by New Holland (Chapter 8, Volume I). The pieces document the creation and design of the only international agreement we have for dealing with climate change as well as the creation of its ‘carbon market’ that was designed and eventually drafted into the Kyoto Protocol by GC in 1997, became international law in 2005, and is trading today about $165 billion per year. The carbon market is a special type of market that trades rights to emit carbon into the atmosphere, and gives rise to a different type of economics. It is an excellent example of what is meant by the new economics of climate change. The concentration of carbon in the atmosphere is not rival in consumption, since carbon dioxide distributes uniformly around the planet and therefore, for physical reasons, every nation in the world is exposed to the same concentration of carbon in the atmosphere, and the attendant climate risks. In economic terms, therefore, the carbon concentration in the atmosphere (and the attendant risk of climate change) is a global public good, perhaps the first and most important global public good that humankind is aware of. The carbon market of the Kyoto Protocol is the first market to trade the rights of use of a global public good. Of course there exist other global public goods – for example the extent of biodiversity in the planet and knowledge as a whole – but the carbon concentration is prominent and critical because carbon emission rights (or ‘carbon credits’) have become a commodity that is successfully traded in the European Union Emissions Trading System (EU ETS) carbon market and is believed could soon become the largest commodity market in the world.

Several articles in the volumes address the economics of the carbon market, starting from the initial two articles that first introduced and explained the concept, and introduced the notion that carbon concentration (and the climate) is a global public good, so that the carbon market is a different type of market in that it trades not private goods as standard markets, but rather a global public good. The concept was initially introduced in ‘The Abatement of Carbon Emissions in Industrialized and Developing Countries’ (Chapter 9, Volume I), an article that GC presented at the International Conference on the Economics of Climate Change at the Organisation for Economic Co-operation and Development (OECD) in Paris, 1993, and in a revised and expanded version in another article co-authored by GC and Geoffrey Heal that appeared in Economic Letters in 1994: ‘Who Should Abate Carbon Emissions? An International Viewpoint’ (Chapter 10, Volume I). These pieces explained the public good aspects of carbon in the atmosphere, and explored the optimal allocation of ‘permits to emit’ across nations to ensure efficient market solutions, developing the connection between equity and efficiency in markets with global public goods. The 1996 Financial Times piece ‘The Greening of the Bretton Woods’ (Chapter 11, Volume I) proposed for the first time the creation of a global carbon market to accompany carbon emission limits, and the 1996 book Development and Global Finance: The Case for an International Bank for Environmental Settlements (Chapter 12, Volume I) published by the United Nations Development Program (UNDP) and the United Nations Educational, Scientific and Cultural Organization (UNESCO), demonstrated the unusual property of environmental markets in linking equity and efficiency, a concept that was essential in obtaining the support of 160 nations – most of them poor nations – who voted for the carbon market at the United Nations Kyoto Protocol in December 1997. The Kyoto Protocol was eventually ratified in 2005, and became international law,2 and at the UNFCCC meeting in Copenhagen December 2009 the overwhelming majority of the nations reaffirmed their support for the Protocol. This was less so in the OECD nations, and yet the Kyoto Protocol remains today the single international agreement on climate change. In addition, several nations have introduced laws similar to the carbon market – such as Australia, in 2008. In 2009 the US House of Representatives voted the Waxman-Market Bill that introduced a ‘cap and trade’ system in the United States, a historic bill that is currently considered for ratification by the US Senate; the US Supreme Court decided in 2007 that a US President has the right to impose carbon limits without Congressional approval. The topics in this collection are therefore of current importance in economic as well as political arenas across the world.

Several articles presented here expand and improve upon the initial results on the carbon market as a way to resolve the allocation of global public goods, and are discussed in what follows. Andrea Beltratti’s ‘Climate Change and Emissions Permits’ in the 1998 book Sustainability: Dynamics and Uncertainty (Chapter 13, Volume I) presents a dynamic analysis of emission permits within the context of the overlapping generations model, considers asset pricing and externalities, and contrasts the interests between generations. The basic questions addressed by this article are: Is there is a useful way to model emission permits in a dynamic market? Can such an analysis provide a perspective to understanding permits that is different from the static markets? Does environmental policy have more or less impact on the market price of permits in a dynamic context? The article by Andrea Prat ‘Efficiency Properties of a Constant-Ratio Mechanism for the Distribution of Tradable Emission Permits’ (Chapter 14, Volume I), in the 2000 book Environmental Markets: Equity and Efficiency, takes a different perspective on the problem of how to allocate permits optimally among nations, which was studied earlier by Chichilnisky, Heal and Starrett in the same volume. Prat considers a specific global negotiation process where instead of holding the total global level of emissions fixed and looking for the right distribution of permits, the reverse is done; that is, given exogenous ratios, one finds a global level of emissions that gives rise to a Pareto efficient allocation. The main proposition in this article parallels the theory of public goods and finds that, given the right regularity conditions, that level exists and is unique. This article proposes a constant-ratio mechanism that has three logical stages, where first one allocates the constant ratio, then one chooses the total amount of emissions, and third, each nation receives its share of permits. The author’s aim is to separate the distribution issue from the efficiency issue.

