New Economist

The Stern report revisited

Australia's Productivity Commission today published a very useful assessment of the Stern report on climate change. The 125 page staff working paper by Rick Baker, Andrew Barker, Alan Johnston, and Michael Kohlhaas, The Stern Review: an assessment of its methodology, provides both an excellent summary and a balanced assessement of the report's analysis and recommendations. Press reports picked up on this particular connclusion:

The Review’s ‘urgent’ language can be explained by it being as much an exercise in advocacy as it is an economic analysis of climate change. It is not surprising, therefore, that reaction to it has been mixed.

Bias? To be sure. But the Commission paper remains broadly supportive of Stern's approach. They acknowledge the immense analytical challenges confronting Stern and his colleagues:

Rarely do analysts confront cost–benefit analyses with dimensions so long-term, uncertain and non-marginal. This places extraordinary strains on analytical techniques that generally have been devised for more conventional projects, and almost inevitably means that value judgements and ethical perspectives become more prominent.

The authors argue (p.xvi) that the Stern report has made an important contribution to the climate change debate:

There appears to be an emerging view that the Review has made a valuable contribution by establishing climate change as an economic issue that can be assessed through the ‘lens’ of a cost–benefit framework. Moreover, the Review team continues to engage with its critics and to expose its work (including rebuttals of critiques) to scrutiny. In some instances, its responses indicate acceptance of criticisms levelled. In this respect the Review continues to be important as a catalyst for engendering further analysis, development and refinement of the economics of climate change.

And conclude that:

Some of the criticisms of the Review are justified. The assertiveness with which some of the headline messages are delivered is not always matched by the caution attached to the evidence and analysis presented within the body of the report. And, relevant questions remain about the way the analysis was focused. It is based on a single high emissions scenario, inclines towards more pessimistic assumptions on damage costs, and adopts unconventional parameters for discount rates. These traits tend to escalate the present value of future costs and thereby elicit urgency in mitigation measures.

This is consistent with the Review authors’ apparent belief that, although catastrophic outcomes may be unlikely, the implications for future generations, were they to arise, would be so detrimental that it would be remiss to fail to give them sufficient weight. There is nothing especially wrong with this view — as one critic has conceded, the Review’s conclusions may well be proved right but for the wrong reasons. However, the Review presents itself to decision makers as yielding conclusions underpinned by conventional, rational economic analysis. In fact, the authors’ concerns about catastrophe in conjunction with their attendant ethical perspectives, permeate many stages of the analysis. More sensitivity analysis to highlight the consequences of alternative views and value judgements would have been valuable.

Anyone interested in climate change should read this paper. It is available free online.

Who’s afraid of a big bad oil shock?

Another Yale professor, William D. Nordhaus, contributed a paper to last weeks BPEA celebration at the Brookings Institution. When the U.S. invaded Iraq in March 2003, many economists feared that the war would lead to a sharp decline in Iraqi oil production, a spike in oil prices, and a woeful economy that would follow the scripts of the oil shocks of 1973, 1978, and 1990. What happened and why is analysed by Nordhaus in a paper entitled: Who’s Afraid of a Big Bad Oil Shock? (PDF). Here are his conclusions:

So what should we conclude? To begin with, the oil shock of 2002-2006 was different from those of earlier period. If we measure the shock as the income effect per year of the price increases, the shock was substantially smaller than the shocks of the 1970s. It occurred more gradually, and the change was much less of a surprise in the context of past experience. Roughly speaking, the shock was about one-third as large as the shocks of the 1970s.

In terms of effects, the impact of the shock on inflation was qualitatively similar although quantitatively different from the earlier shocks. The rise in PCE inflation in the recent shock was consistent with less than full pass-through of the energy-price increase. Unlike the shocks of the 1970s, there appears to have been no substantial pass-through of the energy-price increases into wages or other prices.

The impact of the shock on output was completely different from earlier episodes – indeed the sign was opposite. Output continued to grow relative to potential output after the shock, and unemployment continued to fall. The reason for the anomalous output impact is unclear. One possible reason is that the shock was too small to affect the overall pace of economic growth.

