New Delhi, Jan. 24 -- Both Nordhaus and Stern have contributed immensely to the study of economics and climate change. Their approach was also similar: the use of Integrated Assessment Models to incorporate climate variables into macroeconomic models. Where they differed was in the discount factor. Stern uses a far lower discount factor (1.4 per cent) than Nordhaus (4.3 per cent), which means that his models value the future much more than those of Nordhaus. (Though, in a later 2008 paper, Stern clarified that there is a difference between the social discount rate and the pure time or private discount rate. Climate change being a complex issue, with many pathways to cutting emissions, the social discount rate is a more relevant concept. Hence, using a market or private rate of return as a proxy for the social discount rate, as Nordhaus and others have done, is mistaken.)
In other words, Stern believed in intergenerational equity; that is, we have a duty to future generations and should live within our 'environmental' means so that we leave behind a world that is at least as 'good' as it is today. In economic terms, the rate of pure time preference was far higher in Nordhaus' models, since they were based on prevailing market interest rates.
Nordhaus and Stern also differed in their treatment of risk and uncertainty. Stern incorporates risk into his analysis more systematically than Nordhaus. This is also the reason why Stern takes into account worst-case scenarios-the cases with 'fat tails' that have a low probability of occurring. The different discount factors, or different rates of time preference, also led to differences in their policy prescriptions. While Nordhaus advocated a gradual approach, with emissions reductions rising over time (referred to as the climate ramp), Stern advocated an urgent approach, with emissions reductions beginning today.
Stern's approach was also more normative, as opposed to the more positive approach of Nordhaus. Stern emphasised ethical considerations and intergenerational equity, which is reflected in his call for action today so that future generations are protected. Nordhaus' analysis is more positive and uses cost-benefit analysis to advocate a more cost-effective and efficient path.
In his 2008 paper mentioned above, Stern is critical of Nordhaus' prescription. He argues that the target of 550 ppm of CO₂ stock is itself a dangerous place to start, and that higher concentrations, as proposed by Nordhaus in his 2007 paper, are "unambiguously unacceptable". In this paper, Stern also defended the urgent approach referred to earlier. To quote:
"Finally, and of special importance, starting now in a strong way and with clear signals will allow more time for planned choices, discovery of options, and exploration of the renewal periods and timings for equipment. This is the measured lower-cost approach. Going more slowly and then moving in haste when and if the science is confirmed still more strongly is likely to be the expensive option."
Nordhaus and Stern also differ in the way they treat the social cost of carbon. Nordhaus uses a marginal approach and interprets the social cost of carbon as the present value of future damages caused by one tonne of emissions. Inherent in this are the consumption and investment choices along various paths. Stern does not agree with this interpretation and suggests that the social cost of carbon depends on assumptions about future emissions paths, carbon cycles, climate sensitivity, future technologies and ethical approaches. Different combinations of these will lead to different estimates of the social cost of carbon. Hence, it is not a great policy tool; instead, the marginal abatement cost (MAC) is a better guide to policymaking.
Conclusion
The contributions of Nordhaus and Stern to climate change economics are substantial. While both share some similarities, they differ in their policy prescriptions, mainly because of the different ways in which they treat the discount rate. While Stern has advocated starting now rather than waiting for more scientific confirmation, Nordhaus has suggested beginning gradually and then ramping up efforts as more evidence on the nature and content of climate change emerges. Both approaches have merit, but given the increased frequency of extreme weather events and the devastation being caused by more hot days, rainy days, furious tornadoes and storms, and forest fires, I am inclined to go along with Stern.
Published by HT Digital Content Services with permission from Millennium Post.