A Target GDP Approach to Risk and Return in Climate Change Policy

Climate change is widely recognized as a serious risk that requires worldwide governmental action. In a recent speech to Lloyd’s of London, Bank of England Governor, Mark Carney, drew attention to the risks of failing to act on climate change including the risk to the world’s financial systems. To quote from Carney’s speech,

“The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity. While there is still time to act, the window of opportunity is finite and shrinking.”[1]

Unfortunately, there is no consensus amongst policymakers and researchers on the most appropriate policy responses, including how quickly carbon emissions should be cut. Reaching consensus is made more difficult by the enormous uncertainty inherent in projections regarding the timing and extent of the future warming of the earth’s climate, the level of damages, and humanity’s ability to adapt to a warmer climate.

Adding to this is the fact that the most serious damages are expected to occur many decades into the future. Using typical discount rates, traditional economic analysis would recommend little action be taken at present. Further, world climate is affected by the cumulative stock of atmospheric carbon, so that any actions taken today to reduce carbon emissions will only have an impact after a considerable time lag. Policies to reduce carbon emissions, whether via a carbon tax, cap and trade, or other regulatory schemes, are very costly as they entail a realignment of the economy away from carbon based fuels. Amongst governments and other decision makers there is a natural tension between the desire to delay the implementation of these costly policies and the concern that a more precautionary approach is warranted in the face of these huge uncertainties and time lags.