Additionally, there is modest evidence that the transmission mechanism from energy prices to output has changed from negative to neutral over the last three decades. The reasons for the declining sensitivity are not completely understood, but two underlying causes seem plausible. First, there is evidence that the Federal Reserve reacted more sensibly to energy prices in the 2000s.. ...A second and more speculative reason for the muted macroeconomic reaction is that consumers, businesses, and workers may see oil-price increases as volatile and temporary movements rather than the earth-shaking changes of the 1970s. ...All of these factors would tend to reduce the impact of energy-price shocks on the macroeconomy.

In the end, this suggests that much of what we should fear from oil-price shocks is the fearful overreactions of the monetary authority, consumers, businesses, and workers. A cautious reading today suggests that policymakers should not be afraid of a Big Bad Oil Shock. The most recent evidence suggests that the economy is robust in the face of major energy shocks. The economy weathered an increase in real oil prices of 125 percent from 2002 to 2006 without any major strain. This suggests that policymakers should focus on fundamentals such as employment, real output, and containment of inflation as well as the instabilities caused by financial innovations and risk-taking. Oil-price shocks are neither so big nor as bad as in the 1970s.

See also the background documentation: Notes on Data and Methods (PDF)

Why oil prices are not such a problem for inflation anymore

It has been apparent for some time that changing oil prices no longer pass-through to domestic prices to the same extent they once did. A new study by the central bank of Chile, Another Pass-Through Bites the Dust? Oil Prices and Inflation, provides a useful analysis and explanation of this phenomenon:

This paper presents evidence of an important decline during recent decades in the pass-through from the price of oil to the general price level. We find that this decline is a generalized fact for a large set of countries.

...we use two estimation strategies in an attempt to properly identify the effect of oil shocks on inflation. First, we estimate the traditional Phillips curve augmented to include oil and test for structural breaks in 34 countries. This methodology shows a fall in the average estimated passthrough for industrial economies and, to a lesser degree, for emerging economies.

Second, we estimate rolling vector autoregressions for a subsample of countries for which we have sufficient data. We derive impulse response functions of inflation to oil shocks and interpret the integrals as estimates of pass-through. We find that the effect of oil shocks on inflation has weakened for most of the 12 countries in the sample.

Among the factors that might help to explain this decline, we argue that the most important are a reduction in the oil intensity of economies around the world, a reduction in the exchange rate pass-through, a more favorable inflation environment, and the fact that the current oil price shock is largely the result of strong world demand. These factors help to explain not only why the current shock has had limited inflationary effects, but also why it has had limited consequences for output.

The economics of the Stern Review

For those interested in the economics of climate change, Birmingham University's Economics department and the Institute for Energy Research and Policy are holding a one day workshop on The Economics of the Stern Review.

The purpose of this workshop is to understand why Stern emerges with policy prescriptions which appear to differ from those supplied by previous economic analyses of the climate change problem. Did earlier analyses neglect important aspects of the climate change problem which Stern has managed to address or has the economic and scientific literature upon which they relied moved on? Or is the case that the Stern Review itself is in some respects deficient? The workshop brings together leading members of the Stern Review, contributors to the Review process and economists who have been openly critical of the Stern Review.

It is billed as "an academic debate between the proponents and opponents of the Stern Review of the Economics of Climate Change". The workshop takes place on Friday 9 March at 0930-1745.

Thanks, Sir Nick

We may never get the inside dope, but clearly Sir Nicholas Stern's time in Whitehall did not quite turn out quite as he might have hoped. Sir Nick was appointed appointed head of the Government Economic Service and Second Permanent Secretary to HM Treasury in October 2003, after a stint as Chief Economist at the World Bank.

He was presumably meant to take some of the burden off then-Treasury Permanent Secretary Gus O'Donnell. But before long, he was off heading up the Commission for Africa, followed soon after by his review of the economics of climate change.

