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Climate change: what are the economic impacts and potential solutions?

To stand a chance of meeting the net-zero ambitions of the Paris Agreement, a multi-pronged approach to curbing climate change is needed that permeates all sectors of our society and economy. Done well, this comprehensive approach will ensure a just transition.

COP26 was surely among the most anticipated of United Nations climate summits since they began in 1995. As the world’s leaders gathered in Glasgow in November 2021 to set out renewed plans for meeting the goals of the Paris Agreement, the window of opportunity to avert the most catastrophic of climate change’s impacts felt perilously small, even more so given that the pandemic delayed COP26 by a year.

As the summit closed, progress had been made towards the Paris Agreement’s goals, notably towards securing global net zero by mid-century and keeping 1.5°C within reach; and mobilising finance – from developed countries to developing countries and from across the private and public sector.

But the progress was not nearly enough. Climate change pledges presented by countries at COP26 would only limit global warming to 2.4°C. Certainly, this outcome is better than the 2.7-3.1°C in the absence of these pledges but it would nonetheless be disastrous (see Figure 1). A rise of just 2°C is described as spelling a ‘death sentence’ for vulnerable countries, and any increase beyond 1.5°C will trigger irreversible environmental and ecological damage, and huge economic costs. 

Figure 1: Global greenhouse gas emissions and warming projections until 2100

Source: Climate Action Tracker, May 2021 briefing

Now parties must develop more ambitious plans, or nationally determined contributions (NDCs), for the next COP in Egypt in 2022 – a deadline brought forward from 2025. This provides some hope that the dream of 1.5°C can be kept alive.

Here we outline a selection of economic policy options that could support national and global efforts to meet the goals of the Paris Agreement, from investment in green innovation to carbon taxes. A firm eye is kept on the socio-economic impacts of both climate change and climate change action, one that is needed to ensure a fair transition to a greener future.

The economic impetus for action

In shaping climate policies, and defining their urgency, it is first worth surveying the impacts of global warming. 

The physical damages of climate change are already with us. If action to prevent this damage is insufficient, the harm to human wellbeing and the economy will only worsen and become costlier to fix.

Hurricanes, heatwaves and other weather extremes are taking lives and ruining livelihoods, with human activity to blame for the increasing frequency and severity of these hazards, as the latest Intergovernmental Panel on Climate Change (IPCC) report (2021) confirms.

To give a long list of very recent, and devastating, examples, in 2021, temperatures in the Pacific Northwest hit a record high of 46.6°C during a four-day heatwave, killing more than 200 people. Severe flooding was suffered across Western Europe, Ghana, Niger, India, Afghanistan and South Sudan, while drought and heatwaves hit Central Asia. Tropical Cyclone Seroja struck Indonesia and Haiti reeled from the effects of Hurricane Grace, hampering efforts to recover from a major earthquake that occurred just days earlier.

These disasters are set to increase in number and scale as temperatures rise, taking an obvious toll on human life and wellbeing. They also have effects on the economy that manifest themselves in different ways. First, there are the direct costs of a hazard. Housing, roads and crops may be damaged, which incur costs in terms of rebuilding or a decline in value, for example. 

There are also indirect costs, which can be harder to measure. After an event, we may experience a slowdown in economic activity due to business interruption, disrupted transport networks (for example flooded roads or collapsed bridges) and disrupted supply chains. There are also macroeconomic impacts, whether increases in government debt, negative effects on stock markets or declines in GDP.

It is not only major disasters that have negative effects. Global warming is like a silent killer: average temperatures rise not because every day is a little hotter, but because the number of extremely hot days increases. One impact of more frequent and longer heatwaves is that crops are exposed to harmful temperatures and agricultural productivity falls, with grave implications for the rural poor and global food security. Temperatures above around 30°C are deemed to be harmful to corn, for example (Schlenker and Roberts, 2009).

Research even shows that high temperatures reduce workers’ productivity. Put simply, when daily maximum temperatures get too hot (over 32°C), workers in ‘outdoors’ industries, like agriculture and construction, go home early (Graff Zivin and Neidell, 2014). There are also suggestions that higher temperatures could affect people’s behaviour and decisions in other ways, by reducing their tolerance of risk and increasing their impatience. This has far-reaching implications for our investment decisions, not just financial ones, but whether we choose to invest in our health or children’s education, for example.