The results of Graciela Chichilnisky, Geoffrey Heal and David Starrett’s ‘Equity and Efficiency in Environmental Markets: Global Trade in Carbon Dioxide Emissions’ (Chapter 15, Volume I), also in the book Environmental Markets: Equity and Efficiency, considers the general result about how to allocate the use of total agreed permits across nations so that the market solutions are Pareto efficient. They show the connection between equity and efficiency, which derives from the fact that the permits are rights of use of a global public good, and therefore rights of use should be inversely related to income, as is the case in the Bowen– Lindahl–Samuelson conditions for optimality in the distribution of a public good.

Kristen Sheeran’s article extends the analysis of ‘Who Should Abate Carbon Emissions? An International Viewpoint’ (Chapter 10, Volume I) in ‘Who Should Abate Carbon Emissions? A Note’ (Chapter 16, Volume I), published in Environmental and Resource Economics in 2006. Sheeran revisits this important debate and shows that, in general, efficiency does not require equating marginal abatement costs, and in particular therefore abatement should not be done preferentially in poor nations who have lower costs. Sheeran provides the missing intuition behind the initial results on the topic mentioned above, explaining the critical assumptions that gives rise to the result, and showing that the implications of the 1993 Chichilnisky article (Chapter 9) and the 1994 Chichilnisky and Heal’s result (Chapter 10) are increasingly important given the international debate over the preferential role given to developing nations in the Kyoto Protocol and the roles these countries will play in the future climate negotiations.

Relying on a theoretical model that captures the key practical aspects of climate policies, Jean-Charles Hourcade and Laurent Gilotte’s 2000 article ‘Differentiated or Uniform International Carbon Taxes: Theoretical Evidence and Procedural Constraints’ (Chapter 17, Volume I), published also in Environmental Markets: Equity and Efficiency, demonstrates that an efficient allocation can be achieved by differentiated taxes, and that a uniform carbon tax would be appropriate only if applied together with transfers between nations that would benefit the poorer countries.

GC’s article, ‘Knowledge and Environmental Markets with Privately Produced Public Goods’ (Chapter 18, Volume I) in the book Environmental Markets: Equity and Efficiency, explores common features between environmental assets and knowledge, both viewed as privately produced public goods. The article gives conditions for efficient allocations of resources in economies with such goods, which are independent of the units of measurement and the social welfare functions that are utilized; these extend the conditions of Lindahl, Bowen and Samuelson for standard public goods, showing that the distribution of initial rights on the use of knowledge and environmental assets determines the efficiency of market solutions. Joaquim Oliveira Martins and Peter Sturm join the carbon markets debate in their article ‘Efficiency and Distribution in Computable Models of Carbon Emissions Abatement’ (Chapter 19, Volume I), published in Environmental Markets: Equity and Efficiency, and point out that the connection between equity and efficiency in the allocation of permits to emit disappears if the quality of the atmosphere does not affect the traders’ welfare. In this case of course the public good aspect of the problem also disappears and the climate change problem has no impact on human welfare. This excellent article by Oliveira Martins and Sturm shows that it is crucial to understand how climate affects economic welfare. They adopt a hypothesis that welfare and climate are completely unrelated, a hypothesis that had been generally accepted earlier but now is increasingly contested. This hypothesis is at the foundations of much of the modeling work on the negative costs of climate change that is documented in the 1991 William Nordhaus survey of the literature (Chapter 3, Volume I), which discusses the costs of climate change in terms of the cost of reducing greenhouse gas emissions.