Now it is reported that he is to move to a new Professorship at the LSE, heading up a new India Observatory. Stern may not have won the Whitehall turf war, but one can't help thinking that by playing a key role in two vital issues of our time, he may have actually done more good for the world than if he'd stayed tucked behind a desk at Horse Guards Road. A real 'civil service'.

Climate change: wait, there's more...

As if the 600 page Stern Review on the economics of climate change were not enough to digest, Her Majesty's Treasury has also posted 36 commisioned pieces of supporting research online. Quite a few concern temselves with 'the China problem', some with the economics of adaptation, others with mitigation and abatement. Though many are clearly for the specialists, readers might find some of interest. The full list is over the fold...

Climate change: "the greatest market failure the world has seen"

The Stern Review, the most comprehensive review ever on the economics of climate change, was published today (as I previewed yesterday). The report is nothing if not thorough. All 27 chapters are now available on the Treasury website to download - or I guess you can wait until January and pay Cambridge University Press £29.99 for the book (CUP obviously don't believe in print on demand!). Also available is today's Press notice, along with Sir Nicholas Stern´s presentation (PDF), and speaking notes (PDF).

Sir Nicholas said in his presentation that "we have to muster all the economics we can bring to bear" on climate change - a sentiment few readers would disagree with. Here is a short excerpt from his presentation:

The science tells us that GHG emissions are an externality; in other words, our emissions affect the lives of others. When people do not pay for the consequences of their actions we have market failure. This is the greatest market failure the world has seen. It is an externality that goes beyond those of ordinary congestion or pollution, although many of the same economic principles apply for its analysis.

This externality is different in 4 key ways that shape the whole policy story of a rational response. It is: global; long term; involves risks and uncertainties; and potentially involves major and irreversible change.

Although the press have highlighted some of the doomsday warnings in the report, these are based on the 2100 'business as usual' scenarios - not on likely developments anytime soon. As Sir Nicholas said today, the Review's conclusion are "essentially optimistic. There is still time to avoid the worst impacts of climate change, if we act now and act internationally. He spelled out three strands to policy:

First, we must establish a carbon price via tax, trade and regulation – without this price there is no incentive to decarbonise. Second, we must promote technology: through research and development. Further, private sector investors need confidence that there will be markets for their products: that is why deployment policy also makes sense. And third we must deal with market failure; for example problems in property and capital markets inhibit investments for energyefficiency.

The usual suspects have rushed to condemn the report - some even before it was published. Like Sunday Times journalists and blogger David Smith, I won't comment on it in detail until I've had a chance to read it. But I certainly agree with David's comment that:

..the broad thrust of his report, that money spent now will save much bigger costs later, makes sense, as does his emphasis on carbon trading.

Taking the economics of climate change seriously - at last

Too much of the debate about climate change has centred on the science and politics; too little on the economics. But not for much longer. On Monday the UK government publishes a massive 700 page report on the economics of climate change, the results of over a year's effort by former World Bank chief economist Sir Nicholas Stern and his team.

The Stern Review's earlier discussion paper, What is the Economics of Climate Change? (PFD), gives a preview. It argues climate change is a serious and urgent problem, global in its cause and consequences. Current actions are not enough "if we are to stabilise greenhouse gases at any acceptable level". The "economic challenges are complex", and will require a long-term international collaboration to tackle them.

Today's Observer front page leads with a story emphasising the likely costs: £3.68 trillion: The price of failing to act on climate change

...the most authoritative report on global warming warns it will cost the world up to £3.68 trillion unless it is tackled within a decade. The review by Sir Nicholas Stern, commissioned by the Chancellor of the Exchequer and published tomorrow, marks a crucial point in the debate by underlining how failure to act would trigger a catastrophic global recession. Unchecked climate change would turn 200 million people into refugees, the largest migration in modern history, as their homes succumbed to drought or flood.

Stern also warns that a successor to the Kyoto agreement on cutting greenhouse gas emissions should be signed next year, not by 2010/11 as planned. He forecasts that the world needs to spend 1 per cent of global GDP - equivalent to about £184bn - dealing with climate change now, or face a bill between five and 20 times higher for damage caused by letting it continue. Unchecked climate change could thus cost as much as £566 for every man, woman and child now on the planet - roughly 6.5 billion people.