Climate change has major and costly health impacts that put healthcare systems under further strain. One study in Germany estimates that extreme heat leads to significantly more hospitalisations and deaths across the healthcare system (Karlsson and Ziebarth, 2018). Flooding is another major health risk. It presents immediate threats in the form of drowning or hypothermia, for example, and the trauma brought by flooding has been associated with heightened risk of mental health symptoms. In the UK, the costs of extreme weather events for the NHS are estimated to be £20.8 million annually. 

It has also been suggested that climate change heightens the risk of more pandemics – bringing further costs to health and more economic turbulence. Although, at this time, there is no direct evidence that climate change increases the spread of coronaviruses, it is known that it leads to more movement of animals as they seek cooler climes, creating opportunities for pathogens to jump between species. 

Unequal impacts

Climate change affects everyone, but policy responses to the crisis must account for the fact that some people are affected more than others. Furthermore, climate change and poverty reinforce one another. Instead of focusing solely on climate-specific policies, it is important to ask how broader efforts to improve economic opportunity and reduce poverty and inequality could also reduce the vulnerability of disadvantaged groups to climate change’s effects.

Historically, wealthier countries are responsible for most greenhouse gas emissions, and many still emit many times more than poorer ones. But, it is lower-income countries that bear the brunt of the impacts that arise from these emissions.

Poor households in rural areas are particularly vulnerable to the effects of climate change. Wildfires, cyclones, droughts and floods can ruin agricultural production, directly hurting rural livelihoods (Carleton and Hsiang, 2016). Further, the consensus among scientists is that the predicted increase in the number of hot days every year will occur in countries in the tropics, where most rural poor reside, and damage crop growth (see Figure 2).  

Figure 2: Change in productivity at different temperatures

Source: Aragón et al, 2021 Note: Data from small household farms in Peru show a drop in farm productivity for larger temperature realisations

A host of evidence shows that total damages from natural disasters and higher temperatures are larger in developing countries (Dell et al, 2012Hsiang and Jina, 2014Burke et al, 2015Diffenbaugh and Burke, 2019Carleton et al, 2020Nath, 2021). 

Focusing on GDP declines, it is predicted that emerging markets in more vulnerable locations are likely to bear the brunt of the climate crisis. With just a 1.4°C global temperature increase, the Philippines is set to experience a 1.3% decline in GDP, for example. Under a 3.2°C increase – which could be reached by 2100 without strong actions to mitigate climate change – the loss would be almost 7% (see Figure 3). 

Figure 3: GDP loss by temperature increase scenario

Source: Swiss Re

Poor countries tend to be exposed to higher temperatures. Because of larger temperature-driven reductions in GDP per capita in the poorest countries, it is estimated that the ratio between the top and bottom income deciles is likely to be 25% larger today than it would have been in the absence of experienced global warming (Diffenbaugh and Burke, 2019).

Focusing on public finances, early research shows that climate change has already increased the cost of public borrowing for 25 of the most climate-vulnerable countries – including Bangladesh, Costa Rica, the Maldives, the Philippines and Vietnam – by 1.17 percentage points (Kling et al, 2018). It has also added over $40 billion to the debt interest paid by the 40 most vulnerable nations between 2007 and 2016 (Buhr et al, 2018).

Most research has focused on climate inequalities between countries. It is also the case that there are inequalities within countries and even cities. To give a specific example, when Hurricane Harvey hit Houston, Texas, in 2017, low-income, uninsured Latinx-owned homes were disproportionately flooded by the event (Smiley, 2020). This research suggests that these areas were not more flood-prone for 'natural' reasons but, at least in part, because there is less investment in flood mitigation measures in black and Hispanic neighbourhoods.

Evidence further shows that the health impacts of climate change disproportionately affect some sections of the population. Research on the impact of temperature shocks in England over a decade, for example, revealed that the elderly, children and the economically disadvantaged are the most vulnerable groups (Rizmie et al, 2021).

The economic response to climate change

There is no single pathway to achieving climate targets. A whole systems approach to decarbonisation is needed if we are to limit the climate extremes that cause such damage to human wellbeing, the economy and the environment.

While we don’t know what the low-carbon transition will cost, as it depends on the choices and investments we make today and in the future, the longer we wait to manage that transition, the higher the costs and the graver the environmental risks.

Most progress towards a low-carbon economy to date has been thanks to reductions in coal from energy production, and the final pact agreed at COP26 should ensure even greater reductions. The International Energy Agency estimates that ‘Renewables will overtake coal to become the largest source of electricity generation worldwide in 2025’, and the world now invests more in renewable power generation (excluding nuclear and hydro) than in oil, gas and coal generation combined (see Figure 4).  