The ‘Introduction’ (Chapter 20, Volume I) to the book Environmental Markets: Equity and Efficiency, Columbia University Press, 2000, co-authored by GC and Geoffrey Heal, expands on the original proposal for a carbon market and the explanation how the carbon market could favor both poor and rich nations, explaining also the connection with public policy proposals involving carbon taxes. The analysis provides estimates of the cost of reducing chlorofluorocarbons and CO2 emissions, and inquires into the forestry options to remove CO2 from the atmosphere. A promising new approach, the use of geoengineering, is discussed qualitatively and is also the basis for the more recent piece by Nicholas Stern (Chapter 21, Volume I), ‘Climate Change: Our Approach’ in The Economics of Climate Change: The Stern Review, Part 1, Cambridge University Press 2006. Stern considers the nature of the scientific evidence for climate change, and the nature of the economic analysis required by the structure of the problem which follows from the science. This piece examines the evidence on the economic impacts of climate change itself, and explores the economics of stabilizing greenhouse gas concentrations in the atmosphere.

Pulling these strands of the literature together, one may compare and achieve a perspective on the different approaches and conclusions that are reached by these authors. It seems fair to say that neither Nordhaus’ nor Stern’s pieces build on the public good aspects of climate change, nor the extent to which the carbon market can resolve the climate change problem without net costs to the world economy. This is a new fact that became possible only in the new era when the carbon market is a reality with different economic foundations than other markets. The pieces just mentioned by Nordhaus and Stern compute market costs based on standard economic theory without considering the changes in market prices that the carbon market introduces, which is of interest on its own. In their 2009 book Saving Kyoto, Sheeran and GC show how, with the carbon market in place, there are no net costs to the economy from resolving climate change, since some must pay but others receive the same payments. This is an aspect that goes unmentioned in the excellent pieces by William Nordhaus, Kenneth Arrow, Duncan Foley and Nick Stern discussed above and below. The global public good aspect that is the basis of some of these pieces, starting from 1993, is not covered in Joseph Stiglitz’ 2006 article ‘A New Agenda for Global Warming’ that appeared in The Economists’ Voice (Chapter 22, Volume I). This piece points out that globalization will do little good to solve our global economic problems if we do not do something about the most pressing common environmental problem: global warming. J. Stiglitz points out that the Kyoto Protocol took on the issue of reducing carbon emissions, but despite its achievements, the USA, the world’s largest polluter, refused to join in and continues to increase its emissions, while the developing nations which in the not too distant future will contribute, he says, 50 percent or more of the global emissions, have no firm commitment. J. Stiglitz’ article proposes an agenda that is mostly focused on the United States and developing nations’ pollution.

Included in these volumes are more recent pieces that re-discover and build upon the global public good properties of the climate change problem, obtaining important new results based on the implications of this fact on public policy. In a lucid 2007 piece, Kenneth Arrow’s ‘Global Climate Change: A Challenge to Policy’ in The Economists’ Voice (Chapter 1, Volume II), agrees with the fact that the carbon concentration of the atmosphere is a global public good ‘par excellence’, as in the original 1993 and 1994 pieces mentioned above. Arrow argues that the public good aspects of climate change justify using a much lower discount rate in evaluating the cost and benefits of climate change policy, effectively giving more weight to the future and justifying more widely policy action. A different but related policy point is made by Duncan Foley in his 2007 piece ‘The Economic Fundamentals of Global Warming’ in Twenty-First Century Macroeconomics: Responding to the Climate Change (Chapter 2, Volume II). Foley also agrees with the global public good nature of climate change mentioned above, and argues that the discount factor to be utilized in cost–benefit analysis of climate change policy could even be negative, again because of the global public goods aspects of climate change, which implies that the present and the future could benefit together rather than facing tradeoffs as it is usually believed. Joshua Gans’ article ‘Do Voluntary Carbon Offsets Work?’, also in The Economists’ Voice (Chapter 3, Volume II), explores whether carbon offsets change human behavior – for the better or the worse. The value of carbon offsets and their impact on reducing emissions of CO2 is examined in cases where people or institutions voluntarily purchase carbon offsets that are not imposed by international agreement. Gans asks whether offsets change demand in a way that unwinds the desired CO2 reductions, relieving people’s responsibilities and allowing them to rationalize using more energy for their transportation needs, in which case the system would not work.