...Stern's forecast cost of 1 per cent of global GDP is roughly the same amount as is spent worldwide on advertising, and half what the World Bank estimates a full-blown flu pandemic would cost. Without early intervention, he estimates the cost would be 5-20 per cent of GDP, some paid by governments, some by the private sector.

This report will be of such weight it cannot be dismissed, as others have. The Observer piece says:

Downing Street and the Treasury believe that the report marks a decisive moment in international politics. Stern's is the first heavyweight contribution by an economist rather than a scientist and senior officials believe he will make what might seem a hopelessly ambitious timetable credible. 'This will give us an argument to make,' said a Whitehall source. 'I think we are at a tipping point in terms of the debate, as we were at a tipping point in 2004/05 in terms of the science.'

For more previews, see Will Hutton's Observer piece At last - a map to lead us out of catastrophe, and Reuters: No climate action may spark economic crisis - report

In a related story on green taxes, the Mail on Sunday reports that Secret green tax blitz planned for cars, air travel and consumer goods. They suggest that the government is eying a raft of green measures to help combat climate change, including higher taxes on cars, air travel, fuel, lighting and consumer electronics.

The letter to Mr Brown, marked 'Restricted', demands urgent and radical action in next month's public-spending review and next year's Budget. Changing people's behaviour can be achieved only by 'market forces and price signals', it says, adding: 'Market-based instruments, including taxes, need to play a substantial role. As our understandings of climate change increases, it is clear more needs to be done.'

The Government must 'increase the pace of existing tax measures, broaden them into sectors where incentives to cut carbon emissions are weak and identify new instruments to drive progress in tackling greenhouse gas'.

This debate will run and run. What makes the UK debate interesting is that both opposition parties have supported various green taxes. One hopes we might see a more informed and less polarised debate than is usual on tax matters.

Along with the discussion paper, Stern's lecture/presentation in January to the Oxford Institute of Economic Policy, and his World Economy piece and rebuttal are also worth reading. They are available on Treasury's Stern Review website.

India becomes a gasoline gusher

Few know that the world's third-largest refinery complex lies off the Indian shore - nor that India is now a net exporter of oil. Randeep Ramesh writes about America's dirty secret: India becomes the gasoline gusher in today's Guardian:

Sitting on the edge of the water in the Gulf of Kutch on India's western shore is one of America's dirty secrets. A mass of steel pipes and concrete boxes stretches across 13 square miles (33sq km) - a third of the area of Manhattan - which will eventually become the world's largest petrochemical refinery.

The products from the Jamnagar complex are for foreign consumption. When complete, the facility will be able to refine 1.24m barrels of crude a day. Two-fifths of this gasoline will be sent 9,000 miles (15,000km) by sea to America.

India's biggest private company, Reliance Industries, with a market capitalisation of $33bn (£17.8bn), runs the plant. Controlled by billionaire Mukesh Ambani, whose father Dhirubhai founded the company, Reliance towers over its industry rivals, contributing 8% of India's exports.

The company's ambitions in Jamnagar have helped India move from being a net importer to an exporter of refined petroleum products. "We want to make a statement that India can be an industrial giant. Jamnagar is a refinery for the world, based out of India," said Hital Meswani, executive director of Reliance Industries. "In the mid-90s when this project was conceived, no one believed it would work. We were told there was too much capacity, returns were not great and every management consultant we hired told us don't bother."

New econoblog: Globalisation and the Environment

Another econoblogger added recently is Globalisation and the Environment, by Rob Elliott, Matt Cole & David Maddison - environmental economists at the University of Birmingham. They describe it as "A place to find news, research and discussion on economic issues related to the globalisation and environment debate". So far it looks pretty interesting. Their recent posts include:

Adam Smith Had Nothing to Say on CSR

Global Warming - the most media hyped environmental issue of all time?

Maybe the planet is not doomed after all?

Coal and Global Warming - the China effect

Bush, CO2 and job losses - same excuses