Figure 4: Global energy supply investment by sector

Source: International Energy Agency, 2021 

This is encouraging progress, but far more action is needed across all sectors. An intricate range of economic policy options could propel us along the path towards net zero, offering hope that we will avoid the worst of climate change’s effects.

Investing in green innovation

One route of many towards a low-carbon future is investment in green technologies. Greener energy production may be the success story of climate change mitigation efforts so far, but there is still plenty more innovation to be achieved in the sector that could bring further benefits. 

A wide range of energy technologies can bring us closer to net zero, and could also help to decarbonise the transport sector. Promising developments that may benefit from continued investment in research efforts include:

  • Nanotechnology-based supercapacitors – energy storage devices with graphene nanotube electrodes could offer superior performance to batteries in powering electric cars, and potentially even aircraft and trains.
  • Small modular nuclear reactors, based on the well-developed nuclear-powered engines in submarines.
  • Vehicle-to-grid (V2G) systems – whereby the nation’s electric cars are networked to form a vast electric storage system, akin to the National Grid’s storage.

While many responses to climate change lie in technology, the right economic conditions are needed to develop greener technologies and for these to thrive commercially. Technological innovation creates a virtuous cycle that spurs economies of scale in production and discovery. As solutions are brought closer to reality and become cheaper to develop and implement, there is more incentive for deployment. 

This pattern can be seen in renewable energy and battery technologies. Ten years ago, renewables and electric vehicles were expensive luxuries. But the price of solar photovoltaic energy has dropped by 83%, and the cost of wind by 40% since 2010 , while the cost of lithium-ion batteries – which are used in electric vehicles and to store energy from intermittent renewable sources – has also fallen eight-fold over this period. 

The consensus among economists is that low-carbon, climate-resilient investments offer among the highest returns on investment (both public and private). Further, these returns are higher the sooner we get started and any delay increases costs, decreases returns and threatens stability (Hepburn et al, 2020).

Embracing green business sectors and saying goodbye to carbon-intensive, fossil-fuel-based industries calls for changes in the demand for workers and their skills. It is important that workers from the ‘old’ industries are not left behind and, hence, investment in human capital is necessary. Certainly in the short run, there ought to be plentiful work in the green transition: clean energy infrastructure is particularly labour-intensive and creates twice as many jobs per dollar spent than fossil-fuel investments (Pollin et al, 2008). 

Carbon efficiency

Technological innovation has strong appeal to economic growth ambitions and, with the right steer, clearly leads to gains in carbon efficiency. 

The global economy has become far more carbon efficient in the past half century, cutting emissions per dollar of GDP from about 800 grammes of carbon dioxide per dollar (gCO2/$) in 1960 to a little more than 400 gCO2/$ today, a decline of almost 50% (see Figure 5).

Figure 5: Emissions intensity of GDP

Source: World Bank development indicators

Total emissions, however, have risen and escalated climate change; global carbon emissions are more than three times higher today than they were in 1965. The scale of production has outpaced efficiency and what we are seeing is referred to as relative decoupling – emissions and economic growth are only partially disassociated from one another. 

To reach net zero before time runs out to keep global temperatures below 1.5°C or even 2°C above the pre-industrial average, we would need to break the link between growth and emissions completely, such that emissions strongly decline despite growth. This is absolute decoupling, and to avoid runaway climate change, a global decline in carbon intensity of 14% every year is needed – far more than the 1% decline currently witnessed. 

It is for this reason that some economists argue that our dependency on economic growth is incompatible with absolute decoupling, and that an end to growth economics is the solution to climate change. Only a few economists – and even fewer politicians – have challenged the dominance of economic growth, however, or considered what post-growth economics may look like. 

Others argue that sustainability is unachievable without growth. Investment in innovation can find solutions to pressing problems, like climate change, provided that there is a clear and credible attempt to steer innovation.

For developing countries, growth is needed as a route out of poverty, although the need to decouple emissions from growth remains. 

Technology alone will not save us

While there is some disagreement on the role of growth in efforts to tackle climate change, it is clear that technology is far from the only solution – or the only form of innovation worth investing in. 

Investments should also be in nature, such as tree-planting schemes, and our neighbourhoods and homes – for example, in cycling infrastructure or housing insulation. Investing in green assets like these brings a wider range of benefits than ‘brown investments’ (fossil fuels), particularly for our health and wellbeing. As well as contributing to climate goals, they can promote exercise, cut air pollution and support good mental health. 