The pieces mentioned so far address the first two themes of the book, namely how to think about the general issue of climate change in economics, and the accompanying market and public policy issues that the new thinking entails. Climate change has motivated other new developments in economics. It led to increased awareness about new forms of uncertainty that climate change has created. The 1993 article ‘Global Environmental Risks’ published in the Journal of Economic Literature by GC and Geoffrey Heal (Chapter 4, Volume II) explained how different are the risks we face with climate change from the type of risks that were contemplated in standard models of risk management in economics. The new risks include unknown risks, those whose frequencies and scope is still poorly understood and may be impossible to experiment or duplicate for learning purposes. They include potentially catastrophic risks that are small probability events with major, widespread consequences; endogenous risks that are mostly created by human action rather than by acts of nature; and widely interconnected or systemic risks that can affect everybody in the world at about the same time so sharing or distributing risks among a number of traders is not possible. This piece offers a historic perspective, as well as decision tools and analytical methods for dealing with such new risks. The 1996 article ‘Markets with Endogenous Uncertainty Theory and Policy’ (Chapter 5, Volume II) examines a market where the uncertainty derives from the traders’ actions – as in the current 2008–10 global crisis. It shows that it is possible to define market equilibrium where the traders hedge against the uncertainties that they themselves produce – but it is not possible to recover the first theorem of welfare economics. Market solutions may be inefficient – in fact, the notion of Pareto efficiency itself is ill-defined because preferences may change with the particular equilibrium that is realized. The article shows that an economy cannot fully hedge against the risks that it itself creates, a result that is reminiscent of Bertrand Russell’s results in the foundation of logics, which the article examines.

The ‘Introduction’ to the 1998 book Sustainability: Dynamics and Uncertainty edited by GC, Geoffrey Heal and Alessandro Vercelli (Chapter 6, Volume II), develops similar themes and connects the issue of uncertainty with ‘sustainable development’. Many years later, an article by Thomas Schelling (Chapter 7, Volume II) picks up some of these themes in his excellent ‘Climate Change: The Uncertainties, the Certainties, and What They Imply about Action’ that was published in 2007 The Economists’ Voice. Schelling asks what the world would be like in 50, 75, or 100 years from now, when climate change becomes acute, and how in 75 years from now we may realize we could have predicted today the consequences of climate change on the world, and who are the ‘we’ who might have predicted those consequences. He points out that the uncertainties are immense, but the certainties are significant and compares the Earth with Venus that is so bathed in ‘greenhouse gases’ that its surface temperature is hundreds of degrees above the Earth’s. Schelling asks, if we knew that the Earth is inexorably warming, what would be the most urgent things to do? He agrees that we have to keep studying the phenomena, as huge advances in understanding of the climate and its ecological impact are occurring. Under ‘urgencies’ he puts energy research and development, especially government sponsored, and multi-government R&D. He claims that we need urgently to understand the alternatives to fossil fuels, how much energy can be conserved, how to extract carbon dioxide from the atmosphere, and how we may use geoengineering methods to reflect back sunlight and diminish the greenhouse gas effect.

The pieces just mentioned identify new economic thinking that is needed to cope with the environmental risks we face, and provide suggestions in this direction. For example, to deal appropriately with catastrophic risks – rather than ignoring them on account of their small probabilities – new axioms of choice under uncertainty were introduced in the 2000 article appearing in this volume (Chapter 8, Volume II), ‘An Axiomatic Approach to Choice Under Uncertainty with Catastrophic Risks’ by GC in Resource and Energy Economics. These axioms gave rise to a new theory of risk that parallels Von Neumann and Morgenstern’s formulation on standard risks, yet treats frequent and rare events in the same footing and eliminates the well-known insensitivity of classic expected utility theory to rare events, no matter how important they may be, incorporating outliers and heavy-tailed distributions.

Finally, the remaining chapters of this volume are about important methodological issues arising from the need to refocus economics in a sustainable direction. Sustainable development is a notoriously elusive and difficult topic, but the literature is making progress in this direction. Two initial pieces ‘An Axiomatic Approach to Sustainable Development’ (Chapter 9, Volume II) and ‘What is Sustainable Development?’ (Chapter 10, Volume II) published by GC in Social Choice and Welfare, 1996, and Land Economics, 1997, respectively, provided three axioms that define rigorously the notion of sustainable development and characterized the criteria that they imply.

Following these pieces, a number of other articles reproduced in this volume addressed the problem providing increasingly detailed ways to execute the early definition of sustainable policies. More generally the literature on sustainable development seeks to develop a body of theory with the clarity and the substance of neoclassical theory, avoiding the ‘impatience axiom’ that was introduced by Tjalling Koopmans in his seminal work on economics over time, an axiom that – almost by definition – undervalues the value of the long-term future. Examples of this literature are the 1995 article ‘The Green Golden Rule’ (Chapter 11, Volume II) by GC, Andrea Beltratti and Geoffrey Heal published in Economics Letters, which defines the equivalent of the golden rule of economic growth, for sustainable economies. This can be defined as the maximum level of consumption that a society can achieve sustainably. This article introduced the concept and defined the ‘green golden rule’ and analyzed the existence and properties of solutions. Chapters 5, 6 and 7 of Geoffrey Heal’s book Valuing the Future, published in 1998 by Columbia University Press, contain an excellent summary of the problem of sustainable development starting from standard utilitarian theory and ending with formal approaches to sustainable development that include the axiomatic treatment of sustainable development that was discussed above, offering solutions and analyzing their properties. Chapters 5 and 6 of G. Heal’s book are included in this book (Chapter 12, Volume II), and they analyze utilitarianism and new solutions to resolve the problem of impatience. The 1996 article by Yeganeh Farzin ‘Optimal Pricing of Environmental and Natural Resource use with Stock Externalities’ in the Journal of Public Economics (Chapter 13, Volume II), analyzes interlinked resources and environmental stock externalities. Using a simple dynamic model, the author shows that in the face of such externalities the static market-based policy instruments such as Pigouvian taxes should be modified. Even if for an initial period there is no pollution stock damage, optimal policy still requires that the abatement begins immediately and at increasing rates. This article emphasizes the need to take early action.

The 2005 piece by Larry Karp, ‘Global Warming and Hyperbolic Discounting’ in the Journal of Public Economics (Chapter 14, Volume II), uses a constant discount rate to study long-lived environmental problems such as global warming, and shows that it has two disadvantages: the prescribed policy is sensitive to the discount rate, and with moderate discount rates, large future damages have almost no effect on current decisions. Time consistent quasi-hyperbolic discounting alleviates both of these modeling problems, and is a plausible description of how people think about the future. Karp analyzes a Markov perfect equilibrium in a general model with a stock pollutant, and illustrates the role of hyperbolic discounting in a model with global warming. The 2006 article by Larry Karp and Jiangfen Zhang, ‘Regulation with Anticipated Learning About Environmental Damages’ (Chapter 15, Volume II), describes a regulator that anticipates learning about the relation between environmental stocks and economic damages. It shows analytically that anticipated learning decreases the optimal level of abatement. Learning may favor the use of carbon taxes over quotas. Timoki Fujiia and Larry Karp’s piece, ‘Numerical Analysis of Non-Constant Pure Rate of Time Preference’ (Chapter 16, Volume II), published in 2008, considers a model where current decisions affect welfare in the far distant future, as is the case with climate change – and analyzes the use of a declining pure rate of time preference (PRTP), showing that it provides important modeling flexibility. They describe and provide on-line software, to implement an algorithm and numerically obtain Markov perfect equilibrium for an optimal control problem with a non-constant rate of discount, applying this to a simplified version of a numerical climate change model used in the Stern Review. The latter two articles appeared in the Journal of Environmental Economics and Management.

The recent 2009 article by Martin Weitzman, ‘On Modeling and Interpreting the Economics of Catastrophic Climate Change’ in the Review of Economics and Statistics (Chapter 17, Volume II), picks up the topic of catastrophic risks introduced in the 1993 and 1996 publications (Chapters 4 and 5, Volume II) discussed above. The author uses climate change as a prototype example of structural uncertainty for the economics of a low probability, high impact catastrophe. Even when updated by Bayesian learning, uncertain structural parameters induce a critical ‘tail fattening’ of posterior-predictive distributions. The article suggests that such fattened tails have strong implications for situations like climate change where a catastrophe is theoretically possible, because prior knowledge cannot place sufficiently narrow bounds on overall damages. The paper shows that the economic consequences of such fat-tailed structural uncertainty along with uncertainty about high-temperature damages can readily outweigh the effects of discounting in climate change in policy analysis. The 2009 article, ‘Avoiding Extinction: Equal Treatment of the Present and the Future’ published in the Economics E-Journal (Chapter 18, Volume II), ties together the axioms for sustainable preferences with the introduction of a long-term constraint on the use or extraction of a natural resource or the destruction of a species in the long run.