The choice and shape of our economic activities should operate within safe planetary boundaries. These mark out ‘safe operating spaces’ for humanity that, once crossed, could have irreversible consequences for the survival of humanity. For example, we should be mindful that some of the economic activities that contribute most to climate change also destroy natural habitats, such as deforestation and massive agricultural expansion, and that this destruction contributes to health disasters in the form of pandemics (Settele et al, 2020). 

Carbon taxes 

Taxing producers for their greenhouse gas emissions forces polluters to pay for the damage they cause to human health and the environment – costs that are otherwise faced by society as a whole. It is also argued that taxes on more environmentally harmful products provide incentives for producers to operate in more environmentally friendly ways. 

One policy option is border carbon taxes, which are applied to imported carbon-intensive goods. These are designed to encourage producers in exporting countries with laxer environmental standards to cut their emissions and could help to tackle the problem of countries ‘offshoring’ their emissions through imports. 

Further, carbon taxes could fill the tax revenue gap left by the phase-out of fossil fuels. But this should be just in the short term, given that there will be little carbon to tax in a net-zero economy.

Alongside technological innovation, behavioural change plays a huge role in combating climate change. This is another area in which taxes could help. It has been argued, for example, that household natural gas (and oil) usage could be reduced through tax increases, such as VAT, encouraging the adoption of solar panels, and air or hybrid heat pumps. 

Of course, high energy prices hit poorer households harder so the revenue could be redistributed to lower-income groups (Fried et al, 2020). This could preserve incentives to reduce emissions, while making it very clear that the less wealthy would not be paying for it.

The role of the financial sector

The financial sector can play a central role in the move away from a fossil-fuel economy, and the strategies it can pursue are diverse (Matthews and Caldeira, 2008Pfeiffer et al, 2016). These include engaging with companies through their shareholders, promoting divestment from fossil fuels, and denying funding or credit to fossil-fuel companies looking to develop new projects.

A clear strategy is to put money into greener sectors, although there are some hurdles to overcome here. For example, central banks have become large-scale buyers of assets as part of their mission to promote stable economies. But evidence shows that the European Central Bank’s (ECB) portfolio, for example, tends to give greater weight to carbon-intensive sectors. This is because sectors with higher emissions tend to issue more bonds than cleaner sectors, causing an imbalance. A greater supply of green bonds is needed, and central banks are playing a role in providing incentives for supply by making green bonds suitable for central bank operations (ECB, 2020).

What counts as a green investment can be hard to determine (Mathiesen, 2018Fiedler et al, 2021). To help investors, the European Commission has developed a science-based classification system – the ‘EU taxonomy’ – that defines which economic activities are environmentally sustainable according to their objective, whether climate change mitigation or the transition to a circular economy, for example. Such an approach could be replicated elsewhere.

Enabling access to finance, including insurance, is also essential for combating widening inequalities by ensuring that disadvantaged populations, such as the rural poor in developing countries, can withstand the inevitable impacts of climate change, such as crop damage. 

Keeping 1.5°C alive

Strong and rapid progress in cutting emissions is needed to meet the Paris Agreement’s vision of a net-zero world by mid-century, far stronger than has ever gone before. 

But in his closing statement at COP26, Alok Sharma, presiding over the summit, rued that the final agreement was a ‘fragile win’. While 1.5°C may still be alive, ‘its pulse is weak’. 

COP26’s plea to bolster NDCs in the next year means that the dream of 1.5°C could yet become reality. Of course, this is provided that ambitious commitments are turned into concrete and urgent action.

Economics has a vital role to play in rising to the climate change challenge. It highlights the urgency of action by evaluating the costs of climate change and the future costs of inaction. It can help to ensure that good targets are backed up by good actions by assessing the effectiveness of both mitigation and adaptation efforts. It is key to a just transition, joining up the dots between environmental and social spheres of policy to find fair and synergistic solutions. 

With concerted efforts and concrete actions that are underpinned by these valuable contributions, we are afforded hope that the pulse of 1.5°C will return stronger at COP27 and beyond.

Where can I find out more?

Who are experts on this question?

  • Matthew Agarwala
  • Cristina Peñasco
  • Laura Diaz Anadon
  • Elena Verdolini
  • Diane Coyle
  • Dimitri Zenghelis
  • Cameron Hepburn
Author: Michelle Kilfoyle
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