The 1998 article ‘Economic Returns from the Biosphere’, by GC and Geoffrey Heal (Chapter 19, Volume II), published in Nature, proposes specifically how to extend the scope of market tools that are used to regulate the use of the atmosphere – such as the carbon market – to encompass the protection of the web of species in the plane. The article ‘The Knowledge Revolution’ by GC (Chapter 20, Volume II), extends the concepts and results of markets with privately produced global public goods to the case of knowledge. Knowledge was identified in these pieces for the first time as a global public good. Together with environmental assets, knowledge is believed to be the most important asset for humankind in the twenty-first century. It is argued that knowledge as an input of production replaces capital goods and creates the foundation for a different economy – based on the rights to use a public good, rather than on the rights to use private inputs of production such as land or capital. The concept of the ‘Knowledge Revolution’ was introduced in this piece as are new property rights regimes that can make the use and distribution of knowledge efficient. This concept is now becoming a reality. It leads to a new economy that is very innovative in the use of knowledge and very conservative in the use of physical resources, and is more consistent with a sustainable future.

In addition to the methodological pieces already discussed, climate change forces us to extend the scope of economics to include interdisciplinary research – both theoretical and also policy oriented. Climate change requires the input of physicists as well as economists, addressing problems and creating solutions that are the interface of the two disciplines. Interdisciplinary pieces included in this collection cover issues of sustainable development in conjunction with energy security, namely the ability of a nation to securely provide for its national energy needs, and also the discussion of new technologies that could replace fossil fuels in the provision of electricity with renewable sources. Power plants that produce electricity using fossil energy sources represent a major source of carbon emissions in the world economy (about 41 percent) and are a major challenge for development, because economic development is inextricably connected to energy use. The power plant infrastructure that needs to be replaced involves about $50 trillion in plant and equipment, as demonstrated by the International Energy Agency.

The two last articles included in Volume II, are a 2009 publication by GC and Peter Eisenberger, ‘Energy Security, Economic Development and Global Warming: Addressing Short and Long Term Challenges’ in the International Journal of Green Economics (Chapter 21), which analyzes in detail the short and long-term risks we face with global warming and shows how different are the short from the long-run solutions. The article provides a long-term solution that uses ‘negative carbon’ technologies, namely technologies that take more carbon from the atmosphere than they emit, such as trees can do. The authors find that to make a transition away from the fossil economy and culminating with the solar economy, the transition should rely on ‘carbon prices’ such as those provided by the carbon market of the Kyoto Protocol to create the right incentives for cleaner technologies. They discuss how the carbon market works, and discuss in detail the economics of a transition away from the fossil economy to the solar economy. Another interdisciplinary article is (Chapter 22) ‘Global Warming and Carbon-Negative Technology: Prospects for a Lower-Cost Route to a Lower-Risk Atmosphere’ in Energy and Environment, 2009, by P. Eisenberger et al., which explains that aggressive efficiency improvements and a shift away from fossil fuels cannot offset climate change threats. Following the earlier interdisciplinary work mentioned above, which introduced the ‘negative carbon’ concept, this piece demonstrates the imperative for ‘carbon-negative’ mitigation measures, to reduce the atmospheric carbon faster than carbon emissions will load the atmosphere, by using Intergovernmental Panel on Climate Change (IPCC) scenarios of emissions growth that show that it is the only hope to reduce potentially catastrophic risks of climate change now. Among such ‘carbon negative measures’ the article discusses the air extraction of CO2 coupled with secure storage or use for plastics or for algae applications, which offers advantages of control without direct intervention in the biosphere or major collateral impact. New developments in air extraction show promise of greatly reduced costs, and the possibility of decreasing the concentration of carbon in the atmosphere to substantially lower risk levels in a way that may be economically practicable. These developments create a strong case for expanded R&D efforts aimed at advancing air extraction technology, as recommended by the recent article by T. Schelling (Chapter 7, Volume II) that is discussed above.

The collection of articles in this volume make a strong case for the development of a different type of economics – sustainable economics or green economics – that places more value on the welfare of future generations, and is more sensitive to the importance of resolving long-term problems. The future of economics is elusive and unknown, as is the future of our species. Yet it appears that a transformation of thinking and values is required to make the transition to a new world economy where markets become important tools to implement new sustainable global values, rather than deciding values on their own. The transition to a new economics is occurring, as documented in this book. But it is slow and difficult, and one inevitably wonders what lies in our future. This editor (GC) is optimistic for the long run, but the short run is a different issue. The main issue is whether there is a path from here to the long-run future. Time is of the essence, and only time will tell.


The term ‘The Knowledge Revolution’ is a trademark of the author, Graciela Chichilnisky.

These events are documented in the 2009 New Holland book Saving Kyoto by GC and Kristen Sheeran from which Chapter 8 (Volume I) is taken.